Measuring Performance

B821 Financial Strategy Block 5 Strategic Implications
Unit 10
Measuring Performance: Internal and External Perspectives

Prepared by the Course Team
Masters
This publication forms part of an Open University course B821, Financial Strategy. Details of this and other Open University courses can be obtained from the Student Registration and Enquiry Service, The Open University, PO Box 625, Milton Keynes, MK7 6YG, United Kingdom: tel. +44 (0)1908 653231, email general-enquiries@open.ac.uk Alternatively, you may visit the Open University website at http://www.open.ac.uk where you can learn more about the wide range of courses and packs offered at all levels by The Open University. To purchase a selection of Open University course materials visit http://www.ouw.co.uk, or contact Open University Worldwide, Michael Young Building, Walton Hall, Milton Keynes MK7 6AA, United Kingdom for a brochure. tel. +44 (0)1908 858785; fax +44 (0)1908 858787; email ouwenq@open.ac.uk
The Open University Walton Hall, Milton Keynes MK7 6AA First published 1998. Second edition 1999. Third edition 2000. Fourth edition 2003. Fifth edition 2006. Reprinted 2007. Copyright # 1998, 1999, 2000, 2003, 2006, 2007 The Open University All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without written permission from the publisher or a licence from the Copyright Licensing Agency Ltd. Details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Ltd of 90 Tottenham Court Road, London W1T 4LP. Open University course materials may also be made available in electronic formats for use by students of the University. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to The Open University, or otherwise used by The Open University as permitted by applicable law. In using electronic course materials and their contents you agree that your use will be solely for the purposes of following an Open University course of study or otherwise as licensed by The Open University or its assigns. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of The Open University or in accordance with the Copyright, Designs and Patents Act 1988. Edited and designed by The Open University. Typeset in India by Alden Prepress Services, Chennai. Printed and bound in the United Kingdom by Hobbs the Printers Limited, Brunel Road, Totton, Hampshire, SO40 3WX. ISBN 0 7492 1325 6 5.3
CONTENTS
1 Introduction to Unit 10 2 Corporate governance 2.1 2.2 2.3 2.4 2.5 What is corporate governance? Anglo-American view on corporate governance Continental European (Franco-German) approach Japanese approach to corporate governance Summary 5
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3 Measuring corporate performance 3.1 3.2 3.3 3.4 Introduction Measuring performance External view of performance Summary
4 Performance and governance in other sectors 4.1 Introduction 4.2 Public sector: performance measurement,
accountability and governance 4.3 Organisational performance and governance in
voluntary organisations 4.4 Pension funds and other institutional investors 4.5 Summary 5 Summary and conclusions Learning outcomes Answers to exercises References Acknowledgements
1 INTRODUCTION TO UNIT 10
INTRODUCTION TO UNIT 10
In Blocks 1 and 2 (Units 1 to 3) you studied various tools and techniques to understand the financial performance of a company using financial statements. The focus of study in Block 3 (Units 4 to 6) was on the investment process: in particular, investment appraisal and valuation techniques for a particular project or for a company as whole were discussed. Block 4 (Units 7 to 9) discussed the issues relating to managing risk, with a focus on their financial implications. The aim of this unit is to complete the cycle of financial strategy by discussing the issue of control, with performance measurement and corporate governance as underlying themes. One of the organisational features of a public limited company (plc) is the separation of ownership and control. This introduces what is known as an agency problem: that is, a potential conflict of interest between owners and managers. Agency problems can be and are found in all types of organisation where the members or owners of the organisation delegate the responsibility and powers to oversee its operation. One example could be a public-sector organisation managed by civil servants; another could be a pension fund managed by trustees. In all cases the principal-agent framework is relevant since oversight is delegated. In a publicly traded company the shareholders delegate powers to the board of directors to supervise the performance of the senior management, including the chief executive officer (CEO) of the corporation. Following high-profile corporate failures, such as those of Enron, WorldCom and Parmalat, the issue of accountability has attracted a lot of attention in the management literature and in the wider socio-economic context of business. Addressing this issue from an external perspective, we shall discuss the role of the board of directors, executive remuneration, the market for corporate control and the role of individual and collective investors. An internal perspective examines trends in performance measurement and internal control mechanisms. Linking the external and internal perspectives via remuneration and other managerial incentives linked to performance measures, such as economic value added, is also discussed. A recent study by the International Federation of Accountants (IFAC) and the Chartered Institute of Management Accountants (CIMA) examined a range of issues of performance measurement and internal and external controls under the heading of enterprise governance, as shown in Figure 1.1. This enterprisegovernance framework is a useful way of understanding the issues of corporate control and performance measurement and their link with corporate governance.
In Section 2.3 of Unit 1, a brief introduction to finance and corporate governance was provided.
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UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES
BOX 1.1
A more focused definition of enterprise or corporate governance is given later in Section 2.
Enterprise governance is the set of responsibilities and practices exercised by the board and executive management with the goal of providing strategic direction, ensuring that objectives are achieved, ascertaining that risks are managed appropriately and verifying that the organisations resources are used responsibly.
Information and Systems Audit and Control Foundation, 2001 Quoted in International Federation of Accountants, 2003.
External view Corporate governance
Enterprise governance
Internal view Business governance
Accountability
Value creation
Figure 1.1
Enterprise governance: external and internal views. Source: Adapted from IFAC and CIMA, 2003.
The definition of enterprise governance given in Box 1.1 together with Figure 1.1 provides a view of the scope of control and, within that, the importance of the financial function. It brings together two dimensions of performance. On one side, management (headed generally by the CEO and the board of directors) has responsibility to ensure that the business is conducted efficiently and leads to value creation. On the other side is accountability, ensuring that what is reported externally to shareholders and others conforms to the standards and norms of good reporting practice. Both these dimensions of performance measurement are discussed in this unit in the context of corporate entities as well as other types of organisation such as public-sector and voluntary-sector organisations and pension-fund trusts.
OUTLINE OF THE UNIT

In Section 2 we shall examine the mechanisms of corporate governance. Corporate-governance structures vary across countries. Those differences could be because of differences in the form of organisation (public versus private), differences in corporate laws and differences among general economic systems, characterised by varying degrees in the role that market and state institutions play in the process of allocating resources. We provide a brief survey of market-based Anglo-American views on corporate governance and also on relationship-based Franco-German and Japanese concepts of corporate governance.
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Section 3 deals with issues of performance measurement from an internal and external control perspective in for-profit, privatesector companies. Economic-value-added, balanced-scorecard and value-based management approaches are recent trends in internal performance measurement. The primary issue in each case is accountability of management in both the external and internal context. Divisional performance measures using management accounting-based reports and financial-accounting reports should lead to similar conclusions about the performance of the company. Measurement tools such as economic value added (EVA1) have attempted to bring the economic view of value by adjusting financial-accounting reports and linking them with discounted-cash flow methods by bringing the cost of capital into play. The aim of these value-based performance measures is to align better the interests of managers with those of the shareholders and to reduce agency costs. In Section 3 we also discuss the role of non-executive directors/ audit committees, executive compensation, institutional investors and the market for corporate control as external control mechanisms to reduce agency costs and to achieve corporate objectives. In Section 4, performance measurement and accountability of public, voluntary and investment organisations are discussed. We shall consider the implications for control and corporate governance arising from different objectives of for-profit and not-for-profit organisations. Section 5 summarises the unit.
OBJECTIVES OF THE UNIT

You may recall that early on in Unit 1 we noted that finance is almost unique among management disciplines because it continuously pervades every level of an organisations activity. Our overall aim in this final unit of the course is to demonstrate to you, using the techniques that you have learned in the intervening units, how and why this claim is justified in practice. In particular, we aim to show you:
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the basic principles of financial control that are employed throughout the savings and investment process, from individuals assessing the performance of their investment in shares of a company against their long-term investment objectives, to the departmental managers judging their units performance against its operating budget; the main systems employed by providers of finance and by the markets in order to align the users behaviour with the providers investment objectives; the analogous procedures adopted by the controllers and trustees of public-sector and not-for-profit organisations
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to ensure that their managers achieve their financial objectives, in particular, by maximising value for money. When you have completed your study of this unit, you should be able to:
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assess the relevance and relative efficiency of different structures of corporate governance; describe how external investment managers and internal line managers assess the performance of different investments and operating units respectively; show how performance measures such as economic value added, cash-flow return on investment and discounted-cash flow analysis can be used both as external and as internal performance measures; apply the principles of value-for-money auditing in the context of the public sector; describe the financial objectives and performance measures used by institutional investors such as pension funds.
The FTSE 250 index includes the top 250 companies by market capitalisation listed in the London Stock Exchange.
Before you move on to Section 2, read the following excerpts from the corporate governance policy of Mitchells & Butlers plc, a leading managed public-house operator in the United Kingdom. It was listed on the London Stock Exchange in April 2003 and is a member of the FTSE 250.
BOX 1.2 GOVERNANCE POLICY AT MITCHELLS & BUTLERS PLC

Board structure and process
The Board is committed to the principles of corporate governance as set out in the Financial Services Authority (FSA) Combined Code. These principles include clearly defined operating procedures, the lines of responsibility, and the delegation of authority. The company has complied throughout the year ended 25 September 2004 with all the provisions of that Code. Board evaluation The Board engaged external consultants to assist with a Board effectiveness review during 2003/04. Topics included organisation of the Board, Committee organisation, the roles of Board members, Board composition and Board involvement and communication with shareholders. The review concluded that the Board functioned well and that the mix of skills and experience ensured that sound and balanced judgement was exercised in strategic assessment and decision taking.
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Remuneration and incentives for management The following policy has been applied throughout the year and will apply for the financial year 2005, thereafter the Remuneration Committee (the Committee) will recommend changes as appropriate. The Committee determines on behalf of the Board the remuneration packages of the Executive Directors, the other members of the Executive Committee and certain other senior executives. The Company operates performance-related policies designed to provide the appropriate balance between fixed remuneration and variable risk reward. Using target or projected value calculations, performance-related incentives for Executive Directors will equate to approximately 60% of total remuneration. Share and cash based incentives are designed so as to align the interests of executives with those of shareholders. Executive Directors are required to build and maintain significant shareholdings, equivalent in value to at least twice their basic salary, but three times salary for the Chief Executive. In accordance with the Companys normal policy, the Executive Directors have rolling contracts which are subject to 12 months notice. Non-Executive Directors do not have service contracts. We need to attract and keep the directors needed to run the company successfully. To do this we provide sufficient remuneration and incentives which are linked to company performance. We offer performance-related reward policies and a long-term incentive plan, based on Total Shareholder Return (TSR) and cash Return on Capital Employed (ROCE) targets to encourage continuing company improvement. To align the interests of the participants with those of the shareholders, the plan is based on share, rather than cash, benefits. Accounting and auditing The Board is responsible for presenting a balanced and understandable assessment of the companys position and prospects, and checks that all accounting standards have been followed. Risk management and internal controls We constantly monitor the risks faced by a modern, industryleading corporation such as Mitchells & Butlers. We do this through adhering to the Turnbull Guidance, while reports from the Director of Group Assurance ensure we review risk objectively by balancing risk, cost and opportunity. In turn, the Board regularly reviews the effectiveness of this system. Social/stakeholder issues [...] Our corporate reputation depends on us all acting in good conscience and behaving with integrity in our dealings with employees, shareholders, customers, suppliers and all other stakeholders. Guidelines for proper business conduct are provided, which have been agreed by the Board of Mitchells & Butlers plc
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and describe the standards of behaviour expected from those working for companies in the Mitchells & Butlers Group. Financial reporting transparency Mitchells & Butlers plc is committed to open disclosure and communication with shareholders. Combined Code compliance The Board is committed to compliance with the principles of corporate governance as set out in the Combined Code on Corporate Governance (the Code). The Board is responsible for the Groups system of internal control and risk management and for reviewing its effectiveness. [...] Business performance is managed closely and in particular, the Board and the Executive Committee monitor: strategic plan achievement, through a comprehensive series of strategic reviews; financial performance, within a comprehensive financial planning and accounting framework; capital investment and asset management performance, with detailed appraisal, authorisation and post-investment reviews; and risk management, through an ongoing process, which accords with the Turnbull guidance and provides assurance through reports from the Director of Group Assurance that the significant risks faced by the Group are being identified, evaluated and appropriately managed, having regard to the balance of risk, cost and opportunity. In addition, the Audit Committee receives: reports from the Director of Group Assurance on the work carried out under the annual internal audit plan; and reports from the external auditors. [...] The system of internal control is designed to manage, rather than eliminate, the risk of failure to achieve business objectives and it must be recognised that it can only provide reasonable and not absolute assurance against material misstatement or loss. In line with recent developments in good corporate governance and to comply with the Groups US obligations under the SarbanesOxley Act, the Group has developed a process to review the effectiveness of internal financial control based on the framework published by the Committee of Sponsoring Organisation of the Treadway Commission (the COSO framework).
Adapted from http://www.mbplc.com/index.asp?pageid=449
ACTIVITY 1.1
What mechanisms do you find in place in Mitchells & Butlers plc to reduce agency problems: that is, to align more closely the interests of managers and owners?
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The overall impression that the Governance policy of Mitchells & Butlers plc gives is that the management of the company has adopted various mechanisms to ensure the accountability of the board and senior management, who are responsible for monitoring the performance of all those working for the company. You may have noted some of the following (as well as other mechanisms not listed here) that this company has highlighted in its governance policy.
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Complying with different governance codes/laws such as the Combined Code, Turnbull Guidelines, SarbanesOxley Act. Putting in place procedures for monitoring of the performance of managers by the board of directors through internal control systems. Aligning the interests of the senior management and the board with those of shareholders by relating their rewards with shareholder returns and return on capital employed. Setting the standards for conduct of employees to ensure integrity and to consider wider stakeholder issues.
In the following sections we shall discuss various issues arising from the above in more detail. For example, performance measures and control are considered in Section 3. In the next section, however, we examine what is corporate governance and how its meaning and scope vary across countries.
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2 CORPORATE GOVERNANCE
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2.1
CORPORATE GOVERNANCE
WHAT IS CORPORATE
GOVERNANCE?
Corporate governance comprises the systems and structures through which a firm interacts with outsider holders of ownership claims. It includes the processes adopted and developed by boards of directors to exercise the rights delegated to them by outside claimants. Corporate governance can be said to set the organisational rules of the game for top managers and has a critical impact on organisations because it strongly influences the rules of the game for all stakeholders. A general analytical framework for understanding corporate governance to achieve economic efficiency within individual firms and the economy as a whole would encompass many mechanisms. Goergen et al. (2004) list the following mechanisms. 1 2 3 The market for corporate control (both a hostile takeover market and the market for partial control). Large shareholder and creditor (in particular) bank monitoring. Internal control mechanisms, such as the board of directors, various non-executive committees and the design of executive compensation contracts. External mechanisms, such as product-market competition, external auditors and the regulatory framework of the corporate-law regime and stock exchanges.
The market for corporate control is a market where blocks of shares can be traded and hence control transferred.
It can also be argued that dividend payout policy is an instrument of corporate governance. For example, Goergen et al. (2005) argue that a high payout policy pre-commits managers to generate sufficient cash flows and to pay them out to shareholders. However, finance theory, particularly Miller and Modigliani (1961), provides a strong caveat to such an argument. The Organisation for Economic Cooperation and Development (OECD), recognising the importance of corporate governance in ensuring financial stability in the economy, came up with a set of principles for corporate governance that provide useful benchmarks for the countries belonging to the OECD and for others who may refer to them for help in developing corporate-governance frameworks in their respective countries. Box 2.1 gives details of the basic OECD principles. There are also codes of governance specific to many countries: for example, the United Kingdom, the US, Germany, France and Japan. The United Kingdom has been at the forefront of the debate on
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corporate governance with several major reports published. The Cadbury report (1992) examined the financial aspects of corporate governance; the Greenbury report (1995) studied directors remuneration. Hampel (1998) reviewed various aspects of the recommendations on corporate governance that were made by the two earlier reports and came up with a revised code. In total eighteen reports, codes or guides on corporate governance were published in the United Kingdom between 1992 and 2005.
BOX 2.1 OECD PRINCIPLES OF CORPORATE GOVERNANCE

1 Ensuring the basis for an effective corporate governance framework
The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.
The rights of shareholders and key ownership functions
The corporate governance framework should protect and facilitate the exercise of shareholders rights. These rights include 1) secure methods of ownership registration; 2) convey or transfer shares; 3) obtain relevant and material information on the corporation on a timely and regular basis; 4) participate and vote in general shareholder meetings; 5) elect and remove members of the board; and 6) share in the profits of the corporation.
The equitable treatment of shareholders
The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
The role of stakeholders in corporate governance
The corporate governance framework should recognise the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
Disclosure and transparency
The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, remuneration policy for members of the board and key executives, information about board members, and governance of the company.
Adapted from OECD (2004) Principles of Corporate Governance, p. 1725.
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The principles set out in Box 2.1 are quite comprehensive, covering a wide range of issues for publicly traded companies. An effective corporate-governance framework considering these principles as benchmarks will have mechanisms focused around the relationship between the shareholders and the board of directors and managers, which will be closer to the Anglo-American approach discussed in Section 2.2.
EXERCISE 2.1
What general macro-economic and other factors would influence the nature of corporate-governance mechanisms in a particular country?
Despite the OECDs code on corporate governance, wide differences prevail even among its member countries. In the UK and the US, for example, corporate-governance mechanisms emphasise the relationship between shareholder and management. On the other hand, in countries such as France, Germany and the Netherlands the corporate-governance mechanisms take a stakeholders approach to governance, aiming to balance the interests of owners, managers, major creditors such as banks, and employees. Specific corporate-governance mechanisms found in Anglo-American countries, continental Europe and Japan are discussed later. Here we examine the broader differences in the way corporations are financed and the role of capital markets and banks in five developed countries: the UK, the US, Germany, France and Japan. Figure 2.1 overleaf shows the market capitalisation of these countries expressed over GDP relative to US figures. The UK and US economies have traditionally been dominated by corporate business entities that are mostly listed on the stock markets and have active capital markets with both individual and institutional investors actively involved. The French and German financial systems have been dominated by the banks, which have been the major source of finance for the companies in these countries. Traditionally companies in the UK and the US have raised capital through equity and debt markets. Figure 2.2 overleaf shows the relative importance of the banks and other sources of finance for Germany, Japan and the US. These broad differences in the way the economic resources are mobilised and allocated have a significant impact on governance structures at the company level. To illustrate this, imagine a communist society with no public limited companies, no capital markets and no private-property rights. In such a situation the corporate-governance mechanism, as discussed here, makes little or no sense. At the other extreme, in a free-market economy, where funds are cycled through market institutions, the situation will lead to the evolution of the variety of corporate-governance
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2.0
1.6 UK 1.2 US 0.8 Japan
0.4
France Germany
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Figure 2.1
Equity market capitalisation over

GDP relative to US figures (Hackethal et al., 2005)
80% 75% 74% Germany Japan US
60%
40% 29%
37%
20% 15% 14% 9% 9% 8% 9% 2% 0% Bank loans NBFI loans Bonds
19%
Equity
Figure 2.2 Breakdown of external long-term financing gross flows, average 19952000 (Hackethal and Schmidt, 2004)
mechanisms covered in this unit. It is rather difficult, therefore, to generalise and argue what is the best corporate-governance mechanism, since the suitability of a particular governance structure depends on the ownership patterns in the economy, on the development of financial markets, on the presence of regulatory institutions and on the legacy from the economicdevelopment models previously adopted. For example, in the case of the transition economies of Eastern Europe, it may not be effective to simply adopt Anglo-American corporate-governance mechanisms when these economies are yet to see the development of efficient financial markets, an investing culture among individuals and the development of collective investment institutions. Corporate-governance mechanisms are, therefore, to be viewed as an important constituent of the general business,
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economic and regulatory environment rather than in isolation. We should also note here that the general business, economic and regulatory environment is not static: it keeps changing and, in the case of major change, the corporate-governance mechanism will also change. Having placed the corporate governance in a proper perspective, we shall now look at corporate governance in a more focused way from the Anglo-American, Franco-German and Japanese angles.
ACTIVITY 2.1
Go to the European Corporate Governance Institutes website and find out the codes of governance for different countries. The site lists 178 corporate governance codes, principles and recommendations on the database. Compare the codes of the United Kingdom and US with those of Germany and France, as well as with that of a developing country such as Malaysia. What differences do you find in the codes?
The link to the European Corporate Governance Institutes website is provided on the B821 courses website.
2.2
ANGLO-AMERICAN VIEW ON CORPORATE GOVERNANCE
There have been many different meanings attached to the term corporate governance, including the notion that corporate governance is about the regulation of corporations in the interests of society. The Anglo-American view is that corporate governance should be understood specifically in the light of the corporate objectives set by the owners of the corporation. The shareholders are the primary stakeholders to whom the corporation should be accountable and, as a result, the internal performance measurement and control, as well as the external measures of accountability, should be geared towards the achievement of corporate objectives. Throughout the discussion here we take the definition of corporate governance as ways of ensuring that corporate actions, agents, assets are directed at achieving the corporate objectives established by the corporations shareholders (Sternberg, 2004). A key issue in the Anglo-American framework of corporate governance is the separation of ownership and control and its consequences for shareholders. The issue was pointed out by Berle and Means (1932), but Adam Smith also alluded to this possibility in 1776 in his pioneering work on economics, An Enquiry into the Nature and Causes of the Wealth of Nations. Jensen and Meckling (1976) articulated the issue more precisely in a financial context in their work which views the firm as a nexus of contracts and argued that separation of ownership from control means managers may not always try to maximise shareholder value, as text books assume, but might concentrate instead on acquiring luxuries (such as the executive jet) or power
In this unit, for-profit corporation is used to mean public limited company. There are other forms of organisations, such as proprietorship, partnerships and private limited companies, that pursue the profit motive. The words company and corporation are used interchangeably.
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You first met agency theory in Unit 1.
through size. This phenomenon is now largely explained within what is called the principal-agent framework, or agency-theory framework. Corporate-governance mechanisms are needed to reduce the cost to owners of this separation of management from ownership. The Anglo-American form of economic organisation views capital providers (shareholders and lenders) as primary stakeholders in business. Internal control mechanisms and external measures such as financial reporting, the market for corporate control, auditing, the role of non executive directors are expected to ensure that the market value of the firm is maximised. Contracts are drawn up to motivate managers to achieve this objective. These incentive contracts may include stock options, bonuses linked to profit or return targets and other retirement benefits and are essentially to drive the financial performance of the firm towards a higher market value. Anglo-American corporate governance is characterised by publicly traded shares, the importance of the chief executive officer, a close relationship between the chief executive officer and the board, an active market for mergers and acquisitions, and close scrutiny of the financial performance of companies by supervisory agencies such as stock exchanges, financial-services regulators, credit-rating agencies and investors associations. Some of these features have been contrasted with the governance mechanisms found in France and Germany and are discussed in the next section, Section 2.3.
2.3
CONTINENTAL EUROPEAN (FRANCO-GERMAN) APPROACH
The Franco-German approach to corporate governance views a firm as a collective entity that has responsibilities and duties towards key stakeholders, with shareholders perceived to be only one of such stakeholders. Rebrioux captures the difference between the Anglo-American and continental European views neatly:
... the continental European situation is quite different. Equity holders are usually in a weaker position, reflecting insider control. Different mechanisms are used in order to protect the controlling group (managers, workers and banks) from external control: crossshare holdings, pacts between stockholders, deviation from the one-share-one-vote rule. The nature of power is harder to grasp than in the [Anglo-American] case, for authority is usually more diffused (especially in Germany). If shareholders do have power, it is not only by the virtue of their legal status (as owners).
(Rebrioux, 2002, p. 115)
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For example, corporate laws in Germany give management the power to manage the company in the interests of the wider stakeholders, rather than in the interest of only the shareholders (Schmidt, 2004). Hackethal and Schmidt characterise the traditional German corporate-governance system as given in Table 2.1. Table 2.1 Some features of the German approach to corporate governance
Control versus Liquidity Concentration of share ownership Representatives of block holders on supervisory boards Limited protection for minority shareholders Creditor-oriented insolvency law Reorganisation capability of banks and liquidity insurance Universal banking and participation in debtor firms Proxy voting and supervisory board mandates Firm-specific human capital Strong dismissal protection, imperfect external job markets Work councils and representation on supervisory boards Low powered compensation schemes Conservative, creditor-oriented accounting rules Lax disclosure requirements even for listed corporations No laws prohibiting insider trading*
Relationship lending versus Arms-length lending
Internal labour markets versus External labour markets
Internalisation of information versus Externalisation
Source: Hackethal et al., 2005, p. 399. *Insider trading is now illegal in Germany.
ACTIVITY 2.2
Consider the various aspects of the corporate governance listed in Table 2.1. How would you characterise the organisation for which you work, given these aspects of corporate governance? (If you work for a public-sector or notfor-profit organisation, some of the features may not be relevant to your organisation.)
The major difference between the corporate-governance systems in the United Kingdom and the US as contrasted with continental European countries such as France, Germany and the Netherlands is that Anglo-American companies operate in relatively more liquid capital markets dominated by collective or institutional investors. The market for corporate control is also more active in the United Kingdom and the US (see, for example, the number of hostile
takeover bids in Table 2.2). The market for corporate control in Germany, however, is changing. In 2002, capital gains realised from the sale of cross-shareholdings by industrial groups and banks were made tax free in Germany. This, in theory, should make mergers and acquisition attractive for the investors. The announcement of this change had a positive impact on the valuation of many German companies (Edwards et al., 2004). It shows companies with the largest blocks of cross-shareholding earned more returns, which is understandable as they were more likely to gain from the repealing of capital gains tax. Table 2.2 Some differences between Anglo-American and Franco-German corporate governance
Market for corporate control and executive turnover (various years) Average annual real returns (%) on domestic security portfolios (19602000) Stocks Bonds 50:50
Hostile takeover bids*

Germany France UK USA 5 20 220 431
Block trades{
10 10 9 7
Executive turnover{
12 11 9 n.a.
5.1 5.2 5.5 5.9
4.1 3 2.9 2.4
4.6 4.1 4.2 4.2
Source: Adapted from Hackethal et al. (2005). *Number of takeover bids 198998. { Block trades and executive turnover dates: 198994 for Germany, 198991 for France, 198994 for the United Kingdom, and 198089 for the USA.
The performance of the chief executive officer and board of directors is measured in terms of the creation of shareholder value. As a result, remuneration contracts for managers tend to include incentives linked to profitability and targets for shareholders returns. Table 2.3 shows differences in remuneration structures for companies in a number of OECD countries. More than 60% of the remuneration of chief executive officers in the US is variable, compared with less than 40% in other countries (Table 2.3). This can be explained by the greater influence that American chief executive officers have relative to their boards of directors than their counterparts in Germany, France and the Netherlands.
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Table 2.3 2001 02
Components of CEOs pay as a percentage of total remuneration,

Total remuneration of CEO $ Basic compensation %
46 46 47 43 47 51 46 43 28
Variable pay %
24 26 36 33 36 36 25 30 61
Benefits %
28 21 12 20 13 10 27 21 6
Perquisites %
2 7 5 4 4 3 2 6 5
Belgium France Germany Italy Netherlands Spain Sweden UK USA

Source: Goergen et al. (2004).
696 697 519 060 454 979 600 319 600 854 429 725 413 860 668 526 1932 580
The Anglo-American corporate-governance system is classified as an outsider model and Franco-German systems are classified as an insider model. The term outsider here refers to the senior management of the company, generally headed by the chief executive officer who may also be the chairman and may have an important say in the board of directors. In the insider model with two-tier boards, one management and one supervisory, the chief executive officer will have to balance the interests of wider stakeholders such as employees and the large block holders of shares, typically banks, against those of other shareholders. There are significant differences among the insider approaches of continental European countries. For example, in the Netherlands there are two-tier boards as in Germany, but unlike Germany, where the members of the supervisory board are elected by shareholders at annual general meetings and exert substantial independent influence on management, the members of the supervisory board of Dutch public limited companies are appointed for four-year terms by co-option: that is, by the incumbent members of the supervisory board. This closer relationship between management and supervisory boards makes the Dutch two-tier system somewhat similar to the US system (Chirinko et al., 2004). The Dutch system is also remarkably different in shareholderprotection practices. Although shareholders can exercise control at annual general meetings and large investors can sit on supervisory boards, management can have discretionary powers to issue preference shares at any time, effectively diluting the voting power of ordinary shareholders.
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2.3.1 Are European governance systems converging towards an Anglo-American approach ?

There has been some discussion that insider corporate-control systems of continental European companies are changing towards Anglo-American externally controlled systems. Heckethal et al. (2005) argue, however, that although there have been some changes in German corporate laws, giving more rights to shareholders, and that there have been changes in the role of big banks, the traditional German system of corporate governance remains in place. In France, corporate governance has changed significantly towards the Anglo-American approach. Much of the change in France is driven by the changing nature of the ownership patterns of French companies. In 1985, only 10% of French equity was held by non residents; this rose to 36% by 2000. Most of these non-residents are Anglo-American institutional investors who are driving changes in corporate governance at the firm level (Rebrioux, 2002). According to one argument, the Anglo-American institutional investors find French companies attractive investment options compared with German companies because of the differences in the distribution of power among insiders. Rberioux argues that:
... power in France is traditionally exercised at the top (with the central figure of the President Dircteur General: P-DG), whereas Germany is characterised by a more diffuse control, formally shared amongst managers, banks, and workers, all of whom are considered as active insiders.
(Rebrioux, 2002, p. 125)
In both Germany and France, workers interests are formally represented in the board structures. However, in France, workers involvement is limited to information and consultation as opposed to German co-determination. Rebrioux argues that:
Economic Value Added (EVA) and Market Value Added (MVA) are discussed in Section 3.2.1 of this unit.
... shareholder value is therefore easier (or less costly) to impose in France than in Germany... . It seems easier for external investors to impose new business practices such as Economic Value Added (EVA) or Market Value Added (MVA) in French firms. In short, the rule might be convince the P-DG and the rest will follow.
(Rebrioux, 2002, p. 125)
This explains the increasing importance of performance-based incentive contracts in many French companies. A study in 2000 by LExpansion showed that France was ahead of all other European countries (including the United Kingdom) in using stock options to motivate managers. Goyer (2003) notes three major changes that are literally turning the French corporate governance from inside to out. 1 The changing pattern of ownership structure from concentrated to wider share ownership, with an increasing share of foreign institutional investors. The deliberate strategy of many firms has
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been to sell their cross-shareholdings in order to become attractive for foreign shareholders. 2 The dismantling of the conglomerate structure by many firms to focus on core competencies. This has caused a significant shift in employment relations with the removal of the employment protection offered by the internal labour markets of conglomerates and the cross-subsidisation of poorly performing units by fast growing counterparts. The adoption of performance-based remuneration schemes.
In sum, it can be noted that while significant changes in French corporate-governance mechanisms are underway, the German and the Dutch approaches to corporate governance remain quite distinct in their focus on the stakeholder-based insider control structures and are thereby different from the Anglo-American corporate-governance mechanisms. We shall now take a look at the Japanese governance system before addressing performance measurement in Section 3.
2.4
JAPANESE APPROACH TO CORPORATE GOVERNANCE
A tight network of supplier and buyer companies (keiretsu) is the main characteristic of the Japanese industrial structure. This feature of the Japanese economy has implications for the way corporategovernance mechanisms operate in Japan. Keiretsu are known for their extensive cross-shareholding among members and their main banks. The concept of main bank has many definitions that essentially describe long-term and stable relationships among firms and the banks that finance them. These ties typically include equity as well as debt relations. Firms that maintain close equity and personnel ties with other clients of the same main bank are often called group affiliated or keiretsu members. The groups are described as bank centred or horizontal. Firms with looser bank ties and cross-shareholding arrangements are described as unaffiliated or independent. Gerlach (1992) reports that 7075% of shares owned in Japan belong to the category of affiliated stable investor, defined as long-term keiretsu-affiliated holders of shares. The purpose of the investment by keiretsu members is not simply to earn return on their investments. Keiretsu members are generally business partners of the companies in which they invest, and cross-holdings are expressions of business goodwill, information exchange, and mutual monitoring, so they provide the foundation for long-term open-ended business relations (Clark, 1979). As a result of such ownership structures, boards of directors of many Japanese companies have not given much attention to the interests of non-keiretsu shareholders (Yoshikawa and Phan, 2001). The situation has started to change since the 1990s as Japanese firms have become exposed to expectations from the owners of
foreign multinationals who acquired large shares in equity of Japanese firms such as Mazda, Nissan and Mitsubishi Motors. There has been a demand for increased disclosure and transparency by foreign investors. The corporate-governance systems in Japan seem to be changing because of similar pressures from foreign investors as experienced in France. In addition, increasing competition in the industries where Japanese firms had traditionally built competitive advantage, such as increased competition from Taiwanese and Koreans firms in consumer electronics, from German and American firms in automobiles, from American and European firms in chemicals, has affected the performance of Japanese companies.
2.4.1 The changing face of corporate governance in Japan

Increasing competition, poor industrial performance in the 1990s, and the globalisation of capital markets have set the stage for reforms in corporate-governance systems in Japan. The 1990s crisis experienced by Japanese banks, which played an important role in corporate governance in the country, has further expedited corporate-governance reform in the country. Japan was the first nation to adopt the OECD principles of corporate governance, which were promulgated in March 2000. It is not easy to generalise about Japanese corporate-governance systems, as there are two quite different types of company that became successful after the Second World War. A large number of companies are characterised by the relationship among keiretsu members and their main bank. There are, however, many independent companies with little affiliation to the major corporate groups. In a comparative analysis of the performance of the two types of firm and their corporate-governance systems, Yoshikawa and Phan argue that:
... monitoring by the main bank and keiretsu firms did not always result in enhanced profitability or good performance. In fact, because they were more sensitive to other stakeholders, monitoring by these institutions resulted in lower asset efficiencies, but higher security for stakeholders.
(Yoshikawa and Phan, 2001, p. 201)
Sony is an example of an independent firm that was exposed, from inception in 1946, to international capital markets. Sonys financing pattern and ownership structure have been quite different from those of other Japanese companies. In 1998, foreign investors owned 43.6% of the companys shares compared with 20.3% of Matsushitas, 11.8% of Sharps and 6.1% of Sanyo Electrics, all of which are Sonys competitors. Another feature of Sonys shareholding pattern is that a relatively small percentage of its shares is controlled by stable shareholders and cross-shareholding with supplier firms. With increasing competition and the poor performance of large of number of Japanese companies, the effectiveness of the main bank and keiretsu dominated
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corporate-governance systems of Japan is being debated. There is pressure on companies to improve efficiency and shareholders returns. Indeed, an increasing number of Japanese firms are adopting one or more measures of performance geared towards maximising the wealth of shareholders and thus moving towards Anglo-American corporate-governance systems. As examples, look at the corporate-governance statements of Sony and Mitsubishi Electric given in Boxes 2.2 and 2.3.
BOX 2.2 CORPORATE GOVERNANCE AT SONY

Sony follows the Company with Committees corporate governance system under the Japanese Commercial Code, under which the Board of Directors maintains an important oversight role separate from the executive function and delegates broad authority to the Corporate Executive Officers to run the companys affairs. This separation of functions allows for sound and transparent management as well as swift dynamic decision making in a rapidly changing environment.
Governance structure
As statutory decision-making bodies, Sony has established the Board of Directors, three Board committees (the Nominating Committee, Audit Committee and Compensation Committee) and the Corporate Executive Officers.
Sony initiatives
Sony has added several provisions to its Regulations of the Board of Directors to ensure the separation of the Board of Directors from the execution of business activities, and to advance the proper functioning of the statutory committees. The main provisions are as follows:
l
Separating the roles of the Board chairman/vice chairman and Representative Corporate Executive Officers Limiting the number of terms outside Directors may serve and rotating committee membership Appointing chairmen of statutory committees from the ranks of outside Directors Instituting qualifications for director candidates aimed at eliminating conflicts of interest and ensuring independence Raising the minimum number of Nominating Committee members (five or more), prohibiting the appointment of the CEO or COO of Sony Group (or person at any equivalent position) to the Compensation Committee, and discouraging the concurrent appointment of Audit Committee members to other committees
Adapted from http://www.sony.net/SonyInfo/IR/governance.html
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BOX 2.3 CORPORATE GOVERNANCE AT MITSUBISHI ELECTRIC
Increased flexibility and transparency the management, Increased flexibility and transparency ofof the management, reinforced super visorfunction y function over the management reinforced supervisory over the management
General ShareholdersMeeting Meeting General Shareholders Execution Reporting to Executive ExecutiveOfficers Officers President and and CEO CEO President Executive Executive Officers Officers Each business and management division Appointment/dismissal/supervision Business execution Authorisation transfer Directors Directors Reporting to Appointment Reporting to Supervision
Board Board of of Directors Directors Chairperson Chairperson Auditing Committee Committee Auditing Nomination Committee Committee Nomination Compensation Compensation Committee Committee
More than 50% of members composing each of the three committees shall be outside directors Actual Actualpractices practicesat atMitsubishi MitsubishiElectric Electric
Thorough Thoroughimplementation implementationof ofseparation separationof ofthe theexecutive executivefunction functionfrom fromthe thesupervisory super visory function function(separation (separationof ofthe theCEO CEOand andChairperson). Chairperson). Minimal Minimalnumber numberof ofdirectors directorssimultaneously simultaneouslyassume assumeresponsibility responsibilityas asan anexecutive executive officer officerbased basedon onfunctional functionaljustification justification(four (fourmembers): members):majority majorityof ofthe theBoard Boardof ofDirectors Directors shall shallnot notassume assumeresponsibility responsibilityas asExecutive ExecutiveOfficer. Officer Minimal Minimalnumber numberof ofselected selectedofficers officers(20 (20members) members)to tobe beresponsible responsiblefor forday-to-day day-to-dayoperation operation of ofeach eachbusiness businessdivision divisionand andof ofcorporate corporateadministrative administrativesections. sections. Multi-phase Multi-phasemanagement managementof ofcontingencies contingenciesutilising utilisingthe themeeting meetingof ofExecutive ExecutiveOfficers. Officers. Enhance Enhanceinternal internalcontrol controlsystems systems(expand (expandCorporate CorporateInformation InformationCommittee, Committee, reinforce reinforceinternal internalaudit auditfunctions, functions,etc.). etc.). Conduct Conduct studies studies on on the the framework framework and and systems systems to to further further improve improve corporate corporate value value in in response response to to external external changes, changes, such such as as legislative legislative changes changes of of the the Commercial Commercial Code. Code.
Source: http://global.mitsubishielectric.com/investors/publication/ strategy200505.html
Although these two examples are not exclusive, there does seem to be a trend in Japanese companies towards reorganising their ownership structures to bring them more in line with AngloAmerican patterns. Figure 2.3 shows the recent activity levels of foreigners buying equities and bonds quoted on Japanese financial markets. Apart from in 2002, net purchases of Japanese equities by foreign investors have been positive since the early 1990s. This has significantly changed the overall structure of share ownership in Japan. Foreign ownership of shares had increased from less than 1% in 1992 to more than 20% by 2004, with the ownership by Japanese financial institutions and banks together down from nearly 58% to 39%. The drop in share ownership by business corporations from 29% to 22% during the same period would suggest that
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Japanese companies had also reduced the level of cross shareholdings (this might be an indirect indicator of the decline in importance of the keiretsu system).
Stocks 12 10 8 6 ( trils.) 4 2
Bonds
2 4 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Figure 2.3 Foreign investment in Japanese securities 19952004 Source: Fact Book 2005, Tokyo Stock Exchange, p. 68.
In line with the Anglo-American approach, some Japanese companies have introduced a CEO-type post called executive officer and have reduced the typical number of directors from over thirty to around ten, have included more outside directors and have also separated the board of directors from management committees. According to a Nihon Keizai Shimbun survey in June 2001, 35.7% of the companies surveyed had introduced an executive-officer system and 14% were studying its introduction. A Nomura Research Institute survey of management decision making in Japanese companies conducted in August 2001 showed that 32.7% of the companies responding to the survey had introduced an executiveofficer system by 2001, up from 13% of responding companies in the year 1998. As well as the organisational structure, changes have been made to corporate-performance benchmarks with increasing use of indices such as economic value added, return on investment and shareholders returns. It would be fair to conclude here that Japanese governance mechanisms are gradually shifting towards the Anglo-American approach. There are, however, many challenges and barriers, given the complexity of ownership structure and the roles of financial institutions and banks in Japanese companies (Komiyama and Masaoka, 2002; Jackson, 2002).
2.5
SUMMARY
In this section we have explained the concept of corporate governance and how in practice it translates into a variety of internal and external mechanisms. A generic definition of corporate governance (Sternberg, 2004) was given that essentially suggests
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that corporate governance must ensure that the managers and boards of directors responsible for the achievement of corporate objectives should be ultimately accountable to the owners of firms. Looked at in this way, the relationship between a firms management and owners can be examined in a principal-agent framework. The primary objective of having corporate governance can be viewed as a means of reducing agency costs for the principals. We have provided a survey of three different approaches to corporate governance: Anglo-American, Franco-German and Japanese. The Anglo-American approach to corporate governance emphasises shareholder value as the yardstick around which the performance of management should be evaluated. We contrasted this stockholder (outsider) perspective on corporate governance with the stakeholder (insider) perspective found in the continental European countries. We noted that there are also significant differences in the corporate-governance mechanism within continental Europe, as illustrated by difference in the rights of employees in French companies (with advisory/consultative rights) and those of German companies (with co-determination). We also found that despite apparent similarities with German corporategovernance mechanisms, Dutch companies are in some respects closer to the Anglo-American approach: for example, in the close relationship between the chief executive officer and the board. It was argued that with increasing global competition and an increasing share of foreign ownership of Japanese companies, the Japanese corporate-governance system is experiencing a shift towards the Anglo-American approach. Having examined accountability and performance in a broader context, we shall now look at the performance-measurement systems within firms and examine how firms have tried to interpret the corporate-governance expectation of aligning the interests of shareholders with those of management.
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3 MEASURING CORPORATE PERFORMANCE
3
3.1
MEASURING CORPORATE PERFORMANCE
INTRODUCTION
Measurement of corporate performance cannot be discussed without reflecting on corporate objectives. In Unit 1 and throughout this course we have argued that finance theory implies that maximising the wealth of shareholders, as measured by share-price maximisation, is the goal for a corporation. In terms of management-performance targets, however, accounting-based measures such as earnings and return on equity are often used as benchmarks. How much attention is paid in practice to share-price maximisation as a goal depends on the general business environment and on the approach taken by society towards corporate entities. We have already noted that in continental European countries with a stakeholder view of corporate governance, managers try to balance the interests of the shareholders with those of other stakeholders. For example, a study carried out on Swiss companies found that most managers pursue conflicting targets (Jrg et al., 2003). Many managers declared that this did not maximise shareholder value. The study of 332 companies (75 listed on the stock exchange and 257 unlisted) revealed some interesting findings. The listed companies included some large Swiss companies such Nestl, Credit Suisse, Novartis and UBS. Table 3.1 reports the frequency with which managers claimed to pursue a given target. Numbers in parentheses refer to the number of firms willing to state an opinion. For instance, 94.1% of the firms listed on the stock exchange that responded said they pursued maximisation of customer satisfaction as a target. Table 3.1 What Swiss managers think about corporate objectives
All firms Listed firms
94.1% (68) 87.7% (65)
Answers provided by CFOs, treasurers and controllers

96.2% (210) 80.9% (209)
Maximisation of customer satisfaction Maximisation of stakeholder (shareholders, employees, customers, environment, etc.) value
95.9% (295) 80.6% (294)
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Maintaining independence Maximisation of shareholder value without expropriating other stakeholders Maximisation of market share
Source: Jrg et al. (2003, p.32). Note: The sample was taken in 1998.
78.7% (291) 57.0% (284) 55.5% (281)
79.7% (64) 75.0% (64) 48.4% (64)
75.7% (206) 58.9% (197) 56.1% (65)
One of the main reasons for the above findings could be that the corporate landscape in Switzerland has a similar pattern to that found in Germany and, as we noted in Section 2, the German corporate framework differs in this important focus on other stakeholders from the Anglo-American corporate framework, which focuses on maximisation of shareholders wealth. Compare the following two statements of corporate goals from Nestl, a Swissbased company, and Boots, a United Kingdom-based company.
BOX 3.1 CORPORATE OBJECTIVES

Nestl
Nestls business objective is to manufacture and market the Companys products in such a way as to create value that can be sustained over the long term for shareholders, employees, consumers, and business partners. Nestl does not favour short-term profit at the expense of successful long-term business development.
Boots
Our goal is to make Boots a more modern, competitive and efficient retail business, in order to deliver value to our shareholders.
Sources: http://www.nestle.com/All_About/Business_Principles/ Business+Principles.htm http://www.bootsir.com/boots/companyinfo/ourgoal/
ACTIVITY 3.1
If the corporate objectives are specified in terms of maximising the share price, what are the implications in terms of managerial decision making?
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Within the value-maximisation paradigm there is debate about which value to maximise. For example, Jensen argues that the total value of a firm should be maximised and points out that the total value of a firm is the sum of the values of all financial claims on the firm, including equity, debt, preferred stock and warrants. This takes stakeholders other than shareholders into account, but is expressed in terms of a single, simple objective: managers should, make all decisions so as to increase the total long-run market value of the firm (Jensen, 2001, p. 299). This contrasts with the multiple objectives implied by stakeholder theory, which proposes that the managers should, make decisions so as to take account of the interest of all the stakeholders in a firm (Jensen, 2001, p. 299). Freeman (1984, p. 53) defines stakeholder as, any group of individuals who can affect or is affected by the achievement of an organisations purpose. This definition clearly includes groups such as employees, suppliers, government officials, communities so on, who may not have maximisation of a firms value as their primary objective.
ACTIVITY 3.2
Read the article by Will Hutton on Stakeholder capitalism, and The Economist article The state of denial were in both in the Course Reader. Note the preference by Will Hutton for the Franco-German approach and the argument by The Economist, ten years later, that the Anglo-American model was the more successful model to follow.
3.2
MEASURING PERFORMANCE
Managers espousing stakeholder theory may find it useful to pursue some of those objectives catering to needs of one or more of the non-shareholder groups at the cost of shareholders who are the residual claimants of the business rewards. Jensen argues that:
... it is logically impossible to maximise in more than one dimension at the same time unless the dimensions are monotone transformations of one another. Thus, telling a manager to maximise current profits, market share, future growth in profits, and anything else one pleases will leave the manager with no way to make a reasoned decision. In effect, it leaves managers
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with no objective. There is evidence that pursuing multiple corporate objectives leads to confusion in the minds of managers and adversely affects the chances of surviving in competitive markets.
(Jensen, 2001, p. 301)
Cools and van Praag (2003) examine multiple-target specifications versus single-target specifications in Dutch companies. They investigate two questions. First, what is the relationship between value creation and the multiplicity or singularity of corporate targets communicated in the annual reports? Secondly, they explore the use of single or multiple targets in internal performance measures and their relationship with value creation. Value creation in this study was defined as total shareholder return (TSR): yearly dividends plus capital gains relative to the share price at the beginning of the year. Their analysis of the relationship between the number of targets externally communicated through annual company reports and value creation shows a consistent and significant positive correlation between value creation and the external communication of one quantified target. At the same time, they report negative relationship between the disclosed number of quantified targets and value creation. They dig deeper into this issue by analysing the relationship between the internal use of a single target and value creation. The survey of the chief financial officers (CFOs) of the same eighty largest Dutch companies that were analysed for the first question shows that there was a significant positive association between the internal use of a single target and value creation. The paper also reports that:
69% of all the companies that disclosed quantified corporate targets use exactly the same targets internally and 21% of the companies have translated one of their externally communicated targets into an internally operational measure (either a return on equity target has been translated into a return on capital employed figure, or a net profit target has been translated into an internal EBIT figure).
(Cools and van Praag, 2003, p. 16)
EBIT stands for earnings before interest and taxes.
Although these findings are based on a small sample of Dutch companies, they provide interesting evidence on the likely impact on a firms value as a result of using single versus multiple corporate objectives. We end this subsection with what may sound like a clich, but it makes the point: what gets measured gets managed. Before we move to the discussion of value-based measures of performance and scorecards, try Activity 3.3.
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ACTIVITY 3.3
Consider the managerial incentive contracts in your organisation. Do you find that there is an association between the corporate objectives communicated by your organisation through annual reports and the targets set internally for performance appraisal and incentive schemes? Do you think that a multiplicity of objectives, either in your own organisation or in an organisation you are familiar with, leads to inefficiency in managerial performance?
3.2.1 Economic value added

In this subsection we shall look at how performance measures have been introduced into organisations, within both external and internal accounting processes, in an attempt to ensure appropriate behaviour on behalf of management. Accounting-based measures of performance such as return on equity (ROE) and growth in earnings per share (EPS) lead to the possibility of getting distortion through the choice of accounting policies adopted by the management, which may influence the reported ROE and EPS figures to the advantage of managers without adding much value to the shareholders wealth. Also, divisional performance measures such as target-based accounting measures of cost or revenue may not result in managerial behaviour that is consistent with maximising shareholders wealth. Two key characteristics of the new generation of performance measures are that they are related to shareholder value rather than to accounting numbers and that they look at returns after allowing for the returns expected by investors rather than before. In order to do this, they are based on the concept of economic income rather than accounting profit, where economic income can be defined as income generated by the company net of investors required returns on capital invested. Accountants became interested in the concept of economic, as opposed to accounting, income as far back as the 1930s (Preinreich, 1938). Accounting earnings can be shown to be related to cash flow and hence to economic income in a straightforward manner (Ohlson, 1989 and 1995; OHanlon and Peasnell, 1998) provided one assumes profits are determined according to what is known as the comprehensive-income basis or clean-surplus basis. To conform to this basis, profits must include all changes in book value during the period (transactions with owners, such as dividend payments, excepted). If this is the case, we can write
Economic income is also known as residual income.
NOPATt = Ct + ( At At 1 )
(1)
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where NOPATt = net operating profit after tax for period t;
Ct = cash paid to owners (net of contributions by owners) for period t, where owners are deemed to be all providers of long-term capital (that is, shareholders and lenders);
At = accounting book-value of assets at time t. Economic income, also known as residual income, is accounting profit adjusted for a charge on capital and can be written as
Et = NOPATt WACC At 1
where
(2)
Et = economic income
WACC = weighted average cost of capital, assumed to be
constant over time.
We know from Unit 6 that the value of an entity such as a firm is the present value of the cash flows to the providers of capital.
Vt =
(1 + WACC)
n =1
Ct +
n
(3)
where
Vt = value of company at time t.

Using Equations (1) and (2) and substituting for Ct + n in Equation (3) we get
Vt =
Et + n + (1 + WACC)At + n1 At + n (1 + WACC) n n =1
(4)
= At +
(1 + WACC)
n=1
Et +n
(5)
Equation (5) states that the value of a firm is its book value (debt and equity capital) plus the present value of future economic or residual income, the discount factor being the WACC. From this, it is clear that if, in any one year, economic income is negative, the value of the firm will be reduced hence the expression destroying value. If economic income is positive, the management can be said to have added value. The attraction of Equation (5) is that it allows the value of a company to be expressed as the present value of future income, but instead of cash flows, it uses two accounting measures, book value and NOPAT. Provided accounting policy puts all changes in book value through the income statement, this formula will therefore give the same answer for a companys value as discounting cash flows would have done in Unit 6. Accounting income focuses on income available for payment to investors: for example, in the case of NOPAT, the income after tax
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available to pay interest and dividends. Economic income, as defined in Equation (2), focuses on income that can be distributed by an entity to all its owners after they have been provided with benchmark returns on the capital they entrusted to the company at the beginning of the period. The benchmark return required by investors is, as we discussed in Unit 4, the weighted average cost of capital. As far as economic income is concerned, the WACC is deemed to be a cost rather than a return. Economic income measures the return available for all owners of capital after allowing for the return they require given the risks they have taken. Economic income is an equivalent concept to net present value both are measures of what is sometimes termed excess return.
We saw in Unit 4 that WACC can be estimated from the published and market-price information about a companys shares.
Economic income in external reporting

At present, financial accounts provide only limited information on economic income. For example, the weighed average cost of capital is not automatically disclosed in the financial accounts and no accounting jurisdiction requires pure clean surplus accounting. The United Kingdom Accounting Standards Board and, more recently, the International Accounting Standards Board have, however, been at the head of a move towards reporting economic values and economic income measures in financial accounts. Although there is still some way to go on financial accounting switching to economic income in annual reports, the concept of economic income is now commonly used in the financial markets when analysing a firms performance. Economic income is the same thing as economic value added, which was popularised by consultants Stern Stewart with the trademark EVA1. Stern Stewart advocate that entities should concentrate on maximising EVA1 where EVA = E in our equations. Equation (5) can be written as
Vt = At +
where
(1 + WACC)
n=1
EVA t +n
(6)
EVA t = NOPATt WACC At 1 = (ROCEt WACC) At 1

and ROCEt = return on capital employed in period t, measured by NOPATt /At1.
(7)
Stern Stewart argue, from Equation (6), that it is clear that maximising future EVAs1 will have a direct impact on value, Vt. Equations (6) and (7) also spell out a financial strategy for the firm:
l
Concentrate on those activities that produce positive EVAs1: that is, which earn ROCE in excess of the WACC. Dispose of those activities that produce negative EVAs1: that is, which earn ROCE less than the WACC. Minimise WACC.
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The attractions of the EVA1 formula are twofold. First, as can be seen above, it is simple to understand and relatively straightforward to translate into financial objectives. Senior executives such as those at Disney and Merck in the USA, Volkswagen and Seimens in Germany, Boots and Diageo in the United Kingdom have been in the vanguard of firms adopting this change in financial objectives, away from earnings per share and towards maximising EVA1 through maximising ROCE and minimising WACC. Secondly, EVA1 is a market-value related measure which can be expressed entirely in terms of accounting numbers available both in financial accounts and management accounts. It is also a measure that can be used both by investors external to the organisation and by senior executives and internal divisional managers.
EVA 1 in practice
Despite its theoretical appeal when compared with accountingbased measures, such as return on equity or EBIT, EVA1 is not yet used by many organisations as a performance-planning and control mechanism. A research survey by CIMA published in 2005 found that less than 10% of 124 the United Kingdoms divisionalised manufacturing companies surveyed considered EVA1 as the most important financial measure with which to evaluate the performance of divisional managers. Table 3.2 shows the number and percentage of firms using various financial measures in such evaluations and how they ranked them. Table 3.2 Ranking of three most important financial measures used in practice
Financial measure
Achievement of a target rate of return on capital employed A target profit after charging interest on capital employed (residual income) A target profit before charging interest on capital employed A target economic value added (EVA1) figure A target cash flow figure Other Total number of companies
Most important
9 (7.3%)
Second most important

21 (18.1%)
Third most important

41 (41%)
18 (14.5%)
11 (9.5%)
5 (5%)
68 (54.8%)
23 (19.8%)
5 (5%)
11 (8.9%) 10 (8.1%) 8 (6.5%) 124 (100%)
8 (6.9%) 45 (38.8%) 8 (6.9%) 116 (100%)
10 (10%) 27 (27%) 12 (12%) 100 (100%)
Source: Drury and El-Shishini (2005).
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Positive EVA1 should increase the market value of a firm. Its impact can be measured through what is called market value added (MVA), which is the difference between the market value of a firm and its invested capital. Using the earlier notation,
MVA t = MVt At
where MVt = market value of firm at time t. The evidence for the effect of EVA1 on a firms value and performance is mixed. Kleiman (1999) and Ehrbar (1999) studied the performance of the companies that had adopted EVA1 and concluded that they significantly outperform their competitors. Griffith (2004) studied the stock-market performance of sixty-three publicly traded firms who were clients of Stern Stewart & Company (SSC) and had implemented EVA1 incentive systems. The study finds that:
EVA1 adopters as a whole significantly underperform. An investor buying these SSC clients upon the announcement of the firms adoption of EVA1 and holding through 2003 would have experienced a significant abnormal loss of 55.34%.
(Griffith, 2004, p. 27)
A clear verdict on the effectiveness of EVA1 still needs to emerge and perhaps will be found through more research and it will need time. Popularity of EVA1, however, is spreading out to companies all over the world. We provide two examples of the use of EVA1 below in specific company contexts, but before that we note that, in practical terms, value-base management requires identifying the
Drivers
Price Quantity
Operating profit after tax
Operating profit before tax Tax
Return on sales
Production costs Marketing and distribution costs R&D innovation etc.
EVA
Capital charge
Cost of capital
Capital structure Productivity of capital
Debt and equity mix Cost of debt
Capital employed
Cost of equity Asset turnover
Figure 3.1
Economic value drivers
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factors that need to be managed and controlled to generate economic value. Figure 3.1 identifies the drivers of EVA1. Volkswagen AG, uses EVA1 as a control variable to manage its operations. The following example shows the calculations of EVA1 for its Automotive Division for the year 2002. The results are then mapped on to the EVA1 drivers framework shown in Figure 3.1. We have noted above that calculation of EVA1 requires an estimate of the capital charge and of actual operating profit after tax. While the latter can be obtained from the annual report of a company, the capital charge requires an estimate of the weighted average cost of capital (WACC) and a definition of capital employed. In the case of Volkswagen, the WACC calculation is given in Table 3.3. The company uses the capital-asset pricing model (CAPM) to estimate the cost of equity. Table 3.3
DAX is the stock market index of the German stock market.
Unit 4 explained CAPM as one of the methods of estimating the cost of equity.
WACC of Volkswagen AG for the year 2002

4.2 6.0 0.9 9.6 6 2.1 3.9 66.7 33.3 7.7
Risk-free interest rate (%) Equity-risk premium DAX (%) Volkswagen beta factor Cost of equity after tax = 4.2 + (6.0 0.9) (%) Cost of debt (%) Corporate tax rate (35%) Cost of debt after tax (%) Equity proportion (%) Debt proportion (%) WACC = (9.6 0.667) + (3.9 0.333) (%)
Source: Adapted from Volkswagen AG, Annual Report 2002.
Capital employed is defined by the company as Tangible fixed assets + Capitalised development costs + Intangible assets + Net Inventory + Trade receivables = Total operating assets Deduction capital (non interest bearing trade payables and advances) = Capital employed
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Drivers
NOPAT: 2,876
Operating profit before tax: 4,425 Tax: 35%
Return on sales
EVA: (134)
Capital charge: 3,010
WACC: 7.7% Capital employed: 39,099
Capital structure Productivity of capital
Figure 3.2
Volkswagen AGs, Automotive Division Driver, 2002
It is seen in the above example that Volkswagens economic value added was a -E134 million for the year 2002.
EXERCISE 3.1
Consider the figures for Volkswagen AGs Automotive Division for 2003 and 2004 in Table 3.4. What could be the main drivers for the creation or destruction of value in this case? Table 3.4 Figures for Volkswagen AG s Automotive Division for 2003 and 2004
Cost of capital (%) 2004
Risk-free rate Equity-risk premium (DAX) Volkswagen beta factor Cost of equity after tax Cost of debt Tax (average rate 35%) 3.8 6.0
Value contributed (million euros) 2003

3.9 6.0 Operating profit Share of operating profit of Chinese joint ventures Total operating profit before tax Tax expense (average 35%) Operating profit after tax Invested capital
2004
569 222
2003
649 561
1.05 10.1
0.95 9.6
791 277
1210 424
4.5 1.6
4.5 1.6
514 41,458
786 40,221
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Cost of debt after tax Equity proportion Debt proportion Cost of capital after tax
2.9 66.7 33.3 7.7
2.9 66.7 33.3 7.4
Cost of capital Capital charge EVA
7.7 3,192 2,678
7.4 2,976 2,190
Source: Adapted from Volkswagen AG, Annual Report 2004.
Box 3.2 provides an example of how of EVA1 was used to measure the performance at the Japanese firm, Sony.
BOX 3.2 EVA METHODOLOGY AT SONY

Sony adopted EVA in 2000 as a tool to evaluate performance in order to increase return on invested capital. Our Electronics business was the first to apply this system. The result was a series of decisive actions including the realignment of manufacturing facilities, the application of stringent standards to all new investments, and expanded outsourcing of production. By concentrating resources on the most attractive fields, the Electronics business improved the efficiency of its invested capital and achieved a significant improvement in EVA. During the year, Sony enlarged its EVAlinked compensation system to cover higher ranking managers as well as corporate executive officers. As a result, in each of our Electronics business units, awareness of the cost of capital increased significantly. In the fiscal year ending March 31, 2002, we plan to apply EVA to our Music and Pictures entertainment businesses. Thereafter, we plan to take more decisive steps to use EVA to evaluate corporate management, investment decisions, and to examine operating results throughout the Sony Group.
Sony Annual Report, 2001
Before we move to the discuss another measure of performance, the balanced scorecard, that has become quite popular in private and public-sector companies, try Exercise 3.2 and read the article on EVA1 referred to in Activity 3.4.
EXERCISE 3.2
Given that managers are being judged by EVA1, what would be the impact on the EVA1 numbers if interest rates and hence
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the WACC were to fall, as happened in the late 1990s? Should managers be rewarded or penalised for this? Do you believe that EVA1 should still be used as a management remuneration tool if interest rates rise?
ACTIVITY 3.4
Read the articles in the Course Reader, EVA1 implementation, market over-reaction and The theory of low-hanging fruit, to see how managers and markets reacted to the introduction of EVA1 by the US firms. In particular, note how managerial behaviour has changed since the performance measures and related incentive systems were changed. Before you continue with Section 3.2, read a short article A star to sail by in the Course Reader which provides a review by The Economist of a number of performance measures, including EVA1 and the balanced scorecard, which we describe in more detail next.
3.2.2 Balanced scorecard

Accounting-based or market-value-based performance measures use accounting or cash-flow parameters on a yearly, or in some cases, quarterly basis. This has led to criticism that the short-term focus of accounting-based performance criteria, such as earnings targets, lead to a short-term perspective by managers. The balancedscorecard approach is based on the philosophy of bringing into focus the management processes that are critical for long-term survival and growth of the firm and which ultimately also add value. Kaplan and Norton (1992) proposed a four-dimensional model of performance measurement, giving equal attention to short-term and long-term considerations: financial performance, customer issues, internal business processes, and organisation learning and growth. Performance metrics in the balanced-scorecard approach attempt to monitor organisational performance on multiple financial and non-financial targets. This approach assumes that the four quadrants of metrics complement one another and lead to maximisation of shareholder value. In practice, however, it is going to be very difficult to measure the effectiveness of the balanced scorecard because of the interdependent and sometimes difficult to quantify parameters. Its appeal has been its proximity to stakeholder theory and to the value-chain-analysis framework of competitive-strategy theory. As already noted in Section 3.1, a multiplicity of corporate objectives makes it difficult for managers to focus on maximising value. Nonetheless, the balanced-scorecard approach is becoming popular with managements in both the private
and public sector. In the 2005 survey by CIMA referred to in Section 3.2.1, it was found that 53 of the 124 respondents (43%) used a balanced-scorecard approach to evaluate divisional performance. Other approaches also included customer performance and satisfaction measures, market share, safety targets, quality and productivity, and employee satisfaction (Drury and El-Shishini, 2005).
ACTIVITY 3.5
For a more detailed description of the balanced-scorecard approach read Transforming the balanced scorecard from performance measurement to strategic management, by Kaplan and Norton in the Course Reader.
3.2.3 Performance measurement in BASF

BASF is chemical giant from Germany operating in 170 countries, with production sites in forty-one countries and with more than 81,000 employees. The company has been responding to the changing corporate-governance mechanisms in the light of the German governance code. It is also required to meet governancecode expectations arising from the fact that BASFs shares are listed on the New York Stock Exchange, which makes BASF subject to US capital-market legislation, including the SarbanesOxley Act of 2002. The company has adopted a value-based management approach, as can be seen in Box 3.3.
BOX 3.3 VALUE-BASED MANAGEMENT AT BASF

Our Goal: Create value across the cycle. Earn a premium on our cost of capital.
We earn a premium on our cost of capital to increase the value of BASF. To achieve this goal, we have been expanding on our value-based management strategy since 2003. EBIT (earnings before interest and taxes) after cost of capital is now the key performance and management indicator for our operating divisions and business units. We measure every business decision and our performance on the basis of how it influences earnings after cost of capital in the short and long term. As a result, all of our employees help us to improve cost structures, use our capital more economically and grow profitably. We achieve profitable growth through long-term value-adding investments, but above all through innovations. These include successful new products as well as more competitive production processes. They are generated by an efficient innovation process in an environment that supports creativity and entrepreneurship.
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To obtain the best results from our funds, BASF is concentrating its resources even more closely on those business areas that show the greatest potential for success. Since 2004 we have therefore introduced EBIT (income from operations before interest and taxes) after cost of capital as the key performance and management indicator for our operating divisions and business units. The BASF Group must achieve a minimum EBIT of 10% on operational assets to satisfy the returns expected by both internal and external providers of equity and debt capital, and to cover the required taxes. Based on planned operational assets of E28 billion in 2005, this corresponds to a minimum EBIT of E2.8 billion for the BASF Group. This cost of capital percentage before interest and taxes of 10% corresponds to a weighted average cost of capital (WACC*) of approximately 6% after interest and taxes. The premium on cost of capital is our measurement criteria for value creation. We want to create value across the cycle, which means that we want to earn a premium on our cost of capital. We can earn a premium on our cost of capital both by improving EBIT and by making optimal use of capital employed. In 2004, we earned a premium of E1,825 million on our cost of capital. EBIT after cost of capital is calculated by subtracting income taxes for oil production that are non-compensable with German taxes (E4,856 million) and the cost of capital (E668 million) from the BASF Groups EBIT (E2,662 million). Finally, the EBIT for activities not assigned to the segments (E299 million) is added, since this is already provided for in the cost of capital percentage. Based on average operating assets of E26.6 billion for the segments in 2004, we achieved an EBIT after cost of capital of E1,825 million and thus created corresponding value for our shareholders.
Implementing value-based management

BASF uses EBIT after cost of capital as the basis for performancerelated compensation. The Board of Executive Directors uses this key performance indicator in its annual planning to set targets for the whole BASF Group, and hence for individual operating divisions and business units. At subsequent levels in the organization, the key performance indicator is broken down into financial and operational value drivers. As a result, value drivers can be agreed as business targets at all levels. Target achievement plays an important role in setting the level of variable compensation. Training measures are provided globally to ensure that the value-based management concept is implemented throughout the company. These measures aim to provide all employees with the necessary value-based management skills and increase their understanding of business contexts. Key elements include
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an interactive training program, a business simulation game specially adapted for BASF, and a tailor-made range of seminars on value-based management. In addition, systematic analyses of value drivers show the cause-and-effect relations between operational and financial value drivers and the key performance indicator EBIT after cost of capital and make them easier to understand. All employees can thus identify their personal contribution to added value and act accordingly. This promotes entrepreneurial thinking and decision-making at all levels throughout BASF.
Adapted from http://www.corporate.basf.com/en/investor/strategie/ kapitalkosten/?id=71fYn7lzwbcp.91
ACTIVITY 3.6
What difference do you find between BASF value-based approach and EVA? In the EVA1 framework, the operating profit after tax is compared with a capital charge. In BASFs value-based approach, the company relates EBIT to the cost of capital. The logic in EVA1 is that shareholders get returns (dividends) from after-tax profits and, therefore, NOPAT is more appropriate than the before-tax operating profit. An implication of using EBIT in performance measurement is that tax liabilities are beyond the control of the management and therefore they should neither be rewarded nor penalised because of changes in net profits after tax because of tax rates. How such an incentive system will affect the shareholders returns will depend on the amount of taxes as a proportion of EBIT. Accounting policies may also have an impact on the tax expenses, so it is not easy to assume that managerial behaviour has no effect on taxes.
The value-based approaches to performance measurement are designed to improve on accounting-based indicators of performance reporting and have become quite popular with companies all around the world to align better the interests of managers and shareholders. Academic research on the link between adopting EVA1 and other variants of value-based measures and shareholders wealth does not provide a unanimous verdict. Changing and more focused codes of corporate governance, however, seem to be driving companies and management consultants to come up with internal measures of managerial performance that are more in line with shareholder value. In the next section we discuss external corporate-governance mechanisms.
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3.3
EXTERNAL VIEW OF PERFORMANCE
In the introduction to this unit we referred to the enterprisegovernance framework for understanding performance measurement and accountability issues. External and internal views of performance were noted there. While managers of corporations try to manage the business to achieve its corporate objectives, the external view of the firms performance will depend on who is looking at the firms performance. The important constituency among the interested groups is no doubt those who have invested in the firm as lenders or owners. We have already argued that a firms primary objective is to enhance the value of the firm. Present and potential investors will therefore look for financial reporting systems that convey transparently how well management is employing the capital provided to them. So far in this section we have discussed trends in the internal performance measurement. We now take an external view and start with compliance as one of the mechanisms to improve corporate accountability. The effectiveness of corporate-governance mechanisms depends on how well companies comply with legal requirements and the corporate-governance codes. Compliance requirements are no longer restricted to the transparency and accuracy of accounting reports: governance codes in most countries now require management to take far more specific responsibility for ensuring that corporate-governance mechanisms are put in place so as to minimise their discretion to take decisions that might be against shareholders interests. The introduction of independent directors, remuneration committees and audit committees are some of the measures to improve management accountability that can be seen in corporate-governance policy statements. (See Section 2 above for the example of Sony.) Reports on corporate governance are unanimous in emphasising the importance of compliance with good practices. We examine here a few aspects of external performance and monitoring: executive remuneration, non-executive directors, shareholder activism and the market for corporate control.
3.3.1 Executive remuneration

The corporate-governance debate makes frequent reference to the link between management performance and the executive remuneration. We saw in Section 2 (Table 2.3) that the average remuneration of chief executive officers of American companies is almost three times that of their counterparts in western European countries. Does this difference imply that the chief executive officers in American companies are three times more effective in terms of maximising shareholders wealth? It would be reasonable to argue that this is unlikely. In theory, executive-remuneration policy should be guided by the principle that managers are rewarded for achieving owners expectations in the most efficient and effective manner. From the perspective of agency theory, the remuneration policy should incentivise managerial behaviour to reduce agency costs. In practice, though, it is quite difficult to link
We discuss the role pension funds and other institutional investors play in corporate governance in Section 4.4.
up the performance of senior management with their pay. We saw in Section 3.2 various performance measures that companies are adopting to create a link between performance and pay. In addition, as an external mechanism, corporate codes now require companies to have independent remuneration committees responsible for fixing the remuneration of the chief executive officer and other senior managers. Some companies have started using extensive contractual arrangements detailing financial targets and linking executive remuneration with those targets. GlaxoSmithKline did this a few years ago (see Box 3.4). The company linked growth in earnings per share and total shareholders returns with executive incentives. The new policy was discussed with the largest shareholders and with the National Association of Pension Funds (NAPF). When announcing this change in policy, the chairman of the company said, We have introduced tougher performance conditions which clearly correlate pay with the delivery of strong financial performance and superior returns compared with our peer group. No other pharmaceutical company has adopted such demanding performance criteria. The new policy is clear and unambiguous and will be operated consistently. We firmly believe it is in the best interests of the company and its shareholders. The company had put shareholder value at the centre of performance measurement. The return benchmarks are inflation adjusted and managers are expected to meet and beat the industry averages.
BOX 3.4 GLAXOSMITHKLINE S NEW EXECUTIVE REMUNERATION ARRANGEMENTS

Structure of total package
The compensation packages for GSK Executive Directors are made up of salary, annual bonus and long term incentives (LTIs). The LTIs consist of a mix of share options and performance shares. The two measures which will govern the long term incentive plans are earnings per share (EPS) and total shareholder return (TSR)
Share options
The share option plan uses EPS as its measure. Vesting of options will be dependent on the achievement of stretching and progressive earnings per share targets measured at the end of a 3-year period. Target levels for future option grants will be reviewed annually taking into account GSKs internal projections and external forecasts.
Performance share plan (PSP)

The Performance Share Plan uses TSR as its only performance measure. Instead of FTSE 100, the performance comparator group will be the 15 largest global pharmaceutical companies
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(including GSK) to provide a clear comparison of how GSK has performed relative to its principal competitors. TSR will be measured over a 3-year period and there will be no retesting. Performance shares will only start vesting if GSKs TSR is ranked at least at the median of the performance comparator group. Full vesting will only be achieved if GSKs TSR is ranked first or second in the comparator group. For median performance 35% will vest. Vesting will then occur on a sliding scale up to the maximum.
2003 grant
Details of the 2003 awards to be granted to the executive directors under the Share Option Plan are as follows:
Number of options over ordinary shares or ADSs potentially vesting

EPS growth RPI + 5% or more RPI + (4 4.99%) RPI + (3 3.99%) Less than RPI + 3% Dr J P Garnier (ADSs) 460,000 345,000 230,000 Nil Mr J D Coombe (Shares) 276,000 207,000 138,000 Nil
An ADS is an American Depository Share. These are traded in the New York Stock Exchange and shares are traded on the London Stock Exchange.
One ADS represents two ordinary shares.
Details of the 2003 awards to be granted to the executive directors under the Performance Share Plan are as follows:
Number of ordinary shares or ADSs potentially vesting

TSR position 1st or 2nd 3rd 4th 5th 6th 7th 8th (median) 9th and below Dr J P Garnier (ADSs) 200,000 180,000 160,000 140,000 120,000 100,000 70,000 Nil Mr J D Coombe (Shares) 120,000 108,000 96,000 84,000 72,000 60,000 42,000 Nil
One ADS represents two ordinary shares
The following example illustrates the effect of these grants:

l
If the share price increases from the current level of 12.60 to say 15.00 and GSKs EPS exceeds current market forecasts
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50% of the options will vest and the value accruing to the CEO under the share option plan would be approximately 1.1 million ($2.0 million). The value to the CFO would be approximately 0.3 million.
l
Under the Performance Share Plan, for the same share price increase to 15.00 and if GSKs TSR performance is at least as good as half of its competitor group, the value accruing to the CEO would be approximately 2.1 million ($3.7 million, 35% vesting). The value to the CFO would be approximately 0.6million. Over the same period the additional value delivered to shareholders would be approximately 15 billion.
NOTES 1 Market consensus provides EPS growth forecasts for GSK of 4.9% per annum for the next 3 years. Source : Analysts estimates. 2 Assuming RPI of at least 2% per annum
Appendix: Comparator Group

GSK will measure its relative TSR performance against the
following comparator companies: Abbott Laboratories, Astra Zeneca,
Aventis, Bristol Myers Squibb, Eli Lilly, Johnson & Johnson, Merck,
Novartis, Pfizer, Roche Holdings, SanofiSynthelabo,
ScheringPlough, Takeda Chemical Industries and Wyeth.
In addition to the group outlined above, GSK has referenced pay
to a wider group sourced from the largest 100 companies globally
by market capitalisation. These include selected pharmaceutical,
manufacturing and consumer product companies (comparable to
GSKs over-the-counter business) and for which pay data is
publicly available. In addition to the companies noted above, these
companies are: Amgen, Coca-Cola, Colgate Palmolive, Diageo,
General Electric, Gillette, LOreal, Nestl, Pepsico, Procter &
Gamble, Unilever, United Technologies, Vodafone.
Source: Adapted from http://www.gsk.com/ControllerServlet? appId=4&pageId=402&newsid=92 Updated December 15, 2003. 20012005 GlaxoSmithKline
EXERCISE 3.3
If you were an individual shareholder with a small number of shares in GlaxoSmithKline, do you think the above remuneration packages would create a close link between GSK managers interests and your interests as a shareholder?
The short-term focus by analysts (particularly found in the US, where the focus is on quarterly results and forecasts) could seriously affect the long-term survival of firms. Jensen (2004) argues
that over-valuation of equities arising from a short-term focus has done damage to American companies. In some cases, chief executive officers s and chief financial officers trying to match the short-term expectations of financial analysts and the financial markets resorted to creative accounting and the budgetingtarget game. Pay-off structures heavily loaded with options and other equity-based incentives made the short-term movement of share price an important consideration for chief executive officers and chief financial officers. Jensen (2004) gives a few prominent illustrations. Two of them are reproduced in Box 3.5.
BOX 3.5
Microsoft recently settled with the SEC for creating reserves that lowered current earnings and could be used to pump up future earnings. I am sure this behaviour is not news to many. I am not as familiar with European companies as most of you in the audience, but I understand that in Europe reserves are regularly used to smooth things out, save for the future, and present the story we would like the markets to see, rather than what is actually going on. [...] General Electric under Jack Welch is an interesting example. Out of 48 quarters from 12/31/89 to 9/30/01, GE met analysts forecasts exactly in all but 7 quarters. In those 7 quarters it beat the estimates by 1 cent four times, by 2 cents once, and missed the estimates twice (once by 1 cent and once by 2 cents). What is the chance that could happen if earnings were not being managed? These are not the numbers that would come from pure value-maximising behaviour. Enron, Lucent, Xerox, Rite-Aid, Waste Management and Sunbeam all were similarly involved in lying about earnings.
Jensen (2004)
3.3.2 Non-executive directors/audit committees

The role of non-executive directors assumes importance in corporate governance because it is felt that in Anglo-American companies there is normally a close relation between the chief executive officer and the board of directors. Although less common in the United Kingdom, in the US the chief executive officer is generally chairman of the board of directors. This close link is likely to create a situation whereby the managements decisions are not monitored from an independent perspective in the interest of shareholders. Following the recommendations about the role of non-executive directors in the Cadbury report (1992) and the Higgs report (2003), the United Kingdom Combined Code of Corporate Governance published in 2003 requires that 50% of members be independent. The Smith report (2003) provides detailed guidance on the role of audit committees, as Box 3.6 indicates. The audit committee is made up of non-executive directors only (see Box 3.7).
BOX 3.6 THE AUDIT COMMITTEE AND ITS PURPOSE

The board should establish an audit committee, the main role and responsibilities of which should be:
l l
to monitor the integrity of the financial statements of the company; to review the companys internal financial control system and, unless addressed by a separate risk committee or by the board itself, risk management systems; to monitor and review the effectiveness of the companys internal audit function; to make recommendations to the board in appointment of the external auditor and to remuneration and terms of engagement of following appointment by the shareholders relation to the approve the the external auditor in general meeting;
to monitor and review the external auditors independence, objectivity and effectiveness; to develop and implement policy on the engagement of the external auditor to supply non-audit services.
Where the audit committees monitoring and review activities reveal cause for concern or scope for improvement, it should make recommendations to the board on action needed to address the issue or to make improvements.
Smith (2003)
BOX 3.7 THE ROLE OF THE NON-EXECUTIVE DIRECTOR

Strategy: Non-executive directors should constructively challenge and contribute to the development of strategy. Performance: Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. Risk: Non-executive directors should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust and defensible. People: Non-executive directors are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, senior management and in succession planning.
Higgs (2003)
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The effectiveness of non-executive directors in providing independent oversight of executive and other directors and management can face obstacles in practice. Procedures for the appointment of non-executive directors, their remuneration and their access to good quality and adequate information, as well as the limited time they devote to the role, are some of the factors that might be obstacles to the ability of non-executive directors to protect the shareholders interests. According to one report there may simply not be an adequate number of qualified individuals available and willing to be appointed as non-executive directors in the United Kingdom (Treanor, 2005).
3.3.3 Institutional investors/individual shareholders

So far we have been discussing various mechanisms designed to protect the interests of shareholders. We now discuss what shareholders can do on their own initiative to protect their interests. In theory, shareholders have the right to elect directors to the board and thereby to choose the best possible representatives. In practice, widely dispersed shareholders may not be in a position to monitor the performance of the directors and management effectively. Although corporate governance codes in most countries have now strengthened the rights of shareholders, individual shareholders are more likely to sell their shares rather than engage in activism if they are not happy with the performance of the management. In an efficient capital market, selling shares is the strongest possible single indicator of shareholders dissatisfaction. To enforce their control in this way, however, individual shareholders face big challenges. First is the issue of availability and quality of information. Although the stock exchanges typically require companies to publish all pricesensitive information, managements have discretion regarding the nature, quantity and timing of the information disclosed. Added to this is the challenge that understanding and analysing information requires time, resources and skills that may not be available to individual or small shareholders. Individual shareholders, therefore, despite their ownership stakes, do not usually succeed in exercising their full ownership rights. In most developed countries, though, large institutional shareholders hold a majority of the shares in listed companies and are better placed to exercise their ownership rights. An interesting example of shareholders activism by institutional shareholders was in 200405 when Deutsche Brse wanted to take over the London Stock Exchange, which had been converted into a traded public limited company in 2000. The story is interesting because the London Stock Exchange had formerly been owned and run by its customers (brokerage firms and banks) who traded through the exchange. After demutualisation its main objective became to maximise shareholders wealth, which among other things meant reducing costs and increasing revenue, both disliked by its customers. Read the story in Box 3.8 and then try Activity 3.7.
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BOX 3.8 SHAREHOLDERS POWER

Five years ago members of the London Stock Exchange (LSE) voted to take the 200-year-old institution public. On the continent, Germanys Deutsche Brse and Euronext an amalgamation of several other European bourses followed suit in the next couple of years. Demutualisation turned Europes exchanges from organisations owned by and run for their customers, mainly big banks and brokerage firms, into companies expected to maximise shareholder value. At first, banks were shareholders as well as customers, but many sold their stakes to raise capital. Some of them may be kicking themselves today, as the money managers and hedge funds that now dominate the exchanges boards reap the benefits of rising share prices and greater clout. The clearest sign of shareholder activism was the ousting in May of Werner Seifert, chief executive of Deutsche Brse, for pursuing his courtship of the LSE. The latest came on November 1st. Atticus Capital, a fund that owns stakes in both Euronext and Deutsche Brse, called for Euronext to end its own lengthy wooing of the LSE and start merger talks with the Germans instead. The same day, Britains Competition Commission ruled that bids by both continental exchanges for the LSE could proceed, subject to certain conditions. Euronexts management is believed to be open to talks with Deutsche Brse but, having been snubbed in the past, is waiting for the Germans to move first. It may be that Reto Francioni, who took over as Deutsche Brses chief executive this week, is more willing to talk to Euronext than Mr Seifert was. However, the practicability of a merger remains in question. A marriage of the two main continental exchanges would be likely to raise regulatory concerns. The two also have very different business models. Euronext says it is mulling its options. Whatever we do, it has to create shareholder value, says an adviser close to the exchange. We cant do this on strategic value alone. Similarly, LSE shareholders, buoyed this week by good financial results and a promise that the company will return 250m ($444m) to them, are unlikely to accept anything less than a strong offer. While shareholders flex their muscles, customers sound frustrated. Users are concerned the exchanges have too much control, says Michael Long, of Keefe, Bruyette & Woods, an investment bank. As the London Investment Banking Association has moaned, the cost savings being wrung out of todays leaner exchanges are not being passed on to them. The LSE, for one, has raised its trading fees. The news this week that Eurex US, Deutsche Brses answer to Americas big derivatives exchanges, could close if it does not find a local trading partner is another blow to users, who enjoyed lower trading fees on the Chicago Board of Trade after Eurex US launched its challenge. Recently the Board of Trade has signalled that fees will rise again.
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The irony is that exchange users were leading proponents of demutualisation several years ago. Although it is not clear that users have lost out entirely since then product innovation, operational efficiencies and (at least temporarily) lower fees have all benefited them their search for alternative trading outlets in both America and Europe indicates a desire to gain new leverage. In America, a clutch of big exchange users Citigroup, Credit Suisse First Boston, Morgan Stanley, UBS, Merrill Lynch and Citadel Derivatives Group bought stakes in the Philadelphia Stock Exchange recently, as a way to counter the growing power of the New York Stock Exchange and NASDAQ. Four big investment firms then announced plans to create a new Bostonbased electronic stock exchange, which is not yet operational. In Britain, says Mr Long, there is growing interest among large banks in internalising trades off-exchange matching customers buy and sell orders before sending net trades to exchanges. This already goes on, but does not yet make sense on a large scale. Nonetheless, he says, this could be a threat to the exchanges in the longer term. For now, the exchanges shareholders are much happier than users. Emboldened by the ditching of Mr Seifert, they are unlikely to stop telling executives what they think of their strategies.
The Economist, 11 May 2005, Vol. 377, Issue 8451.
ACTIVITY 3.7
What are the corporate-governance issues arising from the demutualisation of the London Stock Exchange? Demutualisation of the London Stock Exchange fundamentally changed its governance mechanisms. Ownership by shareholders means that the corporate objective became maximising share value. Public limited company form has also exposed the Stock Exchange to pressures of market for corporate control and other external controls such as disclosure requirements under several regulations, including the UK combined code on corporate governance.
Institutional investors have the same objectives as small individual investors, but do not lack time, resources and analytical skills. This makes them an important external group of stakeholders in the corporate-governance structure. Investment trusts, unit trusts, pension funds, mutual funds and hedge funds are some of the types of institutional investors. Insurance companies are another group of institutional investors with substantial ownership stakes in commercial companies. How effectively these institutional investors
exercise their duty towards their contributors/owners depends on the corporate-governance mechanisms in place for them. An individual investor investing through an institutional fund is exposed to a double agency problem, one with respect to the managers or trustees of the fund and one with respect to management of the companies in which the fund invests money. These double-agency costs may be outweighed by the cost and risk of monitoring companies individually. As you studied in Unit 4, the theory of finance would suggest that diversification is one way to minimise risk in any investments. Individual investors can enjoy benefits of greater diversification across companies when they invest collectively through institutional investors at relatively lower cost.
3.3.4 Market for corporate control

The fourth and final aspect of external performance monitoring discussed in this section is that of the market for corporate control. The market for corporate control is considered to be a key corporate-governance mechanism in the Anglo-American model. The argument is fairly simple. In an efficient financial market the share price is expected to reflect information about the financial health of a company. If the share price were falling, it would indicate that the management is not doing its job properly. A falling share prices makes a company vulnerable to takeover bids, with the associated risk for incumbent management of losing their jobs. Therefore, the market as a means of corporate control is an important external mechanism for controlling management behaviour. In corporate-governance codes, this translates into having smooth procedures for transparent and fair transfer of controlling rights. Friendly and hostile takeover activity is quite symbolic of the market disciplining management. The effectiveness of this mechanism of corporate governance should also be judged, however, against shareholders returns. Generally, merger and acquisition activities are driven by potential synergy benefits or transferring the control of poorly managed companies to better managed companies. It is observed that in most takeover situations the shareholders of the target company earn positive abnormal returns in the short term. A recent study of the effect on shareholders wealth of takeovers in Europe came to similar conclusions (Goergen and Renneboog, 2004). This means that there is some hope for shareholders holding shares in poorly managed companies.
We examine the corporate-governance mechanisms for pension funds later in Section 4 of unit.
By abnormal returns we mean returns over and above those expected given the risk of the investment.
3.4
SUMMARY
This section has discussed the issues of accountability and performance measurement both from an internal and external perspective for publicly traded companies. We have argued that to align better the interests of shareholders and managers there is trend toward designing value-based internal measures of
performance such as EVA1. We examined four external control mechanisms: executive remuneration, non-executive directors, shareholder activism and the market for corporate control. We discussed the developments in compliance requirements and best practice codes, particularly in context of companies in the United Kingdom and the US. In the next section, we turn to issues of accountability and performance measurement in the public sector, voluntary organisations and pension funds.
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4 PERFORMANCE AND GOVERNANCE IN OTHER SECTORS
4
4.1
PERFORMANCE AND GOVERNANCE IN OTHER SECTORS
INTRODUCTION
In this section we extend the discussion of accountability and performance measurement in the context of the public sector, voluntary organisations and pension funds. In particular, we find increasing concern for the accountability and performance of public-service providers. In the United Kingdom successive Conservative and Labour governments have carried out wide-spread reforms of the public sector since the 1980s. Under Thatchers Conservative government many of the public-sector enterprises were transferred to the private sector and exposed to direct control by the market-based governance mechanisms that we have discussed in Section 3. In addition to market-based institutions, various regulatory bodies such as the Office of Water Regulation (OFWAT) and the Office of Telecommunications (OFTEL) were also created to monitor the performance of privatised utilities. In other public services provided by central government and local government authorities, reforms were introduced so that they were essentially removed them from direct government control and run as quangos operating under contract with government. Key reforms included the establishment of independent trusts to manage health services in the National Health Service and the establishment of Training and Enterprise Councils (Cornforth, 2003). Since 1997, under Labour governments, concern about public-sector spending and its effective utilisation has been at the top of the agenda. Service and spending targets and value for money have been introduced as controlling tools for improving the performance of public services provided by government run organisations. We discuss the issue of performance measurement, accountability and governance in the public sector in Section 4.2. We shall briefly examine the issues of performance and governance in voluntary organisations and in pension funds in Section 4.3 and Section 4.4.
Quango stands for quasi-autonomous non-governmental organisation.
4.2
PUBLIC SECTOR: PERFORMANCE MEASUREMENT, ACCOUNTABILITY AND GOVERNANCE
4.2.1 What is to be measured ?

Performance measurement requires clear specification of objectives. The challenge in the public sector starts with this first stage of accountability. Most public-sector organisations deliver multiple
services and operate as monopolies. Consider for example the type of services that we get from public organisations: police protection, national security, health services, fire services, works and pension services, education. These are examples of where it is quite difficult to come up with satisfactory objective measures of performance. It is not unusual, however, to hear words like choice, customers, value for money, chief executive officers in the context of public services in an attempt to reflect the application of businessmanagement principles to public-service providers. Private-sector business firms, however, unlike the public sector, generally pursue a very clearly defined profit motive. Stewart and Walsh capture the difference between public and private sector measures of performance:
Profit is the measure of final output [in private firms] ... there are universally accepted, abstract, performance measures, such as return on capital, available. Such simple unequivocal measures are neither available nor appropriate in the public service. A range of measures is needed to cope with the multidimensional nature of public service.
(Stewart and Walsh, 1994, p. 46)
We discussed the use of balanced scorecards as one of the tools private-sector firms use as multidimensional performance metrics in Section 3, but multidimensional metrics result in multiple objectives and are measured against various targets. This can lead to targetology, where a narrow focus on specific targets can adversely affect other aspects of service delivery (Rouse, 1993; Wilson, 2004). For example, the Public Administration Select Committee (PASC) (2003) identified a number of perverse consequences of targets, such as a patient becoming blind because her follow-up appointments were postponed so that new patients could be accommodated to achieve targets for waiting times. Another case is reported about the NHS in England where an opthalmic unit cancelled 19,500 follow-up appointments in six months to achieve the waiting-time target. There are other such illustrations that highlight the difficulty of targets resulting in undesirable consequences (see Table 4.1). Performance indicators imposed without careful thinking may lead to gaming, leading to setting of soft targets by smarter managers and also in some cases may lead to distortion in performance reporting. We may recall here the similarities with the governance issue in commercial firms that we referred to in Section 3.3.1 about the link of performance targets with executive compensation.
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Table 4.1 Targets and results perverse consequences identified by the PASC
Target
Measure school performance on GCSE results Raise conviction rate for criminals
Result
Rise in exclusion of disruptive pupils and hence local crime Conflicts with efforts to reduce prison overcrowding and to prevent re-offending Ambulances keep patients waiting outside Accident and Emergency Departments because the clock only starts ticking when they enter the door.
Accident and emergency patients should wait no more than four hours
Source: Financial Times (22 July, 2003).
In sum, we note that measuring performance is a difficult concept when we examine the way it has evolved in the United Kingdoms public organisations (see Box 4.1 for a number of performance indicators and definitions of measures used in public enterprises). The early evidence on the effectiveness of performance measures is that they are difficult to quantify and monitor and it is unclear whether they have improved the quality of services to beneficiaries. In the following sections, however, we look at the financially oriented performance measures used in public sector.
BOX 4.1 THE LANGUAGE OF THE MEASUREMENT CULTURE A GLOSSARY

l l
Inputs: the resources used by an organisation. Outputs: the services, goods or products provided by the organisation with the inputs. Outcomes: the benefits or value generated by the organisations activities. Performance indicators (PIs): quantifiable measures used to monitor performance and report on it to the public. Management information, which usually includes both numerical and non-numerical ways of monitoring and understanding performance. Performance management, which is used in a wide variety of ways and usually at least includes: identifying objectives; allocating them to individuals or teams; and monitoring progress. Targets: usually desired or promised levels of performance based on performance indicators. They may specify a minimum level of performance, or define aspirations for improvement.
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League tables: intended to enable comparisons of performance between different service providers to be made. Public Service Agreements (PSAs): first introduced in the 1998 Comprehensive Spending Review as an integral part of the Governments spending plans. Each major department has a PSA, setting out the departments objectives and the targets for achieving these. Service Delivery Agreements (SDAs): introduced in the 2000 Spending Review, set out lower level output targets and milestones underpinning delivery of the PSA. Standards: may be used for a variety of purposes, including indicating to the public the minimum standard of service they can expect from a public body, or to a service provider the standard which should be achieved (and against which they may be assessed for compliance). Targets can be based upon standards for example to achieve a minimum standard consistently, or to improve over time so that the standard is achieved. Benchmark: normally involves a detailed analysis of comparative performance to help identify what underlies differences between two similar bodies.
PASC, 2003, pp. 56
4.2.2 Measuring value for money

The public sector is funded from taxes and therefore the interests of the owners (the funding beneficiaries) are not easily identified. The absence of the profit motive and competitive-pricing mechanisms combined with indirect ownership of public assets means financial control systems as used in commercial firms are not fully adaptable to the public sector. However, there have been different approaches to introducing financial management-based tools into audit and control of public-sector activities. In the United Kingdom, the National Audit Office (NAO) monitors the financial performance and audits the accounts of government departments and agencies. The NAO performs financial audits and also value-for money audits of money spent by the government through various departments and agencies. It audits about 550 different accounts and total revenue and expenditure of 700 billions and also makes about 60 reports on value-for-money audits every year (see Box 4.2).
We provide an example of an NAO report on value for money later in the section.
It is clear from the above that the NAO has a primary role in providing a vital and most informed view on the performance of public-sector agencies in terms of value for money. What value for money means and how it can be audited needs to be understood.
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BOX 4.2 NAO S ROLE IN VALUE-FOR-MONEY AUDIT

Under the 1983 National Audit Act, the National Audit Office can examine and report on the economy, efficiency and effectiveness of public spending. We use the following definitions for the three Es: Economy: minimising the cost of resources used or required spending less. Efficiency: the relationship between the output from goods or services and the resources to produce them spending well. Effectiveness: the relationship between the intended and actual results of public spending spending wisely.
Source: http://www.nao.org.uk/about/role.htm
It has been claimed that a form of value-for-money auditing has been with us since the fifth century BC (Dewar, 1989). Its application, however, has only become widespread during the past two decades. Normanton (1966) argued that value-for-money auditing was a response to big government in the twentieth century and that it make[s] a growing contribution to the development of public administration and government as a whole a contribution which no other organ of the state could possibly make. But just when value-for-money auditing has firmly established itself in the public sector, the world it inhabits has changed and the need for value-for-money auditing and its role are in dispute. Power (1994) suggests two extremes of the need for audit in general: on the one hand, it can be argued that audit is a central part of the reinvention of government; on the other hand, value-for-money audit can appear intrusive and out of step with a culture where managers are encouraged to be responsible for their own performance. Part of the confusion lies in the fact that the objectives, methodology and audit standards for value-for-money auditing vary among and within the audit bodies, and differ further among client groups and national contexts. Looking back over the past few decades, it is possible to identify different approaches to value-for money auditing and to some extent to match these to certain sets of circumstances. This review suggests an evolution of value-for money auditing from a hands-on approach, where auditors confronted managers and the public with examples of waste and inefficiency, to a more refined form whereby the value-for-money ethos has empowered managers and the auditors are consigned to their familiar role of checking managements account of valuefor-money achievements.
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BOX 4.3 ORIGINS OF VALUE-FOR-MONEY AUDITING

In [Britain], it is doubtful whether the idea of an audit going beyond consideration of regularity (i.e. checking for the presence of any irregularities) was ever even considered in the early days of parliamentary control of accounts. An interesting insight into some of the early VFM auditing in the UK, from an 1887 audit report, involved the purchase of ribbon for army medals for 20 shillings when it could have been purchased from another supplier for 14 shillings. This case pushed the boundary of auditing beyond regularity. The military department initially refused to reply to the report thus provoking a landmark declaration from the Committee of Public Accounts: If in the course of his audit, the auditor becomes aware of facts which appear to him to indicate an improper expenditure or waste of public money it is his duty to call the attention of Parliament to this (Normanton, 1966). Despite occasional investigations of this type, audit remained mainly of the regularity variety until the late 1940s when the growth in expenditure following the Second World War was matched by a similar extension of the volume and range of value-for-money reports. Pallot (1991) associates the increased emphasis on valuefor-money auditing with increasing concerns about government expenditure in the 1960s and 1970s, which caused government auditors to take a wider perspective and to re-orientate the audit approach towards comprehensive or integrated audits.
Good quality medal ribbons were clearly a vital military accessory
There is no general agreement of what the term value-for-money audit actually means. The International Organization of Supreme Audit Institutions (INTOSAI) is the professional organisation of supreme audit institutions in countries that belong to the United Nations. Its notion of an expanded-scope audit introduces the concept of auditing management activities: There is another type of audit which is oriented towards performance, effectiveness, economy and efficiency of public administration. This audit includes not only specific aspects of management, but comprehensive management activities, including organisation and administrative systems (INTOSAI, 1977). In the USA, the General Accounting Office audit standards take this a step further and consider performance auditing as including the extent to which desired results or benefits ... are being achieved ... whether the objectives of a proposed, new or ongoing program are proper, suitable or relevant (General Accounting Office, 1988). It is generally acknowledged that, as a minimum, a value-for-money audit includes an examination of economy, efficiency and effectiveness. Sharkansky (1991) discusses the different labels given to the activity (for example, the three Es, value for money, operational auditing, effectiveness auditing, performance auditing, programme-results auditing) and comments that: While some may
emphasise the nuances that distinguish these labels and what they signify, their communality lies in their concern with judging the quality of governmental activities as opposed to the auditors classic concern with financial records. The term value for money will, therefore, be used here as a convenient expression, embracing value-for-money in its widest possible sense to embrace everything from economy to policy.
ACTIVITY 4.1
You may find it useful to look back at your previous studies of the three Es, covered in your Stage 1 course (e.g. B800, B713, B700 or equivalent).
When the definition of value-for-money audit is so broad based and difficult to pin down, it is unsurprising that different audit bodies in different countries use a variety of approaches to implement value-for-money auditing. In discussing value-for-money auditing it may be helpful to distinguish between these different approaches. It is possible to identify six different types (see Table 4.2). This list is not intended to be exhaustive, nor does it imply that the auditor must select just one approach. Different types of audit may be selected for different projects and an individual audit may even feature aspects of several approaches. With the possible exception of comparative audit, the different approaches can be seen as representing the evolutionary development of value-for-money auditing, from review of management systems through to the quality audit. It would seem that the involvement of the auditor has an interactive effect with management systems and that, as these systems have improved, the auditor has been able to move on to the next, possibly more efficient, auditing approach. Table 4.2 Six approaches to value-for-money auditing
1 Review of management systems, arrangements and procedures Auditor identifies poor value for money, makes recommendations for improvement and gives advice on management arrangements to improve value for money 2 The value-for-money procedures audit
Auditor checks that an organisation has established objectives, has systems for measuring performance and for ensuring that objectives have been achieved 3 Policy audit
Auditor assesses whether a policy or programme has been effective as well as economical and efficient
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Audit of management representations of value for money
Auditor verifies information prepared by management on the achievement of value for money 5 Comparative-performance audit
Auditor compiles a database to compare cost/performance between similar organisations, identifies and recommends best practice to improve value for money 6 Quality audit
Auditor uses customer-satisfaction surveys to evaluate successful performance; may also verify managements quality assurance information
Source: Bowerman (1996).
PPI/PFI value f or money ?

You may have studied (in the optional Section 9 of Unit 5) PPP and PFI as alternative approaches to project financing.
An alternative approach to obtaining good value for public services has been, essentially, to contract out either peripheral aspects (e.g. provision and maintenance of premises) or complete services (e.g. private-sector prisons). The key mechanism for this, used by UK governments of all political persuasions, is publicprivate partnership (PPP) and its subset private finance initiative (PFI). Here we look at one example of the outsourcing of government estates in the United Kingdom, which is not as straightforward a case of PPP/PFI as discussed in Unit 5, but has got some differences.
PFI: The STEPS d ea l

The Inland Revenue and HM Customs were merged in 2005 into one Department known as HM Revenue and Customs.
In March 2001, the Inland Revenue, HM Customs and Excise and the Valuation Office Agency, which we shall refer to as the departments, signed a contract to transfer ownership and management of the majority of their estate to a private-sector consortium of companies within the Mapeley Group. The deal is known as STEPS (the Strategic Transfer of the Estate to the Private Sector). The contract commenced on 2 April 2001. Essentially the deal involved the selling of the buildings combined with service contracts over a twenty-year period. The deal was justified on economic criteria and some other associated benefits. Over the twenty-year life of the STEPS contract, when compared with the Public Sector Comparator (an option if the departments carried on the present arrangements of owning the buildings and contracting out various services to different parties for maintenance and upkeep of the buildings), the departments expect to save 344 million (in net present values), with an estimated first-year saving of some 27 million. The details of the deal are given in Box 4.4.
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BOX 4.4
The STEPS deal will last for twenty years and comprises the following key elements. (a) The transfer for 220 million of the departments 574 freehold and long-leasehold buildings (comprising 1.3 million square metres space) to a subsidiary of Mapeley (Mapeley STEPS Limited). (b) The remaining estate (124 buildings) comprised liabilities under short-term leases, which were transferred to both Mapeley STEPS Limited and Mapeley STEPS Contractor Limited, a different subsidiary of Mapeley. (c) In return for operating the estate and taking responsibility for rental and other costs, the departments will pay Mapeley STEPS Contractor Limited an average annual charge of 170 million, equating to some 1,500 million over the period of the contract. (d) At the end of the contract, the departments will not own the estate, but will retain a right to occupy the buildings that they wish to remain in, with leases based on market terms obtaining at the time.
Source: National Audit Office (2004, p. 2)
ACTIVITY 4.2
What are the benefits that accrue from the above deal, including value for money? A report by National Audit Office, examining the value for money delivered by the STEPS deal concluded that: (a) the deal has delivered benefits and more are expected;
(b) the departments got a good price;
(c) good risk management will be essential.
Elaborating on the benefits from the deal, the NAO notes
that before STEPS the departments employed approximately
300 staff on estate management. By late 2003, this number
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had been reduced to 160 and is expected to fall further as the contract beds in. The NAO report also mentions that the departments got a good price as Mapley STEPS offered the lowest price by some 500 million and its bid was some 300 million lower than the best alternative to the PFI deal. This deal is different from the standard design, build, finance and operate PFI deal in that there is no construction of an asset. Therefore, the usual risks of time and over-run costs in this case were not a big problem. However, predicting the space requirements of the departments over a twenty-year period and difficulties in forecasting running costs and realisable value from estates at end of twenty years introduce risks in this arrangement. The project was accepted after risk analysis of the deal based on scenario analysis using Monte Carlo simulation.
Figure 4.1 illustrates the value-for-money trade-off through the symbolic use of a see-saw in order to highlight the balancing act private funders and the public sector have to go through before a PFI deal can be closed.
Private funders Private enterprise profit Borrowing costs Bid costs Public sector Reduced risk Competitive quotes Access to innovation Greater freedom to invest Full-time operational benefits
Figure 4.1
The value-for-money trade-off
4.2.3 Governance and accountability in the public sector

So far we have been looking at the issues related to measuring performance and achieving value for money in the public sector. Here we examine the issue of governance mechanisms in the public sector, with a particular focus on financial-management measures in public organisations. The recent approach to accountability and performance improvement in the public sector in the United Kingdom has financial underpinning. In 2004 the United Kingdom government accepted the major recommendations of three committees with the main aim of delivering public services more effectively and efficiently. The Lyons report (2004) reviewed the relocation of public-sector organisations from London to the regions. A major recommendation was to move 20,000 staff from various government offices based in London to the regions.
An additional 7000 jobs have to be abolished. The ODonnell report (2004) examined the efficiency and financing of revenue departments and recommended that the Inland Revenue (income tax) department be merged with the Customs and Excise department. This has already been implemented. Gershon (2004) reviewed efficiency in public-sector organisations. The main recommendations include the identification of cost savings: a target of 2.5% annual savings to the years 200708 was fixed by the government with potential total cost savings of 20 billion. Taken together, the recommendations, which have been accepted by the government, imply a significant restructuring and reform of the way the public sector is organised and managed. In Box 4.5, however, we provide an example from the NHS, which has been subject to continuous reform in the way it is organised and restructured to make it more productive and effective.
BOX 4.5 ROYAL WOLVERHAMPTON HOSPITALS NHS TRUST

In 200203, the Royal Wolverhampton Hospitals NHS Trust completed a five-year recovery plan one year early and recorded a year-end surplus of 0.45 million. By November 2003, however, the trust was forecasting a year-end deficit of 5.1 million and ultimately recorded a deficit of 7.6 million. In December 2004, the deficit forecast for 200405 was 9.4 million, even allowing for planned cost reductions of 6 million. The latest forecast, in May 2005, was for a deficit of 9 million. In response to the rapid deterioration in the trusts financial position, the local Strategic Health Authority commissioned an independent review of its financial management and governance arrangements. The review identified a number of failings at the trust, centred around two key areas:
l
reliance on non-recurrent funding sources to achieve financial balance for a number of years, leading to the apparently rapid deterioration in the financial position when such funding was no longer available; inadequate reporting and scrutiny within the accountability, financial-reporting and committee structure.
The review found that the trusts initial problems, caused by inadequate budget setting and under-estimation of cost pressures, were compounded by a failure at board level to identify and acknowledge the emerging over spending. In particular, the review suggested that:
l
from the evidence available, the Audit and Governance Committee played little part in scrutinising financial plans or performance; there was a widely held view at the trust that there was insufficient financial acumen among the non-executives on the board;
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the finance directors monthly reports to the board used non standard accounting presentations and sparse narrative, resulting in a misleading view of the trusts financial position; there appears to have been little challenge to the format of the boards financial report, despite its apparent lack of clarity; despite the deficiencies in the boards financial report, the lack of challenge from the board was surprising, given the other evidence (including advice from the external auditors) that the trust faced financial difficulties; the management of the trust lacked understanding of the impact of non-recurrent funding, meaning that they did not appreciate the financial difficulties that the trust faced and therefore did not take action to remedy them.
Source: National Audit Office and Audit Commission (2005, p. 32)
EXERCISE 4.1
What are the governance issues raised by the case study in Box 4.5?
4.3
ORGANISATIONAL PERFORMANCE AND GOVERNANCE IN VOLUNTARY ORGANISATIONS
Charities and other voluntary organisations have come to acquire a prominent place in society as institutions that mobilise and utilise resources, for a variety of motives, in the not-for-profit sector. As of 2005, in England and Wales there were 190,000 charities registered with the Charity Commission. With an annual income of 32 billion, almost 600,000 paid staff and 900,000 trustees, this sector is large enough for the public in general and the government in particular to be concerned with the governance of these organisations. Just as in the private and public sectors, a debate has emerged about governance and the publication of a governance code in 2005 by the Charity Commission in England and Wales. The basic principles of good governance that we have been discussing so far are also enshrined in this code. In most countries there is one charity commissioner or some other government-appointed authority who works as main regulator and supervisor of the workings of voluntary organisations. Since voluntary organisations are not set up with a profit motive it is difficult to measure performance in financial terms. Multiple and sometimes ambiguous goals add another problem in assessing their performance. Consider, for example, the statement of purpose by Oxfam, given in
Box 4.6. We can see how difficult it is to have a standard performance-measurement system that could be used for evaluating the performance of management and the trustees in such a case. This does not mean that the activities undertaken by the voluntary organisations are worthless for society; the point we are making is about the difficulty in using objective performance measures.
BOX 4.6 OXFAM

Our purpose
Oxfam works with others to overcome poverty and suffering.
What we do
Oxfam uses a range of approaches to achieve change and improve peoples lives, including saving lives through emergency response; longer term development programmes; and campaigning to achieve lasting change.
Source: www.oxfam.org.uk
Most studies of the organisational performance of voluntary organisations examine financial measures. Total revenue, gift income, annual operating budgets, financial reserves and endowment funds are some of the criteria against which the performance of such organisations has been assessed (see, for example, Olson, 2000; Jackson and Holland, 1998). A problem with financial measures is that they do not tell how efficiently and effectively the organisational goals are achieved. Mobilising resources might be an important function of the board and the management, but it does not necessarily imply that an organisation is equally efficient in achieving its objectives. Governance and accountability issues are further complicated by other important features of voluntary organisations:
l
We have used here the terms voluntary organisations and charities and not-for profit organisations interchangeably.
donors or funding agencies in voluntary organisations are not the same as lenders or shareholders; beneficiaries from activities are not comparable to customers and are therefore unlikely to express their expectations about service standards; the workforce in voluntary organisations consists partly of paid staff and partly of unpaid volunteers.
The above features of voluntary organisations pose challenges to the board members or trustees in monitoring. The performance of boards has been assessed by researchers using agency theory and also resource-dependency theory. We saw in Section 2 that the agency-theory framework has provided much of the platform for corporate-governance mechanisms. In principle, agency theory suggests aligning the
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interests of the board members with those of the owners so that the board provides effective monitoring of the performance of management. Mechanisms to align board members interests with those of owners include giving them share ownership, stock options and independent directors who would keep an arms length relationship with the management to carry out their fiduciary responsibilities of supervising the management performance. The association between the boards who uphold high standards in monitoring practices and improvement in the organisational performance of organisations is not well established (Hillman and Dalziel, 2003). For example, an investigation into the relationship between good governance and financial performance at independent not-for-profit colleges concluded that longer-tenured board members and members with an extensive business background strengthened a boards ability to monitor managerial performance. Bigger boards were also found to be more effective. This last factor has also come up as an important factor in other research (Cornforth and Simpson, 2002). The reason for this is that larger voluntary organisations can afford to ensure, and take steps to ensure, that their board members are better trained and are provided with relevant information enabling them to monitor performance more effectively. Recall the lack of such expertise in the appointed trustees of the NHS hospital discussed in Box 4.5.
The Charity Commission and The National Council for Voluntary Organisations (NCVO) have set up Trustees Services Unit within NCVO to provide support, advice and training to trustees to help them be effective governors in the voluntary organisations with which they are associated.
Callen et al. (2003) found a positive association between having major donors on the board and indicators of organisational efficiency. This finding supports a contention of agency theory (Fama and Jensen, 1983) that major donors perform a monitoring function that is motivated by their investment in the organisation. Because of their substantial financial commitment to the organisation, major donors ensure organisational efficiency. Resource-dependency theory suggests that boards function as a resource for organisations. The board is considered as human capital (expertise, experience and reputation) and relational capital (networks and linkages to external constituencies). Thus the resource-dependency framework expands on agency theory by looking at board members not merely as monitors of performance, but also as resource catalysts for the organisation providing legitimacy, advice, links to other organisations and assistance in acquiring resources (Pfeffer and Salancik, 1978; Hillman and Dalziel, 2003). You will be aware of many prominent personalities and celebrities linking with voluntary organisations to strengthen the reputation and credibility of the organisation. The governance question under resource-dependency theory therefore expects the board not only performs its monitoring role effectively, but also adds value to the organisation by bringing in resources. If they perform the twofold duties well, organisational performance is expected to improve. There is some empirical support for this mechanism of governance. Green and Griesinger (1996) found that boards that engaged in resource-related activities, such as fund raising and making personal financial contributions, were more likely to be associated with measures of improved organisational performance.
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We conclude the discussion on voluntary organisations by noting that the measurement of performance is likely to remain a difficult issue. Given this, accountability and governance will be judged more by the financial and accounting criteria of mobilising resources and ensuring that boards monitor performance efficiently. However, the big question of achieving organisational goals, which as we noted are not clearly defined in many voluntary organisations, will require far more clarity and focus and subsequent assessment against those goals. In the final part of this section we look at the performance of fund managers where the goals are not that difficult to understand and measure.
4.4
PENSION FUNDS AND OTHER INSTITUTIONAL INVESTORS
In this section we examine the performance-measurement and governance issues in the context of collective investors, such as pension funds and institutional investors. In the United Kingdom and USA, institutional investors play a major role in investment. This is typical of countries in which governments, mainly through tax advantages, have encouraged saving for later life via investment intermediaries. For example, in the United Kingdom, saving via a pension fund is tax deductible at the individuals marginal income-tax rate; no tax is payable by the pension fund on gains made or a low rate of tax on income received; and tax is paid by the individual in later life on pensions received only after some allowance for tax-free lump-sum payments. This has led to pension funds and life assurance companies holding the majority of shares listed on the United Kingdom stock market. Pension schemes are significant institutions in the United Kingdoms financial system. Some 750 billion are managed by the boards of trustees of the workplace pension schemes with a further 450 billions managed by life insurance companies (NAPF, 2005). The switch to institutional investment has been less extreme in the USA, where individual investors have been encouraged to set up individual share portfolios as part of saving for retirement. This has led to a massive boom in individual share ownership, but institutional investors still control 40% by value of shares listed on the New York Stock Exchange.
Life assurance companies dominate what is known as the personal-pensions market, where individuals save on their own account rather than through an occupational scheme.
4.4.1 Measurement of trustees performance

We have been arguing throughout this unit that performancemeasurement and accountability issues should be discussed in the context of organisational goals. Pension funds are no exception to this framework. Unlike voluntary and public-sector organisations, the expectations from pension funds are quite clear and therefore the governance mechanisms can be more tractable than in the case of the boards of voluntary organisations.
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Corporate pension funds in the United Kingdom operate under a trust system, where trustees are responsible for the stewardship of the assets invested to meet the current and future pensions of a pension funds members. Legislation, such as the Pensions Acts 1995 and 2004, is designed to protect present and future pensioners by ensuring, for example, that the trustees represent the members best interests and that pension funds are solvent in the sense that they are likely to be able to pay out promised pensions. This is known as satisfying the minimum funding requirement. In addition it is expected that, with their significant investing power, the institutional investors should provide an effective check on the managerial behaviour of the companies in which they invest. First, we shall look at the performance of pension funds on satisfying the minimum funding requirements. In recent years it has emerged that there is a significant shortfall in pension funding in private-sector corporate schemes. As the following article suggests, the company pension schemes in the United Kingdom, as of May 2005, had a short fall of 134 billion.
BOX 4.7 THE TRUE COST OF CORPORATE PENSION SCHEMES

When Gordon Brown, the chancellor of the exchequer, raised employer national-insurance contributions by 4 billion ($7 billion) a year in his 2002 budget, British business cried foul. But on October 31st, David Norgrove, chairman of the Pensions Regulator, set out proposals that will involve a cash call double that amount to get rid of company pension-fund shortfalls over the next ten years, and there was no great fuss. Instead, the stock market was galvanised by a takeover spree by foreign bidders for some big British firms. A sanguine interpretation of this weeks events is that prescient markets had already taken on board the scale of action needed to address pension-fund deficits. More likely, however, they have not woken up to the full impact of the regulators proposals. That would be par for the course. There is a long, worrying history of government meddling in company pensions whose full impact is only appreciated years after the event. The failure to grasp the impact of new measures arises from the complexity of arrangements for funding private defined-benefit (DB) pensions, which are linked to final salary and years of service. This has grown enormously in the past year, as a new insurance and regulatory framework for company pensions has been constructed. The groundwork was completed in April when the Pension Protection Fund (PPF) started and the Pensions Regulator became a force in the land, replacing OPRA, its feeble predecessor. The PPF, supported by compulsory levies on company schemes, provides compensation for members of under funded DB pension plans whose sponsoring employers go bust. From the outset, the
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government has sought to avoid the financial problems afflicting Americas 30-year-old company pension-insurance system. At the latest count, the Pension Benefit Guaranty Corporation (PBGC) had a record deficit of $23 billion on its books, which many believe will require a government bail-out. One distinctive feature of the British approach is that the PPF will rapidly make the levy mainly risk-based. Its charges will take into account both the funding of pension schemes and the risk that their companies may become insolvent. Another is that the regulator has been armed with powers to counter moral hazard the temptation for companies to behave more riskily towards their pension funds once there is an insurance safety-net. But these policies will prove ineffective as long as Britains private DB plans remain perilously under-funded. The PPF does not provide full compensation: working-age members get 10% less in their prospective pension, which is also capped at a mere 25,000 a year; and indexation arrangements for pensions in payment are restricted. As a result, the benefits guaranteed by the PPF are worth some 30% less than the full value that would be secured through a buyout from an insurance company if a scheme had enough money, estimates Nigel Bodie of Watson Wyatt, an actuarial consultancy. Even so, the PPF revealed in July that the total deficit in company pensions under its valuation rules is 134 billion. That estimate is broadly equivalent to the 130 billion deficit that companies are registering under the FRS17 accounting standard, according to new figures this week from the regulator. That gap has emerged in the past few years because falling stock markets, rising longevity and declining interest rates have together battered pension-scheme finances. The deficit has proved stubbornly difficult to shift, despite the recent recovery in stock markets. On October 31st the regulator served notice, in effect, that companies must get rid of these deficits within ten years. It is saying that the trustees of schemes and sponsoring employers must now, in general, draw up recovery plans to eliminate their deficits by around 2015; otherwise it is likely to intervene. It argues that this is a reasonable timetable, since over a ten-year period the financial health of firms is more likely to deteriorate than to improve. The regulators plan is out for consultation, but its broad thrust is unlikely to change very much. Business regards the funding stipulations as onerous. In 2004 employers pumped 25 billion equivalent to 2.2% of GDP into pension funds, more than double the amount in 2001. Around a third of this almost 8 billion was comprised of special contributions to reduce deficits. According to Mr Bodie, the regulators proposals will require companies to stump up about a further 8 billion a year. Estimates for the regulator by PWC, an accountancy firm, demonstrate the potential burden. These show that for 65% of companies, the cost of paying off their FRS17 shortfall would
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amount to less than 25% of their free cash flow (profits plus depreciation). But for 15% of firms, it would absorb 25100%; and for 20% of companies, it would exceed the free cash that they can generate. Furthermore, companies are also facing another financial strain, the payments they must make for pension insurance. Within a few weeks, the PPF will reveal the total bill that it will charge private DB schemes next year the final building-block in the new structure for company pensions. The levy is likely to be double the governments original estimate of 300m a year, says Raj Mody of Hewitt, a human-resources consultancy. Even with such a boost to its resources, there are doubts about whether the PPF will prove viable in the long run without recourse to the taxpayer. In America the PBGC has been overwhelmed by huge claims from foundering industries such as steel and airlines. Its become painfully clear that policy towards pensions has become industrial policy, says Olivia Mitchell, executive director of the Pension Research Council. When this happens, she says, the system ceases to be insurance and becomes bail-out. The immediate danger is that firms may conclude that the load on them is too much to bear. If you push too hard, employers will give up, says Robin Ellison, chairman of the National Association of Pension Funds. Already about 70% of DB schemes are closed to new employees. The NAPF is now expecting a second wave of closures, in which firms would stop the future accrual of pension benefits for existing members of DB schemes. Alternatively, they might make accrual less generous, so that each year of future service builds up less benefit. With so many schemes already closed to new employees, the traditional company pension is a dying species. The worry about the regulators approach is that if business decides the pressure is excessive it can and will advance that date with the undertaker.
The Economist, 3 November 2005, Vol. 377, No. 8451, pp. 5960
4.4.2 Effective monitoring of the corporate performance

Fund managers tend to invest in companies at arms length and have been accused of merely voting with their feet when managers under perform, rather than using their votes or even their personal influence to effect organisational change. We discussed the role of individual and institutional shareholders in the market for corporate control in Section 3.3 and provided an example of a failed takeover bid for the London Stock Exchange and the role of shareholders. A number of high-profile pension funds in the US, most notably CALpers, the pension fund of Californias state employees, have begun to flex their muscles and use their vote more aggressively and some movement has been made in the United Kingdom towards this. Fund managers, and the analysts who sell them ideas, have privileged access to
management in the sense that directors make presentations to fund managers, talk to them regularly on the telephone and welcome visits to company headquarters and other sites. Fund managers can also influence such decisions as choice of chief executive, chair, nonexecutive directors and remuneration policy for executives. In recent years, institutional investors have been pushing firms to adopt the best board practices in corporate governance and we discussed the internal-performance metrics, such as balanced scorecard and EVA in Section 3. Institutional investors have begun using external scorecards on the quality of board-governance mechanisms of the companies they invest in. Institutional Shareholder Services (ISS) and Governance Metrics International (GMI) are two leading rating agencies that rate the corporate-governance mechanisms of companies. The effectiveness of these scorecards, however, is not reliable according to early research on the relationship between the ratings awarded on governance and the stock-market performance of companies (see Box 4.8).
BOX 4.8 CORPORATE-GOVERNANCE SCORES: WHAT THEY TELL AND WHAT THEY MAY NOT
Koehn and Ueng (2005) examining the relationship between governance scores and stock returns conclude that the investors should not rely too heavily upon the governance scores being awarded by ISS (the study examined the sample of companies rated by ISS). Interestingly they note that high governance scores do not mean that the company is highly ethical. If anything, governance and ethics scores seem to be inversely related. A high ethics score may be an indication that the company is engaged in a public relations whitewash, trying to distract attention away from issues of governance or earnings. They also do not find a strong positive correlation between a high governance score and high-quality earnings. They advise: Investors who want to consult governance data before buying or selling stock will be well advised to consult multiple data sources and to supplement quantitative scores from ISS, Fitch, GMI etc.) with the qualitative analysis of governance.
Source: Koehn and Ueng (2005)
Some progress has been made on voting strategy by institutional investors. Most are encouraged to cast their own vote at corporate annual general meetings or extraordinary general meetings, rather than adopting the more passive approach of allowing their votes to be cast as the directors see fit. This passive approach to voting has allowed senior managers of firms with substantial holdings by institutional investor, for example those firms in the FTSE 100, to act as they see fit and to fight off any criticism by small investors, whose holdings are insufficient to make an impact on any vote.
Institutional investors have also become involved in discussions over executive pay; in particular, schemes where pay is linked to performance. They have encouraged schemes such as that implemented at BP, which is designed to achieve just the level of out-performance relative to a benchmark that they, as fund managers, need to achieve (see Box 4.9). You may also recall from Section 3 that before a change in the remuneration packages of GlaxoSmithKlines chief executive and directors the management had discussed the proposals with the National Association of Pension Funds. There is, however, clearly some way still to go as the Financial Times survey described in Box 4.9 below highlights.
BOX 4.9 SHARES IN THE ACTION

An Financial Times survey asks what part leading shareholders play in the running of companies and what top directors think of their investors. How do shareholders actually affect the running of UK businesses? And what do directors of the UKs 100 biggest companies really think of the institutional investors who own their assets? The answers, in a no-holds barred survey carried out by the FT, make salutary reading for those who see the [Anglo-American] model of share ownership as the brave new world order. [See Table 4.4.] Under this vision, well-informed shareholders take an active role in improving company performance; they keep executives on their toes by asking awkward questions about strategy; they punish mistakes by disinvesting; and they reward good performance by bidding up the share price, making it easier or cheaper for companies to raise more money. The reality, as seen through the eyes of the company directors involved, is a little more prosaic. While there is widespread evidence that fund managers are demanding more interviews, the usefulness of meetings is often questioned by finance directors called to them. Many of the 74 finance directors interviewed for the survey resented the time spent educating fund managers who are moved on before gaining adequate knowledge. Several directors were also irked by fund managers who asked for more and more attention. When they want a meeting they want it now, which is very frustrating when you are trying to run a business, said one. Some of the comments will leave their unidentified speakers open to charges of thinking like corporate dinosaurs. Some [institutional investors] believe that they own the business, said one director, but they are traders in financial instruments. That comment ignores the most basic tenet of the [Anglo-American] view of capitalism: shareholders do own the business.
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A more common criticism of shareholders is that they rarely add anything that the companies perceive to be of value. Almost half of those surveyed felt that their main shareholders rarely or never offered any useful comments about their business. A surprising number of directors expressed the view that shareholders were too docile a breed in general. We often wonder why institutional investors tolerate inadequate performance in other companies, said one director. They could often be tougher. We sometimes wish shareholders would be tougher. The poll comprising companies in the FTSE 100 index was conducted by FT journalists with finance directors and in a few cases, with other relevant senior executives. There was a 74 per cent response rate.
Source: Financial Times, 27 April 1998
Table 4.4 What finance directors think of their shareholders

How often do your major investors try to use muscle behind the scenes to make you change your strategy, financial targets or corporate governance?
Occasionally 7% Rarely 51% Never 41% N/A 1%
Do you feel hampered in taking the correct long-term strategy?

Yes 7% No 89% N/A 4%
How often do your major investors make useful comments about your business?
All the time 1% Often 7% Occasionally 43% Rarely 45% Never 3% N/A 1%
How well do your major investors understand your business?

Very well 13% Quite well 29% Well 56% Poorly 1%
Has your major investors involvement over the issue of executive pay been:
Very helpful? 1% Helpful? 24% Neutral? 57% Unhelpful? 3% N/A? 15%
Do you feel major investors are long-term investors?

Yes 98% No 1% N/A 1%
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ACTIVITY 4.3
Listen to Audio programme, Corporate governance, which features BP and Scott Bader, two very different United Kingdom-based companies. Listen for differences between the two companies in perceptions of stakeholders, performance measures, executive remuneration and motivation.
4.5
SUMMARY
In this section, we have looked at performance-measuring and governance issues in the public sector, in voluntary organisations and in pension funds. Increasingly, the yardsticks of performance are being measured in monetary terms and focusing on value-for money criteria. We provided examples of value for money and also illustrated the importance of the financial capabilities required for effective governance mechanisms, as evidenced in the case of the NHS. The absence of clearly defined corporate goals and inadequate incentive structures within voluntary organisations coupled with the fact that many objectives are not easily measurable make the governance of voluntary organisations a real challenge. We have seen how pension funds and institutional investors are judged on performance relative to their twin objectives of satisfying the funding requirements and playing the role of watchdog of companies they invest in. We find that some of private-sector pension funds exposed to risks of lower yields have ended up with under funding.
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5 SUMMARY AND CONCLUSIONS
SUMMARY AND CONCLUSIONS
In this concluding unit, we have attempted to integrate a number of themes from the course as a whole, in particular finance and accounting. The major themes of the unit have been the control and accountability in the internal and external contexts of organisations. We have looked at how accounting and finance are used to control the behaviour of senior managers by outside investors (the corporate-governance issue) and that of middle managers by senior managers through performance measures, both in the public and private sectors. Section 2 situated the issues of performance measurement and control in the broader context of corporate governance. Different views on corporate governance were presented, particularly noting the differences between the Anglo-American, outsider governance mechanisms and the Franco-German and Japanese, insider governance mechanisms. It was suggested that exact measures of performance and control would depend on the general approach to corporate governance taken in different countries. Section 3 discussed various internal measures of performance measurement and control. We noted that there seems to be a trend for performance measurement to be orientated more towards shareholder value, as evidenced by popularity of value-based measures such as EVA1 and balanced scorecards. The section also discussed many external corporate-governance mechanisms such as the role of the board of directors, audit committees, independent directors, institutional investors and the market for corporate control. In Section 4 we extended the corporate governance themes to public-sector organisations, the voluntary sector and pension funds. The challenge of effective corporate governance in the public and voluntary sectors comes from the multiplicity of goals they pursue and their non-financial nature. Absence of clear property rights, pricing mechanism and unclear incentive structures compound the governance challenge. Looking at the extensive literature on corporate governance and plethora of new performance measures emerging frequently, we conclude by noting some basic, but simple economic principles. Adam Smith argued long ago that effective property rights, competitive markets and enlightened self interest are all we require to make the capitalist system work. Two hundred years after Adam Smith, however, the world has become a little more complex and complex organisations have emerged. In both the
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categories for profit and not-for-profit organisations the owners or members are separated from the managers. Therefore, the search for appropriate corporate-governance mechanisms will continue.
LEARNING OUTCOMES
You should now have achieved the following learning objectives and be able to:
l
assess the relevance and relative efficiency of different structures of corporate governance; describe how external investment managers and internal line managers assess the performance of different investments and operating units respectively; show how performance measures such as economic value added, cash-flow return on investment and discounted cashflow analysis can be used both as external and as internal performance measures; apply the principles of value-for-money auditing in the context of the public sector; describe the financial objectives and performance measures used by institutional investors, such as pension funds.
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ANSWERS TO EXERCISES
ANSWERS TO EXERCISES
EXERCISE 2.1
Corporate governance provides a framework for the accountability of managers and the board of directors to ensure that they achieve corporate objectives efficiently. Corporate-governance mechanisms for commercial firms will evolve in response to the ownership patterns of individual firms, the role of the banks and other institutional investors in corporate financing, the corporate laws of the land, the constitutional or other legal rights given to employees of firms, the extent to which financial markets are developed and to the general economic-development approach to industrial ownership and management, for example capitalist or socialist.
EXERCISE 3.1
The annual reports of Volkswagen AG show that in 2003 and 2004 the companys Automotive Division contributed a negative economic value of E2,190 million and E2,678 million respectively. The main drivers of this negative economic value, according to the annual reports of the relevant years, seem to be reduced operating profits owing to deteriorating market conditions and higher investments required as upfront expenditure for new product developments (Volkswagen AG, Annual Report, 2002). The company attributed continued negative value contribution to exchange rate movements, higher sales promotion costs and increased depreciation of property, plant and equipment resulting from the renewal of the product range.
EXERCISE 3.2
The effect of a reduced WACC would be an increased EVA1, provided returns were not also affected. Given that senior managers do not influence the level of interest rates, it could be argued that they should not be rewarded for increases in EVA1 due to such a change. Similarly, they would be unduly penalised if interest rates and hence the WACC rose because of circumstances beyond their control.
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EXERCISE 3.3
Important issues in remuneration policy are the time horizons in performance measurement and the benchmarks. In the case of GSK, we find that the company has linked the executive incentives with EPS growth rates, benchmarked at 4.9% per annum. This benchmark is based on the consensus forecast of analysts. The time horizon is three years. Although the company calls it a long-term incentive, three years would normally be considered short to medium term. A second point worth noting is the importance of analysts forecasts in driving managerial behaviour. In addition to the benchmark of total shareholders returns, there is a benchmark based on the average of industry comparator companies. Careful analysis is required if one is to accept the assumption that the top fifteen global pharmaceutical companies operating from different countries make a homogenous group. It is clear, however, that by having different rewards for exceeding EPS growth and TSR targets this policy implies that EPS growth does not fully capture shareholders returns: that is, the link between EPS and share price is weak enough to require executive remuneration also to be based on shareholders returns!
EXERCISE 4.1
The Wolverhampton case raises several governance themes that we considered in Section 2 above. It highlights a clear lack of internal control mechanisms to prepare operational financial budgets and a lack of an effective reporting system to identify the problems. Reliance on non-recurrent funding sources may be analogously compared with the other income item for private sector firms. If other income were confused with the main source of revenue for a commercial company it would lead to unreliable forecasts of revenue. We raised the issue of non-executive directors earlier and argued that they need to be skilled enough to contribute meaningfully to the board. In the review of the Wolverhampton Trust we can see this is identified as a major problem. A clear need has been felt within the public sector to have more financial directors in the government departments (Gershon, 2004). The inability of the management of the Wolverhampton Trust to understand the financial implications of non-recurrent funding and the lack of knowledgeable board members bring into play the agency problem, albeit in an information asymmetry framework, where the management and the board failed to appreciate the need for appropriate information, its reporting and interpretation.
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REFERENCES
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National Audit Office (2004) PFI: The STEPS Deal, London, The Stationery Office. National Association of Pension Funds (2005) Pension Scheme Governance: Fit for the 21st Century?, London, NAPF. Normanton, E.L. (1966) The Accountability and Audit of Governments, Manchester, Manchester University Press. Organisation for Economic Co-operations and Development (2004) OECD Principles of Corporate Governance, Paris, OECD. ODonnell, G. (2004) Financing Britains Future, Review of the Revenue Departments, London, HMSO. OHanlon, J. and Peasnell, K. (1998) Wall Streets contribution to management accounting: the Stern Stewart EVA1 financial management system, Management Accounting Research, no. 9, pp. 42144. Ohlson, J. (1989) Accounting earnings, book value and dividends: the theory of the clean surplus equation (Part I), in Brief, R. and Peasnell, K. (eds) (1996) Clean Surplus: A Link Between Accounting and Finance, New York, Garland. Ohlson, J. (1995) Earnings, book values, and dividends in equity valuation, Contemporary Accounting Research, vol. 11, no. 2, pp. 66187. Olson, D. E. (2000) Agency theory in the not-for-profit sector: its role at independent colleges, Nonprofit and Voluntary Sector Quarterly, vol. 29, no. 2, pp. 28696. Pallot, J. (1991) Local authority reporting: major advances made, The Accountants Journal, August, pp. 469. Pallot, J. (1991) Accounting, auditing and accountability in Boston (ed.) Reshaping the State, pp. 198232. Pfeffer, J. and Salancik, G. (1978) The External Control of Organisations: A Resource Dependence Perspective, New York, Harper Collins. Power, M. (1994) The Audit Explosion, London, DEMOS. Preinreich, G. (1938) Annual study of economic theory: the theory of depreciation, Econometrica, July, pp. 21941. Public Administration Select Committee (2003) On Target? Government by Measurement, London, The Stationery Office. Rebrioux, A. (2002) European style of corporate governance at the crossroads: the role of worker involvement, Journal of Common Market Studies, vol. 40, no. 1, pp. 11134. Rouse, J. (1993), Resource and performance management in public service organisations, in Kester, I. H., Painter, C. and Barnes, C. (eds) (1993) Management in the Public Sector London, Chapman & Hall.
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Schmidt, R. H. (2004) Corporate governance in Germany, in Krahenn, J. P. and Schmidt, R. H. (eds) The German Financial System, Oxford, Oxford University Press. Sharkansky, I. (1991) The auditor as policy maker, in Friedberg, A., Geist, B., Mizrahi, N. and Sharkansky, I. (eds) State Audit and Accountability: A Book of Readings; Jerusalem, State Comptrollers Office, pp. 7494. Smith, R. (2003) Audit Committees Combined Code Guidance, London, Financial Reporting Council. Stern, J.M., Stewart, G.B. and Chew, D.B. (1995) The EVA1 Financial Management System, Journal of Applied Corporate Finance, vol. 82, pp. 3246. Sternberg, E. (2004) Corporate Governance: Accountability in the Market Place, London, The Institute of Economic Affairs. Stewart, J. and Walsh, K (1994) Performance measurement: when performance can never be finally defined, Public Money and Management, vol. 14, no. 2, pp. 459. Treanor, J. (2005) Non-executive directors could be hard to find, The Guardian, 3 October. Tokyo Stock Exchange, Fact Book 2005, Tokyo. Towers Perrin. (20012002) Worldwide total remuneration, www.towersperrin.com. Wilson, J. (2004) Comprehensive performance assessment: springboard or dead weight?, Public Money and Management, January, pp. 638. Yoshikawa, T. and Phan, P. H. (2001) Alternative corporate governance systems in Japanese firms: implications for a shift to stockholder-centered corporate governance, Asia Pacific Journal of Management, vol. 18, no. 2, pp. 183206.
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ACKNOWLEDGEMENTS
Grateful acknowledgement is made to the following sources:
Text
Box 1.2: Castenskiold, E. and Penrice, V., Governance policy, Investor Centre, www.mbplc.com, Mitchells & Butlers plc; Box 2.3: Mitsubishi Electric Corporation (2005) Corporate governance, http://global.mitsubishielectric.com/investors/publication/ strategy200505.html, Mitsubishi Electric Corporation; Box 3.3: BASF plc, We earn a premium on our cost of capital, http:// www.corporate.basf.com, BASF plc; Box 3.4: GlaxoSmithKline (2003) GlaxoSmithKline announces new executive remuneration arrangements, www.gsk.com, GlaxoSmithKline; Box 3.8: Shareholder power, The Economist, # The Economist Newspaper Limited, London, 11 May 2005; Box 4.7: Out of pocket, The Economist, # The Economist Newspaper Limited, London, 3 November 2005.
Tables
Table 2.1: Hackethal, A., and Schmidt, R.H. (2000) Komplementaritt und Finanzsystems, Kredit und Kapital Beiheft 15 Neue finanzielle Arrangements: Mrkte im Umbruch, Duncker & Humblot; Table 3.1: Jrg, P., Loderer, C. and Roth, L. (2003) Shareholder value maximisation: what managers say and what they do, Department of Finance, University of Bern; Table 3.2: Drury, C. and El-Shishini, H. (2005) Divisional Performance Measurement: An Examination of the Potential Explanatory Factors, Chartered Institute of Management Accountants; Table 3.3: Volkswagen AG, Annual Report 2002, Volkswagen AG; Table 3.4: Volkswagen AG, Annual Report 2004, Volkswagen AG.
Figures
Figure 1.1: The enterprise governance framework (2004) Enterprise Governance, International Federation of Accountants; Figure 2.1: Hackethal, A., Schmidt, R.H. and Tyrell, M., Banks and German corporate governance: on the way to a capital marketbased system?, Corporate Governance: An International Review, volume 13, number 3, May 2005, Blackwell Publishing Limited; Figure 2.2: Hackethal, A. and Schmidt, R.H. (2004) Financing Patterns: Measurement Concepts and Empirical Results, Working Paper Series: Finance & Accounting No. 33 revised, University of Frankfurt; Figure 2.3: Foreign investment in Japanese securities 19952004, Fact Book 2005, Tokyo Stock Exchange; Figure 3.2: EVA drive tree, Volkswagen AG, Automotive Division, 2002, Volkswagen AG.
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ACKNOWLEDGEMENTS
Illustrations
Page 62: # The Hulton Getty Picture Collection; Page 65: The Customs House, Greenock, National Audit Office, PFI: The STEPS Deal, Crown copyright material is reproduced under Class Licence Number C01W0000065 with the permission of the Controller of HMSO and the Queens Printer for Scotland.
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Measuring Performance

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B821 Financial Strategy Block 5 Strategic Implications

Measuring Performance: Internal and External Perspectives

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

External view Corporate governance

Internal view Business governance

OUTLINE OF THE UNIT

OBJECTIVES OF THE UNIT

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

BOX 1.2 GOVERNANCE POLICY AT MITCHELLS & BUTLERS PLC

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

BOX 2.1 OECD PRINCIPLES OF CORPORATE GOVERNANCE

The rights of shareholders and key ownership functions

The equitable treatment of shareholders

The role of stakeholders in corporate governance

Disclosure and transparency

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

1.6 UK 1.2 US 0.8 Japan

Equity market capitalisation over

80% 75% 74% Germany Japan US

20% 15% 14% 9% 9% 8% 9% 2% 0% Bank loans NBFI loans Bonds

ANGLO-AMERICAN VIEW ON CORPORATE GOVERNANCE

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

You first met agency theory in Unit 1.

CONTINENTAL EUROPEAN (FRANCO-GERMAN) APPROACH

Relationship lending versus Arms-length lending

Internal labour markets versus External labour markets

Internalisation of information versus Externalisation

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

Hostile takeover bids*

5.1 5.2 5.5 5.9

4.1 3 2.9 2.4

4.6 4.1 4.2 4.2

Table 2.3 2001 02

Components of CEOs pay as a percentage of total remuneration,

Belgium France Germany Italy Netherlands Spain Sweden UK USA

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

2.3.1 Are European governance systems converging towards an Anglo-American approach ?

JAPANESE APPROACH TO CORPORATE GOVERNANCE

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

2.4.1 The changing face of corporate governance in Japan

BOX 2.2 CORPORATE GOVERNANCE AT SONY

Adapted from http://www.sony.net/SonyInfo/IR/governance.html

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

BOX 2.3 CORPORATE GOVERNANCE AT MITSUBISHI ELECTRIC

Source: http://global.mitsubishielectric.com/investors/publication/ strategy200505.html

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

3 MEASURING CORPORATE PERFORMANCE

MEASURING CORPORATE PERFORMANCE

Answers provided by CFOs, treasurers and controllers

95.9% (295) 80.6% (294)

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

78.7% (291) 57.0% (284) 55.5% (281)

79.7% (64) 75.0% (64) 48.4% (64)

75.7% (206) 58.9% (197) 56.1% (65)

BOX 3.1 CORPORATE OBJECTIVES

3 MEASURING CORPORATE PERFORMANCE

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES

EBIT stands for earnings before interest and taxes.

3 MEASURING CORPORATE PERFORMANCE

3.2.1 Economic value added

Economic income is also known as residual income.

UNIT 10 MEASURING PERFORMANCE: INTERNAL AND EXTERNAL PERSPECTIVES