Essays on Organisational Performance Evaluation

Abstract

Performance may be characterised as being a function of the strategy (or product mix) chosen by the entity, the state of nature, and the environment or technology. The task of the firm is to choose and implement the strategy that will optimise performance. This thesis deals with different aspects of performance evaluation - aspects of the input-output relationship that characterises performance and the issue of optimisation. Organisations differ regarding the goals and objectives they establish. Some organisations, for example, are profit seeking and others are non profit. However, all organisations convert inputs into outputs. An organisation must decide whose goals it is going to pursue. The conventional wisdom is that the interests of shareholders should drive the choice of the objectives for the organisation. That is, the entity should strive to maximise shareholder wealth. Some, however, think that concept is too limiting. A broader view of the problem is to consider all stakeholders, such as employees, suppliers, customers, regulatory agencies and tax authorities. Stakeholder theory, as this notion is called, has a certain emotional appeal. It just seems fair. All of those groups are affected by the actions of the organisation, so perhaps all should have a say in setting the objectives for the oganisation. However, it would be difficult to evaluate Performance in relation to such objectives. It is not easy to know how to make tradeoffs among the various stakeholders. How would a manager allocate her scarce time and effort among activities that would benefit one group over another? It can only be done subjectively. The conventional finance and economics wisdom says that it cannot be done in a systematic way. It proposes that the best thing to do is to focus on the shareholders. They provide the capital to fund the organisation. They bear the residual financial risk if the organisation does not perform well. The result is that maximisation of shareholder wealth is the typical criterion used to evaluate performance. Maximising shareholder wealth may be a good principle to base strategy on, but it is a difficult guideline for operating a business It is not usually obvious what decision could be made today that would maximise wealth. Attempting to maximise profit is often seen as a tool that is more helpful for day-to-day decision making. Profit is a widely available measure that is commonly used for performance evaluation. Some organisations, however, cannot use profit to measure their performance because they are not profit seeking, organisations. Budgeting is a commonly used tool in such organisations. Public sector organisations have traditionally placed heavy reliance on budgets for performance planning and evaluation. Their organisations also make use of efficiency and effectiveness measures of performance. Budgets are frequently used by organisations as part of their performance evaluation plans. However, budgets have many problems. They may provide incentive for people setting the budget and those attempting to meet the budget to misstate their true beliefs about what can be accomplished in a budget period. This is a common problem that is known as budgetary slack. Performance evaluation tools that may alleviate the budgetary slack problem are flexible budgeting and variance analysis. Ordinary budgets are static budgets. They are set at the beginning of the period and measured against the actual outcomes. Flexible budgeting attempts to consider how the budget may have developed considering what was actually produced during the period. It is a particularly valuable tool for evaluating the performance of manufacturing organisations. It is generally believed that better input into the flexible budgeting model would provide more reliable performance evaluation. Activity based costing is a technique that is generally believed to provide this more accurate information. Good decision making is essential to good performance. The NPV method and the IRR method are two of the most used and most advocated tools by which to make investment decisions. However, these tools occasionally result in differing recommendations. Differences in the assumptions relating to the reinvestment of intermediate cash flows have been offered as the explanation for the conflict that can arise between the NPV and IRR methods in the ranking of two projects. A review of the literature argues that this assumption is incorrect and thus cannot be an explanation for the conflict. This thesis discusses the conflict and presents the results of a survey into the incidence of the assumption in a sample of recent management accounting and finance texts. Seven tenths of the texts sampled relied on the reinvestment assumption. Tentative explanations are offered as to why the reinvestment assumption is proposed. Another tool that has been proposed as a solution to the NPV/IRR conflict is the marginal internal rate of return. This method solves some of the problems inherent in the IRR, but not all. The recommendation is to use only the NPV method. It always provides the correct answer. Once the investment decision is made, it is necessary to collect information about the implementation of the decision. An important area where there is not full agreement on how this information should be reported is in the area of the profit that is earned from investments in other companies. The accounting standards require that this issue be reported differently depending on the level of influence that the investor can exert over the investee. This thesis examines the judgement processes of New Zealand financial controllers when determining whether an investor is capable of exercising significant influence over an investee. The results of this study provide evidence that the "2O% interest" threshold is the most important factor in these judgement processes. Further, the results indicate a high degree of inter-subject consensus and intra-subject consistency and self-insight that could be attributed to the high weight given to the "20% interest" threshold. Although the "20% interest" threshold is often criticised for being arbitrary, the results of this study suggest that the use of this cut-off as a judgement cue may help achieve greater consistency and comparability in financial reporting. An issue similar to the intercoporate investment issue arises with reporting the outcome of the foreign operations of an organisation. Financial reporting standards on foreign currency translation in many countries such as New Zealand, US, Australia, and Canada and the international standard issued by the International Accounting Standards Committee require the classification of foreign operations for translation purposes into two mutually exclusive types: integrated and independent. This classification determines the translation method. In judging whether a foreign operation is either integrated or independent, the accounting standard requires the evaluation of five qualitative factors. The standard neither describes the judgement process nor identifies the relative importance of the determining factors. It has been asserted that this lack of clarity may yield dissimilar results for firms whose circumstances are similar and consequently may reduce the comparability of financial statements across firms. Using a repeated measures design, this paper examines the judgement of preparers of financial statements (financial controllers) in determining the designation of foreign operations for translation purposes. The results indicate that the relative importance of the determining factors is about equal. No support is found for the assertion that the use of qualitative factors in accounting standards results in dissimilar judgements (lack of consensus) across respondents. Further, the results show that the subjects demonstrated consistency and self-insight in their judgements. The results also indicate that the judgements of respondents are not biased toward either classification of foreign operation. This suggests that the observed bias may be motivated by economic factors rather than the outcome of using the qualitative cues in the accounting standard. When the respondents were debriefed, several of them identified 'managerial independence' as another determining factor that has not been included in the standard. Once decisions are made and information is available, performance evaluation commences. As mentioned above, variance analysis is a common method used to evaluate performance. Variances generally compare actual performance to some budgeted, standard or expected level of performance. The expected level of performance can be flexed to accommodate changes that have occurred since the budget was first established. Activity based costing provides a technique for providing more accurate information for use in flexible budgeting. The use of activity based costing with the traditional variance analysis framework is examined in this thesis. Performance evaluation is further complicated because of agency problems. Agency problems can arise when a principal contracts with an agent to perform some activity. It may happen that the principal cannot know with certainty whether the agent has acted in the best interests of the principal. Agents may have interests that differ from the principals, and they may be able to pursue those interests without detection. The principal takes steps to reduce the likelihood and the magnitude of the losses that would result from such actions. One group of stakeholders that are susceptible to the agency problem is debtholders. They use various methods such as financial covenants to reduce their agency costs. This thesis examines the perceptions of lending bankers of the use of financial covenants and the consequences of their breach in private lending agreements in New Zealand. Based on a survey of 26 bank loan officers, the results show that lenders' perceived use of covenants is associated with the size of the loan and with capital structure, but not with the term of the loan, size of audit firm and ownership structure (private/public). In the case of a material breach of debt covenants, the action most preferred by bank loan officers is to obtain more detailed and frequent information. High cost options such as recalling the loan and converting a term loan to an on-call loan are less preferred choices. In the event of a technical breach of covenants due to the promulgation of mandatory accounting standards, bankers are likely to require more information from the borrowers and are usually willing to renegotiate the terms of the covenant based on the old standards that were in place at the time of agreement. The results in this study suggest that violations of debt covenants do not necessarily incur high costs to borrowers, and the perceived severity of penalties imposed by creditors depends on the circumstances surrounding violation. Shareholders too are faced with the possibility of incurring agency losses. The board of directors is an important part of the shareholders' methods of reducing agency costs. This study examines the associations between characteristics of initial public offering (IPO) firms and their boards of directors. Four firm characteristics are examined: inside share ownership, assets-in-place, variance of aftermarket returns and firm size. These characteristics are tested for relationships with three aspects of boards of directors: proportion of outside directors, board size rand CEO duality. Based on a sample of 110 New Zealand firms which made initial public offerings of equity securities over the period 1983 to 1987, this study finds that greater variance of aftermarket returns and lower inside share ownership are associated with a greater proportion of outside directors. In addition, larger firms and firms which have lower inside share ownership tend to employ larger boards. Finally, firms with highly variable returns and, surprisingly, smaller, firms are likely to avoid CEO duality. Although some contrary results were found, the findings from this study are generally consistent with arguments that firms with greater agency problems are likely to organize their boards of directors to attempt to mitigate these problems.