Bcu msc cg week 9 liquidity 050812

ASPECTS OF FINANCIAL RISK : LIQUIDITY

MSC ACCOUNTANCY & FINANCE :CORPORATE GOVERNANCE

& OPERATIONS RISK ANALYSIS AND CONTROL

Stephen Ong BSc(Hons) Econs (LSE),

MBA International Business(Bradford)

Visiting Fellow, Birmingham City UniversityVisiting Professor, Shenzhen University

• Discussion : Enterprise culture & Accounting firms

1

• Financial Risks, Liquidity & Working Capital2

• Case Presentation: Arthur Andersen

• Case Discussion : The Collapse of Enron

3

Today’s Overview

Casestudy 4 : Arthur Andersen1. Read and prepare the Casestudy on Arthur Andersen

(Monks & Minow (2011)) for discussion next class. Identify the corporate governance issues faced.

2. You are required to:–Analyse the scenario’s in the case

study and plot the resulting risk analysis on an appropriate risk map.–Map out the stakeholder

power/interest issues, and propose the appropriate corporate actions.

Risk Map Action

High

Medium

Low

Low Medium High

SIGNIFICANCE

PROBABILITY

Requires close monitoring

Manage and monitor Significant focus and action

Accept but monitorManagement effort

worthwhile Manage and monitor

Accept risksAccept but

periodically reviewAccept but monitor

Stakeholder mapping: the power/interest matrix

Figure 4.4 Stakeholder mapping: the power/interest matrixSource: Adapted from A. Mendelow, Proceedings of the Second International Conference on Information Systems, Cambridge, MA, 1986

1. Open Discussion

• Prem Sikka, (2008),"Enterprise culture and accountancy firms: new masters of the universe", Accounting, Auditing & Accountability Journal, Vol. 21 Iss: 2 pp. 268 - 295

2. FINANCIAL RISKS, CONTROLS, LIQUIDITY &

WORKING CAPITAL

2.1 Financial Risks Nature and Background

• Three Main Divisions of Organisation.• Private ~ Organisations motivated by profit or gain• Public Sector operated directly (or indirectly) by

the government with a view to providing society with a service.

• Voluntary, Charitable, Altruistic ~ The Third Sector. Usually centred on social issues. Generally funded by donations.

• However they all have objectives set with the benefit of stakeholders in mind.

Types and Nature• Private Sector:– Sole Traders The sole trader is the owner and

proprietor.– Partnerships ( 2 or more people working together with

a view to profit) Partners are owners and managers– Limited Companies. The owners and major providers

of capital or funding are the shareholders. The company may or may not be listed or ‘quoted’, that is have is shares traded on the stock exchange. The enterprise is ‘owned’ by the shareholders. The Directors are the ‘stewards’ of the shareholders assets.

• Government Bodies, Agencies Etc.

Summary of Financial Risks1. Financing & liquidity risks (Financing,

Liquidity, Cash flow, Credit risks)2. Market risks (interest rate, exchange rate,

commodity price, equity price changes)3. Foreign investment risks (foreign exchange-

economic, political risks)4. Fraud risks (Teeming & lading, accounts

manipulation, advance fee, pyramid scheme frauds)

5. Accounting risks (Accounts, income, measurement, systems risks)

Main Financial Risks• At the Present time acquisition & availability of funding.• Payment default from Clients & Customers.• Liquidity, having sufficient cash flow and working capital

to support the level of operations undertaken.• Interest rate changes (can be up side and downside)• If foreign exchange is involved there will be an exchange

rate risk.• Operational Risk, can we operate in a sustainable

manner• Reputational Risk. Could something damage our

reputation and credibility. Consider how these should be guarded against. (Bonuses & Parliament Expenses egs)

Finance is required for:• Acquisition of fixed assets,

machines equipment etc.• Working Capital, the amount of

money required for the process of trading, buying, selling, paying operational costs, holding stock, time lag in customers paying and so on.

Finance can be sourced: • Internally ~ from generated profits ~ or • Externally ~ From outside the enterprise. This may be in the form of such things as:• Shares ~ Issued (‘sold’) by limited companies. One share = one vote.• Debt ~ money borrowed from external sources. Interest is payable on the

debt and provision for repayment must be made. Can be in such forms as:

– Bank overdraft– Medium to short term loans– Debentures. A long term debt instrument that can be issued

by limited companies– Leasing, usually associated with fixed assets– Venture Capital Organisations– Planning or budgeting for the correct level of finance is

vital.

2.2 Recording & ControlsBasic Functions / departments / divisions

1. Cashier ~ (hard) cash sales and collections and bankings

2. Sales Ledger/Accounts receivable ~ Monitoring & Collecting payment from clients and customers who have been granted credit (time to pay).

3. Purchase Ledger or Accounts payable ~ Monitoring payment to suppliers who have supplied goods or services on credit.

4. Payroll ~ Responsible for salaries, wages, and related Tax, NI etc.

5. Fixed Assets ~ control over the long term assets of the organisation

6. Providing information to and for Management.

7. External Financial Reporting Consider the roles and operations of these

functions:

1 Sales Ledger / Sales DepartmentPurchase Order Received

Goods dispatched

Invoiced raised (detailing value terms etc)

recorded in total

Recorded individually in the customers own record

Monitoring to ensure payment received in due time

Payment received. Customers record updated and any

balance established.

Cheque to Cashiers for banking

Controls.1. Separation of Duties.2. Reconciliation of aggregate

customers balances to Total debtors

3. Aged debtors lists4. Total Debtor days

calculations5. Procedures prior to granting

credit & credit limits

2 Purchases Ledger ~ Accounts Payable

Authorised request for procurement received

Quotations/estimates sought,

Purchase order issued. Progress on delivery monitored

When order delivered a GRN is

raised and sent to purchasing. GRN checked against order and

supplier invoice details. Suppliers account credited with

appropriate amount. At due time, according to terms of trade

Authorisation to Cashier to raise and issue cheque to supplier. Ensure any appropriate discounts are exploited.

Checks and Controls 1. Authorisation procedures2. Verification of Invoices

received 3. Reconciliation of aggregate

supplier balances to Total Creditors

4. Calculation of average creditors days

5. Segregation of duties

Looking deeper• However, if you make purchases to

use or sell on you will have Stocks:• Consumables and raw materials• Work in Progress• Finished Goods all of which are

working capital assets.• What are the risks and controls that

can be associated to stocks?

Stocks Risks and controls• Physical security• Required storage environment• Impact of natural wastage• ‘Shelf Life’ and obsolescence• Regulation, Health and Safety• Excessive stocks• Insufficient stocks• Quality Issues.

Control Systems• Perpetual inventory• Adoption of pricing and valuing system• Determination of Maximum and

minimum stock levels, re-order levels and EOQ’s

• Random Stock checks• Rate of stock-turn reports• Pricing review• Value analysis review

3 Cashier• Concerned with ‘hard cash’ transactions, cash sales

etc. Reconciles cash collected to invoices, till rolls etc. Banking cash.

• Banking cheques from credit customers.• Arranging for standing orders, bank transfers (eg

payroll), credit debit card transactions., any cash required (eg payroll, petty cash)

• Recording all transactions.

• Checks and Controls: Authorisation for payments and cheque signatories. Receipts Periodic bank reconciliations

4 PayrollObvious close working links to cashier.

Responsible for calculation of wages and salaries and accounting for Tax, NI (employer and employee) and any statutory or authorised voluntary deductions.

Payment of authorised expense claims.

Checks and Controls: Procedures to ensure no fictitious employees on payroll Reconciliation to HR records.

Accuracy of wage calculations Tax & NI procedures and authorising payment to HMRC

5 Fixed Asset(s) Control• Records and categorises all fixed assets. • Calculates depreciation in accord with company policy. • Ensures adequate insurance cover, • Compliance with any legal / regulatory requirements.• Arranges for authorised acquisition and disposal.• Monitors repairs and renewals. • Ensure safe and proper usage and physical security.

Controls Authorisation procedures for acquisition and disposal. Verification of physical existence, condition and title. Prevention of misuse Compliance with regulation(s)

6 Information to Management (cost/accounts office)

• Production of such financial information as: Budgets Forecasts Product costs and other cost information Pricing, discounts and allied data Segmental profits and cost, products, divisions etc.

• Management accounts Investment appraisal. Etc. The exact nature and amount of detail may well vary with the level of Management for whom data is being supplied.

7 External Financial Reporting• Provision of legally required financial

statements and information for shareholders, Regulatory bodies, HMRC etc.

• Required financial information for shareholders includes, Trading & Profit and Loss account, Balance sheet, Statement of cash flow, Directors Report, but usually plus a great deal of other information.

• Must also be lodged at Companies House

Cash Flow, Profit, Liquidity Risk and OvertradingProfit is not cash flow ~ Cash flow

is not profit.

Consider this train of events:1st May buy a widget on 30 days credit for £1008th May sell the widget for £150 on 40 days credit12th May buy a widget on 30 days credit for £1001st June pay for the widget purchased on 1st May12th June pay for the widget purchased on 12th May18th June The widget buyer pays you £150. BUT

On the 1st May you made a profit of £50 !

Any potential cash you have generated from the sale in ‘tied-up’ in the working capital cycle.

CASH

Debtors Stocks

Working capital is where the day to day trading operations take place. It is where cash is potentially generated by making profit

What can increase or reduce Working Capital?

Working CapitalIncreases Decreases

Profit(s) Loss(es)

Injection of Capital, shares or loans received.

Redemption of shares, repayment of loans.

Sales of Fixed Assets Purchases of Fixed Assets

Payment or dividends or payments to owners in excess of current years profit.

What Can Increase or Decrease Working Capital?

Increased by:1 Profit(s)2 Injection of Capital from whatever source(s)3 Disposals or sales of fixed assets for cash. (P/x will

not bring in a cash injectionDecreased by:i Loss(es)ii Repayment of loans or redeemable capitaliii Purchases of fixed assets iv Payment of dividends charged to reserves

All of these factors:1. All are as a direct or delegated result of Board policy2. There is no way that an enterprise can

GenerateAcquireUtilise

Monetary resources without it passing through one of those headings.

The overall impact of cash movements in an organisation can be monitored and analysed by

compiling and using a Cash Flow Statement

Working Capital Cycle

Working Capital Stocks Debtors Bank/CashLess Creditors

Purchase stock buy in goods & servicesS

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costs, tu

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to

finish

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Sell goods to customers on credit

Deb

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pay

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WORKING CAPITALMajor Risks;• Overtrading, leading to• Liquidity Risk• Reputational Damage• Credibility Damage• Sustainability and going concern basis in

doubt.• Working Capital ~ Stocks + Debtors + Cash –

Creditors• The day to day trading/operational area.

Working CapitalStocks.Risks ~• Excessive money tied up in stock• Deterioration• Obsolescence• Physical Security• Storage Regulation(s)• Stock out causing disruption, expense,

damage to reputation and client customer relationships.

Controls and Systems• Calculation of appropriate stock

levels. Maximum, minimum, re-order level. Evaluation of EOQ. How often are these reviewed?• Periodic and random stock checks.• RST Reports to highlight changes in

demand and usage patterns• Consideration of suitability of JIT

DebtorsRisks• Default and bad debts• Non compliance with terms of trade• Demands sent to customers who

have in fact paid. (reputational damage)• Money and resources tied up in

debtors.

Controls and Procedures.• Initial credit worthiness checks• Credit limits which are subject to review• Regular credit control checks coupled

with regular debtor days calculations and reports.

• Aged debtors lists.• Sanctions and actions re poor payment

record.• Financial system checks

Consideration of:• Discounts to promote prompt

payment.• Debt Factoring ~ which may be• Non Recourse• Recourse.• Invoice Discounting• Export Factoring.

Creditors.Risks.• Over reliance on a single source• Continuity and sustainability of supply• Quality control• Reliability of supply• Relationship to stock control• Reputational and allied damage

resulting from slow settlement

Controls

• Monitoring• Calculation and regular reports

of creditor days.• Continual review of alternative

and acceptable supply.• Financial system checks.

Cash• Cash Budget with regular checks for

any variation from budget.• Plans and policies for treatment of

short term and long term deficiencies• Use of short and long term surpluses.• Financial systems for protection against

fraud and misuse.• Regular calculation and review of

relevant ratios

Balance Sheet & Risk Areas (1)Fixed Assets xxxx Current Assets:Stocks xxxDebtors xxxBank/cash xxx xxx Creditors 1 year or less:Current liabilitiesCreditors xxx xxx xxx

• Requirements, choice, evaluation, profitability. Physical protection and security. Environmental Health and safety issues. Regulation and compliance.

• Physical security end environment. Sufficient or excessive, Control. Liquidity risk, default risk. Disruption risk

• Maintain reputation. Excessive or low. Liquidity. Continuity of supply. Stakeholder relationships

Balance Sheet & Risk Areas (2)Working Capital xxx Total Assets less current liabilities xxx Creditors in excess of 1 Year xx Net Assets xxx

Capital & Reserves:Share Capital xxx Capital Reserves xxx Revenue Reserves xxx xxx

Profit levels and sustainability

• Adequate but not excessive. Support the volume of trade being undertaken.

• Interest rates, interest cover, impact on gearing eventual repayment.

• Share price movements. Shareholder expectations and dividends. Future capital raising prospects. Capital structure and gearing. Cost of Capital

• Market place reputation and credibility

• Currency Conversion

APPENDIX : THE STAFFORD &

SKEGNESS RAILWAY EXAMPLE

The Earl of Stafford has a brilliant idea for making a lot of money. He wants to build and operate a Railway -“The Stafford & Skegness Railway”He figures out he will need £200,000 to do this.The Noble Earl has lands, coal mines, farms and

estates. He is very wealthy but does not possess that kind of ready cash. (Asset Rich ~ Cash Poor!)

He has a bright idea! He now says his railway will be:

The Stafford & Skegness RailwayCompany Limited.

All he has to do now is find a sufficient number of people (or in modern language punters) who believe in his idea and are willing to SHARE in the venture.

Some may want a greater share or portion than others, but all ventures will eventually receive…..

Certificate No. 123

The Stafford & Skegness Railway Company Limited.

I certify that William Smithers is the registered holder of one ordinary share of £1.00 nominal in the Stafford & Skegness Railway Company limited.

Ivor Penn

Ivor Penn

Company Secretary

Dated Ist January 1875

The Skegness & Stafford Railway Co. Ltd.Balance Sheet at Time 1

Cash 200,000

Ordinary Share Capital.200,000 o/s of £1.00 200,000

Nominal Value of 1 ordinary share = £ 1.00

Balance Sheet value of 1 ordinary share = £200,000/200,000 No.

= £1.00

Skegness and Stafford Railway Co. Ltd.Balance Sheet at Time 2

Land 120,000Buildings 30,000Rolling Stock 45,000Cash 5,000 200,000Ordinary Share Capital.200,000 o/s of £1.00 200,000

200,000

Nominal Value of 1 o/s = £1.Balance Sheet Value of 1 o/s £1.00

Skegness and Stafford Railway Co. Ltd.Balance Sheet at Time 3

Land 120,000Buildings 30,000Rolling Stock 45,000Cash 25,000

220,000

Ordinary Share Capital.200,000 o/s of £1.00

200,000

Profit 20,000

220,000

Nominal Value of 1 o/s = £1Balance sheet value of 1 o/s = £1.10

Market value = £1.40 per o/s

PROFIT• Is an increase in Net Assets

• Is having a bigger business at the end than you had at the start

• Is the ‘return’ you can use or ‘pay out’ without eroding your capital investment

• Market Value of a share can be greater than Balance Sheet value of a share because………

So if he decided to pay a dividend of 5% ie £0.05 per Share: Capital 200,000 P & L A/c (Revenue Reserves) 10,000

210,000

Land 120,000 Buildings 30,000 Rolling Stock 45,000 Cash 15,000

210,000

If we now wanted to raise (say) £140,000 ?

How would this affect the Balance Sheet?

What are the implications?

He could Probably ‘sell’ a £1.00 nominal Share for £1.40 So: Capital 300,000 o/s of £1.00 nom 300,000 Share

Premium A/c (Capital Reserve) 40,000 P & L (Revenue Reserve) 10,000

350,000 Land 120,000 Buildings

30,000 Rolling Stock 45,000

Cash 155,000 350,000

CASE DISCUSSION : THE COLLAPSE OF

ENRON

Cases - The Collapse of Enron: Governance and Responsibility• Enron was a great business success soaring to a market

capitalization in excess of $60 billion and ranking seventh on the Fortune 500 list

• Enron was creative in its financial arrangements, entering into numerous partnerships with a variety of entities– The partnerships allowed Enron to keep substantial losses off its

financial statements• Under increasing pressure from its own failed investments,

facing difficulty in obtaining financing, and under scrutiny from Wall Street, on October 16 Enron reported:– A third-quarter pre-tax loss of $710 million and subtracted $1.2

billion from shareholders’ equity

Cases - The Collapse of Enron: Governance and Responsibility• A central component of Enron’s strategy was to

utilize subsidiaries and special purpose entities• In 1993 Enron established a partnership named

JEDI (Joint Energy Development Investments) with the California Public Employees’ Retirement System (CalPERS) as the limited partner

• In 1999 Fastow proposed establishing a partnership LJM Cayman LP (LJM1) for the:– Ostensible purpose of hedging Enron’s investment in

Rhythms NetConnections by obtaining investments from outside investors

Cases - The Collapse of Enron: Governance and Responsibility• Raptor was Enron’s name for a partnership

used to hedge its merchant investments portfolio in projects and companies

• Enron employees participated in 401(k) retirement plans, and most of them held Enron shares

• The Board of Directors was responsible for the performance of the company and had a fiduciary duty to shareholders

Core Readings

• CIMA - Performance Strategy: Study Text (2013) BPP Learning Media Ltd. Part C : 8

• Baron, David P.(2013) Business and its environment, 7th Edition, Pearson

Next Week’s Ideas for Discussion• Rocco R. Vanasco, (1996),"Auditor

independence: an international perspective", Managerial Auditing Journal, Vol. 11 No.: 9 pp. 4- 48

QUESTIONS?