Exploring our research and expertise across issues from modern slavery to sustainability, corporate reporting to crypto currencies. Accounting and Finance Lancaster University Management School | the place to be Analysing company reports 24Credit risk and accounting numbers 4UK modern slavery reporting 12 FIFTYFOUR DEGREES
Paying the Mafia premium How do the Mafia affect the operations of firms outside their operation. Dr Justin Chircop finds tax avoidance increases as businesses try to compete. 28 In this issue... 24 What can we learn about credit risk from accounting numbers? Dr Argyro Panaretou explains how a switch in measurement basis can provide a better insight into a firm’s credit risk. An Incentive to Increase Misconduct Many CEOs are rewarded for good performance with company stock options. Justin Chircop asks what happens if your company leader is rewarded for taking greater risks. 4 A match made in language and finance Professor Steve Young has been working with computer scientists and expert linguists on an interdisciplinary project to develop a novel app. 12 32 How well are UK companies reporting on modern slavery? Dr Mahmoud Gad’s reveals how far UK companies are complying with modern slavery reporting regulations. 8 Under new Management Dr Mykola Babiak investigates whether crypto fund managers are worth the money to ensure positive returns. Diversity pays There is a well-recognised problem with a lack of diversity in private equity firms, which are renowned for being made up of a small group of homogenous – predominantly male – individuals. 16 20 Do you want the good news or the bad news first? Dr Wendy Beekes' research into Japanese firms shows issues with transparency affect the bad news disclosures more than the good. 2 | Discover more of Lancaster University Management School’s world-leading research at lancaster.ac.uk/fiftyfour
Professor Steve Young and Professor Sandra Nolte Department of Accounting and Finance lancaster.ac.uk/lums/accounting-and-finance Welcome to Accounting and Finance at Lancaster University Management School (LUMS). I am delighted to introduce you to the department, the great work colleagues are doing, and the reasons why accounting and finance attracts so much interest. Accounting and Finance at LUMS is an acknowledged world leader. The department ranks 75th in the latest QS World Rankings by Subject (2024), and is one of the six subject areas that contribute to LUMS’ status as number one for research power among all UK business schools. Colleagues number more than 50, with expertise across a broad range of topics from financial reporting and analysis, through corporate governance and corporate finance, to asset pricing, portfolio management, and quantitative finance. You can find examples of the fascinating research they do throughout these pages. The breadth and depth of our expertise means we are ideally placed to address complex issues impacting financial markets. Take Mykola Babiak as example. His work investigates whether crypto fund managers provide positive value for investors. The answer suggests they do. Our range of expertise also enables us to partner with colleagues in other disciplines to work on the big challenges facing our economy and society, such as climate change, productivity, wealth inequalities, corporate behaviour, and digital technology. For example, our natural language processing work on corporate reports partners with researchers from computer science and linguistics to develop software capable of reading thousands of reports in minutes. We prioritise work that informs industry and business. As an example, Mahmoud Gad’s work on modern slavery reporting is a collaboration with the Financial Reporting Council and the UK Antislavery Commissioner. Argyro Panaretou’s project exploring how to account for credit risk is a partnership with the International Financial Reporting Standards (IFRS) Foundation. Our approach is based on a virtuous cycle where research informs our teaching and vice versa. This cycle delivers direct benefits to our students in the form of exposure to cutting-edge debates and insights that do not feature in standard textbooks but are nevertheless at the forefront of employers’ and regulators’ minds. Examples include work examining how executive pay arrangements can encourage corporate fraud; how corporate governance improves some aspects of reporting but not others; and how organised crime and tax avoidance are linked. Our expertise and applied focus delivers teaching that is academically rigorous and practically relevant – bringing benefits to lectures and seminars. Examples of our skills-focused approach to education include financial analysis using Bloomberg and Refinitiv, python coding, spreadsheet modelling, professional ethics, and support with the Chartered Financial Analyst qualification. And because we operate at the forefront of knowledge in the discipline, our graduates are attractive to top employers. We reinforce this appeal with extensive careers support that includes an award-winning business careers service, supplemented with specialist careers coaches who bring expert knowledge of graduate recruitment in finance and accounting. Our careers coaches work one-to-one with students to support their career journey. Our support starts before students arrive on their degree and continues after they graduate. I hope you enjoy reading more about our work; and if you would like more information then please do not hesitate to contact us. Welcome FIFTY FOUR DEGREES | 3
4 | How well are UK companies reporting on modern slavery?
FIFTY FOUR DEGREES | 5 Legislation means all UK companies must publish modern slavery reports every year in a bid to tackle a pressing global issue. Dr Mahmoud Gad reveals how his research shows not all companies are entirely transparent, and the importance of full and accurate reporting in combatting practices which adversely affect millions of people around the world.
Modern slavery is a global problem. Millions of people suffer because of it, and it generates billions of dollars for criminal networks worldwide. It also poses a serious risk for businesses that may have modern slavery in their operations or supply chains, damaging their reputation and profitability. The UK’s Modern Slavery Act of 2015 marked a significant step in addressing this issue. It mandates companies to publish annual modern slavery and human trafficking statements signed off at the board level. However, recent research by Professor Steve Young and myself, working with the Financial Reporting Council and the UK Independent Anti-Slavery Commissioner reveals varying degrees of transparency in reporting practices among companies listed on the London Stock Exchange (LSE). We analysed the quality of reporting practices for a sample of 100 LSE-listed companies, across the FTSE 100, FTSE 250, and Small Caps. Our analysis covered reporting in the latest available modern slavery statements and annual reports as of June 2021. Our assessment framework is based on a disclosure template developed by the Business and Human Rights Resources Centre to evaluate FTSE 100 companies’ modern slavery statements published in 2018. The template covers six areas of reporting recommended by the Modern Slavery Act: organisation structure, policies, due diligence, risk assessment, training, and effectiveness. We added additional dimensions of reporting practice, such as readability, accessibility, cross-referencing, etc. We measured the quality of reporting at three levels: no/immaterial disclosure, some/moderate disclosure, and comprehensive/full disclosure. REPORTING ISSUES Some of our main findings in the modern slavery statements are: • Around one in ten companies did not provide a modern slavery statement at all. • Only one third of modern slavery statements were clear and easy to read. • Less than half of companies provided a clear and comprehensive discussion of modern slavery concerns in their organisational structure, operating and supply chains. • Only a quarter of companies disclosed results against their key performance indicators (KPIs), and just 12% confirmed they have made informed decisions based on those KPIs. • Only a third of statements clearly identified emerging issues or a long- term strategy. • Most companies provided a link to their modern slavery statement on the Home Office’s online registry, but many failed to provide a direct link to the document or to link to their most recent statement. For annual reports, some of our main findings are: • Reporting on modern slavery issues was surprisingly minimal. • Only 13% of companies referred directly to forced labour and slavery issues in their section 172 statement 6 |
(where companies describe how directors have considered the long- term consequences of their decisions, including their impacts on the community and the environment). • Only 15% of companies discussed modern slavery in the context of principal risks and uncertainties facing the business. • Only 18% of companies referred to performance indicators in the context of slavery and human trafficking. • Only one company included modern slavery KPIs in their section 172 statement. Surprisingly, our analysis revealed minimal reporting on modern slavery issues in the annual reports. Though the UK Corporate Governance Code does not explicitly address modern slavery, it requires companies to disclose risks and opportunities related to the success of the business. With the complexity of global supply chains and the potential economic and reputational damage caused by human rights abuses, modern slavery risks are – or certainly should be – a significant concern for businesses across all sectors, and thus in need of reporting beyond specific modern slavery statements. In fact, only 14% of the annual reports we studied provided a direct link to the corresponding modern slavery statement. This lack of cross-referencing not only reduces transparency on modern slavery issues but also undermines efforts to address the risks. Companies that consistently fail to crossreference their approach to modern slavery will likely struggle to receive recognition for their work in this area. Not all patterns in reporting practices were the same across all the companies in our sample. We found some crosssectional variation according to company size, sector, and business complexity. For instance, FTSE 100 companies tend to report more information on modern slavery than FTSE 250 and Small Caps, but the difference between the latter two groups is not significant. We also found that companies operating in sectors with higher modern slavery risk, such as those working in basic materials, utilities, and consumer staples, tend to provide more detailed disclosure than companies in low-risk sectors, such as tech and financial services. Finally, multi-sector companies tend to provide more transparent modern slavery disclosures than single-sector companies, reflecting their higher operational complexity and greater supply chain diversity. EFFECTIVE ACTIONS The research also highlights areas of concern in modern slavery reporting, including due diligence processes, risk assessment and management, and the effectiveness of actions taken by companies to address the issue. It is crucial for businesses to disclose modern slavery risks in their operations and supply chains, and measure the effectiveness of their actions to promote transparency and accountability. To ensure progress in the fight against modern slavery, companies must take a proactive stance in assessing and managing the risks associated with their workforce and supply chain. Boards must provide oversight and implement effective policies to drive real action in addressing modern slavery. Furthermore, companies should demonstrate the effectiveness of these policies through comprehensive and transparent reporting. Accurate and thorough modern slavery reporting is essential in the battle against human rights abuses. By promoting transparency and accountability, businesses can contribute significantly to the eradication of modern slavery and foster a more ethical and sustainable global economy. FIFTY FOUR DEGREES | 7 Dr Mahmoud Gad is a Lecturer in the Department of Accounting and Finance, and a member of the Pentland Centre for Sustainability in Business. The report Modern Slavery Reporting Practices in the UK: Evidence from Modern Slavery Statements and Annual Reports, was authored by Professor Steve Young and Dr Mahmoud Gad, of Lancaster University Management School, and commissioned by the Financial Reporting Council (FRC) and the UK Independent Anti-Slavery Commissioner (IASC). m.gad1@lancaster.ac.uk Click to listen to the podcast
Under new Management 8 |
The cryptocurrency market is worth trillions. Investors have been drawn to digital assets for the last decade by the promise of big returns. Yet the market is volatile, has already experienced one major crash in its short lifespan, and investors can just as easily lose their funds as increase them. With that in mind, Dr Mykola Babiak investigates whether crypto fund managers are worth the money to ensure positive returns – and if they rely more on luck than skill when it comes to turning a profit for investors. FIFTY FOUR DEGREES | 9
Bitcoin. Ether. Tether. Cardano. Depending on your knowledge, you might recognise each of these as major cryptocurrencies. Cryptocurrency markets are big business. The rising prices and awareness of Bitcoin since its emergence in 2009 have drawn in investors with the promise of significant returns. From a value of US$0.0008 per Bitcoin in 2010 to a market high of US$61,374 in October 2021, there has been the potential to make significant long-term or short-term (the price in September 2021 was US$41,412) gains. Yields from cash, bonds or other traditional assets are seen as paltry in comparison, and people want in, no matter what the risks – Bitcoin dropped 20% of its value over a matter of days in June, and the value at the time of writing had dropped below US$25,000, its lowest level since late 2020. The hyperbolic growth of cryptocurrency markets has led to larger investments in what is a whole new category of specialised funds. While much cryptocurrency trading still takes place on an individual level, as people buy and sell their stashes there is an increased demand for institutionalised investment. Our research investigated the performance of funds that specialise in cryptocurrency markets, to give us a better understanding of the value of digital assets as investments and the value of fund managers in providing a positive return. We looked at the performance of 250 funds specialising in cryptocurrencies between March 2015 and June 2021. That period encompasses a significant boom until December 2017, and a major collapse in early 2018 – the socalled ICO bubble burst. After that, there was sideways movement until Covid-19. The pandemic saw a major market drop, before it soared once more as Bitcoin, Ethereum and all other major cryptocurrencies hit record highs by early 2021. WORTH THE MONEY? The value of fund managers in all markets has been widely debated, especially since the increased popularity of more passive and cheaper forms of investment, such as exchange-traded funds. We wanted to find out if fund managers can generate a return above and beyond the expenses an investor encounters. We focused on four types of fund: Hedge Funds (HF), Tokenised Funds (TF), Managed Accounts (MA), and Fund of Funds (FoF). Hedge funds (60% of our sample) and managed accounts (8%) work in the same way for crypto investors as for standard market investors, whereby high net-worth investors can access a high degree of customisation and expertise. Tokenised funds (10% of our sample) 10 |
are specific to the crypto realm, though similar to buying shares in a regular fund except that quotas are bought in the form of crypto coins or tokens. A fund of funds (6% of our sample) takes a multi-manager approach and invests in a set of funds in the same way as in standard markets. We can classify fund managers’ strategies in similar ways to traditional equity funds: long-short, long-term, market neutral, multi-strategy, and opportunistic. Long-short funds primarily employ a short- or medium-term investment process seeking to capitalise on the volatility of the market. Long-term funds tend to invest in early-stage projects as well as implementing long-only strategies in the largest and more liquid cryptocurrencies. These tend to have the longest lock-up for investors. Market neutral funds seek to have neutral exposure to the market trend by over- or underweighting certain assets. These strategies focus on making concentrated bets based on pricing discrepancies across cryptocurrencies. Opportunistic funds target underpriced digital assets to exploit special situations, such as the announcement of joint ventures, bugs in the protocols, or other events that might affect an asset’s short-term prospect. Multi-strategy funds combine all of the above. POSITIVE RETURNS Our evidence shows that managers of crypto funds are able to generate large and economically significant returns, which may be explained by the low levels of competition on the market. During the time period we studied, the average crypto fund significantly outperformed both the average hedge fund and the aggregate equity market, with an astonishing 600% cumulative return, compared to between 40% and 60% for equity funds. There is no dominant strategy. Some managers outperform others irrespective of their approach, though three strategies reap the biggest rewards: Long-term, long-short, and multi-strategy. Monthly adjusted returns on all funds average 3.71%, with TF generating 8.15% at the top end, more than twice that of other funds: FoF (3.08%); HF (2.7%) and others (3.99%). Overall, the results show that, at the aggregate level, cryptocurrency funds provide positive value for investors above and beyond the standard trajectory of the overall markets, and allowing for a substantial variance in the levels of performance. MORE THAN LUCK These markets are characterised by an incredibly high volatility in returns, making disentangling luck and skill on the part of fund managers more difficult, but the extreme outperformance of managed funds compared to passive investment benchmarks is unlikely to be explained by good luck on the part of fund managers. We found that while the majority of funds produce profits within the 0% to 5% range, with a sizeable number above 10%, the best and worst managers can reach -17% and +38% respectively on a monthly basis. The performance of a handful of the best funds is stronger than anything that could be explained by fortune. So, the evidence is there that managed funds in cryptocurrency markets do pay off – if you can afford them and are willing to take the risk. Although there is evidence of strong economic performance, this is still a highly volatile and risky market, and performances of fund managers are correlated accordingly. FIFTY FOUR DEGREES | 11 Dr Mykola Babiak is a Lecturer in Finance in the Department of Accounting and Finance. His research centres around asset pricing, macro-finance, financial derivatives, and digital currencies. He is particularly interested in understanding how investor expectations and uncertainty affect asset prices. Recently, his work is focused on unravelling the drivers of asset returns and premiums in the foreign exchange and cryptocurrency markets. The paper On the performance of cryptocurrency funds, by Dr Daniele Bianchi, of Queen Mary University of London, and Dr Mykola Babiak, is published in the Journal of Banking and Finance. m.babiak@lancaster.ac.uk
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FIFTY FOUR DEGREES | 13 Professor Steve Young has been working with computer scientists and expert linguists on an interdisciplinary project to develop a novel app, which will help researchers and industry professionals perform large-sample statistical analyses on companies’ annual reports. A match made in language and finance
Annual reports are among the most important documents that companies produce in their reporting cycle. They complement many other disclosures that management make to shareholders and other stakeholders throughout the fiscal year. Shareholders, regulators, stakeholders, journalists and financial analysts all use them to assess firms’ health, prospects, and the quality of management decision-making. These reports contain a lot of information in a qualitative format (text). Until relatively recently, the volume of information in the typical annual report and complementary disclosures could be feasibly analysed by reading it manually. Most annual reports comprised 30 or 40 pages maximum in the 1980s and 1990s, however, over the last two decades their average length has grown dramatically and currently stands at approximately 34,000 words. Some reports are more than 300 pages long, containing more than 100,000 words. Analysing a single report is now a significant challenge; reading multiple reports, along with other company disclosures – as many investors and financial analysts are required to do – is practically impossible. This information-processing problem is exacerbated by the unstructured, non-uniform format of annual reports, making it hard to find specific items of information using manual search techniques. It is no longer feasible for an analyst or an academic researcher to read through hundreds (or even dozens) of annual reports and conduct manual analysis. Some sort of automated approach is required: this is where we come in. Working with Lancaster’s School of Computing and Communications (SCC) and Centre for Corpus Approaches to Social Science (CASS), as well as colleagues from the University of Manchester, we have developed an application to dissect and analyse narrative aspects of these reports. The Corporate Financial Information Environment – Financial Report Structure Extractor (CFIE-FRSE) application is designed to access and process large samples of annual reports disclosures electronically. It helps academic researchers perform largesample statistical analyses; but it also has applications for financial market professionals who conduct analysis using large datasets. CFIE-FRSE enables us to cut through hard-to-understand annual report language and aid users in identifying unusual patterns in corporate reports that may help to distinguish long-term financial strength from inflated shortterm profits. The challenge in designing this type of application is that it requires an interdisciplinary approach. On the one hand, computer scientists and computational linguists working alone can only make so much progress because they do not have the technical financial knowledge to build datasets to train and evaluate their algorithms. Designing an algorithm to extract and process complicated financial disclosures is more challenging than tasks such as measuring the general sentiment of social media posts and movie reviews. On the other hand, while accounting and finance specialists have the subject-specific technical knowhow, they typically do not possess the computing skills required to develop sophisticated algorithms and apply AI techniques. Our interdisciplinary approach brings together experts from computing, linguistics and accounting to build an application capable of extracting and analysing complicated financial disclosures. One of the questions we are addressing is: what makes a ‘good’ annual report? What are the language properties, structure and content that ensure an annual report provides useful information for users? Our findings are entirely consistent with accounting regulators’ assessments of high-quality reporting, and what linguists believe makes writing easy to read and understand. We find that discussion of strategy and business models is associated with high-quality annual reports; as measured by a quality award issued by an expert industry body such as the Investor Relations Society (IRS). Strategy is about how the firm creates and maintains value for stakeholders, the key thing a shareholder or stakeholder wants to know. Much of this information is forward-looking and therefore helps inform investment decisions: investors care more about what is going to happen to the business in the future than what has happened in the past. These dimensions speak very naturally to what we think of as being informative financial reporting and reflect current regulatory guidance on how management can make their financial reports more informative to users. On top of that, we identify a set of linguistic features associated with writing style and presentation of information that enables readers to understand a firm’s message more 14 |
clearly. For example, award-winning reports are more likely to use crossreferencing to increase connectivity between sections and ensure a more integrated discussion. We also find that award-winning reports are grammatically less complex and contain more relevancy markers signalling important content. These language and presentational features help to improve ‘cognitive processing’. Our app measures these features and ranks reports according to content and ease of cognitive processing. More than 26,000 documents published between 2003 and 2017 by companies listed on the London Stock Exchange have been analysed and scored on features such as length, readability, sentiment, and overall reporting quality. Average report readability – measured using an algorithm that penalises long sentences and complex words – is generally poor; and there has been no noticeable improvement over the sample period. Long, unstructured documents containing complex language mean many retail investors and other non-specialist stakeholders struggle to understand the typical annual report. Sentiment also varies dramatically across different sections within the same report. For example, sections where regulation and compliance shape content – such as governance statements and remuneration reports – are characterised by neutral language. In contrast, the tone of language is up to four times more positive in sections where management have more reporting discretion and where performance is the primary focus. Already, the practical applications of CFIE-FRSE are apparent. We are working with the Financial Conduct Authority to develop methods to improve the monitoring of companies by looking at what they disclose, and whether that can help predict future outcomes, particularly negative ones, such as accounting scandals. The Financial Reporting Council (FRC) has worked with us on various aspects of financial reporting. We have looked at strategy reporting and whether the information is useful. Just because management reports some information on strategy does not mean it is going to be useful: the devil is in the detail. The FRC are especially interested in understanding whether, when discussing strategy, management provide bland generic platitudes that fail to disclose any useful information; or whether they are actually saying something meaningful. We have also compiled a report, Hidden Talent, with the Pensions and Lifetime Savings Association around workforce reporting, looking at how much disclosure firms provide around aspects of their workforce, including training, health and safety, and wellbeing. The CIPD, which represent HR professionals, has expressed an interest in developing a framework for how companies should report on their workforce. The analyses we are able to do can test what firms currently say and hence what scope exists for further improvement. Finally, the IRS use aspects of our data and analyses to aid their best Practice Awards judges. The applications are many-fold, and as we refine our work further, we hope to make complicated and extensive annual report disclosures easier to access and analyse. Steve Young, is a Professor in the Department of Accounting and Finance. The original paper Retrieving, classifying and analysing narrative commentary in unstructured (glossy) annual reports published as PDF files, was co-authored by Mahmoud El-Haj, Paulo Alves, Paul Rayson and Martin Walker. s.young@lancaster.ac.uk FIFTY FOUR DEGREES | 15 One of the questions we are addressing using our app and data is: what makes a ‘good’ annual report? ʻʻ ʼʼ
16 | DIVERSIT PAYS
FIFTY FOUR DEGREES | 17 TY There is a well-recognised problem with a lack of diversity in private equity firms, which are renowned for being made up of a small group of homogenous – predominantly male – individuals. Dr Benjamin Hammer shows that increasing diversity can result in better results and buyout performance – key factors in a numbers-based business.
Diversity is a big issue for big business – and it is only growing more important. Increasingly, firms large and small around the world are recognising the importance – and the benefits – of reflecting the views and needs of minority groups when it comes to their operations and strategies. All strategic choices at the apex of a corporation – and thus a company’s performance – result from how managers filter and use information. To do this, they use their cognitive bases and value sets, and if you have a homogeneous group with similar characteristics making these decisions, you are missing out on different perspectives and potential choices. There are recognised benefits to diversifying boards, and there is already evidence that increased gender diversity delivers better firm performance. Studies have shown that more diverse boards are less prone to financial restatements and fraud, and that female board representation is linked to improved governance, environmental sustainability and corporate social responsibility, though it needs to be more than a token presence. Further research shows that Fortune 500 boards with female directors have higher returns on sales and invested capital than their all-male counterparts; and Goldman Sachs CEO David Solomon has announced his firm would not take a company public unless it has at least one ‘diverse’ board member. The Alternative Investment (AI) industry is one area where diversity is much needed. The industry, including hedge funds, private equity funds (PE) and venture capital, is a cornerstone of global wealth management, with around $12tn in assets under management (AuM), 16% of global AuM. Yet it is dominated by a homogeneous group of people – white men who attended elite business schools and came from investment banking or consulting. Women make up only 20% of AI professionals, represent less than 12% of senior positions globally, and in the USA own only 5% of PE firms, 18 |
accounting for 3% of the industry’s AuM. Among VC investors in the USA, only 2% are Hispanic and 1% are Black. There is a clear lack of diversity across the industry, but our research into the effects of diversity of Lead Partner Teams (LPTs) of PE funds on buyout performance shows that more sociodemographic diversity – of age, gender and nationality – leads to higher deal returns. The PE industry is a resultsdriven game, where there are powerful incentives for LPTs to maximise their portfolio company’s value in a short holding period, as large parts of their compensation are tied to deal performance, so there is much to be said for increasing diversity to boost performance – and profits. All diversity can disrupt group processes while simultaneously creating synergistic performance benefits; for a long time, there has been a debate over the ‘bright side’ and the ‘dark side’. On the bright side, diversity is thought to offer improved, more nuanced decision-making due to a broader set of perspectives; on the dark side, the belief is that there will be deteriorated decision-making due to the potential for clashes and a lack of cooperation. Our research took in 241 buyouts between 1997 and 2015 – the vast majority (95.4%) from Europe and North America. Among those buyouts, there were 547 partners, of whom only 27 were female, and 42.8% fell into the 10-year age-group between 35 and 45, the figures demonstrating the lack of diversity, but the results showed the benefits of socio-demographic diversity where it does exist. There are different perspectives when this diversity occurs, but because the different perspectives are not the result of deliberate career choices, these differences are beneficial. Differences in gender, age or nationality do not mean that members do not still share large parts of their cognitive bases and values, reflected in common life choices around work experience and education. This diversity creates a broad pool of opinions with few of the diversity costs that create arguments and a lack of communication and cooperation. The bright side of diversity becomes even more important in complex deals and uncertain deal environments. Large or cross-border deals, as well as inorganic deal strategies, increase the complexity for PE firms, and distinct perspectives, holistic assessments and adaptive thinking are helpful in mastering the deal environment and removing additional transaction costs. The ability to be flexible is critical during times of environmental uncertainty, so LPTs with diverse backgrounds benefit from superior information assessment, with these diverse perspectives, skills and backgrounds becoming more valuable. The same here is true for occupational diversity – LPT members from across different departments and areas of business expertise – but that is not generally the case for PE deals, which tend to suffer worse results as a consequence of this form of diversity. Generally, an increase in occupational diversity can cause communication issues, and this highlights that specialisation in a particular field can be more valuable than occupational diversification. Unlike gender, nationality, or age, the diversity factors around professional skills and attributes gained throughout a career are voluntary and can lead to people with distinct values and cognitive bases – marketing vs finance perspectives, for instance. This creates a lack of common ground, putting up barriers to communication and cooperation, outweighing the potential benefits of additional perspectives. These issues around occupational diversity should not obscure the benefits of socio-demographic diversity, but rather can help PE firms find an adequate balance between too little and too much diversity in their hiring and staffing policies. There can be too much of a good thing when it comes to diversity, when it leads to a lack of a ‘common language’ or a shared value-set owing to differing fields of expertise, but it is beneficial to have as much socio-demographic diversity as possible in the workforce. Hopefully, these results can help to convince more PE firms that it pays to employ such a diverse workforce, and support the drive by non-profit initiatives such as Level 20 to increase diversity in the notoriously homogeneous PE industry. That can only be a good thing. Dr Benjamin Hammer is a Lecturer in Accounting and Finance at Lancaster University Leipzig, and a member of the Accounting and Finance Department in Lancaster University Management School. The paper The More the Merrier? Diversity and Private Equity Performance is co-authored by Silke Pettkus and Norbert Wünsche, of HHL Leipzig Graduate School of Management, and Professor Denis Schweizer, of the John Molson School of Business at Concordia University, Montreal. It is published in the British Journal of Management. b.hammer@lancaster.ac.uk FIFTY FOUR DEGREES | 19
20 | An Incentive to Inc
FIFTY FOUR DEGREES | 21 crease Misconduct Many CEOs are rewarded for good performance with company stock options. But if the leader of your company is financially rewarded for taking greater risks, what happens? Dr Justin Chircop’s research finds that greater risk-taking stock option incentives are linked to a higher level of workplace misconduct in firms.
How do you incentivise your company leader to make decisions that benefit shareholders? For a long time, a typical method has been to pay them, in large part, in stock options. Chief Executive Officers (CEOs) are habitually given share-based payments to align their interests with those of shareholders – often as much as 80% of the CEO’s pay packet is made up of share- based payments. Shareholders’ investments in a company are such that they can take advantage of any benefits of success – the share price is theoretically unlimited, so the upside is unlimited. Contrarily, their downside is limited by the amount of their investment, all they can lose is what they invested – and we have all seen provisos on stock advertisements warning you to only invest what you can afford, as prices can go down as well as up. Shareholders benefit from a higher level of risk-taking in a company. If you are giving these stock options to the CEO, you are telling them they will benefit if they take more risks. Typically, there is a positive relation between risk and return, so the greater the risk, the greater the return. Data shows that, on average, a one per cent change in stock price volatility – the potential for it to go up or down – results in a $138,720 increase in the value of CEO stock options, and thus wealth. The benefits are clear – both for shareholders and for the CEOs themselves as they try to maximise a firm’s value – but there is a dark side to this rewarding of risk-taking. To generate acceptable returns, you need to take acceptable risks. But differentiating between acceptable and unacceptable risk is a very fine line. Stock options incentives can influence investment and financial decisionmaking, and can incentivise CEOs to invest in more risky projects and undertake more risky financing choices, but they can also encourage managers to engage in other risky practices, such as accounting manipulation and fraud. Managers who are under pressure to perform often engage in practices intended to boost firm profitability, but these same practices can compromise workforce safety and wellbeing to meet performance expectations. Previous research has shown that firms that just meet or beat analysts’ forecasts have higher injury rates than those that miss or beat them comfortably, and that local managers will violate rules and regulations when under pressure, a time during which there is also an increase in misconduct. Our research looked at the relation between these CEO incentives and workplace misconduct in the USA – where data is more readily available and accessible. Workplace misconduct includes health and safety violations, non-compliance with labour laws, and other violations broadly related to labour exploitation, and 22 |
misconduct perpetrated by management relating to the working environment. If the use of stock options in executive compensation contracts encourages managers to undertake risky and value-increasing projects, then workplace misconduct can be viewed as such a risky project. This type of misconduct is associated with significant economic costs to employers, employees and society – with the International Labour Organization (ILO) estimating an average of 4% of annual GDP (equivalent to $2.8tn) is lost to its direct or indirect consequences, such as medical expenses, worker compensation and legal costs. Further, workplace violations can have serious repercussions for both the firm and its employees; firms might be legally sanctioned – most commonly financially – or held liable for the loss of employee earnings resulting from worker accidents. We found positive relationship between risk-taking stock option incentives and workplace misconduct – the greater the risk incentives, the more misconduct there is in a company. This is shown in both the number and severity of violations recorded between 2000 and 2018. Further, following the introduction of Statement of Financial Accounting Standard (SFAS) 123R in 2005, which mandated the expensing of sharebased payments in Income Statements, leading to a significant drop in the use of stock options in an executive’s compensation package, there was a reduction in the relationship between the payment of these options and the severity of workplace violations. Our study shows the correlation between risk-taking incentives and workplace misconduct, specifically, aggressive decision-making with regards to employees; now work needs to be done to uncover the exact causes and, thus, solutions. Dr Justin Chircop is a Senior Lecturer in the Department of Accounting & Finance. The paper CEO Risk Taking Equity Incentives and Workplace Misconduct, is co-authored by Monika Tarsalewska, of the University of Exeter, and Agnieszka Trzeciakiewicz, of Hull University. j.chircop1@lancaster.ac.uk FIFTY FOUR DEGREES | 23
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FIFTY FOUR DEGREES | 25 Accounting numbers are very important for the valuation of companies - but they are often based on outdated information. Dr Argyro Panaretou explains how a switch in measurement basis can provide a better insight into a firm’s credit risk. What can we learn about credit risk from accounting numbers?
One of the central functions of accounting is to record firms’ transactions using an appropriate measurement basis. Historical cost accounting was the dominant measurement basis for much of the 20th century, but in the last decades accounting bodies around the world have systematically introduced fair value measurement. Historical cost generally refers to the amount a firm paid for an asset (or an obligation assumed for a liability) at the initial transaction date. Under historical cost measurement, assets and liabilities are recorded at historical cost, with remeasurement encompassing depreciation, amortisation, and impairment charges. Under fair value measurement, an asset is recorded in the financial statements at the estimated price that the firm would have received if it had sold the asset at the reporting date. Similarly, a liability is recorded at the estimated price the firm would have paid to transfer the liability. When the price for an asset/liability is not observable in the market, its fair value is estimated using a valuation technique. Currently in accounting, we have a model where firms measure some assets/liabilities at fair value and some at historical cost, which leads us to an important question. IS IT TIME FOR A CHANGE? Whether we should move to full fair value measurement is a fundamental question, as high-quality financial information is critical for the stability of the markets. Academics, policymakers, and practitioners alike have sought to attribute both positive and negative capital market outcomes to fair value measurement. On the one hand, critics say estimating fair values when assets and liabilities are not traded involves unavoidable measurement error. Critics also argue that when the prices of assets/ liabilities are not observable in an active market, fair value measurement offers managers opportunities for earnings management. On the other hand, proponents argue fair values are more relevant than historical cost, providing useful 26 | ‘‘ ’’ Currently in accounting, we have a model where firms measure some assets/liabilities at fair value and some at historical cost...
information about the amount, timing and uncertainty of future cash flows. While we have a lot of evidence regarding the relevance and reliability of assets measured at fair value, the evidence is much more limited regarding liabilities. This is driven mainly by firms typically measuring most of their liabilities at historical cost. AN OPTION TO MEASURE LIABILITIES AT FAIR VALUE Our study uses the introduction of the fair value option (FVO) for liabilities to provide evidence on the reliability and relevance of fair value measurement for liabilities. The FVO, introduced by both the US and International accounting standard setters, gives firms the option to measure financial liabilities at fair value. If the option is adopted, firms are required to recognize and separately disclose in the financial statements debt valuation adjustments (DVAs). DVAs represent changes in the fair value of liabilities that result from changes in the firm’s own credit risk. Using a sample of US banks that elect the FVO for liabilities, we show that DVAs generally cannot be explained by the same factors that explain changes in market-based measures of credit risk (for example, changes in bond and CDS spreads). This finding may reflect the use of fair value measurement for opportunistic reasons, or it may reflect the role of fair values in providing additional information about the credit risk of the firm that is not captured by the market. To investigate whether information about credit risk is conveyed, we use information from annual reports on whether the fair value estimates for liabilities are based on market information or unobservable inputs. This enables us to distinguish between fair values that reflect mainly market information and those that reflect private managerial information about the credit risk of the banks. INFORMATION ADVANTAGE Our research shows that DVAs can explain future changes in credit risk when the fair value of liabilities is based on unobservable managerial inputs. The results support the view that managers have an information advantage in estimating credit risk, and that fair value measurements based on managerial inputs offer inside information to the market. The results of our study are particularly relevant to practitioners, as we show that fair values can be used to predict credit risk. Further, our results provide a better understanding of how managers use their discretion in computing fair values, and contribute to the debate about the role of fair value accounting in generating financial information that is useful for decision-makers. This work has also important policy implications. I joined colleagues to prepare a comment letter to the International Accounting Standards Board, advising how financial instruments should be measured and classified under the International Financial Reporting Standards (IFRS). We presented evidence from our research on the risk and value relevance of fair value measurement for assets and liabilities, and we suggested ways to reduce the complexities and application issues associated with the current standard on financial instruments. Decision-makers need relevant and reliable accounting information. There is a potential to improve the informativeness of accounting numbers through the use of appropriate measurement basis and associated disclosures. Dr Argyro Panaretou is a enior Lecturer in the Department of Accounting and Finance. Her research focuses on financial accounting and reporting, and particularly on fair value accounting and accounting for financial instruments and credit risk. The article What can we learn about credit risk from debt valuation adjustments? is co-authored with Dr Wen Lin and Professor Grzegorz Pawlina, of Lancaster University, and Professor Catherine Shakespeare, of the University of Michigan. It is accepted for publication in Review of Accounting Studies. a.panaretou@lancaster.ac.uk FIFTY FOUR DEGREES | 27
28 | DO YOU WANT THE GOOD NEWS OR THE BAD NEWS FIRST?
FIFTY FOUR DEGREES | 29 Japanese businesses have long-standing issues with corporate governance and transparency to outsiders. There have been attempts to rectify problems with listed companies in the past two decades, but Dr Wendy Beekes shows that while those firms with superior corporate governance are better at disclosing good news, they still like to keep bad news under their hats.
As a shareholder, you want to know what is happening with companies you invest in. If there are positive results set to send share values rocketing, or negative reports which could lead to a tumble in prices, you rely on companies keeping you upto-date so that you can make informed decisions. The share markets rely on this as well, so that prices best reflect the true state of affairs at any of their listed companies. But such transparency, however desirable, is not always delivered. There are variations in the levels of disclosures from one firm to another, and between countries. A disclosure needs to be timely if it is to be useful to external investors, but managers may intervene, for instance if they plan to vary their own stock holdings or if the firm is seeking additional funding on better terms. The general presumption is that bettergoverned companies are more transparent to investors. To find out if this is the case, we studied more than 1,700 listed companies in Japan, a country where corporate governance (CG) has been a continuing issue. WHAT YOU DON’T KNOW, CAN HURT YOUR INVESTMENTS In the past, Japanese firms have not been viewed as particularly transparent to outsiders. They operate in a code law country, with less investor protection and weaker enforcement than in common law countries such as the UK and USA. Japanese firms’ CG typically follows stakeholder CG, which is characterised by insider-dominated boards, substantial crossshareholdings among affiliated firms, and a main bank which provides loan capital to companies in its group as well as being an influential shareholder. Close relationships between stakeholders means information may be communicated privately rather than via public disclosures, and many Japanese companies still inhibit shareholders from attending annual meetings – holding them on the same day. In 2014, just under half of Tokyo Stock Exchange (TSE) First Section firms held their annual meetings on the same day. Following the banking crisis of the early 1990s, cross-shareholding and main bank ownership have decreased, while foreign ownership has increased. Foreign shareholders emphasise the importance of closer monitoring of management, greater disclosure and improving firm performance. At the same time, the average number of board members has declined and the number of outside directors has risen. Nevertheless the boards of Japanese firms remain insiderdominated, and therefore outside directors’ effectiveness in their role is questionable. Since 2004, the TSE’s CG Principles have highlighted the importance of good CG and transparent disclosure practices. And since 2010, Japanese companies have been able to adopt International Financial Reporting Standards (IFRS); by July 2020, about 200 companies – mainly large multinationals – had chosen to do so, perhaps indicating a commitment to greater accounting quality and transparency. LET’S MAKE IT CLEAR Our study looked at the frequency and timing of disclosures by firms listed on the TSE’s First Section, and the speed of share price adjustments over a 10-year period from mid-2003 to mid-2013. TSE-listed firms are expected to disclose price-sensitive information publicly in a timely and unbiased manner – not to leak it selectively to outside parties. The TSE also highlights the importance of disclosing complete information on important issues impacting on firm performance. One implication is that no disclosure of a material (or important) issue should be withheld or delayed irrespective of whether it relates to good or bad news. The TSE expects timely and complete disclosure. Across our study, Japanese firms released a median of 1.2 documents a month to the TSE, substantially less than the figure of 4.1 documents per month in a previous cross-country study I worked on. This shows Japanese firms are less forthcoming than those in other countries, and other comparisons demonstrated they are slower to release price-sensitive documents. We found that better-governed Japanese companies did make more frequent and timelier corporate disclosures, and that their share prices reflected this information earlier, 30 |
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