F
inance has always been
seen as having two distinct
functions: recording
what has happened (financial
accounting) and helping businesses
to make decisions about the future
(management accounting). Today,
it has a third function: financial
strategy. This incorporates
judgments about risk, which some
companies (especially banks)
have realized must play a larger
part in financial decision-making.
Understanding risk
Fundamental to an understanding
of financial strategy are the
concepts of leverage and excess
risk. “Leverage” is a measurement
of the extent to which a business
is dependent upon borrowings.
The higher the leverage, the greater
the level of risk. In good times,
directors come under pressure to
produce impressive profit growth,
and one easy way to achieve it
is to borrow money and invest
in the most profitable parts of the
business. However, if the economy
turns downward, toward recession,
heavy borrowings turn into
an overwhelming burden.
Leverage becomes toxic.
The risk level generated
by leverage is worsened when
businesses use off-balance-sheet
finance, in other words, when
they do not report loss-making
investments on the company’s
balance sheet, thereby appearing
to boost profits. This leads to an
important question in relation to
modern business: who bears the
risk? Traditionally it was assumed
that the risk taker was the
shareholder, because it is the
shareholders who collectively own
the business. However, in Europe
and the US especially, the desire
to encourage entrepreneurship has
led to generous rules that reduce the
extent to which losses are borne by
business owners. Since 2008, many
business collapses have proved
expensive for customers, staff,
and suppliers, but less so for thebusiness owners, particularly when
the failing institution has been a
bank. Some financial commentators
wonder whether the balance has
swung too far away from tradition.Director involvement
When times are tough, directors
have to make difficult decisions
about investment and dividends.
Usually the directors will have an
agreed policy in place—perhaps
that half the after-tax profit will be
paid as dividends to shareholders,
while the other half will be retained
to invest in future growth. But
during recessions it is wise to keep
more cash within the business, so
directors may decide that dividends
should be cut. If the business also
cuts its investment plans, it can
keep more cash in its current
account, providing the liquidity to
survive difficult trading conditions.
So who is responsible when
things go wrong? This depends on
the systems of accountability and
governance within each company.
Ideally, the directors of the business
should be sufficiently involved to
know when things start to go wrong,
and call for discussion of a change
in strategy. If the directors are too
hands-off, they may feel unable
to hold the CEO fully accountable
when things do go wrong. Alert,INTRODUCTION
The bonus mania which
caused the recession could
never have happened without
corrupted accounting rules.
Nicholas Jones
UK film maker, ex-accountant118