Masaryk University
Faculty of Economics and Administration
Department of Finance
European Financial Systems 2012
21st
and 22nd
June 2012
BRNO
Czech Republic
Edited by Mgr. Petr Červinek
Technical collaboration: Mgr. Petr Červinek
 2012 Masarykova univerzita
ISBN 978-80-210-5940-5
International conference European Financial Systems 2012 focused on prevailing scientific
inquiries in the area of global financial markets and financial systems. Particular attention was
paid to the European financial and sovereign debt crisis, comprising the possibilities of its
resolution and options of its prevention in the future. Fruitful discussions covered recent
findings and trends in banking, insurance, financial engineering, and financial management
alongside with developments in accounting practices and taxation systems.
International Conference Board
Chairman: Ing. Petr Valouch,Ph.D., Head of Department of Finance, ESF MU
Members: prof. Dr. Ing. Dana Dluhošová – VŠB TU Ostrava,
prof. Ing. Viktória Čejková, PhD. – ESF MU,
prof. Ing. Eva Horvátová, CSc. – NHF EU Bratislava,
prof. Dr. Dirk Kaiser – FHS Bochum,
prof. Ing. Eva Kislingerová, CSc. – VŠE Praha,
prof. Ing. Anna Majtánová, PhD. – NHF EU Bratislava,
prof. Ing. Oldřich Rejnuš, CSc. – ESF MU,
doc. Ing. Eva Kafková, PhD. – PHF Košice,
doc. Ing. Jaroslav Sedláček, CSc. – ESF MU,
Ing. František Kalouda, CSc., MBA – ESF MU,
Ing. Peter Krištofík, Ph.D. – UMB Bánská Bystrica,
Ing. Zuzana Křížová, Ph.D. – ESF MU,
Ing. Iveta Ratmanová, Ph.D. – VŠB TU Ostrava,
Ing. František Řezáč, Ph.D. – ESF MU
TABLE OF CONTENTS
Dorota Adamek-Hyska, Piotr Tworek – Cost budgeting methods in construction
projects in Poland................................................................................................................ 6
Beáta Blechová – The analysis of the corporate financial and tax accounting in the EU
and their harmonization.....................................................................................................12
Gábor Bóta, Mihály Ormos – A Nonparametric Serial Correlation Test of the Central
and Eastern European Stock Markets................................................................................18
Viktória Čejková, Svatopluk Nečas – The Insurance Market in Europe ...................................24
Petr Červinek, Jana Hvozdenská – Empirical Test of the CAPM Using Linear
Regression .........................................................................................................................30
Oleg Deev, Veronika Kajurová, Daniel Stavárek – Stock market bubbles investigation
in the Czech Republic .......................................................................................................35
Michal Fabus – The application of OCA criteria on the European Monetary Union ................41
Monika Foltyn-Zarychta – Biases in Contingent Valuation Method Used for Investment
Project Appraisal...............................................................................................................45
Monika Garguláková – Analysis of bankruptcy and secure risk management models
and application for their extension....................................................................................51
Radim Gottwald – Impact of Selected Factors on the Dividend Policy of Joint-Stock
Company ...........................................................................................................................57
Igor Hudák, Eva Kafková – Determination of the general value of selected engineering
enterprises..........................................................................................................................62
Zdenek Hustak – The Alternative Investment Funds Managers Directive and the
Regulation on Venture Capital Funds - selected comments .............................................67
Erika Mária Jamborová – Agency theory and its application in the business of the
financial sector in Slovakia ...............................................................................................73
Magdalena Jasiniak – The effects of domestic and foreign enterprises’ financial activity
in host country economy – comparative analysis..............................................................79
István Joó, Mihály Ormos – Disposition Effect: Do Hungarian investors keep their
mistakes? ...........................................................................................................................85
František Kalouda – Claim Paid Position in Rank of Alternative Source of Funding............... 91
Mária Klimiková, Martin Vovk – The Banking Sector under the Conditions of the
Crisis.................................................................................................................................. 97
Veronika Krsikova, Lukas Rybka – Audit Risk in the Context of the Audit Profession.........102
Jan Krajíček – Banks and Cash Management ..........................................................................107
Veronika Křelinová, Jiřina Krajčová, Pavla Vanduchová – Application of operations
research method to solve increase in unemployment......................................................113
Zuzana Křížová, Eva Hýblová – Changes in Reporting of Goodwill in Mergers &
Acquisitions.....................................................................................................................119
Katarzyna Lewkowicz-Grzegorczyk – Tax progression as an instrument of income
redistribution ...................................................................................................................125
Dagmar Linnertová, Martin Cupal, Oleg Deev – Investigation of the Weekend Effect
on the Prague Stock Exchange........................................................................................131
Makarova Vasilisa – The methodology for the risk detection in non-public companies.
Russia, NRU HSE ...........................................................................................................136
Magdalena Markiewicz – The importance of offshore financial centres in the financial
system in the times of crisis ............................................................................................142
Grzegorz Michalski – Efficiency of accounts receivable management in Polish
institutions.......................................................................................................................148
Peter Mokrička, Petr Červinek – Structured Products and Modern Portfolio Theory.............154
Mihály Ormos, Gábor Bóta – Investigation of weak-form efficiency in the CEE region
applying variance ratio test .............................................................................................160
Gabriela Oškrdalová – Analysis of skimming in the Czech Republic and protection
techniques against skimming ..........................................................................................166
Dalibor Pánek – Trends in the organization of financial supervision over the ocean..............172
Radosław Pastusiak – The use of VaR in the process of transaction system risk
reduction: the example of derivatives .............................................................................176
Oldřich Rejnuš – Risk Factors of Contemporary „Financial Crisis“ and Their Influence
on Future Development of World Economy...................................................................182
František Řezáč – The impact of the financial and debt crises on the investment
activities of insurance companies....................................................................................188
Jaroslav Sedláček, Kristýna Kuhrová – An Analysis of Unsuccessful Mergers in the
Czech Environment.........................................................................................................194
Vladimir Shatrevich – Cost management evolution for manufacturing companies ................201
Miroslav Sponer – Segmentation of corporate clients in a bank..............................................207
Jiří Strouhal – Applicability of IFRS in the Practice of Czech SMEs: Insight of Czech
Accounting Profession Representatives..........................................................................214
Boris Sturc, Natalia Zoldakova – Selected macroeconomic factors and their relationship
to impaired loans of Deutsche Bank ...............................................................................220
Petr Valouch, Maria Králová – Influence of a merger on the value of assets of merged
companies in the Czech Republic ...................................................................................226
Eva Vávrová – Current approaches to assess the financial performance of a commercial
insurance company..........................................................................................................232
Jitka Veselá, Soňa Poláková – The success of the speculative bubbles burst prediction
using Artificial Neural Networks .................................................................................... 237
6
COST BUDGETING METHODS IN CONSTRUCTION
PROJECTS IN POLAND
Dorota Adamek-Hyska, Piotr Tworek
ANNOTATION
The methodical approach to project cost management in the construction industry requires the
knowledge of accounting principles applicable to cost calculations. Such knowledge helps to
exert actual control over expenses incurred on the execution of a construction investment
project. There are various approaches to cost calculation for the presentation in the cost
budget of a construction project. In practice, the methods which can be used for this purpose
include expert estimation, estimation by analogy, parametric modelling and the specific
identification method. The paper focuses on these methods and its main aim is to outline them
and indicate their possible applications in economy, taking Poland as an example.
JEL classification: G31, L74, M49
KEY WORDS
costs, cost budgeting methods, construction projects, construction industry, Poland
INTRODUCTION
A ‘budget’ should be understood as a quantitative action plan, with appropriate resources
allocated for its implementation, established for a given decision-making entity in an
accounting period1
. In particular, a budget is the outcome of a budgeting process, i.e. a set of
various activities performed under the principles and by means of the methods appropriate to
this process2
. An entity which carries out a project in the construction industry must have an
up-to-date project cost budget (plan, estimate) for the entire project lifecycle as well as for
specific reporting periods and works included in a contract3
. Such a document is the basic
action plan, including the allocation of specific resources for its implementation in specific
time. It is also used to measure the project progress and create adjusted cost budgets to reflect
the changes, which occur throughout the performance of construction and assembly works.
The precondition for correctly prepared cost budgets for contracts implemented in an
investment and construction process is to show a true picture of the given project, including
effective provisions of a contract and associated agreements, e.g. financial agreements,
insurance policies and contracts with subcontractors, accepted construction techniques and
technologies, types of resources to be used and the manner in which works are to be
performed (in-house, subcontracting), as well as real price levels and pay rates. In Poland,
cost budgets for construction projects aren’t governed by any legal regulations. Nevertheless,
the experience shows that cost budgeting for a construction project may be divided into the
following stages, i.e. communication of data about a budgeting policy, which has been
adopted, and guidelines for people responsible for preparation of a project cost budget;
identification of factors which may limit the implementation of the construction project;
1
B. Niedbała: Controlling w przedsiębiorstwie zarządzanym przez projekty. Oficyna Wolters Kluwer Business,
Kraków 2008, p. 99 and A. Piosik: Zasady rachunkowości zarządczej. PWN, Warszawa 2006, p. 192.
2
A. Jaruga, W. Nowak, A. Szychta: Rachunkowość zarządcza, Koncepcje i zastosowania. Wydawnictwo
Społecznej Wyższej Szkoły Przedsiębiorczości i Zarządzania, Łódź 2001, p. 658.
3
Appendix to Resolution No. 9/06, passed by Accounting Standards Committee of 18 September 2006 on
adoption of National Accounting Standard No 3 ‘Unfinished construction services”, 2006 Official Gazette of the
Ministry of Finance, No. 13, item 93, point II.1.
7
preparation of so-called partial budgets, e.g. a budget of construction material consumption, a
labour budget, a budget of other direct costs or a budget of indirect project costs; budget
negotiations with superiors; incorporation of partial budgets in the overall project cost
budget; budget coordination and review; final approval of the budget; regular review of the
budget in course of its execution4
.
AIM AND METHODOLOGY
The paper aims to present the cost estimation methods, used to quantify construction project
costs for the needs of preliminary investment cost budgets, which are most popular in Poland.
Therefore, the paper first identifies direct and indirect costs of projects and then moves on to
describe the selected cost estimation methods, i.e. the expert method, estimation by analogy,
parametric modelling and the detailed calculation method. The paper draws on the literature
and analyses the Polish accounting regulations. The paper is also based, to a certain extent, on
the authors’ practical knowledge, the results of their scientific studies and their own
experience. The methods of deduction and synthesis are utilised.
Methods for estimating construction project costs in Poland
The basis for a well-calculated cost budget are possibly most reliable estimates of costs
included in the budget for specific stages and works covered by the contract. Costs of the
project in the construction industry are defined as the value of in-house resources, expressed
in monetary units, held by an enterprise which carries out this project, and external resources
used directly or indirectly for the project preparation, implementation and operation5
.
According to the definition given in the Polish Accounting Act, these are a reduction of
returns, likely to occur in the reporting period, whose value has been determined in a fair
manner, in the form of a decrease in the value of assets or an increase in the value of liabilities
and reserves, leading to a reduction of equity or a growth of its deficit otherwise than by the
withdrawal of funds by the shareholders or proprietors6
. Such costs comprise costs incurred in
the entire project lifecycle and represent costs directly relating to a given project, as well as a
reasonable portion of indirect costs of construction relating to activities performed in order to
prepare, plan or implement the project and operate its product, which are not the contract
implementation costs7
.
• Direct costs of a construction project cover all costs which may be directly, without any
additional allocations and calculations, referred to a given contract underlying the project
and specific stages of the project lifecycle. At every stage, the scope of works and,
consequently, the level of indirect costs, differ. Costs at the preparation stage are all costs
incurred before the commencement of works and related to the preparation to the
implementation of the given project, which directly refer to a specific contract. The
provisions of the National Accounting Standard that is effective in Poland specify the
costs, which are related to the preparation of an offer as direct contractual costs, but they
do not give any further explanation. The International Accounting Standard No. 11
indicates the reason for classification of these costs as indirect contract costs. Under the
international regulations, construction and assembly companies should strive to „(...)
include the biggest possible part of the costs incurred before the commencement of the
contract in the overall budget of contractual costs. (...) It should be done, however, in view
of the possessed knowledge and an investment profitability calculation so that the costs of
4
C. Drury: Rachunek kosztów. PWN, Warszawa 2003, pp. 375-379 and A. Piosik: Op. cit., pp. 199-202.
5
M. Łada, A. Kozarkiewicz: Rachunkowość zarządcza i controlling projektów. Wydawnictwo C.H. Beck,
Warszawa 2007, p. 114.
6
Accounting Act of 29 Sept. 1994, 2002 Journal of Laws No. 76, item 694 as amended, art. 3 par. 1 point 31.
7
Accounting Act of 29 Sept. 1994, 2002 Journal of Laws No. 76, item 694 as amended, art. 28 point 3.
8
information gained this way does not exceed any possible income in this respect”8
. A
criterion to be adopted by entities for the incorporation of pre-contract costs in total costs
of the contract should be the likelihood of the contract conclusion, in addition to the
contract identification, cost breakdown and reliable cost estimates9
. The implementation
stage costs comprise costs incurred during the performance of work, which may be
unambiguously attributable to a given contract, including material consumption costs,
valued at purchase prices of construction materials, payroll costs of production workers
plus charges, including payroll costs of site supervision staff, costs of transport/transfer of
machines, equipment, materials, soil from and to a construction site, costs of
subcontracted services. The operation stage costs are costs whose values result from
estimates prepared by management of an entity, which performs the contract and relating
to the value of future services under the contract, e.g. costs of corrections and guarantee
work, costs relating to maintenance of the facility in non-deteriorated condition, costs of
repairs, maintenance and improvement of the existing facility.
• Indirect costs of a construction project are these cost items which are only partly
connected with the given project. They are often called common costs of the project and
the entity’s other activities. Although the accounting regulations in Poland don’t provide
any definition of indirect project costs, it’s mentioned that indirect costs include only a
reasonable portion of indirect variable costs and indirect fixed costs. The values of
variable contract costs depend on progress in contract execution. These costs are
quantified by means of various units of measure, such as e.g. man hours, machine hours,
ton-kilometres, days etc. Examples of such costs are operational costs of the entity’s own
machines and equipment used in course of contract execution, i.e. costs of inspections and
repairs, fuel costs, operator costs and machine maintenance costs, in case when natural
depreciation, e.g. depreciation in relation to the number of worked machine hours, is used.
The values of fixed contract costs, in turn, do not depend on progress in work. Examples
of such costs are costs of technical support for a construction site, depreciation costs of
machines and equipment (excluding natural depreciation), costs of a project architect’s
supervision and an investor’s supervision, costs of geological, geophysical and geodesic
tests, costs of property insurance for the construction site, costs of land use fees during
construction work, costs of establishment of protection areas, costs of protection for the
construction site, costs of activities carried out by functions which support the project,
such as purchasing or administration10
.
Indirect contract costs (variable indirect costs and fixed indirect costs), which are costs of
manufacture of a specific facility, are attributable to a given contract by means of additional
allocations and appropriate allocation keys. Allocation keys are the figures representing
technical and economic parameters, which have or real or contractual connection with
deductible costs11
. When it comes to indirect costs, the basis for their allocation is most often
progress in work, total direct salaries and wages including charges, time measured by
machine hours or man-hours and the volume and value of consumed direct materials.
Other costs of construction projects comprise costs of liabilities incurred to finance these
projects and related foreign exchange gains/losses, minus income derived from it. It should
8
J. Kalinowski: Kompendium wiedzy o Krajowym Standardzie Rachunkowości nr 3 Niezakończone usługi
budowlane. Analizy-komentarze-przychody, Difin, Warszawa 2007, p. 81.
9
Międzynarodowe Standardy Sprawozdawczości Finansowej a ustawa o rachunkowości - podobieństwa
i różnice. Edited by A. Jarugowa. Stowarzyszenie Księgowych w Polsce, Warszawa 2006, p. 103.
10
Appendix to Resolution No. 9/06, passed by Accounting Standards Committee of 18 September 2006 on
adoption of National Accounting Standard No 3 ‘Unfinished construction services”, 2006 Official Gazette of the
Ministry of Finance, No. 13, item 93, points II.1 and VI.3.
11
E. Nowak, R. Piechota, M. Wierzbiński: Rachunek kosztów w zarządzaniu przedsiębiorstwem. PWE,
Warszawa 2006, p. 39.
9
be stressed, however, that International Accounting Standard No. 23 clearly specifies the
conditions which need to be met if borrowing costs are to be included in costs of manufacture
of a given asset. These costs must be likely to bring returns for an entity in the future and it
must be possible to reasonably estimate a cost of manufacture of a given asset12
.
In business practice, the estimation of identified costs of the project is the determination of
approximate values of costs of resources needed to perform the project activities13
. Resource
planning means finding out what resources, in what quantities and at which project execution
stage will be needed. Input materials for resource planning are frequently: a list of tasks
defined at specific project stages, historical data about types of resources consumed in similar
investments carried out in the past, a pre-defined scope of work or description of resource
pools, i.e. description of potentially accessible resources. Such techniques and tools as expert
opinions and project management support software may be used to this end. It should be
pointed out that cost estimation for the project at the preparation and design stage is, by
necessity, approximate, as it’s done before the project is defined completely14
. Therefore, in
practice, cost estimations at this stage will be based on general assumptions, will concern
substantial cost aggregates and will help to find the best possible option for execution of a
given project.
Both in theory and in practice, there are various approaches to cost estimation for the
needs of cost budgeting in construction projects. For instance, the following methods can be
applied: 1) expert estimation method, 2) estimation by analogy method, 3) parametric
modelling methods, 4) detailed calculation method.
The expert estimation method is based on judgements and experience of people who
prepare estimates15
. This is an inaccurate and subjective method but it’s often employed,
when costs are estimated for projects carried out in a new area or for projects which use new
technologies. The estimation by analogy method (also known as top-down estimation) means
using actual costs of previous, similar projects as the basis for a current project’s costs16
. This
method is frequently deployed when no detailed information about a given investment
project is available. It is less time-consuming but also less accurate. Parametric modelling
methods use various features demonstrated by a project to estimate this project costs. Such
methods include, for example, the cost estimation relationship method and the mathematical
model method. These methods may be employed when data for creation of a relationship or a
model is accurate, and parameters may be quantified. As emphasized by B.J. Madauss „(…)
cost estimation relationships are simple formulas which show that costs are directly
proportional to such physical parameters as volume or weight17
. In many industries all over
the world18
standard relationships, labour-intensity norms and material unit costs have been
developed and defined. In the US aviation industry, cost estimation relationships (CER) have
been used for many years to estimate costs of designing and producing parts with specific
parameters. For example, production costs of a helicopter fuselage can be estimated using the
following formula: C = 2060 × W0,766
× Q-0,218
, where C is the total cost of the fuselage, W fuselage
weight in pounds, and Q - the number of units produced. In the Polish construction
industry, in turn, there is a system called e-sekocenbud. This is a system which provides
comprehensive information about prices in the construction industry, based on a market price
12
International Financial Reporting Standards 2004, International Accounting Standard No. 23, § 12.
13
M. Pawlak: Zarządzanie projektami. PWN, Warszawa 2007, p. 118.
14
M. Pawlak: Op. cit., p. 120. After: R.G. Clught, G.A. Sears, S.K. Sears: Construction Project Management.
John Wiley & Sons, Inc., New York-Chichester-Weinheim-Brisbane-Singapore-Toronto, 2000, p. 27.
15
B. Nita: Rachunkowość w zarządzaniu strategicznym przedsiębiorstwem. Oficyna Wolters Kluwer business,
Kraków 2008, p. 259.
16
M. Pawlak: Op. cit., pp. 119-120.
17
B.J. Madauss: Handbuch Projektmanagement. Schäffer-Poeschel Verlag, Stuttgart 1994, p. 259.
18
M. Pawlak: Op. cit., pp. 120-121.
10
survey conducted on respondents from all over Poland19
. Parametric methods are highly
popular, mainly due to the fact that they are very easy to use. In the Polish construction
business, the most popular cost estimation method is the detailed calculation method, i.e. the
engineering cost estimate method, in which for specific stages and tasks within the
construction project execution process, contractors’ man-hours, material consumption and
machine use are determined and then multiplied by cost rates20
. This method uses procedures
which are appropriate to the standard cost accounting system. If the effect of a construction
project is a typical facility, e.g. a building or a structure belonging to business or social
infrastructure, which is well, or very well, defined, then existing productivity norms and
costs of previously executed similar projects are used in cost estimation21
. In innovative
projects i.e. the ones done for the first time, however, all cost budget elements are estimated
from scratch, based on assumptions resulting from current knowledge about the scope of
projects, with certain confidence levels22
. Therefore, what matters is not precise accuracy of
estimated costs but the fact that they need to be determined on the basis of currently available
data, rates and prices. The detailed cost estimation method may be used only in case when
the structure of project tasks is already known, and that is why it is seldom used in
preliminary cost estimation of construction projects.
It should be emphasized that irrespective of the cost estimation method chosen, cost
estimates in construction projects often carry factors which affect decisions to start or quit
projects and are caused, for example, by various political influences, too pessimistic attitude
to the projects shown by people who prepare estimates and the experience of these people in
producing cost estimations for untypical projects. In addition, people who estimate costs
know that the more accurate the breakdown of the entire project into specific tasks or subtasks,
the more accurate cost estimates. Besides, the following phenomena may be mentioned
as factors contributing to unreasonable cost estimates, i.e. over-optimism, inaccurate
identification of risk areas, inaccurate identification of required expenditure. Therefore, cost
estimates should be given special attention, no matter whether they concern preliminary
projects, main projects or detailed projects, as the criticism caused by a failure to meet
assumed costs is often used by numerous stakeholders to give an unfavourable opinion about
the entire project. In general, this is about a risk of deviations of actual costs incurred during
the project execution from planned costs. Such deviations may be calculated by means of
specific quantitative methods and risk measures23
.
CONCLUSION
In the construction industry in Poland, the selection of an appropriate cost estimation method
for a specific investment project is largely determined by two key factors, i.e. the type of
project (a new project, a project based on new technologies, a project similar to other projects,
a labour-intensive project or a material intensive project), as well as the competence,
knowledge and experience demonstrated by the people who produce the estimates. Every time
the selected method should lead to reliable project cost estimates, irrespective of a project
execution stage. In practical terms, well-estimated costs are the core of every project budget.
If costs are estimated at the first (initial) phase of a project lifecycle, the figures obtained will
always be approximate and calculated for aggregate costs. This is most frequently connected
19
Webpage: http://www.esekocenbud.pl/index2.php, dated 30.12.2009.
20
M. Pawlak: Op. cit., p. 118 and B. Nita: Op. cit., p. 260.
21
Z. Szyjewski: Zarządzanie projektami informatycznymi. Placet, Warszawa 2001, p. 128.
22
Ibidem.
23
See: P. Tworek: Ryzyko wykonawców przedsięwzięć inwestycyjnych. Akademia Ekonomiczna im. K.
Adamieckiego w Katowicach, Katowice 2010, pp. 141-152.
11
with inaccurate definition of project risk areas and expenses needed. These estimates will be
more accurate if the people producing them possess better knowledge of a given project, as
well as specific tasks and subtasks included in this project.
BIBLIOGRAPHY
[1] B. Niedbała: Controlling w przedsiębiorstwie zarządzanym przez projekty. Oficyna
Wolters Kluwer Business, Kraków 2008.
[2] A. Piosik: Zasady rachunkowości zarządczej. PWN, Warszawa 2006.
[3] A. Jaruga, W. Nowak, A. Szychta: Rachunkowość zarządcza, Koncepcje i zastosowania.
Wydawnictwo Społecznej Wyższej Szkoły Przedsiębiorczości i Zarządzania, Łódź 2001.
[4] Appendix to Resolution No. 9/06, passed by Accounting Standards Committee of 18
September 2006 on adoption of National Accounting Standard No 3 ‘Unfinished construction
services”, 2006 Official Gazette of the Ministry of Finance, No. 13, item 93, point II.1
[5] C. Drury: Rachunek kosztów. PWN, Warszawa 2003.
[6] M. Łada, A. Kozarkiewicz: Rachunkowość zarządcza i controlling projektów.
Wydawnictwo C.H. Beck, Warszawa 2007.
[7] Accounting Act of 29 September 1994, 2002 Journal of Laws No. 76, item 694 as
amended, art. 3 par. 1 point 31.
[8] Accounting Act of 29 September 1994, 2002 Journal of Laws No. 76, item 694 as
amended, art. 28 point 3.
[9] J. Kalinowski: Kompendium wiedzy o Krajowym Standardzie Rachunkowości nr 3
Niezakończone usługi budowlane. Analizy-komentarze-przychody, Difin, Warszawa 2007.
[10] Międzynarodowe Standardy Sprawozdawczości Finansowej a ustawa o rachunkowości –
podobieństwa i różnice. Edited by A. Jarugowa. Stowarzyszenie Księgowych w Polsce,
Warszawa 2006.
[11] Appendix to Resolution No. 9/06, passed by Accounting Standards Committee of 18
September 2006 on adoption of National Accounting Standard No 3 ‘Unfinished construction
services”, 2006 Official Gazette of the Ministry of Finance, No. 13, item 93, points II.1 and
VI.3.
[12] E. Nowak, R. Piechota, M. Wierzbiński: Rachunek kosztów w zarządzaniu
przedsiębiorstwem. PWE, Warszawa 2006.
[13] International Financial Reporting Standards 2004, International Accounting Standard No.
23, § 12.
[14] M. Pawlak: Zarządzanie projektami. PWN, Warszawa 2007.
[15] B. Nita: Rachunkowość w zarządzaniu strategicznym przedsiębiorstwem. Oficyna
Wolters Kluwer Business, Kraków 2008.
[16] B.J. Madauss: Handbuch Projektmanagement. Schäffer-Poeschel Verlag, Stuttgart 1994.
[17] Webpage: http://www.esekocenbud.pl/index2.php; dated 10.02.2012.
[18] Z. Szyjewski: Zarządzanie projektami informatycznymi. Placet, Warszawa 2001.
[19] P. Tworek: Ryzyko wykonawców przedsięwzięć inwestycyjnych. Akademia Ekonomiczna
im. K. Adamieckiego w Katowicach, Katowice 2010.
Dorota Adamek-Hyska, M.E. Piotr Tworek, Ph.D.
University of Economics in Katowice University of Economics in Katowice
Faculty of Finance and Insurance Faculty of Finance and Insurance
Department of Accounting Department of Investments and Real-Estates
1 Maja 50 Street, 40-287 Katowice, Poland 1 Maja 50 Street, 40-287 Katowice, Poland
dorota.adamek-hyska@ue.katowice.pl piotr.tworek@ue.katowice.pl
12
THE ANALYSIS OF THE CORPORATE FINANCIALAND TAX
ACCOUNTING IN THE EU AND THEIR HARMONIZATION
Beáta Blechová
ANNOTATION
In some EU Member States, there is a long and complex relationship between financial and
tax accounting, which can be significantly affected by the introduction of new international
financial reporting standards such as IAS/IFRS (International Accounting Standards/
International Financial Reporting Standards). This article therefore aims to analyze the
relationship between financial accounting and reporting for corporate income tax purposes in
the EU and also explore the effects of adopting IAS/IFRS on tax accounting within the EU. At
the same time also reflects on the possibilities of effective influencing the further
development of the relationship between financial and tax accounting in connection with the
growing influence of IAS/IFRS and possible harmonization of the tax base in corporate
income tax.
KEY WORDS
Financial accounting, tax accounting, harmonization of financial and tax legislation,
IAS/IFRS, CCCTB, convergence of financial and tax accounting.
JEL classification: H25, H71, M41
INTRODUCTION
One area that has seen an unprecedented level of international coordination and
harmonization in the last decade is the field of accounting. The emergence of International
Accounting Standards/International Financial Reporting Standards (IAS/IFRS) and in
particular the commitment by the European Union (EU) to mandate the use of IAS/IFRS for
certain EU entities has set in motion a series of changes in global accounting. Global and EU
accounting developments have also created very specific challenges for tax authorities,
because historically, accounting figures have formed the starting point of tax calculations in
many countries. The introduction of IAS/IFRS in Europe introduces a whole new set of
accounting standards which should be assessed by tax authorities to determine whether or to
what extent accounting figures may be appropriate to use in tax calculations. Close
interconnection of the data that forms the input to the corporation financial and tax accounting
brings to the conclusion that these two systems should be closely linked, but this not too
corresponds with the fact, that both of these systems serve to substantially different purposes.
The content of this paper is an attempt to analyze this issue and formulate conclusions about
the relationship between financial and tax accounting, which would respond to the facts found
in the analysis.
AIM AND METHODOLOGY
This article aims to assess the effectiveness of the close interdependence of tax and financial
accounting and to verify validity of hypothesis, that this “close link is advantageous and
therefore desirable with regard to reducing the administrative burden in the area of
financial and tax reporting”.
For this assessment is primarily used method of analysis focused on:
- analysis of the major functions of financial and tax accounting,
13
- analysis of the current degree of harmonization of each of these accounting systems within
the EU,
- analysis of the arguments for convergence or separation of the two accounting systems.
Using the methods of synthesis of the findings identified through these analyses are then
phrased the conclusions about the suitability of the close link these two accounting systems
and is assessing the validity of initial hypothesis about the effectiveness of their close
relationships.
RESULTS
These key findings that emerged from analyses can be summarized as follows:
- main functions of the two accounting systems are quite different and in many cases even
contradictory, so that their interdependence can lead to distortion of their desired outputs,
- degree of harmonization of these accounting systems within the EU is significantly
different, where the unification of financial reporting has been modified by the existence of
international accounting standards IAS/IFRS as well as a variety of control acts of EU
Community law („acquis communautaire“), while the tax reporting system is not yet
harmonized, and the harmonization activities undertaken in this area by the European
Commission do not find desirable support of the majority of Member States, which
consider the tax policy as an internal matter for each state,
- further continuous development of international accounting standards IAS/IFRS is focused
on improving financial reporting function, which has a different mission and aims than tax
reporting, whose needs this development does not take into account, which greatly
complicates the possibility of continuous maintenance of close links between these systems
and increases the administrative burden of it,
- development of IAS/IFRS provides a private company, whose activities may not be in line
with the wishes and intentions of governments in the EU Member States, relating to tax
systems, which represent a significant element of fiscal policy of these states.
The findings gained during the analysis leads to the conclusion, that the close
interconnection of the two accounting systems is not appropriate, as does not reduce the
administrative burden in this area, but rather causes its growth and unwanted interaction
of these systems which will have a negative effect on the proper functioning of these
systems, whose objectives are different. This conclusion does not confirm the validity of the
hypothesis set out in the introduction, that the close interconnection of these two systems is
advantageous and therefore desirable.
The analysis of major tasks which should fulfill the financial and tax accounting
The main task of the corporation's financial accounting is the mandatory disclosure of
annual accounts to interested parties (owners, financing banks, business partners,
employees, etc.). Material of IASB [1] from 2010 as the main objective of financial
statements considers:
- providing information about the financial position, performance and changes in financial
position of the enterprise, that are useful for a wide range of users, who carry out economic
decisions,
- displaying the results of careful and responsible management or results that reflect
management responsibility for the entrusted resources.
In EU Member States, the principles for determining accounting profit are derived from the
relevant provisions of Community law (acquis communautaire), relating to financial
accounting, from implementation of these provisions in national laws, from international or
national accounting standards and from generally accepted practices, for details see e.g.
14
material [2]. The main objective of financial accounting, especially when is based on
IAS/IFRS, is to evaluate the company's ability to generate profits in the future, as a result of
the success (or failure) of the company in managing its capital, which is reflected in its
balance sheet.
The main task of the corporation's tax accounting is compulsory submission of tax returns
from corporate income to tax authorities. Taxable profit (tax loss) is the difference of taxable
income and tax expenses, calculated according to binding tax rules set out by the tax
authority, from which is paid the corporate income tax. In EU Member States, the principles
for determining the taxable income are derived from international tax law (e.g. bilateral
agreements between EU Member States and other countries regarding the treatment options of
double taxation of profits), from the national tax laws and regulations in various states, from
judicial decisions and practice of the courts and from generally accepted practices. The main
objectives of tax accounting include:
- providing the necessary amount of revenue for the state budget,
- redistribution of income, for example higher taxes on the rich than the poor,
- redistribution of resources, for example by encouraging certain types of investments or
“generous” provision of depreciation for tax purposes in certain regions,
- political or paternalistic objectives such as taxation of tobacco products and alcohol in order
to discourage their consumption,
- stabilizing the economy, such as reducing tax rates, where the recession will come.
The historical development so resulted in a spectrum of approaches in the EU Member States.
At one end of the spectrum there are Member States that maintain tax and financial accounts
completely separate. At the other end of the spectrum are the Member States which have
established a direct legal relationship between the financial and tax accounting to prevent the
creation of two different sets of rules. In this case, there is used either “positive” approach, in
which tax legislation continues to carefully targeted aspects of financial accounting and
accepts these aspects either with regard to their text or on their concept, or “negative”
approach, whereby tax legislation adopted financial accounting as a starting position and then
adjust them by exclusion of those aspects of financial accounting, which are not suitable as a
basis for calculating taxable profits.
The analysis of harmonization degree of financial and tax accounting in the EU
While in the area of financial accounting in EU exists already a certain common platform, in
the field of tax accounting such a common platform yet does not exist. In other words, the
policies of Member States relating to financial accounting, has been strongly influenced by a
number of provisions of Community law, while the choice tax policy has a much greater
flexibility.
The harmonization of financial accounting in the EU over time become a means, which
through increased transparency and comparability of financial reporting, that such
harmonization would imply, contributed to the facilitation of freer trade and capital
movements between Member States. A certain degree of harmonization of financial
accounting has been achieved by introducing a series of accounting guidelines and regulations
laying down common requirements for financial accounting, which must respect all EU
Member States. In particular this means the amended directives and regulations as instruments
of Community law, concerning the annual accounts of certain types of companies (Fourth
Council Directive No. 78/660/EEC from 1978), the consolidated financial statements
(Seventh Council Directive No. 83/349/EEC from 1983), the financial statements and
15
consolidated financial statements of banks and other financial institutions (Council Directive
No. 86/635/EEC from 1986), the annual financial statements and consolidated financial
statements of insurance companies (Council Directive No. 91/674/EEC from 1991) and using
of International Financial Accounting Standards IAS/IFRS (] Regulation (EC) No 1606/2002
of the European Parliament and of the Council of 19 July 2002). These standards are often
described as “investor-oriented” accounting standards, whose main objective is to make
available the financial information for provider of venture capital, so they can make informed
decisions regarding the companies, in which the venture capital was invested. Investor focus
IAS/IFRS is evident from some their basic properties, to which can be included in particular
the focus on the balance sheet, fair value accounting and substance over form approach
Harmonization of the corporate income tax accounting in the EU is the subject of intense
interest the European Commission (EC) for more than 10 years, as this sees in the
harmonization of national tax systems in the area of corporate tax a tool to help reduce the socalled
“compliance costs”. These arise in multinational companies operating in several EU
Member States, because of the need to adjust the calculation of its tax obligations to different
tax systems existing in these States. In the EU is currently 27 different rules for calculating
corporate income tax and for companies that operate simultaneously in several Member
States, it causes the emergence of the high compliance costs. The EC believes that the
creation of a common tax base would allow companies to fall them away a portion of these
costs, which could increase the amount of cross-border activities and investment and thereby
also increase the competitiveness of European multinational companies, new jobs creation
and higher economic growth. Thus already in 2001 the EC presented a proposal to create the
Common Consolidated Corporate Tax Base (CCCTB), but since then it has been unable to
find enough support among the Member States. In March 2011 EC introduced the document
COM(2011) 121 final: “Proposal for a Council Directive on a common consolidated
corporate tax base CCCTB [3]. The Commission expects that the proposal for a directive
could be adopted unanimously in 2013 and its implementation would then be carried out in
2013 - 2016th
.
Comparison of the arguments for and against the convergence between financial and tax
accounting
One of the principal arguments for the convergence of fiscal practices and financial
reporting practice is the efficiency of administration. If both systems follow the same rules
of accounting is needed to operate (and verify) only once. The full benefits can be achieved
only if the tax rules are exactly the same as the rules of financial reporting, in other words, if
there are no tax rules.
Another advantage of convergence is that tax implications may limit the natural tendency
of some companies overstate profits. This argument likely involves above all of publicly
traded groups, because other companies have less incentive to overstate profits. In the absence
of harmonization of tax and financial reporting, tax system may suffer by the company
attempt to show the highest costs or losses, that are convenient for them in terms of taxation,
but do not meet the goals of financial reporting to present as objectively as possible the
economic efficiency of these companies.
Another argument for the harmonization is ensuring fair distribution of profits between
investors and the state. If the purpose of financial reporting was in the calculation of
distributable income, then there exists a strong argument for harmonization of the calculation
of taxable income with this calculation. This means that it would be fair that the share of
16
profit allotted to investors and the share allotted to the state would calculated from the same
profit. But the purpose of financial reporting (at least according to IAS/IFRS) is not to
determine distributable profit or taxable income.
On the contrary, the basic argument for the divergence of the financial accounting and
income tax system is the difference between the purposes of these systems described above.
Another reason for this separation is the need to protect the financial reporting against the
tax “pollution” (negative tax effect). If the company is profitable and does not think with
decrease the tax rates, then management is motivated to charge a maximum annual cost for
tax purposes, although they are economically unjustified.
Further reason to preserve the differences of financial and tax accounting system is the
possibility of using different financial reporting rules for different types of entities, such as
publicly traded and not traded companies, where the main justification for a different
approach is that financial reporting typically serves for another purposes in companies with
thousands of shareholders than in companies that have no shareholders. If the purposes of
financial statements are different, it would probably be different also the ways of their
assembling. The simplest would be a total exemption of small publicly not traded companies
from the statutory financial reporting with the fact that these companies would have led only
to their accounts in accordance with the tax requirements. The strict separation the tax and
financial reporting would also allow for some companies to use IAS/IFRS in their
jurisdiction, while other companies in this jurisdiction would continue reporting in accordance
with relevant national accounting rules, where both groups would be come to the common tax
base.
The difference in financial and tax accounting system will also facilitate the
implementation of changes in these systems. If there is a strong link between financial
reporting and taxation, the tax rules can not be changed, without such a change had impact on
unwanted accounts and vice versa.
CONCLUSION
By comparing the reasons for and against close interconnection of financial and tax
accounting we can conclude that the negative impact, that brings close interconnection of
these systems are much more significant than the positives. Similar conclusions also present
e.g. the authors J. Freedman [4], [5], F. Gielen and J. Hegarty [6], F. Roedler [7] and W.
Weaver [8]. It is therefore important for Member States where there is a strong relationship
between the two systems to review the current level of this relationship, because maintaining
the status quo could have detrimental consequences, such as unintended consequences on the
economy, unforeseen effects on tax collections, the development of a yet more complex tax
accounting system etc. This is especially true in those countries where there is more
widespread mandatory use of IAS/IFRS by different groups of companies, since the
amendments to IAS/IFRS and/or national accounting standards may have a knock-on effect
on the determination of taxable profit, so an innocuous change to financial accounting may
threaten an economic activity and have an unpredictable impact on tax revenues.
From the above it is clear that it is almost inconceivable that IAS/IFRS could be adopted
wholesale and without qualification as a basis for the determination of taxable profit. Rather,
if a tax accounting system is to be aligned to any degree with IAS/IFRS (financial
accounting), this will almost inevitably involve selecting certain features of IAS/IFRS which
provide a workable basis for computation of taxable profit. The resulting tax accounting
17
system will almost inevitably become more complex, and the strong relationship between
corporate financial and tax accounting system can thus cause that neither of these accounting
systems will achieve its basic goals.
Therefore, already from the very beginning should be given significant attention to the
macroeconomic implications of convergence or isolated tax and financial accounting. This
decision should only be made after considering these implications at the highest level within
the relevant government agencies and a thorough consultative interaction between these
agencies and the relevant private sector advisers and interest groups, taking into account the
current situation in that Member State and the outcome of the negotiations in EU regarding
CCCTB.
BIBLIOGRAPHY
[1] Conceptual Framework for Financial Reporting 2010. IASB, September 2010.
http://www.iasplus.com/standard/framewk.htm
[2] Gielen, F., Plaats, E., Barros, A., Tranter, J. (2007): Corporate Sector Accounting and
Auditing within the Acquis Communautaire — A Building Block of the Internal Market.
Acquis paper 5-18-07.indd S1, World Bank, Washington 2007
http://siteresources.worldbank.org/INTCENFINREPREF/Resources/Acquispaper.pdf
[3] COM(2011) 121 final: Proposal for a Council Directive on a Common Consolidated
Corporate Tax Base (CCCTB). SEC(2011) 315, 316 final. European Commission,
2011/0058 (CNS), Brussels, 16.3.2011
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2011:0121:FIN:EN:PDF
[4] Freedman, J. (2004), Aligning Taxable Profits and Accounting Profits: Accounting
standards, legislators and judges, eJournal of Tax Research, Vol. 2, No. 4.
http://nzlii.austlii.edu.au/au/journals/eJTR/2004/4.html#Heading7
[5] Freedman, J. (2008), Financial and Tax Accounting: Transparency and 'Truth'. Working
Paper No 02/2008, University of Oxford, Faculty of Law, Legal Studies Research Paper
Series,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1085862
[6] Gielen, F. and Hegarty, J. (2007), An accounting and taxation conundrum - a paneuropean
perspective on tax accounting implications of IFRS adoption, The World Bank,
Centre for Financial Reporting Reform, September 2007, Vienna, Austria
http://siteresources.worldbank.org/EXTCENFINREPREF/Resources/Taxation_
Conundrum.pdf
[7] Roedler, F. (2006), The relationship between corporate income tax reporting and annual
accounts: Current Approach in Austria, Presentation at the World Bank REPARIS
Workshop on 14 March 2006, Vienna, Austria.
[8] Weaver, W. (2006), The Relationship between corporate income tax reporting and
IFRS: The U.K experience, Presentation at the World Bank REPARIS Workshop on
14 March 2006, Vienna, Austria
Ing. Beáta Blechová, Ph.D.
Silesian University in Opava,
School of Business Administration in Karviná,
Univerzitní nám. 1934/3,
733 40 Karviná,
Email: blechova@opf.slu.cz
18
A NONPARAMETRIC SERIAL CORRELATION TEST OF THE
CENTRALAND EASTERN EUROPEAN STOCK MARKETS
Gábor Bóta, Mihály Ormos
ANNOTATION
We test weak form efficiency for the Central and Eastern European stock markets applying
runs tests. We investigate the price changes of seven CEE markets (Austria, Hungary,
Estonia, the Czech Republic, Poland, Romania, Slovakia) for the period 1991-2011. In order
to make the results for these markets directly comparable with results for other developed
markets, Germany, United Kingdom and the USA were also incorporated. Our results present
contrarian pricing behavior in the investigated countries while instead of the mean reverting
(negative autocorrelation) pricing process experienced in the US or in the UK we measure
positive autocorrelation especially in the early years of the investigated stock exchanges.
However we document continuous development in the efficiency of pricing. Our results show
that if the prices are recalculated in USD the significance of inefficiency measures are
weakening or even vanishing.
JEL classification: G14
KEY WORDS
Market efficiency, CEE countries, Runs test
INTRODUCTION
By the original definition if Efficient Market Hypothesis (EMH) holds prices are not
predictable, since supposing rational well-informed investors who properly anticipate the
prices based on their knowledge generate randomly fluctuating prices (Samuelson, 1965).In
order to test the EMH Fama (1970) classified three different forms of market efficiency,
which were slightly modified later (Fama 1991) to the three forms of market efficiency to
tests for return predictability, event studies and tests for private information.
Fama (1965) provided tests of market efficiency by using serial correlations and runs tests and
found that the degree of dependence in daily price changes was not strong enough to increase
the expected profits of investors. Most of the tests about return predictability concentrated on
developed stock markets; only some authors investigated the problem in emerging markets as
well. Harvey (1994) investigated 20 emerging countries (three European among them:
Greece, Portugal and Turkey) in the period from 1976 (or later where data was not applicable)
through 1992 and observed low correlations with returns of developed countries and found
these markets more predictable than developed ones, which can be caused by the
segmentation of these markets from world capital markets. Kawakatsu and Morey (1994)
examined the effects of liberalization in 16 emerging countries (the Czech Republic and
Hungary among them) and found that the liberalization hadn’t improved efficiency, hence
these markets were already efficient before the actual liberalization. Huber (1997) rejected the
random walk hypothesis on the Vienna Stock Exchange for the period 1987-1992 but returns
in years 1990-1992 were closer to random walk than the whole period.Smith and Ryoo (2003)
accepted the random walk hypothesis only for Turkey and rejected for four other European
emerging economies (Greece, Hungary, Poland and Portugal) for the period 1991-1998.
Worthington and Higgs (2004) tested weak form market efficiency in twenty European
markets (sixteen developed countries including Austria, Germany and the UK in the period
19
1987-2003 and four emerging ones including the Czech Republic, Hungary and Poland in the
period 1994-2003) and found that daily returns followed random walk only in four of the
developed (Germany and UK among them) and one of the emerging countries (Hungary).
Borges (2010) examined stock market indexes of six European countries in the period 1993-
2007 and found Germany and Spain weak form efficient, while the results for Portugal,
Greece, France and the UK were mixed.
The goal of this paper is first to examine whether the Central and Eastern European stock
markets are weak for efficient, second how this efficiency evolved during the past two
decades and third if there are any departures from efficiency these are the same as in the
developed markets or we can find different anomalies.
AIM AND METHODOLOGY
We focus on return predictability on the stock exchanges of the Central and Eastern European
region, investigating daily closing prices from 02/January/1991 (or from a later date from
when data is available) to 30/December/2011 of the indexes of the following stock markets:
ATX – Vienna Stock Exchange, Austria; BUX – Budapest Stock Exchange, Hungary; OMX
Tallinn (EST) – Tallinn Stock Exchange, Estonia (from 03/June/1996); PX – Prague Stock
Exchange, the Czech Republic (from 06/April/1994); RMBET (RM) – Bucharest Stock
Exchange, Romania (from 19/September/1997); SAX16 (SAX) – Bratislava Stock Exchange,
Slovakia (from 14/September/1993); WIG20 (WIG) – Warsaw Stock Exchange, Poland (from
18/April/1994).
The indexes are calculated based on the prices of the stocks in their baskets denominated in
local currencies, in order to get comparable results with the international findings we also
calculated the returns in US dollar terms. Beside the aforementioned indexes some others
representing developed markets were also incorporated, again in order to make the results for
the region more comparable: DAX – Frankfurt Stock Exchange, Germany; FTSE100 (FTSE)
- London Stock Exchange, United Kingdom; S&P500 (SP) – United States.
All of the indexes are capitalization weighted, and are total return indexes, so returns are
calculated assuming dividends paid by the stocks are reinvested. The source of the data is
Thomson Reuters Datastream.
Return predictability can easily be investigated by runs tests. If a run is defined as a series of
successive price changes in the same direction, the number of runs in the series can be
compared to the expected value that would be generated by a random process. If the actual
number is below the expected value it shows positive correlation (as the sequences are longer
than the random process’) while a number result above the expected value indicates negative
correlation (as the sequences are shorter than the random process’).
Runs tests are not sensitive to extreme observations as only the direction of changes are taken
into consideration the size of changes are not. Runs test is a nonparametric tests, so the returns
are not required to be distributed normally.
The returns can be measured in absolute terms or compared to the mean return. In the first
case returns above zero are considered as positive returns, in the second case returns above
the mean return of the investigated period are considered as positive changes. So the question
is whether we measure changes as returns or abnormal returns, but given the fact that the
mean of daily returns is close to zero, this differentiation does not have significant impact on
the results (and our actual results confirm that expectation), the second approach accounts for
the effect of time drift in the series of returns. We made the tests using both approaches in
defining the positive or negative changes.
If NA denotes the number positive changes (positive returns according to the first approach or
returns above the mean return of the period according to the second approach), NB denotes the
negative changes, N the number of observations (N=NA+NB) and R the actual number of runs.
20
For large sample sizes the test statistic is approximately normally distributed with the
following parameters (Wald-Wolfowitz 1940):
RESULTS
As the results show in Table 1 and Table 2 the null hypothesis of randomness is rejected at
1% level for the whole period for all CEE indices except WIG, and at 5% level for S&P500.
But while the actual number of runs are fewer than the expected for CEE indices which
indicates positive autocorrelations, for S&P500 the actual number is higher than expected
indicating negative autocorrelation for the period 1991-2011. The null hypothesis cannot be
rejected for WIG, DAX and FTSE.
If we look at the returns measured in USD in Table 4 we have the same result of rejection at
1% for PX, SAX, RM, EST and no rejection for FTSE. For ATX and BUX the null
hypothesis can be rejected only at 10% level for returns measured in USD, with fewer number
of runs than expected. For DAX there is a 5% level rejection for USD terms with higher
actual than expected runs indicating negative autocorrelation.
It is also worth to mention that whether we define positive and negative returns relative to
zero or relative to the mean return of the period doesn’t influence the results, the only index
was BUXUSD where the level of rejection was different: 10% for positive-negative returns
and 5% for returns above-below the mean return1
.
We performed the runs tests nor only for the whole period but for 5 year subperiods starting
each year as well (see Table 3 and 4). For ATX and BUX the null hypothesis can be rejected
only for the periods before 1999, for WIG before 2000 and for PX before 2004 (with less runs
than expected for all cases) so in the last decade these indices seems to follow random walk
with the exception of WIG for the period 2007-2011 where the null hypothesis can be rejected
with more than expected runs. For SAX, RM and EST the null hypothesis can be rejected for
most of the 5 year sub periods (except 1993-1997, 1994-1998, 2000-2004, 2001-2005 for
SAX and 2006-2010, 2007-2011 for RM) with fewer than expected runs (indicating positive
autocorrelation) for all cases and at 1% level for most. For DAX, FTSE and S&P500 the null
hypothesis is accepted for almost all periods before 2000 (except FTSE for 1997-2001). For
DAX and FTSE the null hypothesis is rejected for years 2002-2010, for S&P500 for years
1999-2011 with higher than expected number of runs for all these rejections indicating
negative autocorrelation similarly to the finding of De Bondt and Thaler (1987).
For DAXUSD the null hypothesis can be rejected only for periods before 1999, while for
FTSE there is only one period (2004-2008) when the null hypothesis can be rejected, so the
results for USD returns for these two indices differ significantly from results for local
currency returns. Among the CEE indices only WIG has different results for local currency
and USD measured returns for the 5 year periods, the null hypothesis can be rejected for more
periods for the WIGUSD than WIG.
1
Thisisthereasonwhywepresentonlytheresultofruns test wherethereturns are compared to themeanreturns. As
werun thetest whenthesequences are measuredrelative to zeroas well these results are availableuponrequest
21
Table 1.Runstestsforreturnsmeasuredinlocalcurrencies
So the randomness in daily returns cannot be rejected by runs test for the examined CEE
markets. The results of runs tests for these markets are mixed in the literature. Andor et al.
(1999) investigated the price changes in the Budapest Stock Exchange for the period 1990-
2000 and they found actual number of runs close to the expected values.Worthington and
Higgs (2004) examined 20 European capital markets, among them Austria, Germany and the
UK, (for the period 31/12/1987-28/05/2003), the Czech Republic and Hungary (for the period
30/12/1994-28/05/2003) and Poland (31/12/1992-28/05/2003), and accepted the null
hypothesis of randomness only for Germany and the UK.Borges (2010) investigated six
European markets: France, Germany, Greece, Spain, Portugal, UK for the period 1993-2007
and found that the actual number of runs using daily data were significantly below the
expected value in Greece and Portugal, while for other four countries the actual number was
above the expected, but the differences were not significant.
22
Table 2.Runstestsforreturnsmeasured USD
CONCLUSION
In this paper we find that the examined Central and Eastern European stock market indexes
show continuous development in terms of weak form market efficiency during the past two
decades. The results of runs tests show that the null hypothesis of randomness can be rejected
mostly for years before 2000; however, since then the daily returns of the indexes follow a
random walk process. In the periods when daily returns do not follow random process the
actual number of runs are lower than expected indicating positive autocorrelation, on the
contrary the rejection of the null hypothesis of randomness in the case of developed countries
were associated negative autocorrelation.
Not only for investment decisions is the efficiency of capital markets relevant but for
corporate finance analyses as well. Berk and DeMarzo (2011) summarize the implications of
23
Efficient Market Hypothesis from corporate viewpoint as firms should invest only in projects
with positive net present value in order to maximize its shareholders’ wealth.
Based on the results presented in this paper corporate financial decisions should not differ in
CEE countries from the decisions in developed countries.
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Market, PeriodicaPolytechnica Social and Management Sciences, 7(1), pp. 29–45.
Berk, J. &DeMarzo, P. 2011, Corporate Finance, Global edition, 2nd ed., Pearson
Borges, M.R. 2010. Efficient market hypothesis in European stock markets.The European
Journal of Finance, 16(7), pp.711–726.
De Bondt, W.F.M. &Thaler, R.H. 1987. Further evidence on investor overreaction and
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Fama, E.F. 1991. Efficient capital markets: II. Journal of Finance, 46(5) pp.1575–1617.
Harvey, C.R., 1994 Predictable risk and returns in emerging markets, National Bureau of
Economic Research, Working Paper No. 4621, January 1994
Huber, P. 1997. Stock market returns in thin markets: evidence from the Vienna Stock
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Kawakatsu, H., & Morey, M.R. 1999. An empirical examination of financial liberalization
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Samuelson, P.A. 1965. Proof That Properly Anticipated Prices Fluctuate Randomly,
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Wald, A. and Wolfowitz, J. 1940. On a Test Whether Two Samples are from the Same
Population. Annals of Mathematical Statistics, 11(2), pp.147–162.
Worthington, A.C. & Higgs, H. 2004. Random walks and market efficiency in European
equity markets.Global Journal of Finance and Economics, 1(1), pp.59–78.
Full: name:GáborBóta
Institution: Department of Finance, Budapest University of Technology and Economics
Street :Magyartudósokkörútja 2
City:1117 Budapest, Hungary
Email:bota@finance.bme.hu
Full name: Mihály Ormos
Institution: Department of Finance, Budapest University of Technology and Economics
Street: Magyar tudósokkörútja 2
City: 1117 Budapest, Hungary
Email: ormos@finance.bme.hu
24
THE INSURANCE MARKET IN EUROPE
Viktória Čejková, Svatopluk Nečas
ANNOTATION
The paper showsthe characteristicsof insurance marketinEurope, aswell as ofCEA insurance
marketeconomiesandthe EUsingle insurance market. Variousindicators ofthe level ofthe
insurance marketare used in the paper. In this paperwepresentdata on the levelof the insurance
marketin several advanced economies, withparticular regard todata onindicators ofthe level
ofthe insurance marketin Slovakia andthe Czech Republic.
KEY WORDS
insurance market, insurance marketlevelindicators, premium written, insurance penetration,
insurance companies,life insurance, non-life insurance
JEL classification: G220
INTRODUCTION
The insurance marketinEurope can bedefinedin several ways. For
example:geographicallyasthe insurance market of all the European countries, oras
theinsurance market of27 MemberStates (EU single insurancemarket), or asthe insurance
marketof the MemberStatesCEA(Europeaninsurance and reinsurancefederation), in
2011already with number of 34 in(CEA, 2011). In this paperwe use thecombinedmethods
ofdefinition ofdata on the levelof the insurance marketinEurope.
AIM AND METHODOLOGY
The paperis to give apicture of developmentsin the insurance marketinEurope, based on
selectedindicators in the years2000-2010,with special reference todata on the levelof
indicatorsof the insurance marketin Slovakia and in the Czech Republic. In order toachieve
the aim, we will use the methods of analysis, synthesis andcomparison.
RESULTS
The insurance marketandinsurance industryhasineachmarket economy majorstatuswith
specific objectivesandimportance.It is aspecial branch, in other words, service sectorof
theeconomy, which helps eliminate therisksaffecting theaktivity ofpeople. Theinsurance
industry consists ofinsurance companies, theirclients, insurance brokers,
insurancesupervision, insuranceassociationsandother subjects. (Čejková, Martinovičová,
Nečas, 2011)
The Insurance Market and itslevelindicators
If goes about the number of companies carrying out insurance activities, it had been declining
steadily for a decade, after a wave of mergers and acquisitions at the end of the 1990s
following market liberalisation and deregulation in the EU. In 2010, howerver, this trend was
reversed andthere were5350insurance companies in theCEAcountries. (CEA, 2011) Three
biggest countries(England,Germany,France)with the largestmarketsalso had the
mostinsurers.The potentialandthe levelof the Europeaninsurance market can be proved by
some indicators. For instance: share ofpremiums writtentogross domestic product(insurance
25
penetration) orpremiums writtenper capita (insurance density)andother indicators. Level
indicatorsof insurancemarket assessmarketcompletely. These arethe indicators usedin
developed economies. They are primarily used asthe essentialindicators those are
trackedseparatelyandin thelife insurancesector, non life insurance:
− Premium written,
− Insurance benefit,
− Loss ratio,
− Insurance penetration,
− Concentrationof the insurance market. (Čejková, Martinovičová, Nečas, 2011)
The abovebasic indicators ofmaturity ofthe insurancemarket,insurance
marketconcentrationindicatorusedoutsideof the CzechandSlovak insurance market,inmodified
formas a percentage ofrepresentation of5 or 10largest insurersin the relevantinsurance
market.The insurance marketcan be monitoredand evaluatedalsobyadditional
indicators.(Čejková, Martinovičová, Nečas, 2011)
Otherindicatorscaninclude, for example indicator ofpremiums writtenper capita, whichisin
CEA member countriescommonlyused, is vice versa not indicated in the annualreport of the
SlovakInsurance Association, thus not used in insurance practice of Slovak Republic.
TheAnnual Reportof the CzechInsurance Associationin 2009 mentionsthat the Czech
RepublicandSlovakiaare among theleadersin Central and EasternEurope. In theCzech
Republic,this indicator isaboutone-thirdhigher(EUR 499instead of EUR 366inSlovakia). Even
so, it’s only one-fourththe average inthe EU(EUR1989). (ČAP, 2010) If we look at figures
published by Swiss Re for the year 2010, the situation stays almost the same (Czech Republic
–USD753, Slovakia –USD481). (Swiss Re, 2011)
When comparinginsurance marketsofcontinents, countries of thesecontinents and insurersof
these countries, it does not meanthatnationalinsurance marketsof individual insurersarewelldefined
bynational borders. On the contrary, eachinsurer'seffort isto extend theoffer andsale
ofits owninsurance productsabroad, not only for reasonsof business, butalsoactuarial(risk
greatervariance). Oftenthe natureof insuranceitselfpredeterminesthis approach; most
tellingexample would bea majorsyndicateof underwritersLloyd'sinsuranceandshipping.
The prosperityandgrowth of the insurancesectoris closely linked tooverall
economicdevelopmentofcountriesandcontinents. The biggestinsurance groupin the European
continent -byindicatorpremiums written -isthe GermanAllianz. Otherentities thatbelong to the
Europeanleader ininsurance, theinsurance companyAXA(F), Generali(I), Zurich(CH),
Prudential(GB), Aegon(NL) ING(NL), AVIVA(GB) andothers(seethetable1).
Table 1 Thelargestinsurance groupsin Europe by premium writtenin 2008
Top 10Europeaninsurers
1.Allianz6.ING
2.AXA7.CNP
3.Generali8.Aegon
4.Zurich9.CréditAgricole
5.Aviva10.Prudential
Source:authors according to CEA. CEA Statistics N°40: European Insurancein Figures,
Data1999-2008[online]. 2010 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/publications/statistics
26
If we look at insurance penetrationin selectedEuropean countries,the developmentof this
indicator ranged at first10 statesfrom7.2 to 10% (datafor 2010)with theexception of a
fewcountries(e.g.United Kingdom, Netherlands, Finland, France). The averageheightof
theindicatorwasin 2008inthe EU8.0%and7.7% inCEA. For moreon the developmentof this
indicatortelldatain Table 2.
Table2Insurance penetrationin selectedEuropean countries(%)
Countries 2000 2002 2004 2006 2008 2010
Switzerland 11.2 12.2 11.2 10.1 9.9 10.0
United Kingdom 15.8 14.9 13.9 15.1 13.6 12.2
Ireland 10.1 8.6 8.0 9.1 7.4 8.2
Netherlands 10.2 9.5 9.9 13.6 12.8 13.2
Finland 8.9 8.5 8.7 8.9 8.6 10.4
France 9.1 8.5 9.5 10.9 9.4 10.7
Denmark 6.3 7.3 8.1 8.5 8.9 8.9
Belgium 7.9 8.3 9.8 9.3 8.5 8.3
Germany 6.4 6.6 6.9 7.0 6.6 7.2
Italy 5.7 6.7 7.3 7.2 5.9 8.1
Czech Republic 2.8 3.2 3.8 3.6 3.6 3.9
Slovakia 2.9 3.3 3.5 3.2 3.1 3.1
The EUaverage 8.4 8.3 8.4 9.0 8.0 CEA
8.2 8.1 8.2 8.6 7.7 8.2
Source:authors according toCEA. CEA Statistics N°40:European Insurancein Figures,
Data1999-2008[online]. 2010 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/publications/statistics and CEA. CEA Statistics N°44:
European Insurance in Figures [online]. 2011 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/uploads/Modules/Publications/european-insurance-in-
figures-2011.pdf
If we look at thepositionof thisindicatorinSlovakia and also inthe Czech Republic,
theachievedlevels (in comparison with EU or CEA average) arelessthanhalf and don’t
correspond to thepossibilitiesand prerequisites for the developmentof insurance
industryinboth countries. It can be assumedthatthe insurance marketsinthe
CRandtheSRhavestillenough scope forsupply extensionof insurance products, particularly in
life insurance.
During the1990s, the growth in premiums writtenin Central and Eastern European
countrieswasabout 35%. In particular,Poland, Slovenia, Hungary, Slovakiaand theCzech
Republic overcomeveryquicklythe consequences oflongabsence ofa market environment.
Somecountries in CentralandEastern Europereachedin totalinsurance
penetrationrelativelygood results(see datain Table3).
27
Table3 Insurance penetrationin selectedcountries of CentralandEastern Europe (%)
Countries 1996 1998 2000 2004 2006 2008 2010
Czech Republic 2.6 3.1 2.8 3.8 3.6 3.6 3.9
Estonia 1.8 1.7 1.7 2.1 2.1 2.3 3.0
Latvia 1.5 2.4 2.0 1.8 1.8 2.1 1.8
Hungary 2.2 2.4 2.9 2.9 3.5 3.4 3.2
Poland 2.1 2.8 2.8 3.0 3.5 4.6 3.8
Slovakia 2.4 3.1 2.9 3.5 3.2 3.1 3.1
Slovenia 4.8 4.7 4.4 5.4 5.6 5.4 5.9
The EU average 7.1 7.3 8.4 8.4 9.0 8.0 Source:authors
according to CEA. CEA Statistics N°40:European Insurancein Figures,
Data1999-2008[online]. 2010 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/publications/statistics; CEA. CEA Statistics N°44: European
Insurance in Figures [online]. 2011 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/uploads/Modules/Publications/european-insurance-infigures-2011.pdf;
ČAP. Výroční zpráva ČAP 2006 [online]. 2007 [cit. 2012-04-26]. Available
at: www.cap.cz/ItemF.aspx?list=DOKUMENTY_01&view=pro+web+Výroční+zprávy
The development of the breakdown of premiums by business sector (life and non-life
insurance) in the countries of CEA seems to be a very interesting issue as well.Comparing
thedevelopmentintransition countries(Czech RepublicandSlovakia), cleardiscrepancy between
the statusof these countriesandin developedeconomiesof Europe, wherethe situation
isalmostexactly the opposite(Slovakia hasa fewpercentlarger share oflife insuranceasCzech
Republic).The development of thisrelationshipis characterized bytheCEAdatain Table 4.
Table4 Development ofbreakdown of premiums by business sector in CEA countries
Years Non-life Insurance(%) Life Insurance(%)
1990 54,8 45,2
2000 35.0 65.0
2005 38.2 61.8
2006 38.7 61.3
2007 36.6 63.4
2008 40.3 59.7
2009 40.2 59.8
2010 40.2 59.8
Source:authors according toČAP. Některé vývojové trendy životného pojištění v Evropě. In
Pojistný obzor. 2002. No. 6, p. 4 andCEA: CEA Statistics N°45: The European Life Insurance
Market: Data 2001-2010[online]. CEA, 2012. [cit. 2012-06-19] Available at:
http://www.insuranceeurope.eu/publications/statistics
Theanalyzeddataof selectedcountriesdiffer greatlyinimportanceandstatusof life insurancein the
relevantmarket andoverall economy. First of all, there is a difference betweenthe countries of
CentralandEastern Europeandthestates of EU.Of course,there are differencesbetweentheold
Member Statesarisingfromdifferenttraditions,popularityof certain financialproducts, forms
ofpensionsandinsurance, tax systemetc.
In Table 5, there are data on premiums writtenper capitainselectedcountries thatjoined the
EUin 2004.
28
Table5Premiums writtenper capita(in EUR) inthecountries of CentralandEastern Europe
Countries 2003 2006 2008 2010
Czech Republic 278 399 506 553
Estonia 124 212 277 317
Hungary 218 312 353 307
Latvia 84 127 210 145
Lithuania 70 125 176 n.a.
Poland 148 253 441 355
Slovenia 639 860 999 1022
Slovakia 187 267 376 380
Average of these countries 219 319 417 n.a.
Average inCEA 1540 1891 1805 1870
EU average(27) 1717 2117 2008 n.a.
Source:authors according to CEA. CEA Statistics N°40:European Insurancein Figures,
Data1999-2008[online]. 2010 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/publications/statistics; CEA. CEA Statistics N°44: European
Insurance in Figures [online]. 2011 [cit. 2012-04-26]. Available at:
http://www.insuranceeurope.eu/uploads/Modules/Publications/european-insurance-in-
figures-2011.pdf
With thenational marketsin theEU and EEA countries,theEuropeaninsurance market isa
unique example ofan integrated insurancespace.Insurerscan nowsell theirproducts onEuropean
markets according to license fromtheir home country.Every Europeancustomercould
theoreticallychoose any of theproducts offeredby insurance companiesof different states.Even
in the U.S. we can notfinda similar systemof functioning ofinsurance market. Commercial
insurance companies that operate there, they must apply in each State of the Union, where
they want to sell their insurance products, the license for insurance activities.
CONCLUSION
In this paperwe describedandpresenteddata on the levelof the insurance marketin several
advanced economies, withparticular regard todata onindicators ofthe level ofthe insurance
marketin Slovakia andin the Czech Republic. According to figures both countries achieve a
distinctly lower level when comparing to insurance markets of advanced European countries.
Further development of theinsurance marketinEuropeispossible andwilldepend on several
factors. In addition, it concernstheintegrationof business andmaximum protection forclientsof
commercialinsurance companies. An importantthemeof integrationandthe gradualunification
ofthe marketis toexpandoffer of insurers and saleof insurance productsabroad.
REFERENCES
[1] CEA.CEA Statistics N°40:European Insurancein Figures, Data1999-2008[online]. 2010
[cit. 2012-04-26]. Available at: http://www.insuranceeurope.eu/publications/
statistics
[2] CEA. CEA Statistics N°44: European Insurance in Figures [online]. 2011 [cit. 2012-04-
26]. Available at: http://www.insuranceeurope.eu/uploads/Modules/Publications/
european-insurance-in-figures-2011.pdf
[3] CEA. CEA Statistics N°45: The European Life Insurance Market: Data 2001-2010
[online]. 2012 [cit. 2012-06-19]. Available at: http://www.insuranceeurope.eu/
publications/statistics
29
[4] ČAP. Některé vývojové trendy životného pojištění v Evropě. Pojistný obzor.ČAP, 2002.
No. 6, p. 4. ISSN 0032-2393
[5] ČAP. Výroční zpráva ČAP 2006 [online]. 2007 [cit. 2012-04-26]. Available at:
www.cap.cz/ItemF.aspx?list=DOKUMENTY_01&view=pro+web+Výroční+zprávy
[6] ČAP. Výroční zpráva ČAP 2009 [online]. 2010 [cit. 2012-04-27]. Available at:
www.cap.cz/ItemF.aspx?list=DOKUMENTY_01&view=pro+web+Výroční+zprávy
[7] ČAP. Výroční zpráva ČAP 2010 [online]. 2011 [cit. 2012-03-03]. Available at:
www.cap.cz/ItemF.aspx?list=DOKUMENTY_01&view=pro+web+Výroční+zprávy
[8] ČEJKOVÁ, Viktória, Dana MARTINOVIČOVÁ, and Svatopluk NEČAS. Poistný trh:
teória i prax. 1. vyd. Bratislava: Iura Edition, 2011. 222 p. ISBN 978-80-8078-399-0
[9] ČEJKOVÁ, Viktória and Svatopluk NEČAS. Poistný trh (Vybrané problémy). 1sted.
Bratislava: Vysoká škola ekonómie a manažmentu v Bratislave, 2008. 103 p. ISBN 978-
80-89143-65-8
[10]SWISS RE. Sigma N°2/2011 World Insurance in 2010 [online]. 2011 [cit. 2012-06-19].
Available at: http://media.swissre.com/documents/sigma2_2011_en.pdf
prof. Ing. Viktória Čejková, PhD.
Ekonomicko-správní fakulta MU
Lipová 41a
Brno
Vysoká škola ekonómie a manažmentu verejnej správy v Bratislave
Železničná 14
Bratislava
cejkova@vsemvs.sk
Ing. Svatopluk Nečas
Ekonomicko-správní fakulta MU
Lipová 41a
Brno
necas@econ.muni.cz
30
EMPIRICAL TEST OF THE CAPM USING LINEAR
REGRESSION
Petr Červinek, Jana Hvozdenská
ANNOTATION
This paper summarizes the results of series of empirical tests of the Capital Asset Pricing
Model (CAPM). The empirical tests were performed for the shares traded in the system SPAD
of the Prague Stock Exchange. CAPM is the equilibrium model of the single-index model.
Therefore we use test of linear regression for single-index model. The results indicate that the
CAPM is not appropriate for modelling the return on the considered shares in the considered
time interval.
KEY WORDS
CAPM, linear regression, analysis of variance
JEL classification: G11, C13
INTRODUCTION
Model CAPM is the equilibrium model of the return on a share related to the return on a stock
market index. It technically represents the single-index model of the return on a share. The
single index is the return on the market. The return on the market is represented by a stock
market index. There are made simplifying assumptions on single-index model. Since there is
assumption that the return on a share is linearly related to the return on a stock market it is
possible to test such single-index model (and thus CAPM as well) using statistical methods
applied to classical linear regression.
AIM AND METHODOLOGY
The aim of the whole empirical testing is to apply the classical linear regression to the singleindex
model. We use the method of least squares to estimate the regression coefficients and
we do also the statistical verification of the obtained models. We carry out the analysis of
variance for all obtained models including the statistical significance of the overall fit checked
by the F-test. Furthermore we test the statistical significance of the regression coefficient
including the confidence interval on different significance levels. We calculate the coefficient
of determination and the adjusted coefficient of determination. We also test the assumptions
of the classical linear regression and of the CAPM. We use MS Excel and STATGRAPHICS
Centurion XV for calculation.
RESULTS
We chose the common stocks listed on the Prague Stock Exchange (PSE) traded via the
system SPAD for empirical tests. Via the SPAD are traded so called blue chips of the Czech
capital market. Actually there are 14 different companies which shares are traded via SPAD.
These are as follows:
Fig.1 Companies traded via SPAD
Name AAA Auto
Group
N.V.
CENTRAL
EUROPEAN
MEDIA
ČEZ,
a.s.
Erste
Group
Bank
Fortuna
Entertainment
Group N.V.
KIT Digital,
Inc.
Komerční
banka, a.s.
31
ENTERPRISE
S LTD.
AG
Ticker AAA CETV CEZ ERSTE FORTUNA KITD KB
Name New
World
Resources
Plc
Orco Property
Group S.A.
PEGAS
NONW
OVEN
S SA
Philip
Morris
ČR a.s.
Telefónica
Czech
Republic, a.s.
UNIPETROL
, a.s.
VIENNA
INSURANCE
GROUP
Ticker NWR ORCO PEGAS PM TELE UNI VIG
Source: author
We assume that stock market index PX is suitable approximation of the Czech stock market.
The range of the tested data was set to time interval from May 11th
, 2011 till May 11th
, 2012.
We used close prices to calculate historical one day returns on all the shares. We used these
historical returns as input data for the tests. The extent of used data was 253 historical values
for each share as well as the PX index.
We proceed from the SML (Security Market Line) in the beta version
( ) iifmfi rrrr εβ +⋅−+= ,
the first-pass regression had the form
imiii rr εβα +⋅⋅+= , where
( )ifi r βα −⋅= 1 .
This form better implies the hypothesis that the return on a share ( ir ) depends only on single
factor, which is the return on the market ( mr ), which is approximated by the return on a stock
market index. The variable fr represents risk free return and the variable iε represents the
random (uncertain) element.
To get unbiased estimation of the regression coefficients we used the least squares method.
The estimated values are as follows:
Fig.2 Estimated regression coefficients
Ticker AAA CETV CEZ ERSTE FORTUNA KITD KB
est iα -0,00007 -0,00126 -0,00012 0,00013 -0,00002 -0,00131 0,00082
est iβ 0,74738 1,56014 0,72196 1,95893 0,52806 0,72922 1,19492
Ticker NWR ORCO PEGAS PM TELE UNI VIG
est iα -0,00147 -0,00291 0,00034 0,00108 0,00016 0,00002 0,00051
est iβ 1,29963 0,96953 0,30441 0,16204 0,42559 0,22382 1,06409
Source: author
The obtained theoretical models were tested on the statistical significance of the overall fit
using analysis of variance and the F-test. We present the analysis of variance of the AAA as
the illustration.
32
Fig.3 Analysis of variance of the share AAA
Source
Sum of
Squares (SS)
Degree of
Freedom (DF)
Mean Square
(MS)
F-Ratio
Regression Model
(M)
0,03121466 1 0,03121466 79,12127511
Error (E) 0,09902368 251 0,00039452
Total (T) 0,13023834 252
Source: author
Values of the F-test statistic (F-Ratio) and F-Values ( )DFEDFMF ;1 α− are in Figure 4 and in
Figure 5. By comparing F-Ratio and the appropriate F-Value for the given significance level
and the given degrees of freedom (1 and 251) we made conclusion that we can reject the idea
that the model is statistical insignificant with 90%, 95% and 99% confidence respectively for
all obtained models.
Fig.4 F-Ratio (Values of the F-test statistic)
AAA CETV CEZ ERSTE FORTUNA KITD KB
79,121 171,752 210,628 521,447 72,977 15,877 396,950
NWR ORCO PEGAS PM TELE UNI VIG
261,553 66,575 45,173 7,571 67,294 37,661 228,202
Source: author
Fig.5 F-Values ( )251;11 α−F
Significance Level 0,1 0,05 0,01
F-Value 2,725626 3,878774 6,736922
Source: author
Further we focused on the test of significance for the regression coefficients iβ because of the
important role that this coefficient plays in the CAPM. The t-test statistic produced the
following values:
Fig.6 Values of the t-test statistic
AAA CETV CEZ ERSTE FORTUNA KITD KB
8,895 13,105 14,513 22,835 8,543 3,984 19,924
NWR ORCO PEGAS PM TELE UNI VIG
16,172 8,158 6,721 2,751 8,203 6,137 15,106
Source: author
Fig.7 t-Values ( )2512/1 α−t
Significance Level 0,1 0,05 0,01
t-value 1,65094703 1,96946 2,595558
33
Source: author
By comparing values of the t-test statistic and the appropriate t-value for the given
significance level and the given degrees of freedom (251) we made conclusion that we can
reject the idea that the regression coefficient iβ is statistical insignificant with 90%, 95% and
99% confidence respectively for all obtained regression coefficients.
Thus we confirmed statistical significance of each model as well as of each estimated
regression coefficient iβ .
Next we focused on the adequacy of the obtained models. We tested the assumptions about
the random error in the classical linear regression model as well as the assumptions in the
CAPM. After that we tested for each model how well the regression line approximates the
real data points.
For classical linear model we assume that the random errors iε are independent, normally
distributed random variables with mean equal to zero and with common variance 2
εσ . For
testing of the normal distribution we used STATGRAPHICS Centurion XV and the Shapiro –
Wilk W test. The obtained results are presented in the Figure 8. The red p-values mean that
we can reject the idea that the residuals come from a normal distribution with 95%
confidence.
Fig.8 Results of the Shapiro-Wilk W test
AAA CETV CEZ ERSTE FORTUNA KITD KB
Statistic 0,866977 0,979656 0,984809 0,972946 0,950901 0,817845 0,973135
P-value 0,0000 0,2296 0,6288 0,0229 0,0000 0,0000 0,0248
NWR ORCO PEGAS PM TELE UNI VIG
Statistic 0,981279 0,957916 0,958179 0,921397 0,935076 0,983676 0,939083
P-value 0,3390 0,0000 0,0000 0,0000 0,0000 0,5334 0,0000
Source: author
It is obvious that only for four shares we cannot reject the idea that the residuals come from a
normal distribution with 95% confidence.
On that account we tested each assumption separately. The assumption of the mean of the
random error equal to zero and the assumption of common variance of the random error were
met for all shares. But for all shares was not met the assumption of independence – covariance
between all possible pairs of the given shares was not equal to zero.
Model CAPM assumes another assumption apart from already mentioned assumptions. Model
CAPM assumes that the covariance between the random error and the return on the stock
market index is equal to zero for all possible pairs of given shares and the stock market index.
This assumption can be written as
( )( ) 0=− mmi rrE ε .
This assumption was met for all possible pairs of given shares and the stock market index.
34
We can state that no of the obtained model met all the assumptions given by theory.
Finally we calculated the coefficient of determination which is a statistic that will give some
information about the goodness of fit of a model. Coefficient of determination is a statistical
measure of how well the regression line approximates the real data points. A coefficient of
determination of 1 indicates that the regression line perfectly fits the data.
Fig.9 Coefficient of determination
AAA CETV CEZ ERSTE FORTUNA KITD KB
0,2397 0,4063 0,4563 0,6751 0,2253 0,0595 0,6126
NWR ORCO PEGAS PM TELE UNI VIG
0,5103 0,2096 0,1525 0,0293 0,2114 0,1305 0,4762
Source: author
CONCLUSION
As we can see from the presented results, in the Czech Republic is the model CAPM
statistical significant as well as all regression coefficient but the goodness of fit is too small
for all considered shares. It is evident that in the present circumstances of the Czech Republic
is not the CAPM suitable for explaining the movements of the return on a share.
The use of the CAPM in the Czech Republic is in our opinion questionable. We suggest the
use of alternative theories explaining the movements of the return on a share, for example
Asset Pricing Theory (APT). The APT is the equilibrium model of the return on a share
related to the more than one factor. It is a multi-index model. We recommend the return on a
stock market index as one of the factor considered in a multi-index model.
BIBLIOGRAPHY
[1] Elton, Edwin, J. et al. (2003). Modern Portfolio Theory and Investment Analysis. 6th
ed.
John Wiley and Sons, Inc. : Hoboken. 2003. 705 pp. ISBN 0-471-23854-6.
[2] Pacáková, Viera a kolektív. (2009). Štatistické metódy pre ekonómov. 1. vyd. Bratislava :
Iura Edition. 2009. 411 s. ISBN 978-80-8078-284-9.
Mgr. Petr Červinek,
Department of Finance, ESF MU
Lipová 41a
Brno, Czech Republic
p.cervinek@volny.cz
Ing. Jana Hvozdenská
Department of Finance, ESF MU
Lipová 41a
Brno, Czech Republic
174974@mail.muni.cz
35
STOCK MARKET BUBBLES INVESTIGATION IN THE
CZECH REPUBLIC
Oleg Deev, Veronika Kajurová, Daniel Stavárek
ANNOTATION
In this paper, we employ a special methodological technique to examine the presence/absence
of the phenomenon of stock market bubbles in the Czech Republic. The methodology is based
on the examining of residuals of VAR fundamentals with exclusion of ARCH effects. The
presence/absence of bubbles is studied by Hurst persistence tests and regime switching tests.
Although we observed the bubbles presence over various time periods, almost no evidence of
speculative bubbles was found in the Czech stock market.
KEY WORDS
Stock bubble, regime switching test, Hurst persistence test
JEL classification: G14, G15
INTRODUCTION
Conventional theory of speculative bubbles describes stock bubbles as stock prices that
exceed their fundamental value because current owners believe that the stocks can be resold at
an even higher price in the future. There is still no common framework on how to detect or
predict the formation and burst of a bubble. Since 1980s bubbles are investigated with
application of time series econometric analysis. However, the use of such mathematical
apparatus raises the question of whether econometric tests can truly detect a bubble or just
discover an error in the market evaluation of assets.
The literature on bubbles has taken giant strides in the last three decades that led to several
classes of models with distinct empirical tests, but many questions remain unresolved [5].
Unfortunately, there are few studies investigating the existence of asset bubbles in emerging
markets, especially considering the fact that in the last twenty years those economies were the
subjects of large financial inflows and the data on dividends are of limited use. Emerging
market studies are primarily focused on China or countries of MENA region (such as JahanParvar
and Waters [10], Billmeier and Massa [4], Lehkonen [12] or Ahmed et al [1], [2], [3]),
and reveal inconsistent results. Obviously new methodological approaches and more research
in the area are needed. The individual analysis of the possibility of stock market bubbles in
smaller financial markets in Europe, including the Czech Republic, was not sufficiently
carried out.
The main aim of this paper is to examine the presence of stock market bubble in the Czech
Republic. PX Index including all its components is subject of our research. The presence of
the 2007-2009 market turmoil brought by the global financial crisis is addressed by dividing
the long-time horizon data into three periods: before, during and after the financial crisis.
Empirically testing for bubbles is a challenging task [5]. Since the fundamental value is not
directly observable, it must be estimated. On the other hand, it is difficult to confirm the
existence of a bubble with a particular certainty, since the determination of the fundamental
value is not a trivial task [11]. The majority of valuation models include dividend payments in
their calculations, which values are not available in our inquiry. Therefore, following the
methodology of Ahmad et al [1], [2], [3], we assume that changes in dividends are reflected in
the market prices, and abstract from dividends, basing our analysis only on the stock returns.
36
DATA
We employ the daily data of PX Index representing the Czech stock market and all of its 14
components (basic information about components is given in Table 1), weighted indices of
the profitability of 10-year government bonds for the Czech Republic (as calculated in
Bloomberg), and the MSCI world index, summarizing the development of the global stock
markets. Daily data capture speedy information as both short run and long run dynamic
linkages play role in the bubble formation. Returns of the variables as their first log
differences are used.
Tab. 1 PX Index components
Tick Name Index Weight, % Traded since
AAA CP Equity AAA Auto Group NV 0.167845 2007/09/24
CETV CP Equity Central European Media Enterprises Ltd 1.096195 2005/06/27
CEZ CP Equity CEZ AS 20.740413 1995/07/26
RBAG CP Equity Erste Group Bank AG 18.533592 2002/10/01
FORTUNA CP Equity Fortuna Entertainment Group NV 0.650660 2010/10/21
KITD CP Equity KIT Digital Inc 0.109325 2010/01/25
KOMB CP Equity Komercni Banka AS 17.720545 1995/07/26
NWR CP Equity New World Resources PLC 4.498707 2008/05/06
ORCO CP Equity Orco Property Group 0.199178 2005/02/01
PEGAS CP Equity Pegas Nonwovens SA 0.511181 2006/12/17
TABAK CP Equity Philip Morris CR AS 2.844535 1995/07/26
SPTT CP Equity Telefonica Czech Republic AS 15.916278 1995/07/26
UNIP CP Equity Unipetrol AS 4.019679 1997/08/31
VIG CP Equity Vienna Insurance 12.991867 2008/02/05
Source: Authors’ calculations based on data from Bloomberg
The total sample period is divided into three sub-periods according to the clearly observed
trends in the stocks. The sub-periods are pre-crisis period (May 2004 – July 2007), crisis
period (August 2007 – March 2009) and post-crisis period (April 2009 –March 2012). The
beginning of the study period is chosen as accession date of the Czech Republic to the
European Union. The study period of individual equities depends on their first trading date.
We chose the crisis period to not start with the Lehman bros. bankruptcy and major panic on
the markets, we would like to capture prior anticipations on the market, when the 2007
banking crisis changed the comfort expectations with a fear of it becoming a sovereign debt
crisis.
METHODOLOGY
To estimate the fundamental value of stock returns we apply the methodology based on the
VAR modelling as Ahmad et al [1], [2]. The VAR model with index returns, government
bond’s interest rate and world index returns is employed for each country:
(1)
where are stock returns, are returns of the MSCI world index, are 10-year
government bond interest rate and is an error term.
To exclude the phenomenon of changing volatility in the time series we should remove
autoregressive conditional heteroskedasticity (ARCH) effects from VAR residual series.
According to Engle [5] the nonlinear variance dependence measure of ARCH is:
(2)
37
(3)
with is i.i.d. and is a coefficient for chosen lags.
We use two tests for the identification of stock market speculative bubbles. First, we employ
the Hurst persistence test to find the existence of long-term linear dependence in the stock
market volatility. Second, we perform the rescale range test. This test was developed by Hurst
[9] and was firstly implemented in economic analysis by Mandelbrot [13]. Using the rescale
range (R/S) analysis, the Hurst exponent H is estimated from the VAR residual series:



 ∑ −−∑ −=
=≤≤=≤≤
n
1t
n
t1
n
1t
n
t1
)(t)(min)(t)(max
)(ˆ
1
)/( εεεε
σ nn
n
n
q
SR (4)
where sn is the standard deviation estimation and ε n is the sample mean of the VAR residual
series:
( )∑= n
nn )(/1n εε (5)
R/S is then described as:
( )H
nSR 2/)/( n = (6)
Hurst exponent allows us to reveal the behavior of stock market efficiency over time [14].
If 0 < H < 0.5, it denotes an anti-persistent behavior, which means that positive trends in one
period tend to become negative and vice versa. If 0.5 < H < 1, a persistent behavior is
indicated in stock market behavior, that is, positive trends in one period tend to continue being
positive and vice versa. If H is close to 0.5, it indicates a random walk in data, meaning that
market returns are independent. Estimated Hurst exponents are then used to compute F-values
for the Chow test to examine its statistical significance.
Second test to detect bubbles in stock market time series is the regime-switching test
introduced by Hamilton [8]. The approach of Engle and Hamilton [6] is utilized to test the
null hypothesis of no bubbles:
(7)
where is the white noise and (8)
with being a positive trend and being a negative trend. Moreover, we let:
(9)
(10)
The null hypothesis of no trend is given by and the Wald test statistic calculated as:
(11)
The Wald test statistic evaluates how close the unrestricted estimates come to satisfying the
restrictions under the null hypothesis.
EMPIRICAL RESULTS
Both tests’ results show the same situation of no bubbles in the Czech stock market. There is
no significant difference in persistence of stock returns among all PX Index components, none
of the exponent is significantly in excess of 0.5 (see Table 2).
Stock prices indicate random walk and do not show any speculation developments. The
statistical significance of Hurst persistence tests is verified by the Chow test, F-values of
which are above its critical values, hence the null hypothesis of no persistence in the time
series is rejected. At the same time, Hurst exponents reveal the information on which stocks
are struggling to stay liquid, such as Vienna Insurance, New World Resources PLC, Fortuna
Entertainment Group NV.
38
Tab. 2 Hurst exponents and related Chow test results
Estimated Hurst exponents of residuals
Component
Full
sample
Pre-crisis
period
Crisis
period
Post-crisis
period
CEZ AS 0.57601 0.56752 0.51430 0.49570
Komercni banka AS 0.44444 0.48113 0.53153 0.46061
Erste Group Bank AG 0.53023 0.44858 0.56045 0.56429
Telefonica Czech Republic AS 0.48278 0.51558 0.48049 0.44419
Philip Morris CR AS 0.60144 0.55643 0.66025 0.55190
Unipetrol AS 0.52699 0.54491 0.47263 0.58606
Orco Property Group 0.62472 0.55656 0.48505 0.55976
Central European Media Enterprises Ltd 0.55572 0.51335 0.54610 0.58601
Pegas Nonwovens SA 0.60181 0.63538 0.58011 0.57169
AAA Auto Group NV 0.62470 - 0.51658 0.59340
Vienna Insurance 0.57333 - 0.54670 0.60305
New World Resources PLC 0.64067 - 0.66200 0.58261
KIT Digital Inc 0.51803 - - 0.51803
Fortuna Entertainment Group NV 0.66456 - - 0.66456
PX Index 0.52619 0.57286 0.50823 0.50451
F-values for Chow test
Component
Full
sample
Pre-crisis
period
Crisis
period
Post-crisis
period
CEZ AS 56.22 56.72 59.83 60.94
Komercni banka AS 64.12 61.83 58.81 63.11
Erste Group Bank AG 58.86 63.87 57.12 56.90
Telefonica Czech Republic AS 61.71 59.74 61.88 64.15
Philip Morris CR AS 54.81 56.38 51.73 57.61
Unipetrol AS 59.05 56.01 62.37 55.68
Orco Property Group 53.55 57.35 61.60 57.16
Central European Media Enterprises Ltd 57.38 59.88 57.96 55.68
Pegas Nonwovens SA 54.80 53.12 56.03 56.48
AAA Auto Group NV 53.56 - 59.70 55.27
Vienna Insurance 56.38 - 57.95 54.74
New World Resources PLC 52.72 - 51.68 55.87
KIT Digital Inc 59.60 - - 59.60
Fortuna Entertainment Group NV 51.51 - - 51.51
PX Index 59.09 60.66 60.19 60.40
Critical value F = 4.61
Source: Authors’ calculations based on data from Bloomberg
Results of regime switching tests are reported in Tab. 3. The null hypothesis of no trend in all
investigated stock returns is rejected. Estimated critical value for rejecting the null hypothesis
is in all cases lower than the values of the Wald test statistics. From our test results it even
might seem that such methodology could not disclose the anomalies in stock returns.
Nonetheless, the similar studies on other stock markets prove the ability of the methodology
to capture bubbles in stock prices. For example, using this methodology, Ahmad et al. [1]
cannot reject the null of no trend (presence of price bubble) in Mexico, Sri Lanka and Taiwan.
Therefore, the methodology should be considered to some extant efficient and beneficial.
39
Tab. 3 Wald test results
Component
Full
sample
Pre-crisis
period
Crisis
period
Post-crisis
period
CEZ AS 1284.73 789.23 199.73 636.50
Komercni banka AS 1154.61 658.73 224.51 466.42
Erste Group Bank AG 797.98 876.70 138.00 340.65
Telefonica Czech Republic AS 1152.57 501.19 233.27 563.54
Philip Morris CR AS 1501.57 644.70 365.56 541.49
Unipetrol AS 961.53 395.81 195.65 537.62
Orco Property Group 893.97 416.45 162.42 740.31
Central European Media Enterprises Ltd 1049.05 549.18 208.13 804.76
Pegas Nonwovens SA 924.45 101.68 23.70 771.86
AAA Auto Group NV 545.68 - 142.01 472.78
Vienna Insurance 852.63 - 230.64 753.92
New World Resources PLC 690.52 - 171.68 628.11
KIT Digital Inc 452.08 - - 452.08
Fortuna Entertainment Group NV 358.78 - - 358.78
PX Index 819.36 568.25 136.25 304.38
Critical value χ2
(1) = 3,84
Source: Authors’ calculations based on data from Bloomberg
CONCLUSIONS
Almost no evidence of stock market speculative bubbles was found in the Czech stock market
However, taking into consideration the limitations of the proposed methodology, we could not
declare with the full certainty that asset bubbles are not present in those markets. If tests have
not proved the existence of bubbles, they at least have identified the substantial volatility.
Further search of relevant methodology is needed.
ACKNOWLEDGEMENTS
Support of the Czech Science Foundation within the project GAČR 403/11/2073
„Procyclicality of financial markets, asset price bubbles and macroprudential regulation“ is
gratefully acknowledged.
BIBLIOGRAPHY
[1] Ahmed, E., Rosser, J. B., Jr., and Uppal, J. Y. Emerging markets and stock market
bubbles: Nonlinear speculation? 2010, 1-35.
[2] Ahmed, E., Rosser, J. B., Jr., and Uppal, J. Y. Financial development and bubbles: The
case of the Karachi stock exhange of Pakistan, 2010, 1-27.
[3] Ahmed, E., Honggang, L., and Rosser, J. B., Jr. Nonlinear bubbles in Chinese stock
markets in the 1990s. Eastern economic journal 40 (2006), 1-18.
[4] Billmeier, A. and Massa, I. Go long or short in pyramids? News from the Egyptian stock
market. International Review of Financial Analysis 17 (2008), 949-970.
[5] Brunnermeier, M. K. Bubbles. New Palgrave Dictionary of Economics 2 (2008), 1-18.
[6] Engle, C., and Hamilton, J. D. Long swings in the Dollar: Are they in the data and do
markets know it? American Economic Review 80 (1990), 689-713.
[7] Engle, R. F. Autoregressive conditional heteroskedasticity with estimation of the variance
of United Kingdom inflation. Econometrica 55 (1982), 251-276.
[8] Hamilton, J. D. A new approach to the economic analysis of nonstationary time series
and the business cycle. Econometrica 57 (1989), 357-384.
40
[9] Hurst, H. E. Long term storage capacity of reserviors. Transformations of the American
Society of Civil Engineers 116 (1951), 770-799.
[10]Jahan-Panvar, M. R., and Waters, G. A. Equity price bubbles in the Middle Eastern and
North African financial markets. Emerging Markets Review 1 (2010), 39-48.
[11]Kubicová, I., and Komárek, L. The classification and identification of asset price bubbles.
Czech Journal of Economics and Finance 61 (2011), 34-48.
[12]Lehkonen, H. Bubbles in China. International Review of Financial Analysis 19 (2010),
113-117.
[13]Mandelbrot, B. B. Statistical methodology for nonperiodic cycles: From covariance to
R/S analysis. Annals of Economic and Social Measurement 1 (1972), 259-290.
[14]Rejichi, I. Z., and Aloui, C. Hurst exponent behavior and assessment of the MENA stock
markets efficiency. Research in International Business and Finance 26 (2012), 353-370.
Oleg Deev – Veronika Kajurová
Masaryk University
Faculty of Economics and Administration
Lipová 41a
Brno 602 00
oleg@mail.muni.cz – vkajurova@seznam.cz
Daniel Stavárek
Silesian university in Opava
School of Business Administration in Karviná
Univerzitní nám. 1934/9
Karviná 733 40
stavarek@opf.slu.cz
41
THE APPLICATION OF OCA CRITERIA ON THE
EUROPEAN MONETARY UNION
Michal Fabus
ANNOTATION
The paper deals with the application of selected OCA criteria on the European Monetary
Union, which monitors whether EMU is or is not an optimal currency area. Concludes that
EMU is not according to OCA theory an optimum currency area and outlines what may
follow in the future.
KEY WORDS
Theory of optimum currency areas, European Monetary Union, OCA criteria, future of EMU.
JEL classification: E50, E69
INTRODUCTION
Mongelli defines optimum currency area than the optimum geographical area with a common
currency or several currencies whose exchange rates are irrevocably locked with the
possibility of future reunification. Third currencies against the common currency can float.
The territory of the OCA is the territory of sovereign states using the single currency or to
each other their currencies are fixed. Optimality is defined as the fulfilment of several criteria
involving the mobility of production factors, economic openness, diversification of
production, price and wage flexibility, and more. In achievement of these criteria should the
revenues from membership in a monetary union exceed its costs.
According to another characteristic of OCA, a positive relationship between benefits and costs
will be achieved if the following conditions are observed:
1. The economies of the countries forming the monetary union should be primarily
sufficiently similar to:
- Symmetric shocks affecting them and did not lead to the emergence of imbalances in
the balances of payments;
- Economic cycles are synchronized; resulting in all member countries would prefer the
same interest rates;
- Changes in monetary policy affect them similarly.
2. If the imbalance between the countries' balances of payments, they should be sufficiently
flexible labour markets and capital mobile enough to minimize the cost of adjustment.
3. The single currency area, there is a fiscal mechanism automatically transferred resources
from prosperous regions with low unemployment in depressed regions with high
unemployment.
AIM AND METHODOLOGY
The aim of this paper is to analyze the EMU from the perspective of the theory of optimal
currency areas, identify and evaluate the problems which currently the European Monetary
Union has. The paper contains only outputs of a study aimed to examining the issue.
The economic aspect will be explained using the selected optimum currency area criteria by
which point out the ability or inability to further functioning of the European Monetary
Union.
42
RESULTS
The countries forming the OCA apply among themselves fixed rates, respectively joint
currency and from foreign countries and flexible courses are closely linked to trade in goods
and services, as well as the mobility of production factors. The essence of the OCA theory is
the idea that adopting the single currency, which means waiver of adjustment of monetary and
exchange rate policy is optimal for countries that are exposed to symmetric shocks, or have
flexible mechanisms of absorption of asymmetric shocks. (Šikulová, 2006, p. 11)
The symmetric shocks should not have concerns in this regard, because inside the monetary
union does not cause the need for exchange rate changes. Asymmetric shocks are economic
shocks with different impacts on individual economies and may affect the monetary union,
member states reaching a similar economic level. Although these economies are in fact
varying the structural site, which critical impact of shocks is crucial on the economy. If
countries face asymmetric shocks their negative effects can be muted through different
mechanisms of adaptation defined OCA theory. (Šikulová, 2006, p. 11)
Due to the mutual fixing of exchange rates, or use the single currency, member exposed to
asymmetric shocks, cannot respond changing exchange rate and therefore must choose a
painful alternative in the form of adjustment of prices and wages.
If we consider the two countries and the shock will be affected only one of them comes to
large differences between countries, with countries hit by the recession and the shock passes
the contrary, the second country that is not affected by the shock, goes through boom.
Monetary Union as a whole operates steady but its individual members are not in balance.
Criterion of labor mobility, which is also called Mundell criterion, the euro area does not meet
because the mobility of labor between regions is low and thus its help in dealing with
asymmetric shocks is insufficient.
The criterion of diversification of production in the euro area is only partly fulfilled. While
there are opinions that the diversification of production and consumption in the euro area is
high but "the opposite side of the coin" is that the smaller economies, which have a smaller
share of manufacturing industry, are hardly struggling with the interventions of asymmetric
shocks. Investments entered into less developed regions do not produce the desired effect only
in the form of convergence but also result in economies such as the loss of competitiveness
and ability to respond to asymmetric shock is weakened.
The criterion of openness, this criterion is met in the euro area. Larger economies are, from a
logical point of view, less open, which is not a problem. The problem is again a D4 member’s
country, notably Greece and Portugal, which can include the smaller economies, but the level
of openness to receive the same percentage as the major economies.
The criterion of fiscal transfers cannot be considered as satisfied, because of the euro area
there is no centralized budget or any common European Treasury. A small shift in this area is
the creation of the ESM, which acts as a guarantor of the safety net. There are more and more
strong voices to create a fiscal union, which would function in parallel with monetary union.
In my opinion the creation of a fiscal union will be necessary.
The criterion of consistency of priorities we highlighted the fact that achieving consensus in
dealing with monetary policy, despite the institutional support, does not happen or is
happening only in part. We pointed to the creation of two groups of countries of different
levels of inflation, each group is moving in the opposite direction. The problem of the country
D4 again found themselves in a group of countries that are going the evil path. Germany has
also did not "in a good light" when it was decided to solve their economic situation so
unflattering that their economic growth was accompanied by a weakening of other economies,
the team that defended their interests against the interests of the community.
43
The criterion of consistency we revealed its negative outlook for the future, which in some
countries such as Finland and Slovakia, already factored in the will of citizens to the will of
the political, where the first case, was elected party refused to loan to Greece and the latter in
order to support ESM government fell. The conclusion is that the euro area meets this
criterion only partially, which may shift more towards the "red numbers" if irresponsible
governments irresponsible states recovered.
CONCLUSION
Considering the first three criteria, the economic, the conclusions we suggest that the euro
area's capacity to cope with asymmetric shocks is not good. If the situation remains
unchanged and the euro area will still continue in the same way, it is possible that the costs of
membership in a monetary union will, over time, higher than its benefits. Our point of view is
that the establishment of a common fiscal policy is imperative.
Assume that the criterion of labour mobility is naive to suddenly improve, because the current
lack of legislative support that would need to systems of different countries into line.
Diversification of production may experience growth but also can also stagnate. There is a
presumption that the criterion of openness, which is already met, may experience more
positive outlook. The criterion of consistency of priorities and in particular inflation problem
of differentiation will continue to do what can be more manifest at the entrance of new
members. For the other two criteria, we refer to the fiscal criterion and the criterion of
coherence transfer, they could in the future to record a positive direction, but which will
require some changes. Changing the criteria would be both a centralized institution, which
would be superior to national institutions.
Greater coordination in fiscal policy is likely to become, an integral part of the transformation
that EMU must pass in order for their work better. A situation in which the EMU is, points to
the fact that the validity of the central management of fiscal policies, is becoming essential.
Individual management fiscal policies of individual nations, seems to be problematic because
of poor discipline of several members of the EMU. Failure to adequately respond to
asymmetric shocks, interventions, shows us how important it is to create a stable mechanism
of automatic fiscal transfers, which would be able to set strict rules for all games, with which,
by the ability to flexibly cope with asymmetric shocks has increased.
OCA criteria has shown us that the euro area is far from ideal and the monetary costs of EMU
membership is growing more and more. Although it is difficult to clearly identify the
relationship between costs and benefits of membership in recent years are beginning to
politicians, citizens and realize that the cost of membership can be too high and constantly
pouring money into countries like Greece, also affects the atmosphere of solidarity and
relations between countries. Because of irresponsibility countries such as Greece, the criterion
of coherence in the future even more limited.
BIBLIOGRAPHY
[1] BALDWIN R., WYPLOSZ CH. 2008. Ekonomie evropské integrace. Praha: GRADA
PUBLISHING, 2008. ISBN 978-80-247-1807-1
[2] FRANKEL, J.A., ROSE, A.K. The endogenity of the Optimum Currency Area Criteria.
Economic Journal 108. 1998. 1009–1025.
[3] KRUGMAN P., OBSTFELD M. International Economics: Theory and Policy. Sixth
Edition. 2003. ISBN 0-321-11639-9
[4] MC KINNON, R.I. 1963. Optimum currency areas. American Economic Review 53(4):
717–725.
44
[5] ŠIKULOVÁ, I. Convergence in the process of European monetary integration. 2006 ISBN
80-7144-155-4
[6] EEAG : The EEAG Report on the European Economy, A New Crisis Mechanism for the
Euro Area CESifo, 2011, on-line: http://www.cesifo-
group.de/portal/page/portal/ifoHome/B-politik/70eeagreport
[7] EEAG : The EEAG Report on the European Economy, A New Crisis Mechanism for the
Euro Area CESifo, 2012, on-line: http://www.cesifo-
group.de/portal/page/portal/ifoHome/B-politik/70eeagreport
[8] SCHARPF F.: Monetary Union, Fiscal Crisis, and the Preemption of Democracy. LSE
‘Europe in Question’ Discussion Paper Series. (May 2011). on-line:
http://www.mpifg.de/pu/mpifg_dp/dp11-11.pdf
Michal Fabus, Ing., PhD.
School of economics and management in public administration in Bratislava
Zeleznicna 14, 821 07
Bratislava, Slovak Republic
michal.fabus@vsemvs.sk
45
BIASES IN CONTINGENT VALUATION METHOD USED FOR
INVESTMENT PROJECT APPRAISAL
Monika Foltyn-Zarychta
ANNOTATION
The paper is devoted to theoretical analysis of problems arising in contingent valuation
method used in project appraisal for estimating the value of non-market goods. Using
hypothetical markets for deriving people’s willingness to pay or willingness to accept
compensation for changes in public goods due to project implementation is followed by a
number of specific biases that can distort the final outcome of the analysis. Although the
literature offers various definitions as well as classifications and ways to overcome those
tendencies, some new overview may be seen as indispensable for clarity and efficiency in
using CVM in investment project appraisal procedure.
KEY WORDS
investment appraisal, non-market goods, contingent valuation, bias
JEL classification: G31, H 41, H43
INTRODUCTION
Contingent valuation method (CVM) domain of applicability embrace any quasi-public good
(where are some implicit markets for comparison) and pure public goods (where no such
market exists) [1]. It rests on the assumption of possibility to create a hypothetical market for
such goods and use questionnaires to elicit people’s willingness to pay (WTP) or willingness
to accept compensation (WTA) for those goods, which are not directly observable in prices on
real markets.
Bias itself can be defined as the difference in responses from true values which is nonrandom,
systematic, which means that the answers under- or overestimate the expected results
of the study. If the effects vary, i.e. some answers are lower, some are higher than the true
values, the researcher is faced rather with a random error, not with bias itself [2].
The goal of the research is identification of biases appearing in contingent valuation method
(CVM) used for estimating the value of non-market goods that significantly influence
investment projects appraisal in the light of certain types of investments. Research hypothesis
was formulated as follows: certain characteristics of investment projects make them more
prone to CVM biases.
AIM AND METHODOLOGY
The paper aims at identifying the biases in CVM used for investment project evaluation. The
analysis may be of use for some amendments in appraisal procedure of projects influencing
non-market goods.
The cognitive layer of the research was based on critical studies of literature descriptive for
CVM as well as project appraisal. Biases were observed and analysed in details with use of
deduction and induction methods to reveal their main impact sphere and connection between
investment projects. Then, applying induction method, the investments were divided into four
dimensions to be intertwined with possible biases and to identify their impact on evaluation
results and to test the hypothesis and synthesize the paper goals.
46
RESULTS
Identification of biases in contingent valuation method
The literature on CVM presents vast variety of biases and errors that may emerge during the
assessment process, starting from design, choice of sample, interviewing process and
estimating aggregate willingness to pay or willingness to accept. However, the aim of the
study is identifying biases that are crucial for investment appraisal process considering special
features that an investment project may possess. Therefore, the list of biases presented in the
paper is limited to those mentioned as main types of errors. The identified biases are:
strategic, starting point, payment vehicle, information, hypothetical, temporal, context, order,
embedding and warm glow.1
1. Strategic bias – the bias results in overestimating or underestimating of WTP or WTA
values and arises when the good being valued is a public good or has some features of a
public good, i.e. non-excludability from consumption or non-divisibility. The respondents
tend to understate their true preferences expecting that others will state their bids high enough
to secure providing the good or overstate in order to make sure the good will be available and
due to the fear of “free riders” [3].
2. Starting point bias – appears in close-ended, dichotomous choice or bidding game format
questions2, where respondent may adapt her answer to the first valuation included in the
question. However Pearce and Markandya [4] indicate that the results testing for mean
estimate starting point are discrepant.
3. Payment vehicle bias – emerges from payment vehicle chosen in the questionnaire for
enquiring people’s WTA or WTP. Bias exists when payment vehicle is perceived by
respondents as not acceptable. Typical payment vehicles include levies on income taxes,
water or land rates, increased entrance fees and increased sales taxes. However, in many
countries a relative unfamiliarity with the use of tax levies and referenda can affect the
plausibility of payment vehicles and lead to payment vehicle bias [5].
4. Information bias (framing effect) – results from changes in valuation due to information
received by the respondent. Mathews, Freeman and Desvousges [6] pay attention to the fact
that the information in the survey must be adjusted to the respondents and their cognitive
abilities. It is sometimes quite demanding issue when a scenario must include some
sophisticated, technical issues, percentage information, etc. The danger here lies in filling the
missing or non-understandable information by respondents themselves. What is worth
highlighting is the fact that information effect applies also to normal, marketed goods, present
on real markets [7]. By the same token, the differences in estimations of non-market goods
values can be regarded as, to some degree, natural, as they follow the same patterns as
observed in real markets. Worth underlining is the variety of definitions of information bias.
For example, Pearce and Turner [8] point out that information bias may arise from various
sources, i.e. starting point bias may be interpreted as information bias as well. Hanley and
Spash include this into design biases. On the other hand, Garrod and Willis [9] interpret it as a
framing effect, which they associate with the variations in bids for risk-averse or risk-seeking
individuals depending on the frame the question is put into.
1
Some biases in the literature have different names for the same error or may be identified as a special kind of
some other bias. Therefore, the list presented in the paper is a selection and compilation of the whole range of
specific effects and, in any way, can not be perceived as complete presentation of all systematic errors appearing
in CVM studies.
2
Dichotomous choice questions (referendum method) are questions where one value is presetnted and
respondent may only accept or reject it; iterative bidding game – respondent answers a series of questions: if he
accepts the first bid, in next step the amount is increased (usually doubled), if he rejects it – the value is
diminished.
47
5. Hypothetical bias – the bottom line for the bias is non-existence of actual market for the
good being valued and due to that it can be perceived unsuitably. Boardman (et al.) [10]
underlines the need to precisely specify the good and its effects, especially using sufficient
quantity of information backed up by visual aids to ensure the respondent will be familiar
with the issue. Spash and Hanley explain that the hypothetical market lacks the opportunity
for „learning by doing”, debating on the true value of a good and involving actual cash
outflow from the respondent budget.
Along with hypothetical bias some differences in definitions also emerge. Pearce and Turner
distinct here two separate biases: (a) hypothetical – concerning the problem that the payment
declared by respondents is not actual, that means that he or she does not bear real costs of a
transaction as it is in real market; (b) operational – covering the problem of consistency in
“operating conditions” between hypothetical and actual markets.
6. Temporal bias - Whitehead and Blomquist define temporal bias as an inconsistency in
evaluation due to time difference between the moment of declaring willingness to pay and the
moment of collecting the benefits. Willingness to pay (or willingness to accept) can be
estimated here twofold: as a periodical payment for life cycle of the project or as single
payment “in advance” for all future effects. The former creates the flow of values that should
be discounted as the appropriate rate of discount, whereas the latter can be instantly
interpreted as overall present value for the project benefits, which seems more convenient for
investment appraisal procedure. However, what Whitehead and Blomquist underline, the
latter valuation has its own shortcomings, as respondents often tend to use unrealistically high
discount rates. The problem here may emerge also from overestimation of respondents
financial resources, especially when a long time frame is involved. For investment projects
the choice between those two may not be completely discretionary as it can be determined by
the type of the project and mechanisms of paying for its benefits. The particular interests
should be given here to the investments where the time distance between the payment and the
benefits is long. Under such circumstances the value of discount rate becomes one of the
crucial inputs in the analysis both for financial side and for respondents estimations, where
discounting can be inherently included in their declared preferences.
7. Context effect (availability bias) produces various bids depending on the context of the
event, even if average effect is similar. Higher bids apply to goods or events that are
perceived by society as more dangerous like plane crashes, metro accidents, etc. There is also
a tendency that some sort of risks are perceived as more dangerous (and gather higher bids)
than others even if actual mortality or morbidity rates are similar in the light of probability of
such events. Garrod and Willis enumerate risks like cancer, fire, and flood, genetic
engineering opposed to asthma, diabetes or stroke. Bid inconsistencies are caused by
psychological factors that make certain types of risks more important than others, especially
involuntary risks, catastrophic risks, epidemic risks and others that one has no control over or
when the consequences have not been fully known yet.
8. Order bias (sequence effect) – the ordering of questions may suggest respondents the
importance of a good and influence their bids. Whitehead and Blomquist point out that the
ordering of valuation questions is also important as usually the amounts declared for the first
one are the highest.
9. Embedding bias (scale and scope, part-whole, symbolic, insensitivity to scope) – bias
emerges when different quantities/qualities of a good are valued by respondents at various
levels, i.e. two wilderness areas valued on the same level as only one. The reason for this is
that respondents may perceive some public good as one whole, in some sort of a symbolic
way and do not take into consideration specific features of the good as well as its various
levels [11]. Schwarz [12] brings closer the issue of scale effects sketching the following
bottom line: “respondents do not value the good as described, but the good as represented in
48
their own mental construal of the scenario”. Boardman (et al.) turn attention to the embedding
bias danger when a good possesses existence value due to the fact that respondents may
declare their moral standing towards the problem (like environmental goods) instead of their
actual bids. He indicates that embedding bias is also connected with the existence of
substitutes. If public goods are substitutes for each other, then if they are valued together they
are less desired than separately.3
10. Warm glow bias (moral satisfaction) – respondents declare willingness to pay due to
moral satisfaction they achieve from supporting a problem that is perceived by society as
important and fair. The bias may emerge especially when some goods with existence value4
are taken into account, as it is motivated by a form of altruism. The moral satisfaction rises
with the amount of money declared, which leads to overestimation of results [13].
The influence on investments depending on type of the project
The theoretical analysis of characteristics of biases enumerated in the proceeding section
served as a basis to identify the impact of each one to investment projects and to indicate
those types of investments that are particularly prone to non-random inaccuracy in valuation
results. In order to analyze the influence of biases, investments were divided into dichotomous
types according to four dimensions: (I) type of good that is changed by the project (private vs.
public5
), (II) time frame (long-term vs. short-term), (III) homogeneity (single vs. multipartite)
and (IV) uniqueness (non-unique vs. unique).
Fig. 1. The bias influences on appraisal results according to type of investment project
Source: own study
3
The problem of scope effect can be also seen in studies valuing air quality in Poland conducted by
Dziegielewska and Mendelsohn [14] who changed the pollution reduction level between the 25% and 50% in the
sub-samples and found that the resulted WTP values were insensible to the above. The example of embedding
problem is the result of survey done by Foltyn-Zarychta [15] estimating the willigness to pay for an investment
in sewerage system consisting of 4 tasks, where each was valued from 0,55 to 0,72 PLN in terms of additional
payment for m3
of tap water while The whole project valuation was 1,28 PLN (in terms of additional payment
for m3
of tap water), while the sum of task valuations were 2,54 PLN.
4
Existence value (passive value) is part of total economic value not connected to any human use. It is is an
implicit value placed on goods only because they exist. Typical goods that possess extistence value are
environmental resources, like wilderness areas, endangered species, etc.
5
Some goods are not purely public goods however possess some characteristic of a public good (i.e. nonexcludability
from consumption or non-divisibility) and also suffer similar kinds of biases as pure public goods.
Therefore, any intermediate case is included into “public good” cathegory.
Starting point
Order
Context
Information
IV
III
II
I
Type of investment
project
Type of bias Possible influence for the result of the appraisal
Changing private goods
Long term
Multipartite
Hypothetical
Strategic
Changing public goods
Short term
Single
Non-unique
Unique
Underestimation due to „free-rider” effect or
overestimation to ensure the provision of good
Temporal
Embedding
Warm glow
Underestimation due to protest bids
Under- or overestimation due to differences from
real market
Underestimation of lump sum payments “in
advance” due to very high discount rates
Overestimation of separate tasks due to mental
account, symbolic treatment of project, etc.
Overestimation due to moral satisfaction effect
Payment vehicle
49
The biases identified as influencing only special types of investment projects are: strategic,
payment vehicle, hypothetical, temporal, embedding and warm glow. Four other biases
(starting point, information, context and order; framed dotted in Fig.1.) are diagnosed to
influence all kinds of projects, therefore the lines connecting them to projects types were
omitted.
Out of eight types of investment projects divided according to the selected dimensions, four
were identified as more prone to CV biases (shaded gray in Fig.1.). Projects that change
public goods were found prone to strategic bias appearing due to “free-riders”
underestimating their valuations or respondents tending to overestimate their bids to secure
that the good will be provided. This type of investment is also sensitive to payment vehicle
and hypothetical biases as respondents may tend to oppose to pay for goods available anyway
and as not having the opportunity to “learn by doing” in real markets. Moving to next
dimension, long-term investment appraisal may be distorted by temporal bias, especially
when the questionnaire is aimed at elicitation of one-off payment for all future effects. Next,
multipartite projects are prone to embedding bias, where bids may differ from actual
preferences due to various reasons, usually overestimating the results. The last dimension
refers to uniqueness of project, where two special features make such investments sensitive to
embedding and warm glow biases: existence value and possession of no substitutes. The
impact of those features makes respondents attaching moral value to project effects and
treating it as symbolic way to express their interest in the problem which often leads to
overestimation of bids.
Projects aimed at private goods as well as short-term, single and non-unique are more
resistant to above biases as they are easier comprehensible by respondents, usually smaller,
having substitutes and no existence value. However the result here may be distorted as well
by other biases, especially those emerging from the very process of CVM itself, i.e.
construction of questionnaires (ordering of questions, information, interviewer bias etc.).
CONCLUSION
The study in the paper identified the following biases (divided into two groups) that
significantly influence investment appraisal: (I) strategic, payment vehicle, hypothetical,
temporal, embedding and warm glow, and (II) starting point, information, context and order.
The latter influences all kinds of project, whereas the former group impacts significantly only
selected types of investments.
While identifying the sensitivity of appraisal results, investment were divided according to
four separate dimensions to illustrate their specific features. Of highest sensitivity (measured
by the number of first group biases) were found investments changing public goods (prone to
strategic, payment vehicle and hypothetical biases) and unique projects (embedding and warm
glow biases). Other two dimensions, represented by long time frame and complexity, were
found sensitive to only one of biases from the first group (respectively: temporal bias and
embedding bias). On the basis of the conducted analysis, the research hypothesis that certain
characteristics of investment projects make them more prone to CVM biases was confirmed.
Investment appraisal is a complex process, starting from identifying the effects, through their
valuation and calculation of the present value by applying appropriate discount rate. The
valuation of non-market project effects is a crucial stage for achieving reliable results,
especially when investments change public goods, generate effects for a long time, constitute
of many tasks or are unique.
However, the question of achieving right results of investment project assessment needs
further investigations. Even if contingent valuation allows for estimating the value of goods
not present on real markets, it suffers various inherent disabilities, going beyond the problems
50
raised in the paper. The very process of gathering data is prone to interviewer bias or
anchoring effect accompanied by some specific responses from respondents connected to the
differences in perception between consumer and citizen, which all need profound studies to
reduce those and other disadvantageous impacts.
BIBLIOGRAPHY
[1] Whitehead J.C., Bloomquist G.C. (2006), The Use of Contingent Valuation in Benefit-Cost
Analysis, In: Handbook on Contingent Valuation, ed. by A. Alberini, J.R. Kahn, Edward
Elgar, Cheltenham, Northampton, pp. 92-115.
[2] Spash C. L., Hanley N. (1994), Cost-Benefit Analysis and the Environment, Edward Elgar,
Aldershot.
[3] Pearce D. (1998), Valuing Risks, In: Handbook of Environmental Risk Assessment and
Management, ed. by P. Calow, Blackwell Science, Oxford, pp. 345-376.
[4] Pearce D. W., Markandya A. (1989), Environmental Policy Benefits: Monetary Valuation,
OECD, Paris.
[5] Morrison M. D., Blamey R. K., Bennett J. W. (2000), Minimising Payment Vehicle Bias in
Contingent Valuation Studies, “Environmental and Resource Economics” Vol. 16, pp. 407-
422.
[6] Mathews K. E., Freeman M. L., Desvousges W. H. (2006), How and How Much? In:
Valuing Environmental Amenities Using Stated Choice Studies, ed. by B.J. Kanninen,
Springer, Dordrecht, pp. 111-133.
[7] Pearce D., Barbier E. B. (2000), Blueprint for a Sustainable Economy, Earthscan, London.
[8] Pearce D., Turner R. (1990), Economics of Natural Resources and the Environment, Johns
Hopkins University Press, Baltimore.
[9] Garrod G., Willis K.G. (1999), Economic Valuation of Environment: Methods and Case
Studies, Edward Elgar, Cheltenham, Northampton.
[10] Boardman A. E., Greenberg D. H., Vining A. R., Weimer D. L. (2001), Cost-Benefit
Analysis: Concepts and Practice, Prentice Hall, Inc., Upper Saddle River, New Jersey.
[11] Whitehead J. C., Haab T. C., Huang J-Ch. (1998), Part-Whole Bias in Contingent
Valuation: Will Scope Effects Be Detected with Inexpensive Survey Methods?, “Southern
Economic Journal”, Vol. 65, No. 1, pp. 160-168.
[12] Schwarz N. (1997), Cognition, Communication, and Survey Measurement: Some
Implications for Contingent Valuation Surveys, In: Determining the Value of Non-Marketed
Goods, Economic, Psychological and Policy Relevant Aspects of Contingent Valuation
Methods, ed. by R.J. Kopp, W.W. Pommerehne, N. Schwarz, Kluwer Academic Publishers,
Boston/Dordrecht/London, pp. 165-188.
[13] Carson R.T., Flores N. A., Meade N. F. (2000), Contingent Valuation: Controversies and
Evidence, “Discussion Paper” 96-36R, March, http://escholarship.org/uc/item/75k752s7,
approached on 20.04.2012.
[14] Parry Dziegelewska D., Mendelsohn R. (2005) Valuing Air Quality in Poland,
“Environmental & Resource Economics”, No. 30, pp. 131–163
[15] Foltyn-Zarychta M., Analiza kosztów-korzyści w ocenie efektywności inwestycji
proekologicznych. Prace naukowe. Akademia Ekonomiczna im. K. Adamieckiego, Katowice
2008
Monika Foltyn-Zarychta, Ph.D.
University of Economics in Katowice
1 Maja 50 Katowice
monika.foltyn-zarychta@ue.katowice.pl
51
ANALYSIS OF BANKRUPTCY AND SECURE RISK
MANAGEMENT MODELS AND APPLICATION FOR THEIR
EXTENSION
Monika Garguláková
ANNOTATION
In modern management risk has management become an inevitable part of financial
management. Company financial health is evaluated by financial standing and bankruptcy
models. Article analyzes the selected financial standing and bankruptcy models in terms of
their predictability and based on the results of this analysis suggests a new model for
evaluation of financial risks in the corporate sector.
In the first part we define company financial health according to selected financial standing
and bankruptcy models and analyze their explanatory power.
In article is presented own methodology for financial risk management in the company. Input
data are expertly set based on financial analysis. These data are then used in the calculations
of each of the selected methods. The final part is devoted to interpreting the results of selected
analyzes and makes recommendations for their possible extend of the company risk
management system.
KEY WORDS
risk, risk management methods, bankruptcy and financial standing models
JEL classification: G32
INTRODUCTION
The development of the economic environment, gradually increase the demands on quality,
explanatory power and utility of the work with the financial risk. In the context of the global
financial crisis and the instability of the overall financial system was to strengthen the
importance of control and predicting tools for better stability of the system. According to
Smejkal and Rais, one of very important prerequisites for a successful business is risk
management. Risk conceals the uncertainties from the future events or developments [11]. For
the correct determination of the economic situation of the company and its possible further
development is needed to identify sources of risk and then use it for their management.
Correct identification of possible adverse events is an important part of business [4] [7] [9].
Based on the identification of risks are compiled particular possible development scenarios in
which is tested the sensitivity of the risks to company activity and, moreover, possible impact
on key financial indicators. This article will analyze the financial standing and bankruptcy
models [1] [5] [10] [11]. To these models I have created own methodology for measuring risk,
which is finally used for comparison of different methods and interpretation of informative
value.
AIM AND BASIC METHODOLOGY
This article aims to introduce a new model for company financial risk management. Within
this objective I analyze bankruptcy models, to which I create my own indicator, which I
included in the calculation of basic research models. It is the intensity of risk, which is
52
incorporated into the simulated example, which shows the various changes mathematically.
The main objective is to analyze the results of existing models and compare them with my
own research of working with risk.
Risk management is a way of understanding the potential risks, which occur or may occur in
the company. Risk management techniques associated with company analysis describes a
wide range of literature [3], [5], [6]. For purposes of this article is risk management analyzed
by financial standing and bankruptcy models. They work with such financial indicators that
would be able to properly analyze the financial situation of the company, its health, and also
predict the crisis development. The sources of data are financial statements, balance sheet,
profit and loss statement and cash flow. The specialized literature describes in detail sources
of information and their processing [2], [3], [5], [10].
The models are divided into two main groups. First group represent financial standing models
that belong to the ex-post analysis, which focuses retrospectively, leading to knowledge of the
causes that necessitated the current business situation. It describes only the results that already
exist and cannot be changed. Their use is possible only on a large set of compared data.
Second group represent bankruptcy models that already work with prediction of possible
development. These models belong to the ex-ante analysis.
Selected models and their characteristics
There is a wide range of financial standing and bankruptcy models. Article works only with
selected models, which are among the most used and debated. This is a Kralicek quick test,
Altman bankruptcy Formula, husbands Neumaier Index IN and Taffler index.
Kralicek quick test
Kralicek choose from each group four indicators and according to their final values assigned
to the company points. Description of the indicators:
Equity quote = own equity/total assets
Cash flow in % of sales = cash flow/sales
Profitability of total capital = profit after tax + interests/total assets
Debt repayment period for cash flow = (short + long-term payables + financial
assets)/operating cash flow
Based on the values for individual indicators, the company is assigned by points and the final
grade is calculated as the simple arithmetic average of points for each indicator. The scale of
evaluation indicators is simplify expressed 1 - very good, 2 - good, 3 - middle, 4 – bad, 5 –
company in danger. A more detailed assessment modification shows Kislinger [5].
Altman bankruptcy formula (Z score)
One of the best known bankruptcy models. The new version of the model dated 1983 is usable
also in Czech conditions. It is used in two variants, which divides to joint stock companies
and all others. For the purposes of this article I will use Z score formula for other companies:
5998.04420.03107.32847.01717.0 XXXXXZ ×+×+×+×+×=
where:
X1 = NWC / Total assets
X2 = Profit after tax / Total assets
X3 = EBIT / Total assets
X4 = Basic capital / Total debt
X5 = Sales / Total assets.
Z value moves in the range between - 4 and +8. Rating scale is defined as:
Z > 2.9 financially strong company
1.2 < Z < 2.9 some financial difficulties, unclear further development
53
Z < 1.2 imminent bankruptcy
Index IN
In the Czech conditions also gradually emerged bankruptcy models which were compiled by
husbands Neumaier who gradually developed models IN95, IN99, IN01 and IN05 when the
numerical values correspond to year of usage inception. They are compiled from four trust
indexes [8]. According to discriminant analysis and updates of the previous indexes is actual
index IN05 for which the following applies:
EDCBAIN ×+×+×+×+×= 09.021.097.304.013.005
Where:
A = Assets / Liabilities
B = EBIT / Interest expenses
C = EBIT / Total assets
D = Sales / Total assets
E = Current assets / Current liabilities
The resulting value moves in the range:
IN05 > 1.6 enterprise creates value
IN05 < 0.9 enterprise does not creates value
0.9 < IN05 < 1.6 gray zone
Taffler index
This is a bankruptcy model which works with 4 indicators in the form of discriminant
function:
416.0318.0213.0153.0 RRRRZ ×+×+×+×=
Where:
R1 = Profit before tax / Current liabilities
R2 = Current assets / Liabilities
R3 = Current liabilities / Total assets
R4 = Total sales / Total assets
Company with value higher than 0.3 has a small probability of bankruptcy, while company
with value lower than 0.2 can expect bankruptcy with higher probability.
All models are compiled on the basis of already existing data that are processed mainly from
the financial analysis. Individual results are interpreted in the selected interval, which
indicates in what stage the business is located. They are assigned and compared through
generated sample of monitored data.
EXTENSION APPLICATION
Analysis and comparison of different studied methods is performed on expertly selected data.
Calculations are working with absolute values from financial analysis, especially with ratio
indicators. These are shown in the tables below.
Table 1. Data from the balance sheet
Total
assets
Financial
assets
Current
assets
Basic
capital
Equity Liabilities
Current
liabilities
Long term
liabilities
in tsd.
CZK 55000 11300 51000 2000 5000 50000 17600 33000
Source: own processing
Table 2. Data from P&L
54
Cash
flow
Revenues Income
Interest
expenses
Net profit EBIT
in tsd.
CZK 3600 700 135 100 2500 3500
Source: own processing
These indicators are used in conjunction with methodology of individual bankruptcy and
financial standing models, which are dependent on existing data and examined group samples,
from which the individual calculations are based. The determined values set position and
status of the company in relation to financial health and established results interpretation of
the model.
Table 3. Results of the models
Kralicek
quick test
Altman
Z score
IN05 Taffler
index
Value 3.25 1.58 2.05 0.29
Source: own processing
When using the Kralicek quick test, the company is located in the middle operation zone, i.e.,
in the worse average of the selected interval. Similarly is the result using the Altman Z score,
where the company is located in the middle zone of the selected interval. This represents
particular threat for further function of the company when can occur some financial problems.
On the contrary, according to the index IN05 company adds value and classifies to the upper
part of the interval. A similar result also interprets Taffler index, which provides a very low
probability of company bankruptcy.
The main drawback of the calculations is the absence of possible future negative development
of the indicators. This poses the risk that may more affect the status and functioning of the
company. Therefore, I created another own indicator, which I included in the calculation of
the basic models. It is the intensity of risk, Sensitive of risk (SR), which affects the examined
model. I've illustrated it mathematically as the sum of the individual indicators, their intensity
changes and the impact intensity of the risk. Values enter into the calculation in absolute
terms. The correlation and the calculation are expressed in the following form:
i
i
i
n
n
n
ni I
P
P
I
P
P
SR ×




 ∆
+×




 ∆
=
Where:
Pn = Watched ratio indicator
∆Pn = Change of watched ratio indicator
In = Particular sensitivity of risk
SRni = Total risk sensitivity
If the indicator is expressed as a percentage, it shall be adapted to the absolute value:






+=
100
1 n
n
P
P .
To the simulated example I add a new indicator, Sensitive of risk, which may occur in the
company. For easier interpretation of changes in the simulation I choose one indicator that is
used in the financial standing and bankruptcy models. It is an indicator of sales, which will
simulate the desired change. I expertly determine that company sales will reduce by 15%.
55
That this change is calculated by the risk sensitivity formula, which is then reflected in the
final values of selected models. Particular sensitivity of risk is determined by the company
based on the size of the investigated parameters effects. It moves in the interval:
0 < In > 1
Where:
0 = zero probability of influence, no impact
1 = one hundred percent probability of influence, high impact.
Based on the capital structure the company stated that the sensitivity of sales influence on its
economy is 20%. This value is in the interval 0.2. Sensitivity can also be set using the sectoral
analysis, for simplifying of the simulated example I am counting with sensitivity according
the consideration of the company. After substituting into the formula Sensitive of risk results
the following value:
( ) 2.013575.114 ×÷=SR
17.0=SR
The calculated value of 0.17 is assigned to each of the selected models. Since this is a possible
negative impact of risk it is in individual samples of selected models deducted. The resulting
values after inclusion of Sensitive of risk is shown in the table below.
Table 4. Change in value after the application of Sensitive of risk
Kralicek
quick test
Altman
Z score
IN05
Taffler
index
Value 3,25 1,58 2,05 0,29
Value with risk
sensitivity 3,5 1,43 1,88 0,13
Change Slight
deterioration
Significant
deterioration
Slight
deterioration
Significant
deterioration
Source: own processing
After adding risk indicator in the calculations we can see that all values have deteriorated.
This meant a worsening of the position and status of the company. This is a logical change
where in the company position is added possible negative scenario and the indicator should
deteriorate. This effect was confirmed. The calculation was simulated by changing only one
indicator, no additional effects are calculated with impact on other indicators that are likely to
actually occur.
On the results of selected models and by me chosen indicator can be visibly seen the
difference between classical scenario using financial standing and bankruptcy models and
adding Sensitive of risk indicators. Using only one possible risk influencing the company was
generated a major change in endpoint indicator of the company position. This change shows
the low level of explanatory ability when without integration of risks the company can be
stable but after adding risk is in bad position.
CONCLUSION
Article describes in the first part individual financial standing and bankruptcy models that are
currently mostly used in common practice. Thereto was created own model, which is focused
on the simulation of risk and its influence.
Based on the results of the simulation article points out the difference in the calculation of
individual methods and points to a possible deficiency in the original models. Deficiencies
can occur in the form of:
56
- reliability of the information and absence of work with risk,
- insufficiently large sample of surveyed area (i.e. companies),
- unaccepted macroeconomic impacts in the given time period (political situation,
legislative measures, economic situation of the country, etc.).
The article also gives room for further discussion of the investigated area, when the work with
risk allows a wide application in planning of its future development. Due to the fact that
companies are operating in different sectors, regions and differ in their size, their problems
may have greater or lesser impacts also on the macroeconomic level of the economy of the
country or the region. Therefore, a more thorough focus on the negative effects management
could also be beneficial for macroeconomic respect. I will continue to analyze and develop
researched topic, especially relationships between risk indicators. Development and testing of
the model is realized also in the commercial sphere. This paper is one of the research output
of the projekt IGA/Fame/2012/012.
BIBLIOGRAPHY
[1] BELÁS, J; CIPOVOVÁ,. 2011. Internal Model of Commercial Bank as an Instrument for
Measuring Credit Risk of the Borrower in Relation to Financial Performance (Credit Scoring
and Bankruptcy Models). Tomas Bata University in Zlin, Faculty of Management and
Economics [online]. 2011, č. 4. [cit. 2012-05-08] Available at WWW:
<http://www.cjournal.cz/files/79.pdf>. ISSN 1804-1728.
[2] ČERNÁ, A., DOSTÁL, J., SŮVOVÁ, H., ŠPAČEK, E., HUBÁLEK, K. Financial
analysis. 1. issue. Prague: Bankovní institut, a.s., 1997. 293s.
[3] DLUHOŠOVÁ, D. Financial management and business decisions. 1. issue. Prague:
Ekopress, s.r.o., 2006. 191 s. ISBN 80-86119-58-0.
[4] JÍLEK, J. Financial risks. 1. issue. Praha: Grada, 2000. 635 s. ISBN 80-7169-579-3.
[5] KISLINGEROVÁ, E., HNILICA, J. Financial analysis. Step by step. 1. issue. Prague:
C.H. Beck, 2005. 137 s. ISBN 80-7179-321-3.
[6] MAŘÍKOVÁ, P., MAŘÍK, M. Modern methods of performance evaluation and business
valuation: economic value added, market value added. 1. issue. Prague: Ekopress, 2001. 60 s.
ISBN 80-86119-36-X.
[7] MUSÍLEK, P. Capital markets. 1. issue. Prague: Ekopress,.s.r.o., 2002. 459 s. ISBN 80-
86119-55-6.
[8] NEUMAIEROVÁ, Inka; NEUMAIER, Ivan. Index IN05 : Index IN05. European
financial systems: Proceedings of the International Scientific Conference. Brno: Masarykova
univerzita v Brně, 2005. 273 s. ISBN 80-210-3753-9.
[9] REJNUŠ, O. Financial markets. 2. extended issue. Prague: KEY Publishing s.r.o., 2010.
660 s. ISBN 978-80-7418-080-4.
[10] SEDLÁČEK, J. Accounting data in manager's hands - financial analysis in corporate
management. 2. extended issue. Prague: Computer Press, 2001. 220 s. ISBN 80-7226-562-8.
[11] SMEJKAL, V., RAIS, K. Risk management in companies and other organizations. 3.
extended issue. Prague: Grada, 2009.360 s. ISBN 978-80-247-3051-6.
Ing. Monika Garguláková
Tomas Bata University in Zlin, Faculty of Management and Economics, Department of
Finance and Accounting
Mostní 5139, 760 01 Zlín
Email: gargulakova@cotesting.cz
Tel.: + 606388298
57
IMPACT OF SELECTED FACTORS ON THE DIVIDEND
POLICY OF JOINT-STOCK COMPANY
Radim Gottwald
ANNOTATION
The paper focuses on impact of selected factors on the dividend policy of joint-stock
company. Especially, there are analyzed the factors like information asymmetry, managerial
signaling motives and preferences of controlling stockholders. At the beginning of the paper,
different types of the dividend policies are characterized. Then individual factors, which have
an influence on dividend policy, are presented, including level of the influence. Based on the
results of cited empirical analyses, trend in ratio of firms paying dividends and firms do not
paying dividends is presented, along with payout concentration in terms of firms.
KEY WORDS
dividend policy, dividends, information asymmetry, dividend irrelevance theory, dividend
payout, dividend growth
JEL classification: G12
INTRODUCTION
Investing in securities, investors can realize current and capital return. In case of stocks,
current yield is realized by dividend payments. There are some advantages and disadvantages
of dividend payments. Stock prices usually increase when some announcement about
dividend payment is notified. Dividends can provide support to stock price and underscore
good results of the joint-stock company. Dividends may attract investors who prefer current
return, therefore return in the form of dividends. Dividends may reduce agency costs that arise
from conflicts between shareholders and management of a joint-stock company. However,
dividends can reduce internal sources of financing. They may force the company to rely on
costly external equity financing and they are taxed as ordinary income.
AIM AND METHODOLOGY
The objective of the paper is to evaluate impacts of several selected factors on the dividend
policy, which is realized by joint-stock company. Deductive, descriptive and comparative
methods are used in the paper. The progress of relationship between firms that pay dividends
and firms that do not pay dividends is derived from results of cited empirical analyses by
deductive method. The types of the dividend policies are presented by descriptive method.
Comparative method is used to compare number of firms that pay dividends and number of
firms that do not pay any dividends. Within an empirical analysis, payout concentration and
cross-sectional link between payouts and earnings are presented.
RESULTS
Different joint-stock companies realize different dividend policies. Gottwald (2012), focusing
on various types of dividend policies presents, that dividend policy may be explicitly stated,
or investors may infer it from the dividend payments a company has made in the past.
Furthermore, companies usually increase dividends only if they are confident that the increase
is sustainable. Optimal dividend policy is – according to him – such a policy that strikes a
58
balance between current dividends and future growth and maximize the firm´s stock price.
These theories relate to dividend policy:
• the dividend irrelevance theory – firm´s dividend policy has scarcely any effect on
either its cost of capital or its value,
• the „bird-in-the-hand“ theory – firm´s value will be maximized by a high dividend
payout ratio,
• the tax preference theory – investors prefer rather low dividend payout than high
dividend payout.
Joint-stock companies can pay dividends or need not pay dividends. In the first case,
following three possibilities will turn up in time:
• no growth in dividends,
• constant growth in dividends,
• nonconstant growth in dividends.
Factors Having Impact on the Dividend Policy
Final decision to pay or not to pay dividends is formed under the influence many factors.
Among the most important belong:
• information asymmetry,
• clientele demands,
• managerial signaling motives,
• tax deferral benefits,
• investors´ behavioral heuristics,
• idiosyncratic preferences of controlling stockholders,
• behavioral biases at the managerial level.
Impact of Selected Factors on the Dividend Policy
Impacts of information asymmetry on dividend policy is founded by Li and Zhao (2008).
Joint-stock companies that are less subject to information asymmetry are more likely to pay,
initiate, or increase dividends, and disburse smaller amounts. The results persist after
accounting for the changing composition of payout over the sample period, the increasing
importance of institutional shareholdings, and catering incentives. There is a negative relation
between asymmetric information and dividend policy.
Impacts of information asymmetry and other factors on dividend policy is also founded by
DeAngelo, DeAngelo and Skinner (2008). Simple asymmetric information framework that
emphasizes the need to distribute free cash flow and that embeds agency costs and security
valuation problems does a good job explaining the main features of observed dividend
policies - the massive size of corporate payouts, their timing and, to a lesser degree, their
(dividend versus stock repurchase) form. Other factors like clientele demands, managerial
signaling motives, tax deferral benefits and investors’ behavioral heuristics have at best minor
impacts on dividend policy. Factors like the idiosyncratic preferences of controlling
stockholders and behavioral biases at the managerial level have a first-order impact.
Controlling stockholders generally make a difference in observed payout policies. The
probability that a UK firm pays dividends increases with the vote ownership of executives on
the board. At UK firms, dividends vary inversely with insider ownership. There is no material
difference in average payout ratios of US firms that have and do not have blockholders that
own 15%-plus of the stock. Bank control of a German firm increases the probability that the
firm will omit dividends. German firms are usually controlled by a large blockholder, and
59
there is a u-shaped relation between dividends and the proportion of voting equity held by the
largest stockholder. It is possible to compare number of firms that pay dividends and number
of firms that do not pay dividends. Percent of firms that pay dividends and percent with
negative current earnings (losses) are presented in Tab. 1.
Tab.1 Percent of firms that pay dividends and percent with negative current earnings
Year Percent that pay
dividends
Percent with
loss
Dividend payers
/ Percent with
loss
Without
dividends /
Percent with
loss
1991 29.5 37.8 13.3 48.1
1992 29.6 34.2 11.6 43.7
1993 27.6 35.3 10.9 44.6
1994 26.1 32.5 7.3 41.4
1995 25.6 34.4 9.5 42.9
1996 23.8 36.1 9.7 44.3
1997 22.8 37.7 9.3 46.0
1998 22.7 39.7 12.2 47.8
1999 21.0 41.2 9.7 49.5
2000 19.3 46.5 11.3 54.8
2001 19.5 51.6 20.0 59.2
2002 19.9 45.0 12.2 53.1
2003 23.4 39.3 10.7 48.0
2004 26.1 33.6 7.6 42.7
2005 27.6 33.5 8.2 43.1
Source: DeAngelo, DeAngelo and Skinner (2008)
Relatively small number of firms pay most of the aggregate dividends. Similarly, relatively
small number of firms generate most of the aggregate earnings of publicly held industrial
firms. Payout concentration is presented in Tab. 2, concretely percent of total payouts
(dividends plus net stock repurchases) for CRSP/Compustat industrial firms ranked in
descending order of total payout.
Tab.2 Payout concentration
Year Top 25
distributors (%)
Top 100
distributors (%)
Top 200
distributors (%)
Top 500
distributors (%)
1991 43.2 74.6 86.5 96.7
1992 43.6 74.1 85.9 96.4
1993 39.2 72.4 85.1 96.1
1994 37.6 70.7 84.7 95.9
1995 48.4 76.1 87.3 96.5
1996 38.2 69.7 83.6 95.1
1997 40.8 70.9 83.5 95.2
1998 38.9 69.9 82.5 94.5
1999 45.1 72.8 84.8 95.4
2000 47.7 75.1 86.1 96.2
2001 52.4 80.2 89.9 97.5
2002 53.7 79.6 89.5 97.5
2003 54.0 79.3 89.6 97.7
60
2004 48.5 76.5 87.5 97.0
2005 50.2 75.5 86.9 97.0
Source: DeAngelo, DeAngelo and Skinner (2008)
These values mean percents of aggregate payouts supplied by firms in specified group. Total
equity payouts by US industrial firms are highly concentrated among a small number of firms.
In every year, the top 500 firms supply over 90% of total payouts. The supply of total
payouts, like the supply of dividends, exhibits a two-tier structure. In this structure, a
relatively small number of firms deliver the bulk of total equity payouts. The large number of
remaining firms collectively distribute only a modest amount of cash to stockholders. A
similar two-tier structure characterizes the cross-sectional earnings distribution. Earnings are
what make equity payouts possible. Earnings and the concentration of payouts is presented in
Tab. 3, concretely percent of total payouts (dividends plus net stock repurchases) for
CRSP/Compustat industrial firms ranked in descending order of earnings before extraordinary
items.
Tab.3 Earnings and the concentration of payouts
Year Top 25 earners
(%)
Top 100 earners
(%)
Top 200 earners
(%)
Top 500 earners
(%)
1991 35.7 60.5 70.4 80.7
1992 37.7 62.9 73.5 83.9
1993 32.7 61.1 75.8 85.5
1994 32.8 65.5 77.6 89.9
1995 39.4 63.0 75.2 85.8
1996 34.2 61.8 76.0 88.1
1997 37.4 64.1 74.7 87.0
1998 32.9 58.4 68.2 82.3
1999 36.7 59.7 70.0 87.3
2000 41.3 64.4 74.0 86.4
2001 46.4 72.1 79.5 86.6
2002 46.0 68.2 77.7 85.6
2003 43.5 72.8 82.3 91.8
2004 42.6 66.4 78.2 88.4
2005 43.5 67.5 79.8 91.2
Source: DeAngelo, DeAngelo and Skinner (2008)
These values mean percents of aggregate payouts supplied by firms in specified earnings
group. The vast bulk of payouts come from the small number of firms that generate most of
the earnings of publicly held industrials. The lower tier of the industrial population contains,
at the same time, a large number of firms that collectively generate only modest earnings and
distribute only modest amounts of cash to investors. There is a strong cross-sectional link
between payouts and earnings.
Information asymmetry can be reduced in case of public notice of dividend payment. The
market response to some event depends on expected or unexpected event. The are some
differences between stocks related to stock prices, trading volumes, stock prices volatility,
which depend on expected or unexpected event. Different types of stocks are described by
Baye and Jansen (1995). Concretely, yield stocks focused on realization of an yield and
growth stocks focused on realization of a growth. Concretely, profit growth of joint-stock
61
company. They describe dividend yield of yield stocks including ways how to calculate them.
Stock prices of growth stocks can be estimated using expected yields in the future.
Company-by-company analysis of the relationship between dividend payout and future
earnings growth is conducted by Zhou and Ruland (2006). Dividends reduce the funds
available for investment. Many investors associate high dividend payout with weak future
earnings growth. Tests using aggregate market data, however, provided evidence that
contradicts that view. Based on the results of research, high-dividend-payout companies tend
to experience strong future earnings growth.
CONCLUSION
The dividend policy of joint-stock company can be realized by many ways. Several factors
have positive or negative impact on the dividend policy. Factors like information asymmetry,
clientele demands, managerial signaling motives and other play an important role in jointstock
company management decision. Many researchers try to quantify the importance. Based
on cited empirical results, different types of the dividend policy are realized in the US, UK or
Germany. Percent comparison of companies paying dividends and not paying dividends is
presented. Payout concentration, concretely percents of aggregate payouts supplied by firms
in specified group is also presented. The concentration is not distributed too uniformly. Some
researchers also try to analyze the relationship between future earnings growth and dividend
payout. In practice, dividend policy is also influenced by other factors, which are not
mentioned in the paper. However, the mentioned ones belong among very important. Next
research can also continue by study of various dividend policies realized by joint-stock
companies in capital markets. Factors mentioned in the paper also influence other activities of
joint-stock companies.
BIBLIOGRAPHY
[1] BAYE, M. R., JANSEN, D. W. Money, Banking & Financial Markets: An Economics
Approach. 1. issue. Boston: Houghton Mifflin. 1995. 779 p. ISBN 978-0-395-64395-3.
[2] DeANGELO, H., DeANGELO, L., SKINNER, D. J. Corporate Payout Policy.
Foundations and Trends in Finance. 2008, Vol. 3, No. 2-3, pp. 95-287. ISSN: 15672395.
[3] GOTTWALD, R. Implications of Dividend Policies on Stock Returns. FIN STAR NET
2012. 2012, Vol. 1, No. 1, pp. 1-8. ISBN 978-80-970244-5-1.
[4] LI, K., ZHAO, X. Asymmetric Information and Dividend Policy. Financial Management.
2008, Vol. 37, No. 4, pp. 673-694. ISSN: 00463892.
[5] ZHOU, P., RULAND, W. Dividend Payout and Future Earnings Growth. Financial
Analysts Journal. 2006, Vol. 62, No. 3, pp. 58-69. ISSN: 0015198X
Ing. Mgr. Radim Gottwald
Department of Finance
Faculty of Business and Economics
Mendel University in Brno
Zemědělská 1
613 00 Brno
radim.gottwald@mendelu.cz
62
DETERMINATION OF THE GENERAL VALUE OF
SELECTED ENGINEERING ENTERPRISES
Igor Hudák, Eva Kafková
ANNOTATION
In calculating the technical efficiency of manufacturing companies is necessary, regard to the
input and output variables of the model, to choose the appropriate method of calculating the
general value of the enterprise. The aim of this paper is to present a business method as the
most appropriate method of calculating the general value of the enterprise. As benefit of this
paper we considered the evaluation of results calculated with business method, the
identification of method weaknesses and generalization of knowledge for the whole group of
engineering companies.
KEY WORDS
general value of the enterprise, business method, engineering companies, generated cash
flows, sustained value of enterprise, weaknesses of business method.
JEL classification: G30
INTRODUCTION
Due to the economic crisis, the economic activity of enterprises of the global economy has
reduced. The consequences of the crisis have had significant impact in economies with
relatively high share of industrial output in GDP. An expression of the crisis was also a
significant decline in industrial production and trade in the Slovak economy, as the business
sector openness SR significantly affects the domestic economy. In 2009, the insolvency has
become a standard phenomenon, often becomes a secondary insolvency, result of
conservative and cautious behavior of banks was limited access to bank loans. The existence
of so many businesses was threatened. This paper deals with the problem of determining the
general value of the research sample of firms using business methods in the period 2006 -
2010.
AIM AND METHODOLOGY
The main objective of this paper is finding a general value of selected engineering companies
under division 28 – Machinery and equipment calculated by the business method with use of
financial data for the period 2006 – 2010. The content represents partial contribution of the
research to determine the effectiveness of selected engineering firms.
To quantify the general value of the enterprise, we use business method from regulations by
the Ministry of Justice for determining the general value of assets (Z. z. 492/2004). For
valuation of selected companies we use the method proposed by the authors F. W. Ross, R.
Brachmannom and P. Holzner, which is included in the Expert standard for determining the
business value1
.
By the selected methods some authors differentiate between business value, the substance and
mean value of business2
. The basis for determining the business value will be as follows:
1
MIKOLAJ, J. – FORMELA, V. a kol.: Znalecký štandard pre stanovene hodnoty podnikov. Ministerstvo
spravodlivosti SR: Vysoká škola dopravy a spojov v Žiline, Ústav súdneho inžinierstva, 1993. 151 s. ISBN 80-
7100-163-5
2
Tamtiež. s. 16 – 17.
63
C = f (Zt, t, i), where
• C – yield value;
• Zt – net income in period t;
• t – time period;
• i – interest rate (or discount rates, capitalization rates).
In the calculations we used a business method for determining the general value of the
enterprise at a unlimited lifetime of the enterprise as follows:
VŠHP = Hoz + Ht [in €], where
• VŠHP – general value of enterprise determined by business method;
• Hoz – general value of generated cash flows during the reporting period;
• Ht – sustained value.
General value of generated cash flows (Hoz) we determined as follows:
[in €], where
• OZt – general value of generated cash flows (in €);
• n – length of reporting period (in years);
• i – interest rate coefficient (in %/100), less the level of risk, the average rentability and
structure of use capital.
Interest rate coefficient i is calculated in accordance with regulations as follows:
i = (1-DS).NPK.(PK/CK) + NVK.(VK/CK),
where DS is the coefficient of income tax rates, NPK costs associated with the use of
borrowed capital, NVK cost of own capital, PK volume of borrowed capital, VK volume of
own capital, CK total capital of enterprise. Sustained value (Ht), necessary to calculate the
general value of the enterprise, is determined by value of enterprise generated cash flows Hoz
and their parts in the year following the reporting period, reflecting the assumptions of
enterprise to product OZt over unlimited duration period, which is converted to the current
value at the date of valuation. Sustained value is calculated by the quotation:
[in €], if i > g, where
• OZn+1 – volume of generated cash flows in the year following the reporting period (in
€);
• i – interest rate coefficient (in %/100), less the level of risk, the average rentability and
structure of use capital;
• g – sustainable growth rate of general cash flows (in %/100);
• n – length of reporting period (in years).
64
Generated cash flows are defined as cash generated by the expression of particular benefit of
disposable income, earnings or cash flows from the balance to be obtained from the enterprise
activities, the amount depends on the past development of enterprise, current market position
and anticipated development. Generated cash flows can be written as follows:
OZ = (Z - DS) + Odp – Inv [in €], where
• Z – the difference between total income and expenditure in the annual accounts (in €);
• DS – corporate income tax (v %);
• Odp – depreciation and other costs are included in profit or loss from operations,
which are not spending in the current period, for example, creation of reserves,
provisions for long-term tangible and intangible assets (in €);
• Inv – investment in acquisition and adjustments of operational-necessary working
capital, while the adjusted working capital is determined by subtracting nonremunerated
current liabilities from current assets, revenues included in profit or loss
from operations that are not income in the current period, such as dissolution of
reserves, dissolution adjustments to the capital of an enterprise (in €)
The objects of research were selected small and medium enterprises in the industrial division
no. 28 - Manufacture of machinery and equipment according to the classification of SMEs
European Commission, Commission Recommendation 2003/361/EC. This classification is
established by the European Commission adopted a uniform and binding in all EU countries.
The object of investigation was chosen because a key position in the engineering development
of the Slovak economy - employees the largest number of workers, creating a substantial part
of GDP and its products make up the largest share of exports. Criteria for the establishment
survey sample were as follows:
 operation on the Slovak market for at least 5 years (2006 - 2010),
 place of business in region Košice or Prešov,
 small and medium enterprise (employees),
 availability of financial statements of enterprises for the period 2006 - 2010.
The first and second criterion met 107 enterprises, of which met the third and fourth criteria
54. The original base was set in this way reduced to a set of 54 enterprise in sample, from
which were selected by the availability of the accounts 30 companies. The research sample
contained 3,5 % of the industrial business division no. 28 - Manufacture of machinery and
equipment.
RESULTS
We used business method of determining general value of the enterprise on sample of 30
enterprises under division no. 28 in the period 2006 – 2010. As the range of processed data
does not allow us to present the results for all businesses, we decided to describe the
calculation procedure of the enterprise model, which is part of the sample.
The following table shows the development of selected indicators values, actually achieved in
the company during the period 2006 – 2010.
Fig. 1 The real value of the indicators in selected enterprise (in thousands €)
Indicator 2006 2007 2008 2009 2010
Revenues 5 630 5760 5 487 5 593 5 653
Value added 2 496 2 602 2 716 2 841 2 867
65
Profit from economic activity 570 601 448 338 228
Profit from accounting period 440 472 318 236 158
Own equity 1 134 1 467 1 453 1 658 1 743
Source: own elaboration.
For companies reporting positive value of the profit throughout the whole period is usage of
the chosen method without problems. However, if we have company, reporting in the last year
of the period loss (value of 2010 represents the input data for calculation of the permanent
value of the company), it disproportionately reduce the resulting general value of enterprise.
Fig. 2 The volume of the generated cash flows in reporting period (in thousands €)
Indicator 2006 2007 2008 2009 2010
Profit from economic activity after tax 363 274 184 138 162
Depreciation (+) 354 481 523 543 547
Other costs, which are not spending
in the current period (+)
0 0 0 0 0
Investment in operating capital
(operationally required) (-)
21 1 37 1 8
Revenues, which are not income
in the current period (-)
0 0 0 0 0
Investments in the procurement of
fixed assets (operationally required) (-)
273 414 465 365 398
Generated cash flows 423 340 205 315 303
Source: own elaboration.
The most important indicator of the calculation of enterprise value (in terms of its value) is
the profit from operations after tax and depreciation. Other items with their values (positive
and negative) cancel each other. The real problem in calculating the general value of the
enterprise is the availability of the required financial data.
Fig. 3 Calculation of the general value of enterprise (in thousands €)
t = 1 - n OZt (1 + i)-t
OZt x (1 + i)-t
(OZn+1/(i – g)) x (1 + i)-n
VŠHp
2006 423 0,9579
2007 340 0,9177 343
2008 205 0,8791 233
2009 315 0,8421 404
2010 303 0,8067 525
RESULT 1 505 15 503 17 008
Source: own elaboration.
The available financial statements do not always contain all the information. When we are
calculating the generated cash flows, is necessary to establish sustained value of enterprise.
The calculation procedure is shown in Table 3. According to the results shown in Table 3, we
see a significant share calculated by sustained value of enterprise (15 503 thousands €) to the
general value of enterprise. If will the company achieved a negative generated cash flows in
2010 (negative profit, negative amortization), would depend only on what a big drop recorded
in the period of substitution variables in the calculation of the generated cash flows.
If a negative value exceeded – 1 505 thousands € (which is the general value of generated
66
cash flows), would be the resulting general value of enterprise useless (statistically incorrect)
for the detection level of technical efficiency of enterprises through the CCR DEA models.
CONCLUSION
Determination of the general value of the enterprise is necessity for the need of review the
effectiveness of business. The business method of determining the general value of the
enterprise has its weaknesses especially in the calculation of sustained business value, thus
resulting general value of enterprise may become unusable for calculating the efficiency of
the investigated companies. The problem is mainly a negative profit or a loss in the last year
of the period. If this value several times lowers than the calculated value of the generate cash
flows in future years of the period, resulting in negative general value of enterprise. A
negative value is for further data processing useless and entity is excluded from the statistical
file. Despite this deficiency, it was able to determine the general value of 26 companies,
representing 87 % of the sample enterprises, which results are usable for further processing.
BIBLIOGRAPHY
[1] MIKOLAJ, J. – FORMELA, V. a kol. 1993. Znalecký štandard pre stanovene hodnoty
podnikov. Ministerstvo spravodlivosti SR: Vysoká škola dopravy a spojov v Žiline, Ústav
súdneho inžinierstva, 1993. 151 s. ISBN 80-7100-163-5.
[2] HARUMOVÁ, A. a kol. 2008. Stanovenie hodnoty majetku, hlavné aspekty ekonomickej
znaleckej a expertnej činnosti. Bratislava: Iura Editon, 2008. ISBN 978-80-8078-224-5.
[3] MAŘÍK, M. a kol. 2003. Metody oceňování podniku. Praha: Ekopress, 2003. ISBN 80-
86119-57-2.
[4] HATRÁK, M. 2007. Ekonometria. Bratislava: Iura Edition. 2007. 504 s. ISBN 978-80-
8078-150-7.
[5] ZBIERKA ZÁKONOV SLOVENSKEJ REPUBLIKY. 2004. Vyhláška Ministerstva
spravodlivosti SR č. 492/2004 Z.z. o stanovení všeobecnej hodnoty majetku.
[6] EUROSTAT, European Commission. [online]. [cit. 2012-05-24] Dostupné na internete
<http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home>.
[7] ŠTATISTICKÝ ÚRAD SR. [online] [cit. 2011-05-24] Dostupné na internete:
<http://www.statistics.sk>.
[8] VARCHOLOVÁ, T. a kol. 2007. Meranie výkonnosti podnikov. Bratislava: Ekonóm,
2007. 168 s. ISBN 978-80-225-2421-6.
Ing. Igor Hudák doc. Ing. Eva Kafková, PhD.
University of Economics in Bratislava University of Economics in Bratislava
Faculty of Business Economy in Košice Faculty of Business Economy in Košice
Department of Economics Department of Economics
Tajovského 13, 041 30 Košice Tajovského 13, 041 30 Košice
Slovak republic Slovak republic
Tel.: +421(0)55 / 722 31 11 Tel.: +421-55-7223111
E-mail: igor.hudak@euke.sk E-mail: eva.kafkova@euke.sk
67
THE ALTERNATIVE INVESTMENT FUNDS MANAGERS
DIRECTIVE AND THE REGULATION ON VENTURE
CAPITAL FUNDS - SELECTED COMMENTS
Zdenek Hustak
ANNOTATION
The Alternative Investment Funds Managers Directive (AIFMD) published in July 2011 aims
to capture all diverse forms of funds which have not been previously subject to the
harmonised UCITS rules in the EU. The AIFMD represents two tier systems - harmonised
regime for managers of AIFs above certain limit of assets under management (AuM) and less
demanding national regime for smaller players. The AIFMD will be accompanied by
implementing regulation thus adding to the complexity of this new regime. The paper focuses
on anticipated impact of new regime on the private equity and the venture capital industry in
the EU. The Commission proposed specific regulation of the venture capital industry at
December 2011. This may provide an opportunity to re-examine the merits of the AIFMD and
establish more appropriate regime for venture capital industry.
KEY WORDS
AIFMD, investment funds, private equity, venture capital, regulation
JEL classification: G28
INTRODUCTION
Establishment of harmonised EU-wide regime for private placement and fund managers
of collective investment funds not already captured by the Undertaking for Collective
Investment in Transferable Securities Directive (UCITS) had been a priority
on the Commission agenda for quite long.1
AIFMD was published in July 2011 and
implementing Commission´s regulation is due by July 2012. These rules will be accompanied
by numerous technical standards issued by ESMA thus adding to the complexity of new
regulatory regime. Recently, draft of new EU regulation on venture capital funds was
proposed by the Commission. All these documents represent framework for very diverse
spectrum of funds and managers. The impact on various fund sectors is expected to vary
significantly. The venture capital and private equity funds do represent significant players not
only on the financial markets but also on private companies markets. Given the Commission
intentions it seems that the PE/VC managers will need to tackle numerous regulatory
challenges in coming years.
AIM AND METHODOLOGY
This aim of article is to deal with the main features of the new regulatory regime for nonUCITS
funds managers in the EU from the perspective of private equity and venture capital
sector primarily. Given the current stage of development and implementation of the AIFMD,
the focus is on the likely impact on corporate governance arrangements and the business of
the private equity and venture capital funds managers and the relationship towards investee
companies. New directives, draft implementing regulation and proposed regulation on venture
1
Cf. The Commission White paper on Financial Services Policy 2005-2010 issued in late 2005 and White paper
on Enhancing the Single Market for Investment Funds (SEC(2006) 686 Final).
68
capital and numerous policy documents have been reviewed in order to analyze aspects of the
new regime. Certain data form EVCA and CVCA2
were obtained and analysed and numerous
interviews with representatives of the PE/VC sector were held as well. Author´s personal
engagement in preparation of the AIFMD directive in the course of the Czech Republic
presidency to the Council of EU provided useful framework and background information as
well.
RESULTS
Scope of the AIFMD regime
The AIFMD refers to all AIFM managing or marketing Alternative Investment Funds (AIF)
in the European Union (EU). The term AIF covers all types of funds irrespective of legal form
or structure. Unlike the UCITS directive which does not apply to closed-ended types of
collective investment schemes3
the AIFMD capture those funds. The term "Alternative"
means an alternative to funds compliant with the UCITS directive – i.e. AIF is an entity
raising capital from number of investors which is not subject to the authorisation under the
UCITS. E.g. in case of single investor investing in an entity, then such an investment vehicle
cannot qualify as an AIF. The term will be specified in the implementing regulation.
Second element delineating the scope of new regulatory regime is "active marketing" of an
AIF to investors in the EU. This means a direct or indirect offering or placement at the
initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages to or
with investors domiciled or with a registered office in the EU. However, this definition does
not prevent investors domiciled in the EU to invest in the third country AIFs whose managers
do not meet criteria of AIFMD. The marketing of an AIF should be targeted at the
"professional investors". The term professional investors encompass diverse categories of
investors - primarily "professional clients" as defined by MiFID.4
While scope of the AIFMD is very broad it does not apply to certain entities such as holding
companies meeting certain criteria, pension and social security system institutions etc.
Interestingly an exemption is provided to intra-group AIFM managing AIFs whose investor
are only members of the group the AIFM belongs to while no such investor is AIF. The
AIFMD establish special exemption for small AIFMs - managing assets, including any assets
acquired through use of leverage, in total do not exceeding EUR 100 million; or managing
unleveraged AIFs that have no redemption rights exercisable during a period of 5 years
following the date of initial investment in each AIF in total not exceeding EUR 500 million.
Member states may choose not to apply full AIFMD regime to small AIFMs. Nevertheless,
such AIFMs should be subject to mandatory registration and regular reporting regarding AuM
and certain other issues. Interestingly, the AIFMD provides for an opt-in regime for smaller
AIFMs - i.e. they can voluntarily apply for authorisation under AIFMD.
The leverage should be determined at the level of the AIF and should cover any financial
and/or legal structures involving third parties controlled by the relevant AIF (or an AIFM
acting on behalf of the AIF), where such structures directly or indirectly create leverage at the
level of the AIF. From the practical perspective, the use of leverage at the level of a fund does
2
EVCA - European Ventrue Capital Association, CVCA - Czech Venture Capital Association
3
Art.3 lett.(a) UCITS.
4
MiFID Annex II, s. II.1. "In the course of the above assessment [of a potential client to be undertaken by
an investment firm], as a minimum, two of the following criteria should be satisfied:
— the client has carried out transactions, in significant size, on the relevant market at an average frequency
of 10 per quarter over the previous four quarters,
— the size of the client's financial instrument portfolio, defined as including cash deposits and financial
instruments exceeds EUR 500 000,
— the client works or has worked in the financial sector for at least one year in a professional position,
which requires knowledge of the transactions or services envisaged."
69
not seem to be a typical case for venture capital and private equity funds, as the fund
investments are backed by investors' commitments to investment money in a fund. For private
equity funds, the issue of leverage could be potentially relevant in the case that the strategy of
a fund provides for leverage buy-outs and the fund is involved in such a transaction.
European private equity and venture funds under AIFMD
Given the threshold set in the AIFMD, there is the practical question of how many of the AIFs
marketed in the EU will be caught under this regulatory regime. In respect to private equity
and venture capital funds there are only limited data available from the industry associations.
In 2009 overall, private equity sector managers in the EU managed more than 532 billion
EUR from which venture capital funds accounted for 58 billion EUR. What are particularly
relevant are assets under management per individual fund managers. For individual Member
States the average assets under management managed by a single manager ranges from 52
million EUR in Baltic States to 753 million EUR in the UK for the private equity sector as
such. EU-based venture capital managers manage from 6 million EUR in Romania to 143
million EUR in France on average. According to the EVCA 2010 annual report more than
80 per cent of portfolio companies that members of EVCA invest in met the criteria of SMEs.
However, while assessing whether an AIFM is caught under the AIFMD or not the critical
issue is whether a group the AIFM belongs to manages AIFs with assets under management
reaching the threshold limits.
These data clearly imply that a majority of AIFMs which are members of private equity and
venture capital industry associations may not reach the thresholds set out in the AIFMD; and
thus could qualify for the exemption and should be regulated under the national registration
regime. As it is still unclear what shape these national regimes will have, it is difficult to
precisely assess the impact of new regime for private equity and venture capital managers.
Should the member states opt for more stringent regime close to the AIFMD requirement then
an advantage to be regulated under national regime for AIFMs would be very limited.
Operating conditions
The AIFMD sets out specific requirements regarding capital, internal governance
arrangements and remuneration, use of outsourcing, valuation, and depositary functions. In
addition the Directive imposes overarching obligation on AIFMs to:
(a) Act honestly, with due skill, care and diligence, and fairly in conducting their activities;
(b) Act in the best interests of the AIFs or the investors of the AIFs they manage and the
integrity of the market;
(c) Have and employ effectively the resources and procedures that are necessary for the
proper performance of their business activities;
(d) Have in place effective processes for identification and management of conflicts of
interests;
(e) Comply with all regulatory requirements applicable to the conduct of their business
activities so as to promote the best interests of the AIFs or the investors of the AIFs they
manage and the integrity of the market;
(f) Treat all AIF investors fairly.
Capital requirements basically follow the UCITS standards thus requiring AIFMs to have
initial capital of 300,000 EUR in case of internally managed AIF and at least 125,000 EUR in
case of external managers. An additional capital requirement imposed relates to the amount of
assets under management and to the requirement to cover professional liability risks when
professional indemnity insurance may also be used. The level 2 measure should specify
professional liability risks which should be covered and the conditions for determining the
appropriate level of own funds and the insurance to cover these risks.
Internal governance rules for AIFMs are outlined in detail in the AIFMD. These rules build
on similar principles already applicable to the governance of UCITS management companies.
70
The primary focus is on risk and liquidity management, conflict of interest management and
remuneration. The new element is regulation of remuneration of AIFM staff which is based
on similar principles as regulation of remuneration in the banking sector introduced by revised
CBD in 2009. Outsourcing is another area of particular interest to regulators. In fact, rules
regarding outsourcing in the AIFMD represent a standard pattern which can be found in
number of EU directives such as MiFID and UCITS. Delegation of key functions by
AIFMa manager is subject to strict conditions and a detailed disclosure obligation to the
competent authority and to investors as well.
The obligation of AIFMs to establish an independent valuation function is another specific
feature which gave raise to extensive discussion when the directive was negotiated. The
valuation function should be set for each AIF and AIFM manager. While the AIFMD does not
provide for specific valuation methodology it requires extensive disclosure towards investors
and competent authorities.
Following the template set out in the UCITS directive AIFMD requires appointment of
a single depositary for individual AIF by its manager. Functions of depositary of an AIF
should typically cover safe keeping of the assets of the fund, administration of the fund’s
assets, monitoring of the funds operations and individual transactions, ensuring compliance of
operations and transactions with the fund rules and applicable legislation. Depositary should
also ensure that the calculation of the value of units or shares of the AIF is conducted properly
in compliance with the applicable laws. Unlike in the case of UCITS funds as depositary may
be appointed not only credit institutions but also investment firms and in certain cases of
close-ended funds also notaries. There are specific rules regarding liability of a depository for
any loss of assets of AIFs introduced by AIFMD.
Specific requirements do apply for AIFs acquiring control over companies, primarily notlisted
ones. The AIFMD provides an exemption from this regime for acquisition of SMEs by
AIFs as those were not considered as "companies of wider-public interest" and to special
purpose vehicles. Interestingly, EVCA data indicate that vast majority of portfolio companies
of the EVCA members are SMEs thus the AIFMD requirements in respect of these portfolio
companies do not apply unless these are issuers of listed securities. The obligations for the
AIFM are mainly of a disclosure nature – specific notification regarding acquisition of control
and of certain other levels of the stake on the company’s capital, disclosure of the policy for
preventing and managing of conflicts of interest, intentions on future business of the company
acquired including impact on the employment at the target company. Interestingly, these
disclosures should be made not only to the company and the regulator but also to other
shareholders of the target company while these (not being AIFs) do not have any
corresponding obligation. There is also a specific obligation imposed on the AIFMs which
should require the board of the target company to further disclose all information disclosed to
the company to representatives of employees or, should there be no such representatives,
directly to employees. Also specific anti asset-stripping policy rules applicable to all AIFM
managing funds which have acquired control of a company. In particular these represent
limits on distributions and payment of dividends to the shareholders and preventing an AIFM
from either facilitating or providing support to any such action
Proposed regulation on the European Venture Capital Funds
In June 2011 the Commission issued a new policy document setting out a potential policy
objective in respect to the establishment of a single market for venture capital. Among
background considerations mentioned in this document the Commission explicitly state that
"AIFMD does not always appear to be the ideal instrument for the promotion of the crossborder
activity of venture capital in EU. ... Since venture capital was not at the focal point of
the AIFMD rules, the AIFMD requirements are not tailored for venture capital managers." In
respect of relevant legal framework the initial one option considered was re-examination of
71
the AIFMD and setting a more tailored regime for managers of such funds. Nevertheless, the
second option - the establishment of a completely separate system for venture funds forming
new regulation on the European venture capital funds was chosen at the end. Subsequently the
Commission published new legislative proposal regarding the regulation of venture capital in
December 2011 aiming to put new regime in place by mid 2013.
The main feature of this new regulation is voluntary registration of venture capital managers
with their respective competent home authorities in order to enable passporting of their
activities also to other Member States, i.e. a regime similar to passport of a UCITS/AIFMD
management company. Aside from this harmonised regime a national regimes for managers
of venture capital under limit of AuM set by the AIFMD not wishing to use passport should
be maintained. According to the draft regulation the registration requirements should be
relatively "light" compared to the AIFMD authorisation requirements. The notification
procedure for venture fund managers should represent a simplified version of the
UCITS/AIFMD notification procedures. A new harmonised regime should be available only
for venture capital funds whose investors are professional investors within the definition of
MIFID and certain other qualified investors and so far no national discretion to enable
investing in such funds also to retail investors is proposed. Regulatory reporting should be
restricted to annual reporting on the basis of a fund’s audited accounts and annual report.
Similarly to AIFMD, this new regime should apply to any legal form of the venture fund.
The draft regulation elaborate quite in detail on description of what a venture capital fund is –
limiting investment focus to SMEs which should meet certain criteria, e.g. are not publicly
traded, do not borrow money or issue debt securities and entities which are not financial
entities (funds, banks etc.).
The exact scope of new harmonised regime for venture capital funds and its interaction with
AIFMD is delineated clearly – the new European venture capital funds regime should apply
only to managers managing assets under AIFMD exemption thresholds.
Operating conditions which are seen as the critical point of AIFMD having produced
extensive requirements and significant compliance costs to venture capital funds are outlined
in much lighter form in the Commission proposal. Nevertheless, some elements of the
proposal should be subject to a further scrutiny in order to achieve "minimizing of the
compliance costs" as the Commission explicitly states in its proposal.
In respect to the third country entities, the aim articulated in the Commission proposal seems
to be quite open to third countries entities – they should be able to obtain relevant registration
within the EU and benefit from passporting rights as well.
CONCLUSION
The long-term intention of European institutions to regulate alternative funds active on the
internal market has found the final form in AIFMD published recently. The aim to capture all
different forms and sorts of funds led to very structured regulatory regime at the EU level
providing for smaller players to be regulated at the national level in non-harmonised way still.
For the AIFs and their managers which will be captured by the AIFMD new regulatory
requirements are expected to require AIFMs to take numerous measures in order to comply
with the AIFMD requirements thus implying additional costs to the funds and their investors.
The most burdensome measures for the private equity and the venture capital sectors seem to
be the obligation to appoint depositary and the valuation requirements and reporting and
notification obligations towards the investee companies. In the private equity and venture
capital sectors is seems that vast majority of managers VC/PE funds will be eligible for
national registration regime. However, it is still unclear what shape these national regimes
will have. It cannot be ruled out that even less demanding national registration regimes will
bring not only marginal costs to the private equity and venture capital funds.
72
Recently issued proposal of the regulation on the European venture capital funds introducing
special regime for venture capital funds seems to reflect the recognition that AIFMD regime
is not an ideal platform for [at least] certain types of alternative funds. More flexible regime
can be seen as welcome move.
BIBLIOGRAPHY
[1] A new European regime for Venture Capital - Commission staff working document
(issued on June 15 2011)
[2] Commission Recommendation of May 6, 2003 concerning the definition of micro, small
and medium-sized enterprises (2003/361/EC)
[3] EVCA Reporting Guidelines 2010
[4] EVCA response to ESMA Discussion Paper
[5] EVCA Governing Principles
[6] Guidelines on Remuneration Policies and Practices prepared by Committee of European
Banking Supervisors in December 2010
[7] The debate at the European Parliament on November 10, 2010 (Council document Interinstitutional
file 14602/10)
[8] A Guide in Private Equity BVCA and PricewaterhouseCoopers 2004
[9] Final Report of the IOSCO Technical Committee on Private Equity (2008)
[10] Proposal for a Directive of the European Parliament and of the Council on Alternative
Investment Fund Managers and amending Directives 2004/39/EC and
2009/…/EC COM(2009) 207 final
[11] A new European regime for Venture Capital - Commission staff working document
[12] White paper -Enhancing the Single Market for Investment Funds (SEC(2006) 686 Final).
[13] The Directive 2009/65/EC of the European Parliament and of the Council of 13 July
2009 on the coordination of laws, regulations and administrative provisions relating
to undertakings for collective investment in transferable securities (UCITS)
[14] The Directive of the European Parliament and of the Council of June 8, 2011
on Alternative Investment Fund Managers and amending Directives 2003/41/EC and
2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010
[15] ESMA Discussion paper on Key concepts of the Alternative Investment Fund Managers
Directive and types of AIFM
[16] Final report - ESMA's technical advice to the European Commission on possible
implementing measures of the Alternative Investment Fund Managers Directive
Full name: Zdeněk Husták
Institution: The Faculty of Law, Masaryk University Brno
Street: Veveří 70
City: Brno
Email: zdenek.hustak11@centrum.cz
73
AGENCY THEORY AND ITS APPLICATION IN THE
BUSINESS OF THE FINANCIAL SECTOR IN SLOVAKIA
Erika Mária Jamborová
ANNOTATION
Our contribution focuses on the concretization and implementation of the agency theory in
terms of the economic practice, under the influence and impact of the financial and economic
crisis. It is intended to define the different roles, which are significantly affecting business
entities in the financial sector, in characterizing not only the traditional roles - investormanager-employee-client,
but also the role and position of the state as the regulator of the
financial industry sector. The role of the state is determined by the specificity and significance
of the financial sector for the national economy. The aspects of globalization increasingly
emphasize the need for transnational financial sector supervision and regulation thus
exceeding the boundaries of one state.
KEY WORDS
agency theory, the financial sector, banking industry, financial and economic crisis, regulation
JEL classification: G30
INTRODUCTION
The current globalizing environment is significantly affected by the impact of the economic
and financial crisis that currently exists in Europe in terms of the debt crisis. The current crisis
was affected especially by the release of business conditions in the international context, such
as trade liberalization, deregulation of markets, but also by the important phenomenon of
recent decades – the significant development of information and communication technologies.
The business environment is characterized by the growing influence of transnational
corporations, many of which operate in the financial markets. The effort to achieve a
reasonable profit as well as the increasing competition in domestic as well as in foreign
markets is increasingly forcing companies to draw the attention to the economies of scale and
to the search for new competitive advantages. In the financial sector, globalization reflects the
emergence of financial conglomerates, doing business in at least two financial industry
sectors.
Our contribution focuses on the analysis of the application of the agency theory - in
the financial business practice in context of the ongoing financial and economic crisis. The
goal of the financial institution, represented by management, is to achieve profit and client
satisfaction. Increasingly important, however, becomes a long-term relationship with the
client of the bank, ideally during all stages of its life-cycle. Client’s interest lies in satisfying
the demand for financial services in obtaining reliable products at favorable quality, price and
other conditions. As it is evident from the a.m. statements, the management objectives as well
as the client objectives are somewhat contradictory to each other. Based on the abovementioned
objectives there is a complex of relationships. The expression of their context,
conditionality and their impact on the success of the objectives of financial institutions is
subject to our research and the focus of our contribution. In examining this issue, we rely on a
theoretical basis, based on the new institutional economics, the theory of firm, which are
specified in the theory known as agency theory or the problem of principal - agent.
.
74
OBJECTIVE AND METHODS
The aim of our paper is to identify situations in which agency theory is applied in economic
practice, particularly in terms of the banking sector in Slovakia during the current crisis. Our
research focuses on defining the essential aspects of the theory identifying the roles of actors
in financial operations in the context of the specific terms of the economic practice. It also
takes into account the role of state that it plays in the business of banking sector. The paper
also aims to illustrate some specific actions, taken by regulator, to stabilize the conditions in
terms of the impacts the financial and economic crisis to the financial sector. Our goal was to
evaluate all these aspects and by applying the method of the analysis, synthesis and
comparison, induction and deduction to clarify the role of the state as a regulator for possible
further development of the a.m. theory.
RESULTS
Agency theory-basic assumptions
Agency theory prescribes alignment and other mechanisms as possible solutions for specific
problem that organizations commonly face, i.e. the increased agency costs from asymmetric
information and lack of goal congruence between a firm’s principals and agents. According to
Nyberg A.J. et al., the theory suggests that there is potential for “managerial mischief” when
the interests of firms’ owners and managers diverge; one possilbe solution to this “agency
problem” is that firms align owner and agent interests through agents’ equity ownership and
the structure of their compensation. The author states, that the appropriate measure of
financial alignment is the degree to which a CEO’s economic interests covary with those of
the owners. Accordng to scholarly research, performance is a function of ability and
motivation and opportunity. As per the author, agency theory tends to ignore ability, but
CEOs’ abilities obviously do vary and circumstances can constrain decision choices, limit
information, present uncertainties, so it is difficult to prescribe in advance which decisions an
executive should make. Based on his reaserch, Nyberg A.J. et al. argues that, properly used
financial alignment through compensation and stock ownership does not relieve corporate
boards of monitoring responsibilities; instead, it alters the nature of the monitoring that is
required.(1) According to Lan, L. L. and Heracleous, L., the principles of the agency theory control
and motivation based on own interests, are currently not sufficient to explain the
collaborative behavior management systems as well as the business operation environment in
mature market economies as well as to explain the complexity of the real world. The
behavioral assumptions on that agency theory is based are not sufficient. According to those
authors, in order to fill these gaps, researchers are looking for more effective methods - eg,
possibles variables to be selected to evaluate the independence of the board of directors,
agent's equity participation in the company, as well as effective control of firms in the market
environment. They are looking for the context, within these new aspects can be implemented
into the economic practice as well as they are searching for new principles to examine the
basic problems of corporate governance. Lan, L. L. and Heracleous, L. propose to address
these shortcomings of the principal-agent theory by redefining the role of principal owner
(investor) to the company, because the company itself acts in legal relations as a separate
legal entity, entering into a number of relationships with stakeholders. The success of the
company depends on its focus to meet the expectations of stakeholders. Furthermore, the
authors argue that the board of directors acts rather in favour of the interests of stakeholders
than of the owners, and its role is rather in the position of an authorized person as in a position
of an agent charged by the owners. As per the a.m. researchers, the board of directors must be
credible to all stakeholders, which implies, that it can not be charged by a clean agent role.
This expose the role of the board of directors to some opportunism. It is shown, that the
success of the company is closely linked with the success of stakeholders, which is also
75
reflected in a company's financial results. Lan, L. L. and Heracleous, L., propose to extend the
investigation of deficiencies of the agency theory in terms of the institutional theory, based on
a theory of contractual relations. The authors note that the institutional environment contains a
variety of heterogeneous elements and the relationships between regulatory, normative and
cultural-cognitive pillars, which can create conflicts between themselves. Another factor,
according to Lan, L. L. and Heracleous, L., that influences the nature and character of the
company, is the theory of transaction costs. The company must take into account the
competing interests of stakeholders, such as eg interfering in the social dimension of
individual property rights etc. In this context, companies must consider not only the
individual transactions, but also to put in their decisions into account the respect of the impact
of their decisions.(2)
Agency theory and its reflection in the business practices of the financial sector
The agency theory is based on a description of the economic actions such as the contractual
relationship between two or more operators. According to this theory, the principal delegates
the disposal of the fulfillment of specific tasks entrusted to agent. Agent does not act only in
relation to the attainment of the goals of the principal, but he also acts in relation to achieve its
own goals. The division of tasks in principal-agent relationship and the resulting role is not
always clear, but is dependent on some specific situations (e.g. customer as creditor in deposit
business acts as the principal and the bank employee, or manager as the agent). Similarly, the
interests of manager are conditioned by his own motivation (aims and objectives) as well as
by the financial and non-financial incentives reflected in the conditions specified in a
management contract agreed between him and the owner (owner representative) of the
financial institution. The owner’s goal is to achieve a reasonable profit and further success of
the financial institutions with regard to alternative investment opportunities and as well as
with regard to risk (i.e. to achieve a reasonable level of return on equity - ROE and dividend
payments). In connection with the service provided, the uncertainty (as a result of
asymmetric distribution of information) for the customer can decrease particularly by the
staff qualification and experience, as well as by the willingness to care and service the
customer. This is noticeable by the client during the interview before closing the contract, or
subsequent after the conclusion of the contract,during its administration. There are some risk
for the client in the role of principal, especially in the agent information advantage (e. g. in
case of the above-mentioned deposit products), which can be misused by the agent on its own
behalf. The advantage for the agent may is in having information about the status and trends
of the business environment developpment (e.g. development of national economy, capital
markets, the future of the euro...). On the other hand, as reported by S. Ziegler and M. Sohl,
agent-principal relationship is changing and evolving, and it may also happen, that the client
makes use of free advice in the bank, but the actual contract, as a result of the counseling
interview, may be concluded with the less expensive financial service provider (clients - socalled
"free rider" –the transition to a competitor - e.g. the internet bank) (3, p.133).
Applying this theory to the subject of our research, it makes us easier to clarify what types of
principal-agent relationships can arise in the businesses of financial institutions. These factors
significantly affect the creation, modification and implementation of marketing strategies of
financial institutions. S. Ziegler and M. Sohl refer to the inadequacy of this theory, in terms,
that a contract cannot cover all factors that may arise in the business relationship with clients.
As measures against potential hazards by the agent (covert agent characteristics inappropriate
selection of the agent, moral hazard, fraudulent intent of the agent) and its
opportunistic behavior, the authors propose to collect information about the agent (screening),
the surveillance of an agent (monitoring), the convergence of interest and principal agent in
the form of incentives and sanctions (the convergence of interests) and to reduce the
76
information deficit by the principal (signaling). Measures for reducing the information deficit
as well as for preventing opportunistic behavior are however associated with additional costs
(agency costs). These costs consist of the costs of monitoring agent by the principal,
guarantee costs of the agent as well as of the residual loss. (4, p.63)
The impact of the financial and economic crisis on the application of the agency theory
in business practice of financial sector
In the financial sector, can take also the state the partial role of "principal" over the major
financial institutions because of their national economic significance. In regulating the sector,
the state intervenes in the agent’s businesses by the determination of financial markets
legislation, by the licensing policy, by the integrated financial market supervision, by
demanding various statistics and reporting, as well as by state supervision over the selection
of directors and supervisory boards, in assessing professional and moral criteria on those
positions. In exchange for this control, (as a form of interference with free market rules, often
associated with additional costs without no reflection in returns) is, in our view, an evidence
for example the deposit protection act, the investment guarantee fund, or in providing various
financial injections, such as capital investment of the state in the major financial institutions to
reduce uncertainty and to increase confidence of clients of financial institutions. All these
steps are favoring regulated financial institutions on the market with premium conditions, as
there is a direct link between the increase of confidence and the growth of returns in the
financial sector. In this case, we can consider the cost to remediate the banks (i.e. the
strengthening of capital by state in form of capital investment in financial institutions) as a
part of "agency costs", where the state is seen as a principal and the shareholder (owner) as
agent. A concrete manifestation of such interventions is the massive state support to
individual banks in the EU, as well as in identifying 29 banks at the G20 meeting1
, which
must be " saved at any price ", because of their global importance.
Regulator as principal
The impact of the crisis significantly impacted on the development of economic situation in
Slovakia and on the economies of its major international partners. The banking crisis is
reflected in reducing the ability of businesses and households to repay loans. In the banking
area, the Government adopted several measures to counter the impacts of the crisis. The most
important of them included an amendment to the Deposit Protection Act in 2008, in providing
to depositors the unlimited guarantee. Unlimited guarantee was not implemented by all EU
countries. In order to increase competitiveness in deposit products, the guarantee of deposits
under the conditions prevailing in Slovakia joined also some branches of foreign banks doing
business in this country. Unlimited guarantee of deposits met with success, the primary
objective, relating to the stabilization of the situation and to gain the confidence of the
population "to healthy banks" was filled. (5) This step contributed significantly, along with
the decision of the changeover from the Slovak koruna to the euro, to the increase in deposits
in the banking sector as of the end of 2008. In 2009, the Act no. 276/2009 on measures to
mitigate the effects of the global financial crisis on the banking sector was adopted in
1
The G20 Summit in November 2011 set out a list of 29 systemically important financial institutions. The
collapse of these banks would threaten the entire global financial system. These banks need to meet more
stringent requirements on capital requirements and create a plan for disposal without the help of taxpayers if they
find themselves in troubles. G20 agreed to increase capital adequacy requirements for these banks to the year
2016. The Financial Stability Board (FSB), an international body to oversee banks, stated that banks will have to
create by the end of the 2011 the analysis of "living will" (the term is used for documents showing the human
desire not to be artificially kept alive in case of a fatal disease). This list of world's systemically important
financial institutions, called G-SIFI, should be reviewed annually in November.
77
Slovakia. This law allowed certain limiting of shareholders' rights in exchange for the capital
injection of the state, for the purpose of remediation due to the ongoing financial crisis and its
impact. The Slovak Republic did not need to apply this law in either bank. (6) Slovakia
belongs under nine countries in the EU, without the need of financig help to the financial
industry during the crisis. The National Bank of Slovakia (NBS), as a regulator of the
financial market, took measures to reduce the premium payment to bank managers in relation
to the impact of the crisis to. Another measure adopted by the Slovak government as well as
by the Slovak Banking Association was a program of assistance to clients of banks, unable to
repay a housing loan due to economic crisis. Together with the Slovak Consolidation Bank,
this program was joined by 11 commercial banks in the SR. Slovak Banking Association
signed a memorandum of cooperation with the Slovak Ministry of Finance, Slovak Guarantee
and Development Bank and with the Export-Import Bank of Slovakia, to support the business
environment during the financial crisis. Memorandum stipulated the basic framework of state
institutions guarantees for lending to SMEs. According to this memorandum, state-owned
financial institutions have to provide bank guarantees for loans to small and medium-sized
businesses, communities, property owners to housing reconstruction. Memorandum of
Cooperation was concluded for a limited period until the end of 2010 (5).
CONCLUSION
Based on the above mentioned findings, we can say, that despite the liberal market, there are
industries in the national economy, that are of particular importance for the state that are
contributing to the stabilization of the terms of the economic environment. So is undoubtedly
the financial services sector, which comprises on the trust and on social and psychological
aspects associated with the essence of the financial services - money. We can say, that on the
one hand contributed globalization to the release of business conditions, but on the other hand
it brought the growing complexity and increasing uncertainty. Its product is also the present
crisis. To avoid the negative impacts of the financial crisis, in order to stabilize the conditions,
the necessary input from the position of state controller, to establish security and rebuild
confidence was needed, which as we can say, based on our research, has been successful in
the Slovak Republic. The role of state in supervising banks business is essential, especially in
determining the prudential terms of financial institutions, but also in actively entering into the
exercise of ownership rights with certain limitations, during crisis. In this cases the state acts
in the role of principal. While the role of regulators at the national level is relatively clear, it
still raises the issue of transnational regulation of financial institutions, which still, despite the
fact that since the beginning of the crisis slowly passed five years, is still not in place.
The contribution is treated as part of the project VEGA 1/1185/12: Changes in consumer
trends conditional to impact of the financial-economic (social) crisis, reflected by
modifications in the marketing programs of business entities in order to maintain their
competitiveness in international markets (with application to the conditions EU with an
emphasis on SR).
REFERENCES
[1] NYBERG, A. J. et al. Agency theory revisited: CEO return and shareholder interest
alignment. [online]. In: Academy of Management Journal. Oct2010, Vol. 53 Issue 5, p1029-
1049. 21p. 7 Charts, 2 Graphs. DOI: 10.5465/AMJ.2010.54533188. [cit.2012-06-20],
Available on internet:
<http://web.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=4&hid=104&sid=6fb4e17b-dd5a-
4b46-a3ee-0aa1469695d2%40sessionmgr113>.
78
[2] LAN, L. L.; HERACLEOUS, L. Rethinking agency theory: the view from law. [online].
In: Academy of Management Review. Apr2010, Vol. 35 Issue 2, p294-314. 21p. 1 Diagram, 3
Charts. DOI: 10.5465/AMR.2010.48463335. [cit.2012-06-20], Available on internet: <
http://web.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=4&hid=104&sid=33458779-0cd0-
45c2-bf22-bb7a0f79d2a4%40sessionmgr111>.
[3] ZIEGLER, S.-SOHL, M. (Hrsg.) 2011. Moderner Bankvertrieb im Dienst des Kunden:
Neue Wege zu einem kundenzentrierten Marktauftritt.Wiesbaden: Gabler Verlag/ Springer
Fachmedien Wiesbaden GmbH 2011, 2011. p.133. ISBN 978-3-8349-2203-8.
[4] THOMAS, P.2008. Mass Customization als Wettbewerbsstrategie in der
Finanzdienstleistungsbranche. Wiesbaden: Gabler/ GWV Fachverlage GmbH, Wiesbaden
2008, 360 p. ISBN 978-3-8349-1098-1, p.14, p.15, p. 63
[5] © SLOVENSKÁ BANKOVÁ ASOCIÁCIA. 2009. Vplyv krízy na slovenský bankový
sektor. [online]. Bratislava : © Slovenská banková asociácia, 2009. [cit. 2011-02-21].
Available on internet:
< http://www.sbaonline.sk/sk/presscentrum/aktuality/vplyv-krizy-na-slovensky-bankovy-
sektor.html>.
[6] © SLOVENSKÁ BANKOVÁ ASOCIÁCIA. 2009. SBA podpísala memorandum
o spolupráci. [online]. Bratislava : © Slovenská banková asociácia, 2009. [cit. 2011-02-21].
Available on internet: < http://www.sbaonline.sk/sk/presscentrum/tlacove-spravy-sba/sba-
podpisala-memorandum-o-spolupraci-v-oblasti-spolufinancovania-malych-a-strednych-
podnikov.html>.
[7] © SLOVENSKÁ BANKOVÁ ASOCIÁCIA. 2009. SBA a vláda podpísali ďaľšie
memorandum o spolupráci. [online]. Bratislava : © Slovenská banková asociácia, 2009. [cit.
2011-02-21]. Available on internet:<http://www.sbaonline.sk/sk/presscentrum/aktuality/sba-
a-vlada-podpisali-dalsie-memorandum-o-spolupraci.html>.
Ing. Erika Mária Jamborová
Ekonomická Univerzita v Bratislave
Dolnozemská cesta 1
Bratislava, Slovakia
erika.jamborova@gmail.com
79
THE EFFECTS OF DOMESTIC AND FOREIGN
ENTERPRISES’ FINANCIALACTIVITY IN HOST COUNTRY
ECONOMY – COMPARATIVE ANALYSIS
Magdalena Jasiniak
ABSTRACT
The main purpose of this article is to compare the financial effects of foreign and
domestic enterprises’ activity in the host country economy including domestic enterprises
producing only for the internal market and domestic enterprises producing on both the
domestic market and foreign markets. As a result of the researches carried out by the author of
this article: a survey and a comparative analysis of the enterprises’ financial data it appeared
that Polish enterprises producing both for the internal market and external markets are able to
compete successfully with foreign firms on the domestic scene.
KEYWORDS
the effects of financial activity, financial analysis, foreign enterprises’ activity
JEL classification: G32
INTRODUCTION
Foreign investors have been present in the Polish economy since the mid-1970s the
19th century. Nowadays enterprises with participation of foreign capital are an integral part of
the polish economy and market relations. Moreover the activity of foreign enterprises in the
host country economy is the main subject of many scientific studies in polish literature.
The main purpose of this article is to compare the effects of financial activity of
enterprises owned by foreign investors, domestic enterprises producing only for the internal
market and domestic enterprises producing both for the internal market and external markets
in host country economy.
In Poland, studies on the activity of foreign enterprises, carried out at the
microeconomic level are very rarely. There are also not many comparative studies on
domestic enterprises and the enterprises with participation of foreign capital, particularly in
the financial sphere. Such comparisons are sometimes only a part of a broader analysis. In the
foreign literature studies in this sphere are carried out on a relatively advanced level. The
comparative analysis are often carried out among the foreign enterprises in the host country
economy, the domestic enterprises producing only for the internal market and the domestic
enterprises producing for both - the internal and external markets, however, rarely from the
financial perspective.
M. Grasserii indicates, inter alia, that the foreign enterprises have higher productivity
and profitability of sales than domestic ones. Foreign enterprises are also more indebted than
domestic enterprises producing for both - internal market and external markets.1
D. Castellani
and A. Zanfei confirm that foreign enterprises achieve better effects of their activity than
domestic enterprises. However, these differences are rendered down when the comparisons
are made between the foreign enterprises and domestic enterprises that operate in
international scale. It appeared that domestic enterprises producing both for internal and
external markets are more productive and innovative than foreign enterprises in the host
1
M.Grasserii, Domestic Multinationals and Foreign – Owned Firms in Italy: Evidence from Quantile
Regression, The European Journal of Comparative Economics, vol.7,n.1, 2010, s.61-86
80
country.2
Blakeley’s report indicates that foreign enterprises in relation to domestic ones are
characterized by higher return of assets and higher return of capital. Foreign enterprises have
also higher productivity than domestic ones, although the productivity of domestic enterprises
producing for both internal and external markets is similar to the level of foreign enterprises’
productivity.3
As well as the authors cited above, the authors of polish studies (among others. M.
Jaworek, W. Karaszewski, J. Różański) point out that foreign enterprises use more advanced
solutions in organizational and innovative spheres, more advanced than those applicable in the
host country (assuming that the level of development of the home country economy is higher
than the level of development of the host country economy), that may have a significant
impact on strengthening their market position in relation to domestic enterprises and has an
influence in achieving relatively high financial results.
METHODOLOGY OF THE RESEARCH
The research was carried out in 2011. The survey questionnaire was made among 100
randomly selected enterprises with 100% domestic capital ( 0,05 % of total population) and
100 randomly selected enterprises with 100% foreign capital ( 38,5% of total population),
operating in the industrial processing section in the region of Lodz. The obtained return of a
survey questionnaires was 118, including: 42 questionnaire from foreign enterprises and 76
from domestic ones. Among domestic enterprises were selected:
• domestic enterprises producing only for internal market (47 enterprises)
• domestic enterprises producing both – for internal and external markets (29
enterprises)
The next stage of the research was gathering the financial data of surveyed enterprises
for the year 2010 and comparative analysis of selected financial indicators. The structure of
enterprises was similar in terms of size, measured in number of employees4
. In this stage
domestic enterprises were also selected into two groups, those producing only for internal
market and those producing for both – internal and external markets.
CHARACTERISTICS OF FOREIGN AND DOMESTIC ENTERPRISES
FINANCIAL ACTIVITY – RESEARCH SURVEY
During the research enterprises were asked about the evaluation of their financial
condition on the basis of chosen financial indicators, common for this kind of analysis: return
of sales, general debt and current liquidity. The level of return of sales indicator in surveyed
enterprises is presented in table 1.
Table 1. Return of sales indicator in domestic and foreign enterprises
Type of enterprises
Return of sales
Total
high medium low
foreign 28,6% 52,4% 19,1% 100,0%
2
D.Castellani, A.Zanfei, Internationalization, innovation and productivity: how do firms differs in Italy?, the
World Economy, n.30 (2007), s.156-176.
3
N.Blakeley, Why do foreign – owned firms perform better than New Zeland – owned firms?, The Treasury,
Kaitohutohu Kaupapa Rawa 2009, T2009/2747s. 4-6.
4
Level of employment:
- up to 9 – microenterprises
- from 10 to 49 small enterprises
- from 50 to 249 medium enterprises
- more than 250 big enterprises
81
domestic producing only for internal market 21,3% 55,3% 23,4% 100,0%
domestic producing both for internal and
external markets
25,0% 46,4% 28,6% 100,0%
Source: own elaboration
Among the surveyed enterprises the highest level of return of sales indicator achieve
foreign enterprises - 28,6% of foreign enterprises in total. In the case of the domestic
enterprises who achieve high return of sales, there is a higher share of enterprises producing
for both internal and external markets (25% of the enterprises) than domestic enterprises
producing only for the internal market-21,3% of the enterprises. Therefore, domestic
enterprises are able to achieve the level of return of sales indicator close to foreign enterprises
while they expand their activities on external markets.
Table 2 presents the structure of surveyed enterprises in terms of general debt level.
Table 2. The level of general debt of foreign and domestic enterprises
Type of enterprises
General dept Total
high medium low
foreign 0,0% 35,7% 64,3% 100,0%
domestic producing only for internal
market
2,1% 36,2% 61,7% 100,0%
domestic producing both for internal
and external markets
10,7% 53,6% 35,7% 100,0%
Source: own elaboration
Domestic enterprises producing only for the internal market as well as foreign
enterprises are characterized by a rather low level of indebtedness (61.7% and 64.3%
indications). None of the foreign enterprises evaluate their level of indebtedness as high while
among domestic enterprises producing only for internal market there are only 2.1% with high
general debt. The level of general debt of domestic enterprises producing both for internal and
external markets is greater in relation to other enterprises. A 64.3% of these enterprises are
characterized by medium and high level of indebtedness. Probably the entry of domestic
enterprises on external markets has been connected with the necessity of increasing the risk of
the activity by the acquisition of additional (foreign) capital. However, the level of return of
sales ratio of these domestic enterprises was relatively high, so a greater level of debt in those
enterprises probably does not constitute a threat for their further activity.
The share of foreign capital in the financing enterprises’ activity has a direct impact on
the level of their current liquidity. The characteristic of the surveyed enterprises in terms of
ability to pay off current liabilities is presented in table 3.
Table 3. The current liquidity of the domestic and foreign enterprises
Type of enterprises
Current liquidity
Total
high medium low
foreign 50,0% 50,0% 0,00% 100,0%
domestic producing only for internal market 38,3% 53,2% 8,5% 100,0%
domestic producing both for internal and
external markets
17,9% 60,7% 21,4% 100,0%
Source: own elaboration
The characteristics of surveyed enterprises in relation to their current liquidity is
clearly differentiated, although largely shows the relationship that occur between the level of
general debt of the enterprises and the capability to pay off current liabilities. Among the
foreign enterprises preserving a low level of debt, every second foreign enterprise is
characterized by high level of current liquidity. Also, the relatively high level of current
liquidity is characteristic for domestic enterprises producing only for the domestic market -
82
among these enterprises 38,3% is characterized by high level of current liquidity. Foreign
enterprises as well as domestic ones producing only for internal market achieve also relatively
low level of general debt. Domestic enterprises producing both for the internal and external
markets have the lowest level of current liquidity. Among this group of enterprises there is
21,4% enterprises that are characterized by low current liquidity ratio. At the same time, the
level of general debt of these enterprises was the highest.
The results of survey about the financial condition of enterprises in the region of Lodz
indicate that:
• domestic enterprises producing for the internal market and foreign markets are similar
to the foreign enterprises in terms of sales profitability, despite a higher level of debt
and lower level of current liquidity in relation to foreign enterprises,
• domestic enterprises producing only for internal market achieve low level of
indebtedness and rather high level of current liquidity – similar to foreign enterprises
but their sales profitability is lower in relation to foreign enterprises.
These findings are essential for further comparative analysis, based on more detailed data,
contained in the financial statements of surveyed enterprises.
CHARACTERISTICS OF FOREIGN AND DOMESTIC ENTERPRISES
FINANCIAL ACTIVITY – FINANCIAL DATA COMPARATIVE
ANALYSIS
The results of comparative analysis based on financial data of the surveyed enterprises
are not always compatible with the results of the survey carried out in the same group of
enterprises, especially in the case of foreign enterprises. Detailed data includes table 4.
Tabela 4. Chosen financial indicators of foreign and domestic enterprises
Ratios
Type of enterprises
foreign
domestic producing
only for internal
market
domestic producing both for
internal and external markets
ROS 4,4% -0,2% 8,0%
current liquidity 1,93 1,63 1,59
general debt 52,8% 43,4% 60,3%
Source: own elaboration
The analysis of enterprises’ financial data presents that domestic enterprises producing
both for the domestic and foreign markets can achieve the highest level of sales profitability -
8,0%-almost twice higher than foreign enterprises for that the value of this indicator is 4,4%.
In contrast, domestic enterprises, producing only for the internal market are characterized by
the lowest level of sales ratio (-0.2%). Meanwhile, the survey and the analysis of literature
indicate that the foreign enterprises generally are characterized by the highest level of
profitability of sales. However it may be confirmed that domestic enterprises producing only
for the internal market are characterized by the low profitability of sales.
In the case of comparative analysis of the current liquidity ratio the relations between
type of enterprises and the level of current liquidity are similar to those observed in the
survey. Foreign enterprises are characterized by the highest level of current liquidity ratio,
while the domestic enterprises producing for both - domestic and foreign markets achieve the
lowest level of current liquidity ratio (the value of current liquidity ratios respectively 1,93
and 1.59). The average value of current liquidity ratio for domestic enterprises producing only
83
for the internal market is 1,63. However, it should be noted that the average values in the
range 1,5-2,0 are recognized in the literature of the subject as the most optimal values.5
The comparative analysis of the enterprises’ general indebtedness partially confirms
the conclusions of the survey carried out among the same group of enterprises. Actually the
level of debt of the domestic enterprises producing both for internal and external markets is
the highest among the surveyed enterprises (value of the ratio - 60.3%), however, the
domestic enterprises producing only for the internal market are characterized by lowest (even
in relation to foreign enterprises) value of this ratio - 43,4%. Meanwhile, in the literature it is
considered that foreign enterprises are more willing to carry out the activity at higher level of
risk and to realize less safe policy of debt (sometimes even at very low financial liquidity) in
relation to domestic enterprises.
CONCLUSIONS
The presented results of the survey and comparative analysis of financial data among
the randomly selected group of foreign and domestic enterprises in the region of Lodz tend to
reach a slightly different conclusions from those presented in the literature. At first, according
to the literature, foreign enterprises more frequently than the domestic ones are realize more
aggressive policy of debt. Foreign enterprises generally achieve high level of general debt
even at risky level of current liquidity ratios. It is also considered that the foreign enterprises
achieve better effects of their activity than domestic enterprises. Meanwhile, on the basis of
the carried out analysis, it can be noted that domestic enterprises producing both for the
internal and foreign markets are ready to take the risks associated with a relatively high share
of foreign capital in financing their activity and does not lose the ability to regulate the current
liabilities. The high proportion of foreign capital in the financing the enterprises’ activity
(even connected with a temporary reduction of the enterprises’ ability to pay off the current
liabilities) can bring positive effects as a result of the use of financial leverage. If the
enterprise is supported by additional (foreign) capital used for conducting investments, that
profitability is higher than the cost of capital needed for their realization, it may increase its
profits. Profits from the investment activity may be designed for paying off the liabilities and
it secure from loosing enterprise’s liquidity.
The development of domestic enterprises activity on the foreign markets probably had
a positive influence on increasing profits from sales. As a consequence domestic enterprises
achieve higher level of sales profitability than foreign enterprises in host country economy. It
may be assumed that polish enterprises producing for both internal and external markets are
able to compete with foreign investors in host country economy. However it would be useful ,
to conduct more extensive research in this area.
BIBLIOGRAPHY
[1] Blakeley N., Why do foreign – owned firms perform better than New Zeland – owned
firms?, The Treasury, Kaitohutohu Kaupapa Rawa 2009, T2009/2747
[2] Castellani D., Zanfei A., Internationalization, innovation and productivity: how do firms
differs in Italy?, the World Economy, n.30 (2007)
[3] Grasserii M., Domestic Multinationals and Foreign – Owned Firms in Italy: Evidence
from Quantile Regression, The European Journal of Comparative Economics, vol.7,n.1, 2010
[4] Jaworek M., Bezpośrednie inwestycje zagraniczne w prywatyzacji polskiej gospodarki,
TNOiK, Toruń 2006
5
Depending on the source and the author as an optimal value of the current liquidity ratio is considered 1.5 – 2.
Very often the most unfavorable situation is considered when the current liquidity ratio of the enterprise is below
1 (in some studies less than 1.2) or above 3 (in some studies more than 2.5).
84
[5] Karaszewski W., Bezpośrednie inwestycje zagraniczne w podnoszeniu konkurencyjności
polskiej gospodarki, Wydawnictwo UMK, Toruń 2005
[6] Różański J., Przedsiębiorstwa zagraniczne w Polsce – rozwój, finansowanie, ocena, PWE,
Warszawa 2010
Full name: Ph. D. Magdalena Jasiniak
Institution: University of Lodz, Faculty of Economics and Sociology
Street: Rewolucji 1905 r. No 39 St.
City: Lodz, Poland
Email: magdalena.jasiniak@uni.lodz.pl
85
DISPOSITION EFFECT: DO HUNGARIAN INVESTORS KEEP
THEIR MISTAKES?
István Joó, Mihály Ormos
ANNOTATION
In our paper, we examine disposition effect known from behavioral finance, according to
investors kept their losing positions too long and close their winning positions too early.
Analyzing individual transactions of Hungarian higher education students in 2009 and 2010 –
based on realized and non-realized gains and losses – we came to conclusion that investors
participating in the researches were inclined to disposition. Findings of our paper didn’t
represent fully the general Hungarian investors, although our sample represents well the
population interested in capital markets and participating in higher education.
JEL classification: G12; G14
KEY WORDS
disposition effect, behavioral finance, market efficiency
INTRODUCTION
Our paper focuses on the disposition effect, which derives from a quite difficultly
researchable field of behavioral finance, since here we examine individual investment
decisions. Disposition effect first described by Shefrin and Statman (1985), where they show
that investors close their winning positions too fast, while hold their losing positions too long.
Bases of the hypothesis are prospect theory, mental accounting, fear of regret and lack of self-
control.
In prospect theory Kahneman and Tversky (1979) explain that in winning situations (range)
people avoid risk (their utility function is concave), while in losing situations they prefer to
take risk (their utility function is convex). According to this theory, in risky situations we are
preoccupied with the changes in our property instead of measuring the utility of the available
wealth and our actions are dominated by the aims of avoiding losses. This means that we are
afraid to close our losing positions (at least until we see a little shed of hope that prices would
turn around), while in winning situations we are inclined to grab the first opportunity to sell
our assets.
In order to define the inflexion point of the “S”-shaped utility curve described by the prospect
theory, Thaler (1984) created the definition of mental accounting. According to this theory,
investor opens a new “mental account” in each and every buy, which he handles as separate
accounts irrespective of each other. Thus, both for his losing and winning positions, he uses
separate accounts and accordingly, he is prone to apply separate strategies, which along with
the utility of prospect theory explains the inflexion point at the value zero (reference point).
First Odean (1998) complets the measurement of disposition effect explicitly, he empirically
verifies truthfulness of the hypothesis by using real trading data accessed from 10 000
investors accounts. His findings demonstrates that individual investors keep up their losing
positions too long, while they do the opposite in winning situations. Later, Shapira and
Venezia (2001) and also Feng and Seasholes (2005) elaborate on the methodology of Odean
(1998) and they justify the relevance of the phenomena as well.
DATA
We examined two distinct periods from 16th
March 2009 to 17th
April 2009 and from 8th
February 2010 to 30th
April 2010. Our research based on trading results of 130 Hungarian
university students. We used data (assignment data, gender of clients, university/college of
86
clients, clients balances at end of research period) provided by Erste Investment Plc. (who
was conducting the stock market games), and additionally from trading data gathered from the
database of Budapest Stock Exchange (daily minimum and maximum of stocks, its opening
and closing prices), furthermore from questionnaires filled out by the participants. In order to
avoid distortion and bias we corrected trading data with dividends. Additionally, we excluded
sales data of existing investors portfolios before examined periods, as we have no information
on the exact buying price.
Table 1 summarizes the basic trading results and habits of participants. As a part of the
comparative studies described in our paper works with a greater amount of data (such as
Odean (1998) 10 000 investors, Weber and Welfens (2007) 3000 investors). So our study is
mostly comparable with the sample of 125 investors of Boebel - Taylor (2000) from New
Zealand. Analysis on a bigger sample is hindered by difficultly acquirable trading data, but
these two “stock market games” using real money provided us with an opportunity to examine
inclination of Hungarian higher education students to disposition. 13,08% of the total
participants (130 in both of the games) were female, who closed an average of 16 deals.
While being less active, female investors were generally more successful than male
participants (-1,1% compared to -5,28%).
Participating investors placed a total of 4868 orders (closed, modified, withdrawn, expired),
from which 2808 were completed (an average of 22 transactions per person). In order to
measure yield earned during the examined period we performed 163 artificial closings using
the closing prices of April. During the game of 2009, the investor closing most transactions
reached an amount of 201, while in 2010 180 transactions.
Higher education students traded in total amount of 504,1 million HUF with a transaction fee
of 0,86 million HUF, and they suffered a total loss of 3,16 million HUF (24 thousand per
investor on average), without costs they suffered a total loss of 2,30 million HUF (17
thousand on average). Students closed the year of 2009-2010 (in aggregate) with a security
account balance of 33;4 million HUF, which contained 265 thousand HUF per account. The
largest closing portfolio in 2009 was 1,8 million HUF and 2,9 million HUF in 2010.
The surprising result, which presents itself by looking at the obtained yields is worth noting:
on average, the students closed the years of 2009-2010 (in aggregate) with a loss of 4,69%,
while in the examined 2009-2010 period BUX index (Hungarian stock index) increased by
24,5%, which can be considered as a benchmark of the present analysis. It is important to bear
in mind that in the examined period, in year 2009, only one investor was able to surpass
benchmark index with a yield of 42,63%, while in 2010 none of participating students were
able to do so (highest yield: 18,08%).
In the two examined periods, the index characterizing the Hungarian Stock Exchange, BUX,
increased 27,75% (year 2009) and 21,19% (year 2010). Consequently, we kept this in mind
when evaluating our results.
AIM AND METHODOLOGY
We tested the disposition effect with Odean’s (1998) PGR and PLR ratio. In our study we
examined the portfolio of investors on every day when they sell a stock and we divided their
positions into four possible categories depending on the sell and buy price. In case of sold
stocks, sell price was compared to the original average buy prices and so we categorized
stocks into winning (realized gain – RG) or losing (realized loss – RL) groups.
We ranked each and every other stock which was in our investors portfolio into unrealized
gain (paper gain – PG) or unrealized loss (paper loss – PL) based on the average buy price
and the given days closing price.
87
Table 1 Results and trading habits of participants
March 16-April
17, 2009
Febr. 8April
30,
2010
2009-
2010
Number of investors 42 88 130
Percentage of female investors 19,05% 10,23% 13,08%
Total no. of transactions (closed, expired, modified,
withdrew) 2 074 2 794 4 868
Total closed transactions 1 110 1 698 2 808
Forced closed transactions 64 99 163
Total turnover (thousand HUF) 178 413 325 695 504 108
Total trading costs (thousand HUF) 416 445 861
Trading results -905 -2 255 -3 159
Trading results without costs -489 -1 810 -2 299
Average total turnover (thousand HUF) 4 352 3 701 3 908
Average total trading costs (thousand HUF) 10 5 7
Average trading results -22 -26 -24
Average trading results without costs -12 -21 -17
Mean closing balance (thousand HUF) 136 321 265
Total closing balance (thousand HUF) 5 159 28 283 33 442
Average position taken 26 19 22
Return of market proxy for the period (BUX) 27,75% 21,19% 24,47%
Average return -3,02% -5,45% -4,69%
Average return of females 4,62% -6,20% -1,10%
Average return of males -5,06% -5,36% -5,28%
Average position taken of females 14 17 16
Average position taken of males 29 20 23
Under realized or unrealized gain we understand the cases, when the given trading days
minimum and maximum price was above the average buy price (in the first case the sell
happened and the second the stock was kept). Accordingly, we categorized stocks into
realized or unrealized loss, if the given trading days minimum and maximum price was below
the average buy price (and the share was sold or kept).
After ranking stock positions into RG, RL, PG, PL categories we examined disposition effect
on accumulated level:
(1)
(2)
When the proportion of gains realized (PGR) and the proportion of losses realized (PLR) are
equal, then there is no disposition. However, the value of PGR is significantly higher than the
value of PLR we rather realize winning stocks fast and hold losing stocks too long. In other
words: in this case the investors are less intent on realizing their losses, thus the disposition
effect (DE) is typical of their behavior.
In our study we used several conditions defining PGR and PLR values. Similarly to Odean
(1998), in cases the average buy price was between the daily minimum and maximum, we
disregarded these positions and didn’t calculate with them, since the daily data was not at our
disposal, thus it was impossible to rank the kept positions as winning or losing. Furthermore,
we also disregarded one-element portfolios, when the client remained without stocks after the
selling transaction.
We only took stock positions into consideration (leveraged positions were excluded). Reason
for this decision was on the one hand that possible compulsory liquidation of deadlines and
88
certificates would distort our findings, on the other hand in examined period there was a
significant amount of certificate expiration, which also result in artificial closings on
individual accounts. In case of non-leveraged share portfolios, we didn’t have to consider
these artificial closing conditions.
The disadvantage of Odean’s (1998) method is that it only considers the day of sells and buys;
consequently, movements during the holding days doesn’t matter. It poses a further problem
that analyzing on individual level we would mechanically get wrong result during the
regression analysis that the more shares we keep in our portfolio, the less inclined we are to
disposition effect. However, this would only be the natural concomitance of PGR-PLR. We
got same result if trade often, then difference between PGR-PLR would indicate a growing,
PGR/PLR quotient would indicate a declining disposition. Thus, considering the above,
existence of disposition effect is only worth analyzing at aggregate level.
RESULTS
Our PGR,PLR analysis shows, that Hungarian investors inclined to disposition in 2009 and
also in 2010. In 2009 51.9% of the winning positions were closed while in losing positions
this percentage was only 38.7%. Consequently, investors sold their winning positions 13,3%
more frequently. These findings show the presence of disposition effect on Hungarian capital
market. In case of 2010 these values were 63.6% (PGR) and 48.8% (PLR). Our PGR, PLR
values are close to results of Australian and Chinese researches.
According to PGR, PLR values disposition effect (DE=PGR-PLR) in years 2009-2010 (in
aggregate) is statistically significant at 1% level, while in case of 2009 and 2010 values the
significance level is 5% as we can see in Table 2.
Based on all this we can claim that, similarly to results of international researches, the
phenomenon of keeping losses too long and realizing gains quickly is demonstrable in
Hungarian investors behavior. On a sidenote, we'd like to mention that basis of the effect
derives from different heuristic distortions and framework dependences, so fact that
individuals exhibit similar patterns of behavior regardless of nationality and market meets our
expectations. PGR/PLR ratio, which is used to measure disposition effect, was 1,33 for our
aggregate 2009-2010 period, which is slightly lower than Odean's (1998) 1,51 and Chen et al
's (2007) 1,67. However, research regarding New Zealand, which is most similar to ours in its
sample size, opposite with ours showed no significant disposition. Consequently, based on
our analysis Hungarian investors are less inclined to disposition, but the effect is still
significantly present. It is also worth noting that ratios of 2009 and 2010 are not significantly
different, so despite the fact that market conditions were completely different in these two
periods, behavior of investors seems identical. Regarding the findings it is important to
emphasize that equity markets rose both in 2009 and 2010, so we had no opportunity to
analyze the effect on a falling market.
CONCLUSION
In our paper we demonstrated that, similarly to investors of other countries, Hungarian higher
education students inclined to disposition in both sample periods (2009 and 2010). In light of
these results we can claim that Hungarian students behavior during the stock market rise of
2009 – 2010 strongly corresponds to descriptions found in scientific literature. We have to
note, that the circle of investors involved in our research don’t represent the hole Hungarian
investor population as the participants are relatively young in age with little deviation, their
financial knowledge is higher than average while their assets are lower, but these parameters
expectedly don't change the results: according to the literature this bias affect all group of
investors.
Table2PGR,PLRvaluesofHungarianinvestorsininternationalcontext
HungaryUSAChinaAustraliaGermanyNewZealandTaiwan
200920102009-2010Odean(1998)Chenetal.
(2007)
Brownetal.
2006
Weber-
Welfens
(2007)
Boebel-Taylor
(2000)
Shuetal.
(2005)
Numberofinvestors42881301000046969-300012553680
Realizedwinner10896204138834142625540
Realizedlooser463985119303831985382
Paperwinner100551557965631664951077
Paperlooser73411141103483100
12084
306
PGR0,5190,6360,5680,1480,5190,5100,3000,1160,347
PLR0,3870,4880,4270,0980,3100,2300,2000,1100,141
Disposition(DE,PGR-
PLR)0,133**0,148**0,141***0,050***0,209***0,280***0,090***0,0060,205***
PGR/PLR1,3431,3031,3301,5101,6742,2171,5001,0552,461
SE0,05650,06820,04370,00140,00750,0002
tstatistics2,352,173,2334,7482,6058,030,751046,9
*10%;**5%;***1%levelofsignificance
DecisionsofinvestorssellingastockwereanalyzedaccordingtoOdean’s(1998)method.Onthedayofsellingtransactiontheinvestors’portfoliosweredividedintocategoriesaccordingtowhethertheywerewith
realizedgainsorlossesorpapergainsorlosses.Afterthissegmentationwecalculatedproportionofgainsrealized(PGR)andproportionoflossesrealized(PLR),thedifferencedescribesdisposition(DE=PGR-PLR).
Thedifferencesprovedtobestatisticallysignificantbasedonresultsoftstatisticscheckconducted,sotheanalyzedinvestors’inclinationtodispositionisprovable.WesetupseveralconditionsattheanalysisofPGR
andPLRvalues.Iftheaveragesalepricewasbetweenthedailyminimumandmaximum,thesepositionswereexcluded.Portfoliosconsistingofonlyoneelementwerealsoexcludedifafterthesaleandpurchaseofthe
givencapitalmarketinstrumenttheinvestorremainedwithoutanyothercapitalmarketinstrument.Finally,similarlytoOdean(1998),weonlytooksharepositionsintoaccount(excludingleveragedsharepositionsas
well).
90
Knowing the findings of present research, we aim to extend this study to a wider group of
investors, which would come with a several year long sampling if possible. In this case,
beside rising markets, we could analyze bear markets as well. Furthermore, with the
segmentation of investors, we could analyze this effect on Hungarian market in correlation
with inclination to disposition, investment yield, experience, education, sex and other investor
characteristics.
BIBLIOGRAPHY
[1] Boebel, Richard B. – Taylor Luke (2000): The disposition effect: Do New Zealand
investors keep their mistakes? Department of Finance and Quantitative Analysis, University
of Otago, New Zealand.
[2] Brown, Philip – Chappel, Nick - da Silva Rosa, Ray – Walter, Terry (2006): The Reach of
the Disposition Effect: Large Sample Evidence Across Investor Classes. International Review
of Finance, Vol. 6, No. 1-2, pp. 43-78.
[3] Chen, Gong-meng – Kim, Kenneth – Nofsinger, John R. – Rui, Oliver M. (2007): Trading
Performance, Disposition Effect, Overconfidence, Representativeness Bias, and Experience of
Emerging Market Investors. Journal of Behavioral Decision Making, Vol. 20, pp. 425 – 451.
[4] Feng, Lei – Seasholes, Mark S. (2005): Do Investor Sophistication and Trading
Experience Eliminate Behavioral Biases in Financial Markets? Review of Finance, pp. 305-
351.
[5] Kahneman Daniel –Tversky Amos (1979): Prospect Theory: An analysis of Decision
Under Risk, Econometrica, Vol. 47, No.2, pp. 263-291.
[6] Odean, Terrence (1998): Are Investors Reluctant to Realize Their Losses? The Journal of
Finance, Vol. 53, No. 5, pp. 1775-1798.
[7] Shapira, Zur – Venezia, Itzhak (2001): Patterns of Behavior of Professionally Managed
and Independent Investors. Journal of Banking and Finance, Vol. 25, pp. 1573-1587.
[8] Shefrin, Hersh –Statman, Meir (1985): The Disposition to Sell Winners Too Early and
Ride Losers Too Long: Theory and Evidence. The Journal of Finance, Vol. 40, pp. 777-790.
[9] Shu, Pei-Gi – Yeh, Yin-Hua –Chiu, Shean-Bii –Chen, Hsuan-Chi (2005): Are Taiwanese
individual investors reluctant to realize their losses? Pacific-Basin Finance Journal, Vol. 13,
pp. 201– 223.
[10] Thaler, Richard (1984): Mental accounting and consumer choice. Marketing Science,
Vol. 4, pp. 199-214.
[11] Weber Martin – Welfens Frank (2007): An Individual Level Analysis of the Disposition
Effect: Empirical and Experimental Evidence. Sonderforschungsbereich 504 Publications,
2007
Full name: István Joó
Institution: Széchenyi István University, K&H Bank
Street: Egyetem tér 1.
City: 9026 Győr
Email: jooistvan@gmail.com
Full name: Mihály Ormos
Institution: Budapest University of Technology and Economics, Department of Finance
Street: Magyar Tudósok körútja 2.
City: 1117 Budapest
Email: ormos@finance.bme.hu
91
CLAIM PAID POSITION IN RANK OF ALTERNATIVE
SOURCE OF FUNDING
František Kalouda
ANNOTATION
Paper discusses the evaluation of the claim paid as a source of financing of business activities.
It notes the current situation in which claim paid is in the literature of mainstream theory of
corporate finance as a source of financing practically absent.
The paper analyzes the key factors in the characteristics of the sources of funding sources
used and assess this resources by simple statisical method (frequency test). It compares the
selected sources of funding to the claim paid as well as to the volume (size of source).
Results supports the wiev that there is not reason to ignore the claim paid as a source of
financing of business activities.
KEY WORDS
Claim paid, parameters, comparison.
JEL classification: G22, G32
INTRODUCTION
The status of claim paid as a source of funding in mainstream domestic corporate finance
theory is still some ambivalence.
On the one hand, the theory commonly recognizes insurance as one of legitimate protection
against the risk, especially in cases of fatal risks that may affect the continuity of business
activity fundamentally (natural disasters). The role of claim paid is a threshold matter, clear
and unquestionable in principle. On the other hand is claim paid so far not accepted as a
standard, or an alternative source of financing.
AIM AND METHODOLOGY
The fundamental aim of this paper is to contribute to the inclusion of claim paid between
sources of financing business activities and especially in connection with the generally
problematic financing company in the extreme situation (natural disaster or other
insurable risks).
The decisive contribution of the instrumentation methodology consists of literature review
and comparison. They are also used in routine analytical and synthetic procedures. The
statistical methods used is a simple test frequency. With regard to the data base contribution
for the current state of affairs is question to discussion the original level of representativeness
of the analyzed foreign sources.
Source citations in Fig 1 was chosen because of the need to evidence the results of searches.
RESULTS
At the level of sub-goals in this paper is primarily on the definition of parameters and
requirements which meet the funding source.
Parameters of the generalized sources of funding
The first result of this paper is the frequency test. It provides information about how often the
given characteristics of the sources studied so far appears. Information is presented in Fig. 1.
92
Parameters of sources are divided into groups within which the score is determined in
descending order of frequency of their occurrence in the studied resources.
Fig. 1 Parameters of the generalized sources of funding (frequency test).
GROUP
parametr of resource more characteristic feature
resource
Size / Availability / Feasibility …………………. (frequency 10x)
„easier access“
(HRDÝ, M. a kol., 2008,p. 99)
uncertainly disposable (available)
(SVITÁKOVÁ a kol., 2011, p. 7 ) uncertainty in principle (from donors and government)
unavailable for start-ups
(SVITÁKOVÁ a kol., 2011,p. 10)
property
(DLUHOŠOVÁ, 2006, pp. 49, 52) structure (own and foreign), availability requirement in terms of the
(SYNEK, (2000, p. 115) capital (basic capital)
conditional application
(DLUHOŠOVÁ, 2006, p.52) conditional compliance "obligations under the law"
narrowness
(SVITÁKOVÁ a kol., 2011, p. 7 ) limited amount of funding (from donors and government)
sufficient amount of
(KISLINGEROVÁ, 2004, p. 285)
Size/amount of the source
(SYNEK, 2000, p. 114) „ …. have just as much capital it needs.“
realistic sources
(SYNEK, 2000, p. 115) actual amount, not “the sum of the balance sheet”
Manageability ..…………………………………………….. (frequency 5x)
pružnost („flexibility“)
(DARMODARAN, 2001, p. 563) preferred parameter of the source of financing
manageability of resource („control“)
(DARMODARAN, 2001, p. 563) preferred parameter of the source of financing
long maturity
(VALACH, 2003, p. 82)
high flexibility
(VALACH, 2003, p. 82)
riziko použití zdroje
(VALACH, 2003, p. 82)
Stability ………………………………………………………..( frequency 5x)
sustainability
(SVITÁKOVÁ a kol., 2011, str. 7 ) source must be able to reproduce
usability at a profit
(SVITÁKOVÁ a kol., 2011, str. 7 ) this source is not otherwise available (microfinancing)
stability in time
(KISLINGEROVÁ, 2004, p. 507) stability small and great, source permanent and temporary
time aspect
(SYNEK, 2000, p. 115) short-time and long-standing
(DLUHOŠOVÁ, 2006, p.53)
Price …..………………………………………………………. (frequency 4x)
low interes rates
(KISLINGEROVÁ, 2004, pp. 520-521)
low fees
(KISLINGEROVÁ, 2004, pp. 520-521)
minimum cost
(VALACH, 2003, p. 82)
price oft the source
(DLUHOŠOVÁ, 2006, p.104) profitability in relation to activities funded
Creation …………………………………………………………… (frequency 3x)
way to create
93
SYNEK (2000, p. 115) the law (e.g)
DLUHOŠOVÁ (2006, p.52)
Fig. 1 Parameters of the generalized sources of funding (frequency test) - continue
transparency
KISLINGEROVÁ (2004, pp. 366-367) in conection with the leasing opaque
Function ……………………………………………………………. (frequency 3x)
function of source
SYNEK (2000, p. 115) specific (if possible)
influence on the failure of a company
VALACH (2003, p. 82)
influence on the contron on a firm
VALACH (2003, p. 82)
Yet Unquoted .....……………………………………………………( frequency 2x)
legality
conformity with good morals
Source: see the quotations inside Fig. 1
Quantification of selected sources of funding
Input data indicates Fig. 2. In the second step, the claim shall be compared with selected now
standardized sources of funding in terms of quantity (some alternative resources and IPO).
Fig. 2 Quantification of selected sources of funding (billion Kč) – input data
period (year)
source of financing 2004 2005 2006 2007
2008
claim paid (nonlife) 35,4 34,3 38,4 36,7
39,2
leasing incl. credits 138,8 154,5 169,4 180,1
174,2
factoring 41,1 86,8 110,4 135,1
141,9
IPO 1,8 0,0 2,8 2,2
4,7
TOTAL 365,9 443,5 503,0 568,5
601,9
Source: Statistická ročenka ČR 2004, 2005, 2006, 2007, 2008, 2009; MELUZÍN, T.ZINECKER,
M. 2009. IPO, prvotní veřejná nabídka akcií jako zdroj financování rozvoje
podniku. Computer Press, 2009. Vydání první. 188 stran. ISBN 978-80-251-2620-2, str. 173.
http://www.pppcentrum.cz;http://www.asociaceppp.cz;www.cap.cz;www.cnb.cz;www.clfa.cz;
autor´s calculations
Note: IPO volumes are in source listed in the Euro. Conversion is performed at CZK in all
cases using CNB exchange rate of the last working day of the year.
Horizontal and vertical analysis of the processed input data presents Fig. 3.
94
Fig. 3 Quantification sources of funding (billion Kč) - horizontal and vertical analysis
Source of period (year)
financing 2004 2005 2006 2007
2008
claim paid 35,4 16,3% 34,3 12,4% 38,4 12,0% 36,7 10,4%
39,2 10,9%
(nonlife) 100% 96,9% 108,5% 103,7%
110,7%
leasing 138,8 64,0% 154,5 56,1% 169,4 52,7% 180,1 50,8%
174,2 48,4%
incl. credits 100% 111,3% 122,1% 129,8%
125,5%
factoring 41,1 18,9% 86,8 31,5% 110,4 34,4% 135,1 38,23%
141,9 39,4%
100% 211,2% 268,6% 328,7%
345,3%
IPO 1,8 0,8% 0,0 0,0% 2,8 0,9% 2,2 0,6% 4,7
1,3%
100% 0,0% 155,6% 122,2%
261,1%
TOTAL 217,1 100% 275,6 100% 321,0 100% 354,1 100%
360,1 100%
100% 127,0% 147,9% 163,1%
165,8%
Source: Statistická ročenka ČR 2004, 2005, 2006, 2007, 2008, 2009; MELUZÍN, T.-
ZINECKER,M.(2009);http://www.pppcentrum.cz;http://www.asociaceppp.cz;www.cap.cz;ww
w.cnb.cz; www.clfa.cz;author's calculations
Note: IPO volumes are listed originally in Euro. Conversion is performed at CZK in all cases
using CNB exchange rate of the last working day of the year.
DISCUSION
Parameters of sources of funding
Frequency test (in Fig. 1) showed that the quantitative aspect is in evaluation the importance
of funding sources significant criterion. Under the current state of knowledge can even be
seen as the decisive criterion.
The debate is still the aggregation partial or individual characteristics into groups.
Quantification of the selected sources of funding
The quantitative assessment should be considered in a broader context. One of them is
undoubtedly the fact that the absolute amount of claims paid will always be (at least to some
extent) depend on the externalities that the insurance industry's control. A classic example of
these influences are natural disasters.
Probably the most interesting result from the application of quantitative evaluation is that the
IPO is completely negligible as a source. The contrast between the frequency of this source in
the literature and its totally negligible size could hardly not be greater.
95
CONCLUSION
In this paper we analyzed the data lead to the clear conclusion that there is no parameter or the
description of standard sources of funding that would prevent claim paid considered as a
source in the same category.
The first result of this paper is conclusion that neither the absence specific characteristics of
claim paid in standardized financial resources (available only in precisely defined situations,
etc.) can not be an obstacle to the inclusion of the indemnification set of corporate finance.
One of these unique characteristics, however, favors the claim paid almost completely virtually
unconditional availability of this resource in case of accession of claims addressing
the risk of gambling situations.
The inclusion of claim paid between the standard considered sources of funding also supports
the quantitative aspect (see Fig. 3). It can perhaps discuss whether or not it is appropriate to
include claim paid to the category of alternative sources.
The paper was created with the support of the Endowment Fund for Support Educationin
Insurance, Prague within the project "Claim paid as a source of financing in the extreme
situation (the insured event)."
BIBLIOGRAPHY
Books
[1] DARMODARAN, A., 2001. Corporate Finance:Theory and Practice. 2nd ed. John Wiley
& Sons, Inc. 2001, 982 stran. ISBN-978-0-471-28332-4
[2] DLUHOŠOVÁ, D., 2006. Finanční řízení a rozhodování podniku : analýza, investování,
oceňování, riziko, flexibilita. Praha: Ekopress. ISBN 80-86119-58-0
[3] HRDÝ, M. a kol. 2008. Komplexní řešení teoretických a aplikačních problémů
financování malých a středních podniků v podmínkách tržního prostředí Evropské unie.
Západočeská universita v Plzni, 2008, 172 s. ISBN 978-80-7043-746-9
[4] KISLINGEROVÁ, E. a kol., 2004. Manažerské finance. I, vyd., Praha, C.H.Beck, 2004,
714 s. ISBN 80-7179-802-9
[5] MELUZÍN, T.- ZINECKER, M., 2009. IPO, prvotní veřejná nabídka akcií jako zdroj
financování rozvoje podniku. Computer Press, 2009. Vydání první. 188 stran. ISBN 978-
80-251-2620-2
[6] SVITÁKOVÁ, J. a kol., 2011. MIKROFINANCOVÁNÍ z dobré i stinné stránky: aneb …
Jak to funguje a zkušenosti českých organizací. Vyd. 1. Praha: Nadační fond Mikrofinance,
2011. 84 s. ISBN 978-80-260-0942-9
[7] VALACH, J. a kol., 2003. Finanční řízení podniku. Ekopress, 2. vydání, Praha 1999,
dotisk 2001, 2. dotisk – 2003. ISBN 80-86119-21-1.
Legal standards
Zákon č. 593/1992 Sb., o rezervách pro zjištění základu daně z příjmů ve znění pozdějších
předpisů
Yearbooks and Statistics
Statistická ročenka ČR 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2010
Ročenka Hospodářských novin 2003, str. 38 a 65
Statistika leasingu, nebankovních spotřebitelských úvěrů a splátkových prodejů v ČR v roce
2004, Česká leasingová a finanční asociace, Praha 2004
Odvětvové analýzy ASPEKT, číslo 9/IV, Pojišťovnictví, leden 2002
Internet resources
http://www.pppcentrum.cz; http://www.asociaceppp.cz; www.cap.cz; www.cnb.cz;
www.clfa.cz
96
František KALOUDA, Ing., CSc., MBA, Masaryk University, Department of Finance,
Faculty of Economics and Administration
Lipová 41a, 602 00 BRNO
Czech Republic
kalouda@econ.muni.cz
97
THE BANKING SECTOR UNDER THE CONDITIONS OF THE
CRISIS
Mária Klimiková, Martin Vovk
ANNOTATION
Long-term imbalance of the largest economies, which is crossing sustainable limits, global
overbalance in global markets and ideas that internal self-regulatory devices of banking
system are sufficient, led to outbreak of financial crisis, which has had global character. The
aim of the paper is to analyze the impact of crisis on banking sector and pointing out on the
influence of banking sector to creation of the financial crisis.
KEY WORDS
Financial crisis, the banking sector, impacts of crisis, contributions, mortgage, credit, account
receivable, profitability of banking sector.
JEL classification: G21
INTRODUCTION
The present deepening economic crisis, which according to the experts has been the worst
since the times of the world economic crisis in the period between the two world wars has had
an impact on the financial markets all over the world. The impulse for the rise of the recent
crisis was the crisis of the real estate market in the USA, which resulted from granting the risk
mortgages to the inhabitants with lowers value of financial standing.
AIM AND METHODOLOGY
The aim of the paper is to explain the task of commercial banks at arising of the financial
crisis, point at the new, already implemented as well as prepared measures of regulatory
organs for prevention of crisis and analyze the development of banking sector in Slovakia in
recent years.
The subject matter of this problem were searched reasons of the rise of the crisis in the USA,
its transition to Europe and other parts of the world. We have also concentrated on the
measures to mitigate the crisis impacts in the USA and Europe, especially on the task of the
regulatory organs being prepared. One part of the research was also the development of
banking sector in Slovakia in recent years (due to the limitation of the size of the paper we are
giving survey of this development for the last 3 years.
RESULTS
1. Current Financial Crisis
1.1 The Share of the Banks on the Rise of the Financial Crisis
Granting credits to risk clients evokes the question why, when granting credits, the banks
were so benevolent and granted financial means to the clients with high possibility of rise of
bad debts. The approach of the banks is connected with the principle of their attitude to
credits, where their attitude “originate and keep” in the eighties was changed to the attitude
“originate and distribute” in the nineties. In the first case the banks recorded the granted
credits in the balance account of the bank as accounts receivable, in their approach “originate
98
and distribute”, banks sold the accounts receivable on credits (securitization). This way the
banks had sufficient cash to be able to continue investing. In spite of attractiveness of these
products, in this phase the sharp increase in the amount of granted credits was not yet seen,
because the rating agencies estimated such credits as highly risky, thus being too risky for
most investors.1
A radical change came only after the innovations on the financial markets introducing the so
called innovative financial instruments (MBS – Mortgage-Backed Securities) and ABS
(Assets-Backed Securities) functioning as bonds. In addition to MBS and ABS their
modifications e. g. CDO (Collateralized Debt Obligation) as well as CDS (Collateralized
Default Swap) were created. On the basis of the above, the securitization caused on one hand
an enormous expansion on the secondary market, on the other hand it made the risk be shared
by more subjects. The securitization enabled banks to get rid of the risk which was further
shared by individual investors who were buying financial products generated from risk
credits. The above analysis shows that on one hand the banks were creating risky products as
they could sell them further, on the other hand the investors were buying those products not
understanding their principle. The third subject were the rating agencies, which were the most
criticized for originating the crisis.
To be able to make such risky deals, commercial banks created the so called shadow banks
out of the bank regulation system, which cannot be directly prevented by the present
regulation. At the same time instead of accepting a more strict legislation there were attempts
to abate the conditions for financial services and companies, i. e. liberalization and
deregulation, one of the key events in this sphere was cancellation the Glass-Steagall Act in
the year 1999.
1.2 Excessive Expansion
In addition to the influence of the above factors, many problems of the European banks
(besides the present writing off the Greek debts) were caused by the banks themselves. In the
period before the crisis, the European banks were developing their business more quickly than
the overseas banks (especially in Asia and the USA). Granting credits of much higher amount
than the deposits means the necessity of higher reliance on the loans, which at the same time
makes them more vulnerable. The banks with higher Loan/Deposit Ratio have a higher need
or refinancing. The ratio of loans and deposits in the USA is 72%, in Japan 99.5%, in China
66.6%, in the European banks it is as much as 115.5%.
Thanks to the above mentioned development trends, the balances of the banks were growing
at enormous speed. Thus the new entities of private capital reached the room for their
originating, such as hedge funds or private equity companies, which were using mainly
resources for their risky financial operations. These operations were in great extent financed
by so called carry trades, i. e. lending cheap Japanese yen at zero interest rate and their further
investment in other currency destinations.
Increasing interest rates by FED after the year 2004 supported these tendencies. The growing
interest rates in the USA were attracting the resources from other countries as well. Due to
this the countries with large balance of trade excess, such as e.g. oil exporting countries were
investing a lot. But these resources were not used productively to invent new technologies,
expand production or to do other activities creating added value. All the money was used by
American households to buy houses, big automobiles and to live luxurious lives on credit.
Thus, the bubble was not created only on the real estate market but there was an enormous
credit bubble. Other important factors of starting financial crisis were the liquidity crisis
1
http://hnonline.sk/ekonomika
99
(which was directly connected with the loss of trust) and the activity of rating agencies, which
we are not going to deal with due to the limitation of the paper extent.
2. The Impact of the World Financial Crisis on the Banking Sector in Slovakia
2.1 The Factors Activating the Impacts of the Crisis in the Slovak Republic
Penetration of the world crisis in the Slovak banking and business environment depends on
the factors which multiply it - supporting factors as well as the factors which slow it down –
reducing factors. The crisis is penetrating in different forms – channels, where there are
supporting and reducing factors acting against each other.2
The reduction of the value of assets in the foreign financial markets where the financial crisis
was reflected mainly by decrease of profitability (pension funds, share funds, unit-linked
products), the fall of liquidity in the foreign liquidity market (influence on the increase of
price of the resources of finance), the problems in real economy, the decline of liquidity of
financial instruments market, which the banks use to hedge their market risks can be
considered to be the channels of expanding the crisis in Slovakia.3
2.2 Profitability of the Banking Sector in Slovakia
The impact of the present crisis has not been so hard in the banking sector in Slovakia mainly
thanks to a very cautious credit policy of the commercial banks due to which the banks are
granting fewer credits than needed by the business sector. It is shown by the Loan to Deposit
Ratio coefficient, which in Slovakia is of about 85%. The good situation in the banking sector
in our country is also reflected in the volume of profits reached by the banks, which is
growing especially due to the growth of net interest incomes.
According to the data of the National Bank of Slovakia, the banking sector profit of the year
2010 increased by 101.4% to 503.82 mil Euro. The year 2010 was a revival of the Slovak
financial sector, growth of profitability and improving the total financial position. (In the year
2009 the profit of the banks decreased by 50.8% to 250.1 mil Euro.)
In the year 2011 the net profit of the banking sector increased by 34% to 674 mil. Euro, but an
important part of the profit was represented by one-off incomes. After deducting them, the net
profit of the sector of the last year was similar to the one of the year 2010 (503 mil. Euro). Net
interest yields for the last 12 months reached a year-to-year increase of 7% to 1.8 mld Euro.
The growth of net yields on fees and commissions was at the level of 5% (0.461 mld Euro).
Towards the end of the year 2011 there was an important increase caused by one-off (other)
net yields, which reached the value of 173 mil Euro. In the year 2011 the banks granted
historically the highest number of new mortgages (more than 3.8 mld Euro). Towards the end
of December 2011, the volume of all credits reached the value of 36.4 mld Euro (towards the
end of the year 2010 it was 33mld Euro). There was a year-to-year slight decrease of bad
debts from 6.2% to 5.96%. The net profit of the banking sector of the first 3 months of the
year 2012 fell by almost one fifth to 142 mil. Euro. It was caused mainly by increase of
provisions, resulting from devaluation of credits, as well as from newly introduced banking
deliveries. The main income of the banks and the net interest yield increased only very
slightly (3%), in spite of an enormous increase (17%) of the bank costs on deposits. The
second most important source of income, net yields, were at the same level as in the previous
year. In comparison with the last year, there was a decrease of running profit by 4%, being the
first decrease since the year 2009. One of the reasons is also introduction of the bank delivery.
2
Kováč, M., Kováčová, Ľ.: Vplyv finančnej krízy na inovácie, SjF TU v Košiciach, Ústav technológií
a manažmentu, 2008, strana 5.
3
ŠRAMKO, I.: Výhľad hospodárskeho vývoja a dopad finančnej krízy na Slovensko, Národná banka Slovenska,
2008.
100
For the first 3 month the banks delivered more than 22 mil Euro to the account of financial
assets. A total year-to-year increase of balance account was 5%, on the assets side due to the
loans granted to inhabitants and on the liabilities side due to the retail deposits. In the previous
period the banks were increasing their own capital needed for the credit granting growth. Due
to the retained profit of the previous year the equity of the banking sector was increased by
16%.
Fig. 1: Profits and average ROE of banking sector in Slovakia
Source: http://www.sbaonline.sk/en/banking-sector/statistics/
3. The Measures of the ECB to Mitigate the Impacts of the Crisis and Prevention of
Crises
The world financial and debt crises have given rise to the regulatory measures to prevent the
rise of new crises.4
The reform of regulation and supervision of the financial sector in the
USA contains legislative suggestions of regulation of financial market, forming the DoddFrank
Act and rise of new institutions on the basis of this act. The main reforms following the
Dodd-Frank Act are aimed at capital requirements and size of liquidity and give limits to the
size of banks and remunerations in the banking sector.5
At the same time there is a reform of regulation and supervision of the financial sector in the
EU. It consist of the Larosier´s reform of regulation – the regulation of rating agencies, then
the parallel banking system, the securitization products and remedy of derivative market,
forming of consistent uniform regulations functioning in the whole EU. At the same time
European supervising of the financial market has been introduced (ESRB, ESFS, EBA and
others).
CONCLUSION
At present there are changes in the strategic priorities of the banking sector. The prior
orientation of the management of banks is not only oriented at their profitability, but mainly at
bank´s liquidity and its capital adequacy. Banks must get oriented at the capital adequacy
growth by asset selling and capital rise. There is liquidity surplus of the banks in Slovakia, but
it is mostly a short-term one. The value of 10 year resources has rapidly increased, what is
reflected in the approach of banks to granting credits to business sphere and making the
granted credits more expensive. The profitability of banking sector in Slovakia is influenced
4
Zdroj: SITA, REUTERS.
5
PAVLÁT, V., KUBÍČEK, A.: Regulace a dohled nad finančními trhy, str. 91
101
by passing the act on special contributions of selected financial institutions., If we are to
evaluate the expectations in the development of profitability, in the near future the banks in
Slovakia will have to concentrate on implementation of new regulatory and legislative rules as
well as to accept new taxes and contributions, that is the development of profitability may be
adverse.
BIBLIOGRAPHY
[1] KLIMIKOVÁ, M.: Banking Sector Analysis in Terms of the Financial Crisis. In: Almanac
of papers of international scientific conference E T E R 2011, University of Economics in
Bratislava, s. 163-170, ISBN 978-80-225-3286-0
[2] KLIMIKOVÁ, M., VOVK. M. et al.: Banking Management and Marketing, IRIS,
Bratislava 2012, ISBN 987-80-89238-63-7
[3] KOVÁČ,M., KOVÁČOVÁ, Ľ.: Influence of financial crisis on innovations, SjF TU v
Košiciach, Ústav technológií a manažmentu
[4] MAKÚCH, J.: Prediction of economic development in Slovakia, lecture on the conference
„Financial management of enterprises 2011“
[5] MRAVCOVÁ, VAVŘINKOVÁ: Looking for the evidence of the credit crisis. 82 s. In:
Trend, 19.2.2009, ISSN: 1335-0684
[6] PAVLÁT, V., KUBÍČEK, A. : Financial markets regulation and surveillance, 2.vydání,
Praha, Vysoká škola finanční a správní, o.p.s, 2010, 228 s., ISBN 978-80-7408-036-4 6.
[7] ŠRAMKO, I.: Expectation of economic development and impact of financial crisis in
Slovakia , National Bank of Slovakia
[8] VOVK, M.: BASEL III. – Review, In.: Almanac of papers of international scientific
conference FIN STAR NET 2011, ISBN 978-80-970244-4-4
[9] www.banky.sk, NBS, SAB, SITA, REUTERS
Ass Prof. Ing. Mária Klimiková, PhD.
University of Economics in Bratislava
Faculty of National Economy
Dolnozemská cesta 1
852 35 Bratislava
Slovakia
klimikova@centrum.sk
Ing. Martin Vovk, PhD.
University of Economics in Bratislava
Faculty of National Economy
Dolnozemská cesta 1
852 35 Bratislava
Slovakia
martin.vovk@euba.sk
102
AUDIT RISK IN THE CONTEXT OF THE AUDIT
PROFESSION
Veronika Krsikova, Lukas Rybka
ANNOTATION
The economic life is closely associated with the audit profession that is accompanied by audit
risks. These risks are usually determined by business risks. All accounting units are subject to
the business risks while carrying out their business activities. The accounting unit
management is responsible for identifying potential risks and responding appropriately. The
audit profession might eliminate these risks. The auditor is focused on the risks which may
affect the financial statements due to the fact that not all risks concern a preparation of
financial statements. The auditor obtains sufficient and appropriate evidence in order to
acquire an reasonable assurance whether the financial statements give a true and fair view in
all material respects in accordance with a valid financial reporting framework. The audit risk
is when the auditor expresses an inappropriate opinion on the financial statements. Therefore,
it is necessary to analyze the audit profession together with the audit risks relating to an
auditor auditing the financial statemets in accordance with ethical principles.
KEY WORDS
audit risk, audit profession, business risk, ethics of auditor
JEL classification: M42
INTRODUCTION
There is more and more attention paid to the audit profession nowadays. A role, range as well
as scope of audit are emphasized constantly because the audit is likely to be considered as a
tool to achieve a financial stability as well as an efficient and effective tool in fighting a
corruption in the economic environment.
A risk is an integral component of each and every business activity. There are the business
risks with successful accounting units, too. A task of the accounting unit management is to
identify potential risks and to respond appropriately.
The audit profession may be considered as a factor in eliminating business risks as well.
However, the auditor can not pay attentiont to all risks but only to those risks affecting the
financial statements. The auditor asssesses the risks in account balances in order to detect
material misstatements in accounting or while preparing the financial statements.
AIM AND METHODOLOGY
The article objective of "Audit Risk in the Context of the Audit Profession" is to clarify the
audit risk and to highlight the importance of the audit proffesion which has taken an important
place in the economic life of the Slovak Republic after more than twenty years of its
existence. The audit profession has gradually established itself as a separate profession
dealing with the risks affecting the financial statements. The current economic situation has a
significant impact on the work of auditors. On the one hand, increased risks in business brings
an increase of the audit risks, too. On the other hand, there is a reduction of contract prices for
audit and assurance services and an increased need for an insurance against risks.
103
Partial objectives were set in order to achieve the article objective such as a definition and
analysis of the audit profession as a prevention tool in economic life, an analysis of ethical
principles kept by auditor when auditing the financial statements, an analysis of audit risk
which is associated with a contract risk and a definition of auditor’s report contaning auditor’s
opinion on the audited financial statements based on the conclusions coming from an analysis
of the obtained audit evidence.
The method of analysis was applied when preparing the article in which the audit risk was
analysed as a part of the audit profession. The auditor is obliged to plan and perform the audit
to reduce the audit risk to an acceptably low level, which is in accordance with the
predetermined audit objectives.
We also highlighted the ethical principles necessary for the auditor auditing financial
statements. We found that the independence of auditor is an essential ethical principle in
relation to the audited financial information, to those who prepare and use this information.
Eventually, we concluded to a need of the audit profession in a financial crisis by the method
of deduction. The auditor reveals potential risks of accounting units and increases a credibility
of information presented in financial statements.
RESULTS
The audit profession as an important element of prevention in the economic life
The audit is a process of obtaining and evaluating evidence regarding informations about
various activities and events by an auditor. The objective is to assess a consistency of the
obtained informations with the predetrmined criterias and to advise the detected results to
interested parties.
The audit is performed by auditors in accordance with a valid legal legislation. The auditors
verify if the financial statements are in all material respects in accordance with a valid
financial reporting framework.
The financial statements are an object of the audit examination. The financial statements
directly connects accounting with auditing. An accounting unit is obligatory to keep accounts
from the date of its registration in the Commerical Register until the date of its cessation. The
accounting unit quantifies its business activities by keeping accounts resulting in the
preparation of financial statements at the end of the accounting period by the accounting unit
management. All consolidated financial statements as well as selected individual financial
statements are compulsory to be audited.
Illegal tax evasions, frauds or failures to pay compulsory payments to Social or Health
insurance companies is less likely in audited accounting units.1
The audit profession is bound
to be considered as an important factor in eliminating business risks accompanying the
business activities of all accounting units but also as a tool in ensuring a protection of ethical
business activities.
1
http://www.skau.sk/data/Auditorska%20profesia%20a%20hospodarska%20kriza%20v%20SR%20%20%20clanok%20%2021%2002%202012.pdfČlánok
(12/03/2012).
104
Ethics of Auditor
The auditor is an important element of transparency in accounting units that is obliged to act
in accordance with ethical principles whose violation could be affected by disciplinary. The
auditor, therefore, has to avoid any ethical conflicts respecting the ethical principles in her/his
own interest.
A characteristic feature of the audit profession is an independence that the auditor is required
to maintain. The independence means an expression of the auditor‘s opinion on the audited
financial statements without any commands or effects of other persons. The independence
enables to the auditor to provide an impartial and unequivocal conclusion which is necessary
for a well performed audit. The independence with an objectivity represents fundamental
pillars of the audit profession.
The independence is required not only for performing audit, but also for other services
regarding future financial statements. The independence is an important attribute which has
become a basis of many laws in many countries. The independence is defined in the Ethical
Code of Auditors of SKAU, but also in the Act No. 540/2007 Coll. on Auditors, Audit and
Audit Oversight.
Audit based on risks
The audit process represents a risk for the auditor. The risk undoubtedly increases due to the
current economic crisis entailing business risks, too. The auditor performing a risk-based
audit shall acquire an reasonable assurance that the financial statemens shall not contain
material misstatements caused by a fraud or error. The reasonable assurance is high but not
absolute level of assurance considering the existence of natural limits of the audit.
The audit objective is to enable to the auditor to express an opinion whether the financial
statements are in all material respects prepared in accordance with a valid financial reporting
framework. In order to meet the audit objective, it is necessary for an auditor to plan and
perform the audit to reduce the audit risk to an acceptably low level. The auditor performs
procedures in order to obtain sufficient and appropriate evidence constituting a basis when
formulating an audit opinion which is an important part of the auditor's report.
The audit risk is a risk that the financial statements contain material misstatements and/or a
risk that the material misstatements will remain undetected. The risk of the material
misstatements existence in financial statements is a combination of inherent and control risk.
The risk of not detecting material misstatements is a detection risk. The auditor performs the
procedures focused on an assessment of the risks of material misstatements and reducing a
detection risk.
The inherent risk represents a predisposition of claims to misstatements that may be
significant individually or together with other misstatements while no approrpiate controls.
The inherent risk relates not only on a level of financial statements as a whole but also on a
level claims.
The control risk is a risk that the implemented system of internal control of accounting unit
will not prevent, reveal or corrent in time misstatements which may be significant either
individually or together with other misstatements. The accounting unit is supposed to identify
and asses the risks accompanying the business and other risks (e. i. fraud) and to respond by
implementning a system of internal control.
The control risk will always accur due to natural limitations of the system of internal control.
Therefore, the auditor has to understand the internal control of accounting unit and to perform
the procedures in order to assess risks of material misstatements on the level of claims.
105
A fraud risk, which means intentional acting of management to gain advantages unfairly or
illegally, is a part of the inherent or control risk. There are two major types of intentional
misstatements. That is a misstatement resulting from a dishonest financial reporting or
a misstatement resulting from a misappropriation of assets.
The detection risk is the fact that an error or a misstatement may remain undetected. It usually
arises by an inefficient or incorrect implementation of the audit procedures in practice. The
detection risk exists independent from the inherent or control risk as the auditors are allowed
to decide for audit procedures and change them individually. The detection risk is supposed to
be in an inverse relationship with the inherent and control risk. The greater the inherent or
control risk, the less acceptance rate of the detection risk. The detection risk can not be
reduced to zero because the auditor can not test all transactions from a particular category,
account balances or the information reported.
The auditor’s interest is in the material misstatements of the financial statements as a whole.
The auditor consideres the risk of material misstatements on a level of financial statements as
a whole as well as on a level of transactions, account balances, values reported and related
claims.
The auditor shall have a deep understanding of the accounting unit, its environment when
auditing and performing the following procedures of risk assessment: analytical procedures,
obtaining information from employees, an observation, a review.
The auditor, while assessing the risks according to a professional judgment, determines which
risks require a specific attention, such as significant risks often related to significant nonroutine
transactions and matters require a judgment. There is an inverse relationship between
the significance and risk which means the higher level of significance, the lower audit risk
which could be accepted.
Independent Auditor’s Report
The auditor comes to a conclusion representing a basis to formulate an audit opinion on the
audited financial statements on the ground of the sufficient and appropriate evidence obtained
when auditing.
The auditor's opinion is the most important part of the auditor's report representing a tool of
communication between the auditor and clients. It is a delcaration of an opinion of
independend person based on cogent evidence.
The auditor’s report provides information on the audit subject, audit responsibility,
management responsibility as well as auditor’s opinion on the audited financial statements.
The independent auditor expresses to the shareholders and creditors, by a formulation of
her/his opinion on the financial statements in auditor's report, that the information presented
in financial statements are true and fair in all material respects.
CONCLUSION
The audit profession can be considered as an emerging discipline in the Slovak Republic
compared with many countries. Its roots go back to the 19th century. However, its origin is
much older. The first findings of the activity appeared thousands of years ago.
It has become a major independent proffesion as a result of historical development. It faces
national and international demands from the public, clients, creditors, banks or other parties. It
has gradually adapted to the current requirements of the business environment.
The audit profession holds an important place in the economic life of the Slovak Republic at
present. The audit profession may be defined as an important element of prevention in the
economic invironment but also as a tool in eliminating business risks that every accounting
unit faces when carrying out its business activities. Therefore, it is necessary to emphasize the
106
importance and necessity of the audit profession as an option of the risk emilination
accompanying the business activites of all accounting units.
BIBLIOGRAPHY
[1] DVOŘÁČEK, J.: 2005. Audit podniku a jeho oparací. Praha : C. H. BECK. 165 s. ISBN
80-7179-809-6.
[2] Etický kódex audítora SKAU.
[3] KAREŠ, L. 2010. Audítorstvo. Bratislava : IURA EDITION, 2010
[4] KASZASOVÁ, K., PAULE, I. a kol.: 2005. Audítorstvo. Bratislava: SÚVAHA. 2005.
314 s. ISBN 80-88727-93-6.
[5] KRIŠKOVÁ, Petra (dizert.). Teoretické aspekty auditu ako východisko pre riešenie
špeciálnych problémov ekonomickej praxe : dizertačná práca. Škol. Ladislav Kareš.
Bratislava, 2010. 101 s.
[6] MÜLLEROVÁ, L.: 2007. Auditing pro manažery. Praha : ASPI. 2007. 133 s. ISBN 978-
80-7357-308-9.
[7] Príručka Medzinárodných usmernení pre audit, uisťovacie služby a etiku. 2007. IFAC.
ISBN 978-80-89265-04-6.
[8] RICCHIUTE, D. N., 1994. Audit. Praha : VICTORIA PUBLISHING, 1994. 792 s. ISBN
80-85605-86-4.
[9] SEDLÁČEK, J.: 2001. Auditing. Brno : MASARYKOVA UNIVERZITA. Ekonomickosprávní
fakulta. 2001. 176 s. ISBN 80-210-2527-1.
[10]ŠKULTÉTY, Jozef - KRIŠKOVÁ, Petra. Profesia účtovník - jej súčasnosť a budúcnosť. In
Účtovníctvo - audítorstvo - daňovníctvo : v teórii a praxi. - Bratislava : SÚVAHA, 2012.
ISSN 1335-2024, 2012, roč. 20, č. 4, s. 114-115.
[11]www.epi.sk
[12]www.euroekonom.sk
[13]www.kpmg.com
[14]www.skau.sk
Ing. Veronika Krsikova
Internal PhD. student
Department of Accounting and Auditing
Faculty of Economic Informatics
University of Economics in Bratislava
Dolnozemska cesta 1, 852 35 Bratislava
Slovak Republic
veronika.krsikova@gmail.com
Ing. Lukas Rybka
Internal PhD. student
Department of Accounting and Auditing
Faculty of Economic Informatics
University of Economics in Bratislava
Dolnozemska cesta 1, 852 35 Bratislava
Slovak Republic
lukas.rybka@euba.sk
107
BANKS AND CASH MANAGEMENT
Jan Krajíček
ANNOTATION
One of the major components of banking, which has its own historical traditions, is primarily
a commercial bank - the financing of large firms and the problems that are associated with it.
It involves a two areas, both our own bank marketing, creation of new banking products and
their further use, while the satisfaction of bank customers.
In particular, the large bank clients are crucial - their meaning is not, I'll just their size, but
also many other clients who are strings attached, be it retail as well as well as corporate
clientele.
One of the ways to attract and retain customers is especially large Cash Management – which
is an important part of business management, municipalities. For banks, it is an opportunity to
get his client to offer more products designed for comprehensive management of financial
flows. It may not be a new product, but it is crucial to their composition and offer bank
clients.
KEY WORDS
Bank Cash Management Cash Pooling Cash Collection
JEL classification: G390
INTRODUCTION
In order to detect approach of banks in the Czech Republic companies were surveyed with the
following result. 27 questionnaires were sent to banks in the Czech Republic. Were excluded
from the research building societies and banks, whose target group is mainly retail clients.
In order to get enough relevant information, was implemented at two banks that failed another
survey, this time a personal way, so as to gather a sufficient number of correspondents, whose
answers can be evaluated.
The survey aimed to obtain data for analysis based on the following groups of questions:
- How the banking sector approaches Cash Management;
- About what clients are interested;
- What bank products to include Cash Management;
- Preview of the banking sector, the advantages in terms of Cash Management Bank and the
client;
- What about the banking sector clients interested in the case of Cash Pooling;
- What form of Cash Pooling is on offer to their customers;
- Preview the profitability of the banking sector in terms of pooling cash and bank client.
AIM AND METHODOLOGY
In his paper aims to deal with especially highly sophisticated new products and the
relationship marketing and development in relation to the new banking products. Their use is
aimed in principle only to legal persons.
As a basic method of scientific inquiry primarily consider the methodology of pragmatism
that is in my view the most appropriate methodology for investigating phenomena in the
financial sector.
108
Yet consider, in my view to proceed to examine from the perspective of other scientific
methodology especially "New positivism" and "Critical rationalism".
In particular, consider the methodology of pragmatism for the area of scientific inquiry for the
best. This approach is influenced by my own particular experience in banking and nonbanking
sector. Crucial to the investigation and determination of objectives, in banking, which
is primarily will benefit from the new banking services.
Cash Management issue is current and its application contributes to cost savings in the
business sector.
RESULTS
All of the surveyed banks that responded to the questionnaire have in their Cash Management
menu and only one of them has failed in its bid Cash Pooling. What has, however, deserves
more attention is the issue of offers for individual client segments.
Cash Management
The vast majority of banks offer the business sector, municipalities and Cash Management in
principle, regardless of the size of the client. Only about half the number of banks offering
Cash Management to selected clients. This approach is particularly affected certain risk-free
Cash Management, unless its part of the Cash Pooling. Yet only a certain share offers to
selected clients indicates the impact of segmentation by banks that are trying this risk-free for
clients to choose the product so that it may not continue to offer significant and cost for their
clients the most valuable part of the Cash Pooling.
Cash Pooling
Here the situation is completely different. Regardless of the size and number of client
accounts, banks offer Cash Pooling selected clients and especially those which are of interest the
interest to keep the client even if there is a reduction of proceeds.
1 CASH MANAGEMENT STRUCTURE
The biggest offer individual products included in the Cash Management are focused on basic
banking products liability and balance-neutral, such as current accounts, both in CZK and
foreign currency payments.
Virtually all banks have in their offer Cash Pooling, as part of the Cash Management. Cash
Pooling may in certain cases, risk-free transactions, but not without interest, less shares in the
offering:
- Foreign exchange transactions, operational and investment loans. Lower rates are influenced
by their risk - these are essentially the products associated with the risk in their provision.
- Credit cards are also offered as part of the Cash Management fewer respondents.
It is a product that as part of the Cash Management is designed primarily for the management
client.
- It is surprising low utilization of the possibilities offered by cross-selling1
, because
employee accounts offering less than half of the respondents. The employee accounts both
banks extend the number of clients and also have a neutral impact on the overall balance of
the bank where the funds are only transferred between client accounts in the bank.
- Cash Collection offers the vast majority of respondents, even if it does not in service centers,
service centers cash because they are basically secured form of service centers.
1
Cross-selling, when as part of a sales strategy to sell the product, are also offered other products that the
primary product may not be directly related.
109
Fig.2 Survey in banks – Structure of Cash Management
Question
Consent in the
Questionnaires
Consent
personal
meetings
Total
responses
consistently
What can you offer as part of the Cash Management
The management of current accounts in CZK
and payments local, cross border and foreign
9 2 11
The management of current accounts in foreign
currencies and cross border and foreign
payments
9 2 11
Cash transactions in domestic currency and
foreign currencies
7 2 9
Treasury operations - term deposits, savings
accounts and savings deposits
8 2 10
Foreign Exchange Transactions 5 2 7
Operational credits 5 2 7
Investment loans 4 1 5
Cash Pooling 8 2 10
Debit Card Payment 5 1 6
Credit Card Payment 4 1 5
The management of employee accounts 2 2 4
Cash Collection (especially for business
companies)
5 2 7
Using of service centers 0 0 0
Source: Own research results in banks
2 CASH POOLING
They have in their offer almost all banks, and given the rules that apply for Cash Pooling is
advantageous for them to provide Real Cash Pooling. The difference is between the number
of offers on real or fictitious Cash Pooling, as well as offers to local, multinational and
multicurrency accounts, is not so significant, indicating that banks are prepared to offer cash
pooling according to client needs.
Significant lower supply of credit and no compensation offer cash pooling, which banks
consider from your perspective as less advantageous.
Fig.3 Survey in banks – Offers of Cash Pooling
Question
Consent in the
Questionnaires
Consent
personal
meetings
Total
responses
consistently
Real (basic characteristic of the transfer of account
balances, account for the main group to the end of
the day, positive balances are used to cover any
deficits in other accounts within the group and thus
leads to savings in external funding)
8 2 10
Fictive (as opposed to real cash pooling funds to
transfer does not, but there is only a mathematical
combination of balances on individual accounts so
that account balances remain unaffected)
6 2 8
Local (all accounts involving only one currency in
that particular business entity with the bank,
including accounts of subordinate units)
6 1 7
110
Multinational (involving all the accounts of a
business entity with the bank, together with the
inclusion of accounts of subsidiaries and affiliates
of banks, regardless of the state in which it
operates)
6 2 8
One currency (involving all accounts in one
currency of a particular business entity with the
bank. It is also the inclusion of sub-account units
6 2 8
Multi currency (involving all accounts in the
particular business entity with the bank, including
accounts of subordinate units)
5 2 7
Credit (credit reduces the load debit balances on
accounts with balances are included in the accounts
and the credit is reduced credit lines and credit
exposure associated with a lower interest credit
drawn)
2 1 3
Compensation (to reduce the risk to the client;
balances on credit and debit accounts are not offset,
but the credit balances are used as collateral
pumped Debit reduces the risk to the client, which
is not reduced drawdown loan and related interest,
but the compensation is provided for reducing
credit risk)
0 0 0
Source: Own research results in banks
3 ADVANTAGES AND DISADVANTAGES OF MANAGEMENT CASH
AND CASH POOLING
Fig.4 Survey in banks – Advantages and disadvantages of Management Cash and Cash
Pooling
Question
Consent in the
Questionnaires
Consent
personal
meetings
Total
responses
consistently
Advantages and disadvantages of Management Cash
Benefits of Cash Management for the bank
outweigh the disadvantages (particularly in
relation to costs)
7 2 9
Benefits of Cash Management Bank for the client
outweigh the disadvantages (particularly in
relation to costs)
9 2 11
Cash Management is disadvantageous to the bank 0 0 0
Cash Management is disadvantageous to the client 0 0 0
Advantages and disadvantages of Cash Pooling
Benefits of Cash Pooling for the bank outweigh
the disadvantages (particularly in relation to costs)
2 1 3
Benefits of Cash Pooling Bank for the client
outweigh the disadvantages (particularly in
relation to costs))
6 2 8
Cash Pooling is disadvantageous to the bank 2 1 1
Cash Pooling is disadvantageous to the client 0 0 0
Fees for managing cross-border (foreign) Cash
pooling is significantly lower than the revenues it
1 2 3
111
Cash Pooling imaginary, in our view we consider
it better than real
2 1 3
Source: Own research results in banks
4 APPROACH TO CASH MANAGEMENT
Replies banks only confirm the Cash Management disadvantageous to the bank, but it is
necessary to assess the overall benefit of the client's bank and its use in bank acquisitions and
selected clients and clients in which the bank has an interest. The best demonstration is in
following SWOT analyses.
Fig. 5 SWOT Analysis of Cash Management - Banking Sector
„S“ Strengths Offer new sophisticated product.
Certain fee for Cash Management.
Extended offer passive, the bank risk-free products.
Penetration into other business segments that require sophisticated services.
„W“ Weakness Decrease (outflow) interest income from lending.
Request intra bank highly sophisticated information system.
Increased pressure on the qualifications of the staff to work with clients.
„O“ Opportunities Getting new clients, mainly from the "blue chips", for which they are mainly
system primarily intended Cash Management.
Improving market position.
Empowering the bank to make payments.
The increase in other clients who are interested in using the speed, and
lower fees in payments with major clients of the bank.
„T“Threats
Loss of interest income in the short term may adversely affect the financial
results and associated reorientation of the bank.
Relatively easy possibility of developing a similar system by other banks –
banking services have considerable disadvantage easy contouring.
Source: Own research and analyses
Fig. 6 SWOT Analysis of Cash Management – Business Sector
„S“ Strengths Reducing the cost of liquidity.
Better use of financial flows.
Saving s in financial costs.
Centralization of transactional processes.
„W“ Weakness Increase links with the bank.
Administrative complexity in the application of unfavorable tax laws.
„O“ Opportunities Possibility to use the acquired free financial resources.
Better control of intra-holding and financial flows.
Moving demanding financial activities the bank.
Outsourcing in activities which better ensures the bank, especially Service
centers.
Use of Cash Collection for commercial organizations.
„T“ Threats
Possible limitations own controls over financial flows in favor of the bank.
Excessive confidence in the work of the bank, which may be reflected in the
inadvisability of products offered by the Bank.
Move the operating funds to the parent organization.
Source: Own research and analyses
112
CONCLUSION
Banks in the Czech Republic are on their site offers the Cash Management and Cash Pooling
incorporated in various ways from the failure to complete the description of these services,
only that is to provide comprehensive descriptions of the products offered. Access to
individual banks primarily affects their marketing strategy in relation to clients.
Only highlight existing and potential clients on special products and the main form of
communication and client is guided through a bank (Relation Ship Manager) consultants, who
also initiated discussions with the client and offers him a suitable product (Tailoring - sewing
products-made).
BIBLIOGRAPHY
[1] BARITSCH, V.: Bank Treasury Management, ifs Schoul of Finance 2008, Cantenbury,
1. vydání, 353 s., ISBN 0-85297-697-6
[2] COOPER, R.: Corporate Treasury and Cash Management, Palgrave Macmillan 2004,
New York, 416 s., ISBN 978-1-4039-1623-5
[3] KRAJÍČEK, J.: Banky a očekávaný vývoj v České republice a Evropské unii. In
Finanční řízení podniků a finančních institucí 1. vydání. Ostrava, VŠB - TU Ostrava,
Ekonomická fakulta, katedra financí, 2005. od s. 223 - 228, 530 s. ISBN 80-248-0938-9
[4] KRAJÍČEK, J.:Bankovní marketing a nové trendy v komerčním bankovnictví.
In Evropské finanční systémy 2007. 2007. vyd. Brno, Masarykova univerzita, od s. 196
- 202, 449 s. ISBN 978-80-210-4319-0. info
[5] WERDENICH, M.: Modernes Cash Management, Verlag 2008, München, 2.
aktualisierte Auflage, 279 s., ISBN 978-3-636-03123-5
Ing. Jan Krajíček
Masaryk University
Faculty Economics and Administration
Department of Finance
Lipová 41 a
602 00 Brno
Czech Republic
krajicek@econ.muni.cz
113
APPLICATION OF OPERATIONS RESEARCH METHOD TO
SOLVE INCREASE IN UNEMPLOYMENT
Veronika Křelinová, Jiřina Krajčová, Pavla Vanduchová
ANNOTATION
Even today, it is clear that the Czech Republic has failed to cope with effects of a financial
crisis that broke out in 2011. Surely would be nice to say that this crisis is similar to that
which we went through in 2008, which would be much easier as well as its subsequent
solution, where it would be possible to use past experience. However, this global crisis,
compared to the current one, spread from the bottom upwards. Politicians around a world are
therefore not able to effectively stimulate an economy or deal with subsequent problems. This
has resulted in a gradual loss of confidence both in financial and business sphere but also in
households, which were touched mainly by a development of a labour market. As a result,
household consumption and firms investment has declined and spun a spiral leading to ever
higher unemployment and slower economic growth. This paper offers a view to solve the
problem of increase in unemployment in the Czech Republic with the aim of optimizing from
a perspective of state government spending. For this, will be used a model of a jobseeker at
the age of 26-35 years with a gross wage in the amount of 8,000 CZK.
KEY WORDS
Unemployment, Jobseeker, State, Multi-Criteria Analysis Model of Variants.
JEL classification: C36, C13, C52
INTRODUCTION
Unemployment is one of the main macroeconomic problems during the lingering economic
crisis which does not relate only to the economically weaker countries, but also covers
developed countries. The increase of the unemployment in the developed countries was not
only the result of natural development, but one of the main causes could be built-in stabilizers
of the government fiscal policy. In the countries that do not use their human resources
enough, occurs not only to losses of gross product, but also decreases the economic efficiency
and increasing social tensions. Although the most of us do not realize it, we come across with
the problems os the multi-criteria decision making in everyday life very often. But in fact
need not to be only problems decision-making that have society-wide impacts (e.g. a selection
procedure advertised by the state institution). Frequently this type of a task, without realizing
it, we use for example in a travel agency, to ensure our holiday, when choosing a computer
for a home use, to select a banking institute to save our money and others for a man more or
less important decicions. Therefor, we decided to apply this method of the operations research
to solve the problem of the unemployment in the Czech Republic.
AIM AND METHODOLOGY
The aim of this paper is to provide a view to solve the problem of the unemployment in the
Czech Republic in order to optimize government expenditures from the perspective of the
state. For this will be used a model´s jobseeker at the age of 26-35 years with a gross wage of
8,000 CZK, to which will be applied to a multi-criteria decision making method.
114
Multi-Criteria Decision Making Methods
Tasks of the multi-criteria decision making methods solve problems, when the optimal
decision has to convenient more than one criterion, where the entered criteria may have
quantitative and qualitative nature and they can also be maximization and minimization, and
also can be conflict to each other. In the event that the set of variants is given by the final list
of variants, we are talking about multi-criteria analysis model of variants. But if the set of
possible variants is specified by the conditions that have to be accomplished in the selection
of the optimal variant, it is the model of the multi-criteria programming. For solving the
problem outlined by us (see section Mathematical Solution of the Problem of the
Unemployment Increase) was selected just the first approach (is known the final list of the
variants of the problem solving), which is the multi-criteria analysis model of variants.
Multi-Criteria Analysis Model of Variants
In models of multi-criteria analysis (or evaluation) of variants is given the final set of m
variants that are evaluated according to n criteria. (Brožová, Houška, Šubrt, 2009, p. 4) The
task is to find the variant which is according to all evaluation criteria generally rated the best
(i.e. optimal or compromised variant), or arrange given variants from the best to the worst or
eliminate variants which are inefficient. If the evaluation of the variants for selected criteria is
quantified, data of this mathematical model can be organized into a criterial matrix. It may
look like this:
(1)
In this criterial matrix Y = (yij) is the element yij evaluation of the i-th variant according to the
j-th criterion. Columns (f1 to fn) are consistent with the criteria and lines (a1 to am) with the
evaluated variants. (Brožová, Houška, Šubrt, 2009) The diagram of the criterial matrix shows
that it includes the evaluation of all variants by all selected criteria and elements of the matrix
need not to be only numbers. During the analyzing of the tasks of the multi-criteria evaluation
of variants the decision making subject may choose the following (basic) objectives: a)
selection of the one variant designated as a compromise no matter which variant will be
evaluated as the second or next in order, b) complete ordering of the set of variants from the
"best" to the "worst", c) distribution of the set of variants on the "good" and "bad".
Mathematical Solution of the Problem of the Unemployment Increase
In the following part of the paper will be mathematically formulated and then solved the
problem of the increase of the unemployment in the Czech Republic (mainly due to the global
economic crisis) in order to optimize government expenditures from the perspective of the
state. To achieve the defined aim (or problem solving) was chosen the model jobseeker at the
age of 26 to 35 years who lives alone, is childless, registered at the Employment Office and
his gross wage is 8,000 CZK.1
To solve problem outlined by us we have to determine
particular variants of the solution (will be marked with the letter V), where each variant
represents one of several possible ways to achieve the defined aim. It will also be necessary to
determine criteria to which will be subordinated the selection of the best possible variant of
the solution (will be marked with the letter C) and subsequently to obtain relevant results and
to come to the aim, we have to calculate the weight of individual criteria. Although this step is
1
During the analysis (or calculations) of the situation it was necessary proceed from the situation in which the
jobseeker has been employed before his registration at Employment Office, i.e. it was proceed from the wage of
the person in the time when he was employed.
115
one of the starting steps for analysis of the multi-criteria analysis model of variants, the
gaining of the weight in the numerical form is often very problematic. Therefore, to determine
the weights we use one of the methods for estimating weights of criteria, which is the scoring
method. A precondition of the scoring method is the ability to express the importance of each
criterion by a specific number of points within a predetermined scoring scale, e.g. as 1 to 10,
while the more important the criterion is, the more points it is assigned to. If the score of the ith
criterion is marked with symbol pi, then can be the estimation of the criteria obtained by the
following equation (Jablonský, 2002):
(2)
Based on these preconditions, we chose to the solution of the problem the following variants
(see below) which will be considered according to the selected criteria, to which will be
placed the weights on the basis of calculations. Consequently, according to calculations,
variants will be examined at the selected type of jobseeker (on the basis of his gross wage),
and in view of the state will be selected the most favourable variant (according to the
jobseeker). With the respect of the studied problem scope, it is solved only in terms of utility
of the individual variants.
Recognition and Development of Individual Variants of the Solution
This part of the paper is focused on the short and accurate description of the possible variants
of the solution of the problem defined above thus, to achieve the set aim.
Variant 1 (V1) is based on the precondition that the jobseeker has been employed before a
registration at the Employment Office. The nature of this variant is that the jobseeker is
entitled to unemployment benefits and social benefits (which here include state social benefits
and benefits in the material poverty). Furthermore there is a jobseeker, per who the state pays
state health insurance (i.e. this is the non-monetary income). The payment of all these benefits
is not dependent on the public assistance.
Variant 2 (V2) is based on the precondition that the jobseeker has been employed before the
registration at the Employment Office. The nature of this variant is that the jobseeker is
entitled to unemployment benefits. Furthermore there is a jobseeker, per who the state pays
state health insurance (i.e. this is the non-monetary income). The payment of all these benefits
is not dependent on the public assistance. The difference compared to the previous variant is
the fact that the jobseeker can not receive social benefits.
Variant 3 (V3) is based on the precondition that the jobseeker has been employed before the
registration at the Employment Office. The nature of this variant is that state pays health
insurance for the jobseeker (i.e. this is the non-monetary income). The payment of the health
insurance for the jobseeker is not dependent on the public assistance. In this case, the
jobseeker receives only non-monetary income in the form of the health insurance, which is
paid by the state. But he is not entitled to unemployment or social benefits.
Variant 4 (V4) is based on the precondition that the jobseeker has been employed before the
registration at the Employment Office. The nature of this variant is that jobseeker is not
entitled to any government benefits (i.e., the jobseeker is not entitled to the payment of
unemployment or social benefits) and the state does not pay the health insurance for him.
Unlike previous variants the jobseeker is not entitled to unemployment and social benefits,
but even the non-monetary income in the form of health insurance.
Variant 5 (V5) is based on the precondition that the jobseeker before the registration at the
Employment Office has been employed. The nature of this variant is that the jobseeker is
entitled to unemployment and social benefits (which here include state social benefits and
benefits in the material poverty). Furthermore, the state pays the health insurance for the
jobseeker (i.e. this is the non-monetary income), and the payment of all of these benefits is
entitled to the public assistance of the third month of the registration at the Employment
116
Office. This variant is similar to variant V1, but with the difference in conditional payment of
these benefits.
Determination of Criteria and Their Weights
Based on the previous preconditions for the state was established the following criteria which
are deciding for selected problem solving. These criteria are: C1 - expenditures on the state
policy, C2- unemployment rate,2
C3 – level of the welfare state, C4 – unrests, C5 – necessity of
the legislative changes, C6 – stop the growth of the informal economy, C7 – public-service
work. To determine the weights of individual criteria it was used scoring method, where the
importance of each criterion was expressed by the number of points within the scoring scale
from 1 to 5 which was specified by us. How more significant the criterion was (in terms of
state), the more points was assigned to it. Subsequently, to determine the weights of criteria
there were used relation 2 and the resulting weights (vi) were rounded to 2 decimal places.
Fig. 1 Criteria Evaluation and Their Weights in Terms of the State
Criterion Number of points = pi Weight = vi
C1 – expenditures on the state policy 3 0,11
C2 – unemployment rate 5 0,18
C3 – level of the welfare state 4 0,14
C4 – unrests 5 0,18
C5 – necessity of the legislative changes 3 0,11
C6 – stop the growth of the informal economy 5 0,18
C7 – public-service work 3 0,11
In total 28 1
Source: Own processing
Evaluation of the Utility of the Individual Variants of the Solution
In the following part of the paper there are the individual variants evaluated in terms of the
utility. These variants are in more detail specified and arranged in the matrices. The first is the
matrix of absolute utilities, where the criteria of the given variants are expressed numerically
in natural units of measurement, or verbal description.
Fig. 2 Matrix of the Absolute Utilities in Terms of the State
MU V1 V2 V3 V4 V5
C1 CZK 45 391 23 195 3 615 0 45 391
C2 -
mild
increase
lower
decrease
higher
decrease
higher
decrease
lower
decrease
C3 - higher lower lower lower higher
C4 Y/N N Y Y Y Y
C5 - none lower lower strong lower
C6 - no no no no yes
C7 Y/N N N N N Y
Source: Own processing
Note: MU = Measure Unit. Y/N = Yes/No
The next step is to transfer values (verbal expression) listed in the matrix of the absolute
utilities of using a 100 point scale for comparable units in order to work with them. The best
2
Expenditures on the state policy are the sum of expenditures in the first 5 months, providing support, health
insurance and social benefits. The exception is a variant V4, where the costs to the state policy are zero.
C V
117
variant under each criterion is assigned a value of 100 and then the others are recalculated to
this best variant.
Fig. 3 Matrix of the Simple Utilities in Terms of the State
V1 V2 V3 V4 V5
C1 0 49 92 100 0
C2 15 65 80 100 65
C3 75 25 25 25 75
C4 100 0 0 0 0
C5 100 50 50 25 75
C6 25 25 25 25 100
C7 0 0 0 0 100
Source: Own processing
The final step in the evaluation of the utility of the variants is to create a matrix of weighted
utilities, which has, in addition to an ideal variant, shows the final result and it is the
recalculation of the values of the matrix of simple utilities with the help of the weights, which
we found by using the scoring method.
Fig. 4 Matrix of the Weighted Utilities in Terms of the State
Weight V1 V2 V3 V4 V5 M
C1 0,11 0 5,39 10,12 11 0 11
C2 0,18 2,7 11,7 14,4 18 11,7 18
C3 0,14 10,5 3,5 3,5 3,5 10,5 14
C4 0,18 18 0 0 0 0 18
C5 0,11 11 5,5 5,5 2,75 8,25 11
C6 0,18 4,5 4,5 4,5 4,5 18 18
C7 0,11 0 0 0 0 11 11
∑ = U - 46,7 30,59 38,02 39,75 59,45 100
Source: Own processing
Note: U = Utility
Now if we consider the utility of individual variants from the perspectives of the state at the
jobseeker referred to in the last, fourth, table (or matrix of the weighted utilities), we come
here to the following conclusions, namely that from the term of the state the best variant is the
variant V5, with the utility of 59.45 %.
RESULTS
With the respect to the fact that the task of the multi-criteria analysis model of variants is to
find the variant, which according to all the decision criteria is evaluated as the best (i.e.
optimal variant), or line up the individual variants from the best to the worst and also allow
the state in terms of the selected jobseeker on the basis of his gross wage, to choose the best
variant, these variants, that have come from the evaluation as the best, may be ranked (based
on utility) as follows. The first in the order was placed the variant V5 with the utility of
59.45 %, the second the variant V1 with the utility of 46.7 %, the third the variant V4 with
utility of 39.75 %, the fourth the variant V3 with the utility of 38.02 % and as "the worst" was
evaluated the variant V2 with utility of 30.59 %.
C V
C V
118
CONCLUSION
Based on the above mentioned total evaluation of all variants in terms of the utility, we can
conclude following conclusions. At the selected jobseeker in terms of the state it was
evaluated as the best the variant V5, which is based on the precondition that the jobseeker has
been employed before the registration at the Employment Office. The nature of this variant is
that the jobseeker is entitled to unemployment and social benefits and also on non-monetary
income in the form of health insurance that the state pays for him. The payment of these
benefits is dependent on the public assistance from the third month of the registration at the
Employment Office. The worst was at the selected jobseeker in terms of the state the variant
V2, which is based on the precondition that the jobseeker has been employed before the
registration at the Employment Office and the nature of the variant is that the jobseeker is
entitled to unemployment benefits and non-monetary income in the form of the health
insurance, which state pays for him, with the unconditional payment of such benefits to public
assistance. If the state operated only with utility of the variants, chose with the most
probability variants described above, based on information listed in Fig. 4. On the other side,
it would be very interesting to consider an important quantity, which is the risk endangering
the implementation of the individual variants that would certainly very influenced the state to
choose the best (or optimal) variant. The final decision would depend only on what attitude to
this factor takes the state. It would also be useful to explore this problem from the perspective
of a citizen of the Czech Republic, where the aim would be to optimize his income from the
state budget and from the perspective of employers with focusing on his labour costs.
BIBLIOGRAPHY
[1] BELTON, Valerie and STEWARD, Theodor. Multiple criteria decision analysis. Dordrecht:
Kluwer Academic Publishers, 2002, 372 p. ISBN 0-7923-7505-X.
[2] BIERMANN, Harold J., BONINI, Charles. P. and HAUSMAN, Warren H. Quantitative
analysis for business decisions. Homewood: Richard D. Irwin, 1986. 732 p. ISBN 0-256-03381-1.
[3] BROŽOVÁ, Helena, HOUŠKA, Milan and ŠUBRT, Tomáš. Modely pro vícekriteriální
rozhodování. Praha: ČZU v Praze, 2009. 178 p. ISBN 978-80-213-1019-3.
[4] EHRGOTT, Matthias. Multicriteria optimization. Heidelberg: Springer, 2010, 323 p. ISBN
978-3642-0597-59.
[5] FOTR, Jiří and ŠEVCOVÁ, Libuše. Manažerské rozhodování – postupy, metody
a nástroje. Praha: Ekopress, 2010. 474 p. ISBN 978-80-86929-59-0.
[6] GOLA, Petr. Jak jednotlivé vyspělé země bojují s nezaměstnaností? [online]. 2011, [cit.
05.09.2011]. Available at WWW: <http://www.finance.cz/zpravy/finance/236055-jak-jednotlivevyspele-zeme-bojuji-s-nez
amestnanosti-/>.
[7] JABLONSKÝ, Josef. Operační výzkum. Praha: Professional Publishing, 2002. 323 p. ISBN
80-86419-42-8.
[8] TRIANTAPHYLLOU, Evangelos. Multi-criteria decision making methods: A comparative
study. Dordrecht: Kluwer Academic Publishers, 2000, 370 p. ISBN 978-079- 2366-072.
[9] ZONKOVÁ, Zdenka, Rozhodování managera. Ostrava: VŠB-TU Ostrava, 1995. 99 p. ISBN
80-7078-254-4.
[10] ŽENÍŠKOVÁ, Marta. Pojistné na sociální zabezpečení zaměstnavatelů, zaměstnanců, OSVČ,
dobrovolně důchodově pojištěných. Olomouc: ANAG, 2010. 143 p. ISBN 978-80-7263-579-5.
Ing. Veronika Křelinová, Ing. Jiřina Krajčová, Ing. Pavla Vanduchová
VSB – Technical University of Ostrava, Faculty of Economics
Sokolská třída 33
701 21 Ostrava 1, Czech Republic
Email: veronika.krelinova@vsb.cz
Email: jirina.krajcova@vsb.cz
Email: pavla.vanduchova@vsb.cz
119
CHANGES IN REPORTING OF GOODWILL IN MERGERS &
ACQUISITIONS
Zuzana Křížová, Eva Hýblová
ANNOTATION
Recent growth of the service sector and of the information technology- related business, along
with the dramatic increase in the number and size of mergers and acquisitions, has made
accounting for intangible assets very significant, especially in the field of reporting of
goodwill. Comparative analysis is focused on the differences between IFRS, US GAAP
accounting procedures and Czech accounting legislation. Main areas of analysis and synthesis
are the identification of mehods for goodwill recognition and reporting. The result is to
recommend more broadly voluntary disclosure in the reported financial statements of
companies.
.
KEY WORDS
Accounting standards, disclosure of intangibles, goodwill, intangible assets, mergers and
acquisitions, reporting
JEL classification: M41
INTRODUCTION
The relatively recent growth of the service sector and of the information technology- related
business, along with the dramatic increase in the number and size of international mergers and
acquisitions, has made accounting for intangible assets (IA) very significant (Lev, 2001)
According to Kang (2011) are few comprehensive guidelines for corporations in either
International Financial Reporting Standards (IFRS) or in United States Generally Accepted
Accounting Principles (US GAAP) on how to report IA, other than for purchased goodwill
and some development costs, in company financial statements. There is in the accoutancy of
intangibles sometimes-large difference between accountig rules and guidelines implemented
in different parts of the world.
Although accounting rules of different countries are converging, differences still remain also
with regard to the treatment of intangibles. The most important progress made in the last
years is that the intangible assets to be accounted for have been described extensively togeher
with procedures for their impairment and amortisation. In order to calculate or valuate reliably
a monetary value for particular intangibles different methods and procedures are followed.
Another major obstacle is formed by the fuzzy character of goodwill (Seetharanam et al.,
2006), which is often described as an amount of money paid in excess of the goods acquired.
Given that goodwill is usually a significant part of the total purchase price and often the
largest component, it is right that stakeholders should be told what it represents but two
doubts remain as to whether accounting standards go far enough. Is a qualitative description,
along the lines required in the revised standards, adequate for stakeholders’ needs? And
secondly, what happens if companies fail even to comply with this simple disclosure
requirement? This article analyses in more depth what can be done in analysing goodwill.
120
AIM AND METHODOLOGY
Goodwill as a important part of intangible assets has been more and more interesting not only
for researchers but mainly for company managers and owners. This article deals with
differences in accouting treatments and reporting in financial statements pursuant to the IFRS
in comparison to the US GAAP and the Czech accounting legislation. The rewiew also lists
current trends, terms and definitions used in dealing with term goodwill in publications on
intangible assets and mergers and acquisitions.
Our results are going to be a part of a research project of the Grant Agency of the Czech
Republic no. P403/11/0447 entitled “The Analysis of Taxation and Accounting Practices
during Mergers”. The aim of the project is to analyse accounting and taxation practices during
mergers, identify the differences in procedures, and to evaluate their influence on the reported
situation concerning equities and capital of the participating companies and investments of
partners. This article is based on analysis and comparisons of relevant literature resources,
mainly articles and conference papers, but also legislative acts and monographs.
RESULTS
Zanoni (2009) is providing a precise and accurate definition of goodwill, which allows to
differentiate between goodwill emerging from a business combination recognized by
standards and internally generated goodwill. From a theoretical perspective, the goingconcern
goodwill is the present value of abnormal earnings flows expected by the firm.
Accounting treatment of goodwill
According to Reporting Goodwill Internationaly (2008) the recent issue of revised accounting
standards for business combinations under US GAAP (SFAS14R) and IFRS (IFRS3R) has
been a significant step down the road to convergence. One of the most interesting changes has
been the adoption by the Financial Accounting Standards Board, in the US, of the IFRS
requirement for acquiring companies to disclose and explain the nature of the goodwill arising
from the purchase price allocation.
SFAS141R will require acquirers to disclose “a qualitative description of the factors that
make up the goodwill recognized. It goes on to suggest that these might include expected
synergies and intangible assets that do not qualify for separate recognition. The new US
GAAP requirement remains noticeably weaker than the IFRS3 equivalent which is for “a
description of the factors that contributed to a cost that results in the recognition of
goodwill, a description of each intangible asset that was not recognised separately from
goodwill and an explanation of why the intangible asset’s fair value could not be
measured reliably or a description of the nature of the excess recognised in profit or
loss.”
In the Czech Republic application of the International Financial Reporting Standards is
compulsory for all accounting units issuing securities registered on the regulated securities
markets of the EU Member States. The intangible asset area is settled in the Czech accounting
legislation in Standard no 013 Long-Term Intangible and Tangible Assets (Křížová,
2008).
This standard contains definition and pricing of long-term intangible and tangible assets,
depreciation principles, procedure of account recognition on acquisition, technical valuation
and asset write off. Like the other standards the Czech Accounting Standard no 013 is
governed by Act no 563/1991 Coll., on Accounting, and Decree no 500/2002 Coll., executing
some provisions of the Accounting Act. The standard contains the list of assets defined as
long-term intangible assets. These include establishment costs, intangible results of research
and development, software, rights of determinable value and goodwill. The condition for
121
classification as long-term intangible asset is usable life of more than one year and the asset
value higher than the valuation limit determined by the accounting unit. This class also
includes other long-term intangible assets, long-term intangible work in progress, and
advances provided for this type of assets. According to Czech accounting legislation in
Standard no 013 goodwill is a positive or negative difference between the valuation of the
entity, or its part in the sense of the Commercial Code, acquired by purchase, deposit or asset
and liability appreciation in the context of company transformation, except for change of legal
status of the company, and the sum of the individually revaluated asset items reduced by
taken over liabilities.
Defining goodwill broadly
According to Zanoni (2009) six components of goodwill emerging from a business
combination are identified. Similar to other, this author breaks down the goodwill emerging
from a business combination in overpayment, synergies between the target and the
acquiring firm, reevaluation, newly identified intangible assets, and internally generated
goodwill.
One of the reasons often given to why goodwill has not been described is that it cannot be
done or is too difficult. The following are examples of what goodwill is comprised of and how
to place a value on it and describe it. There are unlikely to be intangible assets which do not
meet the recognition criteria stipulated in FASB 141 and IFRS 3. However, if there are such
assets they should be allocated to goodwill. The standards require them to be disclosed and
reasons given why they have not been valued. The standards prohibit the valuation of
workforce as an identifiable intangible asset, therefore if one has any value it should be
included within goodwill.
Table 1. Reasons mentioned in purchase price allocated to goodwill
Justification of goodwill Frequency mentioned
Rights-related reasons Technology
related reasons 9
Customer-related reasons 20
Contract-related reasons 2
Cost-savings-related reasons 21
Expertise-related reasons 24
Other reasons 13
Source: Boekestein, B. (2009) p. 394
The value of a business is often greater than the sum of the individual components. This value
increase is quantifiable and should be allocated to goodwill and described. Of course the
reverse is true as well. Our research has seen no such analysis describing such underlying
value attributed to goodwill.
The application of the breakdown approaches using the example of a business combination
between two Italian banks (Unicredit and Capitalia) presents Zanoni (2009): Real goodwill,
terminal goodwill, current and growth goodwill, businesses goodwill, as well as
positional and system goodwill are identified.
DISCUSSION
One of the reasons often given to why goodwill has not been described is that it cannot be
done or is too difficult. This is not the case. The following are examples of what goodwill is
comprised of and how to place a value on it and describe it. There are unlikely to be
122
intangible assets which do not meet the recognition criteria stipulated in FASB 141 and IFRS
3 (R). However, if there are such assets they should be allocated to goodwill. The standards
require them to be disclosed and reasons given why they have not been valued. The standards
prohibit the valuation of workforce as an identifiable intangible asset, therefore if one has any
value it should be included within goodwill.
Economy of scale creates significant cost synergies when businesses combine. This can be
rigorously quantified and is often a key motivation for the acquisition (Sedláček at al., 2011).
For example, a saving of annual head office costs might be quantified at £5m a year, equating
to a capital value of £50m. Unit costs can also be greatly reduced through increased
purchasing power, creating further cost synergies.
According to Goodwill Reporting Internationaly cross-selling opportunities create sales
synergies which can be quantified. For example, Aviva’s acquisition of the RAC enabled
Aviva to sell RAC services to its existing customers as well as being able to sell Aviva’s
products and services to RAC’s existing customers. The portfolio effect can also be created
where two powerful portfolios combine, facilitating an increase in overall sales because of
their combined attraction.
Examples of goodwill qualitative descriptions
In its 2006 annual report Mittal Steel Company discloses details of the acquisition of Arcelor
for €29 billion, of which €6 billion was allocated to goodwill. In addition Mittal completed
two earlier acquisitions in 2005 for a total of €8 billion, including €1 billion of goodwill. One
note covers all three acquisitions and states that “Goodwill recorded in connection with the
above acquisitions is primarily attributable to the assembled workforces of the acquired
businesses and the synergies expected to arise after the Company’s acquisition of those
businesses. (3) Granted these acquired businesses are similar, as they are all steel producers,
but is a generic disclosure that does little more than repeat the wording in IFRS3 really
adequate to explain to stakeholders what €7 billion was spent on?
It is depressing how many large companies decide that the present, decidedly unchallenging,
requirements of IFRS3 for disclosure of the components of goodwill are all too much, and
choose to remain silent, with the acquiescence of their auditors. For example, Goodwill
Reporting Internationaly states, that the acquisition of Allied Domecq by Pernod Ricard in
July 2005 cost around €15 billion of which €3 billion was allocated to goodwill.
There are numerous other examples of a complete disregard of the requirement to disclose the
components of goodwill. Alcatel allocated €8 billion to goodwill on the acquisition of Lucent
in April 2006. In the year to September 2007, Siemens completed two major acquisitions at a
combined cost of €7 billion, of which close to €5 billion was allocated to goodwill.
It may be too much to hope that an arcane accounting disclosure requirement might protect
stakeholders from poor company managements but stronger disclosure requirements and a
requirement to quantify, at least in broad terms, and have audited, the components of goodwill
would bring improvements in information for stakeholders to assess for themselves significant
business investments.
CONCLUSION
The following conclusion can be drawn from this study: discussions about the role and
reliability of information of the basic financial accounting statements continue to be evoked
by bankruptcies of large companies or by the ongoing global financial crisis.
Questions are often asked what causes the profound differences between the accounting and
the market value of companies. Analyses and research results in this area often speak about
very different ways of human capital management, differences in customer relationships, use
123
of information technologies, employee knowledge or specific corporate organisational
cultures.
Due to the shift in the way investors and other stakeholders consider emerging economies and
their companies, most of the international attention is now on a select group of high-flying
and top-performing emerging market companies (Smith et al., 2003). It may be naïve to assert
that total transparency regarding IA would automatically enhance the quality of corporate
information being distributed to external stakeholders.
Quantification and qualitative descriptions of goodwill brings may be a discipline to the
acquisition process and management, knowing that their estimates would be subject to
audit scrutiny, might be dissuaded from repeating some of the excesses of the past. Such
a process would be effective even if the quantification of the components of goodwill did not
have to be disclosed in the annual report itself.
Ackowledgements
The paper contains results of project of Grant Agency CR No. 403/11/0447 The Analysis of
Taxation and Accounting Procedures during Mergers. The project solution, which will be
conducted in 2011–2013, was entrusted to the team of the Department of Finance, Faculty of
Economics and Administration, Masaryk University in Brno.
BIBLIOGRAPHY
[1] Boekestein, B. (2009) Acqusitions reveal the hidden intellectual capital of pharmaceutical
companies, Journal of Intellectual Capital, Vol. 10 No.3, pp. 389-400, ISSN 1469- 1930
[2] Goodwill Reporting Internationally retrieved from:
http://www.intangiblebusiness.com/Reports/Goodwill-Reporting-Internationally~1071.html
[3] Kang, H.H., & Gray, S.J., (2011) Reporting intangible assets: Voluntary disclosure
practices of top emerging market companies, The International Journal of Accounting, Vo.
46, Iss. 4, pp. 402 – 423, ISSN 0020-7063
[4] Křížová, Z. (2009). Why Are the Intangible Assets so Interesting for Revenue Authorities?
In Global Conference on Business and Finance Proceesings, Volume 4, No. 3 Atlantic City,
USA.
[5] Křížová, Z. (2008). Many Changes in Recognition and Depreciation of Intangibles. In 4th
Workshop on Visualising, Measuring and Managing Intangibles and intellectual Capital.
Hasselt, Belgium: EIASM, pp. 101-111.
[6] Lev, B. (2001). Intangibles: Management, Measurement, and Reporting. Washington, DC:
The Bookings Institution. ISBN 0-8157-0094-6
[7] Mittal Steel Company NV Statutory Financial Statements 2006 note 3, page 51- 54
[8] Sedláček, J., Křížová, Z., Hýblová, E.: (2011) Development of mergers and acquisitions in
the conditions of the Czech economy 2001–2010. Acta univ. agric. et silvic. Mendel. Brun.,
LIX, No. 7, ISSN 1211-8516
[9] Seetharanam et al., (2006), Managing impairment of goodwill, Journal of Intellectual
Capital, Vol 7 No.3, pp. 338-53, ISSN 1469- 1930
[10] Smith, G. et al. (2003). Emerging Might: Champions in China, Russia, and Elsewhere
Lure. https://www.businessweek.com/magazine/content/03_28/b3841025_mz047.htm
[11] Zanoni, A. B. (2009) Accounting for Goodwill, Routledge Taylor and Francis, New
York, 189 p. ISBN 978-0-415-45149-9
124
Ing. Zuzana Křížová, Ph. D.
Masarykova univerzita
Ekonomicko-správní fakulta
Katedra financí
Lipová 41a
602 00 Brno
Czech Republic
E-mail: krizovaz@econ.muni.cz
Ing. Eva Hýblová, Ph. D.
Masarykova univerzita
Ekonomicko-správní fakulta
Katedra financí
Lipová 41a
602 00 Brno
Czech Republic
E-mail: hyblova@econ.muni.cz
125
TAX PROGRESSION AS AN INSTRUMENT OF INCOME
REDISTRIBUTION
Katarzyna Lewkowicz-Grzegorczyk
ABSTRACT
Empirical studies confirm that progressive personal income tax can become an important
instrument of income redistribution. The purpose of this paper is to demonstrate how income
redistribution criteria can influence the structure of income tax. After examining the nature of
and reasons for the redistribution of income, the author provides analysis of the Polish
personal income tax system.
KEY WORDS
personal income tax, progression, redistribution
JEL classification: D31, H23, H24
INTRODUCTION
Progressive income tax is an important tool for income redistribution. It is also commonly
used to mitigate income inequality. By pursuing a system of progressive taxation, the state
can diminish the purchasing power of the rich, and, at the same time, increase the purchasing
power of those whose incomes are relatively low1
. Progressive income tax has an embedded
mechanism to differentiate tax burdens, as it imposes heavier levies on wealthier citizens.
Nevertheless, effective tax progression does not depend only on the number and magnitude of
tax rates or the level of tax scale thresholds, but also on other elements of tax structure –
particularly tax reliefs. Personal income tax reliefs usually have the opposite effect, i.e. they
reduce tax progression. This happens when well-off taxpayers are more likely to benefit from
various tax credits, theoretically available to all2
.
AIM AND METHODOLOGY
This paper pays special attention to the way in which actual redistribution of income is
determined by the structural elements of income tax. The present study uses as its object the
Polish personal income tax system. The analysis was prepared on the basis of statistical data
on personal income tax obtained from the Polish Ministry of Finance. To analyse the data,
which are provided in a tabulated form, the author uses a comparative method.
Income redistribution – advantages and drawbacks
Redistribution of income is the process during which income structure is altered to benefit
some people at the expense of others3
. It is a secondary distribution of income within society,
encompassing cash flows transferred between the market participants and state or selfgovernment
budgets4
. According to J. Ostaszewski, secondary distribution is only possible
when the primary one has already taken place, and when the resultant disproportions seem to
1
Dziemianowicz (2007), p. 36.
2
Małecka-Ziembińska (2006), p. 8.
3
Stiglitz (2004), p. 41.
4
Radziukiewicz (2011), p. 14.
126
require certain corrections5
. The process of redistribution involves the levying of various
income and property taxes (or tariffs), as the source of state revenue. This money is
subsequently used to support citizens who do not have any labour income (e.g. the
unemployed, pensioners), or to finance free public goods (e.g. health service, defence,
education, the judiciary and public administration)6
. As can be seen, redistribution mainly
occurs through taxes and social transfers.
The literature on the subject provides a variety of arguments in favour of and against
redistribution. R. Bugaj, for instance, distinguishes four principal reasons for income
redistribution7
. First, excessive income inequality is ethically objectionable. Second, for the
sake of equality of opportunity – which is conducive for economic growth – it is necessary to
decrease income disparities created by the market. Third, policies that reduce inequality can
help prevent social conflicts and stimulate social capital accumulation. Fourth, a more even
distribution of income is desirable because it increases demand, both globally, as well as in
specific sectors of the economy8
.
There are three main counterarguments against income redistribution9
. First of all, there is the
ethical approach holds that any social inequalities and economic disparities resulting from
free market should be acknowledged as natural. Secondly, there is a necessity to preserve
large income ‘gaps’ because their existence provides a strong stimulus for individual
economic activities. Thirdly, considerable differences in income levels strengthen the
propensity to save.
Income redistribution is present in all modern public finance systems, although to varying
extents10
. Higher income earners pay higher taxes, thus subsidising state budget to a greater
degree that low earners. Tax revenues are then made available to society in the form of
subsidies for various goods and services (public and social), or as state benefits for those in
need. It certainly is not the purpose of redistribution to achieve total equalisation of income; it
is rather used in order to avoid extreme or unjustified disparities. Neither is redistribution
supposed to become a ‘punishment’ for the rich, although some taxpayers from the highest
income brackets may perceive it as such. Therefore, the distribution of income in society is
5
Redistribution of income earned as a result of primary distribution occurs at various levels of the financial
chain. For example, savings accumulated in households find their way into the banking system, where they are
used to create secondary income in the form of credit. In property insurance, premiums paid by the insured from
their primary incomes become a source of secondary income, i.e. compensation for sustained damage paid to the
insured parties. Under the social security system, contributions obtained from the primary income generated by
earners and employers are converted into secondary income as social benefits granted to eligible individuals.
However, the largest part of redistribution is realised by the public finance sector, including the social security
system [Ostaszewski (2003), pp. 107-108].
6
Radziukiewicz (2011), p. 14.
7
Bugaj (2002), p. 150.
Analysis of reasons behind income redistribution from the point of view of economic theory is also undertaken
by e.g.: M. J. Radziukiewicz (2011), E. Aksman (2010), E. Małecka-Ziembińska (2006). M. J. Radziukiewicz
mentions three causes and aims of redistribution: income inequality, scale of poverty and social norms. E.
Aksman offers a different interpretation. For her, the most important factors are: social justice, the boosting of
economic efficiency and the political issue of economic interests pursued by certain social groups. According to
E. Małecka-Ziembińska, many countries have two motives for the redistribution of budget resources: (i) the
fiscal motive, stemming from the obligation to implement public tasks by funding them from guaranteed state
revenue, and (ii) the regulatory motive, i.e. the necessity to adjust the incomes of citizens.
8
See also [in:] Bugaj (2002), pp. 150-151 [quoted after:] Kotler et al. (1999), p. 373.
9
Bugaj (2002), p. 151.
10
Aksman (2010), p.7.
127
determined by policies which enhance the incomes of individuals (through social transfers),
and, on the other hand, policies which lead to their reduction (through taxes)11
.
RESULTS
A progressive personal income tax is widely used as a means towards a more equitable
society. Apart from the fiscal function, redistribution is its major raison d'être. Moreover,
income tax is a personal tax: the particular elements of its structure (e.g. annual tax-free
allowance, reliefs and exemptions, the progressive tax scale) allow, at least in theory, for
adjustment to the individual situation of each taxpayer. As such, it is common in most of the
developed countries.
Progressive personal income tax in Poland
In Poland, personal income tax is levied on a tax base calculated in accordance with a two-tier
tax scale, in effect since 1st January 200912
. For taxation to be just, the established tax rates
must take into account what income level is regarded as the minimum necessary to survive.
The theory of taxation asserts that income which guarantees minimum livelihood must not be
taxed – such a minimum is referred to as ‘personal allowance’ or ‘personal exemption’13
. This
tax-exempt amount is an integral part of the tax scale14
.
Let us analyse the distribution of the tax burden according to income brackets and percentage
share of taxpayers who have benefited from tax deductions in the last few years (Fig. 1).
Fig. 1. Personal income tax payers and tax due according to tax rate bands in years 2005-2010
Year Tax rate bands Number of taxpayers Structure of taxpayers
(in %)
Tax due
(in %)
Deducting taxpayers
(in %)
2005 up to 37 024 22 356 919 94.46 57.48 42.78
37 024-74 048 1 102 502 4.66 20.94 81.19
above 74 048 208 327 0.88 21.58 79.93
Total 23 667 748 100 100 44.89
2006 up to 37 024 22 215 807 93.34 56.17 23.62
37 024-74 048 1 319 557 5.54 21.50 63.30
above 74 048 266 467 1.12 22.33 75.14
Total 23 801 831 100 100 26.40
2007 up to 43 405 22 893 583 94.66 59.54 37.65
43 405-85 528 1 083 448 4.48 20.56 73.95
above 85 528 208 272 0.86 19.90 73.78
Total 24 185 303 100 100 39.59
2008 up to 44 490 22 525 382 92.15 52.30 -
44 490-85 528 1 575 511 6.45 23.19 above
85 528 342 230 1.40 24.51 Total
24 443 123 100 100 -
2009 up to 85 528 24 019 988 98.41 76.97 above
85 528 387 295 1.59 23.03 Total
24 407 283 100 100 -
2010 up to 85 528 24 094 441 98.11 77.32 above
85 528 463 567 1.89 22.68 Total
24 558 008 100 100 Source:
own analysis on the basis of [Informacje Ministerstwa Finansów…].
11
Radziukiewicz (2010), p. 154.
12
The basic legal act that regulates personal income tax in Poland is the Act of 26th July 1991 (Dz.U. z 2010 r.
Nr 51, poz. 307). When the bill on personal income tax was first passed, the tax rates were as follows: 20, 30 and
40 per cent. In 1994, they were raised to 21, 33 and 45 per cent; 1997 brought another amendment: 20, 32 and 44
per cent; whereas the lower tax rates introduced in 1998 (19, 30 and 40 per cent) were in use until 2009.
13
Gaudement, Molinier 2000, p.462.
14
In the case of personal income tax, this means the possibility to reduce one’s taxable income by an amount that
is deemed as tax-free. In recent years, the tax-free personal allowance has grown considerably: from PLN
2295.79 in 2000 to PLN 3091 in 2010. So the current tax-exempt income rate has remained unchanged for three
years now.
128
The data from the above table show that there is a downward trend to tax progression in
Poland. This is so because in 2007 and 2008 the tax thresholds were raised, whereas three tax
rates were replaced by two (18 and 32 per cent) on 1st
January 2009. In that year, tax
progression was reduced for both the taxpayers who had previously been the middle tax rate
payers and those who had paid the top tax rate.
It stems from the above data that in 2008, approx. 92.2% of the Polish taxpayers fell within
the lowest tax bracket, 6.5% paid the middle tax rate, while 1.4% paid the highest rate of tax..
Thus, tax progression concerned about 8% of the taxpayers. Over 52% of the PIT revenue
derived from the first income bracket, 21.19% from the second income bracket, and 24.51% from
the third one. In 2009, the overwhelming majority (98.41%) of taxpayers belonged to the
lowest income bracket. Tax progression encompassed merely 1.59% of taxpayers. Whereas in
2010, the share of taxpayers from the first income bracket dropped by 0.30 percentage points,
while at the same time the share of taxpayers from the second bracket grew by 0.30 p.p. More
than 77% of the personal income tax due revenue was obtained from first-bracket taxpayers,
while approx. 23% from the second-bracket group. Following the introduction of the two-tier
tax scale, taxpayers who had previously been in the second income bracket, found themselves
in the lower bracket with the 18% tax rate, whereas the former top tax rate payers (who paid
40% in 2008), now qualify for the 32% tax rate.
Fig. 1 also contains information on the percentage share of taxpayers who took advantage of
tax reliefs in each income group (for years 2005-2007). In 2005 and 2007, more than 40% of
the taxpayers used tax deductions. The year 2006 was exceptional in this respect as a sharp
drop (to 26.40%) in the share of such taxpayers was then recorded. This was caused, among
other things, by changes in tax relief legislation, as well as by the abolition of most tax reliefs
in 200415
. The year 2007 saw another increase (to 40%) in the percentage share of deducting
taxpayers. This change can be accounted for by the introduction of a new tax relief, namely
the so-called Child Tax Credit16
. It is easily noticeable that nearly twice as many taxpayers
from the second and third income brackets took advantage of tax credits than those from the
lowest bracket. This is confirmed by the fact that top earners were the main beneficiaries of
tax reliefs, which had a major influence on their tax burdens and evidently flattened
progression.
CONCLUSION
Tax progression is meant to relieve the tax burden of lower-income earners. And, indeed, it
does so in some countries. In Poland, however, although the tax system involves progression,
it is the poorest taxpayers who are left to bear the greatest burden of maintaining the state17
.
15
Before 2006, personal income tax payers were entitled to so-called Home Renovation Tax Credit, which was
abolished in that year. Still, those taxpayers who had not managed to deduct the full amount of that tax relief
were allowed to deduct it in the following years, including the 2006 tax return. While in force, that tax credit
played an important role.
16
Since 2008 it has been possible to deduct a prescribed sum of money from tax due for each child (own or
fostered); this deduction is known as pro-family tax credit. [Art. 27 f ustawy z dnia 26 lipca 1991 r. o podatku
dochodowym od osób fizycznych …op. cit.]. Tax returns for years 2007, 2008, 2009 and 2010 showed that this
deduction was utilised by, respectively, 3.97 million (16.43% of all taxpayers), 4.2 million (17,21%), 4.3 million
(17.77%) and 4.3 million (17.52%) of persons who had obtained taxable income in given tax year. In 2010, the
total amount deducted in accordance with this provision reached PLN 5.68 billion, i.e. 11.45% of tax due, after
the deduction of health insurance premiums. Average child credit deduction was PLN 904.
17
Surveys conducted in years 2006-2009 show that Poles prefer the progressive tax system. Flat-rate tax is far
less popular. A vast majority of respondents wanted low-income earners to pay lower taxes, while higher earners
to pay higher taxes than was the case in Poland [K. Lewkowicz-Grzegorczyk (2011), pp. 166-168].
129
In the years 2005-2008, on average, over 93% of the Polish taxpayers were subject to flat
taxation, since they fell within the first income bracket. This means that, regardless of their
income, they were all eligible for the lowest tax rate. Consequently, tax progression applied,
in average terms, to just 7% of all the taxpayers from the second and third income brackets.
The new tax rates (18% and 32%), which were introduced in 2009 caused a further flattening
of tax progression: in the years 2009 and 2010 it concerned a mere 2% of taxpayers. As many
as 98% of all taxpayers found themselves below the first threshold of the tax scale. H.
Kuzińska expressed the belief that even that rudimentary progression was likely to be
abolished and replaced with a flat-rate tax. She was afraid that the Poles would soon endorse
an unjust tax system, where official statistics did not cause popular discontent or heated
debates as to tax rates and tax reliefs18
.
Studies demonstrate that tax progression is also affected by tax reliefs, joint taxation of
spouses and single parent tax credits. It should be emphasised that only those taxpayers whose
income is sufficiently high can take advantage of tax reliefs. Lower income earners are not
able to utilise tax credits in full. This is usually the case in the lowest earning groups, and can
lead to hostile attitudes towards the entire system of taxation. The poorest families do not
have the opportunity to fully benefit from the tax credit system. This remains largely the
privilege of the better-off, in spite of the fact that tax reliefs and tax progression should rather
improve the welfare of financially underprivileged families (by easing the tax burden of low
earners) and reduce income disparities.
BIBLIOGRAPHY
Aksman, E. (2010). Redystrybucja dochodów i jej wpływ na społeczny w Polsce w latach
1995-2007, Warszawa: WUW. ISBN 978-83-235-0779-6.
Bugaj, R. (2002). Redystrybucja dochodów w systemie podatkowo – budżetowym [in:]
Kowalik, T. (ed.), Nierówni i równiejsi sprawiedliwość dystrybucyjna czasu transformacji w
Polsce, Warszawa: Fundacja Innowacja, pp. 147-188. ISBN 83-86169-31-1.
Czekaj, J., Owsiak S. (1992) Finansowy mechanizm alokacji zasobów w gospodarce
rynkowej, Warszawa: Wydawnictwo Naukowe PWN. ISBN 83-01-10874-6.
Dziemianowicz, R. I. (2007). Efektywność systemu opodatkowania rolnictwa, Białystok:
Wydawnictwo UwB. ISBN 978-83-7431-139-7.
Gaudement, P. M., Molinier J. (2000). Finanse publiczne, Warszawa: Państwowe
Wydawnictwo Ekonomiczne. ISBN 83-208-1234-8.
Informacja dotycząca rozliczenia podatku dochodowego od osób fizycznych opodatkowanych
na ogólnych zasadach za lata 2005 - 2010, Warszawa: Ministerstwo Finansów.
Kot, S. M., Malawski, A., Węgrzecki, A. (eds) (2004). Dobrobyt społeczny, nierówności i
sprawiedliwość dystrybutywna, Kraków: Wydawnictwo Akademii Ekonomicznej. ISBN 83-
7252-243-X.
Kotler et al. (1999). Marketing narodów. Strategiczne podejście do budowania bogactwa
narodów, Kraków: Wydawnictwo Profesjonalnej Szkoły Biznesu. ISBN 83-7230-025-9.
Kuzińska, H. (2006). „Jakie stawki podatkowe”? Olympus nr 2, pp. 13-23.
Lewkowicz-Grzegorczyk, K. (2011). Realizacja zasady sprawiedliwości na przykładzie
podatku dochodowego od osób fizycznych, Optimum Studia Ekonomiczne nr 1, pp. 148-170.
ISSN 1506-7637.
Małecka-Ziembińska, E. (2006). Podatek dochodowy jako regulator dochodów osób
fizycznych w Polsce okresu transformacji ustrojowej, Poznań: Wydawnictwo Akademii
Ekonomicznej. ISBN 83-7417-131-6.
18
Kuzińska (2006).
130
Ostaszewski, J. (ed.) (2003). Finanse, Warszawa: Difin. ISBN 83-7251-347-3.
Radziukiewicz, M. (ed.) (2010). Wpływ nierówności i redystrybucji dochodów na
konsumpcję gospodarstw domowych, Warszawa: IBRKK. ISBN 978-83-61284-21-5.
Radziukiewicz, M. J. (2011). Redystrybucja dochodów. Kto zyskuje? Kto traci?, Warszawa:
Polskie Wydawnictwo Ekonomiczne. ISBN 978-83-208-1992-2.
Stiglitz, J. E. (2004). Ekonomia sektora publicznego, Warszawa: Wydawnictwo Naukowe
PWN. ISBN 83-01-14338-X.
Ustawa z dnia 26 lipca 1991 r. o podatku dochodowym od osób fizycznych (Dz.U. z 2010 r.
Nr 51, poz. 307).
Katarzyna Lewkowicz-Grzegorczyk, Mgr.
Department of Finance, Accounting and Computer Science
University of Bialystok
Faculty of Economics and Management
k.grzegorczyk@uwb.edu.pl
131
INVESTIGATION OF THE WEEKEND EFFECT ON THE
PRAGUE STOCK EXCHANGE
Dagmar Linnertová, Martin Cupal, Oleg Deev
ANNOTATION
Since the 1980's numerous studies based on historical data have shown that stock returns
depend on the day of the week. So called weekend effect suggests that stock returns on
Mondays are often significantly lower than those of the immediately preceding Fridays. In
this proceeding we will apply the analysis of the weekend effect on the Prague Stock
Exchange. We argue that the stock return on PSE (represented with PX Index), measured as
closing to closing prices, should depend on the day of the week. In general, we assumed that
the returns on Mondays should be lower and the returns on Fridays should be higher and also
Monday return is significantly lower than the non-Monday return.
KEY WORDS
EMT, weekend effect, close to close, PSE
JEL classification: G1, G10, G14
INTRODUCTION
For many years there are disputes between investors and academics about the importance of
the past history of security price changes to prediction concerning of the future development
in stock prices. On the one hand there is a lot of chart theories, on the other hand there is the
theory of random walks. Chart theoretic believe that the past behavior of a security's price is
rich in information concerning its future behavior. History repeats itself in that patterns of
price behavior will tend to recur in the future. [3] By contrast the theory of random walks says
that the future path of the price level of a security is no more predictable than the path of a
series of cumulative random numbers. The random walk theory is an important implication of
the efficient market hypothesis, that is, future changes in stock prices, should for all practical
purposes, be unpredictable. [10] The theory says that successive price changes are
independent, identically distributed random variables. The series of price changes has no
memory, the past cannot be used to predict the future in any way. [3] According the theory of
random walks the charting has no real value for investors.
Several studies confirmed that stock market return depends on the day of the week. There
exists the evidence that the returns from the close of the last trading day of the week to the
Monday close tend to be negative while the returns of the last trading day of the week tend to
be positive. [7] This anomaly is very often known as the weekend effect. Weekend effect is
the effective market theory anomaly according that stock display significantly lower returns
over the period between Friday's close and Monday's close.
AIM AND METHODOLOGY
Lakonishok and Smidt found the evidence of the weekend effect (anomalous behavior) in the
Dow Jones Industrial Average from the period from 1897 to 1986. [8] They used 90 years of
daily data on DJIA1 to test the existence of seasonal patterns in the rates of return. They find
evidence of anomalous returns around the turn of the week, around the turn of the month and
1
Dow Jones Industrial Average Index
132
around the turn of the year. The weekend effect says that rates of return on Monday tend to be
significantly negative, and rates of return on the last day of week tend to be high. [9] In their
study the trading days have changed from six to five because during the examined period
Saturday trading was stopped. In general, there was some larger and
statistically significant positive rates of return on the last trading day of the week. They found
out that there is a tendency for a higher rate of return on the last trading day of the week,
without importance if the last day was Friday or Saturday. Even when Friday was not the last
trading day it still has a relative high rate of return. In they study the percentage of positive
rates of return was significantly below 50 percent for Monday and significantly above 50
percent for Friday and Saturday. Cross examined the distribution of price changes on the S&P
index on Fridays and Mondays. He documented the example of non-random movements in
stock prices. He examined the distribution of price on Fridays and Mondays, and the
relationship that exists between price changes on those two days. His sample period consisted
of the 844 sets of Fridays and following Mondays from January 2, 1953 to December 21,
1970. It those days New York Stock Exchange was opened for both days. Findings are
following - although there is an equal probability of an advance or decline on Monday after an
advanced Friday, the probability a decline is almost three times as large as the probability of
an advance on Monday after a declined Friday. [2] Kamath examined day-of-the-week effects
and the weekend effects for 10-years period of the 1980's on six different stock market
indicators. On all six indicators, the Monday mean returns were negative and the Friday mean
returns were positive. The statistical tests rejected the equality of the each trading day's mean
return for all six indicators. The day-of-the-week effect was found to be present during the
1980's on all six stock market indicators. The statistical evidence also supported one
explanation of the weekend effect in the study. It was described as the overreaction-correction
explanation in which the Monday effect returns tend to systematically offset the proceeding
Friday returns, on all six indicators. [7] Jaffe and Westerfield [5] found weekly seasonal
effects on the Japanese stock markets. They found that the lowest means return in the
Japanese stock market occurred on Tuesday not Monday. In providing international evidence
on the weekend effect Jaffe and Westerfield [6] examined similar behavior of stocks markets
in UK, Japan, Canada and Australia mad confirmed the lowest mean return for the Japan and
Austria on Tuesday. Arsad and Coutts [1] investigated weekend effect in the FT 30 with
14887 daily returns from 1935 to 1994, they found out that although the weekend effect exists
for the entire period it does not exist for all of the twelve five year sub-samples.
The purpose of the study was to investigate the presence of weekend effect in stock market
return for the time period from January 2002 to May 2010. The study should answer the
question if stock return shows different effect on a particular day of trading. We collected data
sample of 2083 observations and the final analysis was executed in the data sample of 1669
observations that fitted the predetermined pattern.
Tests are not performed on the daily prices themselves but on the first differences of their
natural logarithms. Daily returns are calculated as:
tt pptR loglog 11 −= ++
where pt+i is the price of the security at the end of day t+1 and pt is the price at the end of day
t. "Close to close" data does not contain information about the payment of dividends. There
are three reasons why used changes in are log prices rather than simple price changes. First,
the change in log prices is yield, with continuous compounding, from holding the security for
that day. Second, the variability of simple price changes for a given stock in an increasing
function of the price level of the stock. And the third, for changes less than ± 15% the change
133
in log price is very close to the percentage price change, and for many purposes it is
convenient to look at the data in terms of percentage price changes. [4] We used a specific
pattern to precede available data. We assumed that it is not important the exact day in the
week but the number of days before that day when the Prague Stock Exchange was closed or
opened. Generally, the weekend effect emerge because a stock exchange is closed for two
days and investors after a stock exchange re-opening react to new information or event that
occurred during these two days. Alternatively, investors can not do anything during both
Saturday and Sunday even though they got new information during the weekend. There is
where the anomalies exist. Because of this we created the basic pattern 1111100111112
(where 0 stands for closed PSE and 1 stands for open PSE and bold numbers represent Friday
and Monday) that mirrors one week and all data compiled according this pattern (see Table
1). This process ensured that the Monday in our analysis reflects the situation when the
Prague Stock Exchange was closed exactly two days and other days had a propitiate number
of days when the stock exchange was opened.
Fig. 1 Pattern according data was proceeded
Mon-Tue Tue-Wed Wed-Thu Thu-Fri Fri-Mon
10011111 10011111001 10011111001 111110011 111110011111
Source: own patter
RESULTS
Information about index PX are summarized in the Fig. 2. Our sample period consists of the
set of 1669 data from January 3, 2002 thought May 15, 2010 for which the Prague Stock
Exchange (PSE) was opened. Data are divided for each day of the week. It shows that,
Wednesday had the lowest mean which is 1108,21 and the highest mean was on Friday
(1118,99). The index maximum (1936,9) was achieved on Monday and index minimum
(397,6) on Friday.
Fig. 2 Summary statistic for index PX n = 1669
Statistic Mon Tue Wed Thu Fri
Observations 353 334 334 335 313
Mean 1110,83 1108,44 1108,21 1115,45 1118,99
Standard error 15,53 15,98 19,96 19,94 16,48
Min 399,8 404,4 402,5 405,1 397,6
Max 1936,9 1913,4 1908,3 1925,5 1910,1
Source: authors’ calculations
Fig. 3 summaries statistic for returns of index PX. The average return for the entire study
period was -0,0001 and the standard deviation of the return was 0,0157. The skewness was
0,6785. Skewness refers to asymmetry of the distribution. The kurtosis was 13 and it is not
normal because the difference from 3 was quite high. When the return of each day was
analyzed, the findings indicated that Friday (close Thursday to close Friday) had an average
return of 0,0003 (the second largest returns) and Monday (close Friday to close Monday) had
average return -0,0011 (that reflects the minimum). This sign of the findings were in line with
day of the week effect studies. The highest standard deviation was on Friday (close Thursday
to close Friday) 0,0171 and the lowest standard deviation was on Tuesday 0,0143.
2
Mon, Tue, Wed, Thu, Fri, Sat, Sun, Mon,, Tue, Wed, Thu, Fri
134
Fig. 3 Summary statistic for returns of PX n = 1669
Statistic All days Mon-Tue Tue-Wed Wed-Thu Thu-Fri Fri-Mon
Observations 1996 353 334 334 335 313
Mean -0,0001 0,0005 0,00003 -0,0006 0,0003 -0,0011
Standard
deviation 0,0157 0,0143 0,0149 0,0153 0,0171 0,0171
Skewness 0,6785 -0,4417 1,2133 -0,5061 2,5397 -0,0438
Kurtosis 13 8 4 5 32 8
Min -0,1109 -0,1003 -0,0358 -0,0808 -0,1109 -0,0995
Max 0,1619 0,0704 0,0829 0,0623 0,1619 0,0885
Source: authors’ calculations
Graphical illustration of PX index daily returns is demonstrated in following chart (Figure 4).
Fig. 4 Summarized of daily returns of PX index
Source: authors’ graph
Where every bar represents daily return for a particular day during the analyzed period it
means 1669 observations. In the chart you can see the minimum return -0,1109 that was
achieved on Friday (close Thursday to close Friday) and the maximum return 0,1619 that was
achieved on Friday as well. According to visualized data it is unclear to suggest any
significant differences between daily returns on Monday and any other days. You can see that
data is concentrated in close vicinity of zero, which means the no change of return is of
highest probability. We can confirm that the lowest average value of index was on Tuesday
(1108,44) not on Monday but the highest value of PX index was achieved on Friday
(1118,99).
When we analyzed summary statistic for PX index returns the situation was similar. The
lowest average return was achieved on Monday (-0,00111) but the highest average return was
achieved on Thursday (0,00058) not on Friday. On the other hand, both the return minimum (-
0,1109) and maximum (0,1619) were achieved on Friday. Standard errors have been rounded
to one significant place. Because the fact that the standard error is of the same magnitude as
the average return itself (see Figure 5) the weekend effect is very unclear, if any.
135
Fig. 5: PX index n = 1669
Statistic Mon-Tue Tue-Wed Wed-Thu Thu-Fri Fri-Mon
Average return 0,0005 0,00003 -0,0006 0,0003 -0,0011
Standard error 0,0005 0,0005 0,0006 0,0006 0,0006
Source: Source: author’s calculations
CONCLUSION
We are not able to confirm weekend effect on the Prague Stock Exchange. Although, we
figured out that the lowest average return was on Monday but the lowest value of index was
achieved on Friday not on Monday. There are no other symptoms of weekend effect. There is
not the highest average return on Friday but on Tuesday as well as differences between
returns on Monday and any other business days are not significant different compare with
Monday or Friday. It means that the return of PX index is as much distributed (see Standard
error of PX returns) that is difficult to find any pattern.
BIBLIOGRAPHY
[1] Arsad, Z., Coutts, A.: The weekend effect, good news, bad news and the Financial Times
Industrial Ordinary Shares Index: 1935-1994, Applied Econommics Letter 3 (1996), 797-801.
[2] Cross, F.: The Behavior of Stock Prices on Fridays and Mondays, Financial Analysts
Journal 29 (1973), 67-69.
[3] Fama, E.: The Behavior of Stock-Market Prices, The Journal of Business 38 (1965), 34-
105, p.34.
[4] Fama, E.: The Behavior of Stock-Market Prices, The Journal of Business 38 (1965), 34-
105, p.45-46.
[5] Jaffe, J., Westerfield, R.: Pattern in the Japanese common stock return: Day of the week
and turn of the year effect, Journal of Finance 20 (1985), 261-272.
[6] Jaffe, J., Westerfield, R.: The week and effect in common stock returns: The international
evidence, Journal of Finance 40 (1985), 432-453.
[7] Kamath, R.: An Investigation of the Day-of-the-Week-Effects and the Weekend Effects in
Different Stock Market Indicators in the 1980s, American Business Review(1992), 62-72,
p.62.
[8] Lakonishok, J., Smidt, S.: Are Seasonal Anomalies Real? A Ninety-Year Perspective, The
Review of Financial Studies 1 (1989), 403-425.
[9] Lakonishok, J., Smidt, S.: Are Seasonal Anomalies Real? A Ninety-Year Perspective, The
Review of Financial Studies 1 (1989), 403-425, p.410.
[10] Mishkin, F., Eakins, S.: Financial Markets and Institutions, 6th edition, Addison
Wesley (2008),p.l32, ISBN: 978-0321374219.
Martin Cupal Oleg Deev Dagmar Linnertová
FEA MU FEA MU FEA MU
Lipova 41a Lipova 41a Lipova 41a
Brno Brno Brno
602 00 602 00 602 00
136
THE METHODOLOGY FOR THE RISK DETECTION IN
NON-PUBLIC COMPANIES. RUSSIA, NRU HSE
Makarova Vasilisa
ANNOTATION
Risk-management and financial management are going to become the main components of
corporate economic governance, for all the existing theories of financial management
consist both of financial analysis, planning, and the allowance of the implied volatile of
further incomes and costs. According to the methodology of a systematic analysis, ERM
system must be presented as a multi-level system, which involves all employees in the
process of risk management. The process of risk identification is in the focus of
implementation ERM system. Classification should be matching the theoretical requirements
of organization management and be externally and internally balanced. The providing
method of classification drafting allows to develop methodological base for measure risk
assessment in order to further integrated and complex enterprise risk management.
KEY WORDS
the requirements for the risk classification, flexible and adaptable classification, businessprocess
risk groups
JEL classification: G32
INTRODUCTION
Risk-management and financial management are going to become the main components of
corporate economic governance, for all the existing theories of financial management
consist both of financial analysis, planning, and the allowance of the implied volatile of
further incomes and costs.
The modern economic environment differs from the economics of the past by the
possibilities of identification and assessment of risk and effects of it implementation. In
general, it takes an opportunity to minimalize risks, avoid them or to transfer them to the
third party of the financial relations.
Modern risk-management is not the temporary process of the corporate risk reduction. It is
the complete methodology of taking and managing risks.
The greatest part of solutions in business is related to the losses of the specific resources in
sake of further uncertain profits. The core principle in the process of corporate governance
is the ability of making choice between the quality of further risk and the amount of the
possible profit.
The technology of risk-management is of dual nature.
In the shot term, the mechanism of risk-management can help to avoid risks to a group of
stakeholders, but in long term perspective it can diminish the value for the shareholders.
For example, the transfer costs of the next period will have negative impact to the amount
of NOPAT.
Risk-management has a shot history. The most recent theory of venture risk-management
is the enterprise-wide risk management. The ERM (enterprise-wide risk management) is the
system internal control and corporate government. The ERM ought not only to protect
company, but also take into account all modern mechanisms of a creation value for
137
stakeholders. In other words, the ERM is the activity, which targets both to protect
company from indefiniteness and suspense, and to create the value for stakeholders.
AIM AND METHODOLOGY
Nowadays, a public company is able to provide information about risks to shareholders and
potential investors. That is the requirements of the majority of the stock markets regulators.
Such companies have quite well-developed tools of risk assessment and risk management
(Fig.1). At the same time, the management of non-public companies are interested in ERM
implementation in governance process, for it is the necessary element of internal control.
For such companies the methodology of risk management will be directed not only at
compliance with external requirements, but at the improvement of the internal control and risk
reduction measures such as NOPAT, FCF, company Market Value, Book Value or Carrying
Value. The preferences in choosing a financial indicator under risk are demonstrated in fig.
2. The introduction of corporate standards of risk management is a very time-consuming
process that does not allow to receive a satisfactory result. The main efforts is made to
identify the risk factors related to their activities. This paper looks into the process of
identification of risk factors non-public companies.
According to the methodology of a systematic analysis, ERM system must be presented as a
multi-level system, which involves all employees in the process of risk management. So, the
ERM is the summary of coherent elements integrated in one process in which both CEO’s
and the staff participate in revealing and managing potential risk factors.
The main goal of ERM is to provide the most effective capital turnover and to increase
market value of assets. At the same time, the ERM is the process of detecting,
understanding, measuring, monitoring, reporting risk and risk control.
So, the process of risk identification is in the focus of implementation ERM system.
First of all, it is the identification of certain risk sources and further assessment of the
results. As a rule, one of the following methods is used for gathering original information.
All the common methods are the next:
1. Questionnaire;
2. Analysis:
- financial statements;
- current statements;
- organizational charts;
- flow maps reflecting company business-process;
3. Inspector visits on industrial premises;
4. Consulting with inner and outside specialists.
The elements of these methods are useful in financial management (ARR, IRR, break-even
point, etc.) and most of them are based on accountancy and do not include the expectations
and forecasts. They are not oriented at VBM and do not take into consideration the
specificity of each particular company. The result of those methods is a compilation of
diverse and contradictory risk that cannot often be compared. Types of risk in the list usually
are heterogeneous and disparate.
The requirements for the classification creation are based on the existing risk management
theories and the result of recent research. The requirements are the following:
- Classification should be value oriented and balanced on the threat sources.
- Classification should be flexible and adaptable and should consists of fixed and
adjustable parts.
- Classification should be based on a unified methodology for using in a different
situations and cases.
- Classification should be compatible with the basic principles of management.
138
In our opinion, we can presume business processes, areas of governances and management
environment as a threats, thus reduce or increase value sources. The methodology for the
detection of business processes is borrowed in BSC theory.
Business processes are grouped in two groups: main and auxiliary and they are of four types:
planning, supply, manufacturing and sales, after-sales services.
Auxiliary business processes are determined separately in each case individually for each
company.
Marketing, organization, financing, HR-management are the areas of governance.
Environment, stakeholders, shareholders, the social environment and the state refer to
management environment.
The basis of classification is a projection of the business processes on the areas of
governances and management environment in accordance with proposed dividing.
The ability to define private risks is the flexibility of the classification. Private risks are
identified at the intersection of business processes with areas of governances and management
environment. Further private risks are arranged into groups and higher level classes.
Therefore the mode is being implemented at the level of the individual enterprise with the use
of private risks. General view of the classification is presented in the fig 3.
Private risks are the primary risks identified in the projection of the business processes on the
areas of governances and management environment. Four groups of risk are formed as a
result of the projection. First eleven risk groups (right vertical column in the table) are
formed as a projection of areas of governances and management environment on the business
processes. That are management and governance risks.
Risk groups formed as the projection of the business processes on the areas of governances
and management environment (at the bottom of a table) are business-process risk groups. The
consolidation of risks in business processes, areas of governances and management
environment are the general enterprise risks (left vertical column in the table). Integral risk is
determined by summing-up the all-risk groups, but that kind of risk has the theoretical
meaning and does not is not suitable for use in practical purposes.
In order to form a General concept of risk management all of the identified risk factors should
be split on the horizon of planning (operational, tactical, strategic). This splitting is
necessary for solution of important methodical task: the formation of the spectrum of risks
and risk profile.
Spectrum of risks is the static category. Spectrum of risks changes rarely and on under the
influence of economic environment. The recommended composition of the spectrum of
risk is about five main strategic risks. Spectrum of risk consists of only strategic risks.
Risk profile is more dynamic category and usually changes more often than once a year. Risk
profile consists of operational and tactical risks, sometimes includes private risks.
RESULTS
Best practice corporate governance and risk management do not attempt to eliminate risk.
Rather, they are designed to help organizations maximize capital turnover whilst, et the same
time, transforming uncertainty into risk, which can be identified, assessed and may be
measurable. Analysing and the following implementation of the classification all the possible
risks lies in the base of ERM for non-public. According to the recent principles of
management, earch classification should be matching the theoretical requiments of
organization management and be externally and internally balanced. The internal balance of
proposed classification is between private and integrate risks, the external - between
management environment and risk factors. The dividing on the planning horizons helps to
achieve purposeful internal balance. The providing method of classification drafting allows to
139
develop methodological base for measure risk assessment in order to further integrated and
complex enterprise risk management.
Fig.1 Risk-management Standards
Developer Overview Application area
AS/NZS
4360:2004.
Purpose of the standard is the detecting,
understanding, measuring, monitoring, reporting
risk and risk control. Standard is useful and
applicable to various enterprise and private person
activities. The standard defines the main
requirements to the risk management process and
is not specific to a particular industry or economy.
This Standard is
recommended, but not
obligatory and may be
applied to a very wide
range of activities,
decisions or operations of
any public, private or
community, enterprise,
group or individual.
A Risk
Manageme
nt Standard.
FERMA,
2002.
It is an optional requirement and is intended for
maintains the system of risk management at any
enterprise. Contains a clear sequence of actions
and specific recommendations to use a specialist
without any additional training
The Standard is for using
in corporations or public
organizations, for any
activity whether short or
long term.
COSO
ERM -
Integrated
Framework.
, USA,
2004.
It is developed for using in the internal audit
process in order to improve the reliability of
reporting. The implementation of standard
requires the involvement of an external consultant.
The application of
Standard is necessary in
order to meet the stock
market requirements.
Basel II.
2004
Basel III.
2010
Basel
Committee
on Banking
Supervision
.
It is designed to enhance the quality of risk
management in the banking sector in order to
strengthen the financial system as a whole. Is
aimed at creating risk sensitive system, is based on
quantitative risk assessment.
• Basel II focused on ‘asset side’ of B/S.
Basel III focused mostly on ‘liability side’:
definition of capital, liquidity.
- Post the Global Financial crisis, focus of
regulation on: longer-term/stable liquidity;
leverage ratios (RWA framework can’t be
arbitraged); higher quality of capital (e.g. equity,
CoCos, loss absorbing hybrids); higher quantity
of capital.
The requirements are
needed for use in the
banking sector to
strengthen the resilience
of it.
Risk
managemen
t ISO
31000:2009
ISO/ IEC
31010:2009
Internationa
The most modern, international standards.
Provides adaptable to the specific needs risk
management.
In the standard describes a program of
introduction of the system of risk management.
The detailed program of risk management is not
provided.
Enterprises should describe its scheme to support
It can be applied
throughout the life of an
organization, and to wide
range of activities
including strategies and
decisions, operations,
processes, functions,
projects, products,
140
l
organizatio
n for
standardizat
ion
the risk management with the help of architecture
risks, strategies and protocols.
services and assets. The
International Standard can
be applied to any type of
risk, whatever in nature,
whether have positive or
negative consequences.
Fig. 2 The preferences in choosing a financial indicator under risk
0%
10%
20%
30%
40%
50%
60%
70%
80%
NOPAT FCF Book value Market value
Source: Market Risk Management at Russian Power Companies. – www.kpmg.com
Fig.4 General view of the classification
The main business processes
Auxiliary
business
processes
Risk groups
Planning Supply
Manufactu
ring and
sales
After-
sales
services
Areas of governance
1.
Marketing
Rmp Rms Rmms Rmas Rma Marketing risks
2. Organizat
ion
Rop Ros Roms Roas Roa
Organizational
risks
3. IT RITp RITs RITms RITas RITa IT risks
4.
Financing
Rfp Rfs Rfms Rfmas Rfma Finance risks
5. Innovatio
n
Rip Ris RHRms RHRas RHRa Innovation risks
6. HR Rhrp Rhrs Personnel risks
Management environment
7. Sharehol
ders
Rshp Rshp Rshms Rshas Rsha
Shareholder action
risks
8. CEO’s Rceo’sp Rceo’ss Rceo’sms Rceo’sas Rceo’sa
CEO’s action
risks
9. State Rstp Rsts Rsms Rsas Rsa Political risks
10. Social
environment
Rsep Rses Rsems Rseas Rsea Social risks
11. External
(outer)
environment
Reep Rees Reems Reeas Reea
External
environment risks
Planning
risks
Procurem
ent and
logistics
Production
and
property
Trade-
service
risks
141
risks risks
CONCLUSION
ERM system is a multi-level system, which involves all employees in the process of risk
management. ERM is the summary of coherent elements integrated in one process in which
both CEO’s and the staff participate in revealing and managing potential risk factors.
The main goal of ERM is to provide the most effective capital turnover and to increase
market value of assets. At the same time, the ERM is the process of understanding,
measuring, monitoring, reporting risk, and risk control. The requirements for the
classification creation are based on the existing risk management theories and the result of
recent research. The requirements are the following: classification should be value oriented
and balanced on the threat sources; should be flexible and adaptable; should be useful in a
different situations and cases and should be compared with the using of based principles of
management.
Traditional methods for gathering original information of themselves will only ever be an
estimate. Additionally they can be badly parameterised, misused and built on assumptions
which can quickly become out of date as markets change direction.
The offered method allows to take into account each of the sources of volatility of non-public
company revenues and expenses.
BIBLIOGRAPHY
[1] Badalova Anna G. Methodological approach to developing balanced risk classification of
the enterprise - http://www.creativeconomy.ru
[2] Hull John C. Risk management and financial institution. – Pearson Education Inc. 2007.
[3] Market Risk Management at Russian Power Companies. – www.kpmg.com
[4] Principles of good governance. – www.prmia.org
[5] House Linacre, Jordan C. Hill. The professional handbook of financial risk management.
- Reed Education and Professional Publishing LTD. 2000
Full name: Makarova Vasilisa
As. Prof., Dept of Financial Markets and Financial Management
Institution: National Research University Higher School of Economics
Street: 16 Sousa Pechatnikov street
City: Saint-Petersburg
Email: vasilisa_m@mail.ru
142
THE IMPORTANCE OF OFFSHORE FINANCIAL CENTRES
IN THE FINANCIAL SYSTEM IN THE TIMES OF CRISIS
Magdalena Markiewicz
ANNOTATION
The goal of the article is to verify the significance of offshore financial centres (OFCs) in
terms of destabilization of the international financial system. Statistical data confirm that
many multinational corporations hold the headquarters in the countries offering some
privileges and most of OFCs offer also low corporate taxes (CIT, VAT). Initiatives designed
to strengthen supervisory systems are not effective enough, but the application of uniform
methods and standards of monitoring the international system is a hard undertaking.
KEY WORDS
offshore financial centres, multinational corporations, globalisation, offshore banking, tax
competition, crisis
JEL classification: F23, G15, H21, H26
INTRODUCTION
The offshore financial centres (OFCs) are the beneficiaries of either the globalisation process
and the liberalisation of international capital flows. The determinants of OFCs’ success lay
also in the field of multinational corporations’ expansion and increasing possibilities of
moving the parts of entrepreneurial activities outside the home countries. OFCs, before
becoming the countries having modern economic systems, were the countries placed in the
transit corridors, or they offered shelters for the sailors and travellers. Their economies were
dependant on tourism and exchange of goods. Recently their way of functioning is based on
services connected with the flows of foreign capital and innovations in banking technology.
AIM AND METHODOLOGY
The aim of the article is to present the increasing importance of offshore financial centres in
terms of globalisation in the financial system. The problem of OFCs’ popularity started to be
imperative again after global financial crisis, when the governments of most countries seek
the budget income from corporate an individual taxes to cover the deficit in the public
finance, while big multinational corporations locate their headquarters in the countries
offering lower tax burden. The detailed analysis was based on tax rates and special privileges
offered by offshore financial centres. In the text there were used statistical data from
consultancy agencies and statistical departments of government institutions and empirical
description of the processes having place in the countries perceived as tax havens.
RESULTS
Statistical data confirm that many multinational corporations hold the headquarters in the
countries offering some privileges. In 2011 as many as 1340 regional headquarters in Hong
Kong had the parent company located in the other country or territory (315 in the USA, 222 in
Japan and 117 in Great Britain). Most of OFCs offered lower corporate taxes (CIT, VAT)
than the average in OECD countries. A harmful tax competition might be considered in case
of these offshore centres that do not follow the principles of equality of taxation, or execute it
143
only in relation to foreign entities, applying rates at zero or at significantly lower level than
for residents.
Services in OFCs
The most common services offered by OFCs are: offshore banking, offshore insurance
services, capital market services, asset management and tax planning.1
Offshore banking
regards especially wide range of foreign exchange market operations. Offshore insurance
services are provided to minimize the tax burden and risk management. Capital market
operations are considered in the light of issuing shares, bonds or other instruments due to
increase in capital or exemption from taxes. Asset management may allow to avoid a decline
in the value of domestic currency by individual clients or companies derived from the
countries having unstable banking system or volatile political situation. Tax planning bases on
minimizing the fiscal burden according to the legal rules and opportunities.
Attractive services offered by OFCs influenced the growing contribution of such countries to
global capital flows. The volume asset and liabilities management in OFCs was estimated in
2009 at the level of 5 billion USD, what may be compared to 8 billion USD managed by
institutions in the USA, Germany and France.2
In the same time the value of assets under the
management of OFCs jurisdictions was five times higher than at the beginning of the nineties
20th
century. The Cayman Islands themselves had operated the assets of the 1,4 billion USD
value, while The British Virgin Islands were home to almost 700 000 offshore companies.3
Globalisation has significantly affected the possibility of using offshore financial centres.
From the corporate point of view, especially of international banks and corporations, the thing
of great importance is the minimization of the tax burden due to varying tax rates in different
parts of the world. With this aim multinational corporations create subsidiaries and internal
financial settlement centres, together with establishing their headquarters in OFCs.4
An
example may be the HSBC bank, registered in Hong Kong and London. Figure 1 shows the
number of regional headquarters in Hong Kong by country in which the parent company was
located. A regional headquarters is an office that has managerial control over offices in the
region (i.e. Hong Kong plus one or more other places) on behalf of its parent company located
outside Hong Kong. More than half headquarters are related to the United States, Japan or
United Kingdom.
Fig. 1 Number of regional headquarters in Hong Kong by country/territory where the parent
company was located
Year
Number of
regional
headquarters
in Hong
Kong
Country /Territory of a parent company which has a regional headquarter in Hong Kong
United
Statesof
America
Japan
United
Kingdom
The
mainlandof
China
Germany
France
Netherlands
Singapore
Italy
Switzerland
Australia
Sweden
Taiwan
Korea
Canada
2007 1 246 298 232 124 93 76 56 50 43 27 47 21 20 28 16 14
2008 1 298 311 238 119 95 77 59 50 46 32 53 19 18 26 19 13
2009 1 252 289 224 115 96 74 66 54 43 40 46 22 21 19 18 12
2010 1 285 288 224 113 99 72 62 52 41 43 47 24 26 30 19 15
2011 1 340 315 222 117 97 84 63 54 43 43 39 32 31 22 20 16
1
D. K. Eiteman, M. H. Moffett, A. I. Stonehill, Multinational Business Finance, Pearson Education, 11th
Edition, Boston 2006, p. 699-700
2
M. Gonzales, A. Schipke, Bankers on Beach, „Finance and Development”, June 2011
3
Places in the Sun, „The Economist“, Special Report: Offshore Finance, 22 February 2007
4
J. Madura, International Corporate Finance, South-West Cengage Learning, 10th Edition, 2010, p. 398
144
Source: Business Expectation Statistics Section, Census and Statistics Department, The
Government of the Hong Kong Special Administrative Region, http://www.censtatd.gov.hk/,
15.05.2012.
In 2011 there was also observed the countable rise in the number of headquarters from the
United States and Germany and Australia and at the same time decline in number of
headquarters of the companies from Japan, Switzerland and Taiwan.
Companies over time have become increasingly multinational, and capital can be managed
from any place in the world. The liberalisation of rules on foreign exchange restrictions and
technological innovation provided quick and inexpensive transfer of funds. Interest in
offshore financial centres of the world is hard to define, however, because of the limitations of
statistical data collection and banking secrecy. Capital flows can be one of the factors
contributing to higher economic growth of offshore centres. These countries also benefit from
low tax and high employment level. Institutions using OFCs pay registration fees and license
renewal to the government. Nevertheless, the main benefits, from the point of view of OFCs,
seem to be the possibility of employing the labour force, the intensification of tourism and the
modernization of telecommunications and transport infrastructure. Estimating the future cash
flow to be generated by a foreign project requires estimating the taxes that will occur in a
particular case. Each country generates tax revenues in a specific way, has a unique tax
system and systems of duties and benefits.
Tax competition and tax rates in OFCs
Tax competition is a phenomenon that is directly related to the process of globalisation,
especially along the increase of international capital mobility. The liberalisation of capital
flows and the decline in transaction costs due to settlement technologies make investors
looking for attractive investments in the country and abroad. The countries started to compete
with the aim to increase their attractiveness. From a theoretical point of view, the tax
reduction may not be the cause of decline in revenue, because along with increased capital
inflows increase the tax base. The optimal solution would be an agreement between countries
that are not competing against each other in terms of tax rates. This is not feasible with at least
two reasons. First, the waiver by the country's sovereignty tax policy is quite controversial.
Despite the efforts surrounding the creation of a single European market, they have not yet led
to the unification of tax rates in member countries. To achieve optimal results, harmonization
and coordination of fiscal policy would have to take place in all countries. If such changes
only affect a single country, it would not have prevented other countries to continue applying
lower competitive tax rates. The phenomenon of tax competition can only be measured by
differences in tax rates between countries. It should be emphasized that the comparison of
effective tax rates is difficult, because the available data on nominal rates do not include
various types of tax relief and tax incentives and economic structure of the country.
Multinational corporations typically consider therefore corporate income tax, which is a direct
tax and some indirect taxes like value added taxes, withholding taxes, personal and excises
taxes, provisions, tax treaties concerning avoidance of double taxation, foreign tax credits,
intercompany income taxation and taxes on undistributed earnings.5
Value added tax is a
special type of sales tax, assessed at one or more stages of a production process. For example,
in Canada it is levied when production is complete, in the USA when products are retailed, in
most European countries it is levied on increment, being a difference between a wholesale and
retail price. Withholding taxes are imposed on dividends and interest payments to foreign
investors and debt holders. While involving restrictions to long term investment capital, as a
result they are frequently modified by bilateral tax treaties.
5
J. Madura, International Corporate Finance, op. cit., p. 344-348 and S. H. Kim, Global Corporate Finance,
Blackwell Publishing, Malden-Oxford 2006, p. 499-502
145
On the Fig. 2 there are shown the rates of corporate income tax (CIT) and value added tax
(VAT) in selected offshore financial centres in the world. These rates are compared with the
average rate of OECD countries. The figure does not take into account the countries and
territories in which the CIT and VAT rates are at zero level. Such countries in 2011 were,
among others, Andorra, Anguilla, the Bahamas, Bahrain, Bermuda, the British Virgin Islands,
the Cayman Islands, the Maldives, the Turks and Caicos Islands and Nauru. The vast majority
of offshore tax rates is lower than average tax rates in highly developed OECD countries.
Fig. 2 The rates of corporate income tax (CIT) and value added tax (VAT) in selected
offshore financial centres in the world in 2011
0
5
10
15
20
25
30
35
40
M
alta
St.Kitts
and
Nevis
the
Netherlands
AntillesM
onacoDom
inicaG
ranada
Costarica
Antigua
and
BarbudaPanam
a
BarbadosO
ECD
Luxem
bourg
the
Cook
Islands
Hong
Kong
Singapur
M
auritius
LichtensteinM
acauCyprusG
ibraltar
Switzerland
Isle
ofM
anVanuatu
Jersey
Island
the
M
arshallIslands
%
CIT
VAT
Source: Paying Taxes 2012, Doing Business, World Bank, http://www.doingbusiness.org;
LowTax.net, www.lowtax.net; World TaxRates, www.taxrates.cc, 11-15.05.2012.
The interesting example are the Netherlands Antilles, where the standard rate of corporation
tax is at the level of 30%, increased even to 34,5% by a 15% island surcharge, applying to all
types of companies. However, lower tax rates of 2% to 3% apply to offshore companies, as
international holding companies, and certain types of onshore companies. Additionally, a tax
exempt status can be achieved for selected types of financial activities. Corporations resident
in the Netherlands Antilles are subject to corporate income tax on their worldwide income.
Corporations, which are not established in the Netherlands Antilles are subject to CIT in so
far as they receive Antillean source income (non-resident taxpayers).6
The example of no tax country were the Maldives, that did not impose any kind of income
tax, corporate tax or property tax. Bank profit tax of 25% was the only direct tax imposed in
Maldives and it was charged to all commercial banks. It comprised 2% of the total
government revenue. Major indirect taxes in the Maldives were import duty and tourism tax.
Import duty was collected from imported goods at varying rates from 5% to 200%. It brought
approximately 25% of the government annual revenue from taxation.7
Tourist tax was
gathered at a flat rate of 8 USD per night per bed, regardless of the tariff rate for the bed, on
every night any tourist spent in the Maldives. Tourist tax brought around 15% of the total
income derived annually from taxation. Lease and rentals of resorts as well as state owned
enterprises are the other sources of the government revenues. Every boat and motor vehicle
must have an appropriate license, by paying a license fee to the government.
Foreign direct investment in the Maldives had been a key to the conception of a successful
tourism industry, which contributed to one-third of the Maldives' GDP. Tax system was one
6
World TaxRates, www.taxrates.cc, 15.05.2012
7
Ibidem
146
of the important elements building the positive attitude of international investors towards
investing in the Maldives. Apart from the tax rate entrepreneurs take into consideration
easiness of paying taxes, what means that the existing tax system is very simple and easy to
administer. The countries in which they spend the least amount of time for tax procedures are:
the Maldives, the United Arab Emirates, Bahrain, Qatar, the Bahamas, Luxembourg, Oman,
Switzerland, Ireland and the Seychelles.8
The criticism against OFCs
In recent years, there has been growing recognition of the necessity to develop understanding
of the activities of OFCs. Some OFCs have confined a significant component of global
financial flows, and their linkages created the perspective for affecting financial stability in
many countries. In July 2000, the International Money Fund’s Executive Board made an
assessment based on extending financial sector activities through a voluntary program of
measurement and technical assistance. The aim was to reinforce financial supervision on
OFCs, with the intention that international rules and arrangements applying to OFCs may
promote closer cooperation with and among supervisors. Therefore the IMF undertakes
detailed assessments of the extent to which OFCs meet the standards advocated by the
international standards setters, and of any further action required to meet these standards.9
Tax competition analysis indicates that it has both positive and negative aspects. Any
reduction in tax rates designed to reduce the burden on domestic and foreign investors can be
regarded as positive. However, if such action applies only to foreign investors, it is a negative
development. A harmful tax competition might be considered, therefore, in case of these
offshore centres that do not follow the principles of equality of taxation, and only in relation
to foreign entities apply rates at zero or significantly lower than for residents.
In conjunction with the use of many privileges in offshore financial centres and lower tax
rates than in developed countries, since the seventies 20th
century, specific regulations were
designed to prevent the outflow of capital from countries maintaining higher tax rates. For this
purpose it was established the international cooperation to counter harmful tax competition.
Such organizations like the OECD, the European Union, the Financial Stability Forum or the
Financial Action Task Forum10
defined the list of countries and territories applying harmful
tax competition and introduced recommendations for the control of foreign companies and
users of tax credits. The tension of international organizations have produced the results. Most
of the countries have brought their legislation to international standards, or at least signed
agreements with other countries intended for tax information exchange. In the end of 2009,
the OECD has removed all the countries from the so-called black list associated with the use
of harmful tax competition. Nevertheless, in 2010, there were still 17 tax jurisdictions on the
list of the countries which have agreed with the OECD regarding the introduction of
international standards, but did not keep these contracts.
CONCLUSION
The importance of offshore financial centres at the beginning of their existence was marginal
due to low volumes of capital flows. Together with their development, the growing
importance of OFCs started to influence destabilizing the international financial system. Both
attraction and criticism to OFCs are rising due to several reasons, which are: reducing the tax
8
Paying Taxes 2012, Doing Business, World Bank, http://www.doingbusiness.org/, p. 3
9
International Money Fund, http://www.imf.org/external/NP/ofca/OFCA.aspx, 20.05.2012
10
The Financial Action Task Force (on Money Laundering) (FATF) is an intergovernmental organization
founded in 1989 on the initiative of the G7 countries. The purpose of the FATF is to develop policies to combat
money laundering and terrorism financing. The FATF Secretariat is housed at the headquarters of the OECD.
147
rates to a level unacceptable for other countries, problems with enforcing tax claims, the
generation of threats to international financial stability by the free movement of capital,
money laundering and financing terrorist activities. These effects are observed not only in
OFCs, but also in onshore financial centres. The arguments for OFCs are that they make
efforts to prevent money laundering and to strengthen the supervisory system. Their decisions
on taxes does not seek to make infringements of the interests of other countries, but relate to
one's own benefits. On the other hand, increasing importance of offshore centres is against the
interests of countries, which exhibit strong demand for tax revenues, especially in the times of
global crisis and suffer from a large drop in profits due to the transfer prices and profit
transfer abroad. The problem becomes if the authorities not only do not have the ability to tax
the financial resources that are accumulated in the accounts in OFCs, but are also not entitled
to information about the amount of those funds. Offshore centres are very reluctant to
introduce changes, in the fear against the loss of earned income. Their counter-arguments are
based on the idea that setting the level of tax rates is the independent responsibility of each
country, and the facilities used by them comply with applicable laws. Undoubtedly, money
laundering is associated with the OFCs and tax havens’ operations because of the
shortcomings and gaps in banking regulations either as in civil and criminal law in these
countries. IMF data confirm that the annual value of the revenue arising from money
laundering ranges from 600 to 1800 billion USD.11
OFCs, in order to fight with the negative
image, established the Offshore Group of Banking Supervisors, the task of which is checking
the implementation of FATF recommendations for these countries.12
Despite many initiatives
designed to eliminate money laundering by the application of uniform methods and standards
of operation and monitoring, it is still observed low efficiency of these actions.
BIBLIOGRAPHY
[1] Business Expectation Statistics Section, Census and Statistics Department, The
Government of the Hong Kong Special Administrative Region, http://www.censtatd.gov.hk/
[2] Eiteman D. K., Moffett M. H., Stonehill A. I., Multinational Business Finance, Pearson
Education, 11th Edition, Boston 2006.
[3] Financial Action Task Force, http://www.fatf-gafi.org.
[4] Gonzales M., Schipke A., Bankers on Beach, „Finance and Development”, June 2011.
[5] International Money Fund, http://www.imf.org/external/NP/ofca/OFCA.aspx
[6] Kim S. H., Global Corporate Finance, Blackwell Publishing, Malden-Oxford 2006.
[7] LowTax.net, www.lowtax.net.
[8] Madura J., International Corporate Finance, South-West Cengage Learning, 10th Edition,
2010.
[9] Places in the Sun, „The Economist“, Special Report: Offshore Finance, 22 February 2007.
[10] Paying Taxes 2012, Doing Business, World Bank, http://www.doingbusiness.org.
[11] World Tax Rates, www.taxrates.cc.
Magdalena Markiewicz, Dr
University of Gdansk, Institute of International Business
Armii Krajowej 119/121
Sopot, Poland
Email: m.markiewicz@ug.edu.pl
11
International Money Fund, http://www.imf.org, 22.05.2012
12
Financial Action Task Force, http://www.fatf-gafi.org/, 25.05.2012
148
EFFICIENCY OF ACCOUNTS RECEIVABLE MANAGEMENT
IN POLISH INSTITUTIONS
Grzegorz Michalski
1
ANNOTATION
Accounts receivable management should contribute to realization of basic financial purpose
of an enterprise which is the realization of such strategy which is linked with its owner (or its
stake holders) wealth maximization. The enterprise performance and value maximization
strategy realization is more effective when it is realized in the most efficiency way. It is also
executed with a focus on risk and uncertainty (Gentry 1988, Michalski 2012). This paper
presents the consequences that can result from operating risk to determine the level of
accounts receivable in the enterprise. The change in the level of accounts receivables in an
enterprise increases net working capital level and influence costs of holding and managing
accounts receivables. As illustration material is used data collected from 2009 and 2010
financial statements of over 3000 Polish enterprises.
JEL classification: G32, G11, M11, D81, O16, P33, P34
KEY WORDS
efficiency of decisions, accounts receivable management, entrepreneurial finance
INTRODUCTION
The topic of the paper is linked with scientific inquiries in the area of global financial markets
and financial systems in the discussion how the post crisis changes influence current accounts
receivable management in firms. The general attention of the paper is paid to the European
financial and sovereign debt crisis, changing the cost of capital rate for the firm and in the
result their decision in the choice the most suitable accounts receivable policy. The impact of
the financial crisis in the Polish enterprises makes the accounts receivable management more
flexible because the managers rather prefer to be more careful and should use more flexible
accounts receivable approach to gain higher level of sale. The main contribution of the paper
is to check if the model expected changes, had the place. The empirical data from Polish firms
shows STAR/ASSETS relation growth, that inform about more flexible accounts receivable
policy choice. Similarly STAR/CA relation growh confirms more flexible accounts receivable
policy choice. The same way STAR/EBIT relation growth means more flexible choice in
accounts receivable policy. That means the empirical data from Polish firms for 2009-2010
years suggests that for Polish managing teams risk aversion has stronger influence on current
assets investment policy than pure economic indicators. The financial aim of the enterprise is
maximization of enterprise value. Financial literature contains information about numerous
factors that influence enterprise financial efficiency. Among those contributing factors is the
extent of the net working capital and the elements shaping it, such as the level of cash tied up
in accounts receivable, inventories, the early settlement of accounts payable, and operational
cash balances (Michalski 2010). Not all enterprises has to do with all aspects of liquidity
decisions or current assets management. Part of them serve their clients only as service
1
Acknowledgment: the research is financed from the Polish science budget resources in the years 2011–2014 as
the research project financed by National Science Centre granted according decision nr DEC-
2011/01/B/HS4/04744.
149
providers with no or almost no inventory cycle presence. Other enterprises use do not produce
anything but only redistribute final products, but many of them have full or almost full
operating cycle with inventories of raw materials, final products inventories, accounts
receivables and cash (Michalski 2009).
AIM AND METHODOLOGY
The paper discuss the level of accounts receivable investment which are the result of trade
credit terms. The decision whether to extend the trade credit terms, is a compromise between
limiting the risk of allowing for the payment postponement from unreliable purchasers and
gaining new customers by way of a more liberal enterprise trade credit policy (Michalski
2007). This decision shapes the level and quality of accounts receivable. Robishek (Robishek
1965, Gentry 1988, Michalski 2008d) discus risk involved to accounts receivable decisions,
which must be accepted by financial institutions pledging of accounts receivable of the
enterprise. Smith (Smith 1973, Gentry 1988) predicts and Michalski (Michalski 2008a) shows
that portfolio theory may be used to decrease accounts receivable risk. Friedland (Friedland
1966, Gentry 1988) agree with, that current assets could be viewed in portfolio context.
Pringle and Cohn (Pringle 1974, Gentry 1988) and later Michalski (Michalski 2012,
Michalski 2008c) try to adapt the CAPM theory to working capital elements. Bierman and
Hausman (Bierman 1970, Gentry 1988) discuss the granting policy of an enterprise and shows
that trade credit policy requires balancing the future sales gains against possible losses.
Lewellen, Johnson and Edmister (Lewellen 1972, Lewellen 1973, Gentry 1988) explain how
and why traditional devices used for monitoring accounts receivable should be changed by
new and better ones. Freitas (Freitas 1973, Gentry 1988, Michalski 2008b) shows relation
between liquidity and risk during accounts receivable management. The question discussed in
this article concerns the making decisions by enterprises in accounts receivables area.
If holding accounts receivable on a level defined by the enterprise provides greater
advantages than negative influence, the enterprise efficiency will grow. Changes in the level
of accounts receivable affect the efficiency of the enterprise. To measure the effects that
these changes produce, we use the following formula, which is based on the assumption that
the enterprise efficiency is the sum of the future free cash flows to the enterprise (FCF),
discounted by the rate of the cost of capital financing the realization of enterprise
performance and value maximization strategy:
( )∑= +
∆
=∆
n
t
t
t
CoC
FCF
V
1
,
1 (1)
where ∆V = enterprise efficiency increase (measured as enterprise value growth); ∆FCFt =
future free cash flow growth in period t; and CoC = cost of capital financing the strategy
serving here as discount rate.
To estimate changes in accounts receivable levels, we accept discount rate equal to the
average weighted cost of capital (CoC). Such changes and their results are strategic and long
term in their character, although they refer to accounts receivable and short run area decisions,
see: (Maness, Zietlow 1998, pp. 62-63; Michalski 2008c). The basic financial aim of the
enterprise is not only the enterprise value creation but as close as possible realization of the
performance and value maximization strategy of that enterprise. For assessment of financial
decision enterprises, should be used rules claiming that the higher risk should be linked with
the higher cost of capital rate used to evaluate the future results of current decision. That is
positively connected with the level of efficiency and effectiveness in realization of the
enterprise performance and value maximization strategy. Cost of financing accounts
150
receivables policy is a result of the risk included to the enterprise strategy of financing and/or
investment in accounts receivables (Michalski 2008b).
During estimation of the free cash flows, the holding and increasing of accounts receivables
ties up money used for financing accounts receivables. If accounts receivables level increases,
the enterprise must utilize and tie up more money, and this decreases free cash flows.
Production level growth necessitates increased levels of cash, inventories, and accounts
receivable. A part of this growth will be covered with current liabilities that automatically
grow with the growth of production and sales. The remaining cash requirements (that are
noted as net working capital requirements increase: ΔNWC) will require a different form of
financing.
Accounts receivables policy decisions changing the terms of trade credit create a new
accounts receivable level. Consequently, accounts receivable policy has an influence on
enterprise efficiency. This comes as a result of alternative costs of money tied in accounts
receivable and general costs associated with managing accounts receivable. Both the first and
the second involve modification of future free cash flows and as a consequence the enterprise
efficiency changes (Michalski, 2008b).
Case. The enterprise managing team forecasts that its cash revenues without changing current
policy will be at the level CR0 = 100000 €. According to the same forecast VC = 40% × CR.
Forecasted operating costs of accounts receivable management in the enterprise, kAAR = 28%.
Cost of capital rate, CoC = 14%. Without change of accounts receivable policy 40% of the
enterprise customers use 1% cash discount paying on the 10th
day. The remaining customers
pay at the 30th
day. Forecasted bad debts losses are 2% of CR. The changes of accounts
receivables policy (from 1/10, net 30 to 2/7, net 45) considered by enterprise managing team
will result: 60% of enterprise customers use 2% cash discount paying on the 7th
day. The
remaining customers will pay at the 45th
day. Forecasted bad debts losses will grow up to 3%
of CR. Forecasted cash revenues after accounts receivable policy change reach CR1 = 140000
€. The effects of changes in accounts receivable policy would be felt for seven years. The
horizon could be, according to enterprise forecast finite or infinite and depends on
information collected by managing team.
Without change of accounts receivables policy, 60% of cash revenues is collected on
the 30th
day, the rest: 40% will be regulated up to the 10th
day, so the ACP0 is:
22104,0306,00 =×+×=ACP days. The ACP1 after change is:
2,2276,0454,01 =×+×=ACP days.
That is why expected increase of average level of accounts receivable is:
( ) 2544
360
100000
2,224,0
360
140000
222,22 =××+×−=∆AAR €. Therefore as a result of trade
credit policy change, the average state of accounts receivable will grow for 2544 €.
Then is possible to forecast ΔEBIT:
7..1€19808%)40100000%1%60140000%2(
)100000%2140000%3(2544%286,040000)1(
FCFNOPAT
EBITT
=∆==××−××−
+×−×−×−×=∆×−
Next the managing team of the enterprise can estimate change in the enterprise efficiency:
83415
14,1
2544
14,1
1
1
14,0
19808
2544 77
=+





−×+−=∆V €.
151
RESULTS
There are possible three ways of managing of accounts receivable. The restrictive
policy with as small as possible levels of accounts receivables, the flexible policy with as
liberal policy in accounts receivables as needed to activate the cash revenues collection and
the moderate accounts receivables policy in the middle.
More restrictive solutions are cheaper thanks to smaller costs of managing accounts
receivables but they are also linked with higher level of operational risk. That results with
higher cost of capital from financing and smaller efficiency from free cash flows generated by
enterprise operations. On the other side, more flexible solutions are linked with lower level of
operational risk. That results with lower cost of capital from financing and higher efficiency
from free cash flows generated by enterprise operations.
Generally aimed on realization of the performance and value maximization strategy
enterprises, should to choose more safe and more flexible accounts receivable policies. In fig.
1. there is data collected for Polish enterprises, for years 2009 and 2010. We can observe the
levels of accounts receivables for enterprises which maintain inventories and manage the
account receivables (the firms without positive levels of inventories and accounts receivables
were excluded).
Fig. 1. Short-term receivables in Polish enterprises in 2009 & 2010. Logarithmic scale.
Source: [MPB]
Table 1. Short-term receivables levels in Polish enterprises in 2009.
Source: [MPB]
Where: EBIT - Earnings before interests and taxes, STAR – short–term accounts receivables,
LTAR – long term accounts receivables, CA – current assets.
Table 2. Short-term receivables levels in Polish enterprises in 2010.
152
Source: [MPB]
CONCLUSIONS
The main contribution of the paper is to check if the accounts receivable management
model expected changes had the place. The empirical data from Polish firms shows
STAR/ASSETS relation growth, that inform about more flexible accounts receivable policy
choice. Similarly STAR/CA relation growth confirms more flexible accounts receivable
policy choice. The same way STAR/EBIT relation growth means more flexible choice in
accounts receivable policy. That means the empirical data from Polish firms for 2009-2010
years suggests that for Polish managing teams risk aversion has stronger influence on current
assets investment policy than pure economic indicators.
Fig. 2. Short-term receivable policy changes in Polish enterprises in 2009 & 2010.
Source: [MPB]
Where: EBIT - Earnings before interests and taxes, STAR – short–term accounts receivables,
CA – current assets.
Accounts receivable management decisions are very complex. On the one hand, too
much money is tied up in accounts receivables, because of an extreme liberal policy of giving
trade credit. This burdens the enterprise with higher costs of accounts receivable service with
additional high alternative costs. Additional costs are further generated by bad debts from
risky customers. On the other hand, the more liberal accounts receivable policy could help
enlarge inflows from cash revenues. Data used for our calculations comes from over 3000
Polish enterprises and their financial statements. Because not all of them use accounts
receivables management in connection to real operational cycle with inventories was used
only that of them which have positive levels of accounts receivables. For our information is
helpful median and winsorized mean, which show that short term accounts receivable to total
assets was in 2009 and 2010 years in Polish enterprises near to 19,4%; the relation short term
assets to earnings before interests and taxes was in 2009 and 2010 years near to 264%
(truncated mean). That shows that firms generally use rather stable policy in managing
accounts receivable.
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153
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[5] Friedland S. (1966), The Economics of Corporate Finance, Eglewood Clifs, New Yersey,
Prentice – Hall.
[6] Lewellen W. G., R. O. Edmister (1973), A General Model for Accounts Receivable
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[7] Lewellen W. G., R. W. Johnson (1972), Better Way to Monitor Accounts Receivable,
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[8] Maness T., J. Zietlow (1998), Short-Term Financial Management, Dryden Press, Fort
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[9] Michalski G. (2008a), Operational risk in current assets investment decisions: Portfolio
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[10] Michalski G. (2008b), Corporate inventory management with value maximization in
view, Agricultural Economics-Zemedelska Ekonomika, ISSN: 0139-570X, Volume: 54 Issue:
5 Pages: 187-192.
[11] Michalski G. (2009), Inventory management optimization as part of operational risk
management, Economic Computation and Economic Cybernetics Studies and Research,
ISSN: 0424-267X, Volume: 43 Issue: 4, Pages: 213-222
[12] Michalski G. (2010), Planning optimal from the firm value creation perspective. levels of
operating cash investments, Romanian Journal of Economic Forecasting, ISSN 1582-6163,
Volume: 13 Issue: 1 Pages: 198-214
[13] Michalski G. (2007), Portfolio management approach in trade credit decision making,
Romanian Journal of Economic Forecasting, ISSN 1582-6163, Volume: 8 Issue: 3 Pages: 42-
53.
[14] Michalski G. (2008d), Value-based inventory management, Romanian Journal of
Economic Forecasting, ISSN 1582-6163, Volume: 9 Issue: 1 Pages: 82-90.
[15] Michalski G. (2012), Financial liquidity management in relation to risk sensitivity:
Polish firms case, Quantitative Methods in Economics, Vydavatelstvo EKONOM, ISBN978-
80-225-3426-0, Bratislava, p. 141-160.
[16] Michalski G. (2008c), Decreasing operating risk in accounts receivable mangement:
influence of the factoring on the firm value, Culik, M., Managing and Modelling of Financial
Risk, Pages: 130-137.
[17] MPB: Monitor Polski B, Data source for Polish enterprises, ISSN: 1233-4502.
[18] Pringle J. J., R. A. Cohn, Steps Toward on Integration of Corporate Financial Theory,
Readings on the Management of Working Capital, ed. K. V. Smith, St. Paul, Minnesota, West
Publishing Company, 1974.
[19] Robishek A. A., D. Teichroew, J. M. J. M. Jones (1965), Optimal Short – Term
Financing Decision, Management Science, vol. 12, no 1, ser. A, Sciences, 1965, pp. 1-36.
dr Grzegorz Michalski, Assistant Professor, Department of Corporate Finance and Value
Management, Wroclaw University of Economics, Wroclaw, Poland, ul. Komandorska
118/120, Z-2, KFPiZW; PL53-345 Wrocław, Poland, ph. +48503452860, fax +48717183313,
Grzegorz.Michalski@ue.wroc.pl; http://michalskig.com/
154
STRUCTURED PRODUCTS AND MODERN PORTFOLIO
THEORY
Peter Mokrička, Petr Červinek
ANNOTATION
The subjects of this paper are structured products assessed in a portfolio context. The authors
are trying to find ways to build a portfolio of financial instruments, which includes structured
products. The construction of portfolio should be relatively simple. Therefore, the authors
have chosen modern portfolio theory as the first approach. In this paper are demonstrated the
possibilities of application of modern portfolio theory methods on the structured products.
KEY WORDS
Structured products, certificate, return, risk, portfolio
JEL classification: G11, G24
INTRODUCTION
Structured products are modern financial instruments, which make investments and
investments strategies utilized derivatives (especially options) accessible for retail investors
too. These financial products optimize return-risk profile of investors or rather tailor
investments to expectation of investor, his investment horizon and his risk inclination.
Usually structured products are both in literature and in information brochures of issuers of
these instruments presented only in comparison with direct investment in the underlying asset
to which the structured product is related. The value derivation of structured product from the
value of underlying asset can be considered as one of basic characters of structured products.
From a legal standpoint almost all of these instruments (certificates) are debentures of the
issuer1
.
One of the basic investment principles is diversification – distribution of risk across more
investment classes and investment instruments. Therefore it is important to assess the
structured products in the portfolio context too. So we can consider a portfolio including
structured products, but also a portfolio which includes only the structured products. The
authors are aware of only one source that is considering structured products in a portfolio
context. Blümke describes the possible problems of constructing a portfolio that contains
structured products.
AIM AND METHODOLOGY
The aim of this paper is the application of modern portfolio theory (Markowitz portfolio
theory and the model CAPM) to structured products. In this paper we work with the
assumption that an investor buys and sells structured products during the term i.e. investor
does not buy on the day of issue and does not sell the product on the due date. Particularly the
second of the mentioned assumptions is significant because the value of structured products is
derived from their building components, which include the options. At the due date of the
product, which is the same due date of contained option, the option would had only intrinsic
1
Compare SVOBODA, Martin; ROZUMEK, David. Investiční certifikáty. Praha: Komise pro cenné papíry.
2005. 48 s. ISBN 8023953176
155
value. Its value is also affected by the time value of options included during the duration of
the product.
In the application part were examined 5 different types of structured products, namely bonus,
discount, express, sprint and guarantee certificate. All of the selected products are traded on
the quality segment Scoach Premium in Frankfurt, which ensures the highest standards of
quality when trading in structured products such as certificates, warrants and reverse
convertibles2
. The data source was the provider of financial information ARIVA.DE AG,
which also operates a web application of Scoach platform.
RESULTS
All considered types of products are classified as investment products. That means that these
products do not contain leverage. More precisely, financial leverage of these products does
not have a symmetrical and unlimited effect in comparison to leverage products such as
warrants or knock-out products. In this chosen set is included one product with a full
guarantee on invested capital (guarantee certificate), one product without guarantee on
invested capital (sprint certificate) and three products with a partial guarantee on invested
capital (discount, bonus and express certificate).
Bonus certificate is a structured product that contains a conditioned promise of issuer to pay
the investor in advance determined return (so-called bonus return) at maturity if the value of
underlying asset has never been at or below of the barrier during the lifetime of the product.
In case that the value of the underlying asset is above so called bonus level the investor
receives the current value of the underlying asset (taking account of the so-called ratio), i.e. its
return potential is unlimited. In case that is achieved the level of barrier at any time during the
duration of certificate, the value of certificate copies the development of the value of the
underlying asset in rate 1:1 (if leaving dividend income out of account). Any dividend income
following from holding of the underlying asset, the investor renounces in favor of the issuer,
which one can finance the bonus mechanism from them (buy barrier down-and-out put
option).
Discount certificate is a structured product by which is possible to simply say that the investor
purchases the underlying asset at a reduced price. Providing of the discount by the issuer and
its size determines the premium collected for sold call option, which is a part of this structure.
Because of sold call option the investor can reach a return also in case of stagnation or even
slight decrease of value of the underlying asset. On the other hand the return potential of this
instrument is limited to the level of the cap parameter (which is giving the value of the
underlying asset when the investor reaches the maximum possible return) which actually
corresponds to the exercise price of the sold call option.
Express certificate is an investment certificate by which is known only a maximum duration
of a certificate because the product can become due and payable prematurely. During the
term, several deadline dates are set by which is compared the current value of underlying
asset with predetermined price level for the underlying asset (usually the value of the
underlying assets at issuance of certificate). If the value of the underlying asset on a given
deadline date equals or exceeds a predetermined reference value for the underlying asset, the
product becomes due and payable prematurely and the investor receives payment of a return
specified in the issue conditions. Otherwise, the duration of the certificate goes to the next
2
Scoach Europa AG.
156
relevant deadline date. If the certificate was not settled until the maturity date than at due date
is again compared the current value of the underlying asset with the reference value. If the
current value of underlying is higher, the investor becomes a return predetermined in the issue
conditions (the return usually increases for each deadline day). In case that the actual value of
underlying asset is lower than the reference value, but is above the predetermined barrier, the
investor is paid all of its invested capital (valid for purchases at issue). In case that the value
of underlying is below the barrier at maturity, investor becomes the actual value of underlying
asset.
Sprint certificate enables an investor to achieve double appreciation in the underlying asset
value growth in a predetermined range at maturity. The purchase of call option allows this
double appreciation. This purchase is financed by selling additional call options denominated
in the same underlying asset. The sold call options (or more precisely their exercise price)
limit return potential of investor. In case that value of the underlying asset goes down investor
records the same investment result (loss) as the underlying asset itself.
Guarantee certificate (as the name implies) guarantees investors returning of (all) invested
capital at maturity. It is necessary to realize that the guarantee is related only to market risk
(not to credit risk). The component which secures a guarantee is mostly a purchased zero
bond. Its value on the maturity date corresponds to the value of the underlying asset (value of
the certificate) at issue (reflected by the ratio). The difference between the value of a zero
bond and its nominal value is then used by issuer to profiling a performance component of the
product for which an investor must generally expect lower participation rate of growth in
value of the underlying asset (the participation rate is less than 100 %).
Fig.1 Investigated structured products and their underlying
WKN3
DZ3SLM BHF0M3 SG1T0G TB26ZU GS34GM
Product type
Sprint
certificate
Guarantee
certificate
Express
certificate
Discount
certificate
Bonus
certificate
Underlying
asset
Siemens BMW
Deutsche
Bank
Adidas RWE
Source: authors
We applied modern portfolio theory methods on the stated investment instruments. We used
Elton et al. as the source of the modern portfolio theory methods. We applied mainly the
Markowitz approach (known as Mean-Variance Portfolio Theory), the model CAPM a so
called Cut-Off Rate.
Although the methods are described in detail by Elton et al., we will state the most crucial
parts of the theory.
We used the close prices of the considered investment instruments and of the index DAX4
to
calculate one-day return on the particular instrument ir using the following form
1
1
−
−−
=
t
tt
i
P
PP
r ,
3
Wertpapierkennnummer – German equivalent to the ISIN (International Security Identification Number)
4
In some methods is used so called market portfolio. We will use the stock market index DAX as the
approximation of the market portfolio.
157
where tP is the price of the particular instrument at time t .
We applied all the methods over this data. First we calculated estimation of the mean,
estimation of the variance and estimation of the standard deviation for sample of the one-day
returns on the investment instruments and the index DAX. Thus we obtained return and risk
of particular instrument. The values of the return and risk are as follows in the Figure 2.
Fig.2 Return and risk of return on the investment instruments
DZ3SLM BHF0M3 SG1T0G TB26ZU GS34GM DAX
Expected
Return ir -0.00101 0.00042 0.00001 0.00009 -0.00068 -0.00039
Variance
2
iσ
0.00032 0.00048 0.00092 0.00000 0.00076 0.00034
Standard
Deviation
iσ (Risk)
0.01786 0.02195 0.03032 0.00208 0.02749 0.01852
Source: authors
We constructed the portfolio with minimal risk that would be located at the efficient frontier.
There is one requirement for the construction of such a portfolio. The requirement states that
the investor should place all the capital. We can write
1
1
=∑=
n
i
iX ,
where iX is the proportion invested in the asset i .
We solved an optimization problem with a constraint. We solved the problem using so called
Lagrange multipliers. The Lagrange function was
( ) 





−⋅+= ∑=
1,,,,
1
1
2
121
n
i
ipn XXXXL λσλ ,
where ∑∑= =
⋅⋅=
n
i
n
j
ijjip XX
1 1
2
σσ is the portfolio return variance and ijσ is the covariance
between the returns on assets i and j .
The solution of this optimization problem is a vector of the proportions invested in the
investment instruments. Using these weights we calculated the return on the minimum risk
portfolio and the risk of the minimum risk portfolio. We could trace out the efficient frontier
by increasing the expected return on the portfolio. This would modify the optimization
problem. There will be a second constraint. So the Lagrange function would be of the form
( ) 





−⋅⋅+





−⋅+= ∑∑ ==
p
n
i
ii
n
i
ipn rrXXXXXL
1
2
1
1
2
2121 1,,,,, λλσλλ ,
where pr is the expected return on the portfolio.
158
A specific portfolio of risky assets that any investor would hold could be identified according
to Elton et al. Such a portfolio lies at the tangency point between the efficient frontier and the
riskless return5
. To identify this portfolio one should maximize function
p
fp rr
σ
−
,
where fr is the riskless return.
Further we employed the model CAPM in the form
iMiii rr εβα +⋅+= .
We estimated the regression coefficients ( iα and iβ ) using the least squares method. The
values of the estimated coefficients for all considered investment instruments are presented in
the Figure 3.
Fig.3 Estimates of the coefficients of the CAPM
DZ3SLM BHF0M3 SG1T0G TB26ZU GS34GM
iα -0.00068 0.00077 0.00047 0.00012 -0.00023
iβ 0.84661 0.88892 1.17901 0.07828 1.16172
Source: authors
For the case that there exists the constraint that all proportions should be zero or positive
(short selling not allowed) we employed the method stated in Chapter 9 by Elton et al. We
calculated so called Cut-Off Rate (for the calculation technique of the Cut-Off Rate see Elton
et al.). The investment instruments are added to the portfolio as long as
i
i
fi
C
rr
>
−
β
.
The asset’s unsystematic risk is necessary for the calculation of every iC . For the calculation
of the unsystematic risk we used the form
2222
iMii εσσβσ +⋅=
Values of the 2
iεσ are presented in the Figure 4.
Fig.4 Values of the 2
iεσ
DZ3SLM BHF0M3 SG1T0G TB26ZU GS34GM
0.00007 0.00021 0.00044 0.00000 0.00029
Source: authors
5
We used the German 12-month T-Bill with the yield 1.75% p.a.
159
Every portfolio that we constructed is presented in the Figure 5 including expected return on
the portfolio and the risk of the expected return on the portfolio.
Fig.5 Constructed portfolios
Portfolio with minimal risk
min. risk and
given return
tangency point
short selling
not allowed
Proportion
of
DZ3SLM -0.0399 -0.1350 -0.3478 0.0000
BHF0M3 -0.0121 0.0380 0.1504 0.2920
SG1T0G -0.0143 0.0000 0.0319 0.0000
TB26ZU 1.0756 1.1106 1.1888 0.7080
GS34GM -0.0093 -0.0136 -0.0232 0.0000
return on portfolio 0.00014 0.00026 0.00054 0.00019
risk of the portfolio 0.00162 0.00200 0.00416 0.00729
Source: authors
The minus sign indicates short selling of the particular investment instrument.
CONCLUSION
We showed that it is possible to employ all the main methods of modern portfolio theory
when constructing a diversified portfolio of the structured products. We also showed that
there is possibility to solve the construction problem even if there is not allowed short selling.
There exist other mathematical methods for solving such a constraint – for example Wolfe’s
method.
BIBLIOGRAPHY
[1] ARIVA.DE AG. [online]. cit. [21.5.2012]. Dostupné na WWW: <http://ag.ariva.de/>
[2] BLÜMKE, Andreas. How to invest in structured products: a guide for investors and asset
managers. Chichester: John Wiley &Sons Ltd. 2009. 374 s. ISBN 978-0-470-74679-0
[3] Scoach Europa AG. [online]. cit. [21.5.2012]. Dostupné na WWW:
<http://www.scoach.de/de/ueber-uns/scoach-europa/boersenhandel>
[4] ELTON, Edwin J. et al. Modern portfolio theory and investment analysis. 6th ed..
Hoboken, N.J. : John Wiley & Sons, 2003. 727 pp. ISBN 0-471-23854-6.
[5] SVOBODA, Martin; ROZUMEK, David. Investiční certifikáty. Praha: Komise pro cenné
papíry. 2005. 48 s. ISBN 8023953176
[6] Deutsche Bundesbank. Time series WT4120: DE0001137347 / Yields / 1,750 BSA 11.
[online]. cit. [21.5.2012]. Dostupné na WWW:
<http://www.bundesbank.de/statistik/statistik_zeitreihen.en.php?lang=en&open=&func=row
&tr=WT4120>
Ing. Peter Mokrička
Masaryk University
Faculty of Economics and Administration
Lipová 41a, Brno
mokricka@econ.muni.cz
Mgr. Petr Červinek
Masaryk University
Faculty of Economics and Administration
Lipová 41a, Brno
cervinek@econ.muni.cz
160
INVESTIGATION OF WEAK-FORM EFFICIENCY IN THE
CEE REGION APPLYING VARIANCE RATIO TEST
Mihály Ormos, Gábor Bóta
ANNOTATION
We test weak form efficiency for the Central and Eastern European stock markets applying
variance ratio test. We investigate the price changes of seven CEE markets (Austria, Hungary,
Estonia, the Czech Republic, Poland, Romania, Slovakia) for the period 1991-2011. In order
to make the results for these markets directly comparable with results for other developed
markets, Germany, United Kingdom and the USA were also incorporated. Our results present
contrarian pricing behavior in the investigated countries while instead of the mean reverting
(negative autocorrelation) pricing process experienced in the US or in the UK we measure
positive autocorrelation especially in the early years of the investigated stock exchanges.
However we document continuous development in the efficiency of pricing. Our results show
that if the prices are recalculated in USD the significance of inefficiency measures are
weakening or even vanishing.
JEL classification: G14
KEY WORDS
Market efficiency, CEE countries, Variance ratio test
INTRODUCTION
The simplest and most general definition of Efficient Market Hypothesis (EMH) is that stock
prices always fully reflect all available information. Prices are in equilibrium and only new
information can move them from this equilibrium; price reactions on new information are
instantaneous and correct. In other words, if EMH holds prices are not predictable, since
supposing rational well-informed investors who properly anticipate the prices based on their
knowledge generate randomly fluctuating prices (Samuelson, 1965).
As the aforementioned definition of EMH is too general to test, different forms can be
separated based on the subsets of information that fully reflected in prices. In his review about
previous researches done on market efficiency Fama (1970) classified three different forms of
market efficiency. Weak form tests investigate whether prices fully reflect past prices or
returns. Semi-strong form tests examine how fast prices reflect on public announcements,
while strong form tests question whether investors have private information that is not fully
reflected in market prices. Later Fama (1991) modified the definitions of the three forms of
market efficiency to tests for return predictability, event studies and tests for private
information. In the case of semi-strong and strong forms the changes are limited to the titles,
while in the case of weak form tests Fama proposed change in the coverage to include tests
for forecasting power of other variables than past prices and returns, cross-sectional
predictability of returns and investigation of anomalies in return patterns as well.
Since then several papers tested the three forms of market efficiency on different markets and
periods using various methods. Fama (1965) provided tests of market efficiency by using
serial correlations and runs tests and found that the degree of dependence in daily price
changes was not strong enough to increase the expected profits of investors. In his
aforementioned article (Fama 1970) the author also reviewed the early tests of market
efficiency and the results of weak form tests showed that the evidence for dependence in
161
successive price changes was statistically significant but not strong enough to reject the
hypothesis of efficiency. Later Fama (1991) admitted that controversy about market
efficiency is mainly concentrated on the predictability of stock returns, but concluded that
new results about predictability, although being more precise suggested the same as early
tests.
Poterba and Summers (1987) investigated stock market returns in the US (between 1871 and
1986), 17 other countries (among them Austria, Germany and the UK, for the period 1957-
1985) and returns of individual stocks (1926-1985) and found positive serial correlation over
short periods and negative correlation over longer intervals applying variance ratio test. They
concluded that the random walk hypothesis could be rejected based on the summarized results
of the different data sets, while the results from individual data sets didn’t support its
rejection. Lo and MacKinlay (1988) investigated weekly returns (of US indices, portfolios
and individual stocks) between September 1962 and December 1985 using variance ratio test
and they rejected the random walk hypothesis but added that the rejection of the random walk
model does not necessarily imply the inefficiency of stock-price formation. Most of the tests
about return predictability and weak form efficiency concentrated on the US and other
developed markets; only some authors investigated the problem in emerging markets as well.
Harvey (1994) investigated 20 emerging countries (three European among them: Greece,
Portugal and Turkey) in the period from 1976 (or later where data was not applicable) through
1992 and observed low correlations with returns of developed countries and found these
markets more predictable than developed ones, which can be caused by the segmentation of
these markets from world capital markets.
DATA
We focus on return predictability on the stock exchanges of the Central and Eastern European
region, investigating daily closing prices from 02/January/1991 (or from a later date from
when data is available) to 30/December/2011 of the indexes of the following stock markets:
ATX – Vienna Stock Exchange, Austria; BUX – Budapest Stock Exchange, Hungary; OMX
Tallinn (EST ) – Tallinn Stock Exchange, Estonia (from 03/June/1996); PX – Prague Stock
Exchange, the Czech Republic (from 06/April/1994); RMBET (RM) – Bucharest Stock
Exchange, Romania (from 19/September/1997); SAX16 (SAX) – Bratislava Stock Exchange,
Slovakia (from 14/September/1993); WIG20 (WIG) – Warsaw Stock Exchange, Poland (from
18/April/1994),
The indexes are calculated based on the prices of the stocks in their baskets denominated in
local currencies, in order to get comparable results with the international findings we also
calculated the returns in US dollar terms. Beside the aforementioned indexes some others
representing developed markets were also incorporated, again in order to make the results for
the region more comparable: DAX – Frankfurt Stock Exchange, Germany; FTSE100 (FTSE)
- London Stock Exchange, United Kingdom; S&P500 (SP) – United States.
All of the indexes are capitalization weighted, and are total return indices, so returns are
calculated assuming dividends paid by the stocks are reinvested. The source of the data is
Thomson Reuters Datastream.
Table 1 presents the descriptive statistics of the daily log returns of the indexes for the whole
examined period and for two sub periods (1991-2003 and 2004-2011).
The standard deviations of dollar term returns are higher than the returns measured in local
currencies in all but one cases (DAX in the first sub period). For the whole investigated period
FTSE has the lowest maximum, highest minimum daily return and lowest standard deviation,
while the lowest and highest daily returns and highest standard deviation are associated with
ESTUSD, SAXUSD and WIGUSD respectively.
162
Most of the indexes (except SAX and SAXUSD for the whole period, RM, RMUSD, SAX
and SAXUSD for the first sub period and EST, ESTUSD for the second sub period) are
negatively skewed, so the probability of large decreases in returns is larger than the
probability of large increases. The Jarque-Bera statistics and the corresponding probabilities
indicate that the null hypothesis of normally distributed daily returns can be rejected for all
indexes and periods.
METHODOLOGY
The variance ratio is a special way to test the random walk hypothesis. As Poterba and
Summers (1987) compare different random walk tests, they find that variance ratio tests are
among the most powerful tests and they are more powerful than Fama and French (1988)
regression based procedure. Summers (1986), Poterba and Summers (1987), Cochrane (1988),
Fama and French (1988), Lo and MacKinlay (1988), Campbell and Perron (1991) show that
unit root tests have low power against alternative hypothesis like stationary process and it is
difficult to reject a false null hypothesis of random walk. The variance ratio test is developed
by Lo and MacKinlay (1988). Let Pt denote the natural logarithmic equity price series at time
t. The hypothesis of pure random walk process with drift 
t t 1 tP α P ε−=+ + ,
wheret is a white noise process with zero expected (E(t)=0) value and constant
variance (σε
2
=E(t
2
)). One of the main feature of the Lo and MacKinley (1988) test that one
can apply alternative assumptions on the error term t like heteroskedasticity, which is
common in daily returns and can be observed in our sample as well. Lo and MacKinlay use
the fact that in a random walk process the variance of the kth difference would be equal to k
times the variance of the first differences i.e. the variance of k-difference of this process is
proportional to k:
( ) ( )2
t t kVar P P kσ ε .−− =
Since Pt is a logprice index, Pt-Pt-k is the k holding period return. Therefore the null
hypothesis of the variance ratio is
.
Lo and MacKinley (1988) test the null under homo- and heteroskedastic circumstances.
RESULTS
We present the variance ratio test result in Table 1. For the whole investigated period in local
currency only the German and Poland stock exchange indexes show pure random walk;
however if we calculate all the indexes in USD, than only the DAX index show non
significant difference form the null hypothesis of random walk. The Anglo-Saxon market,
both the US and the British stock indexes presents mean reverting behavior, as their variance
ratios are smaller than one, which means that these indexes are negatively autocorrelated for
smaller k values. Contrary to the US and UK markets the CEE countries’ indexes show
variance ratios higher than one in all significant cases both in local currencies and in USD.
This result coincides with Urbán and Ormos (2012) analyses on equally weighted portfolios,
where they show that contrary to the US market in Hungary the equally weighted portfolios
163
cannot beat the value weighted portfolios even the strategy generates negative Jensen (1968)
alpha. As one of the main reason of the abnormal return of an equally weighted portfolio is
the mean reverting behavior if the prices induce positive autocorrelation than the abnormal
return disappears.
On the other hand based on the results of the unit root and runs tests it seems to be worthwhile
to have a closer look at the time varying behavior of market pricing. We divide the whole
sample into two parts: (1) from 1 January 1991 or from the starting date of the specific
exchange to 31 December 2003 and (2) from 1 January 2004 to 31 December 2011. In the
case of the variance ratio test the standard error of the estimation is decreasing in the function
of the length of the time series, this is the reason why we investigate only sub-periods. By this
division for the period of 1991-2003 we have a maximum sample size of 3390 observations
for those markets for which were operated at that time, and 1638 observations for the
Romanian market which opened only in 1997 and we have 2087 observations for the period
of 2004-2011 for all markets.
Table 1. Variance ratio test
This table shows the results of the variance ratios (VR) with the probability (p-value) of the
null (log price is martingale) for daily price indexes from the Austrian (ATX), Hungarian
(BUX), German (DAX), Estonian (EST), London (FTSE), Czech (PX), Romanian (RM),
Slovakian (SAX), US (Standard and Poor’s 500, SP) and Poland (WIG) stock exchange. The
variance ratios and their p-values are calculated by using heteroskedastic robust standard
164
errors, unbiased variances with allowing drift for k periods of 2, 5, 10, 20, 30, 50, 100, 200
and 300.
In the first (1991-2003) all the CEE markets show positive autocorrelation but the Poland
market. The size of the non-random component in the process is increasing in the function of
the investigated number of k periods. It is striking that if we recalculate the prices in USD
some of the significant non-unit variance ratios are disappearing and the level of significance
is decreasing in all markets but the Czech and Estonian for all periods.
In the case of the later period (2004-2011) the pricing show an improving efficiency. The sign
of the autocorrelations are the same, but in most of the markets their significance levels are
weakening or totally vanishing. The most striking results for this period compared to the
previous one are the cases of the Czech and Hungarian markets, where all the significant
positive autocorrelations are vanishing both in local currencies and in USD. The other indexes
present smaller transitory component if they are calculated in USD, which underline the fact
that most of the investors on these smaller CEE markets are international institutional
investors.
CONCLUSION
In this paper we find that the examined Central and Eastern European stock market indexes
show continuous development in terms of weak form market efficiency during the past two
decades. If we compare the test results for the 1991-2003 and the 2004-2011 periods the nonunit
variance ratios disappear or at least their significance levels decrease. It is an interesting
fact that variance ratios indicate higher efficiency for the indexes calculated in USD instead of
local currencies, and strong positive autocorrelation in local currencies. This effect can be
associated by the higher inflation rates in the investigated countries compared to the United
States and can be another representation of mild segmented capital markets.
BIBLIOGRAPHY
[1] Campbell, J.Y. &Perron, P. 1991. Pitfalls and Opportunities: What
Macroeconomists Should Know About Unit Roots, in: Blanchard, O. J., Fischer, S.
(Eds.), NBER Macroeconomics Annual, 6, pp. 141-220.
[2] Cochrane, J.H. 1988. How big is the random walk in GNP? Journal of Political
Economy, 96(5), pp. 893-920.
[3] Fama, E.F. 1965. The behavior of stock-market prices. The journal of Business,
38(1), pp.34–105.
[4] Fama, E.F. 1970. Efficient capital markets: A review of theory and empirical work.
Journal of Finance, 25(2), pp.383–417.
[5] Fama, E.F. 1991. Efficient capital markets: II. Journal of Finance, 46(5) pp.1575–
1617.
[6] Fama, E.F. & French, K.R. 1988. Permanent and temporary components of stock
prices. The Journal of Political Economy, 96(2), pp. 246-273.
[7] Harvey, C.R., 1994 Predictable risk and returns in emerging markets, National
Bureau of Economic Research, Working Paper No. 4621, January 1994
[8] Jensen, M.C. 1968. The Performance of Mutual Funds in the period 1945-1964, The
Journal of Finance, 23(2), pp. 389-416.
[9] Lo, A.W. &MacKinlay, A.C. 1988. Stock market prices do not follow random walks:
Evidence from a simple specification test. Review of financial studies, 1(1), pp.41–
66.
165
[10] Poterba, J.M. & Summers, L.H. 1987, Mean reversion in stock prices: Evidence
and implications. National Bureau of Economic Research, Working Paper No. 2343,
August 1987
[11] Samuelson, P.A. 1965. Proof That Properly Anticipated Prices Fluctuate Randomly,
Industrial Management Review, 6(2), pp. 41-49
[12] Summers, L. H. 1986. Does the stock market rationally reflect fundamental values?
Journal of Finance, 41(3), 591-601.
[13] Urbán, A. & Ormos, M. 2012.Performance Analysis of Equally Weighted
Portfolios: USA and Hungary. ActaPolytechnicaHungarica, 9(2) pp. 155-168.
Full name: Gábor Bóta
Institution: Department of Finance, Budapest University of Technology and Economics
Street: Magyar tudósokkrt. 2.
City: 1117 Budapest, Hungafy
Email: bota@finance.bme.hu
Full name: Mihály Ormos
Institution: Department of Finance, Budapest University of Technology and Economics
Street: Magyar tudósokkrt. 2.
City: 1117 Budapest, Hungafy
Email: ormos@finance.bme.hu
166
ANALYSIS OF SKIMMING IN THE CZECH REPUBLIC AND
PROTECTION TECHNIQUES AGAINST SKIMMING
Gabriela Oškrdalová
ANNOTATION
The subject of the paper “Analysis of skimming in the Czech Republic and protection
techniques against skimming” is an analysis of skimming in the Czech Republic,
an identification of warning signs of skimming, a creating of a model of this type of fraud and
an identification of the basic recommendations for payment card users to reduce security risks
connected with using of payment cards.
KEY WORDS
e-business, e-banking, security, risk, security risks, fraud, skimming, payment card
JEL classification: G020, G210, G290
INTRODUCTION
Skimming is one of basic types of frauds in the e-banking and e-shopping field, with which
we can meet in the Czech Republic and all over the world. Except the skimming we can
assign so called Lebanon loops, hidden cameras, touch sensors, counterfeit payment cards,
phishing, pharming, spoofing, trashing and theft of payment card to the basic types of frauds
in the e-banking and e-shopping field. Relatively often particular types of frauds are
combined together. In this paper we will analyse skimming. For example, this type of
payment card frauds can be connected with a hidden camera or a touch sensor. These
combinations of particular types of frauds increase the success probability for a defrauder and
possibilities of using obtained information from the payment card by their copying from the
magnetic strip. For example, using a hidden camera or touch sensors installed on an ATM
enable obtaining user’s PIN code by a defrauder. In this case the defrauder has information
from user’s payment card copied from the magnetic strip on the payment card and also knows
the right PIN code for this payment card. In this moment a danger of an abuse of this
information by a defrauder, an unauthorized person, is very high. The ground of skimming
fraud has been known for a long time and has been described in many scientific and
unscientific publications, technical solution possibilities exist and are relatively often used. So
is it true that numbers of skimming cases have been decreasing in the last years?
AIM AND METHODOLOGY
The aim of this paper is an analysis of skimming in the Czech Republic, an identification of
warning signs of skimming, a creating of a model of this type of fraud and an identification of
the basic recommendations for payment card users to reduce security risks connected with
using of payment cards. The mentioned aim is reached by using of generally science methods,
primarily analysis, description, synthesis, induction, deduction and modeling. Normative and
positivist methodologies have been employed to reach the aim.
RESULTS
The ground of skimming fraud is to obtain sensitive information about a payment card when
the original data are copied from the magnetic strip on the payment card unknown to the
167
payment card holder – the authorized person1
. All protective elements are not copied (for
example CVC2/CVV2 code), i.e. the abuse of a counterfeit payment card made on the basis of
obtained data by copying from a original payment card is not possible in cases, when these
protective elements are checked (for example by making cash withdrawals when the second
track is checked). But it is not true that today frauds can not use obtained sensitive
information. The risk is not zero. Some banks do not check protective elements. In these cases
it is possible to make cash withdrawals by counterfeit payment cards.2
Also we can not forget
that it is possible to abuse obtained sensitive information by transaction when the payment
card does not participate physically.
Skimming cases in the Czech Republic
According to the Police of the Czech Republic3
the copying of payment cards is most often by
an ATM where defrauders copy data from a magnetic strip of a payment card by a special
equipment – a skimmer and then they use them to produce a counterfeit payment card
(according to the Police this way is most often) or by sellers when a dishonest shop assistant
copies data from a magnetic strip of a payment card before giving it back to the customer.
Then the obtained sensitive data can be abused (according to the Police this type of fraud is
most often at bars, restaurants, sometimes at petrol stations or at hotels).
Now we can get back to the question: Is it true that numbers of skimming cases have been
decreasing in the Czech Republic in the last years? Unfortunately as we can see in the first
figure “Skimming in the Czech Republic (2005 – 2012)” numbers of skimming frauds do not
have a clear trend, so it is impossible to state that numbers of skimming have been decreasing
in this period. It is very important to draw attention to the year 2012. In the first six weeks of
this year 46 skimming causes were monitored (for example, in the whole year 2011 74
skimming causes were monitored, in the year 2010 only 50 cases).
A skimmer is installed most often on an ATM. According to the Police of the Czech
Republic4
a skimmer is installed most often in the area of an input hole for payment cards,
when an ATM is modified by an installation of various extensions on these holes, similarly to
the Lebanon loop. Another possible way is that a skimmer is installed as a panel on an
original part of an ATM. In some described cases a skimmer was installed on an equipment
for an insertion of a payment card to access to a bank self-service area5
. In the case of frauds
caused by sellers two basic ways are possible. A skimmer can be installed directly on a
payment terminal (for example on an input area for payment cards, similarly to a skimmer on
an ATM). On the other hand the skimmer can be a separate equipment and then a dishonest
shop assistant makes use of the inattention, ignorance or carelessness of a payment card
holder by using the payment card to pay (in these cases it is not possible to exclude that the
1
According to some definitions the skimming is defined only as copying of sensitive information about the
payment card from its magnetic strip, according to some definitions the skimming includes using a hidden
camera or touch sensors to obtain the PIN.
2
KLUFA, F., SCHOLZ, P., KOZLOVÁ, M.: Cashless payment frauds in the Czech Republic (in Czech). Czech
Consumer Association [on-line]. [10 January 2012]. WWW:
<http://www.konzument.cz/publikace/soubory/pruvodce_spotrebitele/A5_bezhotovostni_podvody.pdf>.
3
POLICE OF THE CZECH REPUBLIC: ÚOOZ SKPV : Skimming (in Czech). Police of the Czech Republic
[on-line]. [17 January 2012]. WWW: <http://www.policie.cz/clanek/skimming.aspx>.
4
POLICE OF THE CZECH REPUBLIC: ÚOOZ SKPV : Skimming (in Czech). Police of the Czech Republic
[on-line]. [17 January 2012]. WWW: <http://www.policie.cz/clanek/skimming.aspx>.
5
One of real cases of this skimming way is described in KOLINA, J.: False card readers have been installed on
bank branches in Prague recently (in Czech). Lidovky.cz [on-line]. [17 January 2012]. WWW:
<http://www.lidovky.cz/falesne-ctecky-karet-jsou-uz-i-v-praze-primo-na-pobockach-pka-
/ln_domov.asp?c=A110201_203656_ln_domov_kim>.
168
attention of a payment card holder is took away by a shop assistant or another person). In
some cases even a shop assistant can copy data from a payment card without any possibility
of supervision by the customer when the payment card is taken out of his sight (a shop
assistant can give reasons for this action by a malfunction of an using payment terminal, a
necessity of a verification of an authenticity of customer’s payment card, a reaching a higher
safety). The Association for bank cards confirms this fact6
. Even the Association describes
cases when a shop assistant copied data from customer’s payment card instead of making the
payment for goods and services. Then the customer is informed that the realization of the
payment was not successful (two manipulations with the payment card could be suspicious for
the customer).
Fig.1 Skimming in the Czech Republic (2005 – 2012)
* Number of skimming frauds in first six weeks of 2012.
Source: Author according to: POLICE OF THE CZECH REPUBLIC: ÚOOZ SKPV :
Skimming (in Czech). Police of the Czech Republic [on-line]. [17 January 2012]. WWW:
<http://www.policie.cz/clanek/skimming.aspx>; CZECH TELEVISION: Foreigners allegedly
installed card readers on ATMs in Prague (in Czech). Czech Television [on-line]. [19
February 2012]. WWW: <http://www.ceskatelevize.cz/ct24/domaci/164694-cizinci-pry-
montovali-v-praze-ctecky-na-bankomaty/>.
Copying of sensitive data from a payment card is possible in other cases too. Except other, the
Association for bank cards describes the case when defrauders impersonate policemen and
pretend checking the authenticity of payment cards and meanwhile they copy sensitive
information from a magnetic strip of a payment card by miniature skimmers. In these cases
defrauders ask payment card holders to tell them PIN code.7
So we can note there are many
ways for skimming. One of possible ways of this type of fraud is represented in figure 2 “The
fraud with a counterfeit payment card with using a skimmer and a hidden camera or touch
sensors”.
6
BANK CARD ASSOCIATION: Types of frauds : Skimming (in Czech). Bank Card Association [on-line]. [17
January 2012]. WWW: <http://www.bankovnikarty.cz/pages/czech/media_bezpecnost.html#Skimming>.
7
BANK CARD ASSOCIATION: Types of frauds : Skimming (in Czech). Bank Card Association [on-line]. [17
January 2012]. WWW: <http://www.bankovnikarty.cz/pages/czech/media_bezpecnost.html#Skimming>.
169
Recommendations to reduce the skimming risk
Recommendations to reduce skimming risk are variable. It is possible to install a special
equipment (attachment) on an ATM or on an equipment for an insertion of a payment card to
access (bank) self-service area that prevents frauds from installing a skimmer. A special
construction of an ATM and an equipment for an insertion of a payment card can contribute
to reduce the skimming risk too. Then we can mention installations of anti-copying – antiskimming
equipment and using anti-copying and anti-skimming software in ATMs,
monitoring of ATMs, etc.
It seems that recommendations for reducing the skimming risk are intended only for banks,
operators of payment systems and terminals. But it is not true. It is necessary to appeal to
payment card holders (users) too. They should know basic security rules for using payment
cards and observe them. For example, we can mention “keep a payment card safe”, “do not
share the PIN code with anyone”, “do not write the PIN code on the payment card”, “do not
keep the PIN code near the payment card”, “choose and use a safe, strong PIN code”, “check
an ATM, a payment terminal or an equipment for an insertion of a payment card do access to
a self-service area and their surroundings” (is this equipment modified or no?, was an
additional equipment installed?, is using of payment cards observed by somebody?). When
using a payment card, a payment card holder should not be disturbed, should be concentrated
and should not allow anybody to distract his attention. If payment card holder has a suspicion,
he should interrupt the transaction and contact the bank or police. Interruption of the
transaction is right in cases when the personal safety zone is disrupted. When entering a PIN
code, a payment card user should blot out the keypad by the opposite hand to prevent a fraud
from obtaining his/her PIN code (for example by a hidden camera). A payment card user
should be careful when using the payment card at shops to pay for goods and services too.
The payment card should not be given to a shop assistant (or other person). If this rule is
broken, a payment card user should observe carefully what the person makes with the
payment card. When having a suspicion, the transaction should be interrupted and the bank or
police contacted. From security point of view it is unacceptable when a payment card holder
agrees with using the card without any supervision or tells a shop assistant or another person
the PIN code. If a payment card user has more payment cards, it is possible to recommend to
divide these payment cards for particular purposes (for example one of cards can be used for
enter self-service area).
170
Fig. 2 The fraud with a counterfeit payment card with using a skimmer and a hidden camera
or touch sensors
Source: Author
Producing counterfeit
payment card
Using the counterfeit payment card
by defrauder to withdraw cash,
pay for goods and services etc.
The defrauder has the counterfeit
payment card and the PIN code
Obtaining user’s PIN code by
a fraud with the aid of hidden
camera or touch sensors
Entering user’s PIN code
Obtaining information from
the payment card by their
copying from the magnetic
strip
Using the modificated ATM
or payment terminal by a
payment card user, including
entering user’s PIN code
Inserting user’s payment card
into the ATM or the payment
terminal
Modification of ATM or
payment terminal, eventually
their environment by a fraud
Installation of a hidden
camera or touch sensors
Installation of a skimmer
171
In connection with skimming we should remind recommendations as “use day, week or
month limits for payment card transaction”, “check carefully your bank account and payment
card statements, when you get them”, “if you find a discrepancy in your bank account and
payment card statements (for example a transaction you have not made by your payment card,
the amount of a transaction is higher than it really was), you should contact your bank,
payment card issuer and complain about the transaction” and “if you have a suspicion that
data from your payment card were copied, you should contact police and the bank to stop-list
or block the payment card”. These common recommendations contribute to reduce the
skimming risk.
CONCLUSION
The ground of skimming fraud is to obtain sensitive information about a payment card when
the original data are copied from the magnetic strip on the payment card. The ground of
skimming fraud has been known for a long time, possibilities to reduce the skimming risk
exist, but in this year the number of skimming frauds in the Czech Republic has increased
dramatically. But not only banks, payment card issuers or payment system operator are
responsible for reducing of the skimming risk, payment card users are of great importance to
reduce it too. One of the problems in this field is an unsatisfactory financial literacy of
payment card users, breaking basic rules for safe using of payment card and low respect for
basic recommendations for reducing of the skimming risk. The switchover from payment
cards with magnetic strips to payment cards with chips will eliminate this risk, because the
skimming fraud is connected with payment cards with magnetic strips only.
BIBLIOGRAPHY
[1] BANK CARD ASSOCIATION: Types of frauds : Skimming (in Czech). Bank Card
Association [on-line]. [17 January 2012]. WWW:
<http://www.bankovnikarty.cz/pages/czech/media_bezpecnost.html#Skimming>.
[2] CZECH TELEVISION: Foreigners allegedly installed card readers on ATMs in Prague (in
Czech). Czech Television [on-line]. [19 February 2012]. WWW:
<http://www.ceskatelevize.cz/ct24/domaci/164694-cizinci-pry-montovali-v-praze-ctecky-na-
bankomaty/>.
[3] KLUFA, F., SCHOLZ, P., KOZLOVÁ, M.: Cashless payment frauds in the Czech
Republic (in Czech). Czech Consumer Association [on-line]. [10 January 2012]. WWW:
<http://www.konzument.cz/publikace/soubory/pruvodce_spotrebitele/A5_bezhotovostni_pod
vody.pdf>.
[4] KOLINA, J.: False card readers have been installed on bank branches in Prague recently
(in Czech). Lidovky.cz [on-line]. [17 January 2012]. WWW: <http://www.lidovky.cz/falesne-
ctecky-karet-jsou-uz-i-v-praze-primo-na-pobockach-pka-
/ln_domov.asp?c=A110201_203656_ln_domov_kim>.
[5] POLICE OF THE CZECH REPUBLIC: ÚOOZ SKPV : Skimming (in Czech). Police of
the Czech Republic [on-line]. [17 January 2012]. WWW:
<http://www.policie.cz/clanek/skimming.aspx>.
Gabriela Oškrdalová
Faculty of Economics and Administration, Masaryk University
Lipová 41a
Brno
oskrdalo@econ.muni.cz
172
TRENDS IN THE ORGANIZATION OF FINANCIAL
SUPERVISION OVER THE OCEAN
Dalibor Pánek
ANNOTATION
Text of the paper includes the curent issue of institutional arrangements and supervision of
financial market supervision in the United States and Canada with the aim of understanding
current trends in the financial system.
KEY WORDS
Financial supervision, institutional arrangements of supervision, financial system, financial
institutions risks
JEL classification: G100
INTRODUCTION
Regulation and supervision of banks with supervision of other financial institutions can be
traced back over three decades past. Regulatory and financial market supervision is given
special attention in connection with the liberalization of financial markets, the emergence of
national and multinational financial groups, the international harmonization of business rules,
financial institutions and resolving financial crises. The roots of the existence of regulation
and supervision of financial institutions are in the historical development of financial systems
of individual countries and are associated with the pursuit of stability and security operations
of financial institutions.
AIM AND METHODOLOGY
Aim of this paper is to describe and talk about the current trend of development and
organization of regulatory and supervisory systems in the United States and Canada. They
used methods of description and comparison.
TRENDS IN THE ORGANIZATION OF FINANCIAL SUPERVISION
OVER THE OCEAN
Canada
Canada's financial system is stabilized by long-term, methodologically sophisticated, retains
its resistance to internal and external negative influences. Stability was not compromised even
during the global financial crisis in the predominance of economic ties with the United States
of America. In the financial system are applied conservative care and preventive approaches
to stability.
The federal government has supervisory committee as a coordinating body for financial
institutions (IFCS-Financial Institution Supervision Committee), which sets the regulatory
173
policy of the country. Includes activities of the Ministry of Finance responsible for financial
supervision and four independent agencies:
- OSFI (Office of the Superintendent of Financial Institutions),
- Central Bank of Canada,
- CDIC (Canada Deposit Insurance Cooperation),
- FCAS (Financial Consumer Agency of Canada).
FICS regular five-year survey conducted by state legislation and the need for legal regulations
in force in the financial system for the central bank.
Central Bank of Canada is responsible for the performance of monetary policy, sets key
interest rates, shall submit regular reports Ministry of Finance, the lender of last resort and
provides loans to enhance liquidity and non-bank financial institutions if interest so requires
stability of the financial system.
The institution's deposit insurance in financial systém is Canada Depozit Insurance
Corporation /1967/. Deposits are insured up to 100 thousand dollars member banks of the
institution.
Office of the high key roles in supervision of financial institutions is established OSFI Office
of the Superintendent of Financial Institutions / 1987 . Institution is an independent
oversight agency for the Canadian government, the main objective is to support public
confidence in Canadian financial system. On the basis of a special law acts as the primary
regulator of federally operating banks, insurance companies and pension funds.
OSFI Supervisory Authority has the primary responsibility in proportion areas of assistance
aimed at minimizing the losses of depositors and shareholders. It sets out the capital adequacy
of the banking sector, usually at higher standards than the international rules.
The main responsibilities of OSFI:
- the conditions for the activities of financial institutions,
- evaluation of information obtained from financial sector and compliance with reporting
obligations of financial institutions,
- organization of regular meetings with management of financial institutions,
- authority in the presence and hearing about the results of discussions,
- assessing the risks of financial institutions and to become acquainted with results,
- advisory body to exercise oversight of corrective actions and monitor their performance,
- prepare an annual report on the financial sector for the Ministry of Finance.
The activities OSFI is internally organized into organizational units (sectors) methodology
reflecting the mission and goals of the institution supervision [1] :
- financial services sector,
- sector methodology.
USA
The basic supervisory authority in the United States is the Federal Reserve System (1913),
which shares responsibility for the regulation and supervision of financial markets. In addition
to the performance of monetary policy is focused to financial stability, protecting consumers
174
of financial services and participate with other bodies (particularly the Federal Deposit
Insurance Corporation) to the supervision of financial institutions.
The global financial crisis and a series of bankruptcies of financial institutions has opened
space for discussion and implementation of major changes regulatory and supervisory
USA. Has the need to increase the efficiency of supervision
The basic structure of supervision of financial institutions in United States is as follows:
- national commercial banks and branches of foreign banks supervised by the Office of
Comptroller of the Currency (OCC),
- financial and bank holding companies supervised by the Federal Reserve System alone
(FED),
- national and state commercial banks are supervised by the FED along with Federal
Deposit Insurance Corporation (if they are involved in the deposit insurance system),
- national and state savings banks are supervised by the Office of Thrift Supervision
(OTS),
- national and state credit unions supervised by the National Credit Union Administrativ
(NCUA)
- securities and Exchange Commission (SEC) has oversight responsibility of the
securities and exchange market,
- insurance corporations are regulated and supervised by the National Association of
Instances Commissioners (NAIC).
In July 2010, signed by President of United States of America [2] fundamental reform of
financial sector supervision. Surveillance system was expanded to include elements of the
functional organization of the creation of special institutions this mission:
- National Bank Supervisor ( NBS ) is part of the organizational arrangements of the
Ministry of Finance,
- Consumer Financial Protection Agency as an independent office of the acquiring
authority in protection of clients,
- Financial Services Oversight Council with task to reduce systemic risk and
coordination supervisory authorities of other financial market,
- Office of National Insurance (ONI) as part of the organizational structure of the
Ministry of finance is intended to coordinate the supervision of the insurance sector.
Major share of the financial crisis had a failure of major financial institutions and the current
system of regulation and supervision, with the lack of monitoring and detecting threats to the
risks undertaken. Decided by financial institutions (financial holdings) of the U.S. financial
markets were overseen by the FED. The financial crisis has revealed the need to strengthen
the supervizory in monitoring of potential systemic risk and its solution. Autonomy
monitoring program for the financial institution has limited options addressing the threat of
the entire financial systém. Due to the financial crisis proved to be a major strengthening
consolidated supervision of financial institutions, risk management and consumer protection.
175
CONCLUSION
The internal organization of institutions monitoring and targeting of the Canadian High
Authority for the supervision of financial institutions is evident its functional layout with
minimum content elements of a sectoral organization. Surveillance system as a whole
includes the principle of decentralization, financial sector supervision. Its current arrangement
corresponds to the historical development of the regulatory and supervizory with traditional
key roles the Ministry of Finance in Canadian financial system.
Changes in financial sector supervision in U.S. in its essence does not include elements of
integration of surveillance, the system shows no tendency to simplify the organization, there
are still possibilities of duplication in supervisory practice. New legislative and related
organizational structure of supervision in U.S. strengthens the functional elements of the
system, leaving the sector structure. There is not a tendency of integration of the supervisory
system, are still used traditional authority of state institutions.
BIBLIOGRAPHY
[1] PAVLÁT,V. - KUBÍČEK, A. Regulace a dohled nad finančními trhy. Praha: VŠFS
EUPRESS, 2010. 228 s. ISBN 978-80-7408-036-4.
[2] REVENDA, Z. Centrální bankovnictví. Praha: Management Press, 2001. 613 s.
ISBN 80-7261-051-1.
[3] HOWELLS, P. - BAIN, K. The Economics of Money, Banking and Finance. Pearson
Education Limited, 2005. 602 s. ISBN 0 273 69339 5.
[4] www.bankofcanada.ca (centrální banka Kanady)
[5] www.infosource.gc.ca (informační portál vlády Kanady)
Ing. Dalibor Pánek, Ph.D.
Ekonomicko-správní fakulta MU
Lipová 41a
602 00 Brno
Česká Republika
panek@econ.muni.cz
[1] OSFI: Organizational structure. [on line]
Available: < http://www.infosource.gc.ca / / www. osfi-bsif.gc.ca/osfi/index-e/ osfi-bsif.gc.ca/osfi/index-e /
[cited 10/10/2011]
[2] Act by Democratic Senator Christopher Dodd and a member of the House of Representatives, Democrat,
Frank Barney (note. Author)
176
THE USE OF VAR IN THE PROCESS OF TRANSACTION
SYSTEM RISK REDUCTION: THE EXAMPLE OF
DERIVATIVES
Radosław Pastusiak
ANNOTATION
The goal of this paper was to show the applicability of VaR risk management tool to increase
the efficiency of transaction system for the WIG20 futures traded on the Warsaw Stock
Exchange. For this purpose, a simple but presenting high efficiency trading system based on
data from the years 2003-2011 was built. It is a mechanical system, providing the investor
with specific values signaling the reversal of position in everyday trading. In such conditions
the system showed a maximum drawdown of capital of -804 points. Then the method of
historical simulation was used in order to calculate VaR for the series of analyzed data at the
confidence level of 0.95, which equaled -530 zł. The practical significance of these
calculations is high, because the calculated VaR was introduced into the transaction system
algorithm, yielding new parameters. The system shows the 4.000 points higher efficiency than
before, and lower maximum drawdown of capital.
KEY WORDS
Value at Risk, risk, capital market, technical analysis, mechanical system
JEL classification: G17, G14, G13, G12, G11
I. INTRODUCTION
The investments in derivatives market are characterized by high risk. This risk is understood
as the possibility of incurring severe losses, often excessing the possessed capital. The
investor active in the derivatives market is affected by psychological factors which generate
specific state of emotions, resulting in possible mistakes while making decisions. In order to
increase the chances of success in this market, the investor can apply a mechanical system
using an embedded algorithm which will assign him/her each day a specific signal depending
on the established position. Well set up mechanical system should generate profits in the
future. For the purpose of this paper liquid instruments with a relatively long trading period WIG
20 futures listed on Warsaw Stock Exchange (GPW) - were used. When using the
transaction system, the investor has to take into account the possible drawdown of capital
after a series of loss signals, and there is also the possibility of an unexpected event causing a
rapid change in value of the contract in the opposite direction to the position held by the
investor.
The goal of this paper is to show the functioning of the mechanical system for derivatives
using the VaR tool. It has been assumed that the VaR in the algorithm of the mechanical
system increases efficiency and eliminates the potential periods of horizontal trend in the line
of capital.
177
II. CHARACTERISTICS OF THE TRANSACTION SYSTEM FOR WIG
20 FUTURES
Nowadays, popular and frequently used mechanical systems are based on technical analysis
indicators. The advantage of mechanical systems is that generated signals are unambiguous.
This means that in every situation the investor knows exactly what to do. It is also important
that systems based on mathematical and statistical formulas are easy to test on historical data
and may also respond to real-time data. Despite the advantages, many users of this method
fail to succeed. Its application requires the subordination of investment decisions to the
signals generated by the system.
It is worth considering what is easier: the analysis based entirely on historical data or step by
step analysis of current situation? Both undoubtedly require a broad knowledge and skills.
The difference is that the latter is accompanied by emotions. The market often creates
situations suggesting increasing the position, its closing, searching for peaks or valleys. In
emergency situations the investor often closes prematurely profit position or worsens a loss
position1
. Every success and failure results in positive or negative emotions affecting future
behaviour. Building and using mechanical transaction systems can completely eliminate the
investor’s sentiment. The analysis itself is carried out by means of calculation giving in result
the signal: "buy" or "sell". The investor who uses a mechanical strategy is responsible only for
order processing2
. Lack of sufficient confidence in the system means that the investor does
not execute all commands and independently tries to find a convenient position to close the
transaction. Therefore, self-construction and in-depth testing of the system allows for a
required state of trust and confidence in the correctness of its decisions. Custom design allows
the investor creating a model that will bring a satisfactory rate of return and acceptable level
of losses3
.
The purpose of using a mechanical transaction system is to minimize losses and maximize
profits. When building the system, it must be remembered that technical analysis is just a set
of observed phenomena recurring in time. Transactions in the stock market, that are executed
via investment system based on technical analysis indicators, will also be recurring in some
way. If the number of transactions is high enough, they will be distributed in a way that is
possible to predict with some approximation. It is important that the technical methods of
market analysis are not very precise and measurable - just as the market - and therefore are
not infallible. Users of this method must accept the fact that every profit generates specific
costs. When analyzing the system one should therefore carefully review the relationships
between profit and loss positions. The use of the investment system is generally justified in
the long run. In a short period of time it may happen that the investor closes a few/several loss
transactions, which are in completely no relation with calculations and expected efficiency of
the system. However, based on statistics and probability, it is certain that in the long run
profits and losses will be offset and the efficiency of the system will be similar to the
efficiency calculated by the investor. The integrity of the system depends on a number of
principles which have to be followed when designing the algorithm4
.
Before starting the investment, the expected level of profit has to be determined. The
universal approach would be to determine the annual rate of return, which will indicate the
accuracy of the whole system. It is noteworthy that the higher are the expectations the greater
will be the risk. Determination of the maximum capital drawdown will allow for specifying
the size of losses, which will be acceptable to the psyche of the investor. This is an important
1
See also: Elder A., Zawód inwestor giełdowy, Oficyna Ekonomiczna, Kraków 2001
2
Gazeta Parkiet webpage: http://www.parkiet.com/artykul/14,322057.html, April 2010.
3
LeBeau C., Lucas D. W., Komputerowa analiza rynków terminowych, Warszawa 1999, p. 4
4
Schwager J.D., Analiza techniczna rynków terminowych, WIG Press, Warszawa 2002, p.594
178
element in the period in which the system makes a series of incorrect decisions. The
predefined level of drawdown shows how much the investor’s psyche and, above all, his
portfolio can endure and not fall out of the market and how big losses in relation to the whole
possessed capital the investor should withstand till the moment of the upturn of the capital
curve and the return to growth trend.
For the purpose of this paper a simple mechanical system was developed. The algorithm of
the system focuses on the analysis of the difference between maximum and minimum values
of futures over the past five trading days. It looks like below:
( ) ( ) ( ) ( ) ( )
18
0011223344 MinMaxMinMaxMinMaxMinMaxMinMax
S
−+−+−+−+−
= −−−−−−−−
where:
S – signal
Max-4 – maximal value in contract points four days back
Min-4 - minimal value in contract points four days back
Max-3 – maximal value in contract points three days back
Min-3 - minimal value in contract points three days back
Max-2 – maximal value in contract points two days back
Min-2 - minimal value in contract points two days back
Max-1 – maximal value in contract points one day back
Min-1 - minimal value in contract points one day back
Max0 – maximal value in contract points on the day
Min0 - minimal value in contract points on the day
The number 18 in the denominator of the algorithm allows for the averaging of system
indications and in the analyzed period of trading (9 years) shows the adaptation of the system
to the downward, horizontal and growth market. The initial capital required for one contract is
10.000 zł. Detailed results of the system are shown in Table 1 and Figure 1
Fig 1. Summary of the transaction system for WIG 20 futures in the years 2003-2011.
Initial capital in zł 10.000
End capital in zł 98.620
Net profit (without reinvestment) in points 8.862
Average annual rate of return 98,46%
Investment period 9 years
Number of transactions 1418
Average duration of established position 1,6 days
Profit transactions 658
Accuracy 46,4%
Average profit from profit transaction in points. 40,5
Loss transactions 760
Accuracy 53,5%
Average loss on loss transactions in points - 29,4
Maximal drawdown of capital in points - 804
Source: Author’s elaboration
The system is highly profitable, despite the advantage of the number of loss transactions the
average profit significantly exceeds the average loss. Transaction costs were estimated at 2
points. The system was developed using " data snooping", but a long period of testing (as well
as profitability analyzed under different market conditions: bull market, bear market,
consolidation) indicates the possibility of its successful use in real life.
179
The introduction of additional protection based on VaR to the system can contribute to
reducing the maximum drawdown of capital and shortening of the period of capital curve
consolidation in the period between quotations 1750 to 2100.
III. APPLICATION OF VALUE AT RISK INDICATOR
VaR (Value at Risk) can be defined as the maximum loss of market value of portfolio or of
financial instrument, possible to bear in a specified period of time and at a given confidence
level.
The use of Value at Risk is associated with a number of benefits which include the following
aspects5
:
• VaR enables uniform formulation of various types of risk;
• Takes into account the diversification of the portfolio;
• Having appropriate data on realized losses that exceed VaR it can be relatively easy to
verify this method;
The VaR method has advantages but also disadvantages:
• In situations where the loss exceeds VaR a company has no information regarding the
level of expected losses;
• In certain situations it might be impossible to distinguish between portfolios in terms of
risk, although their risks are obviously different;
VaR depends on two elements that should be determined by the management of every
company. These parameters are:
Significance level (for example, JP Morgan uses 0.05, and the Basel Committee 0.01) - the
significance level, which is close to 0 can also be used interchangeably with the confidence
level, which is the difference between 1 (100%) and the significance level. When the
significance level is lower (confidence level is higher), the VaR is higher6.
An important criterion for the VaR is the time horizon. Banks typically use one day, but
businesses can take periods of up to 1 month. The longer the time horizon, the higher the
value of VaR.
Consequently, the VaR can be written as an equation:
( ) α=−≤ VaRWWP 0
where:
α - the significance level ,
W - value of the portfolio (instrument) at the end of the period, defined as a random variable,
W0 - the current value of the portfolio (instrument).
In case of the analyzed scheme, the VaR was calculated with the use of historical simulation
method. On the basis of a distribution of 2263 daily rates of return from the system, the
following procedure was applied:
• The first step is to obtain a series of percentage changes of prices for the established
position throughout the analyzed period,
• The results should be sorted in ascending order,
• The last step of calculating Value at Risk is to determine the percentile adequate to the
desired level of confidence - a result of this step gives the value of VaR.
5
See: Jajuga K., Kuziak K., Papla D., Ryzyko rynkowe polskiego rynku akcji – Value at Risk i inne metody
pomiaru [in:] Rynek kapitałowy: skuteczne inwestowanie część I., Uniwersytet Szczeciński 2000
6
Jajuga K., Miary ryzyka rynkowego – część trzecia, Rynek Terminowy no. 8/2000
180
The value corresponding to the probability level equal to 0.95 is -5.3%, which means a
possible drawdown of the capital of 530 zł on a single trading day. This information can be
used in current trade but also as an additional variable in the developed algorithm.
In order to use VaR to protect the capital against the negative influence of a random factor, an
additional protection in the form of the maximum daily loss limit of -53 points was
introduced. When this value is reached, the investor closes the position, and opens it again in
the final fixing. The time series analysis of daily volatility of futures during the nine years
period showed that it has worked in dozens of cases. Fig 2 shows the new transaction system
parameters.
Fig 2 Summary of the transaction system for WIG 20 futures in the years 2003-2011 with
capital protection at the level of VaR.
Initial capital in zł 10.000
End capital in zł 134050
Net profit (without reinvestment) in points 12405
Average annual rate of return 137,83%
Investment period 9 years
Number of transactions 1418
Average duration of established position 1,6 days
Profitable transactions 658
Accuracy 46,4%
Average profit from profit transaction in points. 40,5
Loss transactions 760
Accuracy 53,5%
Average loss on loss transactions in points - 24,5
Maximal drawdown of capital in points - 559
Source: Author’s elaboration
Compared to the system version without the capital protection level, the system’s efficiency
improved significantly by 3543 points and the maximum loss on capital also decreased to 559
points. Thus, the average loss on transaction fell from 29.4 points to 24.5 points. In this
perspective, it is clear that the use of additional level of protection yielded positive results in
form of increased efficiency and lower value of capital exposed to loss.
However, the influence of VaR on the consolidation of capital is low. The system still shows
a horizontal trend between quotations 1750 and 2100, although this time without such a large
capital decline as before, but it should be noted that the use of VaR changed little in this
regard.
IV. RESULTS
The goal of the paper was to show that VaR can be a good way of increasing the efficiency of
the transaction system and can eliminate the potential periods of the horizontal trend in the
line of capital. The goals were achieved partially. Indeed, the use of VaR calculated using the
historical simulation is an interesting solution, significantly increasing the efficiency of the
system, but in this case it does not reduce the period of horizontal trend of capital generated
by the transaction system. Despite this, the VaR instrument is an interesting alternative for
investors using mechanical transaction systems. When using this solution in practice, the
following restrictions should be taken into account:
• VaR assumes a "normal" functioning of the market. VaR-based risk measurement gives
correct results only when there are no unusual, extreme situations in the market,.
• VaR gives the probability that the loss should not exceed the predefined level, but says
nothing about the possible size of loss in extreme situations.
181
This means that investor in the derivatives market must be prepared for various unusual
scenarios that have not yet emerged in the historical data. In addition, it is worth noting that
the transaction system used here is very specific, in particular:
• The capital line does not take into account the taxation of income,
• The adjusted system with protection level on the VaR line does not include transaction
costs of protection activation and delayed market entry,
• The analysis of cases of particularly high daily volatility showed situations where, during
the session, the level of protection was activated but later the market changed the direction
and, consequently, the final loss was lower than the protection level. The algorithm of the
system did not take into account such situations, which in some cases during the analyzed
period, resulted in overstatement of the loss.
BIBLIOGRAPHY
[1] LeBeau C., Lucas D. W., (Compter analysis of future market) Komputerowa analiza
rynków terminowych, Warszawa 1999,
[2] Elder A., (Occupation equity inwestor) Zawód inwestor giełdowy, Oficyna Ekonomiczna,
Kraków 2001,
[3] Jajuga K., Kuziak K., Papla D., (Market risk the Polish stock market - Value at Risk
and other methods of measurement) Ryzyko rynkowe polskiego rynku akcji – Value at Risk i
inne metody pomiaru [in:] Rynek kapitałowy: skuteczne inwestowanie część I. Wyd.
Uniwersytet Szczeciński 2000,
[4] Jajuga K., (Measures of market risk – part three) Miary ryzyka rynkowego – część trzecia,
Rynek Terminowy no. 8/2000.
[5] Murphy J. J., (Technical analysis) Analiza techniczna, Wig Press, Warszawa 1995,
[6] Schwager J.D., (Technical analysis of futures markets) Analiza techniczna rynków
terminowych, WIG Press Warszawa 2002
[7] Tharp Van K., (Exchange, freedom and money. Speculator's Guide) Giełda, wolność i
pieniądze. Poradnik spekulanta, WIG-PRESS, Warszawa 2000,
[8] Witryna Gazety Parkiet - http://www.parkiet.com/artykul/14,322057.html, April 2010
Dr Radosław Pastusiak
Center of Corporate Finance
Faculty of Economic and Sociology
University of Łódź, Poland
Ul. Rewolucji 1905 r nr 39
90-255 Łódź
rpastusiak@uni.lodz.pl
182
RISK FACTORS OF CONTEMPORARY „FINANCIAL
CRISIS“ AND THEIR INFLUENCE ON FUTURE
DEVELOPMENT OF WORLD ECONOMY
Oldřich Rejnuš
ANNOTATION
The article deals with problems of contemporary “financial crisis” that appeared in 2008 and
subsequently developed into very serious global economy crisis. First of all, factors that lead
to the crisis are identified, consequently, their influence on contemporary developmental
trends, intruding operation of world financial system and endangering future development of
world economy are analyzed. At the same time essential issues regarding future “market
economy", which depends on contemporary society are formulated.
KEY WORDS
Financial crises, risk factors, economic crisis, financial markets, global economy, market
economy, critical factors, state regulation, quantitative easing,
JEL classification: G01
INTRODUCTION
There is a number of opinions on the causes and origin of contemporary “financial crisis”;
these opinions are neither unanimous, nor clarifying. Nevertheless, it cannot be called into
question that a deep economic crisis appears all of a sudden; its causes are formed step by
step. As this is the most important crisis that arose since the Great economic crisis in 1929, it
is necessary to analyze it in details. Unless its causes are eliminated, it might not be solved
satisfactorily. And in case it is solved after all, it might come again in the future; considering
ongoing globalization of financial system, functioning of global world economy might be
totally endangered.
AIM AND METHODOLOGY
The goal of this paper is to specify the most important risk factors that lead to contemporary
“financial crisis” and consequently to analyze how they participate in contemporary negative
development trends that might seriously disrupt allocation function of the whole globalized
world financial system and endanger functioning of world economy.
RESULTS
Despite economic crises evince many common features, each of them is specific. This applies
also to contemporary “financial crisis” that started in 2008 by failure of financial system in
the USA and consequently spread quickly to economically most developed countries of the
world. It is undisputable that this crisis did not emerge suddenly; it resulted from a number of
negatively impacting factors over a long period; as they were not solved, they developed into
following negative development trends.
183
1. Process of growing indebtedness of economic subjects
This is an exceptionally important trend, very specific for contemporary “financial” crisis. Its
importance is enhanced by the fact that it is connected with indebting of all kinds of economic
subjects, households, companies as well as states.
 Household indebting is connected with the politics of governments of economically
developed countries and their central banks to increase domestic consumption and to
support economic growth on one hand, and with effort of companies to increase their
revenues by means of sale support of goods and services on the other hand.
 Indebting companies is based on widely spread opinion that external funding resources are
cheaper than internal funding resources on one hand and on demands of partners
(shareholders) to maximize profit and payment of shares (dividends) on the other hand.
This is the reason why most companies get indebted more and more and in case that
economic situation worsens, they are more susceptible to bankruptcy.
 Indebting of (most) states is growing as a result of long term deficit fiscal politics of
governments of individual states on one hand and as a result of the fact that expenses of
regional governments are higher than their incomes1
.
It is clear that in case the trend of growing indebtidness of economic subjects keeps growing,
it will be more and more difficult to fund them, since their debt costs will grow due to the
growth of risk of possible insolvency. Finally it might result to the possibility that the
investors might lose their confidence in their debt instruments, which would prevent them
from having access to financial markets. This might result in household insolvency,
bankruptcies of banks and other subjects or even to collapses of state finances of heavily
indebted countries.
2. Growth of differences in economic and political power of individual subjects
This developmental trend is based on gradual growth of differences between states,
corporations and even individuals (households) in terms of their economic and political power
or their influence on human society:
 Economic (political) power of states is employed in their foreign policies; economically
strong states enforce their will to weaker countries. This is made directly by means of
bilateral contracts or by means of membership in international or supranational institutions,
where important states usually have bigger power.
 Economic power of corporations becomes evident especially in case of “supranational
companies”; many financial institutions belong among them. Their economic power is
based on their economic results, as they are sometimes higher than VAT of smaller
countries on one hand, and they get majority position in their fields on the other hand. This
leads to restriction of competition and pushes market conditions to those of oligopoly in
which they try to get as important position as possible on the other hand. It has been proved
that gradual growth of size of corporations is connected with their growing economic
power, which enables strong lobbing and might lead to political influence. Supranational
corporations often move their production to developing countries with a goal to minimise
production costs (especially payroll costs). This results in production restriction in home
1
US public debt reached nearly 16 trillion USD; European Union debts have exceeded the value of 12 trillion €.
184
countries; goods produced abroad has to be imported to those countries and consequently
decreasing number of job opportunities, creating business balance deficit. As it is possible
to establish daughter companies anywhere in the world, legislative differences in individual
countries are taken into account for this purpose to make use of „transfer pricing“.
 Dominant position of individual in society represents an important factor that has
developed into an important development trend. It can be characterized as always growing
increasing of incomes2
(and consequently value of owned property) of individual
members of society. It results in growing number of “millionaires” or “billionaires“, who
so often enforce special privileges within human society. This would not cause a problem
in case that the differences in incomes of individuals were based on merit and contribution
of individuals to their society. In fact, this is often made by means of breaking law
(hidden) and bribery. In some countries, it can even be connected with misuse of state or
business functions, possibly even without any possibility of personal sanction (immunity).
The worst think is, that all those “tunnelled” values are consequently transformed to debts
of individual states, which means to the back of “common” taxpayers.
All above mentioned facts lead to the fact that market competition is declining. It means that
fair prices are not created any more. Without fair (market) recognition, contemporary
economy cannot work effectively.3
3. Creating new sorts of synthetic derivative instruments
New sorts of financial investment tools are presented and offered in the market. These are
often not instruments that would be beneficial for the economy; these are mostly investment
instruments made on purpose, bringing prosperity before all to their issuers. The most
problematic factors we face in the process of creating new sorts of financial investment
instruments are considered creating new sorts of derivative investment instruments (so called
structured products), derived from many sorts of different underlying assets as well as
calculated use (or misuse) of securitization:
 Creating structured products can be characterized as constructing new, often
purposefully very complicated sorts of synthetic financial investment tools based on the
principle of derivation from various underlying assets.4
Even in case that there are specific
regulation restrictions in different countries, these often rather risky instruments are almost
without any restrictions offered to investors, due to liberalization and internationalization of
contemporary financial market.
 Purposeful utilization of securitization is based on transformation of non-liquid financial
investment assets (before all loans) to marketable securities. This is, of course perfectly all
right, unless investors are disadvantaged. But in case these transformations are purposefully
2
In some cases, top managers in the US get salaries exceeding average salaries by many hundred times (eg.
US).
3
see Zelený, M. Geneze krize [5].
4
This means structured deposits, structured bonds, securities of collective investment structure funds and
securitized derivatives - see Rejnuš, O.: Finanční trhy, s. 579-660 [2].
185
very complicated and nontransparent5
, they enable to transfer bad quality assets and for
much higher prices than those negotiated for case of their direct sale.6
Creating new synthetic derivative investment instruments leads to growing number of
securities that are not directly connected with real economy and represent only a certain
intergrade without any real economic benefit. Most often, their issuers profit from them
(mostly financial institutions) mostly to the detriment of investors. Issuing these obligations
supports creating so called: „pyramidal superstructure“. It grows or fails depending on the
growth or fail of their basis, or, in other words, with growth or decline of prices (values) of
underlying assets from which individual “superstructural” investment instruments are, directly
or indirectly, derived.
Based on previous analysis of the most important contemporary negative development trends,
a question comes into mind, what essential measures were taken since the beginning of
contemporary “financial crisis” in individual countries and supranational economic entities
and whether they proved successful.
As far as indebtedness issues are concerned, the US government “solves” it, together with
FED policy, by means of so called “quantitative easing”, which is nothing but continuation of
extreme state expenses. It leads to further increase of American state debt, which means this is
not an effort to solve contemporary crisis. To the contrary, the European Union (primarily
Euro zone countries) tried to solve the problem (until recently) the other way, by cost-saving
fiscal policies of individual states. Of course, this threw the weakest countries into recession,
that was accompanied by disproportionately high unemployment and was followed by social
unrest. This led to strongly increased risk of their possible bankruptcy and failure to pay back
their obligations, which would seriously jeopardize existence of many (chiefly European)
banks and commencement of so called avalanche spreading of bank crisis. This is why the
European Union management, together with European Central Bank and with support of the
International Monetary Fund, started to implement similar supportive policy as the US.
As far as decaying market competition is concerned, this problem is solved neither in America
and Europe nor in other parts of the World. On the contrary. Both the strongest countries of
the World and important companies are trying to strengthen their dominant position. At the
same time, influence of rich individuals is increasing; they are not only representatives of
steering bodies of important corporations, they are represented in governments and
parliaments of most countries and they often advance their own interests. This leads to
distortion of market environment, without which contemporary economy cannot work7
and, at
the same time, the principle of equal rights of citizens is infringed.
As far as creating harmonized international regulation, focused on business activities of
financial institutions and properties of publicly marketable instruments are concerned, this
problem is not satisfactorily solved either. The European Union has established several
5
Real value of securitized assets is only known to the relevant financial institution, where newly issued securities
are usually divided into several, by rating differently assessed tranches.
6
These are so called „Assed Backed Securities” [ABS] – see Rejnuš, O. Finanční trhy, s. 613-627 [2], or Jílek,
J. Finanční a komoditní deriváty v praxi [1].
7
It is impossible to set fair (market) prices without market competition; economy cannot work effectively
without them.
186
institutions, but has not solved anything yet and the US have even cancelled the most
supplementary regulation measures that had been accepted some time ago. It is clear that
different legislation of individual states, that is based on different principles, makes the
possibility of international harmonization of regulation principles much more difficult and
that, without unified regulations, there will always be ways how to circumvent regulation in
individual states.
It seems to be clear that the solution of all aforementioned crisis factors is highly problematic
and cannot be successful without close international collaboration. However, now, individual
countries and supranational economic associations8
try to solve their economic problems very
individually. The reason is, first of all, based in the fact that most politicians are concerned on
their own political success and they prefer political success of their own countries or political
parties and this is why the solutions they advance are not always optimal from the point of
view of economy. Another factor is the way how parliamentary democracy works. The fact,
that functional term of office of politicians (and it is the same in case of economic bodies of
companies) is restricted, they prefer short-time solutions to long-term ones, to sophisticated
strategies.9
This leads to further worsening of economic crisis and postponing it indefinitely.
CONCLUSION
Above mentioned facts show that contemporary “financial crisis” will surely not be solved in
the nearest future. On the contrary, we can reasonably expect that contemporary trends of
European Union business policy (especially Euro zone) and the US will be more and more
confronted with intentions of the most important Asian or other countries, where interests of
„BRIC“10
countries must not be undervalued. Since we can reasonably assume that politics of
quantitative releasing of the US, enforced over a long period, and strong monetary expansion
focused on rescue of European banks or bankrupting European Union countries will cause
high inflation in the future, which will be followed by distinctive weakening of US dollar and
Euro. It will give rise (even in case that the Euro zone will retain) to strong financial market
shocks. It will lead to currency turbulences that will impact the whole world and
consequentially will lead to global financial and global world economic crisis. It is supposed
to be much more intensive than any other crisis in the past and it might bring immense
consequences for the whole mankind.
BIBLIOGRAPHY
[1] Jílek, J. Finanční a komoditní deriváty v praxi, Praha, Grada Publishing, 2005.
ISBN 80-247-1099-4
[2] Rejnuš, O. Finanční trhy, 3. rozšířené vydání, Ostrava: Key Publishing, 2011, 679 s.
ISBN 978-80-7418-128-3
[3] Rejnuš, O. Globální finanční krize a její hodnocení z hlediska budoucího vývoje světové
ekonomiky, Trendy ekonomiky a managementu, ročník III, číslo 5, 2009, s. 37-49. ISSN
1802-8527
[4] Seknička, P. Ekonomie regulace: Lekce z globální finanční krize, s. 19-42, Praha,
nakladatelství Vladimír Lelek, 2011. ISBN 978-80-904837-0-5.
[5] Zelený, M. Geneze krize, http://blog.aktualne.centrum.cz/blogy/milan-zeleny.php?
itemid=5788
[6] http://usdebtclock.org
8
Before all, European Union is concerned.
9
Particular example of such nonconceptual operative decision making is decision of German government on
cancelling nuclear power engineering for the sake of results of future elections.
10
These are Brazil, Russia, India and China.
187
[7] http://www.google.com/publicdata/explore
[8] http://www.verejnydluh.cz/
Full name: prof. Ing. Oldřich Rejnuš, CSc.
Institution: Masaryk University, Faculty of Economics and Administration
Street: Lipová 41a
City: Brno, Czech Republic
Email: rejnus@econ.muni.cz
188
THE IMPACT OF THE FINANCIALAND DEBT CRISES ON
THE INVESTMENT ACTIVITIES OF INSURANCE
COMPANIES
František Řezáč
ANNOTATION
Financial and debt crises have not significantly influenced the activities of insurance
companies, especially their investment activities. Using methods for the analysis to show that
the European insurance market and insurance market in the Czech Republic there was little
change in the financial position of insurance companies available funds. The paper aims to
analyze current trends and structure of investment activities of chosen insurance companies in
the Czech Republic. The comparison of investment activities in European and Czech
insurance markets is also provided.
KEY WORDS
Financial and debt crises, investment activities of insurance companies, investments, financial
instruments.
JEL classification: G 22
INTRODUCTION
Following the 2008 financial crisis in the United States, the conditions of investment activities
of financial institutions became constricted in the European Union as well. The situation is
further amplified by the current debt crisis in Europe, which not only affects the
macroeconomic conditions and indicators, but also has a significant impact on the
competitiveness and threatens the existence of the European economic community. For
insurance companies, it resulted in the increased capital requirements and stricter rules for
investing available funds from company’s technical provisions into different financial
instruments.
Capital requirements for domestic insurance companies depend on the nature of insurance
business and are specified in the Insurance Act. Commercial insurance company is also
required to establish technical provisions to cover the liabilities of insurance or reinsurance
activities, the time of occurrence and amount for which are not entirely specified. The
Insurance Act regulates the formation and usage of technical provisions, as well as the
structure of investments. Additional statute of the Czech National Bank defines the limits of
investing into particular financial instruments on the financial market.
AIM AND METHODOLOGY
The aim of the paper is to analyze trends in the allocation of available funds by the chosen
Czech insurance companies as well as the structure of their investments from the beginning of
financial and debt crises till the present times. Methods of description and content analysis are
implemented in the discussion of the problem.
189
RESULTS
The objective of investment activities is to appreciate the capital of the insurance company.
Therefore, insurance company must invest the available funds in way that it could be able to
fulfill the obligations to clients at any time in the future. Insurance companies invest
temporarily available funds from their technical provisions and equity capital in order to
appreciate it on the financial market.
For the analysis of investment activities of insurance company, it is necessary to differentiate
investment activities for the purposes of life insurance and investment activities for purposes
other than life insurance. When technical provisions of life insurance funds are invested, the
emphasis of the investment choices is on safety and return, if the necessary liquidity is
certainly ensured. Safety and liquidity are two basic parameters in the case or investing
technical provisions of other insurance activities. When the certain level of risk and liquidity
is reached, the aim of the maximization of returns might be addressed.
To meet the requirements for investment activities, insurance companies should be guided by
the following principles:
• Safety – all investments should provide a guaranteed return;
• Profitability – all investments should ensure profits from its holding or sale;
• Liquidity – all investments, especially those of technical provisions, should ensure the
availability of funds to cover claim payments of insurance companies as quickly as
possible;
• Diversification – all investments should be spread among greater number of
companies and other legal entities, which could not have any common owners or other
influential relationships.
Figures 1 and 2 illustrate the difference between investment activities of European insurance
companies and the situation on the Czech insurance market.
Fig.1 Investment activities of European insurance companies according to Comité Européen
des Assurances - CEA
Source: Comité Européen des Assurances - CEA
190
Certain observations might be derived from the comparison of these graphs:
• Clear long-term trend of asset growth is evident on the insurance market of both
European Union and Czech Republic.
• Both insurance markets prefer investing in safer financial instruments, however on
different levels.
• The overall situation on insurance markets show that the global financial crisis did not
have a significant impact on market developments, what is an extremely different
result comparing to other financial markets (for example, banking market)
• It is still not clear, how European debt crisis has affected insurance market. However,
considering the fact, that insurance companies invest considerable amount of their
funds into government bonds, it became obvious that further financial troubles of
several countries, such as Greece, Ireland, Portugal, Spain or Hungary, might lead to
unexpected losses.
• Investment managers of insurance companies have to reassess company’s investment
portfolio and find alternative ways for investing funds.
• Any losses from risky financial instruments might lead to the decrease of assets, which
threaten the obligations of the insurance company to cover claim payments committed
previously.
• The problem might be addressed by the implementation of the first pillar of the
Solvency II EU Directive, which set out qualitative and quantitative requirements for
solvency capital, technical provisions and investment activities.
Fig. 2 Assets and financial activities of Czech insurance companies according to the Czech
Insurance Association - ČAP
Source: Czech Insurance Association – ČAP
According to the 2007 annual report of the Czech Insurance Association1
(before the financial
crisis) the assets of ČAP members have been increased by 6.6%, when in the previous year
the growth was 3.7%. A similar growth of 4.1% in investment activities was recorded, while
in the previous year investment activities grew by only 2.2%. Since 2001 debt securities
1
The annual report is available at: www.cap.cz/CZ_vyrocni_zprava_2007
Total assets
Investments
Debt securities
Stocks and other
securities
Direct investments
Deposits in financial
institutions
191
played the most significant role in investment activities of insurance companies. In 2007 the
share of debt securities in the investment portfolios of insurance companies was around 70%,
while deposits in other financial institutions formed only 10% of portfolio.
The 2007 annual report of the Czech Insurance Association2
(the beginning of the financial
crisis) reveals early signs of the possible impact of the financial crisis, when life insurance
activities had a significant decrease and led to the cumulative losses of 9.5 million CZK. The
losses were mainly caused by losses from investment activities. Other insurance activities
resulted in the amount of 5.1 billions CZK and stayed at the same level as in the previous two
years.
The 2008 annual report of the Czech Insurance Association3
confirmed the stability of the
insurance market and its positive developments despite of the economic instability and
financial turmoil. However, the impact of the financial crisis on the financial results of ČAP
members is apparent, since the total volume of insurance premiums increased by 3.1% to
141.4 billion CZK. Annual asset growth had slightly accelerated from 6.7% to 7.3%, while
investment activities increased by 5.4% in 2008 against the 6,3% growth in the previous year.
The nature of investment activities has remained largely unchanged. Nevertheless, the share
of debt securities in the investment portfolios of insurance companies increased from 74.9%
to 78.6%. The share of bank deposits decreased from 9.6% to 8,1%.
In 2010, Czech Insurance Association4
evaluated a slight slowdown in insurance companies’
asset growth, when assets of its members comprise 431.3 billion CZK (328.8 billion CZK in
2009), a growth of 7.5% against the growth of 7.8% for the previous year. The share of debt
securities in the investment portfolio was 79.1% (similar to previous years). Bank deposits
have been accounted for 8.2% share in the investment portfolio of insurance companies.
Figure 3 discloses the investment portfolio of Česká pojišťovna in years 2008-2010 as an
example of investment activities in the insurance market of the Czech Republic.
Fig. 3 Investment activities of Česká pojišťovna, a.s.
Text. Text. Text. Text. Text. Text. Text. Text. Text. Text. Text. Text. Text. Text. TText.5
Section Title
Source: The 2010 annual report of Česká pojišťovna, a.s.
2
The annual report is available at: www.cap.cz/CZ_vyrocni_zprava_2008
3
The annual report is available at: www.cap.cz/CZ_vyrocni_zprava_2009
4
The annual report is available at: www.cap.cz/CZ_vyrocni_zprava_2010
Other investments
Investments by fair value
Investments for sale
Investments hold till maturity
Loans
Equity holdings
Real estate
192
The difference between the revenues and expenses from insurance company’s investment
activities is also of particular interest to our study. As an example, such indicators for
Generali pojišťovna in years 2006-2010 are reported in Figure 4.
Fig. 4 Revenues and expenses from investment activities of Generali pojišťovna, a.s.
Source: The 2010 annual report of Generali pojišťovny, a.s.
Neither the changes in amount of investment activities nor the differences between the
revenues and expenses from investment activities do not confirm general assumptions for the
significant negative impact of the financial crisis on the insurance market in the Czech
Republic. Czech insurance companies did not suffer from significant decrease in assets or
unexpected shortcomings in investment activities.
CONCLUSIONS
Reported results of investment activities of insurance companies in the period 2008-2010
reveal that investment activities of European insurance market or Czech insurance market
were not significantly influenced by the global financial crisis. The investments in debt
securities are still preferred, while the share of bank deposits in the investment portfolio of
insurance companies is declining. Therefore, insurance market remains stable and is yet able
to flexibly respond to developments on the financial market.
However, still deepening debt crisis in Europe could affect the investment activities of
insurance companies in a more damaging way through threatening the usage of different
financial instruments. The decrease in such activities might be caused by the following
situations:
• Less amount of insurance premiums due to the decline of living standards and
business revenues (decline in personal and business incomes first of all lead to the
rejection of insurance services)
• The deterioration of conditions for investing available funds into different financial
instruments on the financial market.
The decrease in such activities might have an impact on the following indicators:
• Lower returns on investments
• Inability of insurance companies to cover insurance claims
• Lower clients’ trustworthiness in insurance companies
• Higher legal risks for insurance companies
193
To conclude, it should be stated that insurance companies will probably be able to handle the
changing situation in financial markets and their investment activities will not change
significantly in the future.
BIBLIOGRAPHY
CHONG, Yen Yee. Investment risk management. 1. [s.l.] : [s.n.], 2004. 223 s. ISBN 0-470-
84951-7.
MAJTÁNOVÁ, A., DAŇHEL, J., DUCHÁČKOVÁ, E., KAFKOVÁ, E. Pojišťovnictví –
Teorie a praxe. 1. vyd. Praha: Ekopress, 2006. 288 s. ISBN 80-86929-19-1.
ŘEZÁČ, F. a kol. Marketingové řízení komerční pojišťovny. 1.vyd. Brno: MU, tisk:
BonnyPress, 2009. 210 s. ISBN 978-80-210-4799-0
ŘEZÁČ, F. Řízení rizik v pojišťovnictví. 1. vyd. Brno: Masarykova univerzita, 2011.
222 s. ISBN 978-80-210-5637-4
Czech Insurance Act (Zákon č. 363/1999 Sb., o pojišťovnictví)
Official web pages of Czech insurance companies
Ing. František Řezáč, Ph.D.
Masaryk University
Faculty of Economics and Administration
Lipová 41a, 602 00 Brno
rezac@econ.muni.cz
194
AN ANALYSIS OF UNSUCCESSFUL MERGERS IN THE
CZECH ENVIRONMENT
Jaroslav Sedláček, Kristýna Kuhrová
ANNOTATION
Mergers are perceived as strategic decisions made by owners (and the management) of a
company which bring significant changes of the activity of the company. A successful merger
can cause a concurrence of several individual factors affecting the company and thus increase
its economic performance and stability. However, in the case of an unsuccessful merger, the
resulting impact of all factors can be so negative that it can threaten the very existence of the
transformed company. The great risk related to mergers provides inspiration for their deeper
exploration and publishing of results in scientific papers and professional literature. Although
there is a lot of theoretical knowledge and studies published, the proportion of unsuccessful
mergers is not negligible and this situation has been unchanged for a long time. This paper
deals with the identification of unsuccessful mergers in the Czech Republic and the
comparison of their development with the published data.
KEY WORDS
company transformations, types of mergers, merger development, unsuccessful
mergers,macroeconomic environment, regression and correlation analysis
JEL classification: M 21, G 30
INTRODUCTION
The first mergers and acquisitions were reported at the end of the 19th
century, when a need
for greater investments in business appeared in the USA together with the effort to strengthen
the position of some companies at the market. These mergers mainly provided a horizontal
growth of monopolies within an economic field. At the beginning of the 20th
century, the
interest shifted to oligopolies and vertical combinations were implemented (upstream or
downstream mergers). The motivation for company combinations then changed gradually
from the effort to enter unrelated fields (conglomerate mergers), to combine companies
similar in field but with a different production (congeneric mergers), and finally at the end of
the last century to the effort to gain a target company in a different country. In the last decade,
mergers and acquisitions are mainly motivated by globalization, support by governments, and
growth of private equity funds. This uneven development of mergers and acquisitions,
referred to as merger waves, has been a subject of many studies and publications analysing
the causes and also consequences of these mergers. For more see e.g. Allen & Overy (2011),
Bruner (2004), Martynova and Rennebook (2008) and Lipton (2006). Although we can
explain and describe the merger waves, we do not know what triggers them and we cannot
identify the moment when a wave begins forming or dying [3].The studies usually do not
differentiate between mergers and acquisitions and use a summarizing term M&A. However,
there are quite important process differences between these two (legal, accounting, taxation,
and social differences) that have economic effects on the participating companies [2] and
[11].
A closer observation of the causes leading to company transformations allows us to classify
seven attitudes, identified by Trautwein (1990) as motivation theories, which ultimately lead
to reaching a higher value for owners of the successor company (investors). The most recent
study KPMG (2011) ascertained that the main motive for mergers and acquisitions is the
effort to achieve a higher market share – this was reported by 48% of companies merging in
the period 1997–2009. The other reasons for mergers and acquisitions implemented by the
195
clients of this auditing company are summarized in Table 1.The fact that interfirm transaction
activities are becoming global, across countries and continents, brings still new obstacles to a
successful integration of companies and an increased risk of failure. Mergers and acquisitions
do not have to be a guarantee that expected effects will be generated and they do not imply
success automatically. They are implemented to bring advantages but we have to take into
account that they are a sophisticated process in which company processes of different
companies with different cultures are to be reconciled. The aims of our research are to classify
mergers from the perspective of their success or failure, to find the rate of unsuccessful
transactions implemented in the Czech territory, and to compare the data with the published
results. The hypothesis is that the rate of failure should correspond to thedata published in
foreign literature.
Tab. 1: The rationale behind the acquisition in the period 1997 - 2009
Motives %
Increase market share 48
Geographic growth 35
Expanding into a growing sector 27
Cost synergies 19
Investment opportunity 18
Enter a new market 17
Acquire brand/additional service 13
Other 12
Diversity 10
Source: KPMG (2011)
AIM AND METHODOLOGY
The most frequent reason for a failure of a merger or an acquisition is unrealistic estimations
of the future potential of the companies after the combination, a lack of concept and strategic
management, little flexibility and inability to respond quickly to changes. A huge weak point
is the human factor, mainly the absence of a will to identify with the new company,
inexperience and little expertise of the management which can spoil even a good initial plan.
The combination is doomed to failure from the very beginning if it is only a fulfilment of
undue ambitions of the bosses of combining companies. Most of the studies investigating the
success of mergers ascertained that 54% up to 90% of implemented transactions did not bring
the expected benefits or ended in failure [6]. According to KPMG (2011), which sums up the
Figure 1: Tracking trends in M&A value enhancement over the past 12 years
Source: KPMG (2011)
196
results of mergers of their clients in the past 12 years, the value for company owners after the
combination increased in 17%up to 34 % of transactions, while in the other implemented
cases the economic effect did not occur or the value of the company after the combination
even decreased (for details see Fig.1).
Very (2004) considers a merger or an acquisition unsuccessful when the value of the acquirer
after the acquisition is lower than expected at the moment of transaction negotiations. The
defined main causes of failures of mergers and acquisitions, which are usually brought about
by problems in the acquisition processmanagement, are presented in Fig. 2.
Figure 2: The causes ofunsuccessfulacquisition
Apparent problems associated with failure
Too high a
price
Individual
reactions
Collective
resistance
External
events
Skeletons in the
closet
Difficulties in managing the acquisition process
What's at
stake
Information
scarcity
Structure of
the process
Time
pressures
Human side of
organizations
Source: Very (2011)
The focus of studies and publications, e.g. Very (2004), Stahl and Mandenhall (2005), Zappa
(2008), etc., is mainly on acquisitions, which are related to financial flows and economic
effects for investors. They do not require an assent of all companies entering the transaction
and they can even be hostile.The inflow of new resources, changes in owners, new
management and integration of the controlled company into the group should ensure the
expected return on the investment. Mergers, as similar transactions, are not usually analysed
separately although the successor companies gain control of the others which is similar to
acquisitions and the other companies are legally dissolved [9]. However, this is not a purchase
– mergers are combinations of two groups of owners into one whole, there is no risk of
overbidding, which is important for the scheduling of the entire operation, and the ownership
structure of the successor company usually remains the same as the structure of the merging
companies, which can cause complications in the strategic planning. Therefore, when
analysing the causes of merger failures, the question of the “purchase price of the dissolved
companies” will not be as important as in the case of acquisitions although it plays a role,
especially in the case of a merger of companies thathave a
different(mutuallyindependent)shareholders (owners)[10].The research investigates mergers
implemented in the Czech territory in 2005–2008, recorded in the Trade Register[13]. To
obtain empirical data, a representative sample was created by a random choice from the basic
set of all companies where a merger occurred within the explored period. The sample contains
201 companies and these are divided by the field of economic activity and years when the
transformation took place (see Table 2).
To be able to ascertain the merger failure rate, we need to separate the unsuccessful
transactions from the successful ones. The initial criterion of the selection is the evaluation of
a possible unlimited duration of the company and ability to develop further. A bankruptcy
declaration or entering liquidation of companies which implemented a merger in the explored
period, are considered a danger to their further existence. Also the successor companies that
did not achieve the expected economic advantage after a merger will be considered
unsuccessful. The criterion will be the disposable profit achieved by the participating
companies in the year before the merger and of the successor company in the three years after
197
the merger. The expected economic advantage has not been achieved if a profit is reported in
the period before the merger but in the following years there is a loss or a negative profit for
all the four years.
Tab. 2: The temporal and field classification of the companies within the sample
Field / number 2005 2006 2007 2008 In total
Agriculture, forestry and fishing 1 2 2 3 8
Industry, mining and extraction 13 11 9 13 46
Trade, transport, accommodation and restaurant services 9 11 16 16 52
Building industry 2 1 5 11 19
Information and communication activities 3 4 6 5 18
Activities related to real estates 2 10 12 14 38
Other activities 3 3 6 8 20
In total 33 42 56 70 201
Source: authors
After separating the unsuccessful mergers, the selected set can be tested for the production
power of the successor company and the achievement of the expected synergy effect. The
basic measure is the return on assets calculated using equation
(1)
where: ROA– return on assets
EAT – earning after tax
A – total assets
In the year before the merger (Rf-1 ), the performance of all participating companies enters the
calculation so that it could be compared with the performance of the successor company. We
can expect a positive effect of the merger on ROA as a consequence of consolidation of assets
and liabilities of the merging companies but accounting procedures themselves should not
affect the general evaluation. The return on assets as of the balance sheet day expresses the
sum of values of n-merging companies
(2)
The macroeconomic effects caused e.g. by the economic (2007-2008) and then debt (2009)
crises have been removed from the profit reported by the successor company in the period
after the merger Rfup to Rf+2. The values of the reported profit are modified using the GDP
change index in permanent prices within individual fields and years. The calculation of the
return on assets for the year R is done using equation
(3)
The companies in the sample were classified using the criterion of the return on assets into six
levels (Table 3).
Tab. 3: Successful and unsuccessful companies by the return on assets criterion
Level Classification Description
1 successful
ROA is higher in all monitored periods after the merger than before the
merger.
2 successful
ROA in the year of the merger is lower than before the merger; in the
following two years it is higher.
3 successful
The values of ROA fluctuate; the weighted mean of individual years after the
merger exceeds the value before the merger (weights 1, 2, 3 – the weight grows
with time, considering that complete stabilization comes about 12–18 months
after).
198
4 unsuccessful
The same procedure of evaluation as in 3 but the weighted mean does not
exceed the value of ROA before the merger.
5 unsuccessful
ROA fluctuates after the merger with a falling trend there is a loss at least in
one of the periods or ROA dropped by more than 10 % (the weighted mean
compared to the value before the merger).
6 unsuccessful
ROA after the merger is lower in all monitored periods than the total ROA
before the merger.
Source: authors
Based on the classification of the companies in the sample, we can establish the distribution
function π = the number of unsuccessful companies /the number of companies in the sample
(n), which provides each merger in the sample with the probability of its failure. If the
distribution is to be generalized to all mergers that took place between 2005 and 2008 (on
condition that the same evaluation system is applied), we need to establish the reliability
interval using the interval estimate of the middle value for alternative distribution with
parameter π:
(4)
The condition for the use of normal distribution approximation: nπ(1 – π) > 9 (5)
where: – quantile of normal standardized distribution
α – level of significance
RESULTS
The results of company classification using the criterion of maintained existence (K1) and
profit achievement in the four-year period (K2) are summarized in Table 4. After excluding
all unsuccessful transactions, the development of the return on assets was explored as
calculated using equations (2) and (3) for the companies, remaining in the sample. Based on
the calculated values of return on assets and their development in time, the remaining
companies could be classified into groups by the achieved level of criterion (K3) presented in
Table 3. The results of the classification by criterion K3 are added to the resulting Table 4.
Tab. 4: The total classification of mergers in the sample by criteria K1 up to K3 (number of
transactions)
Criterion 2005 2006 2007 2008 In total Proportion in the sample
K1 – number of the excluded 2 3 5 3 13 6.47 %
K2 – number of the excluded 2 4 8 12 26 12.94 %
K3 – successful (level 1) 2 2 3 6 13 6.47 %
K3 – successful (level 2) 2 3 4 6 15 7.46 %
K3 – successful (level 3) 11 11 11 16 49 24.38 %
K3 – unsuccessful (level 1) 6 7 15 15 43 21.39 %
K3 – unsuccessful (level 2) 6 6 5 6 23 11.44 %
K3 – unsuccessful (level 3) 2 6 5 6 19 9.45 %
Total number in the sample 33 42 56 70 201 100.00 %
Source: authors
To be able to verify the validity of the condition based on inequality (5), we calculate the
distribution function
Condition based on (5) has been met because: nπ(1 – π) = 201* 0.6169(1 – 0.6169) = 47.5 > 9
199
For the selected level of significanceα = 0.05 and the table value of quantile of normal
distribution1.96, we can establish the reliability interval using equation (4)
The interval estimate for A(π) is then (0.54969 ; 0.68411) and we can expect the real proportion
of unsuccessful mergers in all implemented mergers between 2005 and 2008 to be 55%–68%
with 95% reliability.
CONCLUSION
The proportion of unsuccessful mergers in the Czech Republic in the examined period ranged
around the level published inliterature. The hypothesis has been confirmed and leads us to
further questions that would be suitable to answer in relation to merger failures. These are
mainly the causes of the failures of the transactions and a search for their possible prevention
or reduction. Finding the causes of failures and their analysis together with proposals for an
improvement of the entire process of company combinations is, as this paper, a part of our
further research conducted within CR Grant Agency project no. 403/11/0447 “The Analysis
of Taxation and Accounting Procedures during Mergers”.
BIBLIOGRAPHY
[1] Allen& Overy2011. The Allen & Overy M&A Index,Q4 2010 Insight Report,[on-line]. [Accessed
2011-05-15]. Available at<http://www.allenovery.com/AOWeb/binaries/60916.PDF>.
[2] Bohušová, H., Svoboda, P. 2010. Comparability of financial statements. Acta
Universitatis Agriculturae et Silviculturae Mendelianae Brunensis, LVIII, 6: 67–78.
[3] Brealey, R. A., Myers, S. C., Allen, F., 2006. Principles of corporate finance. 8 th ed.
Boston: McGraw-Hill, 1028 p.
[4] Bruner, R. F., 2004. Applied mergers and acquisitions. Hoboken: John Wiley & Sons
Inc., 1029 p.
[5] KPMG 2011. A new dawn: good deals in challenging times. [on-line]. [Accessed 2012-
05-02]. Available at <http://KPMG_MA-New-Dawn-2011.pdf-Adobe Acrobat Pro>.
[6] Kuhrová, K. 2012. The causes of the failed merger of companies. Diploma theses. Brno:
MU ESF, 72 p.
[7] Lipton, M. 2006. Merger Waves in the 19th, 20th and 21st Centuries, [on-line]. York
University: Osgoode Hall Law School. [on-line]. [Accessed 2011-05-12]. Available
at<http://tiny.cc/8qd1u>.
[8] Martynova, M., Rennebook, L., 2008. The Performance of the European Market for
Corporate Control: Evidence from the 5th Takeover Wave, [on-line]. [Accessed 2011-05-
11], Available at <http://ssrn.com/abstract=941731>.
[9] Sedláček, J., Konečný, A., Valouch, P., 2011. Analysis of the Financial Crisis Effect on
Company Mergers.In Recent Researches in E-Activities. Jakarta: WSEAS, pp. 106-111.
[10] Sedláček, J., 2007. Analysis of the Financial Burden of the Czech Enterprises in Period
1996 – 2005. Journal of Economics, 55, 6: 582-593.
[11] Skálová, J.- Čouková, P. 2009. Accounting and tax implications of transactions in the
business company.2nd ed. Prague: Wolters Kluwer CR, 436 p.
[12] Stahl, G. K., Mendenhall, M. E. 2005. Mergers And Acquisitions: Managing Culture And
Human Resources. Stanford: Stanford University Press,434 p.
[13] Trade Register, 2011. [on-line]. [Accessed 2011-05-16]. Available
at<http://ov.ihned.cz/index.php?p=302000>.
[14] Trautwein, F. 1990. Merger Motives and Merger Prescriptions. Strategy Management
Journal, 11, 4: 283-295.
200
[15] Very, P. 2004. The Management of Mergers and Acquisitions. New York: John Wiley &
Sons.
[16] Zappa, M. 2008. The Fundamentals of Strategic Logic and Integration for Merger and
Acquisition Projects. Zürich: Swiss Federal Institute of Technology ETH Zurich.
Jaroslav Sedláček, Kristýna Kuhrová, Masaryk University, Faculty of Economics and
Administration, Department Finance, Lipová 41a, 602 00 Brno, Czech Republic, email:
sedl@econ.muni.cz, Kristýna Kuhrová <253338@mail.muni.cz>
201
COST MANAGEMENT EVOLUTION FOR
MANUFACTURING COMPANIES
Vladimir Shatrevich
ANNOTATION
This paper researches of newest tendencies of cost management evolution. The main goal of
this paper is to evaluate of the current situation, tasks and development trends for the
manufacturing companies in developing countries. The aim of this paper is to analyze the
crucial aspects of cost management tools that influence the financial output of the companies.
Our main conclusion is that cost management needs to be upgraded with some tools from
strategic management. This conclusion is done based from the results of the existing literature
that shows that cost strategy is main competitive advantage used by companies from
developing countries. Authors use evolutionary approach presenting strategic cost
management as improved cost management. In this paper strategic cost management is
analyzed as evolutionary transition phase to consistent strategic management for companies in
developing countries.
KEY WORDS
Cost management, manufacturing, business strategy, innovation, sustainable development,
strategic management.
JEL classification: E01, E23, E64, O31, O33, O38
INTRODUCTION
As well as a long-term perspective, the concept of competitiveness and sustainable
development entered in the Latvian system of planning under the influence of international
commitments and planning practices. The concept of sustainable development in the Latvian
public space appeared only around 1995 and its increased use is observed only since 2000.
Sustainable development is most often seen declarative as a question of environment and
natural resources quality; as a problem of a single ministry, not reflecting in planning policies
of industry.
Nowadays currently developing countries have pointed mufacturing emphasis from the
product that helps to increase competition level of the brand and technology, developing an
industry standard, to production process mostly decreasing cost level. The explanation
suggested for above mentioned fact is that developing countries may be expected to play a
role of residual or alternate suppliers of growth products on world markets due to their late
entry into the world markets for growth products. It is difficult for developing countries to
spend on research and on product development and make loyalty of consumers to products
manufactured, technology and innovations improves the standards and manufacturing process,
but requires a lot of investment (R&D), which is why, is easier for companies in developing
countries to focus on decreasing the cost level. This takes into account both demand factors,
such as consumers preferences and the business cycle, and supply factors, such as the lack of
human skills in developing countries. Because developing countries are likely to be residual
suppliers of growth products, they probably absorb a relatively large share of demand
fluctuations during the business cycle, being able to expand their exports of these products
during the upcoming phase of the business cycle, when industries are working close to
202
capacity in industrialized countries, but experiencing a decline in sales (or in the growth rate
of sales) during the downturn phase.
Nevertheless to respond to competition and develop in long term perspective, organizations
should create sustainable competitive advantages in order to maintain current customers and
acquire more customers. Strategic management is the best instrument to compete rivals at
short and long runs, but too expensive for companies in developing countries.
After overviewing series of literature in previous works authors presented strategy model
which explains the role of different strategies for manufacturing industry according to income
level (Shatrevich, 2012). (Figure 1) It is also important to understand the performance and
profit output implementing these strategies.
Leaders (primary suppliers) High value added products
Followers (secondary suppliers) Low value added products
Roleofstrategyforcompanymanagement
MinimumMaximum
simplificationsophistication
Incomelevel,R&Dinvestmentamount
Low-cost advantage strategy
Product differentation
strategy
Transitional strategy
Innovation leading strategy
Sustanable development
strategy
Figure 1. Model of Strategy role for manufacturing industry.
A new era in strategic management was generated by the idea of competitive advantages
based on core competencies and resources. Over time, the increasing attention given to
intangible and invisible assets has emphasized the role of new sources of competitive
advantages. The growing role technological advantage represented in strategic management,
as technological cycles become shorter and innovation becomes critical for survival,
contributions in strategic management require a renewed integration of their perspectives and
a closer connection with the business world.
But sustainability issues are too complex and interconnected to be managed by small and medium
companies. Usually only large companies could afford such complex and sophisticated strategy
system.
Author and some researchers [Hilton et al. (2000)] believe that traditional cost systems used
by companies in developing countries will be switched by strategic cost management.
Traditional cost systems focus on measuring and controlling product costs. Therefore, they
are not producing information needed at current business environment.
As a result, new cost management concept emerges. This system integrates some crucial part
from strategic management as aims to produce a continuous cycle of information about
activities at both short run and long run to add value to customers and reduce costs [Hamilton
(2004), Horngren et al (2003), Nicolaou (2003)].
203
Despite cost management is a common concept in literature, this concept is not well defined
in acceptable way [ Horngren et al. (2003), Agrawal et al. (1998) ]. Some researchers looked
at long-term dimension of cost management. Within that, strategic cost management has
special attention as a system that not only traditional cost systems bat also generates
necessary information to support strategic management and sustain competitive advantage at
the long run [ Blocher et al. (1999), Shank (1989) ]. Other researchers [Hilton et al. (2000),
Dailey (1998)] ignore dividing cost management into two constructs according to time
dimension. Therefore, cost management concept used to maximize profit and sustain
competitive advantage at short run and long run as well.
Usually cost management is considered as a system of improvement. This system aims to
permit organizations to seek what is needed to cement its ties with customers to attain their
satisfaction and reduce costs at the same time via specific tools to maximize profit and
sustain competitive advantage by using long-term strategies [Horngren et al. (2003), Nicolaou
(2003), Barfield et al. (2001), Hilton et al. (2000) ].
In the 1980s Porter’s models helped companies to analyse the industry and gave vectors to
their strategies, companies now need new models to create and manage knowledge and
learning from market. Companies now compete in a very complex and dynamic environment,
where knowledge and information is increasingly becoming the most valuable resource. The
impact of technology, innovation and globalization increasingly defines that high capability of
companies to transform, create knowledge and to be innovate is crucial to compete
successfully.
AIM AND METHODOLOGY
The object of this paper is cost management. The aim of this paper is to analyze the crucial
aspects of cost management tools that influence the financial output of the companies. (table
1). Our main conclusion is that cost management needs to be upgraded with some tools from
strategic management. This conclusion is done based from the results of the existing literature
that shows that cost strategy is main competitive advantage used by companies from
developing countries. The broad number of studies indicate that more innovative companies
and companies which have sufficient level of strategic management seem to be more
competitive, nonetheless that the empirical evidence is not totally conclusive it seems that
both in developed and in developing countries innovative activities do influence the decent
output probability, and it is expected that company needs a minimum level of strategic
thinking and innovation level in order to be competitive on the world market. So the less
innovative and strategic level company has the lower competitive level probability.
Firstly we analyze a traditional cost management as part of popular cost strategy amongst
companies from developing countries. Presenting cost management as a set of certain tools,
then compare existing literature, followed by an explanation of influence these tools have on
financial result.
Most companies in developing countries have a product specialisation and cost strategy based
on low wages and process innovations of standardised and incrementally improved
products- to compete on the world market while the enterprises of the developed countries
and of some specific sectors of developing countries do have a product innovation strategy.
So an important conclusion for the comparison of the outcome of different strategies, are
these differences those probably explain poor financial results of the company. In some
models we are trying to analyse the possible explanatory factors of sustainable financial
output probability, the main conclusion shows that implementing strategic management
elements and innovation efforts have a positive impact on financial output, but there is also an
interesting controversial facts that companies in developing countries have a lack of resources
to implement consistent strategic and innovation efforts.
204
Authors use evolutionary approach presenting strategic cost management as improved cost
management. This means that strategic cost management is analyzed as evolutionary
transition phase for companies in developing countries.
RESULTS
Recent studies pointed to the importance to distinguish between activities in short run and
long-term strategies that adopted to create and sustain competitive advantages [Morse et al.
(2003), Horngren et al. (2003), Blocher et al. (1999) ]. Accordingly, cost management is an
information system that supports the entire managerial functions, which are: strategic
management, short-term planning, operational decision-making, and control techniques [
Blocher et al. (1999)]. Thus, strategic cost management is used to support strategic decisions
such as selecting products, manufacturing techniques and distribution channels.
Table 1 Tools of Strategic Cost Management
Tool Description
Value chain anaysis add value to customers ،reducing costs, and understanding relation between business
organization and booth customers
Activity based costing an analytical tool aims to provide accuracy in allocating
indirect costs.
Competitive advantage
analysis
defining strategy that an organization could adopt to excel over rivals.
Target costing cost that an organization is willing to incur according to competitive price that could be
used to achieve desired profit
Total Quality Management adopt necessary polices and procedures to met customers expectations
Just-In-Time a Comprehensive system to buy materials or produce commodities when needed in
appropriate time
SWOT analysis a systematic procedure to identify critical success factors of an organization
Benchmarking a process performed to determine critical success factor and study ideal procedures of
other organization in order to improve operations and dominate market
Balanced scorecard an accounting report of critical success factors about the organization. It is divided into
four major dimensions: financial performance, customers'
satisfaction, internal operation, and innovation and growth
Theory of constraints an accounting report of critical success factors about the organization. It is divided into
four major dimensions: financial performance, customers'
satisfaction, internal operation, and innovation and growth
Continuous conducting continuous improvements in quality and other critical success factors
source: Blocher et.al. (1999)
Figure 2. Model of Strategic Cost Management for manufacturing industry.
SWOT analysis, Benchmarking – identifying cost management
cruical factors.
Competitive advantage analysis both for company and for rivals
Balanced Scorecard Tool - Determining financial and non-financial
issues, performance evalutaion
Building Value Chain
Total Quality Management
Operations Management
Traditional Cost Management
StrategicManagementtool
Buildingstrategicsystem
TraditionalCost
management
block
205
Figure 2 presents a model of strategic cost management. The model contains a few
interconnected blocks as representation of continuous improvement.
Consequently, that model is not related directly to strategic cost management, but presents
some issues to integrate in cost management in order to improve competitive advantage
system as part of long term strategic system.
CONCLUSION
Strategic cost management presented in this paper is a new concept of cost management. It is
analyzed as a new system to be integrated in order to implement crucial issues needed for
strategic management to help organization to create and sustain competitive advantages. It has
to include long-term objectives, which are responding to client requirements comparing to
competitors, ability to innovate products, quality, and efficiency. Traditional cost
management instrument should be upgraded with important element from strategic
management.
Authors point that there is no general acceptance of tools could be used within strategic cost
management, authors presented only concept. In addition, some tools have more attention
than others do.
So, on the one hand, the company needs a minimum level of innovation and therefore the less
innovate ones do not export. This fact probably could explain the low export probability of
minimum level innovative companies. On the other hand, on the international markets a
combination of an intermediate innovative level with low wages seems to be a good
competitive strategy, especially for developing countries.
Nowadays currently we see that developing countries have high tax rates and government
shares relative to their state of development. The analysis also shows that high tax rates and
government consumption at early stages of development can slow the structural
transformation and economic growth, and the size of government expands as an economy
develops over time.
In this paper we proved the importance of innovative activity to compete on the world market.
This conclusion was confirmed. Also we explained briefly the difficulties in comparing
results of the existing literature and in fact the sometimes apparently contradictory results
could be explained by the particularities of each of the studies. This was especially so where
different studies use different kinds of companies and strategies (large versus small
companies, or specific sectors are discussed. This problem was clearly confirmed by the
different outcomes from the models. The results of the standard model show that innovation
and highly qualified human resources would be a method to reach the international standards
of the world market and therefore it is necessary to compete in export markets. We analysed
the results of the standard model in the existing literature and found that they are very similar
to those of other studies and, and more important, it seems that the existing differences could
be interpreted. So paper does not generate contradictional results. This paper confirms that the
least innovative companies have the lowest export probability; this relationship is reflected by
the number of studies and has no contradictions. On the other hand, the paper defines a certain
negative effect for two aspects (product diversification and the size of the company) on export
probability. So the companies most specialised in only one or a few products (percentage of
sales related to the main product) are more competitive on the world market than the
companies with a broad range of products, regarding the company innovation strategy and
size.
Our final conclusion is that the innovative activities are related to export; we understand that
the interpretations for the relationship presented in this paper are theoretical and abstract
explanations do not allow us to clearly define them. However, the modern studies did not
specify the strong linear relationship either. Nonetheless, the product strategy as a part of
206
innovation strategy should be analysed more broadly as causal and significant factor of
export, especially in the case of the developing countries. This means that the relationship
between innovation and international trade has to be analysed more broadly.
BIBLIOGRAPHY
[1] Agrawal, S., S. Mehara and P. Sigel.1998. Cost Management System: An Operational
Overview. Managerial Finance. 24 (1).
[2] Blocher, E., K. Chen, and T. Lin. Cost management: A Strategic Emphasis. The McGrawHill
Companies, Inc. (1999).
[3] Dailey, M. Pattern. 1998. Analysis for Cost Management: A Case Study and Model.
Journal of Cost Management (6-8).
[4] Hamilton, A. 2004. Cost Management. AACE International Transactions.
[5] Horngren, C., S. Dater, and G. Foster. 2003. Cost Accounting: A Managerial Emphasis.
Prentice Hall. Eleventh Edition. Business Decisions. McGraw-Hill Companies, Inc.
[6] Hilton, R., M. Maher, and F. Selto. 2000. Cost management: Strategies for Business
Decisions. McGraw-Hill Companies, Inc.
[7] Morse, W., D. James, and A. Hartgraves. Management Accounting: a Strategic Approach.
Thomson South-Western (2003)
[8] Nicolaou, A. 2003. Manufacturing Strategy Implementation and Cost Management
Systems Effectiveness .The European Accounting Review. 12
[9] Strategy role for manufacturing industry, Vladimir Shatrevich, Janis Zvanitajs, economics
and management: 2012. 17 (1) McGraw-Hill Companies, Inc. (1999).
[10] Shank, J. 1996. Applying Technology Investments ‫ــــ‬ From NPV to Strategic
Cost Management (SCM). Management Accounting Research. 7 (2).
[11]Porter, M. 1991. Towards A Dynamic Theory of Strategy. Strategic Management
Journal. 12.
[12] Porter, M. Competitive Advantage: Creating and Sustaining Superior Performance. Free
Press (1985) Available at: http://www.netmba.com/strategy/value-chain/.
Vladimir Shatrevich
Riga Technical University
Meza street 7/1, LV-1048
Riga, Latvia
vladimirs.satrevics@rtu.lv
207
SEGMENTATION OF CORPORATE CLIENTS IN A BANK
Miroslav Sponer
ANNOTATION
The goal of this paper is to define applicable segmentation criteria for corporate banking
clients based upon analyses of corporate client needs. In the first section, I summarize the
principles of segmentation and segmentation specifically as it relates to bank strategy. I
further analyze client needs and developments in business in the Czech Republic. Applicable
segmentation criteria are proposed based upon corporate client need analyses and on a
comparison of the segmentation criteria used by leading financial institutions in the Czech
Republic and the European Union.
KEY WORDS
Segmentation, segmentation criteria, segment, bank strategy, corporate client.
JEL classification: G21
INTRODUCTION
The planning of overall bank strategy and the bank’s marketing and business activities should
be based, in addition to other factors, upon the needs of clients in the particular market. Proper
targeted client segmentation may thus become a basis for successful planning and for the
selection of suitable markets and marketing procedures by the bank.
Client segmentation thus serves as an important springboard for determining business strategy
and is currently considered a principle for banks as they develop marketing approaches.
Segmentation is defined as a process of grouping clients into segments. Clients in a particular
segment have identical or similar requirements and needs which may be subsequently
addressed by suitable products or services. Client segmentation therefore involves the
classification of clients into segments, with the intent of answering the needs of the individual
segments, and thus individual clients, in the best manner possible.
The client segmentation process takes place in several phases. First, the market to be
segmented must be selected along with the type of client representing the focus. This phase is
primarily tied to the question of whether the bank’s chief focus is on private clients or
business clients. This controls the amount of attention paid to the private versus business
client segment. The second phase lies in determining the segmentation variables.
Segmentation variables or segmentation criteria are criteria which allow differences or
similarities between clients and their needs to be defined. In the third phase of the
segmentation process, the individual segments are designated and analysed. The proper
segmentation criteria must be selected. These are then used to designate client segments for
further analysis. The fourth phase of segmentation lies in analyzing individual client segments
and preparing a marketing approach and suitable products and services for particular clients.
AIM AND METHODOLOGY
This paper aims to propose suitable segmentation criteria for corporate bank clients based
upon the analysis of corporate client needs.
To propose segmentation criteria for a bank’s corporate clientele, the clients’ needs must be
known, as well as their expectations for bank products and services. The segmentation criteria
currently employed by banks in the Czech market and the EU must also be compared since
the Czech Republic adopted EU criteria on January 1, 2005. It must be emphasised that no set
208
of segmentation criteria is perfect, neither is any market segmentation – exceptions will
always arise. Banks must always keep their clients’ interests and needs uppermost and
continuously verify whether the segmentation criteria they have selected correspond to client
needs.
RESULTS
Nature of Segmentation
Using segmentation, banks can individualize and quantify groups with identical behaviour,
characteristics, needs and requirements they may wish to address. A precise description of
who clients are and what they are requesting, i.e., their targeted identification, is an important
step in the bank’s understanding of its clients’ behaviour.
Proper targeted client segmentation forms the basis for successful planning and selecting
suitable markets and marketing procedures. A failure to understand or designate appropriate
client target groups often results in marketing and sales campaigns that don’t work and lead to
poor economic overall results.
“Market segmentation” may give rise to an image of the market being divided, with the bank
focusing on the most advantageous segment. But in fact the process is more complex. The
principle of targeted marketing requires that significant market segments be understood. If
targeted marketing is to succeed, it must respect market similarities and differences and not be
based on a random distribution of clients into segments. Further, the segments created are not
permanent. Segment characteristics may change over time, as may the way they are
manifested and their size. The segments selected must thus be continually monitored to ensure
they retain their profile and that their market orientation still corresponds to the segment as
originally designated.
Key Phases in the Segmentation Process
Before the segmentation process begins, the type of market to be segmented must be
designated, along with the factors influencing client behaviour. Segmentation criteria must be
defined highlighting the differences and similarities between individual groups of clients used
to define the segments. The segments must be defined in a way which clarifies what a suitable
combination of marketing tools for that specific segment would be. The segmentation process
may be divided into four phases: market definition, selection of segmentation criteria,
segment creation, segment analysis and marketing mix preparation.1
Corporate Bank Client Needs
Corporate client needs differ significantly depending upon the type of company involved. For
example, the needs of industrial enterprises, construction companies and municipalities differ
from those of businesses with respect to investment. But the most significant differences may
be seen between large, medium and small enterprises.
Large, stable enterprises with a significant market position usually do not invest in
development as much as smaller, still developing companies. Large enterprises usually fund
their operations using current asset credits or factoring. They commonly use leasing for
technology and automobiles and standard banking choices such as current accounts, home
banking, payment cards, etc. Their needs mostly concern insurance for exchange rate or
interest risks, sophisticated deposit services, quality and prices. Their motivation programs
focus on providing employee benefits in the form of retirement insurance of life insurance.
This is an opportunity for the bank to boost cross-selling with these clients and reinforce their
business relationships.
1
KOTLER P. Marketing Management. 7th edition Prague: Victoria Publishing, 1992. p.280 ISBN 80-85605-08-
2.
209
Midsize businesses with a significant market position often have needs similar to large
enterprises. They usually do not have large investments, using only existing bank services,
including funding. They emphasize quality of services and banking product prices. But still
developing midsize businesses which have not reached the required market share have
different needs. They are focused on investment, development and making use of standard
banking services, for which they request quality. Here the bank has enough room to structure
client funding both in terms of investment and operations and to offer products within the
banking group, for example using technology leasing. The bank may introduce the client to
factoring services, connected receivable insurance or the chance to secure exchange rate risks.
This segment is particularly attractive to banks because bank product prices are not the
client’s first concern.
Most small enterprises have been operating in the market for a short period of time. These
enterprises are still developing and make use of standard bank services without putting
significant emphasis on the quality and prices of services provided. Most start to use credit
products by replacing overdrafts with operational loans and make bigger investments in the
construction and reconstruction of their companies. Here, an opportunity arises for banks to
fund their investment needs via technology and automobile leasing and by offering products
from within the banking group. Key products used by small enterprises are current accounts,
internet banking and payment cards. Using of loans increases in hand with company size. In
contrast, overdrafts decrease with the size of the enterprise.
Comparison of Segmentation Criteria for Corporate Clients of Selected Banks in the
Czech Market with the Segmentation Criteria Designated by the European Union
Every financial institution designates segmentation criteria based upon the strategy selected
and the institution’s objectives. Because the Czech Republic adopted European Union
segmentation criteria on 1 January 2005, banks operating in the Czech marketplace should
make use these criteria, including segment titles. The bank designates other segmentation
criteria and client services need not correspond precisely to the EU segments: rather, this is
dependent upon on the bank and its strategy.
The following figure compares the segmentation criteria for selected banks in the Czech
market with the segmentation criteria designated by the EU.
Fig.1 Comparison of segmentation criteria
Source: Komerční banka, a.s. marketing research (the values indicated represent the sales of individual
enterprises in CZK)
EU KB ČS ČSOB HVB Citibank RB
SE
> 100
TOP
> 1800 (60)
TOP
Podniky
působící více
než 3 roky
na trhu
SE
> 50
SE
ME
> 30
> 1 500
SE
LE
> 1 500
> 60
> 300
TOP
ME
ME
SE
> 500
> 75
TOP
SE
ME
> 300
> 100
> 10
TOP
Prague 3
Micro
Enterprises
TOP
Micro
Enterprise
ME
TOP
> 1 500
> 250
> 300
> 50
> 60
> 10
SE
TOP
> 25
Small business
> 1 800
EU KB ČS ČSOB HVB Citibank RB
SE
> 100
TOP
> 1800 (60)
TOP
Podniky
působící více
než 3 roky
na trhu
SE
> 50
SE
ME
> 30
> 1 500
SE
LE
> 1 500
> 60
> 300
TOP
ME
ME
SE
> 500
> 75
TOP
SE
ME
> 300
> 100
> 10
TOP
Prague 3
Micro
Enterprises
TOP
Micro
Enterprise
ME
TOP
> 1 500
> 250
> 300
> 50
> 60
> 10
SE
TOP
> 25
Small business
> 1 800
210
Legend:
-  number of employees
- TOP – Large enterprises
- ME – Medium enterprises
- SE – Small enterprises
- Micro Enterprises
- Small businesses – Micro Enterprises
The graph makes clear that every bank employs various segmentation criteria for breaking
clients down into segments in keeping with its strategy. Banks use various segmentation
criteria and name individual segments variously.
The segmentation criteria of key players in the Czech banking market– Komerční Banka, a.s.,
Česka Spořitelna, a.s. a Československá Obchodní Banky, a.s. – are very similar and approach
the segmentation criteria designated by the EU. As the figure clearly shows, these banks focus
on the small and midsize enterprises which drive the Czech economy and form the majority of
all companies in the CR. All banks have a segment created for small and midsize enterprises,
but each bank uses different segmentation criteria for placing clients into these segments.
None of the banks listed takes the number of employees into account as a criterion. All banks
follow company sales.
Designating Corporate Client Segmentation Criteria
Most banks operating in the Czech market use client sales achieved over the latest fiscal year
as the key criterion. This was formerly not so. Most banks took client credit turnover as their
basis. Credit turnover refers to the total sum accepted in the client’s account over the
designated period (usually a calendar year). Client credit turnover is not a criterion which
provides maximum information on company size because it may be distorted by various
effects (e.g., fund transfer from one client’s account to his/her other account, derivative
operations when funds are transferred to the bank’s internal accounts and back, and especially
payments made at two or more financial institutions). The banks should therefore use the
client’s income based on the tax return submitted as the key segmentation criterion.
Ownership structure is a less frequently used criterion. It is necessary to verify who in fact
owns the client, especially if a legal entity is the majority owner. Even a small company with
profit amounting to CZK 10 million may be a member of a large, economically
interconnected group and must be approached as such. Attention should also be paid to
enterprises owned by the state, state organizations and municipalities. Some banks have a
special municipality segment in which municipality experts take care of these clients.
“Loan exposure” should be regarded as another key segmentation criterion. Client loan
exposure represents the volume of loans provided or approved as well as off-balance sheet
transactions per client. Banks should consider this criterion important given the profit
generated from such transactions, from bank asset management and from taking into account
the approach to clients with a large volume of loan exposure.
Based upon these analyses the following segmentation criteria are proposed:
- client profit,
- loan exposure,
- membership in an economically connected group.
State-owned clients, state organizations and municipalities should receive special attention.
211
Segment Definition Based upon the Segmentation Criteria Designated
The third step in segmentation lies in designating specific corporate client segments. Segment
creation and subsequent allocation of clients are up to the bank and form a prerequisite for
proper targeting of the bank’s business policy.
The author proposes to define the basic segments using the EU segmentation criteria:
Fig.2 Basic segments proposed
Micro enterprises turnover < CZK 60 million
Small enterprises turnover < CZK 300 million
Medium enterprises turnover < CZK 1,500 million
Large enterprises turnover < CZK 1,500 million
Source: Author
This is only a basic breakdown to be expanded by relevant segmentation criteria because
turnover does not suffice as the sole criterion.
The author further proposes to break down the segment of small enterprises into sub-segments
because a client with CZK 10 million in turnover will very likely have different needs than a
client with CZK 60 million in turnover. Therefore, a breakdown of small enterprises into two
sub-segments is proposed:
- mini enterprises with turnover up to CZK 30 million and
- micro enterprises with turnover up to CZK 60 million.
For the small enterprise segment, no further supporting segmentation criterion is necessary
(given the size of these clients and the products they use).
Loan exposure is proposed to be added into the small enterprise segment. The small enterprise
segment would include clients with CZK 60 – 300 million in turnover and clients with
turnover of less than CZK 60 million but a loan exposure exceeding CZK 10 million. This
criterion is added because of the development and growth of small enterprises in the Czech
market. Banks should focus on clients which make greater use of financing. These clients
bring the bank more profit than those who do not use financing at all. It is also likely these
clients are going to grow and that is why it is necessary to pay attention to them. A loan
exposure of CZK 10 million for a company with turnover lower than CZK 60 million is not
negligible and may testify to planed company development.
The author proposes no further modifications to the midsize enterprise segment in terms of
adding an auxiliary segmentation criterion. These are established enterprises and their needs
do not change in any significant way.
The large enterprise segment should be a subject of attention both because of the
segmentation criteria designated but also by virtue of its size. Enterprises with a turnover
exceeding CZK 1,500 million should be served by the most experienced bank consultants.
From this point of view, it would be appropriate not to pay attention solely to company
turnover but also to the financing services used by the client and the associated loan exposure
criterion. Further, membership in an economically interconnected group should be taken into
212
account. The large enterprise segment therefore includes clients fulfilling the following
parameters:
- turnover exceeding CZK 1,500 million
- loan exposure exceeding CZK 500 million
- companies which are members in an economically interconnected group which achieved a
turnover exceeding CZK 300 million.
Clients with a loan exposure exceeding CZK 500 million who make use of sophisticated
financial services are significant partners for a bank. That is why such clients must be
provided the highest quality services, using the bank’s best expertise.
Fig. 3 Proposed segmentation criteria
Micro enterprises mini enterprises turnover < CZK 30 million
micro enterprises turnover CZK 30 - 60 million
Small enterprises turnover CZK 30 - 60 million
enterprises with a turnover < CZK 60 million and credit
exposure > CZK 10 million
Medium enterprises turnover CZK 300 - 1,500 million
Large enterprises turnover < CZK 1,500 million
enterprises with a turnover < CZK 1,500 million and
credit exposure > CZK 500 million
enterprises with a turnover > CZK 300 million belonging
to ESSK with a turnover > CZK 1,500 million
Sources: Author
CONCLUSION
The segmentation criteria proposed are in line with the EU segmentation criteria, correspond
to CR market development and reflect the needs of corporate clients. Concentration of the
largest and most significant clients in the large enterprise segment ensures service by the
bank’s expert consultants and custom-made services. The bank has also room to create
product packages specifically designed for and answering the needs of individual client
segments.
Proper breakdown of clients into segments is important for the quality of services provided,
something clients look for and require. Providing quality services represents a significant
competitive advantage in the banking market and that is why banks pay ever greater attention
to the segmentation process.
BIBLIOGRAPHY
[1] DVOŘÁK P.: Bankovnictví pro bankéře a klienty. 3rd edition Prague: Linde a.s., 2005.
681 p. ISBN 80-720-515-X.
[2] HAVLÍČEK K., KAŠÍK M.: Marketingové řízení malých a středních podniků. 1st edition
Prague: Management Press, 2005. 171 p. ISBN 80-7261-120-8.
[3] KINCL J.: Marketing podle trhů. 1st edition Prague: Alfa Publishing, 2004. 172 p. ISBN
80-86851-02-8.
[4] KOTLER P. Marketing Management. 7th edition Prague : Victoria Publishing, 1992. 789
p. ISBN 80-85605-08-2.
213
[5] STEHLÍK E., BÁRTA V.: Segmentujeme spotřební trhy. 1st edition Prague:
PROFESSIONAL PUBLISHING, 2005. 145 p. ISBN 80-86419-76-2.
[6] TOMÁŠEK M.: Bankovnictví jednotného vnitřního trhu Evropské Unie. Edited by
Richard Salzmann. 1st edition Prague: Linde, 1997. 516 p. ISBN 80-7201-052-2.
[7] Komerční banka : Vztahy s investory [on-line]. Prague: Komerční banka, a.s., 2012.
Available at: http://www.kb.cz/cs/com/investor/main_events/index.shtml
[8] Česká spořitelna : Vztahy k investorům [on-line]. Prague: Česká spořitelna, a.s., 2012.
Available at: http://www.csas.cz/banka/menu/cs/banka/nav10013_vztahy_k_investorum
[9] Československá obchodní banka: Vztahy k investorům [on-line]. Prague: Československá
obchodní banka, a.s., 2012. Available at: http://www.csob.cz/bankcz/cz/Csob/O-
CSOB/Vztahy-k-investorum/
[10] Europa: Portal of the European Union [on-line]. 2007. Available at: http://eur-
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2004:063:0022:01:CS:HTML
Ing. Miroslav Sponer, Ph.D.
Department of Finance, Faculty of Economics and Administration at Masaryk University
Lipová 41a
602 00 Brno
sponer@econ.muni.cz
214
APPLICABILITY OF IFRS IN THE PRACTICE OF CZECH
SMES: INSIGHT OF CZECH ACCOUNTING PROFESSION
REPRESENTATIVES
Jiří Strouhal
ANNOTATION
The originality of the paper also consists in offering insights of Czech accounting profession
representatives onto the issues of IFRS/IFRS for SMEs implementation. There was employed
an interpretive research design to provide deep, rich understanding and theoretical
generalisation of approached field of research. The interviews with the representatives of
accounting profession hope that the major benefit of the IFRS for SMEs adoption will be
elimination of duplicate accounting, unification of the accounting system within international
groups and the higher comparability of accounting data.
KEY WORDS
implementation, IFRS, IFRS for SMEs, accounting profession, Czech Republic, CEE
countries
JEL classification: M41, G30
INTRODUCTION
Economists consider that Central and Eastern European countries have pretty well developed
market economies, with an institutional environment substantially similar to that of developed
Western economies (Rapacki and Prochniak, 2009). This is why these countries are
considered good investment opportunities and worthy of conducting researching in. However,
the accounting (financial reporting) models in these countries display both similarities with
and differences from those in developed economies. Generally, they underwent several
reforms, being modelled after one or more models of developed countries, and especially after
the European Directives and International Financial Reporting Standards (IFRS), but their
particularities strongly affect the way in which the accounting model is operated.
Small and Medium-sized Enterprises (SMEs) constitute the most dynamic sector of CEE
countries and represent approximately 99% of the business entities in each such country. In
the European Union these entities have accounting obligations, but recently the EU began
focusing on better regulation, modernization and simplification of legislation for them.
Consistent with its intent to address the need for international comparability in terms of
financial reporting by SMEs, International Accounting Standards Board issued in July 2009
the International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for
SMEs).
The IFRS for SMEs is considered as a response to strong international demand from both
developed and emerging economies for a simpler version of IFRSs (Jermakowicz and Epstein,
2010), and the project had the support of the majority of national and regional accounting
standard-setters throughout the world, including the EU. But EU’s position vis-à-vis the IFRS
for SMEs is difficult to assess, because different countries and different stakeholders have
different positions. The European Commission held a consultation in 2010 in order to
understand the view of European stakeholders on the IFRS for SMEs, and the European
Financial Reporting Advisory Group conducted a compatibility analysis.
215
Main objective of this paper is to find out the perception of the representatives of Czech
accounting profession about the possible implementation of the IFRS, or IFRS for SMEs
respectively as a reporting framework for the Czech companies.
LITERATURE REVIEW FOCUSING ON ACCOUNTING
CONVERGENCE
The process of accounting convergence and the issues related to the implementation of IFRSs
worldwide are topics of much interest recently for standard setters, researchers and
practitioners. Previous studies on IFRSs application documented an increase in comparability,
transparency and quality of financial reporting (Jermakowicz, 2004). Significant impact on
the companies’ reported equity, increasing volatility of results and a diminishing degree of
conservativeness were reported (Jermakowicz, 2004; Jermakowicz & Gornik-Tomaszewski,
2006; Callao et al., 2007). Also, previous studies analyzed the obstacles and difficulties in the
application of full IFRSs (Larson & Street, 2004; Jermakowicz & Gornik-Tomaszewski,
2006).
The national characteristics, i.e. each country’s accounting culture and traditions, have
developed over (a long) time in close relationship with the political, social and economical
environment of each of them, influencing the way in which IFRSs are applied. Factors such as
the role of the State, the type of legal system in place, the preferred providers of finance, the
relationship between accounting and taxation, the culture, or the role of the accounting
profession significantly influence accounting practices (Nobes & Parker, 2008). Also,
previous research indicated that the lack of political will, rooted in local culture and a strong
national outlook prevent a truly harmonized accounting framework (Callao et al., 2007), that a
magnitude of differences exists between countries and high costs to eliminate them
(Jermakowicz & Gornik-Tomaszewski, 2006); that local traditions exercise a strong influence
on the implementation of new concepts, and that tax and legally-based orientation hinder the
harmonization process (Larson & Street, 2004; Vellam, 2004).
As being a part of European Union all listed companies in the Czech Republic shall report
under IFRS framework since 1st January 2005. Employees of Czech companies which were
obliged to shift the reporting paradigms from Czech concept towards IFRS confirmed that this
transition was not easy. Except demanding preparation, which includes theoretical
preparation, implementation of new accounting rules, adjustment of accounting systems and
considering the impact of the new way of reporting for the company, it is necessary to
understand the philosophy of the standards and to learn new way of “accounting thinking”.
In many EU countries, financial reporting is linked to taxation, which is inconsistent with
IASB’s philosophy and raises issues for an accurate IFRSs application, and especially that of
the IFRS for SMEs. The application of the IFRS for SMEs will imply breaking the traditional
bond between the financial statements and the income tax return (Jermakowicz and Epstein,
2010), which makes countries such as France or Germany to oppose to this standard. On the
other hand, many emerging markets that became ‘new’ EU members have oriented their
accounting model towards IFRSs (Sellhorn and Gornik-Tomaszewski, 2006), but they cannot
viewed as a homogeneous block because of their different approaches to accounting reform.
Rodrigues and Craig (2007) underlined that these countries should adopt standards which are
relevant and useful for them and assess the costs and benefits before making a decision.
As already mentioned the accounting legislation in the Czech Republic (with the exception of
interpretations) is issued by Ministry of Finance Czech Republic (MF CR). According to the
current position of this organ (European Commission, 2010) there could not be expected an
obligatory adoption of IFRS for SMEs in the Czech Republic unless required by the European
Union. MF CR hopes that IFRS for SMEs will not be widespread due to the differences of
216
local legal frameworks, national economics and the structure of the companies in particular
EU countries. For this reason is preferred the revision of current 4th and 7th EU Directive
according to current trends and needs.
MF CR also argues that IFRS for SMEs could not bring a higher comparability level as there
are not defined any official forms of financial statements and IFRS for SMEs (as well as big
IFRSs) just determine what shall be disclosed. Despite of this pessimistic view MF CR
believes that IFRS for SMEs might be beneficial just for companies that are subject of
consolidation process as it would simplify this process.
RESEARCH METHODOLOGY
Main objective of this paper is to find out the perception of the representatives of Czech
accounting profession about the possible implementation of the IFRS, or IFRS for SMEs
respectively as a reporting framework for the Czech companies. For this purpose there have
been interviewed the typical representatives of accounting profession, i.e. preparer (I1),
auditor of financial statements (I2), user of financial statements (I3), representative of
professional chamber (I4) and representative of accounting regulator (I5). The structured
interview consisted of 10 questions about IFRS and IFRS for SMEs implementation. Six
questions were common for all interviewees; four questions were based on interviewees’
profile.
RESULTS
The views of interviewees vary when discussing the scope of companies which shall
implement IFRS for SMEs. Generally they are for application of this standard by joint-stock
companies and limited companies with the special consideration of public interest.
Interviewee I3 is aware that IFRS for SMEs could represent an incredible administrative
burden for small companies.
Interviewee I2 wonders about the definition of the companies with public interest. “According
to this definition (financial sector excluded) there is expected also the number of employees
exceeding 4,000. There is a question, whether this definition based on Czech Act on Auditors
is not too liberal and why the number of employees is not lower, e.g. 3,000 – in such a case
we could have much more companies which have to apply the full set of IFRSs. Of course
other companies will apply IFRS for SMEs. There is quite hard to consider as a criterion a
turnover – you can reach different turnover as a trader (however it depends on commodities)
or as a provider (e.g. services with pretty high value added).”
Application of IFRS for SMEs in the Czech Republic mean a total change of accounting
thinking from rule based to principle based. All interviewees believe that the major costs of a
possible application of the IFRS for SMEs will be the training expenses and costs with the
preparation of second financial statements based on Czech accounting regulation due to the
tax purposes (I2, I4, I5). Additional costs shall be also expected with the upgrade of
accounting software (I2, I3, I5). Interviewee I1 concludes: “The major costs will be about
high quality training and training materials (literature) in Czech language – accounting under
IFRSs is not about bookkeeping, which is traditional in our area, but about reporting and
presentation. It is not a job for just one person in company, but it will be about collaboration
of much more people. This I consider as a problematic, as a lot of managers do not have a
good financial background and it is sometimes hard to explain them the accounting issues and
effects of their decision on accounting profit. There is also necessary to state that the quality
software adapted on the reporting under several reporting frameworks is necessary. In case
that there will be any reaction of Czech tax system, it will not bring a simplification of work
but it brings just another duty of record keeping from which will be necessary to transform the
accounting profit based on Czech rules. This definitely has to be changed and it will be a
217
crucial element in initial discussion about the possible adoption of this standard in the Czech
Republic (and I guess not only here). And I still do hope that it won’t be cost over benefit...”
Interviewee I5 also reminds that the introduction of IFRS system (and probably this also
might be a case of IFRS for SMEs) to company is made by external accounting experts or
auditors what is very expensive.
Interviewees believe that the main benefit of the application of the IFRS for SMEs will be the
unification of accounting methods and principles which will lead towards higher
comparability of accounting information. Interviewee I1 describes her experiences with “big”
IFRS: “I’m experienced just with big IFRSs. I guess that after one has some good knowledge
of IFRS, he’ll recognize that sometimes it is really upright to report under IFRS rather than
under Czech practices. Of course it will have a substantial impact on accounting profit and its
distribution, what could be less favourable for shareholders. From this point of view, in case
that IFRS for SMEs will be adopted as a legal framework, it has to be really simplified from
big IFRSs and all issues have to be explained (what’s a problem of current version of IFRS
for SMEs as issued by IASB).” Interviewee I3 concludes: “I really hope that the major benefit
will be the abolishment of duplicate accounting (accounting for Czech authorities based on
Czech accounting x IFRS for parent company).”
Interviewees agree that in case that the IFRS for SMEs is obligatory in whole EU, the benefits
will be considerably higher. Considering the relation between accounting and taxation as a
crucial issue for the eventual adoption of IFRS for SMEs, we are providing the reaction of all
interviewees:
• It is necessary to harmonize tax and accounting issues. Calculation of taxes in such
case has to be based on IFRS for SMEs. Otherwise it wouldn’t make any sense for
companies – as the burden will be higher than benefits from this standard. (I1 –
preparer)
• In case that the current approach to taxation will be very same, the scissors between
accounting and tax point of view will get apart. So it’ll be about the reaction of
Income Tax Act. (I2 – auditor)
• I can imagine that accounting units prepare their IFRS for SMEs financial statements
and for the tax purposes shall be adjusted just some taxable revenues and taxable
expenses. (I3 – user)
• I’m pretty aware that the situation will be very same like nowadays – citing the
Income Tax Act as a tax base you have to use the profit not based on the IFRS (IFRS
for SMEs) influence – i.e. to use the profit based on Czech accounting. Of course there
is a question what “profit without IFRS influence” really it is, in case you are posting
and reporting under IFRS approach. Therefore majority of companies calculate the
differences between IFRS and Czech accounting legislation and these differences have
to be a part of the tax profit calculation. From my point of view the best option would
be that a taxable profit shall be a profit based on the regulation under which I prepare
my financial statements, i.e. in case of IFRS for SMEs, the tax base shall be IFRS for
SMEs. (I4 – professional chamber)
• I can imagine that the calculation of tax base could be same like now, i.e. accounting
profit shall be adapted for non-tax deductible items. But, to be able to apply this view
in practice, it’ll be about the adoption of the full IFRS for SMEs or some shorter
version as a Czech accounting standards. After that it will be possible to change
Income Tax Act and non-deductible costs and expenses will be valid for all
companies. (I5 – accounting regulator)
All interviewees are aware of a widespread of fair value due to the less liquidity and
efficiency of markets in the Czech Republic. It is therefore quite interesting the auditor’s view
(I2): “I’m for the applying of fair value only in case there exists for the asset/or liability active
218
market. I’m for the elimination of the qualified estimation – in such a case there shall be
rather preferred historical cost.” Interviewee I5 agree and follow up: “Fair value accounting
has a general problem in case, that the fair value is not objectively measured. Fair value shall
be used “prudently” in SMEs books and this value has to be really reliable and objective.
From this point of view I rather prefer historical costs accounting with impairment tests.”
CONCLUSION
Summarizing the results of this research there shall be highlighted following issues:
• professional accountants hope that the major benefit of the IFRS for SMEs adoption
will be elimination of duplicate accounting, unification of the accounting system
within international groups and the higher comparability of accounting data,
• elimination of the linkage of national accounting system to tax system or preparation
of such improvements of tax legislation that will make IFRS for SMEs capable to
apply as a reporting framework,
• professional accountants and regulator are aware of the higher initial costs linked to
shift of reporting frameworks,
• professional accountants and regulator are for sensitive use of fair value approach,
• professional accountants and regulator believe that the major users of financial
statements based on IFRS for SMEs will be capital providers and potential investors.
Acknowledgment
This paper is one of the research outputs of the project P403/11/0002 registered at Czech
Science Foundation (GAČR).
BIBLIOGRAPHY
[1] Callao, S. – Jarne, J. I. – Lainez, J. A. (2007): Adoption of IFRS in Spain: Effect on the
Comparability and Relevance of Financial Reporting. Journal of International Accounting,
Auditing and Taxation, 2007, no. 16, pp. 148-178.
[2] European Commission (2010): Consultation on the IFRS for SMEs: Response of Ministry
of Finance Czech Republic. Retrieved from:
http://circa.europa.eu/Public/irc/markt/markt_consultations/library?I=/accounting/2010_consu
ltation/authorities_standard/ministry_finance/_EN_1.0_&a=d.
[3] Jermakowicz, E. K. (2004): Effects of Adoption of IFRS in Belgium: The Evidence from
BEL-20 Companies. Accounting in Europe, 2004, vol. 1, no. 1, pp. 51-70.
[4] Jermakowicz, E. K. – Gornik-Tomaszewski, S. (2006): Implementing IFRS from the
Perspective of EU Publicly Traded Companies. Journal of Accounting, Auditing and
Taxation, 2006, no. 15, pp. 170-196.
[5] Jermakowicz, E. K. – Epstein, B. J. (2010): IFRS for SMEs – An Option for US Private
Entities? Review of Business, 2010, pp. 72-79.
[6] Larson, R. K. – Street, D. L. (2004): Convergence with IFRS in An Expanding Europe:
Progress and Obstacles Identified By Large Accounting Firms‘ Survey. Journal of
Accounting, Auditing and Taxation, 2004, no. 13, pp. 89-119.
[7] Nobes, C. – Parker, R. (2008): Comparative International Accounting. 10th Edition.
Harlow: FT Prentice Hall, 2008.
[8] Rapacki, R. – Prochniak, M. (2009): Real Beta and Sigma Convergence in 27 Transition
Countries (1990-2005). Post-Communist Economies, 2009, vol. 21, no. 3, pp. 307-326.
[9] Rodrigues, L. L. – Craig, R. (2007): Assessing International Accounting Harmonization
Using Hegelian Dialectic, Isomorphism and Foucault. Critical Perspectives on Accounting,
2007, no. 18, pp. 739-757.
219
[10] Sellhorn, T. – Gornik-Tomaszewski, S. (2006): Implications of the IAS Regulation for
Research into the International Differences in Accounting Systems. Accounting in Europe,
2006, vol. 3, no. 1, pp. 187-217.
[11] Vellam, I. (2004): Implementation of IFRS in Poland: Can True Convergence Be
Achieved in Practice? Accounting in Europe, 2004, vol. 1, no. 1, pp. 143-167.
Ing. Jiří Strouhal, Ph.D.
University of Economics Prague
Faculty of Business Administration
Department of Business Economics
W. Churchill Square 4
130 67 Prague 3, Czech Repbulic
Strouhal@vse.cz
220
SELECTED MACROECONOMIC FACTORS AND THEIR
RELATIONSHIP TO IMPAIRED LOANS OF DEUTSCHE
BANK
Boris Sturc, Natalia Zoldakova
ANNOTATION
There are three hypotheses considered in this article. As first stands hypothesis of mutual
horizontal correlation of macroeconomic indicators in EU17 and in Germany separately. It
establishes that these factors are highly correlated. Second hypothesis says that the same
factors are correlated also vertically – between Germany and euro area. Third hypothesis is
focused on claiming that the portion of impaired loans on total loans of Deutsche Bank
correlates with the development of significant macroeconomic factors. According to the
findings will be created a model quantifying mutual relationship of portion of impaired loas
and important macroeconomic factors.
KEY WORDS
stepwise regression, impaired loans, macroeconomic indicators, forward selection, euro area,
Deutsche Bank
JEL classification: G21
INTRODUCTION
This article is created as addition to research that primarily focuses credit risk
management I commercial banks. We pay attention mainly to macroeconomic impacts
because the principle of complete observation is based on proceeding from macroeconomic
view to microeconomic. Possibility and level of impact of these indicators is deduced from
existence of common currency area, similar legislation and other historical factors. Mutual
relations between factors are demonstrable but these relations change in time so that there can
rise differences that could be caused by modifications of relevant time periods applicable to a
certain monitored relationship of two or more indicators. The topic of correlation of these
factors is permanently current, it is observed also in cause of permanent considering euro area
to be optimal currency area (for instance in comparison with US)
Germany will be compared vertically because it is significant for smaller economies like
Slovak Republic (export and import partner), for euro area and furthermore for European
Union as a whole. Differences between indicators in euro area and Germany could be a threat
for euro area functionality in case of extreme values or they can signal imbalances that could
result into assets bubbles, to overheating or lagging.
Third we focused on Deutsche Bank. The question of optimal (or acceptable) portion of
impaired loans is current in cause of permanently increasing requirements on banking
activities with accent on safe and low-risk entrepreneurship. These requirements serve as a
frame for profitability and risk of banking operations.
Some groups of authors prefer analysis of all the levels of classified loans (or assets in
general) but this article includes existence only impaired loans (not all the classified) that are
determined by following definition:
The impairment amount of a loan is defined in mathematical terms. The lender calculates
this amount by subtracting the amount expected to be recovered on the loan from the initial
book amount of the loan. Impairment may be called "delinquency" or "default" in common
221
language. Delinquency means enough time has passed since the payment was due for the
lender to suspect the payment will not be made. Default means the borrower has failed to
meet the terms a lender provided to restore a loan from delinquency. In both cases, the loan
would be considered impaired if the lender feels there is no evidence the debt will be
collected based on the financial status of borrower, credit status and other factors.
AIM AND METHODOLOGY
First goal is analysis of selected macroeconomic factors for whole EU17 and correlations
of their values in period of 9 consecutive years always on 1st
January of each year (if the data
on this date are not available, we use first available day after this date). This analysis should
point to cohesion of development of selected factor of the analysis because their mutual
relations are essential in establishing the basis for following analysis.
Macroeconomic indicators that will be observed for their impact on defaulting of subjects
could be similarly with many authors split into following groups (1): cyclical variables,
indicators of price stability, indicators of households and businesses, indicators associated
with financial markets and external indicators. Indicators of household and businesses in most
cases can be classified into one of the remaining groups and therefore we will consider only
the four remaining groups (2)
Clear list of macroeconomic variables considered in this observation is in the Table 1.
Fig.1: List of macroeconomic variables
cyclical variables level of GDP in consumer prices, number of
employed, average wage index, average
monthly wage
indicators of price stability M1, PPI, inflation
indicators associated with financial markets 3M Euribor, interest rate
external indicators EUR/USD, export, import,
Cyclical indicators: this group consists of variables that describe the overall state of the
economy, as regards the level of GDP, number of employed, average wage index and the
average monthly wage. It is expected to be negatively correlated with the portion of impaired
loans to businesses and households. The increase in above mentioned is a positive sign of
economic development and is therefore lower probability of failure in paying back the loan.
Conversely, increase of unemployment causes that some subjects, especially households lose
ability to repay loans and the portion of impaired loans will grow.
Indicators of price stability: the main indicator in this group is inflation. We assume that
its value is negatively correlated with portion of impaired loans because with growing
inflation decreases real value of loan and therefore businesses and households would be
failing in smaller extent. With inflation are closely linked also other variables like producer
prices index and the amount of monetary aggregate M1. They have in terms of repayment of
loan same impact as inflation.
Indicators of financial market: interest rate for up to 1 year, from 1 to 5 years, over 5
years, 3 month Euribor
External indicators: regarding the impact of oil prices on ability of firms and households
to repay loans, we know with certainty that rise in oil prices increases costs of households and
businesses and thus affects portion of impaired loans. Also about export we can say that its
growth means improving of situation of enterprises (in turn their positive development has
positive impact on households and that improves their repayment activity). On the other hand,
we cannot say what impact will have the exchange rate EUR/USD, its depreciation or
222
appreciation on financial situation of sectors. On one hand, strengthening of currency is a
positive sign of economic development and households and companies should consequently
perform better and should also fail in repaying loans in smaller extent. But on the other hand,
strengthening the currency makes our products more expensive in foreign markets and that
negatively affects position of our businesses reducing their competitiveness and thus the
number of subjects that fail to pay back increases.
Our second objective is to compare these factors between euro area and Germany. Thus
we see extent to which corresponds development of these factors between this country and the
EU17 as a whole. This fact will be crucial in determining the impact of global variables (such
as EUR/USD or M1) on German economy and correlation of development of these indicators
with emphasis on national difference and global view at the same time.
Third objective is to specify correlation of development of selected macroeconomic
indicators with portion of impaired loans on base of foregoing analyses and on base of
calculated portion of impaired loans in relation to total loans of selected bank group with
headquarters in Germany, to find their mutual relationship and to quantify it. The portion of
impaired loans is based on official data from annual reports published by Deutsche Bank on
annual basis.
RESULTS
In pursuing the first objective, we primarily focus on monitoring indicators for the entire
EU17. Significant correlation is seen between Brent and PPI, while with CPI shows Brent
almost no relationship. PPI and outstanding level of M1 is also significantly positively
correlated. Significantly negatively correlated is unemployment with 3M Euribor, and
therefore slightly weaker but also quite significantly with interests on loans in all 3 categories.
Wages development is positively correlated with the development of PPI, with the
outstanding level of M1 as well as with its index.
For Germany we can state similar results as for the entire EU17 because of the common
currency and common data for monetary aggregate M1. Differences are obvious in case of
correlation of unemployment, which is not significantly correlated with any of the selected
factors like it was in case of EU17. Significant negative correlation between interest on loans
and M1 shows natural relationship of these variables in the economy. Export and Import is
logically positively correlated with PPI.
From vertical point of view on correlations as the second goal of the article can be picked
up naturally high positive correlation between PPI of Germany and EU17, while CPI shows
less clear values. Germany in relation to the entire EU17 has negative values - although not
significant. As to wages, Germany does not correlate with EU17and inflation in Germany
correlates similarly to EU17.
Portion of impaired loans in DB portfolio correlated negatively with PPI in euro area but
especially with Germany, while with oil prices was relatively low negatively correlated.
Higher negative correlation was confirmed in relation to aggregate M1. The highest
correlation appeared in relation to export and import in negative direction and with net export
in positive way with EU17 and negative with Germany. Other factors that could be considered
as significant - such as unemployment or wages - showed weaker relationship to portion of
impaired loans.
Final correlations and their comparison proved similar results for relationship with EU17
as with Germany. Undeniable factor is common currency, unmeasured value of M1 for
223
Germany separately, as well as the relation between Euribor and interest rates monitored.
Negative correlation value achieved (-0.9227) and after this value is the correlation of
Deutsche Bank with export, import and net export of EU17 and also Germany (the highest is -
0.88204 with EU17 export). It can be concluded that Deutsche bank group clearly correlated
with monetary aggregate M1 negatively. Although we expected closer relationships with
other indicators - like PPI, unemployment and wages, the results point to their different
development in monitored period. Partially could be considered time lag but not higher than
one year because the insolvency of debtors in case of households and companies appears
following changing wages and unemployment and demand decrease. With involving a lag of
1 year would be results similar.
Model creation:
In order to create model that includes significant factors for influencing impaired loans for
each bank in relation to EU17 and Germany, we used stepwise regression. It includes
regression models in which the choice of predictive variables is carried out by an automatic
procedure. We used one of the often used approaches – forward selection – because it
involves starting with no variables in the model, trying out the variables one by one and
including them if they are statistically significant.
For model were selected the most significant factors:
EUR/USD
PPI
M1 level outstanding
M1 index
Net export
DB in relation to EU17
The model resulted following values:
Fig.2: Model results DB vs. EU17
Standard T
Parameter Estimate Error Statistic P-Value
CONSTANT 0.16544 0.0358274 4.6177 0.0017
PPI -0.124408 0.0317829 -3.91433 0.0045
Since the P-value is less than 0.05, there is a statistically significant relationship between the
variables at the 95.0% confidence level. The equation that relates to used model is:
DB Impaired Loans/ Total Loans = 0.16544 - 0.124408*PPI
DB in relation to Germany
Fig.3: Model results DB vs. Germany
Standard T
Parameter Estimate Error Statistic P-Value
CONSTANT 0.184399 0.0363336 5.07515 0.0010
PPI -0.142953 0.0326306 -4.38096 0.0023
DB Impaired Loans/ Total Loans = 0,184399 - 0.142953*PPI
Forward selection determined PPI to be the only significant factor in this case.
224
CONCLUSION
Our findings lead to a conclusion that some of indicators were correlated strong and
some less significantly. That rejects first hypothesis as it says that all the indicators should be
correlated strong. Although Germany is a member state of EU17, we cannot unify the volume
of impact of macroeconomic factors for all the members. When argumenting with cohesion of
M1 with other factors, it is possible to simplify its significance to a fact that increasing
liquidity on financial markets is linked with growth of economy as a rule. The same argument
could be used for EUR/USD and Euribor.
Second hypothesis was partially true. In relation to horizontal correlation were the values
of vertical correlation higher in absolute value in most of cases. In lot of cases of local
statistical data (that means the data common for all the countries of euro area were not
compared) occurred correlation with level of 0.9 – 1. In other cases were the results caused by
nonfinancial factors – for instance the difference between labor market in euro area and
Germany is important and the result of reaction to macroeconomic situation can be influenced
by social policy or focusing on particular sectors of economy (correlation in unemployment -
0,386). Also wages pointed to lower positive correlation within Germany and EU17 (0,688).
Regarding inflation, it was quite correlated (0,869). In this case showed the most extreme
results net export that was not correlated really much (-0,717). GDP showed correlation of
0,863.
Third hypothesis was rejected following the results of final correlation of macroeconomic
indicators and development of portion of impaired loans. Although we included bank group
and not only bank separately, it is not possible to confirm strong correlation between factors
and portion of impaired loans. As this strong relationship was not proved, we focused also on
lower correlations of these variables and impaired loans. EU17 indicators show better values
than local factors. But in general is not possible to unify a relationship of certain factor (or
factors) with the portion of impaired loans with unified impact symbolized by similar
correlations (when using selected objects).
Despite determined correlation values we used for quantifying of relationship between factors
and impaired loans stepwise regression. It enabled us to select significant macroeconomic
indicators that were selected from previous set of factors according to correlations. The results
of regressions with independent variables used for EU17 and for individual country pointed to
significance of one factor - for DB it was PPI. In spite of strict selection is acceptable
conclusion that macroeconomic indicators impact impairing loans in comparison with
microeconomic indicators not significantly but this observation with larger statistical data
could show different results. Our statistical data set is tied to developed countries and their
macroeconomic conditions are relatively stable.
After all can be concluded that our findings lead to assumption that in the major economies of
euro area depends the portion of impaired loans in relation to total loans of bank institutions at
relatively low degree on macroeconomic factors but despite this finding they must be included
in risk management of banks.
225
BIBLIOGRAPHY
(1) Kalirai, H., Scheicher, M.: „Macroeconomic Stress Testing: Preliminary Evidence for
Austria“, OeNB Financial Stability Report 3, 58-74, 2002
(2) Zeman, J., Jurca, P. : „Macro Stress Testing of the Slovak Banking Sector“, 2007
Contact details
Ing. Natalia Zoldakova,
Ekonomicka univerzita v Bratislave
Narodohospodarska fakulta
Katedra bankovnictva a medzinarodnych financii
natalia.zoldakova@euba.sk
Ing. Boris Sturc, CSc.,
Ekonomicka univerzita v Bratislave
Narodohospodarska fakulta
Katedra bankovnictva a medzinarodnych financii
ESF MU Brno
sturc@dec.euba.sk
sturc@econ.muni.cz
This article was created as a part of project OP VaV namely Creation of excellent workplace
of the economic research for solutions of civilization challenges in 21st century (ITMS
26240120032). We support research activities in Slovak Republic. The project is co-financed
by EU resources.
226
INFLUENCE OF A MERGER ON THE VALUE OF ASSETS OF
MERGED COMPANIES IN THE CZECH REPUBLIC
Petr Valouch, Maria Králová
ANNOTATION
The aim of this paper is to assess whether mergers of companies in the Czech Republic
influence the value of the total assets of merged companies in the period of three years after
the merger. At the first stage of the statistical evaluation of the influence of mergers on
particular accounting, financial and economic quantities of merging companies in the Czech
Republic in 2001–2010, the influence of mergers on the total value of assets of merged
companies 3 years after the merger is assessed in comparison with the sum of total assets of
merging companies as of the date of merger. This article is one of research outputs of the
project of the Czech Science Foundation no. P403/11/0447 - The Analysis of Taxation and
Accounting Practices during Mergers.
KEY WORDS
Merger, total assets, financial statements, influence of the merger on the value of total assets.
JEL classification: G34
INTRODUCTION
The issue of economic, legal and other motives for mergers, the efficiency of mergers, their
development and trends have been discussed by many authors [1], [2], [5]. Domestic authors
dealing with mergers usually concentrate on the analysis of their development without a
deeper analysis of their economic impacts [3], [4]. An analysis of economic effects of mergers
is still missing for the Czech Republic, both because it is difficult to obtain the necessary data
as relevant economic data and financial statements of merging and merged companies are not
published and persons responsible for preparation and implementation of mergers are often
groundlessly unwilling to provide external parties with internal motives and reasons for
mergers of the companies they control or own. However, to finalize the process of a merger
properly and successfully, it is necessary to verify whether the position of merged companies
in the market has been strengthened and the economic efficiency of their activities has been
increased. Our research evaluates the effect of mergers of entrepreneurial entities with
headquarters in the Czech Republic in 2001–2010 on selected accounting and economic
indicators of the merged companies with the aim to reveal troublesome matters and impacts of
mergers of these entities on their economy and position in the market. The first outcome of
the research is an analysis of the influence of mergers on total assets of merged companies in
the period of 3 years after the merger.
AIM AND METHODOLOGY
The aim of this paper is to assess whether mergers of entrepreneurial entities with
headquarters in the Czech Republic implemented between 2001 and 2010 influenced the
value of total assets of the merged companies in the period of 3 years after the merger (or its
decisive day) in relation to the sum of the values of total assets of the merging companies as
of the decisive day. The period of three years after the merger has been chosen to reduce the
effect of some accounting methods demanding revaluation or exclusion of some assets from
the balance sheet of the merged company and also because it is assumed that the three-year
227
period is sufficient to exclude short-term effects of the merger such as the re-setting of
company processes in the merged company that occur immediately after a merger and can
have an essential effect on the evaluation of economic parameters of the merger. The data in
the Trade Bulletin and the Trade Register of the Czech Republic show that 2396 mergers of
entrepreneurial entities took place in the Czech Republic between 2001 and 2010 (mergers
implemented by non-profit or other entities have been excluded). Out of these mergers, 2255
were mergers while no new company is formed, during which one of the companies legally
ceases to exist without liquidation and its equity is transferred to another existing (successor)
company, and 141 were mergers while a new company is formed, during which two or more
companies cease to exist without liquidation and their equity is transferred to a newly
established successor company. It was essential for us to obtain financial statements of the
merging companies as of the decisive day (or the day preceding the decisive day) and
financial statements of the merged company from the 3 years following the decisive day.
Although these accounting units are obligated to publish their financial statements in
compliance with Article 21a of Act no. 563/1991 Coll., on accounting, by submitting them to
the collection of documents of the Trade Register, only 314 companies, i.e. only 14 % of
merging and merged companies, met this condition in all the demanded years. Two more
companies had to be excluded due to the missing data in their financial statements preventing
their complete analysis. As a result, 312 companies that met their legal conditions and
published all necessary data of the financial statements in all the demanded periods were
included in our statistical assessment of the influence of mergers on the value of total assets.
At the same time, we have to note that this fact needs to be taken account of when interpreting
the following conclusions. When interpreting the p-values of undermentioned tests it is
essential to bear in mind the fact that the sample of 312 companies cannot be considered
completely random as it exclusively consists of the merging companies that published their
financial statement in compliance with the act on accounting in all 4 demanded periods.
As regards the actual statistical assessment of the effect of mergers on the size of total assets
of merged companies 3 years after the merger, we proceeded in three steps. First, we looked
for an answer to the question whether a merger influences the value of total assets of the
merged company 3 years after the merger regardless of the size of companies. Second, we
tried to answer whether a merger effect on the value of total assets of the merged company 3
years after the merger is influenced by the size of the merged company. Third, we explored
the question whether the merger effect on the value of total assets of merged companies 3
years after the merger appeared in particular size categories. For these purposes, the merged
companies were divided into four categories: mini companies with the value of total assets up
to 20 million Czk, small companies with the value of total assets over 20 million CZK but 100
million CZK at maximum, medium companies with the value of total assets over 100 million
CZK but up to 500 million CZK, and large companies with the value of total assets over 500
million CZK. Because of the small number of companies within categories mini and small,
these were united into one category (hereinafter referred to as msmall). All statistical tests
were conducted at a statistical significance level α = 5%.
RESULTS
Regarding the question whether a merger influenced the value of total assets of merged
companies three years after, we used the paired t-test. First, the null hypothesis and the
alternative hypothesis for the original variable total assets were formulated:
H0: the sum of values of total assets of merging companies as of the decisive day does not
differ from total assets of the merged company three years after the merger.
228
H1: total assets of merged companies 3 years after the merger are higher than as of the
decisive day.
As the paired data of the original variable did not correspond to the assumption of bivariate
normal distribution, the test was conducted using logarithms of total assets and the hypotheses
were reformulated as follows:
H0: logarithm of sums of total assets of merging companies as of the decisive days and
logarithm of total assets of the merged company 3 years after the merger do not differ.
H1: logarithm of total assets of the merged company 3 years after the merger is higher.
The results of the conducted paired t-test of all companies regardless of their size expressed
by the total value of assets are presented in the following table.
Fig.1: Results of the paired t-test of total assets for all companies
Variable
t-test for dependent quantities
Mean
Standard
deviation
N Difference
Standard
deviation
of the
difference
t df p
Confidence
interval
-95.000 %
Confidence
interval
+ 95.000
%
Ln_total
assets
12.71352 2.102529
Ln_total
assets_3
12.61143 1.969695 311 0.102083 1.354779 1.328813 310 0.184887 -0.049077 0.253242
Source: Authors
Table 1 after converting the p-value1
for the above formulated alternative hypothesis shows
that we do not reject the null hypothesis for logarithms. We can also notice that the mean
logarithm of total assets three years after the merger decreased when compared with the mean
total assets as of the decisive day, which can be interpreted as a decrease in mean total assets
three years after the merger. Therefore, we have not verified that a merger increases the value
of total assets of a merged company at 5 % significance level.
At the second stage, we tried to answer whether the merger effect on the value of total assets
of the merged companies is influenced by their size2
. To evaluate this we used the KruskalWallis
test (parametric ANOVA could not be used because the assumption of normal
distribution for each of the 3 size categories of merged companies was not met). The
following null and alternative hypotheses were formulated:
H0: the size of the company expressed by the amount of total assets does not influence the
merger effect on the value of total assets of the merged company.
H1: the size of the company expressed by the amount of total assets influences the merger
effect on the value of total assets of the merged company.
Fig. 2: Descriptive statistics by the size of merged companies (mini and small companies are
included in one category for the reason of their small number)
Variable
Descriptive statistics
N of
valid
Mean Median Minimum Maximum
Interquartile
range
Standard
deviation
Difference_assets_all 312 -1687337 -5869 -246348838 12048034 213810.5 18563365
Difference_assets_large 119 -4473119 -147489 -246348838 12048034 1179993 29925254
Difference_assets_medium 119 25920 -4433 -353772 1148519 163235 199398
Difference_assets_msmall 74 37399.51 2407.5 -62662 669550 34130 120344.3
1
p = 1-0.1849/2 = 0.9076
2
The merger effect is represented by the difference between the value of assets three years after the merger
minus the value of assets as of the decisive day.
229
Source: Authors
The table shows that the sample median of the difference between the values of total assets
three years after the merger and as of the decisive day is the smallest for large companies and
the highest for small companies. This means concerning the value of total assets that small
companies gained the most, in contrast to large companies, in which the total assets three
years after the merger dropped. The same conclusions are reached considering the sample
means. The question is whether the differences among the companies categorized by size are
statistically significant. This will be analysed using the Kruskal-Wallis test; the results are
presented in fig. 3.
Fig. 3: Results of Kruskal-Wallis test
Dependent variable:
Rozdíl_aktiva
Kruskal-Wallis ANOVA by ranks
Independent (grouping) variable: size
Kruskal-Wallis test: H (2, N = 312) = 14.52367 p = 0.0007
Code N of valid Sum of ranks Mean ranks
msmall 1 74 13271 179.3378
medium 2 119 19784 166.2521
large 3 119 15773 132.5462
Source: Authors
As the Kruskal-Wallis test results show, using the selected sample of merging companies at a
significance level of 5% we were able to prove that the size of a company significantly
influences the merger effect on the value of total assets of the merged company 3 years after
the merger (p = 0.0007).
The table of multiple comparisons method shows which categories of companies differ
significantly at 5% level when considering their influence on the merger effect on the value of
total assets of the merged company.
Fig. 4: Results of multiple comparisons method for p values of particular company categories
Dependent variable:
Difference_assets
Multiple comparison of p values (two-tailed)
Independent (grouping) variable: size
Kruskal-Wallis test: H (2, N = 312) = 14.52367 p = 0.0007
msmall medium large
msmall 0.981512 0.001377
medium 0.981512 0.011852
large 0.001377 0.011852
Source: Authors
Table 4 indicates that a significant difference concerning the size influence on the merger
effect on the value of total assets of the merged company was found between small companies
(including mini) and large companies and also between medium and large companies. Small
and medium companies do not differ significantly. The results we achieved by multiple
comparisons of p values also allow the interpretation that large companies are worse off
concerning the total assets 3 years after the merger than medium and small companies. These
results have also been confirmed by the median test. The null and alternative hypotheses were
formulated equivalent with the Kruskal-Wallis test. The results of the median test are
presented in table 5.
Fig. 5: Results of the median test
Dependent variable:
Difference_assets
Median test, median = -5869
Independent (grouping) variable: size
Chi-square= 11.86827 df = 2 p = 0.0026
msmall medium large total
230
≤ Median: observed 26 58 72 156
expected 37 59.5 59.5
observed - expected - 11 - 1.5 12.5
> Median: observed 48 61 47 156
expected 37 59.5 59.5
observed - expected 11 1.5 - 12.5
Total: expected 74 119 119 312
Source: Authors
The results again show that the median test proves a significant influence of the company size
on the effect of the merger on the total assets of the merged company 3 years after (p =
0.0026). The descriptive statistics of the median test also indicate that large companies end up
worse off than medium and small companies, regarding the increase in assets.
The final part of the research endeavoured to ascertain whether mergers increased the value of
total assets of the merged companies 3 years after the merger for each category of companies
(small including mini, medium and large) separately. Again, the paired t-test was used for this
investigation in each category but the original values of total assets were transformed to
logarithms due to the need of normal distribution. This transformation also slightly breaches
the normal distribution but, with respect to the size of the sets, paired t-tests are preferred to
non-parametric tests. Then, the following hypotheses were formulated for particular company
categories:
H0: the merger has no effect on the value of total assets of the merged company in the
corresponding category.
H1: total assets of the merged company 3 years after the merger are larger in the corresponding
category.
The results of the paired t-test for particular company categories are presented in the
following tables.
Fig.6: Results of the paired t-test for the value of total assets of large companies
Variable
Size = large
Test of means in relation to reference constant
Mean
Standard
deviation
N
Standard
deviation
Reference
constant
t df p
Difference_log_assets -0.442903 1.483024 118 0.136523 0.00 -3.24415 117 0.001536
Fig. 7: Results of the paired t-test for the value of total assets of medium companies
Variable
Size = medium
Test of means in relation to reference constant
Mean
Standard
deviation
N
Standard
deviation
Reference
constant
t df p
Difference_log_assets -0.0687 0.684496 119 0.062748 0.00 -1.09486 118 0.275808
Fig. 8: Results of the paired t-test for the value of total assets of small and mini companies
Variable
Size = mini and small
Test of means in relation to reference constant
Mean
Standard
deviation
N
Standard
deviation
Reference
constant
t df p
Difference_log_assets 0.387703 1.754753 74 0.203986 0.00 1.900638 73 0.061298
The results show that the logarithm of total assets increased significantly at 5% significance
level only in small (and mini) companies 3 years after the merger (the p-value of the right
tailed test equals to 0.061298/2=0.0306), meaning that total assets increased significantly. On
231
the contrary, this significant increase in the total assets logarithm was not proved for large
companies – it even dropped in the sample.
CONCLUSION
The statistical investigations performed within our study using a sample of 312 mergers
implemented in the Czech Republic in 2001–2010 lead to the conclusion that a merger does
not have an influence on the value of total assets of a merged company 3 years after the
merger unless we distinguish the sizes of the merged companies expressed by their total
assets. At the same time, we ascertained that the size of a company significantly affects the
merger influence on the value of total assets of the merged company 3 years after the merger.
Total assets of the merged company increased significantly 3 years after the merger only in
small (and mini) companies. Medium companies also manifested an increase3
but this
increase was not significant. The total assets of large companies even decreased 3 years after
the merger. We also found the highest variability in large companies but “on average” the
large companies in the sample manifested the worst results concerning the increase in total
assets of the merged company. The descriptive statistics illustrate4
that means and medians of
the difference of the total assets three years after the merger and as of the decisive day are the
greatest for small companies and the difference decreases with the increasing size of the
company. It follows that smaller companies have a higher increase in total assets after the
merger than medium and mainly large companies. For large companies we can conclude that
though particular companies had a considerable increase in total assets 3 years after the
merger due to the high variability of the found data, “on average” these companies have
worse results than medium and small companies. Generalizing the obtained results (bearing in
mind that the sample is not a random choice, as has been explained in Aim and
Methodology), mini and small companies have the greatest probability that a merger will help
them increase the value of total assets. Although some large companies may profit
considerably from a merger, “on average” a large company can expect a decrease in total
assets within the three years after the merger. If one of the objectives of a planned merger is
an increase in assets of the merged company, statistical results tell us that we should
recommend a merger to small companies.
BIBLIOGRAPHY
[1] Lang, D. W. (2003). The future of merger: What do we want mergers to do: Efficiency or
diversity? The Canadian Journal of Higher Education, 33(3), 19-46.
[2] Mergers and Acquisitions, Edited by B. Cassiman and M. G. Colombo, Edward Elgar Publishing
Limited, 2006.
[3] Skálová, J., Tumpach M., “Cezhraničné fúzie medzi kapitálovými spoločnosťami v Českej
republike a v Slovenskej republike,” Účtovníctvo, Audítorstvo, Daňovníctvo, vol. XVIII, no. 9, p. 323-
326, 2010.
[4] Špatná, B. Přeshraniční a nadnárodní fúze obchodních společností z ČR a dalších členských států
EU, KEY Publishing, 2010.
[5] Werner FM De, B., & Thompson, H. E. (1992). Is economic efficiency the driving force behind
mergers? Managerial and Decision Economics (1986-1998), 13(1), 31-31.
Petr Valouch, Maria Králová
Faculty of Economics and Administration of the Masaryk University
Lipová 41a, Brno, Czech Republic
valouch@econ.muni.cz, kralova@econ.muni.cz
3
See descriptive statistics in tab. 2.
4
See descriptive statistics in tab. 2.
232
CURRENT APPROACHES TO ASSESS THE FINANCIAL
PERFORMANCE OF A COMMERCIAL INSURANCE
COMPANY
Eva Vávrová
ANNOTATION
The aim of this paper is to evaluate current approaches to assessing the financial performance
of a commercial insurance company as a financial institution specializing in covering the risks
taken by economic entities. Its function is also reflected in the specifics of both, financial
analysis and the evaluation of financial performance in the insurance industry, which differs
significantly from other types of financial institutions in other financial sectors, typically from
evaluating financial performance of banks.
The paper describes partial results reached within the research project of the Faculty of
Business and Economics of the Mendel University in Brno MSM 6215648904 / research 02
following the aims and methodology of the given research project.
KEY WORDS
commercial insurance company, insurance industry, financial analysis, profitability, indicator,
return on equity, return on assets, return on sales, technical provisions, premiums written
JEL classification: G 22
INTRODUCTION
The financial analysis in business has become an important tool for assessing the financial
situation of business entities. Less often, however, experts discuss the importance of the
financial analysis of commercial insurance companies. It is mainly used by rating agencies
and insurance industry supervision (BÖHM, 2004), or since 2006 supervisory authority over
the entire financial market in the Czech Republic. Common indicators of a financial analysis
are known, but it is questionable to what extent these indicators are applicable to the specific
entity, such as a commercial insurance company. There are specially adapted ratios for
financial analysis carried out in commercial insurance companies.
AIM AND METHODOLOGY
The main aim of the paper is to analyze and, with the usage of specific indicators, assess the
financial performance of a selected commercial insurance company on the Czech insurance
market and to draw appropriate conclusions.
Ratio analysis is one of the most widely used methods of financial analysis. The ratio
indicator is calculated as the ratio of one or more financial statement items to another item or
group of items (KISLINGEROVÁ, 2004). Commercial insurance companies often use
liquidity ratios, activity ratios, profitability ratios and debt ratios. The basic indicators of
profitability of insurance companies are according to PASTORÁKOVÁ (2006):
1. ROA (return on assets): EAT (earnings after taxes) / assets
2. ROE (return on equity): EAT / equity capital
3. ROS (return on sales): EAT or EBIT1
/ sales
1
EBIT = earnings before interest and taxes
233
The specificity of an insurance function is reflected in adapted ratios used to assess the
financial performance in a commercial insurance company. The following selected indicators
are applicable for general insurers with a predominance of a non-life insurance branch
(MESRŠMÍD, KELLER; 1998).
net premiums written / adjusted equity capital
The values of the equity adjustment are obtained by deducting the outstanding equity share
capital. In the case of Allianz, this equals equity as Allianz has fully paid up equity capital.
adjusted equity capital / earned premium
This indicator measuring adjusted equity capital to net premium earned is also described as an
indicator of solvency of the insurance company, called solvency ratio (see ČEJKOVÁ,
NEČAS, ŘEZÁČ; 2005). Indicator expresses the capitalization of the insurance company.
technical provisions / equity capital
This indicator describes KOROBCZUK (2007) as the indicator of inadequate creation of
technical provisions, where recommended value should be less than 350 %.
technical provisions / earned premiums
The recommended value of this ratio is between 100-150 %. KOROBCZUK (2007) calls this
indicator reserve ratio.
RESULTS
First, I will give an analysis of basic economic indicators of the selected commercial
insurance company such as progression of the premiums written, of profit and equity.
Fig.1 Gross premiums written (in thousands of CZK)
2006 2007 2008 2009 2010
Gross premiums written 9 373 216 9 597 536 9 861 988 10 244 497 10 651 217
in it: non-life insurance 7 230 796 6 990 344 7 188 103 7 258 095 7 030 290
life insurance 2 142 420 2 607 192 2 673 885 2 986 402 3 620 927
Source: Annual report Allianz pojišťovna, a.s.
The table on Fig. 1 shows that in the period between the years 2006 and 2010 the selected
commercial insurance company shows a steadily rising trend in gross premiums written. The
insurance company reached an excellent level of business even in the period of financial crisis
since there is not any sign of slump from the fall of 2008. This insurance company has a large
advantage in non-life insurance in terms of gross premiums written. The proportion between
life and non-life classes of business during the reference period is apparently changing,
namely from 22.8 % up to 33.9 % in life insurance and from 77.2 % down to 66.1 % in nonlife
insurance.
Fig. 2 Equity capital and profit in the years 2006 – 2010 (in thousands of CZK)
Source: own construction based on Annual report Allianz pojišťovna, a.s.
234
The graph on Fig. 2 shows that in the period before 2009 the insurance company led the
undertaking well as its equity capital and profit2
had an increasing trend even in the period
after the onset of the financial crisis. Both parameters, however, point at a small decline in
2010. Now it would be speculative to conclude whether the downturn could be affected by the
market situation or by a new sales service policy of the insurance company.
Analysis of ratios
For the purpose of the analysis of commercial insurance company, special ratios are used that
differ from those used by manufacturing companies (MESRŠMÍD, KELLER; 1998). The only
areas of indicators that are consistent with those that are commonly used are the indicators of
profitability (see MAJTÁNOVÁ, DAŇHEL, DUCHÁČKOVÁ, KAFKOVÁ; 2006).
Fig. 3 Indicators using adjusted equity capital
Source: own construction based on Annual report Allianz pojišťovna, a.s.
Ratio of net premiums written to the adjusted equity capital expresses the insurance
underwriting risk. In the reference period, this indicator shows a downward trend.
Underwriting risk of the insurance company is reduced, which is clearly positive. Indicator
measuring adjusted equity capital to net premium earned is also described as an indicator of
solvency. The increasing value reflects the increasing share of safety capital, which increases
the financial stability of the insurance company mainly for the case of claims.
Fig. 4 Technical provisions ratio (in per cent)
Source: own construction based on Annual report Allianz pojišťovna, a.s.
2
EAT = earnings after taxes
235
Ratio of technical provisions to equity until the year 2009 developed negatively, but in last
year began to rise. However, the recommended values should not exceed 350 %, which the
insurance company does not meet. So we can say that the insurance company has created
more than sufficient technical provisions with respect to the amount of equity. The second
indicator reserve ratio fluctuated during the reference period within 10 percentage points.
Value recommended by KOROBCZUK (2007) indicates 100-150 %. The insurance company
exceeds this value, which again confirms the excessive level of technical provisions created
under the Act Nr. 277/2009 Coll. Allianz has always profiled as a conservative insurance
company, which is confirmed by both indicators.
Fig. 5 Profitability indicators (in per cent)
Source: own construction based on Annual report Allianz pojišťovna, a.s.
The profitability indicators show a similar course. They declined in 2007; two years of
progression followed, and in the last reporting year the indicators decreased again. Return on
equity has maintained above 20 %, which means that the equity of the company annually
produces a profit of over 20%. Return on net sales long-term moves above 10 %. This means
that net premiums adjusted of reinsurance annually gives more than 10 % of profitability.
Return on total assets indicates that the overall property annually produces income of more
than 4 % of assets. All profitability indicators analyzed are at a higher level than the current
level of interest. Thus, the owners have placed their capital efficiently. If, for example, they
had put their capital in bonds, they would have reached a lower value than in Allianz
insurance company. In other words, business risk which the owners are undergoing is
rewarded with sufficient profitability.
CONCLUSION
At this point, I would like to summarize the results and comments, which I got with the help
of financial analysis.
Premiums written of the selected insurance company in the reference period each year grew.
Despite this increase, the trend in net premiums written was negative, which means that the
growth has slowed. Profit of the insurance company rose continuously until 2009 then
followed a small decline, but the last two years the profit was above the amount of 1 billion
CZK. A similar trend was described also in the amount of equity, which is close to 5 billion
CZK. Indicators which I assessed financial performance of the selected insurance company
with consistently showed that Allianz in this respect is improving except for a slight
deterioration in the last year of the period analyzed. Indicators confirm that the insurance
236
company is easily able to cover its obligations with liquid assets. Technical provisions Allianz
maintains at an excessive level as it has profiled itself always as a conservative insurance
company which does not want to expose itself or its clients to any excessive risk. The last
assessed area was profitability. The indicators confirm that Allianz insurance company is for
its owner undoubtedly profitable long-term investment.
Based on the above, we can clearly say that the analyzed commercial insurance company in
its field acts very well and achieves still better results. The results also confirm that the
analyzed insurance company well withstands the financial crisis with no visible effects.
The scientific paper describes partial results reached within the research project of the Faculty
of Business and Economics of the Mendel University in Brno MSM 6215648904 / research
02 following the aims and methodology of the given research project.
BIBLIOGRAPHY
[1] BÖHM, A. Ekonomika a řízení pojišťoven v podmínkách po vstupu České republiky do
Evropské unie. Praha: ASPI Publishing, 2004. ISBN 80-735-7020-3.
[2] ČEJKOVÁ, V., NEČAS, S., ŘEZÁČ, F. Pojistná ekonomika II. Brno: ESF MU, 2005.
ISBN 80-210-3662-1.
[3] KISLINGEROVÁ, E. Manažerské finance. Praha: C. H. Beck, 2004.
[4] KOROBCZUK, L. Informační výstupy pojišťoven: Analýza výroční zprávy. [online] 2007.
Dostupné z: <bivs.as4u.cz/filemanager/files/file.php?file=7369>
[5] MAJTÁNOVÁ, A., DAŇHEL, J., DUCHÁČKOVÁ, E., KAFKOVÁ, E. Poisťovníctvo
Teória a prax. Praha: Ekopress, 2006. ISBN 80-869-2919-1.
[6] MESRŠMÍD, J., KELLER, J. Finanční analýza v pojišťovnictví. Pojistné rozpravy. Praha:
ČAP, 1998, č. 3. ISSN 0862-6162.
[7] PASTORÁKOVÁ, E. Finančná analýza v poisťovniach. Bratislava: Ekonóm, 2006. ISBN
80-225-2214-7.
[8] Výroční zprávy. Allianz. [online] 2011. Dostupné z: <http://www.allianz.cz/o-
společnosti/o-spolecnosti/vyrocni-zprava/>
[9] Zákon č. 277/2009 Sb., o pojišťovnictví. TZ 146 Pojišťovnictví. Praha: C.H.Beck, 2010.
ISBN 978-80-7400-223-6.
doc. Ing. Eva Vávrová, Ph.D.
Dept. of Finance, Faculty of Business and Economics, Mendel University in Brno
Zemědělská 1
Brno
E-mail: vavrova@mendelu.cz
237
THE SUCCESS OF THE SPECULATIVE BUBBLES BURST
PREDICTION USING ARTIFICIAL NEURAL NETWORKS
Jitka Veselá, Soňa Poláková
ANNOTATION
Creating and cracking of speculative bubbles in recent years become more frequent reality of
financial markets. The consequence of bursting speculative bubble is a huge increase in
market risk, drastic reduction of the wealth of investors, decline in economic activity and
substantial disruption of market mechanism functioning. In an effort to mitigate the negative
and dangerous impact of bursting of speculative bubbles in financial markets, analysts are
trying to use various analytical tools and methods for identifying speculative bubbles, and
then to predict its breaking point. One of the modern methods of technical analysis that can be
used for this purpose is a method of Artificial Neural Networks. In the empirical part of this
paper is the method of Artificial Neural Networks practically applied to the development of
the S&P 500 index during the period 02/1999 – 05/2008 in order to verify the predictive
ability of this method in connection with the bursting of Technology (Dot-com) and Real
Estate Speculative Bubble.
KEY WORDS
Speculative Bubbles; Technical Analysis; Artificial Neural Network; Technology (Dotcom)
Bubble; Real Estate Bubble;
JEL classification: G02, G17
INTRODUCTION
Speculative bubbles or irrational deviations of actual market prices from current levels
derived from fundamentals occur in the markets of commodities and securities already for
centuries. A sudden burst of bubbles destabilizes the situation in the market and results in
subsequent financial crisis very often. It is therefore a negative phenomenon, its presence
significantly detrimental to the economic entities – their financial situation and relationships.
Generally harmful effects as a reset of bursting of speculative bubbles always spread the
financial markets, but also the entire economy. Among the best known cases of these harmful
speculative bubbles can be included the Great Crash in 1929, the deepest one-day drop in the
U.S. stock market as a result of the speculative bubble burst in October 1987, Japan´s
speculative bubble of the turn of the 80th
and 90th
of the last century, Technological (Dotcom)
Speculative Bubble that burst in 2000, China Speculative Bubble burst in 2007 or Real
Estate Speculative Bubble whose bursting is considered to be the one of the causes of
subsequent stock market crash in Autumn 2008.
Speculative bubbles are events whose creation and inflation is fueled by psychological
factors, even though at the beginning of speculative bubbles may become favorable
underlying conditions or factors that are followed by overreaction of investors due to their
excessive optimism or pessimism. According to Shiller (2005) a speculative bubble can be
viewed as “unsustainable price growth, which is driven by investors´ buying behavior, and
ignores the fundamental information about the price.”1
1
SHILLER, R. J. Irrational Exuberance. New York: Broadway Books, 2005, s. 27
238
The speculative bubble fed by excessive optimism of investors is in the context of their
creation, inflating and bursting observed several characteristics or factors that may arise
during the “life” of bubbles, which can be summarized as follows:
1. at the time of the initial phase of speculative bubble existence, is typical a stable price
level or even mild deflation in the economy, which created the conditions for an
expansionary monetary policy, characterized by low interest rates and relaxed credit
policy,
2. a significant technological progress and innovation, a very favourable business
environment and conditions around the time when the bubble was created,
3. an excess liquidity in the economy and the speculative capital inflows in the capital
market,
4. a sharp and a steep rise in prices in a relatively short period, which can not be
explained by fundamental factors,
5. an exaggerated optimism, which is not substantiated by rational factors, frenzied
shopping and the crowd behaviour of most investors,
6. particularly in the second half of the existence of bubble, activities of speculators, and
an unhealthy speculation increase,
7. a sudden panic and fear caused by the occurrence of a negative factor (tightening of
monetary policy, raising interest rates and limiting the availability of credit resources
caused by inflationary pressures e.g.),
8. a destruction of investor confidence in further price increases, there are problems with
a lack of liquidity,
9. a fast and a drastic collapse in prices in the market that delivers a fatal loss of the
wealth for most investors.
Characteristic features of speculative bubbles are thus known and their presence has been
verified and identified by means of several specific examples of speculative bubbles which
occured in financial markets history. It seems, therefore, that an early detection of these
characteristic features, including consideration of their chronological order, by the time of the
creation of speculative bubbles could help its early identification, which in some
circumstances may protect the investor against large and tragic losses.
As an auxiliary tool for identifying speculative bubbles would be possible under certain
circumstances use some standard methods or indicators of fundamental and technical analysis.
When the speculative bubble is largely fuelled by irrational, (not fundamental) factors, it can
be expected, that fundamentally correct, (the equilibrium prices derived from the standard
fundamental indicators such as P/E, P/BV and P/S ratio, which in a normal market situation
move in certain, a relatively well defined intervals), prices will significantly diverge from the
actual, current level of prices in the market. The large current value deviation of P/E ratio
indicator from its normal value of 12 to 15 in the period immediately before the speculative
bubble burst points out Veselá (2011), which specifically states that in 1929 the average value
of the P/E ratio indicator in the U. S. market was about 33, in 2000, the average value of the
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P/E ratio indicator for all sectors in the U. S. market was about 44, while the average value of
the P/E ratio indicator applied on the technological industry only was about the 2002
. So it
seems that quite substantial deviations from the results of the most standard valuation models
and multiple deviations pronounced from relative market indicators calculated by
fundamental analysis can point to the existence of speculative bubbles. However, the exact
moment of bursting speculative bubbles can not predict by the methods of fundamental
analysis, because of its focus, substance and explanatory power. Simply put, the question of
the timing of certain events, reactions, behaviour or circumstances, fundamental analysis does
not address or does not have the instrumentation for this purpose.
Differently, an alternative type of the analysis is a technical analysis. This analysis on the
contrary, can contain the timing of certain situations, the behaviour of investors and their
reactions as one of its main objectives. Technical analysis methods are designed to identify
market trends in the market and especially its changes. For this reason, it would be interesting
to verify whether the selected methods of the technical analysis are able to predict the exact
moment of bursting a price speculative bubble in the market.
From a wide range of the technical analysis methods a relatively modern and sophisticated
method of Artificial Neural Networks was chosen. The practical ability of the Artificial
Neural Networks method will be checked to provide investors with an early warning of the
impending collapse of two recently cracked major speculative bubbles worldwide.
AIM AND METHODOLOGY
Proving or disproving the possibility of the exact timing of the speculative bubbles bursting is
the main aim of this empirical case. The extreme volatile period from 2000 to 2008 included
two speculative bubbles which will be analyzed. In the 2000 the “Dot-com” bubble burst
because of the excessive optimistic development of technological stock prices. The
accumulation and the sudden burst of the Real Estate Speculative Bubble were at 2007
present at U.S. stock market.
The inefficiency of the given financial market is the basic presumption for the used model.
The S&P 500 stock market index was chosen because of its high liquidity. The average yield
of S&P 500 in the period of 2000 to 2010 was positive (0.0245%) which is at variance with
the efficient market thesis. On the contrary this point indicates the possibility of using the
technical analysis for the future stock market development. First - the causality between
history and future and second - the trend in the time series of variables analysed are the
necessary premises also. Psychological aspects influencing the financial time series
development were not considered (because of the difficulty of psychological factors
transformation to the time series). Specific time series (trade volume, exchange rate) that can
cause a different delay to S&P 500 and the extraordinary news in media causing spontaneous
and imitating behaviour of investors were not included to the model likewise.
The data of one of the most liquid stock indices (daily close prices of S&P 500 from 2/1999 –
5/2008) were used for the empirical case. The development of the above mentioned index is
illustrated at Tab.1.
2
VESELÁ, J. Okolnosti výskytu spekulativních bublin na finančních trzích. Český finanční a účetní časopis. 2011. sv. 6,
č. 3, s. 18
240
The chosen data were analysed by Artificial Neural Networks (ANNs). ANN is a type of a
mathematical-statistical tool that allowes to investigate very difficult relations (without
possibility to be described by means of standard mathematical functions) between some
particular items of the time series. The ANN is able to find these difficult relations between
time series items paralelly by taking the advantage of its specific architecture. The parallel
calculation (that secure a speed and a possibility to recognize even complicated relations) is
one of its major abilities. The mutually mathematical dependence of each item of the time
series can be applied for the future development of variable analysed.
RESULTS
The time series of S&P 500 was divided to two parts relating two selected speculative
bubbles. These parts of the time series were given to the ANN to examine. The predictions of
ANN were calculated from ten-month´s data for the next two-month´s period. The predictions
were applied on 12 intervals of each time period. Only the 5 most successful ANNs
(generating the smallest error) were used for the future predictions. The signals given by these
5 ANNs were noted. If the future downward trend was the prevailing trend for the next twomonth´s
period (validated by min.of 80% of ANNs), the possibility of bursting of the
speculative bubble occurred. Subsequently these signals were ex-post compared to the real
development of S&P 500 in that period.
Tab. 1 A Summary resumes the predictions of the future S&P 500 trend development in the two
reporting periods
Source: own work with data from the program Statistica (Neural Networks)
The first part of the Tab.1. illustrates the results of each ANN predictions in the “Dot-com”
period. The high probability of bursting the bubble in the beginning of 2000 was signalled.
The “Dot-com” bubble burst in 8/2000 (see Fig.1) – this situation was validated by ANN also.
The second part of the Tab.1 illustrates the ANN predictions in the period of the Real Estate
Speculative Bubble. The significant signals predicting the trend change (till that time mostly
increasing trend) were generated from the end of 2007. The real burst of that bubble occurred
in the same time.
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Fig. 1 View of the development of the S&P 500 in the period in points
Source: own work with data from Reuters
CONCLUSION
The views of theorists and practitioners are all united in the idea that the creation and
particularly rapid and dramatic bursting of speculative bubbles are negative and dangerous
phenomenon that has recently been increasingly present in financial markets. In an effort to
protect investors from the most tragic consequences of speculative bubbles it is still necessary
to search tools that are able to predict the moment of speculative bubble bursting.
The aim of the empirical section of this paper was to check whether the selected method of
technical analysis (applied to two selected speculative bubbles), the method the Artificial
Neural Networks can serve as useful predictive tool when a speculative bubble bursting.
A long-term historical time series of the closing prices of S&P 500 were used for the future
S&P 500 movements predictions. The circumstances of bursting two speculative bubbles
(namely the “Dot-com” and Real Estate Speculative Bubble) were examined by means of
ANN in the period of 1999 – 2008. The main goal of the analysis was the long-term trend
prediction (in this case: two month´s trend). If the trend was predicted by more than 80% of
ANNs and consequently confirmed, the trend generated by most of the ANNs was indicated
as a moment of high probability of bubble bursting.
The sample studied two speculative bubbles and shown that ANN is able to predict a future
significant decrease, which in turn may lead to the price bubble burst, with great precision and
in advance.
Taking into account more mutually influenced financial and economic time series and using
price-making information from media also can be eventually used to extend of this case study
in future (by using some specific coefficients adjusting the probability of the bubble bursting).
Likewise, some of the fundamental analysis method and indicators can be used for the
analysis the period before, after and during the bursting bubble.
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Academia AV ČR, 1993. ISBN 80-200-0496-3.
[3] MINSKY, H. P.: The Financial-Instability Hypothesis: Capitalist Processes and the
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7679-2363-4.
[6] SHILLER, R. J. Investiční horečka: iracionální nadšení na kapitálových trzích. Praha:
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[8] VESELÁ, J. Okolnosti výskytu spekulativních bublin na finančních trzích. Český finanční
a účetní časopis. 2011. sv. 6, č. 3, s. 6-21. ISSN 1802-2200.
Full name: doc. Ing. Jitka Veselá, Ph.D., Ing. Soňa Poláková
Institution: University of Economics Prague, Faculty of Finance and Accounting, Department
of Banking and Insurance
Street: W. Churchilla sq. 4
City: Praque 3
Email: veselaj@vse.cz; sona.polakova@vse.cz;
Masaryk University
Faculty of Economics and Administration
Department of Finance
European Financial Systems 2012
Edited by: Mgr. Petr Červinek
Editorial Board: R. Lukášová, L. Blažek, E. Hýblová, J. Maryáš,
M. Kvizda, J. Nekuda, D. Němec, V. Hynek
Published by: Masaryk University, 2012
1st
edition, 2012, number of copies 90
Printed by: Tiskárna KNOPP, Nádražní 219, Nové Město nad Metují
ISBN 978-80-210-5940-5