MODULE 8 INTRODUCTION TO CORPORATE FINANCIAL GOVERNANCE ADB Private Sector Development Initiative Corporate and Financial Governance Training Solomon Islands Originally by Dr Judy Taylor

Acknowledgement These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme.

Module 8 Outline 3  Introduction to corporate finance governance  Meaning of financial corporate governance  Why is financial corporate governance important?  Financial statements and accounting records: the legal rules  How to undertake financial planning for your business

Meaning of Corporate Financial Governance 4 What is financial corporate governance?  Financial corporate governance relates to the financial obligations and responsibilities of a director. It is a sub category of corporate governance and matters applying to that also apply to corporate financial governance

Corporate Financial Governance Financial corporate governance is a two-step process  internally determined governance rules to comply with  externally imposed governance rules  government regulations through Acts of Parliament. They are also imposed by:  debt covenants by credit providers; and  competition or market regulation.

Financial responsibilities of directors In summary, directors of private companies, public companies and community companies are responsible for the financial management and reporting of the company. Even where professional managers are undertaking the day-to-day tasks it is the directors who are ultimately responsible. The directors are responsible for the systems in place that record report and protect the financial integrity of the organization. An important duty we will revisit is the duty not to trade while insolvent. Directors in the Solomon Islands must ensure that proper accounts are kept in writing or can be easily transferred to written form, that they are held for seven years on company premises. The duties of the directors include ensuring that the financial records are maintained properly and that falsification is avoided and can be easily detected.

Financial responsibilities of directors In addition companies must file an annual report with the Registrar as well as send a copy to the shareholders, if they are a public company or if requested by shareholders if they are private company. Directors have a duty to ensure that the financial statements reporting conforms with those set out in Schedule 3 of the Regulations 2010 and in a manner defined by Regulations The accounts should be compiled using the accrual accounting system. In addition guidance is given in relation to the treatment of accounts receivable, depreciation, inventories and non-current assets. A public company must comply with IFRS or state how and why they so not comply.

Internal control “A process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding achievement of objectives in the following categories (i) Effectiveness and efficiency of operations, (ii) reliability of financial reporting, (iii) and compliance with applicable laws and regulations.” COSO 2005 in Ahmed Naciri, Internal and external aspects of corporate governance, (2009, Taylor and Francis), p 109

How do companies comply? Internal controls identify and design processes to manage risks so that the organisation has control over how its resources are:  directed, through the strategic plan and budget;  monitored, through internal audit, compliance and risk management; and  measured, through the compiling of accounts.

Business success not guaranteed However internal control does not ensure the success of an organisation or make poor mangers into good ones.  If the strategic plan is weak,  If the competitive environment is difficult, or  if the organisation does not have enough liquid funds, the business could still fail.

How to establish Internal Control Subcommittees: Effective working subcommittees are an essential ingredient in establishing good financial governance. Sub-committees facilitate action rather than just discuss direction. Sub-committees should also facilitate information sharing among directors so that decisions are made with everyone’s knowledge and comply with business plans or constraints.

Sub-committees strategic planning, budgeting and finances, internal audit, compliance and risk management, remuneration and HR, techinical The list and structure of subcommittees will vary from company to company.

Financial Governance A Technical Audit compliance and risk management Human Resources Financial Planning, Reporting and budgeting Board of Directors Receipts Payments Budgeting and Planning Financial Reporting Chief Financial Officer

Overview of financial governance  The board sets up a financial, planning reporting and budgeting committee  The Chief Financial Officer then devolves these duties into a number of separate areas which ensures a system is in place to record, verify and measure free of fraud (one model does not fit every organization)  Budgeting and planning  Day to day financial tasks (management accounting)  Reporting

Strategic planning Every board of directors should construct a rolling 5 year plan that sets out the plan for the company.  reviewed annually and adjusted as the conditions require. A basic business plan has several key elements:  Executive summary  Description of the business  Description of the target market  Analysis of the competition  Description of the management team  Marketing strategy The strategic plan becomes a measure of the effectiveness of the directors and management team because the outcomes of the plan and the targets are reported annually

Financial Planning and Budgeting The budget translates the strategic plan into financial units. It is an integral part of the strategic plan and helps to determine if the plan is viable by putting financial figures on its implementation. Key skills that directors require to be able to establish and monitor finances as required by law are Develop a budget Review a budget Analyse any variation Convert actual outcomes to financial reports

Financial Planning and Budgeting For this to happen procedural manuals must be written, implemented and their correct usage monitored. This work will be done by employees of the company under the guidance of the Finance subcommittee. Creating, monitoring and managing the budget is a key to business success, though it does not guarantee it.

How to develop a Simple Budget Begin by asking these questions: What does my plan project? What is my projected revenue? What will it cost us to produce them?

Simple budget What does my plan project? Launch a new product and sell 1000 items What is my projected revenue? What will we sell them for? $3 each Total projected revenue $3* 1000 = $3000 What will it cost us to produce them? Fixed costs per annum Rent 200 Electricity 100 Management salary Variable costs Material inputs - $1 per item, for 1000 pieces1000 Manufacturing wages Total costs$2200 Profit$ 800 (27%) 

Simple budget You must know your business. You need to know what each item will cost in materials. If materials cost $1.8 there will not be a profit What happens if you sell only 750 items not1000? Having a budget does not guarantee that the business will succeed. It shows what will happen if your assumptions are correct and the world behaves as you have planned. The more informed you are about your business, the more accurate the budget, and the more likely your business will make a profit.

Simple budget - revised 21 What is my projected revenue? What will we sell them for? $3 each Total projected revenue $3* 750 = $2250 What will it cost us to produce them? Fixed costs per annum Rent 200 Electricity 100 Management salary Variable costs Material inputs - $1 per item, for Manufacturing wages Total costs$1950 Profit$ 300 (13%)

Complex budget What does my strategic plan say? Will one budget cover all my needs? How many budgets will I need? Manufacturing Purchases Staff Asset management

Designing my budget There is no universal budget model that fits every business. Different business and different industries will have different revenues and expense categories. If a line item must appear in the annual accounts then it must also be included in the budget. The chart of accounts that is developed for internal financial reporting purposes should also be used for developing the budget. The first budget is the most difficult. In the second and subsequent years you can use the first actual year of expenditure and revenue performance as a benchmark.

Who needs to be involved? Budgeting subcommittee Chief financial officer Managers of each division People who produce the items

Steps to develop a detailed budget 7 steps - constitute a loop Step 1. Revenue Step 2. Production Direct Costs Step 3 Other administrative Expenses Step 4 Fixed costs Step 5 Bottom line Step 6 Repeat steps 1 to 5 Step 7 Cash Flow

Step 1. Revenue The Strategic plan/business plan should help in establishing the projected volume of revenue/sales and the pricing of those services. Note the planned volume of sales. How do you set the price? What will the market bear What is the competitive environment The revenue needs to be reviewed repeatedly once all the costs are known.

Step 2. Production Direct Costs Cost of materials or purchases This can be estimated simply if only one or a few products are produced. If the number of products is large, then there should be a separate manufacturing budget. This budget would include each item produced, the volume of the item used per unit and the price of each input. For example if you make toys such as rubber animals, the items that would be included are Moulds - including how many items each mould can produce Rubber – the amount poured in and the amount poured out Stuffing – used inside the toy to give it shape Wire – to help big toys stand up Paint – the amount of each colour of paint used to finish the toys Staff – the amount of staff time in each area to produce each toy The first year these numbers will not be known. They are estimated. They are estimated with input from workers, testing and experience in other firms. The second year costs are easier to estimate and usually reduce with production experience.

Step 3 Other administrative Expenses These include the running costs of the organisation that are not part of the production process. They include: accounting fees, advertising, amortisation (patent or goodwill impairment), audit fees, bank charges, board costs, client support, donations, computer costs, consultancy costs, depreciation (building, motor vehicles, plant and equipment), motor vehicle costs, insurance, interest, legal fees, management expenses, printing and stationery, rates and local taxes, repairs and maintenance, salaries, staff benefits, workers compensation, sundry expenses, telephone and communication costs, training costs- staff and management, travel - local and international, utilities, volunteer costs, taxes.

Step 4 Fixed costs Fixed costs and overheads are those costs that do not vary with the number of units produced. These include rent, managers’ wages and leases. Even if the business produces nothing these costs will be incurred and cannot be avoided.

Step 5 Bottom line Once the board is satisfied with projected expenditure figures, item pricing can be set in line with competitive environment and a profit can be projected.

Step 6 Repeat steps 1 to 5 If no profit is possible at this level then the plan is not viable and the board needs to decide whether to try to: 1. increase volume if there is demand and so reduce the price they sell at, or 2. focus on reducing production costs of each item.

Step 7 Cash Flow Businesses fail because of cash flow problems. It is important to devise a monthly cash flow budget as well as an annual budget. This will ensure you can pay the wages, rent and interest. CASH is KING! Cash flow budget allocates income and expenses to the period when they happen.

Vanity, Sanity, Reality 33  Too often business owners are fixated on the sales of a business which is all about vanity but net profit (or your sales less your expenses) is your sanity. Even more important is your cash flow or whether you have the money to pay your staff, your suppliers and yourself which is reality.  No matter how successful your latest sales push has been or how much profit you have made, nothing brings you down as effectively as a cash flow crisis.

Operate within budget When the budget is complete, every effort should be made to operate within it. It will need to be reviewed and revised regularly to allow for any contingency. Successful businesses often have a rolling budget aligned with their strategic plan, so that they are continually budgeting for at least a year in advance and forecasting 3 or 4 years.

Budget vs Forecast 35 The key difference between a budget and a forecast is that the budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually going. Realistically, the more useful of these tools is the forecast, for it gives a short-term representation of the actual circumstances in which a business finds itself. The information in a forecast can be used to take immediate action. A budget, on the other hand, may contain targets that are simply not achievable, or for which market circumstances have changed so much that it is not wise to attempt to achieve. If a budget is to be used, it should at least be updated more frequently than once a year, so that it bears some relationship to current market realities. The last point is of particular importance in a rapidly-changing market, where the assumptions used to create a budget may be rendered obsolete within a few months.

Review performance against budget Although the budget is prepared annually is should be reviewed monthly or quarterly. At the end of each month, the board needs to compare the actual results of revenue and expenditure with the budgeted results; variances need to be noted and explained. The variances should be categorised as either a 'timing' or 'permanent' variance. a timing variance is where the estimated result did not occur but is still expected to happen at some point in the future a permanent variance is where the expected event is not likely to occur at all.

Reviewing budget BudgetActual Variance$Variance% Revenue $3* 1000 = $ % Fixed costs per annum Rent % Electricity Management salary TOTAL FIXED % Variable costs Material inputs (1000 pieces) % Manufacturing wages TOTAL VARIABLE % Total costs % Profit %

Why have the actual amounts varied from the budgeted amount? Revenue is down 33% from the projected amount. WHY? The committee might report that the departure from projections is due to Orders slow- due to an unforeseen event like flooding, but that since the month’s end orders have already exceeded the next month’s projection, so the difference is due to the timing of orders, not due to a decrease in orders over the projected year. This is a timing difference and it will be resolved in the next reporting period. Entry of a new competitor in the market. This competitor might have new, more efficient, technology that allows them to produce at a much lower cost and sell at a lower price. This would render the company’s current price high compared to the new competitor, and should trigger a significant review of the business. This is a permanent difference that needs serious planning.

A budget as a measure of performance When the budget is reviewed for variance it can also be reviewed for outcomes of the plan. monthly budget reviews become planning performance This helps the board achieve better control over their plan, to set realistic and achievable targets for management, and to provide control over expenditure and profitability.

Other internal control checks The internal audit committee is responsible for reviewing whether the staff, management and board are complying with established internal procedures and whether the accounts presented to the board are reliable, accurate and honest. The compliance committee, will support the internal audit committee by ensuring that the accounts comply with the requirements set down in Companies Act. Often these responsibilities are combined so that there is only 1 committee.