Category: Free Essays

This work was produced by one of our professional writers as a learning aid to help you with your studies

“Recent expansion of nonaudit services by public accounting firms has caused some to question whether auditors who provide nonaudit services to audit clients can remain independent of their clients”

Introduction

The increasing level of frauds and scandals in the corporate sector have resulted in an upsurge in the regulations for audit firms whereby their independence is kept into question due to the non-audit services they offer to their audit clients (IOSCO, 2007). Many public accounting firms provide such services to their clients merely because of convenience, knowledge about the clients’ financial statements and saving extra time spent dealing with audit and non-audit services separately (Muir, 2014). However, financial statement users often perceive it as impairing the auditor’s independence (Al-Ajmi and Saudagaran, 2011). Different views exist about the impact of providing non-audit services to audit clients; they may have negative (Quick and Rasmussen, 2015), positive (Wang and Hay, 2013) or no effect on the auditor’s independence (Jenkins and Krawczyk, 2001). As such, this essay will explore whether the provision of nonaudit services affects auditors’ independence.

Definition and Role of Non-audit Services

Adeyemi and Olowookere (2012) regard non-audit services to be any services provided by an auditor other than their code audit function. These services may include bookkeeping (Jenkins and Krawczyk, 2001), management consultancy (ICAEW, 2015), tax advisory services (Pwc, 2014), human resource consultancy (ABP, 2004) and others. Jenkins and Krawczyk (2001) found that bookkeeping has a negative impact on auditor’s independence, while management consultancy and tax advisory services have a positive impact. The differences occur because of an expectation gap between the auditing professionals and financial statement users (Jenkins and Krawczyk, 2001).

Looking at it from a marketing perspective, organisations providing additional value to their customers other than their core service are considered to be highly competitive and end up being more successful than their competitors (Hoffman, 2009). That is exactly what audit firms strive for when they offer additional services to their clients in anticipation of strengthening relationship with them (Ismail, Hasnah, Ibrahim and Isa, 2006). However, critics object on the income received from non-audit services because their impact on the objectivity of the auditor has long been considered as a potential threat for the auditing process and financial system as a whole (Adeyemi and Olowookere, 2012). Okaro and Okafor (2009) pointed out that an audit firm auditing their own work is not regarded to be independent and the objectivity of their work may be questioned at any point by financial statement users. To avoid any criticisms from their stakeholders, audit firms need to be particular about their audit quality, which is considered to be high if the stakeholders are assured to have no uncertainty and ambiguity in the financial statements prepared by the management (Krishan, Zhang and Sami, 2005).

Negative Impact on Auditor’s Independence
Threat to Audit Quality

The work of an audit firm is to act as an investment guide, which helps in their clients’ valuation and predicting bankruptcy (Salehi, 2009a). Research suggests that there is a strong relationship between the credibility of the statements produced by an audit firm and the investment decision taken by the client (Salehi, 2009a). Therefore the economic development of the client is often dependent upon the credibility of the documents prepared by the audit firm, which depicts the financial standing of the client (Wahdan et al., 2005). Sori and Karbhari (2006) believe that the auditor independence may be affected by this economic bonding between the auditor and the client. In case of an increasing pressure from the client regarding consultancy in investment decisions, the auditor may unintentionally overlook the quality of the actual audit services.

Gwilliam (2010) mentioned that a classic example of audit failure was that of Ernst & Young while conducting the audit of a UK truck manufacturing company, ERF. In that case, the provision of non-audit services impaired the audit quality to such an extent that the firm had to undergo a couple of lawsuits. A part of the case constituted of the company accountant’s attempt to fabricate the VAT returns, so that the repayments from the Customs and Excise could be received. Moreover, the audit team did not work on the VAT separately; they relied upon the figures received from the VAT specialists. This compromise in the quality of audit services resulting from intrusion of additional services, negatively affected the independence of Ernst & Young.

Threat due to the Provision of Joint Services

Another problem arises when the audit and non-audit services are provided in conjunction with each other, whereby the focus on the actual service may be lost (Sori and Karbhari, 2006). Swanger and Chewning (2001) recommended a solution to this issue, i.e. the personnel performing the audit and non-audit services should be separate. Regulatory authorities, however, believe that it would be difficult to track performance if this solution is implemented; hence audit firms should be banned from providing any additional services to their clients (Chadbourne and Parke, 2003). Additionally, the Securities and Exchange Commission adopted rules which limit the audit firms from providing any compensation to their clients in joint services (Chadbourne and Parke, 2003).

Threat of Higher Non-audit Fee

Research indicates that the auditor independence is adversely affected if the fee paid for non-audit services is higher when compared with that of audit services (Frankel, Johnson and Nelson, 2002). Due to the existence of this threat, the Securities and Exchange Commission devised laws which enforced the disclosure of all fees paid to auditors by their clients (Chadbourne and Parke, 2003). Chen, Elder and Liu (2005) found an unfavourable relationship between non-audit services and the degree of acceptance the client showed to the recommendations by the auditor. This imparts that highly extensive additional services result in lower possibility of acceptance from the client, due to the equally high fee attached to them (Reynolds, Deis and Francis, 2004). Therefore, it may turn out to be hazardous for the audit firm’s independence as it would then attempt to introduce even more extensive non-audit services, further complicating legal requirements for itself.

Threat from Relationship with Management

Perhaps the greatest detrimental effect which non-audit services have on auditor’s independence is related to the relationship between the auditor and client management and the way it affects audit approach (Gwilliam, Teng and Marnet, 2014). Despite its economic dependence on its clients, the audit firm’s independence is greatly strengthened by lower levels of competition to cater to its clients (Quick and Rasmussen, 2015).

Positive Impact on Auditor’s Independence
Strengthening Audit Quality

Wang and Hay (2013) provided evidence for a positive relationship between provision of non-audit services and auditor’s independence, indicating that these additional services help the audit firms distinguish themselves from their competitors, whereby they portray their uniqueness in front of their clients. Some authors support this claim by saying that the auditor’s objectivity is strengthened by non-audit services because they help them form a better understanding of their clients (Jenkins and Krawczyk, 2001). Proponents of this view explain that the audit quality is indeed enhanced by the provision of non-audit services, because the auditors are then able to develop a better understanding of their clients’ industry, competitive position, strategies, business model and the risks they face (Ernst & Young, 2013). Gwilliam, Teng and Marnet (2014) mentioned that because of economies of scope, the joint provision of audit and non-audit services has economic benefits for both the auditor and the client. It is mainly because of knowledge spillovers. Limiting the audit firms from providing non-audit services would result in economic inefficiency.

Ernst & Young (2013), for example, takes advantage of its non-audit services through knowledge spillovers; i.e. it uses the financial information gained from auditing its clients to provide advisory and consultancy services to the same clients related to their investment decisions, recruitment, strategic direction and other such internal matters.

While there are concerns regarding clients paying higher fee when they opt for a joint provision of both types of services (Frankel, Johnson and Nelson, 2002), there is another school of thought which directs financial statement users to initially compare the frequency of usage of both audit and non-audit services before jumping to any such conclusions (Ezzamel, Gwilliam and Holland, 2002). This imparts that firms paying higher may be using more of non-audit services than actual audit services.

An example of the positive effect of non-audit services could be gauged from the recent guidelines by the Financial Reporting Council (FRC, 2015), which introduced the revised Auditing Standards ensuring that the auditors are able to get some consultancy and advice regarding provision of non-audit services. Along with explaining its regulations, it also claims to provide guidance to audit firms on how they can use these supplementary services to their advantage, remaining within the ethical code of conduct. Even in case of pressure from the client regarding non-audit services, the auditor must first ensure its stakeholders that it produces completely transparent financial statements and should not get involved in suspicious practices, such as the KPMG case, where the company’s accountants were doubted to be involvement in tax dodging, which they finally had to publicly admit. They then avoided the lawsuits by paying a huge penalty and accepting the conditions imposed by the US Justice Department (Gwilliam, Teng and Marnet, 2014).

Positive Reputation Effects

Supporters of non-audit services do not contradict with the laws related to these services; they in fact believe that if the services are provided with the appropriate measures to safeguard auditor’s independence, they will end up being favourable for both the auditor and the client (Ernst & Young, 2013). Advocates of this viewpoint also found that the income received as a result of providing non-audit services helps in enhancing auditor’s reputational capital, which is the firm’s goodwill in the market (Wang and Hay, 2013). Thus, to sustain their goodwill, audit firms would keep themselves from surrendering to their clients. Evidence from economic models suggests that audit firms may be willing to forgo short-term increases in earnings from non-independent behavior in anticipation of building a better reputation in the long run, leading to higher economic returns (Gwilliam, Teng and Marnet, 2014). Firms would, therefore, abide by the rules as they prove to be a powerful tool to safeguard against any independence violence.

Enhancement in Audit Training

Some researchers believe that if auditing personnel are involved in providing non-audit services, they will not be able to perform the audit tasks in a complex business environment (Sori and Karbhari, 2006). On the contrary, proponents of non-audit services argue that by performing these additional services, junior auditors and audit trainees learn many skills which then help them become more competent accountants, which favourably impacts the audit firm’s independence and audit quality (Gwilliam, Teng and Marne, 2014).

No Impact on Auditor’s Independence

Some researchers believe that there is no relationship between provision of non-audit services and auditor independence (Jenkins and Krawczyk, 2001). Reviewing 20 years of literature, Salehi (2009b) did not find enough evidence about investors being concerned with non-audit services. Quick and Rasmussen (2009) also discovered that there is a lack of evidence supporting the claim that non-audit services are the reason behind impairment of auditor’s independence. Tepalagul and Lin’s (2014) study revealed that providing consultancy services to audit clients does not really affect the perceptions of the financial statement users about auditor’s credibility and independence; it in fact helps in enhancing the organisation’s internal control systems.

Conclusion

There are many reasons due to which an auditor’s reliability and independence may be compromised, one of which is often said to be the additional non-audit services provided by audit firms to their clients. Some researchers believe that these services pose to be a threat to the audit quality and independence by joint provision of both service types, higher non-audit fee and relationship with management. There are others who believe that these services positively influence auditor independence, whereby the audit quality is strengthened and the audit firm enjoys better reputational capital and enhanced audit training. There are still other researchers who found non-audit services to have no impact on the auditor’s independence. Numerous examples of firms are present supporting either of the three viewpoints; it all depends upon the auditor’s strategic moves by which it strives to safeguard its independence and the reliability of its work. The doubts financial statement users have about auditors’ performance can be handled well by standardized processes and transparency of information provided by audit firms.

References
ABP (2004). Ethical Standards 5: Non-Audit Services Provided to Audit Clients. The Auditing Practices Board. [Online] Available at: https://www.frc.org.uk/Our-Work/Publications/APB/ES-5-Non-audit-services-provided-to-audit-clients.pdf
Adeyemi, S.B., and Olowookere, J.K. (2012). Non-audit Services and Auditor Independence – Investors’ Perspective in Nigeria. Business and Management Review, Vol. 2, No. 5, pp. 89-97.
Al-Ajmi, J., and Saudagaran, S. (2011). Perceptions of Auditors and Financial-Statement Users Regarding Auditor Independence in Bahrain. Managerial Auditing Journal, Vol. 26, No. 2, pp. 130-160.
Chadbourne, and Parke, (2003). SEC Adopts Final Rules on Auditor Independence. [Online] Available at: http://www.chadbourne.com/files/Publication/40905c7b-de76-481d-a771-124300cc04ba/Presentation/PublicationAttachment/891d9f5a-b897-44ed-a141-004f2d922405/SECAdoptsFinalRulesonAuditorIndependence.pdf
Chen, K.Y., Elder, R.J., and Liu, J.L. (2005). Auditor Independence, Audit Quality and Auditor-Client Negotiation Outcomes: Some Evidence from Taiwan. Journal of Contemporary Accounting & Economics, Vol. 1, No. 2, pp. 119-146.
Ernst & Young (2013). Q&A on Non-audit Services. Point of View: Our Perspective on Issues of Concern. [Online] Available at: http://www.ey.com/Publication/vwLUAssets/EY-qa-on-non-audit-services-march2013/$FILE/EY-qa-on-non-audit-services-march2013.pdf
Ezzamel, M., Gwilliam, D., and Holland, K. (2002). The Relationship between Categories of Non-audit Services and Audit Fees: Evidence from the UK. International Journal of Auditing, Vol. 6, No. 1, pp. 13-35.
Frankel, R.M., Nelson, M.F., and Johnson, K.K. (2002). The Relation between Auditors’ Fees for Non-audit Services and Earnings Management. The Accounting Review: Supplement 2002, Vol. 77, No. s-1, pp. 71-105.
FRC (2015). FRC’s Work to Enhance Justifiable Confidence in audit through Implementation of the EU Audit Regulation and Directive. [Online] Available at: https://www.frc.org.uk/News-and-Events/FRC-Press/Press/2015/September/FRC-s-work-to-enhance-justifiable-confidence-in-au.aspx
Gwilliam, D. (2010). Trucking on: Audit in the Real World? (Man V Freightliner and Ernst & Young). Journal of Professional Negligence, Vol. 26, No. 4, pp. 180-193.
Gwilliam, D., Teng, C.M., and Marnet, O. (2014). How does Joint Provision of Audit and Non-audit Services Affect Audit Quality and Independence? A Review. Chartered Accountants’ Trustees Limited. [Online] Available at: http://www.icaew.com/en/products/audit-and-assurance-publications/~/media/481bd2be6ac7414cb4248996d259f8f5.ashx
Hoffman, K.D. (2009). Services Marketing: Concepts, Strategies & Cases. Third International Edition. Mason: South-Western.
ICAEW (2015). The Provision of Non-audit Services to Audit Clients. [Online] Available at: http://www.icaew.com/en/technical/ethics/auditor-independence/provision-of-non-audit-services-to-audit-clients
Ismail, I., Hasnah, H., Ibrahim, D.N., and Isa, S.M.(2006). Managerial Auditing Journal, Vol. 21, No. 7, pp. 738-756.
IOSCO (2007). A Survey of the Regulation of Non-Audit Services Provided by Auditors to Audited Companies – Summary Report. [Online] Available at: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD231.pdf
Jenkins, J. G., and Krawczyk, K. (2001). The Influence of Nonaudit Services on Perceptions of Auditor Independence. Journal of Applied Business Research, Vol. 17, No. 3, pp. 73-78.
Krishan, J., Zhang, Y., and Sami, H. (2005). Does the Provision of Non-audit Services affect Investor Perceptions of Auditor Independence? Auditing: A Journal of Practice & Theory, Vol. 24, No. 2, pp. 111-135.
Muir, S. (2014). The Provision of Non-Audit Services to Audit Clients – Still a Difficult Circle to Square. CAPITA Asset Services. [Online] Available at: http://www.capitaassetservices.com/assets/media/SS14384_Non_audit_services_article-v4.pdf
Okaro, S.C., and Okafor, G.O. (2009). Stemming the Tide of Audit Failures in Nigeria. ICAN Students’ Journal January/March, Vol. 13, No. 1, pp. 11-17.
Pwc (2014). EU Audit Reform: Providing Non-audit Services. [Online] Available at: http://www.pwc.co.uk/assets/pdf/pwc-uk-eu-audit-reform-client-briefing-nas-7-aug-2014.pdf
Quick, R., and Rasmussen, B.W. (2009). Auditor Independence and the Provision of Non-audit Services: Perceptions by German Investors. International Journal of Accounting, Vol. 13, No. 1, pp. 141-162.
Quick, R., and Rasmussen, B.W. (2015). An Experimental Analysis of the Effects of Non-audit Services on Auditor Independence in Appearance in the European Union: Evidence from Germany. Journal of International Financial Management & Accounting, Vol. 26, No. 2, pp. 150-187.
Reynolds, J.K., Deis, D.R., and Francis, J.R. (2004). Professional Service Fees and Auditor Objectivity. Auditing: A Journal of Practice & Theory, Vol. 23, No. 1, pp. 29-52.
Salehi, M. (2009a). Non-audit Service and Audit Independence: Evidence from Iran. International Journal of Business and Management, Vol. 4, No. 2, pp. 142-152.
Salehi, M. (2009b). In the Name of Independence: With Regard to Practicing Non-audit Services by External Auditors. International Business Research, Vol. 2, No. 2, pp. 137-147.
Sori, Z.M., and Karbhari, Y. (2006). Audit, Non-Audit Services and Auditor Independence. Staff Paper Universiti Putra Malaysia. [Online] Available at: http://www.researchgate.net/publication/237379279_Audit_Non-Audit_Services_and_Auditor_Independence
Swanger, S.L., and Chewning, E.G. (2001). The Effect of Internal Audit Outsourcing on Financial Analysts’ Perception of External Auditor Independence. Auditing: A Journal of Practice and Theory, Vol. 20, No. 2, pp. 115-129.
Tepalagul, N., and Lin, L. (2014). Auditor Independence and Auditor Quality: A Literature Review. Journal of Accounting, Auditing & Finance, Vol. 3, No. 1, 101-121.
Wahdan, M.A., Spronck, P.S., Ali, H.F., Vaassen, E.V., Herik, H.J. (2005). Auditing in Egypt: A Study of Challenges, Problems and Possibility of an Automatic Formulation of the Auditor’s Report. [Online] Available at: http://ilk.uvt.nl/~pspronck/pubs/Wahdan2005c.pdf
Wang, S.W., and Hay, D. (2013). Auditor Independence in New Zealand: Further Evidence on the Role of Non-audit Services. Accounting and Management Information Systems, Vol. 12, No. 2, pp. 235-262.

This work was produced by one of our professional writers as a learning aid to help you with your studies

Financial statements are useful as they can be used to predict future indicators for a firm using the financial ratio analysis. From an investor’s perspective financial statement analysis aims at predicting the future profitability and viability of a company, while from the management’s point of view the ratio analysis is important as it helps anticipate the future conditions in which the firm should expect to operate and facilitates strategic decision making (Brigham and Houston 2007, p. 77).

Profitability analysis

Harry’s Hamsters Limited (HHL) experienced growth in its profitability from 2007 to 2008; however, the net income reduced significantly during 2009. The return on equity (ROE) was 4.24 percent in 2007, increased to 14.68 percent in 2008 and decreased back to 5.10 percent in 2010. Similarly, the return on assets (ROA) also initially increased and later declined in 2009; the decline was sharper compared to the decline in ROE as the ROA in 2009 of 1.73 percent is lower than 2.08 percent in 2007. The ROE comprises of two main components: the return on net operating assets (RNOA) and the return on debt (ROD). RNOA for HHL has also deteriorated during 2008 decreasing from 16.61 percent in 2008 to 5.08 percent in 2009. The RNOA is used to weigh the overall performance of the HHL management. The ROD component of the ROE has also deteriorated from 13.68 percent in 2008 to negative 3.32 percent in 2009 (Kemsley 2009, pp. 12-16).
The ROCE was the highest in 2008 estimated 11.39 percent. It implies that the capital employed by HHL yielded high returns before the expansion period and that the company was significantly profitable. A considerable decline in 2009 to 4.82 percent can be unfavourable for the investors; however, as the company has not sold its shares to the public a reduction in this ratio for a temporary period is not a major concern for the current owners.
The operating profit margins for HHL initially increased from 10 percent in 2007 to 17.45 percent in 2008; however, the company reported lowered margins of 8.53 percent in 2009. The decline in the operating profit margins of HHL is largely attributed to the increase in costs associated with the expansion of the business. The operating margins are expected to recover over the next year assuming that the new operations will become profitable as sales increase. The cost of goods sold have increased in absolute terms but the overall gross profit margins for the company have improved from 35 percent in 2007 to 42.01 percent in 2009. This implies that the company is effectively managing its relations with suppliers and has kept a control over the costs attached to buying the hamsters for breeding; but the operating costs have increased due to the low sales activity in the new operations.

Liquidity analysis

The current ratio of HHL remains above the minimum threshold of one and is currently 1.22; historically, the ratio has remained between 2.73 and 3.25 times. However, the quick ratio for the company reveals serious concerns as it has decreased from 1.67 in 2008 to 0.22 in 2009. The low quick ratio implies that a considerable portion of the current assets of the company are tied up as part of its inventory (Bragg 2007, pp. 14-16). This could also mean that HHL might be unable to sell the hamsters and sales might be suffering. The company must increase its working capital to meet its near term current liabilities and retain its solvency (Brigham and Houston 2007, pp. 42).

Efficiency analysis

The firm’s efficiency has not necessarily decreased during the last year; an analysis of the efficiency ratios suggests a trend that is different from what is seen through the profitability and liquidity ratios. The inventory turnover has slightly deteriorated from 3.00 in 2007 to 2.89 in 2009; similarly impacting the day’s inventory on hand from 121.67 to 126.35 during the same period. The long inventory holding period suggests that the company needs to improve its liquidity position to maintain its efficiency and aim to reduce its inventory turnover significantly (Brigham and Ehrhardt 2008, pp. 57-62). The days of accounts receivables have reduced from 45.63 in 2007 to 40.05 in 2009 and at the same time the days of accounts payables have reduced even more drastically from 40.56 to 28.08. The operating asset turnover for HHL has deteriorated considerably from 0.87 in 2007 to 0.60 in 2009, owing to a long inventory holding period and a quick payment of the accounts payables.

Capital structure analysis

The capital structure has significantly changed over the past two years as HHL has increased its financial leverage and is using a considerable debt to finance its expansion activities. The debt ratio of the firm has increase from 0.47 in 2007 to 0.60 in 2009; imply that HHL is now funding 60 percent of its assets through debt (Berry 2006, pp. 68-71). The interest coverage ratio of the company had improved considerably in 2008 and was 4.29, but it has deteriorated to 1.89 raising additional concerns for the banks. The ROD for the company has reduced considerably but remains positive implying that the current level of financial leverage is generating additional returns for the company. Operating cash flows (OCFs) for the company remain negative being typical of young firms experiencing a high growth rate, but the ability of HHL to raise additional financing is limited; therefore negative OCFs raise serious concerns for the bank management.

Report to credit committee
Analysis for reasons of results

HHL avails a long-term debt facility of ? 0.45 million and has also utilised an overdraft of about ? 35,000 from its current facility. The company performed exceptionally well during 2008, which led to an increase in its debt facility from ? 0.275 million to ? 0.45 million recently. The recent financial results revealed a tightening credit position of the company during 2009, which led to concerns regarding the excess usage of the overdraft facility by the company. Recent communication with the company reveals that it is facing liquidity problems due to its ambitious expansion program; however, the problem can be solved depending on the ability of the management to realise the seriousness of the situation (Madura 2006, pp. 17-32).
The company is running an overdraft without any immediate plans regarding its understanding to pay back the short-term loan. The overdraft is being utilised to fund the working capital needs of the company, which it did not anticipate during its expansion into southern England. The success or failure of the new operations is yet to be seen and the position will only be clear by next year. The current assets are largely financing the inventory requirements of the company, while the inventory cycles are long and not in a position to be liquidated on urgent need. The company needs to introduce additional capital in order to solve its working capital problems.
The working capital position of HHL can also improve by increasing the days of accounts payable ratio to higher levels or by reducing the inventory cycle if possible (Myers 1984, pp. 126-128). However, both options seem unlikely leading us to prescribe alternative solutions. The company has seen deterioration in the profitability ratios, which has reduced its ability to pay the interest commitments on the outstanding loan. However, the company still maintains an interest coverage ratio of 1.89 and should be able to regain its position once the new operations become profitable.
The efficiency ratios of the firm have remained relatively stable with a slight decrease in the inventory turnover, an improvement in the accounts receivables turnover and a significant drop in the operating assets turnover. The company maintains a high debt ratio and about 60 percent of its assets are funded using debt; however, this is typical of most firms under the initial expansion phase.
The company remains committed to making profits but has not considered rising outside capital by going public in the near future; the only way to maintain its current pace of growth will be either through an injection of personal equity or through the offering of company stock to the public (Ronen and Yaari 2007). The owners have invested most of their life savings into the business and the company cannot possibly raise any further internal financing.

Recommendations regarding bank arrangements

The credit committee is recommended to raise concerns regarding the current liquidity position of the company and to prepare a schedule for the repayment of the overdraft amount over the next six months. The company is expected to recover from the current situation during the next year, but it is important to remain cautious until the sales position appears to improve. Also developing a degree of pressure on the management should clearly communicate the banks position to the firm (Gibson 2009, pp. 212-216). The intention is to educate the company management about the gravity of this situation and ensuring that it is able to recover smoothly from the liquidity crunch, while at the same time minimising the bank’s exposure to the business risk HHL is facing.
The Managing Director of HHL is consistent in maintaining regular contact with the bank; therefore we need to educate him with the possible solutions for recovering from the credit crunch faced by the company. The recommended solutions include a consolidation of the business before considering any further expansion projects, a reduction in the days inventory on hand, increase in the days accounts payables, the retention of profits into the business allowing for no dividend payments over the next quarters, an injection of equity from any other sources available, an increase in collateral to support the bank’s claims and a phasing out of the bank overdraft over the next six months as revenues from the sales are realised (Harvard Business School 2006, pp. 3-12).

Recommendations to management about improving finances of the company

Mr. Michael,
Thanks for a quick response pertaining to the overdraft issue. We have analysed the situation faced by HHL based on the recent financial statements and the qualitative information that we received during our recent correspondence. It is understood that your company has recently gone a major expansion and the short-term impacts are apparent on the financial results in terms of lowered profitability as anticipated. The concern raised by the bank is not directly related to the profitability of your company and we remain concerned about the liquidity position of HHL in months to follow (Bissessur 2008, pp. 142-146).
The understanding between the bank and the company was that the expansion will be fully funded by the increase in the loan facility. This increase in loan was to support both the fixed investment in the expansion project as well as the working capital needs of HHL. However, as it is seen the actual expansion investment has exceeded the anticipated amounts and the company is facing a severe liquidity crunch that needs to be resolved.
The credit committee is concerned regarding the profitability of the expansion project and is not prepared to enhance the overdraft limit until the latest results for the company become available. HHL would have to independently solve this liquidity crunch by either an injection of equity to facilitate the increased working capital requirements or to raise additional external capital. The intention of the company to continue towards is expansion projects can be best facilitated through a public listing of the company to raise additional capital (Hill and Jones 2009, pp. 28-29).
The bank would require the company to pay the entire overdraft drawn in instalments over the next six months. This payment schedule has been drafted after a careful consideration of the credit history of your firm with the bank; in usual circumstances we would have required the repayment of the whole overdraft instantly. Moreover, it must be understood that this correction is in the best interest of your company as it serves to facilitate your understanding of the gravity of the situation faced by HHL.
A large proportion of the current assets held by HHL are tied up in the inventory and the company has no cash reserves available to pay for the maturing current liabilities including the bank’s interest payments. It is important to understand that the company would have filed for bankruptcy if the current overdraft was not available. Therefore, it is a very serious concern which should be resolved as soon as possible (Capon 1990, p. 1145).
The company can adopt some emergency measures to immediately improve its cash position, including a maximum delay in the payment to creditors that might be possible without significantly harming the supplier relations, a quicker recovery of accounts receivables without significantly harming the sales position and an immediate sale of ready inventory on a cash payment discount (David 2006; Ebert and Griffin 2005). Moreover, the company must not withdraw any retained earnings in the form of dividends until the liquidity position is resolved.
Waiting for your response,
Nick Cameron

Bibliography

Berry, A., (2006). Accounting in a business context. Brighton: Cencage Learning.
Bissessur, S., (2008). Earnings quality and earnings management: The role of accounting accruals. Rosenberg Publishers.
Bragg, S., (2007). Business Ratios and Formulas: A comprehensive Guide. New Jersey: John Wiley and Sons.
Brigham, E., and Houston, J., (2007). Fundamentals of Financial Management. Mason: Thomson Publishing Limited.
Brigham, E., and Ehrhardt, M., (2008). Financial management: Theory and practice. Mason: Thomson Higher Education.
Capon, N et al., (1990). Determinants of financial performance: A Meta Analysis. Journal of Management and Sciences, Vol. 36 (10), pp. 1143-1159.
David, F., (2006). Strategic management: concepts and cases, 10th ed. Hong Kong: Pearson education.
Dominguez, K., (2006). Exchange rate exposure. Journal of International Economics, 68 (1), pp. 188-218.
Ebert, R., and Griffin, R., (2005). Business Essentials. Prentice Hall.
Finnerty, J., (2007). Project financing: Asset based financial engineering. New Jersey: John Wiley and Sons Publishing.
Kemsley, D., (2009). Financial Accounting Seminar: Practical Equity and Credit Analysis. New Orleans: Tulane University.
Kumar, K., and Dissel, V., (1996). Sustainable collaboration: Managing conflict and cooperation in systems. Journal of Information Management, 20 (3), pp. 279-300.
Gibson, C., (2009). Financial Reporting and Analysis: Using Financial Accounting Information. Mason: Cencage Learning.
Harvard Business School., (2006). Essentials of strategy. Boston: Harvard Business School Press.
Helfert, E., (2001). Financial Analysis: Tools and techniques, a guide to managers. New York: McGraw Hills.
Hill, C., and Jones, G., (2009). Strategic management theory: an integral approach. Mason: Cencage learning.
Madura, J., (2006). Introduction to business. Mason: Thomson publishing.
McDonald, B., and Morris, M., (1984). The statistical validity of the ratio method in financial analysis: An empirical examination. Journal of Business Finance and Accounting, 11 (1), pp. 89-104.
Myers, S., (1984). Finance theory and finance strategy. Interfaces, 14 (1), pp. 126-137.
Ronen, J., and Yaari, V., (2007). Earnings Management: Emerging insights, in theory, practice and research. New York: Springer Publishers.

This work was produced by one of our professional writers as a learning aid to help you with your studies

Discuss what is meant by the term GAAP and whether it meets the needs of all UK entities.
Introduction

Generally accepted accounting principles or GAAP refers to a set of principles, rules, methods and conventions that provides detailed guidelines and procedures for the preparation, presentation and handling financial and accounting cases. Institute of Chartered Accountants in England and Wales (ICAEW) defines “Generally Accepted Accounting Practice (UK GAAP) as the body of accounting standards and other guidance published by UK Accounting standards Board (ASB)”. In the UK, Financial Reporting Council (FRC) is responsible for setting accounting standards by working closely with national and international accounting standard-setters in order to influence the development of standards. In 2009, ASB proposed a strategy for the future of UK/Irish GAAP and its convergence with International Financial Reporting Standards (IFRS). The intention was to work under the IASB framework which provides detailed guidelines and procedures in the need of all UK entities, hence, cease the existence of UK GAAP. The Board’s proposals set out a three Tier system of differential arrangement based upon public accountability. UK entities would need to determine the appropriate framework to transition, as well as the impact of change to their financial reporting, tax status, business processes and operations in general (Ernst & Young, 2011). Currently in the UK, only entities listed on the regulated market are required to file their accounts in accordance to IFRS, whereas all other UK entities are permitted to use wither IFRS or follow UK GAAP. ASB (2009) proposed three new standards, FRS 100, FRS 101 and FRS 102, that replace all current UK standards. By December 2014, UK GAAP will cease to apply to the financial statements and becomes mandatory for all UK entities for the year end December 2015 or from January 2015 but this is subject to early adoption provisions (ASB, 2009). Early adoption of FRS 101 is allowable without restriction whereas FRS 102 can be allowed on or after the accounting year end 31 December 2012 (PWC, 2013). The impact of each FRS is briefly discussed below.

Needs of UK entities

Entities are of different types of varied sizes with different shareholding and management. Every entity has its own properties but has to act in accordance to the local laws and accounting standards when reporting that gives a user clear picture and nature of business performance. In accounting, “True and Fair View” plays a pivotal role in reporting and presenting financial statements. It remains a fundamental part to accounting within the local and international laws. Under company law, an entity is a separate legal body from its owners. A large entity can be easily distinguished who the owner/manager is, unlike sole traders where it is quite difficult to get a clearer picture although the business forms a separate identity. Charitable organizations, government bodies and some entities have different ways of reporting and in some cases they do not follow UK GAAP in full. Instead, they follow the rules and guidance prescribed by the state and the civil law.

True and Fair view in terms of accounting standards may not be true and fair in terms of tax and to get a clear picture of business transactions, some items should be shown as expenses that wouldn’t be allowed for tax (Sweetman, 2009). Sweetman (2009, p.4) argues, “Very small businesses are unlikely to have fluctuations from year to year in most levels, and if in hard times the list of creditors grows then it seems reasonable to tax what is received rather than what may be received one day”.

Listed and regulated companies are already following IFRS guidelines and procedures for preparation and reporting financial statements but not all entities are in the regulated market and listed. GAAP varies from nation to nation and hence comes IFRS to come into action. Not all the needs of all UK entities are met by GAAP. It may be because of the nature of transactions an entity has. Trading has become global and most companies, from small to large, trade across the borders and in different countries that have different set of rules and regulations which are to be followed in terms of exchange, tax regimes and other accounting standards. Since the globalisation of the business, a single accounting system has been a major debate for all accounting standard setters in the world. There has been a long standing debate for the convergence of UK GAAP into the IASB framework and this has become a reality following the strategic approach taken by ASB in the past few years.

ASB’s Strategy for UK GAAP

In 2009, ASB proposed a “Three-Tier” approach to the transition of UK GAAP into IFRS to the fullest extent possible with the needs of UK entities. This three-tier approach was based on the public accountability.

Tier 1 – All listed and regulated market entities are to follow EU adopted IFRS under this accounting regime.

Tier 2 – All non-publicly accountable entities are to follow IFRS for SMEs under this regime

Tier 3 – All small entities such as private companies are to follow Financial Reporting Standards for smaller entities (FRSSE) under this regime.

Under this proposed change, all entities will have the option to voluntarily adopt a higher tier. One of the objectives of ASB is to offer a comprehensive and clear guidance for all entities by providing high levels of transparency and accountability (ASB, 2009).

ASB (2009) believes that the strategic change will improve the financial reporting in many ways such as simplifying the reporting requirements based on the entity’s accountability and size, basing UK GAAP on IFRS provides a consistent basis of preparation of financial statements with better understanding at all levels of users and improved comparability of financial reports will boost investors’ confidence in the capital markets.

UK GAAP v IFRS: Key Differences
Goodwill: Under IFRS, there is no amortisation used but annual impairment test.
Borrowing costs and development costs: If criteria are met then the costs are capitalised under IFRS but is optional under UK GAAP
Deferred Tax: Temporary differences are recorded under IFRS
Holiday pay accrual: This must be recognised under IFRS
Financial Instruments: Recognition of derivatives under IFRS but only recognised if FRS 26 adopted in UK GAAP
Impact of New Standards

The Financial Reporting Council (FRC) issued three financial reporting standards (FRSs) 100, 101 and 102 following several consultations to move from current FRSs to IFRS framework. Small entities remain unchanged to the standards as there will be no changes to FRSSE with exceptions to minor amendments (FRC, 2013). The FRC (2013) produced an impact assessment for all these new standards which are discussed below in brief.

FRS 100

Application of Financial Reporting Requirements, FRS 100, provides guidance about the reporting requirements for all entities. This tells the companies or LLPs which set of standards they may or must follow. Listed and regulated companies must use their IFRS in their group accounts. Small companies defined by Companies Act 2006 use FRSSE but a revised version from January 2015 with some minor amendments and other entities that are not small have various choices depending upon the situation. Such as FRS 102, the main new UK GAAP and FRS 101, the reduced disclosure framework or adopt the full IFRS. This suggests that companies which are currently using Statements of Standard Accounting Practices (SSAPs) and FRS will end up using FRS 102. FRC (2013) states that the introduction of new standards will have positive impact on the entities where the benefits are impossible to quantify. FRC believes that the main quantifiable cost is the transition costs for individual entities and those entities that apply for reduced disclosure framework.

FRS 101

FRS 101 Reduced Disclosure Framework creates a new type of standard in the UK. It allows subsidiaries of groups preparing consolidated financial statements in accordance with EU adopted IFRS to apply accounting policies that are consistent with the group accounts. FRS 101 allows some qualifying companies to use IFRS and such entities can take exemptions from following items.

Cash flow statements- entities are exempt from preparing cash flow statements
Share based payments- entities are exempt from most of the disclosure requirements by IFRS 2 except description is needed in some areas such as, options exercised in the year and outstanding in the year end
Business combinations- entities are exempt from most of the disclosure requirements but some basic information would still need to be disclosed on the acquisition
Discontinued operations- entities are exempt from the disclosure of net cash flows attributable to the operating, investing and financing activities
Financial instruments- entities which are adopting FRS 101 are exempt from all of the disclosure requirements of IFRS 7, except financial institutions
Fair Values- most entities are exempt from all of the disclosure requirements of IFRS 13 except financial institutions in relation to financial instruments
Impairments- entities are exempt from the disclosure of assumptions, valuation techniques and sensitivities arising from impairments
Related Party Disclosures- as part of the Companies Act 2006, directors’ remuneration is still required to be disclosed but entities are exempt in disclosing the related party transactions
Accounting policies, changes in accounting estimates and errors- entities are exempt from the disclosure and also exempt from disclosing the impact of the application of those standards
Comparatives information- entities are exempt from comparatives for movements on property, plant and equipment (PPE), share capital, intangible assets, and investment property
Capital Management- entities are exempt from the disclosure requirements of capital management but not available to financial institutions
FRS 102

FRS 102, the Financial Reporting Standard is based on IFRS for SMEs and mainly used IFRS language. There are some changes in the terminology of words used in the financial statements, such as, instead of fixed assets, property, plant and equipment has been introduced. There have been significant changes in the financial instruments. Previously, in the UK GAAP, derivatives with zero cost were not recognised but under the new standards, this will be recognised as even small entities have derivatives due to the global trading. ASB realized that FRS 26 (IAS 39) Financial Instruments: Recognition and measurement was not a proportionate solution for all UK entities and hence further areas were expected as part of the convergence process with EU-adopted IFRS. FRS 102 brings in significant improvements in the transparency of financial reporting of financial instruments (FRC, 2013). FRS 102 requires derivatives and some equity instruments to be measured at Fair Value Through Profit and Loss (FVTPL).

Conclusion

The ideas of convergence of UK/Irish GAAP into IFRS have been widely accepted ever since the debate started and it was warmly welcomed. The new UK GAAP will become mandatory for most entities which prepare financial statements for the year end December 2015. The three FRSs will be put in place that replace all the UK accounting standards. Most members were reasonably satisfied with the amendments proposed to the IFRS for SMEs with some unsatisfactory responses for negative goodwill and the removal of fair value option, based on conflicts with EU Directives (ACCA, 2011). Association of Chartered Certified Accountants (ACCA) stated in their report in 2010 following the ASB consultation paper that the new standards would inevitably benefit cross-border trade, reduce costs for companies by providing a single consistent basis of standards, and the cost and time involved in maintaining a separate UK GAAP would be avoided. There might be a number of reasons why convergence was necessary. The application of IFRS may also be driven by national GAAP because of inertia to minimise the changes in financial reporting for stakeholders caused by switching from one set of accounting rules to another (Nobes, 2006). Firms may choose to end their national accounting traditions following the adoption of IFRS (Haller and Wehrfritz, 2013). There might be variations in IFRS reporting due to country-specific factors (Haller and Wehrfritz, 2013).

In the wake of global business and trading relationships across the globe, new accounting standards had to be evolved for a consistent and transparent reporting. This not only creates and boosts confidence to users but also provides clear and concise understanding of the financial reporting systems to any stakeholders or users. The transition for UK GAAP to move and adopt IFRS has remained a huge success and widely accepted by all levels of institutions and individuals. There is no doubt that the standards have to evolve over time. The new level of UK GAAP will provide better understanding and try to remove any ambiguities that are engraved in the accounting standards.

Bibliography
ACCA (2010), “What is the future of UK GAAP?”, Accountants for Business. [Online] Available from http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-afb-fukg.pdf [Accessed: 29th September 2014].
ACCA (2011), “Future of financial reporting in the UK and Ireland: Summary of ACCA Member Surveys”. [Online] Available from http://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-fofr3.pdf [Accessed: 30th September 2014].
ASB (2009), Consultation Paper, “The Future of UK GAAP”.[Online]Available from https://www.frc.org.uk/getattachment/b106b739-316d-4b22-8703-a2ed94ff9863/Consultation-Paper-Policy-Proposal-The-Future-of-U.pdf. [Accessed: 29th September 2014].
Clive Owen & Co LLP, (2012), “The Future of UK GAAP”.[Online] Available from http://documents.cliveowen.com/Future%20of%20UK%20GAAP%20%28Oct-12%29.pdf [Accessed: 29th September 2014].
Deloitte (2014), “Summary FRS 101: Reduced Disclosure Framework”.[Online] Available from http://www.iasplus.com/en-gb/standards/uk-gaap/frs101 [Accessed: 30th September 2014].
Ernst & Young (2011), “UK GAAP vs IFRS” [Online] Available from http://www.ey.com/Publication/vwLUAssets/UK_GAAP_v_IFRS_-_The_basics_-_Spring_2011/$FILE/EY_UK_GAAP_vs_IFRS_-_The%20basics_-_Spring_2011%20.pdf [Accessed: 30th September 2014].
Financial Reporting Council,(2011), “True and Fair”.[Online]Available from https://www.frc.org.uk/FRC-Documents/FRC/Paper-True-and-Fair.pdf [Accessed: 29th September 2014].
Financial Reporting Council (2013), “Impact Assessment” [Online] Available from https://www.frc.org.uk/Our-Work/Publications/Accounting-and-Reporting-Policy/Impact-Assessment-FRS-100,-FRS-101-and-FRS-102.pdf [Accessed: 29th September 2014].
Haller, A & Wehrfritz, M. (2013), “The impact of national GAAP and accounting traditions on IFRS policy selection: evidence from Germany and the UK”, Journal of international accounting auditing & taxation, 22(1), pp. 39-56.
Institute of Chartered Accountants of England and Wales (2014), “ UK GAAP” [Online] Available from http://www.icaew.com/en/technical/financial-reporting/uk-gaap [Accessed: 30th September 2014].
Nobes, C. (2006). “The survival of international differences under IFRS: Towards a research agenda”. Accounting and Business Research, 36(3), 233–245.
PricewaterhouseCoopers (2013), “New UK GAAP or IFRS?: Your questions answered”, [Online] Available from http://www.pwc.com/im/en/publications/assets/new_uk_gaap_or_ifrs.pdf [Accessed: 30th September 2014].
O’Keeffe, I. & Hackett, F. (2010), “The End of UK/Irish GAAP A lot done, more to do”, Institute of Chartered Accountants In Ireland, Dublin; June 2010; 42,3; ProQuest Business Collection; p.16
Smetanka, R. (2012), “GAAP or Non-GAAP?”, Financial Executives; November; 28,9; ProQuest Business Collection; p.13
Sweetman, S. (2009), “Does one size fit all?” [Online] 14th February. Available from http://www.taxation.co.uk/taxation/articles/2009/04/14/18222/does-one-size-fit-all [Accessed:29th September 2014].
Wright, G.B., Fernandez, D., Burns, J., Hawkins, R., Hornsby, C. & Patel, S. (2012), “Big GAAP/Little GAAP: Will The Debate Ever End?”, Journal of Business & Economics Research (Online), 10(5), pp. 291.

This work was produced by one of our professional writers as a learning aid to help you with your studies

THE PECKING ORDER HYPOTHESIS

Determining the optimum capital structure which an organisation should have is a major financial decision, and the importance of decisions regarding capital structure have become even more apparent due to economic events such as the global financial crisis (Baker and Martin, 2011). Hossain and Ali (2012) state that all firms are highly susceptible to decisions regarding capital structure, owing to their internal and external effects on organisations. They further point out that capital structure policies are significant because of their impact on the level of risk and return of a firm. As such, a number of theories have been proposed to explain the capital structure of organisations. One of such is the Pecking order hypothesis. This essay shall examine this hypothesis and how it explains capital structure. Subsequently, it shall be compared to another theory of capital structure, the static trade-off theory, in order to find out how it differs from this theory. Studies testing both theories shall also be examined.

According to Chen and Chen (2011, p. 92), the Pecking order hypothesis is “one of the most influential theories of corporate finance”. Frank and Goyal (2003) further note that much of its influence is drawn from a view that logically fits with facts on how external finance is used by companies. This hypothesis suggests that in making a choice among alternative forms of finance, organisations have a certain order of priorities. In the first instance, firms prefer to make use of internal finance generated by their operating cash flow. When these internal sources are used up, they prefer to borrow. The third option, which is used as a last resort, is the sale of new shares of the company (Pike and Neal, 2009). The rationale for this preference order is the information asymmetry problem, i.e. the disparity between the information managers and potential investors have regarding the financial state of the firm and its prospects. As such, managers are less inclined to issue shares when they believe these shares to be undervalued, and more likely to issue them when it is believed that they are overvalued (Chen and Chen, 2011; Pike and Neale, 2009). As a result of this, shareholders, mindful of their relative ignorance of the firm’s financial state and of this possible behaviour by managers, will view a decision not to issue shares is a signal of good news, while the issuing of shares will be seen as bad, or relatively less good (Myers and Majluf, 1984). These signals are ‘noisy signals’ (Chen and Chen, 2011), and viewing issued shares as overvalued or ‘less good’ affect the price investors will be willing to pay for those shares, and they may consequently mark them down. This could therefore increase the cost of equity for firms (Pike and Neale, 2009). Transaction costs, as Chen and Chen (2011) point out, play a significant role in decisions regarding the firm’s capital structure. This is because the costs involved in obtaining finance internally are less than the transaction costs involved in securing new external financing, as internal funds do not incur transaction costs. As such, it is expected by investors that firms would first finance company investments using internal resources first, then by borrowing till the firm has a suitable debt to equity ratio, and finally, by issuing equity (Myers and Majluf, 1984; Pike and Neale, 2009). Frank and Goyal (2003, p. 218) note that “the financing deficit should normally be matched dollar for dollar by a change in corporate debt”, and as such, if the pecking order is followed by firms, then a slope coefficient of one results from a regression of net debt issues on financing debt. This prediction was strongly supported by results from a study by Shyam-Sunder and Myers (1999), using a sample of 157 which had traded continually from 1971 to 1989. However, it should be noted that this sample was relatively small, and consisted mainly of mature, public firms. Chen and Chen (2011) note that an assumption of the Pecking order theory is that there is no target capital structure.

The pecking order theory has been used widely to explain the financing decisions of organisations. One of its main advantages is that it correctly predicts the effects profits have (Frank and Goyal, 2009; Shyam-Sunder and Myers, 1999). However, there are some problems with this hypothesis. As Frank and Goyal (2003, 2009) observe, firm operations and their accounting structures are more complex than what is represented in the standard pecking order. Furthermore, contrary to what is usually suggested, Frank and Goyal (2003) report that internal financing is usually not enough to cover the average investment spending, and there is a heavy use of external financing among firms. They also note that the magnitude of debt financing does not overshadow equity financing. Additionally, while there is wide support for the pecking order theory among larger firms and in earlier years, with the increase in the number of small firms trading publicly, there has been a decline in the support for the pecking order hypothesis, as small firms tend not to follow the pecking order, leading to a shift in the overall average away from the pecking order (Frank and Goyal, 2003).

Nevertheless, the pecking order hypothesis still offers a useful explanation for the financing model followed by firms, especially larger firms. Some studies of the pecking order hypothesis will be discussed in the next section.

A COMPARISON OF THE PECKING ORDER HYPOTHESIS AND THE STATIC TRADE-OFF THEORY

Having discussed the Pecking order theory in detail, the static trade-off theory will be briefly discussed in this section, and a comparison made to show the differences between both.

The static-trade off theory acknowledges that firms aim to take advantage of the lower cost benefits borrowing offers, particularly the tax shield. However, at the same time, they are also hesitant to increase the financial risks which committing to contracts and making ongoing interest and capital repayments would involve. As such, the returns and cost benefits are traded off against the risks of financial distress from excess borrowing, and firms which have higher and more stable profits would likely operate at higher debt levels, as there would be a greater opportunity to shelter their profits from tax (Pike and Neale, 2009; Shyam-Sunder and Myers, 1999). Figure 1 below illustrates the static trade off theory of optimal capital structure.

FIGURE 1: THE STATIC TRADE OFF THEORY OF OPTIMAL CAPITAL STRUCTURE

Source: Shyam-Sunder and Myers (1999, p. 220)

For a value maximising-firm, benefits and costs would be equated at the margin, and it would operate at the highest point of the curve. For profitable, safe firms, which have higher taxes to shield and assets which would avoid relatively major damage to their asset values, the curve would top out at comparatively high debt ratios (Shyam-Sunder and Myers, 1999). Shyam-Sunder and Myers (1999, p. 220) note that this static trade off theory translates quickly to empirical hypothesis, it predicts that the actual debt ratio will reverse to an optimum or target level, and also predicts “a cross-sectional relation between average debt ratios and asset risk, profitability, tax status and asset type”.

As noted earlier, in the Pecking order theory, there is no target capital structure. However, from the explanation above, it can be observed that this is not the case with the static trade off theory, as it supposes an optimum/target capital structure. This is a key difference between the Pecking order hypothesis and the static-trade off theory. Myers (1984) observes that while in the static trade off there is a debt to value ratio target set by the firm, which it steadily works towards attaining, for the pecking order theory, there is no well-defined ratio of target debt to value, but instead, internal financing is used first, before debt, and then issuing equity, due to signalling issues associated with external funding and asymmetric information (Shyam-Sunder and Myers, 1999).

Hackbarth, Hennessy and Leland (2007) note that there is a debt ‘pecking order’ within the trade-off theory, with a preference for bank debt over market debt, as lower bankruptcy costs are implied. As such, small firms tend towards issuing privately placed debt, while larger firms are more prone to issuing market debt (Blackwell and Kidwell, 1988; Hackbarth et al, 2007).

While the static trade off theory places strong considerable emphasis on taxes and bankruptcy costs (Frank and Goyal, 2007), and the tax shield advantage of debt, the pecking order hypothesis does not really focus on this. However, this shield advantage is quite important, and as Chen and Chen (2011) report, based on their study of 305 Taiwanese electronic listed firms in 2009, large firms tend to take advantage of the tax shield which debt offers. They also point out that due to their lower information asymmetry and lower and more diversified risk, they tend to have relative advantages when raising finance from formal institutions. However, they note that firms still use internal capital to finance new projects, and turn to debt when internal capital is insufficient, in line with the pecking order hypothesis. This is also supported by Graham and Harvey’s (2001) survey of 392 chief financial officers. The results of the survey showed that the tax advantage of debt is seen as moderately important in making capital structure decisions, and for large companies in particular, this tax advantage was cited as ‘most important’.

A key point to note is that profitability, growth opportunities, asset structure and risk are key variables that influence the capital structure a firm adopts (Cassar and Holmes, 2003; Chen and Chen, 2011), and this could also possibly influence the model of capital structure firms appear to follow. The key variables influencing capital structure highlight another difference between both models, which is that while with the trade-off model, variances in an organisation’s leverage are driven by the costs and benefits of debt, with the pecking order theory, these are driven by the net cash flows of the firm (i.e. its cash earnings minus investment expenditures) (Fama and French, 2002).

A test of the static trade off theory and the pecking order hypothesis by Shyam-Sunder and Myers (1999) revealed that the pecking order model has a higher time-series explanatory power than the static trade-off theory. They note that it explains far more of the time-series variance in real debt ratios, rather than the static trade off theory’s target adjustment model. However, they also note that if a firm’s actual mode of financing adheres to the static trade off theory, then the pecking order hypothesis can be rejected, while in contrast, the static trade off theory appears to work when the financing model follows the pecking order as described earlier. Shyam-Sunder and Myers (1999) therefore state that while the pecking order offers a better initial explanation of firms decisions regarding debt-equity (particularly for mature, public firms as used in the sample of their study), the evidence for a definite optimum debt ratio as predicted by the trade-off theory is questionable.

In a test of the pecking order hypothesis and the trade-off theory using a cross-section of the largest listed firms in China, using three models: the determinants of leverage, the relationship between leverage and dividends, and the determinants of corporate investment, Tong and Green (2005) reported the following results: For the relationship between leverage and profitability, a significant negative correlation was observed, and a significant positive correlation was found for the relationship between current leverage and past dividends, both of which showed more support for the pecking order hypothesis over the trade-off theory. However, the results of the third model, corporate investment determinants, were not conclusive. Nevertheless, their conclusion was that the results tentatively supported the pecking order hypothesis in explaining how Chinese companies make their financing decisions. Studies by Myers (1984) and Fama and French (2002) show a lack of a positive correlation between profits and debt, and the researchers view this as a problem with the trade-off theory. Fama and French (2002) note that while the dividend pay-outs for firms which have higher profit levels and firms with fewer investments is higher, in line with predictions of both models, they note that firms which are more profitable are less levered. This is in line with the pecking order hypothesis, but contradicts the trade-off model. They further note that in line with the predictions of the pecking order model, short-term variances in investment and earnings are mainly covered by debt.

CONCLUSION

This essay has examined the pecking order hypothesis and how it explains the capital structure of firms. Its advantages and some of its drawbacks were also highlighted. It was subsequently compared with the static trade off theory, and the differences between both were pointed out, such as the proposition of an optimum/target capital structure, the focus on taxes and bankruptcy costs, and the factors which drive an organisation’s leverage. Tests of both theories highlight some of their strengths as well as their weaknesses, and it was noted that certain other factors, such as firm size, profitability etc. can also determine the explanatory powers of both models.

REFERENCES
Baker, K.H. and Martin, G.S. (2011) Capital Structure: An Overview, in Baker, K.H. and Martin, G.S. (Eds.), Capital structure and corporate financing decisions: Theory, evidence and practice. Hoboken: John Wiley & Sons.
Blackwell, D. W., & Kidwell, D. S. (1988). An investigation of cost differences between public sales and private placements of debt. Journal of Financial Economics, 22(2), 253-278
Cassar, G., & Holmes, S. (2003). Capital structure and financing of SMEs: Australian evidence. Accounting & Finance, 43(2), 123-147
Chen, L.J. and Chen, S.Y. (2011). How the Pecking Order Theory Explains the Capital Structure, Journal of International Management Studies, 6(3), 92-100.
Fama, E. F., & French, K. R. (2002). Testing tradeaˆ?off and pecking order predictions about dividends and debt. Review of financial studies, 15(1), 1-33
Frank, M. Z., & Goyal, V. K. (2003). Testing the pecking order theory of capital structure. Journal of financial economics, 67(2), 217-248
Frank, M. Z., & Goyal, V. K. (2007). Trade-off and pecking order theories of debt. Available at SSRN 670543
Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: which factors are reliably important?. Financial management, 38(1), 1-37
Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: evidence from the field. Journal of financial economics, 60(2), 187-243
Hackbarth, D., Hennessy, C. A., & Leland, H. E. (2007). Can the trade-off theory explain debt structure?. Review of Financial Studies, 20(5), 1389-1428
Hossain, F. and Ali, A. (2012) Impact of Firm Specific Factors on Capital Structure Decisions: An Empirical Study of Bangladeshi Companies. International Journal of Business Research and Management, 3(4), 163-182
Myers, S. C. (1984). The capital structure puzzle. The journal of finance, 39(3), 574-592
Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of financial economics, 13(2), 187-221
Pike, R. and Neale, B. (2009). Corporate finance and investment: Decisions and strategies. 6th edition. Harlow: Pearson Education Limited
Shyam-Sunder, L., & Myers, S. C. (1999). Testing static tradeoff against pecking order models of capital structure. Journal of financial economics, 51(2), 219-244
Tong, G., & Green, C. J. (2005). Pecking order or trade-off hypothesis? Evidence on the capital structure of Chinese companies. Applied Economics, 37(19), 2179-2189

This work was produced by one of our professional writers as a learning aid to help you with your studies

One of the most significant contributions to the investment community has been Markowitz’s modern portfolio theory (MPT) and its foundations in risk return trade-offs and international asset diversification. The growing dependency of Emerging market countries on the US for its stable currency and export sales among other factors has increased their dependence on US markets for their GDP and market growth. This has caused a reduction in the diversification benefits in the Emerging markets. This paper will examine the various empirical evidence on emerging markets diversification and will also construct a portfolio to assess whether investment in these markets still provide benefits.

MPT is based on two key principles of investing, namely that an investor will seek to maximise expected return whilst also minimising risk. Its risk is measured by its standard deviations of returns around expected values. By considering “the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio,” (Litterman (2004) p. 12) An investor can prevent weaknesses in one asset class from reducing the portfolio’s overall return. Therefore a portfolio that is invested in a range of industries or asset classes is more diversified against risks that may affect only one asset class. (Crescenzi (2008) p. 141) The implication is that portfolios are constructed with a rate of return equal to the weighted average rate of return of the holdings and yet its risk will be less than the weighted average return of the portfolio. (Litterman (Ibid) p.14)

Recent developments in Exchange Traded Funds (ETFs) and mutual funds have allowed investors to be invested across a range of markets and countries without being exposed to the potentially large risks of any one internationally traded company. (Crescenzi (Ibid) p.141) More specifically, Index ETF, such as those of iShares, which are designed to closely follow their relevant indices whilst being internationally invested. (Barclays (Ibid) p. 2)

MPT also demands investment in asset classes that correlate as little as possible with each other, as measured by their covariance. In fact, the covariance should be less than one in order to reduce the risk in the portfolio. Asset returns that have covariance equalling one are highly dependent on each other and a covariance of zero means they are independent of each other. Covariance is calculated by multiplying the correlations by the variances of their returns. (Litterman (Ibid) p. 12) A portfolio’s overall risk in relation to its benchmark is measured by its beta. A portfolio with a beta of 1 is has a volatility that is equal to that of its index, whereas a beta greater than one will have greater volatility than the index and is likely to achieve returns greater than the index. It is calculated by dividing a portfolio’s covariance with the index by the index’s variance. (MacKay Shields (2003) p.2)

Mean variance approach

MPT’s mean variance approach demonstrates efficient combinations of high expected returns with a specific level of risk. Any portfolios that exist below the frontier are considered inefficient because they are earning lower returns for the same amount of risk in comparison to those on the frontier. Unfortunately, this is difficult to apply in reality because it requires the use of an optimiser which is based on the calculation of expected returns to arrive at weights. The resulting weights are often considered extreme and inappropriate and the actual calculation of expected returns is also considered difficult to obtain, with the closest and most widely available data being historical returns. Additionally, the approach requires investment in the entire universe of stocks however oftentimes fund managers seek to create portfolios which are invested in a small universe, to attract local investors. (Zimmerman (Ibid) p. 282-262)

Another concern is the models static nature which requires action once the initial allocation of wealth to the securities is made, until the investment horizon is reached. The dynamic nature of stock markets and the wide ranging risks that underline them can greatly impact asset returns, making it crucial for the profitability of an investor to continually rebalance their portfolio according to changes in them. (Korn (1997) p. 12)

Empirical Evidence of Emerging Markets Diversification

There is extensive empirical evidence to support Markowitz’s theory that investment across the globe reduces portfolio risk levels. Cumby and Glen ((1990) cited in Aiello and Chieffe (1999) p. 29) find superior returns are gained by internationally diversified investment funds. Divecha, Drach, and Stefek ((1992) cited in Aiello (Ibid) p. 29) show more specifically that investment in the Emerging markets is likely to reduce a portfolios total risk. Moreover, Masters ((1998) cited in Aiello (Ibid) p. 29) recommend allocate of at least 6 percent in the Emerging markets, to benefit from the rapid economic growth in the region. Speidell and Sappenfield ((1992) Aiello (Ibid) p. 29) maintain that developed countries, unlike emerging markets, move in close tandem with each other and therefore provide less diversification.

A study by Aiello and Chieffe also finds that diversification in the Americas Free Index provides the lowest standard deviation of returns. However, Aiello also notes that the Emerging markets are characterised by high volatility due to asset and sector concentrations, small markets, insider trading and poor information. (Aiello (Ibid) p. 34)

Constructing the Portfolio

Initially a portfolio comprised of solely developed countries will be constructed using index ETFs. iShares Morgan Stanley Country Indices (MSCI) will be used for the purposes of this paper. Initially an assessment of the regional ETF index risk and returns will be made from which individual countries will be selected for investment. A portfolio of developed countries will first be selected followed by a selection of Emerging market countries to assess their impact on the portfolio’s overall risk and return. The period of investment which will be used for the construction of this portfolio will be 2nd January 2009 to 13 March 2009. Unfortunately, access to iShares MSCI data is limited to between 2008 and 2009 for the majority of countries which is insufficient given the significant downturn in the global economy. A time horizon of one year would not highlight the potential benefits, if any, of investing in the Emerging markets. Ideally a two or three year time horizon would be more appropriate.

The above table shows the various Index ETFs by global regions and their corresponding returns, standard deviations, variances and covariance. In comparing the returns it can be seen that the Emerging markets (-8.20%) and Latin America (-3.30%) had the best returns in comparison to Europe (-24.9%) and USA (-18.9%). However, these are also accompanied by high variances relative to developed countries. Covariances between the U.S. and other regions are all under unity and therefore have low dependency in their relationships. The Latin American and Emerging Markets regions proved to have the greatest covariances with the U.S. and therefore have the greatest dependency on American markets for their own performances. This is likely to due to their currencies being pegged to the US dollar and their strong dependency on export sales to the US.

Despite the higher risks associated with investment in the Emerging markets their returns are worthy of investment to diversify a global portfolio. Therefore investment in the Emerging markets will be added to the portfolio. Given the high dependency of Latin American markets on the US, this market will not be included in the portfolio.

Of the developed countries, those with covariances with the US, greater than 0.0007, such as Australia and France will not be included. The remaining countries: US, Canada, UK, Japan and Germany remain for consideration.

The choice of weights invested in the portfolio will depend on their individual risks and returns. The portfolio weights will reflect the risk averse nature of the investor. As can be seen from the table above, Japan and the US have the lowest risk levels but their returns vary greatly being -18.6% and -26.3% respectively. Additionally, the US and UK have similar returns and yet the former has a much lower variance and will not therefore be included in the portfolio. Similarly Germany has a slightly greater risk compared to Canada but with half the return, there is therefore no reason to invest in Germany.

The US and Canada have the highest returns with the US having the lowest standard deviation. It will therefore have a 50 percent weight in the fund leaving Canada 40 percent weight. Whilst Japan has the lowest return it also has the worst return of the three and therefore will have the smallest weight of 10 percent. Since the portfolio is made up of mostly the US index and is not greatly diversified internationally the most appropriate benchmark will be the S&P 500.

The portfolio return for the year to date comes to -16.7%, calculated by summing the weights of each country index multiplied by their returns, thereby outperforming the index by less than 3%. The portfolio beta is 1.01, calculated by dividing the portfolio covariance with the index, by the variance of the S&P500. The portfolio beta being marginally greater than unity implies it is slightly more volatile in comparison to the index, due in large part to the Japanese weighting.

Investing in the Emerging Markets

Given that the Emerging markets have been shown empirically to provide greater diversification benefits and are recommended by the MPT this region will also be considered for investment.

Choosing a set of Emerging market index ETFs will begin by taking out those with the highest covariances with the S&P 500, namely South Korea and South Africa. Taiwan has the strongest return with a risk level, as measured by its variance and standard deviation, close to that of Hong Kong and Singapore. It will therefore have a high weight in the Emerging Markets portion of the fund. Singapore’s returns is the lowest with an almost equal risk level to the other countries, therefore it will not be considered for investment. Malaysia whilst it has a slightly lower return does have the lowest risk level. This is likely to be due to its much more developed stock market and more stable political environment and will help to diversify the region’s risk level in the portfolio. The remaining countries are Taiwan, Hong Kong and Malaysia.

In considering weight allocations countries with low standard deviations, such as Malaysia (50%) will be given greatest weight. Taiwan and Hong Kong have only slightly differing variances but very different returns and therefore their weights, 10% and 40% respectively, will reflect Taiwan’s greater return. The combined return of these three countries is -6.8% which against the MSCI Emerging Markets Index, outperformed by 1.4%. Their combined beta is 0.60, half the volatility of the index. Moreover, its covariance with the S&P 500 is only 0.00051, making it very independent of the US market.

Given the positive returns, low risk and low dependency on the US market, the Emerging markets will be given a weight of 30% in the original developed countries portfolio. This improves the original portfolio return from -17% to -2% which against the S&P 500 benchmark, outperforms by over 16%, during one of the most tumultuous market downturns in recent history. Although the standard deviation of the new internationally diversified portfolio is the same, its beta is 0.90 and covariance is 0.0006 making it very independent of the US market.

Ongoingly investors must assess the risk and return of any of the country index ETFs that he or she is invested in, rebalancing the portfolio accordingly. Factors such as political unrest, financial fraud, poor macroeconomic management and manufacturing can all greatly increase country risks and reduce their returns.

Conclusion

This paper set out to assess whether the Emerging markets still have diversification benefits on a portfolio’s return and risk levels. The various empirical literature examined in the paper conclude that the Emerging markets do still add to portfolio diversification. The portfolio that was constructed also demonstrates the added benefits of investing in these markets to its performance.

Some of the limitations of this paper include the relatively short time frame chosen for the model portfolio. A period of two to three years would have been more ideal. Middle Eastern ETF representations were limited to only Israel and Turkey and therefore did not provide a reasonable representation of Emerging markets in the Middle East.

Bibliography
Aiello, S. and Chieffe, N. (1999) International index funds and the investment portfolio Financial Services Review 8, p. 27–35
Barclays Global Investors (2009) An Introduction to iShares: Exchange Traded Funds, www.ishares.com
Barclays Global Investors, (March 2009) iShares Products http://us.ishares.com/content/stream.jsp?url=/content/repository/material/product_expense_ratio_report.pdf&mimeType=application/pdf
Crescenzi, A. (2008) Investing From the Top Down: A Macro Approach to Capital Markets, McGraw-Hill Professional
Korn, R. (1997) Optimal portfolios: stochastic models for optimal investment and risk management in continuous time, World Scientific
Litterman, B. (2004) Modern Investment Management: An Equilibrium Approach, Quantitative Resources Group, John Wiley and Sons
MacKay Shields (2003) Managed Accounts: Modern PortfolioTheory, MacKay Shields Investment Management LLC
Zimmermann, H., Drobetz, W. and Oertmann, P. (2003) Global Asset Allocation: New Methods and Applications, John Wiley and Sons
iShare ticker symbols and index information sourced from iShares.com
Historical prices from which data was calculated was sourced from yahoo.com/finance

This work was produced by one of our professional writers as a learning aid to help you with your studies

INTRODUCTION

Corporate governance typically describes the way corporate power is exercised within business organisations. Good corporate governance practices are typically defined in terms of practices, processes, and sound economic performance (Turnbull 2010).

The present report examines the implementation of sound corporate governance management practices in William Hill, a U.K. sports betting company. Particular attention will be paid to the practices and processes prescribed by the Corporate Governance Code (2014), the leading template for good corporate governance practices in the U.K. The goal of this report is to enlighten Institutional Investors as to a potential investment in the company.

BRIEF COMPANY BACKGROUND

William Hill is a global sports betting and gaming company, and one of the most trusted brands in the sports gaming industry. According to the company’s latest available key financial statistics, total revenue ascends to ?1.61 billion, gross profit is ?1.32 billion, while EBITDA is ?385 million (Yahoo Finance 2015a). The company’s EBITDA is revealing as to the company’s financial soundness.

The above-mentioned sound financial statistics are clearly reflected in Figure 1 (Yahoo Finance 2015b), which depicts the 5-year stock price trajectory of William Hill. The company’s share price has almost tripled in value since January 2011. Notwithstanding, it should be pointed out that, for the sub-period between 2011 and 2013, the stock price soared; whereas, for the period 2013-2015, the stock price is relatively stable, which might point to the existence of impending regulatory shifts conditioning a potential demand weakness for its gaming products (e.g., the company is currently being affected by a significant decrease in profits accruing from gaming machines, in view of tougher gaming regulation (The Economist 2014)).

Figure 1: Stock Market Price of William Hill (5-year chart)

Source: Yahoo Finance; 5-year stock market prices (closing prices ?)

WILLIAM HILL: A CORPORATE GOVERNANCE ANALYSIS

The present section focuses on the following main five (5) topics of analysis that are relevant to the William Hill, where a more thorough examination of its corporate governance structure and practices are concerned. The first topic addresses the composition of the company’s Board of Directors (“Leadership”); the second topic refers to the company’s governance structures and Boardroom Practices (“Effectiveness”); the third focuses the reporting to shareholders and/or external audit procedures (“Accountability”); the fourth topic refers to the pay level of the company’s Directors and Senior Executives (“Remuneration”); finally, communications and relations with shareholders are also examined (“Relations with shareholders”). These topics are quite crucial to our assessment pertaining to the implementation of effective and sound governance procedures and mechanisms at William Hill.

Leadership – The Board of Directors

William Hill’s Board of Directors is composed of nine Board members (7 men and 2 women). The current Chief Executive Officer (CEO) is Mr. James Henderson, who heads “the Group’s overall strategic direction, the day-to-day management and profitability of the Group’s operations”(Hill 2015a). Mr. Henderson possesses extensive industry experience, having climbed the company’s corporate ladder through his appointment through several company roles. Moreover, the company’s CEO is seconded by the Mr. Neil Cooper, the Group’s Finance Director. Mr. Cooper possesses extensive finance experience, having performed various roles outside the Group. The Board is also composed by the Chairman, Mr. Gareth Davis, who is responsible for the company’s best corporate governance practices. Finally, the Board is also composed of a set of five independent non-executive Directors and a Company Secretary. The company had, in 2013, a number of female Board members compliant with best practices associated with fair gender treatment at the Board level (The Guardian, 2013). However, in the current year, the number of female members seems to have fallen below best industry practices (Tonello 2010), but care should be taken to further increase the percentage of women on Board beyond the prescribed legislation (according to U.K.’s Governance Code, that minimum percentage should equal 25% of women on Board). This might be a temporary setback, but it currently stands as a non-compliance issue (Financial Reporting Council 2014).

The above-mentioned corporate governance structure is compliant with the best practices currently being promoted in the UK, in strict accordance with the UK Corporate Governance Code of 2014 (Financial Reporting Council 2014). The Board’s composition seems to ensure that compliance with the Code is adequately assured. For example, there is a clear division of corporate responsibilities within William Hill, with no function overlap nor unfettered powers of decision held by any specific Board member. Moreover, the percentage of ‘outside’ Directors ensures proper oversight.

Effectiveness – Governance and Boardroom Practice

According to Tricker (2012), there are a number of factors that decisively influence the effectiveness of a company’s governance, the most relevant of which are related to the necessary skillset of the top management team, as well as functional flow of both internal and external communications with stakeholders.

On both counts, William Hill possesses the necessary requisites in order to comply with the outlined good practices of governance. As previously described, the company’s composition is quite diversified and experienced so as to effectively pursue the company’s ambitious goals (the previous section describes in more detail the profiles pertaining to the main Board members); at the same time, the inclusion of non-executive Board members vis a-vis the executive members clearly points out to a proper balance of powers within the sports betting group. That is, good governance practice dictates that ‘inside’ (i.e., executive) vs. ‘outside’ (i.e., non-executive) members co-exist, so that the latter typically do not possess a previous link to the company which might jeopardise their autonomous and independent business judgement.

On the other hand, the flow of information to outside investors seems to be quite proficient, most notably where the structure of communications through the Internet and social media is concerned. For example, the company’s website provides accurate and in-depth details pertaining to the company’s governance structure, balanced Board composition, the company’s articles of association and the company’s latest available annual accounts (for 2014), and the professional details of the company’s auditor and corresponding Annual Report and Accounts. Online transparency seems to be a major company policy, which thus sustains the argument in favor of an effective and balanced governance practice (Hill, 2015b).

It is hoped that this strategy of good corporate governance might also be applicable to the case of institutional investors, who typically require a greater insight into the company’s operations and accounts, information which is normally not available online. This topic might be of importance in the subsequent investment decision making process of institutional investors, insofar as this class of investors typically undertakes a significant proportion of equity into the company and require detailed company information. A major caveat associated with this report concerns the fact that such a subsequent investment position assumed by the institutional investor might be less positively construed by the company’s current management (i.e., it might be seen as a potential takeover of William Hill).

Finally, a formal and rigorous annual evaluation of the company’s top management team is also regularly conducted. The Report on Corporate Governance reveals that good corporate governance is linked to the performance of William Hill. The measures ensuring good corporate governance at the company, in compliance with the U.K. Governance Code, are the following: the induction of Board members through a bespoke program; Board members have full access to all the required information about the company; the Board members are subjected to re-election at least every three years (conditional on effective performance); and the Nomination Committee ensures the nomination for the Board constitutes a transparent process (Hill 2015c).

Accountability – Reporting to Shareholders /External Audit

The Financial Reporting Council prescribes that a truly effective corporate governance structure relies on a number of components, namely: accountability to shareholders and their rights; the full availability of information pertaining to the company’s performance and corresponding governance framework; finally, an ethical framework supporting a certain type of irreproachable behavior pattern by the companies, as evinced by either codes of conduct or statutes. In this respect, a distinction is maintained between the law as a stalwart of basic standards of conduct and corporate transparency and statutes or codes that are more efficient in encouraging best governance practice (Financial Reporting Council 2011).

Accordingly, William Hill’s website provides accurate and timely information to existing and prospective shareholders. This information is quite detailed in the ‘Investors’ area of the company’s website, a fact that reveals the company’s concern with upholding best governance practices. On the other hand, full details pertaining to the company’s auditor has also been properly disclosed, as well as the company’s latest accounts (Hill 2015c).

Remuneration – Directors and Senior Executives

The company’s levels of remuneration to top executives should be sufficiently attractive to attract, retain and motivate Board members with the necessary quality to manage the company successfully. Simultaneously, the pay level should not be substantially above current market prices. A further point concerns the fact that the latter pay level should be adequately linked to both corporate and individual performance (Tricker 2012).

Furthermore, pay levels should be subjected to a transparent and formal procedure, so that the executives involved are not directly responsible for deciding his or her remuneration.

According to publicly available information on this topic, the remuneration level of the leading Board members is available through the ‘Directors Remuneration Report’, which has been included in the company’s annual accounts for the latest year. A detailed breakdown of the accrued remuneration benefits is explicitly detailed in the report. This practice of publicly divulging remuneration levels of William Hill’s top management is quite compliant with U.K.’s best governance practices. Moreover, the remuneration decision process, although somewhat complex, is fully transparent as the existence of mechanisms that ensure that the pay level is not determined by the interested party, and is effectively linked to individual performance (Hill 2015c). A potential area of non-compliance resides in the fact that the ‘Remuneration Report’ does not fully disclose the remuneration levels for all the Board members, as well as in the fact that the disclosure of remuneration information pertaining to its CEO, although explained, is not entirely formulated in a simple and effective manner.

Relations with Shareholders

Effective governance practices dictate that relations with shareholders should be adequately based on the mutual understanding between the company’s top management and the heterogeneous set of interests pertaining to existing shareholders. Moreover, a transparent process of communications between these two structures should also be implemented, properly taking into account the pursuit of the company’s organisational goals (Tricker 2012).

According to publicly available information, The Board remains strongly committed to maintaining good relationships with external investors, through constant dialogue, presentation of financial results, and adequate availability of top management to discuss governance issues, thus indicating efficient governance procedures (Hill, 2015d).

RECOMMENDATION

Global demand for gaming products is typically growing, as the popularity of both gambling and online entertainment continues its expansion at a truly global level. This global expansion should stand to benefit William Hill, and its long-term growth expansion. There are, however, two caveats (KPMG 2010) that warrant an investor’s attention.

First, the online gaming market is undoubtedly a very attractive area of expansion for software developers, casinos and other land-based gambling operators, related suppliers, and industry newcomers and investors alike. This might increase a given company’s operating costs, dragging down future growth, as competitive pressures increase in the industry.

Second, there are several quite unpredictable political and legislative hurdles in place in many countries, and those obstacles might also condition future global growth. Nevertheless, online gaming seems to have a promising foothold in many European markets. Under this perspective, an investment in William Hill is also an investment into the future of online gambling, and the risk-return payoff might be quite interesting from a financial point of view. The online gaming industry thus possesses enormous growth potential, especially in advanced markets such the U.S. and the U.K.

Notwithstanding, an impending ethical governance issue within the company might be linked to the allegations that the company might be exploiting addicted gamblers, by further enticing them through the advertisement of credit services to problematic gamblers (news.co.au 2015). This might pose a serious legal risk that might ultimately result in the dampening of growth and should be vehemently addressed through the implementation of adequate governance procedures.

The present report sustains that an institutional investment in William Hill is thus justified by the company’s sound and promising financial standing, the existence of proper mechanism that ensure that effective and robust corporate governance procedures and mechanisms have been properly implemented, and, ultimately, by the very buoyancy of the sport gaming industry in advanced economies.

CONCLUSION

In view of the analysis provided by this report, it is our assessment that William Hill is quite compliant with the UK Corporate Governance Code of 2014 (notwithstanding the fact that some issues pertaining to the process of effectively communicating remuneration levels to interested external stakeholders should be made more transparent and the number of female members to the Board should be increased). Finally, an investment decision by our institutional investors should be pursued, taking into consideration the company’s financial soundness and its medium to long term growth prospects, notwithstanding the existence of impending regulatory issues that might condition the global growth of the sports betting industry.

REFERENCES
Hill, W., 2015a. Board of Directors [Online]. Available: http://www.williamhillplc.com/about/board-of-directors/
Hill, W., 2015b. Board and Governance. [Online]. Available: http://www.williamhillplc.com/investors/board-and-governance/
Hill, W., 2015c. William Hill Plc Annual Reports and Accounts 2014. [Online]. Available: http://files.williamhillplc.com/media/1832/2014-final-results-accounts.pdf
Hill, W., 2015d. Shareholder engagement. [Online]. Available: http://www.williamhillplc.com/investors/board-and-governance/shareholder-engagement/
Financial Reporting Council, 2011. Effective Corporate Governance. [Online]. Available: https://www.frc.org.uk/FRC-Documents/FRC/FRC-Effective-Corporate-Governance.aspx
Financial Reporting Council, 2014. The UK Corporate Governance Code. [Online] Available: https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-2014.pdf
KPMG, 2010. Online Gaming: A Gamble or a Sure Bet? [Online] Available: http://www.kpmg.com/EU/en/Documents/Online-Gaming.pdf
News.co.au, 2015. William Hill offers customers $1000 credit. [Online]. Available: http://www.news.com.au/finance/money/william-hill-offers-customers-1000-credit/story-e6frfmci-1227286743077
The Guardian, 2013. FTSE 100 companies still 66 female directors short of boardroom target. [Online]. Available: http://www.theguardian.com/business/2013/oct/07/female-directors-boardroom-target-business-cable
The Economist, 2015. A risky business. [Online]. Available: http://www.economist.com/news/britain/21598671-gambling-machines-are-controversialand-increasingly-unpopular-risky-business
Tonello, M., 2010. Board Composition and Organization Issues. In: Baker, H.K. and Anderson, R., eds. Corporate Governance: A Synthesis of Theory, Research, and Practice. United States: John Wiley and Sons Inc., pp. 195-223.
Tricker, B., 2012. Corporate Governance. Principles, Policies and Practices. Second edition. United Kingdom: Oxford University Press.
Turnbull, C.S.S., 2010. What’s Wrong with Corporate Governance Best Practices?. In: Baker, H.K. and Anderson, R., eds. Corporate Governance: A Synthesis of Theory, Research, and Practice. United States: John Wiley and Sons Inc., pp. 79-96.
Yahoo Finance, 2015a. Key Statistics. [Online]. Available: https://uk.finance.yahoo.com/q/ks?s=WMH.L
Yahoo Finance, 2015b. Basic Chart. [Online]. Available: https://uk.finance.yahoo.com/q/bc?s=WMH.L&t=5y&l=on&z=l&q=l&c=

This work was produced by one of our professional writers as a learning aid to help you with your studies

Introduction

Power Up Plc is planning to set up a new power plant. The company has three options to choose from – gas power, nuclear energy or renewable energy power plant. This report analyses the financial viability of the three options by using the net present value method. The net present value is one of the most scientific methods for capital appraisals as it discounts the future cash flows. The results from the net present value method are also compared with three other capital appraisal methods – discounted payback period, accounting rate of return and internal rate of return methods. All calculations are based on the data provided in the case.

The capital appraisal methods are based on projected cash flows and discount rates and hence any changes in their values can have a significant impact on the value of a project. The report also discusses other information that would help in finalising one of the options as a preferred one.

Capital Appraisal

The net present value is one of the preferred capital appraisal methods as it gives the absolute net value of a project to a company. The net present value method discounts the future cash flows of an investment by its discount rate. The discount rate is based on the risk of the project and gearing ratio.

According to the Capital Asset Pricing Model, the expected return on equity is given by the following formula (McLaney, 2009, p. 199).

Expected return on equity = Risk-free return + Beta*(Market return – risk-free return)

The gilts (T-bills) have the lowest risk as it is backed by the government and is as good as risk-free. The return on gilts is taken as the risk-free return.

The Weighted Average Cost of Capital (WACC) is given by the following formula (Brealey & Myers, 2003, p. 389).

WACC = Rd*(1-T)*(D)/(D+E) + Re*(E/D+E)

Where

Rd = Return on debt
T = Taxation rate
Re = Return on equity
D = Value of debt
E = Value of equity
D/(D+E) is the gearing ratio of a company.

The expected return on equity and WACC calculations for the three options are shown in the table I. They are based on the data provided.

Table I – Cost of equity and WACC

The cost of equity is highest for the nuclear power plant because of its high beta. Even though the WACC of nuclear and renewable energy options are more than that of the gas plant option the differences are significantly less as compared to the differences in cost of equity. The high equity costs of the nuclear and renewable energy options are countered by their high gearing which limits the increase in the WACC due to lower cost of debt and tax deductibility of interest rates.

The net present value calculations for the three options are based on the following common assumptions:

The power plant starts operations at the beginning of the 4th year.

The direct, and licensing and ancillary revenues are increased annually by the rate of inflation. As an example, the revenues in the 4th year are calculated by compounding four times the current revenue estimates with the annual inflation rate.

All yearly clean-up costs are also increased by the annual inflation rates to take into account the likely increase in costs over years.

The depreciation is taken into account from the first year to spread the total cost of the project over the 25 years period.

It is assumed that the company will raise the full cost of loan in the first year itself and hence the interest costs are assumed from the first year itself.

The annual interest costs calculated by multiplying the total building cost and debt rate are more than the annual interest costs given in the case for the gas power and renewable energy plants. The annual interest costs given in the case are used for the net present value calculations assuming that the company will use debt less than 100% of the building cost in these options.

The annual capital allowance is 10% of the total building cost of the power plant. The capital allowance is used from the 4th year onwards when power plant starts operations.

The appendix I and II shows the profit and loss, and net present value calculations of the gas power plant option. The actual tax is calculated on the basis of the capital allowance as accounting depreciation is not recognised by the taxation authorities for income deductibility. The net cash flows in the appendix II are discounted by the WACC (10.72%) of the gas power plant option. The net present value of the gas power plant is ?1,636 million. The positive net present value of the power plant indicates that the firm’s value will increase by this amount if the project is run successfully over 25 years as per the projections.

The appendix III and IV shows the profit and loss, and net present value calculations of the nuclear power plant option. The WACC used for discounting the nuclear power plant cash flows is 12.10%. Even though the cost of equity for the nuclear power plant option is significantly higher than the equity for the gas power plant, the increase in the WACC is limited by the higher gearing of the nuclear power plant. The net present value of the nuclear power plant is ?1,062 million. This is ?574 million lower than the net present value of the gas power plant. Even though the nuclear power plant adds value to the firm, the gain is significantly lower than in the gas power plant. Hence the gas power plant is favoured over the nuclear power plant in the net present value capital appraisal method.

The appendix V and VI shows the profit and loss, and net present value calculations of the renewable energy plant option. The net cash flows in the appendix VI are discounted by the WACC of 11.05%. The net present value of the renewable energy power plant is ?1,052 million. This is similar to the net present value of the nuclear power plant but significantly lower than the gas power plant.

The gas power plant has the highest net present value among the three options and hence it is the preferred option under the net present value option. But the projections are based on a number of assumptions and these should be thoroughly checked before finalising the option. As an example, the net present value relies on the cost of capital which may not be simple to calculate in situations like varying inflation rates (Howe, 1992, p. 34).

The net present value is one of preferred capital appraisal methods as it gives the absolute value addition by a project. But there are other methods also which are less complex and need lesser calculations. They are used by managements for quick assessment of investments. The three other capital appraisal methods used for evaluating the power plant options are discounted payback period, accounting rate of return and internal rate of return.

The discounted payback period method calculates the period in which the cumulative discounted future cash inflows equal the discounted initial investment. Some companies use payback period method but the discounted payback period method is better than the payback period method as it discounts the future cash flows. If the cumulative discounted cash flows of the proposed investment turn positive in the year ‘n’, then the discounted payback period is given by the following formula. .

Discounted payback period = (n-1) years + (-Cumulative cash shortfall at the end of (n-1) year) / (Net cash flows in the year n)

Discounted payback period gives a quick assessment of the time when a company will receive back the cash invested in a project. But the discounted payback period method ignores all cash flows after the cut-off date (Brealey & Myers, 2000, pg. 97). Ignoring cash flows after the discounted payback year may result in opting for an option that would add lower value to the shareholders.

Accounting rate of return is the ratio of the average accounting profit over the duration of a project to the average investment. Average investment is calculated as the average of the initial investment and final value of investment at the end of the project. As the full value of all three power plants is depreciated by the end of the project, the final value of the investment is 0.

The internal rate of return gives the discounting rate at which the net present value is 0. It gives a quick measure of the return rate as compared to the cost of capital. Also it gives a measure of how much cost of capital can change before the project value becomes 0. But it has its limitations too as it does not take into account the scale of investment (Chang & Swales, 1999, p.133).

The appendix VII shows the gas power plant values in the above mentioned three capital appraisal methods. The investment in the gas power plant will be recovered in 5.84 years. As the period is less than the project life, the project is approved under the discounted payback period method. The option also has a very high accounting rate of return of 93.71%. The internal rate of return for the gas power plant is 33.77% which indicates that the cost of capital can increase substantially before the net present value of the project will become 0.

The appendix VIII shows the capital appraisal values of the nuclear power plant. The investment in the nuclear power plant will be recovered in 13.22 years, lower than the life of the project but higher than the gas plant. The accounting rate of return and internal rate of return are 18.72% and 16.25% respectively. The lower internal rate of return indicates that there is little scope for the cost of capital to increase before the net present value of the project will become 0.

The appendix IX shows the results of the three capital appraisal methods for the renewable energy option. The results are similar to that of the nuclear power option with even lower safety of margin in the internal rate of return.

The results of three capital appraisal methods also favour the gas power plant followed by the nuclear and renewable energy plants.

The external consultant has highlighted the varying degrees of risks associated with three alternatives. Nuclear power plants are regarded as higher risk than a gas or a renewable energy plant due to the potential losses if things go wrong. Any leakage or explosion in a nuclear plant can release hazardous radioactive particles that can cause severe damage to human lives and environment. The damage in a gas power plant explosion is likely to be less severe and even lower in a renewable energy option. But the risk factor is not extremely high in nuclear power plants as demonstrated by the successful operation of a large number of nuclear power plants across the globe.

The higher beta and expected rate of return for equity reflect the higher operational risks associated with the nuclear plant and renewable energy options, and also higher gearing risks. The operational risks are included in the discount rates for different options. The beta of Power Up with the nuclear plant option is 1.5 as compared to the beta of 0.8 with the gas plant option. The cost of equity in the nuclear plant option at 20.8% is significantly more than the 12.8% for the gas plant option to reflect higher commissioning risks of a nuclear plant. The beta for renewable energy option is also higher than the gas power option because of delays faced in regulatory approvals in setting up a large scale renewable energy project.

Partial increases in the equity returns of the nuclear and renewable energy options are due to increases in the gearing ratio. The return on equity increases with the increase in debt-equity ratio (Miller, 1988, p. 100). But the fact that nuclear option has a higher equity rate than the renewable energy even though it has lower gearing indicates that operational risks are included in the discount rate.

Also the rates of debt for both nuclear and renewable power plants are higher than the gas power plant which reflects the higher bankruptcy fears due to high gearing (Brealey & Myers, 2000, p. 482). The inclusion of different operational and financial risks in higher discounts rates means that there is no need to further increase the discount rates.

The above capital appraisal of the three options is based on certain assumptions which should be verified before making a decision. First, the net present value of the gas power plant is highly dependent upon the gas prices in the future. The net present value calculation assumes that the gas prices will grow at the 3% rate of inflation. But gas supplies are limited because they are non-renewable. The growing demand of electricity and power across the world, especially from developing countries like China and India has increased oil prices in the recent years (Dolbeck, 2008, p. 1). It is also likely to impact gas prices. Hence it is important to check the likely gas prices over a long-term with well-established institutions that are focused on trekking and projecting oil and gas prices.

Second, the weighted average cost of capital method assumes that the company is going to maintain same debt-to-equity ratio during the duration of the project (Massari et al., 2007, p. 153). It is most likely to change as the company generates profits and possibly invests in other projects. The future debt-to-equity ratios for the company should be checked with the finance department. If changes in the gearing ratio do happen over the period of the project then they should be reflected by using an appropriate capital appraisal method like the adjusted present value method.

Third, a significant part of revenues is to be generated from licensing and ancillary activities. This needs to be analysed in view of the government’s policies on climate change. The possibility of decline in gas power plant licensing and ancillary revenues in the medium to long-term future should be analysed and appropriate impact in terms of future cash flows should be built in the capital appraisal model.

Fourth, the gearing ratio of the gas power plant option is half or lower than half of the gearing ratios of the nuclear and renewable energy options. Modigliani and Miller (1963, p. 434) showed that the value of a firm increases with increase in debt due to tax benefits of interest. Hence it would be useful to check with the corporate finance department of the company the reason behind the low gearing ratio for the gas option.

Conclusion

The capital appraisal methods – net present value, discounted payback period, accounting rate of return and internal rate of return – favour the gas power plant over the nuclear and renewable energy plants. But the calculations are based on certain assumptions which should be thoroughly vetted before finalising the option. Any changes in revenues and/or costs will have an impact on the results of the capital appraisal methods.

Personal learning

The exercise to evaluate three power plants has increased my personal knowledge in the field of corporate finance. The things learnt in this module and as well as things learnt previously were reinforced during the analysis of this case study.

First, the cost of debt increases with the degree of gearing as lenders take more risk and debt assumes some of the characteristics of equity. At higher gearing levels, the lenders are exposed to more risk and have lower safety of margin. This is evident as the cost of debt in the renewable energy option is more than the cost of debt in the nuclear energy option due to higher gearing. The variation in the cost of debt across the three options is also in line with the Modigliani and Miller proposition II that states the cost of debt remains constant during the initial increases in gearing but then increases to reflect higher risks and bankruptcy costs (Brealey & Myers, 2000, p. 482). The cost of debt increases from 9% in gas power plant at 30% gearing to 10% in nuclear power plant with 60% gearing, a 1% increase in cost of debt when gearing increases by 30%. But the cost of debt then increases to 11% as gearing changes to 65% in the renewable energy power plant, same absolute 1% increase in the cost of debt when gearing increases by only 5%.

Second, the issue of new equity will result in dilution of earnings per share and would be a matter of concern for the management (Opler et al., 1997, pg. 21). This appears to be one of the reasons behind the higher gearing in both nuclear and renewable energy options as low gearing in these two options would result in issue of high amount of equity and significant dilution of earnings per share in the initial years of the investment.

Third, the net present value calculations depend on a number of factors and it is important to research them. As in this case, changes in gas prices in the future may dramatically impact the net present value of the gas plant but not of nuclear and renewable plants. Also, government regulations change over time and can impact values of a project. The focus on climate change may encourage the government to give more subsidies to renewable and nuclear plants in the future. This would put a gas power plant into disadvantage and the company may find it difficult to find buyers for its electricity. Hence such factors should also be taken into consideration before finalising an option.

Bibliography and references
Brealey, R. A. and Myers, S.C., 2000. Principles of Corporate Finance, 6th edition, Tata McGraw-Hill Publishing Company.
Brealey, R. A. and Myers, S.C., 2003. Capital Investment and Valuaion, McGraw-Hill Company.
Chang, C.E. and Swales, G.S., 1999. A Pedagogical Note on Modified Internal Rate of Return. Financial Practice & Education, Vol. 9, Issue 2, pp. 132-137.
Dolbeck, A., 2008. Valuation of the Oil and Natural Gas Industry. Weekly Corporate Growth Report, Issue 1473, pp. 1-12.
Howe, K.M., 1992. Capital Budgeting Discount Rates Under Inflation: A Caveat. Financial Practice & Education, Vol. 2, Issue 1, pp. 31-35.
Massari, M., Roncaglio, F. and Zanetti, L., 2007. On the Equivalence between the APV and the wacc Approach in a Growing Leveraged Firm. European Financial Management, Vol. 14, No. 1, pp. 152-162.
McLaney, E., 2009. Business Finance: Theory and Practice. Pearson Education Limited, 8th edition.
Miller, M.H., 1988. The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, Vol. 2, No. 4, pp. 99-120.
Modigliani, F. and Miller, M., 1963. Corporate Income Taxes and the Cost of Capital: a Correction. American Economic Review, Vol. 53, Issue 3, pp. 433-443.
Opler, T.C., Saron, M. and Titman, S., 1997. Designing capital structure to create shareholder value. Journal of Applied Corporate Finance, Volume 10, Number 1, pp. 21-32.

This work was produced by one of our professional writers as a learning aid to help you with your studies

The Budgeting Process and the use of Budgetary Information
Planning, Control & Budgeting

CIMA Official Terminology (2005) defines planning as: ‘The establishment of objectives, and the formulation, evaluation and selection of the policies, strategies, tactics and action required to achieve them. Planning comprises long term/strategic planning and short term/operational planning. The latter is usually for a period of up to one year.’

It further defines a budget as: ‘A quantitative expression of a plan for a defined period of time. It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows.’

The above 2 definitions make the relationship between planning and budgeting relatively clear. A budget provides a numerical analysis of a plan. Planning can be both long and short term and budgets can cover the same timescales as the plan. However, longer term planning is generally both more aspirational and more uncertain as it requires significant assumptions to be made and this is equally reflected in longer term budgets.

CIMA also defined budgetary control as ‘The establishment of budgets relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision’.In other words, budgetary control provides a measure by which objectives and assumptions can be verified and amended in order to improve business performance. The validity of the measure will only be appropriate if the budget setting process is appropriate and leads to a realistic budget given factors known at the time of preparation.

Gowthorpe (2011 p.359) recognised that ‘budgeting, for most organizations, is an important dimension of the processes of planning, controlling and evaluating outcomes’.

To summarise, planning is the establishment of objectives, strategies and tactics to meet the desired performance of the business. A budget is a financial translation of the plan. Plans will generally involve improvements to the business either in sales, growth, diversity or other business developments over the planning cycle and as such the budget shows what this will mean for the business after taking account of the costs involved in achieving the performance. Budgetary control allows a business to track its progress against its plan by comparing the budget to the actual finances.

Budgets can be established via a top down or a bottom up approach. Top down budgets are imposed from above by senior management/the board whereas bottom up are participative and involve managers in the budget setting process (Gowthorpe 2011).Further to the overall top down or bottom up approach there are numerous methods for establishing the budget.

Gowthorpe (2011) and Siyanbola (2013) both reviewed the variety of approaches to budgeting. These consisted of incremental budgeting, zero based budgeting (ZBB), base budgeting (BB) & activity based budgeting (ABB).

Many business adopt incremental budgeting which uses the previous budget as the base from which to begin the new budget. This type of approach may be as straightforward as determining an inflationary factor to all cost lines. It tends to be relatively simple and cuts down the time spent on budgeting however, the key disadvantage is that this approach may under or overestimate the required budget’. This means that individual departments may be disadvantaged compared to others or if this approach is applied over more than one year, budgets may become misaligned with the real world conditions. It can further lead to inefficiencies being perpetuated year after year.

A second method is ZBB. This ignores any previous budgets and starts the process from the very beginning. In this approach each department is required to justify their budget. This is obviously time consuming but can be very useful in raising financial awareness across the business and will tend to mean that inefficiencies are not perpetuated.

BB is a method that has 2 phases to it. In phase 1 the business calculates what resources would be needed to keep going and then any additional spend needs to be justified on a cost/benefit basis. This is less time consuming than ZBB but can still lead to problems in both determining what level of resource may be considered ‘just enough’ and it doesn’t account well for volume shifts in revenue or product mix.

ABB could also be adopted. This calculates the cost of producing each unit of activity. This type of budgeting tends to lead to better cost focus but it does require a lot of effort to measure and it assumes a linear relationship of costs to activities which may not apply in all cases.

Finally there is Kaizen budgeting which assumes anticipated cost improvements in the budget. In reality, all budgets in business today tend to have an element of Kaizen budgeting. Incremental budgeting may have inflationary increases which will often be overlaid with efficiency challenges. A department may find themselves justifying their case for an increase in budget for a new activity using ZBB and will then still be passed an efficiency challenge to achieve.

Process for Preparation of an Annual Master Budget

The process for preparation will differ depending upon the organisation but will normally incorporate the following:

Budget responsibilities – it will be necessary to determine the budget leader in an organisation. This is normally the Financial Controller or Corporate Finance Team but some organisations have a specific budget and planning team who coordinate all the budget activities.
Budget timescales – the entire timetable needs to be set out and published to all those people who have input to the budget setting process. The timetable will cover everything from the date that templates are expected to be published through to submission dates, review periods and re submission deadlines.
Budget assumptions – all budgets will generally require some key assumptions to be made at an overall company level in relation to items such as inflation, cost of capital, exchange rates if relevant, productive hours & growth. Some of these may be assumptions in individual budgets such as sales budgets but it is essential that the master budget process consolidates all the assumptions made. This is to ensure that budgets are aligned across the business. For example, if the sales department budgets for a 10% increase in sales based on assuming excellent marketing of the new product that is being launched in the middle of the year, then it is important that the business understands if marketing have budgeted for the campaign and if production are planning to launch on time and have the relevant production quantities planned. If this is not the case then the budgets are misaligned and potentially unrealistic.
Budget instructions / manual – instructions need to be compiled for use alongside any assumptions /pre-set criteria that people need to incorporate.
Budget templates – templates need to be designed and prepared. These are often locked spreadsheets with only certain fields being available for entry. Standard templates are critical for consolidation purposes and avoidance of errors in consolidation.
Review process (often 2 stages) – this can differ widely across organisations but is often in the form of a submission and first presentation to senior management and/or the FD followed by rework to incorporate requested changes which will then be consolidated into the master budget for presentation to the board of directors.

Further to the steps above the annual master budget is compiled by consolidating all the departmental and or functional budgets into one overall budget. Walther (2014) noted that ‘the budget construction process will normally follow the organizational chart. Each component of the entity will be involved in preparing budget information relative to its unit’. Depending upon the business this could include, production budgets, sales budgets, overhead department budgets, investment budgets but will also include the cash budget. The order in which the budgets are prepared is important however, as the outputs of each budget will make the inputs for the next budget. Below is a simple graphical representation of the order of completion of a master budget.

Potential Behavioural Issues Arising from the Budgeting Process and the use of Budgetary Information

Bruns (1975 p.178) stated that ‘budgets are potential means of influencing behaviour’ and that ‘control is the successful exercise of power to influence’, hence there are many potential behavioural problems that can emerge from the budgeting process. There has been significant research exploring the effects of type of approach on the behaviours. Merchant (1981) studied how the size, diversity and degree of decentralisation affected the choice of approach which in turn affected the behaviours.

Banks and Giliberti (2008) considered that top down budgets generally have less ownership within a business since those responsible for delivering have had little or no say in the setting process and as such may be more difficult to deliver. This will depend on how challenging the budget is of course. Conversely bottom up budgets tend to have more buy in from managers but this still doesn’t necessarily mean they will be achieved and nor does it necessarily mean the budget is more accurate. Furthermore, budgets that engage the management in their development may still not have ownership if managers don’t believe that the engagement is genuine.

If the budget being set is deemed to be unachievable by those expected to deliver it, then this can become demotivating. Setting a stretch target can be motivating for people but too much stretch and they will feel as though it is not worth any effort as they cannot achieve it even if they try.

Budget owners may try to build in budgetary slack in order to make it more likely they can achieve or outperform their budget. No matter the environment, it can be very difficult to avoid budgetary slack being built into the numbers as it can be very difficult to assess or prove the level of slack built in by an astute manager. Camman (1976) and Merchant (1985) found that a managers propensity to create slack is affected by the system adopted but that this propensity is generally lower in a more participative approach whereas Antle and Eppen (1985) and Lukka (1988) argued that high participation created slack.

However, Onsi (1973) suggested that slack was not necessarily always a bad thing. It could provide funds to be able to undertake valuable activities that would not necessarily be approved by stakeholders if more transparent due to requirements for returns from the business. He also found that slack was more likely in successful firms in good markets thereby making it possible to achieve efficiencies and continue to meet expectations of shareholders in more difficult times.

If incremental budgeting is used in a business, managers may either deliberately spend up to their budgets or in some cases overspend so they can get a bigger base to start from the following year. Clearly this is not necessarily optimising for a business and this is where good budgetary control can help. Analysis of variances should be against budget at the lowest level practicable so that it is clear whether the result is due to accurate budgeting or other factors that were not budgeted originally.

The temptation to spend up to budget will almost certainly happen if an organisation adopts a ‘use it or lose it’ approach to budgeting. In today’s world, there is increasing pressure in many businesses to drive down costs as a result of decreasing margins. As such, if a budget has not been used, it can be tempting to assume it is not needed and as such reduce the following years start baseline. If the manager has made a great effort to gain efficiencies during the year, then this does not necessarily feel like a suitable reward as it is simply likely to make it harder to achieve the following year. If the efficiencies are sustainable then this may be realistic but if they were one-off opportunities that the manager took advantage off, then they will not necessarily be repeatable. The budget setting process must include a certain amount of flexibility or the budget is likely to be either unrepresentative of the actual picture or it may cause inflexibility within the business in its ability to react apropriately to short term events and changes. Sudden market changes could lead to a need to increase production of one product at the expense of another and it may be that the margin on the increased product is not as profitable. However, the process must allow for a view of the bigger picture. It may well be that the margin per product is lower but the market change means that far more product can be sold thereby increasing profits overall. The budget process should not stop the right decision being made.

The above discussion highlights the importance of a company adopting a genuine and appropriate approach to their budget setting process as it is a time-consuming and as such an expensive exercise. It would be a shame if this time consuming and expensive exercise simply produced a document that no one felt ownership for and that was in reality neither achievable for the business nor representative of the best outcome that could actually be achieved.

References
Antle, R. & Eppen, G. D., 1985. Capital Rationing & Organizational Slack in Capital Budgeting. Management Science, 31(2), pp. 163-174.
Banks, A. & Giliberti, J., 2008. Behavioural Aspects of Budgeting. In: McGraw-Hill, ed. Budgeting. s.l.:McGraw-Hill, pp. 217-215.
Bruns, W. J. & Waterhouse, J. H., 1975. Budgetary Control & Organization Structure. Journal of Accounting Research, 13(2), pp. 177-203.
Cammann, C., 1976. Effects of the use of Control Systems. Accounting, Organizations & Society, 1(4), pp. 301-313.
CIMA, 2005. CIMA Official Terminology. 2nd ed. Oxford: CIMA Publishing.
Gowthorpe, C., 2011. Business Accounting & Finance. Third ed. Andover: Brendan George.
Lukka, K., 1988. Budgetary Biasing in Organizations. Accounting, Organizations & Society, 13(3), pp. 281-301.
Merchant, K. A., 1981. The Design of the Corporate Budgeting System: Influences on Managerial Behaviour and Performance. Accounting Review, 56(4), pp. 813-829.
Merchant, K. A., 1985. Budgeting & the Propensity to create Budgetary Slack. Accounting, Organizations & Society, 10(2), pp. 201-210.
Onsi, M., 1973. Factor Analysis of Behavioural Variables Affecting Budgetary Slack. Accounting Review, 48(3), pp. 535-548.
Siyanbola, T. T., 2013. The Impact Of Budgeting And Budgetary Control On The Performance of Manufacturing Company in Nigeria. Journal of Business Management & Social Sciences Research (JBM&SSR) , 2(12), pp. 8-16.
Walther, D. L., 2014. Chapter Twenty-One: Budgeting: Planning for Success. Available at: http://www.principlesofaccounting.com/chapter21/chapter21.html

This work was produced by one of our professional writers as a learning aid to help you with your studies

Introduction

The intention of this essay is to analyse the development of ‘Behavioural Finance’ within the field of finance and investment. It will highlight some of the literature that has come about as a result of research in the field, some of the implications it has had on historical theories and some of the implications it has had within the world of investment.

The Birth of Behavioural Finance

Behavioural Finance is considered by many to be a new field within finance, but it does have its origins in the early 20th century. One of the initial publications to highlight the importance of investor psychology was authored in 1912 by George Selden, the intention of this book was to discuss the “belief that the movements of prices on the exchanges are dependant to a very large degree on the mental attitude of the investing and trading public”(Selden, 1912, pp. Preface), this was a pioneering thought and began the start of linking psychological aspects within the world of finance.

Throughout the 20th century, many developments were made in relation to combining psychological aspects to the world of finance. Since George Selden, many have built upon this idea and “in 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance.”(Sewell, 2010, p.1). This was of importance as considering the dynamic nature of finance, a decision one makes can often be offset by the introduction of new and inconsistent information, this may often lead practitioners to make irrational decisions which in turn affects markets, pricings and causes inefficiencies. After this, John Pratt “considers utility functions [and] risk aversion”(Sewell, 2010, p.1), which considers how practitioners evaluate a monetary amount gained or lost and also how they feel about incurring various levels of risk and how this affects behaviour and decision making. From this point the research and developments entered rapid expansion as more researchers and prominent people within the fields began to take interest in this idea that psychology may play an important role within markets and practitioner behaviour..

In 1973, two psychologists, Amos Tversky and Daniel Kahneman put forth an article and within this paper they “explore[d] a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e., by the ease with which relevant instances come to mind.”(Tversky and Kahneman, 1973, p.207).

A heuristic is something that financial “practitioners use [as a] rule of thumb…to process data… they are generally imperfect. Therefore, practitioners hold biased beliefs that predispose them to commit errors.”(Shefrin, 1999, p. 4). This along with the earlier articles and research began to explore in more depth the affects of individuals’ cognitive errors and misjudgements which we now know can lead to market inefficiencies.

Then, in 1974, Tverky and Kahneman produced another article with the intention of further developing the field and gaining a more in depth determination of the heuristic identified in their previous paper, within this article they had identified and described three heuristics which can be seen to be in use when making decisions under uncertainty. These three heuristics are as follows; “representativeness, which is usually employed when people are asked to judge the probability that an object or event A belongs to class or process B,”(Tversky and Kahneman, 1974, p.1124) in simple terms this is when someone tries to predict the probability of an unknown event by comparing it to a known event and assuming the probabilities will be similar. This can and usually does lead to errors as practitioners may over or underestimate the probability, and also may misjudge the comparative example which in turn will lead to errors.

The second heuristic is that of “availability of instances or scenarios, which is often employed when are asked to assess the frequency of a class or the plausibility of a particular development,”(Tversky and Kahneman, 1974, p.1131) in simple terms they have described a way in which individuals are more inclined to assess the frequency of an event by the ease in which instances of the events can be brought to mind.

The third heuristic is that of “adjustment from an anchor, which is usually employed in numerical predication when a relevant value is available”(Tversky and Kahneman, 1974, p.1131) in simpler terms they have described how an individual will use an initial piece of information and then any other piece of information gained thereafter will encounter a bias based on the initial information. This leads the practitioner to hold on to their initial beliefs in regard to the scenario and leads to an inaccurate reading of the situation resulting in errors.

These are heuristics, which are mental-shortcuts which, through a lack of adequate mental analysis and evaluation, lead to an inaccurate reading of the situation, leading to a misjudgement. These heuristics are important as they began to form reasons why financial practitioners’ are prone to make mistakes, which in-turn lead to market inefficiencies and in the area of investment cause stock-prices to deviate from their fundamental value.

From this point, Tversky and Kahneman went on to produce another article in 1979 They discovered that people tended to value losses greater than equivalent gains; “An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights.”(Tversky and Kahneman, 1979, p. 263). This was named Prospect Theory. This was an important development as it showed further irrational behavioural of practitioners and put greater emphasis on the study of how human errors do affect the financial markets, something that was held in contrast to popular belief at the time, it also contributed further to the study of how practitioners deal with the evaluation of money.

Then, in 1985, Werner De Bondt and Richard Thaler published an article that discovered that “most people tend to ‘overreact’ to unexpected and dramatic news events.. The empirical evidence… is consistent with the overreaction hypothesis… market inefficiencies are discovered.”(De Bondt and Thaler, 1986, p.793). This discovery, aided by the previous advancements of the better part of a century’s worth of research effectively formed the start of what has become known as behavioural finance and was of great importance and the field now had empirical evidence which backed up theory to suggest that psychological errors contributed to market inefficiencies thereby putting into question historical theories which had once been considered valid.

To summarise, over the course of the 20th century there has been significant research within the field of psychology and then a merging of psychological research with the field of finance. Many consider Amos Tversky and Daniel Kahneman to be the pioneers with the vast amount of research they conducted in the field, which lead to Werner De Bondt and Richard Thaler producing empirical evidence, with the use of psychologically based background, in their paper; “Does the Stock Market Overreact?”which proved that at times there exists inefficiencies within the markets.

How it has Affected Historical Theories

The birth of Behavioural Finance has had many implications within the fields of finance and investment. One of its greatest and most important impacts is calling into question the rationality of financial practitioners, this notion that practitioners are rational provided an assumption which formed the foundation on which some of the most influential economic and financial hypothesis were created.

To analyse the full impact of behavioural finance as a topic is something that cannot be achieved within this essay, instead it will discuss its effect on Efficient Market Hypothesis (EMH), a theory put forth by Eugene Fama in 1970 titled “Efficient Capital Markets: A Review of Theory and Empirical Work,”(Fama, 1970) . Within the document Fama describes an efficient market as “a market in which prices always ‘fully reflect’ available information,”(Fama, 1970, p. 383) in order for markets to fully reflect available information an assumption is made that the markets and the investors within them are rational, this is one of the assumptions that provides a foundation for Efficient Market Hypothesis;

This notion of rational markets and investors has been seriously questioned by the development of ‘Behavioural Finance’ and due to the research that has been conducted and empirical evidence which proves that at times the markets both over and under react to information which results in inefficiencies; it can be stated that the Efficient Market Hypothesis isn’t entirely correct. This is important as since the theories inception; financial practitioners accepted it as valid and began to develop ideas, models and other theories with EMH as a foundation. Other theories such as Capital Asset Pricing Model have been put into question as they were developed and “buil[t] on the assumptions of EMH.”(Bell, 2010).

The development of ‘Behavioural Finance’ and the findings from various researches which put into question market efficiencies, it can now be stated that long held beliefs and theories about the way markets and financial practitioners operate can be considered false. It has also brought about an idea named ‘Adaptive Market Hypothesis (AMH)’ which was put forth in 2004 by Andrew Lo, he argues that “the emerging discipline of behavioural economics and finance has challenged [EMH], arguing that markets are not rational… [he] propose[s] a new framework that reconciles market efficiency with behavioural alternatives.”(Lo, 2004). This new hypothesis seems to make more sense and is in conjunction with behavioural finance issues and while we wait for it to be solidified by long-term empirical evidence, it seems that the future is more AMH than EMH.

Its implications for Investment

Since the development of ‘Behavioural Finance’ and the psychological aspects that are at play within the world of finance and within the investors psyche have been seen to “lead to unhelpful or even hurtful decisions. As a fundamental part of human nature, these biases affect all types of investors,”(Byrne and Utkus, 2013, p.4) and often lead to misjudgements and errors, the implications for this are that each and every investor will make use of these heuristics and inevitability will make mistakes. The world of investment has now recognised that this area of study is of great importance and can help explain not only investor behaviour, but also the behaviour of markets. One of the intentions of ‘Behavioural Finance’ is to identify these errors and their causes so that investors are in a position to work around them or profit from other investors’ mistakes.

There are now many heuristics and biases which have been discovered and have an impact on financial practitioners decision making ability and in turn have implications for markets, some of these are as follows; Availability Bias, Representativeness, Gamblers Fallacy, Frame Dependence, Mental Accounting, Loss Aversion and Overconfidence to name just small amount. One of these biases, ‘Overconfidence’, “has found that humans tend to have unwarranted confidence in their decision making. In essence, this means having an inflated view of one’s own ability.”(Byrne and Utkus, 2013, p.4). In terms of investment this can lead some investors to have placed an overestimation on their own investment choices and ability and as such, at times, disregard the overall external factors which have an impact on the market. Another affect that overconfidence may have on certain investors is in relation to trading, for example, too much confidence is placed within their own ability to trade. “Professors Brad Barber and Terry Odean studied US investors with retailed brokerage accounts and found that more active traders earned the lowest returns.”(Byrne and Utkus, 2013, p.6).

Another bias is that of the ‘loss aversion’ where “behavioural finance suggests investors are more sensitive to loss than to risk and return,”(Byrne and Utkus, 2013, p.8) where traditional finance theory tended to focus solely on the relationship between risk and return. Two professors, Hersh Shefrin and Meir Statman, developed theories put forth by Tversky and Kahneman in a paper titled “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence”where they found evidence to suggest that investors “sell winners too early and hold losers too long.”(Shefrin and Statman, 1985, p.777). This can negatively affect investor returns and depicts some form of short-termism within investors’ psychology down to the bias of loss aversion.

Conclusion

To conclude, ‘Behavioural Finance’ is a field that has had profound effects on the world of finance and investment, so much so it has put into question previous theories that were once considered valid and used as a foundation for most economic and financial hypotheses such as EMH and CAPM. As the field has developed practitioners have taken more notice of their own and others’ irrational behaviour, which is important considering prior to the introduction of psychological issues most were of the belief that themselves and others were rational. This can now be considered to be false, and as the dynamic nature of the financial work-environment induces mental and behavioural short-comings it is likely that the field will see further developments.

Bibliography
Bell, W.P. (2010). Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC). [Online]. Available at: https://williampaulbell.wordpress.com/2010/01/15/capital-asset-pricing-model-capm-and-efficient-market-hypothesis-emh-contributing-to-the-global-financial-crisis-gfc/
Byrne, A.B. and Utkus, S.U. (2013). “Behavioural Finance – Understanding how the mind can help or hinder investment success,”Vanguard, pp.1-32. [Online]. Available at: https://www.vanguard.co.uk/documents/portal/literature/behavourial-finance-guide.pdf
De Bondt, W.B. and Thaler, R.T. (1986). “Does the Stock Market Overreact?”The Journal of Finance, 40(3), pp. 793-805. [Online] Available at: http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1985.tb05004.x/pdf
Fama, E.U. (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance, 25(2), pp.383-417, Wiley Online Library [Online] Blackwell Publishing for the American Finance Association. Available at: http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1970.tb00518.x/pdf
Lo, A.L. (2004). The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective, National Bureau of Economic Research, pp. 1-31. [Online]. Available at: http://opim.wharton.upenn.edu/~sok/papers/l/JPM2004.pdf
Selden, G.C. (1912). Psychology of the Stock Market. New York, Ticker Publishing Company. Available at: https://archive.org/details/psychologyofstoc00seldrich
Sewell, M.S. (2010). “Behavioural Finance,”University of Cambridge. [PDF] Available at: http://www.behaviouralfinance.net/behavioural-finance.pdf
Shefrin, H.S. (1999). “Beyond Greed and Fear: Understanding Behavioural Finance and the Psychology of Investing.”New York. Oxford University Press, Inc.
Shefrin, H.S. and Statman, M.S. (1985). “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence,”The Journal of Finance, 11(3), pp.777-790. [Online] Available at: http://www.economia.unimib.it/DATA/moduli/7_6069/materiale/shefrin-statman-85.pdf
Tversky, A.T. and Kahneman, D.K. (1973). “Availability: A Heuristic for Judging Frequency and Probability,”Cognitive Psychology, 5(2), pp. 207-232 [Online]. Available at: http://dtserv2.compsy.uni-jena.de/__C1257641005FF6B0.nsf/0/1538BC6A54743092C125764700444391/$FILE/TVERSKY+Availability+A+heuristic+for+judging+frequency+and+probality.pdf
Tversky, A.T. And Kahneman, D.K. (1974). “Judgement under Uncertainty: Heuristics and Biases”, Science, 185(4157), pp.1124-1131. [Online]. Available at: http://psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf
Tversky, A.T. And Kahneman, D.K. (1979). “Prospect Theory: An Analysis of Decision under Risk”Econometric, 47(2), pp. 263-291. [Online]. Available at: https://www.princeton.edu/~kahneman/docs/Publications/prospect_theory.pdf

This work was produced by one of our professional writers as a learning aid to help you with your studies

Introduction

The intention of this essay is to explain how Bank of England monetary policy has affected inflation rates within Great Britain, we will take data for the time period 2009-the present, the reasoning for this is this was the time-period that ‘Quantitative Easing’ was introduced. It will state recent developments in regard to interest rate policies and highlight what ‘Quantitative Easing’ is and how it forms part of monetary policy. It will use recent data in regard to the setting of interest rates and inflation and how inflation and interest rates affect businesses and individuals.

What is the Bank of England?

The Bank of England is the Central Bank of the United Kingdom. The mission of the bank is “to promote the good of the people of the United Kingdom by maintaining monetary and financial stability”; she is sometimes referred to as the “Old Lady of Threadneedle Street” and was founded in 1694 (Bank of England, 2015).

A Central Bank “is nowadays primarily an agency for monetary policy. It usually also has important financial stability functions, and those become more prominent during times of financial turmoil,” (Ortiz and Yam, 2009, pp.17) and although it has many differing functions dependant on which country the central bank operates in “one could infer that the objective underlying all functions was “for the economic interests of the nation, consistent with government economic policy”” (Ortiz and Yam, 2009, pp.18).

The Bank of England is engaged in all of these functions, however the purpose of this essay is to highlight monetary policy and inflationary matters; as such we will now concentrate on the monetary policy function of the Bank of England.

What is Monetary Policy?

Monetary Policy has been defined as “the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side of economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity” (Economic Times, 2015). Within the United Kingdom, the Bank of England has a Monetary Policy Committee (MPC), “The MPC sets an interest rate it judges will enable the inflation target to be met,” (Bank of England, 2015) this target is “defined by the Government set inflation target of a 2 per cent year-over-year increase in the Consumer Prices Index” (Bank of England, 2015).

Monetary Policy is important as it is used to maintain and engineer stable prices and confidence in the currency through the setting of interest rates, again this is defined by the government’s inflation target. A central bank has two tools it can use to try to influence the economy in terms of monetary policy; the setting of interest rates and the expansion and contraction of the money supply.

One of the key elements of monetary policy is how a central bank tries to keep the supply and demand for goods in some form of equilibrium by changing its official interest rate. This is known as the ‘Base Rate’ or ‘Bank Rate’, and it signals and attempt to influence the overall level of activity in the economy. “When demand for goods and services in the economy exceed supply, inflation tends to rise above the Bank’s target rate of 2%. On the other hand, when supply exceeds demand, inflation tends to fall below the Bank’s 2% target” (Bank of England, 2015). By changing the interest rate the bank is able to influence other banks and building societies in their borrowing and lending activities and therefore affect spending in the economy. It does this in an attempt to keep inflation in line with its pre-determined target of 2%. “A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can also affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans.” (Bank of England, 2015)

Another, more unconventional, form of monetary policy is that of “Quantitative Easing”. This is when a “Central Bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target.” (Bank of England, 2015) This was first used in the UK in March 2009 and involves the “cash injection [which] lowers the cost of borrowing and boosts asset prices to support spending and get inflation back to target. If inflation looks like being too high, the Bank of England can sell these assets to reduce the amount of money and spending in the economy.” (Bank of England, 2015) Considering the current state of the British economy with a transition from a majority of full-time to part-time workers (see Fig.2), a decrease in the real wage growth (see Fig.3) and a decrease in real average weekly earnings (see Fig.4) it can be stated that the Bank’s current monetary policy is acting against its own interests; “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability” (Bank of England, 2015).

(Fig.2)

(Fig.3)

(Fig.4)

What is Inflation?

Inflation has been defined in a number of ways, one of these definitions is that it “is the rate of increase in prices for goods and services [and] there are a number of different measures of inflation in use. The most frequently quoted and most significant one [is] the Consumer Prices Index (CPI)” (BBC, 2015)

CPI is “the speed at which the prices of the goods and services bought by households rise or fall. Consumer price inflation is estimated by using price indices. The price index estimates changes to the total cost of this basket. Most ONS price indices are published monthly. (ONS, 2013)

Inflation is of great significance as it affects the prices of all goods and services, and as mentioned above it has an effect on real wages and their growth, its affects on businesses and therefore their employment policies i.e. full time as opposed to part-time employment, consumption and an ability to save.

Recent Monetary Policy

We have established that Monetary Policy consists of a setting of an Interest Rate or ‘Bank Rate’ and also a relatively new form of monetary policy called ‘Quantitative Easing’. Since ‘Quantitative Easing’ is new and was first introduced in 2009 we will use policy and the relevant interest rates relating to this time-period.

The following is an extract taken from the Bank of England’s website: “The previous change in Bank Rate was a reduction of 0.5 percentage points to 0.5% on 5 March 2009. A programme of asset purchases financed by the issuance of central bank reserves was initiated on 5 March 2009. The previous change in the size of that programme was an increase of ?50 billion to a total ?375 billion on 5 July 2012.” (Bank of England, 2015) As we can see the Bank has kept its interest rate policy at a constant for the last 6 years, a record-low.

Recent Inflation

Using the same time-period as above we can show the inflation rate and how it has fluctuated:

(Fig 1.)

As can be seen from the graph above the level of inflation began to appreciate with the setting of the 0.5% interest rate which is in conjunction with economic theory as individuals tend to borrow therefore spend more which leads companies to raise prices. However, during 2012 other factors came into effect and we have seen depreciation in inflation. Of late one such factor could be the decrease in oil prices which has lead “to significant revenue shortfalls in many energy exporting nations, while consumers in many importing countries are likely to have to pay less to heat their homes or drive their cars.” (BBC, 2015). This is of importance as consumers use oil and other natural resources and it makes up part of their essential consumption, for example, if oil prices decrease then the cost of travelling, heating and lighting becomes cheaper.

As can be seen from the graph and the monetary policy that has been implemented by the Bank of England we can see the bank has entered into an unknown territory in that it has encountered an inflation level very close to 0% and also have an interest rate policy close to 0%. The level of inflation is below its desired target of 2% and therefore they, ideally, would like to be in a position to lower the interest rate to generate an increase in inflation, however, should the Bank of England begin to increase interest rates we would see an increase in the payments of debt. This remains true for governments also, with Britain’s debt rapidly increasing as a percentage of GDP (see Fig.5) this would ensure if not increase the probability of the government itself defaulting on its debt. With many other factors such as lowering oil prices, high unemployment, and a decrease in consumers’ disposable income aiding in the depreciation of inflation it will be interesting to see the Bank of England’s next change in monetary policy and to observe its implications.

(Fig.5)

The Effects of Inflation

Inflation has many different effects on a variety of different practitioners such as businesses and individuals. For businesses high levels of inflation can lead to higher sales revenue and therefore higher profit margins, however, this can be a short-lived occurrence as the cost of sales will also be affected increasing business costs and lowering profit margins. It is also likely that employees will at some-point request an increase in wages to keep pace with the raising costs of goods and services. Business will also need to be aware of the changing conditions within central and commercial banks as if inflation is raising beyond a pre-determined level then the central banks will alter their interest rate to ensure they meet their targets. This in turn will affect commercial banks and therefore the general cost of borrowing; this can also effect debt repayments and eventually profit-margins.

Low levels of inflation can also lead to higher sales revenue as customers take advantage of an increase in purchasing power and are therefore more likely to make rapid purchases, however, when inflation levels are low this suggests that interest rates are high and therefore saving becomes more attractive however this is not always the case. This could then lead to lower sales revenue as consumers will tend to favour savings over spending.

For individuals, high levels of inflation mean that prices of goods and services are increasing therefore individuals on a fixed income are proportionately spending a larger amount of their income on essentials, leading to a lower amount of disposable income. This means that interest rates are low and therefore saving becomes unattractive leaving consumers at the behest of the macroeconomic environment. However, dependant on the levels of inflation it is quite likely that the central banks will adjust interest rates accordingly and raise them, allowing consumers to benefit from the possibility of saving.

There are some other external factors which are out of the control of the Bank of England which also have an effect on British consumers and inflation such as “currency exchange rates, other countries interest rates and oil prices.” (Ramady, 2009, pp.10)

Conclusion

In conclusion, we have discussed the Bank of England and its monetary policy and how the setting of interest rates has an effect on inflation and how this in turn affects businesses and individuals. We have seen that there are numerous different ways in which interest rates and inflation can be adjusted given the economic environment and how the central bank and commercial banks control monetary policy to meet a pre-determined inflationary target – this target is 2% within the United Kingdom.

We have also used data and recent policy to illustrate the affects, which has brought us to an interesting point in economic history in that the central bank, commercial banks, businesses – large and small – and consumers have entered into a predicament in that we have a situation where both inflation and interest rates have reached near or exactly 0%. The central banks, various other large financial and political institutions must now create and adapt to a different strategy as it seems they have exhausted the use of their monetary policy tools and although ‘Quantitative Easing’ tends to boost the economy short-term, we have still seen this new tool used on multiple occasions.

It seems that if their current strategy was working, why all around the world are we continuing to observe economic instability in various forms such as high unemployment, highly volatile inflation – and deflation in some areas -, a reduction in real wages and a shift from mainly full-time to part-time working hours, these different negative economic consequences of a policy that results in more instability whilst the stated of objective of the institution is “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability”(Bank of England, 2015).

Bibliography
Bank of England. (2015). “About the Bank”. Available at: http://www.bankofengland.co.uk/about/Pages/default.aspx
Bank of England. (2015). “Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at ?375 billion.” Available at: http://www.bankofengland.co.uk/publications/Pages/news/2015/004.aspx
Bank of England. (2015). “How does monetary policy work?” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx
Bank of England. (2015). “Monetary Policy Committee (MPC).” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/overview.aspx
Bank of England. (2015). “Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability” http://www.bankofengland.co.uk/Pages/home.aspx
Bank of England. (2015). “What is Quantitative Easing?” Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx
Bank of England. (2015). “What we do.” Available at: http://www.bankofengland.co.uk/about/Pages/onemission/default.aspx
BBC. (2015). “Falling Oil Prices: Who are the winners and losers?” Available at: http://www.bbc.co.uk/news/business-29643612
BBC. (2015). “Q&A: Inflation Explained.” Available at: http://www.bbc.co.uk/news/business-12196322
Economic Times. (2015). “Definition of ‘Monetary Policy’”. Available at: http://economictimes.indiatimes.com/definition/monetary-policy
Ortiz, S. And Yam, J. (2009). “Issues in the Governance of Central Banks”, Central Bank Governance Group, pp.17, [PDF]. Available at: http://www.bis.org/publ/othp04.pdf
Telegraph. (2015). “Inflation: RPI, CPI and RPIJ explained.” Available at: http://www.telegraph.co.uk/finance/economics/9792480/Inflation-RPI-CPI-and-RPIJ-explained.html
Bank of England. (2015). “QE – Quantitative Easing (QE) – Injecting Money Into The Economy.” http://www.bankofengland.co.uk/education/Documents/resources/postcards/qecomp.pdf
Office of National Statistics (ONS), (2013). “Consumer Price Indices – A Brief Guide” http://www.ons.gov.uk/ons/guide-method/user-guidance/prices/cpi-and-rpi/consumer-price-indices–a-brief-guide.pdf
Bank of England. (2015). “Quantitative Easing (QE) – Injecting Money Into The Economy” [PDF] http://www.bankofengland.co.uk/education/Documents/resources/postcards/qecomp.pdf
Ramady, M. (2009). “External and Internal Determinants of Inflation: A Case Study of Saudi Arabia,” Middle East Journal of Economics and Finance, pp.10 [PDF] Available at: http://faculty.kfupm.edu.sa/FINEC/ramadyma/articles/External%20&%20Internal%20Determinants%20of%20inflation-A%20Case%20Study%20of%20Saudi%20Arabia.pdf
Illustrations

Figure 1. United Kingdom Inflation Rate (1915) [Image] Available at: http://www.tradingeconomics.com/united-kingdom/inflation-cpi

Figure 2. Three month average for the percentage of people working full and part time respectively, September-November 2000 to September-November 2013 [Image] pp.9 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 3. AWE real wage growth and the range of real wage growth estimates using other ONS wages and price series, Q1 2001 to Q3 2013, per cent change on the same quarter a year ago [Image] pp.5 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 4. Real Average Weekly Earnings and Real Average Hourly Wage, Index 2005=100 [Image] pp.8 Available at: http://www.ons.gov.uk/ons/dcp171766_351467.pdf

Figure 5. UK National Debt % GDP [Image] Available at: http://www.economicshelp.org/blog/334/uk-economy/uk-national-debt/