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FINANCE AND ACCOUNTING 1

Finance and Accounting

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FINANCE AND ACCOUNTING 2

Finance and Accounting

Firm valuation involves the determination of the value of the assets of a firm or the firm

value itself (Brown and Caylor, 2006). During the analysis of a firm's value, an analyst looks at

the management of the firm, what the capital structure is composed of, the possibility of future

cash flows and the market valuation of the assets. The value of an asset in the market is

determined by what a willing buyer can consider a willing seller in return for the asset.

The value of a firm is derived from the expectations of future cash flows by investors and

the management of the firm as opposed to a common belief that the value is found in the

financial statements (Velez and Tham, 2001). Firm value can be stated as the sum of claims of

all the security holders, creditors, common equity and minority shareholders and other

stakeholders.

The value of a firm can be used for financial modeling and portfolio analyzing and in

general industry comparison with other firms. There are several valuation models in accounting

used to determine the value of a firm, and they include Modigliani-miller theorem and the

discounted cash flow methods. In the Modigliani-miller model of firm valuation, the value of a

firm is determined by the sum of equity and debt in the financial statements of the firm. The

equity value of the firm is the present value of the free cash flow at the weighted average cost of

capital excluding debts (Velez and Tham, 2001). The discounted cash flow method involves

discounting the projected future cash flows. The cash flows used in the valuation are free cash

flows after considering the need for reinvestments in the firm and noncash charges. Short term

cash flows are not used in the valuation since they are susceptible to manipulation. The value of

a firm in accounting is a function of the change in book value, discounting factor and earnings.

In a bid to determine the effectiveness of a corporate strategy, the ultimate test is whether

a firm is creating value for its shareholders. Measurement of the value of a firm does not

consider only the historical value of a firm but its ability to create value in the future. When

companies create economic value for their shareholders, they thrive, and value creation occurs

when capital is invested at a rate of return higher than the cost of capital. Research indicates that

FINANCE AND ACCOUNTING 3

companies dedicated to value creation are healthier, are a going concern and have more

opportunities for the public.

Research conducted on the effect of corporate governance and family ownership on firm

valuation through investment efficiency in Asia emerging markets finds that a good corporate

governance results in better investment decisions and increased firm value (Cheung et al., 2011).

The research found out that investors do reward firms for improvement in the corporate

governance. Proper corporate governance enhances a firm’s accountability and makes the work

of monitoring of the firm by the shareholders and outsiders easy. As a result, this leads to more

efficient investment decisions and an increased firm value (Brown and Caylor, 2006).

The research findings indicate that the market rewards Asia firms for improvement in the

corporate governance. Higher firm valuation is as a result of improvement in the corporate

governance practices through investment efficiency by being more transparent. The relationship

between the level of corporate governance score and firm values is positive suggesting that firms

which increase their investment with proper corporate governance benefit by receiving a higher

market valuation (Cheung et al., 2011).

Market efficiency can be defined as a situation where the stock market prices fully reflect

all the necessary information about the stock or the market. Therefore an efficient market is one

where the market prices give a true estimate of the value of the investment. According to Kothari

(2011), market efficiency is the view that price represents the present value of the future

expected dividends. It should be noted that market efficiency does not necessarily mean that the

price should equal the true value. The only requirement for market efficiency is that errors in the

market price be unbiased. It follows then that the price can be above or below the true value as

long as the deviations are random. The fact that the deviations of the market price of the stock

are random it gives the implication that there is an equal chance that the stock is either

undervalued or overvalued (Jarrow and Larsson, 2012).

A random deviation of the market price from the true value should mean that no investor

or group of investors should find undervalued or overvalued stocks. It is sometimes possible that

a particular market is efficient concerning particular investors and not others. It is unlikely to

FINANCE AND ACCOUNTING 4

find an efficient market common to all investors. This is sometimes due to differential tax rates

and transaction costs which may give some investors advantage relative to others.

Markets are efficient because of the arbitrage forces are constantly at work. If the certain

value-relevant information is not incorporated in the price arbitrage forces will make prices to

adjust until they reflect the information (Lee and Kothari, 2001).

According to research by Kothari (2001) on “market efficiency and capital market

research in accounting," economist have never taken the efficacy of the arbitrage mechanism

seriously always assuming that it involves no capital. The notion that price is equal to value as

the definition of market efficiency should be abandoned, and more thoughts should be given to

the distinct ways current market price differs from the fundamental value (Lee and Kothari,

2001). Instead of assuming market efficiency we should study what leads to the price being

efficient, how and when it occurs and seeks a way of improving the current market price rather

than ignoring it.

The role of accounting number in the contract is a significant part of the demand for

accounting information. Accounting information enhances the efficiency of contracting, and it is

built on the agency theory (Christensen et al., 2016). According to agency theory, accounting

information facilitates contracting process by minimizing the agency costs as a result of seeking

external financing.

In research on Accounting Information on Financial Contracting: An Incomplete

Contract Theory Perspective, the integral question is how accounting information is facilitating

the transaction between the financier and those seeking finance (Christensen et al., 2016).

In a scenario of debt financing, a manager acting on the interest of shareholders may

embark on actions that increase the riskiness of firm or investment in unprofitable investment

opportunities, in a bid to protect shareholders from such opportunistic actions covenants can be

include in debt contracts that seek enough financial interest of the shareholders in the firm while

at the same abating opportunistic actions by the management. The implication is that contract

efficiency role of accounting information is seen in its ability to hinder opportunistic behaviors

of the borrowers (Christensen et al., 2016).

FINANCE AND ACCOUNTING 5

Part 2

Debates on executive compensation have gained currency and has become one of the

most controversial corporate issues of recent times. It has taken an international trend which has

seen shareholders regaining some decision making powers from the executive board. Similar to

other hot-button issues in the corporate world such as short-termism and risk-taking since the last

financial crisis executive compensation has also taken a center stage. The UK has always been

forefront in the regulation of executive compensation, but numerous jurisdictions in other parts

of Europe and some countries have followed suits and surpassed. For example, the US known for

its friendly corporate laws has introduced say on pay and some other Europe jurisdictions have

already tied the shareholder's votes on the executive pay and have capped executive salaries and

introduced pay ratios for the executives and the employees (Petrin, 2015).

With the introduction of pay ratio as an addition to the annual report, the chief executive

officers pay will be expressed as the ratio of the pay of an average employee. The UK

incorporated companies will be required to their wage ratio and justify the disparities. In a bid to

give workers a voice in the boardroom level, companies will either choose to assign a non-

executive director as a head of the employees, establish an advisory council for the employees or

nominate one director from the workforce.

With the new reforms in 2013 in the UK executive compensation framework,

shareholders will have more power to block ridiculous pay packages and the diversity of the

board will be monitored. The new government plans to curb executive pay will also ensure that

firms justify high salaries by disclosing in their remuneration reports (Petrin, 2015).

The goals of the new framework which will ensure that there is a distinct relationship

between pay and performance, reduction of rewards for failures, promotion of better

engagement between shareholders and the companies and empowering the shareholders to hold

companies accountable through binding votes (Petrin, 2015).

These measures indeed will curb executive pay, and they will take the following

approach: curbing financial disclosure requirement, disclosure on remuneration to be removed,

prohibiting performance-related compensation, use of pay ratios and remuneration caps to

FINANCE AND ACCOUNTING 6

control salaries and finally ensuring that employees and shareholders participate in the

remuneration setting process (Petrin, 2015).

The Green bury report in 1995 was drafted to address concerns over remuneration of

company directors in large public companies the UK. The major concerns included the size of

the basic pay increases, gains from share options and the compensation of the director if he or

she losses office. The Green bury was based on the principle of accountability, transparency, and

performance. The report contained a proposal that ensures that the remuneration of the director is

attached to his or her performance and enhancing of more accountability and transparency in

determining the executives pay (Hughes, 1996).

Green bury recommendations included the following all public companies should

establish a remuneration committee and any company who does not should disclose why in its

next annual report outlining their arrangement in place (Bruce and Buck, 2007). The

remuneration committee should be tasked with the following mandate; determination of

company policy on remuneration, individual packages for each executive director and to report

directly to the shareholder's matters relating to executive remuneration. Green bury required full

disclosure of information relating to all executive compensation, all components of remuneration

package should be disclosed, for example, the annual bonuses, long-term payments and the

performance criteria on which these payments are based on (Hughes, 1996).

Notable Green bury report also helped in curbing excessive remuneration of the

executives by ensuring improved accountability and disclosure of executives pay and giving

shareholders boardroom representation on matters of remuneration policies.

Recent figures show an increase in the executive pay in the UK which has attracted anger

due to the belief that such pay bear little relationship to the performance of the same companies

run by the chief executive officers (Bell and Van Reenen, 2012). In a study by Bell and Van

Reenen (2012) on the link between the pay of top business people and the performance of their

respective firms, a database of pay of CEOs, senior executives and employees was created

covering 400 firms in the UK over the period since the year 2001. The firms which were

included in the database accounted for 90 percent of UK stock market capitalization. This was a

FINANCE AND ACCOUNTING 7

comprehensive research which covered every employee of the firms from the cleaner to the top

executives and linked to the performance in the stock market.

The findings of the study revealed a big difference in the average pay. It reveals a stark

difference on how CEOs earn around 40 times more than the average employee (Bell and Van

Reenen, 2012). This multiple rises to up to 80 when we consider the top companies in the FTSE

100, and it further revealed that majority of the compensation for the CEOs comes from bonuses

and stock incentive plan while 95 percent pay for the average employees comes from basic

salary.

Evidence from this research shows that when pay increase with improvement in the

corporate performance (Bell and Van Reenen, 2012). However, pay for the CEOs goes up much

more than those of ordinary employees. The research unearthed that an increase in the firm’s

value by 10 percent due as measured by shareholders returns results to 3 percent increase in the

CEOs pay while for the other employees get only 0.2 percent. This shows how pay and

performance are collated and driven by bonuses and incentives packages (Bell and Van Reenen,

2012).

Some of the relevant reforms that may strengthen this relationship include encouraging

transparent reporting of pay by companies and requirement for the board to disclose to the public

and shareholders how growth in the pay of the CEOs is correlated with the performance of the

company(Gregg et al., 2010).

Lloyds Bank Group PLC

In the annual report of 2016 under executive salary awards for 2016, the committee of

remuneration ensures that the salaries of the executive directors are competitive against the

market. The committee of remuneration is keen on both the average award of the colleagues

across the group which is 2016 was 2 percent and the proposal for the increment of 2 percent

also for the CFO and CRO. Since 2011, a base salary increment was proposed for the group chief

executive. The total salary for the group CEO is $1,125,000.

The pay for the Group Chief Executive seems appropriate because hiring was done on the

basis that upon the government shareholding plummeting in the rage of 15-20 percent or less, the

FINANCE AND ACCOUNTING 8

committee for remuneration will consider being revised or increased depending on the market

conditions. As at the time of drafting this annual report, the government shareholding stood at 9

percent, and the committee resolved that they will start adjusting the salary of the group chief

executive towards the reference salary.

Board and Governance Structure

Lloyds Group is lead by an effective and committed board charged with the long-term

growth of the group. Board is composed of a chairman, independent non-executive directors, and

executive directors. Responsibility at the head of the company is divided and documented in the

group’s corporate governance framework. The Board committees make recommendations on

matters as enshrined on the corporate governance framework pertaining to internal risk, financial

reporting, governance and remuneration. The group chief executive is responsible for day to day

management of the business.

In general, the board is composed of the following committees' nomination and

governance committee, audit committee, risk committee, responsible business committee,

remuneration committee and the group chief executive committee each mandated with different

duties as spelled in the Corporate Governance Framework.

One of the notable weaknesses of this group governance structure is that it is large and

issues such as conflict of interest, slow decision making, and agency problems do arise, however,

the current governance has a clear set of guidelines on remuneration of the executives which is

the duty of the remuneration committee.

FINANCE AND ACCOUNTING 9

References

Brown, P. and Howieson, B., 1998. Capital markets research and accounting standard

setting. Accounting & Finance, 38(1), pp.5-28

Oler, D.K., Oler, M.J. and Skousen, C.J., 2010. Characterizing accounting

research. Accounting Horizons, 24(4), pp.635-670.

Vélez-Pareja, I. and Tham, J., 2001, June. Firm valuation: free cash flow or cash flow to

equity. In CONFERENCE OF THE EUROPEAN FINANCIAL MANAGEMENT ASSOCIATION,

2001b, Lugano, Switzerland.[Links].

Oler, D.K., Oler, M.J. and Skousen, C.J., 2010. Characterizing

FINANCE AND ACCOUNTING 10

accounting research. Accounting Horizons, 24(4), pp.635-670.

Vélez-Pareja, I. and Tham, J., 2001, June. Firm valuation:

free cash flow or cash flow to equity. In CONFERENCE OF THE

EUROPEAN FINANCIAL MANAGEMENT ASSOCIATION, 2001b,

Lugano, Switzerland.[Links].

FAROOQ, M.S. and THYAGARAJAN, V., VALUATION

OF FIRM: METHODS & PRACTICES-AN EVALUATION.

Brown, L.D. and Caylor, M.L., 2006. Corporate governance

and firm valuation. Journal of accounting and public policy, 25(4),

pp.409-434.

Cheung, Y.L., Stouraitis, A. and Tan, W., 2011. Corporate

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markets. Journal of International Financial Management &

Accounting, 22(3), pp.246-273.

Jarrow, R.A. and Larsson, M., 2012. The meaning of market

efficiency. Mathematical Finance, 22(1), pp.1-30.

Christensen, H.B., Nikolaev, V.V. and

WITTENBERG‐MOERMAN, R.E.G.I.N.A., 2016. Accounting

information in financial contracting: The incomplete contract theory

perspective. Journal of accounting research, 54(2), pp.397-435\

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Hughes, J.J., 1996. The Greenbury Report on directors’

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FINANCE AND ACCOUNTING 11

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