Undergraduate study in Economics,
Management, Finance and the Social Sciences
Accounting:
markets and
organisations
J. Haslam, D. Chow,
A. Nayak and
S. O’Brien-Weeks
AC3193
2023
This guide was prepared for the University of London by:
Professor J. Haslam, Sheffield University, Dr Danny Chow, Durham University, Amanda Nayak
MSc FCCA and Stuart O’Brien-Weeks MPhys CA FHEA
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or
arising from, the guide. If you have any comments on this subject guide, please communicate
these through the discussion forum on the virtual learning environment.
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us know.
Accounting: markets and
organisations
J. Haslam, D. Chow, A. Nayak and
S. O’Brien-Weeks
AC3193
2023
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London’s
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 6 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ). For more information,
see: london.ac.uk
Contents
Contents
Chapter 1: Introduction........................................................................................... 1
1.1 Introduction............................................................................................................. 1
1.2 Syllabus and learning outcomes for the course.......................................................... 1
1.3 Employability outcomes............................................................................................ 2
1.4 Introduction to the subject area................................................................................ 2
1.5 Route map to the guide............................................................................................ 2
1.6 Overview of learning resources................................................................................. 3
1.7 The examination....................................................................................................... 7
Part 1: Capital markets............................................................................................ 9
Chapter 2: Accounting information – the user perspective.................................. 11
2.1 Introduction........................................................................................................... 11
2.2 The ‘lemons problem’.............................................................................................. 12
2.3 The importance of trust in accounting information and the role of regulation........... 13
2.4 The need for additional information........................................................................ 17
2.5 Overview of chapter............................................................................................... 18
2.6 Reminder of learning outcomes.............................................................................. 18
2.7 Test your knowledge and understanding................................................................. 18
Chapter 3: Capital market players and an introduction to analysts..................... 19
3.1 Introduction........................................................................................................... 19
3.2 The complex world of banking................................................................................ 19
3.3 Investment banks................................................................................................... 21
3.4 The need for information......................................................................................... 22
3.5 Buy side and sell side analysts................................................................................ 23
3.6 Role of the investor relations officer........................................................................ 24
3.7 Other market participants....................................................................................... 24
3.8 Overview of chapter............................................................................................... 26
3.9 Reminder of learning outcomes.............................................................................. 26
3.10 Test your knowledge and understanding............................................................... 26
Chapter 4: Sell side and buy side analysts............................................................ 27
4.1 Introduction........................................................................................................... 27
4.2 The sell side analyst – purpose and role.................................................................. 28
4.3 The sell side analyst – the inputs............................................................................. 29
4.4 The sell side analysts – the outputs......................................................................... 30
4.5 The sell side analyst – a day in the life..................................................................... 31
4.6 Do investors listen to sell side analysts?.................................................................. 31
4.7 Conflicts of interest for sell side analysts................................................................. 32
4.8 Changes in legislation affecting sell side analysts.................................................... 33
4.9 Buy side analysts and fund managers...................................................................... 34
4.10 Overview of chapter............................................................................................. 35
4.11 Reminder of learning outcomes............................................................................ 35
4.12 Test your knowledge and understanding............................................................... 35
Chapter 5: Information dissemination.................................................................. 37
5.1 Introduction........................................................................................................... 37
5.2 Regulatory financial information............................................................................. 38
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AC3193 Accounting: markets and organisations
5.3 Non-financial information....................................................................................... 39
5.4 Meetings with management................................................................................... 41
5.5 Investor relations.................................................................................................... 41
5.6 The Investor Relations Officer.................................................................................. 43
5.7 Regulations............................................................................................................ 43
5.8 Overview of chapter............................................................................................... 44
5.9 Reminder of learning outcomes.............................................................................. 44
5.10 Test your knowledge and understanding............................................................... 45
Chapter 6: Key accounting ratios and measures for the capital markets............. 47
6.1 Introduction........................................................................................................... 47
6.2 The foundations of ratio analysis............................................................................. 48
6.3 Isolating operational analysis.................................................................................. 52
6.4 The need for standardised data............................................................................... 56
6.5 Capital market metrics............................................................................................ 58
6.6 Non-GAAP metrics................................................................................................. 59
6.7 Overview of chapter............................................................................................... 60
6.8 Reminder of learning outcomes.............................................................................. 60
6.9 Test your knowledge and understanding................................................................. 61
Chapter 7: Accounting information in action I: Valuation multiples..................... 63
7.1 Introduction........................................................................................................... 63
7.2 Equity value vs enterprise value.............................................................................. 63
7.2 Introduction to multiples......................................................................................... 66
7.3 Equity multiples...................................................................................................... 67
7.5 Enterprise value multiples....................................................................................... 68
7.6 Turning multiples into valuations............................................................................. 70
7.7 Multiple valuation complications............................................................................. 72
7.8 Overview of chapter............................................................................................... 74
7.9 Reminder of learning outcomes.............................................................................. 74
7.10 Test your knowledge and understanding............................................................... 74
Chapter 8: Accounting information in action II: Residual income valuation......... 77
8.1 Introduction........................................................................................................... 77
8.2 Core concepts of intrinsic valuation......................................................................... 77
8.3 Abnormal profit...................................................................................................... 79
8.4 Residual Income Valuation Model (RIVM)................................................................ 80
8.5 Alternative model................................................................................................... 82
8.6 Clean surplus assumption....................................................................................... 82
8.7 Activities to try....................................................................................................... 83
8.8 Advantages and disadvantages of using accounting data for both multiple and RIVM
valuation models.......................................................................................................... 83
8.9 Overview of chapter............................................................................................... 83
8.10 Reminder of learning outcomes............................................................................ 84
8.11 Test your knowledge and understanding............................................................... 84
Chapter 9: The earnings game............................................................................... 85
9.1 Introduction........................................................................................................... 85
9.2 The earnings game................................................................................................. 86
9.3 The nature and cause of earnings management....................................................... 86
9.4 Evidence that earnings management exists............................................................. 88
9.5 How does earnings management occur?................................................................. 89
9.6 The impact and problems created by earnings management.................................... 91
9.7 Ethical dilemma for analysts................................................................................... 92
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Contents
9.8 Overview of chapter............................................................................................... 92
9.9 Reminder of learning outcomes.............................................................................. 92
9.10 Test your knowledge and understanding............................................................... 93
Chapter 10: Earnings management and accounting choices................................. 95
10.1 Introduction......................................................................................................... 95
10.2 ‘Noise’ within financial reporting.......................................................................... 95
10.3 Performing accounting analysis............................................................................. 97
10.4 Undoing accounting distortions in action............................................................ 101
10.5 Overview of chapter........................................................................................... 104
10.6 Reminder of learning outcomes.......................................................................... 104
10.7 Test your knowledge and understanding............................................................. 105
Part 2: Management accounting......................................................................... 107
Introduction............................................................................................................... 107
Organising your studies.............................................................................................. 107
Chapter 11: Introduction to control systems – personnel controls, cultural
controls, action controls and results controls..................................................... 109
11.1 Introduction....................................................................................................... 109
11.2 The importance of management control.............................................................. 110
11.3 Causes of management control problems ........................................................... 114
11.4 Action, personnel and cultural controls................................................................ 115
11.5 Results controls ................................................................................................. 119
11.6 Conditions needed to implement effective results controls................................... 120
11.7 Reminder of learning outcomes.......................................................................... 120
11.8 Case studies....................................................................................................... 121
11.9 Test your knowledge and understanding............................................................. 121
Chapter 12: Control system tightness and control system costs........................ 123
12.1 Introduction....................................................................................................... 123
12.2 Control system tightness..................................................................................... 124
12.3 Control system costs........................................................................................... 128
12.4 Adaptation of control systems............................................................................. 132
12.5 Summary............................................................................................................ 133
12.6 Reminder of learning outcomes.......................................................................... 133
12.7 Case study......................................................................................................... 134
12.8 Test your knowledge and understanding............................................................. 134
Chapter 13: Designing and evaluating management control systems. Identifying
financial responsibility centres........................................................................... 135
13.1 Introduction....................................................................................................... 135
13.2 Designing and evaluating management control systems (MCS)............................ 136
13.3 Identifying financial responsibility centres and transfer pricing methods............... 138
13.4 Transfer pricing................................................................................................... 141
13.5 Methods of setting transfer prices....................................................................... 142
13.6 Reminder of learning outcomes.......................................................................... 145
13.7 Case study......................................................................................................... 146
13.8 Test your knowledge and understanding............................................................. 146
Chapter 14: A detailed look at planning and budgeting..................................... 147
14.1 Introduction....................................................................................................... 147
14.2 Budget purposes................................................................................................ 147
14.3 Planning cycles................................................................................................... 148
14.4 Target setting..................................................................................................... 149
14.5 Recasting the budget.......................................................................................... 150
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AC3193 Accounting: markets and organisations
14.6 Common financial performance target issues...................................................... 150
14.6 Criticisms of budgeting and consideration of beyond budgeting........................... 152
14.7 Reminder of learning outcomes.......................................................................... 153
14.8 Case study......................................................................................................... 153
14.9 Test your knowledge and understanding............................................................. 153
Chapter 15: Incentive systems............................................................................ 155
15.1 Introduction....................................................................................................... 155
15.2 Purposes and types of incentives......................................................................... 155
15.3 Monetary incentives........................................................................................... 156
15.4 Incentive scheme design..................................................................................... 158
15.5 Incentive formulas and subjective rewards........................................................... 158
15.6 The shape of the incentive function..................................................................... 159
15.7 Criteria for evaluating incentive systems.............................................................. 160
15.8 Group rewards................................................................................................... 160
15.9 Reminder of learning outcomes.......................................................................... 161
15.10 Case study....................................................................................................... 161
15.11 Test your knowledge and understanding........................................................... 161
Chapter 16: Financial performance measures and their effects......................... 163
16.1 Introduction....................................................................................................... 163
16.2 Using market measures of performance for managerial appraisal......................... 164
16.3 Using accounting measures of performance for managerial appraisal................... 165
16.4 Reminder of learning outcomes.......................................................................... 170
16.5 Case study......................................................................................................... 171
16.6 Test your knowledge and understanding............................................................. 171
Chapter 17: Remedies to the myopia problem................................................... 173
17.1 Introduction....................................................................................................... 173
17.2 Pressures to act myopically................................................................................. 173
17.3 Ways to decrease myopia.................................................................................... 174
17.4 Strengths of several performance measures......................................................... 178
17.5 Issues in creating the correct measures............................................................... 179
17.6 Reminder of learning outcomes.......................................................................... 179
17.7 Case study......................................................................................................... 180
17.8 Test your knowledge and understanding............................................................. 180
Chapter 18: Using financial results controls in the presence of uncontrollable
factors................................................................................................................. 181
18.1 Introduction....................................................................................................... 181
18.2 The controllability principle................................................................................. 181
18.3 Deciding on whether factors are uncontrollable................................................... 182
18.4 Controlling for the distorting effects of uncontrollables........................................ 183
18.5 Methods which can be used to determine the impact of the event....................... 184
18.6 Reminder of learning outcomes.......................................................................... 186
18.7 Case study......................................................................................................... 186
18.8 Test your knowledge and understanding............................................................. 186
Chapter 19: Management control-related ethical issues.................................... 187
19.1 Introduction....................................................................................................... 187
19.2 Ethical behaviour in a business context............................................................... 188
19.3 Ethical models.................................................................................................... 188
19.4 Analysing ethical issues...................................................................................... 189
19.5 Some management control-related ethical issues................................................ 190
iv
Contents
19.6 Reminder of learning outcomes.......................................................................... 192
19.7 Case study......................................................................................................... 192
19.8 Test your knowledge and understanding............................................................. 192
Chapter 20: Management control in not-for-profit organisations...................... 193
20.1 Introduction....................................................................................................... 193
20.2 Types of not-for-profit organisation..................................................................... 193
20.3 Key similarities and differences in management control between for-profit and notfor-profit organisations............................................................................................... 195
20.4 Not-for-profit budgeting..................................................................................... 195
20.5 Difficulties in measuring and rewarding performance........................................... 197
20.6 Accounting differences........................................................................................ 198
20.7 External scrutiny................................................................................................. 198
20.8 Public sector scorecard....................................................................................... 199
20.9 Employment characteristics................................................................................. 200
20.10 Summary.......................................................................................................... 200
20.11 Reminder of learning outcomes........................................................................ 200
20.12 Test your knowledge and understanding........................................................... 201
Appendix 1: Solutions to activities and sample examination questions............ 203
Note to students......................................................................................................... 203
Chapter 6................................................................................................................... 203
Chapter 7................................................................................................................... 204
Chapter 8................................................................................................................... 205
Chapter 9................................................................................................................... 207
Chapter 10................................................................................................................. 210
v
AC3193 Accounting: markets and organisations
Notes
vi
Chapter 1: Introduction
Chapter 1: Introduction
1.1 Introduction
Welcome to the course AC3193 Accounting: markets and organisations.
Producing financial information can be time consuming and expensive.
Many people are aware of how financial information is produced, how
it looks and what it can tell us. This course however will explore which
stakeholders use this financial information and how they use it.
This module is structured into two parts, with each part focusing on
different users of financial information.
Part 1 will explore how financial information is utilised by external
stakeholders of a company, particularly those stakeholders within the
capital markets. We will explore the ways in which financial information
can be dissected and used to make investment decisions. We will also
explore the dangers that exist when relying on financial information
prepared by participants internal to an organisation who may have other
incentives to focus on.
Part 2 focuses on stakeholders internal to an organisation and how financial
information can be used to control organisational performance. This section
has a focus on management accounting including: financial and other
controls, organisational structures, performance measurement and incentive
systems, budgetary control and public-sector and non-profit financial
management within the organisational and human behavioural context.
This chapter aims to provide a brief overview of the chapters in the subject
guide.
1.2 Syllabus and learning outcomes for the course
The up-to-date course syllabus for AC3193 Accounting: markets and
organisations can be found in the course information sheet, which is
available on the course VLE (virtual learning environment) page.
This course is designed to address contemporary issues in both financial
and management accounting in the context of theoretical and empirical
development. At the end of the course and having completed the essential
reading and activities, you should be able to:
•
discuss the role of key capital market players, institutional investors
and evaluate their importance in information dissemination
•
advise on how accounting information can impact valuation of
securities and other decisions made by market participants
•
appreciate the earnings game and the flexibility in accounting
practices to allow earnings to be managed
•
evaluate issues arising from management control in its organisational
context
•
discuss various approaches to performance measurement and control
in various types of organisations, and devise and evaluate indicators of
performance
•
discuss contingency theory and its impacts on management control
practices in organisations
1
AC3193 Accounting: markets and organisations
•
discuss the ethical issues of using management control methods and its
use in non-profit organisations.
In order to achieve this, each module is broken down into further detailed
learning outcomes.
1.3 Employability outcomes
Below are the three most relevant skill outcomes for students undertaking
this course which can be conveyed to future prospective employers:
1. communication
2. persuasion and negotiation
3. emotional intelligence.
1.4 Introduction to the subject area
This module builds on the previous modules AC2091 Financial reporting
and AC2097 Management accounting. It does this by exploring how
financial information is used by participants other than those who create the
financial information. We will look at how participants in the capital markets
might choose to use statutory financial statements to assess investment
opportunities. We will also explore how senior management might choose to
use internal financial information to control activities and performance.
In addition, the module will explore real life scenarios for financial
reporting and how financial information can impact social interactions.
1.5 Route map to the guide
Chapter 1 is an introductory chapter. Chapters 2 to 10 focus on how
financial information is used by the capital markets as well as what market
participants are wary of when reading financial information.
Chapters 2 to 5 focus on external users of information, particularly
those within the capital markets. The chapters focus on who these key
players are, what they use financial information for, and the role they
play in information dissemination. Chapter 2 introduces the reason
why financial information is so important to the capital markets and
Chapter 3 then offers some clarity into what is meant by ‘the capital
markets’. Chapter 4 introduces one of the primary users of financial
statements – the analysts. In this chapter, you will discover their role
and how they assist in the workings of the capital markets. Chapter 5
introduces the methodologies used by many large, listed corporations to
ensure information is provided to the markets appropriately and legally.
Chapter 6 analyses financial statements to identify the information they
can provide to external users in the capital markets. This includes the key
metrics which can be drawn out of financial information in the form of
ratio analysis and the ‘story’ that can be told through the numbers.
Chapters 7 and 8 explore and develop valuation techniques that can
be utilised when analysing financial statements. This includes the use of
comparable company valuations as well as the residual income valuation
model (a model which directly uses financial statements to determine
company value).
2
Chapter 1: Introduction
Chapters 9 and 10 then discuss the dangers of relying too much on
information prepared by internal stakeholders who may have other
priorities. The chapters explore why organisational management may wish
to influence their earning potential. Chapter 10 explores how an analyst
may need to analyse and adjust accounts before using them for valuation
techniques.
Chapters 11 to 20 focus on management accounting (introduced
further before Chapter 11).
1.6 Overview of learning resources
1.6.1 The subject guide
The goal of this subject guide is to provide you with an overview of the
topics covered in this course. To begin with, you should read through the
chapters in order, attempting the activities when listed. You should also read
the Essential readings, either when directed to or at the end of the chapter.
Each chapter includes a list of learning outcomes, summarising the content
you should have mastered before moving on to the next chapter.
The reading for this course is divided into two categories: Essential and
Further. You will be given online access to the Essential publications
(individual book chapters, journal articles, etc.) either via the Online
Library or through PDFs uploaded to the VLE. You are not required to
access or buy the Further readings, but they may prove helpful to you in
your study.
1.6.2 Essential reading
The Essential reading for Chapters 2–10 is:
Laskin, A. Investor relations and financial communication: creating value
through trust and understanding. (Hoboken, NJ: Wiley Blackwell, 2021)
[ISBN 9781119780458] Chapters 1, 2, 3, 4, 5 and 6.
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 6th edition [ISBN 9781473779082] Chapters 1, 3,
4, 5, 7 and 8.
Valdez, S. and P. Molyneux An introduction to global financial markets.
(Bloomsbury Academic, 2015) [ISBN 9781137497550] Chapters 1, 2 and 5.
Brochet, F. and D. Kiron ‘Google and earnings guidance’, Harvard Business
School Case 111–026, Harvard Business School 2010 (revised April 2011).
For Chapters 11–20, the Essential reading is:
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 1–12, 15 and 16.
In addition to the main textbook, there are several key journal articles
that you are required to read, which you will find listed in the individual
chapters.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
3
AC3193 Accounting: markets and organisations
1.6.3 Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the virtual learning environment
(VLE) and University of London Online Library (see below).
Other useful texts for this course include:
Chapter 2:
Bloomfield, R.J. ‘A pragmatic approach to more efficient corporate disclosure’,
Accounting Horizons 26(2) 2012, pp.357–370.
Li, F. ‘Annual report readability, current earnings and earnings persistence’,
Journal of Accounting and Economics 45 2008, pp.221–223.
Cazier, R.A. and R.J. Pfeiffer ‘Why are 10-K filings so long?’, Accounting
Horizons 30(1) 2016, pp.1–21.
Chapter 3:
Arnold, G. Modern financial markets and institutions: a practical perspective.
(Financial Times, 2011) [ISBN 9780273730354]
Chapter 4:
Groysberg, B. and P.M. Healy Wall Street research: past, present and future.
(Stanford University Press, 2013) [ISBN 9780804785310] Chapter 2.
Chapter 5:
Laskin, A. ‘Investor relations practices at Fortune-500 companies: an
exploratory study.’ Public Relations Review, 32(1) 2006, pp.69–70.
Chapter 6:
Lee, K. and D. Taylor Financial statement analysis under IFRS. (Financial Edge
Training, 2018) 6th edition [ISBN 9781916502802] Chapter 6.
Chapter 7:
Antill. N., K. Lee, and D. Taylor Company valuation under IFRS. (Harriman
House, 2020) 3rd edition [ISBN 9780857197764] Chapter 1.
Chapter 8:
Srinivasan, S., B. Cheng and E. Riedl ‘Coca Cola: residual income valuation
exercise,’ Harvard Business School Exercise 113-056, 2012.
Chapter 9:
Collingwood, H. ‘The earnings game: everybody plays, nobody wins’, Harvard
Business Review R0106C, 2001.
Chapter 10:
Antill. N., K. Lee and D. Taylor Company valuation under IFRS. (Harriman
House, 2020) 3rd edition [ISBN 9780857197764] Chapter 4.
Chapter 11:
Hammer, M. Beyond reengineering: how the process-centered organization is
changing our work and our lives. (New York, NY: Harper Business, 1996)
[ISBN 9780887307294].
Chapter 12:
Hofstede, G. Culture’s consequences: international differences in workrelated values. (Beverley Hills, CA: SAGE Publications, 2001)
[ISBN 9780803913066]
4
Chapter 1: Introduction
Ma, J. ‘Dear investors: letter from Jack Ma as Alibaba prepares roadshow’,
Financial Times [London, UK] 5 September 2014. Available online at
www.ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
Petruno, T. ‘Sunrise scam throws light on incentive pay programmes’, Los
Angeles Times [Los Angeles, CA] 15 January 1996. Available online at
articles.latimes.com/1996-01-15/business/fi-24821_1_incentive-pay-plans
The Economist ‘Tesco’s accounting problems: Not so funny’, The Economist
[London, UK] 27 September 2014. Available online at www.economist.
com/business/2014/09/27/not-so-funny
Chapter 13:
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education Ltd, 2015) 15th edition
[ISBN 9781292078977] Chapter 22.
Chapter 19:
Association of Chartered Accountants (ACCA) ‘ACCA code of ethics and
conduct’, ACCA www.accaglobal.com/gb/en/about-us/regulation/ethics/
acca-code-of-ethics-and-conduct.html
Birsch, D. and J.H. Fielder The Ford Pinto case: a study in applied ethics,
business and society. (Albany, NY: State University of New York Press, 1994)
[ISBN 9780791422342].
UK Government ‘Whistleblowing for employees’, GOV.UK
www.gov.uk/whistleblowing/who-to-tell-what-to-expect
Chapter 20:
Moullin, M. ‘How the public sector scorecard works’, Public sector scorecard
www.publicsectorscorecard.co.uk/how-the-pss-works.html
Office for National Statistics www.ons.gov.uk
1.6.4 Websites
Unless otherwise stated, all websites in this subject guide were accessed in
May 2023. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
1.6.5 Accounting note
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the virtual learning environment (VLE). It
is essential that you check the VLE at the beginning of each academic year
(September) for new material and changes to the syllabus. Any additional
material posted on the VLE will be examinable.
1.6.6 Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at: https://my.london.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgot
Password’ link on the login page.
5
AC3193 Accounting: markets and organisations
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
•
Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
•
Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
•
Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
•
Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
•
External material: Links out to carefully selected third-party
resources.
•
Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
•
Collaborative activities: Work with fellow students to build a body
of knowledge.
•
Discussion forums: A space where you can share your thoughts
and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
•
Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide guidance
on how to approach the questions.
•
Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
6
Chapter 1: Introduction
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team
using the ‘Chat with us’ function.
1.7 The examination
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Programme
regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
A full sample examination paper will be uploaded to the course VLE page.
Remember, it is important to check the VLE for:
•
up-to-date information on examination and assessment arrangements
for this course
•
where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
7
AC3193 Accounting: markets and organisations
Notes
8
Part 1: Capital markets
Part 1: Capital markets
Welcome to the capital markets (‘markets’ in the course title) section
of AC3193 Accounting: markets and organisations. In this section
(Chapters 2–10) of the course, we will examine how external parties to an
organisation use the financial statements produced by management within
the organisation.
We look in particular detail at the participants of the capital markets who
may be using the financial information for investing purposes, who these
parties are, what they do and how they interact with each other. This will
include equity analysts from both the sell side and the buy side and how
these participants obtain further clarification from the Investor Relations
Officers within the firm.
Once we understand the parties interested in financial information, we
will explore some of the methods that they apply to assist with investing
decisions as well as the issues they need to be aware of when relying upon
information produced by third parties with their own incentives.
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AC3193 Accounting: markets and organisations
Notes
10
Chapter 2: Accounting information – the user perspective
Chapter 2: Accounting information – the
user perspective
2.1 Introduction
We start in this chapter with the key concept of why financial information
is important and why an entire profession has been built around the needs
of investors.
The chapter will explore the need for credible accounting information
to be published, the importance of ‘trust’ within the profession, the
regulation which has evolved and the importance of the audit profession.
The chapter will look at specific examples of how the profession attempts
to build this credibility as well as the historical period known as the ‘dot
com bubble’ and how a lack of financial information caused financial
distress in the markets.
2.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading
and activities, you should be able to:
•
explain the relationship between users of financial information and the
producers of financial information and why financial information is
important to external parties
•
critique the accounting standard setting process for both USGAAP
and IFRS, highlighting the strengths and weaknesses of the standard
setting process
•
explain the mechanisms used in the capital markets to ensure that
credibility is created behind financial information disclosures made by
internal management
•
discuss, in the context of the dot com bubble, difficulties that have
occurred when financial information has been insufficient for capital
market participants.
2.1.2 Essential reading
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 6th edition, Chapter 1 extracts.
US Securities and Exchange Commission press release, Sept 24 2019
https://www.sec.gov/news/press-release/2019‑186
2.1.3 Further reading
Bloomfield, R.J. ‘A pragmatic approach to more efficient corporate disclosure’,
Accounting Horizons 26(2) 2012, pp.357–370.
Li, F. ‘Annual report readability, current earnings and earnings persistence’,
Journal of Accounting and Economics 45 2008, pp.221–223.
Cazier, R.A. and R.J. Pfeiffer ‘Why are 10-K filings so long?’, Accounting
Horizons 30(1) 2016, pp.1–21.
2.1.4 References cited
Akerlof, G.A. ‘The market for lemons: qualitative uncertainty and the market
mechanism’, The Quarterly Journal of Economics 84(3) 1970, pp.488–500.
IFRS Foundation, ‘Who uses IFRS accounting standards?’,
www.ifrs.org/use-around-the-world/why-global-accounting-standards/
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AC3193 Accounting: markets and organisations
Financial Accounting Standards Board, ‘About the FASB’ (updated April 2023)
www.fasb.org/info/facts
UK Financial Conduct Authority, ‘Final notice to Tesco PLC and Tesco Stores
Ltd’ (updated March 2017) www.fca.org.uk/publication/final-notices/
tesco-2017.pdf
US Securities and Exchange Commission, Press release, Dec 9 2020,
www.sec.gov/news/press-release/2020-312
2.2 The ‘lemons problem’
Imagine, if you can, that you are planning to make a large, potentially
life changing personal purchase. For example, you plan to buy a car, or a
home. Let us then imagine that the only thing you know about this new
car or home is that it exists and that the current owner is willing to sell
it. Put aside the fact that you would desire further information and think
about the dangers and fear that you might experience spending a large
sum of money on something when you know nothing more than the fact
that the asset (a car or home in this case) exists.
Some of the questions you might ask yourself are:
•
How do I know if it is suitable for me?
•
How do I know it is the right quality for me?
•
How do I know it is valued correctly?
The answers to these questions are unavailable without further
information.
Now imagine that you can increase, ever so slightly, the amount of
information you have. Imagine that you have access to the historical prices
for which ‘similar’ homes and cars have sold. This provides information
about the minimum price for which people have sold their homes and
cars, as well as the maximum price and everything in between. But would
this give you answers to the questions above? Unlikely. In this scenario,
and assuming that you really needed a home or a car, you might need to
consider what the ‘average’ price may have been and begin your search
with this value in mind.
Now let us imagine that you are not alone: hundreds of other people are
also searching for a new home or car. They would be facing the same
issues as you and they too may be fearful of overpaying for an asset about
which they know very little.
However, there would be a mismatch in the market. The current owners of
the homes and cars would know the quality of their assets and be hoping
to sell them for an appropriate amount. Unfortunately for them, without
any detailed information, you may be unwilling to pay the asking price.
Perhaps you would be tempted to try to negotiate the price down a little,
in the fear that the asset is not as good as the price suggests – and perhaps
all the other possible buyers would try to do the same.
This would cause two opposing conflicts in the market.
i.
Any owner of a good quality house/car is going to become frustrated
at the offers they receive as they are all too low. As such, they are
likely to remove the asset from sale on the market.
ii. Any owner of a poorer quality house/car is likely to see that you and
others are beginning your negotiations near the ‘average price’. This
will incentivise them to sell their house/car at this increased price.
Where does this lead us? If those vendors selling good homes and cars are
removing their assets from the market and those with poor quality homes
12
Chapter 2: Accounting information – the user perspective
and cars are flooding the market, people like you – who are trying to buy
new homes/cars – will quickly realise that the majority of assets being sold
are poorer quality. As a result, you (and others) will adjust your ‘average
price’ downward. This will surely create a downward spiral where, once
again, vendors with poor quality assets continue to benefit but anybody
with a slightly better asset will only be able to sell their asset for a lower
price than is fair.
In a few years, when your car is old and needs replacing, will you go back
to buy a new one from the same place? Unlikely. When your home becomes
too small for your needs and you need to buy a larger home, will you be
happy knowing that you bought an overpriced home last time? Unlikely.
And you won’t be alone.
If we lived in this world, nobody would be buying cars or homes. This is
the exact problem that exists in the capital markets where investors and
vendors are buying/selling shares, both from a primary point of view
(i.e. when companies issue new shares to investors) or on the secondary
market (i.e. when investors trade the shares they currently own between
themselves).
Without accounting information, investors would not be able to tell the
difference between a good investment and a poor one. Only average prices
would be offered and, before long, companies which represent a good
investment would be unable to obtain additional investment at a fair price;
only poor quality companies would be able to do this. It would not be long
before investors would give up and the capital markets would collapse.
This is a key reason why information from organisations and companies
needs to be revealed to the market. This is known as the ‘lemons problem’
(Akerlof, 1970).
2.3The importance of trust in accounting information
and the role of regulation
As we have just explored, in a hypothetical world where company
information is lacking, it is predictable that investors would slowly
withdraw from investing in companies and the world of capital fluidity
would break down.
We should therefore explore whether information being provided by
companies can solve this problem by itself.
The answer – unfortunately – is: not directly. Imagine that directors,
entrepreneurs or other vendors of shares are asking you to invest in their
companies. Imagine that they can communicate with you about what the
company does, how successful it has been and what they plan to do in
future. Will this help you to make your investment decision?
Maybe not.
You will face similar issues and the situation is likely to play out as it did
before. Good companies will tell you all about the positive reasons why you
should invest. Poorly performing companies will see that you are willing
to invest more and so they will attempt to ‘pool’ themselves with those
companies which are truly good investments by saying similar things.
Over time, investors will realise that they still cannot differentiate between
poor investments and good investments because everybody is providing
such similar information. Once again, ‘average’ offerings will prevail
and good companies will withdraw from asking for your investment,
due to the undervaluations. As before, markets will be dominated by
underperforming, overvalued choices.
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AC3193 Accounting: markets and organisations
Once again, the market will break down.
The missing element in this hypothetical scenario is not just ‘information’.
Instead, it is information which allows those companies with good
performance to differentiate themselves from poorly performing companies.
A mechanism is needed which limits poorly performing companies from
attempting to pass themselves off as anything other than that.
Activity 2.1
Read the following sections from Chapter 1 of Palepu et al. (2022).
• The role of financial reporting in the capital markets
• Influences of the accounting system on information quality
Ensure you are comfortable with the terminology used regarding financial statements,
which you should have learned in earlier modules, including the following:
• What is meant by ‘asymmetry’?
• Who are the financial intermediaries within the capital markets?
• Who are the information intermediaries?
2.3.1 The role of regulation
As at September 2022, 167 jurisdictions around the world have fully
adopted International Financial Reporting Standards (IFRS) as produced
by the International Accounting Standards Board (IASB). One of
the missions of the IASB is to ‘bring transparency by enhancing the
international comparability and quality of financial information, enabling
investors and other market participants to make informed economic
decisions’ (IASB).
In 2018, it was estimated that $35 trillion of global GDP occurred in
jurisdictions that required the use of IFRS Standards. This amount
represents almost half of global GDP.
The majority of the remaining global GDP is accounted for by one
jurisdiction which has not adopted IFRS: the United States of America.
In the US, the Financial Accounting Standards Board (FASB) is the
recognised and designated standard setter for public companies. The aim
of the FASB is to ‘improve financial accounting and reporting standards to
provide useful information to investors and other users of financial reports
and educate stakeholders on how to most effectively understand and
implement those standards’ (FASB).
Although these two standard setting bodies take slightly different
approaches and have slightly different requirements for the preparation
of financial statements, they do agree on the same frameworks – mainly
that accounts should be relevant, reliable and comparable. Within these
agreements, they also both agree that financial reporting should help users
to predict the future cash flows of an organisation and that for financial
reports to be reliable, they must be verifiable and faithfully representative.
If companies follow the accounting standards set by bodies such as the
FASB and the IASB, investors should have access to information that will
help them to differentiate between companies with good prospects and
those that are likely to struggle.
However, we must consider whether such standards and regulations
are sufficient to stop inferior firms attempting to pass themselves off as
financially strong firms. The ‘lemons problem’ can only be resolved if
information is sufficient to make this distinction clear.
14
Chapter 2: Accounting information – the user perspective
Activity 2.2
Access the websites of the two key global standard setters:
• International Accounting Standards Board (IASB)
• Financial Accounting Standards Board (FASB)
Explore the composition of the standard setting boards in each and consider the
following questions:
1. What background does each of the board members have?
2. How do they represent different users of financial information?
3. What different points of view do you think these standard setters could offer?
4. Do you think the diversity is sufficient for all users of financial information?
2.3.2 The importance of the auditing profession
People preparing accounting information are expected to follow certain
standards. This should ensure that users of financial information are able
to consider a company’s current and future potential performance. Such
information will be much more reliable if it is verified by somebody other
than those preparing the accounts. This is where the auditing profession
comes in.
The primary role of the auditing profession is to collect what is referred to
as ‘sufficient and appropriate’ audit evidence from numerous sources and
use this evidence to conclude on whether, in their opinion, the financial
statements give a true and fair view of the company’s financial position and
performance.
In many jurisdictions around the world, listed companies on stock exchanges
are required, by local law, to have their financial statements audited by
an independent public accountant. This enhances the credibility of such
statements. Individual users of accounts can have more confidence in
the information, and the markets should work much more effectively as
investors have more faith and trust in the information underlying the system.
The role of the auditor also acts internally, encouraging those who are
responsible for preparing the accounts to do so with honesty – and thus
deterring poor quality companies from attempting to pass themselves off as
a better company, due to the fear that they will be caught out.
Can we trust that audit processes are carried out consistently from
company to company and across jurisdictions? Fortunately, in many
countries and regions, there are required audit standards and regulations
set by various bodies. In much of Europe, auditors are expected to follow
directives set by the International Auditing and Assurance Standards Board
(IAASB). In the US, the Public Company Accounting Oversight Board
(PCAOB) has the power to inspect and investigate audit work as auditors
follow Generally Accepted Auditing Standards, which are comparable to
the International Auditing Standards.
Activity 2.3
What would be the consequences if company management were accused of falsifying
financial performance?
What consequences would there be even if no legislation was in place?
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AC3193 Accounting: markets and organisations
As before however, we must consider whether the existence of an audit
requirement for listed companies – and the associated safeguards provided
by audit standards – is sufficient to solve the ‘lemons problem’.
The importance of the auditing profession is clear. Unfortunately, this
is never more apparent than when there are failures in the industry. In
recent history, there have been numerous occasions where an independent
accountant auditing a company failed in its duty. This has often sent
shockwaves through the market as investors question whether or not they
can rely on the work of auditors.
In 2014, UK supermarket Tesco was found to have overstated profits by
£263 million – which was not highlighted by their then auditor, PwC.
Although PwC were investigated and escaped official censure from the
UK Financial Reporting Council, the value of Tesco plummeted by over
£10 billion with the news that their finances were less reliable.
Another example is that of General Electric. In 2018, the Securities and
Exchange Commission began investigations into ‘aggressive accounting’
practices, specifically with regard to over-inflated profits coming from
reductions in historical cost estimates rather than real current performance.
The SEC also found that current performance was supported at the
expense of future cash collection. This revelation led General Electric’s
share price to plummet by almost 75%. The incident raised concerns over
the relationship that auditing firm KPMG had with General Electric. It
was noted that KPMG had audited General Electric for over a century and
questions were raised over whether this meant that KPMG were truly an
independent accountant or not.
Such examples could suggest that audits are not always robust,
undermining the role accounting information might play in fully resolving
the ‘lemons problem’.
2.3.3 Legal liability
While the auditing profession adds value to the information provided
by management within organisations, it is important to remember
that management carry the ultimate responsibility for the validity of
information. In Chapters 9 and 10 of this manual, we will explore how
management may be able to make decisions which allow for distortion
in accounting information as well as why, under some accounting
jurisdictions, this is possible.
Because the auditing profession has natural weaknesses in itself, it is clear
that management are likely to need some additional form of deterrent, to
discourage them from misleading the users of accounting information in
the hope that auditors will not recognise the distortion.
In many jurisdictions around the world, this deterrent comes in the form
of localised directives and legal statutes. There are many complexities in
this area, depending upon which jurisdiction’s law needs to be followed.
Broadly speaking, however, management can be found guilty of an offense
if information provided within financial reports is found to be misleading
and intended to harm investors.
In 2019, the Securities Exchange Commission in the US charged global
information and media analytics firm, Comscore Inc. and its former
CEO. The SEC found that, under the direction of the CEO, revenue was
improperly increased by $50 million. Without admitting or denying these
findings, the CEO paid a penalty of $700,000 and agreed to reimburse
Comscore with $2.1 million. The CEO was also barred from serving as an
officer or director of a public company for 10 years.
16
Chapter 2: Accounting information – the user perspective
Activity 2.4
Read the findings of the SEC investigation into accounting fraud at Comscore Inc. (US
SEC press release, Sept 24 2019). See how the directors were seen to be personally liable
and were fined. While you read, consider the following questions:
1. What did the SEC accuse directors of doing?
2. Why did the directors have this opportunity?
3. What actions did the SEC threaten to take against the directors?
4. How does such an investigation improve the credibility of accounting within the US?
Activity 2.5
Attempt question 2, 3, 4 and 5 from the questions, exercises and problems at the end of
Chapter 1 of Palepu et al. (2022).
2.4 The need for additional information
The ‘greater fool theory’ suggests that prices in markets can increase not
due to underlying performance, but simply because people are able to
sell investments at an overvalued price to a ‘greater fool’ – as long as that
fool accepts that the price is reflective of a strongly-performing company.
As with the ‘lemons problem’ (discussed earlier), this allows poorlyperforming companies to overstate their performance. Once a fool (an
investor who has overpaid for an asset) realises their investment was not
a good one, all they need to do is find a ‘greater fool’ to sell to at an even
more inflated price; in this way, the first fool can still make a gain. This
works as long as the world is full of ‘new fools’.
There is no better illustration of this than the ‘dot com boom’ of the 1990s,
which was followed by the ‘dot com bust’ of the 2000s.
Many investors were happy to invest in fledgling internet-based companies,
hoping that – in the short term at least – they could ‘ride the wave’ and
make some major gains. The problem was that many investors did not
bother to read information provided by these companies. Nor did they
seem to care that many companies showed very little evidence of revenue,
let alone earnings!
Because of the demand, investment banks encouraged fledgling companies
to seek a listing. This exacerbated the problem as it meant investors
continued to be attracted to the market, further increasing demand for any
company with ‘dot com’ after its name.
As it became clear that many of these companies did not have a sufficiently
developed operating model, many corporations failed and investors were
left facing large losses.
In the 21st century, there is a current drive for investors to understand
more about organisations, attitudes and approaches towards their
environmental, social and governance responsibilities i.e. ESG.
For large investment firms, this is becoming more and more important.
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AC3193 Accounting: markets and organisations
Activity 2.6
Read the case study ‘A clutter of standards and guidelines: The development of ESG
reporting’ at the end of Chapter 1 of Palepu et al. (2022). Focus on the following sections
(although you may of course read more if you are interested):
• An introduction to ESG reporting
• ESG frameworks and standards
• Players in the market for ESG information
• The future of ESG reporting
As you read, try to answer the following questions:
1. What potential use can ESG information have for investment decisions?
2. Why is it important for market participants to have quality information with regards
to ESG disclosures when compared with financial reporting disclosures?
3. What threats might exist with regards to the usefulness of ESG reporting?
2.5 Overview of chapter
This chapter has explored the core reason why financial information is so
important in allowing investors to differentiate between good and poor
investments.
The chapter has highlighted how markets would collapse without credible
information and what mechanisms are used to attempt to solve this
problem.
2.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the relationship between users of financial information and the
producers of financial information and why financial information is
important to external parties
•
critique the accounting standard setting process for both USGAAP
and IFRS, highlighting the strengths and weaknesses of the standard
setting process
•
explain the mechanisms used in the capital markets to ensure that
credibility is created behind financial information disclosures made by
internal management
•
discuss, in the context of the dot com bubble, difficulties that have
occurred when financial information has been insufficient for capital
market participants.
2.7 Test your knowledge and understanding
1. What is the ‘lemons problem’ and how do the markets attempt to solve
this problem?
2. Why is the auditing profession alone insufficient to solve the ‘lemons
problem’?
3. If an entrepreneur is attempting to sell their business, explain why
offering information about their performance is critical to a fair
valuation.
18
Chapter 3: Capital market players and an introduction to analysts
Chapter 3: Capital market players and an
introduction to analysts
3.1 Introduction
This chapter will offer more clarity into the rather opaque and sometime
confusing world of the capital markets. The capital markets are a network
of complicated relationships developed from a simple concept – the need
to connect borrowers with lenders. By the start of the 21st century, the
participants in these markets have become widely varied in both their
roles and their objectives.
The chapter will identify these key players within the capital markets
and ensure that their primary roles are understood. The chapter will also
introduce a selection of the participants who are to be explored in more
detail in later chapters of this manual.
3.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain how information is used with the network of the capital
markets
•
describe the role of key market participants who operate within the
capital markets
•
identify the differences between a sell side analyst and a buy side
analyst.
3.1.2 Essential reading
Valdez, S. and P. Molyneux An introduction to global financial markets.
(Bloomsbury Academic, 2015) [ISBN 9781137497550] Chapters 1 and 5
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 5th edition [ISBN 9781473758421] Chapter 9
extracts.
3.1.3 Further reading
Arnold, G. Modern financial markets and institutions: a practical perspective.
(Financial Times, 2011) [ISBN 9780273730354].
3.1.4 References cited
Palmieri, R., D. Perrin and M. Whitehouse ‘The pragmatics of financial
communication. Part 1: From sources to the public sphere’, International
Journal of Business Communication, 55(2) 2018, pp.127–134.
3.2 The complex world of banking
Imagine an entrepreneur has an idea but no finance, while a saver has
funds they wish to invest. In a simple world, it may be possible that these
two people could talk to each other. The entrepreneur could explain their
idea; the saver could listen and then decide whether to invest or not.
In such a simplified world, there would be direct contact between the
entrepreneur and the saver.
Unfortunately (or fortunately, depending on how you look at it), we do not
live in such a simple world. Instead, we live in a world of multinational
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AC3193 Accounting: markets and organisations
corporations, fighting for market space with local independent businesses.
A world where companies can grow from being small-cap to being worth
trillions of dollars. A world where companies can operate with as few as
one or two employees, or as many as tens of thousands of employees.
It would be impractical for an individual saver to approach a large
multinational corporation to ask whether the firm requires some
additional finance. Likewise, it would be difficult for large corporations,
in order to raise the finance they need, to hold discussions with individual
savers around the world to ask for investment.
The banking system is here to operate as the ‘go between’, joining
entrepreneurs/businesses and investors together. This is the role that
banks excel at. By acting as a go-between in this way, banks are able to
pool smaller funds together to create larger funds; they can accumulate
multiple short-term deposits over time and make use of them to offer
longer term borrowings. In addition, since large numbers of entrepreneurs
and businesses access them, banks can prepare portfolios of investments to
reduce the risk to savers, compared with the risk to someone who invests
directly in a single company.
But how do banks work? And how do they use the financial information
provided by entrepreneurs and companies?
The history of banking is a complicated one. A story of crusades,
international tea trade and civil war dramas, followed by growth, panic,
regulation, deregulation, mergers, failings, regulation again, followed by
deregulation again, followed by crashes, and then more regulation.
Today, most banks can be classified into one of four categories (or maybe
five depending on how you look at them). However, it is worth noting that
many banks have divisions which cross these boundaries: no bank falls
‘perfectly’ into any one category and many could be considered to fall into
multiple categories.
Retail banks
e.g. Lloyds Bank
Private banks
e.g. Coutts
Commercial banks
e.g. Barclays
Investment banks
e.g. Goldman Sachs
20
Retail banks are what most people are likely to recognise as
a ‘bank’. These banks often focus on individuals from whom
they accept deposits (e.g. as a current access account) and
to whom they make loans (e.g. car loans, home improvement
loans, mortgages).
There is overlap in the services provided by retail banks and
private banks. However, private banks exist to accept deposits
from and offer loans to ‘high worth’ individuals. People often
become customers of such banks by invitation and these banks
are attractive due to the specialist nature of advice which they
can offer such wealthy individuals.
Commercial banks are those whose clients are companies.
They are often still household names due to their presence and
many deal with deposits and loans. However, they also offer
assistance with transactions, especially overseas transactions
where there is a need for foreign currency support.
Investment banks have complex relationships with a number
of different parties. Their main aim is to connect savers and
borrowers (just like other types of bank). However, they tend to
focus on larger, more complex transactions. Investment banks
engage in a wide range of activities including advising on
mergers and acquisitions; research across equities, bonds and
foreign currency; and sophisticated trading and restructuring.
We will explore this in more detail later.
Chapter 3: Capital market players and an introduction to analysts
Universal banks
e.g. Bank of America
Some banks have attempted to position themselves as
‘universal banks’ or a ‘bank for all’. Such banks attempt to
provide all the services described above. However, regulation
complicates the matter as certain parts of banking may need
to be separated from others for safeguarding reasons.
Table 3.1: Categories of bank.
Activity 3.1
Read Chapter 1 of An introduction to global financial markets (Valdez and Molyneux,
2015).
Ensure you feel comfortable with the difference between primary and secondary markets
and the different ways in which investors can invest in corporations.
3.3 Investment banks
The focus of this section of AC3193 is the investment banking sector.
The key users of financial information tend to operate in and around
investment banks and so their activities are central to our study of the use
of financial accounting information.
The services offered by investment banks differ from bank to bank, which
can make the industry appear more confusing. In addition, more specialist
institutions exist which focus on certain aspects of investment banking and
then offer their unique services to larger, more generic institutions. That
said, most services can be placed in one of the following categories.
Raising finance
This was the primary purpose of investment banks. The
bank can assist large corporations issuing stock or debt
instruments and help organisations to find investors who
have sufficient funds to invest.
Financial advisory
services
Investment banks offer advice for companies on how to
utilise the financial resources which are available. This
advice can cover such topics as whether to merge with or
acquire other companies or whether to dispose of parts
of their own business.
Corporate lending
Although investments banks’ primary role may be to
assist companies in raising finance, many are able to offer
direct finance themselves.
Research
Many investment banks have divisions which assist
investors in deciding where to invest. The analysts
working in these divisions will be introduced later in this
chapter and explored in more detail in Chapter 4.
Investments and
investment trading
Due to the nature of the work investment banks
perform, they are aware of what may or may not be
a good investment. Consequently, they often invest in
the markets themselves and exploit their knowledge to
generate trading and other investment returns.
Table 3.2: Categories of service offered by investment banks.
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AC3193 Accounting: markets and organisations
Activity 3.2
Read Chapter 5 of An introduction to global financial markets (Valdez and Molyneux,
2015).
Prepare an answer for questions 1 and 4 from the end of the chapter.
Activity 3.3
Explore the websites of the following investment banking firms:
• Goldman Sachs
• Bank of America
• Deutsche Bank
The aim of this activity is to learn about the different functions provided by these
organisations within the capital markets, joining investors/savers with borrowers.
Try to answer the following questions for each bank.
Goldman Sachs
Look at the details about the following services provided by Goldman Sachs:
• asset management
• investment banking
• research.
How do you think these departments interact with each other? For what reasons do you
think each department would need financial information?
Bank of America (BofA)
You should see that BofA offers both corporate services and ‘retail services’ (e.g. credit
cards, car loans, home loans and bank accounts to individuals). Explore the ‘Business and
Institutions’ section.
Here, you should find a section for ‘Institutional Investing’.
Do these services seem similar to those offered by Goldman Sachs? Do they use the
same language? Do BofA and Goldman Sachs mean the same thing when they refer to
‘investment banking’?
Deutsche Bank
Focus on the ‘corporate/institutions’ section. What similarities are there between the
services offered by Deutsche Bank and by the banks you have already explored?
3.4 The need for information
As stated in the section above, the banking system was primarily set up
to join those who need money with those who have money, but most
investors will be unwilling to risk their money unless they know whether
the expected return will meet their needs. To assess the risk to their
investment, they will need information.
As discussed, it would be difficult for individuals to directly ask
corporations if they require their investment, or for large corporations to
ask hundreds of investors for finance. In the same way, it can be difficult
for investment banks to obtain information directly. As such, the financial
intermediaries within the market must manage information in a number of
ways. Figure 3.1 summarises the options available.
22
Chapter 3: Capital market players and an introduction to analysts
Figure 3.1: Communication between corporations and investors.
(Source: adapted from Palmieri, 2018)
Figure 3.1 shows a number of ways in which corporations communicate
with investors. Corporations can produce one-way information such as
annual accounts or quarterly earnings releases, which can be issued and
communicated directly to the investors. However, such communications
lack ‘reciprocation’ (i.e. they are one way only). It may be important for
corporations to make clarifying statements or to answer questions, but
opportunities for this to occur are limited. If a corporation allowed all
shareholders to ask questions of them, any meeting could last a long time.
There are more standardised processes by which corporations offer
feedback, accept queries and engage in discussion with investors.
However, these processes necessarily involve a smaller pool of participants.
This is where financial intermediaries such as investment banks can excel
and support a wider base of investors.
3.5 Buy side and sell side analysts
Figure 3.1 identifies two specific parties of importance, who are central to
the operation of financial markets: buy side analysts and sell side analysts.
We will look at these roles in more detail in the following chapters.
Their overall roles in the financial markets and their use and creation of
financial information are summarised in Table 3.3.
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AC3193 Accounting: markets and organisations
Buy side analysts
Sell side analysts
Buy side analysts work in the investment Sell side analysts do not actually invest
management firms that are the main
themselves.
buyers of securities in the capital markets. Instead, we may consider them to be
Buy side analysts work for senior
analysts who sell their ideas. These
fund managers who actually make
ideas often come as recommendations
the investment decisions. Their role
to ‘buy’, ‘sell’ or ‘hold’ stock, depending
is to provide the fund manager with
on whether they feel stocks are over or
investment ideas, drawing from their own under-priced.
research and the research of sell side
These ‘ideas’ are often summarised within
analysts.
a report which is then ‘sold’. These reports
may be read by buy side analysts or by
individual investors.
Table 3.3: Roles of buy side and sell side analysts.
3.6 Role of the investor relations officer
Figure 3.1 demonstrates that, for an organisation to successfully manage its
ability to obtain finance itself, accurate and reliable information about the
company is essential. Due to the sophisticated needs of investors, combined
with increasingly stringent regulation, companies have professionalised and
streamlined how they communicate financial information to markets. Most
companies have now established an ‘Investor Relations’ departments to deal
with these issues. This will be explored in more detail within Chapter 5.
3.7 Other market participants
Our discussion so far has covered only the ‘tip of the iceberg’ in terms of how
financial markets operate. Indeed, there is a multitude of other participants
– some who wish to borrow, some who wish to invest, and others who wish
to exploit price movements to generate profits. There is also a multitude of
instruments which can be used to invest/borrow money. Below are some
other participants in the markets which you should have some awareness of
(although a detailed understanding is not required for this course).
Central banks
Central banks are often the main monetary authority of a country. They can
help to manage public debt by both borrowing from and investing in the
markets. This can include the purchasing of government debt when needed.
They also often manage the nation’s reserves (such as gold reserves), issue
currency and can act as a lender of last resort.
Pension funds
Pension funds are investment institutes whose aim is to ensure the right
levels of income and capital growth are created to fund their clients’
retirement. To do this, they often invest in a portfolio of shares which meets
their required aims. These firms may need to meet the required investment
strategies for those who save for retirement via a defined contribution
scheme. However, they may also assist organisations who have committed
to a defined benefit scheme; asset management is crucial to meeting these
pre-agreed obligations.
24
Chapter 3: Capital market players and an introduction to analysts
Mutual funds
Mutual funds allow small shareholders to group their investments together
with other shareholders so as to spread their risk. The pool of investments
is managed by a fund manager and the shareholders share the returns
obtained. This allows investors who might not be able to invest in multiple
investments independently, to manage their level of risk to a lower level.
Stock exchanges
A stock exchange is a regulated marketplace where investors can sell
and buy stock between different parties. Stock exchanges can facilitate a
corporation that wishes to raise finance by issuing and then trading stock
for the first time on the market. They also act as a place where secondary
transactions can take place (i.e. where owners of stock can sell if they
no longer wish to own the stock themselves). Some of the biggest stock
exchanges are:
•
NASDAQ
•
New York Stock Exchange (NYSE)
•
London Stock Exchange (LSE)
•
Tokyo Stock Exchange (Tosho)
•
German Stock Exchange (Boerse).
Credit rating agencies
These agencies focus on bond issues and other loan stock. Their function is
to rate the risk of default associated with these different debt instruments
and therefore add (or take away) credibility from companies wishing to
borrow money in that format. The three biggest agencies are Standard
& Poors, Moody’s and Fitch Ratings. Many investment funds will only
consider investing in a bond which is rated above a certain level, so any
company that does not have a suitable rating will find it difficult to begin a
conversation with the investment banks.
Hedge funds
Hedge funds are a specific type of investment firm which has less
regulation than a standard investment bank. The main focus is to ensure
they make returns on behalf of investors by investing into different
instruments. The big difference between them and regular investment
firms is that they seek to obtain a return regardless of whether stock prices
rise or fall. To make returns when stock prices fall, they must enter into a
number of agreements which other investment firms are not allowed to
perform due to the increased risk.
Short sellers
Short sellers are market participants who are looking to make returns on
stock which they expect to fall in value (similar to part of the hedge fund’s
aim). To do this, they seek stocks which, in their opinion, are overvalued.
This can attract unwanted attention from other market participants if it
signals that stock they own may not hold its value.
25
AC3193 Accounting: markets and organisations
Activity 3.4
Read the following sections from Chapter 9 of Palepu et al. (2022).
• Introduction
• Investor objectives and investment vehicles
• Equity security analysis and market efficiency
Then prepare an answer to question 4 at the end of the chapter.
3.8 Overview of chapter
This chapter has introduced a number of the key players who participate
in the capital markets, as well as the core underlying ‘raison d’être’ of the
capital markets (i.e. to join savers and borrows/entrepreneurs together).
It has also touched on the role of analysts, who are employed by
investment banks to determine whether or not an investment meets their
objectives.
3.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain how information is used with the network of the capital
markets
•
describe the role of key market participants who operate within the
capital markets
•
identify the differences between a sell side analyst and a buy side
analyst.
3.10 Test your knowledge and understanding
1. What are the key differences between an investment bank and a
commercial bank? How could their activities complement each other
and what dangers might exist for an organisation which is allowed to
perform both roles with no limitations?
2. Explain how market participants contribute to market efficiency and
conclude whether a market would ever be able to operate with a
strong form of efficiency.
26
Chapter 4: Sell side and buy side analysts
Chapter 4: Sell side and buy side analysts
4.1 Introduction
In this chapter, we will explore in more detail the differences between sell
side and buy side analysts. We will understand what role these analysts
play in the market and learn how they go about their work, how important
they are considered to be and the impact they can have on the capital
markets.
Due to the public nature of sell side analysts and the work they do, there
is a lot of knowledge and literature available to understand how they
operate and the benefits they bring. Buy side analysts, on the other hand,
are much more private and having a competitive edge assists them in their
main role within the market. As such, their role is much more opaque.
4.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the aims of a sell side analyst, how they operate and what
skills are needed
•
critique the role of a sell side analyst, including the importance of their
role in the capital markets
•
demonstrate an understanding of and explain the role and
responsibilities of a buy side analyst
•
describe the nature of the institutions in which buy side analysts work
•
compare and contrast the required roles of buy side analysts and sell
side analysts.
4.1.2 Essential reading
Laskin, A. Investor relations and financial communication: creating value through
trust and understanding. (Hoboken, NJ: Wiley Blackwell, 2021) Extracts
from Chapter 3.
Barker, R., J. Hendry, J. Roberts and P. Sanderson ‘Can company-fund manager
meetings convey informational benefits? Exploring the rationalisation of
equity investment decision making by UK fund managers’, Accounting,
Organisations and Society Journal 37(4) 2012, pp.207–222.
4.1.3 Further reading
Groysberg, B. and P.M. Healy Wall Street research: past, present and future.
(Stanford University Press, 2013) , Chapter 2.
4.1.4 References cited
Brown, L.D., A.C. Call, M.B. Clement and N.Y. Sharp. ‘Inside the “black box” of
sell side analysts’, Journal of Accounting Research, 53(1) 2015, pp.1–47.
Kecskés, A., R. Michaely and K. Womack ‘Do earnings estimates add value to
sell-side analysts’ investment recommendations?’, Management Science
63(6) 2017, pp.1855–1871.
Jung ,M., Y. Lu and H. Wu ‘How does reputational capital affect professional
behavior? Evidence from analysts who become all-stars’ (2019) www.bayes.
city.ac.uk/__data/assets/pdf_file/0003/479640/JLW_20190726.pdf
Butters, J. ‘FactSet Earnings insight: 10 March 2023’, FactSet Research Systems
Inc. https://advantage.factset.com/hubfs/Website/Resources%20Section/
Research%20Desk/Earnings%20Insight/EarningsInsight_031023.pdf
27
AC3193 Accounting: markets and organisations
Barclays Corporate and Investment Bank, www.cib.barclays/investmentbanking.html
Schipper, K. ‘Analysts’ forecasts’, Accounting Horizons 5(4) 1991, pp.105–121.
Groysberg, B. and P.M. Healy Wall Street research: past, present and future.
(Stanford University Press, 2013).
4.2 The sell side analyst – purpose and role
If we look at analysts as simply buy side vs sell side, it may be easy to
think that buy side analysts ‘buy’ companies while sell side analysts ‘sell’
their ideas. Although this is true to some degree, it does not capture the
full story.
Both types of analyst look at the financial data available in order to come
to a decision as to whether to buy, sell or hold a stock. So why are sell side
analysts called sell side analysts?
Although this terminology may have been introduced to differentiate them
from buy side analysts, we may consider the sell side analyst as one who
sells ‘ideas’. A sell side analyst researches companies and offers advice
(their ideas and opinions) to investors seeking an opinion as to whether a
stock is currently over- or undervalued.
Many of the larger investment banks have a division dedicated to this role.
Barclays, for example, have over 450 publishing analysts working in their
corporate and investment bank arm, while JP Morgan and Morgan Stanley
have many more. Although the sell side is dominated by larger investment
banks, there are also many more specialised research houses, such as
Bernstein, Autonomous and Liberum.
Sell side analysts usually specialise in a particular industry. It is common
for large investment banks to split their equity research departments into
approximately 25–35 different sectors, with analysts working in teams
of approximately 8–15 people for larger sectors, down to teams of 2 for
smaller, more niche sectors. Each analyst is likely to cover (i.e. write
research on) 6–15 stocks, depending on the size and complexity of the
companies.
Activity 4.1
Research the following companies online and find information about their sell side
analysts. (Note: companies may not call them SSAs and may instead focus on the ‘equity
research’ that they perform for clients.)
• Credit Suisse
• Bank of America
• Edison Research Group
• Alliance Bernstein LP
Use your research to answer the following questions:
1. What type of research do the sell side analysts do?
2. How do they go about performing this research?
The sell side exists because there is a demand from the buy side for these
services. Asset management firms have thousands of potential investments
and it would be difficult and costly for these firms to research all of
these investments in-house. Consequently, a large part of this research is
effectively outsourced to the sell side.
28
Chapter 4: Sell side and buy side analysts
4.3 The sell side analyst – the inputs
Sell side analysts are widely acknowledged to be the primary users of
financial information (Schipper, 1991). Let us explore what they attempt
to achieve with this information and how they blend it with other
information. In essence, analysts are industry experts, focused on one
particular sector in most cases. They absorb information from management
(e.g. earnings guidance) and elsewhere (e.g. from financial statements) to
produce their recommendations and reports for investors (see Figure 4.1).
Figure 4.1 Sources of information used by sell side analysts.
The evidence used by sell side analysts comes from a wide variety of
sources – financial, non-financial, qualitative, quantitative, historical and
forecasted. Table 4.1 summarises data from a research paper about where
analysts find ‘useful’ information. Note in particular the heavy reliance on
their own industry knowledge.
Analysts’ inputs
Respondents
who answered
‘very useful’
Average score
(higher value
means more useful)
Your industry knowledge
79.35%
5.15
Private communication with management
64.96%
4.70
Earnings conference calls
61.96%
4.67
Management’s earning guidance
61.41%
4.65
Quality / reputation of management
46.45%
4.22
Recent earnings performance
41.30%
4.18
Recent 10-K or 10-Q
42.39%
4.16
Other analysts’ earnings forecasts
46.20%
3.96
Primary research
7.07%
2.16
Table 4.1: Sources of ‘useful’ data for analysts.
(Source: Brown et al., 2015)
Many analysts have a background or interest in specialised industries,
sometimes through earlier career experiences. An analyst who knows the
industry that they are attempting to research will have a much stronger
basis for providing well-informed opinions to the markets.
29
AC3193 Accounting: markets and organisations
Table 4.1 also shows that various forms of interaction with company
management are vital to the role of sell side analysts. In Chapter 5, we will
look more closely at Investor Relations Officers (IROs), who are often the
main conduit between the company and the analyst. From IROs, analysts
are able to obtain updates about matters such as company earnings as well
as responses to questions about financial data.
Accounting information produced by companies themselves (e.g. the
recent 10-K) appears towards the bottom of the list in Table 4.1. Although
this suggests that such information is not as ‘useful’ as other sources, this
likely reflects the foundational nature of financial statement information –
it has always been available and analysts would struggle to perform their
job without this publicly available financial data as a starting point. This
will be explored in more detail in Chapters 7 and 8.
An interesting aside from this research is that only 7.07% of analysts
agreed that ‘primary research’ was ‘very useful’. It is important to note
that this research was undertaken in 2015 and, since then, there has
been a trend for investment banks to be more interested in ‘alternative
information’ often derived from primary research. This is driven by
demands from investors, who are looking to get an edge in a highly
competitive market. Given this development, some investment banks are
beginning to look towards more non-traditional sources of data which can
be used to analyse and infer company performance and provide a better
service to clients. Alternative data examples include using satellite imagery
to observe customers entering a retail store, or analysing credit card
spending data to predict company sales.
Activity 4.2
Use the internet to research ‘UBS Evidence Lab’. Read articles and/or watch videos to see
how this department of UBS is driving value through data analytics.
4.4 The sell side analysts – the outputs
The ultimate output for a sell side analyst is their recommendation.
This is always communicated in a research report and/or presentation,
depending upon the audience. Investment banks use two widely accepted
recommendation systems; Figure 4.2 explains the differences between these
systems.
Absolute rating system
Relative rating system
This system results in one of three recommendations:
2. sell
A relative rating system allows an
analyst to show which stocks the analyst
most and least prefers for investment
purposes.
3. hold.
This system effectively ‘ranks’ stocks as:
The analyst’s opinion usually follows pre-defined rules set by the
research house for which they work. For example, if an analyst
believes there is more than 15% upside based on current stock
prices, this is automatically classified as a ‘buy’; anything with
a downside of more than 10% is automatically considered as a
‘sell’; and anything in between is considered as a ‘hold’.
1. overweight – favourite stock
1. buy
The main advantage of this system is its simplicity and
unambiguous recommendations.
Figure 4.2: Absolute and relative rating systems.
30
2. equal weight
3.underweight – least favourite stock.
The difficulty with this system is that
even an underweight stock may be
considered good – but not as good as
an overweight recommendation.
Chapter 4: Sell side and buy side analysts
Ultimately, the method used depends on the research house’s or
investment bank’s business preference.
4.5 The sell side analyst – a day in the life
An analyst’s work is likely to differ from day to day and from organisation
to organisation. However, Groysberg and Healy (2013, p21) described a
‘typical’ day for a sell side analyst.
Activity 4.3
Chapter 2 of Groysberg and Healy (2013) is available on the VLE. Read the section ‘The
Work of an Analyst’ and consider the following questions:
1. What skills would an analyst need during the morning meeting?
2. What feedback do you think an analyst would receive from their reports?
3. What is Bloomberg chat messages? Why do analysts not use email?
4.6 Do investors listen to sell side analysts?
An important question to explore is whether investors listen to sell side
analysts. The evidence is mixed. Here we shall examine two issues: first,
the importance of the analyst’s reputation as captured by their ‘all-star’
status; and second, a study of the market’s reaction to recommendations.
4.6.1 Analyst credibility – ‘all-star’ rankings
Institutional Investor – a leading publisher of journals, newsletters and
research – publishes an annual survey to identify those analysts who are
highly regarded by the market in each sector. Nearly 1,000 investment
professionals from the industry vote for their favourite sell side analysts
and those analysts who perform well are referred to as ‘all-star’ analysts.
Do these analysts perform better than non-all-star analysts? Research
suggests that ‘increased reputational capital emboldens professionals to
take bolder actions to exert their market influence’ (Jung et al., 2019). In
other words, if people hold an analyst’s work in high regard, they are more
likely to listen and react to what that analyst says.
4.6.2 Consistency of message alongside recommendation
Figure 4.3 comes from a research paper by Kecskés et al., 2017. This
research was conducted to assess the impact an analyst can have on a stock
when they issue a stock recommendation opinion. The paper measures
what is referred to as the ‘excess return’ generated by the stock on the day
the opinion was published (day 0 on the x-axis) and on subsequent days.
Excess return represents the differences between the performance of the
stock and the performance of the market over a common period. So, for
example, if an analyst issues a recommendation of a buy we might expect
that stock to perform better than the market. If the stock went up 4% but
the market only went up 1%, the excess return would be 3%.
31
AC3193 Accounting: markets and organisations
8
6
3.64%
4
Excess returns (%)
Upgrades with earnings
estimate increases
(line 1 = top)
5.26%
Upgrades with no
earnings estimate
revisions (line 2)
2.82%
2
2.21%
Upgrades with earnings
estimate decreases
(line 3)
0
-2
Downgrades with earnings
estimate increases
(line 4)
-1.77%
Downgrades with no
earnings estimate
revisions (line 5)
-2.45%
-4
Downgrades with earnings
estimate decreases
(line 6 = bottom)
-5.06%
-6
-6.10%
+126
+105
+84
+63
+42
+21
+15
+10
+5
0
-1
-8
Days relative to recommendation change
Figure 4.3: Excess returns on stock in response to analyst recommendations.
(Source: Kecskés et al., 2017)
From the two most extreme lines, we can see that the market appears to
react decisively when an analyst makes either an upgrade or a downgrade,
as long as it is consistent with a matching upgrade or downgrade to
their earnings estimate. However, when analysts upgrade their stock
recommendation while downgrading their earnings estimate (or vice
versa), the market appears indifferent to this news: there are much smaller
‘excess returns’ and the stock often continues to track the market, with no
significant reaction from investors.
From this, we can conclude that investors do listen to sell side analysts as
long as their messages are consistent and credible.
4.7 Conflicts of interest for sell side analysts
Many professional roles in finance experience ethical behavioural
issues and conflicts of interest, and the role of the sell side analyst is no
exception. The extracts below, taken from interviews with a company
executive, an analyst and an IRO, indicate that an analyst’s role is complex
and there are significant threats to their independence.
‘If someone has written something that is wrong and I’m feeling
particularly vindictive when it comes to year end, I don’t take
their question until last… …it’s in my gift to humiliate them in
front of their peers.’
(anonymous corporate executive)
I’ve been threatened with being sued. I’ve had companies
phoning up a chairman of my biggest banks.
I [need to be] absolutely confident that I’ve made the right call.
(anonymous analyst)
‘So of course you want to control the narrative. You’ve got to be
on the front foot with that, because if somebody gets there first,
it takes on a life of its own. So that’s why dialogue with analysts
and the buy side guys is so important, because that’s where the
external narrative starts. You need to influence that quite early.’
(anonymous IRO)
32
Chapter 4: Sell side and buy side analysts
For an illustration of the mixture of buy/hold/sell recommendations
for S&P 500 companies and relevant sectors in 2021, view S&P 500:
Percentage of Buy, Hold, and Sell Ratings’ on p.31 of Butters, J., FactSet
Earnings insight, 10 March 2023.
Activity 4.4
When making recommendations to the markets, analysts are acutely aware that they are
publicly sharing their personal (if indirect) view about the stewardship and direction of a
company.
Likewise, corporate executives know that almost everything they publicly say will be
scrutinised by analysts, who will interpret the information to support their own opinions.
If analysts are remunerated based on the quality of their research, yet need access to
management to obtain supporting evidence, what conflicts of interest do you think could
exist which might mean the analyst’s report lacks objectivity? Draw on the brief interview
evidence and the distribution of stock recommendations provided above.
4.8 Changes in legislation affecting sell side analysts
In January 2018, new European legislation came into force: the ‘Markets
in Financial Instruments Directive’, known commonly as MiFID II. This
legislation aimed to offer greater protection to investors while attempting
to improve the functioning of the capital markets.
With over 30,000 pages of rules which govern trading in European
markets, MiFID II represents one of the biggest changes to the investment
industry in decades and requires immaculate compliance. It governs sell
side analysts, all market participants who operate within the European
markets and also high-speed digital trading.
One area which has had a particularly large impact on sell side analysts
relates to the settlement of analysts’ fees. Historically, there was little
formal payment by investors for the research conducted by a sell side
analyst. Instead, if investors appreciated an analyst’s work, they would
simply allocate trades to the analyst’s firm – meaning the analyst’s firm
would receive commission fees on the transactions instead. This meant
that, although investors were paying hundreds of millions of dollars in
fees, it was difficult to determine how much of that fee related to trading,
and how much related to the advice and research which had previously
been offered.
Since MiFID II however, sell side analysts have been expected to issue a
‘pricing menu’ of services they offer, in an attempt to ensure transactions
and services are as transparent as possible. Although this may seem to be
a positive move for an opaque industry, it does lead to issues for sell side
analysts.
Previously, investment and fund managers were happy to meet with
analysts in order to hear their views and recommendations, knowing
that if the meeting yielded no benefits, it would cost them nothing. Now,
however, these fund managers need to think carefully about whether a
call, meeting or presentation with a sell side analyst will be worthwhile
once there is an explicit cost for that interaction.
As such, there is the risk that fund managers may bypass sell side analysts
altogether, instead obtaining their own information from IROs (effectively
for free). Alternatively, if they still wish to use a sell side analyst, they may
attempt to negotiate much lower fees.
33
AC3193 Accounting: markets and organisations
Activity 4.5
Read the following sections from Chapter 3 of Laskin, 2021:
• Institutional investors
• Traders
• Portfolio builders
• Sell-side
1. Why do you feel sell side analysts are so important for the capital markets to operate?
2. Could the capital markets operate without sell side analysts?
4.9 Buy side analysts and fund managers
In Chapter 3, we considered different market participants, including
investment banks and (briefly) pension funds and hedge funds. These
latter parties invest on behalf of a range of clients, in opportunities that
will obtain the desired type of return. Fund managers specifically take
responsibility for where to invest.
Buy side analysts are tasked with filtering the various investment ideas
in the market, including those from sell side analysts, and recommending
the most fruitful ones for their manager (the individual responsible for
managing the fund or portfolio – i.e. the ‘fund manager’ or ‘portfolio
manager’). Therefore buy side analysts work closely with the sell side and
are the key link between analysts and asset managers. Buy side analysts
are also expected to generate ideas of their own. Consequently, they may
perform similar tasks and activities to sell side analysts.
One important practical issue is the number of stocks monitored by buy
side analysts and fund managers in investment firms. These small teams
may cover 100–150 stocks, which may make it difficult for them to remain
up to date. By utilising the sell side, who cover a much smaller number
of stocks, the buy side can monitor this high volume of stocks without
incurring a large in-house cost (see Figure 4.4).
Stock
Stock
Stock
Stock
Sell Side Analyst
Stock
Stock
Stock
Stock
Sell Side Analyst
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Sell Side Analyst
Stock
Stock
Stock
Stock
Sell Side Analyst
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Sell Side Analyst
Buy Side Analyst
Buy Side Analyst
Stock
Sell Side Analyst
Sell Side Analyst
Sell Side Analyst
Fund manger
Portfolio management
of 100-150 stock
Buy Side Analyst
Sell Side Analyst
Buy Side Analyst
Buy Side Analyst
Sell Side Analyst
Sell Side Analyst
Sell Side Analyst
Figure 4.4: Monitoring of stocks by fund managers and analysts.
34
Chapter 4: Sell side and buy side analysts
Activity 4.6
Read the following sections of Barker, R., J. Hendry, J. Roberts and P. Sanderson
‘Can company-fund manager meetings convey informational benefits? Exploring the
rationalisation of equity investment decision making by UK fund managers’, Accounting,
Organisations and Society Journal 37(4) 2012 pp.207–222.
• Abstract
• Introduction
• Evidence of the apparent paradox
• Can non-price sensitive information be useful to fund managers?
• Do fund managers interpret ‘useful information’ rationally?
Then answer the following questions:
1. What do you think buy side analysts would consider to be the most important factors
for success?
2. How do buy side analysts communicate with company management compared with
sell side analysts?
3. Why do you think buy side analysts may wish to hold meetings with management?
4.10 Overview of chapter
This chapter has explored the role that analysts play in the market,
differentiating between the sell side and the buy side. The chapter has
clarified how the two roles differ and what their objectives are, while also
providing insight into their day-to-day roles and how market participants
view their importance.
4.11 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the aims of a sell side analyst, how they operate and what
skills are needed
•
critique the role of a self side analyst, including the importance of their
role in the capital markets
•
demonstrate an understanding of and explain the role and
responsibilities of a buy side analyst
•
describe the nature of the institutions in which buy side analysts work
•
compare and contrast the required roles of buy side analysts and sell
side analysts.
4.12 Test your knowledge and understanding
1. How may equity fund managers benefit from meetings with company
management?
2. Explain how research supports the contention that the analytical work
and recommendations of analysts do influence the market.
3. MiFID II is a significant regulatory change impacting the buy side and
the sell side. Describe the key changes emerging from the regulation
that are relevant to analysts (buy side and sell side) and comment on
whether you think these changes will improve the quality of research
in the market.
35
AC3193 Accounting: markets and organisations
Notes
36
Chapter 5: Information dissemination
Chapter 5: Information dissemination
5.1 Introduction
In Chapter 2, we discussed the importance of information in aiding the
capital markets to function appropriately. Chapters 3 and 4 explored the
users of this financial information and the reasons why these market
participants need the information.
In this chapter, we will look at the mechanics of how information is
communicated from within a company to those outside the company. This
will include the formalisation of financial information and also some of the
more functional processes which allow companies to ensure the market is
aware of their financial performance.
5.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the importance of, and the role of, an Investor Relations
Officer (IRO) and how their success can be measured
•
explain how the role has changed over time and the reasons behind
these changes
•
describe the importance of the regulatory framework within the
investor relations profession and briefly discuss what is involved.
5.1.2 Essential reading
Laskin, A. Investor relations and financial communication: creating value through
trust and understanding. (Hoboken, NJ: Wiley Blackwell, 2021) Extracts
from Chapters 2, 4, 5 and 6.
5.1.3 Further reading
Laskin, A. ‘Investor relations practices at Fortune-500 companies: an
exploratory study’, Public Relations Review 32(1) 2006, pp.69–70.
5.1.4 References cited
IFRS Foundation, IFRS Standards Required 1 January 2021. (IASB, 2021)
[ISBN 9781911629832].
IFRS Foundation, Conceptual framework for financial reporting. (IASB, 2018)
https://www.ifrs.org/issued-standards/list-of-standards/conceptualframework/
International Integrated Reporting Council (IIRC), International Integrated
Reporting Framework. (December 2013) www.integratedreporting.org/
wp-content/uploads/2013/12/13-12-08-THE-INTERNATIONAL-IRFRAMEWORK-2-1.pdf
G20/OECD, Principles of Corporate Governance. (2015) www.oecd-ilibrary.
org/governance/g20-oecd-principles-of-corporate-governance2015_9789264236882-en
Financial Reporting Council, The UK Corporate Governance Code. (July
2018) www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0d2f4f48069a2/2018-UK-Corporate-Governance-Code-FINAL.pdf
National Investor Relations Institute, https://www.niri.org/about-niri
Brown, L.D., A.C. Call, M.B. Clement and N.Y. Sharp ‘Managing the narrative:
Investor relations officers and corporate disclosure’, Journal of Accounting
and Economics 67(1) 2019 pp.58–79.
37
AC3193 Accounting: markets and organisations
5.2 Regulatory financial information
From your earlier studies, you should be familiar with the nature of
regulatory financial information. That is to say, you know that companies
are often required by legislation to prepare financial statements. Although
different jurisdictions might use different language or have different
requirements (for example, small companies may be exempt from
reporting certain information), it is generally accepted that companies
should provide shareholders with information about the following:
Assets
A present economic resource controlled by the entity as a result
of past events.
An economic resource is a right that has the potential to
produce economic benefits.
Liabilities
A present obligation of the entity to transfer an economic
resource as a result of past events.
Equity
The residual interest in the assets of the entity after deducting
the liabilities.
Income
Increases in assets, or decreases in liabilities, that result in
increase in equity, other than those relating to contributions
from holders of equity claims.
Expenses
Decreases in assets, or increases in liabilities, that result in
decrease in equity, other than those relating to distributions to
holders of equity claims.
Table 5.1: Types of information that companies should provide to shareholders.
(Source: adapted from IASB, 2018)
The aim of this is to ensure that financial information is useful to
those who need it. Most jurisdictions require companies to provide the
following, as a minimum:
Balance sheet
(statement of financial position)
Including assets, liabilities and equity
Income statement
(statement of profit or loss)
Including income and expenditure
Cash flow statement
(statement of cash flow)
Reconciliation of how the cash balance has
changed from previous year
Statement of shareholders’ equity Reconciliation as to how equity has changed
(statement of changes in equity) from the previous year
Notes
Extra details, both quantitative and
qualitative, regarding the above statements
Table 5.2: Key financial information required by most jurisdictions.
These statements should be familiar to you; whether you are looking at
companies who follow USGAAP, IFRS or any other localised GAAP, similar
documents are always produced.
In Chapter 6, we will look at using this quantitative financial information
to understand the performance and position of the companies via
accounting ratio analysis.
Activity 5.1
Research three companies which follow different accounting standards and examine the
similarities and differences between their financial statements.
For example, you could research:
38
Chapter 5: Information dissemination
• Take-Two Interactive Software Inc (US GAAP) – www.take2games.com/ir/sec-filings
• Gaming Realms plc (UK GAAP) – www.gamingrealms.com/wp-content/uploads/
Gaming_Realms_AR_2021-FINAL.pdf
• Capcom (Japanese GAAP) – www.capcom.co.jp/ir/english/data/annual.html
Activity 5.2
Read the following sections from Chapter 4 of Laskin (2021):
1. Communicating financial information
• Income statement
• Balance sheet
• Cash flow statement
• Statement of stockholders’ equity
2. GAAP and Non-GAAP financial disclosure
(Note: The section regarding financial analysis will be covered in Chapter 6 of this guide.)
3. Why do you think the cash flow statement is required for investors when the income
statement is also produced?
4. If you were planning to invest in a company, which part of the financial statements
would you consider to be the most important and why?
5.3 Non-financial information
Alongside the regulatory financial information, many jurisdictions also
require companies to provide further information about more than just
finances. In the US, under SEC requirements, companies are expected
to provide information covering 16 different ‘items’ with a number of
subsections (see Figure 5.1). The financial statements (in their core form)
are presented in Item 8 and although other sections may include financial
information, they are often used to add commentary to key elements (e.g.
Item 7) or about aspects of the business which are not related to historical
financial performance at all (e.g. Item 1A).
Part I
Item 1
Business
Item 1A
Risk Factors
Item 1B
Unresolved Staff Comments
Item 2
Properties
Item 3
Legal Proceedings
Item 4
Mine Safety Disclosures
Part II
Item 5
Market for Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Item 6
[Reserved]
Item 7
Management’s Discussion and Analysis of Financial Condition and Results
of Operations
Item 7A
Quantitative and Qualitative Disclosures About Market Risk
Item 8
Financial Statements and Supplementary Data
Item 9
Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Item 9A
Controls and Procedures
39
AC3193 Accounting: markets and organisations
Item 9B
Other Information
Item 9C
Disclosure Regarding Foreign Jurisdictions that Prevent Inspections
Part III
Item 10
Directors, Executive Officers and Corporate Governance
Item ii
Executive Compensation
Item 12
Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
Item 13
Certain Relationships and Related Transactions and Director Independence
Item 14
Principal Accountant Fees and Services
Part IV
Item 15
Exhibit and Financial Statement Schedules
Item 16
Form 10-K Summary
Figure 5.1: Required information under SEC requirements in the US.
In 2013, the Integrated Reporting Council (now part of the IFRS
foundation) released its first version of a framework to establish principles
and concepts to govern an overall ‘integrated report’.
Although not replacing traditional reporting (such as the financial
statements), this framework encourages the collation and presentation of
key factors which drive business value. The hope is that companies will
be able to show how key resources and relationships interact with the
external environment and how this adds value. The IRC model was built
around eight components:
•
Organisation overview
•
Governance structure
•
Business model
•
Risks and opportunities
•
Strategy and resource allocation
•
Performance
•
Outlook
•
The basis of presentation.
Activity 5.3
Read the following article about the foundation of Integrated Reporting from the
Association of Certified Chartered Accounts website: www.accaglobal.com/pk/en/student/
exam-support-resources/professional-exams-study-resources/strategic-business-leader/
technical-articles/the-integrated-report-framework.html#Principle-based-framework
Activity 5.4
Read Chapter 5 from Laskin (2021). (Note: Do not read the section regarding financial
analysis as this will be covered in Chapter 6 of this guide.)
1. How do you think information regarding the nine categories defined by PwC as
‘extra-financial information’ would help analysts to perform their work more
accurately?
2. Is there any other information you think should be included in a company’s 10-K form
as required by the SEC?
40
Chapter 5: Information dissemination
5.4 Meetings with management
Although the financial statements are well understood by market
participants and the supply of non-financial information assists with
understanding of these statements, it should be noted that this is
one-way communication – i.e. the company informing stakeholders
by communicating financial and related information. In itself, such
information does not allow market participants to engage with the
company to ask questions.
The OECD Principles of Corporate Governance (a benchmark used by the
G20 countries) state:
‘Channels for disseminating information should provide for equal,
timely and cost-efficient access to relevant information by users.’
The UK corporate governance code (2018) suggests:
‘In order for the company to meet its responsibilities to shareholders
and stakeholders, the board should ensure effective engagement
with, and encourage participation from, these parties.’
In practice, many listed companies couple the release of any financial
information with an announcement and a webinar/conference call. At
this time, management are able to present and discuss their report with
more freedom than would be allowed by a regulated proforma, while
participants on the call are able to ask questions which aid their own
understanding of the company.
Activity 5.5
Spend some time looking at a listed company’s investor page to review a quarterly
announcement. See if you can find the presentation that came with this announcement.
Some companies record their meetings so that they can be made public at a later date.
For example, Colgate-Palmolive filed a regulatory 10-Q form (US quarterly
report) with the SEC on 28 October 2022: www.sec.gov/Archives/edgar/
data/21665/000002166522000027/cl-20220930.htm
On 28 October 2022, the company held a Quarterly earnings presentation and review,
where analysts were invited to join and ask questions about the company’s latest
performance. The presentation is available here:
https://investor.colgatepalmolive.com/static-files/840770a1-2151-46b0-87ab33868dad40a8
You can listen here, if you enter your details and state that you are a student:
https://event.choruscall.com/mediaframe/webcast.html?webcastid=GYFzWP77
Answer the following questions:
1. How does the presentation compare with the formality of the 10-Q?
2. What extra information is provided by management in the presentation?
3. What types of questions do the analysts ask?
4. Do you feel the analysts would have sufficient information from the reported 10-Q
alone?
5.5 Investor relations
In a world where communication possibilities come with ease, speed and
volume, it is increasingly important for companies to think carefully about
how they control the messages being received and acted upon by different
market participants. For this reason, many listed firms invest in what is
termed ‘investor relations.
41
AC3193 Accounting: markets and organisations
‘Investor relations is a strategic management responsibility
that integrates finance, communication, marketing and
securities law compliance to enable the most effective two-way
communication between a company, the financial community,
and other constituencies, which ultimately contributes to a
company’s securities achieving fair valuation.’
(National Investor Relations Institute)
The above definition from the NIRI provides a telling insight into what
companies try to accomplish by managing their relationship with investors.
A ‘strategic management responsibility’ suggests that investor relations is
something which is ‘planned’ and ‘controlled’ in the long term, and not
merely reactionary to crisis or fads. The fact that it integrates finance,
marketing and compliance suggests that, to be successful, an investor
relations officer will require a variety of skillsets.
The definition of investor relations also points out that the intention is not
to inflate the share price or the view of the company, but to contribute to a
‘fair valuation’. This suggests that the primary goal of investor relations is
to act with honesty and openness.
The concept of investor relations has evolved over the years, particularly
as a result of the digital age. Figure 5.2 illustrates this evolution, from
simple ‘public relations’ performed by a PR expert, through finance experts
delivering key financial updates, to the complex multi-skilled process that
exists today.
1945–1975
The Communication Era
1945–1975
The Communication Era
2005–
The Synergy Era
Publicity and public information offered as
promotional activities and to meet disclosure
requirements.
Information sharing was often one way, with the
ultimate aim of bringing benefit to the organisation.
Information was often delivered by a
communications technician with a background in
communication and journalism.
Two-way communication began but was still
mainly driven by the corporation wanting to
deliver messages. The main purpose during this
era was to promote the business and thus increase
its valuation.
Information often originated from the finance and
accountancy teams and so was often delivered by
an accounting technician.
Two-way communication evolved, placing as
much emphasis on what investors wanted to hear
and ask as on what the company wanted to say.
The primary aim was to ensure investors saw the
company in a fair way; as such, this
communication was beneficial to both the
corporation and to investors.
Many firms created stand-alone IR departments
and recruited employees with varied
backgrounds, often having dual degrees.
Figure 5.2: The evolution of investor relations.
(Source: adapted from Laskin, 2021)
42
Chapter 5: Information dissemination
5.6 The Investor Relations Officer
A modern investment relations department requires employees with
multiple skills. Not only must they be aware of regulatory requirements
which govern the firm (and themselves – see section 5.7 below), they
also need to understand their impacts on the capital markets and other
stakeholders of importance to the business.
An investor relations officer (IRO) may be seen as a conduit allowing twoway communication between the corporation and stakeholders such as:
•
analysts
•
investors
•
customers
•
senior members of the organisation, such as the Chief Financial Officer,
the Chief Executive Officer and the company president.
It is helpful to understand the important skills required for the role as well
as how IROs prioritise their work.
Activity 5.6
Read the following sections from Laskin (2021):
• Investor Relations Officers
• Ethics and professionalism
Brown et al. (2019), in their article ‘Managing the narrative: Investor
relations officers and corporate disclosure’, give some crucial insight into
the role of an IRO – particularly in Tables 2, 7 and 8.
Activity 5.7
Review Tables 2, 7 and 8 in Brown et al. (2019). This article is available in the Online
Library.
1. How important do you feel two-way communication methods are for IROs?
2. Why do you think ‘preparation’ is a key factor in assessment of an IRO’s job
performance by their superiors?
3. Why do you think IROs rank meetings with hedge funds as less acceptable (i.e. less
likely to be granted private access) than other analysts?
5.7 Regulations
Investor Relations Officers are in a powerful position to influence the
markets. By offering information in a timely fashion, withholding
information, offering clarity or creating opaqueness, they can affect how
investors see a firm – and determine whether they see its true value at an
appropriate time.
Prior to the year 2000, it was possible for different investors to obtain and
access different information at different times from companies, depending
on who they were and who they had access to. In October 2000, the SEC
adopted a new rule: Regulation Fair Disclosure (or RegFD for short).
The main aim of Reg FD was to ensure that, when information is produced
for the purpose of investment, all shareholders are treated equally.
Within the EU, the Market Abuse Directive (MAD) was issued, with
EU members expected to implement local legislation which followed
the directive (this has since been replaced with the EU Market Abuse
Regulation). The directive’s aim was similar to that of RegFD.
43
AC3193 Accounting: markets and organisations
Before the introduction of such legislation, it was possible for corporations
to provide information to closely connected investment institutions and
financial analysts, allowing these parties to ‘beat the market’ and obtain
higher returns on their investments.
This led many IROs to look at how information can be disseminated
electronically. Originally, such information was released via SEC filings
(in the US at least). Today, it is accepted that IROs may make use of the
company website to release information directed at investors, as long as
this pattern has been established.
The adoption of Reg FD also meant that many IROs needed to ensure
CEOs were trained in what information was public and what was not.
Meetings between corporate management and investors/analysts needed
to be controlled very carefully; in fact, there are many documented cases
where IROs and CEOs have simply not answered a question (or have
checked the regulations before answering), to ensure they are not guilty of
breaching Reg FD.
Over the years, analysts have come to understand that obtaining sensitive
information before the markets is unlikely and, indeed, that they should
actively avoid seeking such information. Meetings between IROs and
investors/analysts have therefore become much more about ‘clarifying’
information that is already in the public domain, rather than sharing new
information.
Activity 5.8
Read the following sections from Chapter 6 of Laskin (2021):
• Legal and regulatory environment of investor relations and financial communication
• Regulation FD
How do you think this regulation may need to change in the future?
5.8 Overview of chapter
This chapter has discussed the type of information which is required to be
disclosed by corporations from both a financial and non-financial view. The
chapter has explored the methodologies required by legislation for disclosure
of information, while also illustrating other methods utilised by corporations.
The chapter then explored the importance of the Investor Relations Officer
in communicating information from the corporation. It also considered the
interactions of IROs with the capital markets.
Finally, the chapter explored the issues prior to the year 2000 which
might have allowed certain participants in the capital markets to obtain
information earlier than others and the regulations brought in to prevent
this.
5.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
44
•
describe the importance of, and the role of, an Investor Relations
Officer (IRO) and how their success can be measured
•
explain how the role has changed over time and the reasons behind
these changes
•
describe the importance of the regulatory framework within the
investor relations profession and briefly discuss what is involved.
Chapter 5: Information dissemination
5.10 Test your knowledge and understanding
1. Two-way communication between the capital market investors and
corporations is aided by the investor relations officer. Explain how this
role has evolved over time and justify the skillset required by a modern
IRO.
2. Explain why Regulation Fair Disclosure was required and discuss
some of the complications this legislation has created in disseminating
information to the markets.
45
AC3193 Accounting: markets and organisations
Notes
46
Chapter 6: Key accounting ratios and measures for the capital markets
Chapter 6: Key accounting ratios and
measures for the capital markets
6.1 Introduction
In order to assess an organisation’s potential, an analyst must understand
the company strategy, assess whether that strategy is achievable and
identify the risks if assumptions change.
As such, it should be possible to read financial statements in the context
of a company’s stated strategy and goals and see how those goals are
reflected in both financial performance and stability.
The most well-established methodology for analysing financial statements
is to use ratios. Importantly, ratio calculations means very little in
themselves. It is only by comparing such analytical measures to history
or to (say) industry peers or averages that we can begin to draw some
interesting insights.
This material may be familiar to you from earlier studies. However there
are certain elements specific to capital market participants that you may
not have encountered before; they will form the most important part of
the chapter.
6.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain key metrics which are used to analyse company performance
and the importance of analysing operations
•
calculate key metrics from company to company which will allow for
comparison of performance
•
analyse how a company’s strategy and market position are reflected
within the financial metrics.
6.1.2 Essential reading
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 6th edition. Extracts from Chapter 5.
6.1.3 Further reading
Lee, K. and D. Taylor Financial statement analysis under IFRS. (Financial Edge
Training, 2018) 6th edition. Chapter 6.
6.1.4 References cited
Sainsbury’s plc Annual Report 2022, www.about.sainsburys.co.uk/investors/
results-reports-and-presentations
Tesco plc Annual Report 2022, www.tescoplc.com/investors/reports-resultsand-presentations/annual-report-2022/
Best Buy Co. Inc, Form 10-K, 2021, https://www.sec.gov/Archives/edgar/
data/764478/000076447821000024/bby-20210130x10k.htm
Harvey Norman Holdings Ltd, Year-End Report, June 2021, http://clients.
weblink.com.au/news/pdf/02415189.pdf
47
AC3193 Accounting: markets and organisations
6.2 The foundations of ratio analysis
Ratio analysis involves comparing one number from the financial
statements with another, with the aim that the resulting figure will give
some crucial insight into performance, position, stability or liquidity of
a company. As stated above, looking at such a relationship for just one
company, or for one period in isolation, gives very little insight. Only when
the relationships are analysed with respect to previous accounting periods,
other similar firms across the industry or against an expected/required
benchmark, do ratios show their true value.
You should be aware that there are no regulations, standards or rules
which define ‘ratios’; any relationship which gives insight into a set of
financial statements can be useful for a user of accounts. That said, there
are some common metrics which are used when attempting to understand
a company’s performance within common categories.
Note: when performing ratio analysis, you must take care to use financial
information that is robust and reliable. Scepticism about financial
statements is explored more in Chapters 9 and 10 of this course.
6.2.1 Profitability, performance and growth
When analysing financial statements, you are likely to encounter the
following key metrics.
Return on Equity (ROE)
ROE =
Using accounting measures, this relationship gives an
indication of how much return is being generated for
shareholders compared to the finance which equity
investors have invested in the company.
profit after tax
shareholders ′ equity
It is useful to compare this from year to year to see if
a company is using equity finance wisely and offering
growth. Alternatively, this value can be compared
with other companies to indicate whether the first
company offers better returns than competition
within the same industry.
Lorem ipsum
Investors can also look at this metric to see if
it meets their own minimum requirement when
compared to the risk taken on investing in such a
company.
Return on Equity can be decomposed into further ratios, which can give
greater insight into what drives the company’s ROE. One such method is
the Dupont decomposition.
Return on Equity = Net profit margin × Asset turnover × Asset to equity
Profit after tax
Shareholders’ equity
=
profit after tax
sales
×
sales
total assets
×
total assets
shareholders’ equity
Note that the rules of multiplication mean that the sales cancel each other
out in the first two terms, and the total assets cancel out in the last two
terms, leaving the original calculation: ‘Profit after tax/Shareholders’ equity’.
Net profit margin: The net profit margin indicates, for every $1 of sales made, how
much is left as profit once all costs have been incurred (including
profit after tax
interest and tax expenses).
sales
The higher this percentage, the more a company appears to be
able to control costs compared to the premium charged on sales.
48
Chapter 6: Key accounting ratios and measures for the capital markets
Asset turnover:
sales
total assets
Asset to Equity:
The asset turnover gives an indication of the success a company
can have in utilising its assets to generate sales.
The higher the number, the more sales the company is able to
generate from every $1 invested in assets.
This ratio gives a little insight into the source of finance being
used to fund a company’s operations.
total assets
shareholders’ equity A company’s assets must be funded from a combination of debt
and equity finance. Therefore, the higher this number is, the
more debt finance a company must be using to fund its assets,
and hence its operations.
Conversely, the closer this number is to 1, the more equity
finance is being used instead.
Worked example 6.1
Consider the following two companies and their respective data.
Noble Inc.
Gentry GmBH
Sales
$30.0m
$35.0m
Profit after tax
$1.2m
$2.5m
Total assets
$10.0m
$29.2m
Shareholders’ equity
$8.3m
$17.2m
Other finance
$1.7m
$12.0m
$10.0m
$29.2m
Using this data, we can see that the return on equity appears similar for both
companies:
ROE
Noble Inc.
Gentry GmBH
$1.2
= 14.4%
$8.3
$2.5
= 14.5%
$17.2
But upon further decomposition, we can see that the companies are
achieving this in different ways.
Noble Inc.
Gentry GmBH
Profit margin
4.0%
7.0%
×
Asset turnover
3.0 times
1.2 times
×
Asset to equity
1.2 times
1.7 times
=
ROE
14.4%
14.5%
These calculations show that the main driver of Noble Inc’s ROE is high
asset turnover. As such, Noble Inc is able to generate higher than normal
revenue from their assets. In other words, the company uses its assets more
effectively to generate revenue. This can be interpreted as a measure of
efficiency.
Gentry GmBH on the other hand, generates revenue less effectively; it
achieves a 14.5% ROE by focusing on cost control, as evidenced by the
higher profit margin. Also assisting the ROE is the fact that Gentry GmBH
utilises more debt to generate performance. This debt appears to be
serviceable as evidenced by the higher profit margin.
49
AC3193 Accounting: markets and organisations
6.2.2 Efficiency of utilising resources
Asset management is a key indicator of a firm’s effectiveness in utilising
the resources which have been made available to it. We touched on this
type of analysis above, when looking at the turnover of total assets in the
ROE decomposition. The focus of this analysis is not necessarily on profit,
but instead on the effectiveness with which management use resources.
This can be assessed by looking at working capital (i.e. current assets less
current liabilities) as well as non-current assets.
Net working capital to
sales:
net working capital
revenue
Net working capital
turnover:
revenue
net working capital
Days receivable:
This ratio allows users of accounts to see how many
cents need to be invested in working capital per $ of
revenue generated.
The lower this ratio, the more effectively a company is
utilising its short term resources.
Conversely, net working capital turnover tells us how
many $ of revenue are generated for every $ invested
into working capital.
This tells us the same information but from a different
angle. Here, a higher number suggests that a company
is better at utilising its short term resources.
This ratio gives an indication of how successful a
company is at collecting cash after the point of sale.
accounts receivable × 365 days
This figure represents the average time taken for the
revenue
company to collect debt. The shorter this time period
is, the quicker a company is at realising cash after a
sale.
Days payable:
accounts payable × 365 days
cost of sales
Inventory days:
inventory × 365 days
cost of sales
50
Similar to days receivable, this ratio indicates how long
an organisation takes, on average, to pay its suppliers.
It could be argued that the longer this ratio is, the
more effectively a company is managing its working
capital. This is because, the longer this period is, the
longer finance is retained inside the business before
being used to settle a liability.
This ratio gives an indication of how long a firm takes
to sell an ‘average’ item of inventory.
Shorter numbers indicate that a firm is effectively
turning over inventory more quickly and is therefore
being more efficient with its resources.
Chapter 6: Key accounting ratios and measures for the capital markets
Worked example 6.2
Look at these extracts from a company’s financial statements:
£’000
£’000
Revenue
3,200
Trade receivables
260
Cost of sales
1,900
Inventory
180
Gross profit
1,300
Trade payables
235
Receivable days =
260
365 = 29.7 days
3200
Inventory days =
180
365 = 34.6 days
1900
Payable days =
235
365 = 45.1 days
1900
This company takes approximately 34.6 days to sell inventory, and then
29.7 days to receive cash from customers. Therefore, in total, it takes 64.3
days for the company to turn an average purchase of inventory into cash
received.
In comparison, the company is paying for those supplies after an average of
45.1 days.
This suggests that the company needs to finance 19.2 days worth of
operations from its own sources of finance. This is known as the ‘cash
conversion cycle’ (sometimes referred to as the working capital cycle).
Cash conversion cycle = Receivable days + Inventory days – Payable days
6.2.3 Liquidity ratios
Liquidity ratios allow users to understand the financial stability of an
organisation, by considering whether the organisation is able to meet its
current obligations with the resources which are available to it. The higher
the ratio, the more likely it is that an organisation can continue to trade
comfortably.
Current ratio:
current assets
current liabilities
This ratio simply looks at assets which are likely to be
realised into cash within the next twelve months (i.e.
utilised to meet forthcoming obligations). A value greater
than 1 suggests that the company should be able to meet
obligations as long as its current assets can be realised.
Quick ratio:
This ratio is very similar to the current ratio. However, it looks
at whether the organisation can meet its current obligations
current assets – inventory
without the need to sell inventory (since inventory is
current liabilities
considered to be the least liquid of current assets).
Again, a value greater than 1 suggests a more financially
stable organisation.
Cash ratio:
This takes the previous ratios one step further and assesses
whether an organisation is able to meet its current
cash and cash equivalent
obligations from cash reserves. This removes the need to
current liabilities
realise cash from other current assets.
Once again, a value of 1 can act as a benchmark for a
company which is more financially stable.
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AC3193 Accounting: markets and organisations
6.2.4 Long term solvency
Beyond short term survival, it is important for many market participants to
understand whether a firm is likely to survive in the long term. One way
to assess this risk is to consider the sources of long-term finance that an
organisation uses/relies upon and assess whether the obligations which
come with this can be met by the organisation.
Debt to Equity ratio:
total debt
shareholders’ equity
Debt to Capital ratio
total debt
total debt + shareholders’ equity
These two ratios, although different,
offer the same analysis. They reflect the
reliance upon debt compared to equity
sources of finance.
Since sources of debt finance carry the
obligation to meet finance payments,
higher values may indicate a company
which is at greater risk of being unable to
meet these payments.
Interest cover (earnings method):
When coupled with the ratios above,
these interest cover ratios give further
operating profit
insight into whether a company is
finance expense
generating sufficient income from
its performance to meet financial
Interest cover (cash flow method):
obligations. As this number approaches
1, an organisation is at greater risk of
cash flow from operations (before interest)
defaulting on required payments.
interest paid
Activity 6.1
Read the following sections from Palepu et al. (2022):
• Introduction
• Ratio analysis
• Measuring overall profitability
• Decomposing profitability: Traditional approach
• Evaluating investment management: Decomposing asset turnover
• Evaluating financial management: Financial leverage
6.3 Isolating operational analysis
In finance, we generally like to separate operating analysis from the
analysis of capital structure (i.e. the chosen mix of debt and equity). This
is because the two analyses are very different in nature. For example,
assessing an airline’s operations entails looking at issues such as airport
hubs, fleet management and pricing mix. In contrast, exploring capital
structure ignores these issues and looks at the profile of cashflows
available to service different levels of debt. Therefore, in the capital
markets, users often want to isolate operating analysis and deal with
capital structure issues separately.
To illustrate this idea further, let us consider the two UK-based
supermarkets Tesco plc and Sainsbury’s plc. Figure 6.1 shows the income
statements of the two companies from 2021.
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Chapter 6: Key accounting ratios and measures for the capital markets
Tesco plc
Sainsbury’s
plc
Continuing operations
Revenue
61,344
29,895
Cost of sales
(56,750)
(27,529)
Impairment reversal on financial assets
39
Gross profit/(loss)
4,633
2,366
Administrative expenses
(2,073)
(1,430)
Other income
220
Operating profit/(loss)
2,560
Share of post-tax profits of joint ventures and associates
15
1,156
Finance income
9
20
Finance costs
(551)
(322)
Profit/(loss) before tax
2,033
854
Taxation
(510)
(177)
Profit/(loss) for the year from continuing
operations
1,523
Discontinued operations
Profit/(loss) for the year from discontinued operations
(40)
Profit/(loss) for the year
1,483
677
Figure 6.1: Financial statements of Tesco plc and Sainsburys plc.
(Source: data from Tesco plc and Sainsbury’s plc 2022 annual reports)
We can see that, although these companies would both be considered as
‘grocery stores’, they generate earnings in slightly different ways.
Sainsbury’s plc generates £220m of ‘other income’, which represents
25.8% of the pre-tax profit. Tesco does not have an equivalent line. On the
other hand, Tesco plc generates £15m of earnings from investments and
also generates £39m of earnings due to a reversal of an impairment on
financial assets.
It is also clear that the two companies’ earnings are impacted differently
by their financing. Sainsbury’s finance costs make up 1.1% of their overall
pre-tax costs while Tesco’s finance cost is only 0.9% of their overall pre-tax
costs.
If an analyst wished to understand which ‘grocery store’ is performing
better, it might be useful for them to look only at the performance of each
company’s operations and related net assets. In other words, an analyst
who focuses on a specific sector (in this case food retail) would be most
interested in the ‘food retail’ performance of both companies. This is not
to say they will ignore other items – such as interest (which is financing
rather than operating) or impairments; rather, they will deal with those
separately from their core focus on the food retailing business.
To do this, they must take the financial statements and remove the impact
of financial investments and borrowings to generate net operating profit
after tax. Be wary: this is not always simply the ‘operating profit’ taken
from the income statement (as can be seen by the fact that Tesco includes
a gain on reversing a financial asset impairment above the gross profit
line) – see Figure 6.2.
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AC3193 Accounting: markets and organisations
Profit or loss
$XXX
Less:
Post-tax investment income
$X × (1 – t)
Post-tax interest income
$X × (1 – t)
Post-tax ‘one off’ incomes
$X × (1 – t)
Add back:
Post-tax interest expense
$X × (1 – t)
Post-tax ‘one off’ expenses
$X × (1 – t)
$XXX
Net Operating Profit After Tax (NOPAT)
Figure 6.2: Calculating net operating profit after tax.
The analyst should also analyse the balance sheet and only take into
account assets which are used in core operations and liabilities created
because of those operations. Financial assets, financial liabilities,
investments and even ‘excess cash’ should be excluded as they are not
required for the core operations of a business (see Figure 6.3).
Note: Excess cash is deemed to be cash which is over and above the ‘normal’
amount needed to fund operations. This may be difficult to know with
precision; however an analysis of similar companies’ cash balance to sales
ratio may indicate if a company holds more cash than required.
Net Operating Working Capital
Current Assets
$XXX
Excluding: Excess Cash
Less:
Current Liabilities
($XXX)
Excluding: Current debt
PLUS
Net Non-Current Operating Assets
Non-current operating assets
$XXX
Less:
Non-interest bearing Non-Current liabilities
($XXX)
Net Operating Assets
$XXX
Figure 6.3: Calculating net operating assets.
Knowing these two figures allows an analyst to calculate Return on Net
Operating Assets (RNOA) rather than just ROE. This gives a greater level
of insight into a company’s operational performance.
Worked example 6.3
The following data has been extracted from the Sainsbury’s plc and Tesco
plc financial statement. The operating profit has been taken and adjusted
accordingly to present a Net Operating Profit after Tax (Figure 6.4).
54
Chapter 6: Key accounting ratios and measures for the capital markets
Tesco plc
Sainsbury’s plc
1,483
677
Post tax investment income
(40)
-
Post tax finance income
(7)
(16)
Post tax finance expense
413
255
One off loss on discontinued operations
40
Profit/(loss) for the year
Less:
Add back:
(Note: This loss is presented post tax in the SPL)
Net operating profit after tax
1,889
916
Figure 6.4: Calculation of NOPAT for Tesco plc and Sainsburys plc.
This has assumed the ‘other income’ within the Sainsbury’s accounts is still
operational by nature.
Note: To achieve the same figure more quickly, you can start with the Operating
Profit (which is pre-tax), adjust for anything which is needed appearing above this
line, and then multiply the result by (1 – effective tax rate). For Tesco:
(£2560 − £39) × (1 − 25%) = £1889
The Net Operating Assets can then be obtained by extracting the appropriate
figures from the balance sheet. Note how this differs from the traditional ‘net asset’
figure (see Figure 6.5).
Operating working capital
Tesco plc
Sainsbury’s plc
Inventories
2,339
1,797
Trade and other receivables
1,263
683
Current tax assets
93
Cash and cash equivalents
2,345
825
(9,181)
(4,546)
Current tax liabilities
(11)
(169)
Provisions
(283)
(100)
(3,435)
(1,510)
Goodwill and other intangible assets
5,360
1,006
Property, plant and equipment
17,060
8,402
Right of use assets
5,720
5,560
Trade and other receivables
159
65
Deferred tax assets
85
Less:
Trade and other payables
Net non-current operating assets
Less:
Trade and other payables
(53)
(24)
Deferred tax liabilities
(910)
(806)
Provisions
(183)
(171)
27,238
14,032
Net operating assets
23,803
12,522
15,644
8,423
vs
Net assets
Figure 6.5: Net Operating Assets and Net assets for Tesco plc and Sainsbury’s plc.
55
AC3193 Accounting: markets and organisations
We can then see how the traditional ROE differs from the RNOA (Figure 6.6).
Tesco plc
Sainsbury’s plc
ROE
9.5%
8.0%
RNOA
7.9%
7.3%
Figure 6.6: ROE and RNOA for Tesco plc and Sainsbury’s plc.
These calculations reveal something of interest. We can see that Tesco plc
is generating a higher ROE than Sainsbury’s plc. However, in terms of their
core operations, the return generated is much more similar. As such, we may
conclude that these two companies are operationally comparable, even if
Tesco plc generates further return from its financing/investing activities.
Activity 6.2
Study Table 5.3 from Chapter 5 of Palepu et al. (2022). Then answer the following
questions.
1. How does the ROE of H&M compare to that of Inditex and other peers?
2. Compare and contrast the RNOA of the different companies. What conclusions can
you draw from this about the performance of each company as a fashion retailer?
6.4 The need for standardised data
As discussed above, a single financial ratio calculated alone means very
little. To gain insights, we need to compare these metrics over time, from
company to company, or from industry to industry. This does, however,
create problems.
Not all financial statements follow the exact same format. For example, the
statements of companies that follow accounting standards under USGAAP
will look different to those produced following IFRS. As such, it may be
difficult to compare the ratios described above.
In addition, companies may have one-off balances and transactions which
need to be excluded or presented in isolation so we can see what the
figures look like without these non-recurring events. If such adjustments
are not made, ratio movements may look unusual; ratio analysis could
suggest that a company’s performance and position have moved – either
favourably or adversely – even though the opposite is actually the case.
To attempt to solve this problem, it is useful to ‘standardise’ the financial
statements before calculating financial ratios.
Simply put, this involves rewriting the financial statements into an
order which suits the party performing the analysis, and categorising
transactions and balances into simpler categories. There is no one way of
doing this; the approach an analyst takes will depend on the companies
they are looking at and the particular aims of their analysis.
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Chapter 6: Key accounting ratios and measures for the capital markets
Worked example 6.4
Best Buy Co. Inc is a consumer retailer of electronics with more than 1,000
stores across the USA and Canada. The company follows USGAAP. Harvey
Norman Holdings Ltd is a large national retailer of electrical products (and home
furnishings), based in Australia but with stores globally. The company prepares
accounts following Australian Accounting Standards and local legislation.
The unadjusted income statements, as prepared under their respective
jurisdictions, are shown in Figures 6.7 and 6.8.
Fiscal year ended
January 30, 2021
Revenue
$
47,262
Cost of sales
36,689
Gross profit
10,573
Selling, general and administrative expenses
7,928
Restructuring charges
254
2,391
Operating income
Other income (expense):
Gain on sale of investments
1
Investment income and other
37
Interest expense
(52)
2,377
Earnings before income tax expense
Income tax expense
579
Net earnings
$
1,798
Figure 6.7: Unadjusted income statement for Best Buy Co. Inc.
(Source: Data from https://www.sec.gov/Archives/edgar/
data/764478/000076447821000024/bby-20210130x10k.htm)
June 2021
$000
Note
Sales of products to customers
3
2,768,328
Cost of sales
(1,838,365)
Gross profit
929,963
Revenues received from franchisees
3
Revenues and other income items
3
1,345,782
324,521
Distribution expenses
(49,971)
Marketing expenses
(377,639)
Occupancy expenses
3,13,15
(243,066)
Administrative expenses
4
(637,583)
Other expenses
(67,585)
Finance costs
4,19
(50,213)
Share of net profit of joint venture entities
27
8,320
Profit before income tax
Income tax expense
Profit after tax
1,182,529
5
(335,684)
846,845
Figure 6.8: Unadjusted income statement for Harvey Norman Holdings Ltd.
(Source: Data from http://clients.weblink.com.au/news/pdf/02415189.pdf)
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AC3193 Accounting: markets and organisations
It can be seen that, although the data is similar, it is presented slightly differently.
This makes it difficult to calculate ratios or to compare performance or financial
stability. The statements can be standardised in the following way.
• Consider the proforma for a standard/normal income statement.
• Classify each item in the unadjusted income statements so that it ‘best fits’
into a logical part of the standard proforma. (Ensure you are consistent from
company to company.)
• Calculate the subtotal of each proforma line item and re-prepare the income
statement using this new format.
By following these steps, an analyst will produce a statement similar to that in
Figure 6.9.
Best Buy Co. Inc
2021
HNH Ltd
2021
Revenue
47,262
2,768
Cost of sales
(36,689)
(1,838)
Gross profit
10,573
930
Selling, general and admin expenses
(7,928)
(1,308)
Net other operating income/expense
(254)
1,603
Operating income
2,391
1,225
Net non-operating income/expense
38
8
Net interest expense
(52)
(50)
Pre-tax income
2,377
1,183
Tax expense
(579)
(336)
Net earnings
1,798
847
Figure 6.9 Standardised income statements for Best Buy Co. Inc and Harvey
Norman Holdings Ltd.
This will allow the analyst to generate ratios such as profit margins and interest
cover for the two companies on a like-for-like basis.
Activity 6.3
Obtain the financial statements of Apple Inc and Samsung Electronics Co Ltd from the
investor section of their websites. Attempt to standardise the income statements so that
they are in the same format.
Note: Cengage (the publisher of the core text Palepu et al. (2022) has some material
available online that may help you to produce standardised accounts using Excel
functionality. This would make the process quicker if you were required to standardise
multiple accounts over multiple years.
Visit www.cengage.uk/ to find out more.
6.5 Capital market metrics
The above ratios can all be used by analysts to ensure they understand
the financial performance and position of a company from its financial
statements. Those involved in making investments and offering advice will
need to go further, exploring investment ratios such as dividend yield and
earnings per share. The key investor ratios are outlined below.
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Chapter 6: Key accounting ratios and measures for the capital markets
Earnings per share (EPS): This is a key metric which allows investors to see the
magnitude of return they obtain for each individual share
earnings
they own.
number of ordinary shares
Care must be taken when looking at the number of
shares in issue in case a historic bonus issue could skew
the data.
USGAAP and IFRS require listed entities to calculate and
present this value on the face of the income statement.
Earnings yield:
EPS
share price
This allows investors to see the proportional return a
company is generating compared with the value tied up
within the share.
Although a company may have a growing EPS, if the
share price is outgrowing this, then the yield will be
dropping.
This relative measure may therefore be more insightful
and a better metric to compare from company to
company.
Dividend yield:
dividend per share
share price
Although earnings yield can give a good indication of a
company’s ability to generate a return, it does not reveal
the cash return that an investor is likely to obtain since
companies may choose not to pay out 100% of the
earnings figure.
The dividend yield is therefore a better metric as
investors can see how much they are likely to obtain in
cash terms from having an investment in a company.
PE ratio (P/E ratio)
share price
earning per share
This ratio is the inverse of the earnings yield. It gives an
indication of how much investors are willing to pay for
$1 of current earnings.
For example, a PE ratio of 9 suggests investors are willing
to pay $9 today for $1 of current earnings.
This is an indicator that investors see potential in future
earnings. The higher the metric, the more the markets
must believe the company’s future holds good prospects.
Activity 6.4
Using either Google finance (Google.com/finance) or Yahoo Finance (finance.yahoo.com),
search for a number of companies who operate in the same industry. Can you see that
the metrics above have been calculated and presented for you?
Which metrics are missing, so you would need to calculate them for yourself?
6.6 Non-GAAP metrics
Within Chapter 2, we explored the need for regulated accounting
standards. Capital market participants require comparable data from
one company to another as this is crucial for understanding. Without
consistency, it would be difficult to trust financial information.
In recent years however, some company management teams have
recognised that these standards do not always allow them to capture the
unique nature of their individual company. As a result, many companies
choose to offer guidance on their performance using different metrics –
non-GAAP metrics.
59
AC3193 Accounting: markets and organisations
Some of the largest companies listed on US stock exchanges use non-GAAP
metrics to discuss performance. For example:
•
Walmart Inc. reports Return on Investment (ROI) and Return on
Assets (ROA) within its SEC filings.
•
Amazon.com Inc reports what it deems to be its ‘free cash flows’.
•
CVS Health Corporation reports an adjusted operating income and
adjusted EPS.
•
United Health Group Incorporated reports an adjusted
operating income and adjusted EPS, but only in its quarterly earnings
release (not within the SEC filings).
•
Exxon Mobil Corporation reports an adjusted earnings figure.
•
Berkshire Hathaway Inc reports and comments on the ‘gain in
float’ (a term it defines).
•
Alphabet Inc reports a ‘constant currency’ revenue figure and the
growth of this metric.
It is interesting to see, however, that Apple Inc chooses not to make any
additional non-GAAP metrics available.
Activity 6.5
Research a selection of the above companies’ SEC filings (10-Ks and 10-Qs), available on
their Investor Relations webpages or via the ‘SEC Edgar search and access’ function.
Find the discussion behind these metrics; read why management have chosen to disclose
these metrics and why they are considered important.
Assess the possible dangers of relying on these metrics for third parties such as analysts
or shareholders.
6.7 Overview of chapter
This chapter has covered numerical analysis that analysts could perform
on company financial statements in order to obtain insights into how
the company is performing. Particular attention has been paid to the fact
that comparison – to other companies, to historical performance or to
expectations – is crucial to such analysis.
The chapter has further highlighted the need to break down the overall
analysis into constituent parts, so that an analyst can see the company’s
successes and failures in a granular way. This includes decomposing
‘return’ metrics as well as attempting to see overall performance compared
to performance of the core operations of a company.
The chapter concludes with a review of common metrics used in the
capital markets to consider whether companies are offering the markets an
appropriate level of return.
6.8 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
60
•
explain key metrics which are used to analyse company performance
and the importance of analysing operations
•
calculate key metrics from company to company which will allow for
comparison of performance
•
analyse how a company’s strategy and market position are reflected
within the financial metrics.
Chapter 6: Key accounting ratios and measures for the capital markets
6.9 Test your knowledge and understanding
Luke & Laing (L&L) and LAZD are two publicly listed home furnishing retail
stores in the UK. L&L has smaller operations and is located only in affluent
areas based in the South East of England. Its stores are only located on busy
high streets. LAZD on the other hand operates nationally, with much larger
stores in out of town retail areas.
The following information is taken from the companies’ 2022 financial
statements.
Revenue
Luke & Laing
LAZD
£000s
£000s
2,000
32,000
Cost of sales
920
26,500
Gross profit
1,080
5,500
Cash and cash
equivalents
90
1,400
Trade receivables
50
300
Inventory
340
540
Other current assets
30
320
Trade payables
70
1,900
Other current liabilities
20
300
1,130
22,400
640
12,700
PP&E
Intangible assets
Based on the reported information above, which company is more efficient
at utilising its resources?
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AC3193 Accounting: markets and organisations
Notes
62
Chapter 7: Accounting information in action I: Valuation multiples
Chapter 7: Accounting information in
action I: Valuation multiples
7.1 Introduction
As we have seen in previous chapters, buy side and sell side analysts
are key players in the capital markets. To be able to offer advice about
whether stocks represent buying or selling opportunities, they need an
understanding of the value of the firm.
In this chapter and the next, you will be introduced to two valuation
models which can be used to understand share valuation. It is worth
noting that analysts use a number of different models to estimate
valuation. Some of these models make explicit use of accounting
information and so are the focus of this module.
7.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the conceptual methodology for valuing entities using a range
of metrics known as ‘multiples’
•
discuss the importance of choosing a ‘comparable company’ and
critique the use of proxy firms in valuations
•
calculate the value of a company using equity multiples and enterprise
value multiples
•
analyse whether a company may be over- or undervalued through the
use of multiple data.
7.1.2 Essential reading
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 6th edition.Extracts from Chapter 7.
7.1.3 Further reading
Antill. N, K. Lee and D. Taylor Company valuation under IFRS. (Harriman
House, 2020) 3rd edition. Chapter 1.
7.2 Equity value vs enterprise value
Before we begin to explore how financial information can be used to drive
an understanding of the value held within a company, it is important
to ask the question ‘What are we valuing?’. Only if we can answer this
question will some of the following techniques make sense.
A rudimentary way of valuing a company may be to ask the question:
‘How much must I pay to own the company?’ A simple answer to this
would be to state that it would depend on the share price: as long as
you own the shares in the company, you own the company. This may not
represent the value of the company, however.
Imagine, if you will, two entrepreneurs each starting a business. Assume
that they have similar ideas and the companies they wish to create will
operate in almost exactly the same way. (Perhaps also assume that the
market is large enough for both companies to grow without impacting
each other.)
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AC3193 Accounting: markets and organisations
Say entrepreneur 1 begins their business by investing £1,000 for 1,000
shares, whereas entrepreneur 2 begins by investing only £100 for 100
shares and also borrowing £900 from a family friend.
Now move forward in time by one year. Let us suggest that entrepreneur
1 has taken out dividends over the year which have been equivalent to the
interest paid by entrepreneur 2 to their family friend. Let us also assume
that their success has been identical. The two companies have identical
revenues, identical costs and identical investments into assets.
Clearly, the two companies’ operations are identical and so they should
be valued the same. However, the allocation of the value will differ. In
entrepreneur 1’s company, all the value belongs to the shareholders; thus
it will have a large equity value and no value allocated to debt holders. For
entrepreneur 2’s company, even if the overall value is identical, the equity
value will be much lower because there is a high proportion of debt. From
this we can conclude that there is an important difference between the
value of the operations and the value of the shares.
For this reason, we must differentiate between what is known as
‘Enterprise Value’ and ‘Equity Value’:
•
Enterprise value is representative of the value of the operations of a
business, regardless of how those operations are financed.
•
Equity value represents the residual ownership of the business once
all other finance has been repaid.
Enterprise value and equity value would only be the same in a business
with no debt. It is important for analysts to be able to move from one
measure of value to the other through what we refer to as the ‘enterprise
value bridge’ (see Figure 7.1).
Non-core/
nonoperational
assets
Enterprise
value
e.g
excess
Non-core/
cash
non-held,
investments
operational
on other
assets
company
Non-operational
liabilities
e.g noncontrolling
interest
Figure 7.1: The enterprise value bridge.
64
Debt finance
e.g
debentures,
preference
shares, loans
Equity
value
Chapter 7: Accounting information in action I: Valuation multiples
Worked example 7.1
A company has determined its value of operations as £2.4 billion.
It has short term debt of £4.8 million and long term debt of £51.1 million.
On average it holds £3.2 million of excess cash and also holds £0.7 million
of investments.
If the company has 200 million outstanding shares, what is the implied
share price?
Note: The enterprise value is considered to be the value of operations, but
it is not only operations which bring value to a company. The business may
have investments and ‘excess cash’ which also have value.
Remember: Excess cash is cash that is surplus to operational
requirements.
Once we add these values, we have the total value of the company.
However, not all of this value can belong to the equity investors if debt
exists. We must therefore subtract from this value any ‘non-operational’
debt.
Remember: Any operational liabilities will already be captured in the
enterprise value.
Enterprise value
£2,400,000,000
Plus: excess cash
£3,200,000
Plus: non-operating investments
£700,000
Less: short term debt
(£4,800,000)
Less: long term debt
(£51,100,000)
Equity value
£2,348,000,000
£2,348,000,000
Implied share price = 200,000,000 = £11.74
Worked example 7.2
A company’s current share price is £11.74.
It has short term debt of £4.8 million and long term debt of £51.1 million.
On average it holds £3.2 million of excess cash and also holds £0.7 million
of investments.
If the company has 200 million outstanding shares, what is the value of its
operations?
Total equity value = £11.74 × 200,000,000 = £2,348,000,000
Equity value
Less: excess cash
£2,348,000,000
(£3,700,000)
Less: non-operating investments
(£900,000)
Plus: short term debt
£4,800,000
Plus: long term debt
£51,100,000
Enterprise value
£2,400,000,000
As we move through the rest of this chapter and Chapter 8, it is important
to recognise that the techniques we use may be valuing equity or
enterprise value. Either way, we should always be able to move from one
to the other.
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AC3193 Accounting: markets and organisations
Activity 7.1
Using a set of financial statements from a company you have researched so far, attempt
to see which figures you would need to add and subtract from the equity figure to
determine the enterprise value.
How would the following be treated?
• Lease liabilities
• Non controlling interest
• Pension liabilities
• Deferred tax
7.2 Introduction to multiples
As discussed above, when valuing a business, we may choose to value
its equity or its operations (enterprise value). We can now move on to
consider the concept of a ‘multiple’.
In essence, a multiple is a ratio of one company metric compared to
another. The standard form of a multiple is a valuation number divided
by an accounting number. For example, imagine we are looking at a
company’s balance sheet. We might wish to compare its book value with
its market value – i.e. to assess how the market value of the company
compares with the numbers on the balance sheet. We can use a multiple to
make this comparison.
Remember that a multiple consists of a valuation number divided by an
accounting metric. Here we would divide the share price (the valuation
number) by the book value (the accounting number), to form what is
commonly known as the ‘price to book’ multiple.
Worked example 7.3
AB Corporation is currently trading at $0.70 per share. It has net assets of
$6.2m and 20 million ordinary shares in issue.
Net asset per share = $6.2m = $0.31 per share.
20m
$0.70
As such, the share price to book value (P/B) = $0.31 = 2.3 times.
In isolation, a P/B multiple of 2.3× tells us that the market values the
company well above its book value. Why might this be? The market
value will reflect many things about the future of the company whereas
the financial statements mainly capture what has happened already. We
could interpret this 2.3× multiple as a positive signal that the market is
expecting the company to generate future profits and add value in the
future beyond the existing book value.
We can further analyse multiples by comparing them with historic values
and with peer companies. By looking at AB Corporation’s P/B multiple
in the context of its competitors and history, we can begin to understand
whether it is overvalued or undervalued in comparison with other
companies.
Several common metrics are used and these can be classified under two
categories:
66
•
equity multiples
•
enterprise value multiples.
Chapter 7: Accounting information in action I: Valuation multiples
7.3 Equity multiples
When looking at how value is linked with performance, it is important
to ensure we are comparing like with like. To maintain the integrity of
our calculations, we must ensure that both elements of the multiple – the
valuation number and the accounting number – are consistent. So, for
an equity multiple, the valuation number will be equity value (in total or
per share) and the accounting number should also be an equity number
(e.g. net income/profit after tax or book equity).
If we analyse a company’s financial statements, it will become clear which
financial measures an equity holder is linked to (see Figure 7.2).
Revenue
Cost of sale
Gross profit
£’000
12,672
(5,953)
6,719
Administative expenses
Distribution expenses
EBIT
(3,357)
(1,356)
2,006
Finance costs
EBT
(61)
1,945
Income tax
Earnings
£’000
ASSETS
Non-current assets
Current assets
LIABILITIES
Current liabilities
Non-current liabilities
(296)
1,649
5,744
3,136
8,880
2,167
1,225
3,392
NET ASSETS
5,488
EQUITY
5,488
Linked to
equity
Figure 7.2: Financial measures linked to equity.
Since earnings and net assets are attributable to equity shareholders, it is
reasonable to look at how each of these metrics compares to a share price.
As such, two common equity multiples are used:
Price/Earnings ratio
Also known as the P/E ratio, this compares a company’s
share price with the company’s earnings per share.
The higher the multiple, the more the markets appear to
be willing to pay for one dollar of current earnings.
A higher P/E ratio could therefore indicate that the market
sees greater potential in a company’s future earnings.
Price/Book value ratio
Also known as the P/B ratio, this calculates price per
share versus net assets per share (also known as book
value per share).
The higher the multiple, the more the market must be
taking into consideration value which is not recorded in
the balance sheet (e.g. from potential future earnings or
unrecorded intangible assets).
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AC3193 Accounting: markets and organisations
Activity 7.2
Search for the following companies on Yahoo finance (finance.yahoo.com):
• Lululemon Athletica Inc (LULU)
• Under Armour Inc (UAA)
• Levi Strauss & Co (LEVI)
• Columbia Sportswear Company (COLM)
Use the data available to answer the following questions:
1. What P/E ratios do the four companies have?
2. What does this tell you about what investors think about the four companies?
When using equity multiples to understand companies, it is important to
be aware of possible fundamental differences between companies which
could influence the ratios and, as a result, distort comparisons.
It is advisable to consider the following key questions:
Do the companies have similar capital structures?
If the companies are financed differently, this will distort equity multiples.
A company with lots of debt will have lower earnings (due to higher
interest) and, all other things being equal, a higher P/E. Thus companies
operating in a similar industry and with similar operations may have
different P/E ratios.
This is also true for the P/B ratio. Two companies may have very similar
operations but a company with a greater level of debt will have a different
net asset value as a result.
Do the companies have similar accounting policies?
This again could impact both of these equity multiples. Take for example
the concept of depreciation. If one company depreciates assets on a
straight line basis over 5 years, while a similar company uses reducing
balance at 10% per year, then both their earnings and asset figures will
appear different despite similar operations.
Are the company’s earnings normal?
Multiples are very useful for comparing companies to each other and
comparing one company from year to year. However, we must ensure that
any comparison is like for like. If a company has one-off gains or unusual
expenses in a year, that year may not have a ‘normal’ multiple. As such, it
may be necessary to determine a ‘clean’ earnings figure, excluding nonrecurring income and expenditure. Unfortunately, the identification of
non-recurring income or expenditure can be difficult.
7.5 Enterprise value multiples
As discussed above, there are various challenges when using an equity
multiple. An alternative is to use enterprise value multiples. Such multiples
are not influenced by financial structures (i.e. the chosen mix of debt and
equity). The following performance metrics contribute to enterprise value
multiples.
68
•
revenue
•
earnings before interest and tax (EBIT)
•
earnings before interest, tax, depreciation and amortisation (EBITDA).
Chapter 7: Accounting information in action I: Valuation multiples
Since all of these flows are ‘owned’ by both debt (interest) and equity
holders, the valuation number in the multiple should be the enterprise
value (the value of debt plus the value of equity) – i.e. the value of a
company’s core operations.
EV/revenue
This metric is useful when attempting to compare companies
that are not all profit making (for example, early stage
companies that have not yet made any profits).
Care must be taken however as revenue recognition policies can
vary widely from one company to another.
EV/EBIT
This metric is widely used where an industry is financially
diverse.
EBIT should be ‘cleaned’ to a normalised value so it is not
distorted by one-off impacts.
Care must be taken to ensure that accounting policies are
equivalent, to allow a fair comparison.
EV/EBITDA
This metric is highly relevant for companies that are asset
intensive. In these industries, depreciation/amortisation policies
are highly influential and subjective.
It is worth noting that all of these metrics require us to use the enterprise
value (EV). Remember, this value can be determined by bridging from the
equity value. Other techniques are available to calculate the enterprise
value (such as discounted cash flows) but these are outside the scope of
this course.
Activity 7.3
Using a company from your earlier research, ensure you are comfortable identifying the
revenue and EBIT figures which can be used in the multiples above.
How would you go about determining an EBITDA figure? What figures would you need to
find, and from where could you obtain these figures?
Activity 7.4
The following data has been obtained from Stensgaard Incorporated.
Actual
Year 1 est.
Year 2 est.
Share price ($)
33.2
38.1
41.6
Enterprise value ($m)
34.7
40.7
45.1
Sales ($m)
12.0
12.7
13.8
EBIT ($m)
1.8
1.9
2.2
EBITDA ($m)
1.99
2.2
2.5
Diluted EPS ($)
2.94
3.22
3.71
Calculate the earnings, sales, EBIT and EBITDA multiples against their appropriate ‘value’
for the three periods given.
What is happening over time? Can you determine why this might be happening?
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AC3193 Accounting: markets and organisations
7.6 Turning multiples into valuations
So far, we have seen that we can compare market perception of value from
one company to another by assessing company valuations using a multiple.
For example, if company X is valued at 10× earnings and company Y at
13× earnings, we might conclude that the market has more confidence in
the future prospects of company Y.
This raises the possibility of using valuation multiples to derive a
valuation, by a technique known as a ‘relative valuation’. Such a valuation
is dependent on how the market views similar companies. For example, if
one company is valued at 15× earnings, you might assume that a similar
company has a similar value.
This method of valuation carries particular risks. If the market participants
are overvaluing a particular type of industry, this technique will overvalue
other companies in the same industry. (This was explored in some detail
in Chapter 2, in the context of the Dot Com bubble/crash.) In other words,
this technique assumes that the market is valuing companies appropriately.
There are five key steps in using this method to value a ‘target’ company:
Step 1: Identify comparable companies
Comparable public companies should be of a similar nature to the target
company being valued. It is often difficult to identify a company which is
a perfect match, but the closer the commonality on issues such as industry
and product segments, the better the valuation is likely to be.
To identify comparable companies, it is important to assess company
disclosures such as segmental reporting and company strategy.
Step 2: Calculate comparable multiples
Once we have identified some comparable companies, we need to
calculate the multiples the market is using. For example, we could
calculate a current P/E ratio for each company. Any multiples calculated
based on earnings should be ‘cleaned’ to exclude non-recurring activity.
Step 3: Determine a universal multiple
Next, we should assess the calculated ratios of the selected companies to
identify a fair metric to apply to the target company. It may be that all
comparable companies have similar multiples; in this case, it is likely that
another, similar, company within the industry will have a similar multiple.
In most cases, analysts will calculate an average multiple for a group of
comparable companies. If necessary, they will then make adjustments to
this average to reflect differences between the group of companies and the
company that is being valued.
Step 4: Apply the universal multiple
Once a suitable multiple has been established, we need to apply this to the
target company. For example, a universal P/E ratio can be multiplied by
the target company’s Earnings to value equity.
Step 5: Obtain the desired value
The result of the calculation in step 4 is the implied value of the company.
We must take care, however, to interpret this value correctly. If an equity
multiple has been used, the value represents the equity of the company;
if an enterprise value multiple has been used, the result is the enterprise
value of the company. If an enterprise value multiple has been used, but
the researcher needs the equity value, then a bridge from EV to equity
value must be crossed (see section 7.2).
70
Chapter 7: Accounting information in action I: Valuation multiples
Worked example 7.4
Leopard Skin Incorporated operates within the sports apparel industry,
selling sports clothing and athleisurewear across the United States. The
company’s most recent financial performance is captured in the following
income statement.
$’000
EBIT*
747.4
Finance cost
(16.7)
EBT
730.7
Income tax
(210.4)
Earnings
520.3
*After depreciation and amortisation of $77.7million
Requirement
Using the EV/EBITDA multiple, determine a relative valuation per share for
Leopard Skin Inc.
Answer
Step 1: Identify comparable companies
Similar companies who operate in the same industry as Leopard Skin
include:
Chermelon Inc
WetherSports Fashion plc
Over Steel Inc
Sprint Case Inc.
Step 2: Calculate comparable multiples
We can obtain the following information from the comparable companies’
annual reports. (For simplicity, we have assumed the data is ‘clean’ and
normalised.)
Chermelon
WetherSport
Over Steel
Sprint Case
EBIT
$1,333.9m
£721.1m
$486.3m
$860.0m
D&A
$224.1m
£177.8m
$139.2m
$197.0m
EBITDA
$1,558.0m
£898.9m
$625.5m
$1,057.0m
Enterprise
value
$12,351.0
$124,356.0
$4,466.8
$3,299.0
138.3×
7.1×
3.1×
EV/EBITDA 7.9×
Step 3: Determine a universal multiple
Looking at the data in step 2, WetherSport appears to be an outlier. Further
research should be undertaken to decide whether it should or should not
be included in the analysis.
For this example, it is to be eliminated as a balance which would distort
any final result.
Universal multiple =
(7.9 + 7.1 + 3.1)
= 6.1 times
3
Step 4: Apply the universal multiple
EV
Implied relative value = EBITDA × EBITDA
Implied relative value = 6.1 times × (747.4 + 77.7) = $5,033.10
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AC3193 Accounting: markets and organisations
Step 5: Obtain the desired value
The value obtained represents the enterprise value of the chosen company.
To convert this from EV to equity, we must establish non-core assets and
liabilities.
Assume the following has been researched from the company financial
statements:
Leopard Skin Inc has short term debt of $4.8 million and long term debt
of $51.1 million. On average it holds $3.2 million of excess cash and also
holds $0.7 million of investments.
The company has 200 million outstanding shares.
Enterprise value
$5033.1m
Plus: excess cash
$3.2m
Plus: non-operating investments
$0.7m
Less: short term debt
($4.8m)
Less: long term debt
($51.1)
Equity value
£4,981.1
Value per share =
$4,981.10
= $24.91
200
Activity 7.5
You are attempting to value the equity of Jovial Incorporated using EV/EBITDA multiples
of similar companies.
You have established the EV/EBITDA of four other companies who operate in similar
industries to Jovial Inc.
Company 1
6.6×
Company 2
6.4×
Company 3
6.2×
Company 4
6.0×
Company 5
5.8×
You have also established that Jovial Inc is forecast to generate $1.45 million of EBITDA,
has $3.50 million net debt and has 102 million shares outstanding.
Establish a share price valuation range for Jovial Inc.
7.7 Multiple valuation complications
The process of valuing a company using this relative process appears to be
quite straightforward. However, when researching and obtaining the data
required, you may encounter difficulties in the following key areas.
7.7.1 Obtaining a ‘clean’ number
Company financial statements often record transactions using the
methodology required by the GAAP being followed. This will mean that
one-off transactions appear in an appropriate line in the income statement;
they will not necessarily be shown as a separate item unless required by
the GAAP.
As such, to ensure this technique is as robust as possible, we may need to
read extra detail and notes from annual reports to discover if such unusual
activity has occurred and, if so, what adjustments we need to make to the
published figures.
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Chapter 7: Accounting information in action I: Valuation multiples
Activity 7.6
Using the following information obtained from a target company’s 10-K, prove that the
correct EBIT figure which should be used for an EV/EBIT multiple valuation is $993.00.
Net revenues
$
5,349.1
Cost of sales
2,546.0
Gross profit
2,803.1
Selling, general and administrative expenses
1,727.6
Amortisation expense
82.5
Restructuring costs
93.4
Acquisition-related costs
103.0
Asset impairment charges
2.3
Gain on sales of assets
(20.1)
Operating income
814.4
Interest expense, net
74.4
Loss on early extinguishment of debt
1.1
Other expense, net
27.4
Income (loss) before taxes
711.5
(Benefit) provision for income taxes
(52.2)
Net income (loss)
763.7
7.7.2 Impact of mergers and acquisitions
Most of the multiples analysed within this chapter require the comparison
of valuation with performance. It should be noted, however, that a
valuation represents a moment in time, while performance is measured
over a period of time.
As a result, incidents occurring during the year may mean that the annual
value used is not a fair representation of the company’s performance
during the year.
For example, imagine a company acquires a new subsidiary during the
year. Any market data at the end of the year about the value of the
company (whether equity or EV) will represent the value of the combined
company. In contrast, the performance metric (e.g. EBIT) will partially
represent the period of time before the acquisition and partially the period
afterwards.
7.7.3 Mechanics that do not make sense
Above all, we must remember that valuation techniques are not an exact
science. As such, there may be times when a valuation does not appear
reasonable. At these times, it is important to recognise the limitations of
this methodology, rather than accepting the valuation simply because the
steps were followed correctly to produce a result.
After any valuation, we must take a step back and consider how possible
and how plausible the result is. It is vital to ensure that any valuation
fits with the narrative of the company in question – i.e. its position in the
market, its strategic direction and its financial performance.
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AC3193 Accounting: markets and organisations
Activity 7.7
Read the following sections from Chapter 7 of Palepu et al. (2022).
• Valuation using price multiples
• Main issues with multiple-based valuation
• Selecting comparable companies
• Multiples for firms with poor performance
• Adjusting multiples for leverage
(Further detailed mathematical models of multiples are not required for this module.)
7.8 Overview of chapter
This chapter has introduced the concept of enterprise value as opposed to
equity valuation and considered why an analyst may choose to focus on
one rather than the other.
The chapter has then explored the concept of a ‘multiple’ and, more
importantly, how multiples can be used to assist with the valuation of a
company.
7.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
describe the conceptual methodology for valuing entities using a range
of metrics known as ‘multiples’
•
discuss the importance of choosing a ‘comparable company’ and
critique the use of proxy firms in valuations
•
calculate the value of a company using equity multiples and enterprise
value multiples
•
analyse whether a company may be over- or undervalued through the
use of multiple data.
7.10 Test your knowledge and understanding
1. You are attempting to establish the equity value of one share for
Gandol plc, a company running a chain of hotels.
The following information has been obtained from the financial
statements of Gandol plc.
£’m
EBIT
395.0
Finance expense
(55.0)
340.0
Taxation
(58.0)
EBT
282.0
Depreciation and amortisation total £25.4 million and the company
has net debt of £320.5m and 2000m outstanding shares.
The following company EV/EBITDA multiples have been established.
74
Chapter 7: Accounting information in action I: Valuation multiples
Main activity
EV/EBITDA
Curse Inc
Hotel operations
6.1
Wand GmbH
Hotel and entertainment venues
7.2
Broomstick Pty
Travel and hotel company
4.5
Value a single share of Gandol plc and explain the reasoning behind
your valuation technique.
2. Explain the difficulties in identifying a comparable company when
using the P/E ratio multiple to value a company.
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AC3193 Accounting: markets and organisations
Notes
76
Chapter 8: Accounting information in action II: Residual income valuation
Chapter 8: Accounting information in
action II: Residual income valuation
8.1 Introduction
In the previous chapter, we looked at a valuation technique known as
relative valuation using multiples. This method enables us to value a
company based on the value of another similar company using information
from the financial statements. Financial statement information can also be
used to establish an estimate of intrinsic value – an analyst’s estimate of
the ‘true’ value of the firm.
There are multiple techniques available for analysts to determine an
estimate of intrinsic value. However, we are primarily interested in
techniques which use accounting information as their key driver. In this
chapter, you will be introduced to the concept of ‘residual value’, what it is
and how it can be used to understand the value of a company.
8.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the nature of a company’s ‘abnormal’ profit, how it is
calculated and the difficulties and assumptions in its use
•
explain the concept and rationale behind using residual income in
valuation and the advantages and disadvantages of the technique
•
calculate the value of a company using residual income.
8.1.2 Essential reading
Palepu, K., P. Healy and E. Peek Business analysis and valuation. (Cengage
Learning EMEA, 2022) 6th edition. Extracts from Chapter 7.
8.1.3 Further reading
Srinivasan, S., B. Cheng and E. Riedl ‘Coca-Cola: residual income valuation
exercise’, Harvard Business School Exercise 113–056, 2012.
8.1.4 References cited
Gordon, M.J. and E. Shapiro ‘Capital equipment analysis: the required rate of
profit’, Management Science 3(1) 1956, pp.102–10.
Ohlson, J.A. ‘Earnings, book values and dividends in security valuation’,
Contemporary Accounting Research 11(2) 1995, pp.661–687.
Annual report of Pearson plc, 2021 (https://plc.pearson.com/investors)
8.2 Core concepts of intrinsic valuation
Accounting information and valuations are inherently linked, although
it can sometimes be difficult to see this clearly. Before considering how
accounting information can be used, it is important to review key aspects
of the core valuation techniques. All these techniques ultimately rely on
the concept of ‘cash flow’.
Approaches to valuation in finance theory consider that the value of any
asset is represented by the present value of future free cashflows. This can
be stated formally as:
value of a company = present value of future cashflows
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AC3193 Accounting: markets and organisations
To apply this in practice, the analyst must resolve a number of issues:
•
What discount rate should we use to establish present values?
•
How long into the future do we need to forecast cashflows for?
•
How can we estimate what the future cashflows are going to be?
•
Which cashflows should we include/exclude?
When attempting to answer these questions, it is common to start by
examining dividend flows. The only ongoing cashflows that equity
investors receive are the dividend cashflows the company is expected to
pay out. We can therefore say:
value of a company (P0) = present value of future dividends (D)
This can be considered as the sum of an ongoing stream, represented as
follows (where ‘r’ is the discount rate required):
2
3
4
5
n
1
+
+
+
+
+ ⋯+
2
3
4
5
(1 + r) (1 + r)
(1 + r)
(1 + r)
(1 + r)
(1 + r) P0 =
This is called the Dividend Discount Model (DDM).
Unfortunately, unless we are going to spend a lot of time considering what
a company’s dividend might look like in 50 years’ time, this formula does
1
not seem particularly useful. It should
also be noted that a dividend in
50 years’ time is unlikely to have much value in current terms once it has
been discounted. As such, a few assumptions can be built in to simplify the
calculations.
One approach to dealing with this practical challenge is to assume
that dividends grow at a constant rate. For example, if we assume that
dividends grow at an annualised factor of ‘g’ (e.g. 3%), the formula above
can be reduced to:
P0 =
D0(1 + g) D0(1 + g)2 D0(1 + g)3 D0(1 + g)4
D (1 + g)n
+ ... + 0
+
+
+
2
3
4
(1 + r)
(1 + r)
(1 + r)
(1 + r)n
(1 + r)
Equation (1)
We can then multiply equation (1) by 1 + g to get a second version:
1+r
P0
(1 + g)
D (1 + g)2 D0(1 + g)3 D0(1 + g)4
D0(1 + g)n
= 0
+
+
+
⋯
+
(1 + r)
(1 + r)2
(1 + r)3
(1 + r)n
(1 + r)4
Equation (2)
If we then subtract equation (2) from equation (1), we are left with:
P0 = D0(1 + g)
(r – g)
This formula allows us to value a company based on a dividend that has
recently been paid out, an expected growth rate and a desired rate of
return. (This is the Gordon Shapiro model, which was developed in 1956.)
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Chapter 8: Accounting information in action II: Residual income valuation
Activity 8.1
Heggem plc has recently paid out a dividend of 10c and the market expects this to grow
at a rate of 7% for the foreseeable future.
How valuable would a share of Heggem plc be to an investor who expects a rate of
return of 11%?
8.3 Abnormal profit
In section 8.2, we suggested that dividends are the only cash flow which
an equity investor obtains from an investment. For certain companies,
however – such as those not paying dividends – there is an argument
that dividends alone do not capture all of the economic value. In these
situations, we must use other accounting information to provide a more
complete valuation.
This brings us to a concept known as ‘abnormal profit’. This is the profit
made once a charge for equity capital has been applied – that is, the profit
earned by a business above and beyond the profit required by equity
investors.
Worked example 8.1
Consider the company income statement shown below:
€’000
Revenue
65,870
Cost of sales
(20,261)
Gross profit
45,609
Distribution costs
(8,136)
Administrative costs
(12,490)
Operating profit
24,983
Finance costs
(454)
Profit before tax
25,437
Taxation
(4,097)
Profit after tax
21,340
This income statement does not show the expected return that equity
investors require to be satisfied with the investment.
Assume equity investors have invested €122,910,000 and require an
expected return of 8%. This would suggest the required profit (i.e. a
cost of equity) is €16,388,000.
If this value is removed from the profit after tax, we see the following:
Profit after tax
21,340
less: Cost of equity
16,388
Abnormal profit
4,952
This abnormal profit can also be described as ‘residual profit’ or even
‘economic profit’.
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AC3193 Accounting: markets and organisations
Activity 8.2
Company XYZ has capital structure which is 50% debt and 50% equity. Total assets are
£2,000,000.
Coupon on debt is 7%, cost of equity is 12% and taxes are 30%.
If EBIT is £200,000 calculate the following:
• net income
• residual income.
Comment on the results.
8.4 Residual Income Valuation Model (RIVM)
If we accept the premise that equity value is derived from the return a
company offers above and beyond the required return, then we can adjust
earlier models to reflect this.
First, consider how the book value of equity in a company’s balance sheet
may be reconciled from one year to the next.
Opening book value of equity
£200
Earnings
£100
Dividends
(£20)
Change in retained earnings
£80
Closing book value
£280
Figure 8.1: Reconciliation of book value.
Assuming D is the dividend paid out, E is earnings made and B is the book
value of equity, the relationship between book value, dividends and profit
can be written as:
B₁ = B₀ + E₁ – D₁
B₁ = B₀ + E₁ – D₁
B₁ = the
B₀ +value
E₁ – D₁of the dividend, we can write:
Alternatively, if we wish to know
D₁ = E₁ – (B₁ – B₀)
D₁ =
= E₁
E₁ –– (B₁
(B₁ –– B₀)
B₀)
D₁
D₁ = E₁ + (B₀ – B₁)
or:
D₁ =
= E₁
E₁ +
+ (B₀
(B₀ –– B₁)
B₁)
D₁
Activity 8.3
Using the values in Figure 8.1, ensure you are comfortable using the two versions of the
formula for D1.
Earlier, we encountered the following model to value a company based on
dividends:
₀ =
₁
2
3
4
5
n
+
+
+
+
+ ⋯+
4
5
2
3
(1 + ) (1 + )
(1 + )
(1 + )
(1 + )
(1 + )
Substituting in the second formula for D1 above, we can write:
P0 =
E1 + (B0 – B1 )
(1 + r)
+
E2 + (B1 – B2 )
(1 + r)2
This can be simplified to:
80
P0 = B0 +
Σ
∞
En – rBn-1
n=1
(1 + r)n
+
E3 + (B2 – B3 )
(1 + r)3
+⋯+
E1+ (Bn–1– Bn )
(1 + r)n
Chapter 8: Accounting information in action II: Residual income valuation
Although this may look mathematically challenging, it represents a simple
idea: the value of a company is its book value (B0) plus the stream of
discounted residual income (the part of the calculation after the + sign).
Worked example 8.2
123 Corporation generates EBIT of $500,000 per year and this is likely
to continue at the same rate for the foreseeable future. The company has
$4,000,000 of assets, financed 30% by equity and 70% by debt.
The debt coupon rate is 5%, the estimated cost of equity is 12% and tax is 40%.
Calculate the intrinsic value of 123 Corporation if the book value per share
is $12 and there are 100,000 shares outstanding.
Answer
Due to the company’s financial structure, the costs of capital can be
calculated as follows:
Capital value
Cost of capital
Equity
30%
$1,200,000
$ 144,000
Debt
70%
$2,800,000
$ 140,000
100%
$4,000,000
Based on this, the company’s income statement will be:
EBIT
$ 500,000
Int
$ -140,000
EBT
$ 360,000
Tax
$ -144,000
Earnings
$ 216,000
Given the expected return required by equity investors, the residual income
can be determined as follows:
Residual income
= Earnings – Capital charge
= $216,000 – $144,000
= $72,000
$72,000
The residual income per share =
= $0.72 per share
100,000
Intrinsic value per share = B0+ pv of future RI
(
= $12 +
1
× $0.72 = $18
(12%
3
5
Activity 8.4
3
2
Braun Baum GmbH is currently funded 5 by equity and 5 by debt.
It generates a regular EBIT of €700,000 a year and this is expected to continue for the
2
foreseeable future.
5
It has €3 million of assets and 200,000 shares. The book value per share is €9.
The interest on debt is paid at 3%, corporation tax is 20% and equity investors expect a
return of 10%.
What is the value per share using the RIVM method?
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AC3193 Accounting: markets and organisations
8.5 Alternative model
The version of the RIVM used above requires the calculation of earnings
after a capital charge for equity has been applied. It can however be
written in a slightly different way (as devised by Ohlson, 1995).
The current RIVM version is:
P0 = B 0 +
En –rBn–1
n
n=1 (1 + r)
∞
Σ
With a quick adjustment, we can write:
P0 = B 0 +
Σ
(En/Bn–1 –r)Bn–1
(1 + r)n
n=1
Σ
(ROE – r)Bn–1
(1 + r)n
n=1
∞
We can then see that En /Bn–1 is the effective return a company is able
to generate on equity each year – that is, the Return on Equity (ROE). As
such, one final rearrangement gives:
P0 = B 0 +
∞
This provides a slightly different view: the (ROE − r) part of the formula
is deemed to be ‘investment spread’ and shows the excess return that a
company can offer over and above the required return, while allowing for
analysis using percentages rather than currency figures.
8.6 Clean surplus assumption
The above model was built on two assumptions:
•
An investor is expected to receive a dividend which reflects the
required return.
•
The book value of equity is reconciled from one year to the next by
adding earnings and subtracting dividends.
Although these assumptions ensure a cleanly derived formula, they are
only valid when we have what is referred to as ‘clean surplus’. Clean
surplus means that the change in a company’s book value comes from
earnings and transactions with owners (e.g. dividends) alone. In other
words, ignoring share issuance and repurchases:
Closing BV = Opening BV + Earnings – Dividends
However, we know that this is not the case for many companies. For
example, other gains and losses which impact book value are shown in a
‘Statement of Other Comprehensive Income’. You can view an example of a
‘Consolidated statement of comprehensive income’ on p.135 of the annual
report of Pearson plc (2022), available at https://plc.pearson.com/sites/
pearson-corp/files/pearson/annual-report-2022/Pearson_2022_annual_
report.pdf.
This is therefore a limitation of the model. Fortunately, analysts rarely
forecast the types of items that are recognised in the ‘Statement of Other
Comprehensive Income’ and so this limitation should not materially distort
forecasts.
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Chapter 8: Accounting information in action II: Residual income valuation
8.7 Activities to try
Activity 8.5
GHJ Inc is expected to earn $1 earnings per year for the foreseeable future. The dividend
pay-out ratio is 100% and the company has a book value per share of $6.
Investors expect an average return of 10% on their investment.
Calculate the value of stock using:
• the dividend discount model
• the Residual Income Valuation Model.
Comment on the results.
Activity 8.6
DFG Ltd is expected to have an EPS over the next three years equal to $2, $2.50 and
$4 per share.
The pay-out ratio is likely to be 50% in years 1 and 2; however, the business is expected
to close in year 3 and pay out all retained earnings as a dividend.
The current book value per share is $6 and the company’s cost of capital is 10%.
What is the current value per share using the residual income valuation model?
8.8Advantages and disadvantages of using accounting
data for both multiple and RIVM valuation models
Key advantages of multiple and RIVM valuation models are that:
•
they are useful to double check other valuation methods
•
they can be used if cash flows are negative
•
valuation is consistent with accounting principles.
Key disadvantages of multiple and RIVM valuation models are that:
•
accounting information could have been distorted by accounting
choices (see Chapters 9 and 10)
•
there is a need to understand the expected shareholder return.
Activity 8.7
Read the following sections from Chapter 7 of Palepu et al. (2022):
• Defining value for shareholders
• The discounted abnormal profit model
• Accounting methods and discounted abnormal profit.
8.9 Overview of chapter
This chapter has introduced the concept of residual income and showed
how this can be calculated from a company’s income statement. The chapter
has then suggested that this residual income is the extra value that a
company is able to generate, above and beyond its book value. As such, if
we combine the value of the company’s balance sheet with the present value
of this future residual income, we can determine the value of equity.
The chapter provided numerous examples and activities to demonstrate
these ideas, concluding with a discussion of why this methodology is
useful for analysts.
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AC3193 Accounting: markets and organisations
8.10 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the nature of a company’s ‘abnormal’ profit, how it is
calculated and the difficulties and assumptions in its use
•
explain the concept and rationale behind using residual income in
valuation and the advantages and disadvantages of the technique
•
calculate the value of a company using residual income.
8.11 Test your knowledge and understanding
1. Explain why residual income valuation methodologies typically result
in a smaller proportion of the overall valuation being attributed to the
terminal value.
2. The Ohlson model (1995) equates value to:
Σ
(ROE – r)Bn–1
(1 + r)n
n=1
∞
Explain the role of the investment spread in this formulation of value.
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Chapter 9: The earnings game
Chapter 9: The earnings game
9.1 Introduction
In this chapter, we will explore the importance of the ‘bottom line’ – i.e.
earnings – within financial statements. We will consider the importance
of this financial performance metric to the markets and to executives, and
then examine the challenges that accounting principles can create when
looking at this metric.
The chapter will then explore the ways in which management may be
tempted to ‘manage’ earnings, to present markets with a positive picture of
the company’s economics. Finally, we will explore what tools are available
to management to achieve such an outcome.
9.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the earnings game and explain why market participants may
choose to partake/accept that the earnings game occurs
•
discuss methodologies behind earnings management and contrast this
with expectations management
•
explain how earnings management differs from fraud
•
discuss the reasons why many companies choose to use non-GAAP
measures and the implications of widespread use.
9.1.2 Essential reading
Brochet, F. and D. Kiron ‘Google and earnings guidance’, Harvard Business
School Case 111–026, Harvard Business School 2010 (revised April 2011).
9.1.3 Further reading
Collingwood, H. ‘The earnings game: everybody plays, nobody wins’, Harvard
Business Review R0106C, 2001.
9.1.4 References cited
Ronen, J. and V. Yaari Earnings management: emerging insights in theory,
practice, and research. (New York: Springer, 2008) [ISBN 9780387257716]
Degeorge, F., J. Patel and R. Zeckhauser ‘Earnings management to exceed
thresholds’, The Journal of Business 72(1) 1999, pp.1–33.
SEC, ‘Press release: SEC charges Under Armour Inc with disclosure failures’
(May 2021) www.sec.gov/news/press-release/2021-78
Graham, J.R., C. Harvey and S. Rajgopal, ‘The economic implications of
corporate financial reporting’, SSRN Electronic Journal 40(1–3) 2004,
pp.3–37.
Eccles, R.G., R.H. Herz, E.M. Keegan and D.M.H. Phillips The value reporting
revolution: moving beyond the earnings game. (Chichester: John Wiley &
Sons, 2001) [ISBN 9780471398790]
Storey, R.K. and S. Storey ‘The framework of financial accounting concepts
and standards’, Special Report No. 181-C, Financial Accounting Standards
Board, 1998.
IFRS Foundation, Conceptual framework for financial reporting. (IASB, 2018)
https://www.ifrs.org/issued-standards/list-of-standards/conceptualframework/
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AC3193 Accounting: markets and organisations
9.2 The earnings game
Earnings is a critical metric, reported by management to the markets and
used by market participants in a number of ways. In Chapter 6, we saw
that the metrics ‘earnings per share’ and ‘earnings yield’ are commonly
used to judge the performance of a company. Likewise, in Chapter 7, we
saw the use of earnings in multiples and relative valuations using metrics
such as the P/E ratio or EV/EBIT(DA).
Earnings are also important to company executives. A survey by Graham et
al. (2004) asked executives what they considered to be the most important
performance metric. The results of this survey can be seen in that paper
(available in the Online Library), in Table 2, Panel A: Unconditional
averages (p.50); you will see that ‘earnings’ was the clear leader in terms
of its perceived importance.
Within the same research paper, executives were asked whether they felt
it was important to compare one earnings figure to another. You can view
the responses to this question in Graham et al. (2004), Table 3, Panel A:
Unconditional averages (p.51); the majority of executives felt that it was
important to compare a reported quarterly earnings number with the
following benchmarks (in order of importance):
•
same quarter last year EPS
•
analyst consensus forecast of EPS for the current quarter
•
reporting a profit (i.e. EPS>0)
•
previous quarter EPS.
Such comparisons, however, may lead executives to ‘play the earnings
game’.
The earnings game can be defined as:
“Interactions between firms and stock market participants over
the communication of earnings numbers”
(Eccles et al., 2001)
There are some key dangers to the earnings game: if executives are aware
of the importance of their earnings figures, they might:
a. attempt to manage their earnings figure to ensure they meet or beat
expectations (earnings management)
b. attempt to change the expectations of those participants who are keen
to observe a company’s earnings figure (expectations management).
Let us explore these two concepts.
9.3 The nature and cause of earnings management
The conceptual framework of accounting issued by the IASB states that the
general purpose of financial reporting is:
‘to provide financial information about the reporting entity that
is useful to existing and potential investors, lenders and other
creditors in making decisions’.
(IFRS Foundation, 2018)
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Chapter 9: The earnings game
The FASB accounting framework suggests that the primary objective is to:
‘provide information that is useful to present and potential
investors and creditors and other users in making rational
investment, credit, and similar decisions’.
(Storey and Storey, 1998)
Although these statements require further interpretation, the key point
to note is that most accounting standards allow some form of discretion.
Managers have a degree of choice when communicating the performance
of their company to meet these obligations. For example:
•
management may choose whether development costs are expensed
through an income statement or held as an intangible asset, to reflect
management’s intention and ability to use intangible items
•
management may value inventory either on a first-in first-out basis or
using an average cost basis
•
management may choose the appropriate economic life and
depreciation methodology for non-current assets.
Unfortunately, opportunistic managers may take advantage of this freedom
of choice. Decisions may be made within the business to ensure that a
reported earnings figure is higher or lower than it would have been if
other decisions had been made.
Ronen and Yaari (2008) identified three possible types of earnings
management:
Beneficial earnings
management
Taking advantage of the flexibility in the choice of
accounting treatment to signal the manager’s private
information on future cash flows
Neutral earnings
management
Choosing an accounting treatment that is either
opportunistic (maximising the utility of management only)
or economically efficient
Harmful earnings
management
Using tricks to misrepresent or reduce transparency of the
financial reports
Table 9.1: Three types of earnings management.
If accounting standards allow such discretion in accounting choices and
reporting of financial performance, you may wonder why there should be
any possible controversy. We will examine this in the remainder of the
chapter.
Activity 9.1
Think about the following participants in the capital markets, discussed earlier in the
course.
• Management of the company
• Auditors of the company
• Analysts analysing the company
• Investors investing in the company
Identify possible reasons each group might have for either issuing or accepting earnings
figures which have been managed.
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AC3193 Accounting: markets and organisations
9.4 Evidence that earnings management exists
9.4.1 Surveys
In 2005, Graham et al. surveyed and interviewed more than 400
executives, with the aim of determining what drives decisions around
reported earnings.
One part of their research focused on why executives considered it so
important to meet earnings benchmarks. You can view the responses
to this question in Graham et al. (2005) (p.52, Table 4, Panel A:
Unconditional averages); the main reason given was that executives wish
to ‘build credibility with the capital market’ – including, of course, the
sell side analysts. This provides evidence that management clearly see the
possible benefits of managing the earnings profile of their businesses.
9.4.2 Statistical research
In 1999, Degeorge et al. published a paper exploring historical company
performance in relation to market expectations. Their aim was to identify
earnings management in relation to reporting positive profit, sustaining
current performance and meeting analysts’ expectations. Figure 6 in that
article, ‘Histogram of forecast error for earnings per share: exploring the
threshold of meeting analysts’ expectations’, illustrates how companies
meet analyst’s expectations. Access the article in the Online Library and
look at Figure 6: the x-axis shows how forecasts and actual earnings
differed in cents and the y-axis shows the frequency of forecasts that
fall within that bracket. The tau value indicates how skewed the chart
is comparted with a ‘normal distribution’; the calculated value of 6.61 is
considered ‘large’.
This chart is just one of many illustrations which show an apparent
statistical anomaly in the number of firms which demonstrate earnings per
share falling just below target.
Activity 9.2
Access Degeorge et al. (1999) in the Online Library and study Figure 6.
1. Can you explain the anomaly that is visible in this chart?
2. What conclusions can you draw from this evidence?
3. Why do you think it is useful for a company to meet earnings benchmarks?
4. Why do you think it is bad for a company to miss earnings targets?
Hints
Think about other ‘normal distribution’ patterns you might be aware of (e.g. the height of
a population of people, or exam marks achieved). What would you expect the pattern to
look like?
Do you think the peak of this chart is where it should be?
9.4.3 Empirical examples
In 2021, the SEC made a press release detailing charges it had brought
against the sports apparel manufacturer Under Armour Inc. The charges
specifically accused the company of misleading investors as to the basis of
its revenue growth.
As an example, the release stated that, in 2015, the company was failing to
meet analysts’ expectations regarding revenue growth. This was a result of
warm winter weather impacting sales of cold-weather apparel. In response
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Chapter 9: The earnings game
to this, Under Armour accelerated sales which were already agreed with
customers by shipping products earlier than customers had originally
requested them.
Without admitting or denying the findings of the SEC order, Under Armour
Inc agreed to pay a $9 million penalty to settle the action.
In another example, as discussed in ‘The earnings game’ (Collingwood,
2001), Cisco Systems is used to illustrate the effects of not playing the
earnings game. From 1999 to 2000, Cisco’s shares increased from $26 to
$60 per share. However, in the second quarter of the year 2000, it reported
earnings per share of one cent less than expected. Its share price then
dropped by 13%. Collingwood quotes a seasoned stock broker as saying
‘things must be pretty bad if Cisco can’t come up with one lousy penny’.
The fact that a broker could even say something like this strongly suggests
that companies are expected to ‘find’ what is needed to meet analysts’
expectations. Perhaps it was the fact that Cisco couldn’t do this that
‘spooked’ investors so much.
9.5 How does earnings management occur?
Earnings management can be categorised within two broad categories.
‘Accruals’ earnings management was often seen to be the main focus
when attempting to meet required targets. However, with greater scrutiny
from the regulatory bodies of accounting and with auditors’ increasing
scepticism, academic literature and media have began to focus more on
‘real’ earnings management.
Let us consider the differences between the two.
9.5.1 Accruals management
Accruals earnings management can be defined as the practice of utilising
flexibilities within accounting choices that meet GAAP standards but also
allow management to meet their own financial reporting objectives.
The following techniques may be considered:
Income smoothing
The practice of creating allowances and provisions within
good years, when they can be ‘afforded’, and then
releasing them in poorer years.
Big bath behaviour
In a poor year, management may be incentivised to make
impairments and write-offs which historically would have
been defended. This effectively turns a ‘bad year’ into a
‘really bad year’ so as to make future periods look better.
Accounting changes
Management may choose to change accounting estimates
or methodologies in order to change the impact on
earnings from one year to another.
Classification of
expenditure
The metric of gross profit is often seen to show the
success of core operations (i.e. products and services
sold), whereas operating profit is a sign of successful
business overall.
Management may choose to report good news above
the gross profit line but classify bad news as something
below the gross profit line.
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AC3193 Accounting: markets and organisations
Revenue manipulation
The accounting standards behind revenue recognition are
complicated as company sales are often very complex.
Management may look for opportunities to meet
accounting standards using complex agreements that
allow them to recognise sales in a specific period – e.g.
‘Bill and hold’ and ‘Right to cancel sale’ arrangements or
changing the length of a performance obligation to which
revenue is matched.
Table 9.2: Techniques for earnings management.
9.5.2 ‘Real’ earnings management
Accruals earning management can be seen as something which is done
‘within the accounting figures’. Real earnings management, in contrast, is
something that happens in action. That is to say, management may choose
to deviate from normal business practices so as to change reported income.
Activity 9.3a
You are the senior manager of a division within a large pharmaceutical company. You
have just received a message from the CEO. It looks as though the company might not
reach the desired EPS target. You have therefore been asked to consider what actions you
can take which might help boost EPS for the year.
What real life actions could you take?
Hints
Ask yourself:
• Do you often have large R&D expenditure?
• Does your division have a number of project start dates coming up soon?
• Are customer contracts agreed in advance and do they normally have a strict list
price?
• Do you hold a number of assets with a large realisable value?
• Is inventory normally valued at standard cost, including apportioned overheads?
Activity 9.3b
Review your suggested actions in response to Activity 9.3a.
What problems do you foresee in the future if these actions are taken?
9.5.3 Is earnings management fraud?
The simple answer is ‘no’. A more reasoned answer is ‘probably not’.
Although these methods of earnings management, as well as the
motivations behind them, may (and should) be discussed from an ethics
point of view, everything we have discussed above complies with either
accounting rules or commercial business decisions.
Only violations of GAAP could potentially be considered to be fraudulent
reporting (the deliberate misrepresentation of information in order to
mislead the users of the financial statements). It may be worth noting that,
in the case of Under Armour Inc. (discussed in section 9.4.3), the SEC did
accuse management of failing to disclose information which should have
been disclosed. However, due to the agreed settlement, this was not taken
any further.
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Chapter 9: The earnings game
That said, there is often a fine line between earnings management and
fraud. Recording sales before they are realisable does not follow GAAP,
and hence could be considered fraudulent reporting. Yet shipping goods
to customers earlier than agreed (or billing and holding) has a similar
outcome but may be considered earnings management.
Likewise, overstating inventory by recording fictitious inventory items is
fraudulent, but increasing production to ‘store’ overheads in the balance
sheet is a business decision which under GAAP would mean costs are held
as assets.
Activity 9.4
Research the following SEC investigations:
• The Kraft Heinz Company – Inflated cost savings (www.sec.gov/news/pressrelease/2021-174)
• Luckin Coffee Inc – Materially misstating revenue (www.sec.gov/news/pressrelease/2020-319)
• Interface Inc – improper reporting of quarterly EPS (www.sec.gov/news/pressrelease/2020-226)
Can you see why the SEC charged these companies and why these issues were
considered to be more than just ‘earnings management’?
Are there any other examples you can find?
9.6The impact and problems created by earnings
management
From what we have seen so far, it is fair to conclude that earnings, and
its management, is important for managers and executives. We have seen
how earnings management can assist managers personally, as well as those
around them. However, it should be noted that earnings management
creates problems too.
Distorts corporate
decision making
Simply put, real earnings management distorts
management’s usual decision-making processes. This may
mean that decisions are made which are not in the best
interests of the company as a whole – e.g. the delay of
important research and development, or of an important
project.
Big baths can hide
problems
If management partake in ‘big bath’ opportunities, this
may mean that underlying issues are not addressed
appropriately and are instead consigned to history. If
the company had not attempted to operate a ‘big bath’
approach, they might have tried to solve the issues instead.
Wage ‘theft’ from
employees
One way in which companies may try to achieve a
specific earnings figure is to cut back on expenditure
wherever possible. This may lead to companies deliberately
underpaying employees.
Undermines analysts’ If earnings management is prevalent, analysts may be
work
forced to disregard earnings figures. This means that
analysts have fewer metrics to use to consider the potential
of a company and they are left performing little more than
guess work.
Table 9.3: Problems caused by earnings management.
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AC3193 Accounting: markets and organisations
9.7 Ethical dilemma for analysts
An analyst’s reputation is based on their ability to predict future cash flows
and earnings that a company will generate. As a result, analysts may be
reluctant to voice controversial or different opinions and so most analysts’
public opinions are similar.
However, although an analyst’s public opinion may align with the consensus,
this does not necessarily mean the analyst fully believes it. In fact, over the
years, it has become open knowledge that analysts’ opinions may differ.
This has lead to a metric known as ‘the whisper number’, which attempts
to capture the difference between consensus analyst predictions (which
are public) and the predictions the same analysts would make if polled
anonymously.
If the whisper number differs significantly from analyst consensus, this may
indicate that analysts are more aware of earnings management occurring.
Activity 9.5
Look at the website www.earningswhispers.com/. Read the latest news and see how the
earnings whisper differs from analyst consensus.
Activity 9.6
Read the Harvard Business School Case Study 111-026: ‘Google and earnings guidance’
(Brochet and Kiron, 2010). After reading the case study, attempt to answer the following
questions.
1. For what reasons do you feel Google should offer earnings guidance to analysts?
2. How have Google’s share prices changed compared with other companies listed in
the case study who do offer guidance to the markets?
3. Do you think other firms should or should not, and can and cannot, imitate Google’s
attitude towards earnings guidance?
9.8 Overview of chapter
This chapter has highlighted the importance to the capital markets
of earnings-based information and metrics. It has also explored how
such information is perceived to be important to executives within an
organisation. The chapter then focused on the techniques available to
executives to ‘manage earnings’, both from an accruals point of view and
also from a real point of view.
With an awareness of this flexibility, investors and analysts may be more
sceptical when using accounting information for investment purposes.
9.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
92
•
describe the earnings game and explain why market participants may
choose to partake/accept that the earnings game occurs
•
discuss methodologies behind earnings management and contrast this
with expectations management
•
explain how earnings management differs from fraud
•
discuss the reasons why many companies choose to use non-GAAP
measures and the implications of widespread use.
Chapter 9: The earnings game
9.10 Test your knowledge and understanding
1. Explain the concept of the earnings game and discuss why and how
management may choose to participate.
2. Which parties could face detrimental consequences of the earnings
game and what impact would this have on them?
3. Evaluate whether earnings management can be considered to be fraud.
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AC3193 Accounting: markets and organisations
Notes
94
Chapter 10: Earnings management and accounting choices
Chapter 10: Earnings management and
accounting choices
10.1 Introduction
In Chapter 9, we looked at the reasons why management may consider
their earnings metric to be of key importance and how markets could
react if management did not meet earnings consensus. In Chapter 2, we
explored the role of information and the regulatory bodies tasked with
setting accounting standards.
In this chapter, we will explore how users of accounts can interrogate the
accounting standards used by an organisation and assess whether they are
appropriate. Where accounting standards may not be appropriate, we will
explore how users of financial information can address this to gain greater
understanding and insight from the financial statements.
10.1.1 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
critically appraise accounting choices made by firms
•
compare and contrast the advantages and disadvantages of rulesbased accounting standards compared with principle-based accounting
standards
•
identify potential red flags in accounting which may suggest earnings
management is occurring
•
perform some simple accounting adjustments which may be needed on
company accounts.
10.1.2 Essential reading
Palepu, K., P. Healy and E. Peek Business analysis and valuation (Cengage
Learning EMEA, 2022) 6th edition. Chapters 3 and 4.
10.1.3 Further reading
Antill, N., K. Lee and D. Taylor Company Valuation under IFRS. (Harriman
House, 2020) 3rd edition. Chapter 4.
10.1.4 References cited
Marks and Spencer Group Plc, Annual report, 2022. https://corporate.
marksandspencer.com/investors/our-performance-updates/2022-annualreport
Apple, 10-K SEC filing, 2013 and 2022. https://investor.apple.com/sec-filings/
default.aspx
10.2 ‘Noise’ within financial reporting
Most accounting standards have been written using the accruals concept
as a basis. That is to say that assets, liabilities, equity, income and
expenditure should be recognised when they satisfy the definitions. This
does not always equate to when cash is exchanged between parties for
services/products. It also means that income earned must be matched
against the expenditure incurred earning it.
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AC3193 Accounting: markets and organisations
The application of the accounting principles is the responsibility of
management who have superior knowledge about a business’s activities.
Chapter 2 of this course explored the need to ensure the credibility of the
information provided by management. Auditing, standards, legal liability
and public enforcement exist to ensure management correctly follow the
standards set. Unfortunately, ‘noise’ can still exist or be created.
Accounting ‘noise’ means that the information presented in the financial
statements may not give a true representation of a company’s economic
activity. That is not to say that management are not following the
accounting standards; this ‘noise’ can be much more subtle.
10.2.1 Noise from account rules
The rigidity of accounting standards in a rules-based system may not
allow management to express the finances of a company in a way which
truthfully reflects the firm’s economic substance.
For example, under USGAAP ASC 730, companies must expense research
and development costs as incurred (with only a small number of exceptions).
This could therefore create a number of oddities which will mean that users
of accounts may not see the true economic performance of a business. For
instance, a company that spends multiple years researching and developing
pharmaceutical products will need to pass all R&D expenditure through the
income statement long before any revenue is generated.
This creates a potential incentive for companies to outsource their R&D
so that development completed by a third party and then acquired by the
reporting company can be recognised as an intangible asset. While this
outsourced service is being developed, it may not appear in the primary
company’s accounts.
IFRS takes a slightly different approach to writing accounting standards,
setting principles instead of rules. However, this too can create difficulties
as management must understand the principles and apply them as they
feel appropriate. Using R&D as an example again, IAS38 states that
research must be expensed and development can only be capitalised if it
meets certain criteria. This means management must understand what is a
research cost and what is development, as well as considering the criteria
of IAS38 and whether they are met. Users of accounts may not have full
insight into these decisions and, as a result, may not fully understand the
information as presented.
10.2.2 Forecast errors
Compared with outsiders, management have superior insight which
allows them to produce more accurate financial information. However,
management still lack the ability to predict the future. Unfortunately,
several aspects of accounting require management to predict the future
before presenting information – namely:
96
•
present value of share options
•
expected value in use of assets
•
probable future liabilities
•
expectations to be a going concern
•
realisable value of stock
•
irrecoverability of debt
•
useful lives of NCAs
•
expectations of NCA disposals.
Chapter 10: Earnings management and accounting choices
The extent of forecast errors depends on the complexity of business
transactions, the predictability of the firm’s environment and unforeseen
economy-wide changes.
If management’s expectations differ from reality, the financial information
will incorrectly reflect the company’s position.
10.2.3 Management’s accounting choices
Management are often required to make choices about how to account
for certain items. These choices are allowed by the accounting standards,
which have been written to offer flexibility to management, to ensure
financial statements reflect choices within the business. Examples of such
choices are:
•
holding assets at historical cost rather than revaluing assets to fair
value
•
choosing the useful economic life of an asset
•
choosing the valuation method of inventory (FIFO, AVCO, LIFO).
These choices provide opportunities for distortion of accounting numbers
and the potential to hide important information from external users.
Activity 10.1
Think about the ‘noise’ that can occur within accounting. What other accounting
standards are you aware of where noise may be created due to:
• rigidity in accounting
• reliance on management’s future expectations
• choices made by management in accounting policies and estimates?
10.3 Performing accounting analysis
Consider your role as a user of accounts. To ensure that the information
is ‘useful’ to us, we must first ensure that the accounting is a fair
representation of what we expect from the business.
The auditing profession exists to ensure financial statements are free from
material misstatements (i.e. they are true and fair). However, the audit
report issued is an ‘opinion’ based on the auditor’s own experience and
expectations and on evidence provided by internal management. As such,
a user of the accounts should not necessarily accept the accounts as a
reflection of their own opinion.
In fact, a key role of analysts is to ensure the accounts are a fair reflection
of their own opinion, in terms of whether to buy, hold or sell stock. Only
after completing this assessment will an analyst perform any type of
analysis (as per Chapter 6) or perform any valuation (as per Chapters 7
and 8). Palepu et al. (2022) identify six steps in this process.
Step 1: Identify key accounting policies
First, the analyst must identify key policies and estimates which are
affected by the risks and success of the company. It is likely that any
‘noise’ created by these policies will have the most material impact on the
company finances. Therefore, more time should be spent on these items
than on others.
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AC3193 Accounting: markets and organisations
Worked example 10.1
The UK retailer Marks and Spencer (M&S) sells clothing and food. The
business is operated from physical stores on key high streets, and has an
online presence too.
For such a company, it is likely that inventory, as well as property, plant,
and equipment, will be material to operations. As such, we must identify
how the company accounts for these items.
We can extract such information from the company’s annual report. For
example, note 1 on pp.130–139 of the M&S Annual Report 2022 states that:
• ‘Inventories are valued on a weighted average cost basis…’
• ‘All inventories are finished goods.’
• ‘Depreciation [of property, plant and equipment] is provided to write
off the cost of tangible non-current assets (including investment
properties), less estimated residual values on a straight-line basis…’
Step 2: Assess accounting flexibility
Next, analysts must determine whether management have choices and
flexibility in the accounting standards which regulate the key parts of
the business. Knowledge of the accounting standards is critical here. For
example, identifying that a company uses straight-line depreciation is of
little use unless there is knowledge that the company could have chosen to
use a reducing balance basis instead.
Likewise, noting that a US based company expenses R&D costs when
incurred only becomes useful in analysis of accounting choices if we are
aware that this was not a choice but is instead dictated by the standard.
Financial statements based on flexible standards should allow
management to create informative statements. Statements based on
standards with little flexibility will only be useful if the core methods fairly
reflect the organisation’s activities.
Step 3: Evaluate accounting strategies
Where accounting choices have been made, the analyst must examine
the reasons behind these choices and consider whether management are
using particular accounting strategies to accurately communicate or to
misrepresent the true economic performance of the company.
The analyst must assess whether management is incentivised to inflate
earnings, cover poor governance, or prepare for tougher times ahead – all
potential reasons why accounting choices may be exploited.
Activity 10.2
Review the case study ‘FinTech corrupted – The fall of Wirecard’ at the end of Chapter 3
in Palepu et al. (2022).
Consider the following questions:
1. Why were investors guided towards relying on ‘adjusted versions of financial
statements’?
2. What factors affected management’s reporting incentives?
3. What reasons may management have had for not fully disclosing key parts of
acquisitions?
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Chapter 10: Earnings management and accounting choices
Step 4: Evaluate the quality of disclosure
Although accounting standards often dictate the supporting information
which needs to be disclosed within accounts, many firms choose to offer
additional voluntary disclosures to provide readers of accounts with a
better insight into the performance and decisions being made within the
company.
Higher levels of disclosure can be seen as an attempt by management
to be open and transparent with the capital markets, whereas reduced
or minimal disclosure can be interpreted as a sign that the company
is attempting to hide information. Therefore, analysts must consider
disclosures when assessing the reliability of the accounting information.
Worked example 10.2
Apple Inc’s revenue recognition for many of their products requires Apple to break
down the contract value (or price) into a number of performance obligations.
For example, when an iPad is sold for $799, Apple needs to assign some of this
revenue to the hardware being delivered to a customer and some to the software,
software updates and software support.
The level of detail offered by Apple can be seen to have changed over time,
becoming more opaque.
The 2013 Apple Inc financial statements included the following detail in their
notes on revenue recognition:
‘In 2013, 2012 and 2011, the Company’s combined ESPs for the unspecified
software upgrade rights and the rights to receive the non-software services
included with its qualifying hardware devices have ranged from $5 to $25.
Beginning in September 2013, the combined ESPs for iPhone and iPad were
increased by up to $5 to reflect additions to unspecified software upgrade
rights due to expansion of essential software bundled with these devices.
Accordingly, the range of combined ESPs for iPhone and iPad as of September
2013 is $15 to $25. Beginning in October 2013, the Company anticipates
increasing the combined ESPs for Mac from $20 to $40 to reflect additions to
unspecified software upgrade rights related to expansion of bundled essential
software. Revenue allocated to such rights is deferred and recognized on a
straight-line basis over the estimated period the rights are expected to be
provided for each device, which ranges from two to four years.’
The equivalent disclosure in 2022 however, showed the following:
‘Revenue allocated to the product-related bundled services and unspecified
software upgrade rights is deferred and recognized on a straight-line basis
over the estimated period they are expected to be provided.’
This lack of disclosure is something that analysts and users of the accounts must
consider when analysing the company’s performance and assessing whether one
year’s performance is likely to be comparable to another’s.
Activity 10.3
Find the most recent 10-K filed by Apple Inc, either by visiting Apple’s own investor
website or by using the SEC EDGAR search and access tool. Within ‘Item 8 Financial
Statements and Supplementary Data’, look at the note in which Apple are expected to
disclose their revenue by segment (Note 2).
Do you think this breakdown gives sufficient insight into Apple’s successful lines or is it
possible that management might be trying to make their product success more opaque?
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AC3193 Accounting: markets and organisations
Step 5: Identify potential red flags
When looking at company financial information, analysts must pay
particular attention to any possible warning signs. The items in the
following list do not offer definitive proof that executives are participating
in earnings management, but they could be an indicator of potential
misreporting.
•
Unexplained changes in accounting, especially when performance is
poor.
•
Unexplained transactions that boost profits.
•
Unusual increases in receivables in relation to sales (which could
indicate a relaxed credit policy or artificially loading up distribution
channels to record revenue).
•
Unusual increases in inventories in relation to sales (as a sign of over
production or delayed sales).
•
Increases in the gap between net profit and cash flows.
•
Use of R&D partnerships, SPEs or the sale of receivables to finance
operations (e.g. off-balance-sheet liabilities).
•
Unexpected large asset write-offs with little justification.
•
Large year-end adjustments which could indicate aggressive interim
reporting.
•
Changes in qualified audit opinions or auditing personnel, which could
suggest that outgoing auditors have challenged the management.
•
Poor internal governance.
•
Related-party transactions with little business justification.
Step 6: Undo accounting distortions
In the previous steps, an analyst will have identified key accounting
choices, accounting noise and possible red flags which could suggest
that management have exploited accounting flexibility. Finally, they must
consider whether any accounting treatment is a fair reflection of legitimate
business activities or whether managerial judgement is creating bias
towards a specific objective. If necessary, the analyst may need to make
adjustments to the accounts before using them for valuation purposes.
It is also worth noting that different firms use different accounting
methods and estimates. Two firms with similar economic activities,
but which use different methods and estimates, may have drastically
different financial statements. Analysts therefore need to make their own
adjustments to allow fair comparison of firms’ financial statements.
Activity 10.4
Read Chapter 3 of Palepu et al. (2022).
Then attempt questions 1 to 4 at the end of the chapter.
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Chapter 10: Earnings management and accounting choices
10.4 Undoing accounting distortions in action
10.4.1 Aggressive or conservative depreciation policy
Recall that common depreciation methods are straight line, reducing
balance or on a ‘per unit of production’ basis. To calculate the depreciation
expense, and therefore the carrying amount on the balance sheet,
management must choose an appropriate method and also consider the
useful life and expected residual value of the asset.
Worked example 10.3
Consider the following:
Company A, an airline firm, purchases aircraft which it then depreciates
over a useful economic life of 12 years. The company assumes a residual
value of 15% is appropriate.
Industry peers, however, use a useful life of 20 years and a residual value
of 10%.
Company A has a fleet of aircraft which costs €22,484 million and has
accumulated depreciation of €12,384 million.
If we consider the industry peers’ assumptions to be more appropriate, let
us adjust Company A’s balance sheet and income statement with regards to
these matters.
(Assume tax is 30%.)
a. Compare current accounting to desired change
Old depreciation expense =
Adjusted expense =
(€22,484 − €3,373)/12 yrs
(€22,484 − €2,248)/20 yrs
Difference
Average asset life =
old accumulated deprecation
= €1,593
= €1,012
= €581
old annual deprecation expense
=
€12 ,238
= 7.682 years
€1 ,593
Adjusted accumulated depreciation = 7.682 × €1,012
= €7,775
Old accumulated depreciation
= €12,238
Difference
= €4,463
b. Make the accounting adjustment to the financial
statements
Adjust the income statement
Decrease the depreciation expense by €581
Increase tax expense by €174.3 (€581 × 30%)
Increase profit by €406.7
Adjust the balance sheet
Increase the value of assets by €4,463
Adjust deferred tax by €1,339 (€4,463 × 30%)
Increase retained earnings by €3,124 (€406.7 × 7.682 years)
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AC3193 Accounting: markets and organisations
10.4.2 Early or late recognition of revenue
Recall that under IFRS and USGAAP, revenue must be assigned
appropriately to contract obligations and should only be recognised when
a contract obligation has been satisfied.
Management choice exists when determining the performance obligations
as well as how much revenue should be assigned to each element.
Worked example 10.4
Company 123 Inc produces fitness bikes and offers customers a
subscription to online classes. Separately, a fitness bike retails at $900 and
a 12-month subscription fee is $350.
The company changes its pricing strategy so the bike retails at $1000
but a 12-month subscription is given away free with the purchase. The
company considers that no additional costs are to be incurred for this free
subscription, so the bike revenue will be recognised in the same way (i.e.
$1000 upon delivery of the bike).
The company has steadily sold 500,000 bikes over the past 8 months using
this policy.
As an analyst, you consider that this technique has been used by
management to recognise revenue early. What adjustments will you make
to the financial statements?
(Assume tax is 30%.)
a. Compare current accounting to desired change
Total revenue recognised in current year = 500,000 × $1000 = $500m
The new pricing strategy could be considered as two performance
obligations being sold at a discount.
Discount offered = ($900 + $350) − $1000 = 20%
($900 + $350)
New contract pricing should be broken down into:
$900 × (1 − 20%) = $720
$350 × (1 − 20%) = $280
Correct revenue to recognise for the bike = 500,000 × $720 = $360m
For subscription, assume average length of subscription to date = 4
months (8 months / 2 since products sold evenly).
Revenue to recognise =
Revenue to defer =
8
12
4
12
× $280 × 500,000 = $46.7m
× $280 × 500,000 = $93.3m
b. Make the accounting adjustment to the financial
statements
Decrease revenue by $93.3m
Decrease tax expense by $28.0m
Decrease profit by $65.3m
Increase deferred income by $93.3m
Adjust deferred tax by $28.0m
Decrease retained earnings by $65.3
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Chapter 10: Earnings management and accounting choices
10.4.3 Understated allowance for doubtful debt
Management are required to ensure that any receivables in the financial
statements meet the definition of an asset – i.e. an economic resource that
has the potential to produce economic benefit. Management are expected
to use their inside knowledge to forecast any possible receivables which
are likely to be irrecoverable or doubtful.
However, management forecasts may be more optimistic than those of the
user of the financial statements. As such, additional allowances may be
needed.
Activity 10.5
You work as an analyst on the sell side and are currently assessing the allowance for
doubtful debts on a major retailer.
You notice that, historically, the company has created an average allowance of 2.46% for
receivables. This year, however, the allowance has been reduced to 1.99%.
You feel that this is inappropriate. The current gross receivables is £672,054 with an
allowance of £13,377.
What adjustments would be needed within the income statement and balance sheet to
correct for your opinion?
(Assume tax is 30%.)
10.4.4 Adjusting for delayed impairments
Under IFRS, an asset should be impaired when its carrying amount
exceeds its recoverable amount – for example, when there are significant
technological, market, economic or legal changes that impact a company.
However, management may wish to delay any impairment, to ensure asset
values are high and to keep expenses low. This could be beneficial for the
company should any debt covenants be linked to asset value, but could
also be beneficial if management’s remuneration is linked to profit.
Analysts will need to consider whether industry peers have recently
impaired assets or whether significant changes in the economy/industry
could indicate impairment.
Activity 10.6
You are working as an analyst focusing on the automotive industry. You have noticed that
one client holds ¥817,300 million of intangible assets which include R&D.
As a result of changes in climate legislation, many automotive firms are impairing
their R&D which relates to diesel technology. Most peers have recently impaired their
intangibles by approximately 5.4%.
What adjustments would be needed within the client’s income statement and balance
sheet to apply this impairment?
(Assume tax is 24%.)
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AC3193 Accounting: markets and organisations
Activity 10.7
Read the following sections from Chapter 4 of Palepu et al. (2022):
• Asset distortion
• Overstated depreciation for non-current assets
• Key intangible assets off balance sheet
• Accelerated recognition of revenues
• Allowances
10.5 Overview of chapter
Following on from earlier chapters, which explored the reasons for
financial reporting, the metrics used to assess company performance
and the ways in which accounting information can be used to establish
company value, Chapter 9 recognised that accounting information can be
distorted to ensure management meet earnings targets.
This chapter has offered further explanations as to why financial
statements may not always show reliable information, even when
following accounting standards. The chapter offers a framework for
users of financial information to follow to determine whether financial
statements can be considered robust or whether adjustments are needed.
The chapter then explored a small number of examples where an analyst
may consider the financial statements to be misleading, identifying the
adjustments that are needed before the information can be used for
further analysis.
10.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
104
•
critically appraise accounting choices made by firms
•
compare and contrast the advantages and disadvantages of rulesbased accounting standards compared with principle-based accounting
standards
•
identify potential red flags in accounting which may suggest earnings
management is occurring
•
perform some simple accounting adjustments which may be needed on
company accounts.
Chapter 10: Earnings management and accounting choices
10.7 Test your knowledge and understanding
1. You have been analysing the depreciation policy of L&L. After assessing
the following extract, you are not comfortable that the policy for
fixtures and fittings is appropriate.
Fixtures and fittings
Cost of assets at end of year
£1,200
Accumulated depreciation at end of year
£650
£550
Depreciation on fixtures and fittings is calculated using the straight-line
method to allocate their cost over a useful economic life of 10 years. A
residual value of 10% is assumed.
Most companies in the industry assume a much shorter useful
economic life and very rarely do the assets have a residual value. As
such, you would like to adjust the accounts to reflect a useful life of 7
years and a residual value of 0%.
Calculate the impact of this adjustment on both the balance sheet and
the income statement of L&L. (Assume tax is 20%.)
2. Following your analysis, you have been asked by a colleague to offer
some guidance to new analysts about how to identify potential ‘red
flags’ in accounting.
Briefly list some of the issues that you may identify when you analyse
a company which would warant the gathering of further information.
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AC3193 Accounting: markets and organisations
Notes
106
Part 2: Management accounting
Part 2: Management accounting
Introduction
Welcome to the management accounting section of AC3193
Accounting theory.
In this section (Chapters 11–20), we will look in detail at management
control. The section considers why and how organisations control and
measure their activities. It takes a broad approach which could be useful
for all management personnel. For students of management accounting, it
broadens understanding of the whole control and measurement function.
This will enable you as management accountants to be a more effective
part of the management team, linking your deep knowledge of accounting
with a good understanding of how financial results and reports are used
within the organisation and how they can be made more effective in
enabling managers to pursue organisational targets.
Organising your studies
In Chapters 11–20 of the subject guide, the topics are organised based
on the chapters of the textbook listed below. The textbook is very
comprehensive, citing many sources giving different viewpoints and
examples. Due to its comprehensive nature, for most chapters, there are
few further readings.
The subject guide topics are based around the contents of each textbook
chapter and are aimed at giving you a summary of the main themes with
activities guiding you towards issues which may be amplified in the text.
There are some suggestions of using web-based examples.
The end of each chapter gives a case study from the textbook with
suggested questions to direct discussion. The case studies are used to help
the topics come alive. However, the examination paper will require essay
questions to be answered.
Essential reading
The reading for this course is divided into two categories: Essential and
Further. You should purchase the textbooks in the Essential reading
list below; you will also be given online access to the other essential
publications (individual book chapters, journal articles, etc.) either via the
Online Library or through scans uploaded to the VLE. You are not required
to have access to, or or to buy, the Further readings, but they may prove
helpful to you in your study.
For Chapters 11–20, the Essential reading is:
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554].
Further reading
Further reading for Chapters 11–20 is:
Chapter 11
Hammer, M. Beyond reengineering: how the process-centered organization is
changing our work and our lives. (New York, NY: Harper Business, 1996)
[ISBN 9780887307294].
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AC3193 Accounting: markets and organisations
Chapter 12
Hofstede, G. Culture’s consequences: international differences in workrelated values. (Beverley Hills, CA: SAGE Publications, 2001) [ISBN
9780803913066]
Ma, J. ‘Dear investors: letter from Jack Ma as Alibaba prepares roadshow’,
Financial Times [London, UK] 5 September 2014. Available online at www.
ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
Petruno, T. ‘Sunrise scam throws light on incentive pay programmes’, Los
Angeles Times [Los Angeles, CA] 15 January 1996. Available online at
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentivepay-plans
The Economist ‘Tesco’s accounting problems not so funny’, The Economist
[London, UK] 27 September 2014. Available online at www.economist.
com/business/2014/09/27/not-so-funny
Chapter 13
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: a managerial
emphasis. (Harlow: Pearson Education Ltd, 2015) 15th edition [ISBN
9781292078977] Chapter 22.
Chapter 19
Association of Chartered Accountants (ACCA) ‘ACCA code of conduct and
ethics’, ACCA www.accaglobal.com/uk/en/member/standards/ethics/accacode-of-ethics-and-conduct.html
Birsch, D. and J.H. Fielder The Ford Pinto case: a study in applied ethics,
business and society. (Albany, NY: State University of New York Press, 1994)
[ISBN 9780791422342].
UK Government ‘Whistleblowing for employees’, GOV.UK www.gov.uk/
whistleblowing/who-to-tell-what-to-expect
Chapter 20
Moullin, M. ‘How the public sector scorecard works’, Public sector scorecard
www.publicsectorscorecard.co.uk/how-the-pss-works.html
Office for National Statistics www.ons.gov.uk
Further information
Details on the VLE, learning resources and examinations can be found in
the introduction to this guide: Chapter 1.
108
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
Chapter 11: Introduction to control
systems – personnel controls, cultural
controls, action controls and results
controls
11.1 Introduction
In AC2097 Management accounting, which is a prerequisite for this
course, we discussed the advantages of, and problems with, using
accounting measures to appraise managerial performance. Here, we
will look in detail – from first principles – at why and how organisations
control and measure their activities and how the use of accounting results
is only part of that process.
11.1.1. Aims of the chapter
This chapter aims to:
•
introduce the concept management control
•
look at the various methods of control and the different ways in which
they are used by companies, depending on their needs
•
consider the importance of controls
•
explain the different types of control, such as action, personnel,
cultural and results controls.
11.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain why an understanding of management control is important for
managers in all areas of an organisation
•
describe the management process in terms of objective setting,
strategy formulation and management control
•
discuss some causes of management control problems
•
explain the terms: action controls, personnel controls and cultural
controls
•
identify, for each of these types of control, ways in which it can be
implemented, the most appropriate conditions for its use and the
problems that should be considered
•
explain results controls and describe the steps required to implement
them
•
identify the conditions needed to implement effective results controls
and discuss why they are important.
11.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 1–3.
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AC3193 Accounting: markets and organisations
11.1.4 Further reading
Hammer, Michael Beyond re-engineering: How the process-centred organisation
is changing our work and our lives. (New York: Harper Business, 1996)
[ISBN 9780887307294].
11.2 The importance of management control
Budgets are part of the planning and control function of an organisation.
However, they are only a small part of what has to happen in order to
ensure that an organisation functions and meets its objectives.
People are involved at all stages in order for an organisation to operate. It
is people who create actions, so the objective of management control is put
in place systems that encourage desirable behaviour from employees and
guard against undesirable actions.
Activity 11.1
Examine this organisation chart for a hospital.
HOSPITAL ORGANISATION CHART
Board of Directors
Administration
department
Finance
Personnel
Records/statistics
Training
Hospital library
Continuing
professional
development
Medical
departments
General medicine
Surgery
Gynaecology
Maintenance
Dental
Security
Ophthalmic
Cleaning/gardening
Laundry
Purchasing/stores
Figure 11.1: Organisation chart.
Then imagine all the different jobs that there are in each area. Consider that each role
requires a job description and that each task has to follow a procedure to ensure it is
correctly done and mistakes are not made.
Activity 11.2
Familiarise yourself with the control process diagram below. Note that this process applies
– to a greater or lesser extent – to each job and person performing that job.
Collect information
about the role and
activities of the job
Set tasks and
goals
Communication and
co-operation
Measure progress
Figure 11.2: Control process diagram.
110
Allocate
responsibilities
Support units
Laboratory
Imaging
Pharmacy
Physiotherapy
Endoscopy
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
The control process diagram in the above activity is circular because
processes need to be regularly reviewed to ensure that they remain
relevant.
Organisations need processes, called controls, to ensure that the
appropriate activities take place, that performance is monitored to ensure
that there are no mistakes and to improve processes. Controls fall into the
following categories: cultural, personnel, action and results.
Cultural controls are built on shared traditions, norms, beliefs, values,
ideologies, attitudes and ways of behaving which are accepted by the
group. An organisation’s culture encourages mutual monitoring and group
pressure being placed on individuals who do not follow group norms.
These controls work best where the group shares emotional ties.
Personnel controls rely on employees’ natural tendency to control and
motivate themselves. They encourage self-control, intrinsic motivation,
ethics, morality, trust and loyalty.
Action controls specifically state the actions that an employee should
take. The action is the focus of the control (e.g. sewing buttons on shirts).
Results controls are different in that they do not specify how a role
should be performed but what the outcome is expected to be.
Returning to our hospital example in Activity 11.1, a nurse working on a
ward may have the following controls:
•
Cultural: training and rules on how to perform procedures laid down
by the association.
•
Personnel: a motivation to do the best for patients, the team and abide
by medical ethics.
•
Action: shift hours, checks on punctuality, procedures that must be
carried out for each patient at certain times, rules on filling in records
of patient treatment, etc.
•
Results: promotion, maybe team-based rewards.
Activity 11.3
The following matrix gives a good indication of when these different controls may be
used. Consider the four control types and then fill in each box with the most appropriate
type.
Ability to measure results
Excellent
Knowledge of
which specific
actions are
desirable
Poor
High
Low
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Feedback
The following are examples of how you might have filled in this matrix:
• high ability to measure results and high knowledge of which specific actions are
desirable – action control; e.g. a routine job such as sewing shirts
• high ability to measure results but poor knowledge of specific actions – results
control; e.g. managing a department, organising a delivery schedule
• low ability to measure results but high knowledge of specific actions – cultural control
and action control; e.g. a nurse
• low ability to measure results and poor knowledge of specific action – personnel
control; e.g. research and development laboratory.
It is important for managers in all areas of an organisation to have a
thorough understanding of management control. This relates to all the
resources that a manager might use and includes both machines and
people. Therefore every manager should understand which controls are
appropriate for their department and how they will be used.
The issues below relate to Merchant and Van der Stede (2017) Chapter 1,
which you can read either before, or in conjunction with these notes and
activities.
Activity 11.4
Answer questions 1 and 2 before you check your answers!
1. Which of the following people are not likely to be interested in the contents of the
textbook?
a. Financial specialists
b. Personnel directors
c. Sole traders
d. Auditors.
2. Each of the following describes a problem mentioned in Chapter 1 of Merchant and
Van der Stede (2017) that had occurred in organisations due to lack of management
control. Match the scenarios in (a) to (e) to the organisations in (i) to (v).
a.
Students’ grades change dramatically.
i)
A motor manufacturer
b.
An employee sends details of secret research ii)
to the media.
A bank
c.
Employees shredded 90,000 documents.
iii)
The Bank of England
d.
A company designed software to deceive
regulators.
iv)
A schoolteacher
e.
An employee fell asleep at the keyboard.
v)
A service centre working for the government.
3. Explain in your own words what happened in each scenario described in question 2.
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Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
Feedback
1. (c)
2. a. (iv) b. (iii)
c. (v)
d. (i)
e. (ii)
11.2.1 Objective setting
All organisations should be able to identify their purpose. This is
sometimes done by use of a mission statement. The following are
examples of the mission statements of different types of organisations:
Save the Children
‘Our mission is to to inspire breakthroughs in the way the world treats
children and to achieve immediate and lasting change in their lives.’
San Diego Zoo
‘San Diego Zoo Global is committed to saving species worldwide by uniting
out expertise in animal care and conservation science with our dedication
to inspiring passion for nature.’
IKEA
‘Our vision is to create a better everyday life for the many people.’
Activity 11.5
Using the internet, look up the mission statement of any organisation you are interested
in. Then ask yourself whether you think the mission statement is sufficiently clear so that
you can identify the specific activities that the organisation carries out.
Make notes of your views.
11.2.2 Strategy formulation
Strategy formulation aims to identify an organisation’s future strategy
and to define the ways in which its resources will be used to achieve its
strategic goals.
Some companies’ starting point is to identify specifically where they are
heading and plan accordingly. Others allow their strategy to emerge from
the environment and interactions between employees and management,
utilising spontaneous decisions or local experimentation. The latter is
more likely to take place in organisations where there are often influential
changes in the environment that will affect the future (e.g. research
organisations, service providers, etc.).
11.2.3 Management control
Management control comprises all the measures that are put in place to
help sustain a workforce. It includes the strategies that management use to
encourage, enable and, possibly, force employees to work in the ways the
organisation requires.
Activity 11.6
Explain how object setting, strategy formulation and management control are related.
11.2.4 Behavioural emphasis
It is people who create actions, so the objective of management control
is to put in place systems that encourage desirable behaviour from
employees and guard against undesirable actions.
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Activity 11.7
What three issues are suggested in Chapter 1 of Merchant and Van der Stede (2017) that
need to be determined for each employee?
Think about which of these issues could be relevant for an electrician working in a
maintenance department of a university. Jot down your thoughts and compare your notes
with those of other students on the VLE.
11.3 Causes of management control problems
11.3.1 Lack of direction
Employees need to know what they are expected to do and how they can
maximise their efficiency to help fulfil the objectives of the organisation
they work for. If this is not clear, employees will set their own goals, which
may not coincide with the organisation’s requirements.
11.3.2 Motivational problems
An organisation’s goals are more likely to be met if employees are
motivated to work productively.
Apart from preventing activities such as fraud, organisations need to
create a climate which deters employees from time wasting and, more
importantly, a work environment that enables people to gain satisfaction
from working hard.
Office workers who cannot really see the outcome of their work because it is
just part of a system may not be motivated to work hard consistently. They
may spend part of their time at work engaged in nonwork-related activities
like surfing the internet. Contrast this with teachers who are very engaged
and therefore spend extra time encouraging their pupils to be enthused so
that they will make progress. This is not to say that all office workers are
disengaged and all teachers are devoted, but it does highlight the lack of
satisfaction experienced when an employee does not feel fulfilled.
11.3.3 Personal limitations
A person may not be equipped for the job they are required to do, either
because of poor recruitment or poor training. They may have been
promoted beyond their abilities. They may not have been given sufficient
information to do the job or the job may be too difficult to do in the time
allowed.
11.3.4 Characteristics of good management control
Good control is evident if management is confident that no major or
unpleasant surprises will occur. Not having perfect control (which is
impossible) is called control loss. If the control loss is high, extra measures
must be put in place as long as they are cost effective (i.e. implementing
the controls costs less than the potential loss).
Sometimes, more effective operations can be brought about by
significantly changing the way things are done. For example:
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•
Activity elimination: when a company does not have expertise in a
particular area they may consider outsourcing.
•
Automation, computers, robots, expert systems, production
automation: these may be more cost effective than human staff. This
may result in the avoidance problems of inaccuracy, inconsistency
and poor motivation. However, only certain tasks can be dealt with in
this way and personnel with different skills are required to install and
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
operate them effectively. They bring their own control issues in terms
of correct training, reduced access to avoid improper use or fraud,
maintenance and back-up procedures in case of failure.
•
Centralisation of key decisions: this occurs to ensure continuity
and oversight of important decisions (e.g. major acquisitions and
divestments of subsidiaries, significant capital expenditure and
negotiating sales contracts with important clients).
•
Risk sharing: this includes insurance and undertaking joint ventures
with other companies.
Activity 11.8
Give specific examples of these activities, all of which help to create effective
management control:
• activity elimination
• automation
• centralisation
• risk sharing.
11.4 Action, personnel and cultural controls
It will be helpful if you read Chapter 3 before Chapter 2 of Merchant and
Van der Stede (2017). Chapter 3 discusses the control mechanisms that
will be in place regardless of whether results controls are also used. If you
read this chapter before Chapter 2, you will have an understanding of how
the day-to-day operations of organisations are planned, controlled and
supervised.
Chapter 2 on results controls explains how some management control
systems rely on the measurement of specific individual activity where
the tasks are not defined but the expected outcomes are agreed and, if
achieved, can be specifically rewarded.
The issues below relate to Merchant and Van der Stede (2017) Chapter 3
which you can read either before, or in conjunction with these notes and
activities.
11.4.1 Action controls
Action controls specifically state the actions an employee should take
in order to do their job properly. The action is the focus of the control
(i.e. if the employee carries out the work in the way specified, it is under
control). If the employee acts in a different way, and if it is observable,
then corrective action can be taken.
Activity 11.9
Describe the action controls that might be in place for someone who works on a
supermarket checkout.
Action controls may be negative (i.e. stopping an employee from
performing incorrect actions) or positive (i.e. guiding employees on how
to perform the tasks required of them).
Behavioural constraints are built in with the intention of preventing
employees from performing incorrect actions. The constraints include:
•
physical (e.g. locks on cabinets, computer passwords)
•
administrative rules (e.g. limiting spending authority, separation of
duties (internal control))
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•
Mechanical deterrents (e.g. building steps into a procedure to guard
against incorrect/dangerous actions, such as a microwave that does
not work with the door open).
If employees know the system well, they can find a way around many of
these controls.
Activity 11.10
Think through what checks or constraints may be in place at a supermarket checkout.
Preaction reviews
Action plans and budgets prepared by employees can be reviewed
by superiors. Where necessary, more details can be requested and
modifications made before approval is given.
Activity 11.11
Suggest what daily plans can be put in place to ensure that supermarket checkouts are
staffed adequately.
Action accountability
Employees can be held accountable for the actions they take. Actions
are defined as acceptable (or not) and are communicated to employees.
Employees’ activity is observed or tracked. Correct actions are praised and
may be the focus of rewards, whereas wrong actions are corrected and
may incur sanctions.
Actions are communicated either administratively through written
instructions or lists, or socially by means of colleagues modelling
acceptable behaviour.
In some areas, professional conduct is expected and, though not
necessarily clearly defined, these norms are understood by each
profession.
Communication is important. The reasons for performing actions correctly,
and the consequences of not performing them correctly, should be
communicated.
Redundancy
This involves using back-up employees or machines to create extra
resources to take over if something goes wrong. This ensures that the
process is not interrupted.
Prevention action controls and detection action controls
Prevention action controls ensure that employees perform correct behaviour.
This may occur through direct supervision. Detection action controls
are applied either routinely or as a result of a specific problem after the
wrong behaviour has been observed (e.g. checking mechanisms that draw
attention to the problem such as quality checks or cash reconciliations). The
existence of these checks often deters incorrect behaviour.
Conditions determining the effectiveness of action controls
•
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Knowledge of the desired actions – this is easy to determine in
routine procedures (e.g. a specified production activity or loan
approval decisions in banks). However, complex or uncertain tasks
(e.g. supervision, machine repairs, market research and research
engineering) are not routine and require judgement and initiative.
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
•
Ability to ensure that the desired actions are taken – this can be tricky
in situations where employees understand the checking system that
is in place and so can circumvent it, either to hide their mistakes or
benefit from the bonus system by deliberate fraud.
11.4.2 Personnel controls
Personnel controls build on employees’ natural tendencies to control and
motivate themselves. They encourage self-control, intrinsic motivation,
ethics, morality, trust and loyalty.
The objectives of personnel controls are to:
•
clarify expectations by ensuring that employees understand what the
organisation wants
•
help to ensure that employees have the capabilities to do the job (i.e.
the necessary experience, intelligence, resources and information)
•
enable employees to self-monitor.
Personnel controls require good selection and placement, training, efficient
job design and provision of the necessary resources.
11.4.3 Cultural controls
Cultural controls are built on shared traditions, norms, beliefs, values,
ideologies, attitudes and ways of behaving that are accepted by the group.
The culture of the workplace encourages mutual monitoring and group
pressure on individuals who do not follow group norms. These controls
work best when there are emotional ties within the group.
Organisations have cultures which embody the rules that are acceptable to
them. Some rules are written, others are unwritten. Where cultural norms
are strong, employees feel safe and accepted (as long as they stay within
the norms) which leads to them working well together.
Cultural codes are usually drafted by top management and the legal
department, and are regarded as the fundamental principles of a company.
The codes may be changed due to specific incidents within the company or
industry, legal changes, leadership changes or business strategy changes.
Codes of conduct may – or may not – help to control employee behaviour.
Leadership from the top is important (i.e. top management should be seen
to take the organisation’s codes of conduct seriously).
Activity 11.12
Do an internet search for codes of conduct. Some are drawn up by professional bodies,
for example The Nursing and Midwifery Council, others are drawn up by companies, for
example Coca Cola, and some for not-for-profit organisations, for example Action Aid.
If you were working for one of these organisations, would you find the code helpful?
What other parties would be likely to read the cultural code of an organisation?
Make notes of your ideas and discuss these with other students on the VLE.
11.4.4 Encouraging effective cultural and personnel controls
Group-based rewards
These aim to motivate cooperative and effective working of the group
towards organisational goals. The rewards may be profit-sharing for all
employees or group rewards.
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Open book management
This idea involves making much more financial and other information
available to employees so that they can see the effects of their actions on
the company’s performance. Employees must be trained to understand the
information and how they can contribute to the company’s performance
and earn group rewards.
A culture change may be needed from the top-down approach, which
exists in many organisations, in order to encourage employees’ ideas and
enable their ideas to be implemented.
Intra-organisational transfers of employees or employee
rotation
This activity encourages employees to work in different parts of the
organisation. It can help to develop a wider understanding of the
interconnectedness of the different activities in an organisation. It can also
deter collusion in fraud by stopping employees becoming too familiar with
a department’s activities, colleagues and processes. Care must be taken to
make this a positive experience for employees who are transferred.
A policy on whistle-blowing is required to ensure that employees
who experience or observe wrong practices (e.g. fraud, bullying of
subordinates) are able to speak out, knowing that they will be protected
and that action will be taken (see also Chapter 19.)
Physical and social arrangements
Office layouts that encourage collaborative working can be positive. Social
arrangements should be agreed in discussions between employees and
management (e.g. dress code and institutional habits).
Tone at the top
Leaders need to be role models.
11.4.5 Summary
Cultural codes are general, relating to all employees or a group of
employees. Personnel controls build on the culture of the organisation and
encourage personal responsibility. Action controls focus on particular ways
to do specific tasks or roles.
11.4.6 Proactive and reactive controls
Many measures are proactive to prevent problems from occurring (e.g.
expenditure approvals, computer passwords and dividing up duties).
Other measures are reactive (i.e. measuring the activities as they happen
and intervening to correct actions if necessary). The purpose is to guard
against people in the organisation either from doing something they
should not do or not doing something that they should do.
Activity 11.13
Give an example of how your school, college or university uses both proactive and
reactive controls.
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Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
11.5 Results controls
The issues below relate to Merchant and Van der Stede (2017) Chapter 3
which you can read either before, or in conjunction with these notes and
activities. The concept of results controls is that employees should feel
that they are in business for themselves, and that their actions will lead
to better or worse implications for themselves. For this to work effectively
for the organisation, goal congruence is needed so that the actions which
benefit the employee also benefit the organisation, and employees are
enabled to see the consequences of their activity. Employees are therefore
empowered and motivated to use their judgement to develop the best way
of achieving the required outcomes.
Results controls are mostly used for controlling the behaviour of
professionals and managers, that is ‘Someone who is responsible for
achieving a result rather than performing a task’ (Hammer, 1996).
Results controls are needed if an organisation is to become decentralised.
11.5.1 Steps
Defining performance dimensions
People work towards the goals and measurements that are set for them,
which means that what is measured tends to get done. If performance
dimensions are not correctly defined, employees will not be working
towards the correct goals (e.g. if a maintenance department were
rewarded based on the number of repair jobs they completed within a
specified time frame, they would give priority to jobs that took the shortest
time to complete and more complicated jobs, which might be critical to
operations in the production area, would be put at the bottom of the list,
even if this disrupted output).
Measuring performance
Many performance measures can be financial (e.g. return on assets). Nonfinancial measures such as market share are also common and, as they are
in number form, they are easy to measure. Other non-financial measures
require judgement (e.g. employee traits such as taking the initiative).
These are often recorded on a scale of, for example, one to 10.
In the manufacturing area, measures such as output per hour and amount
of unproductive time may be used.
A situation may arise in which the required financial performance needs
to be translated into operational performance. This is sometimes called a
hinge or linking pin process.
If more than one results measure is used, the weighting of each should be
made clear to employees so that they are aware of what their priorities are.
Setting performance targets
Once performance measures are decided, the level of expected
achievement must be agreed between employees and their managers.
Providing rewards
Although rewards are often financial, other rewards that make employees
feel empowered and effective can be equally important (e.g. promotion,
job security or recognition).
The rewards should encourage the greatest motivation, but they must also
be cost effective. For rewards to be effective, they need to be valued by
the individual employee. Some may prefer immediate cash bonuses, while
others may prefer increased pension contributions or more interesting work.
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Activity 11.14
What is involved in the following steps that are used to implement results controls?
• Defining performance dimensions
• Measuring performance
• Setting performance targets
• Providing rewards.
Make notes of your ideas and discuss these with other students on the VLE.
11.6 Conditions needed to implement effective results
controls
11.6.1 Knowledge of desired results
It is not always easy to determine performance targets for each role within
an organisation in such a way that profitability (or effectiveness in a notfor-profit organisation) is always improved. It is also important to give the
right weightings to each activity. Using the wrong measures or weighting
can lead to employees performing the wrong actions.
11.6.2 Ability to influence desired results (controllability)
Employees must be able to affect the results that are measured by their
own actions. If employees have little ability to control their activity, then it
may not be possible to use results controls.
11.6.3 Ability to measure controllable results effectively
The purpose of results controls is to motivate employees to perform the
appropriate activities. Results measures should be precise, objective,
timely, understandable and cost-effective. If it is very difficult to measure
the results efficiently, then results control may not be the correct method
to adopt.
Activity 11.15
Why is each of the following important?
• Knowledge of desired results
• Ability to influence desired results (controllability)
• Ability to measure controllable results effectively.
Make notes of your ideas and discuss these with other students on the VLE.
11.7 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
120
•
explain why an understanding of management control is important for
managers in all areas of an organisation
•
describe the management process in terms of objective setting,
strategy formulation and management control
•
discuss some causes of management control problems
•
explain the terms: action controls, personnel controls and cultural
controls
Chapter 11: Introduction to control systems – personnel controls, cultural controls, action controls and results controls
•
identify, for each of these types of control, ways in which it can be
implemented, the most appropriate conditions for its use and the
problems that should be considered
•
explain results controls and describe the steps required to implement
them
•
identify the conditions needed to implement effective results controls
and discuss why they are important.
11.8 Case studies
1. Read the case study ‘Leo’s Four-Plex Theater’ at the end of Merchant
and Van der Stede (2017) Chapter 1, pp.22–23, then answer the
following questions:
•
What does the theatre’s control system lack?
•
What control improvements would you suggest?
2. Read the case study ‘EyeOn Pharmaceuticals’ at the end of Merchant
and Van der Stede (2017) Chapter 3, pp. 114–19, then answer the
following questions:
•
How would you categorise the control strategy used in the
research and development area?
•
Evaluate the control strategy. What, if anything, should EyeOn
managers do differently?
•
How can the productivity of research and development be
measured?
11.9 Test your knowledge and understanding
1. Describe action controls, personnel controls and cultural controls.
Explain why, with so many other controls available, results controls are
also used.
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Notes
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Chapter 12: Control system tightness and control system costs
Chapter 12: Control system tightness and
control system costs
12.1 Introduction
In Chapter 11, we identified different methods of controlling and
encouraging good work performance. In this chapter, which draws on
Chapters 4 and 5 of Merchant and Van der Stede (2017), we will look in
detail at how controls can be designed to encourage the most efficient
and effective working environment. We then turn to consider the costs
of designing, implementing and sustaining a control system. The costs
involved are both direct costs as well as the costs that result from poor
design, which can lead to time being wasted by following the wrong goals
and manipulating the situation so as to appear to be following the right
goals.
We finish the chapter by considering the issues that arise where companies
have divisions in different countries or environments and therefore
cannot necessarily adopt the same systems across the whole organisation.
The knock-on effect will be that there will be more expense involved in
designing appropriate systems, but in the long run it is likely to be more
cost-effective to do this than to have an inefficient operation.
12.1.1 Aims of the chapter
This chapter aims to:
•
outline the issues involved in creating a well-designed management
control system
•
give a summary of the direct and indirect costs of operating the
system.
12.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the issues to be considered in implementing tight results
controls
•
explain the issues to be considered in implementing tight action
controls
•
explain the issues to be considered in implementing tight personnel
and cultural controls
•
identify, in general terms, the direct costs of management control
systems
•
describe behavioural displacement related to results, action and
personnel and cultural controls
•
describe gamesmanship, creation of slack resources, data manipulation
and operating delays
•
explain the negative attitudes that may arise through poor design of
controls
•
identify the types of situation where adaptation of control systems may
arise.
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12.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 4 and 5.
12.1.4 Further reading
Hofstede, G. Culture’s consequences: international differences in workrelated values. (Beverley Hills, CA: SAGE Publications, 2001) [ISBN
9780803913066].
Ma, J. ‘Dear investors: letter from Jack Ma as Alibaba prepares roadshow’,
Financial Times [London, UK] 5 September 2014. Available online at www.
ft.com/content/54a53a50-353d-11e4-aa47-00144feabdc0
Petruno, T. ‘Sunrise scam throws light on incentive pay programmes’, Los
Angeles Times [Los Angeles, CA] 15 January 1996. Available online at
http://articles.latimes.com/1996-01-15/business/fi-24821_1_incentivepay-plans
The Economist ‘Tesco’s accounting problems not so funny’, The Economist
[London, UK] 27 September 2014. Available online at www.economist.
com/business/2014/09/27/not-so-funny
12.1.5 References cited
Hofstede, G. Culture’s consequences. (Beverley Hills, CA: Sage Publications,
2001) Second edition [ISBN 9780803973244].
‘Dear investors: Letter from Jack Ma as Alibaba prepares roadshow’, Financial
Times, 5 September 2014.
12.2 Control system tightness
The issues below relate to Merchant and Van der Stede (2017) Chapter 4
which you can read either before, after or in conjunction with these notes
and activities.
An important decision in all areas of organisational control is ‘how tight
should controls be?’. This is related to the definition of the action to
be controlled, the ability to measure it accurately and the rewards or
penalties of meeting – or not meeting – the target.
All controls must be specific, and the desired results must be
communicated and accepted by those being controlled. Where the
controls can be used exclusively in a particular performance area, the
controls should be complete (i.e. they should cover all areas of expected
performance).
12.2.1 Issues to be considered in the design of good results
controls
Congruence
In order to be effective, results controls must be goal congruent (i.e.
they should guide the manager to make decisions that are in line with
the organisation’s objectives). This requires that the objectives are well
understood.
Activity 12.1
Give two examples of ambivalent objectives, either from your own experience or from
Merchant and Van der Stede (2017).
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Chapter 12: Control system tightness and control system costs
Specificity
Managers must know specifically what their targets are. These are
often financial, which is realistic when actions lead to easily measured
outcomes, but is more difficult in some areas of a business and in some
types of industry or organisation.
Activity 12.2
Describe two situations when it is difficult to set easily measurable targets, either from
your own experience or from Merchant and Van der Stede (2017).
Communication and internalisation
Managers must understand what their targets are and have a desire
to meet them. They must understand what they need to do in order to
achieve them.
This can vary due to:
•
employees’ qualifications
•
the extent to which the managers feel they have control to meet the
measured results
•
the manager’s participation in the goal-setting process and the extent
to which they consider the targets achievable.
Completeness
The measures should cover all the areas over which the manager has
control. Areas that are not measured tend to be ignored as energy is put
into those that are measured. The difficulty is that some areas are difficult
to measure.
Activity 12.3
Give two examples of how unmeasured areas may be disregarded by employees, either
from your own experience or from Merchant and Van der Stede (2017).
Performance measurement
Measures need to be precise, objective, timely and understandable.
Incentives
Results controls are most effective if there are consequences from meeting
or not meeting targets that have been set.
The expected actions and the rewards must be linked. Two types of link
can be used. A direct link translates performance into specific additional
rewards. Usually achievement is highly rewarded and failure receives little,
if any benefit. A definite link means that no excuses will be considered
and failure leads to high penalties.
Activity 12.4
Describe two examples of penalties resulting from missing targets. Use the internet to
research some recent examples.
Tight controls and too tight controls
Some very routine activities can be measured closely using modern
technology (e.g. devices scanning employees’ actions).
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Care must be taken to ensure that these actions are considered reasonable
by those being measured. Communication and discussion between
management and employees is vital. This will ensure that management
can find out whether a measure is acceptable and that employees can
understand the purpose of the control. Employees might be able to suggest
better approaches since they are doing the day-to-day work.
Activity 12.5
Describe an example of this sort of monitoring. You can follow this up by looking
at the discussion about this subject on the ACAS website: www.acas.org.uk/index.
aspx?articleid=5721
12.2.2 Issues to be considered when designing tight action
controls
The aim here is to ensure that employees whose work is controlled by
action controls are doing things correctly and do not have opportunities to
make mistakes or commit fraud.
Behavioural constraints
This involves physical and administrative ways to encourage correct
behaviour, such as:
•
physical – locks, passwords, restricted access to information
(dependent on job responsibility)
•
administrative – restricting decision-making authority and ensuring
that higher level employees do not become indispensable
•
separating duties – ensuring that no one person can complete a
transaction.
Employees may override internal controls or collude to hide mistakes or
perpetrate fraud.
Pre-action reviews
These involve checking before a new activity is implemented or changes
are to be made to improve current working. Reviews should be frequent
and should investigate the situation in detail. They should be performed
by diligent, knowledgeable reviewers. They are mostly used where a
significant investment is proposed, particularly when it is irreversible and
thus affects the fortunes of the organisation (e.g. business plans, projects
requiring capital investment).
These reviews may also be used to keep down day-to-day spending
and may include tactics like using black-and-white photocopies and
double-sided printing only to ensure that, before a division commissions
management consultants, they have checked that the expertise does not
exist in-house.
Activity 12.6
Do an internet search on how companies keep their costs down. You will find some
interesting examples.
Action accountability
This creates specific rules or ways of working which become the measure
for appraisal, reward or punishment. Unacceptable behaviour must also
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be defined. It can be effective if the policies and guidance are understood
and accepted. These can be improved by the participation of employees in
setting the rules and by communication and training.
These measures work well where the required actions are routine and well
defined, and where adhering to them is important, for example:
•
for safety in hospitals, care homes or nuclear power facilities
•
for the prevention of fraud in, for example, banks.
Tight control measures are not suitable for the parts of a job that require
skills, judgement, discretion or creativity. In these areas, appropriate action
cannot be closely defined. Tight controls may limit employees’ judgement
and creativity, delay decisions, erode morale and frustrate highly skilled
employees.
Action tracking
If rules are to be enforced, actions must be tracked. This is becoming
easier with modern technology. It is essential, since it is important that
employees know that they will be caught if they do not follow the rules.
Action reinforcement
Rewards and punishments for not keeping to the rules must be known
and enforced. There must be sufficient expert knowledge to observe and
expose the ways in which employees do – or may be able to – bypass the
controls. This is particularly true in companies where systems are largely
performed using IT, where sufficient controls may not be incorporated
because the IT expertise in the organisation is not sufficient.
Where tight controls have been implemented, care must be taken to
ensure that they are not eroded when activities are reorganised. During
the reorganisation, some procedures that are in place as checks and
balances may not be understood and may be considered as non-value
adding or inefficient.
12.2.3 Issues to be considered in the design of tight personnel and
cultural controls
Personnel and cultural controls focus on developing good work
performance that results from employees being motivated and
experiencing self-satisfaction from performing well. This is reinforced by
a positive corporate culture that encourages people to feel part of a team
and to not want to let the team down. Loyalty is also encouraged.
The controls are intended to encourage and improve the employees’ work
ethic and team norms (e.g. at interview stage enabling candidates to
observe the work ethic and commitment of other workers). There should
be group incentive plans, which require regular training with rewards for
attendance. There should also be training in ethics.
Activity 12.7
Using information from the section ‘Tight personnel/cultural controls’ in Merchant and
Van der Stede (2017), make notes on how Kellogg and Dell have implemented improved
understanding of the company’s ethics.
Discuss your thoughts with other students on the VLE.
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12.3 Control system costs
12.3.1 Introduction
The aim of implementing management control systems (MCS) is to
create a higher probability that employees will pursue the organisation’s
objectives. Although there is a benefit to the organisation, the design,
implementation and monitoring of MCS nevertheless costs money.
The easiest costs to identify are direct costs, but there may also be indirect
costs caused by poor control design or using the wrong type of control.
These costs may be difficult to identify and quantify.
Direct costs
Direct costs are all the costs that are incurred in designing and
implementing MCS. These can include procedures manuals and staff
training as well as the work that goes into such activities, such as time
spent on monitoring staff, planning and budgeting, and pre-action
reviews. Organisations also need to factor in the payment of bonuses and
maintenance of internal audit staff.
Organisations should attempt to determine how much of the work
identified above is routine checking and how much is undertaken to
enable strategic goals to be realised. This helps to indicate whether it
is possible to reduce costs without harming the implementation of the
strategy.
It is important that the activities of internal checking and internal audit
are transparent, both inside the company and externally, as great harm
can be done to a company’s reputation if it becomes apparent that robust
financial controls are not in place.
(Note that the topic of internal auditing is not covered on this course.
AC3093 Auditing and assurance introduces students to this subject.)
Activity 12.8
Read through the case study of PNB Paribas in the section ‘Direct costs’ in Merchant
and Van der Stede (2017) Chapter 5 to understand the importance of monitoring the
behaviour and decisions of staff.
Indirect costs
Indirect costs are the result of the MCS being ineffective or creating
problems. It is unlikely that there is any organisation that does not have
some activities performed by employees that do not contribute to the wellbeing of the company (e.g. gamesmanship, operating delays or negative
attitudes).
12.3.2 Behavioural displacement
This occurs when the design of the MCS produces and encourages
behaviour that is inconsistent with an organisation’s objectives.
Behavioural displacement and results controls
These outcomes are what takes place when the results measure is
incongruent with the true objectives of a company. When the measure is
too broad to focus on important activities or if there are too many ways in
which the measures can be met or the organisation has focused only on an
easily quantifiable measure, then it is likely that this will occur. In these
situations, employees will find ways to meet the targets with the least
effort on their part, possibly resulting in poor overall performance.
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Activity 12.9
Now take a look at the five bullet points in the section ‘Indirect costs: Behavioral
displacement and results controls’ (p.187) in Merchant and Van der Stede (2017) Chapter
5. Choose two of these examples and make notes on how better controls could be
implemented. (These will be formally covered in later chapters, but for now put yourself
in the employee’s position and think about what would encourage you to focus more on
effective work rather than just meeting targets.)
Discuss your notes with other students on the VLE.
It is often difficult to find measures that capture the activities of a
role sufficiently to encourage behaviour that is focused on strategic
performance. ‘There are very few jobs, even presumably simple jobs, where
what is counted is all that counts – in other words, results controls are
almost invariably incomplete’ (Merchant and Van der Stede (2017) p.175).
Behavioural displacement and action controls
The problem of means-ends inversion occurs where employees focus
on the actions they have the authority to perform rather than on what
they are meant to accomplish (e.g. managers are given a top limit on the
amount they can spend on capital expenditure so invest in several small
projects, even though each of the projects is suboptimal).
Action controls may be incongruent, and because employees need to stay
within the rules, they become ineffective. An example of this can be found
in the case of a computer customer advice centre where advisers were
required to spend no longer than 13 minutes on each call. No commission
was paid on longer calls. Staff found ways to cut calls off, but customer
service ratings dropped below the industry average, with the result that
the company’s reputation was damaged.
Some action controls can be so rigid that they do not give employees
the opportunity to try out better ways of performing a task. This
level of control may be good in stable environments with centralised
knowledge, but can stifle change and innovation in competitive, fastchanging situations. However, detailed rules do have an important role in
circumstances where health and safety are paramount.
Behavioural displacement and personnel/cultural controls
This displacement usually arises when the wrong type of employee is
recruited, the training is poor or the cultural controls are implemented in
the wrong setting.
Activity 12.10
Read the case study of Levi Strauss in the section ‘Behavioural displacement and
personnel/cultural controls’ in Merchant and Van der Stede (2017) Chapter 5. Make
notes of the steps you would have taken to deal with the problem of workers injuring
themselves in the course of trying to meet piecework goals.
Discuss your notes with other students on the VLE.
12.3.3 Gamesmanship
Gamesmanship occurs when actions are taken by employees to improve
their performance indicators without producing an improved performance.
Below are two examples.
Creation of slack resources
This is a well-known device which enables managers who are appraised
on performance to negotiate lower targets or more resources than they
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may need to perform their task. This often occurs when managers risk loss
of bonuses, pay rises or promotion if targets are missed. Slack can lead
to wasted resources and obscures underlying performance. However, a
certain amount of slack can relieve a manager’s stress, provide a cushion
against unforeseen change and enable innovation to be implemented. This
is discussed in more detail in Chapter 19 of this subject guide.
It is only possible to eliminate slack in highly stable conditions with
predictable outcomes so forecasts can be set from the top down and there
is no information asymmetry.
Data manipulation
This can be seen in two ways:
1. Falsification: this involves reporting data that has been changed.
2. Data management: this is action that is taken to make performance
look better without there being any real economic advantage to the
organisation. It can involve moving activity to a different time period
(e.g. ‘saving sales’ for the next budget period if the target for bonuses
in the current period has already been met or making results look
worse in a poor period so that the next period will look better by
comparison).
Data management can be implemented by using accounting actions and
operating actions.
Accounting action can mean changing accounting methods that
the organisation uses (e.g. depreciation rates or methods of revenue
recognition).
Operating actions can include deferring expenditure (e.g. on
maintenance) or trying to accelerate sales (e.g. by recognising as sales
goods that are in the hands of distributors but have not actually been sold
and so could be returned to the company by the distributors).
Activity 12.11
Read the section ‘Data manipulation’ in Merchant and Van der Stede (2017) Chapter
5, and then read The Economist article ‘Tesco’s accounting problems. Not so funny’ (27
September 2014) at www.economist.com/business/2014/09/27/not-so-funny
Use it to explain Tesco’s sales activity, as a result of which the auditor PwC considered
issuing a warning that there was a ‘risk of manipulation’.
Alternatively, do an internet search to find a similar issue with another company (e.g.
McDonald’s).
These actions, which report improved accounting income, can have
serious effects on the business in the future. Examples of this include:
aggressive sales tactics can harm customer satisfaction; saving sales
can lead to increased overtime payments in the next period to meet the
additional sales demand; or employee productivity may be reduced due to
underspending on maintenance.
Manipulating data by affecting the accuracy of the company’s information
system can lead to management relying on erroneous data when making
decisions and forecasts.
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Activity 12.12
Read the section ‘Data manipulation’ in Merchant and Van der Stede (2017) Chapter 5,
and then look at the Los Angeles Times article ‘Sunrise scam throws light on incentive
pay programmes (15 January 1996) at http://articles.latimes.com/1996-01-15/business/
fi-24821_1_incentive-pay-plans
Then explain why Sunrise Medical’s bonus plan led to outright fraud.
12.3.4 Other costs of action controls
Operating delays
Controls such as unreasonable limits on access to certain areas (e.g.
stockrooms) or passwords needed to access information that needs to be
reviewed regularly can be very time consuming. This may be minimised by
introducing up-to-date electronic methods (e.g. retina recognition).
Major delays can be caused by requiring multiple layers of approval for
action from different levels of the hierarchy. This not only potentially
means that actions are delayed, which could result in lost sales or
production output, but can be demoralising for employees who know their
area of expertise and can see opportunities being missed due to lack of
authorisation. This can also lead to managers and employees going ahead
with actions or spending money first and getting authorisation afterwards
(act first and apologise later).
12.3.5 Negative attitudes
Feeling disempowered and/or ignoring controls can not only lead to
wrong decisions being made but can affect an employee’s whole attitude
to the controls in place. This might lead them to ignore other constraints
on their behaviour. Alternatively, they may experience tension, frustration
and conflict leading to absenteeism, lack of effort and higher staff
turnover. Pressure to hold onto one’s job due to economic pressures and
the need for job security can encourage unethical conduct.
Negative attitudes produced by results controls
Employees may have negative reactions to the controls because the targets
that are set are too difficult, not meaningful or they are not able to control
them. If the targets are too difficult, employees feel too pressured, and if
this involves a number of people, this could lead to industrial action.
Inequitable rewards and most forms of punishment can cause negativity.
Even the target setting process may not be welcomed, particularly if it is
poorly implemented. Participation in the process can help to create an
acceptable system.
While weaker employees may be negative because the system may uncover
their inadequacies, stronger employees may be negative about flaws in
the system. This could lead to some of the harmful behaviours we have
already discussed.
Negative attitudes produced by action controls
If action controls appear to set in motion micro-management of employees’
activities, they may be resented by responsible employees who consider
that they are being ‘checked up on’. There may also be cultural and
location issues which call for different action controls in different
situations or countries. This is something that multinationals need to
consider when imposing a system in different environments.
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Activity 12.13
Read the examples in the section ‘National culture’ in Merchant and Van der Stede (2017)
Chapter 5. This describes the merger between the Bank of America and Merrill Lynch, and
the different attitudes to action controls in 7-Eleven Japan when it expanded to America.
Make notes as you do this reading, and discuss your thoughts with other students on the
VLE.
12.4 Adaptation of control systems
Management control systems which are working in a particular situation
may need to be adapted when they are implemented in different scenarios
(e.g. as mentioned above, in different countries or cultures). This also
applies to businesses that have different parts undertaking different
operations (e.g. services or products) or where some divisions are
expected to pursue different strategies from others.
Multinational companies usually have significant decentralisation and
may have divisions operating in different industries and in different parts
of the world. They will be using financial results controls to monitor
performance. These organisations may experience information asymmetry
with divisions that will know their own business well. This makes it harder
to determine which controls are effective.
12.4.1 National culture
National culture has been defined as ‘the collective programming of the
mind that distinguishes the members of one group or society from another’
(Hofstede, 2001).
Thus employees from different cultures must perceive controls as
culturally appropriate (i.e. they must fit with the shared values of the
society from which the employees come). The characteristics of a national
cultural and the political and economic environment are likely to affect
a company’s corporate goals. American companies are most likely to put
shareholders first, whereas in China there is a culture of putting ‘customers
first, employees second and shareholders third’, according to Jack Ma of
the Alibaba Group, a multinational technology conglomerate (Financial
Times, 2014).
This, in turn, affects the MCS that will be suitable to be adapted in a
different country or society.
12.4.2 Local institutions
Countries will differ with regard to:
•
regulations on corporate governance and governance interventions
•
company law, contract law and employment law
•
the existence and strength of trade unions
•
the effectiveness and efficiency of financial markets in raising capital
and the rules on disclosure
•
the strength of regulations, auditing and enforcement.
All these will be important in setting, especially, results controls.
12.4.3 Difference in local business situations
Business environments can differ significantly across countries as well as
within different countries. This will affect an organisation’s ability to use
the same MCS in different places.
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Regional uncertainty can be seen in:
•
military conflicts, kidnapping, terrorism and extortion threats
•
corporate espionage and theft of company secrets by competitors
•
developing countries where there may be limited access to capital,
weak accounting regulations and poor enforcement of contract
violations.
All of these issues will affect whether a company should set up in another
country. If it does make the decision to go ahead, it will need to decide
on ways of protecting a division and setting performance targets that will
need to be unique to that circumstance.
Governments in different regions take different attitudes to business
intervention. There may be limits on businesses being able to set up due
to government-granted business permits. Price controls and restrictions
on the flow of currencies may be in place. Governments may act to
give preference to local businesses rather than foreign companies. The
countries’ tax laws and employment laws must also be considered.
Inflation may differ from country to country and will often affect
currency rates between countries. High inflation can have an effect on
asset values and erode the value of employees’ earnings. Monitoring
financial performance in this situation may require the implementation of
inflation accounting to mitigate the effect of inflation on asset values and
performance. Alternatively, there may be a flexible budgeting process that
will protect managers from the risk of inflation. The company could also
put greater emphasis on non-financial indicators.
Employees in some developing countries may be less educated or skilled.
This may lead to a preference for more centralised decision structures and
more emphasis on action controls than results controls. Small divisions
may make the separation of duties for internal control difficult.
A national corporate culture that assumes lifetime employment will
require different approaches to long-term incentive plans and may affect
recruitment as the available talent pool will be a smaller.
Activity 12.14
Explain the problems with foreign currency translation and identify four suggested ways
of dealing with the problem. (If you need help with answering this question, refer to
Merchant and Van der Stede (2017) p.186.)
12.5 Summary
As we have seen, creating an effective MCS is complex and every area
must be reviewed regularly by managers to enable the system to be
effective for every employee. It needs to be tight enough and specific
enough to encourage the meeting of strategic goals, but at the same time,
it must be seen as fair and appropriate by the employees and managers
who are required to operate the system.
12.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the issues to be considered in implementing tight results
controls
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AC3193 Accounting: markets and organisations
•
explain the issues to be considered in implementing tight action
controls
•
explain the issues to be considered in implementing tight personnel
and cultural controls
•
identify, in general terms, the direct costs of management control
systems
•
describe behavioural displacement related to results, action and
personnel and cultural controls
•
describe gamesmanship, creation of slack resources, data manipulation
and operating delays
•
explain the negative attitudes that may arise through poor design of
controls
•
identify the types of situation where adaptation of control systems may
arise.
12.7 Case study
1. Read the case study ‘PCL: A breakdown in the enforcement of
management control’ at the end of Merchant and Van der Stede (2017)
Chapter 4, pp.168–72, then answer the following questions:
•
Analyse the challenges faced by PCL in reducing returned sets and
no fault found (NFF) returns.
•
Apart from the recommendations already put forward by PCL,
what other actions might improve the return rate of TV sets?
•
What lessons can PCL draw from its exercise in controlling the
high rate of returns of TV sets to inform its execution of internal
control mechanisms in the future?
12.8 Test your knowledge and understanding
1. Explain the term ‘behavioural displacement’ and give examples of how
this can arise in relation to:
134
•
results controls
•
action controls
•
personnel/cultural controls.
Chapter 13: Designing and evaluating management control systems. Identifying financial responsibility centres
Chapter 13: Designing and evaluating
management control systems.
Identifying financial responsibility
centres
13.1 Introduction
This chapter focuses on the design and evaluation of the various controls
discussed in previous chapters and how they should be used. It looks at
what activities and behaviour are desirable and what is likely to happen.
The difference between the two indicates where controls should be
introduced or changed.
The chapter continues by considering the types of responsibility centres
that are created to enable the use of results controls and the methods of
transfer pricing which are used when different responsibility centres trade
with each other.
13.1.1 Aims of the chapter:
This chapter aims to:
•
draw together the issues already covered in Chapters 11 and 12 of
the subject guide relating to the design and use of different types of
control
•
focus on results controls and how they are used in different
responsibility centres
•
explore in detail the purpose of transfer prices and the different types
of transfer price which companies may use.
13.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
discuss the different situations in which different types of control are
most effective
•
describe different types of responsibility centres and give examples of
each type
•
describe different methods of setting transfer prices
•
explain the situations in which each method is likely to be used and
the limitations of each method.
13.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapters 6 and 7.
13.1.4 Further reading
Horngren, C.T., S.M. Datar and M.V. Rajan Cost accounting: A managerial
emphasis. (Harlow: Pearson Education, 2015) 15th edition
[ISBN 9780134475585] Chapter 22.
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13.2 Designing and evaluating management control
systems (MCS)
The issues in this section relate to Merchant and Van der Stede (2017)
Chapter 6 which you can read either before, after or in conjunction with
these notes and activities.
Designers of MCS need to have some knowledge of a company’s objectives
and strategies. This enables work descriptions, targets and rewards to be
developed. To make these work effectively, MCS design must be tested to
see if control problems – such as lack of direction, motivational problems
or personal limitations – will mean that key actions will not be performed
and key results will not be achieved. If there is evidence of this, then
the controls must be adjusted to make them effective: ‘The discrepancy
between what is desired and what is likely will determine the
choice and the tightness of the management control systems’ (Merchant
and Van der Stede (2017) p.221).
13.2.1 Personnel/cultural controls as an initial consideration
These controls have few harmful side effects and are cheap to implement.
In some small organisations where a team spirit and good day-to-day
communications are possible, these may be the main control systems.
Activity 13.1
Read the examples of good and bad corporate culture in the section ‘Personnel/cultural
controls as an initial consideration’ in Merchant and Van der Stede (2017) Chapter 6.
Make notes on how a good culture can be maintained as a company grows.
13.2.2 Action and results controls
Advantages of action controls
•
Action controls are the most direct form of control. It is easy for
employees to identify what should be done and the emphasis is on
performing actions correctly the first time.
•
Creating documentation of the required actions accumulates
knowledge of what works best. The policies and procedures developed
are an organisational memory which enables the transfer of knowledge
to new employees.
•
Action controls aid organisational control.
Disadvantages of action controls
136
•
Action controls can only be used for highly routine tasks.
•
If not properly designed, the controls may be used on the part of a task
which is easily measurable but of lesser importance (e.g. encouraging
fast throughput of products which leads to poor workmanship and
rejected units). This in turn leads to behavioural displacement.
•
Action controls discourage adaptation and innovation. Employees
assume they are not required to be creative and become passive and
resistant to change.
•
Employees may become sloppy or cut corners.
•
Action controls may cause negative attitudes from creative employees
who want to use their judgement and initiative. This may motivate
them to leave the organisation, leading to high staff turnover and
higher training costs.
Chapter 13: Designing and evaluating management control systems. Identifying financial responsibility centres
•
Action controls which require preaction reviews by superiors can be
expensive. This is because reviewers will be more highly qualified, so
their time is more expensive. Also, delays may occur because they are
busy with their own responsibilities. However, these reviews must be
carried out properly if they are considered necessary.
Activity 13.2
Read the examples of good and bad experiences of action controls in the section
‘Advantages and disadvantages of action controls’ in Merchant and Van der Stede (2017)
Chapter 6. Make notes of the different types of action controls that are described and
discuss these with other students on the VLE.
Advantages of results controls
•
Results controls are feasible when the desired results of the action
can be set, but the way in which the results will be achieved is not
known. Employees are expected to use their skills and judgement to
assess the possibilities and implement those that will work best in the
circumstances.
•
They encourage creativity and new and innovative ways of thinking.
•
Results controls allow employees to be autonomous.
•
Organisations can provide on-the-job training as employees learn by
doing and making mistakes.
•
Results controls are relatively inexpensive to monitor as they do not
require a high level of supervision.
Disadvantages of results controls
•
There is the possibility of congruence or alignment problems due to
imperfect knowledge of the desired results.
•
Good measures should be precise, objective, timely and
understandable. Results controls do not fit these requirements and so
it is difficult to tell whether good actions have been taken.
•
Often results are affected by factors other than the employees’ skills.
•
Targets set are often required to meet multiple, important, but
competing, control functions (e.g. budgets for motivation should be
challenging, for planning they should be realistic and for coordination
they should be conservative to ensure that resources are not wasted).
•
Measures may be too many and conflicting.
Activity 13.3
Read the examples of factors that affect results, important but conflicting control
functions and conflicting measures in the section ‘Advantages and disadvantages of
results controls’ in Merchant and Van der Stede (2017) Chapter 6.
Then think of and describe a situation where you have been given responsibility to do
something but without enough information to be sure you have done the right thing.
13.2.3 Control system tightness and adaption to change
Tight systems are most important in the areas that are most critical for
the company’s success. The level of tightness must be assessed for each
situation and may change over time.
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Activity 13.4
Read the section ‘Simultaneous tight-loose controls’ in Merchant and Van der Stede
(2017) Chapter 6. It describes how a strong culture can enable tight-loose controls to be
implemented. Then makes notes on what you have read.
As organisations grow or respond to their changing environment, the
controls that are in place will adapt. Feedback on the effectiveness of
each control may lead to different types of control being considered.
(See Chapter 12 of the subject guide, where there is a list of many of the
situations where change may be needed.)
The appropriateness of any control is measured by the behavioural
response from those performing the activity that is being measured.
Therefore management need to be sensitive not only to whether the
expected results are being achieved, but also to whether employees
continue to feel that they are relevant and acceptable.
13.3 Identifying financial responsibility centres and
transfer pricing methods
The issues in Sections 13.2 and 13.3 relate to Merchant and Van der Stede
(2017) Chapter 7 which you can read either before, after or in conjunction
with these notes and activities.
Financial results control systems
All types of controls have been reviewed in terms of their features,
appropriateness and limitations. In the following sections of this chapter
we will focus on results controls, in particular financial results controls.
We will consider the operations and limitations which arise in specific
situations. These issues can be measured using financial targets; they
require employees to use their initiative and judgement in order to meet
the requirements of their responsibilities.
It should be remembered that results controls only measure certain aspects
of a job and an employee who is being assessed will also follow action and
personnel/cultural controls as part of their job. For example, a salesman
may have a sales target to meet (results control) which requires that they
show initiative in finding customers and negotiating deals. The salesman
will be required to deal with customers within the organisation’s ethical
guidelines (personnel/cultural control) and complete the relevant forms to
activate the production and dispatch of the goods that have been ordered
(action controls).
Advantages of financial results controls
138
•
Financial controls are a necessary and important part of the success
of for-profit organisations (and are needed for the effective use of
resources by not-for-profit organisations).
•
They allow managers to maximise the monetary effect of operating
initiatives which must be either income generating or money saving.
•
They enable top management to assign targets to different
responsibility centres and measure the results without having to micromanage the actions that lead to the results. Top management will only
get involved where results indicate that there are problems (although
this can lead to employees manipulating results, as discussed earlier).
•
Financial measures are relatively precise, compared to softer measures.
Chapter 13: Designing and evaluating management control systems. Identifying financial responsibility centres
•
The costs of operating and supervising the controls are small, relative
to other controls.
Disadvantages of financial results controls
•
Financial results controls are very specific and usually relate to a
particular time period (often a year). This can encourage managers to
focus on improving the yearly results by making decisions that may
not be goal congruent for the whole organisation.
•
They may discourage investment in activities which are needed for the
future profitability of the responsibility centre.
These are very important issues and we will look at them in depth in
Chapter 15 of this subject guide.
13.3.1. Financial responsibility centres
The most important aspect of a responsibility centre is that its purposes
must be well defined and the resources available and authorisations made
clear. It is within this framework that a manager has responsibility and
within which they must achieve their financial targets.
The financial targets may be very general (e.g. a target return) or they
may be more specific (e.g. the preparation and agreement of a budget to
meet the financial target). As with all controls, there should be defined
consequences of meeting or not meeting the target.
Responsibility centres usually fall into one of four categories: revenue,
expense, profit or investment centres, as detailed below:
Revenue centres
Here managers are held accountable for generating revenues, for example:
•
sales departments in commercial organisations
•
fundraising managers in not-for-profit organisations.
These centres are not profit centres. Revenue targets are set and the costs
of running the centre are monitored separately. For example, in a sales
department the expenses will include the sales manager’s salary, salespeople’s
salaries as well as commissions and the costs of running the department.
In a fundraising department, these expenses will include managers’ and
administrators’ salaries, departmental running costs and, possibly, fundraising
costs, depending on where the responsibility for these lies
Expense (cost) centres
Here managers are held accountable for the expenses or costs of running
the responsibility centre.
These centres are usually categorised as ‘standard’ or ‘engineered’
cost or expense centres, where both the input (e.g. materials, labour,
etc.) and the output (i.e. products and services) can be easily measured. A
production department or a dental practice are examples of these types of
centres. The inputs and outputs can be measured in monetary terms and
there is a causal relationship between inputs and outputs. This enables the
costs to be estimated in relationship to the output (e.g. standard costs can
be flexed to represent actual output).
Or they can be categorised as ‘discretionary’ or ‘managed’ cost
or expense centres. These types of centres provide services to other
centres, and it is often difficult to measure output in monetary terms.
Examples of these include administration, personnel, accounting and
finance, research and development and maintenance departments. The
financial results controls are usually based on an agreed budget which
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may be set incrementally depending on previous experience or may use
some sort of zero based budgeting.
Some organisations convert these centres into profit or break-even centres
by requiring them to charge the departments who use their services. This
is sometimes done by charging market rates and allowing departments
to use external suppliers, thus creating a market. This runs the risk of the
internal department sitting by idly while the user departments are paying
external providers. It also requires a transfer pricing decision to be made.
Profit centres
A profit centre is a part of the business where managers are held
accountable for generating profits (i.e. the manager has significant
influence over both revenues and costs). It is distinguished from an
investment centre in that there is no discrete investment over which the
manager has decision-making control.
The advantage of a profit centre is that it enables the manager to run the
centre as a business. They can make trade-offs between revenues and
costs, and the measures they are likely to take are comprehensive because
the centre can incorporate all the financial aspects of performance.
The advantage of being able to make trade-offs encourages some
organisations to turn sales revenue centres into profit centres by charging
the standard cost of the products to the centre. This requires them to be
answerable for gross profit not sales. Cost centres can be converted into
profit centres as discussed above.
Activity 13.5
Read the section ‘Profit centres’ in Merchant and Van der Stede (2017) Chapter 7,
where you will find examples of cost centres being changed into profit centres by being
empowered to charge revenues. Make notes of the behavioural issues and problems with
price setting which can arise, and discuss these with other students on the VLE.
Investment centres
These are units where revenues, costs and the investment required
to generate returns are identified and where the manager has some
decision-making control or responsibility for the use of all three. There
may be some discretion over which level of profits and which assets the
investment centre manager has responsibility for – for example, should a
proportion of head office costs be charged to the centre?
The financial measures may involve a ratio of net income earned to capital
employed. In some organisations this is regarded as the target when
setting a comprehensive budget which will take into account the strategic
role of the division and any plans to change the assets during the year.
Monitoring throughout the year is then performed relative to the budget.
In other organisations, where investment units largely perform the same
function in different locations, a ‘beyond budgeting’ approach may be used
which measures each unit against the other units using key performance
indicators as well as net income or return on investment.
The different centres described above are convenient labels. In practice,
any variation or hybrid which works for a particular company will be
adopted.
When creating appropriate centres, it is important to follow the lines of
responsibility of each centre and include the items which the manager
should pay attention to.
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13.4 Transfer pricing
13.4.1 Definition
The transfer price is the artificial price that is set by a company which
has products or services that are transferred between profit centres,
investment centres or break-even centres within the same organisation.
The transfer price affects the revenues of both the supplying profit centre
and the costs of the buying profit centre. Hence, the profits of both entities
will be affected in an equal and opposite fashion. The effect on the pre-tax
net income of the company as a whole will usually be unaffected by the
level of the transfer price.
13.4.2 Purposes
The purpose of transfer pricing is to:
•
Provide information to motivate centre managers to make economic
decisions in the best interests of both the centre and the group. The
pricing should appropriately influence the decision on how much
to transfer internally. This can be affected by constrained or spare
capacity in the supplying centre. If one centre is at capacity and cannot
supply the product, the buying centre may need to check whether
another centre can meet the demand before they buy in from external
sources. This situation may be helped by reducing the transfer price
when there is spare capacity.
•
Make available information that is useful for evaluating the economic
and managerial performance of the division. This is important for
motivation and performance appraisal, and also helps with the
allocation of resources within the company.
•
Maintain each manager’s autonomy in running their centre. The
transfer price method should enable the manager to make good
economic decisions. Therefore, once a method is adopted, interference
from top management can lead to poor decision-making and delays.
13.4.3 Top management intervention to maximise group
performance
In order to maximise the net income of the group, top management may
intervene to move profits between company centres or locations.
This may be used:
•
for tax purposes where a company is operating in different tax
jurisdictions so that more profit is declared in the area where taxes are
lower
•
where a centre is in a joint venture with another company, profits may
need to be moved from that centre to another centre within the group
– it is usual for the transfer prices to be set in the contract with the
joint venture to avoid possible expropriation
•
if a company is trading in countries which restrict the repatriation of
profits (possibly because of balance of payments problems or scarcity
of foreign exchange funds), transfer prices can be used to transfer
funds to the home country.
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Activity 13.6
Imagine that you work for a company that has centres that trade in both high tax areas
and a low tax areas. Assume that your company has a centre trading in a country which
restricts repatriation of funds, and that it has a trading centre and a head office in a
country where there are no restrictions.
Explain how the transfer price would be set to reduce taxes and/or enable repatriation of
funds, if the centres are selling different products to each other.
13.5 Methods of setting transfer prices
13.5.1 Introduction
It is important to recognise that some transfer prices can only be used
in certain circumstances, so the ‘best’ price will be the most appropriate
one for the particular situation. Often the method for implementing the
transfer price will be set by top management, but this may not mean that
this will be only method that is used throughout the organisation.
Choosing the appropriate transfer price is most important when a significant
proportion of the centre’s trade is made by divisional transfer and is thus
represented by the transfer price. If trade between two divisions is, say, 2%
of the total sales value or purchase value, even an inappropriate method
will hardly affect the centre’s decision-making or results.
The descriptions and explanations below refer to situations where the
centres trade within one jurisdiction.
13.5.2 Market-based pricing
Market based with perfect competition
This is defined as the existence of a ‘perfectly’ competitive external market
(i.e. no individual buyer or seller can affect the price).
The transfer price is based on the actual price that is charged to
customers. If there is no market price for the particular product required
by the buying division, the price of a similar product can be used,
adjusted for differences between the transferred product and the product
sold to customers. The differences may be the result of packaging costs,
difference in quality or other specific features. If neither of these are
available, the price that a competitor would charge can be used.
Because the market price will be used for trading with an external buyer
or seller, in many cases this method helps both the selling and buying
managers to make an optimal decision from a corporate viewpoint.
If a seller cannot earn a profit from trading at market price, it is
economically unsound for the buying division to pay more to prop up
the division. This would also lower the buying centre’s profits. Therefore
the buying centre will buy from outside suppliers. Similarly, if the buying
division cannot make profits by buying at market price, it should close
down that part of the business.
Market-based price with imperfect competition
Most businesses operate in imperfect markets. However, if they are selling
the same or similar products or services to other centres as they are selling
to external customers, the same price can be used since this represents
the opportunity forgone from not selling externally. The situation may
be different, though, if the loss of sales to other centres would create
spare capacity. This is discussed below. If a supplying centre can supply a
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product that is currently being bought by the buying division externally,
the transfer price is the external price currently being paid. But if the
buying division is happy with the current supplier, it may be necessary
for a lower price to be offered if the buying division wishes to obtain the
work.
Distress market prices
This occurs when a selling centre has already bought a commodity and
the price has gone down significantly but temporarily. Normally the seller
could decide to wait until the market readjusts, but if another centre wants
the commodity it will buy it externally for the distress price, which is not
good for goal congruence since the buying centre already holds inventory.
Top management may intervene and suggest an average price between
the distress price and the normal price. This intervention would need to
be taken into account when appraising divisional performance of both
divisions.
13.5.3 Cost-based methods
Full cost plus
This method calculates both variable and fixed costs for a product or
service and a profit percentage is added. Where a market price is not
available, and both centres are profit or investment centres appraised
on net income, this method is an approximation of market price. It is
considered fair because it allows the selling centre to earn a profit on
internally transferred products or services. The prices are not quite as
responsive to market conditions as the market price but they provide a
measure of long-run viability which is important for both the buying and
the selling centre.
The method is relatively easy to implement because companies have cost
systems in place to calculate the full cost of production.
One of the disadvantages of this is that the seller knows that the actual
cost will form the price and so does not need to be careful to control costs.
This can be mitigated by basing price on standard cost.
Another is that the full cost calculated may not represent the current cost
of production. In many cases historical cost depreciation is included and
the allocation of overhead costs may not have been done using a detailed
approach such as activity-based costing.
It may also be difficult to determine the percentage of profit which should
be added.
Full cost based
This method only uses the variable and fixed costs. It therefore does not
provide a profit for the selling division and gives a reduced price to the
buyer in comparison to it being bought from an outside supplier.
The difficulty with this method is that there is no incentive for the
selling centre to do internal transfers since there is no profit margin and
the selling centre’s profit is understated due to there being no profit
element. The buying division obtains the goods at a price that is lower
than if an outside supplier were commissioned.
Therefore, this method is not suitable where the selling division is a profit
centre. However, it may be used by management for charging a service
department’s costs to user departments to help make decisions about
whether to use the service departments. This cost calculation could use an
ABC analysis.
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Decision-making anomalies have been observed when full cost plus (or
market price) are used in situations where the selling centre has spare
capacity and the buying centre could sell more of the final product if the
product price were reduced. In order to make that decision, the buying
centre needs to know the total variable costs incurred by both centres to
decide by how much the price can be reduced. Even knowing this is not
sufficient to motivate the manager to expand, as the reduced price may
cut the total net profit of the centre, even though it would increase total
corporate profits. The selling centre would see increased profits as a result
of selling more at the same margin as before. To resolve this issue, some
organisations use marginal cost for the transfer price.
Marginal cost based
This price excludes upstream fixed costs and profits. Therefore, the
marginal costs remain visible for the centre that finally sells to outside
customers. However, it provides poor information for evaluation purpose
as the selling centre cannot even cover fixed costs so it incurs a loss and
the profits of the buying centre are overstated.
It is therefore rarely used in practice without some adjustment,
which is discussed below.
Marginal cost plus a lump-sum fee
In this case the marginal cost of each unit is paid and a lump sum for the
use of capacity is agreed and paid regularly to the selling centre from the
buying centre.
The marginal cost of the transfer remains visible and the selling centre
can recover its fixed cost and a profit margin through the lump-sum fee.
However, the fee has to be based on the predetermined amount of use
made by the buying centre of the selling centre’s capacity. Therefore it is a
problem to estimate how much capacity should be ‘reserved’ for internal
sales.
Marginal cost plus proration of contribution
In this case, the monthly payment made by the buying division to the
selling division is based on the total contribution made by the finished
product. This is divided between the two divisions on some reasonable
(agreed) basis.
13.5.4 Dual rate
This method is rarely used, but it is another way to meet the issues
described above. It involves charging and crediting different prices to
the centres. The selling centre receives the market sales price and the
amount charged to the buying centre is the marginal cost of production.
This creates a difference that may be taken into an account and used to
reconcile the differences when consolidating the financial statements.
There would also need to be an adjustment when appraising the results of
the buying division whose net income will be overstated.
Advantages
Dual rate provides the proper economic signals to the centres for decisionmaking and correct information for the evaluation of the seller centre.
It ensures that internal transactions will take place, whereas the other
methods may be considered too complicated by the selling centre.
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Disadvantages
In terms of decision-making, dual rate destroys incentives for the buying
centre to negotiate favourable outside prices from suppliers (as the buying
centre now only pays the marginal cost). It destroys incentives for the
selling centre to improve productivity because it finds ‘easy’ sales inside
the organisation. Dual rate also distorts the buying division’s profits
for evaluation purposes. This would also need to be adjusted for when
appraising the results of the buying division whose net income will be
overstated.
13.5.5 Negotiated price
Transfer prices are negotiated between the selling and buying centre
managers themselves. This method ensures the autonomy of the divisional
managers when compared to methods imposed by head office. It also
allows for flexibility in uncertain conditions.
For this method to work effectively, both centre managers should have
the option to use alternative suppliers or buyers as this will increase
their bargaining power. If the transaction is a small part of one centre’s
operations but a large part of another centre’s operations, then there will
be a power imbalance.
The price may not be economically optimal, but may rather depend on the
negotiating skills of the managers involved.
It is may be costly in terms of management time and this may accentuate
conflicts between centre managers. This method may also require
corporate management intervention.
13.5.6 Simultaneous use of multiple transfer price methods
Even though the methods used may not be perfectly suited to both
decision-making and performance evaluation, it is rare to use more than
one system for the same transactions. The simultaneous use of the multiple
transfer price method is mainly used to meet the needs mentioned above
of moving profits between jurisdictions. Here international (OECD) rules
restrict how the transfer price can be calculated and different countries
may also have rules governing this area.
13.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
discuss the different situations in which different types of control are
most effective
•
describe different types of responsibility centres and give examples of
each type
•
describe different methods of setting transfer prices
•
explain the situations in which each method is likely to be used and
the limitations of each method.
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13.7 Case study
1. Read the case study ‘Diagnostic products corp (DPC)’ at the end of
Merchant and Van der Stede (2017) Chapter 6, pp.233–41, then
answer the following questions:
•
Evaluate the design of the performance bonus system at DPC for
US-based field service engineers (FSEs) as it currently exists and
the way that the programme is being implemented. What changes
would you suggest, if any?
•
Instead of using results controls like the performance bonus
programme, could DPC control its US-based FSEs using only action
and personnel/cultural controls?
13.8 Test your knowledge and understanding
1. With regard to discretionary expense centres, explain how targets are
determined and appraisal is conducted.
Incorporate in your answer examples of these centres, including
some that have fairly easily identifiable outputs and some that have
difficulty in identifying outcomes. Explain how selling their services to
other departments might be useful and what problems might arise.
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Chapter 14: A detailed look at planning and budgeting
Chapter 14: A detailed look at planning
and budgeting
14.1 Introduction
As already discussed in previous chapters, setting targets, measuring
results and rewarding performance are vital aspects of management as
they give focus to employees’ activities.
This chapter looks at the role of budgeting in contributing to the
performance of these tasks and the behavioural advantages and
problems which arise as a result. In profit-seeking organisations, it is
essential to ensure that the planned activities contribute to the expected
financial results. The activities should also meet the strategic aims of the
organisation. This involves all managers being committed to meeting their
revenue and cost targets in order to achieve these goals. However, setting
these financial targets will involve the participation of top managers and
the functional managers involved, so that they all understand the issues
that each party is likely to face and the financial targets they are prepared
to agree to.
14.1.1 Aim of the chapter
This chapter aims to:
•
outline the purposes, processes and pitfalls of planning and budgeting.
4.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the main purposes of budgeting
•
identify the three budgetary planning cycles and explain why each one
is necessary
•
describe different ways of setting targets
•
discuss the reasons for setting highly achievable targets and the
situations in which this may not be suitable
•
describe ‘beyond budgeting’ and explain why it has been advocated.
14.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 8.
14.2 Budget purposes
14.2.1 Planning
Successful organisations plan their strategy several years in advance so
that they can be proactive, rather than reactive, in their environment.
They need to identify the strengths and weaknesses, opportunities and
threats, and determine how these might affect different aspects of their
organisation. These plans require both external information as well as the
views and expertise of the managers who will be required to implement the
plans within the organisation. This ‘thinking ahead’ process should involve
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all relevant personnel in considering the practical actions that need to be
taken to meet the organisation’s strategic aims. Financial impacts must be
attached to these actions to ensure that the financial targets will be met.
This is known as feed-forward control, that is comparing predictions of
expected outcomes with desired outcomes and taking corrective actions to
minimise any differences.
The budgeting process involves drawing up a detailed financial plan that
focuses on the next period (usually a year) and represents the practical
activities that are needed to work towards the strategic goals. It should
include every aspect of the business and ensure that all managers are
committed to the outcomes they have agreed to.
Activity 14.1
Read the examples in the section ‘Purposes of planning and budgeting’ in Merchant
and Van der Stede (2017) Chapter 8 of companies who are successful because of
their commitment to comprehensive budgets and are thus prepared to meet future
opportunities.
Make notes about how, if you were a production manager, you would prepare to meet
changing sales targets and discuss these with other students on the VLE.
14.2.2 Coordination
No plan can work without coordination and if this is not properly planned,
this is an area where it would be easy for one part of the organisation
to assign blame to another. The coordination between upper and lower
management, and horizontally across departments, to ensure that
everyone is involved and informed, is vital to the smooth and efficient
running of the operation throughout the year.
Top management oversight
Before they are adopted, plans and budgets must be examined, discussed
and approved at successively higher levels of management to ensure
that they are feasible. The aim is to provide a challenging but realistic
plan, one that incorporates performance targets that can be monitored
using management by exception. Positive or negative variances give top
management early warning of unforeseen opportunities or potential
problems. These can lead to the organisational strategy being reconsidered
or to the activities of subordinate managers being redirected to rectify the
situation.
14.2.3. Motivation
The agreed budgetary target and the actions it represents gives managers
a goal to work towards. Clear, simple and challenging – yet attainable –
goals encourage good performance.
14.3 Planning cycles
14.3.1 Strategic planning
As mentioned above, the strategic plan decides the direction for several
years (three to five, but even up to 10, depending on the type of
business). This provides the strategies for different entities and identifies
the resources that will be needed. This plan informs the annual budget
and it is put together with information from the top management team,
including representation from the research and development, marketing
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and production divisions. It may include the development of new products
and new regions. The plan will also include a review of the existing
products and regions to determine any appropriate action that is necessary
to make them more viable or to discontinue them. There will be a review
of the possibilities of moving into completely new commercial fields.
14.3.2 Capital budgeting
This involves more than just evaluating expenditure on non-current assets.
It includes identifying steps to implement the agreed specific expansion
and replacement programmes for the next few years. The strategy to
implement the required internal activities will be incorporated.
Each part of the company will identify their needs by reviewing their
existing activities and how they need to be adapted. This may include,
for example, finding a new sales outlet, developing employee skills or
employing personnel with different expertise as well as possibly acquiring
new equipment. This is not necessarily a mechanical process as resources
may be limited and managers with good bargaining skills may affect the
direction of the strategy.
A group of corporate managers will be actively involved in the process.
They might review large programmes and help to communicate corporate
priorities, to avoid issues arising due to a lack of direction. They will
also perform preaction reviews to define how any new investment will
be implemented. This is a form of action control that helps functional
managers to understand where their activities fit into the organisation’s
portfolio of activities. Functional managers therefore have a focus and an
opportunity to represent their issues and problems, which gives the process
a bottoms-up aspect. The final aim is to ensure that the programmes
adopted are in each case aligned with corporate objectives and strategies.
14.3.3. Operational budgeting
This budget operationalises the work done in strategic and capital
budgeting to create revenue targets and to make provision for sufficient
expenses to meet the organisation’s goals. Budgets are usually set for
12 months, coinciding with the financial statements, and identify the
activities expected of each responsibility centre.
14.4 Target setting
The budgets, once agreed, become targets that the managers will have to
meet. Ensuring that the budget is met will be a part of their evaluation and
may also be linked to incentives. Performance review, including variances
from the budget, is an opportunity to evaluate effectiveness and efficiency,
and inform organisational learning by, for example, finding savings or,
where variances are favourable, building on the actions that led to the
favourable outcomes. These reviews can therefore lead to continuous
improvement.
14.4.1 Setting financial targets
Targets can be set by:
•
A quantitative model (engineered targets): examples of this
include time and motion studies that identify the time and resources
needed to produce output and which attach current costs to these
resources (a good example is standard cost). These costs will be flexed
by output each period. These models are usually monitored with tight
controls because the link between effort and results is clear.
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•
Incremental budgeting: this is based on historical performance
and is adjusted to include expected changes from the previous year.
They may be agreed after negotiations, as department managers may
know more about expected changes than higher management. Once
these budgets are agreed, the appropriate level of control must be
set. It may be possible to use tight controls, but this also encourages
managers to exaggerate potential cost increases in order to build in
slack, so looser controls may be more suitable.
•
Zero-based budgeting: this requires managers to start from zero
and justify every expense. It is the preferred method when a company
is taken over and efficiencies through cost cutting are expected.
•
Negotiation: this is a process of negotiation between lower and
higher level managers. They will attempt to bridge the asymmetric
gap between higher management who know more about overall
organisational incentives and resource constraints, and lower level
managers who are more aware of the business opportunities and
constraints at the operational level. Fairly loose controls may be more
suitable at this level as there may be great uncertainty about the
period ahead.
•
Setting targets using relative (internal) performance:
companies with highly controlled operations that are similar in all
their branches (e.g. fast food outlets) may use relative performance as
part of the targets that a manager is expected to achieve.
•
Using external benchmarks to set targets: as part of their
strategy, companies will consider where they stand in their industry.
From there, it is a logical step to set targets that are measured against
their competitors, both in terms of setting operating margins but also
in more detailed areas such as product quality, customer service, etc.
Activity 14.2
Read the examples of industry benchmarking in the section ‘Internal versus external
targets’ in Merchant and Van der Stede (2017) Chapter 8. Then do an internet search to
find further examples of benchmarking.
14.5 Recasting the budget
Many companies find that because the budgeting process needs to start
well before the financial year commences, by the time the budget is
operational or within a few months of the beginning of the year, the
budget needs recasting. This means that the original budgetary targets
remain the same but many of the cost and revenue budgets must be
realistically revised, otherwise the variances will be meaningless. Since,
at the profit centre level, the performance targets remain the same,
responsible managers must use their commercial skills to adjust their
activities to the new environment.
14.6 Common financial performance target issues
14.6.1 How challenging should financial performance targets be?
Motivational theory suggests that people make most effort when the
targets they have been set are difficult but possible to achieve (see
Figure 8.1 in Merchant and Van der Stede (2017) Chapter 8). However,
if the targets look too difficult and employees feel as if they are likely to
fail to meet them, they will stop trying. This attitude is also affected by
personality and the degree of uncertainty of the task.
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In practice, studies have shown that, at the profit centre level, targets are
set at a highly achievable levels (e.g. they will be achieved 80 to 90% of
the time). This is not easy as it requires a consistently high level of effort.
Setting highly achievable targets works because this:
•
Increases managerial commitment: managers feel that, despite
having a difficult job they can achieve the targets and so they will
make the effort to do so. Managerial commitment is vital because
the measurement covers a long budget period. If a manager is
unmotivated from the start and fears that targets are unachievable,
this will be compounded by uncertainty in the environment in which
the centre is operating. In turn, decreased motivation may result
in poor decision-making. This problem of a long budget period can
be helped by setting targets to be achieved within shorter intervals.
However, this is expensive as more detailed budgets will need to be
prepared, which requires more time for the reviewing process.
•
Protects against optimistic projections: if sales targets are
expected to be set at highly achievable levels, it means that resources
will be planned to help meet these expectations. More resources will
be acquired if sales are expected to be higher, but if too high a sales
forecast is used, resources may be acquired that cannot easily be
divested.
•
High managerial achievement: since managers feel they can
achieve the targets that have been set, they are motivated to do so
and their self-esteem will be high, which will be reflected in their
performance. This can be reinforced by bonus packages for higher
achievement.
•
Reduces cost of interventions: because the targets are highly
achievable, intervention by higher management can focus on managers
who are not meeting their targets (see Figure 8.2 in Merchant and Van
der Stede (2017) Chapter 8).
•
Reduces game playing: meeting the set targets is very important
to profit centre managers because of the risk of losing bonuses,
promotion and reputation. If it looks as though their targets will not be
met, they will engage in manipulative actions in order to do so. Highly
achievable targets reduce the risk of this happening.
14.6.2 When is it necessary to set challenging profit targets?
If the company is in extreme financial difficulty, setting challenging targets
may signal to managers that short-term profits are a priority over growth.
14.6.3 How much involvement should subordinates have over
setting their targets?
High involvement
•
This enhances managerial commitment as the managers understand
better why the targets are set as they are.
•
Information-sharing managers are closest to local information, while
corporate managers can share corporate priorities and constraints.
•
The process helps cognition – managers have a better understanding of
how to achieve their goals.
•
Managers’ motivation is increased because they have been recognised
as having relevant knowledge and expertise.
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Low involvement
•
Corporate management has sufficient, or better, information than
subordinate managers.
•
Corporate management can evaluate performance on a relative basis
due to running homogenous units (e.g. food outlets).
•
This is preferable when lower level managers are not good at
budgeting (e.g. in some small firms).
•
Corporate managers have better knowledge than lower level managers
because of high-level decisions that change the way a unit operates.
•
Corporate managers may be aware of biases in the management team,
which means that targets should be adjusted (e.g. managers who set
lower targets to make their jobs easier). Optimistic managers may set
targets that are unrealistically high.
14.6 Criticisms of budgeting and consideration of
beyond budgeting
In large, complex organisations it is impossible to get every aspect of
budgetary control completely right. Even if this were possible, it would
be a very time-consuming activity and could cause conflict, feelings of
unfairness and manipulation.
Activity 14.3
Read the section ‘Planning and budgeting practices and criticisms’ in Merchant and Van
der Stede (2017) Chapter 8 to find out how long companies take to prepare budgets and
how many staff are included in this process.
The ‘beyond budgeting’ movement proposes that budgets should not
be produced. Targets and performance indicators should be based on
comparing different business units to each other and against competitors’
performance, using key performance dimensions.
This has worked well, particularly in terms of performance appraisal for
some companies where the business units are fairly homogenous and
so can be compared easily. It is possible, however, that such companies
may still use budgets for planning, coordination and facilitating top
management oversight.
The beyond budgeting movement has criticised budgets as:
152
•
being rife with game playing
•
producing only incremental thinking and minor modifications to the
plans of previous periods
•
locking the organisation into a fixed, inflexible plan, leaving it unable
to respond to changes
•
centralising power and stifling initiative
•
separating thinkers (planners) from doers
•
causing too many costs for too few benefits.
Chapter 14: A detailed look at planning and budgeting
14.7 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the main purposes of budgeting
•
identify the three budgetary planning cycles and explain why each one
is necessary
•
describe different ways of setting targets
•
discuss the reasons for setting highly achievable targets and the
situations in which this may not be suitable
•
describe ‘beyond budgeting’ and explain why it has been advocated.
14.8 Case study
1. Read the case study ‘Kranworth Chair Corporation (KCC)’ at the end
of Merchant and Van der Stede (2017) Chapter 7, pp. 274–82, then
answer the following questions:
•
Identify the key recurring decisions that must be made effectively for
KCC to succeed. In KCC’s functional organisation, who had authority to
make these decisions? Who has the authority to make these decisions
in KCC’s new divisional organisation?
•
Did KCC’s management go too far in decentralising the corporation?
Or did they not go far enough? Or did they get it just right? What are
the reasons for your choice?
•
Evaluate KCC’s new performance management and incentive scheme.
If KCC retains its new structure, what changes would you recommend?
•
Assuming that the R&D is decentralised to the divisions, would this
necessitate making changes to KCC’s performance measurement
incentive scheme? If so, why and how?
14.9 Test your knowledge and understanding
1. Explain the findings of motivational theory relating to target setting,
and indicate ways in which, at the profit centre level, many companies
interpret these ideas on target setting.
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Notes
154
Chapter 15: Incentive systems
Chapter 15: Incentive systems
15.1 Introduction
In this chapter, we will look at appropriate ways in which companies can
reward (or punish) employees’ work. We will also examine the types and
purpose of incentives, how to design a system and how the system can be
evaluated. Different incentives are relevant to different situations and also
to the personal circumstances of individual employees.
15.1.1 Aims of the chapter
This chapter aims to:
•
identify different types of incentives
•
outline the issues involved in determining appropriate and effective
incentive schemes.
15.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the types of incentive that can be used
•
explain the purposes of using incentives
•
identify the different types of short- and long-term incentives, and
explain the different purposes that are served by using these
•
explain why subjective rewards may be used and discuss the
advantages and problems that arise from their use
•
discuss the ways in which group rewards are useful and what their
limitations are.
15.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 9.
15.2 Purposes and types of incentives
15.2.1 Purposes
Well-designed incentives create goal congruence that link an employee’s
self-interest to the company’s goals. The purpose of incentives are:
Informational (effort-directing)
Each incentive informs the employee about the relative importance of the
competing results areas. This may mean that several different measures
are weighted in the overall bonus plan.
Where incentives are focused on the wrong outcomes, these can be
changed in order to direct employees’ efforts to the appropriate area.
Motivational (effort-inducing)
Rewards should encourage the desired behaviours from employees so
extra reward is given if they exert extra effort.
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Attract and retaining personnel
Some companies offer a relatively low basic salary, but have generous
incentive schemes that are paid regularly.
Creating variable costs
Incentive schemes that are performance-dependent have the effect of
making salaries partially variable with company performance.
Activity 15.1
Read the section ‘Purposes of incentives’ in Merchant and Van der Stede (2017) Chapter
9. Then make notes on the Barclays Bank and BP examples, where incentives were given
despite the wrong outcomes. Discuss your notes with other students on the VLE.
15.2.2 Types of incentives
Non-financial
Many incentives are non-financial. Some arise from personnel/cultural
controls (e.g. praise and recognition). Others may result from good
performance (e.g. better job or office assignments, being given more
responsibility or status, or being rewarded with titles, job security, greater
autonomy, power, promotion or opportunities to participate in important
decision-making processes or in executive development programmes).
Some non-financial incentives are ‘perks’ and include things like a reserved
parking place, country club membership, first class travel, merchandise,
prizes and time off, for example.
Financial
Financial incentives include bonuses, salary increases and stock options
(see 15.3 below).
Negative incentives
If an employee’s work is poor, it may be signalled by no bonus being paid,
no salary increase or another kind of penalty. But if this is the case, it may
also be an indication that certain employees need more supervision by
managers, or that the employee should be assigned to less important work.
This could be a demotion or even result in job loss.
15.3 Monetary incentives
Monetary incentives are increases in pay in response to performance.
Different organisations will set up their processes in different ways.
15.3.1 Salary increases
Salary increases are a permanent and continuing change to an employee’s
income. Salary increases that are the result of cost of living increases,
collective bargaining or seniority payments are not specific incentives.
The incentives are awarded on merit, for performance above the norm
with the expectation that this will continue.
15.3.2 Short-term incentives (STI)
Bonuses, commission or piece-work payments encourage employees to
work above minimum expectations. These can be paid annually or more
frequently, depending on the performance being recognised. For example,
piece-work payments and commissions can be paid weekly or monthly.
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Chapter 15: Incentive systems
Bonuses for achieving or even exceeding financial targets may be paid
yearly. Bonuses can also be paid for non-financial performance areas (e.g.
customer satisfaction or quality management). In some cases, even if poor
financial results have been reported, managers are still been paid bonuses
for meeting other targets that have been set. If this is not acceptable, the
organisation can introduce a modifier; this means that if basic financial
targets are not met, other bonuses will not be paid either.
Surveys suggest that eligibility for bonuses and their size increase as
employees move up the organisation.
Short-term incentive schemes are designed to encourage good operational
decisions in order to maximise performance over a month or year,
depending on the frequency of appraisal. For example, a salesman’s
commissions may be paid monthly, whereas bonuses for departmental
financial performance are likely to be paid yearly.
15.3.3 Long-term incentives (LTIs)
Long-term incentives should motivate employees to achieve long-term
growth and increase the value of the business. LTIs tend to be aimed at
higher levels of management who are in a position to make decisions
that have long-term impact. They encourage senior managers to make
decisions which, even though they may have a poor impact on the current
year’s results, will have a significant effect in subsequent years. LTIs are an
attempt to cope with the problem of short-termism in decision-making and
enable senior managers to share in long-term successes.
Typically an LTI will cover performance achieved over three to four years.
The performance targets to be achieved can be cumulative over the years
or by the end of the period set. The latter can be either consecutive (the
next plan starts at the end of the previous one) or overlapping (a new plan
begins each year). Overlapping LTIs make it easier to enrol newly eligible
executives. The use of overlapping cycles is most common.
Activity 15.2
Create a numerical example of nine years of a division’s net income, with a benchmark
target that must be reached over three years, before an LTI is payable and a percentage
reward given for exceeding that target. Explain how the LTI would be paid on a
continuous three-year basis and an overlapping basis.
Stock option plans
Stock options give managers the right (option) to buy a specific number
of shares in the company at a set price during a particular time period
(usually the price set is the share price on the day the right is offered,
which is known as ‘at the money’). The option can be exercised (vested)
over a number of years (e.g.one-fifth per year for five years) and will
expire at some point (e.g. in 10 years). Managers may be required to give
up their unvested options if they leave the company.
Advantages for the company
•
Stock options provide incentive compensation without outlay by the
company.
•
The manager only benefits when the share price goes up. Therefore,
managers benefit when shareholders benefit, developing motivation
to work towards improving the company profits. It ties the manager’s
wealth to the company’s future and encourages them to think like
owners.
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•
It helps with retention of talent, particularly if options have not been
vested.
•
The options create a positive cash flow for the company when the
managers exercise their options and a possible tax-deductible expense.
Disadvantages for the company
•
The issue of shares dilutes the total shareholding and can create
downward pressure on share prices.
•
Managers may feel encouraged to make riskier decisions as they are
rewarded by share price gains but are not penalised (at least in the
short term) by share price losses.
•
Share prices can be volatile for reasons beyond the manager’s control.
•
The attractiveness of stock options varies around the world, but has
always been more prevalent in the USA than elsewhere. Due to the
disadvantages described above, it is now not used so much.
Restricted stock plans
Long-term incentives are often paid with company equity rather than
with cash. Increasing the manager’s ownership share in the company
encourages decision-making which contributes to the company’s long-term
growth. The shares cannot usually be sold for a set period of time after
they have been given and would be forfeited if the manager left before the
end of an agreed period.
They tend to be regarded as a retention tool, rather than as a motivational
one for senior executive talent. If an executive leaves the company, they
typically forfeit unpaid long-term incentives that they otherwise might
have earned.
Performance stock or option plans
The idea behind performance stock or option plans is that the shares do
not vest until a particular performance has been achieved. This may be a
share price, but equally this may be an internal measure of success.
There are many different ways in which the stock options or plans can be
organised, depending on the company’s situation.
Activity 15.3
Search the internet for examples of companies using stock plans as part of their LTIs. You
might look at http://fortune.com/2016/03/11/equity-programs/ or another website. Make
notes on what you discover and discuss these with other students on the VLE.
15.4 Incentive scheme design
Management needs to design incentive schemes carefully, and they should
have a clear understanding of the purpose of each incentive before it is
implemented. Employees need to have a good understanding of why the
scheme has been introduced, how it is going to work and how they can
calculate their entitlement.
15.5 Incentive formulas and subjective rewards
15.5.1 Incentive formulas
Employees whose pay is affected by an incentive plan based on a formula
should receive a contract setting out all the details of their entitlement.
These plans are usually based on the expectation that a certain base level
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Chapter 15: Incentive systems
of work (threshold) will be achieved and a bonus will only be paid if this is
exceeded.
15.5.2 Subjective rewards
Managers who are responsible for running departments and motivating
employees may be required to have the ability to distinguish between the
performance of different employees. They may also value the opportunity
to use financial rewards subjectively, which are not part of the formulaic
system, so as to recognise individual good performance. Subjectivity can
be used in the following ways:
•
All or part of the bonus will be based on the manager’s subjective
judgement about an employee’s performance.
•
The weights on some or all quantitative measures are decided
subjectively.
•
Subjectivity is used to decide whether or not to pay the bonus.
Why use subjectivity?
•
The rewards may be used to recognise a wide variety of evaluation
criteria; at the beginning of an evaluation period, it may not be clear
which activities are most important to emphasise. Choosing the
wrong bases or weightings could motivate employees in the wrong
direction. If the contract remains flexible, employees will be motivated
to do their best and not give up because the target seems impossible.
Equally, if employees do not know what the target is, they will not stop
making an effort once the target is reached.
•
Keeping rewards vague means that employees will not try to
manipulate performance measures.
Although these points are useful for managers, how will they affect the
employees? Subjectivity can reduce the risk of employees not being
rewarded fairly if it enables adjustment for things that are outside the
employees’ control and which reduce their ability to meet targets.
However, subjectivity is likely to increase an employee’s risk, if evaluators
judge them on different criteria from those they were expecting.
Subjective evaluations are likely to have hindsight bias. If employees do
not trust their evaluators to make informed and fair assessments of their
performance, they may become demotivated and frustrated.
Employees may try to influence evaluators to give them a better
evaluation. Therefore the use of subjectivity is most valuable when there
is trust and a good working relationship between the employee and the
evaluator.
15.6 The shape of the incentive function
With formulaic rewards, there is usually a lower cut-off of what employees
have to achieve before a bonus is payable to ensure that mediocre
performance is not rewarded. The level of the lower target will probably
partly depend on the possibility of achieving it.
Equally, there may well be an upper limit as well. This is used because:
•
A very high reward may not be deserved because of windfall events.
•
Employees may take actions that improve the achievements of the
current period at the expense of a future period.
•
The company may wish to avoid the situation of an employee earning
more than their superior in the organisation.
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AC3193 Accounting: markets and organisations
•
It is desirable to keep employee earnings fairly consistent so that they
can sustain their lifestyle.
•
A faulty design plan could lead to very high rewards.
Activity 15.4
Read the section ‘Size of incentive pay’ in Merchant and Van der Stede (2017) Chapter
9. Then make notes explaining how an incentive pay package can play a part in selecting
employees for a role and how it can make it difficult for the company to attract talent.
Discuss your notes with other students on the VLE.
15.7 Criteria for evaluating incentive systems
Incentive packages will be tailored to a company’s needs so there can be a
wide variety of these. Generally, the rewards from the scheme should be:
•
Valued by the recipient. However, this will vary from employee to
employee. The incentive scheme is only part of what attracts an
employee to a job and its importance will vary due to different factors,
such as stages in their career, different lifestyles and their personal
commitments.
•
Large enough to have an impact. Small bonuses can be insulting.
Employees may be contemptuous or angry if their efforts are only
rewarded with this sort of recognition.
•
Understandable to the employee. Poorly understood schemes will not
encourage the desired behaviour.
•
Bonuses should be timely. They should be awarded soon after they
have been earned. This encourages motivation and, as part of the
performance feedback, can help an employee to learn to be more
effective and earn improved rewards in future.
•
Durable (long-lasting). The result of this will be that an employee’s
feelings of motivation and encouragement will last as long as possible.
•
Reversible if an evaluator makes mistakes. Promotion to a higher
role is usually difficult to reverse, but bonuses promised for the
performance of specific tasks can be withdrawn if necessary.
•
Cost effective. The desired motivation must be generated at the least
cost.
Activity 15.5
Read the section ‘Monetary incentives and the evaluation criteria’ in Merchant and
Van der Stede (2017) Chapter 9. Make notes on two different issues that might make
incentive schemes ineffective. Discuss your notes with other students on the VLE. If
possible, work with students who have made notes on two different issues.
15.8 Group rewards
Group bonuses can be useful for cultural control and are important when
group activity is needed and individual contributions are hard to identify.
Individuals in the group will be motivated to work together and anyone
not pulling their weight will be encouraged to do so by the group.
However, group rewards do not provide a direct incentive for individual
employees, so some may not be contributing to the group’s achievements.
This behaviour is likely to be discouraged by group social pressures, but
this may not work if the employee is not a team player.
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Chapter 15: Incentive systems
Stock-based schemes, by their nature, are group rewards since improved
company performance benefits everyone. However, there is little direct
link between these rewards and employee behaviour and so low-level
managers may feel unable to make a difference to performance and
become demotivated.
In some companies group rewards are part of the organisational culture.
An example is the John Lewis Partnership where employees are the only
people who share in the profits that the company makes.
15.9 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
describe the types of incentive that can be used
•
explain the purposes of using incentives
•
identify the different types of short- and long-term incentives, and
explain the different purposes that are served by using these
•
explain why subjective rewards may be used and discuss the
advantages and problems that arise from their use
•
discuss the ways in which group rewards are useful and what their
limitations are.
15.10 Case study
1. Read the case study ‘Harwood Medical Instruments plc (HMI)’ at the
end of Merchant and Van der Stede (2017) Chapter 9, pp. 374–75,
then answer the following questions:
•
What was the purpose of the change?
•
Calculate the bonus earned by each manager for each six-month
period under the new plan and compare this with the old plan.
•
Evaluate the new plan. Is there evidence that it produced the
desired effects? What, if anything, would you change in the new
plan? Explain what and why.
15.11 Test your knowledge and understanding
1. Describe the different types of short- and long-term incentives and
explain the different purposes that are served by using both of these
kinds of incentives.
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Notes
162
Chapter 16: Financial performance measures and their effects
Chapter 16: Financial performance
measures and their effects
16.1 Introduction
Organisations have many aims and responsibilities. These may include
ensuring that products are safe to use, that employees are fairly treated
and work in a safe environment, and that the company recognises its
responsibilities to the local community and the environmental impact
of their activities. However, as well as meeting these obligations,
organisations are required to cover their costs and, in the case of
companies with independent shareholders, must ensure that they
maximise the value of the company to the shareholders who have invested
their money in it.
Investors value the company as the measurement of the discounted total
future net cash flows that the company is expected to make. The discount
rate is set by the likelihood of the cash flows continuing. In a risky
company the discount rate will be high because investors expect a higher
return as they are taking more risk. This is reflected by the company’s
share price.
The company’s value is therefore improved by either increasing the size of
expected cash flows or by making them less risky and therefore reducing
the discount rate.
There is a difference between economic income (as defined above)
measured by the return to equity shareholders and accounting income
measured by using accounting rules. This has important implications for
management control.
16.1.1 Aims of the chapter
This chapter aims to:
•
identify the main measures of financial performance used for higher
managerial performance
•
review the behavioural effects of the practice and explore some of the
ways in which detrimental effects can be remedied.
16.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the advantages and limitations of using market measures of
performance
•
explain why accounting measures are widely used
•
discuss the reasons why, if a company wishes to encourage forwardlooking decision-making by its managers, accounting measures have
severe limitations
•
provide numerical examples of the way in which return on investment
(ROI) and residual income (RI) are calculated and the motivational
issues that the measures are intended to encourage
•
explain the purpose of adopting economic value added (EVATM) as a
performance measure and the disadvantages that might result from
using it.
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AC3193 Accounting: markets and organisations
16.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 10.
16.2 Using market measures of performance for
managerial appraisal
Market measures use the value created (i.e. the return to equity
shareholders) calculated as follows: the dividends paid during the
measurement period plus the change in the market value of the stocks/
shares.
16.2.1 Advantages
Market measures are easy to measure, therefore if managers are rewarded
with stocks/shares this tends to be regarded as fair, since they will benefit
in line with shareholders.
The measure is available on a timely basis. It is precise, the values are
objective (i.e. they cannot be influenced by the managers), and it is
understandable and cost effective.
16.2.2 Limitations
Controllability
The measure may be influenced by activities beyond the control of the
managers being assessed. Although top management performance can
affect the measures to some extent, they are not an indicator of the
performance of individual employees lower down in the organisation. This
may lead to them being demotivated by the use of this measure.
There are many activities beyond the company’s control which can affect
the share price. Therefore, the measure can be adjusted to ‘relative
performance evaluation’, which holds managers responsible for the
difference between the company’s performance and the changes in the
overall stock market or the stocks of peer group companies.
Economic profit has not been realised
Market measures are based on expectations of the future, not the realised
performance. Therefore incentives will be based on expectations.
Congruence failure
The company’s plans and prospects are not well known to the market –
partly due to the company’s confidentiality issues – so valuations are not
likely to be accurate.
Manager influence
There may be plans which, if generally known, could harm the company
in the long run, but managers may leak some of the plans to the public in
order to increase the company’s share price.
Anomalies in valuation
These could be due to rumours or lack of information or due to the fact
that the company’s stock is traded infrequently.
Private limited companies
A company not trading on the stock exchange cannot use this approach.
As with all incentive schemes, the effectiveness of these measures must
be assessed for each company. Due to some of the problems with market
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Chapter 16: Financial performance measures and their effects
measures discussed above, many companies use accounting measures, as
well as (or more often than) market measures.
Activity 16.1
Imagine you are a manager of an investment centre division in a company with 12 such
divisions.
What do you think are the good and bad aspects of being rewarded using a market
measure (which would obviously only be available for the company as a whole, as it
uses the company share price)? Make notes of your ideas and discuss these with other
students on the VLE.
16.3 Using accounting measures of performance for
managerial appraisal
Two types of method are usually used:
1. Residual measures: that is, earnings before interest, tax, depreciation
and amortisation (EBITDA), operating profit net income or residual
income (RI).
2. Ratio measures: that is, return on investment/return on capital
employed (ROI/ROCE), return on equity (ROE), return on net assets
(RONA) or risk-adjusted return on capital (RAROC).
16.3.1 Advantages
Accounting measures:
•
Give investment centre managers the ability to make trade-offs: a
manager can improve ROI by making trade-offs between revenues,
costs and investments.
•
Provide a common denominator: easy comparisons can be made both
internally with other divisions and externally with other companies
and different types of investment (e.g. interest rates).
•
Can be timely and objective: profits can be measured precisely and
objectively almost as soon as the financial period (e.g. a month/year)
has finished and auditors can check the figures.
•
Are conceptually congruent with the organisation’s profit maximising
goals: other methods (e.g. cash flows, sales or shipments) do not
adhere to accrual principles, so are more difficult to interpret or
compare.
•
May be controlled by the managers whose performance is being
evaluated: therefore reports can be tailored to fit with the authority of
any level of manager.
•
Are understandable: since accounting measures are commonplace in
business, managers understand them.
•
Are inexpensive: accounting measures have to be prepared anyway for
legal and information purposes.
16.3.2 Main criticisms
Accounting measures fail to reflect economic income well because:
•
The system is transaction oriented: actions are not recognised unless
and until a transaction occurs (e.g. accounting rules mean that a
company cannot incorporate the advantage of developing a new drug
until regulatory approval is granted).
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AC3193 Accounting: markets and organisations
•
The profit declared is subject to the choice of measurement method:
the annual depreciation charge for a particular asset depends on
estimates of the asset’s life, its scrap value and the depreciation
method used.
•
Accounting measurement rules are conservatively based: they
recognise revenue only when it is contractually agreed, but require
companies to write off intangibles immediately and create provisions
against possible losses.
•
Financial accounts ignore economic value changes of intangibles which
accountants cannot measure accurately and objectively: investments
in research in progress, skilled workers, information systems and
customer goodwill are expenses that are incurred in a financial year
and do not appear as valuable assets in the company’s statement of
financial position (unless there is an obvious, specific, identifiable,
sellable asset, e.g. football players).
•
Profit recognises the cost of debt but ignores the cost of equity capital:
this means that the profits are overstated and it is not clear how much
profit has been earned above the cost of equity capital. This makes it
difficult to compare the results of companies with different mixes of
debt and equity.
•
Accounting profit does not recognise changes in risk: a company’s
future cash flows may have become less risky but this is not shown in
accounting profits.
•
Profit figures focus on the past: economic value comes from future
cash flows and past performance is not an indicator of future
performance.
Therefore it is not goal congruent to require managers to make decisions
which improve future performance but then measure their performance
using backward-looking, conservative measures. These measures
encourage short-term decision-making, not long-term value creation.
16.3.3 Specific problems with ROI, ROCE and ROE
These measures, based on accounting principles, discourage new
investment which will, in the initial years, increase the asset base more
than the percentage impact from the investment on the income statement.
This reduces the ROI percentage compared with the previous period.
Accounting rules do not recognise gains until they are realised, but
recognise investments when they are made.
Example 16.1
A company has several divisions. Divisions P and Q are each considering
similar projects with the same cash flows which will start at the beginning
of year 1. The projects both have the following cash flows:
£,000
Investment
£1,800
For each of the following 5 years the cash flows will be :
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Revenues
£900
Cash expenses
£300
Chapter 16: Financial performance measures and their effects
The budgeted ROI, without the new project for each division at the end of
year 1 is:
Division P
Net assets at end of year
Division Q
£000
£000
£3,800
£6,000
£604
£1,200
Net income
ROI
604/3,800
15.8% 1,200/6,000
20%
Assessing the viability of the projects using discounted cash flow at the
company’s cost of capital of 14%:
Present value of £1 at 14%
Year
Discount factor Cash flow
0
1
1–5
3.433
Discounted cash flow
£000
£000
(1,800)
(1,800)
600
2,060
Net present value
260
The company would be happy if either or both divisions adopted the
project. However, if the managers are awarded bonuses based on their
annual ROI, they will not want their ROI to decrease.
Assuming straight line depreciation, the ROI for each division, with the
new project would be:
Project
Division P
Division Q
without
project
with project
without
project
with project
£000
£000
£000
£000
£000
Net assets: end of year
1,440*
£3,800
5,240
£6,000
7,440
Net income
240**
£604
844
£1,200
1,440
ROI
16.7%
15.8% 844/5240
16.1%
20% 1440/7440
19.4%
*Net assets (£000) = cost less one year’s depreciation at 20% = 1.800–
360 = 1,440
** Net income (£000) = cash flow – depreciation – 600–360 = 240
Division P would be happy to accept the project as it improves the
division’s ROI, but Division Q might reject the project as ROI is reduced in
the first year.
In subsequent years the ROI of the project will increase due to the
accumulated depreciation which reduces the asset base by £240 (000) per
year but net income remains constant, as follows:
Project
Year 1
Year 2
Year 3
Year 4
Year 5
£000
£000
£000
£000
£000
1,440
1,080
720
360
0
Net income
240
240
240
240
240
ROI
16.7
22.2
33.3
66.7
infinite
Net assets at end of year
As well as investing in new projects, managers need to replace existing
assets regularly because of wear and tear. The impact of depreciation
shown above deters managers from replacing assets, so they may continue
to use old assets which have been fully depreciated even though the repair
costs and manufacturing disruption are costly. Replacing assets to improve
efficiency before they are fully depreciated also impacts on the net income
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in the year of changing the assets. It may reduce net income due to loss
on the sale of the asset as well as impacting on the asset base in a year in
which the cost savings have not yet been fully realised.
The above illustration also shows problems that may arise when two
divisions are considering a joint investment, the capital cost of which
will be shared equally. The impact of the investment may improve one
division’s ROI but reduce the other division’s ROI. That division would
probably refuse to take on their share of the project. Thus the opportunity
would be lost – to the detriment of the company as a whole.
Activity 16.2
Using the above example, consider the behavioural impact on the two divisions, if the
company’s cost of capital were 20%. Would the managers’ decisions still be good for the
company? (To help you answer this question, see Merchant and Van der Stede (2017)
Chapter 10, Tables 10.1.and 10.2.).
These measures also:
Can discourage spending on intangible developments
Spending on activities which benefit the future (e.g. research and
development projects, employee training and development, acquiring new
customers, etc.) are all expenses in the period in which they are incurred
but the revenues of cost reductions will be experienced in the future.
Can destroy existing personnel cooperation and lose
customers
Cost cutting to improve short-term profits might mean that employees are
required to work harder or use lower quality materials in the products,
thus making them inferior. In the long run, these actions can lead to staff
turnover, loss of customers and increased product returns and repairs.
Can encourage channel stuffing
Sales are boosted by dropping prices if customers buy in bulk near the end
of the financial period. This recognises more revenue in that period.
Can encourage obtaining operating leases rather than
purchasing assets
Operating leases (as opposed to finance leases) do not have to be
capitalised, so do not increase the company’s asset base. However, they
are usually more expensive in the course of the asset’s life than purchasing
assets would be.
16.3.4 Residual income (RI)
Residual income can be a possible solution to some ROI measurement
problems. It uses the same net income and net asset values as ROI. But
instead of calculating a percentage return, RI reduces the net income by
charging for the use of net assets. It is calculated by using the company’s
weighted average cost of capital multiplied by the value of the net assets.
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Chapter 16: Financial performance measures and their effects
Example 16.2
(Using the same factors we encountered in Example 16.1)
Division P
Division Q
Before
After
Before
After
£000
£000
£000
£000
£3,800
5,240
£6,000
7,440
Net income
£604
844
£1,200
1,440
Less capital charge 14% on net assets
532
734
840
1,042
Residual income
72
110
360
398
Net assets at end of year
The new investment impacts on both divisions’ residual income by the
same amount (i.e. £38,000) so motivates both managers to accept the
proposal. However, in the same way that ROI increases as the assets
depreciate in value, the residual income will also increase over time due to
depreciation without any improvement in net income.
RI is stated as a number, not a percentage, so effectively is only comparing
performance over time within that division. It cannot be realistically
compared with other divisions as larger divisions have larger RI purely
because of scale.
Activity 16.3
Create a numerical example to show that divisions with the same ROI but different scales
(e.g. twice as large) have different residual incomes.
16.3.5. Economic value added (EVA™)
Stern Stewart, a consulting organisation, developed this version of RI in
the 1990s. Their main concern was that some of the financial accounting
rules distorted net income and investment (net assets). They proposed
that the figures should be adjusted for such costs as R&D, advertising,
employee development and goodwill. These costs are normally written
off in the year in which they are incurred, which reduces net income,
but using this approach, costs would be capitalised and written off in the
future periods that benefited from them.
The formula is:
EVA(™) = Conventional divisional net income + accounting adjustments –
cost of capital charge on divisional assets + accounting adjustments.
This method of measuring performance should encourage managers to
invest in forward-looking activities as they know that their net income will
only be reduced by the amount used during the current year and the rest
of the expense will be charged in later periods.
Issues with EVA(™)
Although the measure is referred to as ‘economic’, it does not address all
the differences between accounting income and economic income.
EVA(™) requires judgement to determine which costs to capitalise and over
which years to charge them. This could allow managers to adjust their net
incomes by charging more or less of the intangibles against net income in
order to report more favourable net incomes.
It may be difficult for managers to understand the measure, so they may
not necessarily be encouraged to perform in the desired ways.
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AC3193 Accounting: markets and organisations
Activity 16.4
If you were a member of the top management team considering adopting EVA(™), what
rules or guidelines would you adopt for divisions in order to ensure that intangibles which
are capitalised are later written off in subsequent periods. What problems do you foresee
if guidelines are not provided or monitored? Make notes of your ideas and discuss these
with other students on the VLE.
16.3.6 Comparing divisional performance using current cost
accounting
Difficulties are sometimes encountered when comparing performance
between different divisions if HCA is used. This mostly arises in relation to
non-current assets because younger divisions will have bought their assets
in more recent years. Due to inflation, particularly of land, the assets are
more expensive than the assets of older divisions. This results in younger
divisions facing higher net assets and higher depreciation than older
divisions, leading to reduced net income and ROI or RI.
Historical cost accounts can be adjusted to current cost accounts using
annual indices to change the asset values. This method also reduces the
net income as enhanced depreciation charges are made to cover the
new value of the assets. This technique is also used in countries with
hyperinflation to create comparability with previous years and identify the
aspects of trading that have been affected by inflation.
16.4 Reminder of learning outcomes
Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
170
•
describe the advantages and limitations of using market measures of
performance
•
explain why accounting measures are widely used
•
discuss the reasons why, if a company wishes to encourage forwardlooking decision making by its managers, accounting measures have
severe limitations
•
provide numerical examples of the way in which return on investment
(ROI) and residual income (RI) are calculated and the motivational
issues that the measures are intended to encourage
•
explain the purpose of adopting economic value added (EVATM) as a
performance measure and the disadvantages that might result from
using it.
Chapter 16: Financial performance measures and their effects
16.5 Case study
1. Read the case study ‘Industrial electronics, Inc.’ at the end of Merchant
and Van der Stede (2017) Chapter 10, p.421, then answer the
following questions:
•
Using the new scheme, calculate the bonus award as a percentage
of base salary for the following five divisions as an example of the
performance of the company:
Division
Budgeted
operating
net income
Budgeted
operating
assets
Actual
operating net
income
Actual
operating
assets
$,000
$,000
$,000
$,000
1
1,000
8,000
1,150
7,000
2
1,000
8,000
4,500
7,000
3
50
1000
300
800
4
(700)
3,000
(300)
4,200
5
600
1,000
100
1,800
•
Discuss the advantages and problems of the current bonus system.
•
Discuss the advantages and problems of proposed new system.
•
Suggest ways in which the problems of the new system could be
overcome.
16.6 Test your knowledge and understanding
1. Explain economic income and how it can be measured. Discuss
the advantages and problems of using this measure for divisional
performance appraisal.
2. Explain accounting income and how it can be measured. Discuss
the advantages and problems of using these measures for divisional
performance appraisal. You are not required to compare different
accounting measures (e.g. EBITDA, ROI, RI and EVA(™)).
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Notes
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Chapter 17: Remedies to the myopia problem
Chapter 17: Remedies to the myopia
problem
17.1 Introduction
The word ‘myopia’ is the scientific term for short-sightedness. Its use is
appropriate here because, as we saw in the previous chapter, the main
accounting measures regularly used for results controls encourage a shortsighted approach. This does not mean that managers are deliberately
acting against the economic objectives of the company at large. The
performance measures in place motivate managers to improve their own
performance (and therefore rewards) by making decisions that are not
necessarily in the organisation’s long-term interests.
The chapter broadly explores how top management would like managers
to behave and how results controls can be more effective.
17.1.1 Aim of the chapter
This chapter aims to:
•
look at ways to improve performance measurement and align
managers’ decision-making more closely with corporate goals, by
encouraging managers to look to the future as well as the present.
17.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, and you should be able to:
•
explain the term ‘myopia’ and why managers may act myopically
•
discuss the methods, advantages and difficulties of the following ways
of reducing myopia:
•
reducing pressure on short-term profits
•
controlling investment with pre-action reviews
•
extending the measurement horizon
•
measuring changes in value directly
•
improving the accounting measures
•
measuring a set of value drivers.
17.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 11.
17.2 Pressures to act myopically
All business people know that they need to focus on making activities that
are happening in the present really effective but also take actions that
build towards the future.
For example, a local hairdresser and the staff that work there are good at
their jobs and create a warm, welcoming atmosphere. The salon is busy.
The owner, however, chooses to have the salon completely refurbished,
despite the fact that the old furnishings are attractive and serviceable.
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When asked why they spent the money, they said, ‘Customers both existing
and especially new (who do not yet know how good our service is), want
to feel that we are ahead of fashion from the moment they walk in or see
our place on the internet. We pride ourselves on staying up to date with
techniques and styles, and our environment needs to reflect that’.
Looking after daily business while also looking forward by ensuring that
everyone is trained in new techniques and securing the right look for
the salon are all part of running the business. As this is the owner’s own
business, they will reap the benefits in the future.
Corporate managers, who are encouraged to attempt to show smooth
earnings growth and to meet stock market expectations are not motivated
to invest in the future. They are more likely to focus on ensuring that
current profits meet market expectations.
17.2.1 Gamesmanship
This is a type of behavioural displacement that was discussed in Chapter
12 of the subject guide. It is a way of ensuring that performance coincides
with stock market expectations by enhancing profits. Two suggested ways
are by:
1. reassessing reserves (e.g. bad debt provisions) and writing them back
to improve profits
2. selling financial assets at the right time for the profits from them to hit
the reported earnings.
Activity 17.1
Make notes on the section ‘Pressures to act myopically’ in Merchant and Van der Stede
(2017) Chapter 11. It illustrates gamesmanship (i.e. actions to deliberately smooth
earnings to meet stock market expectations).
Although smooth earnings growth is valued by investors, stock markets
also react favourably to announcements that indicate strategically
important investments are being made. Many companies attract investors
specifically because they show that investing in the future, particularly
in terms of innovation of products and/or markets and innovative new
production technologies, are among their future aims.
Activity 17.2
Read the examples of Amazon and IBM in the section ‘Pressures to act myopically’ in
Merchant and Van der Stede (2017) Chapter 11. Make notes identifying the differences
between the two companies and discuss these with other students on the VLE.
17.3 Ways to decrease myopia
17.3.1 Reduce pressures for short-term profit
Instead of placing the most weighting when calculating bonuses on
reaching demanding short-term profit targets, these weightings can be
reduced and more reward given to actions that improve the organisation’s
longer term prospects. Since these actions will vary according to the
situation, a totally formulaic response is probably unlikely. Merchant
and Van der Stede (2017) cite the example of Johnson and Johnson,
the healthcare and pharmaceuticals company, which reviews salary
and bonuses using a subjective, qualitative approach. This organisation
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Chapter 17: Remedies to the myopia problem
seeks to reward effort and recognise unique performance. (We discussed
subjective appraisal in Chapter 15, section 15.5.2 of the subject guide.)
Alternatively, the short-term profit target itself can be made easier to
achieve, giving managers more time to work on longer term activities.
Usually some guidance and performance structure is needed to encourage
actions that are oriented to the future.
The limitations of this approach is that it may reduce managers’ focus on
short-term results without improving long-term performance. Managers
may need to use non-financial indicators.
Activity 17.3
Read the examples of sport in China and HSBC Bank in the section ‘Reduce pressures for
short-term profit’ in Merchant and Van der Stede (2017) Chapter 11. What problems did
they identify and how did they remedy them?
17.3.2 Control investment with pre-action reviews
This solution attempts to cope with the problems cited in the previous
chapter relating to accepting or rejecting investment opportunities.
Idea 1
This works by dividing the income statement into two parts. The top part
calculates short-term operating performance. Managers are appraised and
earn bonuses for maximising short-term operating income.
The costs of longer term investments are entered below the operating income
line. These costs relate to developmental expenses incurred to generate
revenues in the future. Managers can propose ideas for developmental
investments, indicating the expected pay-offs. These proposals are reviewed
in capital budgeting rounds and the outcomes are monitored.
Idea 2
In order to cushion lower level entities from the impact of developmental
expenses, some companies fund these expenses at higher organisational
levels until they begin to generate revenues.
Idea 3
Firms split themselves into ‘today businesses’ and ‘tomorrow businesses’.
The managers of the ‘today businesses’ are expected to focus on being
lean, efficient and competitive, leading to high net incomes. They are
monitored by tight financial controls. The ‘tomorrow businesses’ managers
focus on new business opportunities (e.g. products/markets). They are
monitored by non-financial performance indicators and action controls.
Activity 17.4
Read the example about Google in the section ‘Control investment with pre-action
reviews’ in Merchant and Van der Stede (2017) Chapter 11. Make notes or discuss with
other students on the VLE whether Google’s approach to innovation and its ease of
execution could similarly be adopted by a company selling tangible products.
Limitations
A clear distinction between developmental and operating expenditure
may not exist (e.g. manufacturing processes and market development
expenditure may benefit the present and the future). This requires
judgement as to whether expenditure is above or below the line. This can
encourage gaming by managers.
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AC3193 Accounting: markets and organisations
Using this approach, the final decisions on which developmental
expenditure to fund are passed to corporate management who are less
well informed than entity managers about the prospects of each specific
entity and its funding needs. This could lead to poor quality resource
allocation decisions or corporate managers funding their own pet projects.
17.3.3 Extend the measurement horizon (use long-term incentives)
Merchant and Van der Stede (2017) base much of their discussion of
measurement horizon on the survey research ‘Changing practices in
executive compensation: long-term incentive plan design’ (Compensation
Advisory Partners 2015).
The idea of using long-term incentives is supported by Christine Lagarde of
the IMF and Fidelity, a top 10 shareholder in many FTSE 100 groups and
several European companies. You can read about their views in the section
‘Extend the measurement horizon’ in Merchant and Van der Stede (2017)
Chapter 11.
In Chapter 15 of the subject guide, we discussed the use of stock options
and/or performance targets over three to five years. The survey indicates
that companies are de-emphasising stock options in favour of performance
targets such as return on investment (ROI), total shareholder return (TSR)
and earnings per share (EPS). It also reports that most companies use
more than one measure, with TSR being the most popular.
Not surprisingly, the long-term incentives that most companies choose to
adopt are the key measures of success in their industry. Companies mostly
use internal goals and an external benchmark (e.g. a peer group).
Problems with long-term incentives
Using long-term incentives to reward managers can be expensive as
managers prefer short-term bonuses. This is partly because short-term
targets are more likely to be achieved and also because this means that
bonuses may be paid more frequently. The unpopularity of long-term
incentives is reflected in the fact that managers apply a high discount of
more than 50% to deferred bonuses. This means that if they are not at
least twice as generous as short-term bonuses, managers will continue to
focus on short-term performance.
A way around this problem is to pay bonuses for annual performance, but
claw them back if future performance suffers.
Long-term performance targets can be set by basing them on the
numbers included in the long-term strategic plan, which is developed
with the advice of senior managers. However, a consequence may be that
innovation is stifled for fear that new ideas will not succeed. This leads
managers to make conservative estimates, which is not an ideal situation
for an ambitious, forward-looking company.
17.3.4 Measure changes in value directly
This approach looks at using economic income for each division in an
organisation. In this case, it is not measured by changes in the stock market
valuation. For each division, economic income is calculated by measuring
the discounted future cash flows that the division will generate in the
future with the existing net assets. This is done at the beginning and end of
the measurement period, using an appropriate discount factor.
Limitations
It is very difficult to know how the market, innovations and so on will
change over the years, so estimates are likely to be unreliable, which
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Chapter 17: Remedies to the myopia problem
calls into question the feasibility of this approach. Who will make the
estimates? If the manager to be rewarded prepares the estimates, there is
an obvious motivation to bias them.
The estimates could be checked by an outsider (e.g. an auditor), but
that person would need an in-depth knowledge about the company, the
specifics about what is being estimated and the future strategic focus of
the company. This would also be very expensive.
17.3.5 Improve the accounting measures
The suggestions below include several that have been mentioned in earlier
chapters, so this section provides a summary of those points and mentions
others. It is likely that adopting these measures would involve deviating
from financial accounting rules and maintaining a separate set of records.
However, this is commonplace for tax purposes and is implied by the
concept of EVATM, so it is unlikely to be too much of a problem as data
processing is straightforward these days.
Suggestions include:
•
Choose depreciable lives for assets which coincide with their economic
lives (not the conservatively short period used by many companies).
•
Charge depreciation on the use of older assets which have been fully
depreciated to recognise the continued use of the asset and prompt the
need for replacements (since the asset can no longer be regarded as a
free resource).
•
Capitalise all expenditure required to generate future cash flows (e.g.
R&D, customer acquisition, employee development). These should
then become expenses in future periods as the revenues arise.
•
Capitalise all leases, not just finance leases.
•
Recognise value changes as they arise rather than waiting for the
completion of a transaction (e.g. the mark-to-market basis could be
used). This holds assets in the balance sheet at market value enabling
profits or losses to be recognised when they occur, not just when
the asset is sold. Oil and gas companies recognise value when a
commodity is discovered rather than when it is sold.
•
Charge an imputed cost of equity capital as well as debt interest.
17.3.6 Measure a set of value drivers
This approach moves away from just relying on financial measures and
incorporates a number of the lead activities that have already been
discussed. These value drivers are not measured in financial terms but by
count or percentage.
The expectation is that in each responsibility area a group of measures will
be put together to encourage managers to be aware of, and be rewarded
for, a wider range of activities that improve performance in the short and
long term.
There are several different models that can be used to provide an
appropriate range of financial and non-financial measures. Any model
would need to be adjusted to the needs of a particular company.
The most famous value driver is the balanced scorecard developed by
Kaplan and Norton. It proposes the following structure, which looks at
achievement from four perspectives:
•
Financial: With a shareholder focus (or other more appropriate
name in the public sector), this perspective looks at organisational
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AC3193 Accounting: markets and organisations
financial performance and the use of financial resources. Measures
include: operating income, margins, return on equity and meeting
budgetary targets.
•
Customer/stakeholder: This operates from the point of view of the
customer or other key stakeholders that the organisation is designed
to serve. Measures include delivery targets, customer services and
complaints, and percentage sales from new products.
•
Internal processes: Here organisations run a tight ship by looking
at quality and efficiency relating to products, services or other key
business processes. Measures include cycle times, yield, quality
measures, efficiency and effectiveness.
•
Organisational capacity (originally called learning and
growth): Organisational performance is viewed through the lenses
of developing staff training, improving infrastructure and technology,
new product development and other capacities that are key to a
breakthrough performance.
17.3.7 History of performance measures
Although the balanced scorecard and other models formalised the
incorporation of non-financial measures in organisations, the idea has
been practised in different ways by companies, particularly non-profit
organisations, for many years.
17.4 Strengths of several performance measures
Performance measures aim to make managers aware of leading activities
which result in future profits. In some cases these may be activities to
which managers have not previously given much attention. This focus
creates a feed-forward control mechanism for emphasising activities with
future impacts.
It is important that measures are chosen carefully to prompt managers to
focus on areas which, if ignored, could lead to a poor performance in the
future. It balances short- and long-term goals.
As well as focusing on non-financial measures, the scorecard and other
methods encourage the disaggregation of financial figures which tend
otherwise to be presented in summary form. Examples include sales of
new products and/or identifying new customers or new regions; cost of
training, maintenance and machine upgrading; and product research and
development, so that they can be looked at in more detail.
The approach fits in well with the stakeholder view of the company.
Financial measures focus mostly on the needs of shareholders. Concerns of
other stakeholders (e.g. employees, customers, suppliers, conservationists
and society at large) can be monitored using other measures.
It helps managers to understand the importance of each activity being
measured as this is part of increasing the value of entities.
The system works best if the measures cover the activities that matter most
to the particular company. This involves the development of strategy maps
that can identify the actions needed to pursue future strategy. The ways in
which these actions will impact on the activities of different divisions and
their managers must be determined in detail.
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Chapter 17: Remedies to the myopia problem
17.5 Issues in creating the correct measures
The first step is to identify the activities that make a difference in the
organisation and measure these. For example, a fast food company was
concerned about staff turnover in its branches. They found that general
staff turnover was not a problem for the success of each branch, but that
supervisory staff turnover was.
Some measures will be subjective (e.g. employee morale). In this
case, managers must decide how they are to be measured. Simplistic
measurement can lead to inappropriate behaviour. For example, requiring
departments to provide a certain number of hours of employee training
could lead to employees being sent on unnecessary courses simply to
meet the target. Identifying the ways in which training has improved the
effectiveness of employees is a better measure.
The effectiveness of customers’ experience could be measured by, for
example, customer turnover, mystery shoppers or customer surveys.
The type and number of measures used to define performance will vary,
depending on the responsibilities of the manager. They should be targeted
at the activities that are relevant to that responsibility area and will be
weighted as to their importance.
Sometimes the measures can reduce effectiveness if they are not carefully
implemented. For example, attempting to meet customer satisfaction
targets can mean that more time is spent on each customer than is strictly
necessary which will reduce the throughput of customers, with a resultant
loss of sales.
Pay-off relationships may not be linear, and once a particular level has
been reached, putting in more effort may be unnecessary and wasteful, for
example in terms of customer satisfaction.
These performance measurement systems can be expensive to implement,
especially if they include consultants’ fees, and will need to be refreshed
regularly to keep them relevant.
17.6 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the term ‘myopia’ and why managers may act myopically
•
discuss the methods, advantages and difficulties of the following ways
of reducing myopia:
•
reducing pressure on short-term profits
•
controlling investment with pre-action reviews
•
extending the measurement horizon
•
measuring changes in value directly
•
improving the accounting measures
•
measuring a set of value drivers.
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AC3193 Accounting: markets and organisations
17.7 Case study
1. Read the case study ‘Mainfreight’ at the end of Merchant and Van der
Stede (2017) Chapter 11, pp.488–500, then answer the following
questions:
•
Mainfreight’s top executives (three of whom are qualified
accountants) maintain that their company does not prepare
budgets. Is this an accurate statement? How does one determine
whether a company prepares a budget or not?
At the very least Mainfreight’s management system is not traditional:
•
What are the key elements of Mainfreight’s results control system?
•
Why did Mainfreight’s managers decide to take a non-traditional
approach?
•
How does Mainfreight perform the functions typically fulfilled by
budgets? Are some of these functions not really that important?
•
Does the Mainfreight system address some of the limitations of
traditional budgets? Does it introduce new limitations?
•
Is Mainfreight a well-controlled organisation?
•
Should companies which currently run budgeting systems adopt
some of Mainfreight’s type of systems?
17.8 Test your knowledge and understanding
1. Identify three methods of reducing managers’ focus on short-term
profits. Explain how each method would work and its advantages and
limitations.
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Chapter 18: Using financial results controls in the presence of uncontrollable factors
Chapter 18: Using financial
results controls in the presence of
uncontrollable factors
18.1 Introduction
Uncontrollable factors are a part of life and their effect on businesses
can be substantial. They are the reason for the existence of the insurance
industry. However, many activities are not covered by insurance or are too
expensive to cover. For example, it may be possible for an airline to insure
against flight disruption due to an event like the Icelandic volcano, but
it would be unlikely that an oil company would be able to insure against
tumbling oil prices.
There are many, much smaller, uncontrollable factors that happen
regularly, for example customers going bankrupt or cancelling a big order,
closing a factory due to strikes, breakdown of transport links to bring
materials to the company or dispatch goods from the company.
On the positive side, unexpected excellent weather may lead to better
crops or a bankrupt competitor may open up the market to higher sales.
The big question is: should individual managers be held responsible for
the impact of these events when it comes to their performance appraisal?
18.1.1. Aim of the chapter
This chapter aims to:
•
address the issue of the extent to which managers should be held
accountable for factors that are outside their control.
18.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the controllability principle and give examples of types of
uncontrollable factors
•
describe the actions that can be taken to control for the distorting
effects of uncontrollable factors before the measurement period
•
discuss the ways in which the distorting effects of uncontrollable
factors can be measured
•
outline the advantages and problems of using subjective evaluations
where there are uncontrollable factors.
18.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 12.
18.2 The controllability principle
This states that a manager should only be held responsible for aspects of
a business that they can control. This means that managers do not have to
take responsibility for factors that cannot be predicted and are therefore
outside their control. This would apply to both losses and gains.
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However, the role of a manager is to use judgement to manage their area
of the business, so it would be reasonable to expect that they would take
all possible steps before the event to protect against the impact of disasters
and maximise the effects of gains. After the event, action should be taken
to mitigate any loss or maximise any opportunity.
It is in the organisation’s best interests not to expect managers to bear
uncontrollable risk because it encourages them to be risk averse. They
will manage in ways that reduce risk, for example by not accepting risky
investments or customers whose financial track record is not perfect. Also,
if they are expected to be accountable for uncontrollable risk, they will
expect much higher salaries. Managers may also ‘gameplay’ by managing
earnings or creating budgetary slack to protect their results from unforeseen
problems. Managers will also waste time and effort finding excuses as to
why these uncontrollable events should not be included their performance.
In fairness, responsibility for these uncontrollable events tends to lie more
with the owners (shareholders) who are the risk takers rather than with
subordinate managers.
Activity 18.1
Using information in the section ‘The controllability principle’ in Merchant and Van der
Stede (2017) Chapter 12, or from other sources, explain the circumstances that influence
the level of a manager’s attitude to risk.
18.3 Deciding on whether factors are uncontrollable
18.3.1 Economic and competitive factors
Examples of these are changes in: consumer preferences, demand, prices
of products or services, input prices, labour cost and exchange rate
fluctuations.
This is the most difficult area to assess when deciding whether factors
are controllable or not, because part of a manager’s role is to predict and
respond to variables in trading by, for example, changing an advertising
campaign or running promotions to stimulate demand, redesigning
products, looking for cheaper suppliers or helping employees to be more
productive.
On the whole, companies do not consider making these changes. However,
in some cases an aspect that affects many parts of a business may call
for central intervention (e.g. corporate hedging to mitigate raw material
prices), so will be uncontrollable by the manager.
18.3.2 Force majeure (act of nature or act of God)
Examples of these are one-off, unexpected events like a severe natural
disaster (e.g. hurricanes, earthquakes, floods) or exceptional events like
those involving riots, terrorism, serious illness or death of key executives,
fires and severe installation breakdowns. These tend to be disasters for
most firms but are bonanzas for the companies that are commissioned to
respond and make good after the disaster (e.g. construction companies,
storage facilities, staff temping offices, hotels).
Most companies will protect managers from the downside risk of these
events as long as there is evidence that the manager has taken all possible
actions to mitigate the effect of the disaster.
Managers cannot avoid the disaster, but subsequently they can act to save
money and the company’s reputation.
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Chapter 18: Using financial results controls in the presence of uncontrollable factors
Activity 18.2
Using information from the section ‘Types of uncontrollable factors’ from Merchant and
Van der Stede (2017) Chapter 12, and/or other sources, make notes of the actions that
some companies have taken to save money or maintain their operating ability despite
force majeure. Discuss your notes with other students on the VLE.
18.3.3 Interdependence
Pooled interdependence
This is a situation where the division is affected by the actions of other
divisions in the company because they use shared resources (e.g. corporate
staff activities such as shared human resources support). Is it fair for
divisions to be affected by the poor performance of these services?
In many organisations this is dealt with by an agreed contract between
the divisions and the corporate service, set at the annual budgeting stage
in relation to the services to be provided and the associated costs. This
protects the divisions against cost increases, but not from poor service
from these corporate services.
Sequential and reciprocal interdependence
This arises where one division is dependent on the work of another
division (sequential) or both provide work to or receive work from other
divisions (reciprocal).
This is mostly dealt with by the use of transfer prices.
18.3.4 Interventions from higher management
These actions essentially take away the autonomy of the divisional
manager. Examples include:
•
dictating a specific transfer price which assists tax minimisation or
funds repatriation
•
stating that the division should sell to a particular customer at a lower
than normal price because other benefits will accrue to different
divisions in the organisation
•
not approving decisions initiated by the divisional manager (e.g.
proposed expenditure, changes to production schedules).
18.4 Controlling for the distorting effects of
uncontrollables
There are two complementary activities that can be incorporated, before
and after the measurement period.
18.4.1 Before the measurement period
It is necessary to define the items that the manager can control or have
influence over, set results measures accordingly and take any other
necessary measures. Examples of the other measures are listed below.
Insurance
Many events can be insured against (e.g. physical damage to company
property, damage caused by employees, employee error, vandalism, riots,
theft, product liability).
Design of responsibility structures
The general rule is that the divisional manager will be accountable for
the costs and revenues that they can control. In terms of the income
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statement, the top section can identify controllable revenues and cost
and therefore controllable income can be calculated. Non-controllable
divisional expenses and allocated central expenses are then deducted to
calculate net income.
Some companies may also include, as controllable, costs they wish
the manager to be aware of or pay attention to. This often occurs with
corporate overheads (e.g. personnel costs, information systems costs).
This may be considered correct for two reasons. First, the manager would
have to incur these costs if they were running their own business and may
need the information as a guide to the prices and volume of sales needed
to make target profits. Secondly, the divisional manager can put pressure
on the corporate departments to control costs and provide competitive
services. Taken to its logical conclusion, this should mean that divisions
could also buy the resources in from outside. Whether or not to allow this
would also be a corporate decision. This indicates that to a certain extent
these costs are controllable by the divisional manager.
It is unwise to expect managers to be charged with responsibility for too
many things over which they have too little control.
Contingency scenario planning
In uncertain environments, this activity encourages managers to build
in contingency planning for possible outcomes and therefore to be
prepared to change their plans if necessary. However, it is more costly
than just preparing for one scenario. Companies need to estimate whether
it is sufficiently likely that their organisation will be caught up in the
contingency that has been forecast.
Updating plans more frequently
If there are considerable future uncertainties, using rolling budgets may
be a useful practice. This is because the standards set to create plans are
more likely to become out of date as time goes by and any contingencies
can be reviewed closer to the time they might be expected to happen.
Since standards become less relevant over time, it may be fairer to review
managerial performance monthly or quarterly rather than (or as well as)
yearly. The disadvantages are the expense of more regular reviews and the
fact that in a shorter time period the outcome of some of the manager’s
decisions may not be reflected (e.g. a sales push may have incurred cost
but not yet resulted in higher sales). (This relates to the issues discussed in
Chapter 17 of the subject guide on extending the measurement horizon.)
18.4.2 After the measurement period
If the uncontrollable event occurs during a measurement period, the
financial impact of the event must be adjusted for before rewards can be
assigned. These adjustments may be done objectively through calculations
or subjectively through an evaluator’s judgement.
18.5 Methods which can be used to determine the
impact of the event
18.5.1 Variance analysis
As well as the normal price, volume, cost and usage variances, other
aspects relevant to particular external factors, which are controllable
either by those factors or the behaviour of other divisions, can be isolated.
Merchant and Van der Stede (2017) identify sales performance which
can be measured against industry volume, market share, sales price and
exchange rate.
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Chapter 18: Using financial results controls in the presence of uncontrollable factors
Activity 18.3
Look at Tables 12.2–12.3 in Merchant and Van der Stede (2017) Chapter 12. Make a
note of which variances are considered to be the responsibility of the trading division.
Make up an example of your own.
18.5.2 Flexible performance standards
The aim here is to adjust the monetary figures for events that are outside
the manager’s control by, for example, recalculating the budget to reflect
current exchange rates or making large changes in input prices (such as
adjusting for oil price changes). However, this is only likely to be done if
the manager has no way of avoiding the change by using other materials
or processes to mitigate the effects. Of course, a favourable price should
also be considered if these are also outside the manager’s control.
18.5.3 Relative performance evaluations
This method does not appraise and reward the managers on the absolute
level of results but in relation to a peer group. This can help deal with
the effects of uncontrollable factors that affect the members of a peer
group. The peer group can be other branches of the company or outside
competitors with similar characteristics (e.g. bank branches, fast food
chains).
Activity 18.4
Read the example of Domino’s Pizza in the section ‘Relative performance evaluations’ in
Merchant and Van der Stede (2017) Chapter 12. Make notes of how the results could be
adjusted for these factors and discuss these with other students on the VLE.
Although relative performance evaluation is not possible in many types of
organisation, some reference to industry performance can be included. The
purpose of this would be either to change targets or as part of a subjective
evaluation.
18.5.4 Subjective performance evaluations
Subjective performance evaluations are done by higher management and
are intended to take into account all aspects of performance, including
uncontrollable events. Instead of using formal calculations, the assessor
judges whether the results are strong or weak. These evaluations can be
useful in correcting flaws in the results measures. The evaluator can take
into account other issues.
The problems with subjective performance evaluations are that the
evaluator has power over the manager, which may create resentment. In
addition, biases may occur, including:
•
Outcome effect bias: where the evaluator brings in knowledge of other
results that may not have a bearing on the manager’s performance.
•
Hindsight effect bias: where evaluators assume that knowledge that
was only discovered later was available to the manager at the time
decisions were made. It appears to the evaluator that events were
more controllable than was, in fact, the case.
•
Deterring learning and motivation: The evaluator may not give much
feedback on how bonuses were derived. This deters learning and
demotivates the manager being evaluated.
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•
Managers may not trust the evaluation if evaluators have failed
to honour rewards or promises made previously. This also affects
motivation and morale.
Subjective evaluations can lead to an excuse culture. In psychology, this is
termed ‘attribution theory’, whereby people attribute success to their own
efforts, abilities and skills, and failure to factors outside their control (e.g.
bad luck, the difficulty of the task or other external factors). Thus they
make excuses instead of learning from their mistakes. They tend not to
focus on achieving targets as much as finding excuses. They may appeal
against their evaluation, thus using energy that could be better directed to
performing better.
Subjective evaluations, if done well, will involve the evaluator taking
considerable time to understand the situations faced by the manager
during the period under scrutiny. They have to consider the extent to
which results were due to effort and to which they were due to good or
bad external effects. This may be a cause of resentment for the manager.
Activity 18.5
Imagine you are an assessor. Make notes of the steps you would take to decide how well
a manager had achieved their targets. Discuss your notes with other students on the VLE.
18.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the controllability principle and give examples of types of
uncontrollable factors
•
describe the actions that can be taken to control for the distorting
effects of uncontrollable factors before the measurement period
•
discuss the ways in which the distorting effects of uncontrollable
factors can be measured
•
outline the advantages and problems of using subjective evaluations
where there are uncontrollable factors.
18.7 Case study
1. Read the case study ‘Olympic Car Wash’ at the end of Merchant
and Van der Stede (2017) Chapter 12, pp.531–32, then answer the
following questions:
•
How large should the bonus pool be for the Aalst location?
•
Since Aalst actually made a loss (and possibly other locations did
too), can the company afford this level of bonus?
•
Is the rain the only reason for lower sales? What other reasons
could there be which might be within the manager’s control?
•
Does the method used encourage staff to welcome the rain? Could
they offer other services that are not rain dependent?
18.8 Test your knowledge and understanding
1. Describe the purpose of adjusting managers’ performance for
uncontrollable events.
2. Explain situations where subjective evaluation is likely to be used.
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3. Explain possible difficulties with this approach.
Chapter 19: Management control-related ethical issues
Chapter 19: Management control-related
ethical issues
19.1 Introduction
Ethics provide a good guide to how employees throughout an organisation
should behave. It is important that a company’s code of ethics is followed
by workers at different levels and is also adhered to by upper and top
management. Ethics are a key part of cultural and personnel controls and
can augment action and results controls.
Basic economics assumes that rational people will act to maximise their
own self-interest and that the purpose of for-profit organisations is to
maximise value for shareholders. These assumptions are too simplistic
and ignore the fact that people live and work within the community of
the company and that organisations have many stakeholders as well
as shareholders. Ethical individuals will consider how their behaviour
impacts on other stakeholders (e.g. other employees, suppliers, customers,
the local community and the environment).
However, doing the right thing does not always lead to better rewards.
There is a tension between selfishness and doing the right thing. Those
who behave unethically often benefit financially and those who do the
right thing can earn lower bonuses. Whistleblowers who bring unethical
behaviour into the public domain can be dismissed or demoted, although
some countries have passed laws protecting the rights of such employees.
19.1.1 Aim of the chapter
This chapter aims to:
•
outline the importance of ethics in organisations and the issues faced
by them when introducing and using ethical controls.
19.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the purposes of having ethical codes for professional
organisations
•
describe how ethical codes are used in companies
•
identify four ethical models and explain how they might be used in
companies
•
discuss the ethical issues of creating budgetary slack
•
explain how good ethics should be disseminated throughout an
organisation.
19.1.3 Essential reading
Merchant K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 15.
19.1.4 Further reading
Association of Chartered Accountants (ACCA) ‘ACCA code of conduct and
ethics’, ACCA www.accaglobal.com/uk/en/member/standards/ethics/accacode-of-ethics-and-conduct.html
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Birsch, D. and J.H. Fielder The Ford Pinto case: a study in applied ethics, business
and society. (Albany, NY: State University of New York Press, 1994)
[ISBN 9780791422342].
UK Government ‘Whistleblowing for employees’, GOV.UK www.gov.uk/
whistleblowing/who-to-tell-what-to-expect
19.2 Ethical behaviour in a business context
Governments and organisations pass laws or have rules to deter unethical
behaviour; however, these cannot be watertight and cover all possible
situations. So ethical standards attempt to fill the gaps. There are
nevertheless situations where, through collusion, unethical behaviour
occurs and can be encouraged within a group, which can lead to ethical
drift. For example, directors and managers who are in sufficiently high
positions to affect reported results may be tempted to do so.
Activity 19.1
Read the details of LIBOR and Tesco’s financial reporting in the section ‘Good ethical
analyses and their importance’ in Merchant and Van der Stede (2017) Chapter 15. Note
down ways in which this could have been avoided and discuss them with other students
on the VLE.
19.2.1 Professional ethics
Most professional bodies expect their members to maintain a code of
professional ethics. Part of a professional body’s role is to monitor the
behaviour of their members and to take disciplinary action if necessary,
in order to protect the reputation of all members. You can read advice for
whistleblowers at: www.gov.uk/whistleblowing/who-to-tell-what-to-expect
and the ACCA code of ethics at: www.accaglobal.com/uk/en/member/
standards/ethics/acca-code-of-ethics-and-conduct.html
19.2.2 Providing example and giving training
Company managers should have policies, rules, checks and balances,
measurement systems, rewards and specific ethical policies in place. In
addition, they should lead by example and provide training sessions, sets
of values and codes of conduct to help employees identify and assess
ethical issues.
19.3 Ethical models
Ethics is about how actions affect the interests of other people. There are
four main theoretical models. However, as we are mostly interested in
management controls in this chapter, we will not go into details about
the models, but will highlight the ways in which they affect management
decision- making and control.
19.3.1 Utilitarianism
The consequences of an action are judged in terms of welfare economics
and cost-benefit analysis. The objective is to act in a way that creates
the greatest good for the greatest number of people affected by the
action. A clear example in business was when, in the 1970s, the Ford
Motor Company discovered a fault in the petrol tank of their Pinto cars
which could result in a fire if the car was involved in a rear-end collision.
Nevertheless, they did not recall the 11 million cars affected for a refit. As
a result, several people died in horrifying accidents. Clearly, their costbenefit analysis model did not place a high enough value on human life.
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Chapter 19: Management control-related ethical issues
19.3.2 Rights and duties
This model identifies the basic rights that people have and the duty they
have to uphold similar rights for others.
In a management context, many of these rights and duties are identified
in contracts and job descriptions. Often, these are challenged by unions
or other worker groups if they seem unfair. This implies that a balance
of power exists within an organisation and this creates its own ethical
dilemmas.
Within the workplace, many rights and duties may be covered by the idea
that employees have the right to be treated politely, not be bullied and so
on.
19.3.3 Justice/fairness
This approach considers that processes should be fair even if outcomes
are not: for example, most people do not object to a rich person winning
a lottery if the process is transparent. In a business context, this indicates
that pay and performance packages should be seen to be fair.
19.3.4 Virtues
This model regards morals to be rooted in virtues (e.g. integrity, loyalty,
courage and, possibly, generosity, grace, decency, commitment, idealism
among many others). These can be built into the personnel and cultural
controls of an organisation. It is important that a company has a code of
ethics to which management and employees can refer if there are disputes
over behaviour. Even if the ethical behaviour guidelines are part of an
employment contract, it is also necessary to have action controls to ensure
that the behaviour of staff falls within the guidelines.
19.4 Analysing ethical issues
If there is a situation in which a person or group appears to have behaved
unethically, the company should ensure that there is a system for
investigating and deciding on the next steps.
The method could follow these steps:
•
Clarify the facts.
•
Define the ethical issue.
•
Specify the alternative courses of action.
•
Compare values and alternatives.
•
Assess the consequences.
•
Make a decision.
Activity 19.2
Imagine an unethical situation that has occurred (in a college, club or business) and apply
the above method to analyse and resolve the issue.
Due to the somewhat ephemeral nature of ethical concepts, different
people may come to different conclusions about a situation. It is important
that managers keep an open mind and are aware of different views when
handling issues of an ethical nature.
It must be made clear that there is a difference between acting unethically
and acting fraudulently. If fraud has occurred, the guilty party will be
dealt with through prosecution. However, many areas of behaviour are not
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covered by the law, so ethical behaviour within an organisation is expected
in order to ensure that there is fairness and efficiency.
19.5 Some management control-related ethical issues
19.5.1 The ethics of creating budgetary slack
This occurs where managers are held accountable for their department’s
performance. In particular, this is relevant where meeting or exceeding
performance targets impacts on receiving bonuses, salary rises or
promotions.
In this situation, the department manager is using their superior
knowledge of the operation of the department in order to draw up such
a budget. It results in targets that are easier to achieve and therefore
bonuses will result.
This could be regarded as unethical as it means that the manager does not
have to work as hard, which results in lower profitability for shareholders.
It can also lead to undesirable behaviour such as splashing out on
unnecessary items to meet the budget spend so that next year’s budget will
not be reduced. Higher level managers will use the budget estimates for
their own aggregated estimates when considering resource allocation and
investment decisions.
However, the creation of slack can be justified by managers who regard
it as protecting themselves against the uncertainty of the future that they
have to deal with. This is useful in companies who consider the budgetary
commitment as a ‘hard promise’ which, if not kept, will result in penalties.
It can be regarded as a reasonable reaction to the imbalance that exists
between lower and higher management, and can be considered as part of
the budgetary negotiation process.
Activity 19.3
Read the section ‘The ethics of creating budgetary slack’ in Merchant and Van der Stede
(2017) Chapter 15. Make notes on the factors to take into account when deciding
whether creating slack is ethical in a particular company, and discuss these with other
students on the VLE.
19.5.2 The ethics of managing earnings
This activity uses either accounting methods or operating methods to
report a company’s earnings that are in line with expectations (e.g.
boosting earnings, smoothing earnings or saving earnings to boost future
results).
Accounting rules, professional ethics and corporate law all consider
this to be, at least, unethical and, possibly, illegal since it goes against
the disclosure of information that directors are required to pass on to
investors. There is massive asymmetry of information between directors
and investors, and therefore audited reports are the only way to discover
a company’s true financial position. Large shareholders may be able
to acquire information and may be able to influence board members.
However, smaller shareholders or potential investors do not have this
option, and therefore the auditors’ role is vital.
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Chapter 19: Management control-related ethical issues
Activity 19.4
Read the section ‘The ethics of managing earnings’ in Merchant and Van der Stede (2017)
Chapter 15, which discusses areas where directors might feel that earnings should be
‘managed’.
Make notes of your views and discuss these with other students on the VLE.
19.5.3 The ethics of responding to flawed control indicators
This situation occurs where an employee’s job is defined by action
controls. They notice that there are more effective ways to work, but
do not mention this and continue on in the way they were originally
instructed. For example, a maintenance worker who is required to
maintain certain machines on a monthly basis may notice that some
parts in a particular type of machine often wear out and need replacing
before the month end, so production has to be stopped in that area. The
maintenance worker may not feel it is their responsibility to bring this
issue to the notice of their supervisor.
This issue is more serious where those with higher responsibility,
particularly in the finance area, can see ways in which they could take
action to improve processes or security. Many finance professionals
are required by their professional bodies to be proactive in helping
organisations to avoid financial disaster if they become aware of a problem.
However, many managers and employees are not bound by such codes.
19.5.6 The ethics of using control indicators that are too good
The existence of computer surveillance which can monitor an employee’s
every move is now technically possible. An issue to consider is whether
there is a conflict between an employer’s right to monitor and an
employee’s right to autonomy, privacy and not to be subject to oppressive
controls (which amount to them working in electronic workshops).
Activity 19.5
Make notes on an employee’s and an employer’s point of view of what each party might
consider to be fair rules in the use of electronic surveillance. The section ‘The ethics of
using control indicators that are too good’ in Merchant and Van der Stede (2017) Chapter
15 makes some suggestions.
19.5.7 Spreading good ethics within the organisation
When companies are small and all employees can relate with the owner,
the role model provided by that person is usually the reference point for
the company’s ethics. Larger companies must develop formalised ethics
programmes with a set of values that the company expects the employees
to conform to. These will evolve into policy manuals, codes of ethics or
codes of conduct.
The codes may include specific guidelines (e.g. gifts from clients should
not be accepted) as well as some that are more general and indicate the
values that employees should uphold.
There should also be training programmes giving employees the
opportunity to discuss scenarios that might arise. The safeguarding of
children and vulnerable adults is a topical example of an area that might
be covered. Actions to be taken and who to go to for advice must be
clearly spelled out.
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Employees may be required to sign up to agree that they will uphold the
company’s code of conduct. It may be necessary to run refresher courses as
new areas are developed. This, of course, would lead to it being necessary
for employees to sign a new agreement that incorporates the changes.
Good practice from those at the top of the organisation is essential. If
this is not apparent, then those lower down the organisation will not
feel obliged to adhere to the code either. Monitoring should be done by
superiors and colleagues, although group norms also play a role here.
There should be a procedure for investigating issues and setting sanctions.
There should also be an ombudsman to represent those employees who
encounter ethical issues.
19.6 Reminder of learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the purposes of having ethical codes for professional
organisations
•
describe how ethical codes are used in companies
•
identify four ethical models and explain how they might be used in
companies
•
discuss the ethical issues of creating budgetary slack
•
explain how good ethics should be disseminated throughout an
organisation.
19.7 Case study
1. Read the case study ‘Two budget targets’ at the end of Merchant and
Van der Stede (2017) Chapter 15, p.694, then answer the following
questions:
•
Determine the facts.
•
Define the ethical issues by identifying the stakeholders and listing
who benefits and who is harmed.
•
How might Joe’s superiors act if they discovered what was
happening?
19.8 Test your knowledge and understanding
1. Identify the different levels of responsibility in a typical public limited
company. Explain one ethical issue an employee at each level may
face, why the issue has arisen and which checks may be in place to
help employees to act ethically.
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Chapter 20: Management control in not-for-profit organisations
Chapter 20: Management control in
not-for-profit organisations
20.1 Introduction
In this chapter we will look at how control systems can be applied to
not-for-profit organisations. This can be difficult because the objectives of
these organisations are not focused on profit making (although, in order to
meet their goals, they must stay financially solvent). They must therefore
identify exactly what their goals are in order to convey them to their
employees. They must identify the tasks that employees must carry out
in order to meet the organisation’s goals as well as the measures that will
indicate how well tasks have been completed.
20.1.1 Aim of the chapter
This chapter aims to:
•
provide a brief summary of how management control can be used in
not-for-profit organisations.
20.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
identify different types of not-for-profit organisation and give
examples of the main types
•
explain the main similarities and differences between for-profit and
not-for-profit organisations
•
discuss ways in which public sector outputs can be identified and
measured
•
explain fund accounting
•
identify the ways in which public sector employment may differ from
that in the private sector.
20.1.3 Essential reading
Merchant, K.A. and W.A. Van der Stede Management control systems:
Performance measurement, evaluation and incentives. (Harlow: Pearson,
2017) 4th edition [ISBN 9781292110554] Chapter 16.
20.1.4 Further reading
Moullin, M. ‘How the public sector scorecard works’, Public sector scorecard
www.publicsectorscorecard.co.uk/how-the-pss-works.html
Office for National Statistics www.ons.gov.uk
20.2 Types of not-for-profit organisation
To clarify the kinds of organisations that fall into this category, we have
divided them into different groups.
20.2.1 Public sector organisations
These are either:
•
national government-commissioned bodies, financed by taxation,
and include those running the government (e.g. the civil service, law
enforcement, defence, health, education, transport)
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AC3193 Accounting: markets and organisations
•
local authorities, which are responsible for services in a particular
region (e.g. refuse collection, road maintenance, public health,
education, planning).
In the UK in 2018, these large organisations employed nearly 7 million
people, approximately 16% of the working population (www.ons.gov.uk).
They provide a public good, which means that although every person
or household pays for the services they provide, no one can claim that a
specific part belongs to them. Therefore although the stakeholders are
the citizens and users of the services, they are only empowered to change
things through personal complaints, voting, petitions and the media. In
the private sector, by comparison, each customer has a defined product or
service and can receive redress if there is a fault.
20.2.2 Professional associations
These are set up to protect members and be a voice for them. They often
restrict membership to those who have attained certain qualifications
and, once admitted, members must adhere to a code of ethics. Annual
membership fees are levied and used for representing and protecting the
rights of members. Professional insurance may also be provided and the
association may also fund research (e.g. the British Medical Association).
These associations are usually run by appointed executives. The main
stakeholders are the members. Employer organisations also benefit
from the reassurance that their employees are governed by a code of
professional ethics.
20.2.3 Clubs
These are usually interest groups that use their membership subscription
to fund their interest (e.g. amateur football clubs, drama groups, etc.). The
main stakeholders are the members.
20.2.4 Charities
These are organisations set up with specific charitable objectives. They
can be very large and operate in many parts of the world (e.g. Oxfam,
Greenpeace) or have a local purpose (e.g. universities, hospitals,
museums). Small local charities may be set up to achieve a particular
purpose (e.g. a fund set up to help with or commemorate a particular
tragedy). In the UK, all charities with an income above £5,000 must be
registered with the Charities Commission, must state their charitable
purpose and must name their responsible officers. They also need to
make their financial accounts available annually. As they are funded by
donations, their stakeholders are their donors and the beneficiaries.
Activity 20.1
Use the internet to find out more about the organisational structure of a government
department, association or charity of your choice. On the VLE, see if other students have
chosen a different one from you, and compare your findings with them.
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Chapter 20: Management control in not-for-profit organisations
20.3 Key similarities and differences in management
control between for-profit and not-for-profit
organisations
Depending on their size, not-for-profit organisations use many of the same
controls as for-profit organisations. All the issues mentioned in Chapter
11 of the subject guide are relevant. Both types of organisation face the
same need for an organisational structure that ensures that employees are
controlled and rewarded, and that good financial systems and checks are
in place.
The key difference is that for-profit companies are required to make a
profit to survive, and preferably maximise profits to meet shareholders’
expectations. They will also have other goals to meet the needs of other
stakeholders.
Not-for-profit organisations do not have this profit goal, but they must
stay financially solvent so that they have the funds to fulfil their purposes.
Therefore they need to define their goals clearly before they can focus on
how to meet them. A local authority must serve its citizens and so must
identify the actions required to meet each of their needs and the different
resources required to do so. This means that their intended outcomes must
be clearly understood.
However, as any observer of national, local or club level politics knows,
deciding on the priorities for spending funds and raising funds is not
always easy. Priorities can be influenced by strong personalities, pressure
groups, the media and public opinion.
20.3.1 Goal ambiguity and conflict
Goal ambiguity arises because there are many competing needs for funds
and usually difficulties and/or resistance to raising the funds required. For
example, should a charity’s funds be used for a sudden emergency if this
means diverting funds from an ongoing project?
Organisations will identify the main activities that have to be undertaken
to meet their stated objectives.
Annual budget preparation tends to be a political process as it determines
the amount of money that will be available every year for each type of
service.
For many organisations, particularly national and local governments, much
of the basic work has been done for many years. Therefore their main
objective is to continually adjust the services to meet modern changing
needs with modern methods.
Conflicts arise continuously as circumstances change. For example, should
a hospital prioritise paediatrics or cancer care, since both could do so
much with more money?
20.4 Not-for-profit budgeting
For not-for-profit organisations, the budget is a vital mechanism for
authorisation and control, even more so than for for-profit organisations.
The funds available are finite and are devolved to managers to meet the
needs of their department. One of their performance measures will be to
keep within the budget while delivering services at the required level.
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AC3193 Accounting: markets and organisations
Three criteria which can be used together are:
•
Economy – this measure tests whether the resources are as cheap as
possible, given the quality required.
•
Efficiency – this measures the output achieved from the inputs used.
•
Effectiveness – this determines whether the expected objectives were
achieved.
Many organisations use incremental budgeting as their starting point each
year. This uses last year’s budgeted amount for each department and adjusts
it for known changes for the forthcoming year. This is the quickest and
easiest way of dealing with the huge task of budget preparation. However, it
is known to encourage budgetary slack. It may also fail to take into account
one-off amounts granted for a particular purpose in a previous year. This
amount may be included in subsequent budgets even though it is no longer
needed for that purpose. It also encourages departments to spend up to the
budget to ensure that the next budget will not be cut.
Situations may arise where funds for the whole organisation have been
cut from previous levels for the following period due to recession and
poor collection of taxes, or, alternatively, more money becomes available
than previously. How should those in authority cope with either cutting
expenditure or agreeing to more spending? What services should be affected?
One of the ways that this can be handled is to cut or increase each
department’s budget by the same proportion as the general change. A
reduction leads to departments individually deciding where to make cuts
and sometimes leads to whole activities, in several departments, having to
be cut. If there is an increase and it is spread across all departments, there
is often not enough to fund a new initiative in any one department so the
money is frittered away on non-essentials.
In order to minimise budgetary game playing and create more effective
decision-making, zero-based budgeting was introduced in 1970. Managers
are asked to identify each activity that their department performs and
justify every cost related to it, starting from scratch. This encourages
budgets which have grown over time to be rationalised. Also, each manager
is asked to prepare estimates of how extra money (say £100,000) could be
spent most effectively in their department so as to achieve more activities or
what they would cut if the money was withdrawn from their budget. These
are known as decision packages. This information allows management
to rank the importance of each decision package against strategic goals
and allocate resources appropriately. The practice may be harder on some
departments than on others, but is intended to be more effective overall.
The process of zero-based budgeting is very time-consuming so generally it
is not be done every year. However, the decision package approach could be
used whenever it is appropriate.
For example, a school might ask different disciplines (science, music, art,
sport, languages) what they could do with extra money (or what they
would cut if money was withdrawn from their budget).
The method attempts to:
•
identify and discontinue obsolete activities
•
increase staff involvement and understanding of how costs arise
•
allocate or reduce resources more effectively.
This tool is not without the risk that managers will exaggerate the benefits
or losses that their department would experience. It can also lead to
tension or resentment.
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Chapter 20: Management control in not-for-profit organisations
Once the annual budgets and planned outcomes have been decided,
targets are set to monitor the outcomes as the year progresses. The targets
may be partly informed by the previous year’s achievements, in the same
way that happens in for-profit companies.
20.5 Difficulties in measuring and rewarding
performance
In order to be able to control not-for-profit organisations, departments
have specific responsibilities that must be met, within a budget. As with
any budget mechanism, this meets with problems of uncertainty over how
much money is required and the likelihood of budgetary slack. However,
many activities can be measured in the same way as they are in for-profit
companies. For example, the time it should take to collect refuse in each
district can be specified; procedures for routine hospital activities can be
laid down, and in both cases action controls can be used.
In not-for-profit organisations, more difficult outcomes tend to have to
be measured. For example, how do you assess whether social work cases
are being handled correctly or if schoolchildren are achieving at expected
levels?
In arenas where several institutions are performing the same work (e.g.
school, hospitals, police forces, prisons), benchmarking is a useful way of
analysing performance. This can be developed into league tables. However,
emphasising the unit’s position in a league table should be used with care
as it can lead to incongruent behaviour by the unit in order to meet the
statistics. Targets may be met by taking resources from other important
activities that are not measured. The measures can be compromised, in
much the same way as is observed in for-profit companies. To use the
measures most effectively, organisations that are not achieving as well
as others should be encouraged to learn from the practices of the most
effective performers. It is also important to incorporate intervening
variables within the measures. For example, schools situated in areas
where pupils are not easily able to continue their studies at home are
likely to be less successful in terms of academic achievement and therefore
they may need more money to develop after-school homework clubs.
In some situations, possibly charities, few comparisons can be made, as the
activity is unique to that organisation. These organisations must develop
their own output measurement methods. One aspect which large charities
often publicise is the percentage of their donations that they spend on
administration. They obviously attempt to keep these costs as low as
possible.
An example of the difficulty that can arise in measuring and rewarding
actions was illustrated when people taking part in an archaeological dig
were paid extra for each item discovered. Unfortunately, this led to diggers
breaking larger items in two so they could receive double pay.
Activity 20.2
Discuss the effect that school league tables have on staff, pupils, parents and prospective
families.
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AC3193 Accounting: markets and organisations
20.6 Accounting differences
In the UK, accounting standards have been compiled for local authorities
based on international financial reporting standards (IFRS) and are issued
jointly by the Chartered Institute of Public Finance and Accountancy
(CIPFA) and LASAAC (the Local Authority Code Board). Charity
regulations in the UK are laid down by the Charities Commission.
The main difference, compared with limited company accounts, is the use
of fund accounting for donations and grants, some of which have been
given for a specific purpose. The use of each fund is recorded and reported
separately. The funds fall into different categories – restricted funds,
designated funds and general funds, which may have different titles in
different jurisdictions.
Restricted funds can only be used for the specific purpose for which they
were set up. For example, a church requires £180,000 to repair its historic
organ. A fundraising campaign is launched and the money is credited
to the restricted organ fund account. This may not be a separate bank
account, but the funds cannot be used for any other purpose. Sometimes
there are opportunities to obtain grants from the government or other
institutions which will match the funding raised by public donations.
Donors will wish to be sure that the money they have given is kept
separately so that the matching funding will be claimed and that money is
only used for the specific purpose.
Designated funds are created for a specific purpose. An example is a
maintenance fund, deliberately set up and financed by fundraising and by
moving funds from the general fund in order to have resources available
for the repair and replacement of assets. These funds are not restricted
and, with the agreement of trustees, can be moved to a different fund if it
is clear that they are not needed for their original purpose.
Auditors will ensure that the funds are only used for the designated
purpose.
The general fund is used to record an organisation’s day-to-day activities.
The income and expenditure account (the general fund) is very similar
to an income statement of a for-profit company but shows any surplus
or deficit for the year rather than net income or net loss. Balance sheets
(where used) also have similarities to their commercial counterparts.
Charities will incorporate all their funds into a consolidated statement
called the statement of changes in fund balances, which shows grants,
money donated, money transferred between funds and monies paid out to
fulfil the restricted or designated needs of the fund.
Activity 20.3
Use the internet to access a charity’s annual report. Look at the roles of the trustees. How
are designated funds accounted for?
20.7 External scrutiny
Not-for-profit organisations are answerable to their stakeholders and
the general public. The existence of widely available information makes
it even more likely that they will be scrutinised. Often, government
regulators have the power to intervene when it is clear that the
organisation is struggling. Directors and trustees can be replaced.
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Chapter 20: Management control in not-for-profit organisations
Activity 20.4
Read the examples in the section ‘External scrutiny’ in Merchant and Van der Stede
(2017) Chapter 16. Make notes on people putting pressure on organisations to be more
effective, then discuss these with other students on the VLE.
There is a risk, particularly in charities, that inappropriate people will
be appointed to high office, such as a large donor or someone who
is well-known in another sphere who brings a good reputation to the
organisation. Often trustees are not paid or are only paid a small amount
(the charity regulations may bar them from being paid) and may have
their own careers so they may not be giving enough skill or attention to
ensuring that the organisation is effectively run.
20.8 Public sector scorecard
In the UK, the Public Sector Scorecard Research Centre is working with
some public sector bodies to develop a scorecard designed for public sector
organisations to help them to focus on continuously developing their
service delivery.
M
an eas
d
ev urem
al
ua ent
tio
n
Strategy
mapping
Developing
performance
measures
Integrating risk
management
Addressing
capablility
Servi
g
pin
ap
ym
Identifying processes
and capability outputs
eg
t
ra
Learning from
performance
measures
St
Clarifying
outcomes
ce im
Re-designing
processes
prove
ment
Figure 1: A scorecard for public sector organisations. Source: Moullin, M. ‘How the
public sector scorecard works’, Public sector scorecard www.publicsectorscorecard.co.uk/howthe-pss-works.html
The scorecard starts with ‘strategy mapping’, that is, working with staff
and service users to identify expected outcomes and the capabilities and
the processes needed to meet them. This leads to investigating ‘service
improvement’ by redesigning processes, including supporting and training
staff to adopt more effective practices.
The next step – ‘measurement and evaluation’ – is defining and agreeing
on appropriate performance measures for each part of the strategic
map. These are filtered to ensure that they are cost effective, provide the
intended value and minimise any undesirable outcomes.
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AC3193 Accounting: markets and organisations
20.9 Employment characteristics
Public sector employees understand that, in some ways, pay structures
and tenure are different from those in the private sector. Salaries are
usually agreed by unions and may include annual cost of living pay rises or
increases when additional responsibilities are taken on. There is usually a
good possibility of tenure unless the organisation needs to downsize. (This
is also true of many roles in the private sector.)
Public sector organisations rarely offer an opportunity for a bonus
structure directly related to performance as is the case in for-profit
companies, but many organisations have pay scales which recognise
greater experience.
It is important to employ (and pay) good quality people if the not-forprofit organisation is to be well-run, with staff using their initiative to
continuously improve the service provided. Often top salaries are similar
to those in for-profit companies and therefore there is an expectation that
the organisation will be well-run and provide a good service. This must
be reflected in all departments, including the financial operation where
efficient working and good internal controls are essential.
There are many jobs that are only available in public sector organisations
(e.g. social work). Many people who choose to work for charities are
partly drawn to these organisations by a desire to work for a good cause.
Activity 20.3
Read the examples in the section ‘Employee characteristics’ in Merchant and Van der
Stede (2017) Chapter 16, relating to the Los Angeles Department of Mental Health and
the attitude of the mayor towards paying high salaries. Do some research to find out how
top salaries in commercial companies in your city or region relate to those in the private
sector. For example, how much is the chief executive of a company based in your city or
region paid (this information will be available in companies’ annual reports) compared to
a top executive in your local authority?
20.10 Summary
Due to the complexity of the goals and the number of interested parties in
not-for-profit organisations, a command and control style of management
may not be effective (some argue that in an innovative and creative
business it is not appropriate either). There are many situations where
discussions are needed to obtain consensus on action, and layers of
regulation, overseers and interest groups need to be satisfied. Results
measures and reward by specific financial bonuses are difficult to identify
and implement. Bonuses may be prohibited by law and are subject to
public scrutiny. However, many people are more comfortable working in
this environment.
20.11 Reminder of learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
200
•
identify different types of not-for-profit organisation and give
examples of the main types
•
explain the main similarities and differences between for-profit and
not-for-profit organisations
Chapter 20: Management control in not-for-profit organisations
•
discuss ways in which public sector outputs can be identified and
measured
•
explain fund accounting
•
identify the ways in which public sector employment may differ from
that in the private sector.
20.12 Test your knowledge and understanding
1. Explain each of the following techniques and why each may be used in
not-for-profit organisations:
•
zero-based budgeting
•
benchmarking
•
public sector scorecard.
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AC3193 Accounting: markets and organisations
Notes
202
Appendix 1: Solutions to activities and sample examination questions
Appendix 1: Solutions to activities and
sample examination questions
Note to students
Solutions are provided only for selected activities and Sample examination
questions.
Chapter 6
Test your understanding
Students could calculate the following ratios:
Luke & Laing
LAZD
Net working capital/Sales
21.0%
1.1%
Net non-current operating assets/Revenue
88.5%
109.7%
PP&E/Revenue
56.5%
70.0%
Net working capital turnover
4.8
88.9
Net non-current operating asset turnover
1.1
0.9
PP&E turnover
1.8
1.4
Trade receivables turnover
40.0
106.7
Days’ receivables
9.1 days
3.4 days
Inventories turnover
2.7
49.1
Days’ inventories
134.9 days
7.4 days
Trade payables turnover
13.1
13.9
Days’ payables
27.8 days
26.2 days
Cash conversion cycle
116.2 days
-15.3 days
Working capital
Utilisation of working capital is much less efficient for L&L with working
capital being much higher as % of sales (or generating much less
revenue/£).
Driver is all three parts of working capital – receivable period being long,
inventory period being long and payable period much higher for L&L
compared to LAZD.
Credit terms with suppliers appear in line with each other, so main driver
is inventory period and receivable period.
Receivable period for L&L looks long for the retail industry.
LAZD operates with a negative working capital cycle which would relieve
pressures on cash flow.
Non-current assets
NCA within L&L are better used, potentially due to space utilisation in
stores or position of the few stores in unique places.
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AC3193 Accounting: markets and organisations
Chapter 7
Activity 7.4
Actual
Year 1 Est
Year 2 Est
EV/Sales
2.9×
3.2×
3.3×
EV/EBIT
19.3×
21.4×
20.5×
EV/EBITDA
17.4×
18.5×
18.0×
P/E
11.3×
11.8×
11.2×
What we can see from this is a peak in lower multiple in the current
year with a greater multiple in year 1 which then drops in year 2. If we
understand that multiples are taking into account expectations of future
performance, we can begin to understand this pattern.
In current values, investors are expecting to see growth in the future,
which they expect in both sales, EBIT, EBITDA and EPS. The greatest
growth is expected to occur between year 1 and year 2 and this is why the
multiples are expected to increase in year 1 before dropping off again in
year 2.
Activity 7.5
Min
Max
Average
Multiple
5.8×
6.6×
6.2×
EBITDA
1,450.0
1,450.0
1,450.0
Enterprise value (multiple × EBITDA)
8,410.0
9,570.0
8,990.0
Net debt
3,500.0
3,500.0
3,500.0
Equity value (EV − net debt)
4,910.0
6,070.0
5,490.0
Number of shares outstanding
102.0
102.0
102.0
Share price (equity / no. shares)
48.14
59.51
53.82
Activity 7.6
Net revenues
$
5,349.10
Cost of sales
2,546.00
Gross profit
2,803.10
Selling, general and administrative expenses
1,727.60
Amortisation expense
82.5
Restructuring costs
Acquisition-related costs
Asset impairment charges
Gain on sales of assets
Normalised EBIT
204
993.00
Appendix 1: Solutions to activities and sample examination questions
Test your understanding
EBIT
£395.0m
D&A
£25.4m
EBITDA
£420.4m
Suitable multiple*
£6.1m
Enterprise value
£2,564.4m
Net debt
£320.5m
Equity value
£2,243.9m
Number of shares
2000m
Share price
£1.12
*The EV/EBITDA multiple for Curse Inc only has been used as this
company is the best reflection of the operations of Gandol plc.
Chapter 8
Activity 8.1
Share price =
D0 (1 + g)
r –g
=
$0.10 × 1.07
0.11 – 0.07
= $2.68
Activity 8.2
Debt
£1,000,000
Equity
£1,000,000
EBIT
£200,000
Cost of debt @ 7%
£70,000
EBT
£130,000
Tax @ 30%
£39,000
Earnings
£91,000
Cost of equity @ 12%
£120,000
Residual income
−£29,000
Although the company appears to be profitable, it is not generating
sufficient returns to keep equity investors satisfied. Any value in the
company is currently being supported by the company’s net assets rather
than performance.
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AC3193 Accounting: markets and organisations
Activity 8.4
Assets
€
3,000,000
Equity
€
1,800,000
Debt
€
1,200,000
€
3,000,000
EBIT
€
700,000
Cost of debt @ 3%
€
36,000
EBT
€
664,000
Tax @ 20%
€
132,800
Earnings
€
531,200
Capital charge @ 10%
€
180,000
Residual income
€
351,200
RI per share
€
1.76
PV of RI
€
17.56
Current BV
€
9.00
€
26.56
Activity 8.5
Dividend discount model:
Share price =
D0 (1 + g)
r –g
=
$1.00 × 1.00
0.10 – 0.00
= $10
Residual income valuation model:
Earnings per share
$
1.00
($6 x 10%)
$
−0.06
Residual Income
$
0.94
PV of RI
$
9.40
Current BV
$
6.00
Share price
$
15.40
Capital charge
The dividend discount model is assessing future cashflows only.
The RIVM is recognising that future cashflows exceed the investors’
expectations by a vast amount, plus the company also has value tied up
in its current asset base.
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Appendix 1: Solutions to activities and sample examination questions
Activity 8.6
Year
0
1
2
3
Opening book value
$
6.00
$
7.00
$
8.25
EPS
$
2.00
$
2.50
$
4.00
Dividend
$
−1.00
$
−1.25
$
−12.25
$
7.00
$
8.25
$
-
$
2.00
$
2.50
$
4.00
(opening BV × 10%)
$
0.60
$
0.70
$
0.825
Residual income
$
1.40
$
1.80
$
3.175
Closing book value
$
6.00
EPS
Capital charge
Discount factor @ 10%
0.909
Present value
$
Total PV
$
5.15
Current BV
$
6.00
Share value
$
11.15
1.27
0.826
$
1.49
0.751
$
2.39
Test your understanding
1. The residual income valuation model calculates the value of a share
using three different phases:
•
Current book value
•
Forecast residual income period
•
A terminal value to reflect all later years into perpetuity.
Since the current book value is one third of this method, the value of
the second and third phases takes less precedence in the RIVM than in
other valuation models.
2. The investment spread is equal to ‘Return on capital’ less ‘Cost of
capital’. To turn this into a monetary amount, multiply by the opening
BV. Once this is done, the model is discounting a stream of RI and so
this formulation is consistent with the conventional RI model.
Chapter 9
Activity 9.1
Suggested solution
Management of the company
If management are issuing accounts whose earnings have been managed,
it stands to reason that there must be an incentive for them to do this –
either personal or operational.
Personal reasons may be linked to remuneration. Many companies offer
incentive packages to management in an attempt to align their personal
reward with that of the shareholders. Such incentives can include share
options or bonus schemes which are activated if a specific target is met.
As such, management may be incentivised to inflate (or even deflate)
performance so as to maximise compensation.
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AC3193 Accounting: markets and organisations
Operational reasons may relate to externalised restrictions which have
been placed on the company from parties such as investors. If a certain
performance-related covenant has been included within a financing
agreement, management may feel the need to ensure this is not broken so
as to keep the finance available.
If discretion is available, management may choose to use this discretion.
Auditors of the company
A continuing difficulty which currently exists within the auditing industry
is how to keep the audit process independent when the accounting firms
which offer auditing services also offer many other accounting services.
Although regulatory bodies attempt to ensure that the integrity of audit
firms is not undermined, there is always a risk that auditors will consider
what other services they may be able to offer to their clients.
With this in mind, it is hypothetically (and controversially) possible that
an audit firm may choose to accept an explanation regarding an aggressive
accounting policy because it aids their relationship with the client (which
will have an impact on potential future services).
Analysts analysing the company
Sell side analysts interact with the market by offering advice to potential
market participants as to whether a stock may be over- or undervalued,
giving reasons why they believe this to be the case.
As part of this process, they listen to management, ask questions and
gather research from numerous sources.
Their reputation is built on their ability to predict the future direction of
a company’s earnings and how this should be seen within the share price.
Since their reputation is built on this, so too are the fees that they are able
to generate.
As a result, an analyst might be incentivized to overlook evidence of
possible earnings management if this creates support for their personal
predictions and thus moves them up in the rankings of sell side analysts.
Investors of the company
It may be more difficult to understand why investors would be willing
to accept figures which may have been managed/distorted through
accounting flexibility. However, it is potentially explained by the financial
theory known as ‘the greater fool’.
This theory suggests that a person (a ‘fool’) may choose to overpay for
some stock in the hope that they will be able to sell it to a ‘greater fool’ at
a higher price.
As such, an investor may be willing to overlook managed earnings in the
knowledge (or hope) that whoever they sell the stock to, will also overlook
this (or not notice).
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Appendix 1: Solutions to activities and sample examination questions
Activity 9.6
Reasons for Google offering earnings
guidance
Reasons against Google offering earnings
guidance.
A large number of analysts follow the company
looking for advice.
Google has little incentive to ensure the capital
markets value it correctly as it is not dependent
on raising finance through these markets. (It
generates vast quantities of finance internally
instead.)
Google’s shareholdings are similar to those of
similar companies which do offer advice.
The analyst consensus is often accurate, even
for companies that do not offer guidance.
Analysts utilise many valuation techniques which
are dependent on earnings (e.g. PEG approach,
EBITDA multiples).
Analysts are paid circa £84k–£110k per year
and should therefore ‘earn’ this salary, rather
than simply obtaining guidance from the
company.
The business is complex, with a number of revenue
streams including advertising, cloud services,
hedging and ‘other bets’.
Earnings per share patterns are not too difficult
to decipher; the graph is a simple upward trend.
Analysts seem to be able to use other metrics
as predictors and the ‘earnings surprise’ that
analysts see with Google is small compared
with other companies that do offer guidance.
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AC3193 Accounting: markets and organisations
Chapter 10
Activity 10.5
Current allowance
£13,377
Required allowance
£16,533
Increase required
£3,156
Adjustment to income statement
Increase bad debt expense by
£3,156
Decrease tax expense by
£947
Net income reduced by
£2,209
Adjustment to balance sheet
Decrease net receivables by
£3,156
Increase deferred tax asset / decrease deferred tax liability by £947
Reduce retained earnings by
£2,209
Impairment required (¥817,300 × 5.4%)
¥44,134
Activity 10.6
Adjustment to income statement
Increase other operating expenditure by
¥44,134
Decrease tax expense by
¥10,592
Reduce net income by
¥33,542
Adjustment to balance sheet
210
Decrease non-current assets by
¥44,134
Decrease deferred tax liability by
¥10,592
Reduce retained earnings by
¥33,542
Contents
Test your understanding
Current depreciation charge = £1200 − £120 / 10 yrs = £108.0 per year
Adjusted depreciation charge = £1200 − £ 0 / 7 yrs = £171.4 per year
Current accumulated deprecation represents approx. 6.02 years of
depreciation (£650 / £108)
Adjusted accumulated depreciation charge = 6.02 years × £171.4 =
£1031.8
Adjustments required
Original figures
Adjusted figures
Cost of assets at end of year
£1,200
£1,200
Accumulated depreciation at end of year
£650
£1,032
£550
£168
108.0
171.4
Depreciation expense
Income statement
Increase depreciation expense by
£63.4
Decrease tax expense by
£12.7
Decrease profit by
£50.7
Balance sheet
Decrease carrying value of assets by
£381.8
Adjust deferred tax by
£76.6 (increase DTL or decrease a DTA)
Decrease retained earnings by
£305.2 (6.02 years × £50.7 per year)
211
AC3193 Accounting: markets and organisations
Notes
212