Tagged what i’ve learned

Accounting and finance: corporations in society

The first in this series can be found at Accounting and finance: the rationale. This post focuses on how corporations interact with society through the systems of accounting and finance. It considers:

  • Why does a company exist to profit shareholders?
  • What happens when a company fails? Who suffers the most?
  • Should companies be blamed for bad behaviour?
  • Is capitalism the answer? Is there are better way, waiting to be imagined?

Why does a company exist to profit shareholders?

This is actually a simplistic question, and perhaps is the wrong question to address the heart of my concerns.

A company focuses on profits to shareholders because that’s the deal it made. Remember: ‘Give me capital now and in return, you have a claim on my future income.’ Because shareholders have a stake in the prospects of a company, they have the right to influence the company’s strategy, usually by voting at general meetings. In reality, though, small shareholders like me have such diluted decision power (and little interest in voting) that we free-ride off the decisions of big institutional investors, who are hopefully voting to maximise the prospects of the company.

Okay, so the real question that I want to ask is actually ‘Why doesn’t a company look after its employees, the community and the environment at the expense of profits to shareholders?’

The answer is a little surprising: it’s meant to.

Shareholders actually have a claim on the residual earnings of a company. Through laws, the government sets the priorities of claims on a company’s assets — shareholders are meant to have the last of it. The company’s earnings must first be diverted to tax, meeting environmental obligations, employee pensions and leave, public reporting requirements, and all those other expenses of doing business in a country. These are all claims on a company’s income and are paid out of money that would otherwise go to shareholders.

Shareholders therefore take on the residual risk. It is risky, owning shares. If, after all of society’s claims on a company’s assets are made, there is nothing left for the shareholder, then they have lost their investment.

What happens when a company fails? Who suffers the most?

Things do go wrong. Think Enron in the United States, and Ansett in Australia. Companies fail for different reasons but it seemed to me that employees suffered the most from collapses.

Banks appear to do relatively well after corporate collapses. This is because when they grant a loan, they are clever enough to use the company’s tangible assets as collateral. A company that fails loses all the value associated with potential future income but it still has its buildings and equipment. When these are sold, the bank’s claim is prioritised and paid first.

Shareholders basically lose their investment because their willingness to pay for the stock was based on the expectation of future income. They may be able to salvage some of their money, once the company’s assets are sold off and debts are paid.

Employees have no ownership claim on tangible assets. Their livelihoods depended on the company’s income. They may lose their severance packages (usually expressed as some weeks of salary), which is important for them to survive the transition into new jobs. The severance package, however, is a minor amount compared to the promised pension (or superannuation). If employee pensions have been held in another trust, then pensions are protected from the collapse. If, however, the pensions are tied to company stocks (as was the case in Enron), then employees suffer at least as much as the shareholders. It’s the ‘all eggs in one basket’ effect on risk.

I’ve seen the Australian people call for compassion for and protection of employees of bust companies. In those situations, the government decided to step in to fund bail-out measures.

Should companies be blamed for bad behaviour?

In my view, there are two reasons we observe bad corporate behaviour:

  1. The company is breaking the rules of the game.
  2. The rules of the game do not reflect society’s values and need to be changed.

If a company breaks the law, then clearly it needs to be condemned for behaving immorally. The government and courts must enforce the law.

If a company acts within the law, yet we find ourselves disapproving of its actions, then as a society, we should lobby for changes in the law. If the priority of claims on a company’s assets and income is skewed too far in favour of shareholders, then the government should tax the company more, impose stricter environmental regulations, increase company contributions to employee pensions, and so on.

It would be nice if companies did all these things voluntarily but I think it would be naive to rely on corporate social responsibility. There will always be a few who lead the way in CSR but most of the pack will behave as dictated by the rules. The most reliable and consistent way to pull up the laggards is to raise the standards and enforce them.

Of course, setting ambitious regulations for corporate behaviour does not preclude education and discussion about a company’s moral behaviour. Exxon can be condemned for lobbying against renewable energy targets and carbon tax, even if it operates within the law. Telstra can be condemned for reducing telephone services to rural areas.

I believe, though, that in general, governments have been too weak. Failures of the financial system to serve society’s purposes are failures of the government more than of individual corporations. The government sets the rules of the system, and the system shapes the patterns of behaviour. In fact, I believe that the management teams of many corporations would be relieved by stricter regulation because it raises the entire playing field. Management can then justify investment into social and environmental initiatives because their shareholders are no more or less disadvantaged than shareholders in other companies.

Is capitalism the answer? Is there are better way, waiting to be imagined?

One day, capital might not be the limiting factor of productivity. One day, natural and manufactured resources may be plentiful. In this future, then, labour might be king and we, as individual owners of our skills, knowledge and experiences, will be powerful and wealthy. Another option might be to form coalitions of individuals, like unions, who are able to command a price for our labour. Labourism may have its own set of problems.

I suspect that capitalism is a robust system and will last a long time yet. We can spend time and have fun imagining a fundamentally different kind of system. However, in the near future, my own efforts will focus on modifying the system we have now to make sure it works for the benefit of the community.

Accounting and finance: the rationale

I’ll do my best to describe my understanding of finance, based on my accounting and finance classes this term, my discussion with the lecturer last week, and some thoughts I’ve put together since then. This post will be long and specific but some people have asked for it.

I will break up the topic into two posts. A 2000 word essay on accounting might be a bit much to take for readers of what Blogshares calls a humorous blog. This post looks at:

  • What is my function as a shareholder?
  • What does it mean, to own a ‘share’ in a company?
  • It seems like only the initial investors provide the needed capital. Why should subsequent investors get dividends and control of the company too?
  • So why does a company’s share price go up and down so much? Surely its assets don’t fluctuate from day to day?

The next post will be released in a few days and will consider:

  • Why does a company exist to profit shareholders?
  • What happens when a company fails? Who suffers the most?
  • Should companies be blamed for bad behaviour?
  • Is capitalism the answer? Is there are better way, waiting to be imagined?

I have been thinking about whether or not it is fair or desirable for people to live off a passive income from their share holdings. Companies operate to maximise profits to shareholders and in doing so, they may do things that I intuitively think is unfair, like downsize (‘rightsize’) their workforce, pollute the environment, avoid tax (legally), and lobby to keep perverse subsidies. What do shareholders do to justify such unswerving loyalty from the company? Well, I don’t do an awful lot, yet I’m getting money from dividends. And so, I’ve been worried that it is unethical for me to invest on the sharemarket.

What is my function as a shareholder?

Another way to ask this question is ‘How do shareholders contribute to the productivity of society?’ The traditionally held notion is that productivity requires three things: land, labour and capital.

In the past, aristocrats had a monopoly on land, which is the limiting factor in an agrarian society. Land is no longer so important, especially with the rise of knowledge-based services and the mass production of crops.

With the abolishment of slavery, nobody owns labour except their own (and maybe some powerful employee unions). Labour is not an asset; it does not show up on financial statements because a company cannot own its employees. Because you can only control your own labour, you will not get rich by working for a living.

Finally, society’s productive endeavours require capital, some means of obtaining the goods (shovels, computers, buildings) to do something. The function of shareholders is to provide capital. They also take on the residual risk, which I will talk about in the next post.

What does it mean, to own a ‘share’ in a company?

A ‘share’ is a claim on the assets of a company. The assets may be tangible, like property or equipment. They may be intangible, like money owed to the company and patents.

However, when an investor buys shares in a company, they’re not really interested in what the company owns at this moment. Its current assets are insignificant compared to the income that the company will generate over its life in the coming years. People choose to invest based on if they believe that future income will justify their initial outlay of cash and if they think they will do better here than putting their money in the bank, property or other stocks.

It seems like only the initial investors provide the needed capital. Why should subsequent investors get dividends and control of the company too?

When a company wants to raise money, it tries to convince potential investors that they will do better buying its stocks than anyone else’s: ‘Give me capital now and in return, you have a claim on my future income.’ The investor weighs up the risks and chooses to invest.

At some point, though, they decide they don’t want this risk anymore. In their opinion, the company’s fortunes are going down or they find an investment that they believe will give them better returns. So the initial investor says to the market, ‘Who would like to buy off me the risk of owning this company?’ and someone says, ‘Based on my analysis of the company’s prospects, I will buy the risk for this amount.’ If the price is acceptable, the exchange takes place.

So why does a company’s share price go up and down so much? Surely its assets don’t fluctuate from day to day?

Shares are a measure of a company’s value. Some of the value is based on its assets and liabilities (debts and obligations) but the most important things to a company’s prospects cannot be represented on a balance sheet. Things like research investment, many patents, staff experience and skills, brand, relationships with existing clients, company leadership, company strategy, all these aspects cannot be valued financially and/or controlled by the company, so do not show up on the balance sheet.

Their effects, however, do show up on the income statement, which shows how much money the company made over the year. Investors trying to decide what a good price for a company is will look at the income statement and extrapolate it into the future. In doing so, they have to make assumptions about the company’s growth rate, tax obligations, industry and political factors, the time horizon, and so on. All those things depend on the hard-to-value factors like brand and staff.

So, the reason why share prices go up and down so readily is that it relies on people’s different judgements of the company’s prospects and their own value of risk. This is why a stock price might plunge if a company is taken to court or spike if there is a new CEO. These factors are generally more important than how many buildings or bulldozers it owns.

The NIMBY monster rears its ugly head

‘Not in my backyard’ or ‘NIMBY’ is a very human attitude. I got it all the time while working as an engineer.

“We’re not going to have that toxic waste dump here! Put it in the city!”

“Incinerators give you cancer! Would you want to live near one?”

Alex told me that residents of Oslo are shouting NIMBY — for the American Embassy! I’ve never thought of the American Embassy as an undesirable neighbour. It makes a sort of sense; I guess the Norwegians are wary of a bomb attack.

A Study Into the Effects of Make-Up on Observers

I had to learn how to put on make-up because I performed in theatrical dance competitions and concerts. Before starting work, the only time I would wear any sort of make-up was for:

  • dance performances;
  • balls and dinner dances; and
  • job interviews.

I now wear a little bit of make-up when I go to work. A style coach at university convinced me to wear make-up to work (we also had an etiquette coach, remember?).

One day, when I was going to do fieldwork all day, I decided to skip putting on that bit of eyeliner, eyeshadow and lipstick.

“Hi Joan,” Nuno said when I arrived at work. “Gee, you look tired.”

Whoops. I guess I set the standard for my appearance on my first day in the office.

The next Monday, I decided to do the full make-up thing: foundation, dark eyeliner, eyeshadow, shiny red lipstick.

I ran into Genevieve at the train station.

“Good morning, Joan. You look nice today.”

*Bing!*

Here are my conclusions, then.

  • Wearing make-up helps you look prettier.
  • But once you start, you can’t stop.
  • If you decide not to wear make-up, you forgo the opportunity to look your best.
  • However, you don’t run the risk of having an uglier-than-usual day.

I explained all this to Damjan. I’ve been thinking about whether or not I want to step onto the make-up treadmill when I go to Cambridge. New people = opportunity to decide such things.

Damo was not satisfied with the rigour of my study and therefore could not place any confidence in my conclusions. Being the statistician that he was, he proposed I do a blind test.

“Right, Joan. Wear make-up one day and don’t tell me. Ask me if you look pretty today and then write down my response. Then, on another day, don’t wear make-up and do the same thing. We can then compare the results because they’ll be meaningful!”

I wondered whether or not the integrity of the test would be compromised by the general practice amongst boyfriends of never saying to girlfriends that they looked anything less than optimal. Then again, I’ve known Damo to err on the side of honesty over diplomacy on some occasions.

Damo became even more animated: he had found a way to enhance his research proposal. “We can make it a double-blind test!” he said.

“What, both of us can close our eyes? And you can guess if I’m wearing make-up?”

“Perfect!” he crowed.

Figure 1: Scenario A, where woman who normally wears make-up stops doing so briefly

Figure 2: Scenario B, where woman who does not normally wear make-up does so briefly

One million yuan

I met Greg in my Dispute Resolution class. He’s a high school teacher. His dad is a retired school principal and mum is a retired nurse.

He was telling me about a life-changing experience. Jill, another person in our class, had led a three week trip to China. On this trip, he and about thirty other teachers saw the huge need for teachers and resources in the Chinese education system.

When Greg got home, he persuaded his newly retired parents to spend six months teaching in China. When they agreed, he organised for them to go over.

Greg tells me that the Chinese and Australian education systems are very different. I suspected this already. He explained that the systems have developed to meet the different needs of the countries. In China, there are so many people and the competition is so fierce that schools are highly disciplined. Students do not question the teacher. The emphasis is on rote learning.

Greg’s parents found this to be an alien environment but they did their best to adapt. Greg’s father is an English teacher. One Friday, in an effort to encourage creative thinking in his Grade 5 students, he set them an assignment: “You have won one million yuan. How will you spend your weekend?”

One million yuan is about AU$160 000. One million yuan is about 125 times what the average urban dweller in China would earn in a year. It’s a lot of money.

On Monday, the students submitted their essays. Something interesting had happened. Greg tells me that 95% of students had described their normal weekends. They did their homework, saw friends, went to the movies. Oh, some of them bought some extra DVDs and computer games but that was it.

What does this mean?

Apparently, the most creative response was from a small boy who wrote that he would spend his one million yuan on grenades and guns. He wanted to go to Iraq to fight the Americans.

Giant block of city ignorance

For my work in Shepparton, I speak to many farmers and country people. I’ve lived in cities and suburbs my whole life. This is something I have to confess to people so that I can explain my ignorance of basic agriculture, geography of regional Victoria, even Australian slang.

Jamie has been my first line of defence in this new environment. He grew up on a farm in south-western Victoria. Often, I let him do the banter and questioning while I sit back and absorb as much information as I can without revealing my city girl cluelessness.

I am grateful that I have had this opportunity to learn more about rural life. I don’t want to be an ignorant urbanite spouting off about water being wasted through irrigation, over-fertilising of crops or vegetation clearing.

Jamie tells me stories about about growing up on a farm.

“The farm back home isn’t big. We grow lavendar, also some beef cattle. Sometimes when a cow has two calves, she’ll pick one to look after and abandon the other. The abandoned one doesn’t last long. It’s just the natural way of things.

Sometimes, though, when dad felt like it, he said to me and my brother, “Josh, Jamie, if you want, you can look after the calf.”

Josh and I would come back after school every day to feed it. It was really cute, looking up at us with its big cow eyes. We were its ‘mum’. It would come towards me and nuzzle my leg. Every time, it would be looking for my udder.

I would hold my hand like this and it would suck my fingers. You have to be really careful, though. You have to have your hand palm upwards. Cows have strong mouths. If you held you hand like this, with the fingers facing down, the calf would snap your fingers backwards when it sucked.”

Goodness. With my newly acquired knowledge, I felt my giant block of city ignorance chip away just that little bit more.

Being brave

It was the end of the formal part of the Friday luncheon. The speaker was thanked and everyone was invited to stay for drinks.

I knew what ‘drinks’ meant. ‘Drinks’ is a chance to get up and network with people. Have you ‘networked’ before? Sometimes I call it ‘schmoozing‘. You talk to people and somewhere in your mind (it could be at the back or the front), you are conscious of making a good impression because this person could be important to you one day.

It’s scary. If you’re nervous about cold-calling, of introducing yourself to random people, of breaking into conversations that have begun without you, then networking is scary. I think it must be even scarier when you’re a junior engineer and there is no compelling reason for the others in the room to speak to you.

I stood up with my glass and looked around. I sipped. Oh. I was looking at the white table cloth again. I forced myself to look up again and caught the eye of my big boss. Quickly, I averted my eyes. That was the easy option, talking to someone I already knew. My boss probably knew that too. I wasn’t going to burden him with my conversation.

As I hovered by my table, I thought about leaving. Others had. It would stop this feeling of wretched stupidity and awkwardness.

Okay, that’s it.

I turned and walked past other tables, past my boss, past the floor-to-ceiling windows framing the sunset over the Yarra River, and approached two men sitting near the front.

“Hello! Can I join you?” I smiled.

“Sure,” they said.

I pulled over a chair and sat down.

Krispy Kreme vs. Boulangerie

While I was in London, Damo generously funded me a 90 pence Krispy Kreme original glazed donut. So much had been leading up to this, my first Krispy Kreme donut.

We stood in front of a Krispy Kreme stall at Victoria Station. From the three people in the queue before us:

“Can I have the large box of donuts, that one…”
“Two chocolate ice glazed, three strawberry filled, one lemon filled…”
“I’d like a dozen donuts…” (Store assistant: “For an extra two pounds, you can have six extra donuts…?”)

Then I stepped forward:

“One original donut, please.”

So how was it? It was tasty — soft and not overwhelmingly sweet. Damo had a bite and said that it was the yumminess of a fresh donut, nothing unique to Krispy Kreme. And besides, it was too soft.

Does it beat mille feuille? Hell, no.

Cat has its privileges

I mentioned briefly that in England, the ‘rank hath its privileges’ culture appears to be alive and kicking. I can explain with the help of the following photo, which I took at a college of Oxford University.

Exhibit A: Cat on grass
Most of the colleges of Oxford and Cambridge that I visited had similar plans: the buildings faced inward on a big quadrangle of grass. Just to prove that Oxford and Cambridge are vastly different institutions, at Oxford these are called ‘quads’ and at Cambridge, they are called ‘courts’.

Anyway, I digress.

It became obvious to me that the purpose of these immaculate lawns, which take up a huge space in the middle of everything, is to provide a means for the high-ranking college members to display their divine superiority; there were signs that warned, ‘Keep off grass. Fellows and their guests excepted.’

There are other outrages too. I saw a building where there was one gate for ‘boys’ and another gate for the Warden and Fellows. When a college runs room ballots to determine which rooms students get to live in, the President of the student body gets first choice, followed by the Vice President and so on. I have also heard that it is common for student societies to be kicked out of a room they had booked well in advance — because a Fellow has decided to have a tea party. And even crazier, did you know that there is a queen of England? I saw her palace and everything. How quaint!

Finally, I’d like to refer back to Exhibit A. Clearly, from the cat’s relaxed pose, it is comfortable ignoring the ‘keep off the grass’ directive. Because no-one’s chasing it off, I can only presume that cats in England rank very highly.

Credit freeze

Some people have trouble controlling how much they spend on credit cards. Perhaps they have three or four cards and juggle debts between them. How can they stop themselves spending?

“Plastic surgery! Cut up your cards!” they’re told.

But what happens if one day you really do need your card and you’ve cut it up? What then?

Someone provided me a neat solution. You can put your credit card into water and freeze it. That way, you don’t have immediate access to it. When you want to use the credit card, you have to take it out of the freezer and let it melt. While it melts, you can think about it — do you really need to spend the money? There’s no way to cheat yourself; you can’t put the block of ice into the microwave because you’d destroy the magnetic strip.

Before you ask, no, I don’t have a problem…although I did spend more money on a camera bag and filters on eBay yesterday.