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Premaster Finance Summary
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Samenvatting van de artikelen die tijdens de premaster finance zijn behandeld
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Summary FinanceImportant definitions
Budget slack = discrepancy between subordinates’ best estimate of performance based on his
private information and budgeted level of performance.
Budget participation = process in which employees are involved in, have influence on, the setting of
budgets that directly affect the employee. Opportunity to share their insights, private information.
Traditional budget-based contracts = link pay to performance explicitly, defines detailed goals for
subordinates, both motivational mechanisms.
Organizational commitment = willingness to exert effort to help organization reach its goals, strong
belief in goals and values of the organization, strong desire to maintain organizational membership.
Principal agent-relationship = principal hires agents to perform task on behalf of principal.
Organizational context manager (principal) – employee (agent). Agent has private information
principal doesn’t know. Information asymmetry is the difference between agent and principal in
information levels. Can be solved by monitoring. Agency framework – EBP often proposed as
solution to reveal private information subordinates superiors. So important to get this private
information since they often are an important source of uncertainties important for an
organization’s strategy. With info about competitor actions, changes in consumer preferences and
technological changes management, often information lower/middle managers hold, superiors can
make better decisions.
Week 1.
Chapter 1. Accounting performance measurement: a review of its
purposes and practices
Introduction
Accounting measures of performance are the traditional way to quantify firms’ performance.
However, non-financial measures are upcoming to motivate and report on performance of firms.
The development of financial measures has been neglected. However, economic value-added, EVA,
is an overall measure of company performance. 3 main functions of financial performance measures
are:
1) Tool of financial management, functional specialism of how financial resources can be used
effectively and efficiently for the greater good of the firm.
2) Major objective of a business firm, how is a firm achieving its financial goals?
3) Mechanism for motivation and control. Financial information provides a window.
Some overlap, i.e. performance may be managed by setting objectives, but other
mechanisms/measures are required to supplement such financial measures.
A tool of financial management
The finance department must manage the financial resources and ensure financial constraints aren’t
breached. Financial control can be seen as the process by which financial plans are monitored and,
when necessary, corrective action is taken (i.e. sig. deviations are detected). 3 areas of focus
financial plans: 1) cash flow planning, cash must be available to meet payments the organization is
obliged to meet. 2) profitability, need to acquire resources at a greater rate than using them. Cash
flow is more focused on how a firm covers short-term obligations, profitability and acquisition of
capital assets take into account the long-term benefits of assets. 3) assets and financial resources for
this – focus balance sheet. The pyramid of ratios shows how these areas are related. Five key ratios
for cash flows:
, 1) Current ratio = current assets / current liabilities
2) Quick ratio = quick assets (current assets – inventories) / current liabilities
3) Inventory turnover period = inventories / cost of sales
4) Debtors to sales ratio = debt / sales = average collection period
5) Creditors to purchases ratio = average payment period
These ratios address different aspects of cash collection & payment cycle. They’re best comparable
per industry or over time. Each part of the ratio should be relevant to the audience being addressed.
The risk associated with a firm’s equity earning has to do with leverage. Fixed assets should be
funded by capital received in the long-term, while working capital should fund only short-term
needs. However, a ratio often has different forms relative to what is meaningful. There’s thus no
definitive set of financial ratios to measure the performance of a business. However, often ratios are
window-dressed, acceptable accounting principles are used to manipulate numbers. This creative
accounting comes from pressures on firms to perform well.
One result of reforms to solve these scandals is greater use of operating information – financial
numbers alone are not enough. However with financial information a cycle of incoming cash flows
payment investors what’s left new investment more profitability more investors. A
vicious cycle has no money left to invest so profitability will decline. The finance function is the
intermediary between internal operations and external shareholders/investors. Are their financial
resources used effectively and efficiently?
An overall business objective
The 2nd major role of accounting performance measure has to do with the financial objectives of a
firm. External financial reporting needs to pay attention to shareholders – what’s a firm’s status of
debt to equity. This has to do with the principal-agent dilemma, the owners (shareholders) seek to
control managers but are restricted by lack of info, how is a company moving? Yearly accounting
statements may repair this imbalance. Active investors would prefer to receive one more often.
The profit and loss account comes down to profit – once all expenses are paid, the rest should go to
shareholders. However, often part is paid as dividend, part is kept as retained earnings for future
expansion, or when in trouble, payment of dividend. A shareholder loses his money when a firm
goes bankrupt. The earnings (profit) per share is a good indicator for shareholders. The share price
takes into account past performance, but also future expectations. An owner doesn’t only look at
how much dividend he received, but also the growth or decline in stock price. This is added to the
value he receives (a form of capital growth).
But what return can be expected? Capital asset pricing model, CAPM, says it depends on 1) the
risk-free rate of return that could be obtained from investing in an interest-bearing investment such
as a government bond 2) riskiness of a particular investment considered. However, should a
company base its share price on past performance? Is it a good predictor of future returns? In this
rapid changing world, probably not. The share price has more to do with all available (private)
information about its future prospects.
Accounting measures to a large extent are based on facts. However, there is also some judgement.
Creative accounting is the length to which accounting judgement can be stretched in the cause of
reporting profit figures helpful to directors etc (i.e. depreciation big part costs, is of judgement how
long assets have future life). Accounting performance measures are thus a weak surrogate for
shareholder returns provide only background and confirmatory evidence.
A mechanism for motivation and control
,The 3rd major role of accounting performance measurement is motivating and controlling activities of
managers so they concentrate on increasing the overall value of a business/shareholders. Activities
in a firm need a common language or unit of measurement – accounting provides this, activities can
be added into overall measures. Also, measures of outcomes and drivers of performance are
important to control performance financial measures alone not sufficient.
Accounting approach to control
The basic accounting approach to motivate and control starts with splitting a firm into responsibility
centres, investment centres where managers have the power to invest in business assets and to use
these assets entrusted to them effectively. At a lower level, profit centres are defined. Managers are
responsible for generating revenue and for managing costs involved in production. The lowest level
is the cost centre, units that only generate costs there to support a business. Their output need
measures other than financial ones to measure it. When it’s difficult to attach revenue to a service, a
transfer price is set up, value attributed to the transferred goods/services. However, inappropriate
setting of transfer prices and the tendency to attempt to create profit centres when they don’t exist
results in dysfunctional activity people will get creative with numbers. Ratios like ROI may lead to
underinvestment solution residual income, profit – charge for equity capital used in period.
Residual income=income−(capital employed x cost of capital %)
Projects that increase residual income over the life of an asset is desirable, projects that
decrease residual income is undesirable.
EVA is similar, more used, an overall performance measure but at the same time can be used to
measure the performance of individual business units EVA results in appropriate motivation, no
dysfunctional behaviour. EVA is most closely correlated with share price. The EVA focuses on
improving shareholder value. Does every manager at every level get the task to improve their EVA,
rewards linked to the results, it would improve shareholder value. However, limitations are 1)
measures for a single period can’t reflect the impact of a decision that has repercussions over
several accounting periods. It is difficult to adjust for future expectations as this is again subjective 2)
even when taking into account multiple periods, historical profits represent the true growth in value
of a business only if the assets it possesses are valued in terms of future expectations rather than
historical attainment. This requires much subjective judgement, open to sig. manipulation.
Performance drivers
A different approach moves away from concentrating on solely accounting measures, adding a wide
range of measures that are belied to drive future economic performance. i.e. the balanced scorecard
is good to structure performance measures (finance, education and growth, internal processes,
customer relationship). 1) The link between the dimensions make clear there’s not a universal set of
performance measures – specific circumstances need specific measures. 2) the 4 areas match the
main stakeholders. 3) clear drive to model main drivers of future performance. 4) requirement of a
limited number of performance measures in each area requires a focus on key success factors.
Measures in each area are often linked and can be reflected EVA can also be used in ‘finance’.
Connections between the approaches
3 functions of accounting performance measures were mentioned, however, sometimes something
is also measured for multiple purposes. A budget can be used as a financial plan (does the firm stay
within appropriate boundaries) and can be used as management control. However serving both
these purposes, planning and control, results in neither being adequately served. For planning, best
estimates or even conservative targets are best, to make sure a firm doesn’t get into trouble.
However, for control, challenging targets are best to motivate workers. The latter receives many
critiques as companies battle with much uncertainty, making forecasts difficult. Firms then not use
budgets for incentives, control anymore, only for planning.
, The beyond budgeting movement has recognized this, stating budgets are often outdated by the end
of the year. There are many weaknesses, but amongst others they constraint responsiveness and
encourage gaming/dysfunctional behaviour. Annually fixed budgets should be replaced by
benchmarked, flexible, performance standards (i.e. a league table). A relative performance target
that’s continuously updated when conditions change is more reliable for the changing environment.
Rewards are typically given with subjective performance evaluations, with emphasis on a workgroup
rather than individual rewards. Pre-set fixed target moving flexible target benchmarked.
Conclusions
Accounting measures have an illusion to be objective. However, they can be defined in a variety of
ways to be appropriate for specific use. It’s a complex process to set up the right ones, especially
when control is attached to it. Accounting provides a window into the firm of activities being
undertaken and their consequences. More recently, EVA came with accounting adjustment to
convert traditional accounting numbers into the most appropriate numbers in the calculation of EVA
EVA motivational target for operating managers. Other models, taking into account subjective
measures, are also good alternatives – like the balanced scorecard.
Key research challenges
There are 3 main challenges. 1) The issue of whether past financial numbers provide a sound basis
for predicting future performance. Past stock prices have shown to not be correlated with future
stock prices. EVA focuses on past performance but turns out to be a good indicator. Non-financial
measurement and information wider environment better foundation. 2) What are relative roles
of financial and non-financial measures in internal control? Strategy mapping is important, making a
logical connection between basic non-financial aspects of performance in a chain to overall financial
outcomes. 3) How useful will budgetary control be in the future? Effectiveness of either using the
traditional approach or beyond budgeting approach is probably best to look at context-dependent.
Chapter 12. Risk in performance measurement
Introduction
Firms need to earn returns for shareholders, as a result of taking risks is there a relationship
between the amount of risk-taking and returns? Risk = any unintended deviation from expectation.
Often higher-risk investments have higher returns, rather than lower-risk investments (like
governments) that have lower results. Financial measures are almost always given without any risk
context – however, without defining the context of risk, judgements about performance will be
incomplete. Risk assessment is involved from the highest level in strategic choices about what
activities to undertake, what assets to buy or what markets to serve to detailed operational
decisions like adequacy of safety measures in the workplace is a firm aware of managing risks?
There’s not much info available on how risk is managed. The financial services industry is, essentially,
managing different types of risks and applies techniques in doing so. The nature of the company’s
activities and its size are key determinants of whether there’s systematic risk management.
Countries manage the risk-taking of firms by letting companies make a list of risks they’re facing or
setting up disclosures on how they tackle them. There’s much evidence on how risk is managed in
large companies, but not so much for small companies that need it the most (most vulnerable). Why
is risk management not spoken of more?
Risk management has developed not until recently, managers need to become aware still;
No incentive system in place for managers to take account of risk;
Too complex for the older generation to understand;
Financial services see it as complex financial instruments, with nothing to offer them;
Quantitative and qualitative techniques are considered inferior to personal judgements;
It’s taking place, but not formally recognized as a process.
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