Principles of Business Introduction to Finance –lecture 4

Overview

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• Why do corporate failures happen?

• Why do accounting scandals happen?

• Case study : Olympus

• Financial risk management

Learning outcomes

By the end of this session you should be able to:

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• Evaluate accounting scandals and be able to explain why they happen

• Understand financial risk• Design and recommend financial controls

Why do corporate failures happen?

- Declining competitiveness- industry structure changes- Leadership failure- Lack of financial planning- Poor governance

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Why do corporate scandals happen?

- Poor governance- Fraud- Poor financial controls- Regulative loopholes

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Accounting scandals

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• £1.1bn accounting scandal where accounting losses were uncovered• Olympus overpaid $1.5m for three acquisitions including a mail order face

cream company and a microwave plastic plate company• Used to cover up investment losses• Michael Woodford, the newly appointed British CEO of Olympus, who

uncovered the fraud was fired after 6 months by the Board of Directors. • He blew the whistle to the Japanese authorities and fled to Hong Kong

(allegedly in fear of his life).

How did it happen?

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“In putting the company first, the honourable way forward would be for you and Mori-san to face the consequences of what has taken place, which is a shameful saga by any stretch of the imagination. It is clear that the current situation is now untenable and to move forward positively the necessary course of action is for you both to tender your resignations from the Board. This approach would allow the situation to be managed in a discreet manner and minimise the reputational damage to both Olympus and yourselves. If your resignations are not forthcoming, then there is a principal obligation upon me in respecting my fiduciary duties, to raise, with the appropriate parties, my fundamental concerns in relation to the governance of the company.” (Woodford 2011, 12)

Letter from Michael Woodford to Chairman of the Olympus Board Tsuyoshi Kikukawa

How did it happen?

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• Following Plaza Accord in 1986, the Japanese Yen appreciated in value triggering a slump in the Japanese export-driven economy

• Olympus suffered in terms of revenue and their investment portfolio. This prompted them to invest in ever riskier investments to the extent that they suffered tens of billions of unrealised losses by 1995 (Dutta, Caplan, Marcinko)

• A complex “loss separation scheme” was set up• This partly involved the CFO and Chairman convincing the Board of Olympus to

agree to pay exorbitant prices for obscure companies

(Source: Dutta, Caplan, Marcinko, 2014)

How did it happen?

“Tobashi” – shifting losses

9(Based on information from Dutta, Caplan, Marcinko, 2014)

Olympus(Scope of Financial

Reporting)

LGT Bank

Shell company

Investment shell co

Investments

1. Collateral: Japanese Gov’t bonds

2. Loan

3. Used loanTo buy junk investments

5. Purchase at artificial premium

4. Buy at Market price

6. Investment shell co repays loan to bank. Bank releases Japanese Gov’t bonds back to Olympus

How did it happen?

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(Source: Dutta, Caplan, Marcinko, 2014)

• Poor internal controls: E.g. Treasury Group both executed and approved transactions, minimal job rotation at high levels in the finance and accounting department

• Governance: External Board members had little power/authority to question the actions of Executive Management, One of the Audit Committtee members was an old school friend of the President

• Lack of independence in Internal audit function: Head of the Finance Department, supervised the Head of the Internal Audit Department

• External auditors replaced: KPMG were replaced by EY in 2009 for overstepping their duties as auditors

• Culture: Those in power were not challenged by the Senior Management Team

The outcome?

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(Source: Dutta, Caplan, Marcinko, 2014)

• President, Vice President, and Chairman all received 3 year suspended jail sentences

• Olympus fined 700 million Yen • Michael Woodford unsuccessfully attempted to get his job back but was

awarded compensation for unfair dismissal.

An introduction to risk

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• Put simply, risk is exposure to danger

• Overall risk for a board of directors:

Inherent Risk x Control Risk x Detection Risk

An introduction to risk

Examples of types of risk:

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• Business risk – The overall risk of something happening that would impact on the organisation’s overall objectives

• Financial risk – The risk of something happening that would impact on the organisation’s ability to present a true and fair view of it’s financial position

• Ethical risk – The risk of the organisation acting, or being seen to act, in an unethical manner.

• Reputational risk – The risk of something happening that could impact on the reputation of the organisation

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Understanding and managing risk

1. Identify risks2. Assess risks (likelihood and impact)3. Design controls to mitigate risks4. Implement controls5. Review effectiveness

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The control environment

The governance and management functions in an organisation, including the attitudes, awareness and actions of management concerning the entity’s internal control and it’s importance to the entity (ICAEW, 2012)

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Finance week 2 pre-seminar workAs a minimum, please make sure you have done the following before each seminar next week:

Seminar 1: • Read Chapter 7 of core text (Atrill & McClaney) and attempt as many of

the questions at the back of the chapter as possible. • You will need access to the financial statements of listed company during

the seminar!

Seminar 2: Read Chapter 12 of core text and attempt as many of the questions at the back of the chapter as possible.

Seminar 3: Using EBSCO, read the following article: Saurav K. Dutta, Dennis H. Caplan, and David J. Marcinko (2014), “Blurred Vision, Perilous Future: Management Fraud at Olympus”, ISSUES IN ACCOUNTING EDUCATION , AAA

Seminar 4: Read Chapter 5 of the core text and attempt as many of the questions at the back of the chapter as possible.