financial management report on agency theory
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Financial Management Report on agency theoryTRANSCRIPT
Arjun Patel: PAT11239405 07/11/2012
Contents
Introduction...........................................................................................................................................1
The tasks performed by the Finance Directors/ Chief financial officers................................................1
Steward.............................................................................................................................................2
Operator............................................................................................................................................3
Strategist...........................................................................................................................................4
Catalyst..............................................................................................................................................5
How have the tasks performed by the CFO changed in the present climate?.......................................6
Communicating with the CEO............................................................................................................8
Contributing to more than purely a financial role.............................................................................8
Adopting a new method for identifying and training talent..............................................................8
Improving business knowledge.........................................................................................................9
How do issues of agency theory and information asymmetry impact on the firm?............................10
What is agency theory?...................................................................................................................10
The conflicts between shareholders and managers........................................................................10
Costs of the management and shareholder conflict........................................................................11
Methods for managing shareholder and manager conflicts............................................................11
Agency conflict between stockholders and creditors......................................................................12
Conclusion...........................................................................................................................................12
References:..........................................................................................................................................13
Bibliography:.......................................................................................................................................15
Arjun Patel: PAT11239405 07/11/2012
Introduction
The on-going financial crisis has led to greater regulation expanding dramatically coupled
with heightened uncertainty about the future, this has directly had an impact on the scope
of responsibilities of a chief financial officer (CFO). In addition to being a leader of a complex
and diverse finance function (Ernst and Young, 2011 p.8). This report will look into the
functions and the new challenges a chief financial officer may now encounter, as well as
how the issues of agency theory and information asymmetry impact on the firm.
The tasks performed by the Finance Directors/ Chief financial officers
In todays’ economic uncertainty the role of the chief financial officer (CFO) is continuously
under scrutiny from both external and internal pressure from the company. This pressure
comes from financial reaffirmations, heightened regulatory requirements due to a weaker
global economy and further pressure from investors. Deliotte (2012) have concluded that in
todays’ modern era the roles CFOs are expected to perform are divided into four categories
these are represented in figure 1, these include steward, operator, strategist and catalyst.
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Figure 1: Represents the four roles a modern CFO must be able to perform (Deloitte, 2012)
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Figure 2 illustrates the order in which a CFO must perform these four modern roles. CFOs
that carry out the wrong order are likely to find themselves moving out rather than up.
Steward
This involves protecting the interests’ of the business by balancing the claims created by
people outside the business. Preservation of the company's assets and resources, managing
risk as well as the use of accounting and control are at the heart of the stewardship role.
The steward must also ensure the company abides by the regulations and legislation of the
company in terms of financial reporting and control requirements; the CFO must also
monitor financial statements to make sure they are timely and relevant thus ensuring its
quality. Ehrenhalt et al (2007) supports that performing the role of stewardship effectively,
requires CFOs to be able to display a variety of different abilities these include:
Not only presenting, but also interpreting the companies information provided by
the financial controller and management accountant on the financial reporting risks.
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Figure 2: Represents the hierarchy of the order in which the
Figure 2: Represents a hierarchy of the order in which the four roles must be performed. (Adapted from: Deloitte, 2012)
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These include going concern and liquidity risk, then to focus on the critical controls.
The CFO must be able to focus on the critical controls of the business.
The CFO must clarify responsibilities by reinforcing Finance’s authority to make
decisions.
Taking greater responsibility for accounting data by effectively communicating with
the Chief Information Officer, then taking responsibility for the collection and
management of financial and management reporting information this can be in the
form of annual reports.
Focus on talent management by hiring knowledgeable experienced accountants,
therefore avoiding restatements of financial information which can be time
consuming and result in further errors being made.
Create standards throughout the company for processes, data and systems therefore
avoiding conflict.
Operator
This role primarily focuses on efficiency and service levels; the key to reaching this is to
create an operating model for finance which balances between service levels and cost
without sacrificing quality such as outsourcing as a method of reducing costs. CFOs that
have demonstrated this role effectively have shown their ability to:
Improve management performance by creating effective programs and measuring
the performance of finance personnel.
Developing better interpersonal skills and applying these to build a stronger team of
internal talent by creating a sense of belonging for finance staff.
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Creating interlinking centres by centralising processes and services to provide
excellence in order to drive efficiency without sacrificing control or quality.
Strategist
Gauss and Halladay (1987, pp.25-26) journal placed a lot of emphasis on future CFOs
becoming increasingly interested in strategic planning; The CFO carrying out the strategic
role will set the company on a future route to improving performance and adding
shareholder value. Ehrenhalt et al (2007) states that effective strategists not only
understand the numbers, but they also understand the business. An effective strategist
shouldn’t just follow the rules, but they should be able to create new approaches
redefining the rules. These conflicting requirements highlight the importance of CFO
involvement especially in todays’ complex business environment.
The strategist provides a financial perspective on the profitable growth and innovation of
the company; by critically analysing financial information in decision making consequently
improving risk awareness. The financial information allows the strategist to distinguish the
links between the various business activities, financial results and to show how company
growth can be achieved profitably and reliably. An effective CFO performing this role will be
able to;
Continuously evaluate strategic decisions such as investment as well as the ability to
make tough decisions when necessary.
Create reports specifically aimed to meet the requirements of critical decisions that
need to be made.
Analyse the company's operations to display how actions and daily decisions can
affect shareholder value.
Arrange improvement projects by importance using value-based portfolio
management.
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Catalyst
The Catalyst is an agent for change, primarily focused on creating a value attitude
throughout the organisation (Deliotte, 2012). This role helps the company execute its
strategies whilst monitoring the task throughout its process to ensure completion. A
challenge this role may face is obtaining the approval of other executives that the role of
catalyst finance should be undertaking. Other executives will soon realise the value of
finances contribution to the company and gradually turn to the CFO for support and
assistance with execution.
CFOs demonstrating their ability to be an effective catalyst have shown the following
capabilities:
Recruiting qualified staff and supporting them grow, as well as allowing them to
migrate between the different functions within the company.
Driving financial thinking and thoroughness throughout the company by promoting
value discipline and monetary literacy.
Driving accountability through personal leadership, dedication and measurement.
Understanding what it takes to achieve tasks within the company and applying that
knowledge to continuously drive execution.
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How have the tasks performed by the CFO changed in the present climate?
In Wu (2011, pp.840-843) journal he elucidates that the past 20 years have been led by
macro-economic uncertainty, economic globalisation and increasingly complex environment
business, which has caused CFOs to adapt and perform different roles. CFOs who want to
get ahead can't afford to ignore any of the four roles. The modern CFO continues to include
the traditional areas of financial stewardship but, has now moved to the more progressive
areas of strategic and business leadership, strategy and overseeing operations which include
growth of the company.
The recent global financial crisis has brought all CFOs on the spotlight more than ever
before. CFOs are primarily evaluated by the company’s overall performance, when company
performance falls short the CFO is usually the scapegoat as in the case of Sir Fred Goodwin
(Goff, 2012) who was predominantly blamed for the collapse of the Royal Bank of Scotland,
despite his decisions being made as a group in the boardroom. Along with new pressures of
continuously being under scrutiny, the modern CFO has now had to undertake additional
responsibility this includes corporate governance, operational and strategic decisions of the
company. The old era of only supplying financial information has moved on, now the CFO is
also providing business advice.
In a recent survey by Ernst and Young (2012) 530 CFOs were asked how important it was to
have experience in a range of roles for a future CFO to perform, selecting only their top
three. The results are summarised in figure 3. CFOs rated that having a wider range of
finance roles, international exposure and embarking on a major strategic change project
where among the top three. This further supports the CFOs roles adapting over the past 20
years.
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The CFO now partakes more in an active role by taking roles such as talent management,
contributing to areas beyond finance, and assuming the role of CEO designate (Kalra, 2011).
The CFO is now required to contribute to three main areas these include:
Improving the company’s compliance with new legislation.
Providing guidance as well as strategic business advice to the CEO.
Ensuring cost efficiency of the accounting and finance function.
Clements (2005, p.1) suggests that the greater demand on the modern CFO has adapted
them to perform many roles these now also include:
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Figure 3: represents a survey questioned to 530 CFOs on the importance of having experience in a range of roles for a future CFO. (Ernst & Young, 2012)
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Communicating with the CEO
Able to convert business objectives into business enablers; this includes knowing when to
outsource finance and accounting functions. Clements (2005, p.1) explains that this can give
greater flexibility in the market place due to it helping maintain profitability.
Taking a greater proactive role; being the driving force behind systems, processes and
employee motivation.
With the CFO being the external face of the company; he needs to ensure consistency and
transparency as well as be knowledgeable in foreign laws and develop skills on change
management, so he can be the main point of contact for the CEO.
Contributing to more than purely a financial role
Performing the role of public relations officer; helping to resolve imbalances between the
external and internal stakeholders this ensures there is balance in the board, consequently
resulting in joint effort to achieve company growth.
Communicating with the various functions in the organisation; helping to improve staff
morale, recruitment and team development this also adds to the importance of being a
good listener and communicator.
Adopting a new method for identifying and training talent
Providing the opportunity for team members to migrate from the finance function;
therefore producing an individual with greater experience in the different areas of the
company as well as higher job satisfaction.
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Providing greater structured internal training; training courses such as leadership
management can give finance members the ability to be more confident with progressing
within the more senior positions within the company, as well as giving them correct skills for
success in the future.
Give employees training in field; this provides employees with a complete perspective of the
business.
Managing the changing expectations of young and new people entering the market; reduction of staff in the middle management levels has led to new staff taking up these new
roles responsibilities their ability to adapt to these are vital for their survival.
Improving business knowledge
Focusing more on the foundations of business rather than accounting controlling; this can
be achieved by delegating routine tasks such as maintaining books therefore creating more
time for the CFO to look at the strategic and corporate sections of the company.
Adding more layers to strategy and decision-making; this means thinking about creating
value in the company rather than just profit and allocating more time to manage external
stakeholder expectations rather than just internal stakeholders. This also means keeping
external stakeholders well-informed. After British Petroleum Company (BP), oil disaster it
sparked concerns amongst investors however, the annual report of BP (2011), highlights
that they want to continue keeping their external stakeholders well-informed about their
future strategies and how they are going to achieve them.
Keep up-to-date and have access to information continuously; with the modern
technological era the CFO should be easily able to access information about the
organisation, keeping on top of all developments as well as the ever changing external
environment such as competitors, markets and the economy.
In Shelton (1987, pp.40-42) journal he explains the importance of looking into the past in
order to understand and face the challenges of the future, there is no doubt that the past
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few years have led to a vast transformation on the roles of a CFO. The time dedicated to the
CFO’s routine administration jobs have now been focused on the larger strategic matters of
the organisation.
How do issues of agency theory and information asymmetry impact on the firm?
What is agency theory?
This is a theory explaining the relationship between principals such as agents and
shareholders. An agent such as a company executive is a person authorised by the principal
such as a shareholder to act on his or her behalf. It is part of an Agents responsibility to try
to act at all times in the best interests of his or her principal. But putting that into the
context of the relationship between the managers of the company and its shareholders and
you have what is known as the "agency problem”. Campbell, Stonehouse and Houston
(2002) elucidate that the agency theory suggests that agents (Managers) may seek to
maximise their own benefit at the expense of their principles (Shareholders).
Today's managers have wider responsibilities to employees, to the environment as well as
the government and these are often in conflict with their responsibility to shareholders
(Hindle 1994, p.31-32). As responsibility faces further down the management ladder these
other responsibilities include more and more into the agency relationship.
The conflicts between shareholders and managers
Agents are likely to have dissimilar motives to principals. They may be influenced by other
factors these may include financial rewards, labour market opportunities, and relationships
with other parties that are not directly relevant to principals (ICAEW, 2012). This can
consequently cause agents to be more hopeful about the company performance as well as
their own; these differing interests amongst both parties can cause agents to have an
enticement to provide bias information. Agents have more knowledge about the overall
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operations and finance of the company therefore they are in a greater position for gathering
information, which principles do not have the access to. Principles may raise their concerns
about information asymmetries as agents are usually in a more knowledgeable position.
Costs of the management and shareholder conflict
Managers may award themselves and staff with greater terms and conditions, consequently
adding as an expense, reducing overall profit therefore lowering shareholder returns. This in
turn may cause a reduction in shareholder returns, causing shareholders to sell their own
shares. The conflict of interest between the two parties may cause agency costs to arise,
these are defined as the costs incurred to maintain an effective agency relationship between
shareholders and managers, an example is bonuses dependant on management
performance, Rosen (1995, pp.12-15) described their sole purpose as a form of
encouragement to managers to maximise shareholder wealth rather than their own
interests.
The three main types of agency costs include:
Opportunity costs lost due to share-holder conflicts, such as shareholder votes
required to carry out certain company issues.
Extra expenses due to monitoring managerial activities these include audit
expenditure.
Restructuring the company to hinder adverse managerial behaviour, this can involve
recruiting outside board members however, it can restrict managerial power.
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Shareholders attempts to prevent undesirable managerial behaviour can also incur a loss on
shareholder wealth, due to incorrect managerial decisions being made. The opportunity
costs of these restrictions have to be balanced in order to improve shareholder wealth.
Methods for managing shareholder and manager conflicts
The methods used for controlling shareholder and manager agency conflicts include:
Providing performance based plans with marginal monitoring therefore encouraging
managers to act in shareholders' interests, most of today’s publicly traded companies now
offer performance shares to their managers.
Direct intervention by shareholders this can be in the form votes to carry out
particular decisions.
The threat of discharging the manager and appointing a new one.
Agency conflict between stockholders and creditors
Shareholders and managers borrow money expecting a return larger than the interest paid
on the loan. Creditors review their risk of the venture and determine their rate of return.
The primary issue causing conflict between these parties is trust. Shareholders attempt to
take risky projects with bondholders’ money through the work of managers; this is because
they have more to gain and only an equal amount to lose from a failed project. The
managers and shareholders must work together to determine how much to deceive
creditors in order to gain the finance.
Conclusion
The role of the modern CFO has undergone numerous changes in the past 20 years; he is no
longer only involved in capital expenditure decisions. The CFOs advice is now required for
matters throughout the organisation, the demands of his job have now diversified due to
new challenges he now faces, he has moved from the routine administrative functions to
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dedicating himself in more strategic issues. However, the CFO also needs to find the correct
balance in keeping shareholders well informed in order to avoid information asymmetries
and agency problems arising. Only when he realises how to adapt and become an effective
collaborator, partner and change-driver that his CEO and the entire company expect, he will
be able to effectively perform his new modern roles expected of him today.
.
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Wu, J. (2011) CFO complex characteristic, agency costs and corporate value: Based on
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Arjun Patel: PAT11239405 07/11/2012
Clements, S. (2005) The changing role of the CFO. As demands on CFOs continue to grow,
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pp.840-843.
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