«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
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Accounting and its Relationshipto Shareholder Value and BusinessStructure
This chapter develops the two themes that were identiﬁed in Chapter 1 as being important to the content of this book: the separation of ownership from control and the divisionalized form of business. The ﬁrst is implicated in the emergence of capital markets and value-based management, the subject of this chapter, in which several tools for measuring shareholder value are described. The link between shareholder value, strategy and accounting is then introduced.
The second theme is the shift towards a decentralized, multidivisional business structure and the measurement and management of divisional (i.e. business unit) performance that has inﬂuenced the development of management accounting. This chapter introduces the structure of business organizations, with emphasis on the divisionalized structure and decentralized proﬁt responsibility. Part II develops the divisional performance issue in much greater detail.
The chapter concludes with a critical perspective that questions the focus on shareholders alone and raises issues concerning accounting in the divisionalized organization.
Capital and product markets Since the seventeenth century, companies have been formed by shareholders in order to consolidate resources and invest in opportunities. Shareholders had limited liability through which their personal liability in the event of business failure was limited to their investment in shares. Shareholders appointed directors to manage the business, who in turn employed managers. Shareholders have few direct rights in relation to the conduct of the business. Their main powers are to elect the directors and appoint the auditors in an annual general meeting of shareholders. They are also entitled to an annual report containing details of the company’s ﬁnancial performance (see Chapter 7).
The market in which investors buy and sell the shares of companies is called the capital market, which is normally associated with the Stock Exchange. Companies obtain funds raised from shareholders (equity) and borrowings from ﬁnanciers (debt). Both of these constitute the capital employed in the business.
ACCOUNTING FOR MANAGERSThe cost of capital represents the cost incurred by the organization to fund all its investments, comprising the cost of equity and the cost of debt weighted by the mix of debt and equity. The cost of debt is interest, which is the price charged by the lender. The cost of equity is partly dividend and partly capital growth, because most shareholders expect both regular income from proﬁts (the dividend) and an increase in the value of their shares over time in the capital market. Thus the different costs of each form of capital, weighted by the proportions of different forms of debt and equity, constitute the weighted average cost of capital. The management of the business relationship with capital markets is called ﬁnancial management or corporate ﬁnance.
Companies use their capital to invest in technologies, people and materials in order to make, buy and sell products or services to customers. This is called the product market. The focus of shareholder wealth, according to Rappaport (1998), is to obtain funds at competitive rates from capital markets and invest those funds to exploit imperfections in product markets. Where this takes place, shareholder wealth is increased through dividends and increases in the share price. The 1990s saw a growing concern with the role of accounting in improving shareholder wealth.
The relationship between capital markets and product markets is shown in Figure 2.1.
Since the mid-1980s, there has been more and more emphasis on increasing the value of the business to its shareholders. Traditionally, business performance has been measured through accounting ratios such as return on capital employed (ROCE), return on investment (ROI), earnings per share and so on (which are described in Chapter 7). However, it has been argued that these are historical rather than current measures, and they vary between companies as a result of different accounting treatments.
Rappaport (1998) described how companies with strong cash ﬂows diversiﬁed in the mid-twentieth century, often into uneconomic businesses, which led to the ‘value gap’ – the difference between the market value of the shares and the value of the business if it had been managed to maximize shareholder value.
The consequence was the takeover movement and subsequent asset stripping of the 1980s, which provided a powerful incentive for managers to focus on creating value for shareholders. The takeover movement itself led to problems as high acquisition premiums (the excess paid over and above the calculated value of the business, i.e. the goodwill) were paid to the owners and ﬁnanced by high levels of debt. During the 1990s institutional investors (pension funds, insurance companies, investment trusts etc.), through their dominance of share ownership, increased their pressure on management to improve the ﬁnancial performance of companies.
Value-based management (VBM) emphasizes shareholder value, on the assumption that this is the primary goal of every business. VBM approaches
ACCOUNTING AND ITS RELATIONSHIP TO SHAREHOLDER VALUE 15
Figure 2.1 Capital and product market structure and interaction include total shareholder return, market value added, shareholder value added and economic value added.
Recent research into the use of value-based management approaches by UK companies is covered by Cooper et al. (2001).
Total shareholder return (TSR) compares the dividends received by shareholders and the increase in the share price with the original shareholder investment, expressing the TSR as a percentage of the initial investment.
Market value added (MVA) is the difference between total market capitalization (number of shares issued times share price plus the market value of debt) and the total capital invested in the business by debt and equity providers. This is a measure of the value generated by managers for shareholders.
ACCOUNTING FOR MANAGERSRappaport (1998) coined shareholder value added (SVA) to refer to the increase in shareholder value over time. He deﬁnes shareholder value as the economic value of an investment, which can be calculated by using the cost of capital to discount forecast future cash ﬂows (which he called free cash ﬂows) into present values (discounted cash ﬂow techniques are described in detail in Chapter 12). The business must generate proﬁts in product markets that exceed the cost of capital in the capital market for value to be created (if not, shareholder value is eroded).
Rappaport developed a shareholder value network (see Figure 2.2). Through this diagram, he identiﬁed seven drivers of shareholder value: sales growth rate, operating proﬁt margin, income tax rate, working capital investment, ﬁxed capital investment, cost of capital and forecast duration. Managers make three types of
decisions that inﬂuence these value drivers and lead to shareholder value:
ž Operating decisions – product mix, pricing, promotion, customer service etc., which are then reﬂected in the sales growth rate, operating proﬁt margin and income tax rate.
ž Investment decisions – in both inventory and capacity, which are then reﬂected in both working capital and ﬁxed capital investment.
ž Financing decisions – the mix of debt and equity and the choice of ﬁnancial instrument determine the cost of capital, which is assessed by capital markets in terms of business risk.
The value growth duration is the estimated number of years over which the return from investments is expected to exceed the cost of capital.
Figure 2.2 The shareholder value network Reprinted from Rappaport, A.
(1998). Creating Shareholder Value: A Guide for Managers and Investors.
(Revd. edn). New York, NY: Free Press.
ACCOUNTING AND ITS RELATIONSHIP TO SHAREHOLDER VALUE 17The seven value drivers determine the cash ﬂow from operations, the level of debt and the cost of capital, all of which determine shareholder value. A detrimental consequence of the emphasis on shareholder value is that it has led to a continued focus on short-term ﬁnancial performance at the expense of longer-term strategy.
Economic Value Added (EVA) is a ﬁnancial performance measure developed by consultants Stern Stewart & Co. It claims to capture the economic proﬁt of a business that leads to shareholder value creation. In simple terms, EVA is net operating proﬁt after deducting a charge to cover the opportunity cost of the capital invested in the business (when by taking one action you lose the opportunity to undertake any alternative; described in more detail in Chapter 3). EVA’s ‘economic proﬁt’ is the amount by which earnings exceed (or fall short of) the minimum rate of return that shareholders and ﬁnanciers could get by investing in other securities with a comparable risk (see Stern Stewart’s website at www.sternstewart.com).
EVA accepts the assumption that the primary ﬁnancial objective of any business is to maximize the wealth of its shareholders. The value of the business depends on the extent to which investors expect future proﬁts to be greater or less than the cost of capital. Returns over and above the cost of capital increase shareholder wealth, while returns below the cost of capital erode shareholder wealth.
Stern Stewart argues that managers understand this measure because it is based on operating proﬁts. By introducing a notional charge based on assets held by the business, managers (whether at a corporate or divisional level) manage those assets as well as the proﬁt generated.
EVA also has its critics. For example, the calculation of EVA allows up to 164 adjustments to reported accounting proﬁts in order to remove distortions caused by arbitrary accounting rules and estimates the risk-adjusted cost of capital, both of which can be argued as subjective, although Stern Stewart argues that most organizations need only about a dozen of these. The increase in shareholder value is reﬂected in compensation strategies for managers whose goals, argues Stern Stewart, are aligned to increasing shareholder wealth through bonus and share option schemes that are paid over a period of time to ensure consistent future performance.
Accounting and strategy
This book treats accounting as part of the broader business context of strategy, marketing, operations and human resources. The focus of accounting in business organizations is shareholder value – increasing the value of the business to its shareholders – through dividends from proﬁts and/or through capital growth.
Strategy both inﬂuences and is inﬂuenced by shareholder value. Strategy is reﬂected in the functional business areas of marketing, operations and human resources, through the actions the business wants to take to achieve, maintain and improve competitive advantage. The relationship between these elements is shown in Figure 2.3.
ACCOUNTING FOR MANAGERS
Financial management (which is outside the scope of this book) is concerned with raising funds from shareholders or ﬁnanciers to provide the capital the business needs to sell and produce goods and services. Financial accounting represents the stewardship function, that managers are accountable to those with a ﬁnancial interest in the business and produce ﬁnancial reports to satisfy that accountability (Chapters 6 and 7). Management accounting provides the information for planning, decision-making and control. Therefore, the main content of this book is the interaction between the functional areas of marketing, operations and human resources – driven by strategy – and how accounting provides a set of tools and techniques to assist functional managers. Management accounting both inﬂuences and is inﬂuenced by the functional areas and by business strategy.
The importance of strategy for management accounting and the information it provides is that a strategic perspective involves taking a longer-term view about the business than is usually provided by traditional accounting reports. Management accounting comprises a set of tools and techniques to support planning, decisionmaking and control in business organizations. Accounting is – or at least should be – integrated with business strategy. However, these same accounting tools and techniques can be used to help evaluate the performance of customers, suppliers and competitors in order to improve competitive advantage. This is called strategic management accounting, which is described in Chapter 4.
Accounting should also extend beyond a narrow concern with ﬁnancial measurement and encompass non-ﬁnancial performance measurement, a subject of steadily increasing importance for those managers who are responsible for achieving performance targets, as well as for accountants (performance measurement is also described in Chapter 4).
Strategy is concerned with long-term direction, achieving and maintaining competitive advantage, identifying the scope and boundaries of the organization and matching the activities of the organization to its environment. Strategy is also about building on resources and competences to create new opportunities and take advantage of those opportunities and manage change within the organization.