ACCA F9 Financial Management - 2010 - Study text

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Chapter 1: The financial management function

In the UK, all listed companies (i.e. stock market companies whose shares are on the

‘official list’ and traded on the London Stock Market) are required to comply with

Listing Rules as a condition of maintaining their listed status. These rules are issued

and enforced by the Financial Services Authority, which is the UK’s regulator of the

financial markets.

One of the Listing Rules is that listed companies must state in their annual report

and accounts that they have:

 complied with the general principles of corporate governance in the Combined

Code and

 either complied with all the detailed provisions (specific requirements) in the

Combined Code, or have not complied. If they have not complied with every

provision, they must explain the reasons for their non-compliance. This is

referred to as ‘

comply or explain’.

As a consequence of voluntary governance codes supported by stock exchange (or

similar) requirements, major companies should in general be managed in the best

interests of the shareholders and the agency problem should be controlled.

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Not-for-profit organisations

 Financial management in not-for-profit organisations

 Value for money (VFM)

 Measuring the achievement of objectives

5 Not-for-profit organisations

5.1 Financial management in not-for-profit organisations

Not-for-profit organisations are entities whose main purpose or objective is non-

financial. They include charity organisations and government departments and

agencies, including the state health service, state schools and universities, and

administrative departments of government.

Every not-for-profit organisation has a main purpose or objective. In a health

service, the main objective is to provide health care. In an education system, schools

and universities exist to provide education. Charities exist to provide aid and

support for specific causes.

However, not-for-profit organisations should also have important financial

objectives, even if these objectives are not their main objective, and they need

financial management. In particular, not-for-profit organisations need to survive,

and to do so they must operate within the limitation of the amount of resources and

finance they have at their disposal. They cannot allow spending to exceed the

amount of funds available, and they also need to ensure that the available funds are

used in the best way possible.

5.2 Value for money

Whereas profit or financial return is an important concept for the financial

management of companies, value for money (VFM) is an important concept in not-

for-profit organisations. VFM is based on the view that not-for-profit organisations

should make the optimum use of available spending, and to do this the organisation

must provide value for money (VFM). Value for money has three elements,

sometimes known as the ‘3Es’:

 Economy. Economy means operating in a way that does not waste money.

Expenditure should be controlled and unnecessary spending should be avoided.

 Efficiency. Efficiency means using resources in the most efficient way possible,

and getting the most out of them. For example, employees should work

efficiently and the aim should be to achieve high productivity levels.

 Effectiveness. Effectiveness means using resources and spending money so as to

achieve targets and objectives.

Chapter 1: The financial management function

Example

A state school might be expected to achieve value for money in the following ways.

 Economy. The school should not spend money unnecessarily on resources. For

example it should negotiate favourable prices for the purchase of school books

and it should not have a larger teaching staff than it needs.

 Efficiency. The school should use its available resources in the most efficient

way possible. It might be required to avoid small class sizes and achieve a

minimum teacher-pupils ratio. It might also be required to ensure that pupils

make full use of available information technology systems or library resources.

 Effectiveness. The school should achieve good results. Pupils should be

expected to pass their examinations with good grades.

A large number of different measurements might be established for economy,

efficiency and effectiveness, and key targets might be selected for the most

important objectives.

5.3 Measuring the achievement of objectives

Setting objectives in not-for profit organisations can be a complex task.

 There are no shareholders. Instead there might be a number of different but

influential stakeholder groups. In a state school for example, the government is

an important stakeholder as owner of the school, but other influential

stakeholders might include pupils, parents of the pupils, educational specialists

and universities.

 It might be possible to identify a single main objective, but in many not-for-

profit organisations there need to be multiple objectives. These should be

objectives for economy and efficiency as well as effectiveness.

 If there are multiple objectives it may be difficult to decide which are most

important. Different objectives may be more important to some stakeholders

than to others. Targets for effectiveness are likely to be the main objectives,

because these relate to the purpose for which the not-for-profit organisation

exists.

 It may be difficult to define targets that are clearly linked to objectives and

which are also measurable. For example, it might be difficult to establish a

limited number of key objectives for a hospital or a national health service.

 Limitations on funding restrict the objectives that are achievable.

A variety of methods can be used to measure the achievement of objectives.

 Targets may be set for both financial and non-financial performance. For

example, a charity may set a target of 80% of funding to be used for good causes

and that spending on administration should be no more than 20% of funds

received.

 A suitable target might be set by using benchmarking. Comparisons may be

made with other similar organisations in the public or private sector and best

practice identified. This could form the basis for the target set.

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 Budgeting systems should be used for planning and monitoring expenditure.

Government funding may be provided for specific purposes such as capital

expenditure. This will be monitored to ensure that the specific objective is met.

Paper F9

Financial management

CHAPTER

The financial management

environment

Contents

1 Theeconomicenvironment

2 Thefinancialmanagementframework

3 Thefinancialmarkets

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The economic environment

 Government economic policy and macroeconomic policy targets

 Economic growth and gross domestic product (GDP)

 Economic policy

 Fiscal policy and its effect on business

 Monetary policy and inflation

 Monetary policy and the exchange rate

 Monetary policy and business

 Other influences of government on business

 Competition policy

 Government assistance for business

 Green policies

 Corporate governance regulations

1 The economic environment

Companies operate within an economic and financial environment, and changes in

the conditions within this environment can be important for financial management.

This chapter provides a brief survey of factors that might need to be taken into

consideration by companies, and that might affect the decisions that management

take.

1.1 Government economic policy and macroeconomic policy targets

Macroeconomics refers to economics at a national or international level, as distinct

from microeconomics, which is the economics of individual firms and markets, and

macroeconomic policy is formulated by the country’s government. Macroeconomic

policy, and changes in economic policy and economic conditions, can have

important consequences for corporate objectives and management decisions.

In advanced economies, there are normally two main macroeconomic policy

objectives:

 to achieve sustained real growth in the national economy

 to achieve ‘full employment’.

Success in achieving and maintaining ‘full’ employment depends to a large extent

on success in achieving sustained real economic growth.

1.2 Economic growth and gross domestic product (GDP)

Economic growth is measured by the rate of growth in economic activity each year

within a country. There are three measures of economic activity: gross domestic

product (GDP), gross national product (GNP) and national income. These three

measures have many common characteristics, and the differences between them are

Chapter 2: The financial management environment

not important for the purpose of studying financial management. This text refers to

GDP.

GDP can be measured in any of three ways:

 by the volume of output of goods and services, and other economic activity, each

year: the output approach

 by the amount of income earned each year by individuals and organisations

within the year (e.g. company profits and the wages and salaries of individuals):

this is the income approach

 by the amount of spending in the economy each year: this is the expenditure

approach

Total GDP should be the same in total using any of the three methods of

measurement. However, the expenditure approach to measuring GDP is the most

useful for the purpose of analysis. Using this approach the total value of GDP

within a given period, typically one year, can be expressed in the following formula:

GDP = C + G + I + (X – M)

where

C = total annual consumption spending each year (by companies as well as

individuals): this is spending on goods and services other than capital investment

G = spending by the government (on consumption and investment by government)

I = investment spending (other than investment spending by government)

X = the value of exports of goods and services

M = the value of imports of goods and services

(X – M) is therefore the annual balance of trade (sometimes referred to as the

‘balance of payments’) for the country in international trade.

This formula shows that growth in GDP from one year to the next can be obtained

through higher spending on consumption, higher government spending, more

investment or an improvement in the balance of trade. However, growth is only

achievable if an increase in C, G or I does not result in a matching fall in one of the

other elements in the formula.

 For example the government might increase its annual spending by raising

taxation. In raising taxation, it will reduce the spending power of individuals

and companies, and as a consequence their might be a matching fall in

consumption spending C or investment by companies I.

 Companies might want to increase investment spending, but to do so they will

need to raise extra funds from somewhere. Funds for investment come from

savings by individuals and organisations, and higher savings will result in less

money for consumption.

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GDP and inflation

The formula for GDP is a ‘money’ measurement that ignores inflation. There is a

difference between:

 growth in GDP in money terms and

 growth in GDP in ‘real’ terms, which is growth after the effects of inflation have

been removed.

For example, if GDP grows at an annual rate of 3% but the annual general rate of

inflation is 2%, real growth in the economy is only 1%. If GDP grows at 3% but the

rate of inflation is 5%, there will be ‘negative growth’ of about 2% in real terms (i.e.

GDP will be about 2% less in real terms than in the previous year).

The government will be concerned about inflation for two reasons:

 It will want to achieve real growth in national income each year, not simply

growth in ‘money’ terms.

 A high rate of inflation can have harmful effects on the economy and lead

eventually to a fall in the rate of economic growth (and possibly economic

recession).

There are several reasons why the government will try to prevent excessive

inflation.

 Inflation results in a transfer of wealth within the economy in ways that might

be considered unfair. Individuals on fixed incomes, such as many people with

fixed pensions, will find that the real value of their income falls each year. Other

members of society, such as owners of property, might benefit from rising asset

prices.

 Inflation creates pressure for general cost increases. Employees will demand

higher annual pay rises if the rate of inflation is rising. Higher employment costs

might force employers to put up the prices of their goods and services, and at

the same time avoid as many extra costs as possible – by making some workers

redundant, perhaps, or by deferring investment spending.

 Experience has shown that a high rate of inflation, and high inflationary

expectations, has the effect eventually of reducing real growth in the economy.

For the government, an economic policy objective to support the aims of growth in

national income and full employment might therefore be to limit the rate of annual

price inflation.

1.3 Economic policy

A government uses economic policy to try to influence economic conditions, with

the objective of achieving sustained growth and full employment and restricting the

rate of inflation. There are two main aspects of economic policy:

 fiscal policy and

 monetary policy.

Chapter 2: The financial management environment

1.4 Fiscal policy and its effect on business

Fiscal policy relates to government spending, taxation and borrowing.

The central government spends enormous amounts of money every year, and

higher government spending increases GDP. However, government spending has to

be financed, and the money is obtained from:

 taxation, and

 borrowing.

When the government plans an increase in its spending programme, it will probably

seek to finance the higher spending, in full or in part, through higher taxation.

Taxation is raised from a variety of sources, but the main sources of tax income are

likely to be:

 the taxation of income of individuals

 the taxation of profits of companies

 indirect taxation on expenditure, in the form of a sales tax or value added tax.

When the government spends more than it raises in taxes, it has to borrow the

difference. In advanced economies, the main sources of borrowing for the

government are:

 to obtain long-term finance, to issue government bonds (known as Treasuries in

the US and gilt-edged securities or gilts in the UK)

 also to obtain long-term finance, the government might offer savings and

investment schemes to individuals. (In the UK, these are operated by the

National Savings Bank)

 to obtain short-term funding, to issue short-term financial instruments known as

Treasury bills. (Treasury bills are a form of short term borrowing because the

borrowed money is repaid when the bills are ’redeemed’, usually after 91 days.)

Fiscal policy and business

Fiscal policy affects business in a variety of ways.

 Companies might try to minimize their tax liabilities, possibly by transferring

business operations to low-tax countries.

 The investment decisions by companies could be affected by tax. For example,

the government might offer some tax relief for new investments, and companies

will expect to receive tax allowances for capital investment.

 Spending decisions by customers could be affected by the rate of sales tax or

value added tax. If the government increases the rate of value added tax, the

volume of customer demand for the goods and services of companies will

probably fall.

 Other tax changes can affect the rate of growth in the economy. For example, an

increase in rates of income tax on individuals will reduce their spending ability.

If the government borrows by issuing bonds, investors will be attracted by the risk-

free nature of investing in the bonds. (These bonds are regarded as risk-free because

the government is most unlikely to default on its debts, especially when the debt is

Paper F9: Financial management

denominated in the national currency. If it needs to it can print more money to pay

off its debts.)

Government borrowing might affect borrowing by companies. If companies also

want to borrow by issuing bonds, they will need to offer a higher rate of interest to

investors than the interest rate on government bonds, to persuade them to put their

money in risky corporate bonds rather than risk-free government bonds.

1.5 Monetary policy and inflation

Monetary policy is policy relating to monetary issues in the economy, in particular:

 the rate of inflation

 interest rates

 the exchange rate for the domestic currency against foreign currencies.

As explained earlier, there is a link between economic growth and the rate of

inflation. Excessive inflation is associated with an ‘over-heating’ economy, leading

to a slow-down in economic growth and possibly economic recession.

A major target of the government’s monetary policy is likely to be control over

inflation. This is currently the main objective of monetary policy, for example, in the

US, the eurozone countries and the UK. In these countries, interest rate policy is the

main instrument of economic policy for controlling the rate of inflation.

The link between interest rates and the rate of inflation can be summarised as

follows.

In order to reduce the rate of inflation in the long term it is essential to reduce

general expectations about what the future rate of inflation will be. Inflation will

increase when inflationary expectations are high.

To reduce inflationary expectations, the authorities must be seen to take action to

reduce inflationary pressures whenever these become evident. In the UK, USA and

eurozone, the ‘authorities’ are the central bank.

The central bank can take action by raising the rate of interest at which it lends

money to other banks. This rate of interest is sometimes called the ‘central bank base

rate’.

There is a ‘transmission effect’ in the economy, whereby the effect of the increase in

the base rate works its way through to the rest of the economy. If banks have to pay

more to borrow from the central bank, they will put up their interests rates to

borrowers. In time higher costs of borrowing might reduce the demand by

companies and individuals to borrow, and this in turn might reduce consumption

spending.

 If spending in the economy is rising too quickly, and there is a risk of inflation,

interest rates should therefore be raised. Higher interest rates will eventually

discourage borrowing and the growth in credit, and so restrict the growth in

spending

 If on the other hand the economy could grow more quickly without the threat of

inflation, interest rates might be lowered, to stimulate spending and investment.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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