manual of business and fiance

The Institute of Chartered Accountants of Bangladesh

BUSINESS AND FINANCEProfessional Stage Knowledge Level

Study Manual

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ii © The Institute of Chartered Accountants in England and Wales, March 2009

Business and FinanceThe Institute of Chartered Accountants of Bangladesh Professional Stage

These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales

ISBN: 978-1-84152-823-6First edition 2009

All rights reserved. No part of this publication may be reproduced ortransmitted in any form or by any means or stored in any retrieval system, ortransmitted in, any form or by any means, electronic, mechanical, photocopying,recording or otherwise without prior permission of the publisher.

© The Institute of Chartered Accountants in England and Wales, March 2009 iii

Welcome to the ICAB

iv © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 v

Contents

Introduction vii

Specification grid for Business and Finance viii

The learning materials ix

Study guide x

Getting help xx

Syllabus and learning outcomes xxi

1. Introduction to business 1

2. Managing a business 23

3. Organisational structure and business forms 59

4. Introduction to business strategy 93

5. Introduction to risk management 143

6. Introduction to financial information 167

7. The business’s finance function 193

8. Measuring performance 221

9. Working capital and treasury management 253

10. The professional accountant 285

11. Structure and regulation of the accountancy profession 313

12. Governance and ethics 329

13. Corporate governance 355

14. The economic environment of business and finance 377

15. External regulation of business 411

Sample paper 435

Sample paper answers 451

vi © The Institute of Chartered Accountants in England and Wales, March 2009

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 vii

1 Introduction

1.1 What is Business and Finance and how does it fit within theProfessional Stage?

Structure

The syllabus has been designed to develop core technical, commercial, and ethical skills and knowledge in astructured and rigorous manner.

The diagram below shows the fourteen modules at the Professional Stage, where the focus is on theacquisition and application of technical skills and knowledge, and the Advanced Stage, which comprisesthree technical modules and the Case Study.

The knowledge base

The aim of the Business and Finance module is to provide students with an understanding of how businessesoperate and how accounting and finance functions support businesses in achieving their objectives.

Progression to application level

The knowledge base that is put into place here will be taken further in the application level BusinessStrategy module, where the aim will be to provide students with an understanding of how businessesdevelop and implement strategy.

Progression to advanced stage

The advanced level paper Business Analysis then takes things further again. The aims of Business Analysisare that students can apply analysis techniques, technical knowledge and professional skills to resolve real-life issues faced by businesses. In that paper the aim is to ensure that students can provide technical advicein respect of issues arising in, for example, business decisions and business transformations e.g. mergers andacquisitions.

The above illustrates how the knowledge base of Business and Finance gives a platform from which aprogression of skills and technical expertise is developed.

Business and finance

viii © The Institute of Chartered Accountants in England and Wales, March 2009

1.2 Services provided by professional accountants

Professional accountants should be able to:

identify the general objectives of businesses and the functions and tasks that businesses perform inorder to meet their objectives

specify the nature, characteristics, advantages and disadvantages of different forms of businessstructure

identify the purpose of financial information produced by businesses and specify how accounting andfinance functions support business operations, including the management of working capital

specify the role of the accountancy profession and why the work of the profession is important

identify the role that governance plays in the management of a business and specify how a business canpromote an ethical culture

specify the impact on a business of the economic environment in which it operates.

2 Specification grid for Business and Finance

2.1 Module aim

To provide students with an understanding of how businesses operate and how accounting and financefunctions support businesses in achieving their objectives.

2.2 Specification grid

This grid shows the relative weightings of subjects within this module and should guide the relative studytime spent on each. Over time the marks available in the assessment will equate to the weightings below,while slight variations may occur in individual assessments to enable suitably rigorous questions to be set.

Weighting (%)

Business objectives and functionsBusiness structures

30

The role of finance and accounting 25

The role of the accountancy profession 15Governance and ethics 15External environment 15

100

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 ix

3 The learning materials

You will find the learning materials are structured as follows:

Title page Contents page Introduction. This includes

– a review of the subject to set the context

– a list of the top level learning outcomes for this subject area entitled 'Services provided byprofessional accountants' (set with reference to what a newly qualified accountant would beexpected to do as part of their job)

The specification grid for Business and Finance

A brief note about the learning materials

Study Guide. This includes

– hints and tips on how to approach studying for your CA exams

– guidance on how to approach studying with this Study Manual

– a detailed study guide suggesting how you should study each chapter of this Study Manual andidentifying the essential points in each chapter

Information on how to obtain help with your studies

The detailed syllabus and learning outcomes

Each chapter has the following components where relevant:

Introduction

– Learning objectives– Practical significance– Stop and think– Working context– Syllabus links

Examination context

– Exam commentary– Exam requirements

Chapter topics

Summary and Self-test

Technical reference (where relevant)

Answers to Self-test

Answers to Interactive questions


x © The Institute of Chartered Accountants in England and Wales, March 2009

4 Study guide

4.1 Help yourself study for your CA exams

Exams for professional bodies such as the ICAB are very different from those you have taken at college oruniversity. You will be under greater time pressure before the exam – as you may be combining yourstudy with work. Here are some hints and tips.

The right approach

1 Develop the right attitude

Believe in yourself Yes, there is a lot to learn. But thousands have succeededbefore and you can too.

Remember why you're doing it You are studying for a good reason: to advance your career.

2 Focus on the exam

Read through the Syllabus andStudy Guide

These tell you what you are expected to know and aresupplemented by Examination context sections in theStudy Manual.

3 The right method

See the whole picture Keeping in mind how all the detail you need to know fits intothe whole picture will help you understand it better.

The Introduction of each chapter puts the material incontext.

The Learning objectives, Section overviews andExamination context sections show you what youneed to grasp.

Use your own words To absorb the information, you need to put it into yourown words.

Take notes. Answer the questions in each chapter. Draw mindmaps. Try 'teaching' a subject to a colleague or friend.

Give yourself cues to jog yourmemory

Try colour coding key points with a highlighter pen. Write key points on cards.

4 The right recap

Review, review, review Regularly reviewing a topic in summary form can fix it in yourmemory. The Study Manual helps you review in many ways.

Chapter summary will help you to recall each studysession.

The Self-test actively tests your grasp of the essentials.

Go through the Examples in each chapter a second orthird time.

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xi

4.2 Study cycle

The best way to approach this Study Manual is to tackle the chapters in order. We will look in detail at howto approach each chapter below but as a general guide, taking into account your individual learning style,you could follow this sequence for each chapter.

Key study steps Activity

Step 1Topic list

This topic list is shown in the contents for each chapter and helps you navigateeach part of the book; each numbered topic is a numbered section in the chapter.

Step 2Introduction

This sets your objectives for study by giving you the big picture in terms of thecontext of the chapter. The content is referenced to the Study guide, andExamination context guidance shows what the examiners are looking for. TheIntroduction tells you why the topics covered in the chapter need to be studied.

Step 3Section

overviews

Section overviews give you a quick summary of the content of each of the mainchapter sections. They can also be used at the end of each chapter to help youreview each chapter quickly.

Step 4Explanations

Proceed methodically through each chapter, particularly focusing on areashighlighted as significant in the chapter introduction or study guide.

Step 5Note taking

Take brief notes, if you wish. Don't copy out too much. Remember that beingable to record something yourself is a sign of being able to understand it. Yournotes can be in whatever format you find most helpful: lists, diagrams, mindmaps.

Step 6Examples

Work through the examples very carefully as they illustrate key knowledge andtechniques.

Step 7Answers

Check yours against the suggested solutions, and make sure you understand anydiscrepancies.

Step 8Chapter summary

Review it carefully, to make sure you have grasped the significance of all theimportant points in the chapter.

Step 9Self-test

Use the Self-test to check how much you have remembered of the topicscovered.

Moving on...

When you are ready to start revising, you should still refer back to this Study Manual.

As a source of reference.

As a way to review (the Section overviews, Examination context, Chapter summaries and Self-testquestions help you here).

Remember to keep careful hold of this Study Manual – you will find it invaluable in your work. The technicalreference section has been designed to help you in the workplace by directing you to where you can findfurther information on the topics studied.


xii © The Institute of Chartered Accountants in England and Wales, March 2009

4.3 Detailed study guide

Use this schedule and your exam timetable to plan the dates on which you will complete each study periodbelow:

StudyPeriod

Approach Essential Points DueDate

1 Read through Chapter 1 of the StudyManual quickly to obtain the backgroundknowledge of which you must be aware.Learn the definitions in the chapter, andthe list of stakeholders and their interests.Make sure you are clear about theimportance of the entity’s primary andsecondary objectives, the SMARTcharacteristics of objectives and the threepoints of reference for measuringperformance.

Finally work through the self-test questionscarefully to ensure that you have graspedthe main points in the chapter.

The definitions of organisationsand businesses

Stakeholders and their interests

The nature and desirable qualitiesof objectives

Measuring profitability, activity andproductivity

Measuring resource use:effectiveness, economy andefficiency

2 Read sections 1 to 9 of Chapter 2 quicklyto get an idea of the principles at issuewhen managing a business, then study eachsection again more slowly, making sure youlearn the definitions and can distinguishbetween the concepts of power, authority,responsibility, accountability and delegation.You should learn too the distinctionsbetween the different types of manager,and the four parts of the managementprocess.

Once you are happy with this you shouldread through sections 10 to 13 on the non-finance functions in any business beforestudying each section, and their definitions,more slowly. Finally you should read atleast twice through section 14 onorganisational behaviour, and then learnthe main features of as many of thetheories contained in it as you can.

Finally, try the self-test questions at the endof the chapter.

Distinction between managementand governance

Distinction between power,authority, responsibility,accountability and delegation

Line, staff, functional and projectmanagers, and the managementhierarchy

Management process: plan,organise, control, lead

Marketing, especially the elementsof the marketing mix

The determinants of behaviour inorganisations, motivation andgroups

3 Chapter 3 falls into two parts:organisational structure and businessforms. Start by reading quickly throughsections 1 to 5 to get a good grounding inwhat is meant by organisational structureand the key issues presented. Next workthrough each of the five sections slowly,making sure you understand the linksbetween the topics.

Next you should read through sections 6to 10 on the legal forms of businesses

Mintzberg’s building blocks

Fayol’s classical principles

Mintzberg’s types of businessstructure and their features

Centralisation anddecentralisation

Business shapes (tall or flat), themanagement hierarchy, span ofcontrol and scalar chain

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xiii

StudyPeriod


quickly to grasp the basic issues, then goback and study first sole tradership, thenpartnership and then incorporation in turn.Once you are happy that you understandthe factors that help determine which forma business takes, study section 10 on thekey decision between trading as a companyor partnership. Skim through section 11.

Finish your study of this chapter by readingthrough section 12 on the different typesof alliance very carefully, as this is a keypractical topic.

Finally work through the self-test questionsat the end of the chapter.

Mechanisticstructures/bureaucracies

Definitions and features of soletraders, partnerships andcompanies

Advantages and disadvantages ofeach form

Deciding whether to incorporate

Types of alliance

4 Chapter 4 is key to this syllabus and youneed to make sure you study the whole ofit very carefully indeed.

Start by reading through sections 1 and 2 atleast twice. Make the links back to earlierchapters as suggested by the text, toincrease your understanding, then readcarefully through section 3, which sets thescene for the rest of the chapter: makesure you understand Figure 4.2 for thepositioning-based view of the strategicplanning process.

Next work your way methodically througheach of sections 4 to 10, which followthrough each part of the strategic planningprocess. Focus on the essential pointslisted here.

The self-test questions at the end of thechapter cover the most important pointslearnt so finish the chapter by workingthrough them.

Definitions of strategy andstrategic management

Corporate, business andfunctional strategies

Formal v emergent approach

Strategic decision-making

Strategic planning process

PESTEL analysis

Porter’s five forces

Competitor analysis

Porter’s value chain

Product life cycle

BCG matrix

SWOT analysis

Stakeholder mapping

Porter’s generic competitivestrategies

Ansoff’s matrix

Levels of plan


xiv © The Institute of Chartered Accountants in England and Wales, March 2009

StudyPeriod


5 There is quite a lot of detail andterminology associated with riskmanagement so you need to study chapter5 relatively slowly; as you proceed, go backover what you have covered as often asyou can so that you grasp why the conceptof risk and its management are soimportant to business.

Read through sections 1 to 6 slowly andcarefully, focusing on each of the essentialpoints listed here. Sections 5 and 6 areespecially important. Then read throughsections 7 and 8 at least twice: remembercrisis management and planning for disasterrecovery are extreme forms of riskmanagement.

Finish the chapter by trying all of the self-test questions.

Risk, uncertainty and their effectson businesses themselves andtheir investors

Attitudes to risk

Risk classifications

Risk concepts: exposure, volatility,impact and probability

Definition of risk management

Risk management process

Crisis management

Disaster recovery

6 Chapter 6 covers the importance of goodfinancial information and of keeping itsecure.

Start by reading through sections 1 and 2 atleast twice, making sure you understandthe different types of information and thedifferent uses to which it can be put. Nextread section 3 carefully, learning theACCURATE acronym, then read throughsections 4 to 6 at least twice to cover data,information processing (CATIVA),processing systems and security(ACIANA).

The remainder of Chapter 6 coversfinancial information specifically, andcontains many links to other parts of theBusiness and Finance syllabus, and indeedto other parts of the Professional syllabus.Start by reading through sections 7 to 9quickly once, to get an idea of the issuescovered, then go back and workmethodically through each section.

The self-test questions at the end of thechapter cover the most important pointslearnt so finish the chapter by workingthrough them.

Uses and types of information

Good ACCURATE information

Sources of data

Information processing: CATIVA

TPS and MIS

Information security: ACIANA

System controls

Users of financial information

Information to support economicdecisions

Framework qualitativecharacteristics: understandability,relevance, reliability andcomparability

Limitations of financial information

Effects of poor financialinformation

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xv

StudyPeriod


7 In Chapter 7 you cover what the business’sfinance function is for and how it setsabout its tasks, especially managementaccounting.

Read quickly through sections 1 and 2 forcontext, then study section 3 carefully sothat you have an overall picture of thevaried tasks undertaken by the financefunction in a business, and its typicalstructure.

Next read through section 4 onmanagement accounting quickly first, thengo back and work methodically througheach sub-section. You need to learn thedifferent ways in which managementaccounting supports the business achievingits objectives; in Management Informationyou will learn more about the techniquesand computations involved.

Read through sections 5 to 7 quickly, thendevote some time to section 8 on the valueof information, and section 9 onestablishing financial control processes.

Finally try the self-test questions at the endof the chapter.

Tasks of the finance function

Structure of finance function

Management accounting

The value of information

Financial control processes

8 In Chapter 8 we look in detail at theimportance of performance measurement.

Read through sections 1 and 2 at leasttwice. Make sure you understand whenperformance measurement is useful(basically, when measures can be comparedwith something else) and can distinguishbetween qualitative and quantitativemeasures. Make sure as well that youunderstand the principles and function ofvariance analysis.

Next look through Furlong Ltd’s financialstatements at the end of section 2 beforestudying each of sections 3 to 6 slowly andmethodically. These look at theprofitability, liquidity/solvency, efficiencyand investor measures that a personoutside a business can calculate from itsfinancial statements. They can also be usedby managers to help manage workingcapital and performance generally.

Study section 7 on the limitations offinancial measures carefully before readingthrough section 8 on the balancedscorecard at least twice, noting theadditional performance measures it uses

The self-test questions at the end of the

Useful comparators forperformance measures

Qualitative and quantitative(financial and non-financial)measures

Internal (management accounting)and external (financial reporting)performance measures

Principles of variance analysis

Profitability measures: ROCE,gross and net margin

Liquidity/solvency measures:current and quick ratios, debt andgearing ratios, interest cover

Efficiency measures: assetturnover, inventory turnover ratioand period, receivables collectionand payables payment periods, thecash operating cycle

Investor measures: EPS, dividendper share, dividend cover, P/Eratio, dividend yield

Limitations of financial measures

Balanced scorecard: ROI, RI,EVA®


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StudyPeriod


chapter cover the most important pointslearnt so finish the chapter by workingthrough them.

9 In Chapter 9 we look at how a businessmanages its working capital (inventory,payables and receivables, and cash).

First, read through sections 1 and 2 at leasttwice, making sure you understand theissues that affect how a business balancesthe need to make a profit against theimperative that it should never run out ofcash. Then read section 3 very carefully onthe further balance required between usingshort term and long term finance to fundworking capital, a decision that is related torisk. Make sure you follow through theworked example closely. Pay particularattention to using ratios to help manageworking capital, working through theexamples and completing the interactivequestion.

After reading through section 4 andcompleting the interactive question, youshould then work slowly and methodicallythrough each of sections 5 to 8. Make surethat you learn as many of the practicalmanagement techniques available forworking capital management as possible.Work through each example very carefully.

You can then skim through sections 9 to11 before trying the self-test questions atthe end of the chapter.

Balancing liquidity and profitability

Financing current assets:aggressive, average and defensivepositions

Using ratios to manage workingcapital

Cash operating cycle

Solving liquidity problems

Managing inventory, payables andreceivables

Treasury management: managingcash balances

Banking system

10 In Chapter 10 we switch to the syllabusarea that covers the accountancyprofession. Read through sections 1 and 2to grasp the main focus of this chapter: thenecessity for an individual professionalaccountant to show integrity (professionalresponsibility) and expertise (technicalcompetence). Then read through section 3on professional responsibility and the detailin section 4 on technical competence: learnas much as you can of this section.

Read through section 5 before studyingsection 6 on professional principles and theICAB Code of Ethics, and sections 7 and 8on accounting principles and standards. Inthis paper you need to focus on the rangeof principles and their impact on theprofessional accountant’s work.

You should read sections 9 and 10together, to give you a grasp of the varyingroles of the professional accountant and,

Importance of accountancy

Professional responsibility

Technical competence

Professional principles (ethics)

Accounting principles

Limits of responsibilities

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xvii

StudyPeriod


perhaps more importantly, the limits tothose roles.

Finish the chapter by trying the self-testquestions. These give you a very good ideaof the types of question that you willencounter in the exam.

11 In Chapter 11 we look at the accountancyprofession as a whole and the way it isregulated. Read sections 1 to 3 quickly thenagain more carefully, making sure youunderstand the principles behind how andwhy the accountancy profession isregulated. You must complete interactivequestion 1 and learn the answer, whichsets out the aims of regulation of theaccountancy profession. Next, readthrough section 6 on disciplinaryprocedures against accountants severaltimes. There is a lot of detail here, aboutICAB’s disciplinary procedures, which youneed to learn.

The self-test questions at the end of thechapter cover the important points learntso finish the chapter by working throughthem.

Structure of the accountancyprofession

Regulation

ICAB disciplinary procedures

12 Read through sections 1 to 3 of Chapter12 quickly and then again more slowly,making sure you understand the idea thatthere is a fundamental conflict betweenshareholders and directors that needs tobe addressed via corporate governance.Then study section 4 very closely, learningthe five key elements of good governance.Next, read section 5 on financial systems,making sure you can see why theimportance of institutional shareholdersderives from the nature of the financialsystem, and why in some countries banksdominate. This leads into section 6, whereyou must learn the OECD Principles, thedistinction between unitary and dual boardstructures, and the outline of the overallBangladesh governance structure.

Read section 7 on business values andethics, and the ways in which an ethicalculture can be promoted, very carefully,before attempting the self-test questions atthe end of the chapter. These give you agood idea of the types of question you willencounter in the exam.

Agency theory: information andaccountability

Perspectives on corporategovernance

Good practice in corporategovernance: key elements

Financial systems

OECD Principles

Unitary v dual boards

Bangladesh governance structure

Business values and businessethics

13 In Chapter 13 there is a lot of detail on theCode of Corporate Governance that you

Comply or explain

Role of the board


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StudyPeriod


need to learn, so read through section 1quickly first and then tackle each sub-section in turn, learning as much detail asyou can. Next, tackle section 2: read itthrough, learning the definitions of internalcontrol and the internal control system,the risk-based approach to this and thecontents of the directors’ statement.

Next read section 3 on the ISC Statementof Principles for institutional investors. Youshould learn these, then read throughsections 4 and 5 on the roles of externaland internal audit in corporate governance.

Don't forget to attempt the self-testquestions at the end of the chapter.

Roles of Chairman and ChiefExecutive

Balance and independence: non-executives

Nomination committee

Re-election of directors

Remuneration committee

Financial reporting

Internal control

Audit committee

Institutional shareholders

AGM

Turnbull guidance on internalcontrol

Shareholder engagement

Roles of external and internalaudit

14 Chapter 14 covers the economicenvironment in which businesses operate.Read through sections 1 and 2 to gain anunderstanding of the market mechanism(demand and supply) then study section 3on demand very carefully, followingthrough the worked example and making agood attempt at the interactive questions.Make sure you are completely happy withthe demand curve and the factors thatdetermine the level of demand (shifts ofthe curve), including price (shifts along thecurve). Next pay the same degree ofattention to section 4 on supply and itsdeterminants, including the sub-section onthe effect of time on supply and demand,and the interactive question.

Only once you are happy with thebehaviour of supply and demand shouldyou study section 5 on the equilibriumprice and how changes in various factorsadjust the equilibrium price, the quantitydemanded and the quantity supplied. Trythe interactive question then make sureyou understand the sub-section on theeffects of price regulation.

How far is demand affected by the variousfactors considered? The answer to this is insection 6 on elasticity: price and incomeelasticity of demand, cross elasticity of

The market mechanism

Demand

Supply

Equilibrium price

Effects of price regulation

Elasticity concepts and calculations

Market structures

Free markets

Market failure

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xix

StudyPeriod


demand, and price elasticity of supply areall important concepts which you mustunderstand and be able to calculate, sostudy this section very closely. Workthrough the example carefully, andcomplete the interactive questions.

Read through section 7 on types of marketstructure very carefully, learning thecharacteristics of each type of structure.Then study section 8 on free markets,making sure you are clear about thearguments for and against completelyunregulated markets, and the reasons whymarkets fail. These are highly examinabletopics.

Complete the interactive question thenfinish the chapter by attempting the self-test questions at the end.

15 In Chapter 15 we return to the principlesof regulation, this time in the context ofbusinesses rather than the accountancyprofession. Read through section 1 verycarefully. It draws together quite a fewideas that we have already seen, such asmarket failure, protection of the publicinterest and the nature of regulation. Thenstudy section 2 equally carefully,completing the interactive questions andmaking sure you understand the intendedand actual effects of regulation on business.

We then move on to some specificexamples of government regulation ofbusiness: of competition (section 3) and ofexternalities (section 4). Study each ofthese sections very carefully before payingequally close attention to section 5, ondirect regulation of people engaged inbusiness activities.

Skim through section 6 before studyingsection 7 on Sarbanes-Oxley carefully, thenpay equally careful attention tointernational regulation of and agreementson trade in sections 8 and 9.

Finish by completing the self-test questionsat the end of the chapter. These give you agood idea of the types of question you willencounter in the exam.

Why business is regulated

Intended outcomes of regulation

Responses to regulation

Regulation of competition

Government intervention in freemarkets

Insider trading, market abuse,fraudulent and wrongful trading,and directors’ disqualification

Sarbanes-Oxley

Free trade and protectionism

Revision phase

Your revision will be centred around using the questions in the ICAB Revision Question Bank.


xx © The Institute of Chartered Accountants in England and Wales, March 2009

5 Getting help

Firstly, if you are receiving structured tuition, make sure you know how and when you can contact yourtutors for extra help.

Identify a work colleague who is qualified, or has at least passed the paper you are studying for, who iswilling to help if you have questions.

Form a group with a small number of other students, you can help each other and study together, providinginformal support.

Call +88 (02) 9112672 or 9115340, or email [email protected]

Watch the ICAB website for future support initiatives.

mailto:[email protected]

INTRODUCTION

© The Institute of Chartered Accountants in England and Wales, March 2009 xxi

6 Syllabus and learning outcomes

The following learning outcomes should be read in conjunction with the Ethics Codes and Standards table insection 6.1 below.

Coveredin chapter

1 Business objectives and functions

Candidates will be able to identify the general objectives of businesses and thefunctions and tasks that businesses perform in order to meet their objectives.

In the assessment, candidates may be required to:

(a) state the general objectives of businesses 1

(b) state the general objectives of strategic management and specify the strategicmanagement process and interrelationship between a business’s vision, mission andstrategic objectives 4

(c) identify the various functional areas within businesses and show how the functionsassist the achievement of business objectives 2, 3

(d) identify the nature and functions of organisational management, human resourcesmanagement and operations management and show how these are influenced byhuman behaviour 2, 3

(e) show, in a given scenario, the relationship between a business’s overall strategy and itsfunctional strategies 4

(f) identify the nature and purpose of strategic plans, business plans and operational plans 4

(g) specify how a strategic plan is converted into fully-integrated business and operationalplans 4, 7

(h) identify the main components of the risk management process and show how theyoperate 5

(i) identify the key issues in relation to risk and crisis management. 5

2 Business structures

Candidates will be able to specify the nature, characteristics, advantages anddisadvantages of different forms of business structure.


(a) identify different forms of businesses and specify their advantages and disadvantages 3

(b) identify the differences between businesses carried out by sole traders, partnerships,limited liability partnerships, alliances and groups, and show the advantages anddisadvantages of each of these structures 3

(c) identify the differences between unincorporated businesses and companies, and showthe advantages and disadvantages of incorporation. 3

3 The role of finance and accounting

Candidates will be able to identify the purpose of financial information producedby businesses and specify how accounting and finance functions support businessoperations, including the management of working capital.


(a) specify the extent to which financial information:

provides for accountability of management to shareholders and otherstakeholders


xxii © The Institute of Chartered Accountants in England and Wales, March 2009

reflects business performance

is useful to users in making economic decisions

meets the information needs of national, social and economic contexts (e.g.national statistical information) 6,7

(b) specify how accounting and finance functions support businesses in pursuit of theirobjectives 7

(c) identify the main considerations in establishing and maintaining accounting and financialreporting functions and financial control processes 7

(d) identify, in the context of accounting systems, the issues surrounding:

information processing information security 6

(e) specify why the management of a business require information about performancemeasurement 6,8

(f) identify the accountant’s role in preparing and presenting information for themanagement of a business 7,8

(g) identify the constituent elements of working capital and treasury and specify themethods by which each element can be managed by the finance function to optimiseworking capital and cash flow 9

(h) specify the relationship between a business and its bankers and other providers offinancial products in the context of treasury and cash management. 9

4 The role of the accountancy profession

Candidates will be able to specify the role of the accountancy profession andwhy the work of the profession is important.


(a) identify the importance to the public interest of high quality, accurate financialreporting and assurance 10,11

(b) specify the rationale for key parts of the profession’s work and the links betweentechnical competence and professional responsibility, including accounting principles,accounting standards, sound business management and the public interest 10,11

(c) specify the key features of the structure of the accountancy profession, the regulatoryframework within which professional accountants work and the ways in which theaccountancy profession interacts with other professions. 10,11

5 Governance and ethics

Candidates will be able to identify the role that governance plays in themanagement of a business and specify how a business can promote an ethicalculture.


(a) state the reasons why governance is needed and identify the role that governance playsin the management of a business 12

(b) identify the key stakeholders and their governance needs for a particular business 12

(c) identify and show the distinction between the roles and responsibilities of thosecharged with governance and those charged with management 13

(d) specify how differences in national and business cultures affect the governance ofbusinesses 12

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© The Institute of Chartered Accountants in England and Wales, March 2009 xxiii

(e) identify the roles and responsibilities of the members of the executive board, anysupervisory board, the audit committee and others charged with governance, internalaudit and external audit 13

(f) identify the roles and responsibilities of those responsible within a business for internalaudit and for the external audit relationship 13

(g) specify the policies and procedures a business should implement in order to promotean ethical culture. 12

6 External environment

Candidates will be able to specify the impact on a business of the environmentin which it operates.


(a) specify the signalling, rewarding and allocating effects of the price mechanism onbusiness (including the concept of price elasticity) 14

(b) specify the potential types of failure of the market mechanism and their effects onbusiness 14

(c) specify the principal effects of regulation upon businesses 15

(d) show how the needs of different stakeholders in a business (e.g. shareholders, the localcommunity, employees, suppliers, customers) impact upon it 15

(e) specify the effects of key international legislation (including the Sarbanes-Oxley Act andtrade restrictions) on businesses. 15

6.1 Technical knowledge

The table contained in this section shows the technical knowledge covered in the CA syllabus.

The level of knowledge required in the Professional stage is shown.

The knowledge levels are defined as follows:

Level D

An awareness of the scope of the standard.

Level C

A general knowledge with a basic understanding of the subject matter and training in its applicationsufficient to identify significant issues and evaluate their potential implications or impact.

Level B

A working knowledge with a broad understanding of the subject matter and a level of experience in theapplication thereof sufficient to apply the subject matter in straightforward circumstances.

Level A

A thorough knowledge with a solid understanding of the subject matter and experience in the applicationthereof sufficient to exercise reasonable professional judgement in the application of the subject matter inthose circumstances generally encountered by Chartered Accountants.


xxiv © The Institute of Chartered Accountants in England and Wales, March 2009

Ethics Codes and Standards

Ethics Codes and Standards Level Professional Stage modules

IFAC Code of Ethics for Professional Accountants(parts A, B and C)

ICAB Code of Ethics(schedule ‘C’ of ICAB Bye-laws, members’ handbook)

A

A

AssuranceBusiness and FinanceLaw

TaxationInformation TechnologyAudit and AssuranceBusiness StrategyFinancial ReportingTaxation

© The Institute of Chartered Accountants in England and Wales, March 2009 1

Contents

Introduction

Examination context

Topic list

1 What is an organisation?

2 What is a business?

3 Stakeholders in the business

4 What are the business's objectives?

5 Mission, goals, plans and standards

6 Has the business performed well?




chapter 1

Introduction to business


2 © The Institute of Chartered Accountants in England and Wales, March 2009

Introduction

Learning objectives Tick off

Identify the reasons why businesses exist

Identify the key features of businesses as distinct from other forms of organisation

Identify who the stakeholders are in an individual business

State the primary and other objectives of businesses

Identify how a business measures whether its objectives have been met

The specific syllabus reference for this chapter is: 1a.

Practical significance

Appreciating what is meant by the term 'business' underlies everything that we study in this paper andothers at Professional level.

Stop and think

You may or may not already have personal experience of dealing with and/or working in a business.Whatever your level of experience, you will find it useful to address right now some of yourpreconceptions about 'business': what do you think are the key features of a business?

To answer this you may like to think in terms of organisations: what do you think are the key features ofany organisation? Why do organisations come into being? What does an organisation achieve that could notbe achieved by an individual working alone? What is different about a business as opposed to, say, a charityor a government department? Who is keen to see a business succeed? How do they know when it does so?

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill begin to see that while they vary tremendously in their operations and environment, the fundamentalfeatures of business organisations remain the same.

Syllabus links

The material in this chapter will be developed further in this paper, and then in the Business Strategy paperat the next level in the Professional stage.

INTRODUCTION TO BUSINESS


1

Examination context

Examination commentary

While the material in this chapter is essentially introductory, questions on business objectives will bedirectly examined.

Exam requirements

Questions are likely to be set either as a straight test of knowledge or in a scenario.




Section overview

There are many different types of organisation in both the not-for-profit and business sectors.

Organisations exist because the collective efforts of people are more productive as a result of them.

All organisations share the feature that they are designed to get things done.

Organisations differ in terms of ownership, control, activity, profit orientation, size, legal status andtechnology.

1.1 Introduction to organisations

Here are some examples of organisations, categorised as to whether they are profit-oriented or not-for-profit.

A multinational car manufacturer (e.g. Ford) An accountancy firm (e.g. KPMG) A charity (e.g. UNICEF) A trade union A local authority An army A club

1.2 Why do organisations exist?

Organisations exist because they:

Overcome people's individual limitations, whether physical or intellectual

Enable people to specialise in what they do best

Save time, because people can work together or do two aspects of a different task at the same time

Accumulate and share knowledge (e.g. about how best to build cars)

Enable people to pool their expertise

Enable synergy: the combined output of two or more individuals working together exceeds theirindividual output ('None of us is as smart as all of us').

In brief, organisations enable people to be more productive.

1.3 What do organisations have in common?

The definition below states broadly what all organisations have in common.

Definition

Organisation: A social arrangement for the controlled performance of collective goals, which has aboundary separating it from its environment.

Not-for-profit (charity/public sector)

Profit-oriented (private sector)



1

The following table shows how this definition applies to two organisational examples: a car manufacturerand an army.

Characteristic Car manufacturer(e.g. Ford)

Army

Social arrangement: individualsgathered together for a purpose

People work in differentdivisions, making different cars

Soldiers are in differentregiments, and there is a chain ofcommand from the top to thebottom

Controlled performance:performance is monitored againstthe goals and adjusted ifnecessary to ensure the goals areaccomplished

Costs and quality are reviewedand controlled. Standards areconstantly improved

Strict disciplinary procedures,training

Collective goals: the organisationhas goals over and above thegoals of the people within it

Sell cars, make money Defend the country, defeat theenemy, international peacekeeping

Boundary: the organisation isdistinct from its environment

Physical: factory gates

Social: employment status

Physical: barracks

Social: different rules than forcivilians

1.4 How do organisations differ?

Organisations also differ in many ways. Here are some possible differences.

Factor Example

Ownership (public vs private) Private sector: owned by private investors/shareholders

Public sector: owned by the nation and managed by the government

Control By the owners themselves, by people working on their behalf, orindirectly by government-sponsored regulators

Activity (i.e. what they do) Manufacturing, healthcare, services (and so on)

Profit or non-profit orientation Business exists to make a profit. An army or a charity, on the otherhand, are not profit-oriented

Size Small local business to multinational corporation

Legal status Company, or an unincorporated body such as a club, association,partnership or sole trader

Sources of finance Borrowing, government funding, share issues

Technology High use of technology (e.g. computer firms) v low use (e.g. cornershop)



1.4.1 Differences in what organisations do

Organisations do many different types of work (activity).

Industry Activity

Agriculture Producing and processing food

Manufacturing Acquiring raw materials and, by the application of labour and technology,turning them into a product (e.g. a car)

Extractive/raw materials Extracting and refining raw materials (e.g. mining)

Energy Converting one resource (e.g. coal) into another (e.g. electricity)

Retailing/distribution Delivering goods to the end consumer

Intellectual production Producing intellectual property e.g. software, publishing, films, musicetc

Service industries These include banking, various business services (e.g. accountancy,advertising) and public services such as education and medicine


Section overview

Organisations have secondary objectives that support their primary objectives.

For a profit-making organisation, the primary objective is to maximise the wealth of its owners; fora non-profit organisation it is to provide goods and services for its beneficiaries.

A business is an organisation which aims to maximise its owners' wealth but which can be regardedas an entity separate from its owners.

2.1 Profit vs non-profit orientation

The basic difference in orientation is expressed in Figure 1.1 below. Note the distinction between primaryand secondary objectives. A primary objective is the most important: the other objectives support it. Weshall come back to this.

Profit-orientedorganisation

Not-for-profitorganisation

OWNERS

MAXIMISE PROFIT/DIVIDEND/WEALTH

PRIMARYOBJECTIVE

SECONDARYOBJECTIVE

REVENUE FROMGOODS/SERVICES

COSTS

PUBLIC BENEFICIARIES

PROVISION OFGOODS/SERVICES

OUTPUT(GOODS/SERVICES)

MINIMISE COST OFPRIMARY GOAL

INPUTS (MATERIALS,LABOUR, FINANCE)

REVENUE (TAXATION)

OUTPUT OFGOODS/SERVICES

INPUTS (MATERIALS,LABOUR, FINANCE)

PROFIT

Figure 1.1: Profit-oriented and not-for-profit organisations



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Profit-oriented organisations are generally referred to as 'businesses', though this is in fact a ratherloose term.

Businesses are profit-oriented but they encompass a variety of legal structures (as we shall see inChapter 3):

– Companies are owned by shareholders– A sole tradership is owned by one individual (usually called the proprietor), and– Partnerships are owned collectively by the partners

Not-for-profit organisations are frequently structured and run on the lines of a business, so that theybenefit from the economy, efficiency and effectiveness in using resources that profit orientation brings,but they are not generally owned by shareholders, proprietors or partners. They do not primarily aimto maximise profit or the wealth of their owners, but rather are focused on providing goods andservices to their beneficiaries at minimised cost.

The type of work engaged in by the organisation does not of itself determine whether it is a profit-orientated or not-for-profit organisation; a business can be involved in providing medical or educationservices just as much as can a charitable or government organisation.

Examples of not-for-profit organisations:

Charities Clubs and associations Trade unions Professional institutes such as the ICAB Government Governmental agencies Local authorities Hospitals Schools

2.2 Definition of a business

It is the primary objective of the organisation that determines whether or not it is a business. Althoughas we have seen 'business' is a loose term which has no legal definition as such, it is useful to have a workingdefinition at this point.

Definition

Business: An organisation (however small) that is oriented towards making a profit for its owners so as tomaximise their wealth and that can be regarded as an entity separate from its owners.

3 Stakeholders in the business

Section overview

A stakeholder is a person who has an interest of some kind in the business.

A company's primary stakeholders are its shareholders. The primary stakeholders in a soletradership or partnership also comprise the business's owners. Secondary stakeholders aredirectors/managers, employees, customers, suppliers and partners, lenders, government and itsagencies, the local community, the public at large and the natural environment.

The social responsibility of a business can encompass the natural environment, human resourcepolicies, sustainable business practices, charitable support and high standards of workplace healthand safety.



You can see from Figure 1.1 that a profit-oriented business exists primarily in order to maximise wealth forits owners, while a not-for-profit organisation such as a charity or a government department existsprimarily to provide services (and/or goods) for its beneficiaries.

In both cases the organisations have stakeholders who are interested in what the organisation does.

Definition

Stakeholder: Literally a person or group of persons who has a stake in the organisation. This means thatthey have an interest to protect in respect of what the organisation does and how it performs.

For a business formed as a company the primary stakeholders are its shareholders. It is their money,invested in the business, which is literally 'at stake'; it can be lost if the business performs badly, and it canearn a decent return if the business does well. The business owes it to the shareholders to look after theirinterests, but it has secondary stakeholders as well, to whom it also has responsibilities, and from whom itmay receive pressure.

Stakeholders in abusiness

What is at stake? What do they typically expect ofthe business?

PRIMARY

Shareholders (orpartners or proprietor)

Money invested A return on their investment so thattheir wealth increases:

– steady, growing profits paid out bythe business

– growth in capital value of their shareof the business

Directors/managers

Employees and tradeunions

Livelihoods, careers andreputations

Fair and growing remuneration

Career progression

Safe working environment

Training

Pension

Customers Their custom Products/services that are of goodquality and value

Fair terms of trade

Continuity of supply

Suppliers and otherbusiness partners

The items they supply Fair terms of trade

Prompt payment

Continuity of custom

Lenders Money lent A return on their investment:

– interest

– repayment of capital

Government and itsagencies

National infrastructure used bybusiness

The welfare of employees

Tax revenue

Reasonable employment and otherbusiness practices

Steady or rising stream of tax revenue

The local community andthe public at large

National infrastructure used bybusiness

The welfare of employees

Reasonable employment and otherbusiness practices

SECONDARY

The natural environment The environment shared by all Reasonable environmental and otherbusiness practices



1

Interactive question 1: Social responsibility [Difficulty level: Intermediate]

What expectations would the local community have of a company operating a coal-fired power stationwithin two miles of a medium-sized town?

See Answer at the end of this chapter.

Therefore, there are wider areas of social responsibility of which the business must take account:

The impact of its operations on the natural environment

Its human resource management policies: for example, the hiring and promotion of people fromminority groups, policies on sexual harassment, refusal to exploit cheap labour in developing countries

Non-reliance on contracts with adverse political connotations: sustainable business practices indeveloping countries, compliance with sanctions imposed by the international community and so on

Charitable support and activity in the local community or in areas related to the organisation's fieldof activity

Above-minimum (legal) standards of workplace health and safety, product safety and labelling,and so on.

4 What are the business's objectives?

Section overview

Every business has a hierarchy of objectives, from its primary objective down to its supportingsecondary objectives. Together these form multiple objectives.

Profit and wealth maximisation is usually the primary objective, though sometimes managers pursuea policy of profit satisficing only.

4.1 The hierarchy of objectives

The fact that a business is oriented towards making a profit means that the simple answer to the question'what are the business's objectives?' is: profit maximisation so as to increase shareholder wealth.

In fact, however, there is a hierarchy of objectives, with one primary objective and a series ofsecondary subordinate objectives which should combine to ensure the achievement of the primaryobjective.

4.1.1 Primary objective

For a business the primary objective is the financial objective of profit maximisation so as toincrease shareholder wealth.

Profit is revenue less costs. It measures the creation of value, in terms of the relationship of inputsto outputs, with the cost of inputs (labour, materials and finance) being less than the ultimate output,which is the revenue generated. Profit thus integrates cost behaviour and revenue performance for thewhole organisation.

The link between profit and shareholder wealth is that the latter can only be maximised if profit isearned at an acceptable level of risk: focussing solely on maximising profit and ignoring risk can lead todecreased shareholder wealth (and financial collapse). Thus avoiding high risk should go hand in handwith making profits so as to maximise shareholder wealth.

Profit is a key indicator for owners

Profit is one of several measures that can be compared across organisations

Profit cannot be pursued at any cost. Any business is subject to the law of the country in which itoperates, and it will also have social responsibilities, as we saw above.



4.1.2 Secondary objectives

Secondary objectives support the primary objective.

Market position

Total market share of each market; growth of sales, customers or potential customers; the need toavoid relying on a single customer for a large proportion of total sales; what markets should thebusiness be in?

Product development

Bring in new products; develop a product range; invest in research and development; provide productsof a certain quality at a certain price level

Technology

Improve productivity; reduce the cost per unit of output; exploit appropriate technology

Employees and management

Train employees in certain skills; reduce labour turnover; create an innovative, flexible culture; employhigh quality leaders

4.2 Is wealth maximisation always the primary objective?

Making as much profit as possible at acceptable risk, or wealth maximisation, then, is assumed to be theprimary objective of businesses. Where the person who has put their money at stake (the 'entrepreneur') isin full managerial control of the firm, as in the case of a small owner-managed company or partnership, thisassumption would seem to be very reasonable. Even in companies owned by shareholders, but run by non-shareholding managers, we might expect that the wealth maximisation assumption would be close to thetruth.

But managers will not necessarily make decisions that will maximise shareholder wealth.

They may have no personal interest in the creation of wealth, except insofar as they areaccountable to shareholders

There may be a lack of competitive pressure in the market to be efficient by minimising costs andmaximising revenue, for example where there are few businesses in the market

4.2.1 Profit satisficing

Decisions might be taken by managers with managerial objectives in mind rather than the aim of wealthmaximisation. The profit and risk levels must be satisfactory and so acceptable to shareholders, and theymust provide enough profits retained in the business for future investment in growth, but rather thanseeking to maximise profit and wealth, managers may choose to achieve simply a satisfactory profit for abusiness. This is called 'satisficing', and is linked to a view of the strategy process called 'boundedrationality' by Herbert Simon – an issue we shall return to in Chapter 4.

4.2.2 Revenue maximisation

Baumol argued that the business acts to maximise revenue (not necessarily profit or wealth) in order tomaintain or increase its market share, ensure survival, and discourage competition. Managers benefitpersonally because of the prestige of running a large and successful company, and also because salaries andother benefits are likely to be higher in bigger companies than in smaller ones.

4.2.3 Multiple objectives

Management writer Peter Drucker points out that:

'To manage a business is to balance a variety of needs and goals…. The very nature of business enterpriserequires multiple objectives'. He suggests that objectives are needed in eight key areas.



1

Market standing: this includes market share, customer satisfaction, size of product range anddistribution resources

Innovation: in all major aspects of the business

Productivity: meeting targets for the number of outputs (items produced or tasks completed) withinset timescales

Physical and financial resources: efficient use (minimising waste) of limited resources (includingpeople, space, materials, plant and equipment, finance and so on)

Profitability: as discussed earlier

Manager performance and development: managerial effectiveness in meeting objectives andcreating a positive environment in the business; grooming of managers for continuity (managerialsuccession)

Worker performance and attitude: labour productivity, stability (controlled labour turnover),motivation and morale, development of skills and so on

Social responsibility: in areas such as community and environmental impacts, labour standards andemployment protection, business ethics and so on (as discussed earlier).

4.2.4 Constraints theory

Simon has pointed out that for some business areas decisions are taken without reference to the wealthobjective at all. This is not because they are ignoring profit, but because profit is not the most importantconstraint in their business. This is perhaps seen most clearly in areas where ethical constraints apply,such as staff relations or environmental protection. It may also be seen in the need to satisfy customerswith quality products and service – which may lower profitability.

5 Mission, goals, plans and standards

Section overview

A business's planning and control cycle is designed to ensure that its objectives, mission and goalsare met by setting plans, measuring actual performance against plans, and taking control action.

The direction of the business is set by its mission, which sets out its basic function in society interms of how it satisfies its stakeholders.

The mission encompasses the business's purpose, strategy, policies, standards of behaviour andvalues.

The business's goals can be classified as its aims (which are non-operational and qualitative) and itsoperational, quantitative objectives.

Operational objectives should be SMART: specific, measurable, achievable, relevant and time-bound.

Plans and standards set out what should be done to achieve the operational objectives.

The organisation's plans are a result of its strategic planning process.

5.1 Planning and control system

Because businesses have primary and secondary objectives they want to satisfy, they need to direct theiractivities by:

Deciding what they want to do to achieve the overall objective – these become detailed objectivesthat the business sets out to achieve, such as 'grow revenue by 20%' or 'reduce costs by 10%'

Deciding how and when to do it and who is to do it (setting plans and standards)



Checking that they achieve what they want, by monitoring what has been done and comparing itwith the plan

Taking control action to correct any deviation.

The overall framework for this is the system of planning and control in Figure 1.2.

Figure 1.2: Planning and control system

Where there is a deviation from plan, a decision has to be made as to whether to adjust the plan (e.g. it wasunachievable) or the performance (e.g. it was sub-standard).

It is the business's primary objective and how it is translated into plans and standards that underlie theplanning and control system. The objective is incorporated in its mission, its goals (its aims and detailedobjectives), plans and standards.

5.2 Mission

Overall, the main direction of a business is set by its mission.

Definition

Mission: 'The business's basic function in society', is expressed in terms of how it satisfies its stakeholders.

Elements of mission Comments

Purpose Why does the organisation exist and for whom (e.g. shareholders)?

Strategy Mission provides the operational logic for the organisation:

What do we do?

How do we do it?

Policies and standards ofbehaviour

Mission should influence what people actually do and how they behave:the mission of a hospital is to save lives, and this affects how doctorsand nurses interact with patients.

Values What the organisation believes to be important: that is, its principles.

Even though the mission can be very general, you can see it should have real implications for the policiesand activities of the organisation, and how individuals go about what they do.

5.2.1 Vision

Some businesses also set out their vision of the future state of the industry or business when determiningwhat its mission should be. For instance, 'being the leading provider of X by 2010' is a vision of the future,which ties it in with a mission of 'providing high-quality environmentally-friendly X to all our customers'.



1

5.3 Goals: aims and objectives

Definition

Goals: 'The intentions behind decisions or actions' (Henry Mintzberg) or 'a desired end result' (ShorterOxford English Dictionary).

Goals give flesh to the mission. There are two types of goal:

Non-operational, qualitative goals (aims), for example, a university's aim may be: 'to seek truth'.(You would not see: 'increase truth by 5%')

Operational, quantitative goals (objectives), for example, 'to increase sales volume by 10%'.

Characteristics of operational goals(objectives)

Example

Objectives should be SMART

Specific

Measurable

Achievable

Relevant

Time-bound

Operational aim: cut costs

Operational objective: reduce budgetedexpenditure on office stationery by 5% by31 December 2007

Interactive question 2: Goals [Difficulty level: Intermediate]

Most organisations establish quantifiable operational goals (objectives). Give reasons why non-operationalgoals (aims) might still be important.


5.3.1 The purpose of setting operational objectives in a business

'Objectives are needed in every area where performance and results directly and vitally affect the survivaland prosperity of the business' (Drucker. Objectives in these key areas should enable management to:

Implement the mission, by setting out what needs to be achieved.

Publicise the direction of the organisation to managers and staff, so that they know where theirefforts should be directed.

Appraise the validity of decisions (by assessing whether these are sufficient to achieve the statedobjectives).

Assess and control actual performance, as objectives can be used as targets for achievement.

5.4 Plans and standards

Definition

Plans: state what should be done to achieve the operational objectives. Standards and targets specify adesired level of performance.



Physical standards e.g. units of raw material per unit produced.

Cost standards. These convert physical standards into money measurement by the application ofstandard prices. For example, the standard labour cost of making product X might be 4 hours at CU6per hour = CU24.

Quality standards. These can take a variety of forms, such as percentage of phone calls answeredwithin three rings (customer service quality standard).

5.5 How are plans set?

The strategic planning process, which we shall see in detail in Chapter 4, sets the overall mission, goals,plans and standards that the business will try to achieve.

6 Has the business performed well?

Section overview

The business will know whether it has achieved its operational and strategic objectives only if itmeasures its performance effectively.

Performance is measured in terms of profitability, activity and productivity.

Resource use is measured in terms of effectiveness, economy and efficiency.

Many businesses identify critical success factors (CSFs) to use as yardsticks against whichperformance, and key performance indicators (KPIs), can be measured and compared.

6.1 Measuring performance

The planning and control system model in Figure 1.2 shows us that actual performance follows on fromsetting operational objectives and developing plans and standards; what is achieved is then compared withthe plan so that control action may be taken to deal with any deviations. Provided this planning and controlmodel is followed effectively the organisation's objective should be achieved.

It is on measuring performance and making the comparison that a great deal of the work of the accountantis focused. Each business will have different ways of measuring its performance and will place greateremphasis on certain factors over others.

6.2 Measuring profitability, activity and productivity

In general, there are three points of reference for measurement in a business.

Profitability

Profit has two components: cost and revenue. All parts of a business and all activities within it incurcosts, and so their success needs to be judged in relation to cost (these will be called cost centres).Only some parts of a business receive revenue, and their success should be judged in terms of bothcost and revenue (as profit centres).

Activity

All parts of a business are also engaged in activities (activities cause costs). Activity measures couldinclude the following.

Number of orders received from customers, a measure of the effectiveness of marketing Number of machine breakdowns attended to by the repairs and maintenance department.

Each of these items could be measured in terms of physical numbers, monetary value, or timespent.



1

Productivity

This is the quantity of the service or product produced in relation to the resources put in, for exampleso many items processed per hour or per employee. It defines how efficiently resources are beingused.

The dividing line between productivity and activity is thin, because every activity could be said tohave some 'product' (if not it can be measured in terms of lost units of product or service).

6.3 Measuring profitability

Profits consist of sales revenue less the costs of the business. Examples:

Materials costs – prices paid to suppliers Labour costs – wages paid Depreciation costs on non-current assets Other expenses, such as local property tax and building rental

Profit is usually measured initially in CUs in absolute terms:CU

Revenue 100,000Cost of sales (58,000)Gross profit 42,000Expenses (24,000)Net profit 18,000

It is then measured relatively, to build up a picture of the business's profitability. Three common measuresare gross and net margin (measured in relation to revenue) and (gross) markup (measured in relation tocost of sales).

Gross margin: Gross profit/Revenue =CU100,000

CU42,000 % = 42%

Net margin: Net profit/Revenue =CU100,000

CU18,000 % = 18%

Markup: gross profit/cost of sales = 72%%CU58,000

CU42,000

Alone these figures convey little meaningful information. What is needed is a comparison with what wasexpected or what was wanted, or what similar businesses have achieved. A net margin of 18% isextraordinarily high for some industries, but quite ordinary for others. Markups tend to be similar acrossbusinesses in the same industry, but net margins can vary tremendously depending on overheads.

Profitability is also often measured in terms of return. For instance, suppose the profit of CU18,000 wasgenerated using assets that cost the business CU1,000,000. The return on capital employed (ROCE) isCU18,000/CU1,000,000 = just 1.8%. If the business could get a rate of 4.5% on its capital elsewhere, thisreturn does not look so great.

If the desired level of profit is not achieved, the owner will close the business and try something else.Exactly the same idea applies to large companies financed by shares: if shareholders do not receive whatthey perceive to be an adequate return on their investment they will take their money elsewhere.

This concept of profit is important to the business's managers. If profit is to be a business's primaryobjective, it must be specified in quantified terms, that is a specific target rate of profit must be set.Effectively, this rate can only be determined by examining the opportunity cost of investing in thebusiness: this is given by the rate of profit available on alternative investments with similarcharacteristics, particularly risk. This is then the minimum rate of return acceptable to the shareholders.



Interactive question 3: Profitability [Difficulty level: Exam standard]

Gridlock Ltd has revenue of CU1.6m, cost of sales of CU0.9m and expenses of CU0.35m. Calculate thefollowing:

(a) Gross margin(b) Net margin(c) Markup on cost of sales


6.4 Measuring resource use: effectiveness, economy and efficiency

A business uses a great many different types of resource in going about its operations so as to achieve itsobjective. As well as materials, labour and finance (as we saw in Figure 1.1), there are also:

Physical assets (buildings, machinery etc) Competencies (what the business is good at doing) Intangible assets (customer goodwill, corporate image, brands) The way in which the business is structured, and The knowledge that is available to the business.

Efficient use of resources is concerned with the economy with which resources are used, and theeffectiveness of their use in achieving the objective of the business.

Economy is reduction or containment of cost; this can be measured against targets.

Effectiveness is the measure of achievement and is assessed by reference to objectives, such aswhether the target profit has been attained.

Efficiency means being effective at minimum cost or controlling costs without losing operationaleffectiveness. Efficiency is therefore a combination of effectiveness and economy.

Many businesses emphasise the importance of developing resources, capabilities and competencies that willimprove efficiency in the future, and so develop and measure critical success factors and keyperformance indicators to show whether performance has been good in key areas.

6.5 Measuring critical success factors (CSFs)

Definition

Critical success factor (CSFs: 'those product features that are particularly valued by a group ofcustomers, and, therefore, where the organisation must excel to outperform the competition' (Johnson &Scholes, 2002).

CSFs differ from one business to another; in some areas of business price may be key, in others quality, inothers delivery, and so on.

CSFs concern not only the resources of the business but also the competitive environment in which itoperates. We shall come back to this in a later chapter.

6.6 Measuring key performance indicators (KPIs)

Once a business has identified its CSFs and the things it must be good at to succeed (its core competences)it must identify performance standards to be achieved to outperform rivals. These standards aresometimes called key performance indicators (KPIs.



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One way of setting KPIs is to use benchmarking, defined as follows.

'The establishment, through data gathering, of targets and comparators, through whose use relative levels ofperformance (and particularly areas of underperformance) can be identified. By the adoption of identifiedbest practices it is hoped that performance will improve'.

Chartered Institute of Management Accountants (CIMA)




Summary

Technology

Individuals Other resources

Social arrangement andcollective goals

Environment

Activity

SizeControl

Financing

Organisation

Owners Legal status

Orientation

To provide goods/services– not-for-profit

To makea profit

Profit maximisation(or profit satisfaction,

revenue maximisation,

multiple objectives,

constraints)

Market position

Product development

Technology

Human resources

Business

Directors

Managers

Employees

Customers

Suppliers

Lenders

Government

Local community

General public

Corporateobjectives

Mission

Goals

Operationalobjectives= SMART

Plans/standards

Performance andmeasurement

Control actionCSFs +KPIs

Productivity

Activity

Profitability

Resource useEffectiveness

EconomyEfficiency

PRIMARY

STAKEHOLDER

SECONDARY

STAKEHOLDERS

SECONDARY

OBJECTIVES

PRIMARY

OBJECTIVE



1

Self-test

Answer the following questions.


2 List four ways in which organisations may differ from each other.

3 A government funded agency exists to provide services to a group of beneficiaries. What would itssecondary objective be?


5 What three things are normally expected of a business by its suppliers as stakeholders?

6 State two possible primary business objectives other than profit/wealth maximisation.

7 Define what is meant by a business's mission.

8 Inch Ltd's operational objective for its Yem manufacturing division is 'increasing manufacturingactivities within a year'. On which one of the SMART criteria for objectives does this objective falldown?

A SpecificB MeasurableC RelevantD Time-bounded

9 Define productivity.

10 Define efficiency.

Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved theseobjectives, please tick them off.




1 An organisation is a social arrangement for the controlled performance of collective goals, whichhas a boundary separating it from its environment

2 They may differ in terms of ownership (public or private), by whom their operations arecontrolled (by owners or managers), what they do, whether they are oriented towards making aprofit, their size, their legal form (club, association, sole tradership, partnership, or company),where they get their money from and what technology they use

3 To minimise the costs of providing the services

4 A business is an organisation that is oriented towards making a profit for its owners but that canbe regarded as an entity separate from its owners

5 Fair terms of trade; prompt payment; continuity of custom

6 Two of: profit satisficing; revenue maximisation; multiple objectives

7 A business's mission is its basic function in society expressed in terms of how it satisfies itsstakeholders

8 B The objective is clearly time-bound and it is specific, as it is clear in which direction it wantsactivities to go. Being related to manufacturing it can be said to be relevant. However, it gives noindication of how the 'increase' is to be measured

9 Productivity is the quantity of goods or services produced in relation to the resources put intotheir production

10 Efficiency is achieving objectives at minimum cost



1


Answer to Interactive question 1

The local community would expect jobs and therefore prosperity to flow from the company, as well ofcourse as electricity. It would also expect safe operating practices and a long term view taken of how thecoal would be transported to the station, and the waste transported from the site. It would be concernedabout direct pollution from gases and ash, and would expect the company to minimise these. Some peoplewould also be concerned about the overall effect on the world's environment, and would expect thecompany to make efforts to minimise its 'carbon footprint'.


Aims can be just as helpful as quantifiable objectives. Customer satisfaction, for example, is not somethingwhich is achieved just once. Some goals are hard to measure and quantify, for example 'to retaintechnological leadership'. Quantified objectives are hard to change when circumstances change, as changingthem looks like an admission of defeat: aims may support greater flexibility.


(a) Gross margin: (1.6 – 0.9)/1.6 100% = 43.75%

(b) Net margin: (1.6 – 0.9 – 0.35)/1.6 100% = 21.87%

(c) Markup on cost of sales (gross profit/cost of sales): (1.6 – 0.9)/0.9 100% = 77.78%

Contents

I

E

T11

Sum

Ans


chapter 2

Managing a business

ntroduction

xamination context

opic list

1 What is management?

2 What is governance?

3 Power, authority, responsibility,accountability and delegation

4 Types of manager

5 The management hierarchy

6 The management process

7 Managerial roles

8 The importance of business culture to

© The Institute of Chartered A

management

9 Management models

10 Business functions

Marketing management

12 Operations management

13 Human resource management

14 Introduction to organisationalbehaviour

mary and Self-test

wers to Self-test

ccountants in England and Wales, March 2009 23



Introduction


Identify the various functional areas within businesses

Show how the business functions assist in the achievement of business objectives

Identify the nature and functions of organisational management, human resourcesmanagement and operations management

Show how the nature and functions of management are influenced by human behaviour

Specific syllabus references for this chapter are: 1c, d.


In order to understand how a business works you need to appreciate how it is managed: what are the rolesand tasks of individual managers, and how do these fit together to form a coherent management structure?

Stop and think

You may or may not already have personal experience of being managed, or even of managing other people.Whatever your level of experience, you will find it useful to address right now some of yourpreconceptions about 'management': what do you think makes a good manager, and what exactly domanagers get up to?

To answer this you may like to think in terms of what managers set out to achieve and how they worktogether to get there.

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill begin to see that while they vary tremendously in their operations and environment, the fundamentalfeatures of management remain the same.

Syllabus links

The material in this chapter will be developed further in this paper, and then in the Business Strategy paperat the next level in the Professional stage.

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Examination context


Questions on the nature of management, business functions and organisational behaviour could all easilyappear in the exam.

Exam requirements

Questions are equally likely to be set as straight tests of knowledge and scenarios.



1 What is management?

Section overview

Management means getting things done through other people. Managers act on behalf of owners in the organisation.

Definition

Management: 'Getting things done through other people' (Stewart).

We defined an organisation in Chapter 1 as 'a social arrangement for the controlled performance ofcollective goals.' This definition itself suggests the need for management.

Objectives have to be set for the organisation Somebody has to monitor progress and results to ensure that objectives are met Somebody has to communicate and sustain corporate values, ethics and operating principles Somebody has to look after the interests of the organisation's owners and other stakeholders

In a business managers act, ultimately, on behalf of owners (shareholders). In practical terms, shareholdersrarely interfere, as long as the business delivers profits year on year.

In a public sector organisation, management acts on behalf of the government. Politicians in ademocracy are in turn accountable to the electorate. More of the objectives of a public sector organisationmight be set by the 'owners' – i.e. the government – rather than by managers. The government might alsotell senior managers to carry out certain policies or plans, thereby restricting their discretion.


Section overview

Governance is the system by which an organisation is directed and controlled. Governance extends beyond management to take explicit account of stakeholders.

Management is essentially a very practical matter: 'getting things done'. It should not be confused with aterm that is frequently used interchangeably with management, which is governance.

Definition

Governance: The system by which businesses are directed and controlled.

Governance incorporates concepts of ethics, risk management and stakeholder protection, extending waybeyond management alone. We shall come back to governance in a great deal more detail later; for now,make sure you are clear that the term 'management' is here being used in the restrictive sense of simply'getting things done'.

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3 Power, authority, responsibility, accountability anddelegation

Section overview

There are a number of significant forces at work in an organisation, which need to be managed. Theyinclude power, authority, responsibility, accountability and delegation.

Power is the ability to get things done.

Authority is the right to do something or to require someone else to do it.

Responsibility is the obligation that someone has to do the thing that the person in authority overthem has required.

Accountability is the responsible person's liability to answer for what has happened to those with alegitimate interest in the matter.

Delegation means giving someone else the responsibility and authority to do something, whilstremaining responsible and accountable for that thing being done properly.

3.1 What is needed for effective management?

Businesses have a large number of different activities to be co-ordinated, and large numbers of peoplewhose co-operation and support is necessary for a manager to get anything done. As you have probablynoticed if you have worked for any length of time, organisations rarely run like clockwork, and all dependon the directed energy of those within them. They need to be managed by managers.

To understand how managers can do their jobs effectively, we need to understand the differences betweenpower, authority, responsibility, accountability and delegation.

3.2 Power

Definition

Power: The ability to get things done.

Power is not something a manager 'has' in isolation: it is exercised over other individuals or groups, and –to an extent – depends on their recognising the manager's power over them.

French and Raven (followed by Charles Handy) classified power into six types or sources.

Type of power Description

Coercive power The power of physical force or punishment. Physical power is rarein business organisations, but intimidation may feature, e.g. inworkplace bullying.

Reward (or resource) power Based on access to or control over valued resources. For example,managers have access to information, contacts and financial rewardsfor team members. The amount of resource power a manager hasdepends on the scarcity of the resource, how much the resource isvalued by others, and how far the resource is under the manager'scontrol.



Type of power Description

Legitimate (or position)power

Associated with a particular position in the organisation. Forexample, a manager has the power to authorise certain expenses, orissue instructions, because the authority to do so has been formallydelegated to her.

Expert power Based on experience, qualifications or expertise. For example,accountants have expert power because of their knowledge of thetax system. Expert power depends on others recognising theexpertise in an area which they need or value.

Referent (or personal) power Based on force of personality, or 'charisma', which can attract,influence or inspire other people.

Negative power (Handy) The power to disrupt operations: for example, by industrial action,refusal to communicate information, or sabotage.

Interactive question 1: Management power [Difficulty level: Intermediate]

Nisar Iqbal is a manager in the IT department of his firm. He has a degree in ICT and 14 staff reporting tohim. What types of power can Nisar exert as a manager in order to make sure a project is completed ontime?


3.3 Authority

Definition

Authority: The right to do something, or to ask someone else to do it and expect it to be done.Authority is thus another word for position or legitimate power.

Managerial authority is exercised in such areas as:

Making decisions within the scope of authority given to the position. For example, a supervisor'sauthority is limited to his/her team and has certain limits. For items of expenditure more than a certainamount, the supervisor has to go to the manager

Assigning tasks to subordinates, and expecting satisfactory performance of these tasks

3.4 Responsibility and accountability

Definitions

Responsibility: The obligation a person has to fulfil a task which s/he has been given.

Accountability: A person's liability to be called to account for the fulfilment of tasks s/he has been given bypersons with a legitimate interest in the matter.

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The terms reflect two sides of the same coin.

A person is said to be responsible for a piece of work when he or she is required to ensure that thework is done

The same person is said to be accountable to a superior when he or she is given work by that superior

One is thus accountable to a superior (or other persons with legitimate interest) for a piece of work forwhich one is responsible.

3.5 Delegation

The principle of delegation is that a manager may make subordinates responsible for work, but remainsaccountable to his or her own manager for ensuring that the work is done, that s/he retains overallresponsibility. Appropriate decision-making authority must be delegated alongside responsibility.

We will come back to delegation at the end of this chapter.

4 Types of manager

Section overview

Different types of manager have different types of authority. A manager may have line, staff, functional or project authority.

Types of manager in a business can be classified according to the types of authority they hold.

A line manager has authority over a subordinate.

A staff manager has authority in giving specialist advice to another manager or department, overwhich they have no line authority. Staff authority does not entail the right to make or influencedecisions in the advisee department. An example might be a human resources manager advising afinance line manager on selection interviewing methods.

A functional manager has functional authority, a hybrid of line and staff authority, whereby themanager has the authority, in certain circumstances, to direct, design or control activities orprocedures in another department. An example is where a finance manager has authority to requiretimely reports from managers in other departments.

A project manager has authority over project team members in respect of the project in progress;this authority is likely to be temporary (for the duration of the project) and the project team are likelystill to have line managers who also have authority over them.

There are inevitable tensions involved in staff managers asserting staff authority in giving specialist advice toother managers.

Problem Possible solution

The staff manager can undermine the linemanager's authority, by empire building.

Clear demarcations for line, staff and functionalmanagers should be created.

Lack of seniority: line managers may be moresenior than staff managers.

Use functional authority (via policies andprocedures). Experts should be seen as a resource,not a threat.

Expert staff managers may lack realism, going fortechnically perfect but commercially impracticalsolutions.

They should be fully aware of operational issuesand communicate regularly with the line managers.

Staff managers lack responsibility for the successof their ideas.

They should be involved in implementing theirsuggestions and share accountability for outcomes.



5 The management hierarchy

Section overview

The relationships of power, authority, responsibility, accountability and delegation together form amanagement hierarchy in most organisations, with a few managers holding the most power andauthority towards the apex, with many managers holding less power and authority beneath them.

Ultimately it is the manager at the very apex – the Chief Executive – who has ultimate authority andbears ultimate responsibility to the shareholders.

Businesses of any size develop a management hierarchy, with some management positions holding morepower and authority than others, the less powerful managers being accountable to the more powerful ones,and the latter being responsible for the performance of the managers lower down the hierarchy. As inFigure 2.1, the hierarchy is usually represented as a pyramid, as top managers are far less numerous thandirect operational staff.

Top

managers:

managing the

business

Middle managers:

managing managers

First-line managers: managing

staff on direct operations

Direct operational staff: doing the work

Few in number, responsible for

overall direction and performance

Many, responsible for ensuring performance

targets are met by first-line managers

Numerous, responsible for ensuring direct

operational staff do what is required

Very numerous, accountable to first-line

managers for getting the job done

Characteristic Power Authority/responsibility

Accountability

Figure 2.1: The management hierarchy

We shall see a great deal more about this in Chapter 3.

6 The management process

Section overview

The process of management comprises planning, organising, controlling and leading.

Planning involves setting detailed objectives and targets in the light of the overall objective, forecastsand resources.

Plans should be constantly reviewed and updated in the light of actual performance.

Organising involves identifying the processes, technology and people that are required and thenallocating and co-ordinating the work.

Controlling follows on from reviewing plans in the light of experience; control actions will often haveto be taken to ensure that the overall objective can still be met.

Leading means generating effort and commitment in a team.

Feedback is an important part of the management process at every point.

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6.1 The management process

The efforts of people in the business (in particular the activities of direct operational staff) needorganising, and as we have seen it is the primary role of managers to 'get things done through otherpeople' (according to Rosemary Stewart). This 'organising' role is actually part of a management processwhich comprises four main tasks: planning, organising, controlling and leading.

6.2 Planning

Following on from the business's overall objective, mission and goals, managers need to set the direction ofthe work to be done. This includes:

Pinpointing specific aims

Forecasting what is needed

Looking at actual and potential resources

Developing objectives, plans and targets

Using feedback from the control part of the process to make necessary amendments to the plan (aswe saw in Chapter 1 when we looked at Figure 1.2 Planning and control systems)

6.3 Organising

Managers allocate time and effort in such a way that the objectives, plans and targets are likely to be met.This includes:

Defining what processes, technology and people are required Allocating and co-ordinating work

6.4 Controlling

Managers monitor events so they can be compared with the plan and remedial action can be taken ifrequired.

6.5 Leading

Managers generate effort and commitment towards meeting objectives, including motivation of staff. Weshall see more about this later in this chapter.

6.6 Putting the management process into action

Any problems foreseen at the planning stage, such as lack of staff, must be taken account of when decidinghow activities should be organised so that, say, more staff are recruited. If, once the plan is put into action,it transpires that as well as too few staff there are not enough staff with the right skills, this controlinformation must be fed back to the planning part of the cycle, where training programmes can beplanned for implementation at the organising stage.

By means of this process, and the important element of leadership, the manager can take resources – staff,money, materials, equipment – and create the required outputs: goods, services, reputation, profit etc.

We shall look in more detail at the planning and control process in Chapter 8.



7 Managerial roles

Section overview

Managers actually do a great many things in the course of the management process, namely handlingdata and information, dealing with people, and making decisions.

Decisions have to be made regarding resource allocation, handling disturbances, negotiating, problem-solving and acting in an entrepreneurial way.

The management process sets out what managers have to achieve and how, but it does not as suchdescribe what managers actually do. Mintzberg (1973) defined what managers do in terms of three keyroles:

The informational role (checking data received and passing it on to relevant people, as well as actingas the 'spokesperson' for his or her team in relation to other teams or his or her own manager)

The interpersonal role (acting as leader for his or her own team, and linking with the managers ofother teams)

The decisional role. It is in this role that managers actually 'do' what we perceive as managing. In thisrole they:

– Allocate resources to operations – for instance, deciding that three people are needed on anaudit assignment

– Handle disturbances – such as dealing with an awkward client, or sorting out a crisis in staffingcaused by illness

– Negotiate for what they need – this may be with more senior managers or with client staff

– Solve problems that arise

– Act as entrepreneur – spotting gaps in the market, or unmet needs in clients.

8 The importance of business culture to management

Section overview

The organisation's culture has a very profound effect on how managers perform their roles.

Culture incorporates the common assumptions, values and beliefs that people in an organisationshare.

Organisational culture varies depending on whether the business is inward or outward looking, andon whether there is a greater comparative need for flexibility or control.

Internal process cultures look inwards and seek control over their environment.

At the other extreme, open systems cultures look outwards and are very flexible about the effects ofthe environment.

A human relations culture is inward-looking but is flexible as it focuses on the needs of people.

A rational goal culture is very aware of the external environment but seeks to control it and its ownprocesses.

Managers have to operate within what is often referred to as the 'culture' of their particular business.

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Definition

Culture: The common assumptions, values and beliefs that people share, 'the way we do thingsround here'.

Quinn (1995) emphasises two distinct tensions that affect the type of culture a particular business manifests:

The tension between having flexibility and having control The tension between whether the business is inward– or outward-looking

Figure 2.2 allows us to identify four different cultural types, which may characterise entire businesses or justparts of businesses.

Figure 2.2: Types of business culture

Each cultural type can be briefly characterised as follows:

Internal process culture: The business looks inwards, aiming to make its internal environmentstable and controlled. Goals are known and unchanging, and there are defined methods, rules andprocedures. Security, stability and order motivate staff. Example: public sector organisations.

Rational goal culture: Effectiveness is defined as achieving goals that satisfy external requirements.The business is structured and controlled so as to deal effectively with the outside world. Competitionand the achievement of goals motivate staff. Example: large established businesses.

Open systems culture: The external environment is a source of energy and opportunity, but it isever-changing and unpredictable. The business must be highly flexible and open to new ideas, so it isvery adaptable in structure. Staff are motivated by growth, creativity and variety. Example: a newbusiness unit working with fast-changing technology.

Human relations culture: The business looks inwards, aiming to maintain its existence and thewell-being of staff. Staff are motivated by a sense of belonging. Example: support service units

The type of culture manifested by an organisation affects the way in which it is managed, as we shall see.

9 Management models

Section overview

Complex realities such as are found in any business of any size can be 'modelled' or described fully, sothat their workings can be understood and the effects of future policies and decisions can bepredicted.

9.1 What is a model?

Models are used in management theory to represent a complex reality, such as a client's business, which isthen analysed and broken down into its constituent parts. Handy points out that management models:

Help to explain the past, which in turn Helps us to understand the present, and thus To predict the future, leading to More influence over future events, and Less disturbance from the unexpected



Some management models are based on the fact that the culture of the business pervades everything itdoes. Of particular importance are the two control-oriented cultures that we saw above: rational goal andinternal process.

9.2 The rational goal model of management

A business with a rational goal culture uses the reason why the business does something to make sure it isdone as well as possible. This is a model of management that has been developed over about 100 years,since the days of Frederick Taylor's 'scientific management' model back in 1915. Taylor analysed factorywork and came to the conclusion that in order for every worker to reach their state of maximumefficiency, managers needed to be in detailed control of every last part of the process. Individual initiativewas not part of the equation; instead Taylor put forward five 'principles' of scientific management:

Determine the one best way of doing a particular task Select the best person to do this task on the basis of their mental and physical capabilities Train the worker to follow the set procedure very precisely Give financial incentives to ensure the work is done in the prescribed way Give all responsibility to plan and organise work to the manager, not to the worker

Scientific management has come in and out of fashion over the years; there are strong elements of themodel in some rational goal ideas commonly seen in organisations today:

Systematic work methods Detailed division of labour Centralised planning and control 'Low involvement' employment relations, such as contract workers

We shall come back to scientific management ideas later in this chapter.

9.3 The internal process model of management

The internal process model looks at how the organisation is doing things, not at why. In businesses with aninternal process model of management we tend to find:

Rationality – use of the most efficient means to meet the business's objectives

Hierarchical lines of authority; managers have closely defined areas of authority, and have noneoutside those areas

Detailed rules and procedures – businesses which are subject to tight regulation and public scrutiny,such as those in the financial services sector, tend to have more rules and procedures

Division of labour – tight limits are set on the areas of responsibility of staff

Impersonality – appraisals of staff performance are based on objective criteria, not personalpreference

Centralisation (we shall come back to this in Chapter 3)

Businesses today operate in an environment which requires a high degree of control (because ofregulations) but in which there is a high degree of competition. Therefore management will apply theprinciples of both the rational goal and the internal process models.

10 Business functions

Section overview

The key functions in any business are marketing, operations/production, human resources andfinance.

The functions that need to be performed in a business depend on many variables, such as what industry it isin, how geographically spread it is, and what its plans are for the future. Historically these functions havebeen identified generically as the following:

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Marketing, including sales and customer service Operations or production, including research and development (R&D), and procurement Human resources Finance

The finance function is a major focus of the Business and Finance syllabus and will be covered in Chapter 7and throughout this Study Manual. Here we shall introduce a few of the principles that underlie the otherfunctions.

11 Marketing management

Section overview

Marketing is the management process which identifies, anticipates and supplies customerrequirements efficiently and profitably. It forms one of the key functions in any business.

A customer may buy goods and services but the person who uses them is called the consumer.

Businesses may work in consumer or industrial markets.

The elements of product marketing comprise the marketing mix, which entails price, product, place(distribution) and promotion. For services it also includes people, processes and physical evidence.

Important issues related to product marketing include quality, reliability, packaging, branding,aesthetics, mix and servicing.

The right price can make or break a product. Setting the price in the light of market demand, costsand competition is a key aspect of marketing management and one in which accountants very oftenplay a supporting role.

Promotion incorporates advertising, sales promotions, public relations and personal selling via a salesteam.

Push techniques of promotion ensure that the product is there for the customer to buy; pulltechniques persuade them to do so.

Making sure products are in the right place at the right time so that customers can buy them is vital.

The key 'place' or distribution decision is whether to sell direct (higher margin, lower volume due toinaccessibility) or whether to go via intermediaries (lower margins, but higher volumes).

11.1 What is marketing?

Definition

Marketing: The set of human activities directed at facilitating and consummating exchanges. It thereforecovers the whole range of a business's activities.

OR

Marketing: The management process which identifies, anticipates and supplies customer requirementsefficiently and profitably.

A distinction can be made between:

A customer, who purchases and pays for a good or service, and A consumer, who is the ultimate user of the good or service



Thus if a business is a manufacturer of corn flakes, its customers are wholesalers, supermarkets and smallshops, but the consumer is the individual who eats the corn flakes. Both customer and consumer need tobe targeted by the business's marketing effort. To obtain greater precision a business may segment itsmarket, that is divide it into smaller parts where the parts can be treated differently for marketing purposesbecause the customers in each part share common characteristics. The business can then target particularmarket segments. We shall come back to this shortly.

11.2 Consumer and industrial markets

Markets can be analysed in terms of the product, or the end-user, or both. The most common distinction isbetween consumer and industrial markets.

Consumer markets are the markets for products and services bought by individuals for their own orfamily use. Goods bought by consumers in these markets can be categorised in several ways:

FMCGs (fast-moving consumer goods). These are high volume, low unit value, fast repurchase, suchas bread, baked beans.

Consumer durables. These have low volume but high unit value. They may be further divided into

– White goods, e.g. fridges, freezers

– Brown goods, e.g. CD players, cars

– Soft goods: these may be thought of as synonymous with consumer durables, e.g. clothes, bedlinen

– Services, e.g. dentist, doctor, holidays

A business which operates in the consumer market, selling to consumers, is often described as being in the'business to consumers', or B2C market.

The main goods and services covered by industrial markets are shown below.

Raw materialsProcessed materialsand components

Capital goods Supplies Services

Iron ore Steel Machine tools Stationery Accountancy

Timber Textiles Computers Carbide tips Legal

Coal Packing materials Buildings Lubricants Distribution

Crude oil Lorries

Businesses operating in industrial markets are often described as 'business to business' or B2B.

11.3 The marketing mix

Definition

Marketing mix: The set of controllable marketing variables that a firm blends to produce the response itwants in the target market (Kotler).

One of the most common ways of presenting the marketing mix for tangible products is the four 'P's.

Product: quality of the product as perceived by the potential customer. This involves an assessmentof the product's suitability for its stated purpose (i.e. its features and benefits), its aesthetic factors, itsdurability, brand factors, packaging, associated services, etc.

Price: prices to the customer, discount structures for the trade, promotion pricing, methods ofpurchase, alternatives to outright purchase.

Promotion: advertisement of a product, its sales promotion, the company's public relations effort,salesmanship.

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Place: distribution channel decisions, website selling (e-tailing), location of outlets, position ofwarehouses, inventory levels, delivery frequency, geographic market definition, sales territoryorganisation.

How the elements are mixed varies enormously from product to product, and from business to business ascan be seen below.

Companyproducts/Marketingmix variable

Internet orderclothes company

Major national drinksmanufacturer

Mainframe computermanufacturer

Product Similar to those ofseveral othermanufacturers

Similar to those of severalother manufacturers

Very advanced, subjectto continual amendment,with a distinct place inthe market

Price A vital factor.Probably lower thansimilar physicallyretailed goods

Similar level and structureto that of several othermanufacturers

Different from that of itsbroad competitors.Customer looks for'value for money' ratherthan initial cost

Promotion Website is the solesource of orders andthe major marketingexpense

A high percentage ofproduct cost. Use of TVand various press media.Sales promotionsimportant

A low percentage ofproduct cost. Use oftrade press and up-market magazines andnewspapers

Sales. No sales peopleas such

A large team of selling-oriented well-trained salespeople

A large team of salespeople trained tocombine selling skillswith good knowledge ofthe product and its use

Place (distribution) No intermediaries.Distributiondetermined by postaland courier systems

Extensive use ofwholesalers, retailers andlicensees of premises.Frequent deliveries,regional warehouses,company owns itstransport fleet

No intermediaries. Smallvehicle fleet. Relativelyinfrequent deliveries.Little storage of finisheditems

Different sorts of business use the same basic marketing tools in very different ways. Conversely, there is atendency for businesses operating in the same markets and with the same products as their competitors touse the marketing mix in the same way.A business operating in one market may vary the marketing mix for various segments of that market. Forinstance, Ford operates in the new car market but does not sell one car in one way to the whole market. Itsegments the market (separating it into various sub-markets which have shared characteristics) and thentargets the consumers within the segment using varying marketing mixes. It places different emphasis onthe mix variables depending on the segment targeted.

Segment of market Target segment by placing most emphasis on

High income groups Promotion – to create the image of quality, status

Families with children Product – size, safety

Low income groups Price – low: Product – reliability, economy



Interactive question 2: Product marketing [Difficulty level: Intermediate]

Pick a product that you see in the supermarket and try to identify how the various elements of themarketing mix have been used in marketing it to you.


11.4 Product

Definition

Product: Anything that can be offered to a market for attention, acquisition, use or consumption thatmight satisfy a want or need. It includes physical objects, services, persons, places, organisations and ideas.Marketers tend to consider products not as 'things' with 'features' but packages of 'benefits' that satisfy avariety of consumer needs.

There are three main elements of a product:

Basic (or core) product – a car. This looks at the perceived or real benefits to be gained from theproduct, e.g. Volvo cars satisfy safety/security needs, BMWs satisfy ego or status needs, etc

Actual product – a Ford Focus

Augmented product – Ford Focus with 0% finance or extended warranty. Essentially an augmentedproduct can be thought of as having more features per CU

General factors to be considered when taking a product from basic to actual and augmented include thefollowing:

Quality and reliability – often linked to the pricing decision, these are used for positioning theproduct. Level and consistency should be considered

Packaging – is it functional (e.g. round a fridge) or part of the overall appeal (e.g. perfume)?

Branding – this is often very important in highly competitive markets

Aesthetics – smell, taste, appearance, etc

Product mix – range of products, e.g. different Ford Focus models

Servicing/associated services – are these required?

11.5 Price

At what level the product should be priced is highly relevant in any marketing mix. Price is particularlyimportant as it is the only P producing revenue (the other three incur costs). We shall see more aboutpricing in Chapter 7 and about market price and factors affecting demand in Chapter 14.

11.6 Place (distribution)

Providing customers with satisfying products at a price they like, while important, is not sufficient to ensuresuccess. Such products must also be made available in adequate quantities, in the locations wherecustomers expect to find them and at the times when customers want to buy them.

MANAGING A BUSINESS 2

The basic decision to be made when considering distribution is whether to sell direct, often via theinternet.

or

Adv

11.7 Pr

Probu

Th

W

Fig

Wconthe

Producer

to use intermediaries to g

antages of selling direct

No need to share profit

Control over ultimate s

Speed of delivery to ultito be quicker

omotion

motion is all about commy it.

ere are four main types of

AdvertisingSales promotion (such aPublic relations; andPersonal selling.

e may distinguish two elem

ure 2.3 Push and pull promo

hen determining its promosumer (in a B2C market).se may be one and the sam

The business = the custIts purchasing manager =A direct operational wo

Producer

Consumer


ive a longer distribution chain:

INTERMEDIARIES

Advantages of using intermediaries

margins

ale

mate consumer likely

More efficient logistically

Costs usually lower

Consumers expect choice at point of sale

Producers may not have sufficient resources tosell direct

unication, thus informing customers about the product and persuading them to

promotion ('the communication mix'):

s 'buy one, get one free' offers)

ents in promotion in Figure 2.3.

PROMOTION TECHNIQUES

tion techniques

tion package, the business should consider the customer and the ultimateIn a B2B market, the business needs to consider buyer, customer and user:e, but if not, all three have to be satisfied:

omerthe buyer

rker = the user

Wholesalers Retailers Consumers

PUSH PULL

Ensuring products/services are availableto consumers byencouragingintermediaries, e.g.Sainsburys, to stock

items

Persuading theultimate consumers

to buy



11.8 The services marketing mix

Marketing services, as opposed to physical products, includes consideration of the four Ps above, as well asthree added extra Ps:

People: the people employed by the service deliverer are uniquely important given they are likely tohave regular interactions with customers. Service businesses therefore need to have excellentrecruitment and selection policies, good training programmes (both in procedures and the serviceethos), standard consistent operational procedures (e.g. airlines), the flexibility to enable staff to givegood service, and effective motivational programmes.

Processes: these often determine the structure of the 'service encounter'. There are some important'moments of truth' that determine how effective a service is, such as enquiries and reservations beforethe service is granted, registration procedures, timing of when the service is consumed (the internetallows the purchase of many services to be done 24/7, for instance), and what happens after theservice has been consumed.

Physical evidence that the service has been performed, such as a certificate or a receipt.

These three are important because of the varying degrees of intangibility that characterise services relativeto tangible products.

12 Operations management

Section overview

Operations management (or production management) means creating the goods or services that thebusiness supplies to customers.

The key variables that must be balanced in order to deliver effective operations are the overall levelof demand for the goods and services, resources, capacity, inventory levels and performance levels ofthe processes required.

Forecasting, whether to 'make or buy', inventory management, supply chain management of suppliersand deliveries, resource scheduling, quality and waste are all areas in which operations managers mustmake decisions.

Definition

Operations (or production) management: Creating as required the goods or services that thebusiness is engaged in supplying to customers.

Operations management is concerned with balancing key variables:

External and internal demand for goods and services

Resources

Capacity of the long-term assets of the business such as machinery, buildings and computer systems,and of the other assets of the business such as people

Inventory levels

Performance of the process which creates the goods or services

There are certain key decisions in operations.

Forecasting demand far enough in advance

Deciding whether products should be made in-house or bought-in from outside ('make or buy')

Deciding whether to operate on a just-in-time basis, or to hold inventory

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Deciding inventory levels and managing inventory efficiently

Managing the supply chain, so inbound deliveries are tied in properly to the production/operationsplan in terms of timing and quality

Scheduling resources to meet the plan

Ensuring that the processes used in operations are managed efficiently

Ensuring quality

Eliminating waste efficiently

13 Human resource management

Section overview

Managing human resources means creating, developing and maintaining an effective workforce whichmatches the business's requirements and which responds effectively to the environment.

Hard approaches to HRM focus on workers as resources; soft approaches emphasise that they arehuman, with short- and long-term needs and goals.

HRM functions include planning and control of personnel levels; job design; recruitment and selection;training and development; performance appraisal; disciplinary procedures; remuneration decisions;grievance and dispute handling; compliance with legal and other standards, including those related tohealth and safety; communication with employees; counselling employees; maintaining information andrecords on personnel; encouraging workforce diversity.

Harvard's four Cs model of HRM suggests that it should achieve: commitment, competence,congruence and cost-effectiveness in the workforce.

13.1 What is human resource management (HRM)?

Definition

Human resource management: 'The creation, development and maintenance of an effective workforce,matching the requirements of the business and responding to the environment' (Naylor).

13.2 Different approaches to HRM

Hard and soft approaches to HRM have been identified, representing opposite ends of the spectrum.

The hard approach emphasises the resources element of HRM. Human resources are planned anddeveloped to meet the wider objectives of the business, as with any other resource such as materialsor money. It involves managing the functions of HRM (set out below) to maximise employeeeffectiveness and control staff costs.

The soft approach emphasises the human element of HRM. It is concerned with employeerelations, the development of individual skills and the welfare of staff. It is exemplified in developing:

– short-term commitment, competence, congruence and cost-effectiveness (the four Cs model,see below)

– long-term individual well-being, organisational effectiveness and societal well-being



13.3 The functions of HRM

Personnel planning and control. Analysis of the business's future need for employee resourceswith respect to quantity and skills, given the nature of the labour market

Job design. Production of a job description and person specification in terms of what is neededregarding experience, skills and education

Recruitment and selection. Choosing the right person for the job described in the job design, usingexternal recruitment consultants if necessary

Training and development. Analysing training needs and organising the provision of training andstaff development to meet those needs. Includes new and existing staff and all levels of management

Performance appraisal. Setting performance standards and competency profiles, and developingformal systems of appraising employees in attaining those standards

Disciplining employees. Developing procedures and sanctions to discipline employees whereappropriate

Remuneration. Designing remuneration packages for employees to provide appropriate incentiveswhile controlling costs in the circumstances of the business and the labour market. May involveparticipation in collective bargaining with trade unions

Grievances and disputes. Setting up employee grievance procedures and participating in theirimplementation. May involve participation in an arbitration process

Compliance with legal and other standards. Involves informing and advising managers ofemployment, contract, health and safety and other relevant law with respect to employees, and settingup procedures to comply with such legislation and other codes of conduct, agreements and standards

Employee communication and counselling. Developing communication channels to and fromindividuals, groups and all employees collectively, and operating such communication procedures

Personnel information and records. Maintaining the records of individual employees concerningrelevant personal and employment details

Workforce diversity. Maintaining an appropriate balance in the workforce in terms of gender,ethnicity, age and disability

While these functions are likely to be the responsibility of a human resource department, many aspects arealso the responsibility of line managers.

13.4 The four Cs model of HRM

The four Cs model was developed at Harvard as a means of investigating HRM issues in a widerenvironmental context rather than merely as a set of functions as listed above. It argues that HRM policiesneed to be derived from a critical analysis of:

Stakeholder demands, including employees as one legitimate stakeholder group

Situational factors (e.g. labour market conditions, management style, technology, ownership,competitive conditions)

The model suggests that the effectiveness of HRM should be evaluated under four headings:

1 Commitment. Assesses employees' motivation, loyalty and job satisfaction. These factors are likelyto measure an employee's commitment to a business. Measures can include labour turnover (howmany people leave in a period compared with how many on average are employed), absenteeism, exitinterviews, and satisfaction surveys.

2 Competence. Relates to employees' skills, abilities and potential. These may be measured by a skillsinventory and appraisal system. The objective of HRM policies in this area should be to attract, retain,motivate, train and promote the right people.

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3 Congruence. This is a measure of the extent to which management and employees share a commonvision for the business and act consistently to attain that vision. Evidence of congruence can includeabsence of grievances, conflicts and strikes, and the state of industrial relations.

4 Cost-effectiveness. Concerns operational efficiency and productivity. Outputs are aimed to beachieved at the lowest input cost. Labour cost and effectiveness by comparison to competitors may bea measure of HRM achievement in this area.

14 Introduction to organisational behaviour

Section overview

Organisational behaviour describes individual and group behaviour in organisations.

Organisational behaviour is affected by many variables, only some of which have obviousmanifestations (they appear above the waterline in the organisational iceberg). These overt variablesinclude customers, organisational goals, technology, physical facilities, organisational design, financialresources, overt competence and skills, and rules and regulations.

There are also some very important variables which are not usually physically manifested but whichare capable of undermining an organisation. These covert variables include attitudes, patterns ofcommunication, informal team processes, personalities, conflict, political behaviour and underlyingcompetencies and skills.

It can be helpful to see an organisation in terms of one or more of Morgan's metaphors: a machine,an organism, a brain, a culture, a political system, a psychic prison, flux and transformation, and aninstrument of domination.

An organisation can be seen as a psychological contract, that is a balance of mutual expectations andneeds. Managers need to be aware of what workers are probably expecting from the organisation.

Important models of human behaviour in organisations include Taylor's scientific management theory,and McGregor's Theory X and Theory Y. Taylor and Theory X both emphasise the importance ofremuneration as a key need and therefore motivator of people.

Maslow's more complex model or hierarchy of people's needs specifies that people's behaviour stemsfrom their desire to fulfil their needs, but that once certain needs (e.g. for a good level of pay) arefulfilled they no longer motivate.

Herzberg goes one further to say that remuneration is simply a hygiene factor: it can demotivate butdoes not of itself motivate people to fulfil their true potential. This can only be achieved by motivatorfactors, such as recognition, challenge, responsibility and advancement.

Teams or groups of people in organisations who communicate with each other and who have aleader, a common sense of identity, a common aim, group norms of behaviour are often veryeffective.

Groups go through a number of stages as they develop: forming, storming, norming and performing(Tuckman).

In an active work group there are a number of key roles, including those of the leader, shaper, 'plant',evaluator, resource-investigator, company worker, team worker and finisher (Belbin).

The effectiveness of a manager is determined by the degree of autonomy and authority they have, andwhat sort of leadership style they manifest.

Leadership style varies from being exploitative and authoritative to being participative. A managerwho subscribes to McGregor's Theory X will favour the former, while a manager who favoursTheory Y will veer towards the latter.

Delegation is a very important means by which managers get things done but it has drawbacks as wellas advantages.



14.1 What is organisational behaviour?

Definition

Organisational behaviour: The study and understanding of individual and group behaviour in anorganisational setting in order to help improve organisational performance and effectiveness (Mullins).

Organisational behaviour is not about human behaviour alone, but about how people's behaviourinterlinks with the business's formal structure, the tasks to be undertaken, the technology andprocesses used, the management process and the external environment.

14.2 The organisational iceberg

A useful image for how human behaviour is affected by many variables and is manifested in organisationalbehaviour is put forward by Hellriegel, Slocum and Woodman as the 'organisational iceberg' (see figure2.4 below).

'One way to recognise why people behave as they do at work is to view an organisation as an iceberg.What sinks ships isn't always what sailors can see, but what they can't see.'

In other words, as well as the formal aspects of a business which one can see 'above the waterline' (theyare 'overt'), there are many behavioural aspects which one cannot see as such (they are 'covert', orunder the water). It is these covert aspects which tend to cause the most problems!

AttitudesCommunication patternsInformal team processes

PersonalityConflict

Political behaviourUnderlying competencies and skills

Formalaspects(overt)

Behaviouralaspects(covert)

Submergedicebergbeneathwaterline

Iceberg visibleabove waterlineCustomers

Formal goals

Financial resources

Organisation design

Rules and regulations

Technology Physical facilities

Surface competencies and skills

Figure 2.4 The organisational iceberg

14.3 Organisational metaphors

In order to help us understand the complex nature of life in businesses, Morgan developed a range ofmetaphors, likening the business to a number of different things in order to bring out certain characteristicsof organisational behaviour. Note that some or all of the metaphors may be applied to the same business –they are mostly not mutually exclusive.

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View the business as: The business is seen as:

A machine A set of efficient operations in a routine, reliable and predictablecontext; effective when business has a stable and protectedenvironment

An organism A living, highly adaptable system; effective when business operates in aturbulent and dynamic environment

A brain Inventive, rational, flexible and creative; effective when business needsintelligent changes and the ability to learn

A culture A complex system made up of unique combinations of ideologies,values, rituals and systems of belief and practice; effective particularlywhen contemplating changes to the business

A political system A pattern of authority, power, superior-subordinate relationships andconflicting interests; helps to understand the practical reality of gettingthings done, or often not getting things done, in a business

A psychic prison A set of illusions about what has happened and is happening; helps tounderstand why businesses do not always act rationally

Flux and transformation A combination of permanent and changing features; effective particularlywhen contemplating changes to the business

An instrument ofdomination

Power struggles which lead to the business pursuing the goals of thefew, not the many; again, helpful in understanding why things do or donot get done

14.4 The psychological contract

Definition

Psychological contract: The business is not a formal entity but is instead a series of mutual expectationsand satisfaction of needs arising from the people-business relationship. These needs and expectations mustbe balanced.

The expectations and needs that are characteristic of individuals in the business are that the business will:

Be safe and hygienic to work in Provide job security Provide challenging and satisfying jobs Have human resources policies that are fair and equitable, including those for equal opportunities Allow staff to participate in decisions affecting them Provide opportunities for personal development and career progression Be respectful to staff Be understanding and considerate about personal problems

The business also has expectations, namely that staff members will:

Work diligently in pursuit of the business's objectives Accept the business's ideology Support the business's image Be loyal and faithful when put in positions of trust Dress respectably



14.5 Models of human behaviour

Early writers, such as Taylor, stated that people were similar and could be treated in a standardised fashion.McGregor, in contrast to Taylor, found that individuals did behave differently from each other. Asindividuals are different, what motivates each individual will differ from person to person.

14.5.1 Taylor's model: scientific management

Taylor made three basic assumptions about human behaviour at work:

People are rational economic animals concerned with maximising their economic gain People respond as individuals, not groups People can be treated in a standardised fashion, like machines

Taylor's conclusions were as follows:

Main motivator: high wages Manager's job: tell workers what to do Workers' jobs: do what they are told and get paid

Interactive question 3: Human behaviour [Difficulty level: Intermediate]

Taylor wrote his Principles of Scientific Management in 1911. How relevant is it today?


14.5.2 McGregor's model: Theory X and Theory Y

McGregor developed two theories, X and Y. Each one represents a different set of assumptions about howpeople are. He did not imply that one or other theory typifies all people. X and Y are two extremes with awhole spectrum of values between the two.

Theory X

Individuals dislike work and avoid it where possible Individuals lack ambition, dislike responsibility and prefer to be led A system of coercion, control and punishment is needed to achieve business objectives Above all, the individual desires security

Theory Y

Physical and mental effort in work is as natural as rest or play

Commitment to objectives is driven by rewards – self-actualisation is the most important reward (seeMaslow's hierarchy below)

External control and threats are not the only way to achieve objectives – self-control and direction arevery important

People learn to like responsibility

The intellectual potential of the average human is only partially utilised – it needs to develop further

In order to understand 'what' motivates people we shall look first at content theories of motivation, thenfocus on creating conditions that meet individuals' needs.

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14.6 Motivation

Definition

Motivation: The degree to which a person wants certain behaviours and chooses to engage in them.

Motivated workers are characterised by:

Higher productivity Better quality work with less waste A greater sense of urgency More feedback and suggestions made for improvement More feedback demanded from superiors

Clearly these are desirable features to have. Research has shown that motivated employees will work at 80-95% of their ability whereas employees lacking motivation will typically work at 30% of their ability.Demotivated workers are likely to become alienated.

14.6.1 Maslow's content theory: the hierarchy of needs

One way of understanding individual behaviour is in terms of the individual's needs, which may beconscious or subconscious. The basic model is in Figure 2.5.

Figure 2.5: Basic model of need-driven behaviour

Abraham Maslow (Motivation and Personality (1954)) suggested a hierarchy of such needs to explain anindividual's motivation.

Self-actualisation

needs

Status/ego needs

Social needs

Safety/security needs

Basic/physiological needs

Figure 2.6: Maslow's hierarchy of needs

People have needs

They formulate goals and strategies to satisfy those needs

Behaviour



A person will start at the bottom of the hierarchy or pyramid and will initially seek to satisfy basicneeds – food, shelter, clothing etc

Once these needs are satisfied they no longer motivate and the individual concerned moves up to thenext level; safety/security needs

Safety needs could encompass physical safety (e.g. wearing a hard hat on a building site) and/orprotection against unemployment, the consequences of sickness as well as being safeguarded againstunfair treatment

Again, once these needs are satisfied (e.g. by company rules re dismissal, pension policies etc) they nolonger motivate and the person moves up to the next level in the hierarchy

Social needs recognise that people want to belong to a group

Status/ego needs involve the desire to have the respect and esteem of others. This could be satisfied,for example, by gaining a promotion

Self-actualisation needs are concerned with what people think about themselves, whether they feelthat their lives are worthwhile and that they have meaning. For many this can only be satisfied byongoing success and new challenges

Needs may be met in or out of the workplace. For example, a person who is captain of a local sports teammay not feel the need to engage in social activities at work.

Maslow's hierarchy does not mention money in its list of specific factors (social needs etc). One of theimportant emphases of the theory was on the significance of non-financial motivators. However, Maslow didsee money as a contributory factor – i.e. money itself is not important except where it helps one satisfy thebasic and safety needs.

While money is likely to be very important in satisfying basic physiological needs it is only importantregarding status needs if status symbols such as BMWs, Rolex watches, etc are valued by others.

14.6.2 Herzberg's content theory: hygiene and motivating factors

Herzberg (Work and the Nature of Man) found that the factors causing motivation and positive jobsatisfaction were not simply the opposites of factors causing demotivation and dissatisfaction.

This led him to suggest a two-step approach to motivation and satisfaction, as shown in Figure 2.7.

Hygiene factors Motivating factors

Figure 2.7: Hygiene (1) and motivating (2) factors

Hygiene factors are involved in dealing with dissatisfaction (step (1)) but motivating factors are neededto ensure actual motivation (step (2)).

Just as hygiene may prevent disease but is insufficient to make people healthy, so dealing with 'hygienefactors' will prevent dissatisfaction but will not necessarily lead to motivated workers. Hygiene factorsare concerned with the context of the job rather than its content:

Company policy and administration Supervision Salary Relationship with other staff Working conditions

Dissatisfactionand

demotivation

Workers nolonger dissatisfied

but not yetmotivated

Positivesatisfaction and

motivation

(1) (2)

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Motivating factors are concerned with the content of people's jobs and need to be addressed to ensuremotivation. They include:

A sense of achievement Recognition Challenging work Responsibility Advancement The job itself

One of the most significant aspects of Herzberg's findings was the classification of salary as a hygiene factor,that is that increasing salary would reduce dissatisfaction but would not motivate workers other thanperhaps as a short-term KITA ('kick in the ass'). Like Maslow, Herzberg emphasised the importance of non-financial motivators.

This was in contrast to the prevailing thought of the time that would attempt to deal with problemsregarding motivation by paying people more.

Note that hygiene factors are concerned with satisfying lower-level Maslow needs (basic, safety, social)whereas motivating factors are more concerned with higher Maslow needs (status and self-actualisation).

14.7 Group behaviour

Definition

Group: A collection of people with the following characteristics:

Common sense of identity Common aim or purpose Existence of group norms (i.e. expected/accepted standards of behaviour) Communication within the group The presence of a leader

14.7.1 The usefulness of groups

As far as businesses are concerned, groups are used to:

Bring together several skills Plan and organise Solve problems/take decisions Distribute information Arbitrate or make awards Co-ordinate between departments

As far as individuals in businesses are concerned, groups are useful to:

Satisfy social and status needs (Maslow) Give support, and Provide social contact and personal relationships



14.7.2 Stages of group development

Tuckman formulated four stages through which groups proceed.

Forming. At this initial stage, the group is no more than a collection of individuals who are seeking todefine the purpose of the group and how it will operate

Storming. Most groups go through this conflict stage. Here, preconceptions are challenged, andnorms of attitude, behaviour etc are challenged and rejected. Members compete for chosen roleswithin the group (e.g. leader, comedian). If successful, this stage will have forged a stronger team withgreater knowledge of each other and their objectives

Norming. This stage establishes the norms under which the group will operate. Members experimentand test group reaction as the norms become established. Typically, the norming stage will establishhow the group will take decisions, behaviour patterns, level of trust and openness, individuals' roles,and so on

Performing. Once this final stage has been reached the group is capable of operating to full potential,since the difficulties of adjustment, leadership contests etc should have been resolved

Tuckman suggested that groups are inefficient at the forming and storming stages, become more efficient atthe norming stage but really need to reach the performing stage for maximum efficiency.

14.7.3 Team roles

Belbin observed that people adopt one or more of the following eight roles when placed within a particulartype of group context, this is a team.

The leader – co-ordinating (not imposing) and operating through others

The shaper – committed to the task; may be aggressive and challenging; will also always promoteactivity

The plant – thoughtful and thought-provoking

The evaluator – analytically criticises others' ideas; brings team down to earth

The resource-investigator – not a new ideas person but tends to pick up others' ideas and adds tothem; is usually a social type of person who often acts as a bridge to the outside world

The company worker – turns general ideas into specifics; is practical and efficient; tends to be anadministrator handling the scheduling aspects

The team worker – concerned with the relationships within the team; is supportive and defusespotential conflict situations

The finisher – unpopular, but a necessary individual: the progress chaser ensuring that timetables aremet

Belbin suggested that an effective team will have each personality type represented, subject to the following:

Only one leader and/or shaper is required Equal numbers of plants and evaluators Equal numbers of company workers and team workers Not too many finishers (probably one is enough)

Belbin later suggested an additional role: the specialist, brought in from outside the team.

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14.8 Leadership style

The effectiveness of any given manager will be influenced by their:

Authority: having sufficient rights to control and judge the actions of subordinates

Autonomy: giving subordinates necessary and reasonable freedom of action to carry out their roles

Leadership: exercising the power conferred by right in such a way as to win a willing and positiveresponse from subordinates

There has been extensive research into 'managerial effectiveness' and numerous attempts todescribe/identify the 'best' leadership 'style' to adopt.

14.8.1 Likert's authoritative – participative continuum

Likert identified four basic leadership styles, in Figure 2.8.

Increasing trust in subordinates’ ability

e par e motivation style

easing delegation

Increasing communication

ork

Exploitative – Benevolent –authoritative

Consultative Participative

Decisionsimposed

Motivatedby threats

Centraliseddecision-making

Little superior/subordinate

communication

Superior +subordinates

act as individuals– no teamwork

Completetrust +

discussion

Motivatedby rewards

– goals agreed

Highdegree ofdelegation

Frequentcommunication

Superior +subordinatesact as a team

Figure 2.8: Likert's four leadership styles

Exploitative-authoritative

– Decisions are imposed by managers on subordinates– Subordinates are motivated by threats– Authority is centralised with minimal delegation– There is little communication between superior and subordinate– There is no teamwork (i.e. managers and subordinates do not act as a team)

Benevolent-authoritative

– Leadership is by a condescending form of the master–servant relationship– Subordinates are motivated by rewards– There is some degree of delegation of responsibility– There is little communication between superior and subordinate– There is relatively little teamwork

Consultative

– Superiors have substantial but not complete trust in their subordinates– Motivation is by rewards and some involvement in objective-setting– There is an increasing degree of delegation– There is some communication between superior and subordinate– There is a moderate amount of teamwork



Participative

– Superiors have complete confidence in subordinates– Motivation is by rewards and participation in objective-setting– There is a high degree of delegation– There is much communication between superior and subordinate– There is a substantial amount of teamwork

Likert considered the participative style to be ideal for the profit-oriented and human-conscious business,and said that all businesses should adopt this style. Other writers disagree, arguing that under certaincircumstances a form of authoritarian management works best, e.g. in the small entrepreneurial business.

Likert also identified four characteristics of effective managers

1 Employee-centred rather than work-oriented2 Set high standards but are flexible in terms of methods to use to achieve those standards3 Natural delegators with high levels of trust4 Encourage participative management

Interactive question 4: Management effectiveness [Difficulty level: Intermediate]

Consider a manager for whom you have worked in the past, or perhaps the manager of the audit on whichyou are currently engaged. Consider objectively how effective that manager was, and try to identify what inparticular the manager was/is good/bad at.


14.8.2 McGregor's Theory X/Theory Y

If a manager believes McGregor's Theory X, then he or she will adopt a coercive, dictatorial approachto leadership. Employees will be seen as a barrier to be overcome.

If Theory Y is believed, then employees are seen as having great potential and the manager's role is to helppeople to realise that potential.

14.8.3 Blake & Mouton's managerial grid

The managerial grid put forward by Blake and Mouton allows us to map a particular manager's leadershipstyle according to where it features on two scales: concern for people, and concern for getting the taskdone.

Figure 2.9: Blake and Mouton's Managerial Grid ® (republished in 1991 as the Leadership Grid)

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Managers at each of the five points marked can be characterised as follows:

9–9 Participative (team manager). High productivity as a result of the integration of task and humanrequirements.

9–1 Authoritarian. People are treated like machines to get the task done.

1–9 'Country club'. Keep everyone happy, don't worry about the task.

5–5 Average. No-one over-exerting themselves.

1–1 Impoverished. No concern for either people or getting the task done. Should these people bemanagers?

14.9 Delegation

Definition

Delegation: Delegation involves giving a subordinate responsibility and authority to carry out a given task,while the manager retains overall responsibility.

Advantages of delegation:

Manager can be relieved of less important activities

It enables decisions to be taken nearer to the point of impact and without the delays caused byreference upwards

It gives businesses a chance to meet changing conditions more flexibly

It makes the subordinate's job more interesting

It allows for career development and succession planning

It brings together skills and ideas

Team aspect is motivational

It allows performance appraisal

Problems caused by poor delegation:

Too much supervision can waste time and be demotivating for the subordinate

Too little supervision can lead to subordinates feeling abandoned and may result in an inferioroutcome if they are not completely happy with what they are doing

Manager tries to delegate full responsibility, that is s/he uses delegation to 'pass the buck'

Manager only delegates boring work

Manager tries to delegate impossible tasks because s/he cannot do it themselves

Managers may not delegate enough because they fear their status is being undermined, and they wantto stay in control

Subordinates may lack the skills and training required




Summary 2/1

Behaviour inorganisations (2/2)

Power

Authority

Responsibility

Accountability

Evaluation of 4Cs

– Commitment

– Competence

– Confidence

– Cost-effectiveness

Marketing mix

Product Price PlacePromotion People ProcessesPhysical evidence

Functions

HRM Marketing

Markets

– Industrial B2B

– Consumer B2C

Finance(Chapter 7)Business functions

Operations/production

Balance variables:

– Demand

– Resources

– Capacity

– Inventory

– Processes

Effective management

= harnessing forces ofTypes of manager

Line StaffFunctional Project

Culture

Internal process

Rational goal

Open systems

Human relations

Governance

(Chapters 12/13)

Managementhierarchy

(Chapter 3)

Management process

Management roles

may be delegated

Informational Interpersonal

Decisional

A business cannot run itself

It needs to be

managed directed and controlled

Planning Organising Control

(Chapter 8)

Leading

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Summary 2/2

How managers behavein organisations

Overtvariables

Covertvariables

Organisationaliceberg

Psychologicalcontract

Metaphors(Morgan)

Delegation

AuthorityHow organisations behave

Behaviour in organisations

Leadership styleHow people behave

in organisationsHerzberg’s hygiene and

motivating factorsMotivation

Maslow’shierarchy

Theory X andY(McGregor)

Scientificmanagement

(Taylor)How groups behave

in organisations

Features Roles(Belbin)

Development(Tuckman)

– Form

– Storm

– Norm

– Perform

Self-test


1 What is the difference between management and governance?

2 When a manager delegates authority and responsibility for a task, they also delegate full accountability.True or false?

3 Cedric is an IT specialist responsible for a new database which is used by all functions in theorganisation. If Kara, a human resources manager, attempted to alter the database parameters Cedriccould prevent her from doing so by exercising:

A Line authorityB Staff authorityC Functional authorityD Project authority

4 Ethel has been given responsibility for identifying the processes, technology and up to five peoplerequired to complete a particular project, and then to allocate the work and co-ordinate it. In terms ofthe management process, Ethel is

A PlanningB OrganisingC ControllingD Leading



5 Which two of the following qualities are typical of a rational goal culture?

A Inward lookingB The need to be flexibleC The need to control the environmentD Outward looking

6 Which two of the following elements of the marketing mix are peculiar to services marketing?

A PriceB PlaceC PeopleD PromotionE ProcessesF Place

7 Randalf, a manager with Trent Ltd, is faced with a decision about a service that is being marketed toconsumers. The service requires four people for delivery and costs CU1,000 when these people aredirectly employed. A sub-contractor has told Randalf that he would charge Trent Ltd CU1,000 todeliver the service to customers. This decision is one about

A Marketing management (place)B Operations management (make or buy)C Finance (relative costs)D Human resources management

8 In terms of the organisational iceberg, which of the following is a covert variable affectingorganisational behaviour?

A Political behaviourB Organisational designC Organisational goalsD Regulations

9 The model of human behaviour that states that humans seeks security above all else is called

A Theory XB Scientific managementC The hygiene factorD Theory Y

10 Sitin's team leader has told him that as a member of the team he is very committed to the team's taskand always promotes activity, but that sometimes he can be too aggressive and challenging. In terms ofBelbin's roles, Sitin is the team's

A PlantB EvaluatorC ShaperD Finisher


MANAGING A BUSINESS


2


1 While management means getting things done, governance means directing and controlling theorganisation for all stakeholders

2 False. The manager remains accountable to senior management for the task

3 C Cedric has line authority only over his immediate subordinates. He has general staff authorityby which he can advise other line managers on using the database, but in an issue such as thiswhere he is responsible for the database, he can exercise functional authority to prevent Karafrom changing the parameters

4 B

5 C and D

6 C and E

7 B

8 A

9 A

10 C





Nisar has resource power by virtue of the fact he manages 14 IT staff, and he has position power as theirmanager. He has expert power by virtue of his qualification. There is no information on which to base anassessment of his coercive, personal or negative power.


In fast moving consumer goods, such as you see in a supermarket, the supplier will have made tremendousefforts to use all aspects of the marketing mix to persuade you to buy and use the product. In terms ofproduct it will have been designed to satisfy a range of your needs, including how you may feel aboutpackaging and the look of it. Its price will have been designed to be affordable to its target market whilstsecuring both a profit and an edge over competitors for both the manufacturer and the supermarket. Theproduct has been placed in the supermarket via a network of intermediaries, although large chains likeTesco frequently deal direct with producers and handle the distribution (inbound logistics) themselves too.It will be placed in a position in the supermarket such that you are encouraged to see it and want it;products vie for shelf space at eye level in the supermarket, and where ranges are situated is a key elementof supermarket marketing. Fresh produce is often placed at the entrance to be appealing to the eye anddraw you in; the fragrance of fresh bread is often piped over from the bakery to appeal to your sense ofsmell at the entrance too. Promotion extends beyond placement on the shelves to include offers such asBOGOF (buy one get one free) and advertising in various media.


Large hotel chains make use of standard recipes and performance standard manuals. Housekeeping staffhave a prescribed layout for each room with training based on detailed, ordered procedures and 'one bestway' to service a room. Staff are expected to clean a set number of rooms per shift with bonuses for extrarooms.

This is just one example of the systematic work methods and detailed direction of labour that we saw in therational goal model of management, and which are much in evidence in today's businesses.


The manager's style – the degree to which they are authoritative or participative – should be evaluated byconsidering how they made decisions, delegated, communicated, motivated and operated the team. If youfound the manager was good it was probably because they focused on employees, set high standards foroutput but were flexible about methods, trusted you and delegated happily, and encouraged you to join inwith decisions and generally feel involved.


Contents

Introduction

Examination context

Topic index

1 Introduction to organisational structure

2 Types of business structure

3 Centralisation and decentralisation

4 Span of control: tall and flat businesses

5 Mechanistic and organic structures

6 Introduction to business forms

7 Sole tradership

8 Partnerships

9 Companies

10 Which form should a business take?

11 Converting from one form to another

12 Alliances




chapter 3

Organisational structure andbusiness forms



Introduction


Identify the various functional areas within businesses

Identify the nature and functions of organisational management

Identify different forms of businesses and specify their advantages and disadvantages

Identify the differences between businesses carried out by sole traders, partnerships, limitedliability partnerships, alliances and groups

Show the advantages and disadvantages of each form

Identify the differences between unincorporated businesses and companies, and show theadvantages and disadvantages of incorporation

Specific syllabus references are: 1c, d; 2a, b, c.


When looking at the overall shape of a business there are two factors to consider: what structure thebusiness takes (is it centralised or decentralised, for instance?), and what form it takes (is it a company, or agroup of companies, say?). Getting the right organisational structure is key to operational success, whileusing the right business form is often central to financial success as well.

Stop and think

You may already have personal experience of different business forms: you may be employed by a largepartnership, and you may audit large groups of companies. The form each business takes is determined by avariety of factors such as regulation, tax efficiency and history. But whatever form the business takes, itsorganisational structure will be determined by how best it can do business. A global business, for instance,will have to make sure that it is structured so that there is the optimum balance of local autonomy andcentralised direction and reporting.

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill begin to see the difference between the structures and forms that organisations take.

Syllabus links

Detailed legal aspects of partnerships and companies are developed further in Law at Professional stage.Accounting for sole traders, partnerships and companies is covered in Accounting; groups are covered inFinancial Accounting. Choosing the right structure and form from a strategic perspective is developed in theBusiness Strategy paper, and optimising the financial aspects of structure and form are covered in FinancialManagement.

ORGANISATIONAL STRUCTURE AND BUSINESS FORMS


3

Examination context


Questions on business structures and forms could both easily appear in the exam.

Exam requirements

Questions are likely to be set in a scenario context. Knowledge-type questions are also likely, based onparticular principles, theories or models.



1 Introduction to organisational structure

Section overview

Organisational structure sets out how the various functions in the organisation are arranged.

Organisational structure comprises six building blocks (Mintzberg): the operating core over whichthe middle line has authority; together these are facilitated by the technostructure and support staff.The strategic apex controls the entire organisation, and in turn it is guided by the organisation'soverarching ideology.

Classical principles of organisational structure emphasised: division of work, the scalar chain, theidentity of authority and responsibility, centralisation, unity of command and direction, initiative,subordination of individual interests, discipline and order, stability, equity, fair remuneration andesprit de corps.

While some classical principles still apply, in practice the values of multi-skilling and flexibility arevery important.

The organisation's structure is conveyed via an organisation chart or manual, and/or in jobdescriptions.

1.1 What is organisational structure?

Definition

Organisational structure: Formed by the grouping of people into departments or sections and theallocation of responsibility and authority, organisational structure sets out how the various functions(operations, marketing, HR, finance etc) are formally arranged.

Organisational structure is a framework intended to:

Link individuals in an established network of relationships so that authority, responsibility andcommunications can be controlled

Allocate the tasks to be done to suitable individuals or groups

Give each individual or group the authority required to perform the allocated tasks, while controllingtheir behaviour and use of resources in the interests of the business as a whole

Co-ordinate the objectives and activities of separate groups, so that overall aims are achievedwithout gaps or overlaps in the flow of work

Facilitate the flow of work, information and other resources through the business



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1.2 The building blocks and co-ordinating mechanisms oforganisational structure

Mintzberg suggests that all businesses can be analysed into six 'building blocks', as shown in Figure 3.1: theoperating core, middle line and strategic apex (the management hierarchy that we saw in Chapter 2) plussupport staff and the technostructure, all taking place within an overall ideology.

Strategicapex

MiddlelineTe

chno

stru

ctur

e

Supportstaff

Operating core

I D E O L O G Y

Figure 3.1: Mintzberg's building blocks

Building block Function

Operating core People directly involved in the process of obtaining inputs, and converting theminto outputs, i.e. direct operational staff.

Middle line Conveys the goals set by the strategic apex and controls the work of theoperating core in pursuit of those goals, i.e. middle and first-line managers.

Strategic apex Ensures the organisation follows its mission. Manages the organisation'srelationship with the environment. Top managers.

Support staff Ancillary services such as PR, legal counsel, the cafeteria and security staff.Support staff do not plan or standardise operations. They function independentlyof the operating core.

Technostructure Analysts determine and standardise work processes and techniques.

Planners determine and standardise outputs (e.g. goods must achieve a specifiedlevel of quality).

Personnel analysts standardise skills (e.g. through training programmes).

Ideology Values, beliefs and traditions, i.e. the business culture.

Interactive question 1: Ideology [Difficulty level: Intermediate]

Where do you fit into the organisational structure of your firm? Try to identify the point at which the firmnarrows to form the 'middle line' and also those departments which are part of the technostructure andsupport. What do you think the overarching ideology of the firm is?




Co-ordinating mechanisms integrate these building blocks into a cohesive unit, as follows:

Direct supervision: giving of orders by a superior to a subordinate Standardisation of work: laying down standard operating procedures Standardisation of skills: requiring workers to have particular skills or qualifications Standardisation of outputs: specification of results such as the setting of targets Mutual adjustment: informal communication and self-government

1.3 Classical principles of organisational structure (Fayol)

Classical theories state that organisations are based on the principle of hierarchy which we saw in outlinein Chapter 2. There is a line of decision-making power from the top of the organisation to the bottom.

Henri Fayol, an early ('classical') management theorist, suggested that all organisations should follow the 14guiding principles outlined in the table below, based on the principles of hierarchy, in order to functioneffectively and efficiently.

Principle Comment

Division of work Work should be divided and allocated rationally, based on specialisation.

Scalar chain Authority should flow vertically down a clear chain of command fromhighest to lowest rank. This principle is linked to the concept of span ofcontrol, which is the number of individuals under the direct supervision of anyone person. (This is discussed further below.)

Correspondence ofauthority andresponsibility

The holder of an office should have enough authority to carry out all theresponsibilities assigned to them.

Appropriatecentralisation

Decisions should be taken at the top of the organisation where appropriate.

Unity of command(for people)

For any action, a subordinate should receive orders from one boss only. Fayolsaw dual command as a disease, whether it is caused by imperfect demarcationbetween departments, or by a superior giving orders directly to an employeewithout going via the intermediate superior.

Unity of direction(for the organisation)

There should be one head and one plan for each activity.

Initiative Employees should be encouraged to use discretion, within the bounds oftheir authority.

Subordination ofindividual interests

The interest of one employee or group of employees should not prevail overthat of the general interest of the organisation.

Discipline A fair disciplinary system can be a strength in an organisation. Members ofthe organisation should behave in agreed ways.

Order People and resources should reliably be where they are supposed to be.

Stability of personnel There should be continuity of employment where possible.

Equity Organisational policies should be just.

Remuneration Rewards should be 'fair', satisfying both employer and employee alike.

Esprit de corps Harmony and teamwork are essential to promote discipline andcontentment.



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1.4 Modern approaches to organisational structure

Modern management theorists emphasise values such as:

Multi-skilling. Contrary to the idea of specialisation, multi-skilled teams (where individuals aretrained to perform a variety of team tasks, as required) enable tasks to be performed more flexibly,using labour more efficiently.

Flexibility. This is perhaps the major value in modern management theory. Arising from thecompetitive need to respond swiftly (and without organisational trauma) to rapidly-changing customerdemands and technological changes, organisations and processes are being re-engineered to flexiblestructures such as the following:

– Smaller, multi-skilled, temporary structures, such as project or task-force teams.

– Multi-functional units, facilitating communication and co-ordination across departmentalboundaries. This is called matrix organisation (which we shall see more about later), and itblurs the principle of 'unity of command', since an employee may report both to theirdepartmental superior and to a project or product manager whose job is to manage all areas ofactivity related to the product or project.

– Flexible deployment of the labour resource, for example through part-time and temporaryworking, contracting out tasks, flexitime, annual (rather than daily) hours contracts and so on.

1.5 Communicating the organisational structure

There are three main methods of communicating the structure of the business. These are outlined in Figure3.2.

ORGANISATION OF THE BUSINESS

Organisation chart Organisation manual Job description

Includes

Details about allpositions in theorganisation

Standard principles andworking practices

A result of 'job analysis'

Includes responsibilities,authority and work involved

Typical descriptions

– Job title– Department– Grade/level– Duties and responsibilities– Limits of authority– Superiors and subordinates

Advantages

Need to analyseorganisation detail

Provides at-a-glance information

Highlights formalrelationships

Pictorial representation of the structure

Disadvantages

Frequent updatingas people leave

Informalrelationships notshown

May implymanagers at thesame level areequally important

May encouragebureaucracy

Figure 3.2: Communicating organisational structure



2 Types of business structure

Section overview

Mintzberg's six building blocks can be combined in five different ways, to form: a simple structure, amachine bureaucracy, a professional bureaucracy, a divisionalised structure or an adhocracy.

These structures are typified in part by whether the external environment is either simple orcomplex, and either static or dynamic.

Mintzberg's building blocks and coordinating mechanisms of organisational structure in Figure 3.1 aregenerally combined in one of five different types of business structure. Each business structure ischaracterised by different types of external environmental and internal factors.

Types ofbusinessstructure

Externalenvironment

Internal factors Key building block Key co-ordinatingmechanism

Simplestructure

SimpleDynamic

SmallYoungSimple tasks

Strategic apex Direct supervision

Machinebureaucracy

SimpleStatic

LargeOldRegulated

Technostructure Standardisation ofwork

Professionalbureaucracy

ComplexStatic

ProfessionalSimple systems

Operating core Standardisation ofskills

Divisionalised SimpleStaticDiverse

Very largeOldDivisible tasks

Middle line Standardisation ofoutputs

Adhocracy/Innovative

ComplexDynamic

YoungComplex tasks

Operating core Mutual adjustment

We shall look at what simple, complex, static and dynamic mean in the context of external environment inChapter 4.

We will study four of these business structures in depth.

Simple business structure – known as the entrepreneurial structure Machine bureaucracy business structure – known as the functional or bureaucratic structure Divisionalised business structure Ad hoc business structure – known as the matrix structure

The suitability of each structure will be dependent on the size of the business; generally speaking, as abusiness grows it will progress from entrepreneurial to functional to divisional structure. A matrix structuremay occur independently or within a functional or divisional structure.



3

2.1 Entrepreneurial structure

Features

Entrepreneur has specialist knowledge of product/service Entrepreneur has total control over running of the business

Entrepreneur

Employees

Figure 3.3 Entrepreneurial structure

The entrepreneurial structure is most suitable where there is one product or a group of similarproducts.

Advantages

Quick decisions can be made with skill and flair Goal congruence – the entrepreneur's objectives are pursued exclusively Flexible/adaptable to change

Disadvantages

Cannot expand beyond a certain size (too many decisions need to be made and too many people needto be managed)

Cannot easily cope with diversification into new products/services about which the entrepreneur doesnot have specialist skills/knowledge

Lack of career structure for lower level employees

May be too centralised, i.e. too much decision-making power retained by entrepreneur

2.2 Functional structure (bureaucratic structure

Features

Jobs grouped by common feature, e.g. production, and ranked in hierarchy, e.g. managers, supervisors,employees etc

Clear lines of reporting and authority exist

Formal procedures and paperwork characterise this type of structure

The vertical flow of authority (scalar chain) can go up and down through the structure from top tobottom



Production Marketing Finance HR

ManagerProduct A

ManagerProduct B

ManagerProcess 2

ManagerProcess 3

ManagerProcess 1

Board of Directors

Managing Director (MD)

Figure 3.4 Functional structure (bureaucratic)

The functional bureaucratic structure is most suitable where there is

Single product/closely-related product forms Relatively stable environment, i.e. one not subject to rapid change A smaller enterprise

Advantages

Good career opportunities, employees can progress 'up through the ranks' Can be efficient as functional tasks are well-known and understood by individuals Exploits specialist functional skills

Disadvantages

Structure is very rigid and unsuitable for– Growth– Diversification

Tendency towards authoritative non-participative management style as clear levels of authority areenforced

Poor decisions/slow decisions which have to pass along a line of authority Functional heads may build empires and interfunctional disputes may result

2.3 Divisional structure

Definition

Divisionalisation: The division of a business into autonomous regions or product businesses, each with itsown revenues, expenditures and capital asset purchase programmes, and therefore each with its own profitresponsibility.



3

Features

Business is split into divisions – division is usually by product or location Divisions are typically given responsibility for their profits and assessed in terms of profit (profit

centre) In Bangladesh the typical approach is to use a holding company and subsidiaries (a group structure –

we shall come back to this later in this chapter)

Group Board ofDirectors

Division 2

Board

Division 1

Board

Division 3

Board

Group services,eg finance

Division manager

PersonnelProduction Marketing

Figure 3.5: Divisional structure

Each division of the organisation might be:

A subsidiary company under the holding company (we shall come back to this) A profit centre within a single business

Successful divisionalisation requires certain key conditions.

Each division must have properly delegated authority, and must be held properly accountable tothe group board (e.g. for profits earned).

Each division must be large enough to support the quantity and quality of management it needs.

The division must not rely on head office for excessive management support.

Each division must have a potential for growth in its own area of operations.

There should be scope and challenge in the job for the management of each division.

If divisions deal with each other, it should be as 'arm's length' transactions. There should be noinsistence on preferential treatment to be given to a 'fellow division' by another division of the overallorganisation.

The divisional structure is most suitable when:

There are larger, more diversified businesses There is diversity by product and/or location



Advantages

Flexible in adapting to growth and diversification – extra divisions can simply be added into thestructure

Good for developing managers as they are given responsibility for divisional profit

Reduces the number of levels of management

Encourages a greater attention to efficiency, lower costs and higher profits

Better decisions on performance made by managers 'in the know'

Releases top management to concentrate on strategic issues

Reduces the likelihood of unprofitable products and activities being continued

Disadvantages

Squabbles over allocation of central costs can occur

Interdivisional trading problems, i.e. at what transfer price should the trades take place?

It may be impossible to identify completely independent products or markets for which separatedivisions can be set up

2.4 Matrix structure

Features

Formalises vertical and lateral lines of communication

Managers appointed for projects or customers – project or customer managers liaise with managersfrom each function (functional managers)

May be temporary, i.e. for one-off contract

Board ofDirectors

MD

Productionmanager

Marketingmanager

Personnelmanager

Financemanager

Manager Project A 0

0

0

Manager Project B

Manager Project C

0

X

0

0

0

0

0

0

0

0 = individual in structureX = reports both to marketing manager and Project B manager

Figure 3.6 Matrix structure showing project managers

The matrix structure is most suitable to

Complex/hi-tech industries Educational establishments where there may be lecturers reporting to both subject and course heads R&D departments



3

Advantages

Reflects importance of project or customer, so may improve relationships and sales Business co-ordinated with regard to technology, information, etc

Disadvantages

Conflicting demands on staff time (staff have to serve two bosses) Conflicting demands over allocation of other resources Dilution of authority of functional heads

3 Centralisation and decentralisation

Section overview

An organisation is centralised when decision-making authority is concentrated in its strategic apex. Centralisation offers greater control and coordination. Decentralisation offers greater flexibility.

3.1 What is centralisation?

We can look at centralisation in two ways.

Geography. Some functions may be centralised rather than 'scattered' in different offices,departments or locations.

So, for example, secretarial support, IT support and information storage (filing) may be centralised inspecialist departments (whose services are shared by other functions) rather than carried out bystaff/equipment duplicated in each division.

Authority. Centralisation also refers to the extent to which people have to refer decisions upwardsto their superiors. Decentralisation therefore implies increased delegation, and autonomy at lowerlevels of the business.

We shall use the terms centralisation/decentralisation to refer to how much authority/decision-makingability is diffused throughout the organisation.

Centralised structures: upper levels retain authority to make decisions

Decentralised structures: authority to make decisions (i.e. commit people, money and resources)is passed down to lower levels of the hierarchy

Definition

Centralised organisation: One in which decision-making authority is concentrated in one place, that isthe strategic apex.

3.2 Factors affecting the amount of decentralisation in a business

Leadership style: if it is authoritative, the business will be more centralised

Size of organisation: as size increases, decentralisation tends to increase

Extent of activity diversification: the more diversified, the more decentralised

Effectiveness of communication: decentralisation will not work if information is notcommunicated downwards

Ability of management: the more able, the more decentralisation



Speed of technological advancement: lower managers are likely to be more familiar with changingtechnology, therefore decentralise

Geography of locations: if spread, decentralise

Extent of local knowledge needed: if required, decentralise

3.3 Which is better – centralisation or decentralisation?

Generally, centralisation offers greater control and co-ordination, while decentralisation offers greaterflexibility as authority is delegated.

Pro centralisation Pro decentralisation (delegation of authority)

Decisions are made at one point and so are easierto co-ordinate.

Avoids overburdening top managers, in terms ofworkload and stress.

Senior managers can take a wider view ofproblems and consequences.

Improves motivation of more junior managers whoare given responsibility and authority.

Senior management can balance the interests ofdifferent functions, e.g. by deciding on theresources to allocate to each.

Greater awareness of local problems by decisionmakers. (Geographically dispersed organisationsare often decentralised on a regional/area basis forthis reason.)

Senior managers keep control. Greater speed of decision making, and response tochanging events, since no need to refer decisionsupwards. This is particularly important in rapidlychanging markets.

Quality of decisions is (theoretically) better due tosenior managers' skills and experience.

Helps develop the skills of junior managers:supports managerial succession.

More likely to produce congruent decisions asdecision-makers are more likely to pursue sameobjectives.

Separate spheres of responsibility can be identified:controls, performance measurement andaccountability are better.

Possibly cheaper, by reducing number of managersneeded and so reduced costs of overheads –simpler structure.

Communication technology allows decisions to bemade locally, with information and input from headoffice if required.

Crisis decisions are taken more quickly at thecentre, without need to refer back.

Policies, procedures and documentation can bestandardised business-wide.

Transfer pricing is less of a problem.



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4 Span of control: tall and flat businesses

Section overview

A manager's span of control quantifies how many people are reporting directly to them.

The scalar chain describes the series of links between the most senior managers and the directoperational staff in an organisation.

Wide spans of control/short scalar chains create flat management hierarchies.

Narrow spans of control/long scalar chains create tall management hierarchies.

4.1 Span of control

Definition

Span of control: The number of people (subordinates) reporting to one person.

The classical theorist Urwich held that:

There needs to be tight managerial control from the top of a business downwards

The span of control should therefore be restricted, to allow maximum control consistent with themanager's capabilities: usually between three and six subordinates

If the span of control is too wide (there are too many subordinates), too much of the manager's timewill be taken up with routine problems and supervision, leaving less time for planning. Even so,subordinates may not get the supervision, control and communication that they require

If the span of control is too narrow (there are too few subordinates), the manager may fail todelegate, keeping too much routine work to himself and depriving subordinates of decision-makingauthority and responsibility. There may be a tendency to interfere in or over-supervise the work thatis delegated to subordinates – and the relative costs of supervision will thus be unnecessarily high.Subordinates tend to be dissatisfied in such situations, having too little challenge and responsibility andperhaps feeling that the superior does not trust them

Influences on the span of control:

A manager's capabilities limit the span of control: there are physical and mental limitations to anysingle manager's ability to control people and activities

The nature of the manager's workload: the more non-supervisory work in a manager's workload,the narrower the span of control and the greater the delegation of authority to subordinates shouldbe

Manager's work

Solitary work(some planningand scheduling)

Entrepreneurialactivities

('external' dealings)

Interactionwith superiorsand colleagues

Supervision

Non-supervisory work

Figure 3.7 The manager's workload

The geographical dispersion of subordinates: dispersed teams take more effort to supervise

Subordinates' work: if all subordinates do similar tasks, a wider span is possible. If close groupcohesion is desirable, a narrower span of control might be needed



The nature of problems that a manager might have to help subordinates with. Time consumingproblems suggest a narrower span of control

The degree of interaction between subordinates. If subordinates can help each other, a widerspan is possible

The amount of support that supervisors receive from other parts of the organisation or fromtechnology (e.g. computerised work monitoring, or 'virtual meetings' with dispersed team members)

Interactive question 2: Work loads [Difficulty level: Intermediate]

For your own firm or perhaps for one of your audit clients, select a manager who you believe may beoverworked. Think about what amount of time that manager seems to spend 'doing' their own work, andhow much time they spend supervising staff. How far do you think the manager's problems are caused byhaving too wide a span of control, and what effect does this have?


4.2 Tall and flat businesses

The management hierarchy determines the 'shape' of the organisation; longer scalar chains create tallerbusinesses.

Definitions

Scalar chain: The chain of command from the most senior to the most junior.

Tall business: One which, in relation to its size, has a large number of levels in its management hierarchy,normally because there are narrow spans of control.

Flat business: One which, in relation to its size, has a small number of hierarchical levels, normally becausethere are wide spans of control.

TALL BUSINESS FLAT BUSINESSV

Figure 3.8: Tall and flat business structures

In the tall business (seven layers), each manager has only three subordinates In the flat business (three layers) each manager has seven subordinates



3

The span of control concept therefore has implications for the length of the scalar chain (Figure 3.9).

MD

MD

Divisionaldirectors Top

management

Middlemanagement

Front linemanagement

Departmentmanagers

Middlemanagers

Sectionmanagers

Assistantmanagers

Supervisors

Front line managersTeam leaders

Direct operational staff

Tall business Flat business

Direct operational staff

Topmanagers

Figure 3.9: Scalar chain in tall and flat businesses

4.2.1 Are tall or flat businesses better?

Tall business

For Against

Narrow control spans Inhibits delegation

Small groups enable team members to participatein decisions

Rigid supervision can be imposed, blockinginitiative

A large number of steps on the promotional ladder– assists management training and career planning

The same work passes through too many hands

Increases administration and overhead costs

Slow decision making and responses, as thestrategic apex is further away



Flat business

For Against

More opportunity for delegation Requires that jobs can be delegated. If managersare overworked they are more likely to beinvolved in crisis management

Managers may only get a superficial idea of whatgoes on

Relatively cheap Sacrifices control

In theory, speeds up communication betweenstrategic apex and operating core

Middle managers are often necessary to convertthe grand vision of the strategic apex intooperational terms

5 Mechanistic and organic structures

Section overview

Bureaucracies or mechanistic organisations suit relatively static, slow-changing operatingenvironments.

Organic organisations are suited to relatively dynamic operating environments.

5.1 What are mechanistic and organic structures?

The terms 'mechanistic' and 'organic' were coined by Burns and Stalker to describe forms of business whichare:

Stable, efficient and suitable for slow-changing operating environments (mechanistic businesses, or'bureaucracies'), and

Flexible, adaptive and suitable for fast-changing or dynamic operating environments (organicbusinesses).

Mechanistic and organic structures can be distinguished from each other on a number of factors.

Factor Mechanistic business Organic business

The task Tasks are specialised and brokendown into sub-tasks.

Specialist knowledge and expertisecontribute to the common task of theorganisation.

How the taskfits in

People are concerned withcompleting the task efficiently, ratherthan how the task can improveorganisational effectiveness.

Each task is seen and understood to be setby the total situation of the business: focusis on the task's contribution toorganisational effectiveness.

Co-ordination Managers are responsible for co-ordinating tasks.

People adjust and redefine their tasksthrough interaction and mutualadjustment with others.

Job description There are precise job descriptionsand delineations of responsibility.

Job descriptions are less precise: people dowhat is necessary to complete the task.

Legal contract vcommoninterest

Hierarchical structure of control. Anindividual's performance and conductderive from a contractual relationshipwith an impersonal business.

Network structure of control. Anindividual's performance and conduct derivefrom a supposed community of interestbetween the individual and the business, andthe individual's colleagues.



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Factor Mechanistic business Organic business

Decisions Decisions are taken by seniormanagers who are assumed to knoweverything.

Relevant technical and commercialknowledge and decision-making authoritycan be located anywhere.

Mission Insistence on loyalty to the concernand obedience to superiors.

Commitment to the business's mission ismore highly valued than loyalty as such.

5.2 Mechanistic structures: bureaucracy

Definition

Bureaucracy: 'A continuous organisation of official functions bound by rules' (Weber).

Continuous organisation: The business does not disappear if people leave: new people will fill theirshoes

Official functions: The business is divided into areas (e.g. operations, marketing) with specifiedduties. Authority to carry them out is given to the managers in charge

Rules: A rule defines and specifies a course of action that must be taken under given circumstances

5.2.1 Characteristics of bureaucracy

Characteristic Description

Hierarchy of roles Each lower office is under the control and supervision of a higher one.

Specialisation and training There is a high degree of specialisation of labour.

Professional nature ofemployment

Managers are employees; promotion is according to seniority andachievement; pay scales are prescribed according to the position or officeheld in the organisation structure.

Impersonal nature Employees work within impersonal rules and regulations and actaccording to formal, impersonal procedures.

Rationality The hierarchy of authority and office structure is clearly defined. Duties areestablished and measures of performance set.

Uniformity in theperformance of tasks

Procedures ensure that, regardless of who carries out tasks, they shouldbe executed in the same way.

Technical competence All managers are technically competent. Their competence within thearea of their expertise is rarely questioned.

Stability The business rarely changes in response to environmental pressures.

5.2.2 Advantages of bureaucracies

Ideal for standardised, routine tasks. For example, processing driving licence applications is fairlyroutine, requiring systematic work

They can be very efficient in stable environments

Rigid adherence to procedures may be necessary for fairness, adherence to the law, safety andsecurity (e.g. procedures for data protection)

Some people are suited to the structured, predictable environment. Bureaucracies tend to be long-lived because they select and retain bureaucratically-minded people



5.2.3 Disadvantages of bureaucracies

Slow decision-making, because of the rigidity and length of authority networks.

Uniformity creates conformity, inhibiting the personal development of staff.

They suppress innovation: they can inhibit creativity, initiative and openness to new ideas and ways ofdoing things.

They find it hard to learn from their mistakes, because of the lack of feedback (especially upwards).

Slow to change: environmental change therefore causes severe trauma.

Communication is restricted to established channels, ignoring opportunities for networking, upwardfeedback and suggestions that may contribute to customer service and innovation.

5.3 Organic organisations

Organic structures have their own control mechanisms.

Control mechanism Description

Status Although organic businesses are not hierarchical in the way thatbureaucracies are, there are differences of status, determined bypeople's greater expertise, experience and so forth.

Commitment The degree of commitment employees have to the goals of thebusiness and the team is more extensive in organic than in mechanisticsystems.

Shared values andcultureError! Bookmarknot defined.

Hierarchical control is replaced by the development of shared beliefsand values. In other words, corporate culture becomes a powerfulguide to behaviour.

6 Introduction to business forms

Section overview

A business may take the form of a sole tradership (one owner), a partnership (more than oneowner) or a limited company (usually many more than one owner).

All businesses have unlimited liability for their own debts.

So far we have considered various factors affecting organisational structure. A key influence in practice isthe legal form the business takes.

Businesses may take one of three basic legal forms.

Sole tradership Partnership Companies

Any business may form an alliance with other businesses, or it may form a group structure. We shalllook at each of these points in turn.



3

7 Sole tradership

Section overview

In a sole tradership there is unlimited liability of the owner for the business's debts.

There is no legal distinction between the owner and the business, but separate accounts should bemaintained for tax purposes.

Sole traders may borrow money and employ people, but they have unlimited risk.

A sole tradership ceases to exist on the death of the owner, though assets (including goodwill) andliabilities can be sold by their estate.

Definition

Sole tradership: A single proprietor owns the business, taking all the risks and enjoying all the rewards ofthe business.

7.1 Features of a sole tradership

There is no legal distinction between the proprietor and the business

The proprietor is wholly liable for the debts of the business, borrowing money in his/her own name

The business is usually financed by a mixture of owner's capital (including retained earnings), loans andshort-term credit

While a sole trader can offer a lender a fixed charge over assets such as buildings and machinery assecurity, they cannot use floating charges over all the business assets as a company can

Sole traders take drawings from the business

Many sole traders employ people to do some or all of the actual work in the business, but it is usualfor the proprietor to take a very active role, doing many different tasks and managing the business in avery 'hands-on' way

A sole tradership business can be sold as a going concern by its owner

If a sole trader dies, the business's assets and liabilities form part of their estate but the sole tradershipas such ceases to exist – there is no perpetual succession

7.2 Advantages and disadvantages of sole tradership

A sole trader has the flexibility of 'being their own boss', taking all the decisions and getting things done intheir own preferred way. There is no publicity requirement of sole traders beyond the requirement toprepare accounts for taxation purposes, and this offers both privacy and cost savings.

However, the fact that they have sole charge can be a disadvantage as there are limits to the skills and thetime of one individual. While no-one shares the profits there is also no-one to share the load. Frequentlysole traders overwork and find it difficult to take a holiday. It is also hard to expand unless there are newideas and new capital.

Sole traders who have employees have the same responsibilities in respect of them as any other business,and of course the sole trader also has the significant responsibility of unlimited liability for the business'sdebts.



8 Partnerships

Section overview

In a general partnership there is unlimited liability of the partners for the business's debts.

The partnership does not have a separate legal existence.

Partnerships may borrow money and employ people, but they have unlimited risk and they cease toexist on the death of one partner.

Definition

Partnership: The relation which subsists between persons carrying on a business in common with a viewof profit.

Two or more people who own a business, agreeing to take all the risks and enjoy all the rewards of thebusiness, are called a partnership. They agree between themselves how the risks, rewards and property areshared. They may agree to contribute different amounts of capital, to take different shares of profits andlosses, to own partnership property in different shares, or to guarantee salaries to certain partners. It is upto them.

Partnership is a common form of business association. It is flexible, because it can either be a formal orinformal arrangement, so it can be used for large organisations or for a small husband and wife operation.

Partnership is normal practice in the professions as most professions prohibit their members fromcarrying on practice through limited companies. Other businesses are not so restricted and generally preferto trade through a limited company for the advantages this can bring.

8.1 Features of a partnership

In many ways trading as a partnership is not so different from trading as a sole trader.

The partners are jointly and severally liable for the debts of the partnership.

The financing issues that face sole traders also face partnerships.

Partners take drawings from the business.

While all the partners may be as actively involved in the business as the typical sole trader, there ismore scope for partners to specialise, and/or to 'take a back seat' in the business.

A share in a partnership is not a form of property as such and selling it can be difficult.

If a partner dies, a general or limited partnership (see below) is dissolved – there is no 'perpetualsuccession'.

In Bangladesh partnership is regulated by the Partnership Act 1890, and the partnership has no separatelegal identity. All partners are jointly and severally liable for the partnership’s debts. If one partner becomespersonally insolvent, for instance, the others must take on his or her own ‘share’ of the partnership’s debtsthemselves.



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8.2 Advantages and disadvantages of partnerships

Partners have the flexibility of 'being their own boss', taking all the decisions and getting things done in theirown preferred way, but without the loneliness and pressure of the sole trader. There is no publicityrequirement of partnerships beyond the requirement to prepare accounts for taxation purposes.

Multiple partners will have different skills and more time to devote to management and expansion than oneindividual. There is someone to share the load and less chance of overwork. New ideas and new capital aremore readily available.

Partners with employees have the same responsibilities in respect of them as any other business. In apartnership each partner has unlimited liability for the business's debts, but they have to share profits.

The relationship between the partners is of crucial importance to whether the partnership realises itspotential. It is based on trust; if the relationship fails and partners fall out, the agreement is at an end andthe partnership essentially ceases to exist. Moreover, partners can be left with liability for debts run up byanother partner, sometimes without their knowledge.

9 Companies

Section overview

In a limited company the owners (shareholders) have limited liability for the unpaid debts of thecompany.

The company is legally distinct from its owners.

The death of a shareholder has no effect on the company; their shares are personal property whichcan be transferred to another person.

Private companies, unlike public companies, may not offer their securities for sale to the public.They are generally smaller as well.

Definition

Company: A legal entity registered as such under the Companies Acts.

A business which trades as a company may be no different from a partnership or sole trader in any otherway than in one important fact: while sole traders and partners as owners take all the risks in the business,having unlimited liability for the debts of the business, the owners of a limited company (its shareholders)have limited liability for its debts beyond any amount they may still owe for the shares they hold. Thecompany has unlimited liability for its own debts.



9.1 Features of a limited company

The company is legally distinct from its owners

As well as a fixed charge, the company can offer a floating charge over its changing assets as securityfor lending

Shareholders take dividends, not drawings, from the business

Directors run the company; shareholders do not take part in the management of the business unlessthey are also directors and/or employees, but they have no automatic right to be directors

Shares are a form of property that can easily be sold by their owners, especially if the company has apublic listing of shares on a public stock exchange; transferring ownership of shares to another personhas no direct effect on the company

If a shareholder dies, their shares are transferred to another person without any effect on thecompany at all – there is what is known as 'perpetual succession'

As the company's shareholders enjoy the benefit of limited liability for the company's debts, there arestringent rules in place which protect the capital contributed by shareholders as a 'buffer' for creditors. Ifthe company becomes insolvent, shareholders cannot receive any of their capital back until creditors arepaid in full.

The company's constitution is set out in its Articles and Memorandum of Association, which are registeredand open to public scrutiny. The Memorandum sets out its relations with the external world and includesclauses on the company's name, on what it aims to do (its objects) and on the maximum share capital it canraise. This total can be increased or decreased. The Articles set out how shareholders relate to thecompany and each other, and how the company is to be run.

9.2 Types of company

Definitions

Public company: A company whose memorandum states that it is public and that it has complied with theregistration procedures for such a company. It may offer its shares for sale to the public at large.

Private company: A company which has not been registered as a public company under the CompaniesAct. It may not offer its shares to the public at large.

In Bangladesh a public company is a company registered as such under the Companies Acts with the Registrarof Companies. Any company not registered as public is a private company.

Public companies do not necessarily have their shares listed on a public stock exchange.

A company must have at least two and can not have more than fifty shareholders (if it is a private company) or(if it is a public company) seven shareholders. Unless there are clauses in the constitution to the contrary,there are no limits to the number of shareholders a company can have.

Public companies must have at least three directors.

9.3 Advantages of companies

The separate legal personality of the company.

The limited liability of its members (shareholders).



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Perpetual succession. A change in the ownership of a company does not affect its continuedexistence.

Transferability of interests. Shareholders in a company can sell their shares either to othershareholders or to outsiders, subject to the provisions of the company's articles and the CompaniesActs. It is not possible for partners to assign or transfer their interest in a partnership (unless theother partners consent). They would have to retire from the partnership, hence causing its dissolution.

Security for loans includes floating as well as fixed charges.

9.4 Disadvantages of companies

Separation of ownership and control. A sole trader and the partners in a firm can all participatein the day-to-day management of the entity: it is effectively 'their' business. The shareholders of acompany, however, do not have such a right, and their input is limited to what can be achieved by thepassing of resolutions at meetings.

Ownership of assets. Due to the concept of separate legal personality, a company owns its ownassets and a shareholder does not have any right to just take a share in them. A sole trader owns hisor her own business's assets, and the partners in a firm own the assets jointly, so that when a partnerleaves he or she is entitled to the value of their share of the assets.

Accounting records and returns. Sole traders and partnerships do not have to keep theiraccounting records in any format prescribed by the Companies Acts, and they do not have to undergoan audit. Companies, both private and public, are subject to stringent rules governing the keeping ofaccounting records, the filing of accounts and the annual return with the Registrar of Companies alongwith the requirement to have an audit for all companies. This degree of bureaucracy can deterbusinesses from incorporation.

Publicity. Due to the need to file accounts, discussed above, it is possible for third parties, such ascompetitors and creditors, to obtain information about the company's financial position and suchsensitive issues as the remuneration of directors. Partnerships and sole traders do not need to makeany of this information publicly available.

Regulations and expense. The law sets out very stringent rules that all companies must follow, onareas as diverse as the maintenance of capital, the contents of the Memorandum and Articles ofAssociation and the amount that can be lent to directors. This adds to the bureaucracy encounteredby companies, and can be expensive.

Interactive question 3: Incorporation [Difficulty level: Intermediate]

In what circumstances can you see that the disadvantages of incorporation may outweigh the advantages?




10 Which form should a business take?

Section overview

Many operational, business, legal, practical and financial factors must be considered when decidingwhich form should be adopted for a particular business.

The following factors should be considered when deciding whether a partnership should incorporate.

Factor Company Partnership

Entity Is a legal entity separate to itsmembers

Has no existence outside of its members

Liability Members' liability can be limited Partners' liability is usually unlimited

Size May have any number of members(at least two for a public company)

Some professional partnerships are limitedto twenty members

Succession Perpetual succession – change inownership does not affect existence

Traditional partnerships are dissolvedwhen any of the partners leaves

Owners' interests Members own transferable shares Partners cannot transfer their interests ina partnership

Assets Company owns the assets Partners own assets jointly

Management Company must have at least one ortwo director(s)

All partners can participate inmanagement

Constitution Company must have a writtenconstitution

A partnership may have a writtenpartnership agreement, or the agreementmay just be verbal

Accounts A company must usually deliveraccounts to the Registrar

Partners do not have to send theiraccounts to a Registrar

Security A company may offer a floatingcharge over its assets

A partnership may not give a floatingcharge on assets

Withdrawal ofcapital

Strict rules concerning repayment ofsubscribed capital

More straightforward for a partner towithdraw capital

11 Converting from one form to another

Section overview

Having taken a particular form, any business may convert to one of the other forms.

It is open to a business of any of the three basic forms to transform itself into one of the other forms.

11.1 Conversion of a sole trader

Usually the decision to convert a sole tradership to a partnership is taken because the proprietorneeds more capital or more management resource or other skill. The decision to convert from a soletradership to a company is usually taken for the same reason, with the added impetus that the ownerwill have limited liability for the business's debts. If a sole trader converts to being a private limited



3

company, he or she may become the sole shareholder or may decide to include other people asshareholders as well.

11.2 Conversion of a partnership

The decision to convert from a partnership to a company is usually taken to acquire more capital and awider skills base, and also of course to benefit from limited liability for the business's debts. If a partnershipconverts to a limited company, how many shares are taken by each partner is determined by agreement anddoes not necessarily reflect what was in the partnership agreement.

11.3 Conversion of a company

Converting 'backwards' from being a company is a complicated manoeuvre which involves selling thecompany's net assets to new owners (the sole trader or the partnership) and then dissolving the companyso that it no longer exists.

12 Alliances

Section overview

A business of whatever form may enter into various types of alliance with other businesses, in theform of joint ventures, licences, strategic alliances, agency or a group structure.

There are various ways in which businesses (of whatever form: sole trader, partnership or company) canwork together.

12.1 Joint venture

A separate company can be formed in which the businesses take a financial stake as shareholders, andmanagement is provided as agreed.

Benefits

Less capital is required than if the businesses were on their own, so there is less risk Reduces competition Enables firms to gain access to restricted markets Access to the skills of each party

Disadvantages

Disputes over how the business should be run, costs incurred, management charges, etc

If the joint venture breaks down, the special skills of a business may be used against it by its formerjoint venture partner

Possible lack of shareholder support

12.2 Licences

A licensing agreement is a permission to another company to manufacture or sell a product, or to use abrand name.

Most licences are restricted geographically so in the case of a sales licence, the licensor (who grants thelicence) can retain control over where the product is sold, and can prevent competition with his ownproducts or those of other licensees. The most common form of licensing agreement is the franchise.



12.3 Strategic alliances

A strategic alliance is an informal or weak contractual agreement between parties or a minority cross-shareholding arrangement (a cross-shareholding is where each party takes a small number of shares in theother parties). Normally no separate company is formed. National airlines have created such alliances tocross-book passengers. Similarly, some European telecom companies have created alliances to aidinternational expansion.

The benefits and disadvantages are similar to those of joint ventures.

In addition:

The looser arrangement is easier to break

They may contravene competition laws, e.g. be viewed as an illegal cartel (we shall see more aboutcartels in Chapter 15)

There may be less commitment than to a joint venture, so the benefits are not as great

12.4 Agents

Agents can be used as the distribution channel where local knowledge and contacts are important, e.g.exporting. The agreements may be restricted to marketing and product support.

Other situations where agents are used include:

Sales of cosmetics (Avon), clothes etc (Ann Summers) Holidays Financial services, e.g. insurance brokers

The main problem for a business that uses agents is that it is cut off from direct contact with the customer.

12.5 Groups

As companies are entitled to own shares, groups of companies may form. In its simplest form, a group ofcompanies might look like Figure 3.10.

owns all the shares of

Parent company

Subsidiary company

Figure 3.10 Simple group structure

In practice, groups are usually much larger and much more complex. There is no necessity for all thesubsidiary company's shares to be held by the parent company and in many groups there are significantminority shareholders of subsidiary company shares.

Advantages

Funds can be moved around a group of companies as required as can people and tax losses

Having distinct parts (in separate companies) or one whole (the group) allows different structures andcultures to be developed as appropriate to each business in the group



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Risk of failure is spread; provided the parent company has paid fully for the shares it holds in thesubsidiary, the insolvency of the subsidiary will not necessarily involve any liability for the parentcompany

Minority shareholdings can be retained in subsidiaries by the entrepreneurs who set up each business.This can help to keep the entrepreneur in the business

Skills, expertise, equipment and administration matters can be shared and/or centralised

Disadvantages

Financial reporting for groups can become extremely complex

Groups of companies require a great deal of administration in terms of annual returns etc

While legally the risk is spread, the failure of a group company can have very detrimental effects on allthe other companies in the group




Summary (3/1)

Degree ofcentralisation

Managementhierarchy

(Chapter 2)

Mintzberg’sblocks

Organisationalcharts etc

Classicalprinciples

Businessfunctions

Geography

ModernprinciplesAuthority

Centralised:Upper levels

retain authority

Decentralised:Authority isdelegated

Tallstructure

Flatstructure

– Span ofcontrol

– Size ofbusiness

Scalarchain

Types

Innovative DivisionalisedProfessionalbureaucracy

Simple/Entrepreneurial

Organic Matrix

Nature ofenvironment

Simple Complex

Static Dynamic

Machinebureaucracy/

functional

Mechanistic

versus



3

Summary (3/2)

Self-test


1 According to Mintzberg, five building blocks of an organisation exist within an overarching sixthelement. He called this sixth element:

A The environmentB The technostructureC The ideologyD The strategic apex

2 Which of the following are classical principles of organisational structure according to Fayol?

A The scalar chainB Matrix structureC Flexibility of personnelD Unity of directionE Division of work

3 Tranche Ltd is a company that was set up by Rosa Tranche, a 25 year old entrepreneur, in 2006. Itoperates in a sector in which innovation is key and which changes very quickly. There are a great manyfactors that drive both supply and demand. Tranche Ltd's three staff are together engaged in varyingand complex tasks which require a high degree of intelligence, flexibility and self-direction. Tranche Ltdwould be expected to have

A An adhocracy structureB A divisionalised structureC A machine bureaucracy structureD A simple structure

Organisational form

Owner’s liability for

debts

Unlimited Limited

Sole trader Partnerships Companies

Alliances Public- Shares

offered to

public

Private –May not

offershares to

public



4 The board of Cranford Ltd has decided that its existing structure is unsuited to the demands of itscurrent environment and strategy, and wish to change to one that is more decentralised. Which of thefollowing aspects of Cranford Ltd and its management would hamper decentralisation?

A It has many employees working in various locationsB It operates in several different sectorsC It has senior and junior managers who are technically ableD It has senior managers who have an authoritative leadership style

5 Which of the following factors directly limits how many subordinates should report to a singlemanager?

A The size of the businessB Where the manager is situated in the management hierarchyC How far the manager is engaged in dealings with customers and suppliersD The length of the scalar chain

6 A bureaucracy is suited to a situation where the business's environment is

A Dynamic and complexB Static and complexC Static and simpleD Dynamic and simple

7 Which of the following statements about sole tradership is correct?

A The business has perpetual successionB The owner has limited liability for unpaid business debtsC The owner must do all the workD The business may borrow money against a fixed charge on the sole trader's assets

8 Pedro, Lynn and Shilpa wish to go into business together. They all wish to take an active role inmanagement. None of them wishes to publicise whether or not they make a financial success of thebusiness. Which business form should it take?

A A partnershipB A public limited companyC A joint venture companyD A private limited company

9 Which, if any, of the following businesses has limited liability for its debts?

A A partnershipB A limited companyC A joint venture companyD None of them

10 A franchise is a form of

A Joint ventureB Licensing agreementC Strategic allianceD Agency




3


1 C

2 A, D, E Flexibility is a more modern approach, while the matrix structure cuts across the classicalprinciple of unity of command

3 A Both the divisionalised and the bureaucratic structure would be unsuitable as the business isso small and young. The simple structure is unsuitable as the tasks involved are complex

4 D

5 C

6 C

7 D

8 A Their desire to avoid publicity prevents them from operating as a company as they must filedetails with the Registrar. A joint venture is applicable for businesses not for individuals.

9 D

10 B





You are likely to be part of the operating core of your firm, along with other unqualified and part-qualifiedaccountants. The structure probably narrows at the level of senior managers, who report upwards to asmall number of partners. At the strategic apex will be not only key fee-earning partners but also othersenior partners who are responsible for strategic aspects of the firm. The technostructure will comprise thesystems and processes that allow the business to function, such as the financial system and ICT. Supportstaff will include administrative staff plus finance and HR staff, plus the training department. The overarchingideology is perhaps one of professionalism, expertise, ethical values and commercial awareness.


Often managers are expected to supervise a large number of staff, say 10 or 15, while still doing a great dealof their 'own' work, such as planning and scheduling, dealing with clients and suppliers, performing technicalwork and having meetings with colleagues and senior managers. At some point some aspect of their workwill suffer, and very often it is all aspects. Staff suffer from too wide a span of control by having too little ofthe right kind of supervision, and too much of the wrong kind, by feeling neglected, and by having to dealwith a stressed manager.


Where a sole trader or some partners have historically been used to taking all the risks and having all therewards of a business, having to share control with other shareholders in a formal way can be problematic.Often they don't like the publicity and the administration that incorporation involves, and in particular don'tlike the fact that customers, competitors and suppliers have access to financial information on the business.The expense and disruption of an audit is often felt to be disproportionate to the benefit gained by thebusiness itself.


Contents

Introduction

Examination context

Topic list

1 What is strategy?

2 Introduction to strategic management

3 The strategic planning process

4 Analysing the environment

5 Analysing the business

6 Corporate appraisal

7 Setting strategic objectives

8 Gap analysis

9 Choosing a corporate strategy

10 Implementing the strategy




chapter 4

Introduction to businessstrategy



Introduction


State the general objectives of strategic management

Specify the strategic management process

Specify the interrelationship between a business's vision, mission and strategic objectives

Show, in a given scenario, the relationship between a business's overall strategy and itsfunctional strategies

Identify the nature and purpose of strategic plans, business plans and operational plans

Specify how a strategic plan is converted into fully-integrated business and operational plans

Specific syllabus references are: 1b, e, f, g.


Every well-managed business should have an overall direction or strategy, around which all the moredetailed plans of the business are constructed. While the strategic management process is not somethingthat you are likely to encounter in practice early in your training, it is something of which you should beaware as it underlies the activities of clients. An understanding of the process of strategic management andhow it fits into the business's day-to-day operations also allows you to appreciate some of the complexitiesof the situations in which businesses find themselves.

Stop and think

What does the word 'strategy' mean to you? Can you identify some strategies that you personally have,such as a strategy to pass your exams? Think about how you have formulated any such strategy, and whatyou do to keep it on course.

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill begin to see the ways in which a business's strategy drives all its operations.

Syllabus links

The topics covered in this introduction to strategic management are developed further in Business Strategyat Professional stage, and in the Advanced stage.

INTRODUCTION TO BUSINESS STRATEGY


4

Examination context


Questions on the strategic management process and on the differences between strategies and plans atdifferent levels in the business could easily appear in the exam.

Exam requirements

Questions are likely to be set in a scenario context. Knowledge-type questions are also likely, based onparticular principles, theories or models.



1 What is strategy?

Section overview

A business's strategy is concerned with its long-term direction and objectives, its environment, theresources it has and the return it makes for its owners.

Strategies exist at corporate, business and functional/operational levels in the business.

Corporate strategy covers the business as a whole.

Business strategies exist for each strategic business unit (SBU), including their competitive strategies.

Functional strategies exist for production/operations, marketing, finance and HR within each SBU.

1.1 What is meant by 'strategy'?

There are probably as many different definitions of 'strategy'Error! Bookmark not defined. (or'corporate strategy') as there are textbooks on the subject. Three possible definitions are as follows:

Definition

'Strategy is the direction and scope of an organisation over the long term, which achieves advantage forthe organisation through its configuration of resources within a changing environment, to meet the needs ofmarkets and to fulfil stakeholder expectations.' Johnson & Scholes (2002).

'Strategy is concerned with an organisation's basic direction for the future, its purpose, its ambitions, itsresources and how it interacts with the world in which it operates.' LynchError! Bookmark notdefined. (2000).

'Strategy is a course of action, including specification of the resources required, to achieve a specificobjective.' (CIMA Official Terminology)

From these definitions we can say that strategy is concerned with:

The long-term direction (objectives) of the business The environment in which it operates The resources at its disposal The return it makes to stakeholders

1.2 Levels of strategyError! Bookmark not defined.

Strategy can exist at several levels in a business as shown in Figure 4.1.

Corporate

Business

Functional (operational)

Figure 4.1: Levels of strategy



4

1.3 Corporate strategyError! Bookmark not defined.

Corporate strategy is generally determined at main board level for the business as a whole. The types ofmatter dealt with include:

Determining the overall corporate missionError! Bookmark not defined. and objectivesError!Bookmark not defined.

Overall product/market decisions, for example to expand, close down, enter a new market, develop anew product etc via methods such as organic growth, merger and acquisition or joint venture etc

Other major investment decisions besides those for products/markets, such as information systems, ITdevelopment

Overall financing decisions – obtaining sufficient funds at lowest cost to meet the needs of the business

Relations with external stakeholders, such as shareholders, lenders, government, etc

1.4 Business strategiesError! Bookmark not defined.

These normally form in strategic business units (SBUs), and relate to how a particular market isapproached, or a particular SBUError! Bookmark not defined. acts.

Definition

Strategic business unit (SBU):Error! Bookmark not defined. A section, within a larger business,which is responsible for planning, developing, producing and marketing its own products or services.

Competitive strategy is normally determined at this level covering such matters as:

How advantage over competitors can be achieved Marketing issues, such as the marketing mixError! Bookmark not defined.

1.5 Functional (operational) strategiesError! Bookmark not defined.

These refer to the main functions within each SBU, such as production/operations, finance, human resourcesand marketing, and how they deliver effectively the strategies determined at the corporate and business levels.

2 Introduction to strategic management

Section overview

Strategic management involves making decisions on the business's scope and long-term direction, andresource allocation.

Strategic planning involves a planning and control process at the strategic level.

A formal approach to strategic planning involves strategic analysis, strategic choice, implementation ofthe strategy chosen, and review and control.

The 'emergent' approach to strategy aims to evolve strategy continuously and incrementally. Ittherefore involves strategic analysis and review/control as with the formal approach, but strategicchoice and implementation are concurrent.



2.1 What is strategic management?

The formal approach to strategic management, on which we shall largely be concentrating in this chapterstates that all organisations need to plan if they are not to drift. Strategic management involves:

Taking decisions about the scope of a business's activities The long-term direction of the business, and The allocation of resources

It involves an entire cycle of planning and control at a strategic level, that is strategic planning.

2.1.1 Formal strategic planningError! Bookmark not defined.

A formal or rational approach to strategic planning involves four key stages:

Strategic analysis Strategic choice Implementation of chosen strategies Review and control

We shall look at each stage in detail later.

Definitions

PlanningError! Bookmark not defined.: The establishment of objectives and the formulation,evaluation and selection of the policies, strategies, tactics and action required to achieve them. Planningcomprises long-term/strategic planning, and short-term/operational planning.

Strategic planError! Bookmark not defined.: A statement of long-term goals along with a definition ofthe strategies and policies which will ensure achievement of these goals.

2.1.2 The emergent approach to the strategy process

The formal approach to strategic management in a process of strategic planning has frequently beencriticised because:

It assumes that human activities are rational and logical, which is very often not the case. Managershave psychological limitations so they cannot weigh up the consequences of options or be theobjective analysts that the formal, rational approach expects. Instead, they do the best they can withinthe limits of their circumstances, knowledge and experience in a process described as 'boundedrationality' by Herbert Simon.

It produces prescriptive solutions for the long-term which are rarely achieved because changes in theenvironment in the short term, such as competitors bringing out new products, necessitate immediatechanges to the strategy.

The emergent approach to the strategy process addresses these two problems by:

Adapting to human needs and Evolving continuously and incrementally

When strategy is allowed to evolve and emerge in this way, the final goal is often unclear and the elementsof the strategy develop over time by continually adapting to the environment.

The emergent approach to strategy can include the same degree of strategic analysis as the formal approachbut strategic choice and implementation go on at the same time in a continuous process. It thereforeinvolves three stages.

Strategic analysis Strategic choice and implementation Review and control

In this 'suck it and see' approach, objectives and strategies are a result of negotiation and discussion, takinginto account the human element in the system (particularly culture and organisational politics). A strategy is



4

likely to be tried and developed as it is implemented. If it fails, alternative strategies will be tried. It is likelyto be more short term than the traditional process, which tends to result in 'here's the strategy for thenext three years, now we implement it'.

Worked example: Honda motorbikes in the US

Honda now dominates the US (and UK) markets for motorcycles but its success in the US was somethingof an accident. Honda entered the US market with a full range of bikes, from small scooters to largepowerful bikes. The initial strategy was to take on US manufacturers of large bikes. The strategy failedbecause, despite Honda having more reliable and better performing bikes, the US brands were far betterknown.

Honda had made no real effort to sell its scooters as they did not meet the needs of its target segment –men buying large bikes. After the failure of its initial strategy Honda needed cash, so it turned to sellingscooters as an 'about town' bike. Small bikes were a success – particularly with those who had neverbought a bike before – and this gave Honda a platform from which it later achieved dominance over thewhole market.

On the face of it the initial strategy was developed along traditional lines but failure turned it into anemergent approach and a successful one.

2.2 Benefits and drawbacks of strategic management and planning

Benefits:

Ensuring a coherent response to changes in market and environmental forces

Making best use of scarce or limited resources

Improving the fit between a business and its environment

Providing a framework for all parts of the business to aim for clear, overall goals over the long term,avoiding the pursuit of short-term goals for short-term gain (short-termism)

Specifying milestones for achievement of goals and monitoring progress by stages

Ensuring harmony of objectives, both between different SBUs and over time (often referred to as'goal congruence')

Improving stakeholder perceptions of the business

Developing future management potential and aiding continuity when senior managers retire

Drawbacks:

Expense in terms of time and money, particularly for small businesses

The danger of creating a bureaucratic structure that is more concerned with completing the formsthan running the business: thus the process may be too slow and the business undynamic

The danger of a 'straitjacket' approach, discouraging opportunism and radical (or innovative) strategies

Less relevance in a crisis

Lower levels of management may pursue their own goals (lack of goal congruence)

The business environment may be too uncertain to predict with any degree of accuracy

2.3 Making strategic decisions

If we assume that strategic management follows the formal model with a logical sequence which involvesanalysing the current situation, generating choices relating to competitors, products and markets (strategic



choice) and implementing the chosen strategies (strategy implementation), then to develop a strategy abusiness has to answer the following questions.

What is it good at? How might the market change? How can customer satisfaction be delivered? What might prevent the plan from coming into being? What should be done to minimise risk? What actions should be followed?

In answering these questions the business needs to make a series of strategic decisions.

2.3.1 Characteristics of strategic decisions

Johnson and Scholes (Exploring Corporate Strategy) have summarised the characteristics of strategic decisionsfor a business as follows.

They concern the scope of the business's activities They match a business's activities to its capabilities and the environment in which it operates They revolve around the allocation of resources They set off a chain of 'lesser' operational decisions They are based on the values and expectations of senior management They dictate the long-term direction that the business takes They lead to change in the business

3 The strategic planning process

Section overview

Strategic planning incorporates internal and external analysis then corporate appraisal, which togetherinform the business's choice of mission, goals and strategic objectives. Any resulting gap between wherethe business is currently headed and where the strategy process has indicated it should be headed isaddressed by making appropriate strategic choices, which are then implemented, reviewed and controlled.

Strategic choice involves generating strategic options and evaluating these, then selecting the mostappropriate.

The business needs to choose competitive, product/market and institutional strategies.

Implementing strategies involves planning resources and operations, structuring the businesseffectively and using appropriate control systems.

3.1 The stages of strategic planning

Using the rational model we can divide strategic planning into a number of different stages: strategicanalysis, strategic choice, strategic implementation and ongoing review and control (see Figure 4.2).

The order in which the stages of strategic planning are carried out depends on whether the business takes apositioning-based or a resource-based view:

The positioning-based view takes it that the forces at work in an industry, sector or market are themost important factors for strategy, so strategy development is about identifying opportunities in theenvironment and developing strategic capability to take advantage of them.

The resource-based view takes it that the business's strategic capabilities are most important,because they explain differences between businesses and the superior performance of some overothers. Strategies therefore are developed on the unique capabilities of the business, and opportunitiesshould be sought to allow the business to exploit these capabilities to achieve competitive advantage.

In what follows we shall be taking the positioning-based view.



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Figure 4.2: Positioning-based strategic planning process

3.2 Strategic analysis

Stage Comment Key tools, models, techniques

Step 1 External analysis(analysing theenvironment)

Identify opportunities and threats inthe business's external environment

PESTEL analysis Porter's five forces analysis Competitor analysis

Step 2 Internal analysis(analysing thebusiness)

Identify strengths and weaknesses.Analyse the business's currentresources, products, customers,systems, structure, results, efficiency,effectiveness

Resource audit Distinctive competences Value chain Supply chain Product life cycle BCG matrix

Step 3 Corporateappraisal

Combines Steps 1 and 2 SWOT analysis

Step 4 Mission, goalsand objectives

Mission denotes values, the business'srationale for existing; goals interpretthe mission for different stakeholders;objectives are quantified embodimentsof the mission

Stakeholder analysis Mission statement

Step 5 Gap analysis Compares outcomes of Step 3 withStep 4

Gap analysis



3.3 Strategic choice

Stage Comment Key tools, models, techniques

Strategic optionsgeneration

Come up with new ideas:

How to compete (securecompetitive advantage) in themarket

Where to compete

Method of growth

Resource-based strategies

Positioning-based strategies

– Porter's generic strategies

– Ansoff's product/marketstrategies

Strategic optionsevaluation

Normally, each strategy has to beevaluated on the basis of

Acceptability to stakeholders

Suitability to the business operationalcircumstances

Feasibility in terms of available finance,resources, time and competences

Stakeholder analysis Risk analysis (see Chapter 5)

Strategy selection Choosing between the alternativestrategies

At the end of the process, the business should have three types of strategy:

Competitive strategies: the generic strategies for competitive advantage a business will pursue.They determine how it competes

Product-market strategies determine where it competes and the direction of growth (whichmarkets a business should enter or leave)

Institutional strategies determine the method of growth (i.e. relationships with otherbusinesses)

3.4 Strategy implementationStrategy implementation is the conversion of the strategies chosen into detailed plans or objectives foroperating units.

The planning of implementation has several aspects.

Resource planning Operations planning Organisation structure and control systems



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4 Analysing the environment

Section overview

The business's external environment incorporates the physical, the general and the taskenvironments.

The task environment may be simple or complex.

Each environment may be static or dynamic.

PESTEL analysis is used to analyse the general environment, namely its political, economic,social/demographic, technological, ecological and legal factors.

Political factors: capacity expansion, demand, divestment/rationalisation, emerging industries, entrybarriers and competition.

Economic factors: wealth (changes in GDP), inflation, interest rates, tax, government spending, thebusiness cycle and productivity.

Social factors (demography): growth, age and geography of population, household and socialstructure, employment and wealth.

Legal factors: changes in civil and criminal laws, employment and health/safety regulations, dataprotection, consumer protection, environmental regulation.

Porter's five forces analysis of the business's competitive environment: potential entrants, customers,suppliers, substitute goods/services, and competitors. The relative bargaining power of customers andsuppliers together with the degree of threat from the others determines how much rivalry there isbetween businesses and therefore how profitable the industry is likely to be.

Competitor analysis involves looking at the business's different types of competitor: brand, industry,generic and form. For each type, their strategy, assumptions about the industry, situation andcapability should be analysed to determine how they will respond to the business's competitivestrategy: laid back, tiger, selective or stochastic.

4.1 What is in the business's external environment?

Businesses exist within an environment which strongly influences what they do and whether they surviveand develop. Strategic planners must take account of potential environmental impacts in order to produceplans that are realistic and achievable.

Definition

Environment of a business: Everything outside its boundaries. It may be segmented according to Figure4.3 into the physical, the general and the task environment.



BUSINESS

TASK ENVIRONMENT

GENERAL ENVIRONMENT

PHYSICAL ENVIRONMENT

ECONOMYSOCIETY

(AND CULTURE)

POLITICS TECHNOLOGY

COMPETINGORGANISATIONSSTAKEHOLDERS

MATERIALS SUPPLIERS

LABOUR

CAPITAL

GOODS TOCUSTOMERS

WAGE TOLABOUR

PROFIT TOINVESTORS

POLLUTION

LAW

ECOLOGY

Figure 4.3: The business's external environment

Definitions

General environment: Covers all the political, legal, economic, social/cultural, ecological andtechnological (PESTEL) influences in the countries a business operates in.

Task environment: Relates to factors of particular relevance to the business, such as its competitors,customers and suppliers of resources.

The task environment may be simple, for instance where there are few competitors and predictableoutcomes and suppliers, or highly complex.

With regard to environmental issues there is a further variable to be dealt with: the time horizon ofchanges in the external environment. Some have long-term impact, which can be dealt with by carefulplanning, but some have short-term or immediate impact, which require crisis management.

4.2 Environmental uncertainty

No business can predict the future with absolute certainty. Strategic planning has to take place in thecontext of an uncertain future environment – competitors may enter or leave markets, new technologiesmay be discovered, governments may change, etc.

A business needs to think about how static or dynamic its future environment is likely to be. We havealready seen in Chapter 3 that these qualities can affect the business's structure.



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4.2.1 Static environments

Some businesses exist in relatively static environments. For example, raw material producers such asfarmers often experience only slow environmental change. Other businesses are insulated from change byinstitutional factors. Solicitors, for example, have traditionally felt themselves to be protected fromcompetition by regulation.

The 'Four Ss' can be used to describe a static environment:

Static – environmental change is slow Single – product/market Simple – technology Safe

In static situations there is often great value in studying the business's historic and current environment. Aschange is only slow the past can be a useful predictor of the future.

4.2.2 Dynamic environments

Most businesses face environments characterised by rapid change and complexity.

The 'four Ds' can be used to describe a dynamic environment:

Dynamic – the speed of environmental change appears to increase through time

Diverse – many businesses are now multi-product and operate in many markets; business isalso increasingly international

Difficult – because of the above factors analysis of the environment is not easy

Dangerous – because of the above factors ignoring the environment can have seriousconsequences for the business

In dynamic environments the past is often a poor guide to the future.

4.3 Analysing the general environment: PESTEL analysis

Using PESTEL analysis we can consider the environmental factors affecting a business under six generalheadings as seen in Figure 4.4:

Political factors Economic factors Social/demographic factors Technological factors Ecological factors Legal factors



POLITICAL FACTORSECONOMIC FACTORS

– Globalisation– Business cycles– Interest rates– Inflation– Unemployment– Exchange rates

ECOLOGICAL FACTORS

– Sustainability issues, eg energy, naturalresources

– Pollution– Green issues

TECHNOLOGICAL FACTORS

– Government investment and R&Dpolicy

– New discoveries: products andmethods of production

– Speed of technology transfer

– Levels of R&D spending bycompetitors

– Developments in other industries thatcould transfer across

PESTEL ANALYSIS

SOCIAL/DEMOGRAPHIC FACTORS

– Income distribution– Social mobility– Levels of education/health– Size of population– Location– Age distribution– Lifestyle changes– Consumerism– Attitudes to work and leisure– Green consumers

POLITICAL FACTORS

– Social welfare policy– Taxation policy– Regulations– Government stability

LEGAL FACTORS

– Competition legislation– Environmental protection laws– Employment law– Consumer protection– Health and safety regulations

Figure 4.4: Possible items in a PESTEL analysis

The aim is to identify the factors which are currently affecting the business and those which are likely tobecome significant in the future. To avoid this becoming merely a listing exercise, the business must identifythe few key influences from all those identified by the analysis, that is, the key opportunities available to itin the external environment, and the key threats which it faces.

Interactive question 1: Business environment [Difficulty level: Intermediate]

You have developed an idea to set up a business publishing brief study notes for student accountants whenyou qualify. Have a try at analysing the external environment in which such a business would exist.




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4.3.1 Political influences

Political influences on businesses are dominated by the influence of government, which can and very oftendoes have a profound effect on the structure of entire industries.

Capacityexpansion

Government policy can encourage businesses to increase or cut their capacity.

Direct taxes can reduce demand and hence supply

The tax system offers 'capital allowances' to encourage investment inequipment

A variety of incentives exist for locating capacity in a particular area

Incentives are used to encourage investment by foreign businesses

Demand The government is a major customer Government can also influence demand by legislation, taxes or subsidies

Divestment andrationalisation

The state may take decisions regarding the selling off or closure of businesses,especially in sensitive areas such as defence.

Emergingindustries

These can be promoted by the government or damaged by it.

Entry barriers Government policy can discourage firms from entering an industry, by restrictinginvestment or competition or by making it harder, by use of quotas and tariffs, foroverseas firms to compete in the domestic market.

Competition The government's purchasing decisions will have a strong influence on thestrength of one business relative to another in the market (e.g. armaments)

Regulations and controls in an industry will affect the growth and profits ofthe industry, e.g. minimum product quality standards

As a supplier of infrastructure (e.g. roads), the government is also in aposition to influence competition in an industry

Governments and supra-national institutions might impose policies which keepan industry fragmented, and prevent the concentration of too much marketshare in the hands of one or two producers

We shall see more about the effect of regulation and other government interventions on businesses inChapters 14 and 15 of this Study Manual.



4.3.2 Economic factors

The economic environment is an important influence at local and national level.

Here are some factors to which businesses must attend.

Factor Impact

Local economictrends:

Type of industry in the area. Office/factory rents. Labour rates. House prices.

National economic trends:

Overall growth or fall inwealth (Gross DomesticProduct)

Increased/decreased demand for goods (e.g. dishwashers) and services (e.g.holidays).

Inflation Low in most countries; distorts business decisions; wage inflationcompensates for price inflation.

Interest rates How much it costs to borrow money (the interest rate) affects cash flow.Some businesses carry a high level of debt. How much customers can affordto spend is also affected as rises in interest rates affect people's mortgage andother debt payments.

Tax levels Corporation tax affects how much businesses can invest or return toshareholders. Income tax and VAT affect how much consumers have to spend,hence their demand.

Government spending Suppliers to the government (e.g. construction firms) are affected bygovernment spending.

The business cycle Economic activity is always punctuated by periods of growth followed bydecline, simply because of the nature of trade. Government policy can cause,exacerbate or mitigate such trends, but cannot abolish the business cycle.(Industries which prosper when others are declining are called counter-cyclicalindustries.)

Productivity An economy cannot grow faster than underlying growth in productivitywithout risking inflation.

We shall look at the economic environment in more detail in Chapter 14.



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4.3.3 Social factors

How a country's population is made up – its demography – gives rise to factors that are important instrategic planning.

Factor Comment

Growth The rate of growth or decline in a national population and in regional populations.

Age Changes in the age distribution of the population.

Geography The concentration of population into certain geographical areas.

Household andfamily structure

A household is the basic social unit and its size might be determined by thenumber of children, whether elderly parents live at home etc. In the UK, there hasbeen an increase in single-person households and lone parent families.

Social structure The population of a society can be broken down into a number of subgroups, withdifferent attitudes and access to economic resources.

Employment In part, this is related to changes in the workplace. Many people believe that thereis a move to a casual flexible workforce; factories have a group of core employees,supplemented by a group of insecure peripheral employees, on part-time ortemporary contracts, working as and when required.

Wealth Rising standards of living lead to increased demand for certain types of consumergood.

Social factors are also important in the context of society's changing attitudes to certain issues such asmarriage, crime etc. Very often these attitudes are voiced by the media (newspapers, TV, radio).

4.3.4 Technological factors

Technological change is rapid, and businesses must adapt themselves to it. It affects activities as follows.

The type of products or services that are made and sold. The way in which products are made: equipment, new raw materials. The way in which services are provided, for example the internet. The way in which markets are identified. The way in which businesses are managed. The means and extent of communications with external clients.

4.3.5 Ecological factors

Factor Example

Resource inputs Managing physical resources sustainably (e.g. replanting forests)

Waste output Managing more efficiently so as not to attract fines

Legislation The effect of transport on the natural environment, 'food miles'

Government Pollution and recycling regulations

Disasters Increasing levels of natural disasters e.g. mudslides, drought due to globalwarming

Demand Consumers demanding environmentally friendly products and disapprovingof excessive waste packaging etc

Pressure groups Green activities have huge influence



4.3.6 Legal factors

Factor Example

General legal framework:contract, tort, agency

Basic ways of doing business, negligence proceedings

Criminal law Theft of industrial secrets, insider dealing, bribery, deception, fraudulenttrading, market abuse

Company law Directors and their duties, reporting requirements, takeoverproceedings, shareholders' rights, insolvency, corporate governance

Employment law Trade Union recognition, unfair dismissal, redundancy, maternity, equalopportunities

Health and safety law Fire precautions, safety procedures

Data protection Use of information about employees and customers

Consumer protection Laws to protect consumers (e.g. refunds and replacement, 'cooling off'period after credit agreements), what is or isn't allowed in advertising

Environment Pollution control, waste disposal

Tax law Corporation tax payment, collection of income tax deducted at sourceand VAT

4.4 Analysing the competitive (task) environment: Porter's five forcesanalysisError! Bookmark not defined.

When looking at the competitive aspect of the task environmentError! Bookmark not defined. of thebusiness, a very useful model is the five forces analysis put forward by Michael PorterError! Bookmarknot defined.. To understand this model we need to distinguish between a market and an industry.

Definitions

Market: Comprises the customers or potential customers who have needs which are satisfied by a productor service.

Industry: Comprises those businesses which use a particular competence, technology, product or serviceto satisfy customer needs, and which therefore compete with each other.

Porter states that there are five competitive forces which influence the state of competition in anindustry as a whole, illustrated in Figure 4.5: potential entrants, customers, substitutes, suppliers andindustry competitors. Collectively these determine the profit potential of the industry as a whole, becauseof the threatsError! Bookmark not defined. they represent (new entrantsError! Bookmark notdefined. and substitutesError! Bookmark not defined.), the bargaining powerError! Bookmarknot defined. they hold (customersError! Bookmark not defined. and suppliersError! Bookmark notdefined.), and the degree of rivalryError! Bookmark not defined. that exists among currentcompetitors in the industryError! Bookmark not defined..



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Figure 4.5: Porter's Five Forces

4.4.1 The threat of new entrantsError! Bookmark not defined. (and barriers toentryError! Bookmark not defined. to keep them out)

A new entrant into an industry will bring extra capacity and more competition. The strength of this threat islikely to vary from industry to industry, depending on:

The strength of the barriers to entry which discourage new entrants The likely response of existing competitors to the new entrant

Barriers to entry Comment

Scale economies As scale of operations increases, the cost per unit of the product or service falls.This means that new entrants must start their operations on a large scale or suffera vast disadvantage. A high level of fixed costs also requires entry on a large scale.

Static market If the market as a whole is not growing, the new entrant has to capture a largeslice of the market from existing competitors.

Productdifferentiation

Existing firms in an industry may have built up a good brand image and strongcustomer loyalty over a long period of time; they may promote a large numberof brands to crowd out the competition.

Investmentrequirements

When investment requirements are high, the barrier against new entrants will bestrong, particularly when the investment would possibly be high-risk.

Switching costs Switching costs refer to the costs (time, money, convenience) that a customerwould have to incur by switching from one supplier's products to another's.Although it might cost a consumer nothing to switch from one brand of frozenpeas to another, the potential costs for the retailer or distributor might be high.

Access todistributionchannels

Distribution channels carry products to the end-buyer. New distributionchannels are difficult to establish, and existing distribution channels are hard togain access to.

Cost advantages ofexistingproducers,independent ofscale economies

Include:

Patent rights Experience and know-how (the learning curve) Government subsidies and regulations Favoured access to raw materials

We shall look at economies of scale in more detail in Chapters 14 and 15.



Entry barriers might be lowered by:

Changes in the environment Technological changes Novel distribution channels for products or services

4.4.2 The threat from substitute products

A substitute product is a good/service produced by another industry which satisfies the samecustomer needs.

Worked example: The Channel Tunnel

Passengers have several ways of getting from London to Paris, and the pricing policies of the variousindustries transporting them there reflect this.

(a) 'Le Shuttle' carries cars in the Channel Tunnel. Its main competitors are the ferry companies, offering asubstitute service. Therefore, you will find that Le Shuttle sets its prices with reference to ferrycompany prices, and vice versa.

(b) Eurostar is the rail service from London to Paris/Brussels. Its main competitors are not the ferrycompanies but the airlines. Initially, prices on the London-Paris air routes fell with the commencementof Eurostar services, and some airlines curtailed the number of flights they offered. Low-cost airlineshave changed this equation by offering a cheaper alternative.

4.4.3 The bargaining power of customers

Customers include both the ultimate consumer and the buyers forming the distribution channel.Customers want better quality products and services at a lower price. Satisfying this might force down theprofitability of suppliers in the industry. Just how strong the bargaining of customers is depends on severalfactors.

How much the customer buys How critical the product is to the customer's own business Switching costs (the cost of switching supplier) Whether the products are standard items (hence easily copied) or specialised The customer's own profitability Customer's ability to bypass the supplier or to take over the supplier The skills of the customer's purchasing staff, or the price-awareness of consumers The importance of product quality to the customer

4.4.4 The bargaining power of suppliers

Suppliers can exert pressure for higher prices in the industry but their bargaining power is dependent onseveral factors:

Whether there are just one or two dominant suppliers to the industry, able to charge monopolyor oligopoly prices (we shall see more about this in Chapter 14)

The threat of new entrants or substitute products to the supplier's industry

Whether the suppliers have other customers outside the industry, and so do not rely on theindustry for the majority of their sales

The importance of the supplier's product to the customer's business

Whether the supplier has a specialised product which buyers need to obtain

Whether switching costs for customers would be high



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4.4.5 The rivalry amongst current competitors in the industry

The intensity of competitive rivalry within an industry will affect the profitability of the industry as awhole. Competitive actions might take the form of price competition, advertising battles, sales promotioncampaigns, introducing new products for the market, improving after sales service or providing guaranteesor warranties.

The intensity of competition will depend on the following factors.

Factor Comment

Market growth Rivalry is intensified when firms are competing for a greater market share in a totalmarket where growth is slow or stagnant.

Cost structure High fixed costs are a temptation to compete on price, as in the short run any salesare better than none at all.

Switching Suppliers will compete if buyers switch easily (e.g. Coke v Pepsi).

Capacity A supplier might need to achieve a substantial increase in output capacity, in orderto obtain reductions in costs per unit.

Uncertainty When one firm is not sure what another is up to, there is a tendency to respond tothe uncertainty by formulating a more competitive strategy.

Strategicimportance

If success is a prime strategic objective, firms will be likely to act very competitivelyto meet their targets.

Exit barriers Make it difficult for an existing supplier to leave the industry.

Long-term assets with a low break-up value (e.g. there may be no other use forthem, or they may be old)

The cost of redundancy payments to employees

If the business is a division or subsidiary of a larger enterprise, the effect ofwithdrawal on the other operations within the group

Interactive question 2: Product rivalry [Difficulty level: Intermediate]

Select a product with which you are very familiar, such as fashionable clothing. Try to identify whether ornot there is rivalry among the competing businesses in the market.


4.5 Analysing the competitive (task) environment: competitor analysis

To analyse the situation and potential activities of industry competitors (the fifth force in Porter's model)we can use competitor analysis. The objective of this is to draw out those areas where the businesscompetes well and has a competitive advantage, and those where this is held by the business's rivals.

A business must define who its current competitors actually are. This group may be larger than isimmediately apparent. Coca-Cola, for example, competes against the following.

Pepsi in the cola market, and retailers' own brands

All other soft drinks

Tea and coffee

Coca-Cola's chief executive has declared that 'the main competitor is tap water: any other definition istoo narrow'



4.5.1 Types of competitor

Kotler lists four kinds of competitor.

Brand competitorsError! Bookmark not defined. are similar firms offering similar products: forexample, McDonald's and Burger King.

Industry competitorsError! Bookmark not defined. have similar products but are different inother ways, such as geographical market or range of products: for example, Amazon and Borders

Generic competitorsError! Bookmark not defined. compete for the same disposable incomewith different products: for example, the HMV shop on Oxford Street in London, which sells CDs andDVDs, and the branch of Books etc on the opposite side of the same street

Form competitorsError! Bookmark not defined. offer distinctly different products that satisfythe same needs: for example, manufacturers of matches and those of cigarette lighters

For each competitor, the following factors can be analysed.

Factor to be analysed Comment

Competitor'sstrategy (for thebusiness as a whole andthe relevant businessunit)

What are the business's stated financial goals? What trade-offs aremade between long-term and short-term objectives?

Do managerial beliefs (e.g. that the firm should be a market leader)affect its goals?

Organisation structure: what is the relative status of functional areas?

What are the managers like? Do they favour one particular type ofstrategy?

To what extent does the business cross-subsidise others in the group ifthe business is part of a group? What is the purpose of the business:to raise money for the group?

The competitor'sassumptions about theindustry

What does a competitor believe to be its relative position in theindustry (in terms of cost, product quality)?

Are there any cultural or regional differences that indicate the waythe competitors' managers are likely to respond?

What does the competitor believe about the future for the industry?

Does the competitor accept the industry's 'conventional wisdom'?

The competitor'scurrent and potentialsituation with regardto:

Distribution Organisation Operations Research and engineering Overall costs Managerial ability Marketing and selling Products Financial strengths

Competitor'scapability

What are the competitor's core competences? What does thecompetitor do distinctively well?

Does the competitor have the ability to expand in a particular market?

What competitive advantages and disadvantages does the competitorpossess?

All these are combined in a competitor response profileError! Bookmark not defined.. Thisindicates the competitor's vulnerability and the right 'battleground' on which to fight.

Kotler lists four response profiles.

The laid back competitorError! Bookmark not defined. does not respond to moves by itscompetitors

The tiger competitorError! Bookmark not defined. responds aggressively to all opposing moves



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The selective competitorError! Bookmark not defined. reacts to some threats in some marketsbut not to all

The stochastic competitorError! Bookmark not defined. is unpredictable

5 Analysing the business

Section overview

Internal analysis encompasses the business's resources and competences, value chain, supply chain andproducts/markets.

A resource audit looks at the business's machinery, culture, structure and intangible assets,management and the information they use, markets, materials, people, processes and finance.

Activities in the value chain are designed to create value: the extra amount or margin that thecustomer is prepared to pay for a product/service over and above its input costs.

Primary value-adding activities: inbound and outbound logistics, operations, marketing and service.Secondary activities support the value-adding ones: infrastructure, HRM, technology andprocurement.

The business's supply chain describes all the suppliers and partners who together support the mutualeffort to produce goods and services for customers. This supply chain needs to be managedeffectively.

The product life cycle describes how a product shows different levels of profitability and investmentover the different phases during which it is on the market: introduction, growth, maturity and decline.

The Boston Consulting Group (BCG) matrix analyses product and SBUs in terms of their relativemarket share and potential for market growth.

5.1 What aspects of the business should be analysed?

Having completed its analysis of the external general and task environment, the business should nextanalyse itself. This primarily involves analysis of:

Its resources and competencies, using a position and resource audit Its 'value chain' Its supply chain Its products and markets, using the product life cycle and the BCG matrix

5.2 Analysing resources and competenciesError! Bookmark not defined. (theposition auditError! Bookmark not defined.)

To develop a strategic plan, an organisation's management must be aware of its current position.

Definition

Position audit:Error! Bookmark not defined. Part of the planning process which examines the currentstate of the entity in respect of:

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



The Ms modelError! Bookmark not defined. categorises the factors to be reviewed in a resourceauditError! Bookmark not defined. as follows.

Resource Example

Machinery Age. Condition. Utilisation rate. Value. Replacement. Technologically up-to-date? Cost.

Make-up Culture and structure. Patents. Goodwill. Brands.

Management Size. Skills. Loyalty. Career progression. Structure.

Managementinformation

Ability to generate and disseminate ideas. Innovation. Information systems.

Markets Products and customers.

Materials Source. Suppliers and partnering. Waste. New materials. Cost. Availability. Futureprovision.

Men andwomen

Number. Skills. Wage costs. Proportion of total costs. Efficiency. Labour turnover.Industrial relations.

Methods How are activities carried out?

Money Credit and turnover periods. Cash surpluses/deficits. Short-term and long-term finance.Gearing levels. (We shall see more about these issues in Chapter 9.)

A resource audit should go on to consider how well or how badly resources have been utilised, andwhether the business's systems are effective and efficient.

Every business operates under resource constraints, that is, limited resourcesError! Bookmark notdefined..

Definition

Limiting factorError! Bookmark not defined. or key factorError! Bookmark not defined.:Anything which limits the activity of an entity. An entity seeks to optimise the benefit it obtains from thelimiting factor. Examples are a shortage of supply of a resource or a restriction on sales demand at aparticular price.

Once the limiting factor has been identified, the planners should:

In the short term, make best use of the resources available Try to reduce the limitation in the long term

Limiting factor analysisError! Bookmark not defined. is part of management accounting as we shall seein Chapter 7.

5.3 Analysing Porter's value chainError! Bookmark not defined.

The value chainError! Bookmark not defined. model of corporate activities, developed byPorterError! Bookmark not defined., offers a bird's eye view of the business and what it does.Competitive advantageError! Bookmark not defined., says Porter, arises out of the way in whichbusinesses organise and perform activities.

Definition

ActivitiesError! Bookmark not defined.: The means by which a business creates value in its products.(They are sometimes referred to as value activitiesError! Bookmark not defined..)



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Activities incur costs, and, in combination with other activities, provide a product or service which earnsrevenue.

Worked example: Value chain in a restaurant

A restaurant's activities can be divided into buying food, cooking it, and serving it (to customers). There isno reason, in theory, why the customers should not do all these things themselves, at home. The customer,however, is not only prepared to pay for someone else to do all this but is also prepared to pay morethan the cost of the resources (food, wages etc). The ultimate value a business creates is measured as theamount customers are willing to pay for its products or services above the cost of carrying out valueactivities. A business is profitable if the realised value to customers exceeds the collective cost ofperforming the activities.

Customers purchase value, which they measure by comparing a business's products and serviceswith similar offerings by competitors.

The business creates value by carrying out its activities either more efficiently than other businesses,or by combining them in such a way as to provide a unique product or service.

Interactive question 3: Creating value [Difficulty level: Intermediate]

Outline different ways in which the restaurant can 'create' value.


5.3.1 Activities in the value chain

Porter (in Competitive Advantage) grouped the various activities of an organisation into a value chain (Figure 4.6).

Figure 4.6: Value chain

The margin is the excess the customer is prepared to pay over the cost to the business of obtainingresource inputs and providing value activities.



Definition

Value chain: The sequence of business activities by which, in the perspective of the end-user, value isadded to the products or services produced by an entity.

Primary activitiesError! Bookmark not defined. are directly related to production, operations, sales,marketing, delivery and service.

Primary activity Comment

InboundlogisticsError!Bookmark notdefined.

Receiving, handling and storing inputs to the production system (i.e.warehousing, transport, inventory control etc).

OperationsError!Bookmark notdefined.

Convert resource inputs into a final product. Resource inputs are not onlymaterials. 'People' are a 'resource', especially in service industries.

OutboundlogisticsError!Bookmark notdefined.

Storing the product and its distribution to customers: packaging, warehousing,testing etc.

Marketing andsalesError!Bookmark notdefined.

Informing customers about the product, persuading them to buy it, and enablingthem to do so: advertising, promotion etc.

ServiceError!Bookmark notdefined.

Installing products, repairing them, upgrading them, providing spare parts and soforth.

Support activitiesError! Bookmark not defined. provide purchased inputs, human resources,technology and infrastructural functions to support the primary activities.

Support activity Comment

ProcurementError!Bookmark not defined.

Acquire the resource inputs to the primary activities (e.g. purchase ofmaterials, subcomponents, equipment). See the section on analysingthe supply chain below.

Human resourcemanagementError!Bookmark not defined.

Recruiting, training, developing and rewarding people.

TechnologydevelopmentError!Bookmark not defined.

Product design, improving processes and/or resource utilisation.

Firm infrastructureError!Bookmark not defined.

Planning, finance, quality control: Porter believes these are cruciallyimportant to an organisation's strategic capability in all primaryactivities.

Linkages connect the activities of the value chain.

Activities in the value chain affect one another. For example, more costly product design orbetter quality production might reduce the need for after-sales service.

Linkages require co-ordination. For example, reducing the level of inventory held requires smoothfunctioning of operations, outbound logistics and service activities such as installation.



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5.3.2 Using the value chain

A business can secure competitive advantage by:

Inventing new or better ways to do activities Combining activities in new or better ways Managing the linkages in its own value chain to increase efficiency and reduce costs Managing the linkages in the value systemError! Bookmark not defined.

5.4 Analysing the supply chain

A simple view of the support activity of procurement would be to state that it is just about getting the bestprice from suppliers for the best quality goods and services, based on an arm's length relationship with thesupplier. Increasingly, however, a business looks beyond their immediate supplier to the whole supply chainsupporting the business in a mutual effort to produce goods and services.

The business therefore needs to analyse the parties in its supply chain and see whether the principles ofsupply chain managementError! Bookmark not defined. can be applied to improve efficiency.

Definition

Supply chain management (SCM)Error! Bookmark not defined.: Optimising the activities ofbusinesses working together to produce goods and services.

SCM is a means by which the business aims to manage the chain from input resources to the consumer. Itcan involve the following aspects.

Reduction in the number of suppliers and much closer 'partnership' relationships with those thatremain

Reduction in customers served for the sake of focus, and concentration of the company's resourceson customers of high potential value

Price and inventory co-ordination. Businesses co-ordinate their price and inventory policies to avoidproblems and bottlenecks caused by short-term surges in demand, such as promotions

Linked computer systems – electronic data interchange saves on paperwork and warehousing expense

Early supplier involvement in product development and component design

Carefully designed distribution system

Joint problem-solving among supply chain partners

Supplier representative on site

The aim is to co-ordinate the whole chain, from raw material suppliers to end customers. The chain shouldbe considered as a network rather than a pipeline – a network of vendors support a network ofcustomers, with third parties such as transport firms helping to link the businesses.

5.5 Analysing products and markets: the product life cycle

Definition

Product life cycleError! Bookmark not defined.: How a product demonstrates differentcharacteristics of profit and investment over time. Analysing it enables a business to examine its portfolio ofgoods and services as a whole.



The profitability and sales of a product can be expected to change over time. The product life cycle is anattempt to recognise distinct stages in a product's history. Marketing managers distinguish between differentaspects of the product.

Product class: this is a broad category of product, such as cars, washing machines, newspapers (alsoreferred to as the generic productError! Bookmark not defined.).

Product form: within a product class there are different forms that the product can take, forexample five-door hatchback cars or two-seater sports cars; twin tub or front loading automaticwashing machines; national daily newspapers or weekly local papers, and so on.

BrandError! Bookmark not defined.: the particular type of the product form (e.g. Ford Focus).

The product life cycle applies in differing degrees to each of the three aspects. A product class (e.g. cars)may have a long maturity stage, and a particular brand might have an erratic life cycle (e.g. Rolls Royce) or not.Product forms however tend to conform to the classic life cycle pattern in Figure 4.7.

Figure 4.7: Product life cycle

Stage in life cycle Comments

Introduction A new product takes time to find acceptance by would-be purchasers andthere is a slow growth in sales. Unit costs are high because of low output andexpensive sales promotion. There may be early teething troubles withproduction technology. The product for the time being is a loss-maker.

Growth If the new product gains market acceptance, sales will eventually rise moresharply and the product will start to make profits. Competitors are attractedand as sales and production rise, unit costs fall.

Maturity The rate of sales growth slows down and the product reaches a period ofmaturity which is probably the longest period of a successful product's life.Most products on the market will be at the mature stage of their life. Profitsare good.

Decline Eventually, sales will begin to decline so that there is over-capacity ofproduction in the industry. Severe competition occurs, profits fall and someproducers leave the market. The remaining producers seek means ofprolonging the product life by modifying it and searching for new marketsegments. Many producers are reluctant to leave the market, although someinevitably do because of falling profits. Some producers may continue evenwhere there are losses, perhaps to support complementary products.

In the strategic analysis process, planners should assess:

The stage of its life cycle that any product has reached. Each product's remaining life, i.e. how much longer the product will contribute to profits.



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How urgent is the need to innovate, to develop new and improved products?

5.6 Planning products and markets: the BCG matrix

Another useful way to look at the products/services the business is engaged in and the markets it services isto analyse them using the Boston Consulting Group (BCG) matrix.

BCG developed a matrix (Figure 4.8) based on research that assesses a business's products in terms ofpotential cash generation and cash expenditure requirements. Products, or SBUs, are categorised interms of market growth rateError! Bookmark not defined. and relative market shareError!Bookmark not defined..

Definition

Market shareError! Bookmark not defined.: One entity's sale of a product or service in a specifiedmarket expressed as a percentage of total sales by all entities offering that product or service.

Assessing rate of market growthError! Bookmark not defined. as high or low depends on theconditions in the market.

Market share is assessed as a ratio: it is market share compared with the market share of thelargest competitor. Thus a relative market share greater than 1 indicates that the product or SBU isthe market leader.

Market share

High Low

High Stars Question marksMarket growth

Low Cash cows Dogs

Figure 4.8: BCG matrix

StarsError! Bookmark not defined.. In the short term, these require capital expenditure(investment) in excess of the cash they generate, in order to maintain their market position, but theypromise high returns in the future. Strategy: buildError! Bookmark not defined. (forgo short-termearnings and profits to build market share).

In due course, stars will become cash cows. These need very little capital expenditure and generate highlevels of cash income. However, it is important to remember that apparently mature products can beinvigorated, possibly by competitors, who could thus come to dominate the market. Cash cows can be usedto finance the stars. Strategy: hold (maintain the market position) or harvestError! Bookmark notdefined. (take maximum earnings in the short term at the expense of long-term development) if weak.

Question marksError! Bookmark not defined.. Do the products justify considerable capitalexpenditure in the hope of increasing their market share, or should they be allowed to die quietly asthey are squeezed out of the expanding market by rival products? Strategy: build or harvest.

DogsError! Bookmark not defined.. These may be ex-cash cows that have now fallen on hardtimes. Although they will show only a modest net cash outflow, or even a modest net cash inflow, theyare cash traps which tie up funds and provide a poor return on investment. However, they may have auseful role, either to complete a product range or to keep competitors out. Strategy: divestError!Bookmark not defined. (release resources for use elsewhere) or hold.

A business's portfolio of products should be balanced, with cash cows providing finance for stars andquestion marks, and a minimum of dogs.



6 Corporate appraisalError! Bookmark not defined.

Section overview

Corporate appraisal brings together the results of the external and internal analyses so that thebusiness can assess its strengths, weaknesses, opportunities and threats (SWOT analysis).

Key areas for SWOT analysis are marketing, products/brands, distribution/logistics, research anddevelopment of new products, finance, production capacity, inventory, management, staff andorganisational structure.

Corporate appraisal brings together the analyses to date.

From theinternalanalysis

Internal appraisalof the business'sSTRENGTHSWEAKNESSES

From theexternalanalysis

External appraisalof theOPPORTUNITIESTHREATSfacing the business

The business's unique strengths, weaknesses, opportunities and threats are analysed using SWOTanalysis.

6.1 SWOT analysisError! Bookmark not defined.

Definition

Corporate appraisalError! Bookmark not defined.: A 'critical assessment of the strengths andweaknesses, opportunities and threats (SWOT analysis) in relation to the internal and environmentalfactors affecting an entity in order to establish its condition prior to the preparation of the long-term plan'.(CIMA Official Terminology

It is important to remember the phrase 'critical assessment' used in the definition above. A simple listing offour types of factor is not likely to produce a robust and workable strategy. The managers involved musthave a detailed and intimate understanding of the nature and implications of the factors. In particular, it isimportant to be realistic, erring neither towards optimism nor towards pessimism.

6.1.1 SWOT: positioning-based or resource-based views?

As stated earlier in this Study Manual, we have so far used a positioning-based approach to our strategicanalysis of the business, so we discuss SWOT at this stage as a kind of summary or synthesis of our priorexamination of resources and environment.

The alternative resource-based approach to strategic analysis would use SWOT as the first stage of thestrategy making process, seeking to establish the nature of the business's core competences before decidingwhat the objectives of strategy should be.

6.1.2 Strengths and weaknesses

The internal appraisal seeks to identify:

Shortcomings in the business's present skills and resources Strengths in its skills and resources which it should seek to exploit



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The precise content of the SWOT analysis will depend on the business. Here are some ideas.

Area Issues

Marketing Fate of new product launches

Use of advertising

Market shares and market sizes

Growth markets

Success rate of the sales team

Level of customer/client service

Products and brands Analysis of sales

Margin, and contribution to fixed costs (see Chapter 8)

Product quality

Reputation of brands

Age and future life of products

Price elasticity of demand (see Chapter 14)

Distribution/logistics Service standards

Delivery fleet facilities

Geographical availability

Research and development Relevance

Costs

Benefits

Workload

Finance Availability of funds

Contribution

Returns on investment

Accounting ratios (see Chapter 8)

Plant and equipment/production

Production capacity

Value of assets

Land and buildings

Economies of scale (see Chapter 14)

Raw material and finishedinventory

Sources of supply

Turnover periods

Storage capacity

Obsolescence and deterioration (see Chapter 9)

Management and staff Age

Skills

Industrial relations

Training

Recruitment

Communications

Business management andorganisation

Organisation structure

Leadership style

Communication links

Information systems



6.1.3 Opportunities and threats

The external appraisal should identify:

Profit-making opportunities which can be exploited by the business's strengths

Environmental threats (a declining economy, competitors' actions, government legislation, industrialunrest etc) against which the business must protect itself

For opportunities, it is necessary to decide:

What opportunities exist in the business environment? What is the capability profile of competitors? Are they better placed to exploit these opportunities? What is the company's comparative performance potential in this field of opportunity?

For threats, it is necessary to decide:

What threats might arise, to the business or its environment? How will competitors be affected?

Opportunities and threats might relate to any or all of the items covered in the PESTEL analysis plus thosein the five forces analysis (customers, suppliers, new entrants, substitutes, and of course competitors).

Interactive question 4: Opportunities and threats [Difficulty level: Intermediate]

Consider your career as a chartered accountant. How well-placed are you to make a success of it?


6.2 Combining the elements of the SWOT analysis

SWOT analysis indicates the types of strategy that appear to be available, to exploit strengths andopportunities and to deal with weaknesses and defend against threats.

Major strengths and profitable opportunities can be exploited, especially if strengths and opportunitiesare matched with each other.

Major weaknesses and threats should be countered, or a contingency strategy or corrective strategydeveloped.

The SWOT analysis is summarised on a cruciform chart. In the example below, the development ofpotential strategies from the analysis is illustrated.

Strengths Weaknesses

CU10 million of capital available.

Production expertise and appropriate marketingskills.

Heavy reliance on a small number of customers.

Limited product range, with no new products andexpected market decline.

Small marketing organisation.

Opportunities Threats

Government tax incentives for new investment.

Growing demand in a new market, althoughcustomers so far relatively small in number.

Major competitor has already entered the newmarket.

The business seems to be in imminent danger of losing its existing markets. A new market opportunityexists to be exploited and since the number of customers is currently few, the relatively small size of theexisting marketing force would not be an immediate hindrance.

In practice, a combination of financial, competition and institutional strategies will be required, aswe shall see.



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7 Setting strategic objectivesError! Bookmark not defined.

Section overview

Analysis of the business's mission and objectives allows it to determine exactly what it is trying toachieve.

Stakeholder analysis – i.e. what the business's stakeholders are trying to achieve – informs thisanalysis.

Stakeholders have internal and external sources of power, and have varying levels of interest in thebusiness. Relative power and interest are assessed via stakeholder mapping, which determines howfar the business should reflect what the stakeholders want. This should be incorporated in its missionstatement.

The business's mission feeds down to its corporate strategy (strategic objectives), then itscompetitive, investment and financial strategies/goals/targets, its business strategies and itsfunctional/operational strategies, plans and standards.

7.1 What are we trying to achieve?

In our positioning-based model of the strategic planning process it is at this point that we look at thebusiness mission and objectives. What is the business about, who is it for, and what is it aiming to achieve?To answer these questions, we need to conduct a detailed stakeholder analysis, before formulating thebusiness's mission and objectives.

7.2 Stakeholder analysisError! Bookmark not defined.

In Chapter 1 we outlined what a stakeholder is. We now need to look at how stakeholders' goals andobjectives for the business are balanced in order to determine what the business's goals and objectivesshould be, in the light of corporate appraisals.

Because of the different interests at stake, the needs and objectives of each set of stakeholders are boundnot to correspond; indeed, they often conflict.

Stakeholders Conflict

Shareholders v Managers/directors Profit v Growth

Shareholders v Managers/directors Growth via merger v Independence

Shareholders v Employees Cost efficiency v Jobs

Customers v Shareholders and managers/directors Service levels v Profits and costs

Shareholders v Bankers Return v Risk

Ultimately the business's objectives tend to follow the wishes of the most dominant stakeholders, itsdirectors/managers, but they are constrained by those of other stakeholders, notably shareholders. Thebusiness needs to pay attention to all stakeholders, whether their needs determine or indeed have anyeffect on the business's objectives depends on the relative power of the stakeholder groups.

7.2.1 Stakeholder mapping: power and interest

Mendelow maps stakeholders on a matrix (Figure 4.8) whose axes are power held and the level ofinterest in the business's activities. These factors help define the type of relationship the business shouldseek with its stakeholders.



AMinimaleffort

BKeep

informed

CKeep

satisfied

DKey

players

Level of interest

Low

High

Low

Power

High

Figure 4.9: Mendelow's power/interest matrix

Power is the means by which stakeholders can influence a business's objectives. Sources of power may beinternal or external.

Internal sources ofpower (fordirectors/managers andemployees)

Comment

Hierarchy Formal power over others in the business shown by span of control

Influence/reputation Informal power from either charismatic leadership or group consensus ona particular issue

Relative pay Better paid employees such as directors and managers have moreposition power as a result

Control of strategicresources

For example trade unions when demand for output is high and labour isscarce, or size of budget allocation

Knowledge skills Individuals deriving power from their specialist knowledge or skills

Environmental control Finance and marketing staff may have a more detailed knowledge of theexternal environment than other functional staff, such as production

Strategicimplementationinvolvement

Many people are involved in implementing strategy, and the use ofpersonal discretion in decision-making can give some element of power

External sources ofpower

Comment

Control over strategicresources

Major suppliers, banks (finance) and shareholders (finance) can exert thisform of power

Involvement inimplementation

Distribution outlets have greater knowledge of customer requirementsthan manufacturers and can therefore dictate to manufacturers, ratherthan vice versa

Knowledge and skills Subcontractors have power if they perform vital activities for a business

External links Public services often consult a wide variety of external stakeholders indecision making and therefore these stakeholders have an informalinfluence over the organisation

Legal rights E.g. government, planning authorities



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The interests of stakeholders involve consideration of two factors.

Where their interest rests, e.g. shareholders want dividends and capital growth, employees wanthigher pay and good conditions, customers want low prices, reliable supplies, and so on

How interested they are, for instance they will be interested if there are alternatives (job, supplier,customer etc), if they are the industry regulator, or if there is a significant capital investment

When considering a potential strategy, the stakeholder should be placed in the appropriate quadrantdepending on their power and their level of interest. The quadrant where they are placed – A, B, C or D –determines how they should be approached.

Key playersError! Bookmark not defined. are found in segment D: strategy must be acceptable tothem, at least and ideally they should participate in it. An example would be a major customer.

Stakeholders in segment C must be treated with care. While often passive, they are capable of movingto segment D. The business should intervene with these stakeholders and keep them satisfied. Largeinstitutional shareholders might fall into segment C.

Stakeholders in segment B do not have great ability to influence strategy, but their views can beimportant in influencing more powerful stakeholders, perhaps by lobbying. They should therefore bekept informed by education and communication. Community representatives and charities mightfall into segment B.

Minimal effort is expended on segment A – they can simply be directed.

A single stakeholder map is unlikely to be appropriate for all circumstances. In particular, stakeholders maymove from quadrant to quadrant when different potential future strategies are considered.

7.3 Determining the mission and strategic objectives

As we saw in Chapter 1, the business's 'missionError! Bookmark not defined.' describes its basicfunction in society. The mission can be set at the beginning of the strategic planning process, or it can derivefrom it after the corporate appraisal. It can include the business's vision of its future state, or the futurestate of the industry.

The mission feeds down into a set of strategic objectivesError! Bookmark not defined., which arestatements of intent to particular stakeholders such as shareholders or employees, building on stakeholderanalysis. These are broken down further into goals, expressed as targetsError! Bookmark notdefined. for the business as a whole and for SBUs in it. In this way, the targets for SBUs are designed withthe business's strategic objectives and mission in mind, so there is goal congruenceError! Bookmarknot defined.. This 'top down' approachError! Bookmark not defined. to formulating the finalstrategic plan can be expressed as a hierarchy (Figure 4.10).



Functionalstrategies Plans and standards

Mission statement Mission

Business strategies Strategies

CompetitiveInvestment strategies Goals = targetsFinancial

Corporate strategy Strategicobjectives

Figure 4.10: Hierarchy of objectives and strategiesError! Bookmark not defined. (top down approach)

For each SBU in the business, business and functional (or operational) strategies need to bedetermined which will ensure that targets are met. These are then broken down into detailed plans to beimplemented according to specified standards.

7.3.1 Mission statementError! Bookmark not defined.

Definition

Mission statementError! Bookmark not defined.: A formal document that states the business's basicfunction in society expressed in terms of how it satisfies its stakeholders.

There is no standard format for a mission statement, but a good basis is to include the four elements wesaw in Chapter 1: purpose of the business, strategy (what it does and how), values and policies andstandards of behaviour.

7.3.2 Strategic objectivesError! Bookmark not defined.

Definition

Strategic objectivesError! Bookmark not defined.: The primary strategic objective – in the case of abusiness, to make a profit for shareholders – plus other major objectives addressed to the stakeholders.

An example of a statement of strategic objectives is as follows:

'Our primary aims are to provide a sound investment for our shareholders by increasing shareholder valueand also worthwhile job prospects for our employees. Our objectives are customer satisfaction, realgrowth in earnings per share and a competitive return on capital employed.'

In Chapter 5 we shall see how the business's attitude to and appetite for riskError! Bookmark notdefined. feeds into the strategic planning process at this point.



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7.3.3 GoalsError! Bookmark not defined. and targetsError! Bookmark not defined.

For the business as a whole and for SBUs in it, the strategic objectives should be translated into quantifiedand specific goals. In relation to the statement of strategic objectives above, for the business concernedthese could be as follows.

Area Goals Target

Revenue Growth CU3m from CU2.5m this year

Gross margin Increase Cost of sales represents 65% of revenue, down from70%

Expenses Reduce Overheads cut to CU300,000 from CU450,000

Earnings per share Growth From CU300,000/1.2m = 25pTo CU660,000/1.2m = 55p

Return on capitalemployed

More competitive From CU300,000/6m = 5%To CU660,000/6.6m = 10%

Shareholder value Increase Move from share price of CU2 per share to CU2.20

Employee jobprospects

Worthwhile Ensure fewer employees leave the business andmore enter training to ensure career progression

Customer satisfaction Ensure customersare satisfied

Improve customer loyalty by raising customerservice levels

We shall see more about targets in Chapter 8.

7.3.4 Strategies, plans and standards

The strategies that are chosen by the business need to be ones which can achieve the targets set out, forinstance to increase sales, reduce costs and raise capital. As we saw in Section 2 of this chapter, these areinitially specific business strategiesError! Bookmark not defined. that tie in with the overallcorporate strategy of the business, comprising:

The competitive strategy – which products and markets do we operate in? The investment strategy – what systems, structure and assets do we need to invest in? The financial strategy – how are we going to raise the necessary funds?

A financial strategy for each area – operations, marketing, HR and finance – plus detailed plans andstandards are then developed that will ensure the targets are met. Usually these plans will at some stagetake the quantified form of a budget, as we shall see in Chapter 7.

We shall see more about selecting a corporate strategy and translating it into the various types of sub-strategy a little later. Before this level of detail is reached, the business needs to check the size of the gapbetween its desired strategic objectives and what it would achieve if it carried on with no changes instrategy. This is called gap analysis.

8 Gap analysis

Section overview

Gap analysis looks at the gap between what the business would achieve if it continued on its existingcourse, and what it needs to achieve as demonstrated by its strategic planning process, measured interms of profit.

A gap in profit could be filled by strategies for improved efficiency, new products/markets, andacquisitions/mergers.



Definition

Gap analysisError! Bookmark not defined.: ‘A comparison between an entity's desired future performancelevel (expressed in terms of profit) and the expected performance of projects both planned and underway.Differences are classified in a way which aids the understanding of performance, and which facilitatesimprovement.'

(CIMA Official Terminology)

The gap is not between the current position of the business and the desired future position. It is the gapbetween the position forecast if the business continues with current activities, and the desired futureposition as set out in the strategic objectives.

Gap analysis is based on two questions.

What are the business's objectives?

What would the business be expected to achieve if it 'did nothing' – it did not develop any newstrategies, but simply carried on in the current way with the same products and selling to the samemarkets?

This difference is the gap. New strategies should close this gap, so that the business can expect to achieveits objectives.

The profit gapError! Bookmark not defined. (Figure 4.11) is the difference between the target profitand the profit forecast.



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The business estimates the effects on the gap of any projects or strategies in the pipeline. Some of thegap might be filled by a new project already underway

Then, if a gap remains, new strategies have to be developed to close it

Target profit

Acquisition and merger

New markets

New products

Improvedefficiency

Profit forecast if no changes

Current positionPast events Future planned

projectsFilling the gap

CU'000

Figure 4.11: Gap analysis



9 Choosing a corporate strategy

Section overview

The business needs a competitive, an investment and a financial strategy: it does not always need anew one, if gap analysis shows that it can simply continue on its existing path.

Generic competitive strategies are cost leadership (being the producer at the lowest cost, notnecessarily the producer who charges the lowest prices to consumers), differentiation (being theproducer of unique and desirable products) and focus (being a niche producer for part only of amarket, concentrating either on cost or on differentiation in that niche).

Product/market strategies comprise market penetration (sell more of the current product in thecurrent market), product development (sell new product in the current market), marketdevelopment (sell the current product in a new market) and diversification (sell new product in a newmarket).

Corporate strategies should be evaluated in terms of suitability, feasibility and acceptability tostakeholders.

9.1 Do we have to choose a new corporate strategy?

If there is no gap then the business can simply choose to continue with its current corporate strategy.Assuming there is a gap, however, the business needs to select competitive, financial and investmentstrategies that will ensure the strategic objectives are met.

We shall concentrate here on two models for competitive strategy: Porter's generic competitive strategies,and Ansoff's matrix. These provide suggested competitive strategies from which the business selects on thebasis of how effectively they close the profit gap.

9.2 Porter's generic competitive strategies

Definition

Competitive strategy: 'Taking offensive or defensive actions to create a defendable position in anindustry; to cope successfully with… competitive forces and thereby give a superior return on investmentfor the business' (Porter).

Porter believes there are three generic competitive strategies: cost leadership, differentiation andfocus (niche).

Definitions

Cost leadership: Producing at the lowest cost in the industry as a whole (not necessarily being theproducer offering the lowest prices to the consumer, though the cost leader can compete freely on price inthe marketing mix).

Differentiation: The provision of a product or service which the industry as a whole believes to be unique.

Focus (or niche) involves a restriction of activities to only part of the market (a segment) through:

Providing goods and/or services at lower cost to that segment (cost-focus) Providing a differentiated product or service to that segment (differentiation-focus)



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Cost leadership and differentiation are industry-wide strategies. Focus involves segmenting the market butinvolves pursuing, within one or just a few segments only, a strategy of cost leadership or differentiation.

9.2.1 Cost leadership

By producing at the lowest cost, the cost leader can compete on price with every other producer in theindustry, and earn higher unit profits, if it so chooses.

How to be the cost leader

Set up production facilities to obtain economies of scale Use the latest technology Concentrate on improving productivity Minimise overhead costs Get favourable access to sources of supply Relocate operations to cheaper countries

9.2.2 Differentiation

The business competes on the basis of particular characteristics of its products. Products may becategorised as follows.

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

Improved products offer better performance at a competitive price.

Competitive products offer a particular combination of price and performance.

How to differentiate

Build up a brand image Give the product special features to make it stand out Exploit other activities of the value chain such as marketing and sales or service Use IT to create new services or product features

9.2.3 Focus (or niche) strategy

The business concentrates its attention on one or more particular segments or niches of the market, anddoes not try to serve the entire market with a single product.

A cost-focus strategy: aim to be a cost leader for a particular niche A differentiation-focus strategy: pursue differentiation for a chosen niche

9.3 Ansoff's matrix: product/market strategies

Ansoff drew up a matrix describing how a combination of a business's activities in current and newmarkets, with existing and new products, can lead to four different competitive strategies for growth.

Figure 4.12: Ansoff's product/market matrix



9.3.1 Existing products in current markets: pursue market penetration

Maintain or increase share of current markets with existing products, e.g. through competitivepricing, advertising, sales promotion

Secure dominance of growth markets

Restructure a mature market by driving out competitors

Increase usage by existing customers (e.g. air miles, loyalty cards)

9.3.2 Existing products in new markets: pursue market development

New geographical areas and export markets Different package sizes for food and other domestic items New distribution channels to attract new customers Differential pricing policies to attract different types of customer and create new market segments

9.3.3 New products in current markets: pursue product development

Introduce new products to existing and new customers in current markets Product development forces competitors to innovate Newcomers to the market might be discouraged

9.3.4 New products in new markets: pursue diversification

The business should have a clear idea about what it expects to gain from diversifying to new products andnew markets at the same time.

Growth. New products and new markets should be selected offering prospects for growth which theexisting product-market mix does not

Surplus funds not required for other expansion needs can be invested in diversification, or they couldbe returned to shareholders

9.4 Evaluating alternative corporate strategies and choosing one

If a business is faced with a gap and has developed alternative corporate strategies, each of which could intheory fill the gap, it needs to:

Evaluate each strategy, then Choose the best one.

Johnson and Scholes set three criteria for evaluating and choosing strategies.

9.4.1 Suitability

Does the strategy fit the business's operational circumstances? Does it:

Exploit strengthsError! Bookmark not defined.? Rectify weaknessesError! Bookmark not defined.? Neutralise or deflect environmental threats? Help the business to seize opportunities? Satisfy the business's objectives? Fill the gap identified by gap analysisError! Bookmark not defined.? Generate/maintain competitive advantageError! Bookmark not defined.? Involve an acceptable level of riskError! Bookmark not defined.?

9.4.2 FeasibilityError! Bookmark not defined.

Can the strategy in fact be implemented?

Is there enough money? Is there the ability to deliver the goods/services specified in the strategy? Can we deal with the likely responses that competitors will make?



4

Do we have access to technology, materials and resources? Do we have enough time to implement the strategy?

Strategies which do not make use of existing competences, and which therefore call for new competencesto be acquired, might not be as feasible as alternative strategies because:

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

9.4.3 Acceptability (to stakeholders)

The acceptability of a strategy relates to people's expectations of it. It is here that stakeholder analysiscan be brought in, which we saw earlier in this chapter.

Financial considerations. How far do alternative strategies contribute to meeting the dominantobjective of increasing shareholder wealth?

Customers may object to a strategy if it means reducing service, but on the other hand they mayhave no choice.

Government. A strategy involving a takeover may be prohibited under competition law (see Chapter15). Similarly, the environmental impact may cause key stakeholders to withhold consent.

The public. The environmental impact may cause key stakeholders to protest.

Risk. Different shareholders have different attitudes to risk. A strategy which changed the risk/returnprofile, for whatever reason, may not be acceptable. We shall look at risk in more detail in Chapter 5.

10 Implementing the strategy

Section overview

To implement the chosen corporate strategy, the competitive, investment and financial strategiesneed to be broken down so there are business strategies and plans for each SBU, and within thesethere are functional strategies and operational plans. These are then expressed in budgets.

10.1 Breaking the strategy down

The selected corporate strategy comprises competitive, investment and financial strategies (see Figure 4.9).there are then further broken down as we have seen into business and functional strategies.

Business strategies determine how competitive advantage is gained by a particular SBU, and inparticular how the marketing mix must be adjusted to achieve this

Functional strategies develop the business strategy for an SBU as it affects the:

– Marketing function– Production/operations function– Human resources function, and– Finance function



10.2 Levels of plan

To implement the strategies, plans need to be produced.

The strategic plan as we have seen, embodies the corporate strategy and strategic objectives. It setsout the general direction that will be taken to achieve the corporate objectives but it is not itself verydetailed

The business plan for the business as a whole or for an SBU sets out the market(s) to be served,how the business/SBU will serve the market(s), and what finance is required (based on the businessstrategy)

The operational plan specifies what is expected of each function in the business as a whole or anSBU, based on the relevant functional strategy, and how specific actions will be taken in order to meetthat expectation

Finally, budgets are prepared that set out the business's plan for a defined period, expressed in moneyterms. Usually a business has a variety of budgets at different levels of detail. The board of directors has asummarised or master budget for the whole entity that expresses the entire strategic plan, whileseparate functions in an SBU of that entity have detailed budgets for what each particular function needsto do to ensure that the master budget is achieved.

We shall look in more detail at budgets and the budgetary process in Chapter 7.



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Summary

Strategic management– Scope of activities – Long-term direction – Allocation of resources

Emergent/formal Strategic planning Benefits/drawbacks

Positioning-based

Strategic analysis

–

(resource audit, competencies,value chain, supply chain,product life cycle, BCG matrix)

–

(PESTEL, five forces,competitor analysis)

–

(SWOT)

–

(stakeholder analysis, missionstatement, strategic objective,goals and targets, strategies,plans and standards)

–

Internal analysis

External analysis

Corporate appraisal

Establish mission, goals, objectives

Gap analysis

Strategic choice

–

AND

–

(Porter’s generic,Ansoff ’sproduct/market)

THEN

–

(Stakeholder analysis, riskanalysis, suitability, feasibility,acceptability)

–

Resource-based strategies

Positioning-based strategies

Strategic evaluation

Strategy selection

Strategic plans

–

(corporate mission/objectiveProduct/marketInvestment decisionsFinancial)

–

(competition strategy)

–

(Business and functionalstrategies)

–

Corporate plan

Business plan

Operational plans

Budgets

Implementation, review andcontrol

–

–

–

Organisational structure andcontrol systems

Resource planning

Operations planning

Resource-based

Self-test


1 The emergent approach to the strategic planning process combines which two of the following stagesinto a single process?

A Strategic analysisB Gap analysisC Strategic choiceD Strategic implementationE Review and control



2 In a resource-based approach to strategic planning, the business's mission, goals and objectives aredetermined

A following stakeholder analysis at the start of the processB following stakeholder analysis and the corporate appraisal stageC following SWOT analysis in the corporate appraisal stageD following competitor analysis at the strategic choice stage

3 Competitors exist in the business's

A Physical environmentB General environmentC Task environmentD Internal environment

4 Linker Ltd has just been informed of a significant new regulation with which it needs to complyimmediately. In relation to this, which of the following statements is true?

A There has been a change in Linker Ltd's task environment which it can cope with using planning

B There has been a change in Linker Ltd's general environment which it can cope with using crisismanagement

C There has been a change in Linker Ltd's task environment which it can cope with using crisismanagement

D There has been a change in Linker Ltd's general environment which it can cope with usingplanning

5 Minion Ltd has conducted a five forces analysis of its industry. This states that competition in theindustry will become less intense in the medium term. Which of the following factors alone wouldexplain this?

A The government has set a minimum capital requirement for anyone entering the industryB A product which claims to eliminate the need for Minion Ltd's product has been launchedC The income levels of Minion Ltd's target market are being eroded by inflationD A key raw material is now in short supply

6 Xenon Ltd runs restaurants while Zenos Ltd operates a chain of cinemas. The two companies are

A Industry competitorsB Generic competitorsC Form competitorsD Brand competitors

7 A competitor with a stochastic response profile

A responds aggressively to all opposing moves by competitorsB does not respond to any moves by competitorsC responds to some moves by competitors, but not allD responds unpredictably to competitor moves

8 Which of the following is a primary activity in Porter's value chain?

A HRMB ProcurementC Outbound logisticsD Technology

9 Penpen Ltd's ‘Freb’ product has high market share in a market that is fully saturated. In terms of theBCG matrix, for Penpen Ltd the Freb is

A A starB A cash cowC A question markD A dog



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10 Hubert is a stakeholder in Vipe Ltd. The company has selected a strategy which is acceptable toHubert and in which the company is keen to secure his participation. In respect to Vipe Ltd Huberthas

A High power and high interestB Low power and low interestC High power and low interestD Low power and high interest




1 C, D Note that gap analysis is part of the strategic analysis process; strategic analysis and review andcontrol are separate processes under both the formal and the emergent models

2 A Options B and C describe the planned strategy approach; Option D describes neither approach

3 C

4 B A regulation is a political/legal factor in the general environment; a regulation taking effect in ashort timescale requires crisis management, while one taking place in the long term requiresplanning

5 A A minimum capital requirement is a barrier to entry, so new entrants will be deterred andcompetition will decrease. Each of the other factors should lead to increased competition: B isa new substitute, C increases the bargaining power of customers, and D increases thebargaining power of suppliers

6 B Restaurants and cinemas compete for the part of consumers' income that is allocated toleisure/entertainment

7 D A, B and C describe tiger, laid back and selective responses respectively

8 C All the others are secondary, support activities

9 B

10 A From its reaction, we can see that Hubert is being treated as a key player



4



You may have thought of some of these factors, or maybe some others. You should have structured youranalysis using the PESTEL framework.

Political factors: status/value of professional exams in education and employment system, potentialregulation of tuition and study methods, effect of laws on the future of the accountancy profession as awhole, possible political instability

Economic factors: effect of business cycle on recruitment of student accountants, effect of interestand exchange rates on business, potential for global market?

Social factors: acceptability of accountancy as a profession, levels of education of entry levelaccountants, size of population and therefore number of student accountants

Technological factors: in what format will study notes be published, and how accessible is thetechnology to the target market? Can technology help to prevent copyright infringements?

Ecological factors: how to produce and market study notes in a 'green' way

Legal factors: employment and health and safety issues; how can the study notes keep up withchanges to the law that need to be included in them?


You should have attempted an analysis of the market from the perspective of the five forces that togetherdetermine the degree of competition in it: buyers' and suppliers' bargaining power, the threat of substitutesand potential market entrants, and the number and power of industry competitors. If you selected onebusiness in a market such as fashion clothing then you will quickly have realised that it is highly competitive.There are relatively low barriers to entry and a very high level of substitutes available, so price competitionis intense. Customers are notoriously fickle and have strong bargaining power, though suppliers often haveless power so the industry is able to push costs lower all the time.


Each of these options is a way of organising the activities of buying, cooking and serving food in a way thatcustomers will value.

(a) It can become more efficient, by automating the production of food, as in a fast food chain.

(b) The chef can develop commercial relationships with growers, so he or she can obtain the best qualityfresh produce at a good price.

(c) The chef can specialise in a particular type of cuisine (e.g. Nepalese, Korean).

(d) The restaurant can be sumptuously decorated for those customers who value 'atmosphere' and asense of occasion in addition to a restaurant's purely gastronomic pleasures.

(e) The restaurant can serve a particular type of customer (e.g. celebrities).


You should have answered this question by using SWOT analysis in terms of your strengths andweaknesses, and the opportunities and threats that face you. It should naturally have led you ontoconsidering how you can overcome your weaknesses and build on your strengths. It should have made youthink about whether you know enough about where the opportunities for doing what you want with yourcareer really lie, and about what potential threats to these may lie ahead.


Contents

Introduction

Examination context

Topic list

1 Introduction to risk

2 Risks for businesses and their investors

3 Types of risk

4 Risk concepts

5 The objectives of risk management

6 The risk management process

7 Crisis management

8 Disaster recovery




chapter 5

Introduction to riskmanagement



Introduction


Identify the main components of the risk management process

Show how the main components of the risk management process operate

Identify the key issues in relation to risk and crisis management

Specific syllabus references are: 1h, i.


The effective management of risk is a key task in any business and accountants can get heavily involved inthe process of identifying, measuring and monitoring risk. Whether a business thrives or fades isdetermined at least in part by how it manages the risks that things may go wrong, and how far it exploits itsopportunities, that is that things will go well. Risk management is, therefore, not merely a defensive attemptto avoid losses; it is integral to seeking and exploiting competitive advantage. In addition, effective riskevaluation and management is increasingly becoming a regulatory requirement.

Stop and think

What does the term 'risk' mean to you? Have you considered how you manage the risks that worry youmost in your life? Do you just accept that we all have to live with risk or do you try to find ways tominimise how much you would suffer if a perceived risk actually happened? These are the issues that facebusinesses as well.

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill begin to see the ways in which risk management is integrated into their operations. Risk is also animportant issue in planning audit engagements.

Syllabus links

The topics covered in this introduction to risk management are developed as well in Assurance, in Auditand Assurance, in Business Strategy and in Financial Management at Professional stage, and in the Advancedstage.

INTRODUCTION TO RISK MANAGEMENT


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Examination context


Questions on risk management could easily appear in the exam.

Exam requirements

Questions are likely to be set in a scenario context. Knowledge-type questions are also likely, set onparticular principles or definitions.



1 Introduction to risk

Section overview

Risk means that something can turn out differently to what you expected, or wanted.

Risk exists in any situation, while uncertainty arises only because there is inadequate information.

Pure risk is the possibility that something will go wrong, and speculative risk is the possibility that itwill go well.

Downside or pure risk represents a threat: things may turn out worse than expected.

Upside or speculative risk represents an opportunity: things may turn out better than expected.

1.1 What is risk?

You know what risk is in everyday terms. You know it is risky to climb a tall ladder, no matter what youmay think there is at the top. You know it is risky to bet your life savings on a horse race, no matter howmuch you might win.

These things are risky because at the point when you decide to do them you cannot be sure how bad theoutcome will be. You may fall off the ladder and injure yourself when you are half-way up. The horse youback may be beaten at the winning post.

On the other hand, you cannot be sure how good the outcome may be, either: you cannot be sure thatthe opportunities won't ever amount to anything. If you don't risk climbing the ladder you will never bethe owner of whatever it is at the top. Most people would think it is too risky to throw away their lifesavings on a race, but there is always the chance that your horse will win. If you don't place the bet youwill miss the opportunity.

Risks and opportunities exist because nobody knows what will happen in the future, and nobody cancontrol it. Of course you can control whether or not you climb the ladder, but you cannot stop othersfrom doing so, and you cannot stop entirely unexpected things from happening.

These issues can be summarised in the following definition of risk.

Definition

Risk: The possible variation in an outcome from what is expected to happen.

We can break this definition down to highlight the following issues to do with risk:

Variability: events in the future cannot be predicted with certainty Expectation: we expect something to happen, or perhaps hope that it will not happen Outcomes: this is what actually happens compared with what is intended or expected to happen

1.2 What is uncertainty?

Risk and uncertainty are not the same things:

Risk (the possibility of variation) exists in any situation Uncertainty arises only because we are ignorant of all the facts: we lack information

Definition

Uncertainty: The inability to predict the outcome from an activity due to a lack of information.



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You can never avoid this uncertainty, in anything you do: it is something that you have to make decisionsabout, or something you need to manage. If you decide to take a risk, or follow up an opportunity, theoutcome may be hugely beneficial – or it may ruin you.

1.3 What are upside and downside risks?

Because events could turn out either better or worse than expected, sometimes we refer to two-way riskor symmetrical risk.

The risk that something will go wrong is called 'downside risk’, if it is likely that things will go right theterm 'upside risk' is used.

1.4 How far does risk affect a business achieving its objectives?

When considering whether a business will be successful and achieve its objectives, the term 'pure risk'describes the possibility that something will go wrong, speculative risk is the possibility that somethingcould go better than expected (though it could go worse). If we all focused on pure risk then there wouldbe little point in taking a risk; the fact that something could go well is the basis on which business flourishes.

It is helpful for businesses to think about risk in the context of managing events with an eye onachieving objectives. This has long been the objective of COSO, an international organisation dedicatedto improving the quality of financial reporting through business ethics, effective internal controls andcorporate governance. Here are the definitions given in the COSO Enterprise Risk Management Framework(2004).

Definitions

Risk: The possibility that an event will occur and adversely affect the achievement of objectives.

Opportunity: The possibility that an event will occur and positively affect the achievement of objectives.

In this chapter we shall be concentrating on risk as defined by COSO.

2 Risks for businesses and their investors

Section overview

Risks for a business include poor market conditions, poor control and poor outcomes ofinvestments. Often businesses look particularly at the risks that they will fail to achieve their criticalsuccess factors (CSFs). How far the business is prepared to take on these risks is a measure of itsrisk appetite.

The risk to those who finance the business (owners and lenders) is that they will suffer poor ratherthan high returns on their investment.

Both businesses and financiers have particular attitudes to the level of risk they are prepared toendure: risk averse, risk neutral and risk seeking.

2.1 Risks for the business

If the objective of a business is to maximise shareholder value then risks for the business are risks oflosses, resulting (directly or indirectly) in negative cash flows. When losses become severe, there might bea risk of insolvency, leading to the liquidation of the business.



The activities of certain businesses are inherently risky because they are potentially dangerous to publicwell-being: transport and pharmaceutical businesses are obvious examples.

The risks faced by businesses in general are as follows.

There are risks that trade conditions might be poor, and sales might fall or costs might rise.A new product launch might be unsuccessful, or an expensive research and development project mightfail to produce a new commercial product

There is a risk that inadequate controls (quality controls, administrative controls, controls overpeople etc) within the business may result in losses through inefficiency, damage to businessreputation, or deliberate fraud

A business might face risks of a financial nature, and losses might occur because of the way it hasfinanced an operation

The larger the business, the more varied are the risks.

Interactive question 1: Business risk [Difficulty level: Intermediate]

Try to identify a small business with which you have some familiarity, such as an audit client or one youhave worked for in a vacation. What risks does the business, as opposed to its owner(s), face?


2.2 Risks for investors

Lenders have to bear the risk that the business will default on its debt obligations, and fail to make aninterest payment or even become insolvent and be unable to repay the loan principal. A lender will expect ahigher return than that offered on, say, Government gilts (commonly taken to be a risk-free investment), tocompensate for the added risk.

Shareholders are the ultimate bearers of risk. If a company becomes insolvent, they will lose all theirinvestment. More important, if company profits fall, dividends and the share price are also likely to fall.Lenders are entitled to interest before any profits can be paid as dividend, so that the risk to income ismuch less for lenders than for equity shareholders.

Risk for shareholders is two-way: there is the possibility of poor returns (no dividends or low dividends,and a fall in the share price), or profits and dividends might be higher than expected, and the share pricemight rise by more than anticipated. Risk is greater for shareholders when there is a greater possibility ofwide variations in profits, dividends and share prices from year to year. The range of potential variation inreturns is known as the volatility of returns.

2.3 Risk and strategic planning

In the strategic planning analysis process it is important to focus on risks that are specific to the business, orthe industry sector in which it operates, rather than general ones. They should be mapped to the relevantthreats and opportunities that they represent to the business. A plan for managing each specific risk canthen be formulated.

It is often useful to relate risks to the business's critical success factors (CSFs) (which we saw in Chapter 1).A significant risk is one that would create an obstacle to any of the CSFs.

2.3.1 Risk appetite

Not all risk is bad, and returns are generally higher for higher-risk projects. As part of the planning process,the business needs to decide what its 'appetite' for risk is, and apply this in choosing appropriate strategies.



5

Definition

Risk appetite: The extent to which a business is prepared to take on risks in order to achieve itsobjectives.

The approach should be as follows.

1 Decide what the business wants to achieve (the strategic objective).

2 Decide what the business's 'risk appetite' is, in other words the extent to which it is prepared totake on risks in order to achieve its objectives.

3 Find strategies to achieve the objectives that do not involve more risk than the business is willing toaccept.

4 If there are no methods of reducing the risk to an acceptable level, the objectives need to be amended.

2.3.2 Attitudes to risk

A risk averse attitudeError! Bookmark not defined. is that an investment would be chosen if ithas a more certain but possibly lower return than an alternative less certain, potentially higher returninvestment.

A risk neutral attitudeError! Bookmark not defined. is that an investment would be chosenaccording to its expected return, irrespective of the risk.

A risk seeking attitudeError! Bookmark not defined. is that an investment would be chosen onthe basis of it offering higher levels of risk, even if its expected return is lower than an alternative no-risk investment with a higher expected return.

2.3.3 Expected returns

When a business looks at an investment it has to judge what return is expected from it. For instance, aninvestment of CU100,000 at a rate of 5% has an expected return of CU5,000.

When the business starts considering risk in relation to an investment it is also likely to derive a range ofpossible returns from the investment, given best-case, worst case and most likely scenarios. These can becombined in a weighted average to give the overall expected return.

Worked example: Expected return

Jack Ltd has the opportunity to invest CU100,000 in a project. The project manager has estimated threescenarios for the project’s annual return, and the related returns and probabilities:

Probability of Annual returnscenario occurring under the scenario

CUWorst case scenario 0.3 2,000Most likely scenario 0.6 5,000Best case scenario 0.1 10,000

The expected return for the project can be calculated using a weighted average:

Annual return Expected returnProbability under the scenario (probability x return)

CU CUWorst case scenario 0.3 2,000 600Most likely scenario 0.6 5,000 3,000Best case scenario 0.1 10,000 1,000Expected return 4,600



Note that the expected return of CU4,600 is not actually predicted as a return; it is used instead as anoverall measure of the investment for decision making and risk evaluation purposes.

3 Types of riskError! Bookmark not defined.

Section overview

Risk is either business risk or non-business risk.

Business risks arise from the business's nature, operations and environment.

Business risks are: strategy, enterprise, product, economic, technology and property risks.

Non-business risks are any other type of risk: financial (credit and market risk) and operational(process, people, systems, legal and (single) event risks).

3.1 Risk classifications

There are several ways in which risks can be classified according to their source or characteristics as shownin Figure 5.1. The main distinction is between business and non-business (financial and operational) risk.

Risk

Business risk

Strategy Enterprise Product Economic Technology Property

Non-business risk

Financial risk Operational risk

Credit OR Liquidity Market Gearing

Default Credit Foreign exchange Interest rate Market

Process People Systems Legal

Event risk

Physical Disaster Social Regulatory OR Political Reputation Legal Systemic Economic

Operating

Figure 5.1 Risk classifications

3.2 Business riskError! Bookmark not defined.

Business risk arises from the nature of the business, its operations and the conditions it operates in. Itincludes:

Strategy riskError! Bookmark not defined.: the risk of choosing the wrong corporate businessor functional strategy



5

Enterprise riskError! Bookmark not defined.: the success or failure of a business operation andwhether it should have been undertaken in the first place

Product riskError! Bookmark not defined.: the chance that customers will not buy thecompany's products or services in the expected quantities

Economic riskError! Bookmark not defined.: the effect of unexpected changing economicconditions

Technology riskError! Bookmark not defined.: the risk that the market or industry is affectedby some change in production or delivery technology

Property riskError! Bookmark not defined.: the risk of loss of property or losses arising fromaccidents

3.3 Non-business risk

Non-business risk is any other type of risk, usually classified as financial risk and operational risk (orevent risks).

3.3.1 Financial risk

Lam, in Enterprise Risk Management, divides financial risk into credit risk and market risk.

Credit riskError! Bookmark not defined. is 'the economic loss suffered due to the default of aborrower, customer or supplier'. In other words it is the risk that customers or borrowers will notpay, or will not pay quickly enough, or that suppliers will cease to supply.

Market riskError! Bookmark not defined. is 'the exposure to potential loss that would resultfrom changes in market prices or rates', which might include share prices, commodity prices, interestrates and foreign exchange rates.

Another way of breaking down financial risk is to look in more detail at the sources of risk that are externalto the business, including:

Liquidity risk: an unexpected shortage of cash

Gearing risk: high borrowing in relation to the amount of shareholders' capital in the business,increasing the risk of volatility in earnings, and insolvency

Default risk: debtors of the business fail to pay what they owe in full and on time

Credit risk: the company's credit rating is downgraded

Foreign exchange risk: making unexpected gains or losses from changes in a foreign exchange rate

Interest rate risk: unexpected change in interest rates placing the business at a financial disadvantage

Market risk: an adverse movement in share market prices

3.3.2 Operational risk

Operational risk is possibly best regarded as all non-business risks faced by a business that are notfinancial risks, but this is an enormously broad definition. We could define it instead in terms of whatcauses it.

Definition

Operational risk: 'The risk of direct or indirect loss resulting from inadequate or failed internalprocesses, people and systems or from external events, including legal risks'. (Basel Committee onBanking Supervision).



Process risk is the risk that a business's processes may be ineffective (fail to achieve theirobjectives) or inefficient (achieve their objectives but at excessive cost).

People risk is the risk arising from staff constraints (for example insufficient staff, or inability to paygood enough wages to attract the right quality of staff), incompetence, dishonesty, or a corporateculture that does not cultivate risk awareness, or encourages profits without regard to the methodsused to make them.

Systems risk is a term that is usually used in the sense of the risks arising from information andcommunication systems such as systems capacity and availability, data integrity, and unauthorisedaccess and use. IT is so central to almost all businesses that it certainly merits a category to itself.

Legal risk is the risk of loss from the fact that a contract cannot be legally enforced. It arises throughuncertainty in laws, regulations and legal actions. Sources of legal risk include enforceability issues aswell as exposure to unanticipated changes in laws and regulations.

Event risk is the risk of loss due to single events that are unlikely but may have seriousconsequences. Natural or man-made disasters are the most obvious examples of event risk. Thesemay include:

– Disaster risk: a catastrophe occurs, such as fire, flood, ill health or death of key people,terrorism and so on

– Regulatory risk: new laws or regulations are introduced, affecting the business's operations andprofitability

– Reputation risk: the business's activities damage its reputation in the eyes of stakeholders.

– Systemic risk: failure by a participant in the business's supply chain or system to meet itscontractual obligations, so the system itself is at risk

Another way of classifying event risks is according to their sources in the external environment:

Physical risks: such as climate and geology

Social risks: changes in tastes, attitudes and demography

Political risks: changes determined by government, or by a change of government

Legal risks: changes in legislation and regulations, including the consequences of breaking the law orotherwise failing to meet legal duties or obligations

Economic risks: changing economic conditions

Operating environment risks: technological changes

4 Risk concepts

Section overview

How big a risk a business is facing is measured in terms of exposure, volatility, impact andprobability.

The scale of any risk for a business depends upon four key risk concepts.

ExposureError! Bookmark not defined. is the measure of the way in which a business is faced byrisks. Some businesses will by their very nature be less exposed than others. A transport companysuch as an airline or a railway operator is considerably more exposed to the operational risk that itscustomers will be injured whilst using its services than is a bank or a firm of accountants. A businessthat has minimal debt finance and no overseas customers or suppliers has little or no exposure to thefinancial risks of either interest rate movements or exchange rate movements.

VolatilityError! Bookmark not defined. is how the factor to which a business is exposed is likelyto alter. A coffee producer is dependent on good weather; businesses like fashion and music aresubject to changes in public taste. Some businesses operate in regions that are politically unstable.



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ImpactError! Bookmark not defined. refers to measures of the amount of the loss if theundesired outcome occurs. Impact might be measured purely in financial terms, or in terms of delay,injuries/loss of life or other ways depending on the type of risk.

ProbabilityError! Bookmark not defined. means how likely it is that a particular outcome willoccur. In some cases it is possible to estimate probability on the basis of past experience (historicalrecords) combined with information about all the variables involved and how they interact. In othersit is much harder to estimate probability because no historical data exists. The development of anentirely new product is an example.

The greatest risks facing a business will arise when:

Exposure is high The underlying factor is volatile The impact is severe, and The probability of occurrence is high

Different combinations of these four risk concepts result in different levels of response from the business.

5 The objectives of risk management

Section overview

Risk management involves identifying, analysing and controlling those risks that threaten the assetsor earning capacity of the business so as to reduce the business's exposure by either reducing theprobability or limiting the impact, or both.

5.1 What is risk management?

Definition

Risk management: The identification, analysis and economic control of risks which threaten the assets orearning capacity of a business.

Risk management is actively used by many businesses, some of which employ risk managers. Smallerbusinesses and individuals may not recognise a specific task of risk management but will nevertheless havedeveloped their own methods of analysing and managing risk.

The purpose of risk management is to understand and then to minimise cost-effectively the business'sexposure to risk and the adverse effect of risks, by:

Reducing the probability of risks occurring in the first place, and then if they do occur Limiting the impact they will have on the business

5.2 When is risk management necessary?

There may be legal requirements to manage risk: you are required by law to insure your car, forinstance

Risk management (in the form of insurance) may be required by licensing authorities andregulatory bodies.

Financial organisations may require risk management: if you have a mortgage your lender no doubtrequires you to have buildings insurance to protect its security



Interactive question 2: Risk management [Difficulty level: Intermediate]

How does business risk management work?


Listed companies in Bangladesh are compelled to manage risk – or at least to disclose to shareholders theextent to which they have considered the risks facing their business.

A risk-based management approach is a requirement for all listed financial institutions under theBangladesh Bank Act. The Act includes guidelines on the management of risk.

A risk-based management approach is a requirement for all UK listed companies under theCombined Code on Corporate Governance 2006. The Code includes guidelines on themanagement of risk.

Listed companies in the US have to comply with the Sarbanes-Oxley Act 2002. This requires thatannual reports should contain internal control reports that state the responsibility of management forestablishing and maintaining an adequate internal control structure and procedures for financialreporting. Annual reports should also contain an assessment of the effectiveness of the internalcontrol structure and procedures for financial reporting. Auditors should report on this assessment.We shall see more about this in Chapter 15.

6 The risk management process

Section overview

Risk management involves identifying risk, assessing and measuring it in terms of exposure, volatility,impact and probability, controlling it by means of avoidance, transfer and reduction, accepting whatremains and then monitoring and reporting on events.

Risks can be identified by considering what losses would ensue: property, liability, personnel,pecuniary and interruption loss.

Once identified, the gross risk is measured by multiplying its probability (a value between 0 and 1)by the impact (the value of the loss that would arise). The aim of risk management is to minimisegross risk.

Some risk can be avoided by not doing the risky activity, and some can be reduced by takingprecautionary measures. Some of what remains of the gross risk can be transferred to someoneelse, especially by insurance. The remaining gross risk must be accepted or retained.

All the elements of the risk management process must be monitored and reported on to anappropriate person.



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6.1 What is involved in the risk management process?

Sharing

Reduction

Avoidance

Awareness andidentification

Analysis: assessmentand measurement

Response and control

Monitoring and reporting

Acceptance

Figure 5.2: Risk management process

Risk awareness and identification, using techniques such as brainstorming and analysis of pastexperience to identify the business's exposure to risks.

Risk analysis (assessment and measurement): this considers the volatility of particular factors,the probability of an event occurring and the severity of the impact if it does. Measurement may bequalitative or quantitative.

Risk response and control: in essence a risk can be avoided (do not do the risky activity), reduced(e.g. by strictly controlling processes), shared (e.g. with an insurer) or simply accepted.

Risk monitoring and reporting is a continuous process.

We shall look at each element of the risk management process in turn.

6.2 Risk awareness and identification

Risk awareness is partly a state of mind, but it is also dependent on how well the matter underconsideration is understood.

Suppose a business was considering launching a new product in China but knew absolutely nothing aboutdoing business in China. It is highly likely that it will not be aware of the many risks to which the businesscould be exposed because of factors such as different regulations, different ways of approaching customers,differences in disposable income and so on. The risks remain to be identified.

Definition

Risk identification: Identifying the whole range of possible risks and the likelihood of losses occurring as aresult of these risks.

Risk identification must be a continuous process, based on awareness and knowledge that:

Potential new risks may arise Existing risks may change

Exposure to both new and altered risks must be identified quickly and managed appropriately.



There are two approaches to identifying risks, which operate most effectively when combined.

A top-down approach is led by the senior management/board of the business, spending time onattempting to identify key risks. Often, this is linked to the business's CSFs: What might happen toprevent us from achieving each CSF?

A bottom-up approach involves a group of employees, with an expert in risk management, workingtogether to identify risks at the operational level upwards

Categories of loss:

Property loss – possible loss, theft or damage of any static or moveable assets

Liability loss – loss occurring from legal liability to third parties, personal injury or damage toproperty

Personnel loss – due to injury, sickness or death of employees

Pecuniary loss – as a result of defaulting debtors

Interruption loss – a business being unable to operate due to one of the other types of loss occurring

Identifying too many risks can make the risk management process overly complex. The business shouldfocus its efforts on significant risks: those that are potentially damaging to the business's value.

6.3 Risk analysis: assessment and measurement

After risks have been identified, there should be a process of judging whether each risk is serious, andwhich risks are more serious than others.

Definition

Risk assessment: For each risk its nature is considered, and the implications it might have for thebusiness; an initial judgement is then made about the seriousness of the risk.

An aim of risk assessment should be to identify those risks that have the greatest significance, and so shouldreceive the closest management attention.

Each risk can be assessed and graded from two aspects:

Its potential impact Its probability of occurrence

The total potential losses arising as a result of the risk depend on both impact and probability. The term'gross risk' refers to the combination of the impact and the probability of the risk, before taking anycontrol measures into account.

In Chapter 13 we shall look at corporate governance under a risk assessment relevant to large listedcompanies in Bangladesh (the Turnbull Guidance).

Definition

Risk measurement: Identifying the probability of the risk occurring, and quantifying the resultantimpact by calculating the amount of the potential loss using expected values for gross risk.

Probability is measured mathematically, as a decimal between 0 and 1

ImpactError! Bookmark not defined. is quantified using expected values, usually using weightedaverages as we saw earlier in relation to expected returns

Expected value = Probability × Amount of loss



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6.4 Risk response and control

Measurement (qualitative or quantitative) and assessment establish priorities that determine the amount ofmanagement time that should be spent developing and implementing a response to control any particularrisk: obviously, risks with a high impact and a high probability should be considered first.

In the order in which they should be considered the possible responses to a risk, so as to confront it, areas follows.

AvoidanceError! Bookmark not defined.: not doing the risky activity. This may not be an option,but the first question should always be 'Do we need to do this risky activity at all?'

ReductionError! Bookmark not defined.: doing the activity, but using whatever means areavailable to ensure that the probability of the event occurring and the impact if it does are as small aspossible

Sharing: for example taking out insurance against the risk, but only after every effort has beenmade to reduce it, so that insurance premiums are kept as low as possible. Another sharing strategymight be to enter an agreement with one or more other companies (joint ventures, outsourcingarrangements and partnerships with suppliers are all examples). Hedging is a means of sharing marketrisk. Risk sharing is sometimes called risk transfer, but it is rare to be able to transfer all the risk.

Acceptance (sometimes called retention): this should only be considered if the other options arenot viable, for example if the costs of extra control activities and the costs of insuring against the riskare greater than the cost of the losses that will occur if the event happens. The concept ofmateriality should apply: immaterial risks can be accepted. Nevertheless, risks that have beenaccepted should still be kept under review: new developments may mean that a different responsebecomes more appropriate.

6.5 Monitoring and reporting riskError! Bookmark not defined.

Monitoring riskError! Bookmark not defined. should be a continuous, ongoing process, such that if arisky event does occur then the action taken should include an immediate review of the management ofthat risk, followed by changes as necessary. In this sense 'monitoring' is a form of control.

Has corrective action now been taken? Has it been effective?

Was the risk identified in the first place, and if not why not?

If the risk was identified and planned for but the event still occurred is it because early warningindicators were not monitored?

If the response and/or controls were ineffective what changes or new procedures are necessary?

All identified risk management problems that could affect the organisation's ability to achieve its objectivesshould be reported to those in a position to take necessary action.

The chief executive regarding serious problems. Senior managers regarding risk management problems that affect their units. Managers in increasing levels of detail as the process moves down the organisational structure.

A board of directors or audit committee, for example, may ask to be made aware only of problems thatmeet a specified threshold of seriousness or importance.

Banking companies as per Bangladesh Bank regulation have particular requirements as to managing andreporting risk management issues.



7 Crisis management

Section overview

Crisis management involves identifying a crisis and planning a response to it. Three main types of crisis are financial, public relations and strategic. Businesses need contingency plans to deal with a crisis should it occur.

7.1 What is a crisis?

Definition

CrisisError! Bookmark not defined.: An unexpected event that threatens the wellbeing of a business, or asignificant disruption to the business and its normal operations which impacts on its customers, employees,investors and other stakeholders.

Crises can be fairly predictable and quantifiable, or totally unexpected.

7.2 What is crisis management?

Definition

Crisis managementError! Bookmark not defined.: Identifying a crisis, planning a response to the crisisand confronting and resolving the crisis.

Crisis management is much more commonly used in businesses now:

Crises such as natural disasters and terrorism have been seen to have an even more extreme effect inthe context of global trade, so businesses are more motivated to manage crises better

Society is more litigious than it used to be, and businesses are expected to be able to deal better withcrises now than in the past

Better IT and other technology systems allow businesses to be able to do more to avert and/ormanage a crisis

7.3 Types of crisis

There are three main types of crisis in terms of their effects on the business:

Financial crisis – short-term liquidity or cash flow problems, and long-term insolvency problems

Public relations crisis – negative publicity that could adversely affect the success of the business

Strategic crisis – changes in the business environment that call the viability of the business intoquestion, such as new technology making old products or processes obsolete

There are many types of crisis in terms of their cause.

Natural event: physical, especially environmental, destruction due to natural causes such asearthquake

Industrial accident: buildings collapse, fire, release of toxic fumes, sinking or leaking of a ship

Product or service failure: product recall of faulty or dangerous goods; communications, systemsor machine failure causing massive reduction in capacity; health scare related to the product orindustry

Public relations disaster: pressure group or unwelcome media attention; adverse publicity in themedia; removal/loss/prosecution of CEO or other key management



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Business crisis: sudden strike by workforce; sudden collapse of key supplier; withdrawal of supportby major customer; competitor launches new product; sudden shortfall in demand

Management crisis: hostile takeover bid; death of key management; managers poached by maincompetitor; boardroom battles

Legal/regulatory crisis: product liability; new regulations increase costs or remove competitiveedge; employee or other fraud

Worked example: Industrial accident

In 2005 the oil storage depot at Buncefield, Hemel Hempstead suffered a major explosion and fire. Theresult was:

Loss of product Significant loss of capacity Disruption to supplies Loss of business Physical damage to neighbouring houses and commercial premises Environmental damage Damage to reputation Claims for compensation Legal action

Worked example: Public relations disaster

In 1991 Gerald Ratner, head of the chain of high street jewellers that bore his name, explained why hisproducts were so inexpensive. He said that a product sold in his shop was cheap because it was 'totalrubbish'. He 'sold a pair of earrings for under CU1, which was cheaper than a prawn sandwich, but probablywouldn't last as long'. The result: share values fell substantially, Mr Ratner left the company and it was sold.

7.4 Managing a crisis

A crisis happens when a risk becomes a reality. The business should seek to prevent crises, and to havecontingency plans should a crisis occur. It should also act to resolve an actual crisis in the most effectiveway.

7.4.1 Crisis prevention

The business should always seek to prevent a crisis by planning ahead and projecting likelyoutcomes; it should avoid decisions that have the potential to turn into a crisis.

7.4.2 Contingency planning

The business should make a contingency plan for the worst and/or most likely crises to occur. This mustbe kept up to date, and staff should be trained in how it should be implemented in the event of a crisis.

7.4.3 Effective action in the event of a crisis

Assess objectively the cause(s) of the crisis Determine whether the cause(s) will have a long-term or short-term effect Project the most likely course of events Focus resources on activities that mitigate or eliminate the crisis Look for opportunities



In the event of a public relations crisis

Act immediately to prevent or counter the spread of negative information; this may require intensemedia activities.

Use media to provide a counter-argument or question the credibility of the original negative publicity.

Interactive question 3: Contingency planning [Difficulty level: Intermediate]

Consider what you would do if, at a time when your business has a small overdraft and very little moneyexpected in shortly, it is faced with a large demand from a government body which requires settlement inone month.

See Answer at the end of the chapter.

8 Disaster recovery

Section overview

A disaster is a major crisis or event which causes a breakdown in the business's operations andresultant losses.

A business needs to recover from a disaster as quickly as possible. This is helped if the business hasa disaster recovery plan covering standby and recovery procedures and personnel management.

8.1 What is a disaster?

Definition

Disaster: The business's operations, or a significant part of them, break down for some reason, leading topotential losses of equipment, data or funds.

We have seen that event risk is the operational risk of loss due to single events that are unlikely but thatmay have serious consequences. Political risk is one example and is often associated especially with lessdeveloped countries where events such as wars or military coups may result in an industry or a businessbeing taken over by the government and having its assets seized.

Here are some examples, along with some responses and controls, based on reduction and sharing of therisk of the disaster where it cannot be avoided.

A fire safety plan is an essential feature of security procedures, in order to prevent fire, detect fireand put out the fire. Fire safety includes:

– Site preparation (for example, appropriate building materials, fire doors)– Detection (for example, smoke detectors)– Extinguishing (for example, sprinklers)– Training for staff in observing fire safety procedures

Flooding and water damage can be countered by the use of waterproof ceilings and floorstogether with the provision of adequate drainage.



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Keeping up maintenance programmes can counter the leaking roofs or dripping pipes that result fromadverse weather conditions. The problems caused by power surges resulting from lightning can becountered by the use of uninterruptible (protected) power supplies. This will protect equipmentfrom fluctuations in the supply. Power failure can be protected against by the use of a separategenerator.

Threats from terrorism can be countered by physical access controls and consultation with policeand fire authorities.

Accidental damage can be avoided by sensible attitudes to behaviour while at work and goodlayout of workspaces.

Any system which has suffered a disaster must recover as soon as possible so that further losses arenot incurred, and current losses can be rectified.

What is considered a disaster is relative to the size of the business and the significance of the item thatbreaks down. The failure of a hard drive in a single PC could be extremely serious for a small businesswhich depended on that one computer, but in a large business it might cause minimal inconvenience, solong as backup copies of data files are maintained.

Minor breakdowns occur regularly and require short term recovery plans such as agreements with amaintenance company for same or next-day on site repairs. Disasters which result in the destruction of amajor facility or installation require a long-term plan.

A long-term disaster recovery planError! Bookmark not defined. will typically provide for:

Standby procedures so that some operations can be performed while normal services are disrupted

Recovery procedures once the cause of the breakdown has been discovered or corrected

Personnel management policies to ensure that the above are implemented properly

The plan must cover all activities from the initial response to the disaster (crisis management), through todamage limitation and full recovery. Responsibilities must be clearly spelt out for all tasks. Thecontents of the plan will include the following.

Section Comment

Definition of responsibilities It is important that somebody (a manager or co-ordinator) is designatedto take control in a crisis. This individual can then delegate specific tasksor responsibilities to other designated people.

Priorities Limited resources may be available for processing. Some tasks are moreimportant than others. These must be established in advance. Similarly,the recovery plan may indicate that certain areas must be tackled first.

Backup and standbyarrangementsError!Bookmark not defined.

These may be with other installations, or with a business that providessuch services (e.g. maybe the hardware vendor). Alternatively, otherprocesses may be possible, for instance taking cash when credit/debitcard processing is interrupted.

Communication with staff The problems of a disaster can be compounded by poor communicationbetween members of staff.

Public relations If the disaster has a public impact, the recovery team may come underpressure from the public or from the media.

Risk assessment Some way must be found of assessing the particular requirements of theproblem.




Summary

The future is uncertain

Positive event may occur= OPPORTUNITY

Adverse event may occur= RISK

Faced bybusiness

Faced byinvestor

Critical success factors

Strategic planningChapter 4

Riskappetite

Attitude to risk– Risk-averse

– Risk-neutral

– Risk-seeking

Classifying risksee Fig 5.1

Risk concepts– Volatility

– Exposure

– Impact

– Probability

Risk managementAim to: minimise

limit

reduce

Risk managementprocess

– see Fig 5.2Crisis

Crisismanagement– Contingency

planning

– Prevention

– Action

DisasterRecovery plan

Causes

Effects

Occurs

Severe

EITHER OR



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Self-test


1 Which of the following is COSO's definition of risk?

A That events in the future cannot be predicted with certaintyB The possible variation in an outcome from what is expected to happenC The inability to predict the outcome of an activity due to a lack of informationD The possibility that an event will occur and adversely affect the achievement of objectives

2 Which of the following is a downside risk for a business?

A That costs might riseB That revenue might riseC That controls may succeedD That quality might improve

3 Benbuck Ltd has had a wide range of returns to shareholders in recent years. This means that as aninvestment Benbuck Ltd shares are

A Volatile and low riskB Non-volatile and low riskC Volatile and high riskD Non-volatile and high risk

4 Strang Ltd has identified that the new production machinery in which it is considering an investmentmay soon become obsolete on the grounds of low productivity. This business risk could be identifiedas

A A product riskB A technology riskC An enterprise riskD A property risk

5 Mimso Bank Ltd's staff appear to be oblivious to the importance of risk. For Mimso Bank Ltd this is

A A business riskB An enterprise riskC A financial riskD An operational risk

6 The size of a risk facing a business is measured as

A Volatility exposure

B Impact exposure

C Impact probability

D Volatility probability

7 In terms of risk management, choosing to transfer some risk is part of

A Risk awarenessB Risk responseC Risk assessmentD Risk monitoring

8 Brando Ltd has 40 employees engaged in an activity that has been identified as having a high element ofrisk to the company's reputation. The company decides that the activity is necessary but that only 10staff should be engaged in it in future, and these staff should receive extra training. The risk responsesthat Brando Ltd has applied are

A Avoidance and reductionB Transfer and acceptanceC Reduction and acceptanceD Avoidance and transfer



9 Heller & Co is a firm of solicitors which has long been aware that the departure of one partner, MikeHeller, would constitute a crisis for the firm. It has therefore ensured that he is highly paid and thatSue Jones, another partner, shadows his work and knows his clients. On 15 June Mike walks out of thefirm and provokes a serious crisis which the firm's very expensive PR consultants handle. The area ofcrisis management which Heller & Co has neglected to address in their management of the crisis is

A Crisis preventionB Contingency planningC Analysis of the causes of Mike's actions on 15 JuneD Taking action to mitigate the crisis

10 Klib Ltd operates in a politically unstable country. It has arranged that a consultancy firm with accessto similar facilities as Klib Ltd has a complete set of backup files for Klib Ltd. This strategy is part ofKlib Ltd's

A Risk managementB Crisis managementC Disaster recovery planningD Operational planning



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1 D Option A describes variability, option B is not COSO's definition and option C definesuncertainty

2 A All the other options are upside risks

3 C Volatility measures the variation of returns in terms of profits, dividends and share prices; themore volatile the return, the higher the risk

4 B

5 D This is a people risk, which is a kind of operational, non-business risk

6 C

7 B

8 A Reducing the number of staff is a form of avoidance; training the remaining ones is a form ofrisk reduction

9 C

10 C





For many small businesses the most evident risk is that customers do not buy what they supply, whetherbecause of competition, fashion or an economic downturn. This is also the risk that is most difficult to dealwith, though being well-informed and innovative help to ensure that the business can react adequately.There is a real risk too that the costs of providing the goods or service will rise, which again is hard tocontend with as the business may have little or no bargaining power. The risks from inadequate controls areless likely though more catastrophic; most small business owners are very closely involved in the running ofit and keep close control of quality, administration and staff, but there are plenty of businesses which havegone under due to one fraud, or one lapse of quality. Finance is also a serious risk; bank overdrafts can becalled in on demand, and cash flow has often caused very severe problems, even winding up, in otherwisesuccessful businesses.


Businesses develop and implement a system of identification and understanding of the possible risks thebusiness is exposed to and then minimize cost-effectively the business’s exposure to risk and the adverseeffect of risks by:

Reducing the probability of risks occurring in the first place, and then if they do occur

Limiting the impact they will have on the business


You should not wait for further evidence before acting. Immediately take action to maintain or increasecash flow:

Accelerate receipts from customers even if this requires the granting of discounts

Decelerate payments to suppliers even if this means losing discounts

Increase short-term sales but maintain or increase margins on sales if possible

Reduce expenses:

– eliminate non-essential expenses– sell surplus long-term assets– reduce payroll if possible– renegotiate the overdraft and other debts

Contents

chapter 6

Introduction to financialinformation

Introduction

Examination context

Topic list

1 Why is business finance important?

2 Uses and types of financial information

3 Qualities of good information

4 Sources of data and information

5 Information processing

6 Security

7 Users of financial information and theirinformation needs

8 Limitations of financial information inmeeting users' needs

9 The effects of poor financialinformation







Introduction


Specify the extent to which financial information:

– Provides for accountability of management to shareholders and other stakeholders

– Reflects business performance

– Is useful to users in making economic decisions

– Meets the information needs of national, social and economic contexts (e.g. nationalstatistical information)

Identify, in the context of accounting systems, the issues surrounding:

– Information processing

– Information security

Specify why the management of a business require information about performancemeasurement

Specific syllabus references are: 3a, d, e.


The provision and use of financial information lies at the core of the accountant's work.

Stop and think

It is all too easy just to accept that information on a business's finances is useful. Why is it useful, or rather,what makes it useful? To whom is it useful, and when? Where does it come from, and how should it bekept?

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill see how and why businesses need financial information, and their attitudes towards it.

Syllabus links

The topics covered in this introduction to financial information are developed as well in ManagementInformation, Business Strategy and Financial Management at Professional stage, and in the Advanced stage.

INTRODUCTION TO FINANCIAL INFORMATION


6

Examination context


Questions on financial information could easily appear in the exam.

Exam requirements

Questions are likely to be set in a scenario context. Knowledge-type questions are also likely on particulardefinitions or principles.



1 Why is business finance important?

Section overview

Finance plays a central role in a business, so financial information does as well.

Without money a business could not exist: it could not pay its expenses, it could not acquire inventory, andit could not employ labour. It would not want to exist: businesses exist to make money, that is, a profit. Allbusinesses require a level of finance to get started, and then a balance of money coming in and going out inorder to stay in existence.

We have seen several times so far in this text that a business's finances play an important, indeed, centralrole in what it does.

Most of a business's stakeholders have finance at stake in the business; shareholders and lendersobviously invest directly in the business, but in addition managers' and other employees' personalfinances depend on it, suppliers need to be paid by it, customers depends on it for goods and servicesthat will in turn support their finances, and the government wants tax revenue from it

The primary objective of a business is a financial one: to make money for shareholders (to increasetheir wealth by creating shareholder value)

Finance is a separate function in the organisational structure of most businesses (as we shall see in farmore detail in Chapter 7)

How much finance the business needs and how this can be raised often determine the legal form ittakes

Together with its competitive strategy and its investment strategy, the business's financial strategy iscentral to its overall corporate strategy

Businesses are exposed to financial risks of various kinds and must find ways of managing these risks

Because of the central importance of finance in a business it follows that information on the business'sfinances will be needed.

2 Uses and types of financial information

Section overview

Information on the business's finances is used for planning, controlling, recording transactions,measuring performance and making decisions.

Planning, operational, tactical and strategic information are all required.

2.1 Why do businesses and managers need financial information?

Businesses and managers require financial information for:

Planning Controlling Recording transactions Performance measurement Decision making

2.1.1 Planning

Once a decision has been made, say on what competitive strategy to follow, it is necessary to plan how toimplement the steps necessary to make it effective. Planning requires a knowledge of, among other things,



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available resources, possible time-scales for implementation and the likely outcome under alternativescenarios.

2.1.2 Controlling

Once a plan is implemented, its actual performance must be controlled. Information is required to assesswhether implementation is proceeding as planned or whether there is some unexpected deviationfrom plan. It may consequently be necessary to take some form of corrective action.

2.1.3 Recording transactions

Information about each transaction or event is required for a number of reasons.

Documentation of transactions can be used as evidence in a case of dispute

There may be a legal requirement to record transactions, for example for accounting and auditpurposes

Detailed information on production costs can be built up, allowing a better assessment ofprofitability

The efficiency of labour utilised in providing a particular service can be measured

2.1.4 Performance measurement

Just as individual operations need to be controlled, so overall performance must be measured in order toenable comparisons of the actual outcome with the plan. This may involve collecting information on,for example, costs, revenues, volumes, time-scale and profitability.

2.1.5 Decision making

Information is required as a basis on which to make informed decisions. This completes the full circle of thebusiness management process.

2.2 Type of information

Information can be classified according to the use to which it is put. The same type of information will notbe provided to a front-line manager of a team of machine operatives as to the board of directors. This isbecause the front-line manager needs to know how many operatives can be employed on one shift, forinstance, while the board of directors want to know whether enough skilled operatives can be available inthe medium-term to resource increased production of a successful new product.

Information can thus be classified as follows.

Planning information helps people involved in the planning process

Operational information helps people carry out their day-to-day activities, e.g. how manyoperatives are needed on one shift

Tactical information helps people deal with short-term issues and opportunities, e.g. monthlyvariance reports for the factory

Strategic information supports major long-term decision-making, e.g. can resources be madeavailable to expand production?



3 Qualities of good information

Section overview

Information should be ACCURATE and complete. It should have a benefit that is in proportion toits cost, and it should be targeted at its user. It should be relevant and from an authoritative source.It should be provided at the time when it is needed, and it should be easy to use.

Information of whatever type is of good quality if it has eight key characteristics, which are easiest toremember if you use the mnemonic ACCURATE.

Note that the second A here stands for 'Authoritative', an increasingly important concern given the hugeproliferation of information sources available today.

Quality Example

Accurate Figures should add up, the degree of rounding should be appropriate, thereshould be no typographical errors, items should be allocated to the correctcategory, and assumptions should be stated for uncertain information (nospurious accuracy).

Complete Information should include everything that it needs to include, for exampleexternal data if relevant, or comparative information.

Cost-beneficial It should not cost more to obtain the information than the benefit derived fromhaving it (we shall see more about this in Chapter 7). Providers of informationshould be given efficient means of collecting and analysing it. Presentation shouldbe such that users do not waste time working out what it means.

User-targeted The needs of the user should be borne in mind, for instance senior managersmay require summaries, whereas junior ones may require detail.

Relevant Information that is not needed for a decision should be omitted, no matter how'interesting' it may be.

Authoritative The source of the information should be a reliable one (not, for instance, 'JoeBloggs' Predictions Page' on the internet unless Joe Bloggs is known to be a reliablesource for that type of information).

Timely The information should be available when it is needed.

Easy to use Information should be clearly presented, not excessively long, and sent usingthe right medium and communication channel (e-mail, telephone, hard-copyreport etc).

Interactive question 1: Good information [Difficulty level: Exam standard]

Managers often complain that they are weighed down by information which they struggle to make sense ofand to use. Which of the ACCURATE qualities of good information are most often ignored in informationgiven to managers?




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4 Sources of data and information

Section overview

Useful data/information comes from both inside and outside the organisation, from a variety ofsources.

4.1 What are data and information?

These two terms are often used interchangeably and it is useful at this point to make sure you are clearabout the distinction between them.

Definition

Data (plural; singular is 'datum'): Distinct pieces of information, which can exist in a variety of forms –as numbers or text on pieces of paper, as bits or bytes stored in electronic memory, or as facts stored in aperson's mind.

Information: The output of whatever system is used to process data. This may be a computer system,turning single pieces of data into a report, for instance.

4.2 Internal data sources

Capturing data/information from inside the organisation involves the following.

A system for collecting or measuring transactions data – for example sales, purchases, inventoryetc – which sets out procedures for what data is collected, how frequently, by whom, and by whatmethods, and how it is processed, filed or communicated.

Informal communication of information between managers and staff (for example, byword-of-mouth or at meetings).

Communication between managers.

Inside the business, data/information come from the following internal sources.

The accounting records: sales ledgers, purchase ledgers, general ledgers and cash books etc holdinformation that may be of great value outside the finance function, for example, sales information forthe marketing function. To maintain the integrity of its accounting records, a business operatescontrols over transactions. These also give rise to valuable information. An inventory control system,for example, will include details of purchase orders, goods received notes, goods returned notes andso on, which can be analysed to provide management information about speed of delivery, say,or the quality of supplies

Human resources and payroll records, holding information on people, their skills and aspirations,and so on

Machine logs and computer systems in production/operations containing information aboutmachine capacity, fuel consumption, movement of people, materials, and work in progress, set uptimes, maintenance requirements and so on

Timesheets in service businesses, notably accountants and solicitors, containing data on the timespent on various activities, both to justify fees to clients and to assess the efficiency and profitability ofoperations

Staff. Information may be obtained either informally in the course of day-to-day business or throughmeetings, interviews or questionnaires



4.3 External data sources

Capturing data information from outside the business may be formal or informal.

Formal collection of data from outside sources includes the following.

A business's tax specialists will gather information about changes in tax law and how this will affectthe business

Obtaining information about any new legislation on health and safety at work, or employmentregulations, must be the responsibility of a particular person who must then pass on the informationto managers affected by it

Research and development (R&D) work often relies on information about other R&D work beingdone by another business or by government institutions

Marketing managers need to know about the opinions and buying attitudes of potential customers.To obtain this information, they carry out marketing research exercises

Informal gathering of information from the environment goes on all the time, consciously orunconsciously, because the employees of an organisation learn what is going on in the world aroundthem – perhaps from the internet, newspapers, television reports, meetings with business associates or thetrade press.

A business's files (paper and computerised) include information from external sources such as invoices,letters, e-mails, advertisements and so on received from customers and suppliers. Sometimesadditional external information is required, requiring an active search outside the business. The followingsources may be identified.

The internet The government Advice or information bureaux, such as Reuters or Bloomberg Consultancies of all sorts Newspaper and magazine publishers Specific reference works which are used in a particular line of work Libraries and information services The systems of other businesses via electronic data interchange (EDI)

5 Information processing

Section overview

In the information processing system data is input, processed and then output as information.

Information processing needs to be complete, accurate, timely, inalterable, verifiable and assessable(CATIVA).

The transaction processing system (TPS) performs, records and processes routine information formarketing, production/operations, finance and HR functions.

The management information system (MIS) processes data into information that supports andfacilitates decision making by managers.

An expert system comprises a database of data and rules about what should be done when the datatells the user a particular thing.



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5.1 How is data/information processed?

Definition

Information processing: Data once collected is converted into information for communicating morewidely within the business.

To be effective, information processing should meet the following CATIVA criteria:

Completeness Everything that needs to be processed should be processed.

Accuracy Processing should be done so that the data remains true to its sources, and theinformation produced contains no errors.

Timeliness Processing should occur in line with data availability and information needs, whichmeans real time (instantaneously) in many cases.

Inalterability The process should be open to neither unauthorised intervention whilst in actionnor alteration once completed (this aids accuracy and security).

Verifiability The sources of the data and the trail from data through processing to informationshould be capable of being followed through.

Assessability The effectiveness of the processing should be open to scrutiny so that its qualitycan be judged.

5.2 Information systems

Just as materials and labour are processed into outputs by the business's production or operations system,so are data processed into information by the business's information systems.

Definitions

A system: A set of interacting components that operate together to accomplish a purpose.

A business system: A collection of people, machines and methods organised to accomplish a set ofspecific functions.

Information systems (IS): All systems and procedures involved in the collection, storage, production anddistribution of information.

Information technology (IT): The equipment used to capture, store, transmit or present information. ITprovides a large part of the information systems infrastructure.



A system has three component parts: inputs, processes and outputs. Other key characteristics of asystem are the environment and the system boundary – as shown in Figure 6.1.

Figure 6.1 Information system

The data input may be output from other systems: for example, the output from a transactionsprocessing system forms the input for a management information system (as we shall see)

Processing transforms input data into output information. There is not necessarily a clearrelationship between the number of inputs to a process and the number of outputs

Output information is the result of the processing

A system boundary separates the information system from its environment. For example, themarketing information system and the accounting information system are generally separate, but theremay be an interface between the two systems to allow the exchange of resources. There may also beinterfaces between internal and external information systems, for instance between a processingsystem and the sales system of its major suppliers

Anything which is outside the system boundary belongs to the system's environment and not to thesystem itself. A system accepts inputs from the environment and provides outputs into theenvironment. The parts of the environment from which the system receives inputs may not be thesame as those to which it delivers outputs. The environment exerts a considerable influence on thebehaviour of a system; but the system can do little to control the behaviour of the environment

In relation to financial information, the two information processing systems in which we are most interestedare:

The transaction processing system, and The management information system

5.3 The transaction processing system (TPS)

Definition

Transaction processing system (TPS): A system which performs, records and processes routinetransactions.

A TPS is used for routine tasks in which data items or transactions must be processed so that operationscan continue. A TPS supports most business functions in most types of businesses.



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Transaction processing systems

Sales/marketingsystem

Manufacturing/production system

Finance/ accountingsystem

Human resourcessystem

Major functionsof system

Salesmanagement

Marketingresearch

Promotionpricing

New products

Scheduling

Purchasing

Shipping/receiving

Engineering

Operations

Budgeting

Nominal ledger

Invoicing

Managementaccounting

Personnelrecords

Benefits

Salaries

Labour relations

Training

Major parts ofsystems

Sales ordersystem

Marketingresearch system

Pricing system

Materialsresourceplanning

Purchase ordercontrol

Engineering

Quality control

Nominal ledger

Accountsreceivable/payable

Budgeting

Treasurymanagement

Payroll

Employeerecords

Employeebenefits

Career pathsystems

5.4 The management information system (MIS)

Definition

Management information system (MIS): Converts data from mainly internal sources into information(e.g. summary reports, exception reports). This information enables managers to make timely and effectivedecisions for planning, directing and controlling the activities for which they are responsible.

An MIS provides regular reports and (usually) on-line access to the business's current and historicalperformance. The MIS transforms data from underlying TPS into summarised files that are used as the basisfor management reports. It:

Supports structured decisions at operational and management control levels Is designed to report on existing operations Has little analytical capability Is relatively inflexible Has an internal focus

5.5 Expert systems

Expert systems allow users to benefit from expert knowledge and information. The system will consist of adatabase holding specialised data and rules about what to do in, or how to interpret, a given set ofcircumstances.



Worked example: Expert system for loan applications

Many financial institutions now use expert systems to process straightforward loan applications. The userenters certain key facts into the system such as the loan applicant's name and most recent addresses, theirincome and monthly outgoings, and details of other loans. The system will then:

Check the facts given against its database to see whether the applicant has a good credit record

Perform calculations to see whether the applicant can afford to repay the loan

Match up other criteria, such as whether the security offered for the loan or the purpose forwhich the loan is wanted is acceptable, and to what extent the loan applicant fits the lender's profile ofa good risk (based on the lender's previous experience)

A decision is then suggested, based on the results of this processing. This is why it is now often possible toget a loan or arrange insurance over the telephone, whereas in the past it would have been necessary togo and speak to a bank manager or send details to an actuary and then wait for him or her to come to adecision.

Business applications of expert systems:

Legal or tax advice

Forecasting of economic or financial developments, or of market and customer behaviour

Surveillance, for example of the number of customers entering a supermarket, to decide whatshelves need restocking and when more checkouts need to be opened, or of machines in a factory, todetermine when they need maintenance

Diagnostic systems, to identify causes of problems, for example in production control in a factory,or in healthcare

Project management

Education and training, diagnosing a student's or worker's weaknesses and providing orrecommending extra instruction as appropriate

Conditions when expert systems are most useful:

The problem is reasonably well-defined

The expert can define some rules by which the problem can be solved

The problem cannot be solved by conventional transaction processing or data handling

The expert could be released to more difficult problems. Experts are often highly paid, meaning thevalue of even small time savings is likely to be significant

The investment in an expert system is cost-justified

Interactive question 2: Expert systems [Difficulty level: Intermediate]

Explain why businesses use expert systems for decision-making tasks which humans are naturally better ableto perform than computers.

See Answer at the end of the chapter.



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6 Security

Section overview

Information is a valuable commodity and therefore needs to be kept secure.

Security involves prevention, detection and deterrence of problems, plus recovery and correctionprocedures and threat avoidance.

A secure information system is only available when needed and maintains confidentiality. Theinformation is authentic and has integrity. Changes must be authorised. It is designed so that userswill not have to reject the information on the basis that it is faulty in any way (ACIANA – see later).

Security is ensured by means of physical access, security and integrity controls.

6.1 Why is information security important?

If you own something that you value – you look after it. Information is valuable and it deservessimilar care.

Definition

Security (in information management): the protection of data from accidental or deliberate threatswhich might cause unauthorised modification, disclosure or destruction of data, and the protection of theinformation system from the degradation or non-availability of services (Lam: Security of computer basedinformation systems).

6.2 Ensuring the security of information

Aspects of security

Prevention. It is in practice impossible to prevent all threats cost-effectively, but prevention is betterthan cure

Detection. Detection techniques are often combined with prevention techniques: a log can bemaintained of unauthorised attempts to gain access to a computer system

Deterrence. As an example, computer misuse by personnel can be made grounds for disciplinaryaction

Recovery procedures. If the threat occurs, its consequences can be contained (for example,checkpoint programs)

Correction procedures. These ensure the vulnerability is dealt with (for example, by institutingstricter controls)

Threat avoidance. This might mean changing the design of the system

Physical threats to information systems include fire, flooding, adverse weather, earthquake, tsunami,terrorist activity and accidents. These are the physical risks that we saw in Chapter 5, and risk managementis a key issue in ensuring the security of information systems.



6.2.1 Qualities of a secure information system: ACIANA

Availability Information can always be accessed.

Confidentiality Information cannot be accessed by anyone who does not have the right tosee it.

Integrity Data is the same as in its sources and has not been accidentally ordeliberately reduced, altered, destroyed or disclosed.

Authenticity Data and information are taken from bona fide sources.

Non-repudiation Information is not open to being rejected by its intended users on thegrounds of faults in the system.

Authorisation Changes in the system can only be made by persons who are accountablefor them.

6.2.2 Physical access controls

Personnel, including receptionists and, outside working hours, security guards can help controlhuman access

Door locks can be used where frequency of use is low. (This is not practicable if the door is infrequent use.)

Locks can be combined with:

– A keypad system, requiring a code to be entered– A card entry system, requiring a card to be 'swiped'

Intruder alarms

Laptop and other portable computers with access to the system should be kept secure

Staff should be allocated an individual personal identification number, or PIN, which identifies himor her to the building

6.2.3 Security controls in the system

These help to prevent:

Human error

– Entering incorrect transactions– Failing to correct errors– Processing the wrong files

Technical error such as malfunctioning hardware or software

Deliberate actions such as fraud

Commercial espionage

Malicious damage



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6.2.4 Integrity controls in the system

Data will maintain its integrity if it is complete and not corrupted.

The original input of the data must be controlled in such a way as to ensure that the results arecomplete and correct. Input controls should ensure the accuracy, completeness and validity ofinput

– Data verification involves ensuring data entered matches source documents

– Data validation involves ensuring that data entered is not incomplete or unreasonable. Variouschecks include:

– Check digits. A digit calculated by the program and added to the code being checked tovalidate it

– Control totals. For example, a batch total totalling the entries in the batch

– Hash totals. A system generated total used to check processing has been performed asintended

– Range checks. Used to check the value entered against a sensible range, e.g. ledgeraccount number must be between 5,000 and 9,999

– Limit checks. Similar to a range check, but usually based on a upper limit, e.g. must be lessthan 999,999.99

Any processing and storage of data must maintain the completeness and correctness of the datacaptured. Processing controls should ensure the accuracy and completeness of processing.Programs should be subject to development controls and to rigorous testing. Periodic running oftest data is also recommended

Reports or other output should be set up so that they, too, are complete and correct. Outputcontrols could include:

– Investigation and follow-up of error reports and exception reports produced by the system– Batch controls to ensure all items are processed and returned– Controls over distribution/copying of output– Labelling of storage media

The system should have a back-up and archive strategy, including:

Regular back-up of data (at least daily) Archive plans A disaster recovery plan including off-site storage

Users of the system should be given a password. While unauthorised persons may circumvent physicalaccess controls, a logical access system can use passwords to prevent access to data and program files,by measures such as:

Identification of the user Authentication of user identity Checks on user authority

Personnel selection is important. Key people with access to the system should be carefully recruited.There should also be:

Job rotation and enforced vacations Systems logs Review and supervision

For other staff, segregation of duties is a core security requirement. This involves division ofresponsibilities into separate roles:

Data capture and data entry Computer operations Systems analysis and programming



Finally, there should be an adequate audit trail, so there is some means of identifying individual recordsand the input and output documents associated with the processing of any individual transaction.

7 Users of financial informationError! Bookmark not defined. andtheir information needs

Section overview

Different stakeholders use financial information for different purposes, and require differentamounts and types of information for these purposes.

Financial information is useful when it supports economic decision-making by users, and allows themto hold managers to account.

Financial information should have the qualitative characteristics of understandability, relevance,reliability and comparability.

These characteristics are undermined if the information is delayed or costs more to produce thanthe benefits it produces.

7.1 What is financial information used for?

The Framework for the Preparation and Presentation of Financial Statements published by the InternationalAccounting Standards Board (IASB) is focused on published financial statements in particular rather thanfinancial information in general, but it usefully points out that nearly all users use financial information tomake economic decisions, such as those to:

Decide when to buy, hold or sell shares on the basis of their risk and return

Assess how effectively the business's management has looked after its affairs (its stewardship) anddecide whether to replace or reappoint them

Assess a business's ability to provide benefits to its employees

Assess security for amounts lent to the business

7.2 Who uses financial information?

The IASB Framework identifies the following users of financial information and their specific informationneeds. You will see that the users tie in closely with the list of stakeholders that we saw in Chapter 1 of thisStudy Manual.

Users Need financial information to:

Present and potential investors(shareholders)

Make investment decisions, therefore need information on:

– risk and return of investment– ability of company to pay dividends

Employees Assess their employer's stability and profitability

Assess their employer's ability to provide remuneration,employment opportunities and retirement and other benefits

Customers Assess whether business will continue in existence – importantwhere customers have a long-term involvement with, or aredependent on, the business, e.g. where they are supply chainpartners

Suppliers and other businesspartners

Assess the likelihood of being paid when due



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Users Need financial information to:

Lenders Assess whether loans will be repaid, and related interest willbe paid, when due

Governments and its agencies Assess allocation of resources and, therefore, activities ofbusinesses

Assist in regulating activities

Assess taxation income

Provide a basis for national statistics

Help direct policy on, for instance, health and safety and equalopportunities issues

The publicError! Bookmark notdefined. and communityrepresentativesError! Bookmarknot defined.

Assess trends and recent developments in the business'sprosperity and its activities – important where the businessmakes a substantial contribution to a local economy, e.g. byproviding employment and using local suppliers

7.3 When is financial information useful?

The Framework states that financial information is useful to users when it:

Helps them to make economic decisions, and Shows the results of management's stewardship of the resources entrusted to them

For financial information to meet these two objectives it must be prepared on the basis of two underlyingassumptions:

The accrual basis of accounting: the effects of transactions and other events are recognised whenthey occur (not as they are realised in cash), and they are recorded and reported in the financialstatements of the periods to which they relate

The business is a going concern and will continue in operation for the foreseeable future

7.4 Information for making economic decisions and making managersaccountable

When users make economic decisions they need financial information to evaluate:

The ability of a business to generate cash so as to

– pay employees and suppliers– meet interest payments– repay loans and– pay dividends

The timing and certainty of cash flows

In order to make the evaluation as to whether the business can generate sufficient cash on time the userneeds information on the business's:

Financial position (its balance sheet) Financial performance (its income statement) and Changes in financial position (its cash flow statement)

These are contained in the business's financial statements.



7.4.1 Information on the financial position

Factors affecting the business's financialposition:

Information on this factor is useful forpredicting:

The economic resources it controls The business's ability to generate cash in the future

Its financial structure Future borrowing needs

How future profits and cash flows will bedistributed among stakeholders

The business's likely success in raising newequity

Its liquidity Whether cash will be available in the near futureafter taking account of current financialcommitments

Its solvency The availability of cash in the longer term to meetfinancial commitments as they fall due

Its adaptability Its capacity to adapt to changes in the environmentin which it operates

7.4.2 Information on financial performance

Information on the business's profitability, especially variability in profits over time, helps the user to predictor assess:

Potential changes in the economic resources the business is likely to control in the future The business's capacity to generate cash flows from its existing resource base How effectively the business might employ additional resources

7.4.3 Information on changes in financial position

Information on the business's past cash flows helps the user to predict or assess its investing, financing andoperating activities during the reporting period. This helps the user to assess:

How able the business is at generating cash How well the business uses cash that it has generated

7.5 Qualitative characteristics of financial statements

Definition

Qualitative characteristics: The attributes that make information provided in financial statements usefulto users (Framework):

Understandability Relevance Reliability, and Comparability

7.5.1 Understandability

Information should be readily understandable. Users are assumed to have a reasonable knowledge ofeconomic and business affairs and to be willing to be reasonably diligent in the way they study financialinformation. Relevant information should not be excluded from financial statements merely because it ishard to understand.



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7.5.2 Relevance

Information is relevant to users when it influences their economic decisions because they can thereby:

Evaluate past, present or future events, or Correct or confirm past evaluations

Information need not be in the form of a forecast for it to help users make predictions, but it helps them ifunusual, abnormal or infrequent items are separately disclosed.

Relevance is affected by:

The nature of certain items: some pieces of information are highly relevant whatever their monetaryvalue, such as the acquisition of a new business with significantly increased risks

The materiality of certain items: a piece of information is material if its omission or misstatementcould influence users' economic decisions. Materiality depends on the size of the item or error judgedin the particular circumstances of the omission or misstatement

7.5.3 Reliability

Information is reliable if it:

Is free from material error

Is free from bias i.e. neutral

Can be depended on to be a faithful presentation of what it purports to represent, or what it couldreasonably be expected to represent

Is presented in accordance with its commercial substance rather than its strict legal form (substanceover form)

Is complete within the bounds of materiality and cost

Is prepared with prudence, that is a degree of caution is exercised when including items for whichestimates are needed and conditions are uncertain

7.5.4 Comparability

Measurement and display of the financial effect of like transactions and other events must be carried out ina consistent way:

Throughout the business Over time, and Across different businesses

7.6 Constraints on relevance and reliability of information

The Framework sets out two constraints on the relevance and reliability of information:

Timeliness: undue delay in reporting may reduce relevance, but to provide information on a timelybasis it may have to be reported before all aspects of a transaction or other event are known, thusimpairing reliability. In balancing the two characteristics, the overriding consideration is how best tosatisfy the economic decision-making needs of users.

Balance of benefit and cost: the benefits derived from information for all users should exceed thecost of providing it.



8 Limitations of financial information in meetingusers' needs

Section overview

Financial information may be of limited usefulness because its presentation is conventionalised, it isbackward-looking and it omits non-financial information.

8.1 Conventionalised representation

Financial information, particularly financial statements, are usually highly standardised in terms of theiroverall format and presentation although businesses are very diverse in their nature. This may limit theusefulness of the information.

Financial statements are highly aggregated in that information on a great many transactions and balances iscombined into a few figures in the financial statements, which can often make it difficult for the reader toevaluate the components of the business.

8.2 Backward-looking

Financial statements cover a period that has already ended; they are inherently historical and backward-looking, whereas most users of financial information base their decisions on expectations about thefuture. Financial statements contribute towards this by helping to identify trends and by confirming theaccuracy of previous expectations, but they cannot realistically provide the complete information setrequired for all economic decisions by all users.

8.3 Omission of non-financial information

By their nature, financial statements contain information that is financial, not non-financial such as:

Narrative description of major operations Discussion of business risks and opportunities Narrative analysis of the business's performance and prospects Management policies and how the business is governed and controlled

Instead these are normally covered in the Chairman’s Statement and the Directors’ Report, publishedalongside the financial statements.

8.4 Other sources of information

There are other sources of information available to at least some users of the basic financial statements.

In owner-managed businesses, the owners have access to internal management informationbecause they are the management. This information is, potentially, available on a continuous real-timebasis and will include:

– Future plans for the business– Budgets or forecasts– Management accounts, including, for example, divisional analysis

Banks will often gain additional access to business information under the terms of loan agreements

Potential investors, if they are planning to take a major stake or even a controlling interest, willnegotiate additional access to information

Suppliers may be able to obtain reports on the business's credit standing via credit referenceagencies such as Experian. These are also used by lenders

Some information, such as brochures and publicity material (e.g. press releases), is available to all



6

Brokers' reports on major companies are available fairly widely

Press reports and other media coverage (especially on the internet) is available to all.

9 The effects of poor financial information

Section overview

Poor financial information undermines the integrity of financial markets and fails to serve the publicinterest.

Financial information is poor if it does not:

Meet the needs of users Display the qualitative characteristics set out above

The effect of poor financial information is:

To undermine the integrity of financial markets To fail to serve the public interest

Both these areas are fundamental to the work of the professional accountant, which we shall cover inChapter 10 of this Study Manual, and also to the working of the financial system, which we shall look at inChapter 12.




Summary

– Prevention

– Detection

Informationsecurity

– Deterrence

– Recovery

– Correction

– Avoid threats

Sources of data

– Internal

– External

Uses

– Recording transactions

– Planning/controlling

– Measuring performance

– Making decisions

– Planning

– Operational

Types

– Tactical

– Strategic

– Relevance

– Reliability

Qualitative characteristics

– Comparability

– Understandability

For internal useInformation systems

Qualities of goodinformation:ACCURATE

Underlying assumptions

– Accrual basis

– Going concern

withinformation on

– Financial position

– Financial performance

Financial statements

– Changes in financial position

– To make economic decisions

– To hold management to account

– To predict cash flows

Needs of users

For external use

What isneeded?

– (Lack of) timeliness

– Cost/benefit

Limitations

– Conventionalised

– Backward-looking

– Financial only

– Undermine integrity offinancial markets

– Fail to serve the publicinterest

Effects of poor financialinformation

Is it useful?No

– Input Processing Output

– Qualities: CATIVA

Information processing

– TPS

– MIS

– Expert systems

– Physical access

– Security

Types of control

– Integrity

Qualities ofsecure systems:

ACIANA

Financial information



6

Self-test


1 Womble Ltd's managers are quick to address immediate problems as they arise in operations on thebasis of financial information they receive. The company's trial balance always agrees. Monthly variancereports however consistently show that the operation is failing to meet its targets. It would appearthat Womble Ltd's financial information fails to provide managers information for

A Decision makingB Recording transactionsC Planning and controlD Measuring performance

2 Ian has to make a decision about whether to allow overtime tonight to Gonzalez, a customer serviceadviser, but he is unsure whether this extra time is needed between 7pm and 9pm on a Wednesday.The type of information he needs to answer this query is

A PlanningB OperationalC TacticalD Strategic

3 Ralph has presented some information on how to measure performance to a panel of managers at JabLtd. He found this information on the internet the previous evening as a PowerPoint file and haspresented it to the panel unedited. Within five minutes they found it to be highly informative andtargeted at the issues they are concerned with. The drawback to the information as presented byRalph is that it fails to meet the ACCURATE criteria for good information of

A Being cost beneficialB Being relevantC Being easy to useD Being authoritative

4 Pap Ltd makes a single product with five operatives working five machines in a 35 hour week, forwhich they are paid CU7.50 per hour. National insurance etc adds another CU150 to the weeklylabour bill. Last week the gross cost of labour was CU1,950. In which internal source should themanagers of Pap Ltd refer to identify why the bill was this size?

A The payrollB The ledger accountsC The machine logsD The workers

5 Which of the following is the CATIVA definition of verifiability of information processing?

A The data remains true to its sources and contains no errorsB The process is not open to unauthorised intervention or amendmentC The effectiveness of processing is open to scrutiny so that its quality can be judgedD The trail from data through processing to output information can be followed through

6 Hob Ltd needs to ensure that the prices it sets for the services of its consultants are rigorously andaccurately prepared. To effect this, it needs a pricing system as part of its

A Financial accounting systemB Operations systemC Marketing systemD Human resources system



7 Cranfield, a highway engineer, inputs some data about the stage of completeness of the road-buildingproject he is working on into his laptop each night, and by the morning the system has produced areport telling him which tasks will need completing that day and how many labourers will be required.This is an example of

A An expert systemB A management information systemC A transaction processing systemD A human resources system

8 Data verification is a form of

A Physical access controlB Output controlC Integrity controlD Security control

9 For which of the following groups are a company's financial statements primarily prepared?

A The governmentB ShareholdersC Potential investorsD Lenders

10 The fact that financial statements should be free from bias is a facet of which of the followingqualitative characteristics of financial information?

A RelevanceB ReliabilityC ComparabilityD Understandability



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1 C The trial balance balancing suggests that the TPS is effective, and managers can make well-informed decisions when they have to. The company knows it is missing targets so it ismeasuring performance, so its failures must be due to lack of information to plan and thencontrol operations

2 B By its short-term nature the information could not be planning or strategic; the fact that this isa day-to-day issue means it is not tactical

3 D Clearly the users have found the information easy to use and relevant, and the fact that Ralphspent very little time in generating it makes it cost-beneficial

4 A The first place to look is the payroll, which will show whether the variance comes from the payrate, the number of workers paid, or the national insurance etc. The other sources will providefurther information to back up the evidence in the payroll

5 D A describes accuracy; B describes inalterability; C describes assessability

6 C

7 A

8 C

9 B

10 B





The most frequent problem encountered by managers is that the information is not targeted at the user,that is the information system has not been designed with users and their needs in mind. Information that isnot actually relevant to the decisions they make is often included. Management information is frequentlynot easy to use, and it is late i.e. not timely.


The primary reason has to do with the relative costs. A 'human' expert is likely to be more expensive eitherto employ or to use on a consultancy basis.

Secondly, enshrining an expert's accumulated wisdom in a computer system means that this wisdom can beaccessed by more people. The delivery of complicated services to customers, and decisions whether or notto extend credit and so forth, can be made by less experienced members of staff. If a manufacturingcompany has a complicated mixture of plant and machinery, then the repair engineer may accumulate a lotof knowledge over a period of time about the way it behaves: if a problem occurs the engineer will be ableto make a reasoned guess as to where the likely cause is to be found. If this accumulated expert informationis made available to less experienced staff, it means that some of the learning curve is avoided.

An expert system is advantageous because it saves time, like all computer systems (in theory at least) but itis particularly useful as it possesses both knowledge and limited reasoning ability.


Contents

chapter 7

The business's financefunction

Introduction

Examination context

Topic List

1 Introduction to the finance function of thebusiness

2 What does the finance function do?

3 The structure of the finance function

4 Management accounting

5 Managing the finance function

6 The value of information

7 Establishing financial control processes






Introduction


Specify the extent to which financial information:

– Provides for accountability of management to shareholders and other stakeholders

– Reflects business performance

– Is useful to users in making economic decisions

– Meets the information needs of national, social and economic contexts (e.g. nationalstatistical information)

Specify how accounting and finance functions support businesses in pursuit of their objectives

Specify how a strategic plan is converted into fully integrated business and operational plans

Identify the main considerations in establishing and maintaining accounting and financialreporting functions and financial control processes

Identify the accountant's role in preparing and presenting information for the management ofa business

Specific syllabus references are: 1g; 3a, b, c, f.


The role and management of the finance function is of key importance to any business and to anyaccountant involved with that business.

Stop and think

What actually happens in the finance function of a business, as opposed to its marketing,production/operations and human resources functions? How does the finance function fit in, and how doesit support the other functions and thereby help the business to achieve its strategic objectives?

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill see what there is in common in finance functions, and where any differences lie.

Syllabus links

The topic of what the finance function does and how and why it does it are developed as well inAccounting, Financial Accounting and Financial Reporting, in Assurance, and in Management Information andFinancial Management at the Professional stage, and in the Advanced stage.

THE BUSINESS'S FINANCE FUNCTION


7

Examination context


Questions on the finance function could easily appear in the exam.

Exam requirements




1 Introduction to the finance function of the business

In Chapter 2 we saw that the four main functions of a business are marketing, operations/production,human resources and finance. This reflects the model of the business as taking three basic types of resource– materials, labour and money – to produce goods and services which generate profit. It is a major part ofthe finance function's role to look after the business's money.

2 What does the finance function do?

Section overview

The finance function’s tasks are: recording transactions, management accounting, financial reportingand treasury management.

The finance function supports the business’s pursuit of its strategic objectives by providinginformation to measure performance and support decision making, and by ensuring the business hassufficient funds for its activities.

2.1 The tasks of the finance function

The finance function is involved in four specific, but often interrelated, tasks.

Definitions

Recording financial transactions: Ensuring that the business has an accurate record of its revenue,expenses, assets, liabilities and capital.

Management accounting: Providing information to assist managers and other internal users in theirdecision-making, performance measurement, planning and control activities.

Financial reporting: Providing information about a business to external users that is useful to them inmaking economic decisions and for assessing the stewardship of the business's management.

Treasury management: Managing the funds of a business, namely cash and other working capital items,plus long-term investments, short-term and long-term debt, and equity finance.

The separate parts of the finance function carry out the following tasks:

Recording financial transactions:

– Recording financial transactions (credit sales, credit purchases, and cash receipts and payments) inthe books of original entry

– Entering summaries of transactions in the permanent records (nominal, receivables and payablesledgers) from the books of original entry

– Ensuring that resources are properly controlled (stewardship)

Management accounting:

– Preparing financial information for internal users (internal reporting for planning and control tothose charged with management and with governance)

– Identifying or determining the unit cost of the goods and/or services produced by the business,including classification into fixed and variable costs, or direct and indirect costs (cost accounting)

– Planning ahead by preparing forecasts and budgets



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– Assisting management decision-making (cost-volume-profit (CVP) analysis, including breakevenand limiting factor analysis)

– Preparing performance measures and identifying reasons for good and bad performance, includingvariance analysis

– Analysing capital investment decisions

– Determining sales and transfer prices

Financial reporting:

– Preparing financial information including financial statements for external users (externalreporting) to enhance good corporate governance (see Chapters 12 and 13)

– Tax reporting to National Board of Revenue (NBR)

– Regulatory reporting

Treasury management (see Chapter 9):

– Preparing and monitoring cash budgets

– Managing surpluses and deficits in cash balances

– Managing working capital from day to day so as to optimise cash flow, including inventory,receivables and payables management

– Analysing short-term and long-term financing decisions

– Managing investments

– Managing foreign exchange

– Managing financial risk

– Raising long-term finance (debt and equity)

2.2 How does the finance function support the pursuit of businessobjectives?

By providing information to measure performance and support decisions (financial reportingand management accounting)

By ensuring there is finance available for the business's activities (treasury management)

3 The structure of the finance function

Section overview

Many businesses centralise some if not all of the finance function’s tasks.

All aspects of the finance function’s tasks depend on the efficient and effective initial recording offinancial transactions.

How the finance function is organised depends on the size of the business and its overall organisationalstructure. In many businesses, even very large ones, some if not all of the finance function's tasks arecentralised. This is particularly helpful with respect to overall management of cash and to external reporting,but it is not so helpful with respect to making sure that local operational managers get all the information andsupport they need (internal reporting). Total centralisation is even more problematic when the businessoperates in global markets, where exchange rates and time differences make the structure unwieldy.

A typical finance function which performs all the tasks set out above would be structured as in Figure 7.1.Note that the data and information provided by those responsible for recording financial transactions feedinto each of the other three sections.



Against some items we have noted where you will encounter detailed coverage elsewhere in the ICABProfessional syllabus. We refer to:

ACC Accounting, Financial Accounting and Financial ReportingMI Management InformationFM Financial ManagementTAX Principles of Taxation and Taxation

In this chapter we provide an overview of the finance function; some areas are developed further elsewherein this Study Manual, as indicated.

Finance function

Recording financial transactions (ACC):

– Books of original entry

Ledgers–

SeealsoChapter 6

Management accounting:

Cost accounting (M1)

Budgeting (M1)

Management decision-making (M1)

Performance measurement ()

Pricing

–

–

–

–

– Capital budgeting and decisionmaking

–

seeChapter 8

Treasury management:

Cash budgets (MI)

Long-term finance decisions (FM)

Managing financial risk (FM)

Raising investment finance (FM)

Management of cash, includingforeign exchange

Management of working capital

–

–

–

–

–

–

(seeChapter 9)

(SeeChapter 9)

Financial reporting:

Financial statements (ACC);

Tax (TAX)

Provision of information toexternal regulators (ACC);

–

–

–

seealsoChapter 6

seealsoChapter 6

Internal reporting External reporting

Figure 7.1: The finance function

4 Management accounting

Section overview

Management accounts provide information to assist managers with making decisions, with planningand with control.

Management accounting incorporates cost accounting, which involves: gathering information on thecost of each item produced; setting standard costs and budgets, then measuring actual costs againstthese; analysing actual performance.

Not all costs are relevant for decision-making, which itself falls into two categories: decisions aboutallocating resources in the short to medium term, and decisions about long-term investment.

When making decisions about allocating resources, managers may need information generated by:cost-volume-profit (CVP) analysis (breakeven analysis; contribution analysis; limiting factor analysis);pricing analysis.

When making decisions for long-term investments, managers need information based on: capitalbudgeting; capital investment appraisal.

Forecasting, budgeting for and measuring performance are central to managers’ linked tasks ofplanning and control.



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4.1 What is management accounting?

Definition

Management accounting: Providing information to managers within organisations, to assist decision-making, planning and control.

4.2 What is cost accounting?

Definition

Cost accounting: Gathering information about costs and attaching it to each unit of output (a cost unit);establishing budgets, standard costs and actual costs of operations, processes, activities or products; andanalysing variances and profitability.

The managers of a business have to plan and control the resources used. To carry out this task effectivelythey must be provided with sufficiently accurate and detailed information, provided by the cost accountingsystem, to assist in:

Establishing asset valuations (for example, for inventory)

Planning (for example, providing forecast costs at different activity levels)

Control (for example, providing actual and standard costs for comparison purposes)

Decision-making (for example, providing information about actual unit costs for the period formaking decisions about pricing)

4.2.1 Cost classification

Definition

Cost classification: The arrangement of cost elements into logical groups with respect to their nature orfunction.

For inventory valuation and profit measurement, the cost of each unit of output (the unit cost) must becalculated. This is made up of three cost elements classified by the nature of the expenditure:

Materials Labour Expense (such as local property taxes, interest charges and so on)

Cost elements are also classified by the function of the expenditure: each heading may include material,labour and expenses:

Production/operations cost (cost of sales) Administrative expenses Distribution costs

When costs are classified by function it is common for a business to have cost centres for which specificcosts are ascertained, such as a building, a business unit or a machine.



Definition

Cost centre: A function or location for which costs are ascertained.

4.2.2 Direct and indirect costs

A direct cost is a cost that can be traced in full to the product, service, or department that is beingcosted.

– Direct material costs are the costs of materials that are known to have been used in makingand selling a product (or providing a service)

– Direct labour costs are the specific costs of the workforce used to make a product or providea service. Direct labour costs are established by measuring the time taken for a job, or the timetaken in 'direct production work'

– Other direct expenses are those expenses that have been incurred in full as a directconsequence of making a product, or providing a service, or running a department

An indirect cost (or overhead) is a cost of materials, labour or expenses that is incurred in thecourse of making a product, providing a service or running a department, but which cannot be traceddirectly and in full to the product, service or department.

Total expenditure may therefore be analysed as follows.

Materials cost = Direct materials cost + Indirect materials cost+ + +Labour cost = Direct labour cost + Indirect labour cost+ + +Expenses = Direct expenses + Indirect expenses

Total cost = Direct cost (prime cost) + Overhead cost

4.2.3 Cost behaviour: fixed and variable costs

Definitions

Fixed cost: A cost incurred for an accounting period that is unaffected by fluctuations in the levels ofactivity.

Variable cost: A cost that varies with the level of activity.

Semi-variable cost: A cost containing both fixed and variable components and thus partly affected by achange in the level of activity.

Interactive question 1: Variable costs [Difficulty level: Intermediate]

Your colleague has stated to you that a particular cost is a direct cost, and therefore it must be variable. Isyour colleague correct?




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4.2.4 Controllable and uncontrollable costs

Definitions

Controllable cost: A cost which can be influenced by management decisions and actions.

Uncontrollable cost: A cost which cannot be affected by management within a given time span.

Most variable costs are controllable in the short term because managers can influence the efficiencywith which resources are used, even if they cannot do anything to raise or lower price levels.

4.2.5 Who controls costs?

A cost which is not controllable by a junior manager might be controllable by a senior manager. Forexample, there may be high direct labour costs in a section caused by excessive overtime working.The first-line manager may feel obliged to continue with the overtime to meet production schedules,but the manager to whom he or she reports may have the authority to reduce costs by hiring extrafull-time staff, thereby reducing the requirements for overtime.

A cost which is not controllable by a manager in one section may be controllable by a manager inanother section. For example, an increase in material costs may have more than one cause: buying athigher prices than expected (controllable by the purchasing section) or excessive wastage (controllableby the production section).

Some costs are non-controllable, such as increases in expenditure items due to general levels ofinflation.

Some costs are controllable, but in the long term rather than the short term. For example, processingcosts might be reduced by the introduction of new software, but in the short term management mustattempt to do the best they can with the resources and technology at their disposal.

4.3 Costs for decision making

One of the key roles of the information produced by cost accounting is to assist managers in decisionmaking.

A decision involving resources generally means deciding whether or not to incur some new costs, or raisedlevels of cost, in order to generate new or raised revenues. Costs that have yet to be incurred by thebusiness are termed future costs. We can contrast them with the costs of resources that have alreadybeen acquired, or sunk costs.

Costs that may be saved by not adopting a particular course of action are termed avoidable costs. Wecan contrast these with unavoidable costs, which cannot be saved whether the particular course of actionis taken or not.

In many decisions the issue is whether to increase output from the existing level. It is useful here toconcentrate on the difference in total costs between the new and existing levels (the differential orincremental cost), rather than just on the total costs at the two levels of output. The idea of differentialcost leads onto that of marginal cost, namely the additional cost of one extra unit of output.

A final cost to consider is the value of the best alternative course of action that is not chosen, or theopportunity cost of the resources. It is what best could have been done with those resources; itrepresents opportunities forgone.

Worked example: Opportunity cost

If a person has a job offer that pays CU25 for an hour's work, and instead chooses to take a nap for anhour, the actual cost of the nap is zero; the person did not hand over any money in order to nap. Theopportunity cost of the nap is the CU25 that could have been earned working.



Only some costs are relevant costs for the decision-making process, namely those future costs that willbe changed by the decision made now. Costs that will remain unchanged whatever decision is made areirrelevant costs for decision making.

Management decisions fall into two categories according to whether they are about the allocation ofresources in the short to medium term (normally taken to be less than one year), or aboutinvestment in the long term (normally taken to be after one or more years). We shall look at each ofthese in turn.

4.4 Making resource decisions in the short to medium term

When making resource allocation decisions for the next week, month or even year we can assume insimple terms that managers want to spend as little as possible to earn the most amount ofrevenue: they want to maximise revenue and minimise variable costs so that the profit is as large aspossible. This amount then helps pay the business's fixed costs: the profit is a 'contribution' towards thosecosts.

What we have outlined here are the linked concepts of marginal costing and contribution.

Definitions

Marginal costing: Including only variable costs in unit cost when making decisions or valuing inventory(the marginal cost of a unit of inventory excludes fixed costs or its 'share' of overheads).

Contribution: Unit selling price less marginal cost.

Marginal cost and contribution are used to help answer many of the resource allocation questions thatarise, such as:

How many units must we sell of a new product to cover the fixed costs we will incur? Which of two new products should we choose to go ahead with? If we reduce our selling price and sell more units, what will be the effect on profit? We've got increased fixed costs – how many additional units do we need to sell? Our variable costs are going up – what should we do? We have limited amounts of resource – what is the best use we can make of them?

4.4.1 Cost-volume-profit analysis

All the questions listed above relate to the relationship between:

Changes in activity or output (volume) and Changes in total revenue, cost (variable and fixed) and therefore profit

Definition

Cost-volume-profit (CVP) analysis: Establishing what will happen if a specified level of activityfluctuates, based on the relationship between volume and sales revenue, costs and profit in the short term(one year or less), when the output of the business is restricted to what is available from its currentoperating capacity.

Volume has two meanings in this context:

Sales volume, which is extremely difficult to forecast Output volume, which needs to be planned

When sales and output volume are not the same, inventory levels are affected but it is a key assumption ofCVP analysis that all production in a period is sold.



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In the short term, some inputs can be increased, such as materials, but some – such as the capacity ofmachinery – cannot. It takes investment in the purchase of long-term assets to increase capacity.

4.4.2 Breakeven analysis

CVP analysis helps us to understand the relationships between costs, volume and profit and allowsmanagers to identify critical output levels, such as the breakeven point.

Definition

Breakeven point: The level of production and sales at which, after deducting both fixed and variable costsfrom sales revenue, neither a profit nor a loss will occur.

Analysing plans in terms of the breakeven point (breakeven analysis) allows the business to makedecisions as to whether to go ahead with a new product, and on what scale. It is thus an importantcalculation from a decision-making point of view.

When performing breakeven analysis, the key calculation is of the contribution that each unit of productwill make to fixed costs.

4.4.3 Contribution analysis

We saw above that a unit's contribution is its selling price less its marginal (variable) cost. Calculating whatwould happen if the amount of contribution per unit or total fixed costs changed is a branch of CVP analysiscalled contribution analysis.

Worked example: Contribution analysis

An item's contribution is CU4.80 per unit and the fixed costs associated with production of all such items isCU12,000. The breakeven point is CU12,000/CU4.80 = 2,500 units. If we can reduce variable costs orincrease sales price, however, so that contribution is CU5.00 per unit, then the breakeven point falls to2,400 units. Reducing fixed costs to CU11,520 and keeping contribution per unit the same will have thesame effect: CU11,520/CU4.80 = 2,400 units.

4.4.4 Limiting factor analysis

Contribution analysis is particularly helpful when the decision to be made involves a choice between, say,making either one product or another because the business has limited amounts of a certain factor ofproduction, such as material or labour, available. What we do is:

Calculate how much contribution each product makes per unit of the limited factor (or scarceresource), then

Choose the product which makes the most contribution per unit of the limiting factor.

4.5 Pricing

Another key decision that managers need to make is the price at which products or services are to be sold.



In Chapter 2 we saw that there are a number of factors inside and outside the control of the business thataffect customer demand for the business's products or services, the ones within the business's control beingcomponents of the 'marketing mix'. One of the components is price, and by producing information tosupport a manager's decision on how to price goods and services, the finance function plays an importantrole.

In Chapter 14 we shall look at the economic theory behind demand, supply and price. Here we shalllook at the information that is needed in order to make a decision about price.

4.5.1 What factors affect demand?

Within the control of the business (see Chapter 2):

Price Four Ps Marketing research – Product Product research and development – Price Advertising – Promotion Sales promotion – Place Training and organisation of sales force Plus Effectiveness of distribution Three service Ps After-sales service – People Granting of credit to customers – Processes

– Physical evidence

Outside the control of the business (see Chapter 14)

Price of substitute goods (items to which the consumer will switch if the price changes) Price of complementary goods (items which the consumer buys as a result of buying the goods, such

as blades for razors) Consumers' income Taste and fashion

4.5.2 Influences on the business's pricing policy

Costs: In order to make profits a business should ensure that its products are priced above their total cost,including their share of overheads. In the short term it may be acceptable to go below this if the price is stillabove the variable cost of producing one unit, thus ensuring a positive contribution towards the cost ofoverheads.

Competitors: Only a monopoly can set any price it wants. In very competitive markets the individualbusiness has no choice, with the price being dictated by the market. The reality is usually somewherebetween these two extremes. Relative pricing is extremely important in many markets, that is the pricemust be comparable to those of competitors.

Customers: As with all other marketing decisions, a consideration of customer expectations is essential insetting prices. If possible, a business should try to determine exactly how customer demand is affected bychanges in price (price elasticity), and therefore how many sales will result at a given price. We shall look atthis in more detail in Chapter 14.

Corporate objectives

Possible pricing objectives are:

To maximise profits

To achieve a target return on investment. This results in an approach based on adding something tothe quantified cost to the business of providing the product

To achieve a target revenue figure

To achieve a target market share

To match the competition, rather than leading the market, where the market is very price-sensitive



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The management accounting section of the finance function has great involvement in setting prices,especially in relation to costs and corporate objectives.

4.6 Making investment decisions for the long term

The second category of management decision is about investment in the long term, say to increasecapacity following difficult decisions made in the short term because resources were limited.

There are two basic issues at stake:

Does the business have enough long-term funds to make a long-term investment (capitalbudgeting)?

Is the long-term investment worthwhile (capital investment appraisal)?

4.6.1 Capital budgeting

The business should prepare a capital budget, setting out what funds will be available and how they will beused over a time period of, say two years. Capital inflows will be funds from:

Retained earnings (annual net profits less dividends) Share issues New loans or debentures Sales of non-current assets

Capital outflows will be in respect of:

Purchases of non-current assets including investments Repayment of loans Redemption of debentures

Any projected shortfalls of capital will have to be covered by raising new long-term loans or issuingshares; cutting dividends or selling underutilised assets are also options. If the budget shows thatthere will be capital unused (a so-called 'cash mountain') this will also have to be managed. Loans couldbe repaid early, or dividends increased; more likely, new investment projects could be sought out.

4.6.2 Capital investment appraisal

If the business identifies a possible capital investment opportunity, it needs to evaluate or appraise theproject to make a decision as to whether to go ahead with it.

Some businesses use a very simple approach to capital investment: they expect the capital outlay to be 'paidback' within a certain period of time. This payback method favours projects which generate cash in theshorter term, so that there is less risk to the overall level of funding in the business.

Another appraisal method is to calculate whether the project will make a profit over its lifetime. This isimportant but it ignores that fact that:

Profits are arising over a long period of time Profits may not be realised in the short term in the form of cash flows

To address these two problems, when looking at long-term investment we need to look both at cash flowsand at the 'time value of money'.

Definition

Time value of money: The value of a cash flow at an identified time in the future is measured in terms ofcash held now.

If somebody offered you CU10,000 now or CU10,000 in one year's time, you would opt for the moneynow. This is for two reasons:



Taking the money now means you are avoiding the risk that in fact it will not be paid in one year'stime

During the year you can put the money in a deposit account and earn interest on it.

Taking the point about putting money on deposit a step further, we could say that since the CU10,000 willearn, say, 4% over one year, you would only be indifferent about whether to take the money now or in one

year's time if you were offered CU10,000 1.04 = CU10,400 in one year's time or CU10,000 now.

In order to make these decisions the business needs to use discounted cash flow.

Worked example: Discounted cash flow

A business has CU50,000 which it can invest risk-free at 4% per annum in a deposit account. It also has anopportunity to invest the funds now to receive back a total of CU55,650 in 12 months' time; because thisinvestment is not risk-free the business expects a return of 5% on it. What should the business do?

Solution

We can see that CU55,650 is more than the CU52,000 that the business would receive back if it put the

money straight on deposit (CU50,000 1.04), but what about the extra risk it is taking? What we need todo is to discount the amount of money expected in 12 months' time at the rate of interest that the businessexpects of the investment. If this discounted amount – known as its 'present value' – is more than theCU50,000 the business currently holds, the investment would appear to be worthwhile. We discount byusing the inverse of the calculation to calculate interest:

CU55,650/1.05 = CU53,000

Interactive question 2: Discounted cash flow [Difficulty level: Intermediate]

Explain what the business in the worked example above should decide and why.


A business which has as its primary objective the maximisation of shareholders' wealth will chooseinvestments which maximise the present value of its future cash flowsError! Bookmark notdefined..

Discounted cash flow is a very important investment appraisal technique which you will see in a great dealmore detail as you progress in your studies. It is related to the techniques of:

Net present value (NPV) and Internal rate of return (IRR)

4.7 Forecasting

A key element of the work of the management accountant is to look into the future to answer these twoquestions:

What is going to happen? Forecasts for the future are needed on the basis of known amounts, andestimates for areas of uncertainty

What are we planning to do? Budgets are needed to assist in planning and control

Forecasting involves predicting what will happen in the future given what we already know about thepresent. It is particularly important regarding:



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Sales volumes Costs Economic factors (interest and exchange rates) Other environmental factors such as regulation, technological developments and taste

Information from external sources is very important when forecasting. Various mathematicaltechniques can help to make forecasts more sophisticated and more reliable, and these help to make theforecast realistic and up-to-date.

4.8 Budgets and budgeting

We saw in Chapter 4 that the strategic planning process results in the business making plans that eventuallybecome detailed budgets for each area of operations.

Definition

Budget: A plan expressed in monetary terms.

4.8.1 Budgetary process

The preparation and use of budgets are processes that must be effectively managed. The key point is thatbudgets should not just be 'one-off' documents that are prepared and then placed in a file to gather dust;the process should be a continuous one. It is in fact a 'budget cycle'.

Establish objectives

Identify potential strategies

Evaluate options and select course of action

Prepare plans and standards

Strategic planning – see Chapter 4

Prepare budgets for implementing the plan

Implement the long-term plan via budgets

Monitor actual outcomes and respond to deviations

Budgeting

4.8.2 Preparing budgets

Budgets are usually prepared over a period of time such as one year, broken down monthly. There isusually a departmental budget for each separate function or operation in the business, such as for:

Sales (volume and value): sales are often the principal budget factor for the business as a whole,since it is the volume of sales which determines the level of activity in each of the business's functions

Production/operations (volume and value): resources are allocated to achieve the sales budget, andplans are made for how much the resources cost, how effectively they are used and how muchinventory is to be kept

Expenses (value): support activities such as logistics and human resources also need expenditurebudgets

To prepare a set of departmental budgets and amalgamate them into the business's master budget thefollowing steps must be followed:

Decide on course of action and communicate to people responsible for preparing budgets Determine the factor that limits output (the principal budget factor, which is usually sales volume) Prepare budgets for the principal budget factor



Prepare drafts of other budgets Negotiate budgets with managers Co-ordinate and review all budgets Accept budgets Review budgets over time (see below)

A cash budget should also be prepared to ensure that sufficient cash is available at all times to meet thelevel of operations outlined in the various departmental budgets. We shall see more about cash budgets inChapter 9 on treasury management.

4.8.3 Types of budgeting

Most businesses use a system of incremental budgeting. This means that they take the experiences theyhave had of direct costs and support activities in the past year and use these as the base for preparing thenext year's budget, adjusting it for changes or increments (such as to inflation, product mix, volumes andprices) that are expected to occur in the new budget period.

Example: Incremental budgeting

Incro Ltd included an allowance for overheads in its 20X1 budget of CU20,000. Inflation in 20X2 isexpected to be 3%, so the overheads budget for 20X2 is set as CU20,600.

The major problem with incremental budgeting is that 'the costs of non-unit level activities becomeeffectively fixed, so past inefficiencies and waste inherent in the current way of doing things is perpetuated'(Drury, Management Accounting for Business Decisions).

To address these problems with the incremental approach the business can implement zero-basedbudgeting (ZBB), which:

'requires that all activities are justified and prioritised before decisions are taken relating to the amount ofresources allocated to each activity'(Drury, Management Accounting for Business Decisions).

4.8.4 Keeping budgets relevant to users

Flexible budgeting involves adjusting the budget for a period to reflect actual levels of activity inthat period. If, for instance, volume was budgeted in January at 100 units but in fact 200 units wereproduced and sold, a flexible budget system allows the management accountant to adjust all aspects ofJanuary's budget so it relates to the new, higher volume. This 'flexed' budget can then be comparedwith actual results via variance analysis (which we shall see further in Chapter 8), to see how faractual performance was in line with what would have been expected.

A rolling budget system means that, as each month goes by, the budgets for the months ahead arereviewed and, if necessary, revised so that they remain relevant for the remainder of the budgetperiod.



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4.8.5 Purposes of budgets

Budgets are thus crucial in helping managers to plan and control the business's performance.

Purposes of budgets Comments

Guiding managers on how toachieve objectives

Without a detailed plan the achievement of the business'sprincipal objective will be left up to chance

Helping to compel planning The process of preparing, monitoring and amending budgetsis a rigorous one

Allocating resources Every business has finite resources, at least in the short term,and the process of preparing budgets helps to identify whatresources are limited and how best to use those

Setting targetsError! Bookmark notdefined. and allocating responsibility

The budget identifies what is expected of each area of thebusiness and therefore of each manager

Helping to co-ordinate activities Budgets set out a plan for which different resources –materials, people and capacity – need to be co-ordinated

Communicating plans Numbers in a budget state plans very succinctly, assumingthat the people to whom it is being communicated have beentrained to understand what they denote in operational terms

Enabling control Budgets that are kept relevant allow regular, accurate andtimely comparison of actual performance against the budget,so that problems can be identified and control action taken

Helping to motivate employees Managers and other employees are reassured that there is aplan in place, and are keen to see it achieved

Many businesses link achievement of the budget with pay, inthe form of bonuses or commission

Specific reasons for failure to meet targets can be identified,so managers can focus on particular areas for improvement

Helping to evaluate performance Assuming that the budget was realistic to begin with and wasproperly communicated, it can be used to assess how wellthe enterprise and its managers performed – as we shall seein Chapter 8

4.9 Measuring performance

Budgets form the basis of one very important aspect of performance measurement and evaluation that iscarried out by the management accountant, namely variance analysis. We shall come back to this inChapter 8.

4.10 Strategic management accounting

The traditional focus of management accounting has been to provide information for use internally bymanagers. This is not to say, however, that management accountants are not concerned with informationgathered outside the business itself.

Definition

Strategic management accounting: Providing and analysing financial information on the business'sproduct markets and competitors' costs and cost structures, and monitoring the business's strategies andthose of its competitors in these markets over a number of periods.



Strategic management accounting therefore extends the internal focus of traditional managementaccounting to include external information about:

Competitors

The business's strategic position

How to gain competitive advantage by decreasing costs and/or enhancing the differentiation of thebusiness's products

5 Managing the finance function

Section overview

As with any other of the business’s functions, the finance function needs to be effectively organisedand led, with its performance properly planned and controlled.

We saw above that a typical finance function might be structured as in Figure 7.1. The optimum structurefor any particular business will be affected by all the factors considered in Chapter 3. Particular factors toconsider are the business's:

Form (sole trader, partnership, company) Size and geographical dispersion, including the degree of centralisation required Markets History and ownership Culture (human relations, open systems, internal process or rational goal)

Within the finance function its managers are responsible for ensuring that the function is properly managedand achieves its objectives. The way in which they do this is to perform the tasks of management that wesaw in Chapter 2.

5.1 Planning and control

The overall direction of the finance function's work needs to be planned and controlled, including:

Forecasting what is needed (the reports and finance that will need to be available) Evaluating available resources, such as qualified staff and robust information systems Developing objectives, plans and targets Implementing the plan and monitoring performance Using feedback from monitoring to make necessary amendments to the plan

5.2 Organising and leading

Time and effort in the finance function need to be organised so that its objectives and targets are met,including:

Defining what processes, technology and people are required Allocating and co-ordinating work Generating effort and commitment in finance staff

6 The value of information

Section overview

Information is valuable if the benefits it produces exceed the costs of its production. Valuable information comes from a reliable source, is easy to assimilate and is accessible.



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6.1 Cost-beneficial information

As so much of the output from the finance function is in the form of information, it will only successfullysupport the business if it performs its tasks efficiently and effectively. This means that the benefit of theinformation and other outputs that it produces must outweigh the cost of its production (the second C ofthe ACCURATE mnemonic that we saw in Chapter 6).

Information is a very valuable resource, and a key tool in the quest for competitive advantage. Easyaccess to information, the quality of that information and speed in exchanging information have becomeessential elements of business success.

Unlike certain commodities the value of information in general is not based on scarcity: indeed themost frequent complaint of many modern managers is that there is far too much of it.

Moreover, the value of information is in the eyes of the beholder to some extent: information about anew type of plastic may be of keen interest and value to a car manufacturer, but of no value whatsoever toa software house.

6.2 What makes information valuable?

Its source

If external information comes from a source that is widely known and respected for quality,thoroughness and accuracy (Reuters, say, or the BBC) it will be more valuable to users thaninformation from an unknown or untested source, because it can be relied upon with confidence. If aninternal source is known to be accurate, efficient and reliable, the information it produces will be morevaluable to its users.

Ease of assimilation

Information can be presented using not only words and figures but also colour, graphics, soundand movement. This makes the receipt of information a richer and so more valuable experience,and it means that information can be more easily, and more quickly, understood.

Accessibility

If information can be made available in an easily accessible place (such as the internet) users do nothave to commit too much time and effort to retrieving it.

6.3 Assessing the cost and value of information

Information which is obtained but not used has no actual value to the person that obtains it. It is onlythe action taken as a result of a decision based on information which has actual value for a business. Anitem of information which leads to an actual increase in profit of CU90 is not worth having if it cost CU100to collect.

Whether it is worthwhile having more information depends on:

The marginal benefits expected from getting it, and The extra costs of obtaining it

Its value can be measured in terms of the difference it would make to management decisions if theinformation were made available.

As we saw in Chapter 6, a management information system (MIS) is used to produce a wide variety ofinformation so the cost of an individual item of information is not always easy to quantify.

Interactive question 3: Information cost [Difficulty level: Intermediate]

A manager uses particular enquiry software to enquire into her company's MIS. What is the cost of thisenquiry?




Just as the costs of an item of information are harder to assess than might appear superficially, so too thebenefits are often hard to quantify. While nobody doubts that information is valuable, it is not alwayseasy to construct an economic assessment of this value.

A monthly variance analysis will only generate economically consequential decisions if there is somecontrol failure leading to variances, but control failures are not easy to predict.

The economic consequences of a decision are also not always easy to predict.

7 Establishing financial control processes

Section overview

In the finance function there need to be effective financial controls. These depend on an effectivecontrol environment, risk assessment, control activities, effective information and communication,and good monitoring.

7.1 Why are financial control processes needed?

The central importance of the finance function and the risks it faces mean that specific financial controlprocesses need to be implemented by its managers. Financial control is a form of internal control.

7.2 What is internal control?

The Committee of Sponsoring Organisations (COSO) of the US Treadway Commission has aimed since1985 to:

Identify the factors that cause fraudulent financial reporting Make recommendations to reduce its incidence and Establish a common definition of internal controls

Definition

Internal control: A process, effected by an entity's board of directors, management and other personnel,designed to provide reasonable assurance regarding the achievement of objectives in the followingcategories:

Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations

(COSO)

From this definition we can see that internal control:

Is a process: it is a means to an end, not an end in itself

Is effected by people, not merely by policy manuals and forms

Can be expected to provide only reasonable assurance, not absolute assurance, to an entity'smanagement and board that operations are effective and efficient, financial reporting is reliable andlaws and regulations are being complied with

Is geared to the achievement of objectives in one or more separate but overlapping categories



7

7.3 Effective internal control

According to COSO, internal control consists of five interrelated components which together provide aneffective framework for describing and analysing the internal control system implemented in a business.

7.3.1 Control environment

The control environment sets the tone of a business and the control consciousness of its people. Itprovides discipline and structure. Control environment factors include:

The integrity, business ethics and operating style of management How far authority is delegated The processes for managing and developing people in the business

7.3.2 Risk assessment

We saw in Chapter 5 that every business faces a variety of risks from external and internal sources, andthese must be adequately assessed so they can be managed.

Definition

Risk assessment: The identification and analysis of relevant risks to the achievement of assignedobjectives.

7.3.3 Control activities

Having assessed risks the business needs to take the necessary control activities to address those thatthreaten achievement of its objectives.

Definition

Control activities: The policies and procedures that help ensure management directives are carried out.

Control activities occur throughout the business, at all levels and in all functions – not just the financefunction. They include:

Approval Authorisation Verification Reconciliation Review of operating performance Security of assets and Segregation of duties

Segregation or separation of duties is important where power could be abused if only one person wasresponsible for a transaction or asset from beginning to end. An example would be the purchase of a non-current asset such as a car. If only one person had the power to:

Authorise its purchase Record the amount payable and/or pay the bill and Have custody of the car

then there is nothing stopping that person from buying the most expensive car possible then abscondingwith it.



7.3.4 Information and communication

Information systems produce reports, including operational, financial and compliance-related information,that make it possible to run and control the business. In a broader sense, effective communication mustensure information flows down, across and up the business. Effective communication with external parties,such as customers, suppliers, regulators and shareholders, is also important for control.

7.3.5 Monitoring

Internal control systems need to be monitored to assess the quality of the system's performance over time.This is accomplished through ongoing monitoring activities or separate evaluations. Deficiencies in internalcontrol that are detected through these monitoring activities should be reported to more senior managers.Corrective action should be taken to ensure continuous improvement of the system.

7.4 Financial control processes

In Chapter 13 we shall look at the Code of Corporate Governance, which contains a main principle that:

'the board should maintain a sound system of internal control to safeguard shareholders' investment and thecompany's assets'.

It states that internal controls include financial, operational and compliance controls.



7


Summary

Management

Value ofinformation

Financialcontrols

Treasurymanagement

Managementaccounting

Financialreporting

Plan +Control

Organise/Lead

Allocatingresources

BudgetingMeasuring

performanceCost

accountingPricing Investment

decisionsForecasting

– Direct

– Indirect

Cost classification

– Fixed

– Variable

Cost behaviour

– Relevant costs

Cost for decisionmaking

Controllable/uncontrollable

costs

CVP

Breakevenanalysis

Contributionanalysis

Limitingfactor

analysis

Capitalbudgeting

Investmentappraisal

Payback DCF

Finance function



Self-test


1 Linus is an accountant for Magna Ltd, which is considering a substantial new project. Linus has beenasked to assist in determining whether it should be financed by retained earnings, equity, loans or amix of all sources. It would appear that Linus is employed by Magna Ltd’s finance function’s

A Transaction recording sectionB Treasury management sectionC Financial reporting sectionD Management accounting section

2 In order to value inventory, the most important information which the management accountantsupplies is

A How many units are in inventoryB The direct cost of each unitC Unit costsD How many cost centres there are

3 Primus Ltd is planning to increase the level of its activities from 1 January 20X8. In the managementaccounts for the six months ended 30 June 20X7, which of the following costs are likely to have beenaffected by the expansion?

A Fixed costs onlyB Variable costs onlyC Both fixed and variable costsD Neither fixed nor variable costs

4 Hobo Ltd is considering a project which has been recommended by its engineers. The engineers’report, which cost CU10,000 to produce, states that increased revenues of CU100,000 per month willflow from an investment now of CU200,000, plus monthly outflows of CU60,000. Irrelevant costs formaking this decision are

A CU10,000B CU60,000C CU100,000D CU200,000

5 Mush Ltd is considering a new product which will incur substantial additional fixed costs for thebusiness. Yolande, an accountant for Mush Ltd, has been asked to report on the minimum number ofunits of the product that will need to be sold. Which of the following is Mush Ltd expecting Yolandeto use when making her report?

A Payback analysisB Breakeven analysisC Limiting factor analysisD Discounted cash flow analysis

6 Strand Ltd operates in the fast moving consumer goods market, where it is a medium-sized player.When determining how much to charge its customers for one of its established products, the maininfluence on Strand Ltd will be its

A CustomersB CostsC Corporate objectivesD Competitors



7

7 Quantock Ltd is considering a substantial investment for which it will need to raise considerablequantities of cash. It is not yet sure whether or not it should make the investment, as it appears tohave a high level of risk attached to it. The most important technique that Quantock should use inrelation to this investment at this point is

A Cash budgetingB Discounted cash flowC Capital budgetingD Payback

8 Briar Ltd’s managers have been asked to produce budgets for their departments. Raji has submitted abudget for the next year based on this year’s actual performance plus an allowance for inflation of 3%,less an allowance for performance improvement of 2%. The method used by Raji is

A Zero-based budgetingB Flexible budgetingC Rolling budgetsD Incremental budgeting

9 Which of the following statements about the value of information is true?

A It is always a measure of its scarcityB It is subjectiveC It is undermined if it is too accessibleD It is independent of its source

10 Moody Ltd is reviewing its internal control system. Its control activities should be directed atcontrolling

A Threats to its operationsB Its operationsC Threats to achievement of its objectivesD Achievement of its objectives





1 B

2 C How many units are in inventory (A) would be determined by the transaction recording section.Total unit costs (C) are more complex than simply the direct cost per unit (B). How many costcentres there are (D) is irrelevant for inventory valuation

3 D As at 30 June 20X7 the expansion is still six months away, so no costs will yet have been affected

4 A The engineers’ report is a sunk cost and so should not be considered when evaluating whetherthis project should be pursued

5 B

6 D FMCG are highly competitive markets so the prices charged by competitors will in the end bethe greatest influence

7 B Cash budgeting (A) is primarily concerned with working capital. The company is not reallyconcerned with capital budgeting (C) currently because it already knows it will need to raise cash.It will need to prioritise DCF over payback because of the element of risk in the project

8 D Although Raji has made allowances for future changes (inflation and performance improvement),he is still basically using increments in past experience as the basis for his budget

9 B The value of information is in the eye of the beholder, i.e. there is no objective valuation of it. Itis not always valued in terms of its scarcity (A) as even information that is available to all can bevery valuable. Information is undermined if it is not accessible enough (C), and its value is verymuch dependent on its source (D)

10 C



7



Costs can be classified as direct or indirect costs, or as fixed or variable costs. These alternativeclassifications are not mutually exclusive but are complementary to each other. Some direct costs are fixed(although they are usually variable) and some indirect costs are variable. For example, the basic salaries ofproduction staff are effectively fixed direct costs. Expenditure on power varies with levels of output or use,but this is usually treated as an indirect variable cost.


Since the present value of the investment is more than the amount invested, we say it has a positive netpresent value (NPV) of CU53,000 - CU50,000 = CU3,000. This NPV is higher than the CU52,000 -CU50,000 = CU2,000 NPV of the deposit account alternative. Generally, the project with the higherpositive NPV should be accepted, so the investment in the 12-month project should be made.


The information already exists anyway, as it is used for a number of different purposes. It might beimpossible to predict how often it will be used, and hence the economic benefits to be derived from it.

The enquiry software and MIS which are used to process these requests have also been purchased, so itscost is largely fixed. The cost of each individual enquiry is effectively zero.


Contents

chapter 8

Measuring performance

Introduction

Examination context

Topic List

1 Why do we measure a business's performance?

2 What aspects of performance are measured?

3 Profitability measures

Liquidity and solvency measures

5 Efficiency and working capital management measures

6 Investor measures

7 Limitations of financial measures

8 The balanced scorecard






Introduction


Specify how accounting and finance functions support businesses in the pursuit of theirobjectives

Specify why the management of a business require information about performancemeasurement

Identify the accountant's role in preparing and presenting information for the management ofa business

Specific syllabus references are : 3b, e, f.


Measuring the business's performance provides feedback to the key planning and control process ofmanagement, and also helps to fulfil the business's obligations to provide information to those charged withgovernance (the directors) and to external users.

Stop and think

What do we mean by 'performance'? How can it be measured and how should the information be conveyedto users? What will they do with it? Should we just produce quantified measures, or are there qualitativemeasures that may prove useful?

Working context

As you build up your exposure to different organisations in audit or other professional engagements, youwill see how seriously many businesses take the issue of performance measurement, tying it in very closelywith the success of overall strategy and achievement of the objective of increasing shareholder wealth.

Syllabus links

The topic of performance measurement is developed as well in Management Information and FinancialManagement at the Professional stage, and in the Advanced stage.

MEASURING PERFORMANCE


8

Examination context


Questions on performance measurement could easily appear in the exam.

Exam requirements




1 Why do we measure a business's performance?

Section overview

Performance measures are calculated to assess the business’s productivity, effectiveness andefficiency.

Performance measures should be focused on the user and what they need them for.

Comparability (with budgets, trends, other parts of the business and other businesses) is a key issuefor performance measurement.

Performance measures may be qualitative or quantitative (financial or non-financial).

Managers need measurements of the business's performance in order to assess whether objectives of SBUsor indeed the whole business are being met, and if so how:

Productively: what is output relative to what is input? Effectively: how far are targets and objectives achieved? Efficiently: what is the gain that the business has achieved?

1.1 Who uses performance measures?

Interactive question 1: Financial information [Difficulty level: Intermediate]

Who are the main groups of users of financial information, and what information do they need?


A business's management needs to understand and interpret financial information:

As a basis for making management decisions and To help in understanding how external users might react to the information in the financial

statements.

1.2 User focus

The primary focus of users of the financial statements differs according to their interests.

Customers and suppliers are most interested in current liquidity, but also focus on overall pre-taxprofitability and net worth of the company in their evaluation of likely future liquidity

Lenders focus on liquidity, longer-term solvency and ability to service and repay debts

Shareholders' main concern is with risk and return. They therefore focus mainly on gearing anddividend cover to measure the risk, and on post-tax returns and the overall net worth of the companyto measure return. However, they are also interested in solvency, as they will be the first to lose outin the event that the company runs into financial difficulties. Finally, shareholders are interested inliquidity as this affects the security of their dividends.

Although different decisions usually require different information, there is overlap as all potential users areinterested in the financial performance and financial position of the company as a whole.



8

1.3 Using information on performance measurement

The performance measures that are calculated and reported are used by three groups:

Managers, to make control and planning decisions Directors, to assess whether corporate governance is effective External users, to make economic decisions

A performance measure is only useful if it is given meaning in relation to something else: users needcomparability against various yardsticks.

Budgets, targets or standards

Trends over time (comparing last year with this year, say). An upward trend in the number ofrejects from a production process, say, would indicate a problem that needs investigating. The effectsof inflation need to be recognised if financial measures are being compared over time

The results of other parts of the business. Large manufacturing businesses may compare theresults of their various production departments, supermarket chains will compare the results of theirindividual stores, while a college may compare pass rates in different departments

The results of other businesses. Trade associations or regulators may provide details of keymeasures based on averages for the industry. Increasingly, businesses have access to benchmarkingmeasures

As with all comparisons, it is vital that the performance measurement process compares 'like with like'.There is little to be gained in comparing the results of a small supermarket in a high street with a huge onein an out-of-town shopping complex, for instance.

Performance measures do not provide answers but help to focus attention on important areas, therebyminimising the chance of failing to identify a significant trend or weakness. In other words, performancemeasures enable you to ask informed questions.

1.4 Types of performance measure

Qualitative measures are subjective and judgemental, and are not expressed in numerical terms(we do not consider these further here)

Quantitative measures are objective and based on data which must be reliable; they are expressedin numerical terms and can be separated into:

– financial measures (based on data as to sales, profit etc)

– non-financial measures (based on data as to number of items produced or phone callsanswered etc)

Both types of measure can be incorporated into a business-wide set or balanced scorecard of measuresfor use by senior managers and directors, as we shall see later in this chapter.

Performance measures alone are not sufficient for the needs of most external users, and there are otheritems of information which should be looked at:

The content of any accompanying commentary on the financial information provided

The age and nature of the business's assets

Current and future developments in the business's markets, at home and overseas and recentacquisitions or disposals of a subsidiary by the business

Any other noticeable features of the business's financial statements, such as events after the balancesheet date, contingent liabilities, or a qualified auditors' report



2 What aspects of performance are measured?

Section overview

Measures may be made of operational or financial performance.

Operational performance measures are derived from analysing the variance of actual performancefrom what was expected, using standard costs and variance analysis.

Financial performance is typically measured using ratio analysis.

The management accounting section is engaged in measuring the following aspects of businessperformance as part of its support for operational planning and control:

Efficient use of labour and materials Effective buying of materials Control of labour rates of pay and materials prices Labour and asset productivity versus idle time Effectiveness of planning and control mechanisms

The financial reporting section is likely to be responsible for producing financial performance measureson the following key areas:

Profitability Liquidity and solvency Efficiency and working capital management Whether the business represents a worthwhile investment

We shall move onto financial performance measures relevant to a wide variety of users shortly.

Performance measurement specifically for management information is a major part of the ManagementInformation syllabus at the Professional stage so we shall not cover it in detail here. You should be awarehowever that one of the key ways in which performance measures support management planning andcontrol at the operational level is via variance analysis.

2.1 Operational performance: variance analysis

In order for costs to be controlled effectively we need to analyse deviations of actual performance frombudget in detail. This is partly achieved by analysing actual performance against budget at the level of anentire activity or operation, but more useful control information can be obtained by looking at theinformation in more detail, at the cost unit level. To do this, we:

Determine a planned or target cost for the cost unit under efficient operating conditions, whichbecomes its standard cost

Measure in detail the actual costs incurred

Calculate the variances between standard and actual costs

Analyse the causes of the variances and take control action if appropriate

The main headings under which variance analysis measures performance are:

Overall volume of activity

Prices charged (to customers) and prices/rates paid (for goods for resale, materials, labour,overheads etc)

Usage and efficiency (how far the resources used achieved the output that was expected)



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Worked example: Variance analysis

Wenlock Ltd produces Sterms, which are planned to make the following standard contribution margin perunit to the company's fixed costs:

CU CUSales price 200Materials (60)Labour (32)Variable overheads (10)Standard cost (102)Standard contribution margin (SCM) 98

Wenlock Ltd's management has been given the following analysis of the performance of Sterms in February:

Volume Budget Actual Variance(production 100 units 120 units 20 unitsand sales) Per unit Total Per unit Total

CU CU CUSales CU200 20,000 CU195 23,400 3,400CostMaterials 30 kg at CU2/kg 6,000 29 kg at CU2.10/kg =

CU60.907,308 (1,308)

Labour 4 hours at CU8/hr 3,200 4.5 hours at CU7.90/hr =

CU35.55

4,266 (1,066)

Variableoverheads

4 hours at

CU2.50/hr

1,000 4.5 hours at CU2.40/hr =

CU10.80

1,296 (296)

Fixed overheads 7,500 7,650 (150)Profit Budget 2,300 Actual 2,880 580

While the managers will no doubt be pleased to see that the overall level of profit was higher than budget,they will be alarmed to see so many negative variances, which will not really make sense to them. They willnot immediately be able to identify where the improvement in profit arose, and in particular whether or notit means that in sales the company is doing well but in every other aspect of its operations Wenlock Ltd isfalling short of expectations of its performance.



They will be able to tell more from the following performance report, which reconciles budgeted toactual profit:

CU CUBudgeted net profit 2,300VariancesSales margin – price Actual volume difference

between standard and actualselling price

120 (CU195 – CU200) (600)

Sales margin – volume Difference in volume SCM 20 CU98 1,960

Sales margin variance 1,360Materials price Actual kgs difference in price per

kg(29 120) (CU2.00 –CU2.10)

(348)

Materials usage Difference in quantity per unit for

actual volume standard price perkg

(30 – 29) 120 CU2 240

Materials variance(108)

Labour rate variance Actual hours difference in rateper hour

(4.5 120) (CU8.00 –CU7.90)

54

Labour efficiencyvariance

Difference in hours per unit for

actual volume standard rate perhour

(4 – 4.5) 120 CU8 (480)

Labour variance (426)Variable overheadsexpenditurevariance

Actual hours difference in rateper hour

((4.5 120) (CU2.50 –CU2.40)

54

Variable overheadsefficiency variance

Difference in hours per unit for

actual volume standard rate perhour

(4 – 4.5) 120 CU2.50 (150)

Variable overheadsvariance

(96)

Fixed overheadspending variance

Difference between budgeted andactual fixed overheads

CU7,500 – CU7,650 (150)

Actual profit 2,880

We don't need to worry about how the above calculations are arrived at, though we have included thebasis for each calculation for the sake of completeness.

Interactive question 2: Variance analysis [Difficulty level: Intermediate]

What initial conclusions might Wenlock Ltd’s managers make on the basis of the performance report?


Most of the managers’ initial conclusions will require further analysis. In practice there are numerousreasons why variances occur, not least that the standards are out of date! However, we can see thatdetailed and rigorous variance analysis such as this at least points managers in the right general direction forinvestigation and possible control action.

2.1.1 Contingency theory of management accounting

There is no universally agreed management accounting control system that can be applied to all businesses.The contingency theory of management accounting states that it all depends on situational orcontingent factors.



8

2.2 Financial performance measures: ratio analysisError! Bookmark not

defined.

To demonstrate how to calculate some basic financial performance measures and how to use them, weshall use the following set of financial statements.

FURLONG LTD INCOME STATEMENTFOR THE YEAR ENDED 31 DECEMBER

Notes 20X8 20X7CU CU

Revenue (all sales are made on credit terms) 3,095,576 1,909,051Cost of sales (2,402,609) (1,441,950)Gross profit 692,967 467,101Other income 2 744 2,782Administrative expenses 1 (333,466) (222,872)Finance costs 3 (18,115) (21,909)Profit before tax 342,130 225,102Tax (74,200) (31,272)Profit for the year 267,930 193,830

Dividend per share 1.4p 1.0pEarnings per share 12.8p 9.3p

FURLONG LTD BALANCE SHEETAS AT 31 DECEMBER

Notes 20X8 20X7CU CU CU CU

ASSETSNon-current assets

Tangible non-current assets 802,180 656,071Current assets

Inventory 64,422 86,550Receivables 4 1,002,701 853,441Cash and cash equivalents 1,327 68,363

1,068,450 1,008,354Total assets 1,870,630 1,664,425

EQUITY AND LIABILITIESEquity

Ordinary shares 10p each 5 210,000 210,000Share premium account 48,178 48,178Retained earnings 630,721 393,791

888,899 651,969Non-current liabilities

10% loan notes 20Y4/20Y9 100,000 100,000Current liabilities 6 881,731 912,456Total equity and liabilities 1,870,630 1,664,425

NOTES TO THE FINANCIAL STATEMENTS20X8 20X7

CU CU1 Depreciation

Depreciation charged 151,107 120,147

2 Other incomeReceivable on short-term deposits 744 2,782

3 Finance costsPayable on short-term borrowings 8,115 11,909Payable on loan notes 20Y4/20Y9 10,000 10,000

18,115 21,909



20X8 20X7CU CU

4 ReceivablesTrade receivables 905,679 807,712Prepayments and accrued income 97,022 45,729

Total receivables 1,002,701 853,441

5 Called-up share capital

Authorised ordinary shares of 10p each 1,000,000 1,000,000

Issued and fully paid ordinary shares of 10p each 210,000 210,000

6 Current liabilitiesTrade payables 627,018 545,340Accruals and deferred income 81,279 280,464Tax 173,434 86,652

881,731 912,456

3 Profitability measures

Section overview

A business's profitability can be measured in terms of: return on capital employed (ROCE); gross andnet margin.

We have seen that the level of a company's profitability is of interest to virtually all its stakeholders, butmost of all to the shareholders and potential investors.

In our example, the company made a profit in both 20X8 and 20X7, and there was an increase in profitbetween one year and the next:

Of 52% before taxation (342,130 – 225,102)/225,102 100%

Of 38% after taxation (267,930 – 193,830)/193,830 100%

3.1 Profit before interest and tax (PBIT)

Profit before taxation is generally thought to be a better figure to use than profit after taxation, becausethere might be unusual variations in the tax charge from year to year which would not affect the underlyingprofitability of the company's operations.

Another profit figure that should be calculated is PBIT, profit before interest and tax. This is theamount of profit which the company earned before having to pay interest to the providers of loan capital.By providers of loan capital, we usually mean longer-term loan capital, such as loan notes and medium-termbank loans, which will be shown in the balance sheet as non-current liabilities.

Definition

Profit before interest and tax (PBIT): The profit before taxation, plus interest charges on long-termloan capital.

PBIT in our example is therefore:20X8 20X7

CU CUProfit before tax (from the income statements) 342,130 225,102Finance cost regarding the loan notes (from Note 3) 10,000 10,000PBIT 352,130 235,102



8

This shows a 50% growth between 20X7 and 20X8:

(352,130 – 235,102)×100%

235,102

3.2 Return on capital employed (ROCE)

To assess profits or profit growth properly we relate them to the amount of funds (capital) that wereemployed in making the profits. The most important profitability ratio is therefore return on capitalemployed (ROCE), which states PBIT as a percentage of the amount of total capital employed being bothequity and loan capital.

Definition

ROCE =PBIT

Capital employed

Capital employed = Equity plus long-term liabilities

OR = Total assets less current liabilities

We must compare like with like, so if capital means share capital and reserves plus long-term liabilitiesand debt capital, profit must mean the profit earned by all this capital together. This is PBIT, since interest isthe return for loan capital.

In our example, capital employed = 20X8 CU888,899 + 100,000 = CU988,89920X7 CU651,969 + 100,000 = CU751,969

20X8 20X7

ROCE =899,988CU

130,352CU 100%

969,751CU

102,235CU 100%

= 35.6% 31.3%

What does a company's ROCE tell us? There are three basic comparisons that can be made.

Change in ROCE from one year to the next. In this example, there has been an increase in

ROCE of over 4% from its 20X7 level 35.6% - 31.3%

ROCE being earned by other companies, if this information is available, can be compared withthe ROCE of this company.

Current market borrowing rates

– What would be the cost of extra borrowing to the company if it needed more loans, and is itearning a ROCE that suggests it could make profits to make such borrowing worthwhile?

– Is the company making a ROCE which suggests that it is getting value for money from its currentborrowings?

– Companies are in a risk business and commercial borrowing rates are a good independentyardstick against which company performance can be judged

In this example, if we suppose that current market interest rates for medium-term borrowing from banksare around 10%, then the company's actual ROCE of 35.6% in 20X8 is high.



3.3 Gross margin

Definition

Gross margin: The amount by which revenue exceeds cost of sales, expressed as a percentage.

Gross profit

Revenue 100%



8

In the case of Furlong Ltd, gross margin is calculated as follows:

20X8 20X7

Gross margin =576,095,3CU

967,692CU 100%

051,909,1CU

101,467CU 100%

= 22.4% 24.5%

We can see that the gross margin has dropped by 2.1% 24.5% - 22.4% in one year. This may be attributable to:

Falls in sales prices to customers Change in the mix of sales, so more lower margin items are being sold than before Rise in costs per item sold

Margin is always expressed in relation to sales. Another term that is often used is mark-up, which isexpressed in relation to cost. Thus a gross margin of 20% is actually a mark-up on cost of 25%.

Worked example: Gross profit percentages

CUSales 100Cost of sales (80)Gross profit 20

Margin on sales : CU20/CU100 100% = 20%

Mark-up on cost: CU20/CU80 100% = 25%

3.4 Net margin

Definition

Net margin: The amount that PBIT represents of revenue, expressed as a percentage.

PBIT

Revenue 100%

In the case of Furlong Ltd, net margin is calculated as follows:

20X8 20X7

Net margin =576,095,3CU

130,352CU 100%

051,909,1CU

102,235CU 100%

= 11.4% 12.3%

We can see that the net margin has dropped by nearly 1% 12.3% -11.4% in one year. This is less than the

gross margin fall, which suggests that any problem regarding overall profitability relates to trading activity(revenue and cost of sales) rather than overheads.

Interactive question 3: Net margin [Difficulty level: Exam standard]

What mark-up is Furlong Ltd using in each year?




4 Liquidity and solvency measures

Section overview

A business should seek a degree of short term liquidity, plus long term solvency. Both factors areessentially concerned with whether the business has enough cash.

The current ratio and the quick ratio measure short term liquidity.

The debt and gearing ratios, plus interest cover, measure long term solvency.

4.1 Short-term liquidity

Definition

Liquidity: The amount of cash a business can put its hands on quickly to settle its debts (and possibly tomeet other unforeseen demands for cash payments too).

Liquid assets are current asset items that will or could soon be converted into cash, plus cashitself. Two common definitions of liquid assets are:

All current assets without exception

All current assets with the exception of inventories:

– Cash

– Short-term investments for which there is a ready market

– Fixed-term deposits with a bank or other financial institution, for example a six monthhigh-interest deposit with a bank

– Trade and other receivables (because they will pay what they owe within a reasonably shortperiod of time)

A company can obtain liquid assets from sources other than sales, such as the issue of shares for cash, anew loan or the sale of non-current assets. But a company cannot rely on these at all times, and in general,obtaining liquid funds depends on making sales and profits. Even so, profits do not always lead to increasesin liquidity, because funds generated from trading may be immediately invested in non-current assets or paidout as dividends.

A company needs liquid assets so it can meet its debts when they fall due. Payments are continually madefor operating expenses and other costs, and so there is a cash operating cycle from trading activities ofcash coming in from sales and cash going out for expenses. We shall come back to this later in this chapter.

4.2 Liquidity measures: current ratio and quick ratio

Definition

Current ratio =Current assets

Current liabilities

The idea of the current ratio is that a company should have enough current assets that give a promise of'cash to come' to meet its future commitments to pay off its current liabilities. Generally, a ratio in excessof 1 is expected. Otherwise, there would be the prospect that the company might be unable to pay itsdebts on time.

In the case of Furlong Ltd, its current ratio is as follows:



8

20X8 20X7

Current ratio =731,881CU

450,068,1CU

456,912CU

354,008,1CU

= 1.21:1 1.10:1

The ratio exceeds 1 and has improved in the period. We cannot interpret this measure a great deal furtherwithout knowing what business Furlong Ltd is in, and what current ratio similar businesses have.

Companies are not able to convert all their current assets into cash very quickly. In particular, somemanufacturing companies might have slow inventory turnover: they might hold large quantities of rawmaterial inventory, which must be used in production to create finished goods inventory. These might beheld for a long time, or sold on lengthy credit. In such businesses inventories are not very 'liquid' assets. Forthese reasons, we calculate an additional liquidity ratio, known as the quick ratio (or acid test ratio).

Definition

Quick ratio =Current assets less inventory

Current liabilities

This ratio should ideally be at least 1 for companies with a slow inventory turnover ratio (i.e. companieswhose inventory moves more slowly). For companies with a fast inventory turnover, a quick ratio can becomfortably less than 1 without suggesting that the company is in cash flow trouble.

For Furlong Ltd, its quick ratio is as follows:

20X8 20X7

Quick ratio =

731,881CU

422,64CU450,068,1CU 456,912CU

550,86CU354,008,1CU

= 1.14 1.01

The current and quick ratios offer an indication of the company's liquidity position, but the absolute figuresshould not be interpreted too literally. It is often theorised that an acceptable current ratio is 1.5 andan acceptable quick ratio is 0.8, but these should only be used as a guide. Different businesses operate invery different ways. A supermarket group for example might have a current ratio of 0.52 and a quick ratioof 0.17. Supermarkets have low receivables (people do not buy groceries on credit offered by thesupermarket), low cash (good cash management), medium inventories (high inventories but quick turnover,particularly in view of perishability) and very high payables.

Compare this with a combined manufacturing and retail organisation, with a current ratio of 1.44 and aquick ratio of 1.03. Such businesses operate with liquidity ratios closer to the standard.

What is important is the trend of these ratios. From this, we can see whether liquidity is improving ordeteriorating. If a supermarket has traded for the last 10 years (very successfully) with current ratios of 0.52and quick ratios of 0.17 then it should be supposed that the company can continue in business with thoselevels of liquidity. If in the following year the current ratio were to fall to 0.38 and the quick ratio to 0.09,then further investigation into the liquidity situation would be appropriate. It is the relative position that isfar more important than the absolute figures.

Don't forget the other side of the coin either. A current ratio and a quick ratio can get bigger than theyneed to be. A company that has large volumes of inventories and receivables might be over-investing inworking capital, and so tying up more funds in the business than it needs to. This suggests poormanagement of receivables (credit) or inventories by the company, issues we will look at in more detail inChapter 9.

4.3 Long-term solvency

Solvency is the longer-term equivalent of liquidity. Can the business in the long term meet its debts, tradeand remain a going concern?



Measures of long-term solvency are concerned with how much the business owes in relation to itssize, whether it is getting into heavier debt or improving its debt situation, and whether its debt burdenseems heavy or light.

When a business is heavily in debt, banks and other potential lenders may be unwilling to advancefurther funds

When a business is earning only a modest PBIT, and has a heavy debt burden, there will be very littleprofit left over for shareholders after the interest charges have been paid. If interest rates were to goup (on bank overdrafts and so on) or the business were to borrow even more, it might soon beincurring interest charges in excess of PBIT. This might eventually lead to the complete insolvency ofthe business

These are two big reasons why businesses should keep their debt burden under control!

Definition

Debt ratio: The ratio of a business's total current and non-current liabilities to its total assets. This isusually expressed as a percentage.

As a very general guide, you might regard 50% as a safe limit to the debt ratio. In practice, many companiesoperate successfully with a higher debt ratio than this, but 50% is nonetheless a helpful benchmark. Inaddition, if the debt ratio is over 50% and getting worse, the company's debt position will be worth lookingat more carefully.

In the case of Furlong the debt ratio is:

20X8 20X7

Total current and non- current liabilities

Total assets=

630,1870CU

000,100731,881CU 100%

425,664,1CU

000,100456,912CU 100%

= 52% = 61%

In this case, the debt ratio is quite high, mainly because of the large amount of current liabilities. However,the debt ratio has fallen from 61% to 52% between 20X7 and 20X8, and so the company appears to beimproving its debt position.

Gearing (or leverage) is concerned with a business's long-term capital structure. We can think of abusiness as consisting of non-current assets plus working capital (which is current assets minus currentliabilities). These assets must be financed by the long-term capital of the company, which is:

Shareholders' equity, including irredeemable preference shares on which dividends are paid fromshareholders' profit

Non-current liabilities, including redeemable preference shares.

The gearing ratio is a measure of the proportion of a business's capital that is capital on which interest ispaid from profit before shareholders get their dividend.

Definition

Gearing ratio =Non- current liabilities

Shareholders' equity + non- current liabilities. It is usually expressed as a percentage.

In the example of Furlong, we find that the company, although having a high debt ratio because of itscurrent liabilities, has a low gearing ratio. Its only long-term debt is the 10% loan notes.



8

20X8 20X7

Gearing ratio =899,988CU

000,100CU100%

969,751CU

000,100CU 100%

= 10% 13%

As with the debt ratio, there is no absolute limit to what a gearing ratio ought to be. A company with agearing ratio of more than 50% is said to be high-geared (whereas low gearing means a gearing ratio of lessthan 50%). Many companies are high-geared, but if a high-geared company is becoming increasingly high-geared, it is likely to have difficulty in the future when it wants to borrow even more, unless it can alsoboost its shareholders' capital, either with retained profits or by a new share issue.

Interest cover shows whether a company is earning enough PBIT to pay its finance costs comfortably, orwhether its finance costs are high in relation to the size of its profits, so that a fall in PBIT would then havea significant effect on profits available for ordinary shareholders.

Definition

Interest cover =PBIT

Finance cost (on short- and long-term borrowings)

In the case of Furlong Ltd, interest cover is:

20X8 20X7

Interest cover =115,18CU

130,352CU

909,21CU

102,235CU

= 19.4 times 10.7 times

An interest cover of two times or less would be low; it should really exceed three times before thecompany's interest costs are to be considered within acceptable limits.

5 Efficiency and working capital managementmeasures

Section overview

A business should seek to use its assets efficiently and to manage its working capital effectively.

Asset turnover measures how efficiently assets are being used to generate revenue. It can be brokendown into inventory turnover period, receivables collection period and payables payment period.

Subtracting the payables payment period from the other two gives us the length of the cash operatingcycle i.e. the time between paying out for goods/services and receiving money back from sales.

It is useful to measure how efficiently the business is utilising its assets, and especially how well it ismanaging its working capital (current assets less current liabilities).

5.1 Asset turnover

Definition

Asset turnover: How well the assets of a business are being used ('turned over') to generate sales.

=Revenue

Capital employed (total assets less current liabilities)



For example, if two companies each have capital employed of CU100,000 and Company A makes sales ofCU400,000 per annum whereas Company B makes sales of only CU200,000 per annum, Company A ismaking higher sales from the same amount of assets (twice as much asset turnover as Company B) and thiswill help A to have a higher ROCE than B. Asset turnover is expressed as 'x times' so that assets generate xtimes their value in annual revenue. Here, Company A's asset turnover is 4 times and B's is 2 times.

In the case of Furlong Ltd, asset turnover is:

20X8 20X7

Asset turnover = 731,881630,870,1CU

576,095,3CU

456,912425,664,1CU

051,909,1CU


In fact asset turnover and net margin together explain the ROCE; if the ROCE is the primary profitabilityratio, these other two are the secondary ones. The relationship between the three ratios can be shownmathematically.

Definition

ROCE: Net margin Asset turnover = ROCE

PBIT

Revenue

Revenue

Capital employed=

PBIT

Capital employed

For Furlong Ltd:

Net Assetmargin turnover ROCE

20X8576,095,3CU

130,352CU

899,988CU

576,095,3CU=

899,988CU

130,352CU

11.4% 3.13 times = 35.6%

20X7051,909,1CU

102,235CU

969,751CU

051,909,1CU=

969,751CU

102,235CU

12.3% 2.54 times = 31.3%

The company's improvement in ROCE between 20X7 and 20X8 is attributable to higher activity levels, asshown in its asset turnover. Although the net margin fell a little, the higher asset turnover more thancompensated for this.

5.2 Inventory turnover

The inventory turnover ratio measures how often the company's inventory is being 'turned over' in theperiod to generate sales. We normally assume that the faster the turnover the better, since inventory isexpensive to hold.



8

Definition

Inventory turnover ratio:*Inventory

salesofCost

*The figure used for inventory is normally average inventory in the period, i.e.

2

inventoryClosinginventoryOpening

The inventory turnover period measures the average number of days that items of inventory are heldfor.

Definition

Inventory turnover period:Inventory

Cost of sales 365 days

For Furlong Ltd we can calculate inventory turnover ratio as follows for 20X8:

Inventory turnover ratio =2/)422,64550,86(

609,402,2CU

= 31.8 times

We can see from the inventory turnover ratio that inventory is turned over often in 20X8, a sign thatobsolescence and lack of demand would not appear to be problems, and/or that the company pursues apolicy of low inventory.

20X8 20X7

Inventory turnover period =609,402,2CU

422,64CU 365 days

950,441,1CU

550,86CU 365 days

= 9.8 days 21.9 days

Inventory turnover period is another measure of how vigorously a business is trading. A lengtheninginventory turnover period from one year to the next indicates one of two things.

A slowdown in trading, due possibly to reduced demand for the company's inventory

A build-up in inventory levels, perhaps suggesting that the investment in inventories is becomingexcessive

As we saw in our analysis of asset turnover, Furlong Ltd has seen a rising level of trading activity.



5.3 Receivables collection period

The receivables collection period measures how long it takes to collect money from customers who boughton credit, by relating these receivables to the total revenue from credit sales.

Definition

Receivables collection period:Trade receivables

Revenue from credit sales 365 days

The trade receivables figure used is not the total figure for receivables in the balance sheet, which includesprepayments and accrued income. It is itemised in the analysis of the receivables total, in a note to thefinancial statements.

The trend of the collection period over time is probably the best guide when using this measure. If thecollection period is increasing year on year, this may indicate a poorly managed credit control function (andpotentially therefore a poorly managed company). We shall return to this in Chapter 9.

For Furlong Ltd, which makes all its sales on credit, the receivables collection period is:

20X8 20X7

Receivables collection period =576,095,3CU

679,905CU 365 days

051,909,1CU

712,807CU 365 days

= 106.8 days 154.4 days

The collection period has decreased, which is a good sign, but it is still quite long at nearly 3½ months.

5.4 Payables payment period

The payables payment period means how long it takes to pay what is owed to suppliers by relating tradepayables to cost of sales, assuming all purchases are made on credit terms.

Definition

Payables payment period:Trade payables

Cost of sales 365 days

It is rare to find purchases disclosed in published financial statements so cost of sales serves as anapproximation. The payables payment period helps to assess a company's liquidity; an increase is often asign of lack of long-term finance or poor management of current assets, resulting in the use of extendedcredit from suppliers, increased bank overdraft and so on.

For Furlong Ltd it is calculated as follows:

20X8 20X7

Payables payment period =609,402,2CU

018,627CU 365 days

950,441,1CU

340,545CU 365 days

= 95.3 days 138.0 days

The payment period has decreased over the year, which again is a good sign.



8

5.5 The cash operating cycle

Definition

Cash operating cycle: A measure of the length of time in days between a business paying out cash forinputs and receiving cash from customers.

A very simple example is in Figure 8.1:

Figure 8.1: Cash operating cycle

The length of the cash operating cycle is calculated as follows:

Inventory turnover period – payables payment period + receivables collection period

20X8 20X7days days

Inventory turnover period 9.8 21.9Payables payment period (95.3) (138.0)Receivables collection period 106.8 154.4

21.3 38.3

We shall come back to the cash operating cycle, and working capital management, in Chapter 9.

6 Investor measures

Section overview

Investors are concerned with building the value of their investment.

Investor measures include earnings per share (EPS), dividend cover and the price/earnings (P/E) ratio.

Investor measures help shareholders and potential investors to assess the value and quality of aninvestment in a company's ordinary shares. The value of an ordinary share in a company listed on astock exchange is its market value, and so some investor ratios have regard not only to information inthe company's published financial statements, but also to the current share price.

6.1 Earnings per share (EPS)

The return on each ordinary share in a period is the earnings per share (EPS). This is the amount of netprofit for the period that is attributable to each ordinary share which is outstanding during all or part of theperiod.

Calculating the EPS figure is outside the scope of this paper.



6.2 Dividend per share and dividend cover

Definition

Dividend per share:eligiblesharesofNumber

dividendTotal

The dividend per share in pence is calculated as the total dividend for the year divided by the number ofshares eligible to receive a dividend. It is clearly an item of some interest to shareholders. Note thatdividend per share is almost always less than earnings per share, as companies rarely distribute all theirearnings as dividend.

Definition

Dividend cover: A measure of what proportion of the net profit for the year that is available fordistribution to shareholders has been paid (or proposed) as dividend, and what proportion will be retainedin the business to finance future growth.

Earnings per share

Dividend per share

In the case of Furlong Ltd its dividend cover is as follows.

20X8 20X7

Dividend cover =1.4p

12.8p

1.0p

9.3p


A dividend cover of two times would indicate that the company had paid 50% of its net profit as dividends,and retained 50% in the business to help to finance future operations. Retained earnings are an importantsource of funds for most companies, and so the dividend cover can in some cases be quite high.

A significant change in the dividend cover from one year to the next is worth looking at closely. Forexample, if a company's dividend cover fell sharply between one year and the next this could be because itsprofits had fallen, but the directors wished to pay at least the same amount of dividends as in the previousyear, so as to keep shareholder expectations satisfied.

6.3 Price/earnings (P/E) ratio

Definition

Price/earnings (P/E) ratio: The ratio of a company's current share price to its earnings per share.

In Furlong Ltd's case if we assume the company's share price is 54p and 85p at the end 20X7 and 20X8respectively, the P/E ratio is:

20X8 20X7P/E ratio = 85p/12.8p 54p/9.3p

6.6:1 5.8:1



8

A high P/E ratio indicates strong shareholder confidence in the company and its future, e.g. in profitgrowth, and a low P/E ratio indicates lower confidence.

The P/E ratio of one company can be compared with the P/E ratios of:

Other companies in the same business sector Other companies generally

It is often used in stock exchange reporting where prices are readily available.

6.4 Dividend yield

Definition

Dividend yield: The return a shareholder is currently expecting related to the market value of each share.

Dividend per share

Current share price 100%

For Furlong Ltd:

20X8 20X7

Dividend yield = 1.4/85 100% 1/54 100%1.6% 1.8%

Shareholders look for both dividend yield and capital growth in the value of the share at currentmarket prices. Dividend yield is therefore an important aspect of a share's performance.

7 Limitations of financial measures

Section overview

Financial measures are of limited usefulness to users because of problems with: the information onwhich they are calculated; comparison across time; comparison with different businesses.

Using financial measures is not foolproof. There are many problems in trying to identify trends and makecomparisons. Below are just a few.

Information problems

– The base information may be out of date, so timeliness of information leads to problems ofinterpretation.

– Historical cost information may not be the most appropriate information for the decision forwhich it is being used.

– For external users, information often comes from published financial statements which generallycomprise summarised information; more detailed information may be needed.

– Analysis of financial measures only identifies symptoms, not causes, and thus is of limited use onits own.

Comparison problems: trends

– Effects of price changes make comparisons difficult unless adjustments are made.– Impacts of changes in technology affect the value of assets, the likely return and future markets.– A changing environment affects the results reflected in the accounting information.– Changes in accounting policies can affect the reported results.– There can be problems in establishing a normal base year to compare other years with.



Comparison problems: different businesses. Analysing measures for different businesses andcomparing them can be difficult because of:

– selection of industry norms and the usefulness of norms based on averages

– different firms having different financial and business risk profiles, and the impact of this onanalysis

– different firms using different accounting policies

– impacts of the size of the business and its comparators on risk, structure and returns

– impacts of different environments on results, e.g. different countries or home-based versusmultinational firms

8 The balanced scorecard

Section overview

The balanced scorecard attempts to integrate financial performance measures with those forcustomers, internal business processes, and innovation and learning.

Important financial measures for the balanced scorecard are return on investment (ROI), residualincome (RI) and economic value added (EVA®).

What should a business measure, and what weight or importance should it give to each measure?

One answer is: 'measure those aspects of the business that have most impact on whether it achieves itsstrategic objectives'. A business of any size whose strategic objective is the maximisation of profit to buildshareholder wealth will soon lose profits and therefore capital value if it fails to manage its key resources ofcapacity, labour, materials and cash productively, effectively and efficiently. On the other hand, its strategicobjective would probably not be undermined if it used 5% more paper clips than it had budgeted for.

The balanced scorecard combines traditional financial performance measures with measures ofoperational and staff performance, and customer satisfaction. The scorecard was developed by RobertKaplan and David Norton, and it produces a set of measures that allows top managers to focus on factorsthat are significant in achieving long-term control and direction of the business, and profitability in the longterm.

Definition

Balanced scorecard: An integrated set of performance measures linked to the achievement of strategicobjectives.

8.1 Perspectives in the balanced scorecard

The balanced scorecard looks at the business from four important perspectives and answers four basicquestions when establishing the business's vision of itself and its future strategy.



8

Perspective Question

Customer

Examples of measures: satisfaction ratings,retention rates, returns rates

How do customers see us?

Internal business processes (ways ofdoing something)

Examples of measures: product quality,failure rates

What must we excel at?

Innovation and learning

Examples of measures: employee retentionrates, time to market for new products

How can we continue to improveand create value?

Financial

Examples of measures: as above

How do we look to ourshareholders?

VISION ANDSTRATEGY

8.2 Revised financial measures for the balanced scorecard

While the standard profitability, liquidity, solvency and investment ratios outlined above can be used in thebalanced scorecard, some different measures are also frequently used.

8.2.1 Return on investment

Definition

Return on investment (ROI): A relative measure of a particular business unit or project's profitcompared with how much capital was invested to earn that profit.

Remember that we calculated ROCE above as:

PBIT

Total assets less current liabilities 100 = X%

ROI is similar but is focused on individual units or projects. Suppose an SBU has CU100,000 invested in it(calculated by deducting its current liabilities from its total assets) and it makes a profit from operations (=PBIT) of CU10,000. The ROI in that SBU is 10%.

A further measure – residual income – takes account of the cost of the capital involved in the project.

8.2.2 Residual income

Definition

Residual income (RI): An absolute measure of the true economic profit of a business's activities bydeducting from the net profit an amount that reflects the 'cost' of the money that was used to make theinvestment.

For instance, say that the SBU above borrowed the CU100,000 invested at an interest rate of 4% perannum. To calculate the absolute amount of RI we take CU10,000 net of interest of CU4,000. On this basisthe RI is only CU6,000, which is an ROI of only 9%.

8.2.3 Economic value added (EVA )

The supporters of economic value added (EVA ) claim that it is 'the performance measure most directly

linked to the creation of shareholder wealth over time' (Stern Stewart, a firm which holds EVA as a



registered mark or ). The basic idea of it is quite simple: EVA measures in absolute terms the trueeconomic profit of a business's activities by deducting from the net profit after tax an amount that reflectsthe 'cost' of the money that was used to make it, i.e. the investment.

Definitions

Economic value added (EVA®): Net operating profit after tax – (capital employed cost of capital)

Net operating profit after tax (NOPAT) is calculated as PBIT less the tax charge in the incomestatement

Cost of capital: The opportunity cost of the investment, that is the best alternative rate that the businesscould earn on the capital invested. Also known as the required rate of return, the cost of capital iscalculated with reference to market rates, the particular situation of the business, and the degree of risk ofboth the investment and its capital structure (i.e. the mix of debt and equity that funds it).

In the case of Furlong Ltd, if we assume a cost of capital of 12%, its EVA® is as follows:

20X8 20X7EVA® = CU352,130 – CU74,200 – (CU988,899

12%)CU235,102 – CU31,272 – (CU751,969 12%)

= CU159,262 CU113,594

As EVA® has increased by CU45,668 or 40% in the year, the initial conclusion would be that Furlong Ltd hasindeed improved its performance in terms of creating shareholder wealth.



8


Summary

Measuringperformance

Types of measure

Operationalperformance

Balancedscorecard

Financialperformance

Varianceanalysis

Innovation/Learning Customers

Internalbusiness

processes

Financial:ROIRI

EVA

Limitations ofmeasures

Ratioanalysis

Liquidity Solvency Efficiency Profitability

Currentratio

Quickratio

Debtratio

Gearingratio

Interestcover

Margin

Gross

Assetturnover

Net ROCEx =

Investors

Earnings Dividend

P/E Dividendyield

Dividendcover

EPS DPS/

Inventoryturnover

Receivablescollection

Payablespayment

Cash operating cycle

Users of financialinformation



Self-test


1 Company F and Company G have current ratios of 0.9 and 2.5 respectively.

If each company makes a purchase of inventory on credit, what will be the effect on the current ratioof each company?

Company F Company GA Increase IncreaseB Increase DecreaseC Decrease IncreaseD Decrease Decrease

2 If an increase in inventory is funded by a bank overdraft, what will be the effect on the quick (liquidity)ratio?

A IncreaseB DecreaseC Remain the sameD Either increase, decrease or remain the same, depending on the initial size of the quick ratio

3 Which of the following groups would be most likely to be interested in a company’s P/E ratio?

A Its customersB Its employeesC Its shareholdersD Its suppliers

4 ROCE is an example of

A A qualitative financial performance measureB A qualitative non-financial performance measureC A quantitative financial performance measureD A quantitative non-financial performance measure

5 Inpeta Ltd’s performance report for its gog product shows a favourable labour variance during May ofCU120,400. Its labour rate variance for the month was an adverse one of CU9,200. Inpeta Ltd’smanagers may conclude

A That labour’s efficiency was negative in MayB That labour’s efficiency was positive in MayC That labour was paid at a lower rate than was expectedD That no further initial conclusions may be drawn without additional information

6 Erg Ltd’s ROCE is 22.5% and its asset turnover is 5.42. What is its net margin?

........................................ %

7 Oompa Ltd’s cash operating cycle has fallen from 90 days in 20X6 to 75 days in 20X7. Which of thefollowing issues, taken alone, would account for this change?

A It has taken longer for its customers to pay but revenue has remained the sameB Its material costs have fallen and it has taken a longer credit period from suppliersC An additional process has been added to the production processD It has increased its overdraft limit at the bank

8 Economic Value Added (EVA®) is a measure of:

A The economic value of a business’s assetsB The true economic profit of a businessC A business’s gross profitD The value added for the customer by the business’s internal business processes



8

9 In the balanced scorecard, measures of how quickly and fully employee suggestions are implementedwould be included in

A Financial perspective measures

B Customer perspective measures

C Internal business process perspective measures

D Innovation and learning perspective measures

10 Which of the following is a relative rather than an absolute performance measure?

A Residual income

B Gross profit

C Return on investment

D EVA®





1 B Current ratio =Current assets

Current liabilities

Assuming a company increases its inventory level by buying CU1,000 of inventory on credit, bothinventory (CA) and payables (CL) will increase by CU1,000, thereby changing the current ratio.

Company F Company GPresent Proposed Present ProposedCU'000 CU'000 CU'000 CU'000

Current assets 9,000 10,000 10,000 11,000Current liabilities 10,000 11,000 4,000 5,000Current ratio 0.9 0.91 2.5 2.2

(increase) (decrease)

2 B Quick (liquidity) ratio =(CL)sliabilitieCurrent

inventorylessassetsCurrent

If a company funds an increase in inventory via a bank overdraft (CL), the increase in inventorywill have no effect on the quick ratio as the amount is specifically excluded. The increase in bankoverdraft (CL) will decrease the quick ratio as the denominator increases.

3 C The P/E ratio is a key investor performance measure

4 C

5 B While more information may be useful (D), an overall positive labour variance but a negative ratevariance must mean that the efficiency variance is positive (B), not negative (A). The adverse ratevariance in itself means that labour was paid at a higher rate than expected, not at a lower one(C)

6 ROCE = asset turnover x net margin: 22.5%/5.42 = 4.15%

7 B

8 B

9 D

10 C



8



Users Need information to:

Present and potential investors Make economic decisions, therefore need information on:

– risk and return of investment– ability of business to pay dividends

Employees Assess their employer's stability and profitability, and abilityto provide remuneration, employment opportunities andretirement and other benefits. Need information onprofitability and solvency

Lenders Assess whether loans will be repaid, and related interestwill be paid, when due. Need information on solvency

Suppliers and other tradepayables

Assess the likelihood of being paid when due. Needinformation on liquidity and solvency

Customers Assess whether a business will continue in existence –important where customers have a long-term involvementwith, or are dependent on, the business, e.g. where thereare product warranties or where specialist parts may beneeded or where there is a 'partnering' relationship. Needinformation on solvency

Governments and their agencies Assess allocation of resources and, therefore, activities ofentities; assist in regulating activities; assess taxation;provide a basis for national statistics. Need a variety offinancial and non-financial information

The public Assess trends and recent developments in the business'sprosperity and its activities – important where the businessmakes a substantial contribution to a local economy, e.g. byproviding employment and using local suppliers. Needinformation on profitability and solvency

Managers Make decisions about the allocation of resources, andlonger term investment. Evaluate and improve currentperformance. Need information on all aspects of thebusiness




The managers might draw the following initial conclusions:

The reduction in price of Sterms probably led to the increase in volume sold, and overall this had afavourable effect on profit

More was paid per kg of material though less material was used per Sterm; the overall adversematerials variance suggests that it may not be worth paying slightly more for better quality material

More hours were spent on each Sterm but less was paid per hour to workers, which may suggest thatcutting wage rates leads to decreased efficiency due to demotivation, or that using lower grades oflabour results in less efficient working

The rates paid for variable overheads were reduced, but because more hours were spent working,expenditure on overheads rose

More was paid for fixed overheads than was budgeted, which cannot be due to the change in volumes


Gross margin is a measure of how gross profit relates to revenue: we calculate the margin on sales.Mark-up on the other hand measures gross profit as it relates to cost of sales: we calculate the mark-upon cost.

20X8 Gross margin % 20X7 Gross margin %

Revenue 100 100.0

Cost of sales (77.6) (75.5)

Gross margin 22.4 24.5

Mark-up can be calculated by manipulating the gross margin percentages: if we know the gross margin themark-up percentage must be gross margin x revenue/cost of sales:

20X8 20X7

Gross mark-up % 22.4 x 100/77.6 = 28.9% 24.5 x 100/75.5 = 32.45%

Contents

chapter 9

Working capital and treasurymanagement

Introduction

Examination context

Topic List

1 What is working capital?

2 Balancing liquidity and profitability

3 Balancing short-term and long-term finance forworking capital

4 The cash operating cycle

5 Managing inventory

6 Managing trade payables

7 Managing trade receivables

8 Treasury management

9 The banking system

10 The bank/customer relationship

11 The money markets







Introduction


Specify how accounting and finance functions support businesses in the pursuit of theirobjectives

Identify the constituent elements of working capital and treasury

Specify the methods by which each element can be managed by the finance function tooptimise working capital and cash flow

Specify the relationship between a business and its bankers and other providers of financialproducts in the context of treasury and cash management

Specific syllabus references are: 3b, g, h.


It is in the context of working capital management, and especially cash management, that the financefunction has the most direct impact on the success of the business. Cash is king; no business can afford torun out of cash, and nor can it afford not to achieve a reasonable return on cash.

Stop and think

What do we mean by working capital? What should our objectives be in managing cash, inventory,receivables and payables? What do we do if we have a short-term cash flow crisis or excess of cash? Whatdo we do if our deficit/surplus is more long-term? How does the banking system work, and what is thenature of a business's relationship with banks and other lenders?

Working context

You know from your personal experience how important cash is. As you build up your exposure todifferent organisations in audit or other professional engagements, you will see that businesses are equallydependent on proper cash management in order to survive.

Syllabus links

The topic of working capital and treasury management is developed in Financial Management at theProfessional stage, and in the Advanced stage.

WORKING CAPITAL AND TREASURY MANAGEMENT


9

Examination context


Questions on working capital and treasury management could easily appear in the exam.

Exam requirements




1 What is 'working capital'?

Section overview

The components of working capital are inventory, receivables, cash and payables.

Net working capital is made up of current assets less current liabilities:

Receivables + Inventory + Cash – Payables

Investment in working capital is needed to 'oil the wheels' of business.

It is essential to consider working capital as a whole and how the components all fit together. Themanagement of working capital is concerned with the liquidity position of the company, so the main aim isto turn the cash round as quickly as possible whilst ensuring that profitability is not thereby undermined:it is a trade-off.

2 Balancing liquidity and profitability

Section overview

All businesses face a trade off between being profitable (providing a return) and being liquid (staying inbusiness).

Alternative policies in working capital management need to be reviewed in terms of their relative risk andreturn. An important aspect of the risk associated with various options is the effect it has on thecompany's liquidity position. Liquidity is obviously of crucial importance to the financial stability of abusiness; mismanagement of a firm's liquidity position may result in it being unable to pay its debts which, inturn, may result in corporate bankruptcy. A business's liquidity determines its ability to survive. This can beillustrated by looking at each component of working capital in turn.

Cash. A business requires a particular level of cash (or overdraft facility) in order to pay debts whenthey fall due, and particularly to take advantage of any generous discounts offered for prompt payment.However, a better return could be earned by investing any cash surplus in a high-yielding investment.By ensuring that it has sufficient liquid assets (cash), therefore, a business is reducing its chance ofowning more profitable assets.

Receivables. A business could decide that it does not want to offer credit to customers, because thedelay in payment jeopardises its liquidity position. If it tried to adopt this policy however, customerswould be driven away, revenue would fall and profits would fall.

Inventory. In order to satisfy customer demand, manufacturing and retailing firms need to maintainfinished goods inventory; to keep production runs moving without disruption, raw materialsinventories also need to be maintained. This means that a business will have money tied up ininventories that, again, it might feel it could use more profitably elsewhere. However, if inventorieswere not available when required, a potential sale might be lost; the cost of a broken productionfacility may be higher than the cost of holding inventory.

Payables. To improve its cash position a business might decide not to pay suppliers until after two orthree months, rather than after the normal one month. Apart from the obvious cost of lost discountopportunities, the business runs the risk of alienating its suppliers and even losing sources of supply.



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In each of the above instances the business must weigh up profitability versus liquidity. Since ultimatelya business aims to maximise profits, it must establish the financial costs and benefits of different liquiditypositions. Inevitably all working capital decisions reduce to decisions over cash levels, since current assetsshould eventually be turned into cash.

Remember that profit and cash flows are not the same. It is possible to make accounting profitswhile suffering a dramatic decline in the cash balance (and vice versa). In consequence, history is littered withexamples of companies which have gone bankrupt while reporting accounting profits. Since theconsequences of compulsory liquidations are invariably catastrophic for all concerned, it is crucial for abusiness to maintain a sound liquidity position. Cash budgeting and performance measurement arekey techniques in monitoring and controlling that position (see Chapter 8 and your Management Informationsyllabus).

3 Balancing short-term and long-term finance forworking capital

Section overview

Every business faces risk in the way it finances working capital. The more long-term finance is used tofinance trading activities, the lower the risk and therefore the lower the return.

Businesses may be aggressive, average or defensive in their financing policies.

Ratios can be used to assess a business’s liquidity position.

3.1 Financing current assets

For most businesses a proportion of current assets will effectively be permanent. The method of financingthis level is best seen diagrammatically.

Figure 9.1: Financing working capital investment

The options set out in Figure 9.1 are only two of many possible approaches. For example, the use of short-term credit could be extended to finance a proportion of the non-current assets or, alternatively, all of thebusiness's finance requirements could be provided by long-term finance.

Assets Assets

Fluctuatingcurrent assets

Fluctuatingcurrent assets

Non-current assets Non-current assets

Short-termfinance

Long-termfinance

Time Time

Long-termfinance

Short-termfinance

Some permanent currentassets are financed byshort-term credit

More profitable butriskier

All permanent and somefluctuating current assetsare financed out of long-term sources

Less profitable but lessrisky

CU CU

Permanentcurrent assets

Permanentcurrent assets



The choice is a matter for managerial judgement of the trade-off between the relative cheapness of short-term finance versus its risks.

3.1.1 The cost of short-term finance

Short-term finance is usually cheaper than long-term finance due to the risks taken by lenders. Forexample, if a bank were considering two loan applications, one for one year and the other for 20 years, allother things being equal it would demand a higher interest rate on the 20-year loan. This is because it feelsmore exposed to risk on long-term loans, as more could possibly go wrong over a period of 20 years thanover a period of one year.

Occasionally this situation can be reversed. Sometimes short-term interest rates will be higher than long-term rates, as when the market expects interest rates to fall in the long run. But if funds have beenborrowed long-term, early repayment may not be possible or, if allowed, early repayment penalties may beexperienced. The flexibility of short-term finance may, therefore, reduce its overall cost.

Finally, short-term finance also includes items such as trade payables; it can therefore have a low averagecost (interest is charged by banks on overdrafts but not by ordinary suppliers unless an agreed credit periodhas been exceeded). Long-term finance includes equity finance which is particularly expensive; because ofthe risk they suffer shareholders expect high returns, and dividends are not tax deductible.

3.1.2 The risks of short-term finance

The price paid for the reduced cost of short-term finance is an increase in risk.

Renewal risk

Being short-term it has to be continually renegotiated as the various facilities expire. Either because ofeconomic conditions (e.g. a credit squeeze) or because of the financial situation of the business, suchrenewal may be difficult to obtain.

Interest rate risk

If the business is constantly having to renew its funding arrangements, it will be at the mercy offluctuations in short-term interest rates.

3.2 Making the working capital financing decision

No single ideal financing package can be recommended as it all depends upon the risk/return trade-offs ofindividual businesses.

Businesses may be categorised as having aggressive, average or defensive positions in this area, and thecurrent ratio (current assets ÷ current liabilities) can indicate which financing policy is adopted.

Worked example: Aggressive, average and defensive positions

The following three companies have current asset financing structures which may be considered asaggressive, average and defensive:

Balance sheetAggressive Average DefensiveCU000 CU000 CU000

Non-current assets 50 50 50Current assets 50 50 50

100 100 100

Equity (CU1 shares) 30 50 50Long-term debt (average cost 10% pa) – 20 40Current liabilities (average cost 3% pa) 70 30 10

100 100 100

Current ratio 0.7:1 1.7:1 5:1



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Income statementAggressive Average Defensive

CU CU CUPBIT 15,000 15,000 15,000Less Finance cost

(10% long term, 3% current) (2,100) (2,900) (4,300)12,900 12,100 10,700

Tax @ 30% (3,870) (3,630) (3,210)Net profit for the period = earnings available toshareholders 9,030 8,470 7,490

Earnings per share (30,000 or 50,000 shares) 30.1p 16.94p 14.98p

The aggressive company, which has more short-term credit than equity in its structure, returns a higherprofit but at the cost of greater risk revealed in its relatively poor current ratio.

The average company matches its maturities; permanent current assets are financed by long-term debt,while fluctuating current assets are financed by short-term credit. There is less risk here than in theaggressive company, as shown by the healthy current ratio, but considerably less return as well, as seen inthe EPS.

The defensive company has sacrificed profitability for liquidity by using a very small amount of short-termcredit, which finances only some of the fluctuating current assets. This is a low-risk, low return company.

The financing choice must be made by the management of the individual company, bearing in mind thewillingness of creditors to lend and the risk of its industrial sector.

3.3 Financing growth in working capital

The level of working capital directly affects the amount of growth the business can sustain organically fromits own internal resources. Growth in sales volume means additional inventories and receivables. Even if nofurther capital expenditure is required to achieve the growth, the underlying working capital invested in abusiness will still need to increase.

How much growth a business can sustain out of its own resources, before issuing new long-term capital, isconstrained both by:

its anticipated rate of profitability and the underlying asset requirement

If a business is to grow without borrowing or issuing further capital, it needs to increase its profitabilityand/or to make better use of its assets.

3.4 Assessing the liquidity position via ratios

A secure liquidity position is desirable. The business's liquidity position can be assessed in two ways: byratios, and via the cash operating cycle.



Ratio

(Inventory turnoverratio)

Cost of sales

Inventories

Payables×365

Cost of sales

Inventory× 365

Cost of sales

Current assets

Current liabilities

Current assets

Current liabilities

(Current ratio)

(Quick ratio oracid test ratio)

Payables× 365

Cost of sales

Inventoryturnover

Receivablescollection

period

Payablescollection

period

Liquidityratios

(Inventory turnoverperiod)

These can be compared with:

The same company in previous periods Other companies in the same industry

to see whether they are getting better or worse, and how they look against industry averages.

For an individual business, we can gain a better understanding of the effects of funding and operationaldecisions on its liquidity position by manipulating its ratios, as calculated in Chapter 8.

Worked example: Manipulating working capital ratios 1

Right Ltd currently has inventory and payables of CU15,000 and receivables of CU30,000. It pays itssuppliers one month after receiving goods from them but allows its customers two months' credit. RightLtd does not expect any change to its level of business, but it now proposes to reduce its receivables creditperiod to one month to bring it in line with its payables payment period. It also proposes an increase in itsinventory levels, such that its inventory turnover period will increase from 30 days to 60 days. What will bethe effect of these decisions on Right Ltd's ratios?

Current policy days Proposed policy daysCU CU

Inventory turnover/ Inventory 30 15,000 60 30,000Payables period/ Payables (30) (15,000) (30) (15,000)Receivables period/ Receivables 60 30,000 30 15,000Cash operating cycle/ New current assets 60 30,000 60 30,000

Current ratio 3:1 3:1Quick ratio 2:1 1:1

Interactive question 1: Risk in working capital decisions[Difficulty level: Intermediate]

Is Right Ltd’s proposal more or less risky than its current operation?

See Answer at end of this chapter.



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Worked example: Manipulating working capital ratios 11

A profitable business's inventory turnover ratio of 20 rises by 20%. Its number of receivables days rises by10% from 70 days, but its cost of goods sold and payables days remain the same. The effect on its cashoperating cycle is as follows:

Period 1 Period 2Days Days

Inventoryturnover ratio

Cost of sales/Inventory 365/20 18 365/(20 1.2) 15

Receivables days Receivables/Revenue 70 70% 1.1 77

88 92

The cash operating cycle will therefore lengthen.

4 The cash operating cycle

Section overview

The cash operating cycle measures the length of time it takes a business to receive back fromcustomers what it had to pay out to suppliers, plus its profit. Generally, the shorter the cycle thebetter.

An increased cash operating cycle plus increased revenue may be a sign of overtrading and hence ofsevere liquidity and, ultimately, solvency problems.

4.1 Calculation of the cash operating cycleThe cash operating cycle focuses on the length of time between a business paying out cash for inputs andreceiving cash for goods sold. It could be referred to as the working capital cycle. The cycle is normallymeasured in days.

The duration of the length of the cycle (and therefore the amount invested in working capital) is affected by:

Type of industry; in retailing for instance the cycle is short while in house-building it is much longer Liquidity v profitability trade-off (see above) Efficiency of management of inventory, receivables and payables.

Interactive question 2: Cash operating cycle [Difficulty level: Exam standard]

Marlboro Ltd has the following estimated figures for the coming year:

Sales CU3,600,000Average receivables CU306,000Gross margin 25%Inventories

Finished goods CU200,000Work-in-progress (WIP) CU350,000Raw materials CU150,000

Average payables CU130,000

Inventory levels are constant.

Raw materials represent 60% of total production cost.

Requirement

Calculate the length of the cash operating cycle.

See Answer at end of this chapter.

Bus

262

4.2

4.3

iness and finance

© The Institute of Chartered Accountants in England and Wales, March 2009

Investment in working capital

The level of investment in working capital increases considerably over the period of the cycle, as seenin Figure 9.2, which highlights the situation where raw materials are bought, processed into work inprogress, then finally into finished goods. Cash paid out for labour and overheads during this time increasesthe investment.

Figure 9.2: Investment in working capital

A business with inventory days of 50 and receivables days of 60 might appear to have the same workingcapital investment (110 days) as a company with 90 days' inventory and 20 days' receivables. In practice, thelevel of investment in the latter business is lower, as less capital is tied up in inventories (particularly rawmaterials) than in receivables.

The total investment is also influenced by:

Growth (see overtrading below)

Inflation. As the price of raw material inputs rises, together with labour and overhead costs inproduction, a firm is likely to put up its selling prices. Thus, the monetary investment in inventory +receivables – payables increases

Variations between businesses

Different types of business have different working capital requirements.

A large nationalsupermarket chain

A civil engineering firm withmany large projects, e.g.constructing buildings for2012 Olympics

Manufacturer of toys orartificial Christmas trees

High investment in inventory(food and non-food itemssuch as clothing and electricalgoods) in shops andwarehouses.

Relatively low investment inraw material inventory aseach job is unique andsupplies may be bought whenneeded.

Due to the seasonal nature ofthe business, working capitalrequirements will fluctuatesignificantly during the year.

Low investment inreceivables (as most sales arein cash).

Long WIP and receivablesdays. Progress payments areused to offset outflows butthere may be money heldback by the customer untilthe job is deemedsatisfactory.

Receivables will increase ascustomers (retailers) stockup for festivals but will bemuch lower earlier in theyear.

+

–

CU



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A large nationalsupermarket chain

A civil engineering firm withmany large projects, e.g.constructing buildings for2012 Olympics

Manufacturer of toys orartificial Christmas trees

Ability to take long creditterms from suppliers byapplying various sorts ofpressure. Cash operatingcycle may be negative i.e.cash comes in before it ispaid out to suppliers.

The manufacturer is likely tospread its production processover the year to smoothproduction, with inventorybuilding in the run-up to thepeak period.

Cash operating cyclerelatively stable as there isnot that much seasonalactivity. Non-food may have alonger cycle where itemsspend longer in inventory(turnover is less frequent) i.e.overall cycle may be made upof distinct elements.

Cash flow is likely to bedisjointed – outflows whilstinventory is built up with themajority of inflowsconcentrated in a later periodof the year. Cash operatingcycle therefore likely to varysignificantly depending on thetime of year.

4.4 Limitations of working capital performance measures

The measures that we saw in Chapter 8 must be used with care, because:

The balance sheet values at a particular point in time may not be typical.

Balances used for a seasonal business will not represent average levels, e.g. Christmas treemanufacturer.

Such measures concern the past not the future.

Therefore, measures should not be considered in isolation. Trends and industry averages are important.

4.5 Overtrading

The amount of cash required to fund the cash operating cycle will increase as:

The cycle gets longer Sales (and hence purchases of inventory required) increase

This can often happen at the start of a new business, since

There is no trading record, so suppliers are likely to insist on a very short credit period

There is no reputation to draw in customers, so a long credit period is likely to be extended tocustomers in order to break into the market

If the business has found a 'niche market', rapid sales expansion may occur

This can lead to the cycle being 'out of balance', so short-term financing may be necessary to get overthe initial period. If this finance is unavailable it may be necessary to sell non-current assets to pay debtsor, at the extreme, to go into insolvent liquidation. The forecasting of working capital so as to avoidovertrading is thus of particular importance for new businesses.



4.6 Solutions to liquidity problems

The aim must be to reduce the length of the cash operating cycle by:

Reducing the inventory-holding period

Reducing the production period – not easy to do but it might be worth investigating differentmachinery or different working methods

Reducing customers' credit period and tightening up on cash collection

Extending the period of credit taken from suppliers – again, not easy to do as the business hasto comply with their terms, but it is worth considering the advantages and disadvantages of takingearly settlement discounts

5 Managing inventory

Section overview

There are many, usually non-financial, reasons for a business to hold inventory, but it does so atconsiderable cost.

As a result, businesses try to keep inventory levels down as far as possible, using a variety ofinventory control systems: re-order level, periodic review, ABC, economic order quantity (EOQ),just-in-time (JIT) and perpetual inventory.

5.1 Why hold inventory?

Inventory is an idle resource costing the business money, so there must be good reasons for holding it.Again there are trade offs:

Profitability v LiquidityHigher inventories may give higher sales v Higher inventories mean more finance is needed

Reasons for holding inventory:

To meet demand by acting as a buffer in times of unusually high consumption, to reduce the risk ofstockouts or where supplier delivery times (lead times) are uncertain

To ensure continuity of production

To take advantage of quantity discounts by ordering more at a time

To buy in ahead of a shortage or ahead of a price rise

For technical reasons, such as maturing whisky or keeping oil in pipelines

To reduce ordering costs by ordering more items on fewer occasions

Because of seasonality of demand (e.g. Christmas trees) or supply

Because suppliers insist on minimum order quantities

Because special promotions are being offered, e.g. 10p off a can of beans

5.2 Costs associated with holding inventory

Purchase price, i.e. the cost of the inventory itself



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Holding costs:

– Opportunity cost of capital tied up– Cost of insurance– Risk of deterioration, obsolescence and pilferage– Cost of the warehousing function– Cost of stores administration

Re-order costs:

– Transport costs– Clerical and administrative expenses– Batch set-up costs for goods produced internally

These costs vary with the number of orders which will increase as inventory levels are reduced

Shortage costs:

– Production stoppages caused by lack of raw materials– Stockout costs for finished goods – anything from a delayed sale to a lost customer– Emergency re-order costs

The benefits of holding inventory must outweigh the costs.

5.3 Inventory control systems

For both finance and operational reasons it is therefore very important to control inventory levelseffectively. There is a wide range of inventory control systems available.

Re-order level system. A fixed quantity (the optimum order quantity – models exist fordetermining this) will be ordered whenever inventory falls to a pre-determined level (the re-orderlevel). One way of doing this is to put inventory in two receptacles or 'bins'. When one empties, thenext order is placed with the supplier, which should arrive by the time the second bin empties. Thissystem aims to minimise costs while providing the necessary supply to users.

Periodic review system. Inventory levels are reviewed at fixed time intervals to fit in withproduction schedules, and variable quantities are ordered as appropriate. This is a very simple methodof inventory control.

ABC system. The aim here is to reduce the work involved in inventory control in a business whichmay have several thousand types of inventory item. Inventory is categorised into classes A, B or Caccording to the annual cost of the usage of that inventory item, or the difficulty of replacements, orthe importance to the production process. Class A will then take most of the inventory control effort,Class B less and Class C less still. While this seems acceptable for inventories of finished goods, it maycause problems for raw materials. There may be an item which has a very small cost but which is vitalfor the manufacture of the finished product. Such an item would have to be included in the Class Aitems because of its inherent importance, rather than its cost.

Economic order quantity system (EOQ). The EOQ model for inventory control approachesmathematically the problem of when to order inventory and how much to order. The formula is:

EOQ =h

2cd

where c = cost of placing one orderd = estimated usage of the inventory item over a particular periodh = cost of holding one unit of inventory for that period

The purchase price of the item is not included in the calculation; what this method attemptsto do is minimise the costs and maximise the benefit of ordering and holding inventory. It does notconcern itself with whether the best price is being obtained.



Worked example: Economic order quantity (EOQ)

Material X costs CU100 per kg. 2,000 kgs are to be used per year, and holding costs per kg per year areCU5. Each order placed costs CU200 in administration time.

kgs4005

2,0002002:materialforEOQ

Annual usage is 2,000 kgs, so 2,000/400 = 5 orders per year will be placed.

While EOQ appears to be a satisfactorily precise model, it has some serious limitations:

– It is cumbersome to apply

– Some simplifying assumptions are made about usage and a constant purchase price that may beunjustified

– It ignores the potential benefit of taking advantage of bulk discounts

– It can be very difficult in practice to estimate holding costs and the cost of placing each order

Just-in-time (JIT) manufacturing systems. Production and purchasing are linked closely to salesdemand on a week-to-week basis so there is a fairly continuous flow of raw materials inventories intowork in progress, which becomes finished goods to go straight to a customer. This means thatnegligible inventories of raw materials and finished goods need to be held. Features of JIT systemsinclude:

– the need for flexibility of both suppliers and the workforce to expand and contract output atshort notice

– guaranteed quality of raw materials. Quality must be maintained at every stage. There are noinventories in reserve should one batch of raw materials prove to be faulty, so production wouldstop until a further delivery can be made

– close working relationship between suppliers and users including geographical proximity in orderto be able to make immediate deliveries

– willingness of the workforce to increase or decrease working hours from one period to another.This could be done by having a core workforce with a group of part-time or freelance workers

– rationalised factory layout systems to minimise movements between stages

Perpetual inventory methods. Where a business keeps perpetual inventory records, there willfrequently be a replenishment point that triggers off an order. This may be by way of an exception reportfor a computerised system. Such a system relies upon the accuracy of the records, not on physicalmeasures such as the two-bin system. Point of sale terminals in shops automatically update inventoryrecords as each sale is made. One advantage of such a system is the data it provides to management todetermine which product lines are moving rapidly. Marketing managers may also use the data to maketactical decisions on special prices and promotions to sell slow-moving items.

Other ways to manage inventory:

– Sub-contract (outsource) non-core processes, passing on the inventory holding problem toanother business.

– Obtain progress payments from customers, thus reducing the capital tied up in inventory.

– Reduce the number of product lines, e.g. drop products near the end of their product lifecycle.



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6 Managing trade payables

Section overview

Trade credit is generally a cheap source of finance.

Credit periods for the buyer are a source of short-term finance. For example, if a buyer decides not to payits trade debts for a further month, it has obtained a further month's use of its cash.

Trade payables are not, however, without cost:

Credit status may be lost so the supplier gives low priority to the buyer's future orders, withconsequent disruption of activities.

The supplier may raise prices in order to compensate for the finance which he is involuntarilysupplying.

The buyer will lose any cash discount for prompt payment; the cost of the lost discount should becompared with other short-term sources of finance, e.g. overdrafts

The advantages of trade credit are that:

It is convenient and informal (i.e. it is unusual to tell your suppliers that you do not intend to paythem on time, though after a while they will realise anyway)

It can be used by businesses which do not qualify for credit from a financial institution

It does not prevent advantage being taken of settlement discounts (which can result in a very cheapsource of financing) because a period of time is still allowed before payment has to be made

Trade credit can represent a virtual subsidy or sales promotion device offered by the seller – forexample, favourable terms may be offered when a new company is set up

It can be used on a very short-term basis to overcome unexpected cash flow crises

Because of these advantages, a business should:

Consider switching suppliers if better credit terms are available or if better terms exist for solesupplier relationships

Negotiate better terms for buying large quantities

Reconcile statements (make sure that what the supplier says a company owes agrees with what thecompany thinks it owes)

Pay only on completion of correct delivery

7 Managing trade receivables

Section overview

The cost of granting credit to customers has to be balanced against the benefits of doing so.

Proper management of trade receivables should ensure an adequate level of collections.

Trade receivables may be financed by invoice discounting or factoring.

7.1 What is the ideal level of trade receivables?

The management of trade receivables involves the business trading-off:

The costs of extending credit to customers – these include finance costs, irrecoverable debts andadministrative costs of the credit control department

The benefits of granting credit – in their simplest form these are larger profits due to theincreased sales generated because of the credit terms offered



The costs of extending credit can be difficult to quantify (particularly the administrative costs) and thebenefits are also difficult to measure. Most firms would find it very difficult to forecast the precise effect onsales of, for example, increasing credit terms by ten days. Nevertheless, the trade-off must be consideredwhen making credit management decisions.

Managing the level of trade receivables involves some very practical issues, usually undertaken by thereceivables ledger and credit control sections of the business's finance function.

7.2 Credit control and collection policies

Credit control and collection policies should be set at board level. Implementation of the policies may falloutside the remit of the finance function itself, but the treasury management section could certainly beinvolved in credit control.

7.2.1 Credit terms and settlement discounts

Credit terms can be changed and must respond to competition, new markets etc but they will be influencedlargely by trade custom which may, for example, be payment within 60 days.

Settlement discounts are again influenced largely by custom and practice within the industry. Thebusiness must ensure the cost does not outweigh the benefit, and should compare it with the cost of othersources of short-term finance, e.g. overdraft. Offering discounts can be expensive. For example, if it costs acompany 2% discount per month to get receipts early from customers, the annual cost is 1.0212 – 1 =26.8%.

Worked example: Settlement discount

Left Ltd has monthly sales of CU20,000. 25% of receivables are paid within one month of a sale, and 70%are paid within two months, but 5% of receivables are never paid. Left Ltd proposes offering a 3% discountto receivables settling invoices within one month of the invoice date. As a result, monthly sales arepredicted to rise to CU25,000, and 50% of trade receivables will pay within one month. 44% will pay withintwo months but irrecoverable debts will rise to 6%. All sales are invoiced at the end of each month. Thediscount will be offered for all invoices issued from Month 1. By how much will total cash inflows fromtrade receivables in Months 1 and 2 change as a result, and what will be the effect on profit?

Cash receivedSales Month 1 Month 2 Irrecoverable Discount

debts allowedCU CU CU CU CU

Current policy 25% 70% 5%Sales M1 20,000 5,000 14,000 1,000 0Sales M2 20,000 0 5,000 0 0Total cash 5,000 19,000 1,000 0

Proposed policy 50% 97% 44% 6% 50% 3%Sales M1 25,000 12,125 11,000 1,500 375Sales M2 25,000 0 12,125 0 0

12,125 23,125 1,500 375

There is a large cash flow benefit of CU7,125 in Month 1, and a benefit of CU4,125 per month once thenormal pattern is established. The reduction in monthly profits caused by increased irrecoverable debts isCU500, while profits are further reduced by CU375 with respect to the discount allowed.



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The company must communicate its terms to customers clearly and unambiguously:

On orders On invoices On statements

The settlement discount policy must be enforced, otherwise most customers will continue to take thesettlement discount as a matter of course, whether or not they pay on time.

7.2.2 Credit rating

The risk that a customer will not pay its debts can be indicated by giving each customer a credit rating.Customers who pay on time are given a high credit rating, but those who pay slowly are given a low one;some customers may be refused credit altogether, so supplies are only made against cash.

Credit ratings should be based on:

An assessment of the ability of the customer to meet the liabilities

An assessment of financial statements, particularly for major customers

The use of credit-rating agencies (e.g. Dun and Bradstreet) who rate the customer according to anumber of factors related to its ability to pay

An analysis of on going trading experience with each customer

The practice in some industries whereby credit managers liaise regularly to exchange informationwith other businesses. This is very useful, since members will alert each other as soon as problems areidentified

Credit limits on how much can be outstanding on a customer's account at any time. These should bereviewed frequently and reported immediately if exceeded so that necessary action can be taken

Trade and bank references, although these may be so bland as to be of limited value; thesereferences may provide valuable corroboration of other sources of information however

Credit ratings should be reviewed regularly.

Interactive question 3: Collection procedures [Difficulty level: Exam standard]

You are employed in the receivables ledger section of Kott Ltd. Your manager has asked you to help in aproject to improve the cash operating cycle of Kott Ltd.

Requirement

Identify three ways in which collection of amounts owed by customers could be speeded up.

____________________________________________________________________________

7.3 Financing trade receivables

Receivables are an asset, and so can be 'sold' like any other asset by means of invoice discounting orfactoring.

7.3.1 Invoice discounting

This involves selling the invoices to a discounting company for a cash sum, then repaying the discounterwhen the debtor pays the invoice. Note that the business retains full responsibility for sales ledger, creditcontrol and collection functions. However, the discounting company may perform certain credit checks andratings before entering the agreement. This form of discounting is effectively a form of overdraft facility asthe discounter makes a charge for lending the money.



7.3.2 Receivables factoring

This contains three closely integrated elements:

Accounting and collection – the business is paid by the factor as customers settle their invoices orafter an agreed settlement period. The factor maintains the sales ledger accounting function.

Credit control – the factor is responsible for chasing the customers and speeding up the collectionof debts. Recourse factoring means that any bad debts are passed back to the client company. Non-recourse factoring provides 100% bad debt insurance, that is the client does not suffer from the costof bad debts.

Finance against sales – the factor advances, say, 80% of the value of sales immediately on invoicing.

Factoring is becoming increasingly competitive; generally, factors will act for customers with revenue inexcess of CU100,000 and invoices over CU100. The usual fees are about 2-3% of invoice value as anadministration charge, plus a charge for cash advances. The major disadvantage is the loss of immediatecontact with the customer, who may see factoring as a sign of financial problems.

7.4 Good practice in receivables management

Good practice can be summarised as: look after key accounts and manage time scales.

7.4.1 Look after key accounts

It frequently happens that 20% of customers represent 80% of the debts. These customers, and their debts,must receive special attention.

7.4.2 Manage time scales

Attempt to reduce all time scales between placement of an order and receipt of cash from thecustomer, and eliminate any causes of disputes or non-payments. This should serve to tighten up the cashoperating cycle in general.

The following are some practical examples.

To reduce the time between the placement of the order and the receipt of goods by the customer:

– Encourage customers to switch to the quickest method of ordering such as internet ordering

– Make sure orders are taken accurately

– Clear orders for creditworthiness as soon as possible

– Make the despatch as quickly as possible, supported/accompanied by accurate despatchdocumentation; a computerised online order processing and invoicing system will reduce delays

– Use efficient carriers

To reduce the time taken to bill your customer:

– Issue invoices on time – customers will not pay without them

– Ensure disputed invoices are agreed as soon as possible

– Issue statements promptly each month, as many customers pay only on statement; acknowledgedisputed items on the statement, so that the 'agreed' items will be paid more quickly

– Be flexible, and invoice to meet the customer's requirements (e.g. provide duplicate copies ifrequested)

To reduce the time taken to collect debts:

– Credit control reports must state the age of each transaction and the number of days overduefor payment. These aged lists should help detect changes in the length of time taken to collectdebts and can be prepared in total and/or by customer



9

Worked example: Total receivables ageing

November December20X1 20X1Out- % of Out- % of

standing total standing totalCU CU

0-30 days 10,000 86.2 12,000 80.531-60 days 1,000 8.6 2,000 13.461-90 days 500 4.3 750 5.0

90+ days 100 0.9 150 1.111,600 100.0 14,900 100.0

The changes from November to December show customers taking longer to pay. It might be a normalseasonal pattern. If not, the customers who are responsible need to be identified.

Worked example: Customer ageing, December 20X1

Customer 0 – 30 31 – 60 61 – 90 90+days days days daysCU CU CU CU

Sid Ltd 200 – – –Snow Ltd 150 20 – –Gizzard Ltd 120 80 60 40

: : : : :: : : : :: : : : :

12,000 2,000 750 150

Total CU14,900

Gizzard Ltd appears to be one of the problem customers; perhaps it is time to start more aggressivecollection procedures?

7.4.3 Other ideas

Issue credit notes promptly

Deal personally with those people who pass invoices or sign cheques. Do not be fobbed off toooften with 'the cheque's in the mail'!

Pay commission to salespeople on cash collected, not on sales so that they will be motivated toensure their contacts pay up

Set targets for receivables days or percentage overdue accounts; report actual performance againsttargets and review performance regularly: set incentives and pay bonuses to credit managers

7.5 Trade credit insurance

Trade credit insurance insures a business against the possible default and insolvency of its creditcustomers and, where exports are involved, political risk. It is therefore a useful tool in creditmanagement, helping to minimise possible problems from late payment and bad debts.



Credit insurance means a business can:

Insure all or part of its receivables ledger against default by a customer Include a 'first loss' (or excess) on its accounts to be insured Be insured only up to a ceiling ('credit limit')

The premium paid will vary in accordance with the above factors.

The insurer invariably sets a credit limit on the maximum amount that can be insured. Policies cost between0.20% and 0.50% of annual revenue on accounts to be insured. However, premiums are also influenced byfactors such as effectiveness of credit control systems, length of credit given and previous experience ofirrecoverable debts. The policyholder will have to accept part of any loss; credit insurers will typicallyaccept 75% to 95% of any loss, the balance being taken by the policyholder. Insurance brokers or insuranceintermediaries usually arrange policies.

8 Treasury management

Section overview

The risks of running out of cash have to be balanced against the costs of holding cash, just like withinventory.

Businesses have four motives for holding cash: transactions, finance, precautionary and investmentmotives.

Short term surpluses of cash should be invested; short term shortages of cash need to be funded.

Effective transmission of cash will improve the promptness with which the business benefits fromhaving cash.

8.1 The basic trade-off: cost of holding v cost of running out of cash

To manage its cash position successfully the business must trade off the cost of holding cash against the costof running out of cash.

The cost of holding cash, either as a cash float or in a current account, is the opportunity cost of whatelse could be done with the money, like the cost of capital which we saw in Chapter 8. Cash is an idle assetand earns little or no return. If the funds were put to work elsewhere (i.e. invested) they could generateprofits.

The costs of running out of cash vary, depending upon the circumstances of the business. Cashshortages result in the business not being able to pay its payables on time, and this could have manyimplications. Examples include:

Loss of settlement discounts from trade suppliers Loss of supplier goodwill, e.g. refusal of further credit, higher prices, poor delivery Poor industrial relations if wage payments are delayed Creditors petitioning for winding-up the business

Although the above costs may be difficult to quantify the business must at all times ensure that it hassufficient liquidity, in the form of cash balances or overdraft/loan facilities, to maintain its solvency.

8.2 Influences on cash balances

There are a number of motives underlying how much a business would wish to hold as cash:

Transactions motive – to meet current day-to-day financial obligations, e.g. payroll, the purchase ofraw materials, etc

Finance motive – to cover major items such as the repayment of loans and the purchase of non-current assets



9

Precautionary motive – to give a cushion against unplanned expenditure, rather like buffer inventory

Investment motive – to take advantage of market opportunities

8.3 Aim of good cash management

The primary aim of good cash management is to have the right amount of cash available at the righttime. This involves:

Accurate cash budgeting/forecasting (covered in your Management Information syllabus), so thatshortfalls and surpluses can be anticipated

Planning short-term finance when necessary

Planning investment of surpluses when necessary

Cost-efficient cash transmission

8.4 Short-term finance

Receivable factoring and invoice discounting;

Bank overdrafts:

– May be used to fund fluctuating working capital

– Are technically repayable on demand, so carry some risk

– Normally carry a flat charge for the facility and variable interest on the balance, e.g. 1–5% abovebase rate

– Are flexible in that the business borrows only when it needs to (unlike a fixed term loan)

Short-term bank loans:

– Should ideally match the term of the loan with the duration of the project– Can have fixed or variable rates of interest

Operating leases allow the business to have use of long-term assets such as plant or vehicleswithout paying the full amount of their cost. Instead, a regular amount is paid out each month to giveuse of the asset, while the risks of ownership remain with the lessor.

8.5 Investing surplus funds

If a business identifies a short-term surplus of funds it should aim to invest it to earn a return. If thesurplus is of a longer-term nature it should be invested in longer-term projects to increase shareholderwealth, or returned to shareholders as dividends.

Surplus funds can be invested in various financial products:

Treasury bills, which are highly secure and liquid, but offer low returns

Deposits, which offer investment periods ranging from one month to ten years. They are availablefrom banks

Gilts (longer-term government debt), which offer a range of maturities and are secure but offer lowerreturns, e.g. Pratirakha Sanchay Patra

Bonds, which are debentures and loans of companies quoted on the stock market; rates fluctuatewith general interest rates and there is good liquidity

Equities dealt on the Stock Exchange offer good marketability and liquidity but relatively high risk

Most businesses will be looking for a variety of investments in order to minimise the risks involved, and alsoto ensure that some cash is available at short notice and some is invested longer term to obtain higherinterest rates.



When choosing investments from the list above the following factors should be considered:

The amount of funds available The length of time for which the funds are available The likelihood of needing early withdrawal (consider liquidity) The notice period for withdrawal, and penalties The risk and the return of the investment

8.6 Transmission of cash

Making sure that funds such as cash, cheques and automated receipts go promptly into a business's bankaccount is very important.

The interval between when funds are paid into a bank and when they can be drawn upon depends on theclearing mechanism used.

General clearing (mainly of cheques, but most internet transfers take the same amount of time!) –this covers items of any size but there is a three to four day delay before funds are cleared (i.e. can bedrawn upon).

Clearing House Automated Payment System (CHAPS) – this covers items above a certainamount and provides same-day clearing, so funds have value more quickly.

Banks Automated Clearing System (BACS) – this deals with salaries, standing orders and directdebits. The account of the payer is debited on the same day as the account of the recipient is credited.

Practical matters should be managed carefully:

Banking routines – bank regularly

Banking procedure, e.g. varying the route taken for security

Analysis of clearing times, e.g. a percentage of dividend cheques may take up to six months to bebanked so funds are not needed immediately the cheque is written

Same day clearing is available if both parties bank at the same branch

9 The banking system

Section overview

The banking system comprises primary and secondary banks. All banks are financial intermediariesbetween those who have funds (known as 'surplus units') and those who need them (known as 'deficitunits'); the job of banks is to match them up.

If a business is to raise additional short or long-term finance or to invest surplus funds, then this will bedone either through a bank or within the money markets (see section 11).

9.1 Banks

Primary banks are those which operate the money transmission service in the economy. Theyoperate cheque accounts and deal with cheque clearing. They are sometimes also known as thecommercial banks, retail banks or clearing banks.

Secondary banks are made up of a wide range of merchant banks and other banks. They do nottend to take part in the clearing system.



9

9.2 Financial intermediation

Banks take deposits from customers and then use those funds to lend money to other customers. Thisprocess is known as financial intermediation. The banks act effectively as middlemen providing funds forthose that want loans from the deposits made by savers.

Benefits of financial intermediation:

Small amounts deposited by savers can be combined to provide larger loan packages to businesses

Short-term savings can be transferred into long-term borrowings

Search costs are reduced as companies seeking loan finance can approach a bank directly rather thanfinding individuals to lend to them

Risk is reduced as an individual's savings are not tied up with one individual borrower directly

9.3 Assets of banks

Loans to customers and overdrafts of customers (their biggest assets)

Notes and coin – branches require notes and coins to meet demands for withdrawals by customers

Balances with the Bangladesh Bank (the central bank). There is one type – Cash reserverequirement (CRR) @ 5% of demand and time liabilities as a requirement of the Bangladesh Bank

which must be held with the Bangladesh Bank.

Bills. The banks tend to hold very low risk bills. These include:

– Treasury bills – three-month loans issued by the Bangladesh Bank on behalf of the government

– Local authority bills which are similar to Treasury bills but are issued by local government

– Commercial bills of exchange which are a promise by one firm to pay another a stated amounton a certain day

Loans to the money markets or other banks

Securities, such as shares issued by companies, and bonds issued by companies and local authorities

Non-current assets such as land, buildings, computers etc

We shall come back to some of these items later in the chapter.

9.4 Liabilities of banks

The liabilities of the banks are primarily the deposits that customers have paid into the bank in the form oftheir account balances.

We shall look at different types of financial system and the role of banks in them in Chapter 12.

10 The bank/customer relationship

Section overview

The bank/customer relationship is legally quite complex.

When money is paid into a bank by an individual or business and an account is opened then that individualor business becomes a customer of the bank.

The legal relationship between the bank and its customer is actually quite complex. There are potentiallyfour main contractual relationships between the bank and the customer.



10.1 Debtor/creditor relationship

When the customer deposits money the bank becomes the debtor and the customer is a creditor of thebank. If the customer's account is overdrawn however the bank becomes the creditor and the customer isthe debtor.

This relationship is essentially a contract between the bank and the customer.

The bank borrows the customer's deposits and undertakes to repay them The bank must receive cheques for the customer's account The bank will only cease to do business with the customer with reasonable notice The bank is not liable to pay the customer until the latter demands payment The customer must exercise reasonable care when writing cheques

10.2 Bailor/bailee relationship

This element of the relationship concerns the bank accepting the customer's property for storage in its safedeposit. The bank undertakes to take reasonable care to safeguard the property against loss or damageand also to re-deliver it only to the customer or someone authorised by the customer.

10.3 Principal/agent relationship

An agent is someone who acts on behalf of another party, the principal. Within banking theprincipal/agent relationship exists where, for example, the customer pays a crossed cheque into the bank.The bank acts as an agent when, as receiving bank, it presents the cheque for payment to the paying bank,and then pays the proceeds into the customer's account.

10.4 Mortgagor/mortgagee relationship

If the bank asks the customer to secure a loan with a charge over its assets then the relationship betweenthe two is that of mortgagor and mortgagee. If the customer does not repay the loan then the bank hasthe right to sell the assets and use the proceeds to pay off the loan.

10.5 Fiduciary relationship

The bank and the customer also have a fiduciary relationship which means that the bank is expected toact with good faith in its relationship with the customer.

10.5.1 The bank's duties

It must honour a customer's cheques provided they are correctly made out, there is no legalreason for not honouring them and the customer has enough funds or sufficient overdraft limit tocover the amount of the cheque

The bank must credit cash/cheques that are paid in to the customer's account

If the customer makes a written request for repayment of funds in its account, for example by writinga cheque, the bank must repay the amount on demand

The bank must comply with the customer's instructions given by direct debit mandate orstanding order

The bank must provide a statement showing the transactions on the account within a reasonableperiod and provide details of the balance on the customer's account

The bank must respect the confidentiality of the customer's affairs unless the bank is required bylaw, public duty or its own interest to disclose details or where the customer gives his consent forsuch disclosure



9

The bank must tell the customer if there has been an attempt to forge the customer's signatureon a cheque

The bank should use care and skill in its actions

The bank must provide reasonable notice if it is to close a customer's account

10.5.2 The customer's duties

To draw up cheques carefully so that fraud is not facilitated To tell the bank of any known forgeries

Note that there is no specific legal duty on a customer to check their bank statements.

10.5.3 The rights of the bank

To charge reasonable bank charges and commissions over and above interest To use the customer's money in any way provided that it is legal and morally acceptable To be repaid overdrawn balances on demand (although banks rarely enforce this) To be indemnified against possible losses when acting on the customer's behalf

11 The money markets

Section overview

The money markets offer opportunities for investing surplus funds.

The money markets is a term that covers a vast array of markets buying and selling different forms ofmoney or marketable securities. Marketable securities are short-term highly liquid investments that arereadily convertible into cash. The money markets provide financial institutions with a means of borrowingand investing to deal with short-term fluctuations in their own assets and liabilities.

The main traders in the money markets are banks, the government (through the Bangladesh Bank), localauthorities, brokers and other intermediaries.

11.1 Money market financial instruments

There are a variety of different financial instruments that are traded in the money markets. The main typesare:

Bills– short-term financial assets that can be converted into cash by selling them in the discount market

Deposits – money in the bank accounts of banks and other financial intermediaries

Commercial paper – IOUs issued by large companies which can be either held to maturity or soldto third parties before maturity

11.2 The primary and secondary markets

A primary market is where new financial instruments are issued for cash, whereas a secondary marketis where existing financial instruments are traded between participants in the market. The Bangladesh Bankuses the primary market to smooth out fluctuations in its regular cash balances by selling Treasury bills tobanks and securities firms if the Bank needs to raise money, or by buying back Treasury bills if the Bank hassurplus money.



11.3 The local authority market

In this market local government authorities borrow short-term funds by issuing local authority bills with amaturity of about one year or shorter.

11.4 The inter-bank market

This is a market for very short-term borrowing, often overnight, between banks. It is used to smoothfluctuations in the banks' receipts and payments. The interest rate charged in this market is a BangladeshBank rate. The individual banks then use this rate in order to set their own base rates which determine theinterest rate that they will offer to their customers.



9


Summary

Liquidity

Risk/Return

Inventory CashCash operating cycle

Receivables

Payables

Overtrading Growth

Profitability Liquidity

Shortterm

finance

Longterm

finance

Trade credit

Overdraft

Cost v Risk

Equity

Loans

Cost v Risk

Aggressive Average Defensive



Self-test


1 If a company buys a large quantity of goods on credit and immediately sells them on credit at a profit,which of the following both increase?

A Payables and inventoriesB Cash and inventoriesC Receivables and payablesD Receivables and cash

2 The amount of working capital is most likely to increase when

A Work-in-progress fallsB Selling prices increaseC The credit period allowed to customers is reducedD The credit period taken from suppliers is increased

3 When a company purchases a large amount of raw materials on credit, which of the following bothincrease?

A Receivables and inventoryB Current assets and non-current assetsC Payables and cashD Current assets and current liabilities

4 Which of the following is an inventory-holding cost?

A Disruption of production schedulesB Loss of customer goodwillC Shipping and handling costsD Inventory obsolescence

5 The average time in days taken to collect receivables in any year can be measured by

AsalesCredit

365s)receivableClosing(Opening0.5

B365salesCredit

s)receivableClosing(Opening0.5

Cs)receivableClosing(Opening0.5

365salesCredit

D365s)receivableClosing(Opening0.5

salesCredit

6 The following are items from APC Ltd's opening and closing balance sheet and income statement forthe year 20X8.

1 January 31 DecemberCU000 CU000

Receivables 800 900Inventory 600 700Payables 200 250Credit sales CU10,000,000Cost of goods sold CU6,000,000

What is the approximate length of the company's average cash operating cycle during the year?

A 53 daysB 57 daysC 71 daysD 84 days



9

7 Gemstrong Ltd is a retailer which has average sales of CU14.6m per annum and earns a markup of25%. Inventory averages CU2.0m, receivables average CU0.9m and trade payables CU0.6m.

If all sales and purchases are on credit, how long is the company's cash operating cycle (to the nearestday)?

A 66 daysB 69 daysC 104 daysD 109 days

8 A company has a quick ratio of 2. The directors believe that its cash balance is too low and haveagreed to increase the company's payment terms to suppliers from one month to two months.

What would be the effects of this change on the company's cash operating cycle and the company'squick ratio?

Cash operating cycle Quick ratioA Decrease DecreaseB Decrease IncreaseC Increase DecreaseD Increase Increase

9 A company has a quick ratio (receivables divided by payables and bank overdraft) of 0.5. The directorsbelieve that the company has to reduce its bank overdraft and have agreed to alter the company'scredit terms to customers from two months to one month.

What is the effect on the company's cash operating cycle and quick ratio if this change is achieved?

Cash operating cycle Quick ratioA Decrease DecreaseB Decrease No changeC Decrease IncreaseD Increase Increase

10 Consider the following statements:

(1) Recourse factoring involves the factor taking responsibility for irrecoverable debts that have beenfactored.

(2) Invoice discounting involves the invoice discounter taking responsibility for collecting the tradereceivables that have been discounted.

Which one of the following combinations relating to the above statements is correct?

Statement1 2

A False FalseB True FalseC False TrueD True True




1 C Dr PurchasesCr Payables

Dr ReceivablesCr Sales

2 B A, C and D will cause a fall. B may increase receivables

3 D Inventory up; payables up

4 D A and B are likely costs of not holding enough inventory to satisfy demand. C is a cost ofobtaining inventory

5 A Day sales in receivables =salescreditdailyAverage

sreceivableAverage

=365salesCredit

s)receivableClosing(Opening0.5

6 B Average inventory = CU650,000

Inventory period =6,000

650 365 = 39.54 days

Average receivables = CU850,000

Receivables period =10,000

850 365 = 31.03 days

Average payables = CU225,000

Purchases = CU6,000,000 + 900,000 – 800,000 = CU6,100,000

Payables period =6,100

225 365= (13.46) days

Operating cycle 57 days

7 A Receivable days (0.9/14.6) 365 = 22.5

Payables days (0.6/(14.6 ÷ 1.25)) 365 = (18.7)

Inventory days (2.0/(14.6 ÷ 1.25)) 365 = 62.566.3

8 A The credit period from suppliers is deducted from the cash operating cycle. If the period isincreased, this will reduce the operating cycle.

Quick ratio =Payables

CashsReceivable = 2

If both cash and payables are increased, this ratio will also decrease. For example

200

200200 = 2

If we increase cash and payables by 100:

100200

100)(200200

= 1.67



9

9 A The cash operating cycle is the time taken between paying for supplies and receiving cash for thesale of the goods concerned. The cycle will decrease by one month if the company allows itsreceivables one month's less credit.

Use figures to illustrate the change in current ratio.

Current ProposedCU000 CU000

Receivables 10 5(2 months) (1 month)

Overdraft 8 3Payables 12 12

20 15Quick ratio 0.5 0.33

Therefore the quick ratio decreases.

10 A Both statements are false.

Recourse factoring passes responsibility for irrecoverable debts on to the client company (versusnon-recourse factoring where the factor bears responsibility).

The invoice discounter does not assume responsibility for debt collection.





While liquidity as seen in the current ratio is unaffected by the decisions, when we look at the quick ratio,which treats inventory as non-current in the short term, we can clearly see that Right Ltd's short-termliquidity will decrease as a result of the proposed changes, so it is a riskier policy.


Cost of sales = 75% CU3,600,000 = CU2,700,000

Days

Raw materials in inventory60%2,700,000

150,000

365 34

Credit taken from suppliers60%2,700,000

130,000

365 (29)

5

WIP in inventory2,700,000

350,000 365 47

Finished goods in inventory2,700,000

200,000 365 27

Credit given to customers3,600,000

306,000 365 31

Cash operating cycle 110


Set clearly defined procedures to be followed. Establish timings for issuing letters of demand and thepoint when further deliveries should stop

Ensure the receivables ledger section liaises with marketing management to see if the latter can assist

Consider creating a stop list i.e. suspending supplies, etc

Decide whether outside assistance, such as solicitors, trade associations and debt collection agenciesare needed earlier in the cycle to collect overdue debts

Assess whether it may be cheaper to collect debts through the court system than through outsidehelp

Contents

chapter 10

The professional accountant

Introd

Exam

Topi

1

2

3

4

5

6

7

8

9

10

Summ

Answ

Techn

Answ

uction

ination context

c List

Introduction to the accountancy profession

The importance of the accountancy profession

Professional responsibility

Technical competence

The work of the accountancy profession

Professional principles


Accounting standards

Roles of the professional accountant

Limits of the professional accountant's responsibilities

ary and Self-test

ers to Self-test

ical reference


ers to Interactive questions



Introduction


Identify the importance to the public interest of high quality, accurate financial reporting andassurance

Specify the rationale for key parts of the accountancy profession's work

Specify the links between technical competence and professional responsibility

Specify the rationale for accounting principles, accounting standards, sound businessmanagement and the public interest

Specific syllabus references are: 4a, b, c.


Having embarked upon your chosen career as a professional accountant, you want to be able to identify andexplain to people why your profession is important, what it stands for, and how it achieves its aims.

Stop and think

In what way do accountants support the public interest as well as their own? What would happen if therewere no professional accountants? How far is the standing of the profession identified with technologicalcompetence, and how far with 'professionalism'? And when should a professional accountant acknowledgethe limits of their expertise?

Working context

Presumably you entered the accounting profession because you endorsed its work and its value. There canbe many challenges and dilemmas in the working context, which will become increasingly evident as youwiden your exposure to business environments.

Syllabus links

The topic of professionalism in accounting underlies many areas of the Professional and Advancedsyllabuses.

THE PROFESSIONAL ACCOUNTANT


10

Examination context


Questions on the professional accountant will almost certainly appear in your exam.

Exam requirements

Questions are likely to be set in a scenario context, though knowledge-type questions are also likely onparticular definitions and principles.



1 Introduction to the accountancy profession

Section overview

A professional has skill, technical competence and professional values.

The accountancy profession is concerned with assurance and financial reporting so that people maymake resource allocation decisions.

1.1 What is a professional?

Definition

Professional: A person who 'professes' to have skill resulting from a coherent course of study and trainingbased on professional values, and who continues to develop and enhance those skills by experience andcontinuing professional education.

1.1.1 What is a professional accountant?

For the purpose of this chapter the term 'professional accountant' is limited in meaning to a member of theICAB.

1.2 What is the accountancy profession?

The accountancy profession started to take shape as an organised group of professionals in the early tomid-nineteenth century. Initially it grew as a result of the commercial and legal activities involved in personalbankruptcy, and the insolvency and winding up of limited companies, but from quite early on the professionbegan to incorporate many of the features that are familiar today. The Institute of Chartered Accountantsof Bangladesh was formed in 1973 by President’s order No. 2. The earliest accountancy societies can betraced back to Scotland in 1853.

Definition

Accountancy profession: The profession concerned with the measurement, disclosure or provision ofassurance about financial information that helps managers, investors, tax authorities and other decisionmakers make resource allocation decisions.

Thus at the heart of the accounting profession are:

Financial reporting, and Assurance

Definition

Financial reporting: The provision of financial information about an entity to external users that is usefulto them in making economic decisions and for assessing the stewardship of the entity's management.



10

Definition

Assurance: The expression of an opinion or conclusion by a professional accountant in public practicewhich is designed to enhance the confidence of intended users.

Interactive question 1: Accounting profession [Difficulty level: Intermediate]

Think back to when you first decided that you wished to follow a career as a professional charteredaccountant. What were your motives? What were the reactions of your friends and family? Would theyhave been different if you had chosen a career in general management under a large company's ManagementTrainee Scheme? If so, where did the differences lie? What did the term 'profession' mean to you then, andwhat does it mean now?


2 The importance of the accountancy profession

Section overview

The accountancy profession is concerned with supporting the public interest and the effectiveworking of capital markets.

Because accountancy is technically complex, the public interest is best served by having access toprofessionals on whom they can rely.

Public confidence in accountants is driven by their expertise and integrity.

2.1 Why is the accountancy profession important?

The accountancy profession should encompass more than money and numbers. The UK’s ProfessionalOversight Board for Accountancy (now the Professional Oversight Board or POB) states that:

'Accountants should not be limited to discussions within the finance department on technical points ofaccountancy, but rather need to be able to apply their knowledge and expertise to a wide range ofbusiness issues and environments'.

Review of Training and Education in the Accountancy Profession, POB April 2005

In January 2007 the ICAEW launched an updated brand for the Institute. Part of this is reflected in thefollowing 'brand story', which boils down the role of members and the institute, and its values, to thefollowing:

' The role of chartered accountants in the world's economies has never been more important. Peoplemaking financial decisions need knowledge and guidance based on the highest technical and ethicalstandards.

Our members provide this better than anyone. They challenge people and organisations to think andact differently, to provide clarity and rigour, and so help create and sustain prosperity.

As their institute, we create the environment in which those skills are constantly developed,recognised and valued. We shape opinions, understanding and delivery to ensure the highest standardsin business and in the public interest.

Because of us, people can do business with confidence.'



Sir David Tweedie, Chairman of the International Accounting Standards Board (IASB), commented that theaccounting professional should endorse:

'The professional ethics of service to the public and a keenness to uphold a transparentcapital market'.


The work of the accountancy profession is most important and relevant therefore to:

The effective working of capital markets, and The public interest.

2.2 The effective working of capital markets

The accountancy profession is actively involved in ensuring that organisations (both private and publicsector) have access to sufficient finance. Where new finance is needed businesses need to access theprimary capital markets, that is those markets and intermediaries that provide long-term funds, such as:

Stock markets Bond markets Banks and other direct lenders

Securities that are already in issue are bought and sold on secondary capital markets. These ensure thatthere is liquidity in the capital markets, so a holder of securities can quickly realise their holding, and aperson with excess funds can invest these.

The capital markets can only operate effectively where there is accurate and open information which can beused by investors and other providers of finance to make economic decisions, as we saw in Chapter 6. Ifthere is inadequate information, or if information is available to some people and not others(asymmetric information), then some or all investors are at a disadvantage. They will not makeoptimum economic decisions and will not make the returns that they seek. Ultimately confidence in thecapital markets will erode, and the source of new capital for business would dry up.

If financial statements demonstrate the qualitative characteristics that we saw in Chapter 6, they aremore likely to be relied upon by investors. Hence it is in ensuring that there is high quality,accurate financial reporting and assurance that the professional accountant supports theeffective working of capital markets for the benefit of businesses.

We shall be seeing in Chapter 14 more about how (capital) market failures can undermine certainaspects of business.

2.3 The public interest

Definition

Public interest: The collective well-being of the community of people and institutions the professionalaccountant serves, including clients, lenders, governments, employers, employees, investors, the businessand financial community and others who rely on the work of professional accountants. (IFAC)

How far should the public interest be served specifically by the accounting profession?

'Many of the areas in which professional accountants operate are technically complex. They provideadvice on which others, such as shareholders in audited companies, may rely. It is therefore cruciallyimportant that the public should have confidence in [their] integrity.'

Regulation within the accounting profession in the UK: an ICAEW perspective



10

2.4 What drives public confidence in the accountancy profession?

The POB is very clear that it is confidence in high quality financial reporting and assurance that ismost crucial:

'Public and investor confidence in financial reporting is achieved through the publication of consistentlyhigh quality reports that are informative, relevant and transparent and free of material misstatements,whether caused by errors, disclosure deficiencies, erroneous interpretations or intentionalmanipulation. Maintaining this confidence requires expertise and integrity across the profession.'


This links professional accountants in business – the accountants who, as members of boards ofdirectors or in exercise of the authority devolved by boards of directors, are responsible for preparing acompany's financial statements – with professional accountants in public practice who, as auditors oras professionals on other assurance engagements, are responsible for reporting on these statements.

To be seen to have integrity as well as expertise, the professional accountant needs:

'A strong foundation in professional values and in the practical aspects of how these relate to theneeds of users of accounts, including investors in capital markets… [S/he] should have a clear line ofsight from accounting principles through accounting standards and other regulation to highquality financial reporting and governance and the public interest.'


2.5 Why should the accountancy profession act in the public interest?

The accountancy profession takes its task of acting in the public interest seriously. One of the principalobjects in the ICAB's Bye-Laws is the setting and enforcing of standards of performance and conduct formembers:

'To develop, maintain and support high standards of practice and professional conduct which commandpublic confidence.'

The introduction to the ICAB's Code of Ethics makes it clear that a distinguishing mark of the accountancyprofession is its acceptance of the responsibility to act in the public interest. It states that:

‘A professional accountant’s responsibility is not exclusively to satisfy the needs of an individual clientor employer. In acting in the public interest a professional accountant should observe and comply withthe ethical requirements of the Code of Ethics’

Code of Ethics Section 100.1

The ICAB Code of Ethics is issued to all members and states five fundamental professional principles orvalues with which the professional accountant in public practice must comply in carrying out their work(100.4). The first two principles, integrity and objectivity, are highlighted as being the qualities whichunderlie the reliance of the public on accountants.

2.6 What does the public interest require of the professionalaccountant?

A professional accountant should show:

Professional responsibility (integrity) Technical competence (expertise)



3 Professional responsibility

Section overview

People who have less expertise must be able to trust accountants, who have more. The profession'sCode of Ethics is a conceptual approach to professional ethics so that members of the ICAB canensure that they warrant that trust.

To ensure integrity the Code of Ethics has five fundamental principles and also sets out the types ofthreat to these principles that arise, and the sorts of safeguard that can protect against the threats.

To ensure technical competence the ICAB has rigorous entry and education requirements, andadditional requirements for accountants in public and some other types of practice.

To ensure technical competence further, there is an oversight mechanism over how the ICAB self-regulates.

3.1 Fundamental ethical principles: the conceptual framework

Many of the areas in which professional accountants operate are technically complex. Advice is provided onwhich others, such as shareholders in audited companies, may rely. It is therefore important that the publicshould have confidence in the integrity of professional accountants: they should be able to trustaccountants.

The ICAB Code of Ethics' five fundamental principles are to be observed by members in public practice.The Code identifies potential threats to the principles and some corresponding safeguards. Thisconceptual framework enables members to apply ethical standards consistently in a rapidly changingbusiness environment. Because the balance of threats and safeguards must be considered in each case, thereis no opportunity to 'get round' rules by sticking to the letter but not the spirit of the requirements.

The fundamental ethical principles are:

Integrity Objectivity Professional competence and due care Confidentiality Professional behaviour

We shall see a little later in this chapter what exactly these principles mean and how they help to ensureprofessional responsibility in practice.

3.2 Regulation of the accountancy profession

As well as requiring professional accountants in public practice to live by the fundamental professionalprinciples, the accountancy profession has other methods by which public confidence is maintained in theprofessional responsibility of accountants. Professional regulation by the ICAB itself entails:

Rigorous entry and education requirements

Specific additional requirements for professional accountants engagedin audit

Together these help to ensuretechnical competence.

Oversight regulation of the ICAB's professional regulation of itsmembers by the Ministry of Commerce

A rigorous complaints procedure

We shall come back to thesepoints in Chapter 11.



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4 Technical competence

Section overview

The ICAB's entry and education requirements aim to ensure that accountants have the knowledge,understanding, skills, abilities, personal commitment and professional abilities that are required.

There are further requirements regarding continuing membership, and regarding accountants inreserved areas of practice.

4.1 Why is accountancy education important?

The success of the accountancy profession in the UK has always been closely identified with itscommitment to training and education. It attracts bright and dedicated students, only some of whomare graduates and only some of whom hold accounting and finance degrees, but all of whom are willing tostudy at the same time as being employed to do a full day's work, in order to join a profession which offersvariety, credibility, rewards and respect.

In relation to both students and practising chartered accountants, Ian Percy CBE commented that:

'What they are achieving through their examination and qualification process is not a degree signifyinga level of competence, but indeed a passport to be a member of a profession to which they willcontinue to have obligations throughout the rest of their lives.'

Quoted in Review of Training and Education in the Accountancy Profession, POB April 2005

4.2 The ICAB's entry and education requirements

The principal requirements for initial admission to membership of the ICAB are:

HSC/’A’ level :

A+ (CGPA 5.00) in both SSC and HSC Examinations held under any recognized Education Board ofthe Country; or,

Minimum Grade 2As and 3Bs (total 5 subjects) in ‘O’ Level Examinations from University of Londonor equivalent Bodies / Institute; and,

Minimum Grade 2Bs or 3Cs in ‘A’ Level Examination from University of London or equivalent bodies /Institute; or,

Graduates or post-graduates in any discipline having minimum 07 (seven) points with no third divisionor equivalent from any recognized Boards/Public Universities/National University and PrivateUniversities/Institutes (as approved by ICAB)

Completion of at least three years' articleship with a chartered accountants firm

Completion of a course of theoretical instruction

Passing the ICAB's professional examinations

Submission of a certificate of course completion for membership signed by the memberresponsible for the articleship

Payment of the admission and subscription fees

By undertaking prescribed training and education the student accountant is:

Acquiring the knowledge and understanding that underlie what accountants do

Developing the skills and abilities necessary to perform the tasks and roles undertaken by theprofessional accountant

Building personal commitment and professional principles



Accounting training covers both fundamental values and competencies and increasing quantities oftechnical knowledge and skills in tax, financial reporting, governance and related assurancerequirements. A balance is needed between knowing the underlying principles and rules that apply to all ormost transactions and knowing detailed requirements related to specialised transactions. There is anincreasingly strong argument that the ability to read, understand and apply principles and rules is moreimportant in students and newly-qualified accountants than knowledge of detailed technical rules.

Most importantly students should be able to:

Apply basic accounting skills Understand the accounting principles underlying financial reporting and assurance Understand what the numbers that come out of the reporting process are telling them

4.3 Continuing membership of ICAB

To continue in membership all professional accountants must:

Obey the Institute's rules and regulations

Pay the subscription fee annually, and

Undertake continuing professional education (CPE): this involves course attendance.

The purpose of the CPE requirements is to ensure that chartered accountants maintain appropriatelevels of technical and ethical competence.

Members engaged in public practice must in addition:

Hold a Certificate of Practice (COP): this is obtained by showing that the member has maintainedappropriate levels of education and work experience

Implement the Code of Ethics

It is considered particularly important in the public interest that practitioners should have particularlevels of competence and conduct.

4.4 Reserved area of practice

Most activities carried out by accountants are open to all. However, there is one activity, known as areserved area, which legislation requires to be carried out by members of ICAB, which is a ‘recognisedprofessional regulator’. This area is:

Statutory and regulatory audits

The purpose of the legislation is to ensure, in the public interest, that those practising in the reserved areahave the required level of technical competence and are subject to an appropriate disciplinaryregime.

The Institute is a recognised professional regulator for the reserved area. Its Audit Regulations aredrawn up to meet the requirements of the legislation. They apply only to members or firms registered orlicensed to carry out these activities.

The contents of the regulations cover:

Eligibility Conduct (integrity, monitoring, enforcement of discipline, etc) Competence (e.g. continuing professional education)

We shall see more about the overall regulation of the profession in Chapter 11.



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5 The work of the accountancy profession

Section overview

Three aspects support high quality financial reporting and assurance: maintaining control andsafeguarding assets; financial management; financial reporting.

Underlying financial reporting are professional and accounting principles.

There are three basic aspects of the professional accountant's work which should be appreciated by anyaccountancy trainee:

Maintaining control and safeguarding assets Financial management Financial reporting

We shall look at each of these in turn.

5.1 Maintaining control and safeguarding assets

Stakeholders in a business are concerned that the business's assets are kept safe, and that the managers ofthe business are acting in the stakeholders' (especially the shareholders') best interests. The professionalaccountant will therefore seek to ensure that:

1 The recording of transactions is complete, timely and accurate (as we have seen in earlierchapters).

2 The business's internal controls are sufficient.

3 The business's audit committee is properly constituted and has the information and resources thatit needs to fulfil its objectives.

4 The business has non-executive directors who are adequately qualified and resourced so that theycan fulfil their role.

Points 2 to 4 apply particularly to large listed companies. We shall come back to internal controls, and theroles of the audit committee and non-executive directors, when we look at corporate governance inChapter 13.

5.2 Financial management

Definition

Financial management: The management of all the processes associated with the raising and use offinancial resources in a business.

Financial management therefore incorporates aspects of many issues that we have seen in earlier chapters.

Transactions recording Raising new finance Using existing funds in ways which support achievement of the business's objectives Planning and control systems Treasury management

High quality financial management supports good corporate governance as it protects investors against theinterests of managers, who may be tempted to take unnecessary or unconsidered risks with the business'sfinances. We shall return to this key issue in Chapters 12 and 13.



5.3 Financial reporting

The transactions and activities of the business, as represented in its accounting records, must be reportedto external stakeholders, including investors in capital markets. As we saw in Chapter 6, financial reportinginvolves reporting on the financial position of the entity at a particular point in time (the balance sheet), andits financial performance over a period of time (the income statement). It is a key plank in corporategovernanceError! Bookmark not defined., as we shall see in Chapters 12 and 13.

In seeking to ensure that there is high quality financial reporting, the professional accountant has two sets ofprinciples which underlie everything he or she does:

Professional principles Accounting principles

6 Professional principles

Section overview

Professional principles guide the accountant in how to be seen to act in a professional manner in thecourse of professional work.

The fundamental professional principles are integrity, objectivity, professional competence and duecare, confidentiality and professional behaviour.

Threats to the fundamental principles arise from self-interest, self-review, advocacy, familiarity andintimidation.

Safeguards against threats vary according to the circumstances but include: education, training andexperience; continuing professional education; corporate governance regulations; professionalstandards; monitoring and disciplinary procedures; external review.

6.1 What are professional principles used for?

The conceptual framework in the Code of Ethics is used by the professional accountant in practice toidentify, evaluate and address any threats to their professionalism, and then to implement safeguards.

The conceptual framework is covered in detail in your Assurance syllabus. Here we shall use it as a guide tohow a professional accountant should be seen to act in a professionally responsible manner in thecourse of professional work.

6.2 Integrity

Definition

Integrity: A professional accountant should be straightforward and honest in all professional and businessrelationships (IFAC Code of Ethics)

A professional accountant behaves with integrity when he or she is:

Straightforward Honest Fair Truthful



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A professional accountant does NOT behave with integrity if he or she is:

Corrupted by self-interest

Corrupted by the undue influence of others

Associated with information which is false or misleading (for instance if certain parts of it areomitted or obscured)

Associated with information which is supplied recklessly

6.3 Objectivity

Definition

Objectivity: The state of mind which has regard to all considerations relevant to the task in hand but noother.

'A professional accountant should not allow bias, conflict of interest or undue influence of others tooverride professional or business judgements.' (IFAC Code of Ethics)

Being objective means:

Being independent of mind

Not allowing professional or business judgement to be overridden by:

– Bias (allowing one's judgement to be clouded by preconceived or irrational arguments)

– Conflict of interest (allowing one's judgement to be affected by the fact that allegiance is owedto both parties in a situation)

– Undue influence of others (allowing one's judgement to be swayed by persons who wish toimpose their ideas and interests)

6.4 Professional competence and due care

'A professional accountant has a continuing duty to maintain professional knowledge and skill at the levelrequired to ensure that a client or employer receives competent professional service based on currentdevelopments in practice, legislation and techniques. A professional accountant should act diligently and inaccordance with applicable technical and professional standards when providing professional services.'

(IFAC Code of Ethics)

When providing professional services 'professional competence and due care' therefore mean:

Having appropriate professional knowledge and skill

Exercising sound and independent judgement

Acting diligently, that is:

– Carefully– Thoroughly– On a timely basis

Acting in accordance with applicable technical and professional standards

Distinguishing clearly between an expression of opinion and an assertion of fact



6.5 Confidentiality

'A professional accountant should respect the confidentiality of information acquired as a result ofprofessional and business relationships and should not disclose any such information to third partieswithout proper and specific authority unless there is a legal or professional right or duty to disclose.Confidential information acquired as a result of professional and business relationships should not be usedfor the personal advantage of the professional accountant or third parties.'


The professional accountant should assume that all unpublished information about a prospective, current orprevious client's or employer's affairs, however gained, is confidential. Information should then:

Be kept confidential (confidentiality should be actively preserved) Not be disclosed, even inadvertently such as in a social environment Not be used to obtain personal advantage

6.6 Professional behaviour

'A professional accountant should comply with relevant laws and regulations and should avoid any actionthat discredits the profession.'


Behaving professionally means:

Complying with relevant laws and regulations

Avoiding any action that discredits the profession (the standard to be applied is that of areasonable and informed third party with knowledge of all relevant information)

Conducting oneself with

– Courtesy and– Consideration

When marketing themselves and their work, professional accountants should:

Be honest and truthful

Avoid making exaggerated claims about:

– What they can do– What qualifications and experience they possess

Avoid making disparaging references to the work of others

Interactive question 2: Conceptual framework [Difficulty level: Exam standard]

Charis is a chartered accountant who acts on behalf of a charitable trust set up by her family, though she isnot a beneficiary of the trust. Her elder sister is a powerful and articulate trustee and Charis has frequentlyfollowed her wishes in the past, contrary to those of her younger sister and mother who are also trustees.As a result of Charis' and her elder sister's actions a great deal of money has been diverted to the eldersister and the trust has become insolvent. Charis' conduct has been called into question. Which of thefundamental principles in the Code of Ethics have been contravened by Charis?




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6.7 Threats to professional principles

Compliance with the professional principles may potentially be threatened by a broad range ofcircumstances. Threats generally fall into the following categories:

Self-interest threats, which may occur as a result of dominance of the financial or other interests ofthe professional accountant or an immediate or close family member

Self-review threats, which may occur when a previous judgement needs to be re-evaluated by theprofessional accountant responsible for that judgement

Advocacy threats, which may occur when a professional accountant promotes a position or opinionto the point that subsequent objectivity may be compromised

Familiarity threats, which may occur when, because of a close relationship, a professionalaccountant becomes too sympathetic to the interests of a particular group

Intimidation threats, which may occur when a professional accountant is deterred from actingobjectively by threats, actual or perceived

6.8 Safeguards against threats

Safeguards that may eliminate or reduce such threats to an acceptable level fall into two broad categories:

Safeguards created by the profession, legislation or regulation Safeguards in the work environment

Safeguards created by the profession, legislation or regulation include, but are not restricted to:

Educational, training and experience requirements for entry into the profession (as we have seen)

Continuing professional education requirements

Corporate governance regulations (covered in Chapter 13)

Professional standards (the conceptual framework)

Professional or regulatory monitoring and disciplinary procedures (covered in Chapter 11)

External review by a legally empowered third party of the reports, returns, communications orinformation produced by a professional accountant (covered in Chapter 11)

Certain safeguards may increase the likelihood of identifying or deterring unethical behaviour. Suchsafeguards may be created by the accounting profession, legislation, regulation or an employing organisation.They include, but are not restricted to:

Effective, well-publicised complaints systems operated by the employing organisation, theprofession or a regulator, which enable colleagues, employers and members of the public to drawattention to unprofessional or unethical behaviour

An explicitly stated duty to report breaches of ethical requirements

We shall see more about this in Chapter 12.

The nature of the safeguards to be applied in the workplace will vary depending on the circumstances.

In exercising professional judgement, a professional accountant should consider what a reasonable andinformed third party, having knowledge of all relevant information, including the significance of the threatand the safeguards applied, would conclude to be unacceptable.



7 Accounting principles

Section overview

Accounting principles inform professional judgements.

Key accounting principles are: accruals, going concern, double entry, faithful representation (accuracyand completeness), the primacy of substance over form, materiality, neutrality, prudence, timeliness,cost/benefit, consistency and no offsetting.

7.1 What are accounting principles used for?

The professional accountant should always be aware that there are certain accounting principles thatunderlie accounting, financial reporting and assurance. If in doubt about how to report a transaction orevent, the professional accountant should always come back to these principles to inform the professionaljudgement that needs to be made. They are covered in detail elsewhere at Professional stage, but wesummarise them briefly here too.

7.2 Accrual basis

Transactions and other events are recognised when they occur, and not just when cash is received or paid.They are therefore recorded in the accounting records and financial statements of the periods to whichthey relate; for instance, revenue is matched with the expenditure incurred in earning it. Users are therebyinformed both of past transactions and of future obligations to pay and receive cash.

7.3 Going concern

Financial statements are prepared on the basis that the business is a going concern. This assumes that,unless there is a clear intention or need for the business to liquidate or materially scale back its operations,it will continue in operation for the foreseeable future.

If a business is not a going concern, then realistically its value is limited to the resale or salvage value of itsassets less its liabilities.

7.4 Double entry bookkeeping

The fact that every transaction has a dual effect when entered into the ledger accounts of a business is aprime control on the completeness of the accounting records. Even though most businesses use computersoftware to record transactions it is part of the role of the professional accountant to be able to identify, interms of debits and credits, what entries should be recorded for each transaction. This application ofprinciple means that the professional accountant is best placed to identify and remedy errors.

7.5 Faithful representation: accuracy and completeness

For it to be reliable, the information contained in financial statements or other outputs of the professionalaccountant should:

Represent faithfully the business's transactions and other events i.e. be accurate

Be complete (within the bounds of materiality and cost), as incomplete information can be false ormisleading

Information should therefore be as accurate as possible. At the transactions recording level this means thatboth sides of each transaction should be recorded with total accuracy.



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7.6 Substance over form

To represent the business's transactions and other events faithfully, the professional accountant should takeinto account their substance and economic reality rather than just their legal form. For example, twolease agreements, of which one is a means of funding the acquisition of an asset while the other is simplyallowing the entity use of the asset in the short-term are treated differently according to their economicreality rather than their legal form.

7.7 Materiality

Something may be of material importance to the relevance of financial information either by virtue of itssize (in relation to the business) or its nature. Information is material if its omission or misstatement couldinfluence users' economic decisions. This often means that material items should be presented separatelyand should not be aggregated with other items.

7.8 Neutrality

To be reliable, information must be neutral, that is free from bias. Information is biased if it has beenselected or presented so as to influence a decision or judgement in order to achieve a predetermined resultor outcome.

7.9 Prudence

Where there are uncertainties that affect the reliability of information the professional accountant should:

Disclose the nature and extent of the uncertainty

Exercise prudence or 'a degree of caution' when making judgements, so that income and assets arenot overstated, and expenses and liabilities are not understated

7.10 Timeliness

There should not be undue delay in reporting information, but neither is it absolutely necessary to knowabout all aspects of a transaction or other event before it is reported.

Late reporting undermines relevance Reporting too early undermines reliability

A balance must be achieved between early and late reporting based on satisfying the decision-making needsof users.

7.11 Cost versus benefit

The benefit derived from information should exceed the cost of providing it.

7.12 Consistency

Unless there are good reasons for the contrary, items in financial statements should be presented andclassified in the same way from one period to the next.

7.13 Offsetting

Assets and liabilities, and income and expense, should not usually be set off against each other, with only netfigures reported.



8 Accounting standards

Section overview

Accounting standards identify proper accounting practice.

Financial statements should comply with accounting standards.

Listed companies must comply with Bangladesh Accounting Standards (BAS) and Bangladesh FinancialReporting Standards (BFRS), Companies Act 1994 and SEC Act 1993.

8.1 What is the purpose of accounting standards?

To demonstrate technical competence, the professional accountant needs to be aware of and applyaccounting standards as well as accounting principles.

The basic purpose of accounting standards is to identify proper accounting practice for the benefit ofpreparers, auditors and users of financial statements. Accounting standards create a common understandingbetween users and preparers of financial statements on how particular items should be treated, so financialstatements are expected to comply with applicable accounting standards other than in rare, exceptionalcases.

8.2 Types of accounting standard

There are two types of accounting standard that affect the professional accountant in Bangladesh:

International standards, namely International Accounting Standards (IASs) and InternationalFinancial Reporting Standards (IFRSs), produced by the International Accounting Standards Board(IASB)

Bangladesh standards, namely Bangladesh Financial Reporting Standards (BFRSs) and BangladeshAccounting Standards (BASs), produced by the Institute of Chartered Accountants of Bangladesh(ICAB). ICAB usually adopts IASB standards and rarely is there any difference between the ICAB’s andthe IASB’s standards.

Recently ICAB has adopted a number of IASs and IFRSs to make the local accounting standards evenmore converged to IASB standards.

8.3 The standard-setting process

The IASB process for developing new standards involves some or all of the following stages (*those markedwith an asterisk are always required):

Study by staff of national requirements and practices

An exchange of views with national standard setters, to establish the extent to which an internationalstandard is acceptable in national jurisdictions

Consultation with the Standards Advisory Council (SAC)*

A discussion paper

An exposure draft, together with any dissenting opinions held by IASB members*. Its content must beapproved by at least eight of the fourteen members of IASB

Consideration of all comments received on an exposure draft during the comment period*

Public hearings about, and field tests of, the exposure draft



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Publication of the standard, together with any dissenting opinions held by IASB members*. Its contentmust be approved by at least eight of the fourteen members

9 Roles of the professional accountant

Section overview

Professional accountants work in public practice or outside it, in business management.

Additional regulations apply to those working in the reserved area of statutory audit.

A professional accountant who is technically competent and professionally responsible can perform a widevariety of roles.

Traditionally professional accountants have tended to:

Work in public practice with an accountancy firm, or Be employed by a private or public sector organisation to help in its management

In recent times there have been more opportunities to specialise within these two general fields.

9.1 The professional accountant in public practice

A professional accountant in public practice is in a firm providing professional services that requireaccountancy or related skills, including:

Accounting Auditing and assurance (reserved area) Taxation Management consulting Investment business Insolvency Financial management Corporate finance Information and communications technology Forensic accounting

Firms vary in size from the sole practitioner to one of the 'Big Four' multinational accountancy firms:

PricewaterhouseCoopers Deloitte (Deloitte Touche Tohmatsu) Ernst & Young KPMG

These firms are associations of the partnerships in each country rather than having the classical structure ofholding company and subsidiaries, but each has an international 'umbrella' organisation for co-ordination.

As we saw above, there is one reserved area in public practice: statutory audit. There is more regulationinvolved in working in this area. We shall look here at auditing.



9.1.1 Qualification for appointment as external auditor

Definition

Audit: An expression of an opinion as to whether an entity's financial statements have been prepared, in allmaterial respects, in accordance with an applicable financial reporting framework, and thereby give a 'trueand fair view'.

In Bangladesh, a person who qualifies for appointment by a company as external auditor of its financialstatements:

May be a sole practitioner or a partnership firm Must be a member of the ICAB Must hold an appropriate qualification

The Companies Acts set out who is NOT eligible to act as a company's external auditor:

An officer or employee of the company A partner or an employee of any officer, employee to the company A person who is indebted to the company exceeding Tk.1,000. A person who is a director or member of a private company, or a partner of a firm, which is the

managing agent of the company. A person who is a director or holder of shares exceeding 5% of the subscribed capital

9.2 The professional accountant in business

A professional accountant in business is one who is employed or engaged, in an executive or non-executivecapacity, in such areas as:

Commerce Industry Service The public sector Education The not-for-profit sector Regulatory or professional bodies

9.2.1 Roles and responsibilities of the professional accountant in business

In business a professional accountant could be engaged in a wide variety of roles and responsibilities, someof which need not involve use of their technical competence at all. Usually however a professionalaccountant would be involved mainly in the finance function, in some capacity.

Quite often, especially in smaller businesses, a professional accountant may become involved in areas whichare outside their sphere of technical competence, including making decisions on matters concerning:

Law Administration Insurance Pensions Property Personnel Procurement, and IT



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This is perfectly acceptable to some degree, but the professional accountant should remember thatprofessional principles require him or her to act with professional competence and due care so theyshould:

Be open about acting outside their own professional knowledge and skill if this is the case, but still Exercise sound and independent judgement, and Act diligently

In fact many of these areas are ones in which other professionals would normally be involved. It isimportant therefore for the professional accountant to know the limits to their professional responsibilities.

10 Limits of the professional accountant'sresponsibilities

Section overview

While the professional accountant is often engaged in many different areas of business management,there are limits to their professional competence which means they must know when to call infurther expertise, such as from lawyers, actuaries, surveyors and HR specialists.

10.1 How far do the professional accountant's responsibilities go?

Legal matters are normally dealt with by qualified lawyers in an advisory or representative capacity.Many companies employ in-house legal teams, staffed with professional lawyers. The professionalaccountant should be careful not to stray too far into legal matters, beyond those in which they aretechnically competent to some degree (such as company, business and employment law).

Certain administrative matters often fall directly into the role of the professional accountant, such asthe tasks performed by a company secretary:

Share registrations Calling meetings Drafting resolutions for meetings Submitting the annual return to the Registrar of Joint Stock Companies.

The company secretary of a company is often a professional accountant but in a very large or complexorganisation it is normal to have a qualified chartered secretary appointed to this role, especially as thecompany secretary plays a significant role in ensuring good corporate governance (see Chapter 13).

Taking out and claiming against insurance policies often falls into the role of the professional accountant inbusiness. Again professional principles can be very helpful in this role, but beyond a certain level ofcomplexity insurance specialists and actuaries should be used.

The services of actuaries and other specialists should also be engaged when the company is faced withissues concerning its pension fund.

The acquisition, refurbishment or disposal of property often involves the professional accountant invaluation, negotiation, tax and legal aspects. In most circumstances however other professionals will also beinvolved, such as estate agents, valuers, architects and lawyers.

Since people are paid by the payroll function in the accounting and finance department, many companieshave historically also made the whole of personnel the responsibility of the professional accountant. Giventhe complexity of laws and regulations surrounding human resources, and the central strategic role it playsin a business's success, this is an area where an HR professional should really be engaged in anorganisation of any size.



For similar reasons – that is, because suppliers are paid by the accounting and finance department –procurement is also often included in the professional accountant's role. As supply chain management iscentral to achieving strategic objectives, so again above a certain size and complexity it is advisable for mostcompanies to use procurement professionals in this role.

The acquisition and effective use of IT is an important part of the professional accountant's role when it isrelated to transactions recording and all the other aspects of the accounting and finance function's work.Specialist advice should also be sought however.



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Summary

BFRS BAS



Self-test

1 Capital markets in Bangladesh are split into

A The Dhaka Stock Exchange and the Bangladesh BankB Stock markets and bond marketsC Primary and secondary marketsD Securities markets and banks

2 The public must have confidence in the integrity of professional accountants because

A The reputation of the profession depends on itB They provide advice on technically complex areas on which others relyC This will encourage more people to enter the professionD This will encourage more people to seek the services of a professional accountant

3 Which are the two fundamental principles in the IFAC Code of Ethics that underlie the reliance of thepublic on accountants?

A IntegrityB ObjectivityC Professional competence and due careD ConfidentialityE Professional behaviour

4 What is the minimum period of training articleship with an approved CA firm which is required forstudent members of ICAB?

A Two yearsB Two and a half yearsC Three yearsD Three and a half years

5 Which of the following requirements applies to a member who is in public practice over and above amember who is not?

A Obey the ICAB's rules and regulationsB Undertake CPEC Pay the annual subscription feeD None of the above

6 For members of the ICAB audit is a

A Recognised areaB Reserved areaC Reassesed areaD Registered area

7 Distinguishing clearly between an expression of opinion and an assertion of fact is part of theprofessional accountant's fundamental principle of

A Professional competence and due careB Professional behaviourC ObjectivityD Integrity

8 When a professional accountant promotes a position to the point that their subsequent objectivity iscompromised they have fallen prey to the threat of

A Self-interestB FamiliarityC IntimidationD Advocacy



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9 Capitalising the cost of a non-current asset which is not owned but for which a monthly payment ismade implements the accounting principle of

A MaterialityB PrudenceC Substance over formD Faithful representation




1 C Securities markets comprise stock markets and bond markets; together with banks theyoperate in the primary capital market (i.e. as a source of funds for business), but they also act asthe secondary market which ensures that holders of securities can sell and buy securities so asto manage their wealth

2 B

3 A, B See Code of Ethics section 100.1

4 C

5 D

6 B

7 A

8 D

9 C



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Technical reference

1 Code of Ethics (IFAC) 100.1, 100.4, 100.10





Many people want to be chartered accountants because it is a 'good career' rather than because they areintrinsically interested in assurance and financial reporting; these are interests that come later. But it isworth thinking through why you thought it would be a 'good career'. Certainly the rewards are worth it,but what about the hard work in qualifying, and the expectation that you will behave professionally at alltimes? The requirement for objective assessment in technical competence (exams etc) distinguishes theaccountancy profession from most Management Trainee Schemes, plus the need to pay annual subscriptionsand to keep up your technical expertise. Are professionals 'set apart' as a result of all this?


A great deal more about the history and the outcome of this situation needs to be identified, but on theevidence it would appear that Charis has succumbed to her sister's undue influence. Her objectivity hastherefore been compromised; if corruption is proved then her integrity has also suffered. Not exercisingsound and independent judgement contravenes professional competence and due care, and her actions havediscredited the profession which means that she has not behaved professionally.


Contents

chapter 11

Structure and regulation ofthe accountancy profession

Introduction

Examination context

Topic List

1 The structure of the accountancy profession

2 Regulation of professions

3 Regulation of the accountancy profession

4 Disciplinary procedures against accountants


Technical reference





Introduction


Specify the rationale for key parts of the accountancy profession's work

Specify the key features of the structure of the accountancy profession

Specify the regulatory framework within which professional accountants work

Specific syllabus references are: 4a, b, c.


The position of trust in which the public holds accountants means that there is considerable scope forabuse of trust. As with other professions, therefore, the law requires that the activities of accountantsshould be regulated to ensure there is public confidence.

Stop and think

You are probably well aware that both the profession and business in general are increasingly subject toregulation, 'oversight' and, some would say, interference. Why is this so, and how has it affected theprofession and the people in it?

Working context

Professional training, professional principles and accounting principles together should ensure thatprofessional accountants carry out their roles and tasks to a high standard. Regulation helps to ensure this,but it is also there to 'find out' wrongdoers. In a working context, therefore, you need to be aware of boththe requirements of regulations and the role and process for disciplinary procedures.

Syllabus links

The topic of professional regulation underlies many areas of the Professional and Advanced stages.

STRUCTURE AND REGULATION OF THE ACCOUNTANCY PROFESSION


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Examination context


Questions on the structure and regulation of the profession will almost certainly appear in your exam.

Exam requirements

Questions are likely to be set a scenario context, though knowledge-type questions are also likely onparticular definitions and principles.



1 The structure of the accountancy profession

Section overview

In Bangladesh there are two major accounting institutes – The Institute of Chartered Accountants ofBangladesh (ICAB) and The Institute of Cost and Management Accountants of Bangladesh (ICMAB).

The regional organizations of which ICAB is a member are South Asian Federation of Accountants(SAFA) and Confederation of Asian and Pacific Accountants (CAPA).

The international global organisation for accountants is IFAC.

Anyone can call themselves an accountant.

1.1 Bangladesh Accountancy Bodies

The Bangladesh accountancy profession does not only comprise the ICAB. The major accountancyprofessional bodies in Bangladesh include ICAB as well as ICMAB. These are autonomous professionalbodies under the Ministry of Commerce of the Government.

1.2 Regional Accountancy Bodies

The Confederation of Asian and Pacific Accountants (CAPA), established in 1976, representsnational accountancy organisations in the Asia-Pacific region. Today, CAPA has a membership of 34accountancy organisations. CAPA is by far the largest regional accountancy organisation and itsgeographical area spans half the globe. It has six members. ICAB and ICMAB both are members of CAPA.

The South Asian Federation of Accountants (SAFA) was formed in the year 1984 to serve the accountancyprofession in the South Asian Region and uphold its eminence in the world of accountancy. SAFA is anApex Body of the South Asian Association for Regional Co-operation (SAARC) and a Regional Grouping ofInternational Federation of Accountants (IFAC). SAFA represents eight member institutes of the regionwith over 170,000 accountants having membership of the national chartered accountancy and cost andmanagement accountancy institutions in the South Asian countries, namely Bangladesh, India, Nepal,Pakistan and Sri Lanka. SAFA came into existence at the initiative of the accounting professional bodies inthe South Asian Region, which has a bond of culture and homogeneity of professional environment.

1.3 International Federation of Accountants (IFAC)

IFAC is the global organisation for the accountancy profession. It has 163 member organisations, includingthe ICAB. IFAC members represent 2.5 million accountants worldwide, employed in public practice,industry and commerce, government, and education.

The aim of IFAC is to protect the public interest by encouraging high quality practices by the world'saccountants. This includes best practice guidance for professional accountants employed inbusiness, plus a membership compliance programme.

IFAC emphasises the importance of:

Strong international economies

Adherence to high-quality professional standards in the areas of audit, education, ethics and publicsector financial reporting

Convergence of professional standards

Speaking out on public interest and public policy issues where the profession's expertise is mostrelevant



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Through its Code of Ethics IFAC encourages accountants worldwide to adhere to the core professionalprinciples of:

Integrity Transparency Expertise

We shall cover business ethics in detail in Chapter 13.

1.4 Who can call themselves an accountant?

There is no legal requirement for an accountant to be a paid-up member of one of the Regional or IFACbodies. Unlike the Bar Council, which can legally stop an unqualified ‘advocate’ from practising, accountancybodies have no such authority. The term 'accountant' enjoys no special position in law. Anyone is free toadvertise as an 'accountant' and offer the full range of accountancy services, except in one reserved area(statutory audit) where statute demands specific levels of competence. Institute members are thereforeopen to competition from anyone, whether professionally qualified or not, who chooses to enter themarket.

2 Regulation of professions

Section overview

Professions are regulated so that the various aspects of the public interest are kept in balance.

Regulation of professions can take the form of government or government agency regulation, self-regulation by the profession itself, or a combination.

An oversight mechanism can be used to ensure that self-regulation works, and this is the approachtaken to regulation of the accountancy profession of developed countries.

2.1 Why is regulation of professions necessary?

Regulation of professions (either self-regulation or external regulation, or a combination) is needed toprovide the public interest with protection and assurance in situations where the issues are toocomplex for the public to be reasonably expected to look after their own interests. The activities of manyprofessions typically fall into such a category.

Interactive question 1: Regulation [Difficulty level: Intermediate]

What do you think should be the aims of regulation of the accountancy profession?


Many of the aims of regulation result in different priorities for different aspects of the 'public interest'.Subjective judgements are needed to balance interests.



Regulation should not:

Protect vested interests from competition

Be for personal gain or to satisfy prurient interest

Be disproportionate to the benefit gained, such as imposing huge and costly quantities of detailedrestrictions in a heavy-handed and over-rigid manner

Distort competition by imposing extra burdens on some, but not others

2.2 What methods of regulation are there?

Regulation can be:

By government directly via legislation By separate agencies established by government (delegated legislation) By the profession/industry itself (self-regulation) or By a combination of methods

2.3 Does self-regulation work?

Self-regulation in theory provides a common sense, flexible approach because there is detailed knowledgewithin the profession of the issues facing it. It should result in a more efficient and effective outcome.

But self-regulation does not work if:

The regime seems to act against the public interest Regulatory guidance and its importance are neither understood nor enforced Members of the profession do not 'buy in' to the process There is unjustifiable self-protecting regulation

In fact, self-regulation works best when there is an oversight mechanism to ensure that the entireprocess is working.

2.4 What does an 'oversight mechanism' mean?

Society no longer assumes good intent and actions, but requires proof. It is more ready to lay blame and toseek legal remedies ('litigiousness'). Any form of regulation therefore requires an oversight mechanism toensure that it is achieving what it set out to achieve. In the case of self-regulation, it is particularly importantthat the oversight mechanism be independent, to counter accusations of self-interest.

The required features of an oversight mechanism are:

Sufficient independence from the profession being regulated and any other single stakeholder toensure that its decisions are not compromised or perceived to be compromised by undue influence

Knowledge of the profession being regulated

Significant, but non-controlling, input from the profession itself to ensure that decisions:

– Are workable– Will not achieve the opposite of what they intend and– Do not impose costs on society in excess of the benefits gained

The ability to take a wide view to balance the various stakeholder interests that comprise thepublic interest, and to judge the regulator's attempts to do the same

Authority to have decisions acted on across the whole profession, through legislation or voluntaryagreement

Good communication, to ensure that the public interest is seen to be served, without alienating theprofession being regulated

Sufficient resources to carry out effective examination of the regulatory arrangements



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The key participants in an effective oversight mechanism are therefore likely to be:

The government – the ultimate guardian of the public interest in a democracy

Regulators operating in relevant sectors

Members of the profession, to provide an informed insight based on professional experience andin-depth technical knowledge

Members of the public, independent of the profession, with the character and intellectual ability tomake sound judgements on complex issues

3 Regulation of the accountancy profession

Section overview

The Bangladesh government is responsible for the statutory elements of the regulatory framework.

The ICAB is the primary regulator of its members, which is the form of self-regulation adopted inBangladesh.

The SEC and Bangladesh Bank make sure that self-regulation of the accountancy profession iseffective. They have statutory powers in respect of auditing.

3.1 How is the accountancy profession regulated?

Following lengthy debate, the regulatory regime that now exists for the accountancy profession involves:

The government The profession (self-regulation) An oversight mechanism

3.2 The role of the government

The government is responsible for the legislative elements of the regulatory framework. Once theregulatory framework was in place the government delegated certain of these statutory powers tothe SEC, RJSC and Bangladesh Bank, but the government remains responsible via these powers and sohas a continuing responsibility for the system's effectiveness.

3.3 Self-regulation by the accountancy profession

The ICAB has primary regulatory responsibility for supervision of its members acting in theirprofessional capacity so as to maintain standards and the professional standing of accountancy.

In relation to statutory audit (reserved area), ICAB acts as a recognised professional regulator. It musthave the necessary arrangements in place to ensure that members and firms comply with the statutoryrequirements.



3.3.1 The role of ICAB

In relation to its membership ICAB has direct responsibility for:

Entry and education requirements (as seen in Chapter 10)

Eligibility to engage in public practice (as seen in Chapter 10)

Eligibility for the performance of reserved activity under statutory powers delegated by thegovernment (see Chapter 10)

Professional conduct requirements (see Chapter 10)

Dealing with professional misconduct by its members (see later in this chapter)

4 Disciplinary procedures against accountants

Section overview

Part of the ICAB's approach to self-regulation is to ensure there is a clear and effective complaintsand disciplinary procedure relating to members and students.

The ICAB's procedure involves three potential stages: conciliation, investigation and disciplinaryproceedings.

The ICAB takes on cases via referral from regulatory agencies, other accountants, firms, clients, or byself-referral.

As an independent disciplinary body the ICAB should be transparent, independent and fair.

4.1 Why are disciplinary procedures required?

In Chapter 10 we noted that regulation of its members by the ICAB requires a rigorous complaints anddisciplinary procedure involving the ICAB itself. The procedure has been put in place to fulfil the regulatoryneed to protect the public interest.

4.2 ICAB's complaints and disciplinary procedures: Investigation andDisciplinary Committee (IDC)

The Investigation and Disciplinary Committee (IDC) of ICAB is responsible for implementing theICAB's disciplinary procedures, including the handling of complaints against students and members (bothindividuals and firms).

4.2.1 What is a complaint and who can bring one?

Complaints are usually that a student, member or firm:

Is in breach of a regulation Has departed from guidance Has brought the ICAB into disrepute

Anyone can make a complaint: clients, other accountants, the SEC, Bangladesh Bank, RJSC, other regulators,members of the public and even the ICAB itself.

A complaint in relation to a very serious matter which is already in the public domain and which may affectthe reputation of the accountancy profession may be referred straight to the IDC for investigation.



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4.2.2 What is the ICAB complaints and disciplinary procedure?

The procedure for most complaints is as follows:

Conciliation: When a client identifies a problem with a member, a firm or a student, the first step isconciliation. This means trying to find a practical solution, such as giving an explanation or providinginformation to resolve the problem

Investigation (if it has not been resolved through conciliation) by the Investigation and DisciplinaryCommittee (IDC)

Disciplinary proceedings by the Investigation and Disciplinary Committee (IDC)

This procedure is summarised in Figure 11.2, which is used by the IDC to explain the procedure to acomplainant (throughout the chart, 'we' refers to the IDC).



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Figure 11.2: the ICAB’s complaint and disciplinary procedures



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4.2.3 The committees involved in dealing with complaints

If the member, firm or student appears to be in breach of regulations or has departed from guidance, theIDC and Council may be involved.

Also the IDC may ask the ICAB’s Quality Assurance Directorate to conduct a monitoring visit to see howthe member or firm is complying with various standards and regulations.

4.2.4 How are complaints investigated?

The ICAB first writes to the person who has made the complaint (the complainant), then to the member,firm or student setting out full details of the complaint and inviting their comments. It is one of the ICAB'srules that members must:

Answer questions Provide any information the ICAB asks for

If members do not reply to letters initially, the IDC can require them to answer questions and producebooks or papers. If members fail to respond to the IDC's request, they will be in breach of a bye-law andcan be disciplined for this.

Following the initial investigation, if it appears there is a case to answer (or if the complainant insists thatthe IDC considers the case) it is reported to the IDC. At present the IDC consists of 27 members, who areall chartered accountants.

If the IDC decides there is no case to answer, the matter is closed.

If the Council decides that a penalty should be imposed on the member it has the power to:

Issue a reprimand Fine the member or their firm Suspend a member's practising certificate

4.2.5 What happens at IDC investigation?

If the IDC finds that there is a case to answer, it has two options, as follows:

Take no further action: if the complaint cannot be substantiated, there will be no case to answer.

Make a formal report on the findings to Council. where it is of the opinion that the facts orcomplaint require investigation, it shall forthwith give to the member or articled student notice of itsintention to consider the complaint. The Investigation and Disciplinary Committee shall give suchmember or articled student an opportunity of being heard before it and shall, if the member orarticled student so desires, permit such member or articled student to be presented before it bycounsel or by a solicitor or by a member of the Institute. The Investigation and disciplinary Committeeshall thereafter report the result of its enquiry to the Council.

4.2.6 Council Decision

If on receipt of such report the Council finds that a formal complaint has been proved, it shall record afinding to that effect and shall afford to the member or the articled student either personally or throughcounsel or a solicitor or a member of the Institute, an opportunity of being heard before orders are passedagainst him on the case, and may thereafter make any of the following orders, namely:-

reprimand the member or the articled student with or without monetary penalty as the Council inits discretion may decide. The monetary penalty, if any, as may be decided by the Council may notexceed ten thousand taka; or

suspend the member from membership for such period, not exceeding five years, as the Councilthinks fit; or

exclude the member from membership; or

direct the cancellation of, or extend the period of articles or that any period already served undersuch articles shall not be reckoned as such service for the purpose of relevant clause of Bye-law 80



and a person whose articles have been so cancelled under this bye-law shall not, except with thepermission of the Council, be retained or taken as an articled student by a member of the Institute; or

require the complainant to pay monetary penalty which may not exceed ten thousand taka as maybe decided by the Council in its discretion if the complaint is proved to be baseless or unfounded ormalicious

4.2.7 Publication of findings and decisions

Where the Council finds that a formal complaint has been proved, it shall cause its findings and decisions tobe published in the Gazette of Bangladesh and in such journals as it shall think desirable and as soon aspracticable after such findings and decision are pronounced. The publication shall in all cases include thename of the member or articled student concerned.

Interactive question 2: Complaints [Difficulty level: Exam standard]

One of your clients is planning to complain to the ICAB about work carried out by your firm and the pricesit has charged. On what grounds may the client make a complaint to the ICAB?




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Summary

RegionalBodies:

- CAPA

- SAFA

Ministry ofCommerce

(MOC)

Supervision of membersacting in professionalcapacity

IDC



Self-test


1 The forum for discussion of matters affecting all the accountancy bodies in the South Asian region iscalled

A IFACB CAPAC SAFAD FRC

2 Which of the following is an aim of regulation of the accountancy profession?

A To protect the profession from competitionB To protect ICAB members from unqualified accountantsC To protect the public from being misledD To protect small accountancy firms from big ones

3 In relation to self-regulation of the accountancy profession, the most important aspect of the oversightmechanism is that it should be seen to be

A FairB AuthoritativeC ObjectiveD Independent

4 If a member is offered a caution by the Council this means that

A There will be neither publicity, fines nor costs to payB There will be a fine but no publicityC There will be neither publicity nor a fine but there may be costs to payD There will be publicity, a fine and costs to pay



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1 B

2 C

3 D All these qualities are important, but independence is of the greatest importance if themechanism is not to be seen as pursuing the self-interest of the profession

4 C





Regulation should:

Protect the public from being misled, or from suffering from abuse of power through knowledge ormonopoly

In a market economy, facilitate competition and reduce barriers to trade

In the case of professions, ensure that technical, educational and ethical standards aremaintained at a level the public has a right to expect

Be flexible enough to ensure the right result in each of the infinite variety of circumstances that occurin practice, as we have seen in the principles-based framework approach to accounting

Take account of reasonable and informed opinion to ensure that justice is reasonably seen to bedone

Enforce the standards required firmly but fairly to ensure that the general support of those subject tothe regulation is retained, but that transgressors are effectively dealt with

Be transparent in its setting and enforcement to maintain confidence that the public interest is beingsafeguarded


Complaints may be on the grounds that the firm is in breach of an ICAB regulation, has departed fromguidance or has brought the ICAB into disrepute.


Contents

chapter 12

Governance and ethics

Introduction

Examination context

Topic List


2 What is corporate governance?

3 Stakeholders' governance needs

4 What is meant by 'good practice' in corporate governance?

5 The effect of types of financial system on governance

6 Governance structures

7 Policies and procedures for an ethical culture


Technical reference





Introduction


State the reasons why governance is needed

Identify the role that governance plays in the management of a business

Identify the key stakeholders and their governance needs for a particular business

Specify how differences in national and business cultures affect the governance of businesses

Specify the policies and procedures a business should implement in order to promote anethical culture

Specific syllabus references are: 5a, b, d, g.


Governance has become a major issue in recent years and one which has a direct impact on many areas inwhich professional accountants operate, especially audit and financial reporting.

Stop and think

What does the word 'governance' mean to you? How is it different to 'management'? Who governs abusiness – shareholders or directors/managers? And who is it governed for?

Working context

As you become more familiar with audit and assurance engagements you will see how the need both tosupport and to report on a business's governance is a key part of an accountant's role. You will also beginto appreciate what is meant by business ethics – and you may see the effects of low standards of businessethics as well as high ones!

Syllabus links

Governance is developed further as a topic in Audit and Assurance and Financial Reporting at theProfessional stage, and at the Advanced stage. Ethics are a continuing theme also.

GOVERNANCE AND ETHICS


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Examination context


Question on governance and ethics are almost certain to appear in your exam.

Exam requirements

Questions are likely to be set a scenario context, though knowledge-type questions are also likely onparticular definitions and principles.




Section overview

Governance is concerned with the overall control and direction of the business so that the business'sobjectives are achieved in an acceptable manner.

Agency theory states that managers and directors act as shareholders' agents when managing thecompany.

Managers and directors should reflect the interests of shareholders, not their own interests.Historically they were able to pursue their own interests because they had better information thanshareholders, and were not held accountable to them.

We saw in Chapter 2 that governance can be defined as 'the system by which businesses are directed andcontrolled', whereas management is the practical matter of 'getting things done'. Governance then is not thesame thing as managing a business and running business operations. It is concerned with exercising overallcontrol, to ensure that the objectives of the company are achieved in an acceptable manner. If a business isproperly led, directed and controlled then it should be able to get things done properly.

Interactive question 1: Corporate governance [Difficulty level: Intermediate]

You have probably heard a great deal about 'good corporate governance' in the press and maybe in theoffice too. What do you think it means? Why is it an important issue?


1.1 Why is governance an important issue?

Governance has become a very major business issue in recent years because, simply put, in getting thingsdone a business's managers very often lose sight of:

Who they are seeking to benefit, and The fact they should not harm others

This is often referred to as the agency problem.

1.2 Agency theory: shareholders and management

Managers of a company are there to ensure that the interests of the shareholders, who in large companiesare not usually also the managers, are looked after. Managers therefore effectively act as the 'agents' of theshareholders when managing the company, though not in the full legal sense.

The separation of ownership and control, and misalignment resulting in conflicts between the interests ofthose in control of the company and those who own it, is known as agency theory or stewardship theory.This has been well expressed by the Organisation for Economic Co-operation and Development (OECD.

'Put simply, the interests of those who have effective control over a firm can differ from the interestsof those who supply the firm with external finance. The problem, commonly referred to as a principal-agent problem, grows out of the separation of ownership and control and of corporate outsiders andinsiders. In the absence of the protections that good governance supplies, asymmetries of informationand difficulties of monitoring mean that capital providers who lack control over the corporation willfind it risky and costly to protect themselves from the opportunistic behaviour of managers andcontrolling shareholders.'

OECD, Principles of Corporate Governance



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Historically, when managers ran a company in a way that suited their own interests, without due regard tothe interests of the shareholders, they often got away with it because:

They had better information than the shareholders about what was going on They were not sufficiently accountable for their stewardship, decisions and actions

1.2.1 The importance of information

Shareholders make economic decisions to invest in the company's shares, and/or to hold onto theshares, largely on the basis of information supplied by managers in the company's name. The value of ashareholder's investment can therefore be at risk from receiving inadequate information to judge what ishappening.

1.2.2 The need for accountability

Shareholders also rely on managers to account to them for their stewardship of the company'sresources. Through a combination of withholding information, failing to report to shareholders as required(basically, hiding information) and making decisions that are in their own rather than the company'sinterests, managers and company directors have historically been able to avoid true accountability toshareholders.

2 What is corporate governance?

Section overview

Corporate governance is the set of relationships between a company's management, board,shareholders and other stakeholders that provides the structure through which the company'sobjectives are set, attained and monitored. It specifies the distribution of rights and responsibilitiesbetween stakeholders, and establishes rules and procedures for making decisions about thecompany's affairs.

Three perspectives on corporate governance all emphasise shareholders but the public policy andstakeholder perspectives place more emphasis on non-shareholders, and on the need to balance theinterests of all stakeholders.

Definition

Corporate governance: 'A set of relationships between a company's management, its board, itsshareholders and other stakeholders…that provides the structure through which the objectives of thecompany are set …attained…and monitored'.


2.1 What are the objectives of corporate governance?

There are four broad perspectives on what the objectives of corporate governance should be.

2.1.1 The corporate perspective on corporate governance

We normally think of the aim of a company as being to maximise the wealth of the shareholders, providedit conforms to the rules of society (its laws and customs). This means that a company's senior managementshould balance the interests of shareholders with those of other stakeholders in order to achieve long-termsustained value for shareholders.



2.1.2 The public policy perspective on corporate governance

Some would go a little further and argue that the aim of corporate governance is to ensure that thecompany meets:

The objectives of its shareholders, plus The interests of other individuals and groups with a 'stake' in the company, plus The interests of the public at large

In other words, there is a public policy perspective to corporate governance, as well as a corporateperspective.

'From a public policy perspective, corporate governance is about nurturing enterprise while ensuringaccountability in the exercise of power and patronage by firms. The role of public policy is to providefirms with the incentives and discipline to minimise the divergence between private and social returnsand to protect the interests of stakeholders.'


2.1.3 The stakeholder perspective on corporate governance

Taking a more narrow 'stakeholder view', corporate governance means a balance between economic andsocial goals and between individual and communal goals. The framework of corporate governance shouldtherefore:

Encourage the efficient use of resources through efficient investment

Require accountability from the company's senior management (its board of directors) toshareholders for the way it has managed and taken care of those resources

Aim to align the interests of shareholders and companies with those of other stakeholders

2.1.4 The stewardship perspective on corporate governance

Probably the most narrow view of corporate governance is to take the approach that the law requiresdirectors to act in the best interests of the company when acting as 'stewards' of the company'sresources. This is called the stewardship approach or perspective, and is related most directly to solving theagency problem outlined above.

2.2 A definition of corporate governance

Whether a corporate, public policy or stakeholder perspective is taken, rather than the OECD's definitionset out above, we could use the following:

Definition

Corporate governance: A structured system for the direction and control of a company that:

Specifies the distribution of rights and responsibilities between stakeholders, such as the shareholders,the board of directors and management.

Has established rules and procedures for making decisions about the company's affairs.

2.3 Why is a corporate governance system needed?

Corporate governance has always existed in some form or another, but it was not generally explicit,systematic or established in companies until very recently. The huge emphasis that is now placed on theneed for corporate governance follows well-publicised financial scandals in Europe, India and the US, such asSatyam Computer Services, Enron, WorldCom and Parmalat. These scandals had certain things in common,including:



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Deliberate and systematic fraud by the company's most senior executives Weakened boards of directors, and as a result Shareholders and employees losing a great deal of money

Losses extended beyond shareholders to employees and therefore government, as well as lenders. Thishighlighted that the 'world at large' has a legitimate stake in making sure that companies are properlydirected and controlled.

3 Stakeholders' governance needs

Section overview

Stakeholders' interests can often be in conflict, and it is not enough simply to let the most powerful(the shareholders) 'win'.

Stakeholders need the company's corporate governance to ensure that: their interests andexpectations will be reflected in the company's objectives; the scope for conflict of interests isreduced; the company follows good practice in corporate governance and business ethics.

3.1 What are stakeholders' governance needs?

In Chapter 1 we saw the stakes, interests and expectations of each category of stakeholder in a company,and in Chapter 4 we saw how companies can 'map' these points as an aid in determining what thecompany's objectives should be. We need now to look at both conflicts between stakeholders' interestsand their governance needs.

3.2 Conflicts between stakeholders' interests

No company can exactly meet all the expectations of all its stakeholders all of the time. There is often aconflict of interests between different stakeholder groups, with each group wanting different things, inorder to achieve incompatible objectives. In most cases the company will set itself a strategy that at leastattempts to balance these conflicting interests whilst acknowledging that the interests of shareholders aredominant.

Occasionally however there will be a serious conflict of interests.

3.2.1 What are the symptoms of a serious conflict of interests?

There is no standard way in which a serious conflict of interest becomes apparent. It may become evidentby:

Financial collapse without warning, as in the case of US energy corporation Enron in 2002

Directors trying to disguise the true financial performance of the company from shareholdersby 'dressing up' the published financial statements so shareholders cannot judge properly the conditionof their investment

Disputes over directors' remuneration such as huge salaries, bonuses, pension schemes, shareoptions, golden hellos and golden goodbyes and other benefits and, in general, directors' rewards thatdo not vary according to the company's performance and the benefits obtained for the shareholders

Decisions taken by a board of directors to satisfy their own wish for power and rewards rather thanto boost the interests of shareholders, such as recommendations on shareholders accepting certaintakeover bids and offers

3.3 Stakeholders' governance needs

For their interests and expectations to be reflected in the company's objectives For the scope for conflicts to be reduced For the company to adhere to good practice in corporate governance For the company to adhere to good business ethics



4 What is meant by 'good practice' in corporategovernance?

Section overview

Good practice in corporate governance is concerned with: disclosure of information; judgingdirectors' performance and stewardship; reducing the potential for conflict; reconciling the interestsof shareholders and directors.

Key elements in corporate governance: the board (executive and non-executive directors); seniormanagement; shareholders; external audit; internal auditors.

Good practice in corporate governance is concerned with:

Openness and transparency: disclosure of information

Integrity and accountability: monitoring and judging directors' performance based on the returnsthat the company has achieved under their stewardship

Reducing the potential for conflict

Reconciling the interests of shareholders and directors as far as possible

The five key elements which support the drive towards good corporate governance are as follows:

The Board of Directors

– Executive directors of a very high standard in terms of their decision-making and of theculture that they create in the company

– Non-executive directors who are independent of the executives yet who accept that theyhave collective responsibility with the rest of the board for corporate governance

– Committees of the board of directors as a whole that are properly constituted and havethe power and resources to make the decisions delegated to them by the main board.

Senior management of high quality and able to:

– Put into effect the decisions of the board– 'Whistle-blow' on the activities of the company should the need arise

Shareholders who are proactive at meetings and generally ensure that the board is acting in theirbest interests and within the spirit of good corporate governance

External auditors working on behalf of the shareholders totally independently of the directors whenreaching a conclusion as to whether the company's financial statements show a true and fair view

Internal auditors who are independent of the directors as far as possible, reporting to the AuditCommittee of the board or to some other committee dominated by non-executives

'Good corporate governance should provide proper incentives for the board and management to pursueobjectives that are in the interests of the company and its shareholders and should facilitate effectivemonitoring. The presence of an effective corporate governance system, within an individual company andacross an economy as a whole, helps to provide a degree of confidence that is necessary for the properfunctioning of a market economy.'




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5 The effect of types of financial system ongovernance

Section overview

The type of financial system in an economy affects the type of corporate governance that prevails.

A financial system facilitates lending and borrowing, and the transmission of money. It comprisesintermediaries, securities and markets.

The financial system provides a means for households to invest their excess funds, and for businessesto obtain funds.

In order of importance, businesses are financed by retained earnings, direct loans from banks and thesecurities markets in the form of equity finance and bonds.

There are two broad types of financial system: bank-based and market-based.

Which system is in place depends on: whether there is instability associated with financial markets;how far government intervenes in and regulates the system; how effective markets as opposed tointermediaries are at allocating resources; how far markets are limited by market imperfections, suchas transaction costs, insider dealing and asymmetric information.

In Bangladesh the financial system is bank based. Bank-based financial systems are seen in Japan,France and Germany. In these systems, bank lending is the most important source of business finance,after retained earnings (though not in Japan), and banks and businesses are highly integrated.

Market-based financial systems are seen in the UK and the US, with markets being more importantthan banks for long-term finance. This means that the dominant force in external finance forbusinesses is represented by institutional shareholders.

The increasing influence of institutional shareholders means that there is increasing pressure oncompanies: to conduct themselves well; to respond to the requirements of active or 'engaged'institutional shareholders; to provide good information via financial reporting.

In Chapter 9 we looked at the Bangladesh banking system and its role in money transactions, theprovision of short-term finance and the provision of short-tem investment opportunities to treasurymanagers. We now need to look at the overall involvement of banks in Bangladesh’s financialsystem, and other financial systems around the world, to determine why the type of financial systemoverall influences so profoundly the approach taken to corporate governance.

5.1 What is the function of a financial system?

The financial system in an economy facilitates the movement of funds from those who have anexcess of them to those who need them. This means it has two main functions:

Facilitation of lending and borrowing Transmission of money

A financial system comprises:

Intermediaries such as retail banks, insurance companies, pension and other mutual funds andsecurities firms, which together allow holders of wealth to invest either directly or indirectly

Securities i.e. equity (ordinary and preference shares in companies) and debt (debentures, bonds andbills)

Markets i.e. the primary and secondary markets, capital and money markets, and organised exchanges(see Chapter 9)

Generally speaking, individuals and households have an excess of monetary assets (they are savers) andneed to allocate the excess to some form of investment. Where the excess is invested in financial assets, asopposed to physical assets such as housing, these may range from cash and cash equivalents (the least risky



holding) to direct holdings of equity shares in companies (the most risky holding). In between these twoextremes may be indirect investment in equity and debt via a financial intermediary such as a mutual fund,e.g. unit and investment trusts.

Ultimately excess funds are used to finance businesses and governments (the 'borrowers' or spenders).In the case of businesses, financing comes from:

Retained earnings (the most important source of funds in most systems, though not in Japan)

Direct bank loans (the most important source of funds in Japan)

The securities markets in the form of equity and debt finance (the least important source of fundsin all major economies)

5.2 Types of financial system

There are two broad types of financial system:

Bank-based systems Market-based systems

Whether a system favours banks or the markets is determined by how the factors we have seen above arebalanced, namely:

How households prefer to hold their assets

The degree of dominance of the system by financial intermediaries and therefore by indirect asopposed to direct investment

How businesses are financed, that is the balance of retained earnings, debt and equity

In turn, many of these preferences in a system are determined by its attitude to some of the problemsinherent in any system designed to ensure the flow of funds from savers to borrowers:

Instability associated with financial markets

The degree of government intervention in and regulation of the system (government activity hasbecome increasingly discredited)

How effective markets as opposed to intermediaries are at allocating resources (in economicterms, markets are perceived as being better at this)

How far markets are limited by market imperfections, such as:

– Transaction costs– Insider trading, and– Asymmetric information

5.3 Bank-based financial systems

Continental European systems, especially those of France and Germany, have traditionally been bank-basedsystems, as has the Japanese financial system. While there are significant differences between them, we cancharacterise a bank-based financial system as follows:

Households prefer to bear little risk and so allocate more of their financial assets to cash and cashequivalents i.e. deposits with banks

Households have less access to investments in physical assets such as housing i.e. less choice

Where households do invest in securities, this is primarily done via intermediaries such as pensionand mutual funds, so institutional shareholders are influential

There is comparatively more government regulation, often as a result of historic financialcatastrophes

Banks are highly concentrated and integrated in terms of providing both banking (deposit-taking) and non-banking (insurance, etc) services



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Bank lending is the most important source of business finance, after retained earnings (though not inJapan)

Banks and businesses are highly integrated: banks have a long-term relationship with thebusinesses they lend to, usually cemented by the bank:

– Holding equity in the business as well as debt

– Having equity held by the business

– Having access to detailed management information so there is less risk that their lending will bejeopardised by undesirable activities

– Being involved in the business's strategic decisions, often by having seats on the board

– Becoming actively involved if there are financial problems

Markets are volatile and speculative because companies are dependent on bank finance and thushave high gearing

Together these factors mean that the dominant force in external finance for businesses is represented bybanks. However, most bank-based systems are becoming increasingly market oriented, with less regulationand a higher profile for financial markets.

Interactive question 2: Risk [Difficulty level: Exam standard]

In the UK households hold proportionately more of their assets in the form of equity than in Bangladesh.What does this say about UK households' attitude to risk?


5.4 Market-based financial systems

The US and UK systems have traditionally been market-based systems. While there are significantdifferences between them, we can characterise a market-based financial system as follows:

Households bear more risk and so hold proportionately more equity and proportionately fewerdeposits with banks

Households have greater access to investments in physical assets such as housing i.e. morechoice

High levels of indirect investment via intermediaries such as pension and mutual funds mean thatinstitutional shareholders have a great deal of influence

Markets are more important than banks for long-term finance, though retained earnings remain themost important source of funds

They are comparatively unregulated

Banks are more fragmented with less integration of banking and non-banking services (though thisis changing)

Banks have less close relationships with the businesses they lend to, not holding equity andnot being involved in decision-making

Together these factors mean that the dominant force in external finance for businesses is represented byinstitutional shareholders.



5.5 Financial intermediation and the importance of information

In both types of system financial intermediation is of increasing importance, because intermediation is seenas the way to overcome market imperfections, especially that of asymmetric information. While lendingbanks in bank-based systems have access to information about companies that is not shared with investorsin the financial markets, so too have institutional shareholders in market-based systems historically beenkept better-informed than the general public about the affairs of the business in which the intermediaryholds debt and equity.

The increasing influence of institutional shareholders means that there is increasing pressure oncompanies:

To conduct themselves well (good corporate governance) To respond to the requirements of active or 'engaged' institutional shareholders To provide good financial information via financial reporting

6 Governance structures

Section overview

A governance structure is the set of legal or regulatory methods that has been put in place to ensuregood corporate governance. It may comprise both direct regulation and non-statutory codes ofpractice.

The OECD's principles on corporate governance are: promotion of transparent and efficient financialmarkets; protection of shareholders' rights; equitable treatment of shareholders; recognition of therights of shareholders; timely and accurate disclosure of information; an effective board.

A board of directors may be unitary or have a dual (management and supervisory) structure.

Bangladesh business’s governance structure incorporates: statute (the Companies Acts); code ofcorporate governance (by SAFA); Bangladesh Bank Rules for Banking Companies; and the SEC rulesfor listed companies.

6.1 What is a governance structure?

Definition

Governance structure: The set of legal or regulatory methods put in place in order to ensure effectivecorporate governance.

There are two basic governance structures:

Statutes Codes of practice

Different countries use different combinations of statutes and codes of practice, depending in part onwhether they have principles-based or a shareholder-led approach to governance structures.



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6.2 Principles-based approach to governance structures

In most countries the approach to governance structure is determined initially by the desire to adhere tocertain principles of good corporate governance, as set out in the OECD's Principles of CorporateGovernance. These Principles 'focus on governance problems that result from the separation of ownershipand control' and are intended to assist:

'Governments in their efforts to evaluate and improve the legal, constitutional and regulatoryframework of corporate governance…and to provide guidance and suggestions for stock exchanges,investors and companies.'

Preamble to Principles of Corporate Governance, OECD

The Principles are that the corporate governance framework (the governance structure) should:

1 Promote transparent and efficient financial markets, be consistent with the rule of law andclearly articulate the division of responsibilities among different supervisory, regulatory andenforcement authorities.

2 Protect and facilitate shareholders' rights, including the following basic rights:

To have secure methods of ownership registration

To convey and transfer shares

To obtain relevant and material information on the company on a timely and regular basis

To participate in and vote at general meetings, including the right to ask questions of theboard

To elect and remove members of the board

To share in the company's profits

To participate and be involved in fundamental company changes such as amendments to thecompany's constitution

3 Ensure the equitable treatment of all shareholders, including minority and foreign shareholders.All shareholders should have the opportunity to obtain effective redress for violation of their rights:

All shareholders in the same class should be treated equally

Insider trading should be prohibited

Directors and key managers should disclose whether they have an interest in materialtransactions entered into by the company

4 Recognise the rights of stakeholders established by law or through mutual agreements, andencourage active co-operation between companies and stakeholders in creating wealth, jobs, and thesustainability of financially sound entities.

5 Ensure that timely and accurate disclosure is made on all material matters, including thecompany's:

Financial position and performance Ownership Objectives Board remuneration policy Related party transactions Foreseeable risk factors

6 Ensure the strategic guidance of the company by the board, the effective monitoring of managementby the board, and the board's accountability.



Principle 5 enshrines in particular:

The need for and status of the external audit, and

The need for an effective approach to the provision of analysis or advice by analysts, brokers,rating agencies and others, that is:

– Relevant to decisions by investors

– Free from material conflicts of interest that might compromise the integrity of their analysis oradvice

6.3 Shareholder-led approach to governance structures

In the UK and the US in particular, greater emphasis has been placed on the role of shareholders ingovernance structures. This is because they are market-based financial systems where institutionalshareholders have very high levels of investment in the shares of leading companies.

'Institutional shareholders' is a broad term for organisations which invest money on behalf of otherpeople (their beneficiaries). In the UK they comprise:

Insurance companies Pension funds Investment trusts Investment managers who act as agents of the above bodies, e.g. unit trusts

Good corporate governance is greatly assisted when institutional shareholders have an agenda for dialoguewith boards of directors and follow that up so they can secure their own interests and those of theirbeneficiaries. Where this is the case, as in the UK and the US, determining the appropriate governancestructure is said to be a 'shareholder-led process' rather than a principles-based one.

6.4 Possible structures for the board of directors

There are two types of structure for the board of directors as a whole.

A unitary board is responsible for both management of the business and reporting to theshareholders, via the financial statements and shareholder meetings. This is the basic system under UKstatute

A dual or supervisory board structure, as is seen in Germany for instance, with roles split between:

– The management board, with responsibility to manage the company using similar powers tothe unitary board, and

– The supervisory board: an independent separate board elected by the shareholders and theemployees, often comprising a series of committees with delegated powers. In Germany forinstance the supervisory board has powers to:

– Appoint and remove members of the management board

– Request information from members of the management board

– Receive formal reports on policy, financial performance, the state of the company's affairsand exceptional occurrences

– Approve or not approve the income statement, balance sheet and dividends declared

– Inspect books and records

– Perform independent reviews

– Convene shareholder meetings



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6.5 The governance structure in Bangladesh

In Bangladesh company law sets out a great many of the rules on corporate governance, especially withregard to:

The board of directors (a unitary board is required)

Directors' powers and duties

The relationship of the company with directors, such as loans to directors and the interests ofdirectors in company contracts

Accountability for stewardship and financial reporting via the financial statements

Rules on meetings and resolutions

Statutory provisions on corporate governance are outside the scope of the Business and Finance syllabus.

In addition to these statutory rules, large companies in Bangladesh (which we saw in Chapter 11) musteither:

Comply with the SEC requirements on Corporate Governance contained in its notification dated 20th

February, 2006 or Explain why they have not so complied.

6.5.1 the role of the Bangladesh Bank in promoting good governance

The Bangladesh Bank is responsible for promoting high standards of corporate governance. It aims to do soby:

Maintaining ‘The Financial Institutions Act 1993’ and promoting its widespread application andenforcement (see Chapter 13)

Ensuring that related guidance, such as that on internal control, is current and relevant (see theInternal Control and Compliance Framework, 21st July, 2005)

Influencing SEC, BEI and ICAB corporate governance developments

Helping to promote boardroom professionalism and diversity

Encouraging shareholder engagement (see section 14 of Bank Companies Act 1991)

We saw above that one of the key governance needs of stakeholders is for the company to adhere to goodbusiness ethics. We shall look at this point, and the idea of an ethical culture in a company, now, and thenreturn to the Code of Corporate Governance in Chapter 13.

7 Policies and procedures for an ethical culture

Section overview

Ethics tell us how to behave.

Acceptable business values may include: integrity, objectivity, accountability, openness, honesty, truth,transparency, fairness, responsibility and trust.

Business values should be seen throughout the company's culture, and should be actively promotedby the board.

Business ethics are the moral standards that society expects of businesses.

An ethical culture can be promoted by: ethical leadership from the board; codes of ethics or businessconduct; supporting policies and procedures.

An ethical profile produced by means of an ethical audit measures the consistency of a company'svalues base.



7.1 What are ethics?

Definition

Ethics: A system of behaviour which is deemed acceptable in the society or context under consideration.Ethics tell us 'how to behave'.

7.2 What is an ethical culture?

Definition

Ethical culture: A business culture where the basic values and beliefs in a company encourage peoplewithin the company to behave in line with acceptable business ethics.

Every company has different sets of beliefs and values, which together make up its culture, as we saw inChapter 2. What particular business values underlie an ethical culture?

Some of the Nolan principles established by the Committee for Standards in Public Life are a useful startingpoint for business values in a company as a whole:

Integrity Objectivity Accountability Openness Honesty

In Setting the tone: ethical business leadership by Philippa Foster Back (published by the Institute of BusinessEthics) the author lists further business values:

Truth Transparency Fairness Responsibility Trust

The importance of business values in a company's culture is that they underpin both policy and behaviourthroughout the company, from top to bottom.

Along with the business values listed above are statutory requirements of all companies:

Equal opportunities for all No discrimination on any grounds Freedom of information

Values are promoted in the company by the board of directors which should be committed to:

Openness and transparency in decisions and use of resources

Promoting good relationships wherever possible

High standards in their own personal behaviour, especially preparing adequately for andattending meetings, and being involved in decision making

Stakeholders, including customers, employees, investors, government and regulators place great pressureon companies about their values and their business ethics.



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7.3 What are business ethics?

Definition

Business ethics: The ways in which a company behaves in a society which has certain expectations of howa decent company should behave. They represent the moral standards that are expected.

Acceptable business ethics may comprise as a minimum:

Paying staff decent wages and pensions Providing good working conditions for staff Paying suppliers in line with agreed terms Sourcing supplies carefully (Fairtrade etc) Using sustainable or renewable resources Being open and honest with customers

The important point to note however is that society's expectations, which can and do change, mouldbusiness ethics. Expectations have an effect at three levels:

At the overall level of 'what is the role of business in society?' At the level of a specific company, and what it can do to manifest business ethics At the level of individuals within the company

The term social responsibility is often used in this context.

Definition

Social responsibility: How far a company exceeds the minimum obligations it owes to stakeholders andsociety by virtue of regulations and corporate governance. In particular, it is concerned with the company'sobligations to those stakeholders which are unprotected by contractual or business relationships with thecompany, namely local communities, consumers in general and pressure groups.

Neil Cowan, in Corporate governance that works, suggests that business ethics 'come down to [a company's]transparency, trust, openness and real acceptance of responsibility – for bad decisions as well as good ones'.He suggests that:

Transparency includes integrity in the discharge of fiduciary duty, which is a particular issue fordirectors who owe fiduciary duties of care, competence and loyalty to the company

Trust is the element that is most lacking when it comes to the relationship between business and thepublic

Openness in decision-making means that all relevant data and information should be available

Interactive question 3: Ethical pressures [Difficulty level: Intermediate]

In what areas of a business would you say there were the greatest pressures not to behave ethically, andfrom what source does this pressure come?




7.4 How can an ethical culture be promoted?

An ethical culture can be promoted by a combination of:

Ethical leadership from the board of directors Codes of ethics or business conduct Policies and procedures to support ethical behaviour

7.4.1 Ethical leadership from the board of directors

Most of the recent scandals which have created so much interest in corporate governance and businessethics have centred on the fact that the company involved was being led by unethical directors. The degreeof their unethical behaviour may range from criminal dishonesty (such as Bernie Ebbers at WorldCom) to asimple failure to accept responsibility. Such behaviour undermines trust.

The board should provide ethical leadership to the company: it should lead by example. Philippa FosterBack identifies the following attributes and behaviours of ethical leaders:

Attributes Behaviours

Openness Be open minded and willing to learn, and encourage others to learn.

Courage Be determined and direct; actively stamp out poor behaviour.

Ability to listen Be aware of what is going on and know that doing the right thing is the right thingto do.

Honesty Be considerate and cautious in managing expectations.

Fair mindedness Be independent and willing to challenge the status quo.

7.4.2 Codes of ethics or business conduct

There is no general ethical code such as the Code of Ethics for professional accountants to whichcompanies can subscribe. Instead each company should draw up a written code of ethics or statement ofbusiness conduct which is suited to its own unique situation, values and culture.

Definition

Code of ethics: A formalisation of moral principles or values, responsibilities and obligations.

The functions of a code of ethics are:

To tell the world at large what the company is striving to achieve in terms of ethical conduct

To communicate a guide for the company as a whole to follow in its dealings with third parties

To provide guidance for individuals within the company as to how to act

To describe what the company aims to do in the event that an employee highlights unethical behaviourand abuse within the company

In developing a code of ethics the company should have three objectives in mind:

To improve behaviour To build the company's reputation and the trust of stakeholders in the company To improve performance and build value



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A code of ethics should ideally inform directors and everyone else in the company that ethical behaviouris expected of them. This may mean:

Performing their duties and undertaking their responsibilities honestly, objectively and with diligence Loyalty Not acting in a way which will discredit the company Avoiding a situation where they have a conflict of duty between the company's interests and their own Not accepting inducements or bribes which will affect their judgement Keeping information confidential and not using it for personal gain Maintaining high standards of dignity, morality and competence Respecting human rights (of suppliers, workers and the public) Being environmentally aware (in many forms, depending on the industry) Making ethical investments Fighting corruption Whistle-blowing to a regulator or other external body where appropriate (see below)

7.4.3 Whistle-blowing

Employees who make the decision to 'blow the whistle' are driven to do so by their own moral valuesand their need to 'do the right thing', but they will normally only do so once they have tried but failed to getthe problems addressed internally. This is where an effective code of ethics could make all the difference; ifthere were true backing in the company for ethics then problems would get sorted out before the whistlewas blown externally.

7.4.4 Policies and procedures to support ethical behaviour

Communication procedures so everyone is aware of the code of ethics Piloting of the code in draft form so that people have an input to its content Review of the code so that it retains its position at the heart of how the company actually does business Training Speak-up lines/helplines for internal 'whistle-blowing' Performance appraisals incorporating values Remuneration policies not cutting across values Disciplinary policies enforcing values Monitoring of how ethical behaviour is taking place Audit and assurance regarding values Reporting regularly Complaints systems that help employees to draw attention to unethical behaviour An explicitly stated duty to report breaches of specific ethical requirements

7.4.5 Ethical audit

In order to ensure that the code of ethics and its supporting policies and procedures are operatingeffectively, and to improve accountability and transparency towards stakeholders, many companies nowconduct ethical audits.

Definition

Ethical audit: A process which measures the internal and external consistency of a company's values base.

International Society of Business, Economics and Ethics.



The ethical audit produces an ethical profile, which brings together all of the factors affecting a company'sreputation by examining the way in which it does business. At a given point in time, this ethical profile:

Clarifies the actual values to which the company operates Provides a baseline by which to measure future improvement Points the way towards meeting any societal expectations which are not currently being met Gives stakeholders the opportunity to clarify their expectations of the company's behaviour Identifies specific problem areas within the company Identifies the issues which motivate employees Identifies general areas of vulnerability, particularly related to lack of openness

7.5 ICAB members and business ethics

We studied the ICAB's own Code of Ethics in Chapter 10 of this manual. Note that there is norequirement on ICAB's members in business to implement the Code for the business itself, nor toimplement policies and procedures such as a unique Code of Ethics for the business, or an ethical audit.However, members in business are encouraged by the ICAB to promote an ethical culture as far aspossible, and of course should implement the Code in relation to their own conduct.



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Summary (12/1)

Agency problem:

Managers had betterinformation than and

are not accountable to

Shareholders,who own the

company

–Distribution of rights/ responsibilities

between shareholders and managers

Corporate governance

–Sets rules for procedures for makingdecisions for the company

Perspectives

–Corporate

–Public policy

–Stakeholder

Conflicts ofinterest

–Interests and expectationsreflected in objectives

Stakeholders’ governance

needs:

–Scope for conflict ofinterest to be reduced

–

–Good business ethics (12/2)

Good practice incorporate governance –Openness/transparency

Good practice in corporate governance

–Integrity/accountability

–Reducing potential for conflict

–Reconciling shareholders’/directors’ interests

Key elements:

–Board of directors(exec and non-exec,committees)

–Senior management

–Shareholders

–External auditors

–Internal auditors

Unitary

Dual

Which type of governance?Affected by:

Type of governancestructure

Type of financialsystem

Market-based

Bank-based

- Company law

- Bangladesh Bank rules on corporate governance

Bangladesh governance structure

- SEC requires ‘comply or explain’ re

corporate governance – Chapter 13

Code ofpractice

Statutory

OECDPrinciples

Shareholder-led

Governance:Direction and control of company



Summary (12/2)

Business values

– Integrity – Truth

– Objectivity – Transparency

– Accountability – Fairness

– Openness – Responsibility

– Honesty – Trust

Ethics‘How we should behave’

Promoted by boardof directors

‘ethical leadership’

‘How the company should behave’

Business ethics

– Transparent – Trustworthy

– Open – Accepting of responsibility

Ethicalculture

Code of ethics/business conduct

Whistle-blowing

Policies andprocedures

Ethicalaudit



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Self-test

1 The agency problem concerns the misalignment in interests and conflicts of interest between

A Banks and financial marketsB Regulators and professional bodiesC Government and industryD Directors and shareholders

2 In a company with weak corporate governance managers may be able primarily to pursue their ownrather than the company's interests because, in relation to shareholders

A They have more information and high levels of accountabilityB They have less information and high levels of accountabilityC They have more information and low levels of accountabilityD They have less information and low levels of accountability

3 In comparison with the corporate and the public policy perspectives on corporate governance, thestakeholder perspective places least emphasis on

A AccountabilityB Alignment of interests of shareholders and other stakeholdersC Good informationD Efficient use of resources

4 Good practice in corporate governance requires that openness and transparency should be supportedby

A Reducing the potential for conflicts of interestB Disclosure of informationC Reconciling the interests of shareholders and directorsD Judging performance of directors on the basis of return on investment

5 In the Japanese financial system the biggest source of finance for businesses is

A Bank loansB Loans from private individualsC Retained earningsD The capital markets

6 Increased financial intermediation by investment trusts and pension funds means that a financial systemis becoming more market-based. True or false?

7 The OECD's Principles of Corporate Governance require protection of which two of the followingshareholders' rights?

A The right to quarterly general meetingsB The right to real-time information on the companyC The right to a share in the company's profitsD The right to inspect the company's books of accountE The right to remove members of the board

8 In countries with a dual board structure, the supervisory board is elected by

A Shareholders onlyB Employees onlyC Shareholders and employees onlyD Shareholders, employees and members of the management board

9 Business ethics are primarily moulded by the expectations of

A DirectorsB CustomersC GovernmentD Society



Technical reference

1 Governance

Principles of

corporate

governance

2004 (OECD)



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1 D

2 C

3 C

4 B

5 A

6 True

7 C, E

8 C

9 D





Good corporate governance is more than good management and effective leadership: it is about directingand controlling a company so that it meets the objectives that have been agreed with stakeholders,particularly shareholders, and so that it meets the needs of users and the markets for information,accountability and good behaviour.


Equity is a more risky form of investment than cash and cash equivalents so it would appear that UKhouseholds are less risk averse than Japanese ones.


The pressure not to behave ethically in business mainly derives from the need to gain commercial advantagein a fiercely competitive world. Areas where unethical behaviour often occurs are:

Procurement – bribe taking, exploitation of suppliers Excessive client and supplier entertainment Inflated directors' expenses Engaging in conflicts of interests Disclosing or using confidential information


Contents

chapter 13

Corporate governance

Introduction

Examination context

Topic List

1 The Code of Corporate Governance

2 Internal control

3 The ISC Statement of Principles: shareholderengagement

4 Assessing the effectiveness of corporategovernance via external audit

5 The role of internal audit



Technical reference




Introduction


Identify and show the distinction between the roles and responsibilities of those charged withgovernance and those charged with management

Identify the roles and responsibilities of the members of the executive board, any supervisoryboard, the audit committee and others charged with governance, internal audit and externalaudit

Identify the roles and responsibilities of those responsible within a business for internal auditand for the external audit relationship

Specific syllabus references are: 5c, e, f.


Having established that corporate governance is a good thing, we need to consider now how the chosenapproach would affect directors, managers and auditors in Bangladesh.

Stop and think

How does the need to exercise overall control so as to get things done properly affect a company in itsday-to-day operations? What would happen if there were no specific rules in place for large companies?

Working context

The rules on governance have had a profound effect on both assurance and financial reporting inBangladesh. They have focused attention on the importance of both of these fundamental functions of theaccountancy profession.

Syllabus links

Corporate governance is developed further in Audit and Assurance and Financial Reporting at theProfessional stage, and at the Advanced stage.

CORPORATE GOVERNANCE


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Examination context


Questions on corporate governance are certain to appear in your exam.

Exam requirements

Questions are likely to be set in a scenario context, though knowledge-type questions are also likely onparticular definitions and principles.



1 Code of Corporate Governance

Section overview

Irrespective of the Code, all companies must treat shareholders equally.

The disclosure statement for the Code requires a company to state how it applies its principles, andthen either to state that it complies with the Code's provisions, or to explain why it does not socomply.

The Code contains principles for companies and for institutional shareholders to apply.

The principles for companies concern: directors (effectiveness of the main board; division ofresponsibility between Chairman and CEO; balance and independence of board; board appointments/nomination committee; informing and developing the board; evaluating the board's performance;electing directors and succession planning/nomination committee); remuneration (level, make-up andpolicy on remuneration/remuneration committee); accountability and audit (financial reporting,internal control and audit/ audit committee); relations with shareholders (dialogue with institutionalshareholders; the AGM).

The principles for institutional shareholders' concern: dialogue with companies; evaluating corporatedisclosures; voting.

1.1 What is the Code of Corporate Governance?

The Code of Corporate Governance is a code of best practice (it has no statutory force) embodying ashareholder-led approach to corporate governance. It includes requirements of institutional shareholders aswell as of companies themselves.

1.2 The 2005 edition of the Code of Corporate Governance

The Code of Corporate Governance was produced by the South Asian Federation of Accountants (SAFA)in September, 2005. SAFA has decided to update this set of principles as and when the need arises.

1.3 Compliance with the Code of Corporate Governance

The document is prepared with the aim to facilitate its voluntary compliance through adoption or supportby relevant regulatory bodies, stock exchanges as well as corporate entities. Individual member bodies, suchas ICAB and ICMAB, are expected to make their best endeavours for promoting compliance with theseprinciples, which are expected to enhance the governance structures and processes of PIEs which chooseto comply with them.



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1.3.1 Disclosure statement: comply or explain

As per the Security and Exchange Commission (SEC) notification, listed companies must make a disclosurestatement about many of the Corporate Governance requirements:

Reporting on how the company applies the main and supporting principles in the Code of CorporateGovernance, then either

Confirming that it complies with the Code's provisions, or where it does not

Explaining why it does not comply

1.4 The content of the Code of Corporate Governance

The conditions imposed by SEC, vide notification dated 20th February, 2006 to enhance thecorporate governance for the listed companies of Bangladesh are as follows:

1.5 Board of directors:

1.5.1. Board’s Size

The number of the board members of the company should not be less than 5 (five) and more than 20(twenty):

Provided, however, that in the case of banks and non-bank financial institutions, insurance companies andstatutory bodies for which separate primary regulators like Bangladesh Bank, Department of Insurance etc.exist, the Board of those companies should be constituted as may be prescribed by such primary regulatorsin so far as those prescriptions are not inconsistent with the aforesaid condition.

1.5.2 Independent Directors

All companies should encourage effective representation of independent directors on their Board ofDirectors so that the Board, as a group, includes core competencies considered relevant in the context ofeach company. For this purpose, the companies should comply with the following:-

(i) At least one tenth (1/10) of the total number of the company’s board of directors, subject to a minimumof one, should be independent directors.

Explanation: For the purpose of this clause “independent director” means a director who does not holdany share in the company or who holds less than one percent (1%) shares of the total paid-up shares of thecompany, who is not connected with the company’s promoters or directors or shareholder who holds onepercent (1%) or more than one percent (1%) shares of the total paid-up shares of the company on the basisof family relationship; who does not have any other relationship, whether pecuniary or otherwise, with thecompany or its subsidiary/ associated companies, who is not a member, director or officer of any stockexchange, and who is not a shareholder, director or officer of any member of stock exchange or anintermediary of the capital market.

(ii) The independent director(s) should be appointed by the elected directors.

1.5.3. Chairman of the Board and Chief Executive

The positions of the Chairman of the Board and the Chief Executive Officer of the companies shouldpreferably be filled by different individuals. The Chairman of the company should beelected from among the directors of the company. The Board of Directors should clearly define respectiveroles and responsibilities of the Chairman and the Chief Executive Officer.



1.5.4 The Directors’ Report to Shareholders

The directors of the companies should include following additional statements in the Directors’ Reportprepared under section 184 of the Companies Act, 1994:-

(a) The financial statements prepared by the management of the issuer company present fairly its state ofaffairs, the result of its operations, cash flows and changes in equity.

(b) Proper books of account of the issuer company have been maintained.

(c) Appropriate accounting policies have been consistently applied in preparation of the financial statementsand that the accounting estimates are based on reasonable and prudent judgment.

(d) International Accounting Standards, as applicable in Bangladesh, have been followed in preparation of thefinancial statements and any departure therefrom has been adequatelydisclosed.

(e) The system of internal control is sound in design and has been effectively implemented and monitored.

(f) There are no significant doubts upon the issuer company’s ability to continue as a going concern. If theissuer company is not considered to be a going concern, the fact along with reasons thereof should bedisclosed.

(g) Significant deviations from last year in operating results of the issuer company should be highlighted andreasons thereof should be explained.

(h) Key operating and financial data of at least preceding three years should be summarised.

(i) If the issuer company has not declared dividend (cash or stock) for the year, the reasons thereof shouldbe given.

(j) The number of Board meetings held during the year and attendance by each director should bedisclosed.

(k) The pattern of shareholding should be reported to disclose the aggregate number of shares (along withname wise details where stated below) held by:-

(i) Parent/Subsidiary/Associated companies and other related parties (name wise details);

(ii) Directors, Chief Executive Officer, Company Secretary, Chief Financial Officer,Head of Internal Audit and their spouses and minor children (name wise details);

(iii) Executives; and

(iv) Shareholders holding ten percent (10%) or more voting interest in the company (name wisedetails).

Explanation: For the purpose of this clause, the expression “executive” means top five salariedemployees of the company, other than the Directors, Chief Executive Officer, CompanySecretary, Chief Financial Officer and Head of Internal Audit.



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1.6 Chief financial officer (CFO), head of internal audit and companysecretary:

1.6.1. Appointment

The company should appoint a Chief Financial Officer (CFO), a Head of Internal Audit and a CompanySecretary. The Board of Directors should clearly define respective roles, responsibilities and duties of theCFO, the Head of Internal Audit and the Company Secretary.

1.6.2. Requirement to Attend Board Meetings

The CFO and the Company Secretary of the companies should attend meetings of the Board of Directors,provided that the CFO and/or the Company Secretary should not attend such part of ameeting of the Board of Directors which involves consideration of an agenda item relating to the CFOand/or the Company Secretary.

1.7 Audit committee:

The company should have an Audit Committee as a sub-committee of the Board of Directors. The AuditCommittee should assist the Board of Directors in ensuring that the financialstatements reflect true and fair view of the state of affairs of the company and in ensuring a goodmonitoring system within the business. The Audit Committee shall be responsible to the Board ofDirectors. The duties of the Audit Committee should be clearly set forth in writing.

1.7.1. Constitution of Audit Committee

(i) The Audit Committee should be composed of at least 3 (three) members.

(ii) The Board of Directors should appoint members of the Audit Committee who should be directors ofthe company and should include at least one independent director.

(iii) When the term of service of the Committee members expires or there is any circumstance causing anyCommittee member to be unable to hold office until expiration of the term of service, thus making thenumber of the Committee members to be lower than the prescribed number of 3 (three) persons, theBoard of Directors should appoint the new Committee member(s) to fill up the vacancy(ies) immediately ornot later than 1 (one) month from the date of vacancy(ies) in the Committee to ensure continuity of theperformance of work of the Audit Committee.

1.7.2. Chairman of the Audit Committee

(i) The Board of Directors should select 1 (one) member of the Audit Committee to be Chairman of theAudit Committee.

(ii) The Chairman of the audit committee should have a professional qualification or knowledge,understanding and experience in accounting or finance.

1.7.3. Reporting of the Audit Committee

1.7.3.1. Reporting to the Board of Directors

(i) The Audit Committee should report on its activities to the Board of Directors.

(ii) The Audit Committee should immediately report to the Board of Directors on the following findings, ifany:-



(a) Report on conflicts of interests;

(b) Suspected or presumed fraud or irregularity or material defect in the internal control system;

(c) Suspected infringement of laws, including securities related laws, rules and regulations; and

(d) Any other matter which should be disclosed to the Board of Directors immediately.

1.7.3.2. Reporting to the Authorities

If the Audit Committee has reported to the Board of Directors about anything which has material impacton the financial condition and results of operation and has discussed with the Board of Directors and themanagement that any rectification is necessary and if the Audit Committee finds that such rectification hasbeen unreasonably ignored, the Audit Committee should report such finding to the Commission, uponreporting of such matters to the Board of Directors for three times or completion of a period of 9 (nine)months from the date of first reporting to the Board of Directors, whichever is earlier.

1.7.4. Reporting to the Shareholders and General Investors

Report on activities carried out by the Audit Committee, including any report made to the Board ofDirectors under condition 1.7.3.1 (ii) above during the year, should be signed by the Chairman of the AuditCommittee and disclosed in the annual report of the issuer company.

1.8. External/Statutory Auditors

The issuer company should not engage its external/statutory auditors to perform the following services ofthe company; namely:-

(i) Appraisal or valuation services or fairness opinions;

(ii) Financial information systems design and implementation;

(iii) Book-keeping or other services related to the accounting records or financial statements;

(iv) Broker-dealer services;

(v) Actuarial services;

(vi) Internal audit services; and

(vii) Any other service that the Audit Committee determines.

1.9 Reporting the Compliance in the Director’s Report

The directors of the company shall state, in accordance with the annexure attached, in the directors’ reportwhether the company has complied with these conditions.

1.10 Best Practices on Corporate Governance

Apart from the SEC order detailed above, SAFA (South Asian Federation of Accountants) , of which ICABis a member, has adopted Best Practices on Corporate Governance on September, 2005.The document is



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set out as a series of main principles, some of which have supporting principles and all of which haveprovisions.

The main principles for companies themselves cover directors, remuneration, accountability/audit andrelations with shareholders. In summary they are as follows:

A. Directors:

1 Effective composition of board2 Division of responsibility between the Chairman of the board and the Chief Executive Officer (CEO)3 Information for and professional development of the board4 Performance evaluation of the board

B. Remuneration:

1 Level and make-up of directors’ remuneration (the remuneration committee)2 Policy development for directors’ nomination (nomination committee)

C. Accountability/audit:

1 Audit committee and auditors2 Disclosure on share trading3 Financial reporting and annual report.

D. Relations with shareholders:

1 Rights of shareholders

1.10.1 Balance of board members

The board should include a balance of executive and non-executive directors (including some independentnon-executive directors) such that no individual or small group of individuals can dominate the board’sdecision taking (A1)

Principles supporting an effective board

A. Composition of BoardB. Executive and Non-executive Directors and Independent DirectorsC. Independent Director

1.11 Chairman and Chief Executive (A2)

The Board should lay down solid foundation for oversight and management of the company through:

· Clear division of responsibilities of the Chairperson of the board and the Chief Executive;· Recognizing and publishing respective roles of the board and management; and· Establishing an effective ethics and compliance framework

A. Chairperson and Lead Independent DirectorB. Role of ChairpersonC. Powers, Functions & Responsibilities of BODD. Ethics and ValuesE. Meetings of BODF. The Company SecretaryG. Matters to be placed before BOD



Interactive question 1: Board effectiveness [Difficulty level: Intermediate]

What should the board do in order to provide entrepreneurial leadership for its company?


1.12 Training and orientation of board members

Members of the Board and its Committees should not be over extended. All directors should receiveinduction training upon joining the board and there should be an effective orientation program for directorsto regularly update and refresh their skills and knowledge. (A3)

A. Qualification and Eligibility to act as DirectorB. Election of directorsC. Training of BOD

1.13 Performance evaluation

The board should establish a process of performance evaluation in the company to ensure its sustainedsuccess. (A4)

A. Evaluation of BOD as a whole and that of individual directorsB. Evaluation of CEOC. Committees of the BOD

Interactive question 2: Chairman’s responsibilities [Difficulty level:Intermediate]

What are the Chairman’s responsibilities relating to ensuring a well-informed, professional board?


1.14. Remuneration levels

Levels of remuneration should be sufficient to attract, retain and motivate directors and members of seniormanagement of the quality required to run the company successfully, but the company should avoid payingmore than is necessary for this purpose. A reasonable proportion of executive directors’ remunerationshould be structured so as to link rewards to corporate and individual performance. (B1)

A. Remuneration Committee

1.15 Board membership

The board should ensure planned and progressive refreshing of the board. (B2)

A. Nomination CommitteePowers, Functions and Responsibilities of Nomination Committee



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1.16 Financial reporting and control

The board should establish formal and transparent arrangements for considering how they should apply thefinancial reporting and internal control principles and for maintaining an appropriate relationship with thecompany’s auditors. (C1)

A. Audit CommitteeB. Internal Control and Internal AuditC. Appointment & Qualification of External AuditorsD. Disclosure of interest by Auditors’ holding company’s shares

1.17 Trading in company’s shares

Trading in company’s shares by key personnel shall be timely disclosed (C2)

A Disclosure of Interest by Directors, CEO & Executives holding company’s shares

1.18 Periodic financial reporting

The board should present a balanced and understandable assessment of company’s position and prospectsthrough periodic financial reporting which shall include certain other information together with certainstatements/declarations by the directors and the management of the company. (C3)

A. Annual ReportB. Report on Corporate Governance

Interactive question 3: Preparation of financial statements [Difficulty level:Intermediate]

As well as the annual financial statements, how far does the board’s responsibility to provide balanced andunderstandable financial reporting extend?


1.19 Rights of shareholders

The board should respect the rights of shareholders and facilitate the effective exercise of those rights.(D1)

A. Relationship with shareholders



2 Internal control

Section overview

Internal control is a process designed to ensure reasonable assurance about whether the companyhas achieved its objectives, via effective and efficient operations, reliable financial reporting andcompliance with applicable laws and regulations.

The Turnbull Guidance on internal control emphasises that an internal control system shouldfacilitate: operations; risk response; safeguarding of assets; management of liabilities; reporting;compliance.

The board must make a statement on internal control in the annual report.

2.1 What is internal control?

Definition

Internal control: A process designed to provide reasonable (not absolute) assurance regarding theachievement of objectives via:

Effective and efficient operations Reliable financial reporting Compliance with applicable laws and regulations

2.2 The Turnbull Guidance on internal control

In order to maintain a sound system of internal control (principle C3) the following recommendations canbe implemented, which are known as the Turnbull Guidance.

Definition

Internal control system: A system encompassing the policies, processes, tasks, and behaviours in acompany that allow it to:

Operate effectively and efficiently Respond appropriately to risks Safeguard assets from inappropriate use, loss or fraud Ensure liabilities are identified and managed Ensure the quality of internal and external reporting Ensure compliance with applicable laws and regulations, and internal policies

2.2.1 Who is responsible for internal control?

The Guidance makes it clear that the board of directors as a whole has responsibility for:

Policy-making on an effective system of internal control in the company, covering financial,operational and compliance controls as well as risk management systems



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Reviewing the effectiveness of the internal control system in addressing the risks that the board hasidentified face the company (the review tasks can be delegated to board committees)

Reporting on the internal control system to shareholders each year

Management is responsible for implementation of internal control, and for day-to-day monitoring ofthe system.

2.2.2 What constitutes a sound system of internal control?

In determining what constitutes a sound system of internal control for the company, the board’sdeliberations should take a risk-based approach, including:

The nature and extent of the risks facing the company

The extent and categories of risk which it regards as acceptable

The likelihood of the risks concerned materialising

The company’s ability to reduce the incidence and impact on the business of risks that domaterialise

The costs of operating particular controls relative to the benefit thereby obtained in managing therelated risks

A sound system of internal control reduces but cannot eliminate the possibilities of:

Poor judgement in decision-making Human error Deliberate circumvention of control processes by employees and others Management overriding controls Occurrence of unforeseen circumstances

The system of internal control should:

Be embedded in the operations of the company and form part of its culture

Be capable of responding quickly to evolving risks to the business arising from factors within thecompany and to changes in the business environment

Include procedures for reporting any significant control failings or weaknesses immediately toappropriate levels of management, together with details of corrective action being taken

2.2.3 Statement on internal control

In the board’s narrative statement on internal control in the annual report it should disclose that:

It acknowledges responsibility for the system of internal control and for reviewing its effectiveness

The system is designed to manage rather than eliminate the risk of failure to meet business objectives

The system can only provide reasonable, not absolute, assurance against material misstatement or loss

An ongoing process is in place for identifying, evaluating and managing significant risks facing thecompany

The process has been in place for the year under review and up to the date of the annual report andaccounts

The process is regularly reviewed by the board

There is a process to deal with the internal control aspects of any significant problems disclosed in theannual report and accounts



3 The ISC Statement of Principles: shareholderengagement

Section overview

Institutional shareholders should engage with companies to ensure that concerns aboutunderperformance are dealt with and so shareholders derive value from their investments.

The Institutional Shareholders’ Committee (ISC)’s Statement of Principles revised in September2005 is a code of practice which sets out the principles by which institutional shareholders shouldenter into a dialogue with companies based on mutual understanding of objectives (principle D1 ofthe Code).

The ISC refers to the dialogue as shareholder engagement (formerly it was referred to as shareholderactivism), which it sees as being ‘procedures designed to ensure that shareholders derive value from theirinvestments by dealing effectively with concerns over under-performance’. It acknowledges, however, thatsimply selling a holding of shares is often the most effective response to such concerns. In summary, theprinciples are that institutional shareholders (pension funds, insurance companies, investment trusts, othercollective investment vehicles and their agents) should:

Set out their policy on how they will discharge their responsibilities, clarifying the prioritiesattached to particular issues and when they will take action

Monitor the performance of companies in which they hold securities.

Establish where necessary a regular dialogue with companies in which they hold securities

Intervene where necessary

Evaluate the impact of their engagement

Report back to clients/beneficial owners (the people on whose behalf the institutionalshareholders invest funds)



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4 Assessing the effectiveness of corporate governancevia external audit

Section overview

The external audit reports on whether the financial statements present a true and fair view of thecompany’s financial performance and position.

4.1 What is an external audit?

The financial statements of companies are subject to external audit each year by an auditor carrying outan independent and objective investigation, unless they are exempted. The purpose of the externalaudit is to issue an opinion in an audit report whether the financial statements produced by the directorsgive a ‘true and fair view’ of the financial performance of the company during the reporting periodand of its financial position as at the end of the period.

To act as an external audit, or a body corporate, partnership or individual must be a member of arecognised supervisory body, such as the ICAB. They must also hold an appropriate qualification. Externalauditors are appointed by a shareholder vote, following recommendations by the board and auditcommittee.

4.2 What does the audit opinion mean?

Shareholders often believe the external auditor’s opinion means that the financial statements of thecompany are ‘correct’. If the published financial statements are subsequently found to be incorrect, perhapsdue to a fraud, shareholders then blame the auditor for:

Failing to spot the problem

Lacking objectivity

Failing to challenge the views of the company’s management about accounting policies and theaccounting treatment of certain items. In fact, although the external audit must be conducted toprofessional standards, the external auditor is not responsible for detecting fraud and error.

The responsibility for preventing and detecting fraud and error lies with:

Directors, who are required to satisfy themselves that the systems of internal control and riskmanagement are working effectively

Management, who implement and monitor the system of internal control determined by thedirectors

4.3 What is the external audit’s role in corporate governance?

The role of the external audit is a key issue in corporate governance, but in relation to corporategovernance as a system the external auditor simply reports an independent and expert opinion on how thecompany is complying with the Corporate Governance requirements as stated in the SEC law. Theresponsibility to do something about it remains with the directors and shareholders.



5 The role of internal audit

Section overview

Internal audit reports on the company’s internal controls and risk management system.

The audit committee monitors the role and performance of internal audit, including appointing itshead and ensuring it has sufficient resources.

Definition

Internal audit: A semi-independent part of the company which monitors the effective operation of itsinternal control and risk management systems.

The independence of Internal auditors should be preserved so they can carry out the following tasks basedon detailed reviews of areas of the company:

Assessing how risks are identified, analysed and managed

Advising management on embedding risk management processes into business activities

Advising management on improving internal controls

Ensuring that assets are being safeguarded

Ensuring that operations are conducted effectively, efficiently and economically in accordance with thecompany’s policies

Ensuring that laws and regulations are complied with

Ensuring that records and reports are reliable and accurate

Helping management to detect or deter fraud

Helping management to identify savings and opportunities

We saw above that internal audit plays a role in ensuring good corporate governance, along with the board,management, shareholders and external audit. Its remit extends beyond that of external audit however, as itcovers operational controls and non-financial compliance issues.

The Code of Corporate Governance recommends that the board’s audit committee should monitor andassess the role and performance of the internal audit function. This includes:

Appointing the head of internal audit

Ensuring the function has sufficient resources e.g. staff, access to management, and a framework ofprofessional standards. Ideally internal auditors should be able to confer privately with the auditcommittee, without the presence of management, and should have direct access to any member of theboard.



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Summary

–Board responsible

–Sound systems of IC

–Statement on IC

Externalaudit

Internalaudit

Statutory requirement totreat shareholders equally

re information

SEC requirement to‘comply or explain’re Code on

Corporate Governance

Unitary board

Directors

Effective board

Chairman/CEO

Balance andindependence

of board

Boardappointments

Information andprofessionaldevelopment

Evaluating boardperformance

Re-election ofdirectors

Remuneration

Remunerationcommittee

Transparency

Nominationcommittee

Accounting/audit

Financialreporting

Internalcontrol (IC)

Auditcommittee

and auditors

Relations of

company withshareholders

TurnbullGuidance

Dialogue withinstitutionalshareholders

The AGM

Relations ofshareholderswith company

Dialogue withcompany

Evaluation ofgovernancedecisions

Voting

ISC statement:shareholderengagement

Corporate Governance- SAFA recommended



Self-test


1 The Chairman of the board and CEO should be

A The same person

B Different people

C A professional person

D An independent director

2 Report on activities carried out by the audit committee should be disclosed in the

A Directors’ report

B Annual report

C SEC report

D None of the above

3 As per SEC imposed condition, the number of board members of a listed company should not be morethan

A 14

B 16

C 18

D 20

4 As per SEC imposed condition, the number of independent directors of a listed company should be

A 1/6th of total number of directors

B 1/8th of total number of directors

C 1/10th of total number of directors

D 1/12th of total number of directors

5 The audit committee should comprise

A Only independent non-executive directors, at least one of whom should have recent and relevantfinancial experience

B Both independent and non-independent non-executive directors

C Three directors of the company, with at least one independent director

D Both non-executive and executive directors, at least one of whom should have recent andrelevant financial experience

6 Implementing policy for an effective system of internal control is the responsibility of

A ManagersB The ChairmanC The audit committee via the internal audit functionD The board of directors as a whole



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1 B

2 B

3 D

4 C

5 C

6 A The Board sets the policy, the management implements it



Technical reference

Best Practices on Corporate Governance 2005 (SAFA)

SEC imposed conditions of Corporate Governance 2/2006 (SEC)

Internal control: guidance for directors 2005 (FRC)

Statement of principles on the responsibilities of institutional shareholders 2005 (ISC)



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It should set the company's strategic aims, ensure the company has the right resources to meet itsobjectives, review management's performance and set the company's values and standards so that itsobligations to shareholders and others are understood and met.


The Chairman should ensure directors receive accurate, timely and clear information and that theycontinually update their skills, and their knowledge and familiarity with the company. The Chairman shoulddirect the company secretary in relation to information flows, induction of directors and professionaldevelopment. The Chairman should ensure there is proper induction for new directors, and should offermajor shareholders the opportunity to meet new non-executive directors.


It extends as well to interim reports, other price-sensitive public reports and reports to regulators.


Contents

chapter 14

The economic environmentof business and finance

Introduction

Examination context

Topic List

1 Introduction to the economic environment

2 The market mechanism

3 Demand

4 Supply

5 The equilibrium price

6 Elasticity

7 Types of market structure

8 The failure of perfect competition






Introduction


Specify the signalling, rewarding and allocating effects of the price mechanism on business(including the concept of price elasticity)

Specify the potential types of failure of the market mechanism and their effects on business

Specific syllabus references are: 6a, b.


Understanding the workings of the market mechanism is of huge practical importance, for instance insetting prices, approaching the effects of shortages of key resources, and knowing when is a good time toinvest or divest.

Stop and think

What determines how much we earn and what we pay for goods and services? What would be the effect ofa key competitor going out of business? How can we decide what to do when we have limited resources?

Working context

As your exposure to different businesses increases you will appreciate how significant the effect of theeconomic environment is on all areas of enterprise.

Syllabus links

The economic environment is studied further in Business Strategy and Financial Management, and at theAdvanced stage.

THE ECONOMIC ENVIRONMENT OF BUSINESS AND FINANCE


14

Examination context


Questions on the economic environment will certainly come up in your exam.

Exam requirements

Questions will be set in either a scenario context or as a test of knowledge of key principles.



1 Introduction to the economic environment

Section overview

A business's economic environment comprises the macroeconomic environment (global and nationalinfluences) and its own microeconomic environment, especially how market forces affect it.

We saw in Chapter 4 how PESTEL analysis can help a business identify important factors in theenvironment in which it functions. In this chapter we shall focus on the economic environment ofbusiness and finance.

There are in fact two economic environments that affect businesses:

The macroeconomic environment in which all businesses have to operate, which incorporates:

– Global influences: internationalisation of trade, influence of regional economic groups such as theEU, globalisation of markets

– National influences: the business cycle, government policies (e.g. fiscal and monetary policy), inflation

The microeconomic environment of the particular business, which basically involves looking athow the market (or price) mechanism works

2 The market mechanism

Section overview

In a market buyers and sellers exchange 'goods' via the market mechanism, which determines priceaccording to the interaction of supply and demand.

Definition

Market mechanism: The interaction of demand and supply for a particular item.

2.1 What is a market?

The concept of a market in economics goes beyond the idea of a single geographical place where peoplemeet to buy and sell goods. It refers to the buyers and sellers of goods or services who influence its price.Markets can be worldwide, as in the case of oil, wheat, cotton and copper for example. Others are morelocalised, such as the housing market or the market for second-hand cars.

Definition

Market: A situation in which potential buyers and potential sellers (or 'suppliers') of an item or 'good'come together for the purpose of exchange.

Markets for different goods are often inter-related. All goods compete for customers so that if more isspent in one market, there will be less to spend in other markets.



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2.2 How is the market price of goods determined?

Price theory (or demand theory as it is sometimes referred to) is concerned with how market pricesfor goods are arrived at, through the interaction of demand and supply.

3 Demand

Section overview

Demand quantifies how much of a good buyers would buy at a certain price level.

The demand curve is usually downward sloping from left to right when price is measured on the y(vertical) axis and quantity is measured on the x (horizontal) axis. This means that a rise in pricecauses a fall in the quantity demanded.

Within one demand curve only price determines the level of demand.

Other determinants of demand will shift the demand curve. These include: substitutes and complements;income levels (normal and inferior goods); fashion and expectations; income distribution.

The level of demand can change quite rapidly in response to a change in a determinant.

3.1 What is meant by 'demand'?

Definition

Demand: The quantity of a good that potential purchasers would buy, or attempt to buy, if the price of thegood were at a certain level.

If demand is satisfied, actual quantities bought equals demand. If some demand is unsatisfied, more would-bepurchasers are trying to buy a good that is in insufficient supply.

3.2 The demand schedule and the demand curve

The relationship between demand for a good and the price of the good can be shown graphically as ademand curve. The demand curve is derived by estimating in a demand schedule how much of a goodwould be demanded at various hypothetical market prices.

Worked example: Demand schedule and demand curve

Suppose that the following demand schedule shows demand for biscuits by one household over a period ofone month.

Quantity demandedPrice per kg at this price

CU kg1 92/32 83 61/44 41/25 22/36 1



We can show this schedule graphically on a demand curve (Figure 14.1), with:

(a) Price on the y axis, and(b) Quantity demanded on the x axis

Figure 14.1: Demand for biscuits

Changes in demand caused by changes in price only are represented by movements along the demandcurve, from one point on the curve to another. The price has changed, so the quantity demanded changes,but the demand curve itself stays in the same place.

A demand curve generally slopes down from left to right for the following reasons.

(a) For the individual consumer, a fall in the price of the good makes it relatively cheaper compared toother goods so expenditure will be shifted to the good whose price has fallen. It is the relative price ofthe good that is important. A fall in the relative price of a good increases demand for it.

(b) A fall in the good's price means that people with lower incomes will also be able to afford it. Theoverall size of the market for the good increases. The converse argument applies to an increase inprices; as a price goes up, consumers with lower incomes will no longer be able to afford the good, orwill buy something else whose price is relatively cheaper, and the size of the market will shrink.

3.3 What factors determine demand?

Several factors influence the total market demand for a good. One of these factors is obviously its price,but there are other factors too since people buy not just one good with their money but a whole range ofgoods and services.

3.3.1 Price

In the case of most goods (with some exceptions, such as Giffen goods, which we will look at later), thehigher the price, the lower will be the quantity demanded. It is common sense that at a higher price, a gooddoes not give the same value for money as it would at a lower price, so people will not want to buy asmuch. This dependence of demand on price applies to all goods and services, from bread and saltto houses and satellites.

0

1

2

3

4

5

6

0 1 2 3 4 5 6 7 8 9 10

Price(CU)

A

G

Quantity (kg)

DB

E

D

Demand curve



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A demand curve shows how the quantity demanded will change in response to a change in price providedthat all other factors affecting demand are unchanged – that is, provided that there is no change inthe prices of other goods, tastes, expectations or the distribution of household income.

3.3.2 Other factors affecting demand

A different demand curve needs to be produced if there is a change in the other factors affecting demand.We call this a shift of the demand curve. If the change means that demand rises then the downward-sloping demand curve moves to the right; if demand falls then it moves to the left.

3.3.3 Inter-related goods: substitutes and complements

A change in the price of one good will not necessarily change demand for another good. For example, wewould not expect an increase in the price of cocoa to affect the demand for cars. However, there aregoods for which the market demand is inter-related, referred to as either substitutes or complements.

Substitute goods are goods that are alternatives to each other, so that an increase in the demandfor one is likely to cause a decrease in the demand for another. Switching demand from one good toanother 'rival' good is substitution. Examples of substitute goods and services are:

– Rival brands of the same commodity, like Coca-Cola and Pepsi– Tea and coffee– Bus rides and car rides– Some different forms of entertainment

Substitution takes place when the price of one good rises or falls relative to the substitute good.

Complements are goods that tend to be bought and used together, so that an increase in thedemand for one is likely to cause an increase in the demand for the other. Examples of complementsare:

– Cups and saucers– Bread and butter– Cars and the components and raw materials that go into their manufacture

Interactive question 1: Substitute or complementary goods? [Difficulty level: Easy]

What might be the effect of an increase in the ownership of domestic freezers on the demand forperishable food products?


3.3.4 Income levels: normal and inferior goods

More income gives people more to spend, so they will want to buy more goods at existing prices.However, a rise in income will not increase market demand for all goods and services. The effect of a rise inincome on demand for an individual good will depend on the nature of the good.

(a) A rise in income may increase demand for a particular good. This is what we might normally expect tohappen, so they are called normal goods.

(b) Demand for another good may rise with income up to a certain point but then fall as income risesbeyond that point. Goods whose demand eventually falls as income rises are called inferior goods:examples might include cheap brands of sausages or wine. The reason for falling demand is that asincomes rise, demand switches to superior products, for example gourmet sausages and champagne.



3.3.5 Fashion and expectations

A change in fashion will alter the demand for a product. For example, when it became fashionable to drinkwine with meals, expenditure on wine increased. In addition, there may be passing 'crazes', such asskateboards, or football strips during the World Cup.

If consumers expect that prices will rise, or that shortages will occur, they may attempt to stock up on theproduct, thereby creating excess demand in the short term which will increase prices. This can then lead topanic buying. Examples include fear of war or the effect of strikes.

3.3.6 Income distribution

Market demand for a good is influenced by the way in which the national income is shared among people. Ina country with many rich and many poor households and few middle income ones, we might expect arelatively large demand for luxury cars and yachts and also for bread and potatoes. In a country with manymiddle-income households, we might expect high demand for medium-sized cars and TV sets, and other'middle income' goods.

Interactive question 2: Income distribution [Difficulty level: Intermediate]

What do you think might be the demand for swimming pools amongst a population of five householdsenjoying total annual income of CU1m, if the distribution of income is either as under assumption 1 or asunder assumption 2?

Annual incomeAssumption 1 Assumption 2

CU CUHousehold 1 950,000 200,000Household 2 12,000 200,000Household 3 13,000 200,000Household 4 13,000 200,000Household 5 12,000 200,000

1,000,000 1,000,000


3.4 Shifts of the demand curve

When there is a change in one of these demand determinants other than price, the relationship betweendemand quantity and price will also change, and there will be a different price/quantity demand schedule andso a different demand curve. We refer to such a change as a shift of the demand curve.

Figure 14.2 depicts a demand curve shifting to the right, from D0 to D1. For example, at a single price, priceP1, demand for the good would rise from Q0 to Q1. This shift could be caused by any of the following:

A rise in household income A rise in the price of substitutes A fall in the price of complements A positive change in tastes towards this good An expected rise in the price of the good

A fall in demand at each price level would be represented by a shift of the demand curve in the oppositedirection: to the left. Such a shift may be caused by the opposite of the changes above.

Figure 14.2: Outward shift of the demand curve

Remember that:

Price ofthe goods

(CU)

P1



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Movements along a demand curve are caused by changes in the good's price

Shifts of the demand curve are caused by changes in any of the other factors which affectdemand for a good, other than its price

4 Supply

Section overview

Supply quantifies how much of a good sellers will supply at a certain price level.

The supply curve is usually upward sloping from left to right when price is measured on the y axis.This means that a rise in price causes a rise in the quantity supplied.

Within one supply curve only price determines the level of supply.

Other determinants of supply will shift the supply curve. These include: prices of other goods; pricesof related goods; costs; changes in technology; other seasonal and random factors.

For most goods and services, the level of supply changes less rapidly than demand in response to achange in a determinant.

4.1 What is meant by 'supply'?

Definition

Supply: The quantity of a good that existing suppliers or would-be suppliers would want to produce forthe market at a given price.



The quantity of a good that can be supplied to a market varies up or down, as a result of either:

Existing suppliers increasing or reducing their output quantities, or

Suppliers stopping production altogether and leaving the market, or new suppliers entering the marketand starting to produce the good.

If the quantity that suppliers want to produce at a given price exceeds the quantity that purchasers demand,there will be an excess of supply, with suppliers competing to win what demand there is. Over-supplyand competition result in price-competitiveness and ultimately a fall in price.

4.2 The supply schedule and the supply curve

A supply schedule and supply curve are constructed in a similar manner to a demand curve (from aschedule of supply quantities at different prices) but show the quantity suppliers are willing to produce atdifferent price levels. It is an upward sloping curve from left to right, because greater quantities will besupplied at higher prices.

Worked example: Supply schedule and supply curve

The supply schedule for product Y is as follows.

Quantity that suppliers wouldPrice per unit supply at this price

CU Units100 10,000150 20,000300 30,000500 40,000

The relationship between supply quantity and price is shown as a supply curve in Figure 14.3.

Figure 14.3: Supply curve

0

100

200

300

400

500

600

0 10,000 20,000 30,000 40,000

Price(CU)

Quantity supplied (units)



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4.3 What factors influence supply?

The price obtainable for the good

The prices of other goods. An increase in the price of other goods would make the supply of agood whose price does not rise more unattractive to suppliers, or they may want to switch tosupplying something else

The price of related goods in 'joint supply'. For instance, leather and beef are related goods whichare produced jointly when cattle are slaughtered. If the price of beef rises, more will be supplied andthere will be an accompanying increase in the supply of leather

The costs of making the good, including raw materials costs, wages, etc. A rise in the price of oneraw material will cause producers to shift away from supplying goods whose costs and profits areclosely related to the price of that raw material, towards the supply of goods where the cost of thatraw material is less significant

Changes in technology. Technological developments which reduce costs of production (andincrease productivity) will raise the quantity of supply of a good at a given price

Other factors, such as changes in the weather in the case of agricultural goods, natural disasters orindustrial disruption

The supply curve itself shows how the quantity supplied will change in response to a change in price,provided that all other conditions affecting supply remain unchanged. If supply conditions (the price of othergoods, or costs of making the goods, or changes in technology) alter, a different supply curve must bedrawn. In other words, a change in price will cause a shift in supply along the supply curve. A changein other supply conditions will cause a shift of the supply curve itself.

A shift of the supply curve as the result of a fall in costs, either in absolute terms or relative to the costs ofother goods, is shown in Figure 14.4. If the market price of the good is P1, suppliers will be willing toincrease supply from Q0 to Q1 under the new supply conditions.

Figure 14.4: Outward shift of the supply curve

4.4 The effect of time on supply and demand

We need to distinguish between short-run and long-run responses of both supply and demand to changes indeterminants. In the short run both supply and demand are relatively unresponsive to changes in price, ascompared to the long run.

00

Price(CU)

Quantity supplied (units)

S0 S1

Q0 Q1

P1



In the case of supply, changes in the quantity of a good supplied often require the laying off or hiringof new workers, or the installation of new machinery. These changes, brought about by managementdecisions, take some time to implement.

In the case of demand, it takes time for consumers to adjust their buying patterns, althoughdemand often responds more rapidly than supply to changes in price or other demand conditions

Response times vary between markets. In stock markets, for example, supply and demand for companyshares respond very rapidly to price changes, whereas in markets for fuel oils or agrichemicals responsetimes are much longer.

Interactive question 3: Market prices in financial markets[Difficulty level: Intermediate]

In a stock market the 'products' bought and sold include shares in companies. What can you say about thesupply of and demand for these 'products', and how quickly does their price change in response to changesin supply and demand factors?


5 The equilibrium price

Section overview

An efficient market brings supply and demand into equilibrium at the market price, which is wherethe supply and demand curves intersect.

5.1 Price signals and incentives

People who want goods only have a limited disposable income and they must decide what to buy with themoney they have. The prices of the goods they want will affect their buying decisions (ignoring other factors).

Businesses' supply decisions will be influenced by both demand and supply considerations.

Market demand conditions influence the price that a supplier will get for its output. Prices act assignals to suppliers, and changes in prices should stimulate a response from a supplier to change itsproduction quantities.

Supply is also influenced by production costs and profits. The objective of maximising profits provides theincentive for suppliers to respond to changes in price or cost by changing their production quantities.

Decisions by businesses about what industry to operate in and what markets to produce goods for will beinfluenced by the prices obtainable and the costs incurred. Although some businesses have been establishedin one industry for many years, others are continually opening up, closing down or switching to newindustries and new markets. Over time, businesses in an industry might also increase or reduce the volumeof goods they sell.

5.2 What is the equilibrium price?

The market mechanism brings demand and supply into equilibrium.

Definition

Equilibrium price: The price of a good at which the volume demanded by consumers and the volumebusinesses are willing to supply are the same.



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This can be illustrated by drawing the market demand curve and the market supply curve on the samegraph (Figure 14.5).

00

Price(CU)

Quantity supplied (units)Q

P1

P1

P0

A B

C D

Supply

Demand

Figure 14.5: Market equilibrium or the equilibrium price

At price P1 in Figure 14.5, suppliers want to produce more than is demanded at that price the amount ofthe over-supply being equal to the distance AB. The reaction of suppliers as unsold inventories accumulatewould be:

To cut down the current level of production (reduce supply) in order to clear unwanted inventories,and/or

To reduce prices in order to encourage sales

The opposite will happen at price P0, where there is an excess of demand over supply, equal to the distanceCD. Output would increase and/or the price would rise.

At price P the amount that suppliers are willing to supply is equal to the amount that customers are willingto buy. There will be no unusual variation in inventory and, as long as nothing else changes, there will be nochange in price. Consumers will be willing to spend a total of (P × Q) on buying Q units of the product, andsuppliers will be willing to supply Q units to earn revenue of (P × Q). P is the equilibrium price.

The forces of supply and demand push a market to its equilibrium price and quantity.

If there is no change in the determinant of supply or demand, the equilibrium price will rule themarket and will remain stable.

If the equilibrium price does not rule, the market is in disequilibrium, but supply and demand willpush prices towards the equilibrium price.

Shifts in the supply curve or demand curve because of determinants other than price will change theequilibrium price and quantity.



5.3 Adjustments to equilibrium

Equilibrium price, supply and demand must adjust following a shift of the demand or supply curve. There arefour possibilities, therefore, which are illustrated by Figure 14.6.

(i) Increase in consumer incomes (ii) Product becomes unfashionable

Prediction

Rise in market price Rise in quantity supplied

Prediction

Fall in market price Fall in quantity supplied

(iii) Improvement in production technology (iv) Rise in factor costs

Prediction

Fall in market price Rise in quantity supplied

Prediction

Rise in market price Fall in quantity supplied

Figure 14.6: Adjustments in equilibrium

Interactive question 4: Price determinants [Difficulty level: Intermediate]

Explain, in detail, what conditions will determine price in:

(a) A retail fruit and vegetable market;(b) An auction of antiques and paintings.


5.4 Price regulation

The regulation of prices by government provides an illustration of how demand and supply analysis can beapplied. Government might introduce regulations either:

To set a maximum price for a good, perhaps as part of an anti-inflationary economic policy (such asa prices and incomes policy) so suppliers cannot charge a higher price even if they wanted to, or

To set a minimum price for a good below which a supplier is not allowed to fall. For example,OPEC (the Organisation of Petroleum Exporting Countries) has in the past attempted to imposeminimum prices for oil on the world markets.

The government may try to prevent prices of goods rising by establishing a maximum price.

If this price is higher than the equilibrium price, its existence will have no effect at all on theoperation of market forces,

But if the maximum price is lower than what the equilibrium price would be, there will be anexcess of demand over supply. The low price attracts customers, but deters suppliers so supply willfall unless there is scope for the market to exist outside government-sanctioned channels – a so-called'black market'.

PriceCU

P2

P1

0

S

= expansion insupply

Q1 Q2 Quantity

D1 D2

PriceCU

P1

P2

0

D2 D

PriceCU

P2

P1

0

S1

= expansion indemand

Q1 Q2 Quantity

D S2

PriceCU

P1

P2

0

D



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6 Elasticity

Section overview

Price elasticity of demand (PED) measures how far demand for a good will change in response to achange in its price.

The PED of a good is affected by: the availability of substitutes; time; pricing by competitors; whetherit is a necessity or a luxury; what percentage of income is spent on it; whether it is habit-forming.

Income elasticity of demand measures how far demand for a good will change in response to a changein income levels.

Some goods are cross-elastic, so there is a relationship between a change in price for one good and achange in demand for the other.

Price elasticity of supply measures how far supply of a good will change in response to a change in itsprice.

Definition

Elasticity: The extent of a change in demand and/or supply given a change in price.

6.1 Price elasticity of demand

If prices went up by 10% would the quantity demanded fall by 5%, 20%, 50% or what? Price elasticity ofdemand (PED) is a measure of the extent of change in demand for a good in response to a change in itsprice. It is measured as:

PED =Change in quantity demanded, as a percentage of original demand

Change in price, as a percentage of original price

Since demand usually increases when the price falls, and decreases when the price rises, elasticity usually hasa negative value. It is usual to ignore the minus sign, therefore, but note that there are types of goodswhere elasticity is actually positive (we shall come back to this).

PED =Proportional change in quantity

Proportional change in price

=-

2 1 2 1

1 1

Q Q P P÷

Q P

-

(Where P1, Q1 are the initial price and quantity; P2, Q2 are the subsequent price and quantity.)

PED less than 1 = inelastic demand

PED more than 1 = elastic demand

PED = 1 = unit elasticity

Worked example: Price elasticity of demand

The price of a good is CU1.20 per unit and annual demand is 800,000 units. Market research indicates thatan increase in price of 10 pence per unit will result in a fall in annual demand of 70,000 units.

Requirement

Calculate the elasticity of demand when the price is CU1.20.



Solution

At a price of CU1.20, annual demand is 800,000 units. For a price rise:

% change in quantity70,000

800,000 100% = 8.75% (fall)

% change in price10p

120p 100% = 8.33% (rise)

Price elasticity of demand at price CU1.20 =-8.75

8.33= – 1.05

Ignoring the minus sign, the price elasticity at this point is 1.05. Demand is elastic at this point, because theelasticity is greater than one.

Interactive question 5: Price elasticity of demand [Difficulty level: Exam standard]

Using the same details and assuming that the demand curve is a straight line, calculate the elasticity ofdemand when the price is CU1.30.




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6.2 Elastic and inelastic demand

The value of price elasticity of demand may be anything from zero to infinity. Demand is referred to as:

(a) Inelastic if the absolute value is less than 1, and(b) Elastic if the absolute value is greater than 1.

Think about what this means.

Where demand is inelastic, the quantity demanded changes by a smaller percentage than thepercentage change in price

Where demand is elastic, demand changes by a larger percentage than the percentage change in price

6.2.1 Special values of price elasticity of demand

There are three special values of price elasticity of demand: 0, 1 and infinity.

Demand is perfectly inelastic: PED = 0. There is no change in quantity demanded, regardless ofthe change in price. This is the case where the demand curve is a vertical straight line.

Demand is perfectly elastic: PED = (infinitely elastic). Consumers will want to buy an infiniteamount, but only up to a particular price level. Any price increase above this level will reduce demandto zero. This is the case where the demand curve is a horizontal straight line.

Unit elasticity of demand: PED = 1. The percentage change in quantity demanded is equal to thepercentage change in price. Demand changes proportionately to a price change.

6.3 What is the significance of price elasticity of demand?

The price elasticity of demand is relevant to total spending on a good or service, which in turn is a matterof interest to suppliers, to whom sales revenue accrues, and government, which may receive a proportionof total expenditure in the form of taxation.

When demand is elastic, an increase in price will result in a fall in the quantity demanded, and totalexpenditure will fall.

Demand inelasticity above zero means an increase in price will still result in a fall in quantitydemanded, but total expenditure will rise.

With unit elasticity, expenditure will stay constant given a change in price.

Information on price elasticity of demand therefore indicates how consumers can be expected to respondto different prices, so the effect of different prices on total revenue and profits can be predicted.

Interactive question 6: Effect of PED on revenue [Difficulty level: Exam standard]

Product A currently sells for CU5, and demand at this price is 1,700 units. If the price fell to CU4.60,demand would increase to 2,000 units.

Product B currently sells for CU8 and demand at this price is 9,500 units. If the price fell to CU7.50,demand would increase to 10,000 units.

In each of these cases, calculate:

(a) The price elasticity of demand (PED) for the price changes given; and

(b) The effect on total revenue, if demand is met in full at both the old and the new prices, of the changein price.




6.3.1 Positive price elasticities of demand: Giffen goods and Veblen goods

When the price of a good rises, there may be a substitution effect: consumers will buy other goodsinstead because they are now relatively cheaper. But there will also be an income effect in that the rise inprice will reduce consumers' real incomes, and will therefore affect their ability to buy goods and services.The 19th century economist Sir Robert Giffen observed that this income effect could be so great for certainbasic goods (called Giffen goods) that the demand curve may be upward sloping. The price elasticity ofdemand in such a case would be positive.

Giffen observed that among the labouring classes of his day, consumption of bread rose when its price rose.This happened because the increase in price of this commodity which made up a high proportion ofindividuals' consumption had a significant effect on real incomes: people had to increase their consumptionof bread because they could not afford other more expensive foods.

The demand curve for a good might also slope upwards if it is bought for purposes of ostentation, sothat having a higher price tag makes the good more desirable to consumers and thus increases demand.Such goods are sometimes called Veblen goods.

6.4 Factors influencing price elasticity of demand for a good

Factors that determine price elasticity of demand are similar to the factors – other than price – that affectthe volume of demand. The PED is really a measure of the strength of these other determinants ofdemand.

6.4.1 Availability of substitutes

The more substitutes there are for a good, especially close substitutes, the more elastic will be the priceelasticity of demand for the good. For example, in a supermarket, a rise in the price of one vegetable suchas carrots or cucumbers is likely to result in a switch of customer demand to other vegetables, manyvegetables being fairly close substitutes for each other. This factor is probably the most important influenceon price elasticity of demand.

6.4.2 The time horizon

Over time, consumers' demand patterns are likely to change, and so if the price of a good is increased, theinitial response might be very little change in demand (inelastic demand) but then as consumers adjust theirbuying habits in response to the price increase, demand might fall substantially. The time horizon influenceselasticity largely because the longer the period of time which we consider, the greater the knowledge ofsubstitution possibilities by consumers and the greater provision of substitutes by suppliers.

6.4.3 Competitors' pricing

If the response of competitors to a price increase by one business is to keep their prices unchanged, thesupplier raising its prices is likely to face elastic demand for its goods at higher prices. If the response ofcompetitors to a reduction in price by one supplier is to match the price reduction themselves, the supplieris likely to face inelastic demand at lower prices. This is a situation which probably faces many largesuppliers with one or two major competitors.

6.4.4 Luxuries and necessities

Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to bemore elastic.

6.4.5 Percentage of income spent on a good

The smaller the percentage of an individual's income spent on purchasing the good, the more inelasticdemand will be.

6.4.6 Habit-forming goods

Goods such as cigarettes and alcohol tend to be inelastic in demand. Preferences are such that habitualconsumers of certain products become desensitised to price changes.



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Interactive question 7: Demand for a good [Difficulty level: Exam standard]

Under a health strategy, the UK government wishes to increase the purchase of organic food by consumersby 3%. UK government economists have analysed data which reveal that the price elasticity of demand fororganic food is –1.6.

By how much should the government encourage suppliers to change the price of organic food, assuming allother determinants of demand remain the same?


6.5 Income elasticity of demand

Definition

Income elasticity of demand: An indication of the responsiveness of demand to changes in householdincomes.

Income elasticity of demand =% change in quantity demanded

% change in household incomes

Demand for a good is income elastic if income elasticity is greater than 1, so that quantity demandedrises by a larger percentage than the rise in income. For example, if the demand for CDs will rise by10% if household incomes rise by 7%, we would say that the demand for CDs is income elastic. Theseare normal goods.

Demand for a good is income inelastic if income elasticity is between 0 and 1 and the quantitydemanded rises less than the proportionate increase in income. For example, if the demand for bakedbeans will rise by 6% if household incomes rise by 10%, we would say that the demand for baked beansis income inelastic. These are inferior goods.

6.6 Cross elasticity of demand

Definition

Cross elasticity of demand: A measure of the responsiveness of demand for one good to changes in theprice of another good.

Cross elasticity of demand =% change in quantity of good A demanded*

% change in the price of goodB

*(given no change in the price of A)

Cross elasticity depends upon the degree to which goods are substitutes or complements.

If the two goods are substitutes, such as tea and coffee, cross elasticity will be positive, so a rise inthe price of one will increase the amount demanded of the other.

If the goods are complements, such as real coffee and cafetieres, cross elasticity will be negative, soa rise in the price of one will decrease demand for the other.

For unrelated goods, such as tea and oil, cross elasticity will be 0.



6.7 Price elasticity of supply

Definition

Price elasticity of supply: A measure of the responsiveness of supply to a change in price.

Price elasticity of supply (PES) =% change in quantity supplied

% change in price

Where the supply of goods is fixed whatever price is offered, for example in the case of antiques,vintage wines and land, supply is perfectly inelastic and the elasticity of supply is zero. The supplycurve is a vertical straight line.

Where the supply of goods varies proportionately with the price, there is unit elasticity of supplyand the supply curve is an upward slope passing through the origin.

Where the producers will supply any amount at a given price but none at all at a slightly lower price,elasticity of supply is infinite, or perfectly elastic. The supply curve is a horizontal straight line.

6.7.1 Elasticity of supply and time

As with elasticity of demand, the elasticity of supply for a product varies according to the time period overwhich it is measured. Three lengths of time period may be considered.

(a) The market period is so short that supplies of the product in question are limited to existinginventory. In effect, supply is fixed.

(b) The short run is a period long enough for supplies of the product to be altered by increases ordecreases in current output, but not long enough for the long-term plant and machinery used inproduction to be altered. This means that suppliers can produce larger quantities only if they are notalready operating at full capacity; they can reduce output fairly quickly by means of lay-offs andredundancies.

(c) The long run is a period sufficiently long to allow suppliers' long-term equipment to be altered.There is time to build new factories and machines, and time for old ones to be closed down. Newsuppliers can enter the industry in the long run.

7 Types of market structure

Section overview

The market for a good may be structured on the following lines: perfect competition; monopoly;monopolistic competition; oligopoly (including duopoly).

Definition

Market structure: A description of the number of buyers and sellers in a market for a particular good,and their relative bargaining power.



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7.1 Perfect competition

Perfect competition is characterised by:

Many small (in value) buyers and sellers which, individually, cannot influence the market price No barriers to entry or exit, so businesses are free to enter or leave the market as they wish Perfect information such that production methods and cost structures are identical Homogeneous (identical) products No collusion between buyers or sellers

The consequences of perfect competition include:

Suppliers are 'price takers' not 'price makers', that is they can sell as much as they want but only atthe market-determined price

All suppliers only earn 'normal' profits

There is a single selling price (see Figure 14.7)

Price

Quantity

Market price

CU

Figure 14.7: Perfect competition – demand curve

Perfect competition is often seen as an ideal state (for consumers) but very rarely if ever occurs in practice,mainly due to the fact that:

There are often barriers to entry There is asymmetric information (see Chapter 13 for an example of this in the financial markets) Goods are differentiated There may be collusion

We shall see more about these issues a little later.

7.2 Monopoly

Monopoly is characterised by:

One supplier (or one dominant supplier)

Many buyers

Barriers to entering the industry, for instance the capital cost of setting up a national grid of electricitywould be prohibitive for most businesses. Other barriers include:

– Patent protection– Access to unique resources– Unique talent– Public sector monopoly– Size domination of market



The consequences of monopoly include:

The fact that businesses can EITHER set the selling price OR determine the quantity supplied,but the market will determine the other factors

Monopolists can earn greater than normal profits ('supernormal profits')

Monopolies can be further classified as follows:

A pure monopoly is a monopoly by virtue of there being only one supplier in the market

An actual monopoly is a monopoly by virtue of there being one supplier with a dominant marketshare

A government franchise monopoly is a pure monopoly that has arisen specifically by virtue of agovernment deciding to operate in that way

A natural monopoly is a monopoly that arises by virtue of the market displaying such high levels offixed costs and low marginal costs (e.g. public utilities) that economies of scale are such that there isno fear of entry into the market from others

Monopolies are usually (but not always) seen as operating against the interests of consumers, so there isextensive regulation to control them (see Chapter 15).

7.3 Monopolistic competition

Monopolistic competition is characterised by:

Many buyers and sellers (as in perfect competition) Some differentiation between products (not homogeneous as in perfect competition) Branding of products to achieve this differentiation Some (but not total) customer loyalty Few barriers to entry Significant advertising in many cases

Examples include:

Pubs Hairdressers

Consequences include:

Increases in prices cause loss of some customers Only normal profit earned in the long run (as in perfect competition)

7.4 Oligopoly

Oligopoly is characterised by:

A few large sellers but many (often small) buyers Product differentiation A high degree of mutual interdependency

Examples include:

The oil industry (Shell, Esso, BP) Banking (Lloyds TSB, HSBC, Barclays) Washing powder (Procter & Gamble, Unilever)

Consequences include:

Businesses compete through non-price competition, particularly advertising and branding Price cuts are generally copied by competitors but Price increases are not always copied.



14

7.4.1 Duopoly

Duopoly is characterised by:

Two dominant suppliers who between them control prices

A temptation for the two suppliers to act in concert (which is an illegal breach of competition laws inmost countries)

Consequences include higher prices as competition is very limited.

8 The failure of perfect competition

Section overview

Free markets are often seen as efficient in resource allocation.

This efficiency may be: social, allocative, technical or productive.

However, markets can and do fail because of: market imperfections (monopoly, monopsony,asymmetric information, and slowness of response); externalities; public goods; economies of scale(internal and external).

Internal economies of scale arise from: specialisation of labour; division of labour; larger and morespecialised machinery; dimensions; buying economies; indivisibility of operations; holding inventory.

8.1 Is perfect competition (a free market) the best structure?

The following arguments are put forward by advocates of the free market.

Free markets are efficient. Suppliers and buyers react fairly quickly to changes in market conditions inmaking their output and purchasing decisions; resource allocation within the economy is quick toadapt to the new conditions.

Free markets are impersonal. Prices and levels of output are arrived at as a result of numerousdecisions by consumers and suppliers, and not as the result of regulation or central planning

The market forces of supply and demand result in an efficient allocation of economic resources.

– Buyers will want lower prices and suppliers will want higher prices, and a balance of supply anddemand is struck in the market through the price mechanism

– Suppliers will decide what goods to supply, and in what quantities, by relating their prices to thecosts of production (and the costs of the scarce resources needed to produce them)

– If the price of a product is too high, buyers will want to buy less of it. If the price is too low,producers will make less of it and switch their production resources into making somethingdifferent

In this context, there are four types of potential efficiency:

Social efficiency is achieved when, in taking decisions on what goods and services to produce, fullaccount is taken of all external costs and benefits (see the section on externalities below)

Allocative efficiency is achieved when goods and services that are wanted by buyers are producedat minimum cost. Allocative efficiency occurs when resources are allocated in such a way that it isimpossible to re-allocate factors of production to increase overall benefit

Technical efficiency is achieved when goods and services are produced using the minimum amountof resources

Productive efficiency is achieved when the economy produces its goods and services at the lowestfactor cost. It occurs when factors of production are organised in such a way that the average cost ofproduction is at its lowest point



However, the arguments in favour of a free market are based on the assumption that there is 'perfectcompetition', including:

A large number of competing suppliers, each producing a homogeneous product and eachhaving only a small share of the market

Buyers and suppliers having perfect information about markets and prices

There is perfect mobility of factors of production, which can be switched easily from making onetype of good into making another

There is free entry and exit of suppliers into and out of the market

In reality, these assumptions are often not valid. Instead, the free market often fails to allocateresources efficiently.

8.2 Market failure

Definition

Market failure: A situation in which a free market mechanism fails to produce the most efficient (the'optimum') allocation of resources.

Market failure is caused by a number of factors:

Market imperfection with one, or a few, suppliers exerting market power

Externalities

The existence of public goods and benefits that are gained by third parties

Economies of scale. Large-scale production leads to reductions in costs per unit, which are notmatched by price reductions. This leads to above-normal profits and enables large companies todominate smaller companies

8.3 Market imperfection

Market imperfection describes any situation where actual behaviour in the market differs from what itwould be if there were 'perfect' competition in the market. The following are examples of marketimperfection.

If a monopoly supplier controls a market, it might prevent other suppliers from entering the market(for example, by claiming patent rights, or launching a strong marketing campaign with the intention ofkeeping customers away from the new suppliers). By restricting supply in this way, the monopolist maykeep prices higher than they would be in a competitive market.

Just as monopolies are suppliers which dominate supply to a market, monopsony buyers are largeindividual buyers who dominate demand in a market. Monopsonists may exert control over themarket, extracting low prices or other favourable conditions from suppliers.

Consumers may make bad purchasing decisions because they have incomplete and inaccurate, orasymmetric information about all goods and services that are available.

It takes time for the price mechanism to work. Firms cannot suddenly enter a new market or shutdown operations. The slow response of the price mechanism to changes in demand createssome short-run inefficiency in resource allocation.



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8.4 Externalities

In a free market, suppliers and buyers make their output and buying decisions for their own private benefit,and these decisions determine how the national economy's scarce resources will be allocated to productionand consumption. Private costs and private benefits, as opposed to social costs and benefits, thereforedetermine what goods are made and bought in a free market.

Private cost measures the cost to the supplier of the resources it uses to produce a good

Private benefit measures the benefit obtained directly by a supplier or by a buyer

Social cost measures the cost to society as a whole of the resources that a supplier uses

Social benefit measures the total benefit obtained, both directly by a supplier or a buyer, andindirectly (at no extra cost), by other suppliers or buyers

It can be argued that a free market system would result in a satisfactory allocation of resources, providedthat private costs are the same as social costs and private benefits are the same as social benefits. In thissituation, suppliers will maximise profits by supplying goods and services that benefit customers, and thatcustomers want to buy. By producing their goods and services, suppliers are giving benefit to boththemselves and the community.

However, there are instances when either:

(a) Suppliers or buyers do things which give benefit to others, but no reward to themselves, or(b) Suppliers or buyers do things which are harmful to others, but at no cost to themselves

When private cost is not the same as social cost, or when private benefit is not the same as social benefit,an allocation of resources which reflects private costs and benefits only may not be socially acceptable.Here are some examples of situations where private cost and social cost differ.

A supplier produces a good and, during the production process, pollution is discharged into the air.The private cost to the supplier is the cost of the resources needed to make the good. The social costconsists of the private cost plus the additional 'costs' incurred by other members of society, whosuffer from the pollution.

The private cost of transporting goods by road is the cost to the haulage company of the resourcesused to provide the transport. The social cost would consist of the private cost plus the social cost ofenvironmental damage, including the extra cost of repairs and maintenance of the road system,which sustains serious damage from heavy goods vehicles.

Here are some examples of situations where private benefit and social benefit differ.

Customers at a café in a piazza benefit from the entertainment provided by professional musicians,who are hired by the café. The customers of the café are paying for the service in the prices they pay,and they obtain a private benefit from it. At the same time, other people in the piazza, who are notcustomers of the café, might stop and listen to the music. They will obtain a benefit, but at no cost tothemselves. They are free riders, taking advantage of the service without contributing to its cost. Thesocial benefit from the musicians' service is greater than the private benefit to the café's customers.

A large firm pays for the training of employees as accountants, expecting a certain proportion of theseemployees to leave the firm in search of a better job once they have qualified. The private benefits tothe firm are the benefits of the training of those employees who continue to work for it. The totalsocial benefit includes the enhanced economic output resulting from the training of those employeeswho go to work for other firms.



8.4.1 What is an externality?

Definition

Externality: The difference between the private and the social costs, or benefits, arising from an activity.Less formally, an 'externality' is a cost or benefit which the market mechanism fails to take into accountbecause the market responds to purely private signals. One activity might produce both harmful andbeneficial externalities.

Interactive question 8: Externality [Difficulty level: Exam standard]

Much Wapping is a small town where a municipal swimming pool and sports centre have just been built by aprivate company. Which of the following is an external benefit of the project?

(a) The increased trade for local shops(b) The increased traffic in the neighbourhood(c) The increased profits for the private company(d) The increased building on previously open land in an inner city area


8.5 Public goods

Some goods, by their very nature, involve so much 'spillover' of externalities that they are difficult toprovide except as public goods whose production is organised by the government.

In the case of public goods, the consumption or use of the good by one individual or group does notsignificantly reduce the amount available for others. Furthermore, it is often difficult or impossible toexclude anyone from its benefits, once the good has been provided. As a result, in a free market individualsbenefiting from the good would have no economic incentive to pay for it, since they might as well be 'freeriders' if they can, enjoying the good while others pay for it.

National defence is perhaps the most obvious example of public good. It is obviously not practicable forindividuals to buy their own defence systems. Policing is another example, although the growth of privatesecurity firms illustrates how some areas of policing are becoming 'privatised'.

8.6 Economies of scale

When large companies are able to produce goods at a low unit cost because of economies of scale, buteither do not pass these savings onto buyers, or use the advantage to dominate smaller companies, there isa market failure to allocate resources efficiently.

8.6.1 Reasons for economies of scale

The economies of scale attainable from large scale production may be categorised as:

(a) Internal economies: economies arising within the business from the organisation of production, or

(b) External economies: economies attainable by the business because of the growth of the industry asa whole

Internal economies of scale arise from the more effective use of available resources, and from increasedspecialisation, when production capacity is enlarged.



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Specialisation of labour. In a large undertaking, a highly skilled worker can be employed in a jobwhich makes full use of their skills. In a smaller undertaking, individuals must do a variety of tasks, noneof which they may do very well ('Jack-of-all-trades – master of none').

Division of labour. Because there is specialisation of labour there is also division of labour, i.e. workis divided between several specialists, each of whom contributes their share to the final product. Abuilding will be constructed, for example, by labourers, bricklayers, plumbers, electricians, plasterersand so on. Switching between tasks wastes time, and division of labour avoids this waste.

Large undertakings can make use of larger and more specialised machinery. If smallerundertakings tried to use similar machinery, the costs would be excessive because the machines wouldbecome obsolete before their physical life ends (i.e. their economic life would be shorter than theirphysical life). Obsolescence is caused by falling demand for the product made on the machine, or bythe development of newer and better machines.

Dimensional economies of scale refer to the relationship between the volume of output and thesize of equipment (e.g. storage tanks) needed to hold or process the output. The cost of a containerfor 10,000 gallons of product will be much less than ten times the cost of a container for just 1,000gallons.

Buying economies may be available, reducing the cost of material purchases through bulk purchasediscounts

Indivisibility of operations. There are operations which:

– Must be carried out at the same cost, regardless of whether the business is small or large;average fixed costs always decline as production increases

– Vary a little, but not proportionately, with size (i.e. 'semi-fixed' costs)

– Are not worth considering below a certain level of output (e.g. advertising campaigns)

Holding inventory becomes more efficient. The most economic quantities of inventory to holdincrease with the scale of operations, but at a lower proportionate rate of increase.

External economies of scale occur as an industry grows in size. For example:

A large skilled labour force is created and educational services can be geared towards training newentrants

Specialised ancillary industries develop to provide components, transport finished goods, trade inby-products, provide special services and so on – for instance, law firms may be set up to specialise inthe affairs of the industry

The extent to which both internal and external economies of scale can be achieved will vary from industryto industry, depending on the conditions in that industry. In other words, large-sized firms are better suitedto some industries than others.

Internal economies of scale are potentially more significant than external economies to a supplierof a product or service for which there is a large consumer market. It may be necessary for a supplierin such an industry to grow to a certain size in order to benefit fully from potential economies of scale,and thereby be cost-competitive and capable of making profits and surviving.

External economies of scale are potentially significant to smaller businesses which specialise inancillary services to a larger industry. For example, the development of a large world-wide industry indrilling for oil and natural gas off-shore led to the creation of many specialist suppliers, making drillingrigs and various types of equipment. Thus, a specialist business may benefit more from the marketdemand created by a large customer industry than from its own internal economies of scale.




Summary

Determinants

– Price

– Prices of othergoods

– Prices of goodsin ‘joint supply’

– Costs

– Technology

Macro economicenvironment of the business

Micro economicenvironment of the business

Market structure

OligopolyMonopolisticcompetition

MonopolyPerfect

competition

Efficiency inallocating resources

Market failure

Marketimperfections

Externalities

Public goods

Economiesof scale

The market mechanism

Supply Demand

Determinants

– Price

– Substitutes

– Complements

– Income levels

– Fashion/expectations

– Incomedistribution

Movementcurvealong

Shiftcurveof

Supply curve Demand curveEquilibrium (market) price (P)

P

Q

Elasticity

Price elasticityof supply

Income elasticityof demand

Price elasticityof demand

Influences Cross elasticity

Elastic InelasticUnit

Giffen Veblen



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Self-test


1 In terms of the economic environment, the business cycle is part of

A National influences in the macroeconomic environmentB Global influences in the macroeconomic environmentC The microeconomic environment of the firmD The price mechanism in the microeconomic environment of the firm

2 Which of the following are determinants of demand?

A PriceB Cost of productionC Income levelsD Changes in production technologyE Fashion

3 Grets and Pands are substitutes. Which of the following statements will be true?

A A rise in the price of Grets will lead to a rise in demand for PandsB A rise in the price of Pands will lead to a rise in demand for PandsC A fall in the price of Grets will lead to a rise in demand for PandsD A fall in the price of Pands will lead to a fall in demand for Pands

4 When demand for a good rises as incomes rise but then falls back as incomes pass a certain point, thegood is termed

A GiffenB NormalC InferiorD Veblen

5 A shift of the demand curve to the right could be caused by which of the following conditions?

A A rise in household incomeB A negative change in taste for the goodsC A fall in the price of a substituteD A rise in the price of a complement

6 When there is a fall in factor costs the effect will be

A To shift the supply curve to the right so the market price falls and demand risesB To shift the demand curve to the right so supply and the market price riseC To shift the demand curve to the left so supply and the market price fallD To shift the supply curve to the left so the market price rises and demand falls

7 When the government imposes a maximum price on a market, supply will be reduced

A AlwaysB If the maximum price is set above equilibriumC If the maximum price is set below equilibriumD Never

8 The price of a good is CU1.50 and annual demand is 50,000 units. Research has shown that droppingthe price to CU1.40 will increase demand by 5,000 units. What is the PED of the good at CU1.50?

A 0.10B 0.67C 1.50D 1.96



9 The price of Seagrims has fallen by 5% in the last month, and in the same period demand for Halcets,where there has been no price change, has risen by 8%. What is the cross price elasticity of demandbetween Seagrims and Halcets?

A –1.600B –0.625C 1.600D 0.025

10 The oil industry is an example of which kind of market structure?

A Perfect competitionB MonopolyC DuopolyD Oligopoly



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1 A

2 A, C, E

3 A

4 C

5 B

6 A

7 C

8 C (5,000/50,000)/(CU0.10/CU1.50)

9 A +0.08/-0.05

10 D





(a) Domestic freezers and perishable products are complements because people buy freezers to storeperishable products.

(b) Perishable products are supplied either as fresh produce (for example, fresh meat and freshvegetables) or as frozen produce, which can be kept for a short time in a refrigerator but for longer ina freezer. The demand for frozen produce will rise (the demand curve will move to the right), whilethe demand for fresh produce will fall (the demand curve will move to the left).

(c) Wider ownership of freezers is likely to increase bulk buying of perishable products. Suppliers can savesome packaging costs, and can therefore offer lower prices for bulk purchases.


Under assumption 1, the demand for swimming pools will be confined to household 1. Even if thishousehold owns three or four properties, the demand for swimming pools is likely to be less than underassumption 2, where potentially all five households might want one.


The supply of shares in a particular company is relatively static, although new shares will be issued fromtime to time. Demand for a company's shares will depend largely on how well the company is performing,although broader economic considerations are also influential. The price mechanism responds very rapidly –a share price may fluctuate up and down at very short intervals, often undergoing several changes in thecourse of a single day.


(a) A retail fruit and vegetable market

The market will probably consist of many small traders, each with their own stall and competing witheach other.

The supply conditions affecting prices are:

(i) Costs: the main cost to traders will be the cost of their own wholesale supplies, although therewill also be costs of renting a stall and costs of wages/labour. Even so, costs will be lower in amarket of this kind than in a shopping centre

(ii) The availability of stalls: the prices that traders can charge will depend to some extent on thenumber of stalls that there are and the ease with which new traders can acquire a stall and enterthe market.

The demand conditions affecting price are:

(i) The price of similar goods in shops

(ii) Shopping habits – for example whether householders are accustomed to buying their food frommarkets

(iii) The quality of the goods on the market and how they compare with similar goods in shops

(iv) How much money shoppers have to spend



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(b) An auction of antiques and paintings

The items up for auction will probably have a reserve price. Once the price bid during the auctionrises above the reserve price, the seller cannot supply more of the items. They can only sell the itemat whatever the maximum bid price happens to be.

The supply of items for auction is unlikely to be influenced by cost of the items. The factors which arerelevant to the supply decision are:

(i) The reserve price – the minimum price the supplier will accept

(ii) The expected price – the supplier might put an item up for auction in the expectation ofreceiving a certain price

(iii) Other circumstances (such as personal factors) influencing the supplier's decision to sell at all

The price obtained at an auction is mainly determined by demand. Factors influencing demand are:

(i) The number of potential customers at the auction and the amount of money they have to spend(ii) The investment value of the items(iii) The tastes of customers and the artistic value they perceive in the items up for sale(iv) The price of similar items at recent auctions elsewhere

Broadly speaking, it could be argued that prices in a retail fruit and vegetable market are influenced mainlyby costs (wholesale prices), while in an auction of antiques and paintings the main factor influencing pricewill be demand. Different conditions have varying degrees of importance between one type of market andanother.


We can use the same price/quantity change data, assuming that the demand curve is a straight line, althoughwe are now looking at a different point on the curve.

At a price of CU1.30, annual demand is 730,000 units.

For a price fall from CU1.30 of 10 pence:

% change in demand70,000

730,000 100% = 9.59% (rise)

% change in price10p

130p 100% = 7.69% (fall)

Price elasticity of demand =9.59

-7.69= – 1.25,

or 1.25 ignoring the minus sign.

Demand is even more elastic at this point than it was at CU1.20.




(a) Product A

At price CU5:

Change in quantity300

=17.6%1,700

Change in price -40p

= 8%£5

17.6%PED = = -2.2

-8%

Demand is elastic and a fall in price should result in such a large increase in quantity demanded thattotal revenue will rise.

CURevenue at old price of CU5 1,700 (8,500)

Revenue at new price of CU4.60 2,000 9,200Increase in total revenue 700

(b) Product B

At price CU8:

500Change in quantity = 5.3%

9,500

-50pChange in price = -6.25%

£8

5.3%PED = = - 0.85

-6.25%

Demand is inelastic and a fall in price should result in only a relatively small increase in quantitydemanded. Total revenue falls.

CURevenue at old price of CU8 ( 9,500) (76,000)

Revenue at new price of CU7.50 ( 10,000) 75,000Fall in total revenue ( 1,000)


As demand for organic food is elastic, the government can expect a strong response to a reduction in price,that is an expansion of demand down the demand curve as the price drops. This can be calculated asfollows:

Target increase in demand: 0.03PED: –1.6

Percentage change in price needed to achieve target increase: 0.03/1.6 100% = 1.875%


Item (b) is an external cost of the project, since increased volumes of traffic are harmful to theenvironment. Item (c) is a private benefit for the private company which built the complex. Item (d) wouldonly be an external benefit if a building is better for the people in the inner city area than the use of openland, which is unlikely. Item (a) is correct because the benefits to local shops are additional to the privatebenefits of the sports firm and as such are external benefits.


Contents

chapter 15

External regulation ofbusiness

Introduction

Examination context

Topic List

1 Why is regulation of businesses necessary?

2 What form does the regulation of businesstake?

3 Direct regulation of the level of competition ina market

4 Direct regulation of externalities

5 Direct regulation of people in business

6 The effect of international legislation

7 The US Sarbanes-Oxley Act 2002

8 International regulation of trade

9 Free trade agreements






Introduction


Specify the principal effects of regulation upon businesses

Show how the needs of different stakeholders in a business (e.g. shareholders, the localcommunity, employees, suppliers, customers) impact upon it

Specify the effects of key international legislation (including the Sarbanes-Oxley Act 2002 andtrade restrictions) on businesses

Specific syllabus references are: 6c, d, e.


For many people working in business, the practical reality is that there is a great deal of regulation of theiractivities, which imposes a burden from which they feel little benefit.

Stop and think

Why are businesses regulated so much and what is regulation intended to achieve? What does it actuallyachieve? How are Bangladesh businesses affected by international regulation?

Working context

You may find yourself on an engagement where one of the key risks is that the company fails to complywith, or even fails to be aware of, regulations that affect it.

Syllabus links

Regulation is developed further as a topic in Business Strategy and at Advanced stage.

EXTERNAL REGULATION OF BUSINESS


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Examination context


You will almost certainly encounter a question on business regulation in your exam.

Exam requirements

Exam questions are likely to be set in a scenario context, though knowledge-type questions on key pointsand principles are also possible.



1 Why is regulation of businesses necessary?

Section overview

Regulation of businesses addresses market failure and protects the public interest.

Governments intervene in markets to address market failure caused by market imperfection,externalities, asymmetric information and lack of equity.

Regulation also aims to protect the public interest of employees, suppliers, customers, the localcommunity and the public at large from the self-interest of shareholders, directors and managers.

Effect of regulation: facilitation of competition; protection of public from abuse of power; flexibility;fair enforcement; transparency.

Forms of regulation: legislation/delegated legislation; self-regulation plus oversight; a combination.

Regulation of business is needed:

To address market failure and externalities To protect the public interest

Definition

Regulation: Any form of state interference with the operation of the free market. This could involveregulating demand, supply, price, profit, quantity, quality, entry, exit, information, technology, or any otheraspect of production and consumption in the market.

1.1 Addressing market failure

As we saw in Chapter 14, market failure is said to occur when the market mechanism fails to result ineconomic efficiency, so the outcome in terms of allocation of resources is sub-optimal.

Government often seeks to intervene in the case of market failure, and has several alternative ways of doing so:

Providing public goods such as street lighting

Providing merit goods such as education which are in the long-term interests of society

Controlling the means of production through state ownership of industries

Re-distributing wealth through the system for direct taxation of income

Creating demand for output that creates jobs, such as defence contracts or major public workssuch as road-building

Influencing supply and demand through:

– Price regulation (minimum or maximum prices)

– Indirect taxation on expenditure on some goods and services, so that supply is restricted asthe price to consumers includes the tax but suppliers only receive the net-of-tax price (thesupply curve shifts to the left)

– Subsidies paid by the government to suppliers (shifting the supply curve to the right), in order:

– To encourage more production

– To keep prices lower for socially desirable goods whose production the government wishesto encourage

– To protect a vital industry such as agriculture



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Influencing markets through persuasion

Regulating markets through legislation and other means

In this chapter we shall be concentrating on legislation and regulation of markets.

Of the various forms of market failure, the following are the cases where regulation of markets can often bethe most appropriate policy response.

Market imperfection – where monopoly power is leading to inefficiency, government will intervenethrough controls on, say, prices or profits in order to try to reduce the effects of the monopoly

Externalities – a possible means of dealing with the problem of external costs and benefits is viasome form of regulation. Regulations might include, for example, controls on emissions of pollutants,restrictions on car use in urban areas, the banning of smoking, compulsory car insurance andcompulsory education

Asymmetric information – regulation is often the best form of government action wheneverinformational inadequacies are undermining the efficient operation of markets. This is particularly sowhen consumer choice is being distorted. Examples here would include, regulation of financialreporting, legally enforced product quality/safety standards, consumer protection legislation, theprovision of job centres and other means of improving information flows in the labour market and soon

Equity – the government may resort to regulation to improve social justice. For example, legislationto prevent racial and/or sexual discrimination in the labour market; regulation to ensure equal accessto goods such as health care, education and housing; minimum wage regulations and equal paylegislation

We shall come back to regulations with respect to market imperfection and externalities shortly.

1.2 Protecting the public interest

Just as regulation of the accountancy profession is needed to provide the public interest with protectionand assurance, so too with businesses, which are the source of most wealth creation and economic power,but which are focused as we have seen on meeting the interests of:

Shareholders Directors and managers

External regulations on businesses of many different forms are designed to ensure that the needs of theother stakeholders can be met.

1.3 Functions of the regulation of business

Business regulation has the same aims as regulation of the accountancy profession, which we saw inChapter 11.

People find it difficult to trust business entities that exist to make profits for the benefit of one very selectgroup of people, the shareholders. Experience has taught society that this objective has historically beenpursued at the expense of the public interest, so society has increasingly demanded that business activitiesshould be externally regulated, to restore the balance of power.



2 What form does the regulation of businesses take?

Section overview

Business is subject to a great deal of formal legislation/regulation from Parliament, RJSC, SEC andother statutory bodies.

Regulation is efficient where the total benefits to some people outweigh the total costs to others.

Outcomes of regulation: market failures are addressed; social standing of some groups is enhanced;the collective desires of society are enacted; particular preferences in society are developed;irreversibility is dealt with.

Business responses to regulation: non-response; mere compliance; full compliance; innovation (thePorter hypothesis).

2.1 What is the legal meaning of regulation?

In a legal sense, a regulation is a rule created by the government, an administrative agency or anotherbody which interprets a statute, or the circumstances of applying the statute. It is a form of secondary ordelegated legislation which is used:

To implement a primary piece of legislation appropriately

To take account of particular circumstances or factors emerging during the gradual implementation of,or during the period of, a primary piece of legislation

Regulations may also take the form of statutory instruments, statutory orders, by-laws and rules.

2.2 Bangladesh regulation

Bangladesh businesses are subject to regulations imposed by Bangladesh parliament. This takes a variety offorms: Regulations are equivalent to Acts of Parliament. They have a general scope, and are obligatory in all

their elements and directly applicable in different businesses in Bangladesh. Any business’s own lawscontrary to the Regulation are overruled by parliament Regulations. A company’s memorandum andarticles of association must be consistent with the requirements of parliament Regulations.

Notifications/ Circulars/ Decisions are addressed to certain entities or individuals which areimmediately bound by them.

2.3 What is efficient regulation?

Regulation has costs for some and benefits for others. Efficient regulation exists where the total benefitsto some people exceed the total costs to others.



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2.4 Outcomes of regulation

Regulation is justified using various reasons and therefore can be classified in several broad categoriesaccording to its intended outcome. Regulations may be put in place to:

Address market failures (see above)

Increase or reduce the social standing of various social groups

See through the collective desires of a significant section of society

Enhance opportunities for the formation of diverse preferences and beliefs in society

Affect the development of particular preferences across society as a whole

Deal with the problem of irreversibility (current activities will result in outcomes from which futuregenerations may not recover at all)

Interactive question 1: Irreversibility [Difficulty level: Intermediate]

Try to think of at least two ways in which regulations of which you are aware from your general businessknowledge seek to deal with the problem of irreversibility.


2.5 How do businesses respond to regulation?

Businesses can respond in a variety of ways to regulation:

Entrenchment of a particular practice (nil or non-response)

Mere compliance, so that the desired regulatory outcome is met simply by passing on the cost ofcompliance to clients and consumers

Full compliance, so that behaviour is changed and products and processes are adjusted to complywith regulations

Innovation: the Porter hypothesis (see below)

We shall deal with compliance in the next section of this chapter.

2.5.1 The Porter hypothesis

The economist Michael Porter formulated the hypothesis that strict environmental regulations trigger thediscovery and introduction of cleaner technologies and environmental improvements, the innovationeffect. This makes production processes and products more efficient, and the cost savings achieved aresufficient to compensate for both the compliance costs directly attributed to new regulations and theinnovation costs. Overall therefore commercial competitiveness is improved.

2.6 What is compliance?

Definition

Regulatory compliance: Systems or departments in businesses which ensure that people are aware ofand take steps to comply with relevant laws and regulations.



Interactive question 2: Compliance in banks [Difficulty level: Intermediate]

Try to identify what types of regulation are monitored by the compliance sections of a bank.


2.7 The role of regulatory bodies

There is a considerable level of business regulation in Bangladesh, and there are a great many regulatorybodies which oversee and enforce these regulations. Examples include the RJSC, SEC and the BangladeshBank, which we saw in Chapter 11, plus:

The Department of Environment , which oversees regulation relating to the physical and naturalenvironment

The Information Commissioner, who is responsible for enforcing rules brought in by Freedom ofInformation Act 2008

The Controller of Insurance

3 Direct regulation of the level of competition in amarket

Section overview

The level of competition in a market is regulated because the closer a market gets to perfectcompetition, the more efficient the allocation of resources in that market.

Anti-competitive agreements and the abuse of a dominant position are prohibited.

Anti-competitive agreements result from collusion between 'competitors' in the same market, andresult in price fixing, production limitation, sharing markets, and different trading conditions andsupplementary obligations for consumers.

A dominant position arises where one business is able to behave independently of competitivepressures. As a result it may: impose unfair prices; limit developments; apply different tradingconditions and supplementary obligations on consumers. A business will not be considered dominantunless it controls 40% of the market.

A cartel of businesses is involved in collusion on prices, discounts, production etc.

A business that is party to an anti-competitive agreement or a cartel or that abuses a dominantposition may be fined. Cartels may lead to criminal sanctions.

Regulation of competition is effected by the tort law of Bangladesh.

3.1 Why is the regulation of competition important?

In a market economy the allocation of resources is generally determined by the price mechanism. InChapter 14 we saw that the uninhibited and rather idealised operation of the price mechanism is calledperfect competition, but we also saw that there are plenty of circumstances where competition is farfrom perfect, and conditions exist for monopolies to take over.



15

Generally monopolies are not in the public interest as they do not allocate resourcesefficiently. The government seeks to diminish them by fragmenting an industry via different legislation, sothat market share is not concentrated in the hands of one or two producers. The same effect is alsoachieved indirectly sometimes, for instance in the case of new pharmaceutical products, where stringenttesting and government approval are required before they can be marketed.

3.2 Prohibiting anti-competitive agreements

Both informal and formal agreements, whether or not they are in writing, are prohibited if they areagreements resulting from collusion between businesses that have as their object or effect the prevention,restriction or distortion of competition. Many different types of agreement may fall within the prohibitions:

Fixing purchase or selling prices or other trading conditions

Agreeing to limit or control production, markets, technical development or investment

Sharing markets or supply sources

Applying different trading conditions to equivalent transactions, thereby placing some parties at acompetitive disadvantage

Making conclusion of contracts subject to acceptance of supplementary obligations

Market conditions that lead to increased collusive behaviour are covered under the section on cartelsbelow.

3.3 Prohibiting cartels

Definition

Cartel: An agreement between businesses not to compete with each other. The agreement is usuallyverbal and often informal.

Cartel members typically agree or collude on:

Prices Output levels Discounts Credit terms Technology Which customers they will supply Which areas they will supply Who should win a contract (bid rigging).

Cartels can occur in almost any industry and can involve goods or services at the manufacturing,distribution or retail level. Some sectors are more susceptible to cartels than others because of theirstructure or operations. Cartels or collusive behaviour in general are more likely to occur in industries orsectors where:

There are few competitors

The products have similar characteristics, leaving little scope for competition on quality, service, orcost

Communication channels between competitors are already established



The industry is suffering from excess capacity

There is general economic recession

A business that is found to be a member of a cartel can be penalised. In addition, participation inagreements between undertakings at the same level in the supply chain (horizontal agreements) may exposeindividuals responsible for those agreements to criminal sanctions.

4 Direct regulation of externalities

Section overview

Externalities (external costs and benefits) are regulated by a variety of methods designed ultimately toaffect the level of supply: price regulation; direct taxation or tariffs; subsidies to suppliers; quotas,standards and fines.

To intervene in the level of supply in a market where there are problems of external costs and benefits,such as pollution, the government can use:

Price regulations (setting maximum or minimum selling prices, as we saw in Chapter 14)

Direct or indirect taxation or tariffs

Subsidies to suppliers, for instance to encourage exports

Regulation, by means of:

– Quotas, that is physical limits on output so that output is set at the social optimum– Standards that must be complied with– Fines for those businesses that do not meet the necessary standards

Worked example: Regulation of pollution by tradeable permits

Many businesses are set standards for pollution control and quotas for emissions (which may be boughtand sold on the tradable permits market), plus they may be fined if they create unacceptable levels ofpollution. It is hard however to preset pollution fines and output quotas without having accurate andreliable estimates for private benefits, private costs and external environmental damage arising frompollution. In addition, compliance with environmental regulations is costly to enforce, and it may beimpossible to monitor all businesses accurately because of imperfect information. Finally, setting the levelsof the fines can be difficult: some businesses may not cut their emissions of pollutants if the fine they receiveis less than the private benefit they derive from polluting. Fines must have some impact, which is perhapsbest determined by setting them as a percentage of revenue or gross profit.

5 Direct regulation of people in business

Section overview

Directors and other people engaged directly in managing companies are subject to direct regulation:

– To prevent insider trading and market abuse, if the company’s shares are listed.– To prevent fraudulent and wrongful trading, if the company is insolvent.



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It is not only businesses as entities that are subject to regulation. Individuals too are regulated in the waythey manage and deal with listed and insolvent businesses, in order to protect the public and the interestsof company creditors.

5.1 Insider trading of a listed company’s shares

People ‘in the know’ commit a crime under the SEC Act 1993 if they use knowledge they have as business‘insiders’ to make a profit or avoid a loss when buying or selling shares on the back of that knowledgeand at the expense of open dealings in the market. Significant inside knowledge – of a takeover, an oil strikeor a massive fall in profits – will affect the share price when it becomes known, so it is not right thatinsiders should benefit from dealing in advance of the knowledge becoming generally known. The crime ofinsider trading (or dealing) extends to getting someone else to deal, and to disclosing the relevantinformation at all.

5.2 Market abuse

People engaged in the stock market are expected to observe the standard of behaviour that isreasonably expected of such a person, and if they fail to do so they may be fined and even imprisoned for‘market abuse’. The types of behaviour that are covered by these rules include:

Misusing information as an insider

Distorting market prices

Creating a false or misleading impression about supply, demand, prices and values in the market

Recklessly making misleading, false or deceptive statements

Undertaking a misleading course of conduct to induce another person to act in a particular way inthe market

5.3 Fraudulent trading of an insolvent company

Directors of companies must be very careful of the danger of trading when the company is insolvent – thatis, when the company cannot pay its debts as they fall due. If a company that is being liquidated asinsolvent is found to have been carried on with the intent to defraud creditors, or indeed for anyfraudulent purpose, directors and managers who were knowingly party to this are said to have engagedin fraudulent trading, and be personally liable for the company’s debts under the Insolvency Act 1997.They may also face criminal sanctions. A business may be carried on fraudulently just by making onetransaction or by paying off debts rather than making trading contracts.

5.4 Wrongful trading of an insolvent company

Even if there is no fraud involved, a director engaged in wrongful trading may still be required by aliquidator to make a contribution to an insolvent company’s assets under the Insolvency Act 1997. This mayarise where the director knew, or should have known, that there was no reasonable prospect of thecompany avoiding insolvent liquidation, or where the director took insufficient steps to minimisethe potential loss to creditors. Chartered accountants are more at risk of falling foul of these rules thananyone else, as their skills, knowledge and experience mean they are judged by higher standards thanthose applied to non-professionals. This is true even if they are accountants employed as sales or marketingdirectors, for instance, rather than as finance directors.



6 The effect of international legislation

Section overview

International legislation regulates some markets more than others; the effect is generally not global.

International legislation for the regulation of business is driven to a great extent by: internationalbodies (WTO, UN, IMF, ICC, SAARC); governments (especially the US, regional trade groups such asEU, SAFTA and NAFTA); businesses (especially US corporations).

Braithwaite and Drahos, in their book Global Business Regulation, discuss the way that the development ofglobally effective regulation has taken place. They argue that, while laws are passed by national legislatures,the rules they embody are actually created by discussion, negotiation and agreement among a variety ofexpert bodies including states, corporations and international bodies.

The emergence of global regulation does not necessarily happen at the same time as the globalisation ofeither markets or business organisations. Gambling, for example, via the internet, is a global market, but it isregulated in different ways by different states. By contrast, regulations relating to prescription drugs arenow largely global in effect, but national markets are kept isolated from one another by differences ingovernment policy on medicine as a welfare benefit.

The processes that result in developments in global regulation are complex and vary from industry toindustry. But some common features emerge.

The US has huge influence over the globalisation of regulation; the EU is beginning to have similarinfluence. Among individual countries, the UK is second to the US in influence

International organisations such as the World Trade Organisation (WTO), International MonetaryFund (IMF) and International Chamber of Commerce (ICC) also have extensive power to influence thedevelopment of regulations

US corporations are very effective at enrolling the power of their own government andinternational bodies to promote their interests

Regulation has great potential both to further and to frustrate business plans. The adoption of onecompany's patented technology as a global standard confers huge benefit; conversely, regulations relating topollution or working conditions have great potential to drive up costs. It is therefore in the interests ofbusinesses to remain alert to the general thrust of regulation as it affects their industries, and toparticipate in the processes of lobbying and representation that underpin it.

It follows therefore that we should look at the US Sarbanes-Oxley Act 2002, an extreme form of stateregulation which affects many areas in which accountants are involved.

7 The US Sarbanes-Oxley Act 2002

Section overview

The Sarbanes-Oxley Act 2002 is a piece of US legislation that has had a global reach. It directly affectsUK companies that have parent companies with a US listing.

Under Sarbox: the CEO and CFO have explicit responsibility for financial reports; an internal controlreport must accompany annual financial statements; material changes in fortunes must be disclosed ona real-time basis; attempts and conspiracies to commit fraud via document tampering are criminaloffences; the US Public Oversight Board regulates the accountancy and audit profession.

7.1 Why was the Sarbanes-Oxley Act passed?

Corporate scandals such as Enron and WorldCom in the US prompted very significant concerns aboutcorporate responsibility, internal controls, financial reporting, external audit and the prevention of fraud.



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Following this, the Sarbanes-Oxley Act 2002 (Sarbox) was passed, which directly regulates public companieslisted on US stock exchanges.

It was the Enron scandal in particular that prompted the biggest financial reporting provision in Sarbox,namely that companies affected by the Act must establish and maintain accounting procedures that controlcreative accounting, in particular that material off-balance sheet transactions and other relationshipsshould be appropriately disclosed. This requirement, and the complexity of off-balance sheet transactions,has pushed international accounting standards further towards a principles-based approach to financialreporting.

7.2 The effect of Sarbox on UK companies

The Act has no direct effect on companies incorporated and listed in the UK unless they are part of acompany which is listed on a US stock exchange. If this is the case – as it is for many UK companies – thenUK companies too face the task of ensuring their accounting operations comply with the Act. This usuallyinvolves:

A comprehensive external audit by a Sarbox compliance specialist to identify areas of risk, then

The installation of specialised software to provide the 'electronic paper trails' necessary to ensureSarbox compliance.

Although its direct effect in the UK may be limited, Sarbox is a very influential piece of internationalregulation as it demonstrates the 'tightening up' of regulation that occurs when business loses the trust ofthe public. We shall therefore look at some of Sarbox's major provisions.

7.3 Corporate responsibility for financial reports (s302)

The Chief Executive Officer (CEO) and the Chief Financial Officer (CFO):

Must review all financial reports and sign a personal certificate that:

– They do not contain any misrepresentations– Information in the financial report is 'fairly presented'

Are responsible for the internal financial controls

Must report any deficiencies in internal accounting controls, or any fraud involvingmanagement, to the board, audit committee and external auditors

Must indicate any material changes in internal accounting controls

Submission of an inaccurate certification may lead to a fine on the CEO or CFO of up to $5 million plus aprison term of up to 20 years.

7.4 Management assessment of internal controls (s404)

All annual financial reports must include an internal control report. This must:

State that management is responsible for an 'adequate' internal control structure State management's assessment of the effectiveness of the control structure Report any shortcomings in these controls

In addition, external auditors must attest to the accuracy of the company management's assertion thatinternal accounting controls are in place, operational and effective.

7.5 Real time issuer disclosures (s409)

Companies are required to disclose on an almost real-time basis information concerning material changes intheir financial condition or operations.



7.6 Attempts and conspiracies to commit fraud (s902)

In the US it is a crime for any person corruptly to alter, destroy, mutilate, or conceal any document withthe intent of impairing the document's integrity or availability for use in an official proceeding.

7.7 Accounting and audit firms, and whistleblowing

Other sections of Sarbox make the following wide-ranging provisions.

The Public Oversight Board registers and regulates accounting firms in the US.

Audit firms in the US should retain working papers for several years, have quality controlstandards in place, and perform an audit review of each client's internal control systems to ensurethat they reflect the transactions of the client and provide reasonable assurance that thetransactions are recorded in a manner that will permit preparation of the financial statements.

Auditors in the US are expressly prohibited from carrying out a number of services for their auditclient including bookkeeping, systems design and implementation, appraisal or valuation services,actuarial services, management functions and human resources, investment management, legal andexpert services. Provision of other non-audit services is only allowed with the prior approval ofthe audit committee.

There should be rotation of lead or reviewing audit partners every five years.

Auditors should discuss critical accounting policies and possible alternative treatments withthe audit committee.

All members of audit committees should be independent. At least one member should be afinancial expert. Audit committees should be responsible for the appointment, compensationand oversight of auditors. Audit committees should establish mechanisms for dealing withcomplaints about accounting, internal controls and audit.

Employees of listed companies and auditors are granted whistleblower protection against theiremployers if they disclose private employer information to parties involved in a fraud claim.

Interactive question 3: Effect of Sarbox [Difficulty level: Intermediate]

Compliance with Sarbox provisions can be very costly. What effect is Sarbox likely to have on a UKcompany considering a stock market listing in the US?


8 International regulation of trade

Section overview

The benefits of industrialisation have been sought by most economies via either import substitutionor exports.

International free trade supports the efficient allocation of resources in the world by encouraging:specialisation; evening out of surpluses and deficits of resources; competition; economies of scale;closer political links.

Barriers to free international trade (protectionism) are formed by: tariffs; customs duties; quotas onimports; embargoes; hidden subsidies; import restrictions; exchange rate manipulation.



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8.1 What are the economic advantages of international free trade?

The doctrine of comparative advantage states that countries should stick to what they are best at,which may suggest preserving the status quo. Nevertheless the benefits of industrialisation have been soughtby many nations via two main routes.

Import substitution: a country aims to produce manufactured goods which it previously imported.It does this by protecting local producers

Export-led growth: relying on cheap labour, businesses ensure economic growth by exporting. Thesuccess of this particular strategy depends on the existence of open markets elsewhere

Although export-led growth has meant that global trade has opened up, the existence of global free tradeand markets should not be taken for granted in terms of all products and services, or indeed in allterritories. Services in particular are still subject to managed trade (for example, some countries prohibitforeign firms from selling insurance) and there are some services which by their very nature can never beexported (e.g. hairdressing).

Encouraging international free trade has the following advantages.

Countries specialise in items they produce comparatively most efficiently so resources are allocatedefficiently.

Some countries have a surplus of raw materials to their needs, and others have a deficit. A countrywith a surplus (e.g. of oil) can take advantage of its resources to export them. A country with a deficitof a raw material must either import it, or accept restrictions on its economic prosperity and standardof living.

Competition is increased among suppliers in the world's markets. Greater competition reduces thelikelihood of a market for a good in a country being dominated by a monopolist, and will forcebusinesses to be competitive and efficient, producing goods of a high quality.

Larger markets are created for a business's output, and so some businesses can benefit fromeconomies of scale by engaging in export activities. Economies of scale improve the efficiency of theuse of resources, reduce output costs and also increase the likelihood of output being sold to theconsumer at lower prices than if international trade did not exist.

The development of trading links provides a foundation for closer political links. An example ofthe development of political links based on trade is the EU.

Note, however that high transport costs can negate the advantages of specialisation and international trade.

8.2 Barriers to free international trade

In practice many barriers to free trade exist because governments try to protect home industries againstforeign competition. This 'protectionism' can be practised by a government in several ways:

Tariffs or customs duties Import quotas Embargoes (bans on certain imports or exports) Hidden subsidies for exporters and domestic producers Import restrictions Government action to devalue the nation's currency (reduce its foreign exchange value)

8.2.1 Tariffs or customs duties

Tariffs or customs duties are taxes on imported goods. The effect of a tariff or duty is to raise the pricepaid for the imported goods by domestic consumers, while leaving the price paid to foreign producers thesame, or even lower. The difference is transferred to the government sector.

An ad valorem tariff is one which is applied as a percentage of the value of goods imported. A specific tariff isa fixed tax per unit of goods.



8.2.2 Import quotas and embargoes

Import quotas are restrictions on the quantity of a product that is allowed to be imported into thecountry. The quota has a similar effect on consumer welfare to that of import tariffs, but the overall effectsare more complicated.

Both domestic and foreign suppliers enjoy a higher price, while consumers buy lower quantities at thehigher price

Domestic producers supply more

There are fewer imports (in volume)

The government collects no revenue

An embargo on imports from one particular country is a total ban, i.e. effectively a zero quota.

8.2.3 Hidden subsidies and import restrictions

An enormous range of government subsidies and assistance for exports, and deterrents against imports,have been practised.

For exports – export credit guarantees (insurance against bad debts for overseas sales), financial help(such as government grants to the aircraft or shipbuilding industry) and administrative assistance

For imports – complex import regulations and documentation, or special safety standards demandedon imported goods and so on

When a government gives grants to its domestic producers, for example regional development grants fornew investments in certain areas of the country or grants to investments in new industries, the effect ofthese grants is to make unit production costs lower. These give the domestic producer a cost advantageover foreign producers in export markets as well as domestic markets.

8.3 Arguments in favour of protectionist measures

'Protectionist measures taken against imports of cheap goods that compete withhigher-priced domestically produced goods, preserve output and employment indomestic industries.'

In the UK, advocates of protection have argued that UK industries are declining because ofcompetition from overseas, especially Asia, and the advantages of more employment at a reasonablyhigh wage for UK labour are greater than the disadvantages that protectionist measures would bring.

'Protectionist measures might be necessary, to counter 'dumping' of surplus productionby other countries at an uneconomically low price.'

For example, if the European Union (EU) were to over-produce quantities of steel, wine, beef orbutter, it might decide to dump the surpluses on other countries. The 'losses' from overproductionwould in effect be subsidised by the EU governments, and the domestic industries of countriesreceiving dumped goods would be facing unfair competition from abroad. Although dumping hasshort-term benefits for the countries receiving the cheap goods, the longer-term consequences are areduction in domestic output and employment, even when domestic industries in the longer termmight be more efficient.

'Protectionist measures by one country are often implemented in retaliation againstmeasures taken by another country that are thought to be unfair.'

This is why protection tends to spiral once it has begun. Any country that does not take protectionistmeasures when other countries are doing so is likely to find that it suffers all of the disadvantages, andnone of the advantages, of protection.

'Protectionism is necessary, at least in the short term, to protect a country's 'infantindustries' that have not yet developed to the size where they can compete ininternational markets.'



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Less developed countries in particular might need to protect industries against competition fromadvanced or developing countries.

'Protection helps a country in the short term to deal with the problems of a decliningindustry.'

Without protection, the industry might quickly collapse and there would be severe problems ofsudden mass unemployment amongst workers in the industry – workers who must somehow bechannelled into other industries. By imposing some protectionist measures, the decline in the industrymight be slowed down, and so the task of switching resources to new industries could be undertakenover a longer period of time.

'Protection is a means for a country to reduce its balance of trade deficit, by imposingtariffs or quotas on imports.'

However, because of retaliation by other countries, the success of such measures by one countrywould depend on the demand by other countries for its exports being inelastic with regard to priceand its demand for imports being fairly elastic.

8.4 Arguments against protectionist measures

Because protectionist measures taken by one country will almost inevitably provoke retaliation byothers, protection will reduce the volume of international trade. This means that the benefits ofinternational trade will be reduced.

Because of retaliation by other countries, protectionist measures to reverse a balance of tradedeficit are unlikely to succeed. Imports might be reduced, but so too would exports.

Widespread protection will damage the prospects for economic growth amongst the countriesof the world, and protectionist measures ought to be restricted to 'special cases' which might bediscussed and negotiated with other countries.

Protection creates political ill-will amongst countries of the world and so there are politicaldisadvantages in a policy of protection.

As an alternative to protection, a country can try to stimulate its export competitiveness by making effortsto improve the productivity and lower the costs of domestic industries, thus making them morecompetitive against foreign producers.

9 Free trade agreements

Section overview

Free trade is supported by agreements promoted by the WTO.

Regional trading organisations such as the EU, SAFTA and NAFTA form trading blocs withininternational trade.

Free international trade continues to be limited, because of: concentration of political and economicpower in the US; international laws; exchange rate management; collusion between states; politicalregimes; political instability.

Since the Second World War in particular, great efforts have been made across the world to support freetrade and avoid the damaging effects of protectionism. The WTO and regional trading organisations are ofparticular importance.

9.1 The World Trade Organisation (WTO)

The WTO was formed in 1995 as successor to the General Agreement on Tariffs and Trade (GATT),which was itself set up in 1947. The WTO is an organisation that devotes itself to international trade in



goods, services, traded inventions, creations and intellectual property. It is also involved in disputesettlement issues.

The WTO represents nearly 97% of international trade. It seeks to promote the free flow of trade byremoving obstacles to trade. It does this by:

Administering the WTO Agreements (see below) Being a forum for trade agreements Settling trade disputes via the Dispute Settlement Body Reviewing national trade policies Assisting developing countries in trade policy issues Co-operating with other international organisations

The WTO Agreements contain the principles of liberalisation, including commitments by each country:

To lower customs tariffs To lower other trade barriers To open and keep open services markets

The current set of Agreements was finalised at the Uruguay Round of GATT negotiations ending in 1994.The Uruguay Round set up a non-discriminatory trading system spelling out each country's rights andobligations. Each country receives guarantees that its exports will be treated fairly and consistently in themarkets of other WTO members, and promises to do the same for imports into its own market. There issome latitude towards developing countries in how they implement their commitments. There are limitedpermitted exceptions, which are negotiated on a country-by-country basis.

9.2 Regional trading organisations

Countries in various regions have entered into closer economic arrangements such as:

The EU: (the world's largest single market, but it is unusual in that it features a common politicaldecision-making process (Council of Ministers, Commission, Parliament) and a single currency)

NAFTA (USA, Canada, Mexico)

SAARC (Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka)

Mercosur (Brazil, Argentina, Uruguay, Paraguay and now Chile)

ECOWAS (the Economic Community of West African States)

9.3 The European Union (EU)

The European Union operates a single European market across 27 member countries, allowing for the freemovement of labour, goods and services, and free competition.

Physical barriers (e.g. customs inspection) on goods and service have been removed for mostproducts

Technical standards (e.g. for quality and safety) are being harmonised

Governments should not discriminate between EU companies in awarding public works contracts

Telecommunications are subject to competition

It is increasingly possible to provide financial services in any country

Measures are being taken to rationalise transport services

There is free movement of capital within the community

Professional qualifications awarded in one member state are often recognised in the others

The EU is taking a co-ordinated stand on matters related to consumer protection

A common currency, the Euro, has been widely adopted within the EU

There are many areas where harmonisation is some way from being achieved.



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Taxation. Tax rates, which can affect the viability of investment plans, vary from country to countrywithin the EU. With indirect taxation (VAT), whilst there have been moves to harmonisation,there are still differences between rates imposed by member states

Full freedom of trade in services has yet to be achieved

Differences in prosperity. There are considerable differences in prosperity between the wealthierEU economies and the poorest

– Grants are sometimes available to depressed regions, which affect investment decisions– Different marketing strategies are appropriate for different markets

Differences in workforce skills which have a significant effect on investment decisions. Theworkforce in Germany is perhaps the most highly trained, but also the most highly paid, and so mightbe suitable for products of a high added value

Infrastructure. Some countries are better provided with road and rail than others. Whereaccessibility to a market is an important issue, infrastructure can mean significant variations indistribution costs

9.4 The North American Free Trade Agreement (NAFTA)

In 1993 Mexico joined the existing free trade arrangements between Canada and the USA, thus forming theNAFTA area. The agreement covered free trade in 99% of goods and most services, while providing for theobservance of environmental protection standards and legislation on health and safety and labour standards.Most restrictions on foreign direct investment were removed, but with protection for certain prizednational interests such as US airlines and the Canadian media.

9.5 The South Asian Association for Regional Cooperation (SAARC)

The Member States of SAARC comprise Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka,hereinafter referred to as “Contracting States”,

Motivated by the commitment to strengthen intra-SAARC economic cooperation to maximise therealization of the region’s potential for trade and development for the benefit of their people, in a spirit ofmutual accommodation, with full respect for the principles of sovereign equality, independence andterritorial integrity of all States;

Noting that the Agreement on SAARC Preferential Trading Arrangement (SAPTA) signed in Dhaka on the11th of April 1993 provides for the adoption of various instruments of tradeliberalization on a preferential basis;

Convinced that preferential trading arrangements among SAARC Member States will act as a stimulus tothe strengthening of national and SAARC economic resilience, and the development of the nationaleconomies of the Contracting States by expanding investment and production opportunities, trade, andforeign exchange earnings as well as the development of economic and technological cooperation;

Aware that a number of regions are entering into such arrangements to enhance trade through the freemovement of goods;

Recognizing that Least Developed Countries in the region need to be accorded special and differentialtreatment commensurate with their development needs; and

Recognizing that it is necessary to progress beyond a Preferential Trading Arrangement to move towardshigher levels of trade and economic cooperation in the region by removing barriers to cross-border flow ofgoods.



9.6 Is there free international trade?

Before getting carried away by notions that the world is splitting into trading blocs, remember that:

There is increasingly free movement of capital

Global trade is becoming liberalised

Some of the world's markets offering the greatest potential for growth (e.g. India and China) are notpart of a regional trading organisation

New technology, such as the internet, makes it harder to police trade barriers in some areas

However, there remain many issues that prevent complete free international trade.

The concentration of political and economic power in the US and (to some extent) its alliesmeans that the world is still very far from being a fair place.

Some international laws, such as those related to intellectual property in particular, operate againstfree trade in favour of ensuring benefits continue to accrue to limited numbers of people.

Many states operate currency management and do not allow their currencies to fluctuate freely inrelation to other currencies, generally in order to protect their own exports/domestic markets.

Collusion between states operating in particular industrial sectors, such as the oil-producing states inOPEC, distorts free markets in those goods and has significant knock-on effects on the entire worldeconomy.

The political regimes in some states either actively discourage foreign involvement in their markets, orthreaten sanctions such as expropriation of assets.

Political instability and war in many states continue to undermine the ability of those states toenjoy the benefits brought by free international trade.



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Summary

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Self-test


1 The provision of public goods by government is an example of intervention to address market failurecaused by

A Market imperfectionB ExternalitiesC Asymmetric informationD Lack of equity

2 By the direct taxation of income government is seeking to

A Provide public goodsB Provide merit goodsC Redistribute wealthD Create demand

3 Regulation of financial reporting is an example of intervention in order to alleviate market failurecaused by

A Market imperfectionB ExternalitiesC Asymmetric informationD Lack of equity

4 Which of the following is an accurate statement of the external auditor's responsibilities underSarbanes-Oxley provisions?

Regarding certification by the CEO and CFO Regarding management assessment on internalcontrols

A Deficiencies in accounting records must bereported to the auditor

Auditor must attest to the accuracy of theassessment

B No requirement Auditor must attest to the accuracy of theassessment

C Deficiencies in accounting records must bereported to the auditor

No requirement

D No requirement No requirement

5 A UK industry has been lobbying Parliament to require goods bought from three Asian countries forsale in the UK to be subject to additional safety checks. From the perspective of supporting free tradethe UK government may be reluctant to agree as this would be an example of

A A tariffB A quotaC DumpingD An import restriction

6 Which of the following is an international organisation involved in trade that does not excludemembers on the grounds of their location in the world?

A NAFTAB EUC WTOD SAFTA



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1 B

2 C

3 C

4 A

5 D

6 C





There are many possible examples. One of the most obvious is government regulations on emissions, whichseek to prevent the destruction of the natural environment – a pretty important irreversible effect ofcurrent activities on future generations! Another important example is the regulation of pensions, whichshould seek to prevent erosion of the funds available for future pensioners.


Banks need to comply with the Basel Accord, and with regulations produced by the FSA. As with any otherbusiness, they will also need to comply with employment and health and safety regulations.


An established UK company considering a listing in the US obviously believes that there are real benefits tobe obtained from this, not least access to a huge reserve of equity capital. However, it will perform acost/benefit analysis, and if Sarbox costs outweigh the benefits of US listing, it will decide not to go ahead.


Business and Finance

SAMPLE PAPER

1 This sample Knowledge level examination is representative of the content of future examinations atthis level, although in the actual examination, shart-answer questions will be used rather thanmultiple-choice questions.

2 Marks are indicated at the end of each question. The base number of marks per question is 2,although some subjects may include a small number of short questions worth 1 mark each.

3 Unless the question states otherwise select one answer only.

SAMPLE PAPER: QUESTIONS


1 Maria Ragoussi has recently joined the finance function of PTN, a small charity, from Uist Ltd, a largemanufacturing organisation with well-developed performance management systems. She has identifiedthree areas of performance that can be measured in an organisation: effectiveness, economy andproductivity. She states that at least one of these areas is common to both types of organisation,whatever their objective.

For each area of performance, indicate whether it is likely to be a key feature of measuring theachievement of the organisation’s objective for PTN, Uist Ltd, or both.

PTN Uist Ltd Both

Effectiveness

Economy

Productivity

(2 marks)

2 Mandrake Ltd is a large group which processes waste for local authorities. It has stated that it seeks toprovide

'our shareholders with increased value, our customers with value for money, our employees withsecure and interesting jobs and the public with safe and environmentally sustainable waste disposal.'

This is analysed below into four statements. Identify which one is Mandrake Ltd’s primary businessobjective.

A To provide our shareholders with increased value

B To provide our customers with value for money

C To provide our employees with secure and interesting jobs

D To provide the public with safe and environmentally sustainable waste disposal

(2 marks)

3 A consultant has told the board of Pineapple Ltd that the strategic planning process should result in astrategic plan, a business plan and an operational plan. The board is unclear as to what these termsmean.

Identify each plan with its definition.

Strategicplan

Businessplan

Operationalplan

A plan setting out the markets the business intendsto serve, how it will serve each market and whatfinance is required

A plan setting out how overall objectives are to beachieved, by specifying what is expected fromspecific functions, stores and departments

(2 marks)



4 Simian Ltd operates in the financial services sector. Its marketing director is developing the firm’smarketing plan. An external marketing consultant has recommended that the PESTEL frameworkshould be used as part of this process. Which of the following statements correctly describes thereason why the PESTEL framework might prove useful?

A It will identify Simian Ltd’s strengths and weaknesses

B It will allow a detailed analysis of the structure of the financial services industry

C It will act as a detailed checklist to assist in understanding the different influences in Simian Ltd’senvironment

D It will help to identify the relative levels of interest and power of Simian Ltd’s stakeholders

(2 marks)

5 Rumbert Ltd is a large group listed in the UK, with a head office in London and strategic business units(SBUs) spread throughout the world. Only overall strategic direction and consolidated financialreporting are provided by London. All SBUs manage their own marketing and operations, and reportdirectly to regional centres which provide all other forms of functional support.

Rumbert Insurance is an SBU operating in South Africa and reporting to the Rumbert Southern Africaregional centre. It is engaged in providing home and car insurance direct to consumers. Identifywhether the following areas of functional support would be provided to Rumbert Insurance by theRumbert Southern Africa regional centre.

Yes No

Sales management

Financial reporting for the London Stock Exchange

Periodic management accounts

(2 marks)

6 Prentice Ltd is a modern manufacturing operation. It uses components manufactured by suppliers andsub-contractors all over the world to assemble finished goods to customer order in its assembly plant.

Operations managers in Prentice Ltd’s assembly plant must balance certain key issues in order tomanage the process by which finished products are supplied to customers. Identify whether thefollowing issues are among those key issues.

Yes No

Plant capacity

Customer demand

Funding of working capital

(2 marks)



7 The Human Resources Director of Ground Ltd wants new recruits in all areas of the company to havethe qualities and skills that will ensure achievement of Ground Ltd’s objectives now and in the futurefor each area. In order to recruit employees with the desired qualities and skills, Ground Ltd shouldmake use of

A job descriptions

B person specifications

C recruitment consultants

D competency profiles

(2 marks)

8 Asif Ltd is a large supermarket chain in the UK which manages all its distribution internally. Each of the120 stores is a profit centre. As part of its strategy development process, Asif Ltd has identified thefollowing two strategies. Identify whether these are corporate strategies.

Corporatestrategy

Not a corporatestrategy

Offering its distribution capability from warehouse tostores as a service to other supermarkets

Training store staff in the handling of personal safetyissues

(2 marks)

9 Candle Ltd is concerned about the risk management of its information systems function. The SystemsDirector has suggested that information systems management could be wholly outsourced to a thirdparty provider. This action would be a form of

A risk reduction

B risk transfer

C risk avoidance

D risk retention

(2 marks)

10 Identify whether each of the following risks faced by Lump Ltd should be classified as business risk ornon-business risk.

Business risk Non-business risk

Product risk

Event risk

Economic risk

(2 marks)



11 The specialist services division of Klaxon Ltd uses highly-qualified professional staff to provide itsgovernment-accredited service to its customers. The division is developing its business plan and isreviewing a five forces analysis that was conducted by a consultant. This identifies that rivalry betweenthe very few providers of the specialist service will soon intensify.

Identify whether the following factors stated in the report indicate increased rivalry among providersor not.

Indicatesincreased rivalry

Does not indicateincreased rivalry

Government subsidies for existing providers are tobe removed

Two key customers of the specialist service are tomerge

(2 marks)

12 Which of the following forms of business necessarily has a legal identity separate from that of itsowner(s)?

Separate legalidentity

No separatelegal identity

A strategic alliance between a limited company and a limitedliability partnership

A limited liability partnership

A registered company

(2 marks)

13 Mr Dafinone is a sole trader who works alone, maintaining and repairing IT systems. He works about60 hours per week. He wants to take on a major new maintenance and repair contract for a localhospital’s operating theatre. This will require at least 60 working hours each week. It will be extremelyprofitable if he can acquire the necessary equipment.

Identify whether the following statements about his sole trader status are true or false.

True False

It prevents him from employing staff to help withthe contract

It gives him personal liability for any failure of hisin relation to the hospital IT system

It prevents him from obtaining a loan to purchasethe equipment

(2 marks)



14 Sextet Partnership comprises six partners who share profits 6:5:4:3:2:1. They are consideringincorporation as a limited company, Sextet Ltd. Only the six partners will become shareholders onincorporation.

In relation to Sextet Ltd, which of the following statements is necessarily true?

A All partners will be equal shareholders in Sextet Ltd

B If Sextet Ltd wishes to raise new share capital, the number of shareholders may be allowed torise above six

C All shareholders will become directors and will have the right to be equally involved in themanagement of Sextet Ltd

D If one of the shareholders in Sextet Ltd dies, the company will be dissolved

(2 marks)

15 Pliar Ltd is considering a number of options to market a new product with Secateur Ltd’s help. Identifythe description which best suits the business structure suggested for each option.

Groupstructure

Jointventure

Strategicalliance

Buy Secateur Ltd and market the productthrough that company

Form a project team with employees of bothSecateur Ltd and Pliar Ltd and market theproduct through that team

With Secateur Ltd as equal partner, formPlicateur Ltd and market the product throughthat company

(2 marks)

16 The key trade-off that lies at the heart of working capital management is that between

A business stability and solvency

B debtors and creditors

C current assets and current liabilities

D liquidity and profitability

(2 marks)

17 Where demand is inelastic, working capital is most likely to increase when

A work in progress falls

B selling prices increase

C the credit period allowed to customers is reduced

D the credit period taken from suppliers is increased

(2 marks)



18 Identify whether the following tasks are normally undertaken by the treasury department of a largebusiness.

Yes No

Credit control

Short-term investment

Capital investment appraisal

(2 marks)

19 The Chief Executive of Table Ltd is discussing the firm’s most recent financial statements with hisFinance Director. The Chief Executive is not convinced about the usefulness of much of theinformation in the financial statements and, in particular, he identifies three specific characteristics ofthe information that he feels may undermine its usefulness.

Identify whether these characteristics are likely to undermine the information’s usefulness.

Underminesusefulness

Does not undermineusefulness

Its lack of timeliness

The high level of regulation that applies to it

The high level of aggregation it contains

(2 marks)

20 Novel Ltd has been establishing its accounting and finance function. The company has been told thattwo purposes of published, audited financial statements are to help users to assess how effectivelymanagers are running a business and to make judgements about the likely levels of risk and return inthe future.

Which of the following user groups of Novel Ltd’s published, audited financial statements is most likelyto use accounting information for these purposes?

A Community representatives

B Employees

C Shareholders

D Managers

(2 marks)



21 When a company’s accounting and finance function prepares financial statements in accordance withlegal rules and accounting standards, it is engaged in the support activity of

A record-keeping and stewardship

B planning and control

C external reporting

D internal reporting

(2 marks)

22 Mainstream Ltd’s Finance Director wants to establish an effective system in the accounting and financefunction for producing management accounting reports. In establishing such a reporting system, whichof the following issues should be the Finance Director’s primary consideration?

A The information needs of the company’s managers

B The need for effective internal control mechanisms

C The need for cost-effectiveness

D The need for effective information security

(2 marks)

23 Identify whether the following are key issues in relation to information processing in a company’saccounting systems.

Key Not key

Completeness

Non-repudiation

Verifiability

(2 marks)

24 Tram Ltd’s finance and accounting section wants to provide information to management on thecompany’s balanced scorecard. This role would be undertaken as part of Tram Ltd’s

A statutory audit requirement

B financial reporting function

C treasury management process

D performance measurement system

(2 marks)



25 The directors of Braveheart Ltd, a company with multiple projects, are discussing residual income andreturn on investment as potential measures to be used in the company’s performance managementsystem. The Finance Director has made three statements about these measures for performanceevaluation.

Identify whether each statement is true or false.

True False

Residual income is a relative measure

Return on investment is a relative measure

Both measures can be calculated for an individual project

(2 marks)

26 Total usage of one item of Archer Ltd’s inventory for the next month is estimated to be 100,000 units.The costs incurred each time an order is placed are CU180. The carrying cost per unit of the itemeach month is estimated at CU2. The purchase price of each unit is CU4. The economic orderquantity formula is:

(2cd)/h

When using this formula to find the optimal quantity to be ordered, identify the amounts that areincluded in the calculation.

Included Not included

Cost per order (CU180)

Carrying cost per unit per month (CU2)

Purchase price per unit (CU4)

(2 marks)

27 Rust Ltd invoices customers at the beginning of the month following the month in which a sale ismade. All of the cash to be received in respect of these invoices occurs within two calendar months ofinvoicing. The company receives in cash 45% of the total gross sales value in the month of invoicing.Because Rust Ltd operates in a market where there is poor creditworthiness bad debts are 20% oftotal gross sales value, but there is a 10% discount for settling accounts within a calendar month ofinvoicing.

What percentage of the sales invoiced in the first month will be received as cash in the second monthby Rust Ltd?

A 55.0%

B 35.0%

C 39.5%

D 30.0%

(2 marks)



28 Youri Ltd has the following opening and closing balances on its trade receivables budget for next year,20X7:

CUOpening balance on trade receivables (invoiced on 31 December 20X6) 56,000Closing balance on trade receivables (invoiced on 30 November 20X7) 72,000

In 20X7 credit sales are expected to be CU276,000. The company offers a 10% discount on allamounts paid within one month of the invoice date. In 20X7 the company expects 50% of eligibletrade receivables to take advantage of this discount. How much cash does Youri Ltd expect to receivefrom trade receivables during the year?

A CU247,000

B CU243,400

C CU260,000

D CU276,000

(2 marks)

29 Identify whether the following three areas in a company are encompassed by the maintenance ofcontrol and the safeguarding of assets for the benefit of stakeholders, according to the ProfessionalOversight Board.

Yes No

Financial management

Transactions recording

The role of non-executive directors

(2 marks)

30 The managing director of Wendle Ltd wants to understand the links between technical competenceand professional responsibility in the accounting profession. Identify whether he should consider thefollowing areas.

Yes No

Disciplinary proceedings


The profession’s interest

(2 marks)



31 According to the conditions imposed by SEC for corporate governance, an independent directorshould be appointed by the

A company actuary, if it is an insurance company

B company secretary, if it is a listed company

C company valuer of investment properties, if it is a property company

D elected directors

(2 marks)

32 In relation to the external audit of a limited company in Bangladesh, a colleague has made the followingstatements. In each case, indicate whether the statement is true or false.

'To act as external auditor, the person appointed must

True False

be a member of ICAB’

be either a body corporate or a partnership'

hold a recognised qualification obtained in Bangladesh’

(2 marks)

33 The financial statements for the year ended 31 December 2005 of Anson Ltd., a company listed on theDhaka Stock Exchange, depart from the requirements of certain relevant accounting standards andprovisions of the Companies Acts. The company is therefore likely to be referred to which of thefollowing regulatory bodies?

A SEC

B RJSC

C DSE

D None of the above

(2 marks)

34 The Finance Director Trun Ltd is a chartered accountant. She has received notice that, in respect ofTrun Ltd’s financial statements for the year ended 31 December 2005, she could be subject todisciplinary proceedings by the ICAB Council. The Council will be involved if the matter raises issuesaffecting

A the public interest

B the independence of the auditors

C international accounting standards

D All of the above

(2 marks)



35 The investigation and disciplinary committee of ICAB does not perform the disciplinary function.True or False?

True False

(2 marks)

36 Xigent Ltd employs directors of finance, of human resources and of legal services, as well as acompany secretary. The company is having operational problems which are delaying its completion ofa key project. If the project misses its deadline Xigent Ltd may suffer heavy penalties under the termsof its sales contract with the customer. Part of the delay has been caused by strikes due to badindustrial relations with both employees and sub-contractors, but Xigent Ltd is unsure whether thepenalties included in the contract will come into effect given this reason.

Identifying whether the penalties are likely to come into effect is the role of Xigent Ltd’s

A director of finance

B director of human resources

C director of legal services

D company secretary

(2 marks)

37 In seeking to address the problem of the separation of ownership and control, corporate governanceattempts to align the interests of which two of the following stakeholders?

A Investors

B Employees

C Regulators

D Managers

E Auditors

(2 marks)

38 The SEC Corporate Governance Order 2006 requires that the percentage of the board of directorsof a listed company which should be independent directors is

A 10%

B 9%

C 8%

D 7%

(2 marks)



39 The stewardship approach to corporate governance requires directors of limited companies

A to act at all times in the best interests of the company

B to allow shareholders to see detailed accounting records upon request

C to hold regular monthly meetings to answer shareholders’ questions

D to consult the shareholders over difficult management decisions

(2 marks)

40 Part A of IFAC’s Code of Ethics establishes the fundamental principles of professional ethics forprofessional accountants and provides a conceptual framework for applying those principles.

Which three of the following are stated as fundamental principles in IFAC’s Code of Ethics?

A Integrity

B Independence

C Confidentiality

D Objectivity

E Reliability

(2 marks)

41 Sumatra Ltd operates its own internal audit function, choosing not to make use of an external supplierfor these services. In light of this policy, it is vital that arrangements are established within thecompany to ensure that there is no compromise of the

A independence of the internal auditors

B integrity of information security systems

C stewardship of directors

D rigour of financial reporting processes

(2 marks)

42 Fox Ltd’s external auditors have just won a contract with Fox Ltd to provide consultancy services.

Which of the following entities would usually be expected to examine the implications of thissituation?

A The board of directors

B The remuneration committee

C The audit committee

D The non-executive directors

(2 marks)



43 The appointment of suitably qualified, independent auditors is the responsibility of a listed company’s

A shareholders

B audit committee

C board of directors

D finance director

(2 marks)

44 A shopkeeper finds that if he sets the price of a particular product at CU9.00 per unit he sells, onaverage, 150 units of the product per month. However, at a price of CU10.00 per unit, he sells anaverage of 110 units per month. The price elasticity of demand for the product is

A - 0.42

B - 2.40

C - 0.27

D - 0.11

(2 marks)

45 If the minimum price for a good is set by the government above the current free market equilibriumprice, what will be the effect (if any) on demand for and supply of the good in the short term?

Fall Rise No effect

Demand for the good

Supply of the good

(2 marks)

46 Bench Ltd produces chairs. An economist working for the firm predicts that if average incomes risenext year, then demand for the firm’s chairs will increase in direct proportion to the rise in incomes(assuming all other factors remain unchanged). The accuracy of the economist’s prediction depends onwhether the chairs produced by Bench Ltd

A are normal goods

B have many complementary goods

C have few complementary goods

D have few substitutes

(2 marks)



47 It is reported that two large listed companies recently colluded with each other to fix the price of aproduct they both sell in Bangladesh. Collusion of this type is an example of market failure due to

A inequality of resources

B external costs

C market power

D resource immobility

(2 marks)

48 If a listed company does not comply with the SEC order dated 20th February, 2006, that should bestated in

A the directors’ report

B the annual report

C the auditor’s management letter

D all of the above

(2 marks)

49 One of Matrix Ltd’s stakeholder groups is putting the company under pressure to improve its earningsper share. This group is most likely to comprise

A employees

B suppliers

C customers

D shareholders

(2 marks)

50 The key requirement of the Sarbanes-Oxley Act 2002 is that companies affected by the Act mustestablish and maintain accounting procedures that control

A fraudulent trading

B creative accounting

C misappropriation of funds

D off balance sheet transactions

(2 marks)


Business and Finance

SAMPLE PAPER ANSWERS

SAMPLE PAPER: ANSWERS


1 Effectiveness – Both

Economy – PTN

Productivity – Uist Ltd

Both organisations will want to be effective in doing what they do. A not-for-profit organisation suchas a charity will want to be effective whilst operating in an economical fashion; a profit-makingmanufacturing organisation will want to ensure that its resources are used in the most productivefashion but not necessarily the cheapest.

2 A

The primary business objective of a profit-seeking Ltd will be the maximisation of shareholder wealth(A). The other statements are secondary objectives that will be pursued in support of this primaryobjective.

3 A plan setting out the markets - Business plan

A plan setting out how overall objectives - Operational plan

An operational plan specifies what is expected of each function in a business and a business plan setsout the market(s) to be served, how they will be served and the finance required.

4 C

Strengths and weaknesses (A) would be revealed by a SWOT analysis; the structure of an industrywould be revealed by a Five Forces Analysis (B); and helping to identify the relative levels of interestand power (D) refers to stakeholder mapping. A PESTEL analysis (C) reveals the key influences in theorganisation’s macro-environment (rather than its market or task environment).

5 Sales management – No

Financial reporting for the London Stock Exchange – No

Periodic management accounts – Yes

Sales management is part of both marketing and operations, so would be handled by RumbertInsurance itself, not by the Regional Office. Financial reporting is centralised at Head Office so againwould not be provided by the Regional Office. Periodic management accounts would be provided bythe Regional Office as they are neither marketing/operations, nor are they related to strategicdirection or consolidated financial reporting.

6 Plant capacity – Yes

Customer demand – Yes

Funding of working capital – No

Funding of working capital is the responsibility of the finance function rather than operations; theother two are operations issues.

7 D

A job description (A) describes the role rather than the person, and a person specification (B)describes more objective issues relating to the person (qualifications, experience etc.). A competencyprofile sets out skills and abilities required to perform the role (D). Recruitment consultants (C) canbe used once the company has prepared the other three documents.

8 Offering its distribution capability to other supermarkets – Corporate strategy

Training store staff in the handling of personal safety issues – Not a corporate strategy

Training store staff is very much an operational issue that does not constitute a corporate strategy,but offering its capability to other supermarkets is a fundamental long-term ‘directional’ decision whichcommits the company’s resources.



9 B

Clearly the company is not retaining the risk by outsourcing (D). The risk still exists so it is notavoided (C), and outsourcing does not necessarily reduce the probability or impact. Instead, the risk istransferred (B).

10 Product risk – Business risk

Event risk – Non-business risk

Economic risk – Business risk

Business risk arises from the nature of the business, its operations and the conditions it operates in;this includes product risk and economic risk. Non-business risk relates to all other types of risk,including principally financial risk and event risk.

11 Government subsidies removed – Indicates increased rivalry

Two key customers merge – Indicates increased rivalry

A concentration of customers will increase rivalry since the power of customers is thereby increased.Removal of government subsidies creates a more level playing field amongst competitors henceincreasing rivalry.

12 A strategic alliance – No separate legal identity

A limited liability partnership – Separate legal identity

A registered company – Separate legal identity

A strategic alliance is an informal or weak contractual agreement between parties or a minority cross-shareholding arrangement, neither of which imply a separate legal identity from the owners. Bothcompanies and limited liability partnerships are separate legal entities.

13 It prevents him from employing staff – False

It gives him personal liability for any failure – True

It prevents him from obtaining a loan to purchase equipment – False

As a sole trader he can raise loans and employ staff so neither of these statements is true. However,as a sole trader he does have the disadvantage of personal liability.

14 B

Shareholders do not have an automatic right to be a director or to be involved in management (C).The partners’ individual shareholdings will be determined by an agreement that is not necessarilyrelated to the existing partnership agreement (A). The concept of perpetual succession means that thecompany will not dissolve upon the death of a shareholder (D).

15 Buy Secateur Ltd – Group structure

Form a project team – Strategic alliance

With Secateur Ltd as equal partner – Joint venture

Purchasing the company will make it part of a group; forming a project team is a form of strategicalliance (see Answer 12 for definition). Plicateur Ltd would be a separate legal entity owned 50:50 bythe two companies and this is a form of joint venture rather than the more informal strategic alliance.

16 D

All businesses face a trade-off between being profitable (providing a return) and being liquid (staying inbusiness).



17 B

If demand is inelastic then in the face of increased selling prices the quantity demanded falls by asmaller percentage than the percentage rise in price. This will increase revenues so the money tied upin associated working capital items (inventory, receivables and payables) will also increase. A fall inWIP (A) means that cash tied up in inventory falls. A reduction in customer credit period means thatreceivables will fall (C). An increase in suppliers’ credit period (D) means that payables will increase,which reduces working capital.

18 Credit control – Yes

Short-term investment – Yes

Capital investment appraisal – No

Treasury management involves managing cash surpluses and deficits by making short-term investments,and also managing working capital from day to day so as to optimise cash flow, including inventory,receivables (credit control) and payables management. Management accounting will attend to capitalinvestment appraisal.

19 Its lack of timeliness – Undermines usefulness

The high level of regulation – Does not undermine usefulness

The high level of aggregation it contains – Undermines usefulness

By definition financial statements are produced some months after a company’s financial year-end sothe information they contain is not timely; lack of timeliness undermines relevance, though figures maythereby be more reliable. The level of aggregation in the figures can obscure important details and soundermine usefulness. The level of regulation, however, adds to reliability and comparability both ofwhich add to rather than detract from their usefulness.

20 C

Managers have stewardship over resources owned by the shareholders, so the shareholders (C) usethe financial statements to assess the quality and effectiveness of their stewardship. Shareholders ownshares (which are risky investments) in the hope of earning a satisfactory return. Communityrepresentatives (A), employees (B) and managers (D) have other primary interests.

21 C

Record-keeping and stewardship (A) relates to double-entry bookkeeping; planning/control (B) is not afunction of financial statements which essentially look back at past financial performance and position.Financial statements are not primarily aimed at an internal audience (D), which is the role ofmanagement accounting. External reporting is financial reporting (C) – producing financial statementswhich are used primarily by external users.

22 A

Management accounting is driven not by rules or standards but by the need to meet the informationrequirements of managers (A) within an organisation who use the information to plan, control, makedecisions and monitor performance.

23 Completeness – Key

Non-repudiation – Not key

Verifiability – Key

To be effective, information processing should meet the CATIVA criteria – completeness, accuracy,timeliness, inalterability, verifiability and assessability. Non-repudiation is one of the ACIANA qualitiesof information systems security.



24 D

The balanced scorecard is a performance measurement tool (D) focused on a variety of performancemeasures important to a business, rather than purely financial ones.

25 Residual income is a relative measure – False

Return on investment is a relative measure – True

Both measures can be calculated for an individual project – True

Residual income (RI) is an absolute measure of the true economic profit of a business’s activitiescalculated by deducting from the net profit an amount that reflects the ‘cost’ of the money that wasused to make the investment. Return on investment (ROI) is a relative measure of a business’s profitcompared to how much capital was invested to earn that profit. Both measures can be applied toindividual projects.

26 Cost per order (CU180) – Included

Carrying cost per unit per month (CU2) – Included

Purchase price per unit (CU4) – Not included

In the formula, c = the cost of placing one order; d = the estimated usage of an inventory item over aparticular period; and h = the cost of holding one unit of inventory for that period. The purchase priceper unit is not a constituent part of the formula.

27 D

If the company is offering a 10% discount for settling within the first month, then if it receives 45% ofgross sales value that must equate to 45 x 100/90 = 50% of invoices settling within that first month.With bad debts of 20%, that leaves 30% to be collected in the second month.

28 B

The closing receivables of CU72,000 represent the customers who did not take advantage of thediscount available in December; the total invoicing on 30 November must therefore have beenCU72,000 x 2 = CU144,000. This means that from January to October invoicing was CU276,000 -CU144,000 = CU132,000.

Cashreceived

CU

Discountallowed

CUOpening receivables taking discount (CU56,000 x 0.5 x 0.9) 25,200 2,800Opening receivables not taking discount (CU56,000 x 0.5) 28,000 –Sales in year taking discount (CU132,000 x 0.5 x 0.9) 59,400 6,600Sales in year not taking discount (CU132,000 x 0.5) 66,000November invoicing taking discount (CU144,000 x 0.5 x 0.9) 64,800 7,200

243,400 16,600

29 Financial management – No

Transactions recording – Yes

The role of non-executive directors – Yes

POB sets out that maintaining control and safeguarding assets involves: recording transactions;ensuring internal controls are sufficient; ensuring the audit committee is properly constituted andresourced; ensuring there are qualified and resourced non-executive directors



30 Disciplinary proceedings – Yes

Accounting principles – Yes

The profession’s interest – No

Applying accounting principles is an aspect of technical competence. Disciplinary proceedings arerelevant when there has been a failure of technical competence and/or professional responsibility. Theprofession’s interest has no impact.

31 D

32 Be a member of ICAB – True

Be either a body corporate or a partnership – False

Hold a recognised qualification obtained in Bangladesh – False

Sole practitioners can be appointed as auditors and certain overseas qualifications may be recognised.The other statement is correct.

33 D

34 D

35 True

36 C

Enforcement of contracts is clearly a legal matter requiring the attention of the company’s director oflegal services.

37 A and D

The separation of ownership and control refers to the classic ‘agency problem’, in which investors(shareholders) who own the company delegate to managers (as agents) responsibility for running thebusiness for the ultimate benefit of the owners. Corporate governance is fundamentally concernedwith ensuring that the managers act as the owners would want them to.

38 A

39 A

The stewardship approach requires that directors should act at all times in the company’s bestinterests, not in their own. This is a resolution of the agency problem. Allowing shareholders to seedetailed accounting records on request, holding monthly meetings to answer shareholders’ queries andconsulting shareholders over difficult management decisions are not factors that are required by thestewardship approach, though a company can choose to enforce such procedures if it wants.

40 A, C and D

The fundamental principles established by IFAC’s Code of Ethics are integrity, objectivity, professionalcompetence and due care, confidentiality and professional behaviour.

41 A

An effective internal audit function has, as a fundamental requirement, to maintain its independence atall times.

42 C

One of the specific roles and responsibilities accorded to the audit committee by the Combined Codeis the development and implementation of policy on the engagement of the external auditor to supplynon-audit services.



43 A

It is the shareholders who actually vote to appoint the external auditors (A), although this is usually onthe recommendation of the audit committee (B) and the board (C). The finance director (D) may beheavily involved in the conduct of the audit but should not be actively involved in appointment exceptas a member of the board.

44 B

Proportional change in quantity demanded = 40/150 100 = -26.6%

Proportional change in price = 1/9 100 = 11.1%

PED = -26.6/11.1 = -2.40.

45 Demand for the good – Fall

Supply of the good – Rise

Suppliers will be encouraged to supply at that price so supply will increase, whilst at a price above themarket equilibrium price demand will fall.

46 A

With normal goods, if incomes rise demand for the product will rise and this will be the caseregardless of the existence of either substitutes or complements.

47 C

Collusion is an example of market power exerted by a few suppliers

48 D

49 D

Earnings per share is a key investor ratio which measures the return earned by the company per share– obviously of key interest to shareholders rather than any of the other stakeholders listed.

50 B

The accounting procedures need to control creative accounting so that off-balance sheet transactionsare properly accounted for and disclosed

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