Implications of Financial Reporting on Leadership ’s ...1131/FULLTEXT01.pdf · explain the...

Implications of Financial

Reporting on Leadership’s

Strategic Choices

Authors: Svetlin Miroslavov Mirchev

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Tutors: Philippe Daudi;

Mikael Lundgren

Program: Leadership and Management

in International Context

Subject: Business Administration

Level and semester: Masterlevel Autumn

Baltic Business School

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Abstract

The importance of the financial markets has constantly been increasing during the last few

decades. With the increase of the importance of the financial markets the popularity and

importance of financial reporting have also increased dramatically.

The importance of financial reporting has logically created a need for a lot of research in the area.

It is for instance important to understand the links financial reporting has with the different parts

of the business and its implications on them and the business in general. Based on that the

research conducted has focus on the following research issue – identify, understand and explain

the implications of financial reporting on leadership’s decision making process as well as identify,

understand and explain their effects on leadership’s strategic choices.

The aim of the research process is to reach some general conclusions on the issue derived from a

certain context – the crisis in the financial sector originating from the US subprime mortgage

crisis as well as provide basis for further research on the issue.

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Table of Content

1 Rational ..........................................................................................................................4

2 Objectives.......................................................................................................................5

3 Methodology ..................................................................................................................6

3.1 Phases of the research process.................................................................................6

3.2 Major theoretical concepts applied during the research............................................7

3.3 Qualitative Vs Quantitative .....................................................................................8

3.4 Data gathering methods...........................................................................................8

4 Literature Review ...........................................................................................................9

4.1 Shareholder value - the key behind the reason for the implications of financial

reporting on leadership’s decision making process and strategic choices.............................9

4.1.1 Introduction.....................................................................................................9

4.1.2 The Evolution................................................................................................10

4.1.3 The basic consideration .................................................................................11

4.1.4 The Reality....................................................................................................12

4.1.5 The basic principle remains ...........................................................................15

4.1.6 The trade-off between shareholder and stakeholder value ..............................15

4.1.7 Short-term earnings Vs Long-term value creation – the existential question...16

4.1.8 Shortcomings ................................................................................................19

4.2 Financial indicators and their link to leadership.....................................................20

4.2.1 Introduction...................................................................................................20

4.2.2 The basic framework .....................................................................................20

4.2.3 The relevance of financial indicators to leadership.........................................30

4.3 The Information revolution ...................................................................................31

4.4 Structure of shareholding ......................................................................................34

4.5 The strategy perspective........................................................................................36

4.5.1 Introduction...................................................................................................36

4.5.2 Strategic Thinking .........................................................................................37

4.5.3 Strategy Formation ........................................................................................39

4.5.4 Strategic Change ...........................................................................................40

4.5.5 Business Level Strategy.................................................................................42

5 Logical Considerations .................................................................................................43

5.1 Major Drivers behind the Implications ..................................................................43

5.1.1 Shareholder Value .........................................................................................44

5.1.2 The information revolution............................................................................45

5.1.3 Structure of Shareholding ..............................................................................47

5.2 Why are the implications strategic.........................................................................47

5.2.1 Allocation of resources..................................................................................48

5.2.2 Unrealistic value............................................................................................49

6 Case Study – The UBS and its peers during the Subprime crisis....................................50

6.1 Introduction ..........................................................................................................50

6.2 The context ...........................................................................................................51

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6.3 Structure, methods to conduct the analysis and methods of data collection ............52

6.4 The subprime crisis ...............................................................................................54

6.5 The role of “Wall Street”.......................................................................................56

6.6 A financial reporting issue.....................................................................................58

6.7 The UBS and its performance before and during the crisis ....................................60

6.7.1 The UBS .......................................................................................................60

6.7.2 Financial performance before and after the crisis relevant to the research issue

61

6.7.3 The strategic changes subsequent to the crisis................................................66

6.8 The UBS’s peers ...................................................................................................74

6.9 Questioning the case .............................................................................................76

6.10 Conclusions to the case study................................................................................76

6.10.1 Financial reporting effects leading to the implications ...................................76

6.10.2 Major reasons behind the strategic developments ..........................................77

6.10.3 The strategic implications..............................................................................79

7 Conclusion....................................................................................................................85

8 Bibliography.................................................................................................................91

9 APPENDIXES..............................................................................................................93

10 Acknowledgments ....................................................................................................98

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1 Rational

Leadership has always been considered one of the key, if not even the key, variables for

organizational performance. The direction of development of an organization is undoubtedly

influenced by the leadership style and effectiveness of leadership. The leaders are the ones

determining the direction of development and the ones being at the core of the decision making

process within an organization. Consequently they are the ones carrying the ultimate

responsibility for the overall performance of the organization. As an organization performs in

different fields, there are different indicators for the evaluation of the performance of an

organization. One of those indicators is the organization’s financial performance. The financial

performance of an organization is determined and evaluated via a number of financial indicators

(mostly ratios). Those financial indicators or the data needed for their calculation or estimation

can be found in the financial statement and reports of the organizations. This is especially true

for the so called “public companies” or “publicly traded companies”. Those are the companies,

whose share are publicly traded and offered to the public. They are obliged to meet certain

standards so that the potential investors are not misled and offered a clear picture of the

company’s financial performance. A good example of such a high standard is the so called

Sarbanes-Oxley Act, which was introduced in the United States of America in 2002. The activity

of reporting financial data is referred to as financial reporting.

At the core of the evaluation of an organization’s financial and very often even overall

performance are two basic criteria – growth and profitability. While the influence of leadership

on financial performance and financial reporting is rather clear and taken for granted the vice

versa connection – the influence and immediate effects of financial reporting on leadership and

the direction of development of an organization are a very interesting and kind of an intriguing

issue. In other words to what extent does financial reporting affect leadership’s decision making

process.

The importance and popularity of the financial markets all around the world has been constantly

increasing. The number of investors as well as the number of potential investors in them has

been also growing. That has also created a great deal of demand for analysis of the financial

performance of the organizations so that an objective evaluation of their overall performance and

future potential is achieved. As a consequence of that more and more attention is paid to the

organizations’ financial reports by potential investors, analysts and media, etc. Consequently,

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leadership should logically be paying more and more attention to financial reporting and is at the

same time more and more concerned about the issue.

2 Objectives

The study is aiming at finding the relationship between financial reporting and leadership in

terms of the influence of the first one on the latter one as determined by the strategic decision

making process Shareholder value creation is becoming a major goal for the business

organizations worldwide and consequently management’s primary concern. The value of the

company on the other hand depends on the investors’ opinion about the organization, which is

based widely (but no solely) on the way the investors perceive and evaluate the organization’s

performance. As already mentioned above there are different indicators for the evaluation of the

performance of an organization with one of the major ones being the organization’s financial

performance. The financial performance of an organization is determined and evaluated via a

number of financial indicators (mostly ratios), which can be found in the financial statements and

reports of the organizations as well as in some cases different analysts reports and other sources

that use those very same reports as a source. That means that especially in the case of the publicly

traded companies since the financial reports issued by the company are the primary means for the

evaluation of the organization’s financial performance they are also one of management’s primary

concerns. Consequently a potential (drastic) change in the results reported may have very serious

implications on the decision making process, direction of development and immediate

performance of the organization and since they are largely determined by the organization’s

leaders and leadership style they may also result in serious changes in the leadership style and

even leadership in the organization. The research issue of the study is to identify, understand and

explain the implications of financial reporting on leadership’s decision making process as well as

identify, understand and explain their effects on leadership’s strategic choices. It is clear that the

there cold be a numerous amount of implications and that those are highly dependant on the

circumstance. The purpose is to come up with a set of implications within the scope of the study

and provide basis for further research on the research issue.

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3 Methodology

The clarification and thorough explanation of the methods and approaches used during the

research process is one of its most vital parts. In this part of my work the methodology used in

order to answer the research issue and in particular the relevant research techniques and model

used during the research are introduced. The methods of data collection are explained and a

justification of the choice of a methodological approach is provided.

3.1 Phases of the research process

The below explained four major steps are followed throughout the development of the research

process:

1. Literature Review - The literature review part of the work starts with an induction of the

concept of company value, shareholder value and shareholder value creation. Different

aspects of the concept are discussed including its evolution, the basic consideration

behind it, an overall picture regarding the concept’s application in reality as well as its

shortcomings. The second section of the literature review offers a discussion regarding

some key financial indicators and their link to leadership. The section begins with an

outline of the basic theoretical framework from different perspectives and commences to

the identification of a list of financial indicators considered most closely linked to the

topic which are used in the further analysis conducted in the empirical study. The

following two sections of the literature review are dedicated to short discussions of the

information revolution and structure of shareholding aimed at supporting the logical

considerations available in the work as well as the final conclusions. Last but not least

attention is paid to the theoretical framework offered by De Wit and Meyer, which is the

major strategic concept the analyses in the empirical study are based on.

2. Logical considerations – The next part of the work provides some logical consideration

regarding the research issue of the paper. The part is divided into two separate parts with

their respective sections. The purpose of the existence of this section is to on one hand

provide the reader with some considerations on top of and based on the literature

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discussed in the literature review. In addition the logical considerations provide the reader

with the author’s perspective regarding the development of the work.

3. Empirical study – Based on the theoretical framework discussed in the literature review

and the considerations thereafter a case study on an up to date issue will be constructed

and analysed with the purpose of gaining empirical evidence with regard to the research

issue. The case study will be based on the current crisis in the financial sector originating

from the US subprime mortgage crisis. The case study as an empirical research has its own

methodology available in the case study itself.

4. Conclusion – The purpose of the conclusion drawn is to address and answer the research

issue as much as possible based on the review of the existing literature discussed in the

literature review part of the paper, the logical considerations thereafter and of course the

empirical study with its conclusions.

3.2 Major theoretical concepts applied during the

research

Four theoretical concepts are used during the development of the work. The selection of the

theoretical concepts is based solely on their relevance to the research issue. Further explanation

regarding the relevance of the concepts to the research issue is provided at the point of

discussion of the concepts themselves.

1. Company value, shareholder value and shareholder value creation

2. Financial indicators and their relevance to leadership

3. The information revolution and structure of shareholding as determinants in the

process of shareholder value creation

4. Theoretical framework in the field of strategy offered by Bob De Wit and Ron Meyer

in their book “Strategy: Process, Content, Context--An International Perspective”

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3.3 Qualitative Vs Quantitative

In terms of research methods it can be differentiated between qualitative and quantitative

research methods. According to Strauss and Corbin (1990) qualitative research is any kind of

research that produces findings not arrived at by means of statistical procedures or other means

of quantification. Quantitative research on the other hand involves quantitative analysis of

numbers and other data that can be transformed into numbers (Robson, 1993).

Both the qualitative and quantitative research methods have their advantages and disadvantages.

Many examples from science as well as simply from the daily life can be given in order to

illustrate those advantages and disadvantages as well as the differences between qualitative and

quantitative research methods. Instead of looking at the advantages and disadvantages of the two

methods though it is better to concentrate on their appropriateness based on the individual case

and determine which one is more appropriate in the particular situation. The starting point for

determining the appropriate research method is the research issue and the objectives of the

research.

The specifics of the research issue and the objectives of the research in this case require the

application of both qualitative and quantitative research methods. Consequently, both methods

are used during the development of the thesis. While the financial effects of the phenomenon

subprime crises are analysed by means of quantitative research methods, the leadership’s decision

making process and strategic choices are analysed be means of qualitative research methods.

Finally it can be concluded that the research issue has been addressed by using both the

quantitative and qualitative research methods with an emphasis on the latter one.

3.4 Data gathering methods

The research process is based on analysis and interpretation of secondary data. The sources of

data collection used are books, articles and websites of major news providers as well as the

information available on the official websites of the companies included in the empirical research.

When considering the methods of data collection it is very important to keep in mind that the

research issue requires extensive knowledge in many different fields of study like finance,

strategy, economics, etc. It is important to filter the data based on their relevance to the research

issue. A major pitfall is the fact that in case the data are not filtered properly based on their

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relevance to the research issue the analysis may include too much data and the conclusions

reached may be too broad and not concrete. Another important aspect is to make sure that the

data used are reliable, comprehensive and up to date.

There is a lot of research and analysis done in the fields of research associated with the research

issue. Due to the specifics of the latter though it is important to select and filter only relevant and

up to date literature and data for the analysis.

4 Literature Review

4.1 Shareholder value - the key behind the reason for the

implications of financial reporting on leadership’s

decision making process and strategic choices

4.1.1 Introduction

Shareholder value is according to me the key behind the reason for the implications of financial

reporting on leadership. More and more companies nowadays have based their strategies on

shareholder value creation. In order to be able to analyse the role of shareholder value as a key

behind the reason for the implications of financial reporting on leadership we need to first gain

an understanding of the concepts of company value, shareholder value and shareholder value

creation. In order to do that I will review some of the familiar to me literature I consider relevant

for the topic in this part of my literature review dedicated to shareholder value. The two books I

will base this part on are:

1. “Valuation: Measuring and Managing the Value of Companies”, Fourth

Edition by McKinsey & Company Inc., Tim Koller, Marc Goedhart, and David

Wessels - McKinsey & Company Inc is one of the most renowned consulting

companies worldwide. The company was founded in 1926 by James O. McKinsey.

More than 75 years later, the firm has grown into a global partnership serving three of the world's

five largest companies and two-thirds of the Fortune 1000.1 The company’s mission has

remained the same since its foundation (with a little rewording from decade to

decade): to help clients make distinctive, lasting, and substantial improvements in their performance

1 McKinsey & Company, viewed 01. March, 2008, http://www.mckinsey.com/aboutus/wherewestarted/index.asp

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and to build a great firm that is able to attract, develop, excite, and retain exceptional people.2 Since

McKinsey & Company Inc is one of the most experiences and renowned consulting

company in the world with exceptional experience in the consulting of companies

worldwide I consider their opinion very relevant to the topic. At the same time I have

some experience using the book in professional experience and it has proved its

qualities.

2. “In Search of Shareholder Value: Managing the Drivers of Performance” by

Andrew Black, Philip Wright, and John E. Bachman – In addition to McKinsey

& Company Inc’s perspective, which will be the basis of this review I will also add the

perspective offered by Andrew Black, Philip Wright, and John E. Bachman in their

book “In Search of Shareholder Value: Managing the Drivers of Performance”. The

book offers some very interesting ideas, which add up to the ones of McKinsey &

Company Inc and will contribute to a more exhaustive review of the concepts of

company value, shareholder value and shareholder value creation. I admire the ideas

from this book, which will be included in my review.

4.1.2 The Evolution

Many things have changed throughout the development of the current business environment. On

one hand as the economy in the different parts of the world has been growing with a different

pace the expectations of the investors’ regarding their investments in the respective economies

have been adjusting. On the other hand as the needs of the people around the world have been

changing and the intensity of investment in the different industries and sectors of the economy,

the latter have also recorded different paces of growth and the investors’ expectations regarding

their investments in them have also been adjusting accordingly. At the same time as a

consequence of the introduction of new technologies, accounting scandals and other external

developments, the regulations of the financial markets all over the world have also undergone

different changes – new legislation has been introduced, old one has been changed, etc. Those

are just three of the many, many things that have been constantly changing thus affecting the

current state of the global business environment. As pointed out in McKinsey Ironically one thing that

2 McKinsey & Company, viewed 01. March, 2008, http://www.mckinsey.com/aboutus/wherewestarted/index.asp

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did not change was the market’s obsession with quarterly earnings. This focus continues to confront business leaders

with the dilemma of often having to choose between short-term results and the long-term health of the companies

that they lead.3 I think that this quote taken from McKinsey’s famous book is a perfect tool to set

the stage for the upcoming further debate.

Together with the changes in the global business environment and all the existing uncertainty in

the markets the number of methodologies for valuating companies and thus calculating the true

shareholder value have increased and the methodologies have become more and more

complicated. More and more investors, analysts, and investment bankers are turning to fundamental financial

analysis and sophisticated discounted cash flow (DCF) models as the touchstone of corporate valuation.4 The

reason behind the increase in number and complication, which is also accompanied by a great

deal of debate about their accuracy in different situations is to make sure that the true

shareholder value to the investors.

4.1.3 The basic consideration

The basic consideration behind creating value for the shareholders or the so called shareholder

value is that especially starting with the US and the UK. At least in ideology and legal frameworks the

United States and the United Kingdom have given the most weight to the idea that shareholders are the owners of

the corporation, the board of directors is their representative and elected by them, and the objective function of the

corporation is to maximize shareholder value.5 It is worth mentioning here that the principle is one,

which is very close to the principle of representative democracy used in many of the democratic

states nowadays. On a political level the people elect the politicians, who represent them in the

lawmaking body of the nation, while in the corporation the shareholders elect their

representatives in the respective executive body (board of directors, etc), who defend their

interests and promote their idea for future development of the business. There are of course

differences. Unlike most of the democratic political systems where one voter represents one vote

this is not the case with the corporate governance. There are different types of shares and the

3 McKinsey & Company Inc. by Tim Koller, Marc Goedhart, and David Wessels, Fourth Edition, 2005,

“Valuation: Measuring and Managing the Value of Companies”, page 3





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voting power is not equally distributed among the shareholders. At the same time the right to

have more voting power is not granted to the shareholders due to a similarity between them like

the citizenship, but on the basis of the basis of the amount of capital invested by them and the

risk they are willing to take. Both principles have their advantages and shortcomings, but this is

not the topic of this work.

It is also at this stage important to mention what are the factors contributing to the growing

awareness towards shareholder value. According to Black, Wright, and Bachman in their book

“In Search of Shareholder Value: Managing the Drivers of Performance” there are three forces

contributing to the growing awareness towards shareholder value. Three forces in particular have

contributed to a growing awareness of the importance of SHV and value-based management. They are: The spread

of private capital; the globalization of markets; and the information revolution.6

4.1.4 The Reality

Here is the point to mention a few interesting points regarding the investor relations of a

business, which must be discussed regarding the concept of shareholder value, and why they are

so important. It is undoubtedly truth that especially the value of a publicly traded company is

closely associated with the opinion and expectations the different analysis, stakeholders and

especially the potential shareholders have about the future performance of a company.

• The complication with the publicly traded companies

A very accurate point about the fact that the complication with the publicly traded companies

actually comes from the fact that management must deal with outside investors and analysts is

given again by McKinsey and Co in their book “Valuation: Measuring and Managing the Value of

Companies”. They state that: When a company enters the financial (or capital) market, the real market

competition rules are essentially unchanged, but life becomes more complicated because management must

simultaneously deal with outside investors and analysts.7 Here I would just like to mention that narrowing

6 Andrew Black, Philip Wright, and John E. Bachman, 2000, “In Search of Shareholder Value: Managing the

Drivers of Performance”, page 8



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down the complication solely to management is probably the most objective alternative when it

comes to formal power in the organization, but otherwise I would like to also mention that the

image of the organization it is not solely the result of the management’s efforts and performance,

but the result of the efforts and performance of all the leaders of the organization – both formal

and informal.

• The investors pay for the performance that they expect the company to

achieve

Here is a short explanation of how it works technically in simple words offered again by

McKinsey and Co in the same book: The trading activity between investors and speculators sets for those

shares. Each investor determines a value for the shares and trades based on whether the current price is above or

below that estimate of the intrinsic value. This intrinsic value is based on the company’s ability to generate cash

flow in the future. This means, essentially, that investors are paying for the performance that they expect the

company to achieve in the future, not what the company has done in the past and certainly not the cost of the assets

in the company.8 This again according to me puts the emphasis on the future performance of

leadership, because if they do not manage to perform better in the future and do not manage to

convince the potential investors in the fact that hey will then the value of the company and thus

the shareholder value will inevitably suffer.

• The returns that the shareholders earn depend more on the changes in

expectations than the actual performance of the company

Let us now use a short example from the same book and author in order to try to illustrate the

process. After an initial price is set, the returns that shareholders earn depend more on the changes in

expectations about the company’s future performance than the actual performance of the company. For example if a

company is expected to earn 25 percent on its investment, but only earns 20 percent, its stock price will drop even

though the company is earning more than its cost of capital.9

• The potential for future growth and returns must be inferred





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At the same time we need to mention that historic financial data is an indicator of the company’s

historic financial performance. Unlike the company’s potential or future growth and returns the

company’s historic financial performance is based on clear existing data and is relatively easy to

anaylise and measure. Since only a company’s historic growth and returns on capital – not its future

performance – can be measured directly, the potential for future growth and returns must be inferred.10

• Information about the true prospects plays an important role

With resects to everything mentioned above we can conclude that the value of the company and

respectively the shareholder value is largely dependant on the flow of information regarding the

company’s performance and future prospects. According to McKinsey the market’s expectations about the

company’s future performance can deviate from intrinsic value can deviate largely form the intrinsic value “if the

market is less than fully informed about the company’s true prospects.11 It is probably worth mentioning

here that especially in today’s world and after all the accounting scandals we have seen apart from

being not fully informed the market can also be improperly informed about the company’s health

and future prospects.

• Managers need to educate their investors

To conclude this point we need to point out that it is not only the potential investors’ as well as

analysts’ and stakeholders’ sole responsibility to inform themselves about their current or

potential investments’ prospects and learn to understand the data. According to McKinsey, after

educating themselves about shareholder value from both theoretical and practical perspective, in order to be able to

link the concept with their strategies, educating their internal and external constituencies, installing management

systems that encourage real value creation, not merely short term – accounting results hey have one more very

important task (McKinsey page 5). “Finally they need to educate their investors about how and when the company

will create value.12

10

McKinsey & Company Inc. by Tim Koller, Marc Goedhart, and David Wessels, Fourth Edition, 2005,






15

A good contribution to the debate is brought up again by Black, Wright, and Bachman: Especially,

investor communications must aim at ensuring that investors understand your company’s value-based strategies and

goals, and are confident in management’s ability to implement those objectives and deliver on them.13

4.1.5 The basic principle remains

Another extremely important fact pointed out by McKinsey is that the overall stock market

performance from a long-term perspective tracks the fundamental performance of the economy

and the companies. Deviations from fundamentals occur when companies, investors and bankers ignore the

principles of economics or assume that they have changed.14 What I would like to explicitly mention is that

after all the scarce resources and the competing needs is what we all have to take into

consideration. Some leaders’ better or worse performance at certain periods of time reflects on

the business, but the fundamental principles of economics are always valid. It is also worth

mentioning here that especially in some moments not everything depends solely on the leaders’

abilities and knowledge, but also the external events and circumstances play a very important role.

4.1.6 The trade-off between shareholder and stakeholder value

The opinion that by creating shareholder value the leaders actually destroy stakeholder value is

very widely spread around. The point of this work is not to discuss this issue though. For the

sake of sticking to the topic I would just like to mention that the this argument is indeed

somewhat controversial and there are according to me reasonable arguments supporting both

views – that by creating shareholder value the leaders very often destroy stakeholder value and

that there is actually no trade-off between the two. According to McKinsey there is certainly no

trade-off between the stakeholder and shareholder value. As an example of that we can mention

for instance the fact that for instance the employees of a company are also its stakeholders. A

company that tries to fatten its profits by providing a shabby work environment, underpaying employees, and

13

Andrew Black, Philip Wright, and John E. Bachman, 2000, “In Search of Shareholder Value: Managing the




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skimping on benefits will have trouble attracting and retaining high-qualified employees.15 That is to say that if

we imagine the whole process the vise-versa connection of destroying stakeholder value and

compensating it with shareholder value will, or at least should, not work. In order to support

their view McKinsey give an example stating that: When examining employment we found that the United

States and European companies that created the most shareholder value in the past 15 years have shown healthier

employment growth.16

4.1.7 Short-term earnings Vs Long-term value creation – the existential question

Slowly, but surely we are going deeper into the issue of shareholder value and shareholder value

creation, At this point I would like to mention a very important aspect of the issue.

There is no doubt that the truly successful companies are the ones, who focus on the long-term

sustainable development, which leads to stable long-term cash flows, which in term determine

the companies’ value and consequently shareholder value The question though is whether the

companies really do it. Another question is if they do it the right way and if they actually realize

what they do and tackle the issue.

According to McKinsey the companies that focus on the long-term sustainable value creation are

the ones, who contribute the most to the overall economic development and the wellbeing of the

stakeholders. They are also the ones the capital markets indeed reward the most. It is unfortunate,

but truth, however, that managers are under pressure to achieve short-term results at the expense of long term value

creation. Many succumb. In a recent survey of 401 executives, 55 percent of them said they would delay or cancel a

value – creating project to avoid missing the consensus analysts’ forecast for the current quarter’s earnings.17 The

major drawback of those managers’ decisions to sacrifice optimal development and success for

the sake of short-term results is that by doing so they drive the businesses into an unsustainable

path of development. At the same time they create an unsustainable competitive environment

15







17

and the other companies are prompted to deviate from their own optimal paths of development

in order to sustain their existence in the short-run.

Here we can add Black, Wright, and Bachman’s point of view in their book “n Search of

Shareholder Value: Managing the Drivers of Performance” – Understandably, boardrooms and middle

managers are suspicious of the stock market. A superficial glance at the behavior of share prices in the market

might lead you to think that short-termism has priority over long-term evaluation. Companies are convinced that

investors are driven by short-term targets and do not therefore understand management strategies.18

Paradoxically, the misunderstanding between management and investor concerning the short and the long term

arises because of the enormous immediate effects on value of announcements made by companies, even concerning

short term results, if these change the market’s perception of their long term cash flows.19

McKinsey also explain that: The pressure to show short-term results often occurs when the companies start to

mature and begin a transition from high to low growth. Investors clamor for high growth. Managers are tempted to

find ways to keep profits growing in the short term while they try to stimulate longer-term growth. Usually, the

short-term efforts make achieving long-term growth even more difficult, spawning a vicious cycle.20 What I would

like to add to the statement above is that basically all companies go through this process. After

that they are under pressure, because the expectations towards them as mature companies are

even higher.

There is one more very interesting opinion expressed by McKinsey, which I personally fully

support. According to them the accounting scandals in the recent years can largely be attributed

exactly to the fact that management was trying to make sure that the short-term results look

better. Perhaps no action was more disappointing and damaging than the wave of accounting fraud that managers

resorted to in the late 1990s and early 2000s to improve the appearance of their short-term results.21

18

Andrew Black, Philip Wright, and John E. Bachman, 2000, “In Search of Shareholder Value: Managing the








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Overall I would also point out and completely agree with McKinsey’s foreword looking

statement: Stock markets will always clamor for short-term results, just as coaches push athletes to achieve higher

level of performance. That pressure will always be there, and it is not all bad. It is also up to managers to sort out

the trade-offs between short-term earnings and long-term value creation and be courageous enough to act accordingly.

Perhaps even more important, it is up to corporate boards to investigate sufficiently and be active enough to judge

when managers are making the right trade-offs – and to protect them when they choose to build long-term value.22 I

would also like to mention that according to me the success of a business is the result of the

efforts and performance of all the leaders of the organization – both formal and informal. Unlike

management who have the official power in the company there are also many other individuals

within the organization who posses a great deal of informal power and are quite influential within

it. Those individuals also contribute to the success or failure of a company by influencing the

decision making process.

There is though one fact that is according to me indisputable. That is also clearly supported by

McKinsey throughout the whole book. As an example of their opinion I will offer the following

quote taken from the book: Managing for value creation requires many mangers to break with the perspective

that many of their peers typically use. Value managers are a special breed: They focus on long-term cash flow rather

than on quarter – to – quarter earnings. They judge businesses by returns above opportunity cost, not by size,

prestige, and other emotional issues. Most important, they recognize that managing for value means instilling the

philosophy of value creation throughout the organization.23 In this I would like to clearly state my 100%

support for McKinsey’s view and promote it to the readers of this work. I think that indeed the

only way to create value is to focus on the long-term sustainable performance of the organization

and its ability to deliver long-term stable cash flow.

Based on Black, Wright, and Bachman’s opinion: In a company structured to maximize SHV, the

divisional manager will have to be more aware of what the shareholders want - which is nothing but better

returns.24

22







19

4.1.8 Shortcomings

At the end of this part of my work I would like to pay some very special attention to the some of

the corner stones in measuring financial performance and shareholder value.

The first one is regarding the objectivity of the officially published data and how reliable it is for

analysis. As pointed out by McKinsey the financial matrixes used by management for measuring

financial performance are subjective. That is based on the fact that accountants make judgments about

when to record revenues and costs. Often this judgment is colored by personal incentives (e.g. their boss wants the

current quarter to look good.25 The second and more important issue is “that historical financial metrics

cannot capture the trade-offs, managers constantly make between achieving and short-term financial results and

investing for the future.26

In support of this view is also Black, Wright, and Bachman view: Profit, in other words, is an opinion

rather than an established fact. (In Search of Shareholder Value: Managing the Drivers of Performance page

12)”.27

In fact whatever the data we see it can hardly be 100% percent objective, because it is always

induced by somebody, who has his/her personal preferences, frames of references and level of

knowledge and experience. It would be nice to be able to always isolate the biases in the data, but

unfortunately is hard to capture them.

There is for instance the very popular trick of using one-time gains and losses to smooth

operating performance or hit operating targets. Net income and EPS also are subject to one-time gains

and losses. While these gains and losses are real, too often companies use one-gains and losses to smooth out their

operating performance or hit earnings targets.28

25









20

4.2 Financial indicators and their link to leadership

4.2.1 Introduction

The financial ratios are among some of the most important and widely used indicators for

measuring a company’s financial performance. The financial ratios are either directly available in

a company’s publicly available (financial) reports or they can be calculated by using the financial

data published by a company. This is exclusively truth for the companies whose shares are

publicly traded, because even though there are differences in the reporting standards from

country to country the companies whose shares are publicly traded need to report to the public

the data regarding their financial performance regularly. It is very rarely the case that all the

relevant financial ratios are available and do not need to be separately calculated by the analysts,

potential investors or stakeholders, who are interested in them. I must even say that it is

sometimes the case that some of the data needed for the calculation of the ratios is not publicly

available, because the reporting standards of the country where the company’s shares are listed

do not require it.

What I would like to do now is pay some attention to the most widely used financial indicators

and in particular the ones having the most relevance to evaluating a company’s leadership. Even

though there is no doubt that a company’s overall financial performance is certainly dependant

on its leadership and consequently all of its financial results are highly influenced by leadership’s

overall performance we must admit that the influence of leadership on some of the financial

indicators is much more direct and consequently the responsibility of leadership associated with

the results reported on them is a lot more directly linked to leadership’s performance by the

investors, analysts and stakeholders than the results reported on the others.

The purpose of this section is to provide an overall overview of the theoretical framework and a

basis for further analysis. The final product of this section is applied in the empirical study

conducted at a later stage of the development of the work. That is when the specific indicators

used are considered in more detail and explanation to them is provided.

4.2.2 The basic framework

21

Before starting to go deeper into the issue I would like to first explain what a financial ratio is.

There are many different definitions and explanations of what a financial ratio is. I personally

prefer the one given by Bill Webster in his book “Accounting for Managers” – A ratio is a number

that expresses a mathematical relationship between two quantities, such as items on balance sheets and income

statements.29 In fact a financial ratio is a number that expresses the relationship between two

financial figures. Those are usually Income statement, balance sheet or cash flow statement items.

Webster also states very clearly and accurately the importance of financial ratios concepts.

Financial ratio concepts are important for managing cash, capital investment, profitability, and risk. They are the

primary way to speak with depth and precision about management job performance and achieving enterprise goals.30

Here we need to remember that the financial indicators are not only ratios. They can as well be

nominal figures taken from the company’s financial statement. Those are for instance one-time

gains or losses, value of certain assets, etc. Not to mention the share price itself.

Another very important point regarding financial ratio analysis pointed out by Webster is that: A

ratio draws meaning through comparison with other data and standards. By itself, a financial ratio is not worth

much. In context, a manager or outside analyst can tease out meaning to develop an understanding of a company?s

situation and developing trends.31

In order to emphasize this statement I would also like to add Dr Andrew Temte’s statement in

his book “Financial statement analysis”: A financial ratio is not meaningful when analyzed individually. It

should be noted that financial ratios are interrelated - requiring the analyst to evaluate a ratio relative to other

ratios. Ratios alone do not answer questions. They are designed to assist the analyst in determining where to look

and what questions to ask in conducting financial statement analysis.32

Another thing we need to explicitly mention is that there is no 100% comprehensive and

standard set of financial indicators that can be considered relevant for the evaluation of any

company’s financial performance. While some of the indicators are always considered relevant

others are rather industry specific, important based on geographic position, time specific, market

29

Webster, William,2003, “Accounting for Managers”, page 65

30 Webster, William,2003, “Accounting for Managers”, page 65


32 Temte, Andrew (Editor), 2005, ”Financial Statement Analysis” page 119

22

specific and so on and so on. Before we state something concrete about a financial indicator we

need to first make sure that it makes sense. After all, the performance of a business is always

relevant to certain circumstances. This is especially truth nowadays when the business

environment is becoming more and more complex and globalized.

In order to complete the picture I will add another very clear and accurate statement made by

Webster. There’s a ratio for almost any question you’d care to ask - and a couple you might not dare. The ratio

formulas are valuable for the questions they answer. In some cases, they’re more valuable because of the additional

questions they raise.33

The complete picture drawn up to now is very important to understand, because it plays a very

important role in the analysis, which will be done at a later stage of this work. A the conclusion

reached are very closely associated to the circumstances they take place in and while they certainly

answer a lot of questions they do raise many new ones, whose concrete answer is very difficult to

find without raising even more questions whose answers are also quite subjective and difficult to

find.

There are different ways and categories, which the large number of financial ratios available in the

global financial world could be found in. The categorization depends on the purpose of the

analysis, the criteria selected and sometimes even the author’s personal preferences. As

mentioned by Webster the grouping of the ratios into categories brings some order and helps us

gain an understanding about the different parts of a company’s finances and operations.34 Two

different types of categorizations – one offered by William Webster in his book “Accounting for

Managers” and one offered by Dr Andrew Temte in his book “Financial statement analysis” are

offered. I consider both of them very adequate and appropriate for the occasion.

In his book “Accounting for Managers” Webster points out and shortly explains the most

commonly used ratios by dividing them into four major categories:

Liquidity ratios (solvency ratios)

33

Webster, William, 2003, “Accounting for Managers”, page 67

34 Webster, William, 2003, “Accounting for Managers”, page 67

23

Current ratio – This is the standard measure of any business?s financial health. The current ratio measures the

ability of the firm to pay its current bills.35

Current ratio = current assets/current liabilities

Quick Ratio: “Acid Test” – The quick ratio is similar to the current ratio, but it’s a tougher measure of

liquidity than the current ratio, because it excludes inventories.36

Quick ratio = (current assets – inventory)/current liabilities

Net Working Capital (NWC) – Net working capital is not really a ratio in the strictest sense; it’s just a

number. You simply subtract the balance sheet current liabilities from the current assets.37

Net Working Capital = current assets - current liabilities

Activity ratios – Activity ratios measure how well a company conducts its business operations.38

Average Collection Period (ACP) - This ratio, also known as days sales outstanding, shows how quickly

a company converts accounts receivable into cash.39

Average collection period = accounts receivable(sales / 360 days)

Average Payment Period (APP) – This ratio, also known as the accounts payable turnover ratio, tells how

quickly a company is paying its bills, how often its payables turn over during the year.40

Average payment period = accounts payable/(purchases/360 days)

Fixed Assets Turnover (FAT) Ratio – This ratio measures how efficiently a company uses its fixed assets

to generate sales: the higher the better.41

35







24

Fixed Assets Turnover (FAT) Ratio = sales/fixed assets

Total Assets Turnover (TAT) Ratio – This ratio measures how well a company generates sales from

assets. It’s similar to the fixed assets turnover but includes all assets - current, fixed, other long-term.42

Total assets turnover = sales/total assets

Inventory Turnover (IT) Ratio – The inventory turnover ratio shows how often a company replaces its

inventory. This is a key management performance indicator for retail businesses.43

Inventory turnover = cost of goods sold/total inventory

Inventory to Net Working Capital – This ratio tells how much of the company’s funds are tied up in

inventory.44

Inventory to net working capital = inventory/net working capital

Debt Ratios – Debt ratios measure the extent to which a firm relies on debt to finance its operations.45

Debt-to-Assets Ratio – This ratio, sometimes known simply as debt ratio, shows the extent to which a

company is financed with debt.46

Debt-to-Assets Ratio = total liabilities/total assets

Debt-to-Equity Ratio – This ratio measures the percentage of debt tied up in the owner’s equity. Generally,

this calculation uses only long-term debt.47

41








25

Debt-to-Equity Ratio = long-term debt/total equity

Times Interest Earned – Times interest earned, sometimes called the interest coverage ratio, measures the

creditworthiness of a company, the ability of the company to meet its debt payments.48

Times Interest Earned = earnings before interest and taxes (EBIT)/interest

Fixed Payment Coverage Ratio – The fixed payment coverage ratio includes the principal plus interest

amount owed to creditors. It’s another measure of the ability to repay debt.49

Fixed Payment Coverage Ratio = EBIT/ interest + (principal + preferred dividends) x [1-( 1 / tax rate)]

Profitability Ratios – The profitability ratios track how well the firm generates a profit through its

operations. …profitability is the core measurement of a going concern.50

Gross Profit Margin (GPM) – The gross profit margin subtracts the costs of goods sold as a measure of sales

to give the first indication of how much profit is left to cover overhead and other cash items.51

Gross Profit Margin = (sales – cost of goods sold)/sales

Operating Profit Margin (OPM) – The operating profit margin indicates how effective a company is at

controlling the costs and expenses of its operations.52

Operating Profit Margin = EBIT/sales

Net Profit Margin (NPM) – Net profit margin is one of the key performance indicators. The higher the net

profit margin, the more effectively the company is converting revenue into profit.53

Net Profit Margin = net profits/sales

48







26

Return on Investment (ROI) – Return on investment shows how well a company uses its assets to generate

profits.54

Return on Investment = total asset turnover*net profit margin

Return on Assets (ROA) – This ratio tells how effectively a business has been making its assets work. The

ROA measures the use of capital to make profit (before interest and income tax).55

Return on Assets = EBIT/net operating assets

Return on Equity (ROE) – This ratio measures the return earned by a company on its equity.56

Return on Equity = net profits/shareholder equity

Earnings per Share (EPS) – The earnings per share measures the dollar (or in this case in units or currency)

return per share to owners of a company.57

Earnings per Share = total earnings/shares outstanding

Ratios relevant to investing activities

There are also a number of other very widely used ratios in the world of business., which are used

rather for investment purposes then for the purpose of managing a business. This opinion is also

shared by Webster – There are a number of other valuable ratios that haven’t been covered here. Among these

we could mention price/ earnings ratio, price-to-sales ratio, and price-to-book-value ratio, primarily because they’re

more relevant to investing activities than to managing a business.58 The fact that those ratios are used very

widely in investing activities, and are an integral part of the basis used by investors and analysts in

their decision-making process is exactly the reason why I am going to pay an extremely special

54






27

attention to those ratios. For the sake of clarity exactly the three ratios mentioned by Webster -

price/ earnings ratio, price-to-sales ratio, and price-to-book-value ratio, are the ones, which I will

include in my analysis.

As I have already mentioned above the financial ratios used in investing activities are an integral

part of the basis used by investors and analysts in their decision-making process. These ratios

play an instrumental role in the process of shareholder value creation. They are one of the key

factors behind the investors’ decisions whether to buy certain shares or not. My personal

professional experience in investment banking indicates that first of all they play a very important

role in the valuation of a business and second that they are the first place where the potential

investors look in order to start a consideration about investing in a company or keeping they

interest in it. The reason why they are so respected by the investors and analyst is because they

provide them with an indication based on both historic and current financial data of what their

investments are or would be worth compared to certain measures. Since the financial Ratios

relevant to investing activities are indicators financial indicators and because there could be a lot

of different circumstances where they could be applied I would like to here once again state that

there is no 100% comprehensive and standard set of financial indicators that can be considered

relevant for the evaluation of any company’s financial performance. After all, as the great Albert

Einstein once said – everything in this world is relative. This is especially truth in the case of the

ratios relevant to investing activities. There could be many different ratios relevant to investing

activities that investors could come up with, Some of them are very important and widely used

while others a much more rarely used and considered important under certain circumstances. For

the sake of clarity and sticking to the main topic I will focus my attention on four of the most

important and widely used ones. The theoretical frame wok will be taken from

www.investopedia.com – One of the most widely used and reliable source allowing the investors to

find reliable and up to date information at no time, which allows them to be always up date when

they need it.

Price-Earnings Ratio (P/E Ratio) – A valuation ratio of a company's current share price compared to its

per-share earnings.59

59

Investopedia, viewed 03. March, 2008, www.investopedia.com

28

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per

dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an

investor is willing to pay $20 for $1 of current earning.60

Price-Earnings Ratio = market value per share/earnings per share (EPS)

Price-To-Sales Ratio (Price/Sales): A ratio for valuing a stock relative to its own past performance, other

companies or the market itself. Price to sales is calculated by dividing a stock's current price by its revenue per share

for the trailing 12 months.61

The price-to-sales ratio can vary substantially across industries; therefore, it's useful mainly when comparing similar

companies. Because it doesn't take any expenses or debt into account, the ratio is somewhat limited in the story it

tells.62

Price-To-Sales Ratio = share price/revenue per share

Price-To-Book Ratio (P/B Ratio) – A ratio used to compare a stock's market value to its book value. It

is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. Also

known as the "price-equity ratio".63

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is

fundamentally wrong with the company. As with most ratios, be aware that this varies by industry. This ratio also

gives some idea of whether you're paying too much for what would be left if the company went bankrupt

immediately.64

Price-To-Book Ratio (P/B Ratio) = stock price/(total assets-intangible assets and liabilities)

60

Investopedia, viewed 03. March, 2008, www.investopedia.com

61 Investopedia, viewed 03. March, 2008, www.investopedia.com




29

In his book “Financial statement analysis” Dr Andrew Temte points out ten ratios appropriate

for interpreting how well management operates a business and assessing the overall operating

performance.65

1. Total asset turnover – net sales/average total assets66

2. Fixed asset turnover = net sales/average net fixed assets67

3. Equity turnover = net sales/average equity

4. Owners’ equity = common stock + paid-in capital + retained earnings

5. Net profit margin = net income/net sales

6. Gross profit margin = gross profit/net sales

7. Operating profit margin = operating profit/net sales = EBIT/net sales

8. Return on assets = (net income + interest expense)/average total assets

9. Return on owner’s equity = (net income – preferred dividends)/average owners’ equity

10. Return on total equity = net income/average total equity

Looking at the above mentioned list we can notice that Dr. Temte actually offers two new

financial indicators, which he finds relevant and important for measuring management

performance compared to the ones offered by Webster. Those are equity turnover and owners’

equity. Looking at the other eight indicators offered by Dr. Temte we can notice that they are

either the same or quite similar to the ones offered by Webster. The differences are either in the

wording or the formula used, which is mathematically different, but produces the same result or

the exact method of calculation. In addition Webster offers the more general indicator

shareholders equity while Dr. Temte breaks it down to return on owner’s equity and return on

total equity. The meaning of the indicators is essentially the same.

Another extremely important perspective that I would like to add is the one of one of the most

respected and used in the business world data providers. This is the perspective of Thomson

Reuters – the leading source for intelligent information for businesses and professionals.

According to them the ratios relevant for measuring management effectiveness are:

• Return On Assets

65

Temte, Andrew (Editor), 2005, ”Financial Statement Analysis” page 119



30

• Return On Investment

• Return On Equity68

4.2.3 The relevance of financial indicators to leadership

There is no doubt that all the above mentioned financial indicators are very important and widely

used in the field of finance and investment, As mentioned above though their appropriateness

varies from situation to situation. This occasion is certainly not an exception. Exactly on the

contrary. In order to make sure that the analysis makes sense the most appropriate for the

occasion ratios need to be selected.

Based on the theoretical frameworks offered by Webster, Dr. Temte, www.investopedia.com and

my personal experience in the field of investment banking I would like to offer a selection of the

financial indicators I personally consider most appropriate for the occasion.

There are in general two basic criteria, which are most closely watched by the investors and

analysts and based on which the performance of leadership is evaluated. Those are growth and

profitability. That automatically leads to the conclusion that especially since they are the most

widely used and popular ones all the financial indicators indicating a company’s profitability

mentioned above are of interest to the research. In addition to that the trends throughout time

indicating the growth (both positive and negative) are also of primary interest to the research.

There is no doubt that the three ratios relevant to investing activities mentioned above need to be

included in our list of appropriate for the occasion ratios. They are an integral part of the basis

used by investors and analysts in their decision-making process and play an instrumental role in

the process of shareholder value creation.

In addition to the profitability ratios and the ones relevant to investing activities I would like to

point out two others I consider relevant to the topic.

68Thomson Reuters, viewed on 05.05.2008, http://stocks.us.reuters.com/stocks/ratios.asp?

symbol=UBS#Management%20Effectiveness

31

• The Total Assets Turnover (TAT) Ratio – As a key indicator of how well a company

generates sales from assets.

• The Debt-to-Equity Ratio – As a key indicator of the percentage of debt tied up in the

owner’s equity and a key driver behind the cost of capital of a company

There are of course also other financial indicators mentioned above, which one could argue are

relevant to the topic. The inventory turnover for instance is a very important indicator of

management’s performance in the retail business. The fixed assets turnover is a very important

indicator for management’s performance in industries like airline where the amount of fixed

assets is immense. The reason for me to not include them in my list is the fact that the purpose

of this work is to come up with a general framework to serve as basis for analysis. The

introduction of such ratios to the further analysis of this paper may lead to a bias, which is not

desirable in this case.

That leads us to the following list of financial indicators and the trends they indicate

throughout time:

1. Gross Profit Margin (GPM)

2. Operating Profit Margin (OPM)

3. Net Profit Margin (NPM)

4. Return on Investment (ROI)

5. Return on Assets (ROA)

6. Return on Equity (ROE)

7. Earnings per Share (EPS)

8. Price-Earnings Ratio (P/E Ratio)

9. Price-To-Sales Ratio (Price/Sales)

10. Price-To-Book Ratio (P/B Ratio)

11. Total Assets Turnover (TAT) Ratio – As a key indicator of how well a company

generates sales from assets.

12. Debt-to-Equity Ratio – As a key indicator of the percentage of debt tied up in the

owner’s equity and a key driver behind the cost of capital of a company.

4.3 The Information revolution

32

There is no doubt that that during the last couple of decades and especially during the few years

our world is experiencing an information revolution. The amount of information available to the

people has been constantly increasing. The level of sophistication and the variety of the

technology available to access the information like computers and telecommunication equipment

have also been constantly increasing. As a person, who has practical experience in one of the

most dynamic industries requiring the most amounts of information do deal with – investment

banking I can state that the field of finance is one of the most significantly affected ones. In her

article “The Information Revolution” Jessica T. Mathews Offers a very adequate and appropriate

for the topic of this work perspective about the information revolution our world has been going

through for the last almost two decades.

According to Mathews: Decades hence, the phenomena we call globalization will be seen as consequence, not

cause, of the immense changes the world is undergoing. Historians will call this era - dating roughly from 1990 –

the information revolution. By “information” they will mean not only computing and communication technologies

but closely related and equally revolutionary advances in biotechnology.69

Mathews also points out that the information revolution will have the opposite effect with

respect to the physical resources to the industrial revolution, which emphasized physical mass

and access to natural resources. The significant about the former though is that it has the capacity

to alter the relationships and to blur, redraw, or erase boundaries in both time and space.70

In explaining her view further the author writes that: Where events take place – a taxable transaction for

instance – is no longer obvious. The related but more important boundary between home and away blurs in the

marketplace, in war and in personal identity. As flows across national boundaries steadily rise (flows of money,

goods, pollution, popular culture, etc.), the separation between domestic and foreign policy erodes.71

Mathews also emphasizes the important role of technology, playing a crucial role in changing the

relationships transforming international politics and economics. One important consequence is

that the role of governments and their organs is significantly reduced. The enormous increase in the

69

Jessica, T., Mathews, Foreign \policy, \no. 119 (Summer 2000), “The page information revolution”, page 63,

http://links.jstor.org/sici?sici=0015-7228%28200022%290%3A119%3C63%3ATIR%3E2.0.CO%3B2-D

70 Jessica, T., Mathews, Foreign \policy, \no. 119 (Summer 2000), “The page information revolution”, page 63,


71 Jessica, T., Mathews, Foreign \policy, \no. 119 (Summer 2000), “The page information revolution”, page 63,


33

number of people with direct access to vast amounts of information means that the role of governments and their

organs – central banks, intelligence agencies, and the like – in particular, is greatly reduced… The shift in power

from governments to the marketplace is enhanced by the speed with which information is communicated.72

One of the very important differences, which may give competitive advantage to certain societies

is their tolerance to rapid change, writes the author.

The reason for discussing the information revolution the global society is experiencing is that

according to me the information revolution plays a very important role in the developments of

the financial markets thus affecting the financial performance and approach of the businesses

worldwide and inevitably also the field of finance in general through the development of new

financial instruments suitable for the circumstances.

As a key factor behind the development of the financial markets the information revolution

undoubtedly affects the process of shareholder value creation, which as already discussed above

is increasingly the key driver behind management’s decision making. In a more indirect way

through the development of new financial instruments the information revolution also provides

management with a broader choice of opportunities in terms of finance.

All the points made by Mathews support widely my point of view. There are few more points and

comments, which I would like to add to the ones made by Mathews.

• As the global business environment is becoming more and more complicated and needs

of the customers are evolving the mass production is according to me decreasing its

importance, Instead, the more complicated and tailored products are preferred globally.

The information revolution pays a very important role in both the developments of the

new and tailored products through the enhancement of the research abilities and in their

popularization and delivery to the customers.

• The information revolution as well as globalization is certainly the reasons behind the

increasing of flows of money, goods, pollution, popular culture between borders and the

erosion of the separation between domestic and foreign policy. As the investors look

more and more often in investment opportunities globally they need to make sure they

72

Jessica, T., Mathews, Foreign \policy, \no. 119 (Summer 2000), “The page information revolution”, page 64

34

are up to date with the development of prospects regarding their investments. Without

the information revolution this would be unthinkable.

• Time and space are no longer such a significant obstacle to investment due to the fact

that the information revolution enabled the opportunity of an investor receive

information quickly and in a convenient form. Tools like Thomson One banker for

instance enable the investors and analysts to receive information at no time in different

formats like excel.

• While decreasing due to the lower dependence on their support the role of the

governments and their organs like the authorities conducting monetary policy is also

increasing due to the fact that nowadays they are able to influence the markets more

efficiently.

• As we can also see in the World Economic Forum’s criteria for evaluating the countries’

competitiveness, their technological readiness is one of the key factors behind a country’s

competitive position and a key prerequisite for high return on investment (ROI).

4.4 Structure of shareholding

Let me first of all before getting into detail give a short explanation of what an institutional

investor is. Institutional investors may be defined as specialized financial institutions which manage savings

collectively on behalf of small investors, towards a specific objective in terms of acceptable risk, return-maximization

and maturity of claims.73 To the institutional investors as defined by Davis I would also like to add

the private companies in their role of business entities, which invest in other companies on behalf

of their owners.

As indicated in the same work the so called institutional investors’ role in the collection of

savings and investment in securities and other financial assets, as operators in securities markets,

cross-border investors and owners of companies is increasing. Evidence with regard to the

current discussion is provided in the same article and can be found in the appendix of this work.

73

Davis, E., Philip, “The Role of Institutional Investors in the Evolution of Financial Structure and Behaviour”,

page 64

35

As the author points out there are two main systems in terms of the finance and control of

corporations – the Market control via equity and the Direct control via debt, which is a form of control,

characterized by high influence of the banks. The latter one is very typical for continental Europe

and especially Germany and France as well as for Japan. The companies form close relationships

with a small number of creditors and equity holders. The widespread cross-shareholding between

the companies is also very typical. It is mostly the banks, who by being major equity holders and

creditors directly or indirectly control the companies in the economy. The existence of such

systems for finance and control corporations is a clear indication of the role they play in

management’s decision making process.74

As their share and importance are increasing the role they play in corporate governance and the

decision making process undoubtedly follows suit. The larger the shareholding of an institutional

investor (in this case, which holds truth for any investor in general) in a company the more

management will try to make sure that their interest is taken care of. The potential release of bad

results may prompt a large shareholder to decide to sell a large number of shares in the market.

This will automatically create excess supply and affect the share price negatively, which decreases

the value of the company as a whole and results in a reduction of shareholder value as a whole.

The specific thing about the institutional investors is that as mentioned above they represent the

individual interests of their own investors.

74

Davis, E., Philip, “The Role of Institutional Investors in the Evolution of Financial Structure and Behaviour”,

page 82

36

4.5 The strategy perspective

4.5.1 Introduction

The strategy perspective will be introduced into my work by means of Bob de Wit and Ron

Meyer’s book “Strategy: Process, Content, Context--An International Perspective”. The

theoretical framework provided in the book and in particular the strategy debates involving the

strategy paradoxes and strategy perspectives will be used at a later stage of the work. It will be

used as a basis for analyzing the implications of financial reporting on leadership.

In their book “Strategy: Process, Content, Context--An International Perspective” Bob de Wit

and Ron Meyer introduce ten strategy topics. At the heart of every set of strategic issues, a fundamental

tension between apparent opposite sites can be identified. Each topic presents a strategy tension, viewed by

the authors a strategy paradox. Each of the strategy paradoxes in turn has a strategy perspective

corresponding to it.75 An overview of the concept can be found in the table below.

75

De Wit, Bob, Meyer, Ron, West Publishing Company, Saint Paul, 2004, “Strategy: Process, Content, Context-

-An International Perspective”, page 13 and 14

37

Table 4.5.1 Strategic Framework ( DeWit, Meyer, p. 13)

Strategy topic Strategy Paradox Strategy Perspective

Strategic Thinking Logic vs Creativity Rational Reasoning vs

Generative Reasoning

Strategy Formation Deliberateness vs Emergence Strategic Planning vs Strategic

Incrementalism

Strategic Change Revolution vs Evolution Discontinuous Renewal vs

Continuous Renewal

Business Level Strategy Markets vs Resources Outside-in vs Inside-out

Corporate Level Strategy Responsiveness vs Synergy Portfolio organization vs

Integrated Organization

Network Level Strategy Competition vs Cooperation Discrete Organization vs

Embedded Organization

Industry Context Compliance vs Choice Industry Dynamics vs Industry

Leadership

Organizational Context Control vs Chaos Organizational Leadership vs

Organizational Dynamics

International Context Globalization vs Localization Global Convergence vs

International Diversity

Organizational Purpose Profitability vs Responsibility Shareholder Value vs

Stakeholder Value

The topics I consider most relevant to the topic of this work and will be discussed in it are the

ones regarding the strategy process - Strategic Thinking, Strategy Formation, and Strategic

Change. In addition to that one of the topics regarding the strategy context will also be paid

attention to - Business Level Strategy. The strategy perspectives reflected in those topics are the

ones that are expected to be most relevant to the strategic implications of financial reporting on

leadership. The concept discussed is used in the empirical study in order to identify the

implications of financial reporting on leadership’s decision making process as well as leadership’s

strategic choices

4.5.2 Strategic Thinking

• Logic vs Creativity

The paradox of logic versus creativity reflects the understanding that managers need to employ

both intuitive and analytical thinking even if they seem to contradict with each other. A manager’s

intuition is built up through years of experience and contains a vast quantity of tacit knowledge that can only

38

superficially be tapped by formal analysis. Intuition can also give a “richer assessment of, by blending in all types of

qualitative information.76

However it is equally clear to most that human intuition is often unreliable. Cognitive heuristics are “quick and

dirty”-efficient, but imprecise. ….. For this reason many, many academics urge practitioners to bolster their

intuitive judgments with more explicit rational analysis. Especially in the case of strategic decisions, more time and

energy should be made available to avoid falling pray to common cognitive biases.77

Considering the demand for logical and creative thinking the authors explain that on one hand. It

is clear that if managers base their strategic decisions on heavily biased cognitive maps, unconsciously built up

through past experience, this will lead to very poor results. Managers need to have the ability to critically reflect on

the assumptions they hold, to check whether they are based on actual facts, or on organizational folklore and

industry recipes.78 On the other hand ….when employing logic, a thinker bases each step in a train of thought

on the previous steps, following formal rules of valid thinking… However, when creativity is used, the thinker does

not take a valid step, but takes a leap of imagination, without being able to support the validity of the mental

jump… In essence, creating thinking takes liberty un following thinking rules.79

• Rational Reasoning vs Generative Reasoning

The resulting reasoning perspectives are discussed the following way. To deal with strategic problems

the strategists must first consciously and thoroughly analyze the problem situation.80 According to the authors

the process consists of important phases like recognition of the problem, identification of different solutions, screening

of options and ultimately implementation of the strategy.81 In conclusion, advocates of the rational reasoning

perspective argue that emotions, intuitions and creativity have a small place in the strategic reasoning process, but

76


-An International Perspective”, page 57

77 De Wit, Bob, Meyer, Ron, West Publishing Company, Saint Paul, 2004, “Strategy: Process, Content, Context-










39

that logical thinking should be the dominant ingredient.82 In the generative reasoning perspective, emphasis is placed

on the “wicked” nature of strategic problems (Rittel, 1972; Maison and Mitroff, 1981). It is argued that strategic

problems cannot be easily and objectively defined, but that they are open to interpretation from a limitless variety of

angles. The same is truth for the possible solutions – there is no fixed set of problem solutions from which the

strategist must select the best one. Defining and solving strategic problems, it is believed, is fundamentally a creative

activity.83 In conclusion, the advocates of the generative reasoning perspective argue that the essence of strategic

reasoning is the ability to creatively challenge “the tyranny of the given” (Kao, 1996) and to generate new and

unique ways of understanding and doing things.84

4.5.3 Strategy Formation

• Deliberateness vs Emergence

Strategy has to do with the future and future is unknown.85 This is how the authors start the debate

regarding strategy formation. To managers, the idea of creating the future is highly appealing, yet the prospect

of sailing for terra incognita without a compass is unsettling at best.86

To further deepen the debate de Wit and Meyer explain the following: The duality of wanting to

intentionally design the future, while needing to gradually explore, learn and adapt to an unfolding reality, is the

tension central to the topic of strategy formation. It is the conflicting need to figure things out in advance, versus the

need to find things out along the way. On the other hand, managers would like to forecast the future and to

orchestrate plans to prepare for it. Yet, on the other hand, mangers understand that experimentation, learning and

flexibility are needed to deal with the fundamental unpredictability of future events.87

82













40

The authors also point out the perspective of Mintzberg and Waters (1985) in their article. “Of

Strategies: Deliberate and Emergent” that a distinction should be made between deliberate and

emergent strategy. “Where realized strategies were fully intended, one can speak of “deliberate strategy”.

However realized strategies can also come about “despite, or in the absence of intention”, which Mintzberg and

Waters labeled “emergent strategy”. In their view, few strategies were purely deliberate or emergent, but usually a

mix between the two.88

In order to emphasize on the difference between the two types of strategy I would like to offer

the following further clarification from the book. Deliberateness refers to the quality of acting

intentionally. When people act deliberately, they “think” before they “do”. They make a plan and then implement

the plan… Emergence is the process of becoming apparent. A strategy emerges when it comes it being along the

way. Where there are no plans, or people divert from their plans, but their behaviour is still strategic, it can be said

that the strategy is emergent – gradually shaping during an iterative process of thinking and “doing”.89

• Strategic Planning vs Strategic Incrementalism

At one pole we find those managers and theorists, who strongly emphasize deliberateness over emergence. They

argue that organizations should strive to make strategy in a highly deliberate manner, by first explicitly formulating

comprehensive plans and only then implementing them. In accordance with common usage, this point of view can be

referred to as the “Strategic planning perspective”. At the other front are those, who strongly emphasize emergence

over deliberateness, arguing that in reality most new strategies emerge over time and that organizations should

facilitate this messy, fragmented piecemeal strategy formation process. This point will be referred to as the “strategic

incrementalism perspective”.90

4.5.4 Strategic Change

• Revolution vs Evolution

88




-An International Perspective”, page 112,113



41

The discussion on this issue starts with the statement that: There are many actions that constitute a

strategic change – a reorganization, a diversification move, a shift in core technology, a business process redesign and

a product reshuffle, to name a few. In addition to that: The magnitude of change refers to the size of the steps

being undertaken, whereby the question is whether managers should move in bold and dramatic strides, or in

moderate and undramatic ones. The pace of change refers to the relative speed at which the steps are being taken,

whereby the question is whether managers should move quickly in a short period of time, or more gradually over a

longer time span.91

According to the authors the firms are complex systems and the most fundamental distinction

that can be made within a firm is between the business system and the organizational system. The

term business system refers to the way a firm conducts its business. The term organizational system refers to the way

a firm gets people to work together to carry out the business.92

At the beginning of the discussion regarding the demand for revolutionary and evolutionary

change processes it is explained that in the selection of an approach to strategic change most

managers struggle with the question of how bold they should be and that it is widely accepted

among researchers that a balance between revolutionary and evolutionary change processes needs

to be found by managers.93

It is also important to have a clear understanding of revolution and evolution in order to be clear

with the context. Revolution is a process whereby an abrupt and radical change takes place within a sort period

of time. Revolutionary change processes are those that do not build on the status quo, but overthrow it.94 Evolution

is a process whereby a constant stream of moderate changes gradually accumulates over a longer period of time.

Each change is in itself small, but the cumulative result can be large. Evolutionary change processes take the

current firm as a starting point, constantly modifying aspects through extension and adaptation. Some “mutations”

to the firm prove valuable and are retained, while other changes are discarded as dysfunctional. Thus, a new

91




-An International Perspective”, page 164, 165





42

business system and/or organizational system can steadily evolve out of the old, as if the organization were shedding

its old skin to grow a new one (e.g. Aldrich, 1999; Kagono et al., 1985.95

• Discontinuous Renewal vs Continuous Renewal

The following considerations summarize very successfully the authors’ thoughts regarding

continuous and discontinuous renewal and are also appropriate for the purpose of this work. At

one end of the virtual continuum of views, are the strategists who argue that real strategic renewal can only be

achieved by radical means. Revolutionary change, although difficult to achieve, is at the heart of renewal, while

evolutionary change can only figure in a supporting role. This point of view will be referred to as the “discontinuous

renewal”. At the other end of the spectrum are the strategists, who argue that real strategic renewal is not brought

about by an “axe”, but must grow out of the existing firm, in a constant stream of small adjustments.

Evolutionary change although difficult to sustain, is at the heart of renewal, while revolutionary changes are a full-

back alternative if all else fails. This point of view will be referred to as the “discontinuous renewal.96

4.5.5 Business Level Strategy

• Markets vs Resources

The paradox of markets vs resources is another very interesting and closely related to the topic of

this work paradox, which is discussed by de Wit and Meyer in their book. According to the

authors there must be a fit between an organization and its environment”. They also explain that this point is

often expressed by the SWOT analysis. “Yet, fitting internal strengths and weaknesses to external opportunities

and treats is often frustrated by the fact that the two sides pull in opposite directions – the distinctive resource base

and activity system of a firm can point in a totally different direction compared with the developments in their

current markets. The tension identified by the authors arising from the partially conflicting

95




-An International Perspective”, page 1176,177

43

demands of market adaptation and resource leveraging is referred to as the paradox of markets

and resources.97

• Outside-in vs Inside-out

The two conflicting perspectives arising from the paradox of markets and resources are according

to the authors the outside-in and the inside-out perspectives. Managers with an outside-in perspective

believe that firms should be self-centered, but should continuously take their environment as the starting point when

determining their strategy. Successful companies, it is argued, are externally oriented and market-driven (e.g. Day,

1990: Webster, 1994). They have their sights clearly set on developments in the market-place and are determined

to adapt to the unfolding treats and opportunities encountered.98 Managers adopting an inside-out perspective

believe that strategies should not build around external opportunities, but around a company’s strengths. Successful

companies, it is argued, build up a strong resource base over an extended period of time, which offers them access to

unfolding market opportunities in the medium and short term.99

5 Logical Considerations

The aim of this part is to provide the reader with some considerations on top of and based on

the literature discussed in the literature review. In addition the logical considerations provide the

reader with the author’s perspective regarding the development of the work. The considerations

in this part are used for the analysis in the empirical study.

5.1 Major Drivers behind the Implications

Based on the perspectives already outlined in the literature review combined with my own

personal professional experience and impressions that I have I would like to now discuss the

major reasons behind the implications of financial reporting on leadership. There are many

reasons, which could be pointed out as leading to the above mentioned implications. What I

would like to do now though is discuss the most significant ones.

97







44

5.1.1 Shareholder Value

As already outlined in the literature review the concept of shareholder value is the concept that a

major proportion of the businesses worldwide base their strategies for development. It was

developed in the Anglo Saxon world and in particular the UK and the USA. Those are the places

where it enjoys the most popularity nowadays as well.

There are many reasons why the importance of shareholder value has been constantly increasing

recently. The major one according to me is the increasing popularity and importance of the global

financial markets. The increasing popularity and the development of the financial markets

globally have led to the spread of the popularity of the concept of shareholder value all over the

world.

As a consequence of the increased importance of the concept of shareholder value the managers

worldwide are becoming more and more concerned about the impact their decisions may have

on the company’s share price. This of course is logical, because the decrease of the share price

decreases the fortune of the company’s owners.

As already discussed in the literature review a company’s share price is formed based of the

company’s financial performance and the investor’s perceptions and expectations regarding the

company’s future financial performance and in particular its ability to generate cash in the long

run. The more the investors believe that the company will perform well and be able to generate

cash the more they are willing to invest in the company and consequently the higher the share

price.

Except from the expectations regarding the company’s future financial performance a very

important factor is the confidence the investors have in the company. If the company does not

manage to perform well the investors and analysts start to lose their confidence. The company’s

performance can be evaluated based on the financial reports it presents to the public. Those are

mostly the annual and quarterly financial statements issued by them.

Since the company’s management do not want to lose the investors’ and analysts’ confidence they

do their best to make sure that the statements issued by them meet the expectations of investors

45

and analysts. This makes management very cautious and may lead to inappropriate allocation of

resources.

From my personal experience in investment banking and in particular M&A I can state that one

of the major if not the major criterion behind the decision making process of management is the

impact on the financial statements. Complete M&A strategy decisions and investor relations

standards are determined by the impact on the financial statements in the short-run.

5.1.2 The information revolution

The information revolution is another important driver contributing to the implications of

financial reporting on leadership. There are a number of factors contributing to the importance

of the technological revolution:

• Globalization of the investment

• Easier and wider access to information

• The number of people having the opportunity to invest increased drastically

• Global response

• Immediate effects

• Faster decision making process

• Faster execution

In short, the role of the information revolution is that it made it possible for the investors to

invest globally. They are no longer limited to investing in their local markets like countries,

regions and so on. At the same time the information revolution and in particular the

technological developments allowed easier access to investment and consequently the number of

people having the opportunity to invest increased drastically. The technological developments

allow easier and wider access to information, faster decision making and execution. The response

to a release is immediate and takes place globally (different countries, business, social, political,

cultural and most of all economic environments).

Here you may ask what the connection with financial reporting and leadership is. As a

consequence the above mentioned factors the managers of the companies worldwide are a lot

46

more cautious and concerned about the results they will release to the public, because due to the

information revolution the effects that may follow may be very severe.

The fact that people from all over the globe may have invested in a business and there is a global

response to financial reporting makes it very difficult for the management to react to the market’s

reactions. Solely the fact that there are different time zones and the circumstances in the markets

where the investors are located makes the response of management extremely different. A

potential bad response in one country or region may ruin the company’s reputation in that region

as a whole. An attempt to repair the ruined reputation in one region may ruin the company’s

reputation in another.

The easier and wider access to information allows the formation to reach both the investors and

analysts on one hand and the rest of the people on the other. In that case the company must on

one hand deal with the investors and the analysis provided to them by the analysts and the

general public’s opinion on the other hand. The former ones are a determinant of the share price

and shareholder value while the latter ones include all the rest of the stakeholders the company

has and in particular the customers.

The fact that a large number of people have the opportunity to invest is good, but at the same

time the high level of technological development allows people, who are not really aware of what

they are doing by investing in a business to hold an interest in a company. Even though they are

not the most influential investors their decision also create supply and demand of shares on the

financial markets and consequently affect the share price either positively or negatively. On top

of that management should also think about the speculators, who will not miss their chance to

take advantage of a shaky situation.

Due to the fast flow of information the effects of the release of a report, which turns into news

are so immediate that it is almost impossible for management to respond properly right away to

all the reactions by the investors and the general public. The sale or a purchase of shares takes a

click of a mouse while the organization of for instance a press conference takes much longer.

There are of course many different methods used by the companies nowadays, but the response

to the immediate reactions of the investors and the general public remains very difficult.

47

The faster decision making process and faster execution of a transaction or an analytical process

made possible by the information revolution are another determinant due to the fact that

nowadays the investors and analysts can very easily and at no time evaluate their opportunity cost

and decide whether they have better investment opportunities and decide what to do with their

interest in the company. This of course can potentially result in a serious change in the value of

the company.

5.1.3 Structure of Shareholding

The structure of shareholding of a company is one of the first things that the investors and

analysts look at when they analyze a company. The reason is probably not so obvious for the eye

of the non professional. There is actually not a single reason for that, but a number of them

depending on the circumstances. The key behind all the reasons though is always the same – to

determine the influence and the bargaining power of the individual shareholders.

The larger the shareholding of an investor in a company the more the influence that they have in

the corporate governance and consequently in the decision making process of the company and

the easier it is for them to influence the share price directly. That is why a major concern of

management is to make sure that the large (or in most of the cases institutional) investors are

pleased and satisfied with the performance of the company. At the same time the investors are

concerned about the value of their stock in the company.

5.2 Why are the implications strategic

In this part of my work I will explain why according to me the implications of financial reporting

on leadership have a strategic character. In order for something to be strategic it must affect the

company’s strategy. Here comes the logical question what a strategy is. There are many different

definitions of what exactly strategy is given by the different authors doing research in the field.

while the difference in the meaning between them is rather insignificant, the way that the

definitions are presented very widely. According to De Wit and Meyer, who go to the extreme

There are strongly differing opinions and on most of the key issues and the disagreements run so deep that that even

48

a common definition of the term strategy is illusive.100 Anther good definition available on the web is a

term used in business planning that implies a careful selection and application of resources to obtain a competitive

advantage in anticipation of future events or trends.101

5.2.1 Allocation of resources

In order to be able to produce its products or services and thus generate revenue a company need

to exploit the resources it has at its disposal (land labour capital, entrepreneurship). The most

proper allocation of recourses results of course in the best ultimate outcome – highest profits.

The inappropriate allocation of resources in turn results in their underutilization and inevitably

leads to underperformance in the long-run.

The (constant depending on the company) changes of the strategy or deviations from the optimal

long-term path of development of the company inevitably result in the improper allocation of

resources a company has at its disposal. Such improper use of resources could for example be the

unjustified investment of certain amounts of capital in certain projects at the wrong point in time.

From a financial reporting perspective there could be many reasons for that. One of them is to

smooth deviations on financial performance from one period to another especially when there is

a mismatch with the investors’ and analysts’ expectations. The investment in projects certainly

alters the return which the company receives at different points of time. It affects the company’s

revenue and expenses thus ultimately affecting the final financial results and indicators. If for

example the economy in the country, where the company is active is expected to slow in the near

future the company’s results are very likely to suffer due to external circumstances. This can for

example be changed by the company’s management through the occurrence of the so called one-

time items (non recurring items, etc). Those are all items, which occur only once in a company’s

financial statements and change the final results. Those are for instance capital gains or losses,

which occur upon the sale of assets, acquisition or divestiture of a business.

Imagine the simplest and most straight forward example – a company is planning to sell an asset.

Let’s for the sake of simplicity take an example with a manufacturing company, which is highly

100

De Wit, Bob, Meyer, Ron, West Publishing Company, Saint Paul, 2004, “Strategy: Process, Content,

Context--An International Perspective”, page 3 101

Small Business Dictionary, viewed 21 April, 2008, http://www.smbtn.com/smallbusinessdictionary//

49

diversified and wants focus on its core business. In order to do that the company wants to divest

some of its factories. If they sell those assets (factories) they will in accounting terms among

everything else be able to book a “gain on sale”, because the value of the assets has increased.

Keeping all other things equal this gain on sale will result in an improvement of the company’s

profit for the accounting period it will take place in.

Even though this may not be the most appropriate point of time for the transaction to take place,

because in the future the value of the assets is expected to further increase slightly if the company

is expecting a temporary deterioration in results for a particular accounting period the company

may decide to sell the assets in that particular accounting period in order to flatten its results or

meet investors and analysts’ expectations and not destroy shareholder value.

As you can see this is certainly not the most appropriate decision in terms of long-term

development, but it very likely to take place quite often in today’s investment world. I have

personally witnessed such cases many, many times. What makes those kinds of tricks even more

popular is the complexity of the global accounting and reporting standards. It very likely that by

taking such a decision management will be able to at least slightly “deceive” and even please the

investors and analysts even though that should not be the case.

5.2.2 Unrealistic value

As already discussed a number of times in the work financial performance, perception about the

company’s current financial performance as well as the anticipation of the analysts and investors

determine the company’s share price and consequently value.

In addition to the improper allocation of resources, which is undoubtedly the most significant

problem the (constant depending on the company) changes of the strategy or deviations from the

optimal long-term path of development leads also to the creation of an unrealistic value of the

company, because it creates a non realistic impression of the company’s performance among

investors and analysts as well as the general public. The constant creation of deviations from

reality creates a factious perception of the business which the share price of the company is based

on. Based in part on that factious perception the analysts value the businesses they analyse and

the investors decide how much they should invest in a company, which determines the market

value of the company.

50

From personal experience I can say that during my stay in investment banking many of the firms

that we were working on were perceived as either “losers” or “winners”, which did not have

much to do with reality. That had numerous implications on the companies themselves, because

it had an influence on their value. In our case we were interested in the value, because it was one

of the basic arguments for an acquisition or a divestiture deal.

On top of all that the speculators need to also be considered. They also influence the market

value of a company by speculating with its shares. Such artificially created deviations from the

optimal long-term path of development are a perfect occasion for them to speculate on the share

price of a company.

It is of course for the non professional eye quite difficult to imagine how often such deviations

from the optimal long-term path of development are a fact, but just the simple fact that they do

exist and are actually not difficult to achieve can give a lot of food for thought regarding the

efficiency of the financial markets and the objectivity of the value of the businesses worldwide as

well as the values of the world’s leading indexes like Dow Jones, NASDAQ, DAX, FTSE, SMI

and so on.

6 Case Study – The UBS and its peers during the

Subprime crisis

6.1 Introduction

After the discussion of the theoretical framework in the literature review and the logical

considerations made thereafter I would now like to dedicate myself to some research based on

empirical data. I have considered many different options for the purpose, but the one I have

decided to select is a case study. There are two major reasons for that:

1. I want my work to be as up to date as possible. I consider this very important especially

keeping in mind the specifics of the issues discussed. The case study that will be

constructed certainly matches this criterion

2. I want my work to be as appealing to the reader as possible

51

6.2 The context

In this occasion the case study method is used in order to investigate and analyze financial

performance, changes in the strategies and specific consequences on leadership within the

context selected. The ultimate goal is to identify, understand and explain the implications of

financial reporting on leadership’s decision making process as well as identify, understand and

explain their effects on leadership’s strategic choices based on the real-life context of the

subprime crisis.

The case study research to be presented is an empirical inquiry that investigates a contemporary

phenomenon within its real-life context – UBS and its peers during the Subprime crisis. The

major sources of evidence to be used are the available on the internet analyses, articles and news

releases.

The current crisis in the financial sector originating from the US subprime mortgage crisis

provides according to me very good basis for analysis of the research issue and is a very good

opportunity. There are a few major reasons for that:

1. It is a major challenge for leadership

2. It is largely an issue of financial reporting and maintaining confidence in the markets

3. It is an extremely actual and even currently developing issue

4. Has a global impact which is not limited solely to the financial sector

5. It is a major challenge for the state regulators who need to also demonstrate solid

leadership

Consequently a case study on this up to date issue will be constructed and analysed with the

purpose of gaining empirical evidence with regard to the research issue.

As a European and a person closely tied to Switzerland I would like to focus my attention on the

most serious victim of the current crises in Europe– the largest Swiss bank and leading global

wealth manager – The Union Bank of Switzerland – UBS. I consider the recent developments

regarding UBS a perfect illustration of all the issues discussed in my work. In order to make sure

52

that UBS in not an isolated case I also include short discussions regarding three of its peers in the

global financial world and compare them to my major consideration – The UBS AG.

A number of criteria related to the research issue will be used in the selection of the sample of

the companies to be considered within the framework of the empirical study. The aim of the

selection criteria is to ensure the quality, objectivity, actuality and representativeness of the case

study. Those criteria are:

o Value of the company – The companies’ market capitalization as considered by

the total value of their shares.

o Affection by the crisis – How seriously was the company affected by the

subprime crises

o Financial performance – The companies’ financial performance as measured by

the relevant ratios outlined in the literature review.

o Specifics regarding the company related to the crisis – Any specifics which may be

related to the research issue.

6.3 Structure, methods to conduct the analysis and

methods of data collection

The case study is based on a structure which provides an opportunity to first get familiar with the

subprime crises itself – its origin, reasons behind it, available significant responses, scale and

significance from different points of view, potential consequences. After that the focus shifts to

the major target of the research – The Union Bank of Switzerland (UBS). General information

about the institution is provided, followed by information regarding the research issue. After the

UBS attention is paid to its peers selected according to the selection criteria outlined above.

After the information needed for the analysis is provided the case is questioned and the analysis

and interpretation of the findings is conducted. The interpretation and analysis are based on the

questioning of the case and have the purpose of providing answers to the research issue.

The research questions within the empirical study are determined and defined based on the issue

and research question of the paper that the case study is included in - identify, understand and

53

explain the implications of financial reporting on leadership’s decision making process as well as

identify, understand and explain their effects on leadership’s strategic choices.

The interpretation of the data is based on the theoretical framework presented in the literature

review. The analysis is conducted on the basis of the theoretical concepts outlined in the

literature review and the logical considerations. The logical connection between the theoretical

concepts and the real-life context is identified and applied. With the purpose of establishing a

clear and logical connection between the theory and the real-life context and achieving an optimal

result only the most relevant parts of the theoretical concepts outlined are applied within the

empirical study.

The method of data collection for the construction of the case study is based largely on articles

and analysis offered by the world’s leading news agencies and channels like CNN, Swissinfo,

Euronews, Reuters, The Financial Times, and The Economist as well as the official press releases

available of the companies’ websites. The major resource for gathering the articles will be the

above mentioned news agencies and channels’ website. They offer quite up to date, reliable and

relatively objective information based on their own point of view.

Just as in the overall paper the major criteria for the selection of the data collection method are

the relevance of the data to the topic considered and the reliability of the sources. Since the topic

is very specific and comprehensive and requires extensive knowledge in many different fields of

studies only the most renowned sources of information and most of all analysis will be trusted so

that reliability and high level of quality are ensured. The use of up to date data and analysis is in

this case a must.

One must keep in mind that the crisis in the financial sector originating from the US subprime

mortgage crisis is an issue which is developing even at the time of the construction of this case

study. That is why it is crucial to point out that the data used will be the most up to date available

publicly as of the completion of the work and the feasibility if its analysis based on the time

available.

54

In order to illustrate how important the actuality of the data is I would like to finish this part with

a quote of Credit Suisse’s Chief Executive Brady Dougan: In this crisis, a number of times people have

seen a light at the end of the tunnel and it has ended up being a train coming down the tracks.102

6.4 The subprime crisis

The current global crisis in the financial sector originating from the US subprime mortgage crisis

is one of the most serious financial crises in the modern history of the world and the one which

will certainly have some of the most severe long-term consequences on the financial sector. The

financial sector is not the only one, which will be affected though. There will be numerous

consequences for the global economy and the way business is done on the globe. The reason is

that this crisis will introduce significant regulatory changes in the way the economies are

supervised and regulated on national, regional a global level. The first country to initiate changes

was of course the country where everything started – USA the country, which is supposed to

have the most well elaborated financial system, efficient supervisory and regulatory system and

the most attractive financial markets. The changes are at this point not exactly clear, but what has

been announced publicly is that the power of the Federal Reserve of the United States of

America will increase dramatically. State supervision will partially be sacrificed for the sake of

federal supervision.103 There is still a great deal of argument around and the effects of the changes

are being thoroughly discussed. According to Paulson's plan the change are about to be discussed

and take effect in the future and the effects are about to be seen in the long-run.

The US subprime mortgage crisis virtually started or I would rather say came into force with the

bursting of the US housing bubble.104 To be more precise the problem occurred with the high

default rates on mortgages made to higher-risk borrowers. The latter were encouraged with some

incentives by the lenders to assume large amounts of debt hoping to be able to refinance it at a

later stage, which became increasingly difficult with the slump in the housing prices. According to

the numbers available the number of homes subject to foreclosure activity increased drastically

and they were nearly 1.3 million, up 79% from 2006.105

102

Euronews, viewed on 21. April 2008, http://www.euronews.net/index.php?page=eco&article=482825&lng=1 103

Newsweek Magazine; viewed on 21. April 2008, http://www.newsweek.com/id/129826

104 The Wall Street Journal, viewed on 22. April 2008, http://online.wsj.com/article/SB119845906460548071.

html?mod=googlenews_wsj 105

Realty Trac, viewed on 22. April 2008, http://www.realtytrac.com/ContentManagement/pressrelease.aspx?

ChannelID=9&ItemID=3988&accnt=64847

55

What actually made the crisis even worse is the fact that some of the mortgage lenders have

managed with the help of a form of financial engineering called securitization to pass the rights

to the mortgage payments and related credit/default risk to third-party investors via mortgage-

backed securities (MBS) and collateralized debt obligations (CDO). That led to huge losses by

corporate, individual and institutional investors which accumulated large volumes of this type of

instruments as the value of the underlying mortgage assets declined. The best example is the

writedowns incurred by major banks around the globe.

According to the Economist as of December 22, 2007, subprime defaults would reach a level

between U.S. $200-300 billion.106 According to an analysis by the OECD (Organisation for

Economic Co-operation and Development) the losses from the collapse in the US subprime

mortgage market will total between $350bn and $420bn.107 This number though still does not

sound as frightening as the one estimated by the International Monetary Fund (IMF). According

to the IMF the writedowns on US assets could total as much as $945bn.108

Even solely the numbers themselves are enough to give an indication of how serious the crisis is

and how much is at stake. That is also the reason why the regulatory bodies of the countries

responsible for the regulation of the financial markets and especially the Federal Reserve of the

United States of America are so concerned about the issue.

In order to emphasize the significance and tremendous impacts of the subprime crisis I would

like to present a few staggering facts:

• The Dow Jones Industrial Average reached a record high, going beyond the 14,000

territory for the first time ever on or the first time on July 19, 2007. A little bit later

affected by the subprime crisis the index dropped below the 13,000 mark by August 15.

Similar drops occurred globally. Some of the hardest hit were Asia and Brazil.109

106

The Economist, viewed on 23. April 2008 http://www.economist.com/opinion/

displaystory.cfm?story_id=10334574

107 Financial Times, viewed on 23. April 2008, http://www.ft.com/cms/s/0/0cabd3cc-0b40-11dd-8ccf-

0000779fd2ac.html

108 Financial Times, viewed on 23. April 2008 http://www.ft.com/cms/s/0/78249530-05a0-11dd-a9e0-

0000779fd2ac.html

109 CNN, viewed on 23. April 2008, http://money.cnn.com/2007/07/19/markets/markets_530/index.htm

56

• The financial institutions were not the only ones that were hit. Instead, even industries

like metals and mining were very severely hit.110

• The shock of the crisis has encouraged the investors to invest their savings on more

secure investments like commodities, which had a serious impact on food prices. The US

Dollar keeps on suffering even at the point of completing this work.111

The major part of the losses, which have already been incurred and the once, which are expected

to be incurred as estimated by The Economist, The OECD and the IMF can be attributed to the

financial institutions and mostly the banks, which had significant exposures to the US subprime

mortgage market. The US banks were logically the ones, which were hit the most. The impact

was not only on them though. In the following section some of the hardest hit players will be

discussed in light of the research question.

6.5 The role of “Wall Street”

The Wall Street is a street situated in lower Manhattan in the city of New York in the United

Stated of America. As we all know it is famous with the fact that it is the center of the world’s

financial industry. For decades now it has become quite symbolic for the whole financial world.

The Wall Street or its surroundings is the “home” or in other words the place where all the

leading and especially the US financial companies either have their headquarters or other major

representations. A very important fact is that this is the place where The New York Stock

Exchange as well as a number of other stock exchanges like the NASDAQ, AMEX, NYMEX,

and NYBOT are located. Due to the interest that it attracts the Wall Street has also become a

major location for the leading TV channel, who produce their financial news from there.

Ever since its establishment the Wall Street has been attracting and gathering “the smartest

brains” in the financial world. Due to the specifics of their work and the enormous amounts of

pressure that they have to handle they are as well among the people with the highest income and

are used to earning serious performance based compensations for their work. It is exactly those

“smart brains” that have been coming up with the nowadays available extremely complicated

110

The Market Watch, viewed on 24. April 2008 http://www.marketwatch.com/news/story/mining-metals-

companies 111

SundayHerald News http://www.sundayherald.com/news/heraldnews/display.var.2104855.0.mother_of_all_

bubbles_prepares_to_burst.php), (http://news.bbc.co.uk/2/hi/7284196.stm

57

financial instruments allowing them to maximize the profits they make. Some of those financial

instruments are so complicated that it is sometimes complicated even for the professional to

understand what exactly they mean and how exactly they work. What has become an increasingly

concerning matter is fact that they are extremely difficult to regulate by the regulatory bodies of

the global financial markets. In its essence a financial instrument is a real or virtual document

representing a legal agreement involving some sort of monetary value.112 There are different types of financial

instruments. The three major categories for categorizing them are:

• Equity based

• Debt based

• Foreign exchange instruments113

The above mentioned categories have their respective categories and the particular instruments in

them.

The Wall Street is exactly the place where the so notorious collateralized debt obligations (CDOs)

and the whole complicated scheme with the packaging, repackaging and selling of the subprime

mortgages have been invented. In their essence CDOs are derivatives — synthetic financial instruments

derived from another asset.114 In this particular case they consist of subprime mortgages, which are

divided into tranches offering different yield. The more risky ones offering higher yields and the

less risky ones offering lower yields. Here comes the role of other well-known players in the

financial markets – the rating agencies like Standard & Poor's and Fitch Ratings, who rated the

top tranches with the highest possible rating, which makes the CDOs very attractive financial

instruments.

It is not only the financial instruments themselves that are complicated. The complete scheme

itself is extremely sophisticated and it is not a single type of financial institutions involved in it.

The level of sophistication undoubtedly makes the regulation more difficult and I would also say

even almost impossible. It also increases significantly the risks incurred by the financial

institutions themselves.

112

Investopedia, viewed 24. April 2008, http://www.investopedia.com/terms/f/financialinstrument.asp

113 Investopedia, viewed on 24. April 2008, http://www.investopedia.com/terms/f/financialinstrument.asp

114 Time Magazine, 24. April 2008, http://www.time.com/time/business/article/0,8599,1653556,00.html

58

The invention of more and more sophisticated financial instruments has been something that the

Wall Street has always been famous with. This is by far not the first time that the architects of

those instruments have suffered from their own greed and as Richard Bookstaber points out in

his wonderful article for the Time Magazine yet Wall Street still isn't getting the message.115

What one should never forget is that it is exactly those “smart brains” working on the Wall Street

every day that have created the whole mess and not that much the CEOs or chairmen of the

companies they work for. They have of course all been too greedy.

I am finishing this part with Richard Bookstaber’s first sentence – Looks like Wall Street's mad

scientists have blown up the lab again.116 Those “mad scientists” are actually they all – the people

behind the desks dealing with the day to day work and their bosses.

6.6 A financial reporting issue

The subprime creates for the companies affected and especially the financial institutions a huge

financial reporting issue due to the fact that they have to reflect all the damage incurred by them

in their financial statements and publish them so that they are available to the investors and

analysts. As you can imagine the picture is not very exciting and impressive. On contrary it is very

impressive in the negative sense of the word.

The fact that the crisis is so severe and it is so difficult to stop it from developing led to many

undesirable effects which when reflected on the companies’ financial statements created really

bad impression and consequently the financial statements themselves looked everything else but

impressive to the analysts and investors: The most serious of all those effects is undoubtedly the

writedowns incurred by major financial institutions globally. It is exactly those writedowns that

flooded the news recently and triggered the turmoil in the global financial markets.

It is also reasonable to explain what exactly a writedown is and how it works for the financial

institutions who need to deal with the writedowns. In simple words a writedown (write-down)

means. Reducing the book value of an asset because it is overvalued compared to the market value. This is usually

115

Time Magazine,24. April 2008, http://www.time.com/time/business/article/0,8599,1653556,00.html

116 Time Magazine, 24. April 2008, http://www.time.com/time/business/article/0,8599,1653556,00.html

59

reflected in the company's income statement as an expense, thereby reducing net income.117 Let me explain it in a

little bit more detail within the context of this paper. As already explained above the CDOs’ are

financial instruments - derivatives derived from another asset. Those CDOs are indicated on their

owners’ balance sheets. As the prices of the real estate in the United States started to drop and

the number of foreclosures increased dramatically the value of the financial instruments which

are backed by a bad mortgage and a home whose value is decreasing started to decline. Some of

the financial instruments lost their value completely. This lose of value needs to be reflected on

the financial statements of the companies losing it. The loss of value is reflected via a writedown,

which indicates the decrease of value in the balance sheet. This writedown is also reflected on the

P&L though as an expense and it logically has a negative impact on the company’s net profit. As

of 31 December 2007, approximately two thirds of the total UBS losses were attributable to the

CDO desk.118 This led to the losses incurred by the financial institutions all over the globe. The

larger the exposure that a financial institution had to the US subprime mortgage market the more

significant the impact.

One could of course argue that it is not only the businesses that are directly linked to the

subprime crises that suffered. Certain domino effects occurred as a consequence of the problems

that the companies affected by the crisis experienced. Those domino effects resulted from the

change in the flow of their business processes. The change in the business processes in turn was a

consequence of the certain shortages of liquidity experienced by the financial services providers

in parts of their business, the more conservative type of policies adopted by them in an attempt

to make sure that the losses do not skyrocket and the uncertainty in the markets.

The massive deterioration of the financial results of the financial institutions led to a dramatic

decrease in the investors’ and analysts’ confidence in the whole industry. Since the financial

institutions are such an important part of the countries’ financial systems and the global financial

system in general and a significant effect on a large number of other industries inevitable

occurred the confidence in the state of the global economy in general was partially lost as well.

The numbers of the latest (as of April 2008) German IFO confirm that.119

117

Investopedia, viewed on 25. April 2008 http://www.investopedia.com/terms/w/writedown.asp

118 UBS, 25. April 2008, http://www.ubs.com/1/ShowMedia/investors/releases?contentId=140331&name=

080418ShareholderReport.pdf

119 Deutsche-Welle, viewed on 25. April.2008, http://www.dw-world.de/dw/article/0,2144,3291066,00.html

60

At the same time it can be firmly stated that there is not even a single clear indication that the

financial industry is experiencing any trouble which is a consequence of overall bad performance

by the companies and is not related to the subprime crisis. On the contrary, it looks like if it were

not the subprime crisis the whole financial sector would have probably had another good

financial year.

6.7 The UBS and its performance before and during the

crisis

6.7.1 The UBS

According to list of the world's largest corporations published by the renowned Fortune

Magazine – FORTUNE GLOBAL 500, The Union Bank of Switzerland (UBS) is ranked number

27 with a revenue of over $107bln and a profit of over $5,5bln.120

The UBS is much more than just a Swiss bank. It is a global financial services provider. The UBS

is the leading global wealth manager and one of the leading global asset managers. Its major

target group is the wealthy clients. In its domestic market – Switzerland, which is one of the key

markets for banking and financial services in general, the UBS is the market leader in retail and

commercial banking. The company is headquartered in Zurich and Basel, Switzerland and

operates in over 50 countries and from all major international centres. The UBS employs more

than 80,000 people in the countries it has offices in.121

The structure of UBS consists of three business groups and the corporate centre. The three

business groups cover the respective segments that they are responsible for.122

Table 6.7.1.1 UBS Structure (UBS data, www.ubs.com)

Business Group The

UBS Global Wealth Management &

Business Banking

Global Asset Management and

Investment Bank Industrial Holdings

120

Fortune Magazine, viewed on 25. April 2008, http://money.cnn.com/magazines/fortune

/global500/2007/full_list/index.html

121 UBS, viewed on 25. April 2008, http://www.ubs.com/1/e/about.html

122 Reuters, viewed on 25. April 2008, ,

(http://stocks.us.reuters.com/stocks/fullDescription.asp?rpc=66&symbol=UBS

61

Wealth Management International &

Switzerland (segment)

Global Asset Management and

Investment Bank (One single segment)

Holds all industrial

operations

controlled by the Group

Wealth Management US (segment)

Responsible for

Business Banking Switzerland

(segment)

The mission of UBS is “to be recognized as the best global financial services firm”. The shares of

UBS are listed on three of the leading global financial stock exchanges – Zurich, New York and

Tokyo. The revenue of UBS is structured is a way allowing the company to be as competitive as

it can be. The UBS has four core businesses – Wealth Management, Asset Management,

Investment Banking and Retail and Business Banking in Switzerland. A key feature of the culture

of UBS is their openness to change. They have “a distinct culture of ambition, performance and

learning”. The UBS is strongly committed to its clients and appreciates its long-term relationships

with its clients.123

6.7.2 Financial performance before and after the crisis relevant to the research issue

The research issue of the work is to identify, understand and explain the implications of financial

reporting on leadership’s decision making process as well as identify, understand and explain their

effects on leadership’s strategic choices. In order to do to that within the framework of the real-

life example of the case study the relevant financial data need to be gathered and analyzed in

order to gain an overview of the company’s financial performance. This will of course be done

based on the theoretical framework outlined in the literature review. In particular, certain ratios

are selected based on the feasibility for their calculation and the extent to which they make sense

within the real-life example.

The following financial indicators are used for the analysis:

1. Operating Profit Margin (OPM) – The operating margin provides a very good

overview of the company’s operating performance. It is the most general indicator

123

UBS, viewed on 25. April 2008, ,

(http://www.ubs.com/1/RenderImage/about?type=rfaTitle&pageId=&varId=241372&num=0)

62

regarding operating performance and as such is included in the analysis with the purpose

of evaluating management’s ability to handle the companies’ activities on an operating

level.

2. Net Profit Margin (NPM) – The net profit margin is the most general profitability

financial indicator. By comparing the company’s net profit for a certain period to the

company’s revenue for the same period it provides an overview of a company’s overall

performance including also the non operating aspects like handling debt and investments.

Since it also covers the financial effects of strategic decisions like outsourcing or

restructurings if considered for a reasonable period of time it may give very good

indications regarding the sustainability of a company’s development. Especially in this

case the availability of this indicator in the analysis is a must because it shows the drastic

changes from one period to another.

3. Return on Assets (ROA) – The return on assets is a financial indicator comparing a

company’s profitability compared to its asset base. Is its t provides an overview of the

way a company performs based on what it has at its disposal. The inclusion of this

particular indicator in the analysis is a must because it indicates the profitability of a

company compared to its asset base and especially together with the net profit margin the

return on assets may lead us to some very important conclusions. It is important to

mention that is this particular case serious deviations in the companies’ asset bases may

be expected.

4. Return on Equity (ROE) – Equity is exactly what the subprime crises has ultimately

affected due to two major facts:

• The losses incurred by the companies affected by the crisis destroy equity value

• The resulting drop in confidence affects the share price

Consequently, the return on equity turns out to be the key financial indicator in this analysis

5. Earnings per Share (EPS) – The EPS reflects the return that the investors receive for

their investments in the company resulting directly from the company’s financial

63

performance. Since the companies’ profitability was so seriously affected by the subprime

crisis the devotions in the value of the EPS are undoubtedly huge and interesting to

notice.

6. Price-Earnings Ratio (P/E Ratio) – The specifics of this indicator make its availability

in the analysis rather useful because it is in an indicator of a company's current share price

compared to its per-share earnings. It is useful to compare the companies’ current share

price to the EPS after the shocks.

The following financial indicators are excluded from the analysis:

1. Price-To-Sales Ratio (Price/Sales) – The key issue in the subprime crisis is not

revenue disorders, but rather the expenses incurred. Of course there is an effect on

revenue as well but the effects of revenue are nit in line with the profitability effect and

that is why anaysis based on this financial indicator may be rather misleading.

2. Price-To-Book Ratio (P/B Ratio) - The P/B ratio is a very useful financial indicator. It

is one of the major indicators for measuring management’s performance, but just like the

Price-To-Sales Ratio it has a different meaning which does not correspond to the

purposes of the current analysis and may as well be misleading.

3. Total Assets Turnover (TAT) Ratio – As already mentioned above the key issue in the

subprime crisis is not revenue disorders, but rather the expenses incurred. Consequently

just like the Price-To-Sales Ratio the (TAT) Ratio will be excluded from the analysis.

4. Debt-to-Equity Ratio – The financial institutions have very specific balance sheet

structure. Unlike companies in other industries like for instance semiconductor where

debt is a taboo the financial institutions work extensively with debt. That is why one must

be very careful when using debt indicators. Especially in case like the subprime crises

when the uncertainly is so high the applicability of such ratios is highly questionable.

Consequently the Debt-to-Equity Ratio will be excluded from the analysis.

5. Gross Profit Margin (GPM) – The gross profit margin is due to the industry specifics

not a very popular and widely used indicator within the industry. The gross profit itself is

64

very often not even available on the financial institutions’ income statements. Due to the

specifics of the industry and the difficulties with calculating the ratio the gm is not used in

the analysis either.

6. Return on Investment (ROI) – The ROI is another very widely used indicator which is

used to evaluate the efficiency of an investment. It is by far not applicable under the

current circumstances.

Before starting the analysis two very important remarks need to be made. First of all, excluding

the investment banking division and in particular the FIRC the UBS recorded quite reasonable

and strong results in general and second the bad results were mostly recorded in the fourth

quarter of 2007 when the large writedowns started to occur.

That basically means that if it were not the subprime crisis the bank would have most likely

recorded another consecutive year of growing revenue and profitability. It is also extremely

important to mention that this is the first year of negative profitability since the bank’s

establishment in 1998. Up to 2007 the UBS has been constantly recording quite reasonable

results unlike other major financial institutions like for instance the Deutsche Bank whose

profitability was not so strong.

Table 6.7.2.2 Financial Analysis UBS (SEC www.sec.gov, UBS www.ubs.com)

65

UBS’s operating profit margin had been improving until the end of the second quarter of 2007

when it reached the a level of 38.7% compared to a 30.7% at year end 2006 and 32.3% for Q1

2007. In Q3 it fell quite drastically to a level of -12.8%..This dramatic decrease was followed by

an even more dramatic one in Q4 2007 when the level reached 313.1%, which is due to the fact

that both variables in the formula tuned negative and technical the margin turns to a positive

number Both drastic decreases can be attributed to the massive expenses resulting form the

massive writedown resulting in turn from the US subprime crisis. At year end 2007 the UBS

recorded a negative operating margin for the whole year – 9.2%. This result is a consequence of

the bad results recorded in the second half of 2007 and is in strong contrast to the positive –

30.7% operating margin achieved for 2006.

In Q2 2007 the UBS recorded quite a significant increase in its net profit margin mostly

attributable to an increase in the company’s profit from discontinued operations. From Q3 on

the overall profitability of the company followed the deterioration noticeable in its operating

results. The net profit margin fell to -11.1% in Q3 and the extraordinary figure of 303.4% in Q4,

which is due to the fact that both variables in the formula tuned negative and technically the

margin turns to a positive number, flowing the outstanding 35.8% in Q2. Up to Q2 2007 UBS’s

net profit margin remained stable overall.

The company’s return on assets remained stable from in 2005 and 2006 at a level of 0.49%. In

2007 the ratio dropped into negative territory following the negative net profit recorded. There

ate two more important things to mention about the developments regarding this financial

indicator: First of all, it is important to mention that despite the shocks of the subprime crisis

UBS’s asset base never stopper to grow. Second, even though the quarterly results and not

comparable with the annual ones due to the technical aspects of the calculation it is interesting to

notice that the Q2 result was better than the Q1 result and the deterioration started again in Q3.

As a consequence of the enormous amounts of writedowns shareholders equity decreased

significantly. As a result of the hefty profits achieved by the UBS ever since its establishment in

1998 the company’s equity base increased to a level of CHF 51 606 000 at the end of Q1 2007. A

short downward fluctuation followed in Q2 and Q3 was again the turning point. In Q3 UBS’s

equity fell to a level of CHF 48 229 000, followed by another slump to a level of CHF 35 585 000

in Q4. At the same time one must notice that the return on equity had been improving all the

way until Q3.The decrease in 2006 compared to 2005 is a result of the very high profits from

66

discontinued operations recorded in 2005. Excluding the results from discontinued operations

ROE actually increased in 2006 compared to 2005. The quarterly results from the first two

quarters of 2007 confirm the trend of improvement. From a level of 6.7% in Q1 ROE improved

to a level of 11.3 % in Q2 2007. As the profitability slumped in Q3 and the company’s profits

turned negative ROE turned negative as well. Despite the heavily decreasing equity affecting the

denominator in the formula the negative profitability results led to an ROE of -1.5% for Q3, the

dramatic -34.7% for Q4 and an ROE of -10.8% for the whole year 2007.

Some special attention needs to be paid to the so notorious writedowns. The UBS itself has

issued a special statement called “Shareholder Report on UBS's Write-Downs”.124 The statement

was issued on 19 April 2008 and is considered one of the measures to regain confidence. Among

the others are the issuance of new capital placed at strategic investors, changes in the

management board, new selection and control procedures of the management, etc. Those are all

discussed in the next section of the work under the strategic changes taking place. In addition to

that the company launched its own internal investigation about the reasons that led to the current

situation and the consequences from it. This document though was only distributed to the

company’s shareholders. The Shareholder Report on UBS's Write-Downs itself is quite

comprehensive. The statement contains 50 pages of comprehensive information related to the

writedowns.

6.7.3 The strategic changes subsequent to the crisis

The purpose of this section of the work is to identify and explain the strategic changes in the

strategic development of the companies selected. Together with the financial analysis the

identification and explanation of those changes is a key prerequisite to the identification

understanding and explanation the implications of financial reporting on leadership’s decision

making process as well as the identification, understanding and explanation of their effects on

leadership’s strategic choices. As a source of information the articles provided on the websites of

the major news providers as well as the news section on ubs.com are used. The developments are

provided in chronological order and the criteria for selection are their relevance to the research

issue.

124

UBS, viewed on 26. April 2008, , ,

http://www.ubs.com/1/ShowMedia/investors/releases?contentId=140331&name=080418ShareholderReport.pdf

67

January 2007

UBS Granted Mexican Banking License – UBS Granted Mexican Banking License. UBS announced

today that it has received approval from the Ministry of Finance to offer banking services in Mexico. The firm

plans to begin operations in the first quarter of 2007. This license represents a significant step for UBS. Having

operations in Mexico and serving clientele here is an integral component of UBS’s expansion into Latin America,

and we are excited and optimistic about the future of UBS in this country,” said Andre Esteves, chairman and

chief executive of UBS Latin America.125

UBS acquires Standard Chartered’s mutual funds management business in India – UBS

acquires Standard Chartered’s mutual funds management business in India. UBS’s commitment to India was

further underlined when UBS Global Asset Management today announced that it has agreed to acquire Standard

Chartered’s mutual funds management business in India for a total consideration of CHF 147 million.126

February 2007

UBS Completes Acquisition of McDonald Investments Private Client Branch Network –

BS Completes Acquisition of McDonald Investments Private Client Branch Network. UBS announced today

that it has completed the acquisition of the branch network of McDonald Investments, a unit of KeyCorp. The

transaction was announced on September 6, 2006.127

March 2007

UBS to launch new 3-year share buyback program – UBS to launch new 3-year share buyback

program. The program, which replaces the 2006/2007 plan, allows for increased capital flexibility while

maintaining UBS's disciplined approach to shareholder returns. As announced in UBS's fourth quarter 2006

results communications, UBS will today launch a new 3-year share buyback program to replace the 2006/2007

plan, which ended yesterday.128

May 2007

125

UBS, viewed on 26. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=111540

126 UBS, viewed on 26. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=112427

127 UBS, viewed 26. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=113534

128 UBS, viewed 26. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=114926

68

UBS announces reintegration of Dillon Read Capital Management Portfolios into the

Investment Bank. Outside investor funds to be redeemed – UBS announces reintegration of

Dillon Read Capital Management Portfolios into the Investment Bank. Outside investor funds to be redeemed.

UBS announced today that the proprietary funds currently managed by Dillon Read Capital Management

(DRCM) within Global Asset Management will transition to the Investment Bank. DRCM’s principal finance,

credit arbitrage and commercial real estate businesses will be merged with relevant business lines within the

Investment Bank. DRCM’s third party funds will be redeemed. UBS intends to work with DRCM investors to

identify alternative investment opportunities for them” . “Peter Wuffli, Group CEO of UBS said, “UBS remains

totally committed to alternative investment offerings for our clients. However, based on an assessment of a number

of factors, we concluded that the DRCM initiative did not meet our expectations. Consequently we took this

decisive action, which is in the best interests of our clients and shareholder. .

Operating a proprietary trading platform outside the Investment Bank and managing client money alongside

became too complex and expensive. That, among other reasons, is why we have chosen to reintegrate DRCM into

the Investment Bank and to redeem the outside investor funds," said John Fraser, Chairman and CEO of Global

Asset Management. 129

UBS Global Asset Management purchases 51% of Daehan Investment Trust

Management Company – UBS Global Asset Management has entered into a stock purchase agreement

with Daehan Investment & Securities Company Ltd (DI&S) to acquire 51% of Daehan Investment Trust

Management Company Ltd (DIMCO), one of Korea’s largest asset management companies. The joint venture will

combine the international know-how of UBS Global Asset Management with the domestic expertise of

DIMCO”. “UBS Hana Asset Management will be one of the largest asset managers in the Korean market

which represents an important source of new business for UBS.130

June 2007

UBS successfully sells its 20.7% stake in Julius Baer – UBS successfully sells its 20.7% stake in

Julius Baer. UBS AG announced today that it has successfully placed a 15.23% stake in Julius Baer Holding

AG, representing a total of 33,991,870 Julius Baer shares, at CHF 84 per share. The shares were offered to

institutional investors in an accelerated bookbuilding transaction launched yesterday and met strong demand from

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69

high quality institutional investors in Europe and the US. Yesterday, UBS agreed to sell a 5.47% stake in Julius

Baer, representing 12,222,222 shares, to Julius Baer at a price of CHF 90 per share. The pre-tax capital gain

on the sale will be approximately CHF 2.0 billion. Gains from the sale will be used to buy back shares in the

coming months as part of the 2007/2010 share repurchase program announced on 8 March 2007.131

July 2007

Marcel Rohner appointed Group CEO, effective immediately – The Board of Directors has

appointed Marcel Rohner as UBS's Group Chief Executive Officer, effective today. He succeeds Peter Wuffli, who

relinquishes all of his functions at UBS. Raoul Weil will succeed Marcel Rohner as Chairman and CEO of

Global Wealth Management & Business Banking. Marcel Ospel will be nominated for another term as

Chairman of the Board of Directors once his current term expires.” “Marcel Ospel will continue his strategic

leadership at UBS as Chairman for at least another term. A year ago, as part of UBS's systematic management

succession planning, Marcel Ospel expressed a wish to initiate a generational change of management at UBS and

therefore retire from his function within the foreseeable future. He also proposed that Peter Wuffli be nominated his

successor. After careful evaluation, the Board of Directors decided not to accept his proposal. It does not view the

succession of the CEO to the position of Chairman as automatic. Instead, the Board identifies independently the

composition of the leadership team which, in its opinion, suits the bank the best. In this context, it asked Marcel

Ospel to serve for at least another term of three years as Chairman of the Board of Directors.

The Board of Directors and Peter Wuffli therefore decided to institute generational change only in UBS's

operational management. Peter Wuffli will transfer all his functions, effective immediately, to Marcel Rohner, his

deputy. The Board of Directors is extremely grateful to Peter Wuffli for his substantial contribution to the growth

of UBS, especially to the expansion of its franchise, market position and brand strength.132

August 2007

UBS appoints Andre Esteves Global Head of Fixed Income – UBS appoints Andre Esteves

Global Head of Fixed Income. UBS announced today that Andre Esteves has been appointed Global Head of

Fixed Income for UBS Investment Bank. Esteves, most recently Chairman and CEO of the firm’s Latin

American business, UBS Pactual, will relocate from Brazil to London. In his new role, he will be responsible for

overseeing the full suite of fixed income products across all regions. Esteves will continue to report to Huw Jenkins,

Chairman and CEO of UBS Investment Bank. Esteves is a member of the UBS Group Managing Board. We

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70

have a clear growth strategy for our Fixed Income business,” said Jenkins. “Andre brings strong execution and

risk management skills to the role, in addition to his Emerging Markets experience and track record building a

highly successful business. Under his leadership, with a renewed focus on swift implementation, I am confident we

can achieve the ambitious step change in market position we are striving for.133

UBS reports second quarter result of CHF 5,622 million – UBS reports net profit attributable to

shareholders of CHF 5,622 million in second quarter 2007. The investment banking business saw a very strong

rise in M&A and corporate finance fees and higher equity and debt underwriting fees”. “The performance in fixed

income, however, was not satisfactory. Continued difficulties in the US mortgage securities market led to lower

revenues in the rates business and further losses on some of DRCM's former portfolios, which contributed net

negative revenues of approximately CHF 230 million in second quarter 2007. These developments were partially

offset by robust credit fixed income results, which rose on global credit trading and proprietary strategies.134

October 2007

UBS writes down positions, predicts an overall loss in third quarter, and reorganizes

management – UBS writes down positions, predicts an overall loss in third quarter, and reorganizes

management

• Following a write down of positions in fixed income, rates and currencies (FIRC), mainly related to

deteriorating conditions in the US sub prime residential mortgage market, UBS is likely to record an

overall Group pre-tax loss of between CHF 600 million and CHF 800 million for third quarter, ended

September 30. Pre-tax profits for the first nine months of 2007 will be in the order of CHF 10 billion.

Marcel Rohner, Group CEO, will reorganize senior management, take over as Chairman and CEO of

the Investment Bank, and accelerate structural improvements to the firm.

• In third quarter 2007, expected pre-tax loss for the Group between CHF 600 million and CHF 800

million, due mainly to write downs and losses in the FIRC business within the Investment Bank

• For the first nine months of 2007 pre-tax profits for the Group in the order of CHF 10 billion, and

expect to end the year with good level of profits and a strong capital position

• All other businesses in the Investment Bank, as well as the Global Wealth Management & Business

Banking and Global Asset Management business groups, performing very well

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• Management changes:

o Investment Bank Chairman and CEO Huw Jenkins to step down. Group CFO Clive

Standish to retire

o Marco Suter, Executive Vice Chairman, UBS, to become Group CFO

o Walter Stuerzinger, Group Chief Risk Officer (GCRO), to become Chief Operating Officer

(COO), Corporate Center

o Joseph Scoby, Global Head Alternative & Quantitative Investments, UBS Global Asset

Management, to become GCRO, UBS

• Investment Bank changes:

o Robert Wolf, COO, Investment Bank, additionally appointed President, Investment Bank

o Money Markets, Currencies and Commodities (MCC) to be integrated into Fixed Income

o Initiation of cost reductions in Investment Bank135

UBS reports third quarter loss of CHF 726 million pre-tax, in line with announcement on

1 October 2007 – UBS reports an operating loss, before tax and minority interests, of CHF 726 million in

third quarter 2007. This is within the range given in the announcement on 1 October 2007 forecasting a loss of

CHF 600-800 million. After tax and minority interests, the net loss attributable to shareholders was CHF 830

million.136

December 2007

UBS strengthens capital base and adjusts valuations – UBS strengthens capital base and adjusts

valuations. UBS has introduced measures to substantially strengthen its capital position, adding CHF 19.4

billion of BIS Tier 1 capital. These include an issue of CHF 13 billion of new capital. This has been placed with

two strategic investors: Government of Singapore Investment Corporation Pte. Ltd. (GIC), with CHF 11 billion,

and an undisclosed strategic investor in the Middle East with CHF 2 billion. .

At the same time, UBS has revised key input parameters of the models that are used to estimate lifetime default

and resulting losses for sub-prime mortgage pools. As a result of these revisions, UBS will write down its US sub-

prime holdings by approximately a further USD 10 billion. .

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72

After these actions, UBS projects a strong BIS Tier 1 ratio of above 12%.137

Extraordinary General Meeting of UBS on 27 February 2008 – Extraordinary General Meeting of

UBS on 27 February 2008”. “UBS shareholders will receive further information and the agenda items in

January 2008.138

February 2008

New term of office regulation and appointments in the Board of Directors of UBS – New

term of office regulation and appointments in the Board of Directors of UBS. The Board of Directors of UBS will

propose to the Annual General Meeting that the terms of office of Board members be reduced to one year. Marcel

Ospel, Peter Voser and Larry Weinbach will be proposed for re-election for a one-year term. Sergio Marchionne is

appointed non-executive Vice Chairman of the Board of Directors. Peter Voser will take over as Chairman of the

Audit Committee from Larry Weinbach.139

April 2008

Marcel Ospel will not be standing for re-election to the Board of Directors of UBS – Marcel

Ospel will not be standing for re-election to the Board of Directors of UBS. Peter Kurer is nominated for election to

the Board and is proposed as Chairman. Marcel Ospel, Chairman of the Board of UBS, has decided to withdraw

his candidacy for re-election to the Board at the Annual General Meeting on 23 April 2008. The Board of

Directors has accepted its Chairman's decision with regret. At the same time, the Board proposes that the Annual

General Meeting elect Peter Kurer to the Board to succeed Marcel Ospel as Chairman.140

Board of Directors of UBS AG determines exchange ratio for stock dividend – Board of

Directors of UBS AG determines exchange ratio for stock dividend. The Board of Directors of UBS AG has

determined an exchange ratio of 20:1 for the stock dividend. Every registered share of UBS AG will be allocated

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73

one tradable entitlement. Twenty entitlements will enable the holder to acquire one new registered share of UBS

AG for free.141

UBS Issues Shareholder Report on Write-downs – UBS Issues Shareholder Report on Write-downs.

UBS announced today that it has issued a Shareholder Report detailing the key facts relating to the firm’s

positions and losses in the U.S. subprime residential mortgage sector through December 31, 2007. This Report,

which provides an overview of a report which was submitted earlier to the Swiss Federal Banking Commission

(EBK), is available on UBS’ website at www.ubs.com/agm. .

Amongst other things, the Report summarizes: which businesses were affected by the losses; the business models and

growth initiatives pursued in those businesses; how the losses developed in the relevant businesses; the

implementation of Risk Management and Risk Control in those businesses; and the key findings related to the

causes of the losses. .

The Report identifies (and considers the causes of) the losses as originating principally from positions held within

three businesses: the (now closed) internal alternative asset management arm, Dillon Read Capital Management

(DRCM); the Investment Bank's (IB) Rates business (CDO Warehouse and CDO Super Senior Positions held

on the CDO Desk); and the ABS Trading Portfolio managed by the IB’s Foreign Exchange/Cash Collateral

Trading (FX/CCT) division. 142

Current affairs podcast – UBS chairman Marcel Ospel finally walked as a result of the huge losses that

Switzerland’s largest bank had incurred over the US subprime mortgage crisis. I have made my contribution to the

solution. UBS is in a very good position, it has very interesting areas of business and a very strong equity base. It

will get over this and shine once again. We are disappointed, we have disappointed.143

UBS needs time to put house back in order – The designated chairman of the board of UBS says it

will take up to three years to put the Swiss bank hit hard by the United States subprime crisis back on track. In

an interview on Saturday with the Neue Zürcher Zeitung newspaper, Peter Kurer said the bank first had to ride

out the storm and clean up the damage. Kurer said he favoured abolishing the bank's so-called Chairman's Office,

a centre of power which was created by the outgoing chairman, Marcel Ospel, to act as a buffer between the board of

directors and bank management. This office made up of three bank executives would be replaced by committees

141

UBS, viewed on 27. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=139926 142

UBS, viewed on 27. April 2008, http://www.ubs.com/1/e/investors/releases?newsId=140339 143

Swissinfo, viewed on 27. April 2008, ,

http://www.swissinfo.org/eng/multimedia/audios_podcast/index.html?siteSect=15050&ty=pn&sid=8934204&au

toPlay=y

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consisting of internal as well as external experts In this way, Kurer said, operations and strategy would be clearly

separated. He also said the board would need to focus on ensuring "vigorous supervision in all relevant areas".

Kurer also rejected a proposal to separate its private client operations from the stumbling investment unit. "We are

sticking to our integrated model, which interlocks the three businesses wealth management, asset management and

investment banking," he said.144

UBS report details bank's failings – Switzerland's largest bank, UBS, has explained to shareholders

how a breakdown in its risk management procedures resulted in $37 billion (SFr37.6 billion) losses.145

Current affairs podcast – The shareholders’ dislike for Ospel did nit make manz of them more accepting his

nominated successor – legal expert Peter Kurer. We must introduce changes- radical changes with regard to the way

we handle risks; UBS right now doesn’t need a banker, they need somebody who is very strict in cleaning the pace

and doing what they decided to do.146

6.8 The UBS’s peers

In order to gain a broader overview of the strategic developments resulting from the subprime

crisis and make sure that the strategic development that can be noticed by the UBS are not an

exception an overview of three of the other most severely hit banks is offered. Those are Merrill

Lynch and Citigroup – the two banks that suffered the most after the UBS plus Credit Suisse –

UBS’s major competitor in its domestic market Switzerland and one of the world’s largest

financial institutions, which also suffred major losses.

The exact financial consequences from the subprime crisis in detail are not of such high interest

to the research issue. Instead, it is the strategic developments occurring from them that are of

explicit interest. Consequently, a short overview of the writedowns and the strategic

developments resulting from the subprime crisis form the perspective of three of the other most

severely hit banks is offered in the table below.

144

Swissinfo, viewed on 27. April 2008, ,

http://www.swissinfo.org/eng/search/Result.html?siteSect=882&ty=nd&sid=8965689

145

Swissinfo, viewed 27. April 2008, ,

http://www.swissinfo.org/eng/search/Result.html?siteSect=882&ty=nd&sid=8996639

146 Swissinfo, viewed 27. April 2008, ,

http://www.swissinfo.org/eng/multimedia/audios_podcast/index.html?siteSect=15050&ty=pn&sid=9017921&au

toPlay=y

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6.9 Questioning the case

What are the financial reporting effects leading to the implications?

Specify the major reasons behind the strategic developments

What are the strategic implications of financial reporting on leadership based on the theoretical

framework considered and the logical consideration thereafter within the context of the empirical

study conducted?

6.10 Conclusions to the case study

6.10.1 Financial reporting effects leading to the implications

The strategic implications of financial reporting result as a consequence of certain financial

reporting effects that occur and can be noticed on the financial statements of the company or

companies affected. The financial reporting effects are of course largely dependant on the

circumstances – financial heath and stability of the company or companies affected,

environmental changes, etc.

Within the real-life example examined in the empirical study – the current crisis in the financial

sector originating from the US subprime mortgage crisis, called shortly the subprime crisis, the

financial reporting effects that occurred are the enormous writedowns of value reported by a

large number of the financials institutions on their financial statements. They have also led to a

deterioration of a large proportion the financial institutions’ financial indicators including ones

considered relevant for evaluating management’s performance.

The massive effects of the subprime crisis started to occur throughout the calendar years 2007

and 200ß. Most of the writedowns occurred in the second half of the 2007 and the first quarter

of 2008. Consequently, the quarterly financial statements for Q3 and Q4 2007 and Q1 2008 of

the financial instructions affected by the crisis were heavily affected.

The analysis based on the example taken with the UBS indicates certain some quite clear and very

interesting facts and trends. In general, up to Q3 2007 UBS’s results were very satisfactory and it

can even be said that they were in general either improving or remained stable. In Q3 2007 the

huge writedowns of value began. As a consequence of the writedowns of value certain financial

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indicators suffered. The analysis based on the study’s research issue and objectives as well as the

circumstances in the real-life example let to the conclusion that all the financial indicators

observed indicated the above mentioned trend. The Price-Earnings Ratio deteriorated from a

level of 11.94 in 2006 to a level of -23.03 in 2007.

The effects resulting from the writedowns and the consequent effect on the financial indicators

led in turn to some domino effects. As a consequence the overall results of UBS suffered. At the

same time, there is not a single clear indication that the company would have suffered any shocks

or disruptions in its financial performance if the subprime crisis had not taken place.

6.10.2 Major reasons behind the strategic developments

There are three major reasons behind the strategic developments taking place in the aftermath of

the subprime crisis:

• Loss of confidence

The major reason behind the strategic developments that took place within the companies who

suffered from the subprime crisis is undoubtedly the loss of confidence form the investors and

analysts toward not only the companies that suffered, but the industry as a whole. The enormous

number of analysis available in the media critical to the industry is a major proof for that. On

daily basis the analyst were flooding the media with their comments that the industry on a global

level is quite shaky and the final outcome of the crisis is almost impossible to predict. Nobody

could really tell what the complete picture is and how difficult it would be for the regulatory

authorities and of course the companies themselves to cope with the crisis. A major contributor

to both the phenomenon called subprime crisis and the very quick loss of confidence is the

already discussed information revolution. On one hand the information revolution enabled the

“mad scientists” to elaborate the complicated and difficult to control and regulate financial

instruments that led to the crisis and persuade the investors to invest in them. On the other hand

it contributed drastically to the wave of loss of confidence by spreading the fear around very

quickly, which led to domino effects. On top of that, the information revolution paved the way

for a lot of speculation, which of course strengthened the effects of the subprime crisis itself.

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As can be noticed in the announcements of the companies regarding the developments in their

strategy, many of them were desperate to find the so called strategic investors in order to restore

confidence. Those strategic investors are exactly the above discussed institutional investors. In

this case most of those investors were the so called sovereign fund controlled by the

governments of the countries having huge monetary reserves like China, Singapore and Saudi

Arabia. Why are the institutional investors so important for restoring confidence? The answer is

very simple. They bring their money in the form of an investment and become a major investor.

By investing at such a point in time they indicate that they trust management and believe n the

potential of the company. At the same time since they are large investors they have the power to

exercise stricter control on management. There are of course the negative sides of it. For instance

the investment of so much money by a single investor leads to a concentration of power. Despite

all the negative sides though the participation of such institutional investors in the shareholding

has ultimately largely met approval. Another interesting thing to notice is the fact that the already

existing institutional investors have strained their muscles and pushed for many changes like the

changes in leadership in many of the major financial institutions like the UBS and Citigroup.

There is no doubt that the role of the institutional investors in business is increasing. It is

interesting to follow the future developments.

• Major decrease in shareholder value

The major decrease in shareholder value in the companies who suffered form the subprime crisis

was a result of two factors – the decreasing profitability which resulted form the writedowns of

value affecting the companies equity base and the decrease in confidence, which affected the

companies’ market capitalization.

The most straight forward example is the UBS whose Price-Earnings Ratio decreased from 11.04

in 2006 to -23.03 in 2007. As discussed above the two major drivers were the drop in the share

price and the EPS, which in 2007 turned negative.

A major indication for the companies’ attempts to protect their share prices are the extensive

share buyback programs announced by many of them. There are three technical reasons for a

share buyback – an attempt to protect the share price from dropping, expected higher

profitability and an increase in the share price in the future, technical attempts to improve the

Price-Earnings Ratio by leveraging.

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• Deteriorated profitability

The purely financial performance and in this case the losses incurred resulting in a deterioration

of profitability do play a role and are a contributor to the strategic changes in the companies who

suffered. The question here is how important of a factor they are. One should never forget that

the majority of those very same companies who are suffering right now had been successful and

very profitable until the subprime crisis. Anther important thing to keep in mind is that the

subprime crisis is an external event. I would even call it an external environmental shock that was

first of all not created solely by the companies suffering from the crisis and second there is hardly

a financial institution globally that was not affected at all by it. A few financial institutions can not

create such a mess. It is according to me a question of industry development and most of all

attitude.

The deteriorated profitability was a reason for the strategic developments and changes that

occurred due to the fact that the bad results were spread around very quickly and overall created

a lot of turbulence in the markets. Here we are again going back to the information revolution. In

this case its effects are again twofold. On one hand it contributed to the fast spread of the results

in the media globally creating in many of the cases unjustified turbulence. On the other hand it

enabled the investors to react very quickly and simultaneously and with just a click of the bottom

each create enormous deviations in the supply and demand of the shares of the companies they

were selling the shares of, but also of the instruments they were putting the capital they have in.

6.10.3 The strategic implications

The strategic implications on financial reporting are considered in view of the theoretical

framework in the field of strategy offered by Bob de Wit and Ron Meyer in their book “Strategy:

Process, Content, Context--An International Perspective” and in particular the four strategic

topic offered for closer consideration – Strategic Thinking, Strategy Formation, Strategic Change

and Business level Strategy with their respective strategy paradoxes and strategy perspectives. The

focus is put on the strategy perspectives. The implications will be presented first from the point

of view of UBS.

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1. Strategic Thinking – Logic versus creativity – Rational reasoning versus Generative

reasoning

The UBS – As a consequence of the turbulence the UBS is demonstrating a clear orientation

towards a more rational reasoning perspective. The company is clearly giving signs that it is trying

to focus its future development of logic rather than creativity. The following developments

confirm this orientation:

o UBS announces reintegration of Dillon Read Capital Management

Portfolios into the Investment Bank. Outside investor funds to be

redeemed

The Dillon Read Capital Management was at the core of the problem suffered by the UBS during

the subprime crisis. It used to be a hedge fund established with the purpose to deal with the

certain financial instruments on behalf of and using the resources of the UBS. One of those

instruments are the CDOs. When the subprime crises started to develop the Dillon Read Capital

Management fund started to suffer.

With the dismantling of the Dillon Read Capital Management itself and its reintegration into the

UBS investment banking division the UBS has decided to follow a more standard model of

conducting the operations instead of the structure existing up to now based on the risky activities

of a hedge fund. The new model will certainly make UBS’s investment activities more

conservative and based on the rational reasoning based on the developments of the market

instead of the risky type of investments made by the Dillon Read Capital Management fund. At

the same time with this move the UBS ahs avoided the infinite physical collapse of its hedge

fund, which would have devastating consequences appearing in the media.

o Peter Kurer has succeed Marcel Ospel as Chairman

Unlike his predecessor Marcel Ospel, who is a pure banker Peter Kurer is a lawyer. He does have

experience in banking, but he is not pure banker. Despite the fact that many of the UBS’s

shareholders have opposed the nomination Peter Kurer was ultimately appointed a chairman of

UBS. One of the major reasons which were extensively commented rather internally among the

shareholders and not that much publicly is that the fact that Kurer is not a banker, but a lawyer is

actually a positive thing because at this point the UBS needs somebody, who will bring stability

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and confidence and not that much risk with innovative banking solutions and strategies. His

decisions are expected to be based rather on logic and legal (including regulatory) basis rather

than innovative thinking, which was actually probably the major reason for the major reason for

the subprime crisis in general and in particular for the UBS.

The peers’ overview

No concrete evidence of a strategic development or change with regard to strategic thinking in

terms of the logic versus creativity and rational reasoning versus generative reasoning has been

identified based on the announcements of the other three companies included in the empirical

study.

2. Strategy formation – Deliberateness versus Emergence – Strategic planning versus

Strategic incrementalism

The UBS – In this case the UBS is giving indications of focusing on the more deliberate type of

strategic development in the future rather the more emergent one. It is also giving signs on trying

to focus itself on strategic planning rather than strategic incrementalism.

o New 3-year share buyback program – The new 3-year share buyback program

announced by the UBS in March 2007 is a sign that the company is trying to

make sure that take decisions more quickly and decisively by being dependant on

less voting power available to the secondary market. It is also sign of a deliberate

long-term strategy for shareholder value creation.

o Peter Kurer has succeed Marcel Ospel as Chairman – The fact that a lawyer

is appointed to succeed a banker as a chairman increases significantly the

probability that the UBS will be less incremental to changes in the banking world

and more focused on certain long-term goals. The conservative point of view is

very likely to prevail at the expense of the liberal innovative approach.

o UBS strengthens capital base and adjusts valuations – The increase of the

capital base done be the UBS by issuing of CHF 13 billion of new capital placed

with two strategic investors - Government of Singapore Investment Corporation

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Pte. Ltd. (GIC) and an undisclosed strategic investor in the Middle East is a clear

sign of a long term commitment. That very often especially in the banking world

means a more conservative approach and less creativity. The adjustment of the

valuation methods at the same point of time introduces is a clear confirmation of

that. The revision of key input parameters of the models that are used to estimate

lifetime default and resulting losses for sub-prime mortgage pools gives a clear

indication that in the future the UBS will be more cautious and trust its revised

model for valuation.

o The dismantling of the so-called Chairman's Office – The purpose of the

office was to act as a buffer between the board of directors and bank

management. With this move the UBS is aiming to clearly separate operations and

strategy. This will certainly decrease the dependence of strategy from the more

day-to-day business and decrease the ncrementalism.


Similar signs of focusing on the more deliberate type of strategic development in the future rather

than the more emergent one and choosing strategic planning rather than strategic incrementalism

are also given by all the other three companies considered.

Citigroup has announced a number of stock offerings and transfers of equity some of which to

institutional investors like the Abu Dhabi Investment Authority in an attempt to regain

confidence and acquire some capital. Merrill Lynch has also reacted drastically by enhancing its

capital position by issuing $6.6 Billion in preferred stock to long-term investors. The stock was

also placed at strategic institutional investors like the Temasek Holdings, Davis Selected Advisors

and GE Capital. Credit Suisse completed its share repurchase program.

3. Strategic change – Revolution versus Evolution – Discontinuous renewal versus

Continuous renewal

The UBS – The developments with respect to this are somewhat mixed. On one hand the UBS

is demonstrating a rather revolutionary approach with many leadership changes and the

dismantling of the so-called Chairman’s office due to fact that urgent measures are needed. This

83

is also supported by the introduction of the two new major investors. On the other hand it has

demonstrated strong respect and commitment defending its former chairman until the last

second and the introduction of new term of office regulation and appointments in the Board of

Directors of UBS.

o New term of office regulation and appointments in the Board of Directors

of UBS – According to the new regulation the terms of office of Board members

is reduced to one year. That is a clear indication that the company is aiming a

more evolutionary type of strategy development. Instead f granting longer terms

to the board members and expecting them to be able to cope with different types

of circumstances according to the new regulation the board of directors will be

approved every year based on their performance and the circumstances.

o The dismantling of the so-called Chairman’s office - The dismantling of the

so-called Chairman’s office is a revolutionary change not only of leadership, but

also of the way the company will develop and execute its strategy in the future. It

will certainly have reasonable impacts on the company.

o UBS strengthens capital base and adjusts valuations – This move is quite

revolutionary in two aspects. First of all it brings a drastic change in the

ownership of the company. Not only that there is a new large investor, but it is a

foreign (not Swiss) governmentally controlled investment fund. Second, the move

brings a revolutionary change in corporate governance. The new investors have

immense voting power and have their own representatives in the governance

structure of the UBS. On top of that they are bringing completely new cultural

perspective in the governance structure on a large scale - Government of

Singapore Investment Corporation Pte. Ltd. (GIC) and an undisclosed strategic

investor in the Middle East.

o The large number of changes in leadership, but defending their Chairman

until the end - The large number of changes in leadership is are a clear indication

of the deliberate and revolutionary way the company reacted by dismissing people

who had been serving the company successfully for many years up until the crisis

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while on the other hand the fact that the UBS has until the last second tried to

defend its chairman is a sign of a continuous renewal approach.


Not much difference in the strategic developments and changes regarding strategic change in

terms of revolution versus evolution and continuous versus discontinuous renewal.

In all three companies a large number of major changes in leadership have taken place. They are

especially noticeable by Citigroup. Similar to the UBS Merrill Lynch has also announces intention

to declassify its board in 2009. According to the proposal all members of the Board of Directors

of Merrill Lynch will be elected annually for one-year terms commencing in 2009.

4. Business level strategy – Markets versus Resources - Outside-in versus Inside-out

The UBS – The strategic developments regarding UBS’S business level strategy are also

somewhat mixed. Most of the developments indicate a future orientation towards resources

rather than markets and a more inside-out approach.

o UBS announces reintegration of Dillon Read Capital Management

Portfolios into the Investment Bank. Outside investor funds to be

redeemed – Despite the popularity of the hedge funds he UBS has decided to

dismantle its own hedge fund due to the fact that its performance was not

matching the company’s expectations. It was not willing to depend on it anymore

and preferred to invest its resources in a different way. One should never forget

that such turbulent environments where there is a need for hedging risk represent

in general a great opportunity for the hedge funds. Regardless of that the UBS has

decided to focus on its resources and not the market opportunities.

o Peter Kurer has succeed Marcel Ospel as Chairman – The appointment of

Peter Kurer wil inevitably also affect the business level strategy of the UBS. The

fact that Mr. Kurer is not a banker, but a lawyer is very likely to push the UBS

towards a rather resource driven strategy especially under the current

circumstances.

85

o UBS strengthens capital base and adjusts valuations - The capital base itself

represents one of the resources – capital. The introduction of such revolutionary

changes with regard to the resource base means a lot.

o UBS successfully sells its 20.7% percent stake in Julius Baer – The sale of

the UBS stake is according to me a purely outside-in driven decision. The reason

behind it is that despite the fact that Julius Baer is quite a strategic investment for

the UBS the anticipated decline in the industry combined with the one-time item

accounting effect prompted the UBS to divest.


No concrete evidence of a strategic development or change with regard to business level strategy

in terms of markets versus resources and outside-in versus inside-out has been identified based

on the announcements of the other three companies included in the empirical study.

7 Conclusion

The importance of the financial markets has constantly been increasing during the last few

decades. With the increase of the importance of the financial markets the popularity and

importance of financial reporting have also increased dramatically. The attention paid to the

publicly available issued financial statements and reports of the companies not only by the

investors and analyst, but also by the governmental regulatory bodies regulating the financial

markets has also increased drastically. The reason is that those statements and reports are the

major tools used by the investors and authorities to determine the companies’ financial condition

and potential. A major proof of the importance of financial reporting is the thorough regulation

they are subject to in the well developed financial markets.

The importance of financial reporting has logically created a need for a lot of research in the area.

It is for instance important to understand the links financial reporting has with the different parts

of the business and its implications on them and the business in general. Based on that the

research conducted has focus on the following research issue - Identify, understand and explain

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the implications of financial reporting on leadership’s decision making process as well as identify,

understand and explain their effects on leadership’s strategic choices.

The aim of the research process was to reach some general conclusions on the issue derived from

a certain context – the crisis in the financial sector originating from the US subprime mortgage

crisis as well as provide basis for further research on the issue. After some thorough research

following – a literature review, logical considerations and an empirical study, number of findings

have been reached.

Certain phenomenon caused either internally or occurring externally may cause drastic financial

reporting effects and in particular the deterioration of key financial indicators, which may at a

later stage even lead to some domino effects on other not directly linked to the phenomenon

parts of the business. Despite the continuous good performance of the business up to the point

of occurring of the phenomenon and the good overall performance of the business in view of the

parts of the business not directly linked to the phenomenon the implications of those financial

reporting effects may have devastating consequences for the business in general and leadership in

particular. The consequences may as well take their toll on the industry in general and even on

beyond.

Within the real-life example examined in the empirical study the financial reporting effects that

occurred are the enormous writedowns of value reported by a large number of the financials

institutions on their financial statements. Those massive writedowns have also led to a

deterioration of a large proportion the financial institutions’ financial indicators including ones

considered relevant for evaluating management’s performance. Most of the writedowns occurred

in the second half of the 2007 and the first quarter of 2008. Consequently, the quarterly financial

statements for Q3 and Q4 2007 and Q1 2008 of the financial instructions affected by the crisis

were heavily affected.

Some very interesting facts and trends have been identified during the analysis of the UBS – the

company which was at the centre of the empirical study. In general, up to Q3 2007 UBS’s results

were very satisfactory and it can even be said that they were in general either improving or

remained stable. In Q3 2007 the huge writedowns of value began. As a consequence of the

writedowns of value certain financial indicators suffered. The analysis based on the study’s

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research issue and objectives as well as the circumstances in the real-life example let to the

conclusion that all the financial indicators observed indicated the above mentioned trend. The

Price-Earnings Ratio deteriorated from a level of 11.94 in 2006 to a level of -23.03 in 2007.

The effects resulting from the writedowns and the consequent effect on the financial indicators

led in turn to some domino effects. As a consequence the overall results of UBS suffered. At the

same time, there is not a single clear indication that the company would have suffered any shocks

or disruptions in its financial performance if the subprime crisis had not taken place.

Three major reasons behind the strategic developments that took place in the companies as a

result of the subprime crisis have been identified. Those are the loss of confidence, major

decrease in shareholder value and deteriorated profitability. All three are interconnected and

closely linked to each other. Three major drivers proved vital and prompted the effects of those

reasons. Those are the information revolution, which proved an important driver in all three

cases, Shareholder value, which turns out to be a driver behind the loss of confidence and a result

of the deteriorating profitability and the role of the institutional investors whose role seems to be

quite crucial in terms of confidence and restring confidence.

Ultimately, some general conclusions have been reached regarding the implications of financial

reporting on leadership base on the theoretical framework and logical consideration considered

as well as the empirical study conducted. In particular those are the implications on leadership

originating from the huge financial reporting effects resulting from the subprime crisis.

Strategic Thinking

With regard to the topic of strategic thinking the UBS is demonstrating a clear orientation

towards a more rational reasoning perspective. At the same time, no concrete evidence of a

strategic development or change with regard to strategic thinking in terms of the logic versus

creativity and rational reasoning versus generative reasoning has been identified based on the

announcements of the other three companies included in the empirical study.

The UBS is clearly giving signs that it is trying to focus its future development of logic rather

than creativity. Two major strategic developments serve as a proof for that – The early

reintegration of Dillon Read Capital Management, UBS’s own hedge fund and a major cause for

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the writedowns of value, into the Investment Bank and the appointment of Peter Kurer as the

new chairman of UBS. The dismantling of the Dillon Read Capital Management and its

reintegration into the UBS investment banking division is a sign that the UBS has decided to

follow a more standard model of conducting the operations instead of the structure existing up to

now based on the risky activities of a hedge fund. The new model will certainly make UBS’s

investment activities more conservative and based on the rational reasoning based on the

developments of the market instead of the risky type of investments made by the Dillon Read

Capital Management fund.

Marcel Ospel, who is a pure banker, has been replaced with Peter Kurer, who is a lawyer. On top

of that one of the major reasons which were extensively commented rather internally among the

shareholders and not that much publicly is that the fact that Kurer is not a banker, but a lawyer is

actually a positive think because at this point the UBS need somebody, who will bring stability

and confidence and not that much risk with innovative banking solutions and strategies. His

decisions are expected to be based rather on logic and legal (including regulatory) basis rather

than innovative thinking, which was actually probably the major reason for the major reason for

the subprime crisis in general and in particular for the UBS.

Strategy formation

As far as strategy formation is concerned the UBS is giving indications of focusing on the more

deliberate type of strategic development in the future rather the more emergent one. It is also

giving signs on trying to focus itself on strategic planning rather than strategic incrementalism.

Similar signs of focusing on the more deliberate type of strategic development in the future rather

than the more emergent one and choosing strategic planning rather than strategic incrementalism

are also given by all the other three companies considered.

In the case of UBS there are four strategic developments that give an indication towards a more

deliberate type of strategic development in the future. Those are first of all, the new 3-year share

buyback program, which is a sign that the company is trying to make sure that take decisions

more quickly and decisively by being dependant on less voting power available to the secondary

market and a deliberate long-term strategy for shareholder value creation. Second, Peter Kurer’s

appointment as a chairman, which increases significantly the probability that the UBS will be less

incremental to changes in the banking world and more focused on certain long-term goals. The

89

conservative point of view is very likely to prevail at the expense of the liberal innovative

approach. Third, the strengthening of the capital base, which especially in the banking word

means a more conservative approach and less creativity and the adjustment of valuations at the

same point of time is a clear confirmation of that. Fourth, the dismantling of the so-called

Chairman's Office, which is aiming to clearly separate operations and strategy and will certainly

decrease the dependence of strategy from the more day-to-day business and decrease the

incrementalism.

Meanwhile Citigroup has announced a number of stock offerings and transfers of equity some of

which to institutional investors like the Abu Dhabi Investment Authority. Merrill Lynch has also

enhanced its capital position by issuing $6.6 Billion in preferred stock to long-term investors. The

stock was also placed at strategic institutional investors like the Temasek Holdings, Davis

Selected Advisors and GE Capital. Credit Suisse completed its share repurchase program.

Strategic change

Relative to Citigroup and Credit Suisse, Merrill Lynch and especially the UBS seem to be showing

a little bit more dedication to continuous renewal. In all four companies a large number of major

changes in leadership have taken place the latter being especially noticeable by Citigroup. Similar

to the UBS Merrill Lynch has also announces intention to declassify its board in 2009. To be

more concrete, with its decisions to dismantle the so-called Chairman’s office and strengthen its

capital base and adjusts valuations the UBS is demonstrating a rather revolutionary approach.

The introduction of a new term of office regulation and appointments in the Board of Directors

is on the other hand a clear commitment to an evolutionary approach in the future. At the same

time with the large amount of changes in leadership while at the same time defending its

chairman until the end the UBS is giving a somewhat mixed signal.

Business level strategy

With respect to business level strategy there was no evidence of a strategic development or

change in terms of markets versus resources and outside-in versus inside-out, which could be

clearly noticed based on the announcements of Citigroup, Merrill Lynch and Credit Suisse. On

the other hand, the UBS is giving somewhat mixed signals. Most of the developments indicate a

future orientation towards resources rather than markets and a more inside-out approach.

90

The reintegration of Dillon Read Capital Management into the investment Bank despite the

popularity of the hedge and its unwillingness to depend on it anymore and preference to invest

its resources in a different way is a clear integration toward an inside-out approach. The

appointment of Peter Kurer will inevitably also affect the business level strategy of the UBS in

the same direction. Solely the fact that the capital base itself represents one of the resources –

capital means a lot per se. Meanwhile, the sale of Julius Baer can be treated as a purely outside-in

driven decision due to the expected slump in he share prices of the financial sector.

91

8 Bibliography

1. Andrew Black, Philip Wright, and John E. Bachman, 2000, “In Search of Shareholder

Value: Managing the Drivers of Performance”

2. CNN, http://money.cnn.com

3. Davis, E., Philip, “The Role of Institutional Investors in the Evolution of Financial

Structure and Behaviour”

4. Deutsche-Welle, http://www.dw-world.de

5. De Wit, Bob, Meyer, Ron, West Publishing Company, Saint Paul, 2004, “Strategy:

Process, Content, Context--An International Perspective”

6. Euronews, http://www.euronews.net/

7. Financial Times, http://www.ft.com/

8. Fortune Magazine, http://money.cnn.com/magazines/fortune/

9. Investopedia, www.investopedia.com

10. Jessica, T., Mathews, Foreign \policy, \no. 119 (Summer 2000), “The page

information revolution”, http://links.jstor.org/sici?sici=0015-

7228%28200022%290%3A119%3C63%3ATIR%3E2.0.CO%3B2-D

11. McKinsey & Company Inc. by Tim Koller, Marc Goedhart, and David Wessels,

Fourth Edition, 2005, “Valuation: Measuring and Managing the Value of Companies”

12. McKinsey & Company, http://www.mckinsey.com/

13. Newsweek Magazine, http://www.newsweek.com/

14. Realty Trac, http://www.realtytrac.com/

15. Robson, C., 1993, “Real World Research: A Resource for Social Sceintists and

Practicioner-Researchers.”, Oxford, UK : Blackwell Publishers Ltd, 1993.

16. Small Business Dictionary, http://www.smbtn.com/smallbusinessdictionary

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17. Strauss, A. and Corbin J., 1990, “Basics of qualitative research: grounded theory

procedures and techniques”, Sage Publications, Newbury Park

18. SundayHerald News http://www.sundayherald.com/

19. Swissinfo, http://www.swissinfo.org

20. Temte, Andrew (Editor), 2005, ”Financial Statement Analysis”

21. The Economist, http://www.economist.com/

22. The Market Watch, http://www.marketwatch.com/

23. The Wall Street Journal, http://online.wsj.com/

24. Thomson Reuters, http://stocks.us.reuters.com

25. Time Magazine, http://www.time.com/

26. UBS, http://www.ubs.com/

27. Webster, William, 2003, “Accounting for Managers”

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9 APPENDIXES

APPENDIX 1

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95

96

97

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10 Acknowledgments

I would like to express a gratitude and appreciation to several persons who helped me throughout the long and challenging process of completing this research.

I would like to thank the Baltic Business School for providing me with an excellent study environment and material base and a prestigious International Program.

I grate Professor Philippe Daudi, head of the program, for giving me the opportunity to be part of this Master Program and for presenting me memorable lectures and lessons as well as supervising and teaching me throughout the research process. I appreciate all the help and support.

I would like to give a true recognition to Mikael Lundgren. His outstanding support and guidelines consigned me the opportunity to succeed not only now, but in the years to come. His thorough ideas contributed and inspired me and the whole program towards our achievements.

Last but not least I would like to thank the two coordinators – Ms Terese Johansson and Ms. Daiva Baiciunate-Hakansson who supported me and the whole program throughout the whole

academic year.

Finally, I present my appreciation to all the people from the class who created the academic

environment around me.

Thank you all!

Svetlin Mirchev

99

The University of Kalmar

The University of Kalmar has more than 9000 students. We offer education and research in natural

sciences, technology, the maritime field, social science, languages and humanities, teacher training,

caring sciences and social service.

Our profile areas in research are: biomedicine/biotechnology, environmental sciences, marine

ecology, automation, business administration and informatics, but we have research proceeding in

most subject areas of the University.

Since 1999, the University of Kalmar has the right to accept students in postgraduate studies and to

examine doctors within the subject area natural sciences.

Baltic Business School,

at the university of Kalmar

Visiting address: Kalmar Nyckel, Gröndalsvägen 19

SE-391 82 Kalmar, Sweden

Tel: +46 (0)480 - 49 71 00

www.bbs.hik.se

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