ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 1: The role and responsibilities of financial managers

1.7 Stakeholder theory

Agency theory makes the assumption that the main objective of a company should

be to maximise the wealth of shareholders. Stakeholder theory is different. It is

based on the view that the purpose of corporate governance should be to satisfy, as

far as possible, the objectives of all key stakeholders – employees, investors, major

creditors, customers, major suppliers, the government, local communities and the

general public. A role of the company’s directors is therefore to consider the

interests of all the major stakeholders.

Managers should try to achieve a range of different objectives, not just the aim of

maximising the value of the company for its shareholders. This is because different

stakeholders each have their own (different) expectations from the company, which

the company’s management should attempt to satisfy. However, some stakeholders

might be more important than others, so that management should give priority to

their interests above the interests of other stakeholder groups.

Stakeholder theory also considers the role of companies in society, and the

responsibility that they should have towards society as a whole. It might be argued

that some companies are so large, and their influence on society is so strong, that

they should be accountable to the public for what they do. The general public are

taxpayers and as such they provide the economic and social infrastructure within

which companies are allowed to operate. In return, companies should be expected

to act as corporate citizens and act in ways that benefit society as a whole. This

aspect of stakeholder theory is consistent with the arguments in favour of corporate

social responsibility.

1.8 Differing governance models

The differing views about the responsibilities of companies to shareholders and

other stakeholders are evident in differing corporate governance structures and

policies.

 The USA and UK are most closely associated with an agency theory view that

company management should act in the best interests of the shareholders. The

interests of the shareholders are given some protection by law (such as the

Sarbanes-Oxley Act in the US) and by corporate governance codes (such as the

Combined Code in the UK) However, there is relatively little recognition of the

interest of other stakeholders, such as employees, in the governance of

companies.

 Parts of Western Europe, notably Germany, have been associated with a

stakeholder view of company responsibilities. In Germany there is a two-tier

system of boards in large companies, with a management board responsible for

company activities and operations, and a supervisory board with responsibility

for broader company matters and for supervision of the management board.

Many of the supervisory board directors are representatives of the employees,

which means that employee interests have a significant influence on the

discussions and decision-making of the supervisory boards.

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It is also worth noting, however, that within the US and UK there are different

views about the extent to which the directors of companies should comply with the

demands and expectations of shareholders. Traditional institutional investors and

fund managers are broadly supportive of company management, and rely on

management to take decisions that are in the best interests of the shareholders as a

whole. In contrast, activist funds (often hedge funds) holding only a fairly small

shareholding of 1% to 3% in a company might try to force the company to adopt

strategies they believe will ‘extract value’ from the company for the benefit of the

shareholders – such as selling off parts of the business.

A key point to note is that although shareholders might expect a company’s

management to take decisions that are in the shareholders’ interests, there could be

different views about how the interests of the shareholders are best represented. A

significant difference occurs between investors who are prepared to hold shares for

the longer term, in the expectation that the value of the shares will rise, and those

who invest for a much shorter term, hoping to see a profit by ‘extracting value’ from

under-performing companies.

1.9 Resolving stakeholder conflict

In your examination, you might be given a question in which you are asked, as a

company manager or as a financial management adviser, how conflicts between

different shareholder groups and stakeholder groups might be resolved. To deal

with this type of problem, you should consider all the possible courses of action that

a company might take in a particular situation, and the probable response that each

course of action may elicit from each stakeholder group.

In the chapters that follow, the focus of attention will be largely on shareholder

wealth maximisation, but it is always important to remember the potential

significance of other stakeholder interests in a company, including the interest of the

general public and the government.

Chapter 1: The role and responsibilities of financial managers

Improving corporate governance

 Board of directors

 Financial reporting and the external auditors: the audit committee

 Directors’ remuneration

 Internal control and risk management

 Communication with shareholders

 Corporate governance and corporate social responsibility

 Corporate governance in other countries

2 Improving corporate governance

Corporate governance can be improved by taking measures to deal with the

problems. As indicated earlier, these measures might be included in a voluntary

code, or might be made a legal requirement.

In the UK, there is a mixture of voluntary code and legal requirements. For example,

listed UK companies are required by the UK Listing Rules to comply with the

Combined Code on Corporate Governance or explain their non-compliance in the

annual report and accounts. In addition, quoted companies are required by UK law

to disclose details of the remuneration of each individual director and to submit a

directors’ remuneration report to the shareholders for approval, at the annual

general meeting of the company.

Measures recommended by the UK Combined Code for achieving good corporate

governance relate to:

 the board of directors: the board’s responsibilities and the composition of the

board

 financial reporting and the independence of the external auditors

 directors’ remuneration

 internal control and risk management

 communications between the company and its shareholders, and the rights and

responsibilities of shareholders (particularly investment institutions such as

pension funds and insurance companies).

The provisions of the UK Combined Code are described briefly below. These are a

useful guideline to corporate governance issues generally, and how they might be

dealt with in companies in any country.

2.1 The board of directors

Responsibilities of the board

The board of directors should reserve certain decisions for the board as a whole and

should not delegate these decision-making powers to the executive management.

The decisions reserved for the board would include decisions about major strategic

investments.

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Composition of the board

To prevent the board from being dominated by a single individual, the positions of

chairman and CEO should not be held by the same individual. The chairman is

responsible for leading the board of directors and representing the company as a

figurehead, for example in communicating with the shareholders. The CEO is

responsible for leading the executive management team of the company.

In addition, the CEO of a listed company should not go on to become the chairman.

If this happens, the chairman will not be independent, and may also exert a strong

influence over his (or her) successor as CEO.

To prevent the CEO (or chairman) from exerting excessive influence, the board

should include a sufficient number of independent non-executive directors (NEDs).

In large listed companies, at least half the board, excluding the chairman, should be

independent NEDs.

Board committees

The board should delegate certain responsibilities to committees of the board, which

should report back to the main board. The three board committees identified by the

Combined Code are a nominations committee (for appointing directors), an audit

committee (to communicate with the external auditors, recommend the

appointment and annual fees of the auditors, review the need for internal audit

function, etc) and remuneration committee (to consider remuneration policy and

negotiate the remuneration of individual directors).

The audit and remuneration committees should consist entirely of independent

NEDs, to avoid undue influence in these matters by executive directors. The

nomination committee should have a majority of independent NEDs.

Fulfilling responsibilities as directors adequately

The Combined Code states that directors should be able to give enough of their time

to the company in order to carry out their responsibilities. However, it does not

specify any limit to the number of (non-executive) directorships any individual

should hold.

Instead, the Code states that the board as a whole, each of the board committees and

all individual directors (including the chairman) should be subject to an annual

performance review. In principle, any individual who performs badly may be asked

to resign from the board.

In addition, the annual report and accounts should include information about the

number of board meetings and committee meetings attended by each individual

director. This may influence shareholders when they are asked to vote for the re-

election of any individual director at the annual general meeting.

Chapter 1: The role and responsibilities of financial managers

2.2 Financial reporting and the external auditors: the audit committee

To reduce the influence of the executive directors on the external auditors, certain

powers should be delegated by the board to the audit committee. The powers and

responsibilities of the audit committee should include the following:

 Discussing the annual audit plan with the external auditors

 Discussing with the external auditors any significant accounting issues that

affect the content of the annual report and accounts

 Reviewing the auditors’ performance. Where this is poor, the committee may

recommend a change of auditors to the board of directors (which would then

propose a change of auditors to the shareholders)

 Recommending the audit fee to the board of directors

 Monitoring the independence of the external auditors from influence by the

executive directors. One way of doing this is to monitor the amount of non-audit

work carried out for the company by the auditors. The audit committee should

ensure that the audit firm does not over-rely on income from the company,

either from the audit fee or fees for non-audit work.

There has been much debate about whether there should be a compulsory rotation

of audit firms, so that companies are required to change their audit firm at least

every five or seven years. This proposal was strongly opposed by companies and

audit firms.

An alternative suggestion is to require the rotation of key audit partners, who

should not remain as auditor for a particular company for more than a specified

number of years. There is no requirement in the Combined Code about audit

partner rotation, but the 8th European Union Directive, when introduced, will

require the compulsory rotation of key audit partners after no more than seven

years.

The board of directors must state in the annual report and accounts that the

company is a going concern.

2.3 Directors’ remuneration

The board should delegate to a remuneration committee (consisting of independent

NEDs) responsibilities for:

 remuneration policy for executive directors, and

 negotiating the remuneration of individual executive directors.

In the UK, quoted companies are required by law to present a directors’

remuneration report in the annual report and accounts and invite the shareholders

to approve the report at the annual general meeting of the company.

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2.4 Internal control and risk management

The board of directors must review the internal control system, and risk

management system of the company, and satisfy themselves that suitable control

systems are in place. The board should report to shareholders that they have done

so.

The responsibility for carrying out an annual review of risk management and the

internal control system may be delegated to the audit committee.

2.5 Communication with shareholders

The Combined Code requires the board of a company to promote good relations

and good communications with their shareholders.

In addition, institutional investors have a responsibility for maintaining a dialogue

with the company’s board of directors.

A new legal requirement has been introduced throughout the European Union that

listed companies should prepare an annual business review, setting out the

operating and financial position of the company in easy-to-understand language.

2.6 Corporate governance and corporate social responsibility

In summary, the aims of good corporate governance should be to reduce the

conflicts of interest between the board of directors and the shareholders.

The UK Combined Code does not include any provisions relating to Corporate

Social Responsibility. However, some institutional investors seek to promote CSR in

companies, and some institutions will not invest in companies that do not meet

certain minimum CSR requirements.

2.7 Corporate governance in other countries

Regulations and codes of practice about corporate governance vary between

different countries, and the regulations are continually changing.

 In the United States, the main focus of attention has been on the reliability of

financial reporting and internal controls. Following the collapse of Enron in 2001

and other corporate scandals such as WorldCom, the US introduced legislation

in the Sarbanes-Oxley Act 2002. This legislation includes requirements for SEC-

registered companies to submit annual statements about the accuracy of the

financial statements and the adequacy of financial controls (internal controls) in

the company. These controls are subject to annual audit.

 Within the European Union, progress towards good corporate governance is

being achieved by EU Directives such as the 8th Directive. In addition, some

countries have developed their own voluntary codes of governance, such as the

Cromme Code in Germany. In Germany, some of the problems of corporate

governance are different from those in the UK. For example, German companies

have a two-tier board structure. There is a supervisory board of non-executive

Chapter 1: The role and responsibilities of financial managers

directors, led by the company chairman, and there is a management board of

executives, led by the CEO. The non-executives on the supervisory board are by

no means all independent, and they usually include representatives of major

shareholders (who include banks), employees and retired senior executives.

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Role and responsibility of the senior financial management executive

 Advising on financial goals and financial policy development

 Financial strategy formulation

 Minimising the cost of capital

 Financial risk management and monitoring systems

 Ethical issues in financial management

3 Role and responsibility of the senior financial

executive

3.1 Advising on financial goals and financial policy development

A large part of the role of the senior financial manager is advisory, providing advice

on financial strategy and policies. In order to achieve its corporate objectives, a

company must develop strategies. To achieve an objective of maximising

shareholder wealth, financial strategies should be formulated by the board of

directors. Financial strategy is often (but not always) targeted towards achieving

growth in annual earnings and achieving a return on investment in excess of the

cost of the funds used to make the investment.

The main areas where financial managers provide advice to the board of directors or

senior operational management are:

 investment selection and capital investment appraisal

 the allocation of capital resources

 working capital efficiency (not covered in the syllabus for this examination

paper)

 minimising the company’s cost of capital

 dividend policy and retentions policy

 communicating financial policy to internal and external stakeholders in the

company.

Financial managers also have some operational responsibilities, which include:

 financial planning and control

 financial risk management systems, including treasury risk management.

3.2 Financial strategy formulation

The financial manager should provide advice to the board of directors and senior

management about financial strategy. Financial strategy should support the

business strategy of the company. You should keep in mind the following aspects of

financial strategy as you study this subject.

Chapter 1: The role and responsibilities of financial managers

 Achieving the optimal capital mix for the company (mix of equity capital and

debt capital) by minimising the company’s weighted average cost of capital

(WACC). Capital investments that exceed the WACC will usually add to the

value of the company and the wealth of the shareholders.

 Applying a policy for dividend payments and profit retentions that achieves a

suitable balance between the expectation of shareholders for annual dividend

payments, and the need to retain some profits to reinvest in the business to

achieve further growth in profits in the future. (Dividend policy is considered in

more detail later in this chapter.)

 Establishing systems to monitor capital spending and for financial risk

management.

 Developing a framework for financial risk management, with a variety of

strategies for reducing and controlling risks, risk hedging and risk

diversification.

3.3 Minimising the cost of capital

A financial manager must be able to calculate a cost of capital, and should advise

management on what cost of capital should be used to evaluate particular capital

expenditure projects. These aspects of the cost of capital are explained in later

chapters.

A basic policy objective should be to minimise the company’s cost of capital. This is

because for a given annual return, the total value of a company is minimised when

the weighted average cost of capital is minimised.

Example

The annual operational cash flows of Company YZ are $800,000 and are expected to

remain $800,000 in perpetuity.

The total value of the company can be estimated by dividing the annual cash flows

by the weighted average cost of capital.

 If the WACC is 10%, the total value of the company (equity and debt capital) is

$8,000,000 ($800,000/0.10).

 If the WACC is 8%, the total value of the company (equity and debt capital) is

$10,000,000 ($800,000/0.08).

 If the WACC is 5%, the total value of the company (equity and debt capital) is

$16,000,000 ($800,000/0.05).

When the total value of a company is maximised, the wealth of its shareholders is

also maximised, in terms of dollars per share.

The WACC can be changed by altering the financial gearing of the company, and

changing the relative amounts of debt capital.

The differing views on how WACC is affected by financial gearing are described in

a later chapter on the cost of capital.

Paper P4: Advanced Financial Management

3.4 Financial risk management and monitoring systems

Financial managers are responsible for advising operational managers and the

directors of a company about capital investment risk, and should establish a system

for the management and monitoring of risk.

The treasury department should also be specifically responsible for monitoring and

management of treasury risks, such as foreign currency risks and interest rate risks.

Framework for risk management

A risk management framework that is useful to remember is as follows. (It is based

on the COSO risk management framework, developed some years ago by the

Commission of Sponsoring Organisations in the US).

 There should be a well-established culture of risk management. Senior

management should recognise the importance of risk and the need to balance

the desire for high profits and returns with the need to avoid excessive risk

exposures.

 There should be systems for identifying and measuring risks, and recognising

which controls must be managed and controlled.

 Methods for managing risks should be applied to risks that are considered

sufficiently serious, provided that the cost of controlling the risk does not exceed

the potential benefit from reducing the risk of losses.

 The methods used to manage risks should be communicated to all managers

concerned. Managers should be kept informed about risk as well as returns.

 There should be a regular monitoring of risk management systems, methods and

measures, to ensure that they function effectively and achieve their intended

purpose.

Risk assessment will be considered in later chapters, for example with respect to risk

in capital investment projects. The risk in a proposed capital project should be

assessed and the risk assessment should be included in the decision-making process

leading to the decision of whether or not to undertake the investment.

After a capital investment has been undertaken, actual spending and actual returns

should be monitored (in a ‘post investment audit’) to establish whether actual

spending was kept within the planned limit and whether the expected returns were

actually achieved.

3.5 Ethical issues in financial management

In pursuing profits and shareholder wealth maximisation, companies should act

ethically, and in giving advice financial managers should be conscious of any ethical

issues that might be involved in the matter. Business ethics covers aspects of

business behaviour such as:

 Honesty and integrity in business dealings with others: honesty is more than just

remaining within the law!

 Concern for other stakeholders, such as employees, suppliers and customers.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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