Corporate Governance and Financial Management

Computational Optimisation Modelling and Accounting Perspectives

S. Nuryanah, S. Islam

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137435613
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

This book integrates corporate governance, corporate finance and accounting to formulate sound financial management strategies. It offers practical steps for managers using an integrated optimisation financial model to achieve good corporate governance practices which lead to lower risks and higher firm value.

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Sound Financial Management Strategies for Achieving Good Corporate Governance Practices

1.1 Introduction

The subject of this book is the formulation of sound financial management strategies for achieving the economic benefits of good corporate governance (GCG) practices through an optimisation financial model developed from managerial and financial accounting perspectives. This chapter presents the background of this study: the phenomenon of corporate failures, the current global financial crisis and the need for sound financial management strategies for achieving GCG practices. Good financial management strategies that incorporate elements of GCG practices are essential for a company’s survival. This chapter also provides an initial discussion of an optimisation approach as one of the methods for formulating sound financial management strategies. The chapter then emphasises the uniqueness of the current study and lists the aims of and motivation behind the research. A short discussion of the research methodology underpinning the study is presented next, followed by the contributions of the book, and a description of its structure.

1.2 Background of the study

The fragility and volatility of the global economy has had a considerable impact on companies regarding the certainty of their business activities. GCG practice, which offers potential economic benefits for individual companies and the national economy (Clarke 2004), has been suggested as one of the methods to address the issue of corporate failures (OECD 2004, 2009). Despite GCG practice now being mostly compulsory for listed companies around the world, previously few companies viewed GCG practice as a good risk oversight, with one reason being that it is costly to implement (Dallas 2004; Fabozzi and Modigliani 2009). Some companies simply applied the ‘tick-boxes’ style of corporate governance practice (HIH Royal Commission 2003) and ignored the substance of GCG practices such as good management practices, which in turn led to corporate failures (Love 1991; Sarre 2003). The recent corporate failures again highlight the importance of corporate governance. There are ongoing discussions and debates on ‘what went wrong, who was responsible, and what lessons [can be learned] to prevent [corporate failures from] happening again’ (Nordberg 2011, p. 15). While there are many perspectives that can be used to answer these questions, this book attempts to contribute to the discussions from the perspective of insiders of corporations by using managerial and financial accounting perspectives. This book is motivated by reports on the investigation of corporate failures which found that, apart from the unethical behaviour of management, poor management practice, such as lack of sound financial management practice, was one the main reasons for the failures (HIH Royal Commission 2003; Watts 2002).

This book furthermore views that although GCG practice is believed to be one of the key elements in ensuring the long-term survival of a company, the recent phenomenon of corporate failures suggests that GCG practices in form alone do not imply that a company employs sound financial management strategies. For example, reports investigating failed companies found that these companies overlooked the ‘substance over form’ concept in their GCG practices by not embedding and deriving quantitative financial measurements from the GCG principles in their companies’ strategies. In addition, these companies had also failed to take into account the changing economic conditions globally and the dynamism of business environments when formulating their strategies. Complex business environments require a company to incorporate business regulatory environments such as tax, the financial market and the current GCG practices and integrate them into their financial management strategies. By reflecting the real environments faced by a company, these strategies will be effective not only for tackling the risks faced by the company, but also for achieving the economic benefits of GCG practices, for example minimising risks and increasing shareholder value. The question is how to formulate these sound financial management strategies and how to measure the effectiveness of these strategies on GCG practices.

It is argued that an optimisation approach is a useful method for decision-making analysis and hence a valuable approach for formulating optimal financial management strategies. However, a critical review of the literature reveals a number of limitations to the existing financial optimisation models for formulating sound strategies. The main limitations of the previous models can be summarised as: first, they are not contemporary, since they were not developed in the context of current GCG practices. They do not integrate GCG principles in their objective function and constraints. Secondly, most of the existing models reflect more short-term goal orientation such as profit maximisation or costs minimisation. These non-long-term goals are not sufficient for maximising shareholders’ wealth. Thirdly, the objective functions of previous models are mostly based on accrual accounting–based measurements which contain accounting noise such as earnings management. Finally, the previous models do not incorporate managerial and financial accounting perspectives and therefore they are impractical for management decision-making.

In response, this study attempts to develop an integrated financial optimisation model for formulating sound financial management strategies that can achieve GCG practices. Using managerial and financial accounting perspectives, the model integrates current corporate governance practices, the complex regulatory environments and the dynamic business environment, including risks faced by a company. The integrated financial optimisation model will be developed based on theories of corporate governance, corporate finance and accounting. Corporate governance requires management to perform in the best interest of shareholders and to comply with the external system. Corporate finance and accounting theories provide policies that discipline managers to achieve the benefits of GCG practices. Based on these relevant theories, the model reflects the interrelationships between GCG, risk management, corporate finance and accounting practices.

The output of the integrated financial optimisation model is sound financial management strategies that are useful for achieving the benefits of GCG practices. The way sound financial management strategies could support GCG practices is briefly discussed in the next section. The effectiveness of these strategies on GCG practices, in the end, will be assessed based on their impacts on reducing risks and improving a company’s performance.

1.3 Good corporate governance practices and sound financial management strategies

As discussed in the previous section, the global and competitive economy has had a significant impact on companies’ business activities, for example, in companies’ ownership and control, and in fulfilling stakeholders’ rights and distributing the value they create (Clarke and Rama 2008). As the company grows and expands its activities globally, the effective governance of the company becomes even more important since failure would also have a negative impact on the economy and society. In this context corporate governance is defined as ‘the entire network of formal and informal relations involving the corporate sector and their consequences for society in general’ (Keasey et al. 1997, p. 2). Corporate governance also has an important role in guiding a company to comply with the legal, cultural and institutional arrangements it is operating in. Moreover, GCG means that a company needs to consider and embed the relevant risks, including regulations and other external systems controlling a company, such as self-regulation systems and ‘best practice’ norms, and other relevant risks, at the centre of its corporate structure (Farrar 2008; Iskander and Chamlou 2000). However, it is necessary to narrow this broad definition of GCG practices to more specific financial management strategies that can be applied to a company’s business activities so that the benefits of GCG practices can be achieved.

In this way good financial management practices are important for GCG practices since they provide strategies for a company to manage its financial resources efficiently and therefore it can achieve its ultimate goal which is, under theory of corporate finance, to maximise shareholders’ wealth. While this objective is specific to shareholders, it also brings value to the society (Petty et al. 2009). Therefore good financial management practices guide a company to directly fulfil the interests of shareholders which in the end could also benefit other stakeholders. This is relevant to broad GCG principles which ensure that a company protects not only shareholders but also other stakeholders (Brown and Caylor 2009; OECD 2004).

Good financial management and GCG are interrelated. Good financial management practices provide basic principles specific to financial decision-making. These principles complement the broader GCG principles which cover the non-financial area. One of the financial management principles is ‘the agency problem’ which underlies GCG practice. The agency problem is an effect of the separation of management of the firm that ‘managers won’t work for owners unless it’s in their best interests’ (Petty et al. 2009, p. 14). Both good financial management and GCG play their roles in mitigating the agency problem through their controlling instruments. Internal governance instruments cover both financial and non-financial policies. The examples are board governance function, managerial incentive plans, capital structure (leverage), dividend growth policy, risk management practices, and so forth. The financial policies are, in fact, subjects of financial management practices. Broader than good financial management practices, GCG practices require a company to follow GCG best practice and external governance mechanisms, such as external regulatory environments, while it creates value for the owners of a company. If a company does not comply with regulations, the company will face legal risks and potentially incur economic costs that in turn sacrifice shareholders’ wealth. Under financial management practices, the external governance mechanisms are recognised as external threats which need to be accommodated into a company’s strategy.

To conclude, good financial management is part of the internal governance instruments which discipline the managers to perform in the best interests of shareholders (the owners) and hence minimise agency costs. It enables management to review and manage the company’s financial position. Moreover, financial management strategies ensure the achievement of the company’s long-term goal by maximising shareholder wealth. Therefore this is in parallel with the objective and principles of GCG practice which in the end ensures the sustainability of the company. To be effective, however, financial management strategies need to be formulated in integrated ways by incorporating the external regulatory environments and the framework of GCG practice; hence, sound strategies minimise the risks and enhance the economic benefit of GCG practices, that is, improve the company’s value.

1.4 Elements of sound financial management strategies

Sound financial management strategies for achieving GCG practices should have the characteristics described below.

1.4.1 Good corporate governance practices

Corporate governance consists of many dimensions. Inside a company, corporate governance is reflected in the organisation’s structure, including its board structure, supporting board committee, risk-management activities and other internal controls of the company. As external governance instruments, corporate governance comprises formal and informal institutions, laws, regulations and rules which regulate the stewardship of a company to comply with the external systems so that the company achieves not only its financial goals, but also its environmental and social goals (Clarke and Rama 2008; Manzoni and Islam 2009).

Accordingly, good financial management strategies can successfully achieve the benefits of GCG practices if they incorporate the internal and external governance instruments, especially the financial instruments, as stated above. These sound strategies also need to reflect the broad principles of GCG practices that relate to, for example, shareholders’ rights, so that the effectiveness of the company’s corporate governance practices can be monitored and evaluated.

1.4.2 External regulatory environments

Financial management practices, as mentioned in Section 1.3, view external regulatory environments as business constraints since there will be compliance costs or penalties for non-compliance. Therefore, sound financial management strategies have to accommodate the environments in which a company operates. The strategies need to reflect the dynamics of the market, corporate governance regulations, accounting standards and industry practices. This study incorporates external environments in the formulation of sound financial management strategies. These strategies will guide management to comply with the regulations while minimising the costs incurred for compliance, and hence improve firm value.

1.4.3 Managerial and financial accounting perspectives

Sound financial management strategies have to be developed based on managerial and financial accounting perspectives so that the strategies are of significant value for practical managerial decision-making and practical GCG practices. Based on managerial and financial accounting perspectives, sound financial management strategies will show an interrelationship between corporate governance, corporate finance and accounting. Financial statements as a product of management and accounting will be used as an input for developing sound financial management strategies.

For formulating sound financial management strategies that can achieve the benefits of GCG practices, the relevant managerial and financial accounting proxies, policies or measurements are used in this study. The examples are risk-management practices, free cash flows (FCF), leverage, executive compensation, liquidity policy, solvency policy and profitability policy.

1.5 An integrated financial optimisation model based on managerial and financial accounting perspectives as a new approach to formulating sound financial management strategies

An optimisation model is a mathematical model that represents a problem of interest and is a method to solve that problem optimally. It is very useful for decision-making analysis since it helps determine realistic and practical outcomes for management decision-making and design processes (Sarker and Newton 2008). The optimisation model is of value to management for decision-making since the results of the model suggest the available decisions for management to consider, with limited resources. In spite of the various classifications of optimisation models based on objective function, types of constrained or unconstrained problems, variable types and function types, the optimisation model used in this book is a constrained dynamic multi-period linear optimisation model with a single objective function.

The proposed model follows Morris and Daley (2009), Demski (2008), Ho and Lee (2004), Carleton (1970), Hamilton and Moses (1973) and Ijiri et al. (1963) by using accounting information for managerial decision-making so that it reflects managerial and financial accounting practices. It is also based on the underlying concepts of the interrelationships among corporate governance, corporate finance and accounting. Specifically, the model follows the concept of the financial optimisation model of Carleton (1970), as discussed in Lee et al. (2009), and the corporate model of Ho and Lee (2004).

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Table of contents

• Cover
• Title
• 1  Sound Financial Management Strategies for Achieving Good Corporate Governance Practices
• 2  The Foundations for Formulating Sound Financial Management Strategies Using an Integrated Financial Optimisation Model: A Critical Literature Review
• 3  Conceptual Framework and Research Methodology
• 4  An Integrated Financial Optimisation Model for Formulating Sound Financial Management Strategies
• 5  The Context of the Case Study
• 6  The Numerical Model, Results and Analysis
• 7  Implications of The Results for Sound Financial Management Strategies, Corporate Governance, and Managerial and Financial Accounting Perspectives
• 8  Conclusion and Recommendations for Future Research
• Appendix 1:  Financial Data of the Company
• Appendix 2:  Beta Calculation
• Appendix 3:  The Results of the Initial Model
• Appendix 4:  The Final Model 1
• Appendix 5:  The Final Validated Model 1 – Without Perpetuity
• Appendix 6:  The Present Value of the Perpetuity of the Final Validated Model 1
• Appendix 7:  The Final Validated Model 2 – Without Perpetuity
• Appendix 8:  The Present Value of the Perpetuity of the Final Validated Model 2
• Notes
• References
• Index