• Fundamental to an understanding of financial strategy are the concepts of leverage and excess risk. “Leverage” is a measurement of the extent to which a business is dependent upon borrowings. The higher the leverage, the greater the level of risk. In good times, directors come under pressure to produce impressive profit growth, and one easy way to achieve it is to borrow money and invest in the most profitable parts of the business. However, if the economy turns downward, toward recession, heavy borrowings turn into an overwhelming burden. Leverage becomes toxic.
• The risk level generated by leverage is worsened when businesses use off-balance-sheet finance, in other words, when they do not report loss-making investments on the company’s balance sheet, thereby appearing to boost profits. This leads to an important question in relation to modern business: who bears the risk? Traditionally it was assumed that the risk taker was the shareholder, because it is the shareholders who collectively own the business. However, in Europe and the US especially, the desire to encourage entrepreneurship has led to generous rules that reduce the extent to which losses are borne by business owners. Since 2008, many business collapses have proved expensive for customers, staff, and suppliers, but less so for the business owners, particularly when the failing institution has been a bank. Some financial commentators wonder whether the balance has swung too far away from tradition.
• When times are tough, directors have to make difficult decisions about investment and dividends. Usually the directors will have an agreed policy in place—perhaps that half the after-tax profit will be paid as dividends to shareholders, while the other half will be retained to invest in future growth. But during recessions it is wise to keep more cash within the business, so directors may decide that dividends should be cut. If the business also cuts its investment plans, it can keep more cash in its current account, providing the liquidity to survive difficult trading conditions.
• So who is responsible when things go wrong? This depends on the systems of accountability and governance within each company. Ideally, the directors of the business should be sufficiently involved to know when things start to go wrong, and call for discussion of a change in strategy. If the directors are too hands-off, they may feel unable to hold the CEO fully accountable when things do go wrong. Alert, hands-on directors should also spot when rewards for staff are so out-of-control as to threaten the profits being made for shareholders and for the future financial health of the business. “Profit before perks” should be the mindset. Important to good governance is a willingness to ignore the herd. For example, if every US bank began to expand into South America, a smart South Korean bank would refuse to copy. However, in practice, this proves hard to do. Directors meet each other in the same clubs and conferences, and like to be part of the same pack. Nevertheless, US investment guru Warren Buffett has become one of the world’s wealthiest men by ignoring the herd instinct among investors.
• In today’s electronic age, many illegal acts such as credit card fraud, money laundering and identity theft have been made easier due to the increase in business transactions over the internet.
• In more traditional business organisations fraudulent acts, when they occur, can range from relatively minor expense account fraud to more serious embezzlement and huge misappropriation of funds through creative accounting. Other white collar crimes include tax evasion and bribery. Most fraudsters are caught following whistleblowing (colleagues revealing from the wrongdoing of peers or seniors to outside authorities), rather than through internal controls.
• Recently, regulatory bodies such as the FSA and SEC have filed law suits, and some executives have been found guilty, fined and even been given a prison sentence.

Case study: T-Systems International / Deutsche Telekom: Several companies have taken positive steps to eliminate perks as part of a cost-cutting strategy. At the German company T-systems International, an ICT subsidiary of Deutsche Telekom AG, all workers must now fly in coach class, regardless of the traveler’s position within the company, or the distance and duration of their journey. The change from business- to economy-class travel is thought to have saved T-systems $1.5 million annually. Executives were told that the choice was between a reduction in travel expenses, or a cut in their annual bonuses. Since the 2008 financial downturn, there has been an increase in the trend of organizations tightening their purse strings. Even the mighty entertainment company Walt Disney is phasing out executive car allowances. Cost cutting and eliminating perks puts greater pressure on managers to boost their company’s profitability.

 Video 1: Tax evasion / avoidance

 Exercise 1: Fill in the gaps with the missing words! 

 TIPS FOR BUSINESS LEADERS

Business leaders, then, must be as cautious as anyone else about treading the same path as the majority. There are three main types of herd to ignore.

• The third herd behavior to avoid is “followership.” This occurs when companies develop “me-too” products to imitate market innovators. Of course, if a business already has a genuinely differentiated offering, it is wise to follow a new trend. Often, though, businesses rush out copycat products to demonstrate that they are staying competitive in a sector.
• The second herd behavior to ignore is the strategic clash between focus and diversification, and the way the market tends to concentrate on one of these two at any one time. When “focus” is the market mantra, share prices rise in companies that sell off peripheral assets or divisions of the business. This is what happened to British Aerospace (BAe) when it sold its 20 percent stake in the Airbus aircraft business in 2006. At the time, the stock market liked its $2.99 (Ł1.87) billion sale of the largely civilian aircraft maker, since it focused BAe on the defense and military sector. By 2013, this view looked absurd, as Airbus powered ahead but governments— especially the US—cut back on military spending. A worried BAe then approached the owner of Airbus, suggesting a merger and implying that a mix of civilian and military businesses was a preferable focus. Could things really have changed that much between 2006 and 2013, or was BAe responding to the trend for diversification? Strong business leaders look to the long-term and ignore fads and fashions among stock-market analysts and management consultants.
• The first, as mentioned, is the occasional stampede to make takeover bids. In this case, business leaders worry that if they do not buy a rival, someone else will and perhaps create a bigger, more difficult competitor. At such times, there is much talk of synergies (the sum being worth more than the parts) but little mention of long-standing research, which suggests that 60 to 66 percent of all takeovers destroy shareholder value for the winning company. In other words, most takeover bids prove to be a disappointment.

Case study: Nokia: When the iPhone was launched in 2007, Nokia could boast more than 40 percent of the global smartphone market. Despite a series of new product launches by the company, its share of smartphone sales collapsed to around 3 percent in the first quarter of 2013. Throughout this period, Nokia was desperately trying to catch up with Apple’s iPhone— but doing no more than throwing new products at the problem, instead of taking a deep strategic breath and deciding what innovations might earn it a stake of the market. The contrast between Nokia’s behavior and that of Apple’s could not be greater.

Case study: Apple: In 2008 and 2009 the big trend in mobile computing was away from laptops and toward “netbooks.” In 2009, global netbook sales rose by 72 percent. The herd instinct of businesses such as Dell was to produce their own netbook. At Apple, by contrast, boss Steve Jobs announced that “the problem with netbooks is that they’re not better than anything.” He worked to develop a superior alternative to netbooks—the iPad. By mid 2013 the iPad had sold more than 145 million units and the original makers of netbooks (Taiwan’s Asus) had halted production completely.

Those who ignore the herd can apply cool logic to their situation and think ahead to possible future scenarios. The herd tends to think that tomorrow will mean more and more of today. Those who ignore the herd can identify fundamentals that persist over time, while looking toward what might be different tomorrow. As US entrepreneur Sam Walton advised, it often makes sense to “swim upstream.”

 Video 2: Enron: The Smartest Guys in the Room /Documentary/

 Video 3: Crooked E: The Unshredded Truth about Enron

• What was the corporate environment and culture of the company?
• Who were the major players and their roles?
• What “red flags” were there for analysts, auditors, and others to observe?
• What accounting and auditing issues arose within the company?
• How did the Enron scandal impact the accounting profession?

 Exercise 2: Put the events in Enron’s history into the correct order.

Then discuss with your partner what you think was the main reason for Enron’s failure:

• It grew too quickly.
• Its trading business was based on trust, not on capital assets.
• It was not open about its accounts.
• It diversified too much.
• Its directors were only interested in profits for themselves.
• It exploited the deregulation of energy markets and made existing companies jealous.

 Video 4: Wizard of Lies

 Exercise 3: Bernard Madoff: Listen to an interview with Jackie Coleman, a specialist in corporate crime, talks about the Bernard Madoff affair. Describe the events that occurred in these years and say how they affected his career.

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 Video 5: Pyramid scheme

 Video 6: Ponzi vs Pyramid Scheme

 Exercise 4: Examples of euphemisms