Chapter 1: The role and responsibility of the financial manager

Chapter learning Objectives

Upon completion of this chapter you will be able to:

• describe the relationship between strategy development and the goals and policies of a firm
• explain the role and responsibility of senior financial executives/advisors with regard to strategy development
• identify and explain a firm’s reasons and objectives for developing a policy with regard to investment selection and capital resource allocation
• identify and explain the goal of minimising a firm’s cost of capital
• identify and explain the reasons and objectives for developing a distribution and retention policy
• identify and explain the reasons and objectives for communicating financial policy and corporate goals to external stakeholders
• identify and explain the reasons and objectives for communicating financial policy and corporate goals to internal stakeholders
• explain the purpose of financial planning and control as part of financial policy
• explain the reasons and objectives for developing a policy with regard to risk management
• advise the board of directors in a scenario on the setting the financial goals of the business and in its financial policy development
• explain the importance of using financial resources in an efficient, effective and transparent manner and the role of senior financial executives in recommending to management strategies to achieve it.
• explain the ways in which the behaviour of those charged with corporate governance may give rise to a conflict of interest with stakeholders
• identify the potential conflicts between stakeholders and those charged with corporate governance in a specific scenario
• identify, explain and recommend the alternative approaches that may be adopted to resolve the conflicts of interests between those charged with governance and stakeholders
• describe, compare and contrast the emerging governance structures and policies in the UK, the US and Europe, with respect to corporate governance in general and the role of the financial manager in particular
• list and define the ethical principles governing members of the association
• explain the importance of establishing an ethical financial policy for the financial management of the firm (incorporating the ethical principles of the association and the principles of good corporate governance) and describe the role and responsibility of senior financial executives/advisors with regard to its development
• identify and explain the ethical issues which may arise within business issues and decisions of a firm in a scenario question
• analyse the potential impact of the following on corporate objectives and governance
  • of sustainability and environmental risk issues
  • the carbon-trading economy and emissions
  • environmental audits and the triple bottom line approach.

1 Key roles and responsibilities of the financial manager

The financial manager is responsible for making decisions which will increase the wealth of the company's shareholders.

The specific areas of responsibility are listed below.

However, it is also important that the financial manager considers the impact of his role on the other stakeholders of the firm.

You may be asked in the exam to assess the

• strategic impact
• financial impact
• regulatory impact
• ethical impact
• environmental impact

of a financial manager's decisions.

Link between strategy and financial manager's role

You will remember from your earlier studies that the process ofstrategy selection starts with the development of a mission statement. Amission statement:

• is the overriding purpose of the firm
• guides and directs all decisions taken.

The mission is then broken down into broad-based goals, and thenfurther, into detailed objectives. Strategies can then be developed tobridge the gap between current forecast performance and the targets set.

Policy framework

The mission will also provide the basis for the development of a policy framework.

The purpose of this framework is:

• to govern the way in which decisions are taken, and
• specify the criteria to be considered in the evaluation of any potential strategy.

At a broad level, this framework will incorporate guidance on issues such as:

Ethics and social responsibility

A consideration of the role of business in society. It coversresponsibilities towards society as a whole, the extent to which thecompany should fulfil or exceed its legal obligations towardsstakeholders and the behaviour expected of individuals within the firmitself.

Stakeholder protection

The extent to which the needs and wishes of individual stakeholdersare incorporated into decisions and the development of a framework toensure their needs are met and their rights upheld.

Corporate governance

The system by which companies are directed and controlled, including issues of risk management.

Sustainable development

Ensuring that projects and developments that meet the needs of thepresent, do not compromise the ability of future generations to meettheir own needs.

This guidance is often formulated as a general principle:

e.g. all suppliers used must demonstrate commitment to employee welfare,

but may also form the basis for the generation of specific targets:

e.g. increase by 10% the amount of raw materials sourced locally in the next 12 months.

Financial policy

Policies will also be developed to govern decisions within eachoperational area of the business. These policies specify generallyapplicable processes or procedures to be followed when decisions arebeing made, or state one overarching principle which the sets theboundaries for all decisions taken.

For example, within the finance function, policies will be developed over areas such as:

• investment selection
• overall cost of finance
• distribution and retentions
• communication with stakeholders
• financial planning and control
• risk management
• efficient and effective use of resources.

Key areas of responsibility for the financial manager

The main roles and responsibilities of the financial manager can be summarised by the following headings:

• investment selection and capital resource allocation
• raising finance and minimising the cost of capital
• distribution and retentions
• communication with stakeholders
• financial planning and control
• risk management
• efficient and effective use of resources.

The Advanced Financial Management syllabus (and the rest of thisText) covers these areas in detail. This chapter gives a briefintroduction to each of them.

Investment selection and capital resource allocation

The primary goal of a company should be the maximisation ofshareholder wealth, but any number of stakeholders may have views on theobjectives a company should pursue.

Therefore, key policy decisions need to be made:

• How to incorporate ethical issues, such as minimising potential pollution or refusal to trade with unacceptable regimes, into the investment appraisal process?
• What method of investment appraisal should be used?
  • NPV?
  • IRR?
• In times of capital rationing, how are competing projects to be evaluated?
  • use of theoretical methods
  • incorporation of non-financial factors such as:

    (1) closeness of match to objectives

    (2) degree to which all goals will be achieved.

• As markets are not truly efficient, and investors treat earnings and dividend announcements as new information, to what extent should the impact on, for example:
  • ROCE
  • EPS
  • DPS

be considered when evaluating a project?

More on investment selection

Incorporation of corporate policy issues

If for example, a decision has been taken to pay a ‘fair’ wageto all employees regardless of the legal minimum requirement in thecountry where the business is operating, this rule must be applied tothe wages figure used in any project evaluation.

The financial executive must be aware of the policy requirement andensure that sufficient research is carried out in advance that thecorrect figure is used.

Methods of investment appraisal

Assuming that the discounted cash flow techniques are preferredover Payback and ARR (which do not assure the maximisation ofshareholder wealth), it is still necessary to designate which of the DCFmethods is to be applied. Although NPV is theoretically superior, it isnot as well liked by non-financial managers. IRR as a percentage isdeemed clearer and simpler (although the point could be argued!). It isfor the senior financial executive to decide on a method and ensure itis applied correctly.

Capital rationing

The rule for an NPV evaluation states that all projects with apositive NPV should be accepted. However, this presupposes no limits onthe available funds. Where restrictions exist, theoretical models can beapplied:

• Shortages in one period only – use limiting factor analysis (covered in Paper F9).
• Shortages in multiple periods – see chapter 6

However, these methods do not build in evaluation of non-financialfactors such as how well each strategy will meet the objectives set andpractical difficulties that might be encountered along the way.

Forms of evaluation such as Cost Benefit Analysis and WeightedBenefit Scoring can be used where these factors are significant. Thesemethods, pioneered by the public sector where such problems arecommonplace, include techniques to assign money values to non-financialfactors and to weight subjective factors against each other. Detailedknowledge of such methods is outside the syllabus.

Earning and dividend measures

Even where improving shareholder wealth is the primary concern ofthe financial executive, the impact of the investment decisions on thereported position and perceived performance of the firm cannot beignored. In an imperfect market, the earnings of a company and thedividends paid, are treated as relevant information for evaluating acompany’s worth and may impact the share price. Yet it is the shareprice that the executive is trying to improve.

Raising finance and minimising the cost of capital

A key aspect of financial management is the raising of funds tofinance existing and new investments. As with investment decisions, themain objective with raising finance is assumed to be the maximisation ofshareholder wealth.

The following issues thus need to be considered when setting criteria for future finance and deciding policies:

• Is the firm at its optimal gearing level with associated minimum cost of capital?
• What gearing level is required?
• What sources of finance are available?
• Tax implications.
• The risk profile of investors and management.
• Restrictions such as debt covenants.
• Implications for key ratios.

Distribution and retention policy

When deciding how much cash to distribute to shareholders, thecompany directors must keep in mind that the firm’s objective is tomaximise shareholder value:

• Shareholder value arises from the current value of the shares which in turn is derived from the cash flows from investment decisions taken by the company’s management.
• Retained earnings are a significant source of finance for companies and therefore directors need to ensure that a balance is struck:
  • Paying out too much may require alternative finance to be found to finance any capital expenditure or working capital requirements.
  • Paying out too little may fail to give shareholders their required income levels.

• The dividend payout policy, therefore, should be based on investor preferences for cash dividends now or capital gains in future from enhanced share value resultant from re-investment into projects with a positive NPV.

It is the task of the financial manager to decide on the appropriate policy for determining distributions and retentions.

Communication with stakeholders

A vital role for those running a company is to keep both external and internal stakeholders informed of all significant matters.

External stakeholders

External stakeholders to be kept informed would include:

• shareholders
• government
• suppliers
• customers
• community at large.

Internal stakeholders

Corporate goals and financial policies must be communicated to allthose involved within the organisation, whether at a senior level or inoperational positions.

• managers/directors
• employees.

Test your understanding 1

Suggest reasons why it would be important to keep eachof the above stakeholders informed of general corporate goals andintentions.

In addition to information about corporate goals, key matters offinancial policy will also need to be communicated to stakeholders:

• Shareholders will need information about:
  • dividend policy
  • expected returns on new investment projects
  • gearing levels
  • risk profile.
• Suppliers and customers will need information about:
  • payment policies
  • pricing policies.

Financial planning and control

Financial planning and control is the main role of the management accountant within a company.

The senior financial executive will need to oversee the developmentof policies to govern the way in which the process is carried out.

Policies will be needed over areas such as:

• the planning process
• business plans
• budget setting
• monitoring and correcting activities
• evaluating performance.

The management of risk

One of the key matters to consider when developing a financialpolicy framework is the way risk and risk management is to beincorporated into the decision making process.

A number of policy decisions must be made:

• What is the firm’s appetite for risk?
• How should risk be monitored?
• How should risk be dealt with?

A major part of the P4 syllabus involves the choice and use of many alternative methods and products to manage risk exposure.

More detail on risk management

Appetite for risk

Shareholders will invest in companies with a risk profile thatmatches that required for their portfolio. Management should be wary ofaltering the risk profile of the business without shareholder support.An increase in risk will bring about an increase in the required returnand may lead to current shareholders selling their shares and sodepressing the share price.

Inevitably management will have their own attitude to risk. Unlikethe well-diversified shareholders, the directors are likely to beheavily dependent on the success of the company for their own financialstability and be more risk averse as a consequence.

Monitoring risk

The essence of risk is that the returns are uncertain. As timepasses, so the various uncertain events on which the forecasts are basedwill occur. Management must monitor the events as they unfold,reforecast predicted results and take action as necessary. The degreeand frequency of the monitoring process will depend on the significanceof the risk to the project’s outcome.

Dealing with risk

Risk can be either accepted or dealt with. Possible solutions for dealing with risk include:

• mitigating the risk – reducing it by setting in place control procedures
• hedging the risk – taking action to ensure a certain outcome
• diversification – reducing the impact of one outcome by having a portfolio of different ongoing projects.

Policy decisions about which methods are to be preferred should be made in advance of specific actions being required.

Use of resources

It will be important to develop a framework to ensure all resources(inventory, labour and non-current assets as well as cash) are used toprovide value for money. Spending must be:

• economic
• efficient
• effective
• transparent.

Performance measures can be developed in each area to set targets and allow for regular monitoring.

Definitions of the 3 Es

2 Incorporating the interests of other stakeholders

We usually assume that the primary objective of a business is to maximise shareholder wealth.

However, a company is unlikely to be successful unless it also aimsto satisfy the needs of its other stakeholders. The financial managerwill have to identify potential conflicts between stakeholders'objectives and aim to resolve these conflicts.

Test your understanding 2

For each of the following groups of stakeholders in acompany, suggest a potential conflict of interest and give an example ofthe resulting costs such a conflict could give rise to.

Strategies for managing conflict between stakeholders - practical

Hierarchies of decision making (corporate governance codes)

In order to prevent abuse of decision-making power by the executive, control over decisions tends to be distributed between:

• the full board
• individual executive directors making operational decisions
• non-executive directors
  • audit committee
  • remuneration committee.
• shareholders in general meeting
• specific classes of shareholders where particular rights are concerned.

In addition, a company may elect to take some key decisions in consultation with the employees.

More on Corporate Governance

The full board

Whilst for most operational matters, decisions may be taken by theappropriate functional director, matters of corporate policy, investmentdecisions over a certain limit, sensitive decisions etc. are likely torequire the consent of the full board. This ensures that all salientfactors are considered when the decision is taken.

Non-executive directors

Whilst executive directors are employees involved in the day-to-dayrunning of the business, non-executives are independent of the company,and appointed to monitor and challenge the executives as well as toadvise and support them.

Removing decisions such as director remuneration and appointmentfrom the remit of the executive, mitigates the likelihood of directorsmaking self serving decisions contrary to the interests of otherstakeholders.

In addition, creating an audit committee to provide an independentreporting line for internal auditors and external auditors alike,provides a safeguard for shareholders against potential cover-ups ofpoor management practices.

Shareholders in general meeting

Legislation reserves for the shareholders certain key corporatedecisions such as the appointment and removal of auditors and directors.When taking decisions, the directors will be aware that ignoring thewishes of the shareholders would put them at risk of removal.Shareholders may also use the company general meetings as an opportunityto express their concerns and remind the directors of their votingcontrol.

Specific classes of share

In order to protect the rights of non-voting shareholders such asthose holding preference shares, it is common to allow them votingrights in particular circumstances such as where their dividend goesinto arrears.

The principles of corporate governance

Corporate governance is usually defined as ‘the system by whichcompanies are directed and controlled’. The concept encompasses issuesof ethics, risk management and stakeholder protection.

The Organisation for Economic Cooperation and Development (OECD)issues specific guidelines for national legislation and regulation inthe form of the Principles of Corporate Governance. These were exploredin great depth in the P1 paper.

Practical implications

The implications of the guidelines for companies in all countries are a need for the:

• Separation of the supervisory function and the management function.
• Transparency in the recruitment and remuneration of the board.
• Appointment of non-executive directors.
• Establishment of an audit committee.
• Establishment of risk control procedures to monitor strategic, business and operational activities.

However, different countries have adopted different techniques fordealing with these issues. A common distinction is made between:

• the outsider system developed in the US and the UK
• the insider system used in continental Europe and Japan.

The differences can be explained by the different economic environments in which they developed.

Implications for investment policy

The differing corporate governance structures above have practical implications for investment policy.

In the US/UK model the primary responsibility of management is toearn high returns for shareholders, therefore financial managers aremore likely to:

• adopt new technologies
• consider high risk investments.

Performance monitoring and evaluation systems

Managers are more likely to act in accordance with shareholders’wishes when their performance is regularly monitored and appraisedagainst prescribed targets. To be of real value, the targets must becongruent with the maximisation of shareholder value.

Test your understanding 3

List ways in which management performance may beappraised and for each method consider the extent to which it iscongruent with the maximisation of shareholder wealth.

Strategies for managing conflict between stakeholders - theoretical

More on Thomas & Kilmann

Competition

Involves stressing your position without considering opposing points of view.

This style is highly assertive with minimal cooperativeness; the goal is to win.

Useful when:

• action must be taken quickly
• the decision is necessary but will be unpopular
• the issue at hand is vital.

Avoidance

Involves failing to satisfy your concerns or the concerns of the other person.

This style is low assertiveness and low on cooperation. The goal is to delay.

Useful when:

• issues are of minor importance
• tensions need to be reduced
• to buy time. This is valuable where:
  • you need to enlist the support of others
  • the problem is symptomatic of a much larger issue which will need to be resolved first.

Compromise

Involves finding a middle ground or forgoing some of your concerns and committing to other’s concerns.

This style is moderately assertive and moderately cooperative; the goal is to find middle ground.

Useful when:

• issues are of moderate importance
• both parties are equally powerful and equally committed to opposing views
• the issue needs to be resolved promptly.

Collaboration

Involves attempting to satisfy both sides.

It is highly assertive and highly cooperative; the goal is to find a ‘win/win’ solution.

Useful when:

• working in teams
• solutions must integrate a number of perspectives
• support and commitment is needed from all parties
• time is not a key priority.

Accommodation

Involves foregoing your concerns in order to satisfy the concerns of others.

This style is low assertiveness and high cooperativeness; the goal is to yield.

Useful when:

• need to demonstrate goodwill
• issues are of low importance.

Mapping stakeholders

More on Mendelow's matrix

Box A – Direction

Suitable for: Stakeholders who do not stand to lose or gainmuch from the project AND whose actions cannot affect the project’sability to meet its objectives.

They may require limited monitoring or informing of progress butare of low priority. They are unlikely to be the subject of projectactivities or involved in project management.

Method: Simply provide instructions as necessary. These stakeholders are likely to accept what they are told.

Box B – Education and communication

Suitable for: Stakeholders who stand to lose or gainsignificantly from the project BUT whose actions cannot affect theproject’s ability to meet its objectives.

The project needs to ensure that their interests are fullyrepresented. The positively disposed groups from this box may lobbyothers to support the strategy. In addition, if the strategy ispresented as rational or inevitable to the dissenters, or a show ofconsultation gone through, this may stop them joining forces with morepowerful dissenters in boxes C and D.

Method: Management should brief all groups on thereasonableness of project and of any provisions being made for thoseaffected by the decisions. Advance notice will give each more time foradjustment.

Box C – Intervention

Suitable for: Stakeholders whose actions can affect theproject’s ability to meet its objectives BUT who do not stand to loseor gain much from the project.

They may be a source of risk; means of monitoring and managing thatrisk should be explored. The key here is to keep the occupantssatisfied to avoid them gaining interest and shifting into box D.

Method: Usually this is done by reassuring them of the likely outcomes of the strategy well in advance.

Box D – Participation

Suitable for: Stakeholders who stand to lose orgain significantly from the project AND whose actions can affect theproject’s ability to meet its objectives.

These stakeholders can be major drivers of the change and majoropponents of the strategy. The project needs to ensure that theirinterests are fully represented in the coalition. Overall impact of theproject will require good relationships to be developed with thesestakeholders.

Method: Initially there should be education/communication toassure them that the change is necessary, followed by discussion of howto implement it. Key stakeholders will be consulted throughout and willbe part of the decision making process.

Test your understanding 4

For each of the scenarios below suggest the likelysource of conflict and how such a conflict could have been avoided/couldbe resolved.

(1) The directors are keen to invest in new equipment for use in the production process to replace work currently done by hand.

(2) The directors are considering a contract which will significantly increase the size of the company within just a few months.

(3) The marketing director intends to run a month long TV campaign which will cost twice the allocated marketing budget.

3 The strategic impact of the financial manager's decisions

Strategic issues are those which impact the whole business in the long term.

Key strategic issues which may arise from decisions made by the financial manager are:

Does the new investment project help to enhance the firm's competitive advantage?

For example, if the firm has traditionally competed on the basis ofcost leadership, the financial manager needs to ensure that newprojects maintain this position, and that any new finance is raised atthe lowest possible cost.

Fit with environment

A knowledge of the main Political, Economic, Social andTechnological factors which impact the business will help the financialmanager to identify likely opportunities.

Use of resources

The financial manager should identify new investment opportunitieswhich make the best use of the firm's key resources. Knowledge of thefirm's current strengths (core competencies) and weaknesses is criticalin assessing which new projects are most likely to be successful.

Stakeholder reactions

As discussed above, it is critical that the views of allstakeholders are considered when financial management decisions aremade. Theoretically, the directors have a primary objective to maximiseshareholder wealth. However, decisions which appear to satisfy thisrequirement by ignoring other stakeholders' views in the short term candamage the firm's prospects for longer term shareholder wealthmaximisation.

Impact on risk

Investors will have been attracted to the firm because they deemits risk profile to be acceptable. Making decisions which change theoverall risk of the firm may alienate shareholders and damage the firm'slong term prospects.

4 The financial impact of the financial manager's decisions

It is common to assess the financial impact of a financialmanager's decision by focussing on the likely Net Present Value (NPV) ofinvestment projects undertaken. After all, the primary aim of a companyis to maximise the wealth of its shareholders, and NPV represents theincrease in shareholder wealth if a project is undertaken.

However, it is also important to consider the following issues:

Likely impact on share price

In a perfect capital market, the NPV of the project wouldimmediately be reflected in the company's share price. In the realworld, unless the details of the project are communicated effectively tothe market, the share price will not be impacted.

Likely impact on financial statements

In theory, a positive NPV project should increase shareholderwealth. However, if the project has low (or negative) cashflows in theearly years, the negative impact on the financial statements in theshort term may give a negative signal to the market, thus causing theshare price to fall.

Impact on cost of capital

As discussed in detail elsewhere, raising new finance causes thefirm's cost of capital to change. However, undertaking projects ofdifferent business risk from the firm's existing activities can alsoimpact cost of capital. Projects will be more valuable when discountedat a low cost of capital, so the financial manager should avoid highrisk projects unless it is felt that they are likely to deliver a highlevel of return.

Test your understanding 5

The directors of Ribs Co, a listed company, are reviewing thecompany's current strategic position. The firm makes high quality gardentools which it sells in its domestic market but not abroad.

Over the last few years, the share price has risen significantly asthe firm has expanded organically within its domestic market.Unfortunately, in the last 12 months, the influx of cheaper, foreigntools has adversely impacted the firm's profitability. Consequently, theshare price has dropped sharply in recent weeks and the shareholdersexpressed their displeasure at the recent AGM.

The directors are evaluating two alternative investment projects which they hope will arrest the decline in profitability.

Project 1: This would involve closing the firm's domestic factoryand switching production to a foreign country where labour rates are aquarter of those in the domestic market. Sales would continue to betargeted exclusively at the domestic market.

Project 2: This would involve a new investment in machinery at thedomestic factory to allow production to be increased by 50%. The extratools would be exported and sold as high quality tools in foreign marketplaces.

Both projects have a positive Net Present Value (NPV) when discounted at the firm's current cost of capital.

Discuss the strategic and financial issues that this case presents.

5 The regulatory impact of the financial manager's decisions

The extent to which the financial manager's actions are scrutinised by regulators is determined by:

• the type of industry - some industries (in particular the privatised utility industries in the UK) are subject to high levels of regulation.
• whether the company is listed - listed companies are subject to high levels of scrutiny. The Regulator for Public Companies has the primary objective of ensuring clarity for all investors.

The UK City Code

The City Code applies to takeovers in the UK. It stresses the vitalimportance of absolute secrecy before any takeover announcement ismade. Once an announcement is made, the Code stipulates that theannouncement should be as clear as possible, so that all shareholders(and potential shareholders) have equal access to information.

6 The ethical impact of the financial manager's decisions

Ethics, and the company’s ethical framework, should provide abasis for all policy and decision making. The financial manager mustconsider whether an action is ethical at a:

• society level
• corporate level
• individual level.

Explanation of levels of ethics

Society level

The extent to which the wishes of all stakeholders both internaland external should be taken into account, even where there is no legalobligation to do so.

Corporate level

The extent to which companies should exceed legal obligations tostakeholders, and the approach they take to corporate governance andstakeholder conflict.

Individual level

The principles that the individuals running the company apply to their own actions and behaviours.

As key members of the decision-making executive, financial managersare responsible for ensuring that all the actions of the company forwhich they work:

• are ethical
• are grounded in good governance
• achieve the highest standards of probity.

In addition to general rules of ethics and governance, members ofthe ACCA have additional guidance to support their decision making.

ACCA Code of Ethics

At an individual level, members of the ACCA are governed by a setof fundamental ethical principles. These principles are binding on allmembers and members review and agree to them each year when they renewtheir ACCA membership and submit their CPD return.

The fundamental principles are:

• integrity
• objectivity
• professional competence and due care
• confidentiality
• professional behaviour.

Integrity

Members should be straightforward and honest in all professional and business relationships.

Objectivity

Members should not allow bias, conflicts of interest or undueinfluence of others to override professional or business judgements.

Professional competence and due care

Members have a continuing duty to maintain professional knowledgeand skill at a level required to ensure that a client or employerreceives competent professional service based on current developments inpractice, legislation and techniques. Members should act diligently andin accordance with applicable technical and professional standards whenproviding professional services.

Confidentiality

Members should respect the confidentiality of information acquiredas a result of professional and business relationships and should notdisclose any such information to third parties without proper andspecific authority or unless there is a legal or professional right orduty to disclose. Confidential information acquired as a result ofprofessional and business relationships should not be used for thepersonal advantage of members or third parties.

Professional behaviour

Members should comply with relevant laws and regulations and should avoid any action that discredits the profession.

In working life, a financial manager may:

• have to deal with a conflict between stakeholders
• face a conflict between their position as agent and the needs of the shareholders for whom they act.

An ethical framework should provide a strategy for dealing with the situation.

More on ethics

Ethical financial policy

All senior financial staff would be expected to sign up and adhereto an ethical financial policy framework. A typical code would covermatters such:

• acting in accordance with the ACCA principles
• disclosure of any possible conflicts of interest at the first possible opportunity to the appropriate company member
• ensuring full, fair, accurate, complete, objective, timely and understandable disclosure in all reports and documents that the company files
• ensuring all company financial practices concerning accounting, internal accounting controls and auditing matters meet the highest standards of professionalism, transparency and honesty
• complying with all internal policy all external rules and regulations
• responsible use and control of assets and other resources employed
• promotion of ethical behaviour among subordinates and peers and ensuring an atmosphere of continuing education and exchange of best practices.

Assessing the ethical impact of decisions

Once a framework has been developed it is essential that all decisions are made in accordance with it.

This will involve:

• all employees explicitly signing up to the framework
• providing employees with guidelines to apply to ethical decisions
• offering resources for consultation in ethical dilemma
• ensuring unethical conduct can be reported without reprisal
• taking disciplinary action where violations have occurred.

Guidelines for making ethical decisions often take the form of aseries of questions which employees are encouraged to ask themselvesbefore implementing a decision. For example:

• Have colleagues been properly consulted?
• Are actions legal and in compliance with professional standards?
• Is individual or company integrity being compromised?
• Are company values being upheld?
• Is the choice of action the most ethical one?
• If the decision were documented would a reviewer agree with the decision taken?

In addition to written ethical guidelines firms often provideemployees with a list of people who can be consulted in the case of anethical dilemma. For example:

• Line manager.
• Appointed quality and risk leaders.
• Firm legal team.
• Ethics hotline within the firm (obviously only in larger companies is this likely to be affordable).
• Professional hotline – the ACCA for example, provides its members with ethical advice and support, as do many other professional organisations.

Test your understanding 6

Suggest ways in which ethical issues would influence the firm’s financial policies in relation to the following:

• shareholders
• suppliers
• customers
• investment appraisal
• charity.

7 The environmental impact of the financial manager's decisions

In the last few years, the issue of sustainable development hastaken on greater urgency as concerns about the long-term impact ofbusiness on the planet have grown.

The United Nations defines sustainable development as:

Development that meets the needs of the present without compromising the ability of future generations to meet their own needs.

The underlying principle for firms is that environmental, socialand economic systems are interdependent and decisions must address allthree concerns coherently.

In developing corporate policies and objectives, specific attentionshould be given to matters of sustainability and environmental risk.

Specific examples of environmental issues

Carbon-trading and emissions

Firms with high energy use may need to set objectives for theiremissions of greenhouse gases in order to achieve targets set bygovernments under the Kyoto Protocol.

This may include:

• reducing emissions to reduce liability for energy taxes
• entering a carbon emissions trading scheme.

The Kyoto Protocol

The Kyoto Protocol was negotiated by 160 nations in 1997. It is anattempt to limit national emissions of greenhouse gases in order to slowor halt an associated change of climate. The agreement sets emissiontargets for the individual nations. Australia, for instance, has agreedto limit its annual emission by the year 2012 to no more than 108% ofits emission in 1990. For the world as a whole, the aim of the Protocolis to reduce the global emission of carbon dioxide to 5% below the 1990value by the year 2012.

The Protocol was negotiated based on an economic mechanism of‘carbon trading’ evolving; i.e. nations issuing permits for carbonemission, set to match the targets set by the Kyoto Protocol or itsfollow-on agreements. The permits, tradeable, both nationally andinternationally, are intended to operate such that market forcesultimately replace government direction in the process of encouragingmore efficient use of fossil fuel.

Individual companies will be able to decide whether to spend moneyon new ‘carbon efficient’ technology or on the acquisition of carboncredits from those industries or countries which have a surplus.

In the UK for example, there is a carbon emissions trading scheme,which was set up in 2002. Details are provided here only to provide aclear picture of how such a scheme works.

The UK scheme

Organisations can enter the scheme directly, by volunteering toreduce emissions in return for a financial incentive provided by thegovernment. They will be set emissions targets based on a formula. Ifthey overachieve they can sell or bank the excess allowances. If theyunderachieve they must buy the allowances they need.

Some firms already have targets as a result of Climate Change LevyAgreements (CCLAs – see below) set up to help businesses withintensive energy use mitigate the effects of the UK energy tax. Thesefirms can sell their surpluses or buy needed credits.

Other firms, even if they do not emit greenhouse gases, may set up an account to trade in the allowances.

The climate change levy is a tax on the use of energy in industry,commerce and the public sector, with offsetting cuts in employers’National Insurance Contributions – NICs – and additional support forenergy efficiency schemes and renewable sources of energy. The levyforms a key part of the Government’s overall Climate Change Programme.

The role of an environment agency

Government environment agencies (in the UK – Defra – theDepartment for the environment, food and rural affairs) work to ensurethat business meets the environmental targets set internationally. Theyset local business targets in key areas such as:

• energy conservation
• recycling
• protection of the countryside
• sustainable development

which will need to be taken into account when setting objectives for the business as a whole.

Environmental audits and the triple bottom line approach

First coined in the mid-1990’s, the phrase triple bottom line, refers to the need for companies to focus on the:

• economic value and
• environmental value and
• social value

both added and destroyed by the firm.

Providing stakeholders with corporate performance data in each of these areas is known as triple bottom line reporting.

In order to provide credible data, companies will need to:

• set up a suitable management system to capture the information
• ensure the reports are subject to an appropriate audit scrutiny.

Triple bottom line reporting

A triple bottom line approach requires a shift in culture andfocus, and the development of appropriate policies and objectives. Itcan also be used as a framework for measuring and reporting corporateperformance.

Many leading companies are now publishing environmental andsustainability reports – demonstrating to stakeholders that they areaddressing these issues.

In order to provide meaningful data, a business must be able toassess the environmental and social impact of their operations. One wayto do this is to adopt the framework provided by ISO 14000. ISO 14000 isa series of international standards on environmental management. Itprovides a framework for the development of an environmental managementsystem and a supporting audit programme.

Environmental auditing is a systematic, documented, periodic andobjective process in assessing an organisation’s activities andservices in relation to:

• Assessing compliance with relevant statutory and internal requirements.
• Facilitating management control of environmental practices.
• Promoting good environmental management.
• Maintaining credibility with the public.
• Raising staff awareness and enforcing commitment to departmental environmental policy.
• Exploring improvement opportunities.
• Establishing the performance baseline for developing an Environmental Management System (EMS).

8 Chapter summary

Test your understanding answers

Test your understanding 1

Shareholders – The support of shareholders is necessary forthe smooth running of the business. Actions from awkward questions atAGMs through to (in the worst case) a vote to remove the directors, areavailable to aggrieved shareholders. The goals set by a company shouldreflect their concerns as key stakeholders, and communication of themshould reassure shareholders that the firm is acting as they would wish.

Government – Government targets and policies often includespecific expectations of the business community. Keeping governmentdepartments informed of activities and consulting in key areas can helpprevent later government intervention, or punitive action fromregulators.

Customers – A business will struggle to continue withoutthe support of its customers. Today, consumers are increasinglyconcerned about how the goods and services they buy are provided.Companies are therefore keen to demonstrate their commitment to ethical,environmental policies. They can do so by communicating clearly thespecific goals and policies they have developed to ensure they meetcustomer expectations.

Suppliers – If shareholder and customer concern over theprovenance of the supply chain is to be addressed, it is essential thatsuppliers are clear about the expectations of the company. This mayinclude requirements for their own suppliers, the treatment of their ownstaff, the way in which their products are produced etc. The companymust ensure such policies are clear and enforced.

Community at large – The larger community may not have anydirect involvement with the company but can be quick to take actionsuch as arranging boycotts or lobbying if it disapproves of the way thecompany conducts business. Reassurance about corporate goals can reducethe likelihood of disruptive action.

Managers / directors / employees â€“ Senior staff will needto be kept fully up-to-date about all goals and policies set by thefirm, so they can apply them when taking decisions. Explaining toemployees why decisions are being taken can help to ensure co-operationin their implementation.

Test your understanding 2

N.B. You may have come up with different suggestions. Thepoint is to recognise that there are a huge range of potential conflictsof interest and each one results in additional costs for the businessand therefore a reduction in returns to shareholders.

Test your understanding 3

Financial measures

Accounting ratios:

• EPS/ROCE/RI – both suffer from the same criticism – that earnings are not directly related to shareholder wealth and therefore may encourage non-goal congruent behaviour.
• DPS – is a measure of immediate improvement in wealth but must be looked at in conjunction with the company share price. Dividends may be reduced in order to invest in positive NPV projects, but in that case, the gain should be reflected in the share price.
• Economic value added – EVA is a more sophisticated method of residual income (registered as a trademark by Stern, Stewart & Co.), which more accurately measures improvements in shareholder wealth by adjusting the accounting data to eliminate much of the subjectivity and incorporating the company’s WACC into the calculation.

Stock market figures:

• Share price – reflects the expectations of the investors. Is a direct measure of company success but is hard to link directly to directors’ performance as it is affected by so many outside factors.
• PE ratio – as a multiple of share price over earnings it does reflect investors’ view of the investment potential of the company but suffers from the same weakness as all other earnings related measures and is not easy to relate to directors activities.

Shareholder value added

A calculation of the present value free cash flows, this method is amore accurate measure of improvements in shareholder wealth, but itscomplexity makes it of little use as a regular performance measure.

Specific cost/revenue targets

A vast array of financial targets may be set around the levels ofspending and investment, or around revenues earned. Care must be takento ensure that the targets are achievable and within the control of theperson being assessed. Particular attention must be paid to theinterdependence of the various aspects of performance. If managers areincentivised to achieve a reduction in purchase spending for example,alternative measures must also confirm that quality is maintained.

Non-financial measures

Balanced scorecard

Many businesses operate a balanced scorecard approach to managementappraisal. This involves setting targets in all of those aspects of thebusiness where success is necessary if positive NPVs are to be earned.In addition to financial targets, managers are measured on thesatisfaction of customers, improvement of business practices and levelsof innovation. Since achieving these targets should lead to improvedproject returns and greater cost efficiency, a balanced scorecardapproach should lead to improved shareholder wealth.

Employee/satisfaction

In addition, some businesses specifically set management targetsrelated to employee satisfaction ratings, or related targets such asabsenteeism or staff turnover.

Test your understanding 4

1 – Conflict

Many directors will want to purchase the equipment to reduce costs– this should improve profits and potentially their own financialrewards if they are linked.

Employees (and possibly also) their unions may well resist the investment because of the associated job losses.

Customers may be unhappy if the quality of mass produced products is not as good as the handmade versions.

Marketing and sales directors may resist the change if they believethat quality will be undermined, and thereby revenue affected.

Solutions

Potential conflict may have been avoided if reward packageswere linked to a range of measures (such as those used by the BalancedScorecard Approach) ensuring directors considered quality, customersatisfaction and employee welfare in any decisions.

Equally employees could have been consulted in advance about any potential changes – perhaps at a works council meeting.

Management must consider whether the workforce is likely to takeaction such as strikes over the investment. The likelihood increases ifthey are unionised.

If they are unlikely to take any specific action then a campaign of education and communicationmay be sufficient. Management should explain to all the workers why theinvestment is being made and how they will deal with any job losses.Advance notice will give each more time for workers to adjust.

If the unions become involved, it may be necessary to reach a compromisesolution to avoid wholesale disruption to the firm. This may involvephasing in the new equipment over a longer period or offering moregenerous redundancy packages than had been planned.

2 – Conflict

Directors of large companies often earn better rewards packagesthan those of small ones so they are likely to support the change.

Employees should have more job opportunities and are likely to support the change.

Fast growth can be very expensive and put a strain on workingcapital – shareholders may be unhappy if returns are not sufficientlyhigh. In addition, lenders may be concerned by the impact on keyfinancial ratios.

Solutions

Debt holders may well avoid later conflict by including covenants over gearing or other key ratios in the loan agreement.

Directors’ reward packages will encourage goal congruence with shareholders if they are linked directly to shareholders’ wealth.

Potentially high-risk strategies should be carefully evaluated as part of the risk management process required by good corporate governance. This should mean that any later concerns raised by shareholders can be answered.

The audit committee of non-executive directors may advise against the decision if they feel it would put too great a strain on resources.

Shareholders, although unlikely to get involved, could take actionif they were sufficiently unhappy by threatening the directors withremoval if they continue with the plan. This would be seen as a competition approach where a direct confrontation is taken.

3 – Conflict

A conflict may arise between the marketing director and the financedirector over the allocation of resources since the proposed campaignexceeds the budget.

Solutions

Decisions about spending over a certain limit may be referred to the full board for approval, to avoid conflict between individual directors.

If the matter is to be decided between the two directors, it would be better if they could collaborateto find a mutually satisfactory solution. It will be important tomaintain a good working relationship and to set up a policy frameworkfor such decisions in the future.

Test your understanding 5

Strategic issues

Competitive advantage - currently the firm is adifferentiator (it competes on quality rather than cost). The newentrants into the market seem to be cost leaders. Undertaking Project 1might reduce the quality of the Ribs Co tools and undermine the firm'slong standing competitive advantage.

Fit with environment - clearly the environment has changedin the last 12 months. The new imports indicate that perhaps theeconomic environment has changed (movement in exchange rates? removal ofimport tariffs?), and also that customers are seemingly looking forcheaper tools (social factor). Ribs Co is right to try to find newprojects which enable it to compete in this new environment.

Stakeholder reactions - the shareholders are not happy, sothey will welcome the new projects (providing the directors communicatethe positive NPV information effectively). However, other stakeholdersare likely to be less impressed. For example, under Project 1 there arelikely to be job cuts in the domestic market, so the employees, localcommunity and domestic government are likely to be unhappy about thisoption. The directors must consider the long term consequences ofupsetting these key stakeholders in the short term.

Risk - Project 2 appears to be the more risky option - itinvolves exporting goods into a foreign market where Ribs Co currentlyhas no operations. There is no guarantee that the Ribs tools will be asuccess in the new market. However, there is huge potential under thisoption. Clearly the domestic market is becoming saturated, so perhapsnow is the time for Ribs to seek out new opportunities abroad.

Financial issues

Positive NPVs - both prospective projects have positiveNPVs, so theoretically shareholder wealth should increase whichever isundertaken. However, the cash flow estimates need to be analysed andsensitivity analysis should be performed to see what changes inestimates can be tolerated.

Impact on cost of capital - Ribs Co's current cost of capitalhas been used for discounting the projects. However the change in risk(caused by the exposure to foreign factors in both projects) is likelyto change the cost of capital.

Financing - both projects are likely to require significantshort term capital expenditure. The directors will have to consider thesize of investment required, and the firm's target gearing ratio, asthey assess whether debt or equity funding should be sought.

Test your understanding 6

Shareholders:

• Providing timely and accurate information to shareholders on the company’s historical achievements and future prospects.

Suppliers:

• paying fair prices
• attempting to settle invoices promptly
• co-operating with suppliers to maintain and improve the quality of inputs
• not using or accepting bribery or excess hospitality as a means of securing contracts with suppliers.

Customers:

• charging fair prices
• offering fair payment terms
• honouring quantity and settlement discounts
• ensuring sufficient quality control process are built in that goods are fit for purpose.

Investment appraisal:

• payment of fair wages
• upholding obligations to protect, preserve and improve the environment
• only trading (both purchases and sales) with countries and companies that themselves have appropriate ethical frameworks.

Charity:

• Developing a policy on donations to educational and charitable institutions.

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