B. Strategic risk Flashcards
what is CIMA’s definition of strategy?
a course of action, including the specification of resources required, to achieve a specific objective
what is J,S & W’s definition of strategy?
direction and scope of an organisation over the long term
the core of a company’s strategy is about choosing between what?
- where to compete
- how to compete
i.e. sustainable competitive advantage
what is strategic planning?
formulating, evaluation and selecting strategies to enable the preparation of a LT plan of action and to attain objectives
what is the corporate/strategic level of strategy?
strategies of whole organisation
concerned with issues such as
- acquisitions
- entering new industries
- leaving existing industries
what is the business/management level of strategy?
plan on how to be successful
concerned with issues such as
- achieve advantage over competitors
- meet the needs of key customers
- avoid competitive disadvantage
what are SBUs?
strategic business units
unit within an organisation for which there is an external market for products distinct from other units
what is the functional/operational level of strategy?
day to day management of strategies
concerned with: HR strategy marketing strategy IT strategy operations strategy
what is the rational model?
logical step by step approach to strategic planning
requires organisation to analyse its existing circumstances, generate possible strategies, select the best ones and then implement them
what 3 stages did J, S and W group the rational model into? i.e. the JSW approach
strategic analysis
strategic choice
strategic implementation
what are some key considerations of J,S & W’s strategic choice stage?
- strategies are required to ‘close the gap’
- competitive strategy -for each business unit
- directions for growth - which markets/products should be invested in
- whether expansion should be achieved by organic growth, acquisition or some form of joint arrangement
what are the benefits of deliberate LT planning?
forces managers to look ahead
identifies key risks
improved control
encourages creativity
what are the risks of formal planning?
- setting corporate objectives:satisfying stakeholders who have contrasting needs
- short term pressures:principal agent problem
- difficulties in forecasting accurately
- bounded by rationality:internal and external analysis often incomplete
- rigidity
- cost
- management distrust
what are some alternative ways to develop strategies?
Mintzberg emergent strategies
-not formally planned, unexpected events
Lindblom Logical Incrementalism
- current strategy tends to be small-scale extension of past policy rather than radical change
- doesn’t believe rational model of decision making is sensible and suggests not applicable to real world
why does Lindblom think the rational model is not used in the real world?
- strategy is not usually decided by autonomous strategic planning teams that have time to impartially sift through all the information and possible options before deciding on the optimal solution
- instead, managers have to sift through the options themselves but face time and knowledge constraints (bounded rationality) so choose between relatively few options
- typically leads to strategy being small scale extensions of past policy-in other words, managers try to make small changes to what they know has worked well in the past
what advantages does the Logical Incrementalism model have over the traditional rational model?
more acceptable to stakeholders as consultation, compromise and accommodation are built into the process
less of a cultural shift for the organisation to adopt an incremental approach to strategy as the organisation will not be trying to implement major shifts in its activities
what are the disadvantages of incrementalism?
the organisation has no overall LT plan, causing it to suffer from strategic drift, eventually leading to it being unable to meet the needs of its customer
could mean that the organisation fails to make major changes if needed
how did Pfizer use the emergent model?
developed a drug known as Sildenafil to help with high blood pressure
had unexpected side effect so sold as Viagara for billions
what are the problems with a lack of formal planning?
- failure to identify threats:not forward looking
- strategic drift
- harder to raise finance:no plans to pitch
- lack of management skills
what type of organisations are more suited to formal planning such as the rational model?
- in relatively stable industries so time to undertake detailed strategic analysis
- relatively inexperienced managers so planning ensures they are familiar with organisation and gives them a series of guidelines
more informal approaches are suited to which type of organisations?
- in dynamic, fast changing industries where there is little time to undertake formal strategic analysis
- have experiences, innovative managers who are able to quickly identify and react to changes in the organisation and its environment
- don’t need to raise significant external finance
why is strategic planning more complex for NFPs?
- have multiple objectives so harder to priorities
- objectives are more difficult to measure-usually non-financial
- influence/objectives of funding bodies
- recipients of the service are not the ones who pay for it
what are the 3 Es of the VFM model?
economy-inputs to outputs
efficiency-link between inputs and outputs
effectiveness-looks solely at the outputs of the NFP
what are the risks associated with the 3E model?
- wrong choice of measures-just because you can doesn’t mean you should measure
- measures can give contradictory results, and that may mean you priorities one or two of the measures over the others
- internal confusion over which measures to prioritise, leading to demotivated workers and all measures being missed
- economy and efficiency can be in conflict with effectiveness, given that spending more can improve effectiveness or spending less (an improving economy/efficiency) can reduce the effectiveness
- economy and efficiency are often viewed as easier to measure than effectiveness and so can be the focus of performance measures or audits
how can focussing on the wrong E be harmful?
local authority claims handling unit was being measures on time taken to process claims i.e efficiency
they discovered it was quickest to pay every claim without investigating, to meet this KPI
how do firms prioritise the perspectives of strategic planning in different ways?
a traditional approach - stakeholders
‘market-led’ or ‘positioning’ approach
a ‘resource-based’ or ‘competence-led’ approach
what is the traditional approach to strategic planning i.e. by stakeholders?
look at stakeholders’ objectives and make plans to achieve them
useful for NFPs where mission/objective is key
what is the ‘market-led’ or ‘positioning’ approach to strategic planning?
start with analysis of markets and competitors then setting objectives
make sure good fit for the environment
predict changes far in advance
what is the a ‘resource-based’ or ‘competence-led’ approach to strategic planning?
look at what firm is good at i.e. core competencies
critical success factors
what are the key risks of the traditional strategic planning approach?
objectives are very important but this approach can be risky if objectives are set in isolation from market considerations and are thus unrealistic
what are the key risks of the ‘market-led’ or ‘positioning’ approach?
positioning approach lies in predicting the future
some markets are so volatile that it is impossible to estimate further ahead than the immediate short term
what are the key risks of the resource-based’ or ‘competence-led’ approach to strategic planning?
the company becomes obsessed by the things that they can do and lose sight of what is happening in the market and what the customers want-leading to products becoming overly complicated and containing features the customer does not want or understand
what are the 3 key levels of strategy to consider?
1) where to compete
2) how to compete
3) which investment vehicle to use
which 2 questions does Porter argue that organisations need to address?
should the strategy be one of differentiation or cost leadership?
should the scope be wide or narrow?
why does Porter argue agains satisfying all 3 activitities?
end up stuck in the middle so need to make decision early on strategic determination process
what are the following strategies?
cost leadership
differentiation
focus
cost leadership:being the lowest-cost producer
differentiation: creating a customer perception that the product is superior to competitors
focus: utilising either of the above in a narrow profile of market segments, sometimes called niching
what are the potential benefits of cost leadership?
- business can earn higher profits by charging the same price as competitors or even moving to undercut where demand is elastic
- lets company build defence against price wards
- allows price penetration entry strategy into new markets
- enhances barriers to entry
- develops new market segments
what are the risks of cost leadership? (risks if the focus of P3)
- no fall-back position if leadership on costs is lost
- constant investment to adapt to changing market and competitive threats
- failure to pass on cost savings to customers may mean no advantage
- passing on cost savings can lead to price wars with competitors
- fall in price can make product look inferior
how can we attain cost savings using value chain activities?
- reduce costs by copying rather than originating designs
- achieve EoS by high-volume sales allowing fixed costs to be spread over a wider production base
- use high-volume purchasing to obtain discounts for bulk purchase
- locate in areas where cost advantage exists or government aid is possible
- obtained learning and experience curve benefits
what are the benefits of differentiation?
- products command a premium price so higher margins
- demand becomes less price elastic and so avoids costly competitor price wars
- life cycle extends as branding becomes possible-hence strengthening the barriers to entry
how can value change analysis help identify points where differentiation can be achieved?
- creating products which are superior by virtue
- offering superior after-sales service by superior distribution, perhaps in prime locations
- creating brand strength
- augmenting the product i.e. adding to it
- packaging the product
- ensuring an innovative culture exists within the company
what are the risks of differentiation?
- there is a need to continually innovate to defend the position
- smaller volumes
- associated costs e.g. marketing are higher
- performance in a recession may be poor
what are the benefits of the ficus strategy?
- smaller segment and so smaller investment in marketing operations
- allows specialisation
- less competition
- entry is cheaper and easier
what does focus strategy require?
- reliable segment identification
- consumer/customer needs to be reliably identifies-research becomes even more crucial
- segment to be sufficiently large to enable a return to be earned in the long run
- competition analysis-given the small market, the competition, if any, needs to be fully understood
- direct focus of product to consumer needs
what are the risks of focus/niche strategy?
- if successful, may attract other cost leaders/differentiators due to potential low barriers to entry
- low volumes may be sold
how can niching be done via specialisation?
by:
- location
- type of end user
- product or product line
- quality
- price
- size of customer
- product feature
if done properly, it can avoid confrontation and competition yet still be profitable
what are the key risks for market niches?
- niche must be large enough in terms of potential buyers
- the niche must have growth potential and predictability
- the niche must be of negligible interest to major competitors
- the firm must have strategic capability to enable effective service of the niche
how does BA exercise differentiation?
charges premium compared to rivals
procurement:prime landing spots
procurement:HQ food and drink
operations:well-maintained, clean and comfortable
operations-high number of attendants on each flight
marketing-advertising based on quality of service provided
how has Ferrari exercised focused strategy?
focus on niche market:high quality cars at premium price
small percentage of global car market
may shrink or disappear as fashion and tastes change
what are the risks of Porter’s generic strategies model?
- adopting more than one strategy can leave firm ‘stuck in the middle’ but irl this may be too simplistic so do a hybrid e.g. live well for less is differentiation and cost leadership
- cost leadership in itself may not give competitive advantage
- differntiation may not always lead to a business being able to command a high price for its goods
what is the main aim of the market penetration strategy?
increase market share using existing products within existing markets
what is the approach to market pnetration?
stimulate usage by existing customers:
- new uses of advertising
- promotion, sponsorships
- quantity discounts
then attempt to attract non-users and competitor customers via:
- pricing
- promotion and advertising
- process redesign e.g. internet
what are key conditions for market penetration?
considered when
- overall market is growing
- market not saturated
- competitors leaving or weak
- strong brand presence by your company with established reputation
- strong marketing capabilities exist within your company
what is the market development strategy?
increase sales by taking the present product to new markets
e.g. overseas markets
what is the approach to market development?
- add geographical areas - regional and national
- add demographic areas-age and sex
- new distribution channels
what are key conditions for market development?
- slight product modifications might be needed
- advertising in different media and in different ways
- research-primary research cat this point given significance of the investment
- company is structured to produce one product and high switching costs exist for transfer to other product types
- strong marketing ability is needed, usually coupled with established brand backing e.g. CocaCola
what are the risks of market penetration as a strategy?
- has the lowest risk out of Ansoff’s matrix
- key issue may not generate significant returns
what are the risks of product development?
- significant cost
- not good enough so suffer large losses
- someone delivers product sooner or better
- failure damages core brand
- large R&D costs
what is the product development strategy?
focuses on the development of new products for existing markets
offers the advantage of dealing with known customers/consumer bases
what is the approach to product development?
- develop product features of a significant nature
- create different quality versions
what are the key notes to consider for product development?
- company needs to be innovative and strong in the area of R&D and have an established, reliable marketing database
- constant innovation allows for the developing sophistication of consumers and customers and ensures that any product-related competitive advantage is maintained
what is diversification?
new products to new markets
what are the key notes to consider when applying diversification?
- appropriate when existing markets are saturated or when products are reaching the end of their life cycle as it can spread risk by broadening portfolio
- goes through period of being in and out of favour so debate continues on whether this is a good strategic option-risks on missing out on old markets must be outweighed by benefits of new market
why is brand stretching ability a critical success factor of diversification?
will face teething issues which could affect brand reputation
- may not meet objectives in new market
- have excess cash and powerful shareholders
- possible to brand stretch and benefit from past advertising and promotion in other SBUs
- diversification promises greater returns and can spread risk by removing the dependency on one product
- greater use of distribution systems and corporate resources such as research and development, market research, finance and HR leading to synergies
what are the risks of market development?
- costly entry to the market
- fail to understand the new market
- failure damages core brand
what are the risks of diversification?
- riskiest option
- over reliance on market if it’s related(vertical) diversification
- lack of skills or knowledge if its unrelated (conglomerate) SO MORE RISKY
what are some examples of market development failures?
Monsoon clothing starting a male division which failed sue to lack of awareness
M&S attempting to open in mainland Europe but failed due to strategy errors leading to downturns in their core UK market
what is an acquisition?
buy most if not all of the target company’s stakes to assume control
what is a merger?
business combination that results in the creation of a new reporting entity formed form the combined prties
what is organic growth?
growth by internally generated projects
less expensive and risky that acquisition but may be too slow
what is synergy?
advantage gained by having existing resources which are compatible with new products or markets that the company is developing
what are the benefits of acquisition over organic growth?
- high speed access to resources e.g. reputation
- avoids barriers to entry
- less reaction from competitors as they maintain same market share
- can block competitor
- can help restructure the operating environment
- relative P/E ratio, if higher in new industry acquisition may not be possible as dilution of EPS
- asset valuation-asset stripping or potential acquisition’s assets are undervalued
what are the risks associated with acquisitions?
- more costly than internal growth
- cultural mismatch possible
- differences in managers’ salaries
- disposal of assets due to competition regulation
- lack of knowledge
- reduction in return on capital employed
what is due diligence?
investigation of a business prior to signing a contract
help reduce uncertainty and control the risks, especially if unlisted where information is not public
more smooth and effective if both parties are aware of the due diligence activities that are likely to be carried out
how are financial statements used in due diligence?
- financial metrics
- financial forecasts reasonable?
- verification of assets owned
- use external auditors to verify
what are joint development methods?
joint venture strategic alliances franchising licences outsourcing
what are key considerations in any joint arrangement?
sharing of costs sharing of benefits sharing of risks ownership of resources control/decision making
what is a joint venture?
a separate business entity whose shares are owned by two or more business entities
assets are formally integrate and jointly owned
useful approach for:
sharing cost
sharing risk
sharing expertise
e.g. Virgin Trains: 51% owned by Virgin Group, 49% owned by Stagecoach
what is a strategic alliance?
cooperative business activity, formed by two or more separate organisations for strategic purposes, that allocates ownership, operational responsibilities, financial risks and rewards to each member while preserving their separate identity/autonomy
includes partnerships, joint ventures and contracting out services
what is the difference between a joint venture and a strategic alliance?
whether a new business entity is formed or not
strategic alliance is usually a preliminary step to a joint venture
what are the 7 characteristics of a well structured alliance?
- strategic synergy
- positioning opportunity
- limited resource availability
- less risk
- co-operative spirit
- clarity of purpose
- win win
what is franchising?
purchase of the right to exploit a business brand in return for a capital sum and a share of profits or turnover
how does the franchising relationship work?
- franchisee pays franchisor initial capital sum and thereafter franchisee pays royalties/share of profits
- franchisor provides marketing, R&D and advice and support
- franchisor provides goods for resale
- franchisor imposes strict rules and control to protects its brand and reputation
- franchisee buys into a successful formula so risk is much lower
- franchisor gains capital as the number of franchisees grows
- head office can stay small as there is considerable decentralisation
what is licensing?
right to exploit an invention or resource in return for a share of proceeds
little central support
what is outsourcing?
contracting out aspects of the work of the organisation, previously done in-house to specialist providers
what are the key risks of joint development methods?
- strategic fit:partners need to have similar strategies
- cost sharing
- knowledge sharing:trade secrets revealed
- profit sharing
- loss of control
- loss of development opportunities
why did the Innocent McDs collaboration not last?
bad strategic fit
- Innocent drinks not a popular choice over milkshakes and fizzy drinks
- customers felt Innocent smoothie ethos did not line up with McDs
what strategies can businesses use when expanding internationally?
- exporting strategy:sell local goods abroad
- overseas manufacture
- multinational: co-ord value add activities across national borders, increases production capacity
- transnational:no home country, on multiple stock exchanges, considered to be largely theoretical
what risks should be considered for international growth?
- political risk
- foreign exchange risk
- need for capital investment
- risks to customer relationships
- increased risks in the supply chain
- ethical risks
- cultural risks
what is disruptive innovation?
new development that disrupts an existing market or created a new market leading to a the replacement of an existing market an lead to a drop in sales of that product
e.g Amazon disrupting Woolworths, HMC, Debenhams
what are some considerations for successful disruption?
SIMPLICITY RESOURCES:sustainability COST:lower price is attractive ACCESSIBILITY:more access the better QUALITY:better quality is more attractive
how does Elon Musk challenge current concpets?
Paypal: how we pay for things
Neuralink: the way we interact with computers
Tesla: electric cars
SpaceX:reduce cost of transportation into space
Boring Company:underground hyperlink, NY to Washington in less than 30 minutes
What is scenario planning?
involves the creation of detailed possible futures that the organisation may encounter, allowing for the creation of contingency plans
what are the stages of scenario planning?
1) identify high-impact, high-uncertainty factors in the environment (PEST analysis)
2) identify possible futures for each factor
3) cluster together different factors to identify various consistent future scenarios
4) write scenarios (typically around 3)
- optimistic, realistic and pessimistic
5) for each scenario, assess and identify possible courses of action for the firm
6) monitor reality to see which scenarios
7) revise as appropriate
what should be considered when scenario planning?
- use a team for range of opinions and expertise
- identify time frame, markets, products and budget
- stakeholder analysis-who will be the most influential in the future?
- trend analysis and uncertainty identification
- building of initial scenarios
- consider organisational learning implications
- identify research needs and develop quantitative models
what are the downsides of scenario planning?
- costly and inaccurate-uses up substantial resources and time
- tendency for cultural distortion and for people to get carried away
- the risk of the self-fulfilling prophecy ie. thinking about the scenario may cause it
- many scenarios considered will not actually occur
what are the advantages of scenario planning?
- focuses management attention on the future and possibilities
- encourages creative thinking
- can be used to justify a decision
- encourages communication via the participation process
- can identify the sources of uncertainty
- encourages companies to consider fundamental changes in the external environment
what is hame theory?
anticipating actions of competitors and acting accordingly by studying interrelationships between the competitive moves of a set of competitors
derived from mathematical modelling
what are the 2 key principles to game theory?
1) strategists can take a rational, informed view of what competitors are likely to do and formulate a suitable response
2) if a strategy exists that allows a competitor to dominate us, then our priority is to eliminate that strategy
what is the dominant strategy in prisoner’s dilemna?
both invest heavily
what is the equilibrium of prisoner’s dilemna?
both end up increasing spending and end up worse off than if they kept marketing spend low
what is a common application of prisoner’s dilmena?
price wars
no one wins except customer
what is the original prisoner’s dilmena?
police have little evidence
- if one testifies, other gets 10 year sentence
- if both are silent, minor sentence
- if they betray each other, each medium sentence
equilibrium: play defect, better to co operate
what is stress testing?
analysing a business to consider how well it could cope in difficult conditions
what are the 4 categories of stress testing?
Prioritisation
- who is primary customer?
- how do core values prioritise shareholders, employees and customers?
Measurement
- what critical performance variables are you tracking?
- what strategic boundaries have you set?
Productivity
- how are you generating creative tension?
- how committed are your employees to helping each other?
Flexibility
-what strategic uncertainties keep you awake at night?
how does stress testing affect non-financial companies?
less prevalent but can benefit them too
cyber security will affect non-financial industries too
why is there a need for stress testing?
- plays a strategic role
- allows risks to be quantified
- can be imposed on business by lenders
- may be infrequent expenditure that is not accounted for in the budget
- not just testing for the survival of the organisation, shows early warning signs
- correlation between events
what are the sources of business stress?
- technology becoming obsolete/uncompetitive
- changes in customer or consumer tastes
- the economy changes from boom to recession
- rivals build better product
- cybersecurity attack
- workforce strike
- failure of or faults in production systems
how does software play a part in stress testing?
usually performed on computer-generated simulation models
larger orgs will have developed tailored models, smaller orgs should do so within budget but could use Excel
what are the drawbacks of stress testing?
complex
time-consuming
expensive
consider resources and benefits, smaller orgs test less events than larger org
how did Tesco prepare for Corona?
did a doomsday stress test in 2016, HO shut down completely which was seen as extreme but shows incredible foresight
had wfh infrastructure and video calling applications ready
supply chain already adapted, doubled click and collect capacity in 6-week period
saw change in consumer behaviour: transactions down 48% but basket size doubled
what is reputational risk?
that people will have a negative opinion of an organisation and share that opinion with other people
how is reputation different to brand?
brand: what organisation says they will do
reputation: how that promise is carried out, harder to manage, can be caused by individual or company as whole
what are the sources of reputational risk?
employees management accounting fraud bribery and corruption transfer pricing cyber security data protection unethical behaviour
what is ethics?
moral principles that govern a person’s behaviour of the conducting of an activity
actions can be judged to be right or wrong
what are business ethics?
CSR, sustainability
miss-selling, misleading advertising
mistreatment of staff
corruption ad bribery
what is CSR?
corporate social responsibility refers to the idea that a company should be sensitive to the needs of all stakeholders in its business operations and not just shareholders
ethics is just one dimension of CSR
how does CSR fit in with risk management?
align the company’s core values with the values of society, the company can improve its reputation and ensure it has a long term future
what are the benefits of a CSR strategY?
differentiation
high calibre staff will be attracted to firm and retained
brand strengthening
lower costs e.g. less packaging or energy
identification of new markets opportunities and of changing social expectations
resultant overall increase in profitability
NPVs will also increase due to increase sales, lower costs, an extended project life and a lower level of risk
why should a company have CSR metrics?
things that get measured get done
use appropriate metrics to achieve clear goals
how did metrics influence the banking crisis?
Gove of England, Mervyn King, criticised City banks who rewarded staff with huge sums for taking risks and concluded that the large risks were taken due to the bonuses
developed culture of risk
what are the 3 parts of the CIMA Code of Ethics?
part A) fundamental principles and provides conceptual framework
part B and C) illustrate how the conceptual framework is to be applied in specific situations:
-Part B applies to professional accountants in business
-Part C applies to professional accountants in public practice
what are the 5 fundamental ethical principles?
Integrity:fair dealing and truthfulness
Confidentiality: info not disclosed outside and not used for personal advantage
Professional competence and due care: professional knowledge and skills, apply technical and professional standards, CPD
Objectivity:business/professional judgement is not compromised because of bias or conflict of interest
Professional behaviour: comply with relevant laws and regulations
what are the main reasons that confidentiality can be waived?
permitted by law or authorised by a client
required by law
professional duty to disclose e.g. ethical or professional institute compliance
what is the conceptual framework approach?
requires a management accountant to identify, evaluate and address threats to compliance with the fundamental principles rather than comply with a set of rules
what are some ethical threats?
INTIMIDATION threat: may be deterred from acting objectively by threats
FAMILIARITY threat:close or personal relationship makes you sympathetic
ADVOCACY threat:promoting a position or opinion
ADVERSE: does not act with integrity because their interests are oppose to their employer
SELF INTEREST threat:personal conflict of interest
SELF REVIEW threat:previous judgement re evaluated
IFAASS
what are safeguards?
actions or other measures that may eliminate threats or reduce them to an acceptable level
what are the 2 types of safeguards?
created by the profession, legalisation or regulation:
- educational
- CPD requirements
- corporate governance regulations
- professional or regulatory monitoring and disciplinary procedures
- external review by a legally empowered third party of the reports, returns, communications or information produced by a professional accountant
safeguards in the work environment
- firm-wide safeguards
- engagement-specific safeguards
how are ethics a source of risk?
- reputational damage
- fines/discipline
- may affect chances of winning major contracts
what is an ethical dilemna?
if there are two or more interests at stake, even if it is only an ethical duty to oneself
when one or more principles of the code are threatened
how are ethical issues dealt with?
by taking actions (safeguards)
reduce them to a level where they are no longer significant
what steps does CIMA recommend for ethical conflict resolution?
- clarify the situation
- ensure not acting on inaccurate/incomplete information - Analysis
- ascertain ethical issues involved
- behaviour dictated by law? - alternative courses of action
- escalate internally to line manager
- escalate to manager’s senior
- seek advice from CIMA
- report externally to auditors or relevant trade/regulatory body
- remove yourself from the situation
document whole process
what were the issues Nike faced?
- child labour and the sweat shop problem
- workers given a very low wage and overtime in certain countries
- poor or squalid working conditions
- environmental damage done to society by air and water pollution
how did Nike resolve its issues?
PR campaign covering
- employment practices
- training plan
- assessing performance
- ethical responsibility
why is CSR important?
- can benefit an organisation and a risk
- can lead to better relations with external stakeholders
- lead to competitive advantage
- excessive CSP can be viewed as detrimental to shareholders who want to maximise wealth
what ethical issues can arise during budget setting?
conflicting objectives
- lower budget causes problems for entire organisation
- managers compete for master budget set by seniors
- conflict between planning and control
- rewarded for meeting target so may set low targets
undue pressure
- pressurising employees
- might take questionable measures
- quality and employees suffer
how can reputational risks be managerd?
governance employee relations policy framework relating to risks external relations environmental awareness risk sensing tools risk professionals monitoring controls and metrics
how to respond in a crisis?
- complete prevention is impossible
- detection and response are key
- clear escalation policy, well communicated
- scenario planning
- crisis response team
how is transfer pricing a source of reputational risk?
inter-divisional transfers must be priced
- internal sale and internal purchase
- no effect on profit as it is netted off
- split profit by department so both benefit from transaction
- prices have to be established and agreed either centrally or locally
- preference should be to sell internally for selling division
- preference should be to purchase internally for buying
can only transact externally if good commercial reason
what are the objectives of transfer pricing?
goal congruence
performance measurement of managers
maintaining divisional autonomy
minimising the global tax liability
recording the movement of goods and services
a fair allocation of profits between divisions
how can transfer pricing be used to minimise tax liability?
- reduce profitability in high tax country subsidiary
- increase profitability in low tax subsidiary
redistributes profits
prices should be at arms length
according to EY, more than 80% of multinational companies viewed transfer pricing as a major international tax issue
how do tax authorities arrive at a arms length transaction price?
comparable price method-most widely used, market rate
resale price
cost-plus method
what is the APA?
Advanced Pricing Agreement
safeguard position of taxpayer
avoid any disputes and costly penalty of double taxation
EY: more than 60% companies intend to, or do this
what do tax haven countries offer?
- low rate of tax on profits
- low withholding tax on dividends paid to foreign holding companies
- tax treaties with other controls
- a stable economy
- good communications with the rest of the world
- a well-developed legal framework, within which company rights are protected
how can transfer pricing be used to manage cash flow?
dividend payments between foreign parent companies from subsidiaries
sell foods or services to a subsidiary
not possible when the laws require arms length transactions
how does Starbucks pay little to no UK corporation tax?
transfer pricing
buys beans through for the UK through Switzerland based subsidiary. Switzerland unit not required to disclose accounts and pay tax as low as 5%
what is fraud?
dishonestly obtaining an advantage, avoiding an obligation or causing a loss to another party
what are the 3 prerequisites to fraud?
dishonesty on the part of the perpetrator
opportunity for fraud to occur
motive or fraud
how is fraud a cause of reputational risk?
if it becomes public knowledge, it can affect reputation
shows control systems are weak which will worry investors
future investors may be wary to invest
hiding fraud is unethical and worse if found out
what is bribery?
when someone in a position of trust receives a benefit as a reward for voluntarily acting in breach of that trust
bribe can take many forms
what is bribery’s link to reputational fraud?
if found out can lead to negative connotations
HBS study says most significant impact of bribery is negative effect on employee morale
can lead to loss of skilled workers
what is a crisis response team?
team of people who are responsible for coordination a companywide response will help make sure message is consistent with overall strategy, brand and culture
includes clear escalation policy
what is corporate governance?
system by which companies are directed and controlled in the interest of shareholders and other stakeholders
what do codes and practices tend to cover?
role of the board of directors
reliability of financial reports and the relationship between the company and its auditors
interest of the company’s shareholders in the company
what is the importance of corporate governance?
- in most developed countries, listed companies are required to operate systems of corp gov laid down by professional organisations
- requirements are often given the support of the stock exchanges, in that they are built into listing rules
- development of corporate governance codes is closely associated with the UK, hence the UK is a useful model to discuss best practice
- UK Corp Gov: principles based and LSE endorsed
- US system is rules based
- corp gov links to risks and internal controls
when did corp governance start developing?
from corporate failures in the 1980s/1990s
developed further in accordance with the 2008-2009 financial crisis
most recent update in 2018 focuses on areas where Directors’ renumeration reduces likelihood of excessive pay and bonuses and running the organisation with a long term view
what corporate governance these emerged from these collapses?
- poorly-run companies
- poor financial reporting
- an apparent lack of interest by the major investment institutions in the performance of the companies in which they invested
what was the reason for the Maxwell Communications Corporation collapsing?
Robert Maxwell born extremely poor but by time of death was media mogul
After WW2 set up profitable publishing company and became Labour Party member
Took over BPC in 1980 putting company in further debt
After death, transpired that the money taken from the PENSION FUNDS kept the company afloat and boosted the share price
What happened with the Enron scandal?
US energy trader collapsed in Dec 2001 due to:
- not following accounting standards
- lobbied against changing treatment in US financial reporting of special purpose entities
- over-dependence on one auditor
largest bankruptcy in US history and lead to SOX developing
what lead to the Barings Bank collapse in 1995?
Britain’s oldest merchant bank (200 years old)
reason for collapse:
- uncontrolled derivatives traded by Leeson in Singapore office
- lost £800m in unauthorised dealings
- hid in an error account
- he was in charge of dealing desk and back office, DUAL RESPONSIBILITY
- seniors didn’t understand risks
- had to close open contracts at a const of $1.4billion
what lead to WorldCom filing for bankruptcy in June 2002?
biggest corporate fraud in history
due to:
- treating operating expenses as capital expenditure
- misled investors by $75b over 10 years
- began failing late 99 as reduced businesses
- CEO took out millions in PERSONAL LOANS, charged with conspiracy to commit securities fraud
What lead to the Parmalat bankruptcy in 2003?
Italian dairy-foods
51% owned by Tanzi family
reason:
- defaulted on $185m bond payment
- 38% of assets held in Cayman bank account but didn’t actually exist
- letters to auditors were forged i.e. falsified accounts
- 20 people convicted in fraud
- founder and chief arrested on suspicion of fraud, embezzlement, false accounting and misleading investors
what lead to the Equitable Life scandal in 80s?
- sold policed with guaranteed returns
- deteriorating value of stock
- black hole as paying out more than held in reserves
- former management to blame
- aided by failure of regulators to identify mutual insures’ financial position
what was the Volkswagen scandal of 2015?
- diesel engined emitted high levels of NO2 but passed US controls
- prioritise short term profitability and receive bonuses
- seniors not held accountable for intentionally cheating
- failed to publish reports into the issue despite promising it would make certain documents public
- changed renumeration policy
what are the areas of the UK Corporate Governance Code?
- board leadership and company purpose
- division of responsibilities
- composition, succession and evaluation
- audit, risk and internal control
- renumeration
how do the UK and US approaches to corporate governance differ?
UK: comply or explain as principles based
US: enforcement and documentation as rules-based
what are the principles of the board and leadership and company purpose area?
- consideration of what makes the company successful, including an entrepreneurial board, long term sustainability of company’s success, generating wealth for shareholders and contributing to society
- board should effectively engage with stakeholders, particularly shareholders and encourage participation
- board should make sure the necessary resources are in pace for the company to meet and measure performance against the objectives. As part of this risk assessment and mitigation should be carried out and effective internal controls should be in place
- the board should make sure the company values are supported by appropriate policies and procedure for the workforce, including the ability for the workforce to communicate any areas that concern them
when should an explanation be given regarding board decisions?
if more than 20% of shareholders vote against a board recommendation
views received and actions taken should be published within 6 months of the shareholders meeting
what should an NED do if they resign?
provide a written statement about any concerns they had to the chair, which should be circulated to the board
what are the general principles of division of responsibilities?
Chairman (who runs the board) and CEO (who runs the company) should be separate individuals to prevent one individual having too much power
Balance between EDs and NEDs
NED roles:
- strategy
- scrutinising role
- risk role
- people role
what % of the board should be NEDs?
at least 50% of the board
what are the NEDs roles?
STRATEGY role:right and responsibility to contribute to strategic success, challenging strategy and offering advice on direction
SCRUTINISING role:required to hold executive colleagues to account for decisions taken and results obtained
RISK role: ensure the company has an adequate system of internal controls and systems of risk management in place
PEOPLE role: oversee a range of responsibilities with regard to the appointment and renumeration of executives and will be involved in contractual and disciplinary issues
what situations could impair a chair’s independence?
- was an employee within the last 5 years
- represent a significant shareholder
- has close ties with Co.
- holds cross-directorships or has significant links with directors through in other companies or bodies
- received other pay or benefits in addition to a directors’ fee
- had material business relationship with the Co. within the last 3 years
- has served on the board for more than 9 years
- can’t be previous CEO
when can the chair’s role be extended beyond 9 years?
if it helps succession planning and development of a diverse board
must provide an explanation
what are the specific responsibilities of a chair?
- provide leadership, vision and imagination to board
- work closely with CEO
- set the board’s agenda and plan board meetings
- chair all boar meetings, directing debate
- ensure the board receives appropriate, accurate, timely and clear information
- facilitate effective contribution from NEDs
- hold meetings with the NEDs, without the executive directors present
- discuss governance and major strategy with the major shareholders
- ensure that the views of shareholders are communicated to the board as a whole
what are the specific responsibilities of the CEO?
- develop and implement policies set by the board
- assume full accountability to the board for all aspects of company operations, controls and performance
- manage financial and physical resources
- build and maintain an effective management team
- put together systems
- monitor operations and financial results in accordance with plans and budgets
- act as interface between board and employees
- assist in selection and evaluation of board memebrs
- represent the company to major suppliers, customers, professional associations
who are NEDs?
- scrutinise performance of management in meeting goals
- evaluate integrity of financial information and controls
- determine levels of renumeration
- staff directors
who is the senior independent director?
one NED
directly available to shareholders if they have concerns
what does a NED need to be effective?
- build recognition by executives of their contribution in order to promote openness and trust
- be well-informed about the company and the external environment in which it operates
- have a strong command of issues relevant to the business
- insist on a comprehensive, formal and tailored induction, continually develop and refresh their knowledge and skills to ensure that their contribution to the board remains informed and relevant
- ensure information provided is sufficient pre meeting
- ensure quality of information
- question and challenge
- promote highest standards of corporate governance and seek compliance
what is the primary fiduciary duty of NEDs?
to the company’s shareholders
-should not be biased by others
should NEDs be from inside or outside the industry?
easier to demonstrate independence when external
might have useful industry knowledge if internal but harder to prove independence
in practice they are a mix
what are the reasons fo NED independence?
- to provide a detached and objective view of board decisions
- to provide expertise and communicate effectively
- to provide shareholders with an independent voice on the board
- to provide confidence in corporate governance
- to reduce accusations of self-interest in the behaviour of executives
what are the situations where NEDs are unlikely to be independent?
- employee in last 5 yers
- represent a significant shareholder
- has close ties with Co.
- received other pay or benefits in addition to a directors’ fee
- had material business relationship with the Co. within the last 3 years
- has served on the board for more than 9 years
- cross directorship in other companies
after how long should NEDs be subject to a rigorous review?
after serving for 6 years
what is the criteria for EDs?
- a full time ED can’t also take on more than 1 FTSE 100 NED role
- a full time ED can’t also be the chairman of a FTSE 100 company
- a significant portion of an ED’s pay should be performance related
what is the nomination committee?
charges with ensuring the board has the appropriate skills, knowledge and experience
should be a formal, rigorous and transparent procedure for the appointments of new directors to the board
what are the typical roles and responsibilities of the nomination committee?
- regularly review the structure, size, composition and balance of the board
- consider the balance between execs and NEDs
- ensure appropriate management of diversity on board
- reduce dominance in exec selection by the CEO/chairman
- give full consideration to succession planning for directors
- prepare a description of the role and capabilities required for any particular board appointment including that of the chairman
- identify and nominate board candidates to fill board
- make recommendations concerning the standing for reappointment of directors
what does the Uk Corp Gov state about the nomination committee composition?
over 50% of the NC should be INEDs
how often should the directors be evaluated?
annual evaluation regarding whether they are contributing appropriately
submitted for re-election at regular intervals, subject to continued satisfactory performance
how often should the board be formally and thoroughly reviewed?
regularly
use external party
FTSE 350 companies should be every 3 years
chair should act on results of the review, including celebrating the strengths and improving the weaknesses identified
what does the nomination committee work that is included in the annual report entail?
- the process used for succession planning and how many appointments made during the period
- how board evaluation is carried out
- any policy on diversity, how it links to objectives and how the implementation of the policy is progressing
- gender split of the board the first level of management below the board and their direct reports
why is there a need for succession planning for chief exec rule?
2018 Survey by Robert Half:almost half of more than 1100 CFOs do not have a succession candidate in line
- could take more than 6 months to find a CFO
- leaves gap for strategic leadership
- successors might want to leave
nomination committee work is vital to ensure no gap but also retention and progression of workforce
what are the general principles of audit, risk and internal control?
- board should create policies and procedures to make sure that internal and external audit are independent and effective
- should present a balanced and understandable assessment of the company’s position and prospects
- board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives
- maintain control systems
what does the UK Corp Gov code require of an audit committee?
at-least 3, or in the case of smaller companies, 2 INEDS and NO EDs
chair should not be member
at least one member should have recent and relevant financial experience
what is the role of the audit committee?
- to monitor integrity of the financial statements of the company and any formal announcements relating to the company’s financial performance
- to review the company’s internal control and risk management systems
- to review the effectiveness of the company’s internal audit function
- to make recommendations re the appointment, reappointment and removal of the external auditor and to approve renumeration and terms of engagement
- to review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit process
- to develop and implement policy re non-audit services by the external auditor
what happens if there is no internal auditfunction?
audit committee should monitor and review effectiveness of internal audit activities
should consider whether theres is a need for function annually and make recommendation to board on reasons
how is the board responsible for risk managment?
responsible for carrying out thorough review of both emerging risks and key risks that will interrupt business
should incorporate into annual report
should annually conduct review of effectiveness of functions
state whether they consider it appropriate to use the going concern basis of accounting in preparing the financial statements
what are the typical roles of the renumeration committee?
setting the renumeration for EDs and the chairman, including pension rights and any compensation payments
should consider overall company remuneration policy and approach to rewards and incentives
who decides renumeration of INEDs?
determined by the Board or, where permitted by the Articles, a separate committee
what does the UK Corp Gov require of the remuneration committee?
should be 100% NEDs
FTSE300-should have at least 3 members
smaller companies-should have at least 2 members
chair of remuneration committee should have been member of committee for atleast 12 months
what should remuneration for NEDs not include?
share options or any performance related elements
what considerations should the remuneration committee address when setting up the policy and procedures?
- clarity
- simplicity
- risk:reputation, behavioural impact
- predictability
- proportionality: no reward for bad performance
- alignment to culture
what contributions should the remuneration committee make to the annual report?
- strategic reasoning behind directors’ remuneration policies, structures and KPIs
- an explanation about why the remuneration is reasonable, using both internal and external information
- explanation of how remuneration related to the policy and practices for director remuneration
- whether the policy was applied as intended and if not why not
- what communication there has been with shareholders and employees about remuneration and impact it has had on policy
- what communication there has been with employees about directors’ remuneration and how consistent this is with the overall pay structure
- whether any judgement has been used regarding remuneration and why
what are the components of remuneration package?
basic salary: determined by experience and market rate
PRB: linked to LT performance or SH vaue, risk adjusted criteria
Benefits in kind: e.g. company cards, healthcare, life assurance
Pensions:only basic salary pensionable
Share options: align management and SH interests. no downside risk so might encourage risky behaviour or boost short term share price
what is the definition of remuneration?
payment or compensation received for services or employment and includes basic salary, bonuses and any other economic benefits
what is the grant date?
when the employee and employer enter into an agreement that will entitle the employee to receive an option on a future date, provided certain conditions are met
what is the service date?
the date or dates on which the employee performs the services necessary to become unconditionally entitled to the option
what is the vesting date?
date when the employee, having satisfied all the conditions become unconditionally entitled to the option
what is the exercise date?
when the option is taken up
most buy and sell at this date
why have share options as a measure of long-term profitability become less common?
since economy turned bearish
IASB proposes that firms put the cost of share-based awards through the income statement
what is an ESOP?
Executive Share Option
blames for almost every business scandal that has made headlines in the past decade
- manipulate share price
- distort financial statements
what are the features of an ESOP?
- eligible managers are granted an allocation of options as part of his or her annual remuneration, decided by renumeration comm
- options themselves will normally have a striking price that is equal to, or slightly higher than, the share price at the date the options are granted
- there is usually a vesting period of a few years that must pass before the options can be exercised. If the manager resigns or leaves the company during that period then the options will lapse
- the options can normally be exercised on a specific date at the end of the vesting period
what are the 2 main reasons why shareholders might be keen to reward their directors with options?
- if they hold large number of options, they will have a financial incentive to maximise the share price
- an investment opportunity that would be attractive to the shareholders because the potential returns are high might be unacceptable to the directors because they will be exposed to the risks of it going wrong and the loss of their jobs
According to the corporate governance and internal controls principle, what is the board responsible for?
- maintaining a sound system of internal control
- reviewing the effectiveness of internal controls
- reporting to shareholders that this review has been carried out
According to the corporate governance and internal controls principle, what is management responsible for?
- identify and evaluate the risks faced by the company, for consideration by the board
- design, operate and monitor a suitable system of internal control
What is the Turnbull Report?
most specific report regarding the requirements for internal control (1999, revised 2005)
addresses the responsibilities of directors and managers in relation to risk and control
What does the Turnbull Report require?
that internal controls should be established using a RIKS-BASED approach. Specifically a company should:
- establish business objectives
- identify the associated key risks
- decide upon controls to address the risks
- set up a system to implement the required controls, including regular feedback
- review internal controls under the five headings identified by COSO
what are the 5 COSO headings?
- control environment
- risk assessment
- control activities
- information and communication
- monitoring
what should the annual assessment of the system of internal control consider?
- the changes since the assessment carried out in the previous year
- the scope and quality of management’s ongoing monitoring of risks and of the system of internal control
- the extent and frequency of the communication of the results of this monitoring to the board
- the extent and frequency of internal control weaknesses and failing that have been identified during the year
- the effectiveness of the company’s public reporting processes
what should the board’s statement include in regards to internal control?
- that there is an ongoing process for identifying, evaluating and managing the significant risks faced by the company
- that the process has been in place throughout the year
- that the process is regularly reviewed by the board
- that it accords with the Turnbull Guidance
Which Code first required audit committees?
the Cadbury Code
now Corporate Governance code
what are the responsibilities of an audit committee?
- review of the financial statements, and any interim reports produced
- review of the company’s system of internal financial controls
- discussion with the auditors about any significant matters that arose on the audit
- review of the internal audit programme and significant findings of the internal auditors
- recommendations on the appointment and removal of the auditors
- the setting of the audit fee in discussion with the auditors
- review of the audit report and any management letter provided by the external auditors
- review all the company’s internal control and risk management systems (unless this is delegated to a separate risk committee)
- ensure that a system is in place for whistleblowing
what are the key roles of the audit committee?
oversight, assessment and review of other functions and systems in the company
in relation to internal controls, what should the audit committee do?
- review the company’s internal financial controls
- review all the company’s internal control and risk management systems, unless the task is taken on by a separate committee
- give its approval to the statements in the annual report relating to internal control and risk management
- receive reports from management about the effectiveness of the control systems it operates
- receive reports on the conclusions of any tests carried out on the controls by the internal or external auditors
in relation to external controls, what should the audit committee do?
audit committee is responsible for the oversight of relations with the external auditors
audit committee should:
- have primary responsibility for making a recommendation to the board on the appointment
- ‘oversee’ the selection process when new auditors are being considered
- approve the terms of engagement of the external auditors and the remuneration for their auditor services
- have annual procedures for ensuring the independence and objectivity of the external auditors
- review the scope of the audit with the auditor, and satisfy itself that this is sufficient
- make sure that appropriate plans are in place for the audit at the start of each annual audit
- carry out a post-completion audit review
According to UKCG Code, the chair should arrange for which stakeholder groups to attend the AGM?
the directors
the CEO
the chairpersons of the RAN committees
What lead to the Lehman Brothers collapse?
4th largest IB in America
2008 filed for bankruptcy
started credit crunch or financial crisis
reasons:
- poor corporate governance
- poor makeup of board: lacking financial expertise
- theatrical producer on audit committee
- inexperienced CEOs
- one member carrying too many rolls
- Chairman and CEO same person
- asks chief risk officer to leave boardroom during key discussions
What lead to the development of the SOX?
2001/2002 scandals
Enron, Worldcom
how is the SOX different from UKCG Code?
ENFORCEMENT
DOCUMENTATION
- extremely detailed and carries full force of law
- includes requirements for the SEC to issue certain rules on corporate governance
- relevant to US companies, directors of subsidiaries of US listed businesses and auditors who are working on US listed businesses
what are the key points of SOX?
auditors independence:restricted in extra services
audit committee:US listed companies must have audit committee
internal control report:must be included on annual report
certification of accuracy of financial statements
increased financial disclosures:detail off-balance sheet finance
restrictions on dealing:directors cant trade during ‘sensitive times’
audit partner: senior partner change every 5y
What is required in the certification of accuracy of financial statements?
personal responsibility for CEO and CFO when they sign off
criminal offence to file defective financial statements
CEO and CFO must hand back bonuses for previous years if statements need to be amended due to defective financial statements
why should the Board be responsible for managing stakeholders’ interests?
corporate value:build relationships, long-term sustainability
rise in shareholder activism: care about CSR
rise in sustainable and responsible investing
what is CSR?
how a company addresses and manages its environmental, social, corporate governance and economic impacts and how such impacts may affect the company’s stakeholders
contribute to community
powerful differentiator
what is a CSR report?
provides a company with an opportunity to communicate its CSR efforts to the company’s stakeholders and to discuss challenges in a wide array of CSR issues
medium for transparency
provides potential and existing investors with information to assist in analysing investment decisions
how are the key stakeholders of the CSR report?
shareholders:business model, corp gov, sustainability
employees:diversity, health, safety, training
customers:customer service and privacy
suppliers:labour standards and whether to implement own CSR programs
communities:philanthropy, charitable contributions
governments and regulators:lobbying, public policy
what are the other considerations a company and its board might have in regards to CSr?
CEO responsibility and board oversight focus on impact stock exchange reporting initiatives identify corporate team other components of stakeholder engagement
what stock exchange reporting initiatives are UK regulators asking of listed companies?
publish full details of their greenhouse gas emissions for reporting years after 2013
what are the results of an increasing focus on governance issues?
- increasing power of governance bodies
- increasing shareholder power, ensuring that companies are run with shareholders’ interest prioritised
- greater pressure on boards to formulate strategy and be seen to control the businesses concerned
- greater scrutiny of quoted businesses, resulting in more short-termism
- greater emphasis on risk assessments, so directors may feel pressured to undertake lower-risk (and hence lower-return) projects
- greater scrutiny of mergers and acquisitions in particular
how does corporate governance impact organisational strategy?
- no individual can dominate board
- help improve the diversity of board of directors
- adequate internal audit and control systems ensure that the board has accurate information about the current operations of the company
- having good corporate governance is attractive to investors
