Finance and Accounting: Practical and Written Assessment - Assignment Example

?Finance and Accounting: Practical and Written Assessment Table of Contents Answer 3 Answer 2 5 Answer 3 8 MINI CASE 2: GOVERNANCE FAILURE AT ENRON10 Answer 1 10 Answer 2 13 Answer 3 15 Reference List 18 Appendix 1 20 MINI CASE 1: PORSCHE CHANGES TRACK Answer 1 Porsche Automobile Holding also known as Porsche is a German company headquartered in Zuffenhausen, Baden-Wurttemberg. It was a family controlled firm till it was taken over by Volkswagen AG in 2012. The company maintains a straightforward product line. To be precise there were three product lines and a newly proposed line of products, namely 911, Boxster, Cayenne and Panamera. As far as the profitability of the company was concerned, it has been quite impressive in past decade in the automotive industry, as the growth and profit margin of the company in Figure 1 reveals. Figure 1: Growth of Profit and Margin of Porsche Source: (Moffett, 2005) The strategy that Porsche followed for both Cayenne and Boxster was a combination of outsourcing, licensing and in sourcing to influence the investment of the shareholder. Due to this strategy of the company, they enjoyed high return on the invested capital (ROIC), as the increasing sales of the product line shows in Figure 2. Figure 2: Augmenting Sales of Various Product lines of Porsche Source: (Moffett, 2005) During the fall and summer of 2005, two significant announcements were made by Porsche, which changed the directions. The first announcement was that Panamera would be manufactured by the company through company’s own funds and in their own factories. The second decision was that Porsche invested around 3 billion in Volkswagen AG at an interest rate of 20 percent, which was an underperforming automaker of Germany then (Eiteman, Stonehill and Moffett, 2010). In this section of the study, the focus of discussion would be on the strategic decisions that the company has made which augmented its ROIC. ROIC signifies the efficiency of the company in allocating the capital, such that it can get profitable returns on investments. The return assures how well the company is utilising its funds for generating returns. The ROIC can be calculated by subtracting dividends from net income and dividing it by the total capital. All the product line of Porsche, especially Cayenne had a high operating margin as can be seen in Figure 2, in comparison to any other European automobile company. As it has been discussed that Porsche incorporated pioneering strategies and business decisions embedded with technology and capital for Cayenne and Boxster, which was evident from the sales figures. Porsche Boxster was manufactured in Finland by Valmet. So the company skilfully utilised other’s money to manufacture and sell its products. It was working through licensed manufacturing agreement trough which Valmet utilised its own tools and factories for manufacturing Boxster. This decreased the capital requirements of Porsche, which the company utilised to support its own business (Moffett, 2005) Porsche invested around $3 billion in Volkswagen AG, which was though the worst performing company in the industry, but prospects of the company to excel in future were immense, which is why Porsche entered into a strategic alliance with Volkswagen. Due to this reason, it was responsible for approximately 30 percent of automotive manufacturing of Porsche and also assembling. Porsche co-manufactured Cayenne with Volkswagen. The chassis of Cayenne was assembled by Volkswagen on the same assembly line of Volkswagen Touareg. This again reduced the capital requirement of Porsche and allowed the company to focus its capital towards the development of the company. The above strategic decision of the company resulted in the augmenting ROIC of Porsche (Eiteman, Stonehill and Moffett, 2010). Answer 2 The section question of this case is regarding Veselina Dinova’s point of view regarding the attitude of the company towards creating value towards shareholders. Vesi was in dilemma whether Porsche’s strategies were augmenting the wealth of the shareholders or following the traditional framework of stakeholder capitalism. This question came into existence when the investors analysed the performance expectation and motivations of the management of the companies in the public companies. Porsche rewarded its management on the basis of its financial performance in business that is the figures which were found in the financial statements of the company and not on the basis of the market opinion regarding the share price. This issue was considered to be quite controversial since the past 40 years. It was argued by several policy makers that the management of the company need to share similar risks, rewards and motivations as that of the shareholders. The share price should be also considered the core for the investors and the management to analyse their returns. However, it was found that Porsche focused on implementing business strategies with the objective of enhancing the long-term profitability and performance of the company, just like a family-owned business functions. The results of this were an obvious appreciation of profit and goodwill in the market. Another significant point to be considered is the decision of the company to invest $3 billion in Volkswagen AG. This decision however, could be evaluated with the passing time and the results that the industry revealed (Eiteman, Stonehill and Moffett, 2010). In order to discuss Vesi’s dilemma in distinguishing the ability of the company to augment stakeholders’ value and its willingness in doing so, the stakeholders’ wealth maximisation theory would be discussed and a comparative analysis would be drawn with shareholders capitalism hypothesis in order to understand Vesi’s problem. The American-Anglo, which is mainly the American and UK market worked on the philosophy that the objective of the firm should be to maximise the wealth of the shareholders mainly. The focus should be to maximise the return for the shareholders who is measured by the dividends and sum of capital. This philosophy is based on the supposition that the share markets are proficient, the price of stock is correct and all information related to risk and returns are updated. The share prices in turn would be considered the best allocator of capital in the macro economy. In this context, the agency theory can be also discussed. Agency theory puts forward that theories how the shareholders of the company can inspire the management of the company to recognize the commendation of shareholder capital. If the management deviates from the shareholders objectives then it is the responsibility of the board of directors to replace them. However, if the board is weak in such case, the equity market can take over and decisions can be taken in favour of the shareholder through one-share-one-vote policy (Eiteman, Stonehill and Moffett, 2010). On the other hand, stakeholder’s capitalism does not assume the equity market or share prices to be important, but they consider the financial goals to be of primary importance. The shareholder’s interest does not go in line with the interest of other stakeholders always, so the financial statements are the primary tools for decision-making in according to this theory. However, according to the CEO of Porsche, Dr. Wendelin Wiedeking, Porsche has always considered augmenting the value of the shareholders to be of primary importance (Sharma, 2009). There are significant decisions, which the company has taken may be not by just considering the financial statement, but for the long-term profitability of its shareholders such as, its decision to invest in Volkswagen. As can be seen in Figure 3 and Figure 4, in term of competitive positioning and ROIC, Volkswagen was much below Porsche, yet the company ventured in it, which is obviously a sign of intelligent strategic decision-making (Moffett, 2005). Figure 3: Competitive Positioning Source: (Moffett, 2005) Figure 4: ROIC Source: (Moffett, 2005) Answer 3 Yes following the interest of the controlling families of Porsche was different from that of maximising the return of the shareholders. Though both public shareholders and family ownership are based on profitable, augmenting and sustainable business framework, but one major difference between markets and families is the focus of growth. The return that the family derives from the ownership of the business is through distribution of profits (dividend), financial support (the family members enjoy the expenditure and assets owned by the company), compensation and salary (family members who are employed by the company). The returns that the shareholders derived from the firm are through the dividend yields, appreciation in the stock prices. The concept of capital gain is almost similar to that of dividend yield, but the upward movement of share prices in this case is much more complex from the leadership perspective than in case of family owned business focus. IT can be clearly understood that one of the major drivers of the share prices is the firm (Porsche) which guarantees to deliver profitable returns in both bottom-line and top-line of income statement. In case of family managed or owned business, control and sustainability is considered as the drivers of rapid growth (Oliveras and Amat, n. d.). In this context, the difference between the family owned businesses and public owned business can be studied, which will assist in analysing the turn of events in Porsche. In case of family owned companies the business governance includes additional layers of association, which arises due to diverse interconnections among the family members. In case of public companies a pre-defined framework is established and the relationship between every position in the hierarchy is pre-defined and it functions according to the laid regulations. There is no underlying relationship that developed consequently, which is why communication is easier and establishing strategies becomes unproblematic (Madura, 2009). The family owned business find difficulty in raising funds through equity because investors feel that somehow they would be having lesser power in terms of decision making and investment, since in family owned business family member get the upper-hand at significant decision-making and strategy implementation functions. In public owned companies, shareholders have significant position in decision-making as well as strategy implementation along with other stakeholders of the company, which signifies that investors consider public owned companies to be more transparent than family-owned businesses. However, family owned businesses are focused towards suitability. Brand equity, value enhancement, control growth, etc, which is not the case in public companies. Public companies indulge in cut throat competition, risky investments and even in creative accounting practices. On this front, Porsche being a family owned company considered the shareholders value of primary importance has a measured and controlled way of manufacturing products through outsourcing and through strategic alliance, which will minimise their capital engagement and planning for long-term, surely depicts the difference of focus that Porsche depicts from typical public owned company (Loughrey, 2011). Probably this is what the financial statements of the company reflect in Appendix 1. MINI CASE 2: GOVERNANCE FAILURE AT ENRON Answer 1 Enron Corporation is among those companies which initiated the event of insolvency and bankruptcy due to corporate governance failure. The company fell prey due to its incapable audit committee, who did not have the farsightedness to predict that the governance and financial operations of the company were in wrong hands (Deakin, 2003). Officially it is Arthur Andersen LLP, Enron’s auditors who are blamed for such a fate, but the actual culprit behind this situation was the audit committee of the company and the corporate governance. As can be seen in Figure 5, the actual operating income of Enron in all the segments except in wholesale energy and broadband were extremely low or negative till 2000, which signifies the actual financial condition of the company was not stable (Jones, 2011). The original business model of Enron was capital intensive. Massive capital was required for the construction of power plants and pipelines, but these erections did not yield any profit for the company to cover the expenses. As this asset-heavy company aged, it was not able to produce net operating cash in-flow, which was forecasted. Due to which more and more capital was consumed by the company (Deakin, 2003). The less capital consuming side of the company was power trading business of the company, which was service-oriented and the capital infrastructure did not engulf much capital. However, the company and its management did not have the capability to manage their capital efficiently, so the credit rating agencies rated the stocks of Enron as BBB-, which signified being on the edge of speculative grade, as the company was being operated on high debt. The company was functioning on more and more debt but they were not being reflected through the financial statement (Larcker and Tayan, 2011). As can be seen in Figure 5, the internal stakeholders of the company were the board of directors and the management, while the external stakeholders are the regulators, auditors, and equity and debt market (Deakin, 2003). Figure 5: Corporate Governance Structure Source: (Deakin, 2003) The collapse of Enron was so deep that it was difficult for the analyst to predict which reason was major cause of failure. However, the purpose of mentioning the corporate governance structure above was to reveal that the main culprit was the leadership of the board members and the senior management of the company, who failed to safeguard the shareholders and other stakeholders of the company (Coenen, 2009). The internal causes consisted of cases of illegal activities, malfeasance and fraudulent reporting. These internal failures were combination of the failure of corporate culture, which many authors termed as massive incompetence. As far as external causes are concerned, one of the causes was common for every US institution, which was greed and self-interest that failed the entire system. The massive failure was due to the internal financial culture that prevailed in case of accounting earnings and augmenting cost that gradually led to contagion of external governance (Deakin, 2003). Apart from this, cracks in the regulatory system of many businesses of Enron such as power trading led to failure of the company as a whole. Other cases such as auditors’ verdict, equity and debt market were the external stakeholders who added to the fire. A culture of profit at all cost and self-enrichment ruined the business inside out (Chaturvedi, 2009). Answer 2 Preventing is always better than cure, but in few cases lack of prevention takes away the right to cure, which happened in case of Enron. The stakeholders who formed the corporate governance system of the company were unethical. It is a good practice to differentiate the roles of the CEO and the chairman, where the CEO is the chief of the management and Chairman is the leader of the board of directors (Gopinath, 2002). However, when the same individual occupies both the position, immense power gets concentrated in one hand and the management and supervision quality gets diluted (Brooks and Dunn, 2009). This is what happened in case of Enron, where Mr. Kenneth Lay was the CEO and Chairman of the company. For a small period of time Mr Jeff Skilling was handling the position of CEO, but soon after he resigned Mr. Lay has to handle both the positions. If there were two individuals leading two significant segment of the company in proper coordination, then decisions would have been taken in an enhanced way and better ideas could have been generated to reduce excessive capital consumption (Chaturvedi, 2009). The audit committee is one of the major committees with the help of which the board functions. They have the reach of individually enquiring about the functions and workings of the company to check that every business activity being conducted in the firm is done ethically. The Enron audit committee failed miserably in this regard. According to the Special Investigating Committee, the board of directors of the company did appoint the compliance and audit committee for reviewing the transactions, but the committee carried it out in a superficial way. If the audit committee checked the practice of creative of accounting and forced the accountants to put down all the debts of the company on papers, then the investors might have lost faith from the financial status of the company, but at least it could have received government aid and it could be somehow saved through sales of less profitable business wings and fixed assets (Brooks and Dunn, 2009). Apart from this, there was severe conflict of interest among the other stakeholders of the company, which includes the partners. Six among fourteen directors of the board were at conflict with each other due to differences in their areas of interest. The directors of the company could have worked in coordination with each other by taking responsibility to revive each segment of the company. In this way the effort to save every segment of Enron could have reaped good results (Arnold, 2011). As it can be derived, that most of the stated earnings shown in the financial statement of Enron did not actually exist. The debt that the company raised through various partnerships were not disclosed in the corporate statements, which should have been legally done. The compensation package designed for the senior employees and management were lavish and the bonuses earned by the corporate officers were unsuitable. It was clear that the executive officers in the company were successful in controlling the board of directors towards achievement of their goal. The management of the company diversified the company into various industries, where in most of the sectors the company had to face substantial loss (Petrick and Quinn, 2001). This redoubled the attempts of the company to generate capital for generating earnings in order to meet the Wall Street criteria of generating profitable growth. The board of directors were unsuccessful in protecting the interest of the shareholders because of the lack of due diligence. The legal advisers of the company, some of whom also reported the board of directors failed to perform their duties ethically (Svensson and Wood, 2007; Svensson and Wood, 2011). The auditors of Enron, Arthur Andersen also committed grave blunder while making judgement for the accounting treatments for various activities of Enron, which also includes various partnerships. The auditor seem to have severe conflict of interest with its client in which it earned approximately $5 million as its auditing fees in the year 2001 from Enron and around $50 million consulting fees in the same year. The analysts of Enron on the other hand were functioning in simple euphoria of the company’s success in the 1990s, with the investment banks. However, few analysts did notice the fact that the earnings of the company was strangely falling with relation to the falling cash flow of the company. However, in this scenario also the management of Enron was successful in proposing arguments for such a case (Ferrell and Fraderich, 2012). Answer 3 This is one of the most critical questions related to the company, Enron. However, all the companies function under the basic common framework, but every company have different business operational functions, size, capital invested, processes, business model, employee base, etc. This signifies that the fate of every company depends on the way it functions and not on the US Federal framework (Gopinath, 2002). The basic corporate governance framework that the regulatory body has stated is to avoid volatility in the global business environment and maintain balance, which does not signify that even if the business functions are not balanced, companies can run smoothly just by following regulatory corporate governance framework. Apart from this, it also depends on the stakeholders of the company, whether they are following the regulations ethically or not, which was not the case for Enron. The audit committee, who were bestowed with the independence of governing the rules and given financial literacy, did not undertake their duties. The big companies nowadays have such complex business model that only the internal stakeholders truly understand them, so they take advantage of this factor (Boone and Kutz, 2009). If the causes of Enron’s failure are analysed then it can be understood how Enron’s failure was a different case altogether. Enron’s failure was the result of intelligent gambling by its board. The permitting accounting risk was high in the company, in which 50 percent of the assets were allowed to be shifted as off-balance sheet entity. They waved off the codes of ethics and allowed transaction self-dealing. The conflicts of interest that ignited within the directors were completely ignored and neither the compensation of the executives checked or monitored. If the business plan of the company is evaluated, then it can be seen that it was a normal utility firm, which traded energy by acting as an intermediary in the supply chain (Gopinath, 2002). However with the attempt to eliminate the traditional and vertically integrated structure, it went for adopting risky sophisticated form of management. As it can be seen in Figure 6, the share prices of the company were considerably low and the return on equity was diminishing (Anglo American, n. d.). Figure 6: Return on Equity and Share Price of Enron (1992-2000) Source: (Lavelle, 2002) For success the company needs to have a physical presence in the market for energy trading. The company could have derived its competitive advantage through knowledge and liquidity in the energy sector. In this case retaining the confidence of credit market and capital market was necessary. Though there are fixed norms, but in volatile market companies’ operation depends on the situation. Enron even used entities for special purposes, which also created a fake notion of earning growth (Anglo American Business Integrity Compliance Department, 2011; Gopinath, 2002). Reference List Anglo American Business Integrity Compliance Department, 2011. Business Integrity Policy. [online] Available at: [Accessed 11 December 2013]. Anglo American, (no date). Transparency and Ethics. [online] Available at: [Accessed 11 December 2013]. Arnold, V., 2011. Advances in accounting behavioural research. West Yorkshire: Emerald Group Publishing. Boone, L. E., and Kutz, D., 2009. Contemporary Business. 13th ed. New Jersey: John Wiley & Sons. Brooks, L. J., and Dunn, P., 2009. Business & professional ethics for directors, executives & accountants. 5th ed. Connecticut: Cengage Learning. Chaturvedi, S., 2009. Financial management: Entailing planning for the future. New Delhi: Global India Publications. Coenen, T. L., 2009. Expert fraud investigation: A step-by-step guide. New Jersey: John Wiley & Sons. Deakin, S., 2003. Corporate Governance: Lessons from Enron. [online] Available at: < http://www.buseco.monash.edu.au/mgt/research/governance/pdf-downloads/deakin-enron.pdf> [Accessed 11 December 2013]. Eiteman, D. K., Stonehill, A. I. and Moffett, M. H., 2010. Multinational business finance. New York: Pearson. Ferrell, O. C., and Fraderich, J., 2012. Business Ethics: Ethical Decision Making & Cases. 9th ed. Connecticut: Cengage Learning. Gopinath, C., 2002. Corporate Governance Failure at Enron. [online] Available at: < http://www.thehindubusinessline.in/2002/03/04/stories/2002030400110900.htm> [Accessed 11 December 2013]. Jones, M., 2011. Creative accounting, fraud and international accounting scandals. New Jersey: John Wiley and Sons. Larcker, D., and Tayan, B., 2011. Corporate governance matters: A closer look at organizational choices and their consequences. New Jersey: FT Press. Lavelle, L., 2002. Commentary: How Governance Rules Failed at Enron. [online] Available at: < http://www.businessweek.com/stories/2002-01-20/commentary-how-governance-rules-failed-at-enron> [Accessed 11 December 2013]. Loughrey, J., 2011. Corporate lawyers and corporate governance. Cambridge: Cambridge University Press. Madura, J., 2009. Financial markets and institutions. 9th ed. Connecticut: Cengage Learning. Moffett, M. H., 2005. Porsche Changes Track. [online] Available at: [Accessed 11 December 2013]. Oliveras, E. and Amat, O., no date. Ethics and creative accounting. [online] Available at: [Accessed 11 December 2013]. Petrick, J. A. and Quinn, J. F., 2001. The challenge of leadership accountability for integrity capacity as a strategic asset. Journal of Business Ethics, 34, pp. 331-343. Sharma, B. S., 2009. Accounting management: Information for decisions. New Delhi: Global India Publication. Svensson, G. and Wood, G. 2011. A Conceptual Framework of Corporate and Business Ethics across Organizations Structures, Processes and Performance. The Learning Organization, 18. Svensson, G. and Wood, G., 2007. A Model of Business Ethics. Journal of Business Ethics, 77, pp. 303–322. Appendix 1 Source: (Moffett, 2005) Source: (Moffett, 2005) Read More