Management Control Systems (2nd Edition)


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Chapter Code: MCS09

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Management Control Systems Textbook

Financial Control of the Enterprise : Overview

To establish financial control in terms of effective action control and/or results control, an important prerequisite is a control environment that provides minimal opportunities for misrepresenting facts and/or committing fraud. Financial control pertains to processes within the finance department as well as to processes in the entire organization. The important components of financial control are - financial policies and procedures, segregation of duties, book-keeping, financial control tools for reviewing and analyzing financial performance, controlling assets employed in the business, and financial information systems.

A financial policy is a directive on the financial aspects of the organization and comprises guidelines that need to be followed for activities which have a financial implication. It ensures transparency and accountability within the organization.

It should be fair, comply with legal requirements, comprehensively address real-life business situations, and be implementable at a reasonable cost. Procedures specified ensure standardization of work practices in keeping with financial policies. Segregation of duties should include the assurance that no one individual has the physical and system access to control all phases of a business process or transaction. There are four categories of duties in financial control. Authorization refers to the process of reviewing and approving transactions. Custody refers to the control over or access to any physical asset. Record-keeping entails creating and maintaining records of transactions. Reconciliation refers to verifying the processing or recording of transactions to ensure validity, authorization, and regularity.

Book-keeping is the function of storing financial data by maintaining and updating various books of accounts like journal and ledgers. Its focus is on monitoring the organization's financial activities and maintaining documentary evidence of the inflows and outflows. It is required to ensure transparency and enforcing financial accountability. A good book-keeping system enables provision of regular reports to interested parties.

Financial statements and financial ratios are extensively used as tools of financial control. The three financial statements used extensively are: the Balance Sheet, Profit and Loss Account, and Cash Flow Statement. The balance sheet reflects and facilitates control over the wealth and liquidity position of the organization, and the proportion of self-owned financial resources to borrowed funds used by a company. The profit and loss account facilitates analysis of the expenses in relation to the income being generated and the trends in income and expenses over time. The cash flow statement depicts the cash flows from operating activities, investing activities, and financing activities.

Financial ratios are required to reflect the effectiveness of an organization's financial performance and to provide an analytical view of the financial data from multiple perspectives. Broadly, financial ratios are of five types - liquidity ratios, leverage ratios, turnover ratios, profitability ratios, and valuation ratios.

Liquidity ratios reflect the organization's capacity to pay off its short-term obligations and can be classified into three types - current ratio, acid-test ratio, and cash ratio. Leverage ratios assess the capital structure of an organization and the risk arising from the use of debt as a source of funds. They can be classified into structural ratios (financial leverage ratio, debt-equity ratio, and debt-assets ratio) and coverage ratios (interest coverage ratio, fixed charges coverage ratio, and debt service coverage ratio. Turnover ratios (also known as efficiency ratios or asset management ratios) measure how efficiently a company utilizes its assets. Important turnover ratios are the inventory turnover ratio, the debtors’ turnover ratio, the average collection period, the fixed assets turnover ratio, and the total assets turnover ratio. Profitability ratios measure the outcomes of business operations. Gross profit margin, net profit margin, return on assets, earning power, return on capital employed, and return on equity are some of the profitability ratios. Valuation ratios indicate how the stock of the company is valued in the capital market. Some valuation ratios are the price earning ratio, yield, and the market value to book value ratio.

Among the widely used financial performance indicators, EVA, MVA, CFROI, and SPM are performance measurement tools for the organization as a whole, while the segment margin report helps to analyze the performance of responsibility centers. Economic Value Added (EVA) is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in the company. Market value added (MVA) is the difference between the market value of a company (which includes both equity and debt) and the capital that lenders and shareholders have invested in the company over the years. It is a measure of the amount of wealth a company has created since its inception. Cash-flow return on investment (CFROI) is calculated by dividing discounted future cash flows by total capital assets. It measures the real cash return (cash return adjusted for accounting differences and inflation) on the invested capital. The Strategic Profit Model (SPM) considers Return on Net Worth (RONW) as the most informative and significant measure of the profitability of a business. It identifies three focus areas to improve the RONW - through profit margin management (net profit/net sales), asset management (net profit/total assets), and debt management (total assets/ net worth).

The performance of a responsibility center can be evaluated using a segmented income statement in the contribution format. In order to assess performance, it is important to assess the income as well as the costs (traceable fixed costs and common fixed costs) of responsibility centers. Common fixed costs support the operations of more than one segment but are not traceable to any particular segment. Traceable fixed costs would cease to exist if the particular segment or business unit were to be shut down. The segment margin is arrived at by first deducting variable costs from revenue to get the contribution margin, and then deducting the traceable fixed costs from the contribution margin.

Measurement and control of assets employed plays a very important part in monitoring and controlling the performance of a company or business unit. Tangible assets are classified into fixed assets and current assets. When investing in fixed assets, organizations need to consider - usefulness and cost vs. benefit of the asset; buy or lease options, and financial implications. Net working capital (current assets minus the current liabilities) is a measure of the organization's operational efficiency and short-term financial health. Computerized financial information systems enable better control over the organization’s operations by making available financial data from various perspectives at the click of a button. In keeping with the various activities in an organization (sales, purchase, inventory, production, logistics, etc.), financial information systems comprise financial accounting systems, sales accounting systems, purchase accounting systems, and inventory accounting systems. Financial accounting systems facilitate generation of variance reports which compare the actual expenses and incomes with the budgeted figures, trend analysis, and support ratio analysis on a real-time basis. Sales accounting systems aim at fulfilling the financial control goals of monitoring sales revenues, timely collection of amounts receivable, and evaluating the performance of various products, customer categories, and distribution channels. Purchase accounting systems aim at fulfilling the financial goals of ensuring that purchases are made at an optimal cost, keeping a close watch over timeliness and value of cash and bank outflows to vendors, analyzing input costs, and lowering associated costs of purchasing. Inventory accounting systems focus on financial control goals of monitoring inventory movements and ensuring timely replenishment, optimizing inventory holding costs, and assessing inventory-related losses. Various reports are generated by the financial information system to achieve its goals.

There are various roles (personnel of the finance and accounts function, auditors, management, Board of Directors, etc.) in an organization that can and should exercise control over its financial aspects. Personnel of the finance and accounts function are responsible for different aspects of day-to-day financial control in an organization. The responsibilities of the management include - maintaining an environment that is conducive to financial control; formulating and adhering to financial policies and procedures; authorizing transactions, analyzing business performance; ensuring financial growth, profitability, and sustainability of the organization; and conducting periodic reviews of financial controls to ensure their adequacy. The responsibilities of the Board of Directors include - approving policies, budgets, and capital expenditure decisions; reviewing utilization of resources; reviewing audited financial statements; appointing external auditors and members for top management positions and deciding on their compensation; and guiding the management on strategic decisions that have a long-term financial impact. Other employees and external entities such as regulators, customers, suppliers, and financial analysts may also contribute to financial control.

Chapter 9 : Overview

Introduction to Financial Controls
Financial Policies and Procedures
Segregation of Duties

Tools of Financial Control
Financial Statements
Financial Ratios
Economic Value Added (EVA)
Market Value Added (MVA)
Cash Flow Return on Investment (CFROI)
Strategic Profit Model (SPM)
Segment Margin Report

Controlling Assets Employed in the Business

Fixed Assets
Working Capital

Financial Information Systems and Control
Financial Accounting System
Sales Accounting System
Purchase Accounting System
Inventory Accounting System

Roles in Financial Control and Accountability
Annexure 9A: Computation of Financial Ratios
Annexure 9B: Analyzing Trends in Financial Performance - An Illustration