JMAA 2014.9

Volume 10, Number 9, September 2014 (Serial Number 112)

Journal ofModern Accounting and Auditing

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Journal of Modern Accounting and Auditing

Volume 10, Number 9, September 2014 (Serial Number 112)

Contents Auditing & Cost Management

A Statistical Analysis of Reliability of Audit Opinions as Bankruptcy Predictors 917

Carlo Caserio, Delio Panaro, Sara Trucco

The Theoretical Perspectives and Managerial Implications of the Balanced Scorecard (BSC) in the Italian Public Utilities 932

Francesco Agliata, Maria Rosaria Petraglia, Danilo Tuccillo

Finance

Global Financial Crisis: Systemic Failure and the Underlying Knowledge Gap 950

Mir Obaidur Rahman

Financial and Structural Stimuli for Regional Growth 959

Viktorija Šipilova

Corporate Governance & Human Resource Management

Corporate Sustainability and Ethical Codes Effectiveness 969

Daniela M. Salvioni, Riccardo Astori, Raffaella Cassano

Human Resource Controlling and Human Resource Management: Practice of Small and Medium-Sized Building Companies in the Czech Republic 983

Filip Bušina, Martin Šikýř

Journal of Modern Accounting and Auditing, ISSN 1548-6583 September 2014, Vol. 10, No. 9, 917-931

A Statistical Analysis of Reliability of Audit Opinions as

Bankruptcy Predictors

Carlo Caserio eCampus University, Novedrate, Italy

Delio Panaro University of Genoa, Genoa, Italy

Sara Trucco University of Pisa, Pisa, Italy

This research measures the reliability of audit firms in predicting bankruptcy for United States (US) listed financial

institutions. The object of analysis is the going concern opinion (GCO), widely considered as a bankruptcy warning

signal to stakeholders. The sample is composed of 42 US listed financial companies that filed for Chapter 11

between 1998 and 2011. To highlight the differences between bankrupting and healthy firms, a matching sample

composed of 42 randomly picked healthy US listed financial companies is collected. We concentrate on financial

institutions, whereas the existing literature pays considerably greater attention to the industrial sector. This research

imbalance is remarkable and particularly unexpected in the wake of recent financial scandals. Literature points out

two main approaches on bankruptcy prediction: (1) purely mathematical; and (2) approaches based on a

combination of auditor knowledge, expertise, and experience. The use of data mining techniques allows us to

benefit from the best features of both approaches. Statistical tools used in the analysis are: Logit regression, support

vector machines (SVMs), and an AdaBoost meta-algorithm. Findings show a quite low reliability of GCOs in

predicting bankruptcy. It is likely that auditors consider further information in supporting their audit opinions, aside

from financial-economic ratios. The scant predictive ability of auditors might be due to critical relationships with

distressed clients, as suggested by recent literature.

Keywords: bankruptcy, financial institutions, going concern opinion (GCO), data mining

Introduction

Along the time, bankruptcy prediction has been one of the targets that many researches tried to accomplish. In the early 1970s, several models were proposed, basing the analysis on the traditional financial ratios (Beaver, 1966; 1968; Altman, 1968).

By the time, while the information technology evolved and the need for more trustable predictions was felt by the investors, the bankruptcy prediction models progressed through the utilization of even more advanced techniques, based on data mining (Divsalar, Roodsaz, Vahdatinia, Norouzzadeh, & Behrooz, 2012),

Carlo Caserio, Ph.D., researcher, Faculty of Economics, eCampus University. Email: c.caserio@ec.unipi.it. Delio Panaro, research fellow, Department of Mathematics, University of Genoa. Sara Trucco, Ph.D., research fellow, Department of Economics and Management, University of Pisa.

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A STATISTICAL ANALYSIS OF RELIABILITY OF AUDIT OPINIONS

intelligence modeling techniques (Demyanyk & Hasan, 2010), and artificial neural networks (Alfaro, Garcìa, Gàmez, & Elizondo, 2008).

On a parallel track, many studies rely on the relevance of the going concern opinion (GCO), through which seasoned auditors report the early warning signs of bankruptcy (see, among others, Casterella, Lewis, & Walker, 2000).

The global financial crisis, started in 2007, along with the recent financial scandals, has brought about increasing attention paid to the auditor opinions issued on distressed clients. The GCO represents one of the most relevant judgments the auditors express, as it is even able to affect the equity markets (Blay, Geiger, & North, 2011) and the investors’ behavior (Menon & Williams, 2010).

Given the importance of the GCO, several papers in the literature try to explain the relationship between the GCO and bankruptcy prediction.

Lennox (1999) argued that the role of auditors is foremost to warn investors when a company is likely to go into bankruptcy. Hence, auditors are obliged to issue a “going concern qualification”. Some scholars took the opposite view and concluded that the GCO, at best, offers only marginal information to stakeholders (Mutchler, Hopwood, & McKeown, 1997). Still, other authors gauged the reliability of auditors in issuing a GCO and they found that a large number of opinions tend to be wrong about the likelihood of bankruptcy. Actual outcomes often turn out to be quite different from what these auditors were predicting (Malgwi & Emenyonu, 2004).

Uneven results of this nature are justified by auditors who say that they are only responsible for reporting the past and the present. They do not consider themselves as “clairvoyants”, therefore, they should not be held responsible for predicting the future of a company (Casterella et al., 2000).

Investors pay increasing attention to the GCO, because they consider it as a preliminary bankruptcy warning signal. Investors, thus, need a transparent and credible audit opinion in order to make decisions. They would not rely on audited financial reports if they consider that opinion to be of low credibility (Robertson & Houston, 2010).

Still, other authors worried that a GCO issued on a firm would serve as a “self-fulfilling prophecy”, accelerating its failure by reducing public confidence in the firm’s capacity to continue as a going concern (Carson, Fargher, Geiger, Lennox, Raghunandan, & Willekens, 2012; Pryor & Terza, 1998; Citron & Taffler, 1992; Merton, 1968).

An audit opinion coherent with the real business situation of the audited firm could reduce the information asymmetry between capital demand and supply and thus, it could improve the investors’ awareness of the risks they run in investing in the audited companies (Holt & DeZoort, 2009).

The choice to focus the analysis on the financial institutions is due to the fact that the existing literature on the relationship between auditing and bankruptcy prediction pays considerably greater attention to the industrial sector (Carson et al., 2012; Wertheim & Fowler, 2012). We believe that the financial sector is even more relevant, since it involves a wider range of stakeholders. Relatively few researchers have written papers aligned with our focus on the financial sector (Kumar & Ravi, 2007; Malgwi & Emenyonu, 2004).

We conducted the study on United States (US) listed firms, because the US is still considered as the premier market and financial center and also because in the US, the Sarbanes Oxley Act (SOX) (US Congress, 2002) has a larger impact on the audit opinion than comparable laws in other countries. The US is also the place where frauds, scandals, and collapses have the biggest resonance, thus, it deserves greater attention from regulators.

The research is organized as follows. Section 2 provides an analytical literature review of GCO and its relationship with bankruptcy prediction models. Section 3 defines the research design. Section 4 describes the sample creation and data collection. Section 5 shows statistical analysis and findings. Sections 6 and 7 propose conclusions and suggestions for future researches.

Literature Review

Auditors have the responsibility to issue an audit opinion in order to assure that the financial reporting gives a true and fair view in accordance with the financial reporting framework used for preparation and presentation of the financial statements.

If the auditor has some substantial doubts about the firm’s ability to continue as a going concern, he/she has to issue a modified GCO. Such modification of opinion is called “emphasis of a matter” and it informs users of uncertainties or disagreements over accounting principles. Otherwise, if this emphasis of matter regarding the going concern is not sufficient to express the severity of the financial situation of the firm, the auditor must issue a qualified opinion, indicating the reasons of this choice.

The term “going concern” is based on the “continuity assumptions” that an entity will continue in operations for the foreseeable future and will be able to realize assets and discharges. Modification of opinion should be useful for the stakeholders to be informed of the financial conditions of the firm and for the management to take corrective actions, especially to prevent the failure of the firm.

The guidelines on going concern involve both accounting and auditing standards to regulate the preparation and evaluation of the financial statements of listed companies.

The accounting standard provides a description of going concern principle in International Accounting Standard (IAS) 1 (Disclosure of Accounting Policies, 1975). It states that a firm has to prepare its financial statements under going concern conditions. If the management has significant doubts about the ability of the entity to continue as a going concern, the uncertainties must be disclosed.

The issuance of the auditing standards related to the going concern started in 1974 when the American Institute of Certified Public Accountants (AICPA) issued the Statement on Auditing Standards (SAS) 2 and continued with SAS 34 (AICPA, 1981), SAS 59 (AICPA, 1988), SAS 126 (AICPA, 2012), and International Standard on Auditing (ISA) 570 (International Federation of Accountants, 2009). Whereas there is no relevant difference between SAS 126 and SAS 59 (SAS 126 is just a clarity redraft of the previous standard), there are instead differences between SAS 59 and SAS 34. Some authors, indeed, argue that SAS 59 was issued in order to reduce the investors’ surprise related to the bankruptcy (Asare, 1990; Holder-Webb & Wilkins, 2000). Moreover, while SAS 34 allows auditors to express their concerns about the continuity of the company by issuing a qualified opinion, SAS 59 allows them to issue an unqualified “modified” opinion. SAS 59 provides the following four categories of conditions/events that may raise substantial doubt about going concern:

(1) Negative trends in financial ratios; (2) Indicators of possible financial difficulties; (3) Internal matters; (4) External matters. The guidance contained in SAS 59 leaves much to auditors’ discretion, thus a huge part of the auditors’

judgments is based on their perceptions and the external events impacting their profession.

According to these considerations, auditors could commit two types of errors in modifying an audit opinion for substantial doubt about going concern: Type 1 is a false positive, which occurs when the auditor issues a GCO and the firm continues in business; Type 2 arises when the firm is going to fail and the auditor does not issue a GCO. As causes of the Type 1 error, Kida (1980) found the “self-fulfilling prophecy” effect and a deteriorated relationship with the client. About the Type 2, the risk of lawsuit by creditors and the loss of reputation could be factors explaining the error.

Prior literature streams attempted to find out the elements affecting the decision to issue a GCO, such as financial conditions of the audited firms, litigations, turnaround initiatives, size of the audit firm (Bruynseels, Knechel, & Willekens, 2013; Reynolds & Francis, 2000; Blay et al., 2011; Musvoto & Gouws, 2011; Chen, Xiumin, & Xin, 2013).

Bruynseels et al. (2013) investigated the link between management’s turnaround initiatives and auditors’ opinions, finding that turnaround actions are associated with a higher likelihood to receive a GCO. Reynolds and Francis (2000) questioned whether the client size affects the propensity of auditors in issuing a GCO. They considered the economic dependence and the reputation protection as variables of their study, finding that the issuance of a GCO by Big 5 audit firms is not affected by client size. Blay et al. (2011) provided evidence that the GCO is considered as an external communication of risk, as this type of audit opinion allows stakeholders to have incremental information related to distressed firms. Musvoto and Gouws (2011) argued that GCO assumption is anti-measurement in nature, as it is difficult to measure the attributes of accounting phenomena under GCO assumptions. Chen et al. (2013) evaluated the link among insider trading, litigation, and GCO, finding that the probability of receiving a GCO is negatively associated with the level of insider selling.

In the American context, the issuance of the SOX of 2002 can be considered as an answer to recent accounting frauds, but it did not change going concern issuing regulations (Bellovary, Giacomino, & Akers, 2006). Regarding this matter, some scholars tried to identify the state of the going concern decision in the post-SOX era (Nogler & Jang, 2012).

Bankruptcy Prediction Models and GCO

Even if the fundamentals of the bankruptcy prediction models can be found in historical contributions based on financial ratios (Beaver, 1966; 1968; Altman, 1968; Altman & Hotchkiss, 2006), attempts were carried out in order to improve the effectiveness of the bankruptcy prediction, taking advantage of other increasingly sophisticated models (Demyanyk & Hasan, 2010).

Among them are logistic regression techniques (Logit) (Ohlson, 1980), early warning systems (Davis & Karim, 2008), and artificial neural networks to forecast the main financial ratios (Celik & Karatepe, 2007) or predict the outcome of Chapter 11 bankruptcy (Luther, 1998). Still in the succeeding years, scholars tried to identify warning bankruptcy signs among the disclosure issues, through data mining (Divsalar et al., 2012), text mining (Shirata, Takeuchi, Ogino, & Watanabe, 2011), multivariate analysis (Mutchler, 1985), multivariate adaptive regressions (De Andrés, Sánchez-Lasheras, Lorca, & De Cos Juez, 2011), and more advanced fuzzy clustering analysis (Lenard, Alam, & Booth, 2000).

Most researches dealt with the bankruptcy prediction carrying out the implicit assumption to find out the factors which could span the information in the financial ratios (Pinches, Mingo, & Caruthers, 1973; Zavgren, 1985), determining the most critical and sensitive financial ratios which could represent an early warning against bankruptcy risk (Altman, 1968; Beaver, McNichols, & Rhie, 2005).

According to a wide range of scholars, auditors could have a key role in assessing the bankruptcy risk and thus in preventing a financial collapse.

Hodges, Cluskey, and Lin (2005) analyzed whether the most common cross-sectional bankrupt predictors—Altman Z-score, cash flows, and financial ratios—along with audit opinion, observed in the three years before the bankruptcy, gave back trustable predictive information about the collapse. The results show that the audit opinion does not represent an effective warning sign for impending bankruptcy and, at the same time, neither the other predictors provide very reliable information about the bankruptcy risk. On the same literature stream, Malgwi and Emenyonu (2004) focused on United Kingdom (UK) financial institutions considering a time lag going from 1977-1978 to 1999-2000. They wondered whether there exists an association between the bankruptcy of the banks and the preceding audit opinions. They thus used audit opinions as a proxy to evaluate the auditors’ effectiveness in predicting failure. They found that a large number of unqualified opinions were issued before the bankruptcy, different from what they expected.

A similar analysis was carried out by Casterella et al. (2000). They observed that auditors do not consider themselves as “clairvoyants”, thus they should not be required to predict the future of a company. Furthermore, in some cases, issuing a qualified opinion might also affect the events and might lead companies to go bankrupt (Hopwood, McKeown, & Mutchler, 1989).

However, there is a rich literature supporting the role of the GCO in predicting the failure of a company. Hopwood, McKeown, and Mutchler (1994) found that audit opinions have not a lower ability in predicting bankruptcy than that of financial ratio-based models, as it was expected.

Mutchler et al. (1997) examined whether auditors issuing a GCO on soon-to-be-bankrupt companies are influenced by contrary information (e.g., the default on debt) and by mitigating factors that offset such contrary information. Results suggest the existence of a significant correlation between GCO decisions and the probability of bankruptcy. By using three variables to indicate the debt status of the companies observed, namely, payment, covenant defaults, and cured defaults, their study represents the next step in the research of Chen and Church (1992) who analyzed the correlation between the GCO and a single debt status variable only. In turn, the analysis of Mutchler et al. (1997) was taken up and extended by Foster, Ward, and Woodroof (1998) who analyzed the usefulness of debt default and the GCO in the bankruptcy risk assessment. They found that loan default and loan covenant violations explain the bankruptcy at the time of the last annual report issued before the violation happened.

According to Lennox (1999), one of the roles of the auditors is precisely to warn investors when a company is likely to go bankrupt. He underlined that if there are possibilities that a company ceases to trade in the foreseeable future, then the auditors must give a GCO.

Moreover, Bryan, Tiras, and Wheatley (2005) considered that if the role of the GCO is to anticipate the signal of a possible bankruptcy, then the stakeholders should have the possibility to defend against the risk to have losses, carrying out timely actions.

Research Design

In this research, we measure the reliability of audit firms in predicting bankruptcy for US listed financial institutions. The focus of our research is the set of financial institutions which filed for Chapter 11 from 2002 to 2011. We retain that the sector of financial companies is the most significant given its impacts on a wide range

of stakeholders and even on the economic system as a whole. We, however, noted that in spite of such significance, quite low attention has been paid by scholars so far. They, instead, devote much more space and interest to industrial companies.

Our main assumptions are concentrated on the role that traditional accounting ratios may have in impacting the probability of the issuance of GCOs. Specifically, a worsening of financial ratios should increase the probability for auditors to issue a GCO and for companies to file for Chapter 11, according to a literature stream and professional associations (SAS 59, AICPA, 1988; Hopwood et al., 1994; Lennox, 1999).

We formulate our research questions on the basis of the controversial findings about the reliability of the auditors in predicting bankruptcy and in accordance with the literature review. Specifically, in addition to the stream of the literature that supports the relevance of financial ratios in supporting the auditors’ decisions about the issuance of a GCO, we further consider that the impact of financial ratios on auditors’ decisions is supported by the same SAS 59 which provides, among others, the negative trends in financial ratios as a condition that may cause a doubt about the company’s ability to continue as a going concern.

According to such a diversified set of sources which consider financial ratios affecting the issuance of a GCO, we formulate as follows our first research question:

RQ1: Which ratios are mostly correlated with the issuance of a GCO? Starting from the first research question, we will have to go in depth into the usefulness of financial ratios

in predicting the risk of bankruptcy. Even when we found a correlation between some specific ratios and the issuance of a GCO, we cannot so

far assert that those ratios are also useful predictors of bankruptcy risk, because the issuance of a GCO might not be correlated with the bankruptcy risk as well.

Therefore, we need to make a preliminary investigation on the capacity of financial ratios in predicting the bankruptcy risk, even considering that a diversified part of literature supports the use of financial ratios in predicting bankruptcy or in being a warning signal (Altman, 1968; Beaver et al., 2005). We thus aim to check if financial ratios are really useful to predict the risk of bankruptcy. On this basis, we formulate our second research question as follows:

RQ2: Are financial ratios useful in predicting the risk of bankruptcy? As from the above literature analysis, a large part of scholars believe that the audit opinion aims to provide

the stakeholders with the most reliable information about the bankruptcy risk of the company (Casterella et al., 2000; Lennox, 1999).

On this basis, we formulate as follows our third research question: RQ3: Is the audit opinion helpful in predicting the risk of bankruptcy?

Sample Selection and Data Collection

As the first step, we collected all the 996 US listed companies that filed for Chapter 11 between 2002 and 2011 from the Edgar Securities and Exchange Commission (SEC) database. Companies file for Chapter 11 when they, or their creditors, ask for protection under the bankruptcy laws of the US in order to restructure the financial conditions. We consider the Chapter 11 as a proxy of bankruptcy.

From the websites of all the 996 companies, we detected the sector and excluded those outside the financial sector. This skimming produced a list of 60 financial US listed firms (see Table 1). For each company, using Thomson Reuters Datastream, we extracted the audit opinions and the classical accounting performance

ratios used for financial statement analysis, excluding firms with missed values. We ended up with a list of 42 companies. We then divided financial ratios into three categories, depending on the financial statement document to which they refer: statement of cash flow, balance sheet, and income statement (see Table 2).1

Table 1 Distribution of US Listed Firms That Filed for Chapter 11 in the Sample Period (2002-2011) Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total All firms2 252 161 75 67 77 44 72 132 64 52 996 Financial firms3 6 8 3 4 4 4 6 17 6 2 60 % of financial firms out of all firms4

Table 2 Set of Financial Ratios Used in the Analysis Statement of cash flow ratios Balance sheet ratio Income statement ratio Cash flow/sales (CFS) Convertible debts (CD)/total assets Net income available to common (NIAC) Increase/decrease in cash and short-term investments (IDCSTI)

Short-term debts (STD) and current portion of long-term debts (LTD)/total assets Earnings before interest and tax (EBIT)

Total debts (TD)/total assets Net sales (NS) or revenues Total shareholder equity (TSE)/total asset Operating income (OI) Decrease in investments (DI) Equity in earnings (EE) Increase in investments (II) Return on assets (ROA) Discontinued operations (DO)/total assets Return on investment (ROI) Long-term borrowings (LTB)/total assets Return on sales (ROS) LTD/total assets Return on equity (ROE) Net debts (ND)/total assets Other liabilities (OL)/total assets Reduction in long-term debts (RLTD)

The Edgar SEC database provided us with the type of qualified audit opinions issued during the sample time period (e.g., going concern or others). Table 3 classifies the collected data and shows their composition.

Table 3 The Sample Total number of US financial firms

Number of financial firms filing for Chapter 11

Number of financial firms with no data available

Net number of financial firms filing for Chapter 11

996 60 18 42

From the extraction achieved on the Edgar SEC database, we found that 10 firms out of 42 received a qualified audit opinion, for a total number of 21 qualified audit opinions. All of them were GCOs. For each of the 10 firms analyzed, we collected the year(s) of receiving a GCO, the year of filing for Chapter 11, and the time lag calculated as the difference between the year of filing for Chapter 11 and the last audit report (see Table 4). The remaining 32 firms received an unqualified opinion.

1 A detailed description is reported in Appendix A. 2 All US listed firms that filed for Chapter 11 in the sample time period distributed per year. 3 All US listed financial firms that filed for Chapter 11 in the sample time period distributed per year. 4 Percentage of US listed financial firms that filed for Chapter 11 in the sample period over all US listed firms that filed for Chapter 11 in the sample time period.

Table 4 Details on Financial Firms Receiving GCO(s) Firm filing for Chapter 11, receiving GCO(s)

Y_GCO Y_Chapter 11 Y_audit opinion Time lag

1 2003 2005 2003 2 2 2009, 2010, and 2011 2011 2011 0 3 2004 2009 2009 0 4 1999, 2000 2002 2000 2 5 2000, 2001 2003 2001 2 6 2001 2002 2001 1 7 2004 2010 2009 1 8 2001, 2003 2005 2003 2 9

2001, 2002, 2003, 2004, 2006, and 2007

10 2000, 2001 2003 2001 2 Notes. Y_GCO: year of receiving GCO(s). Y_Chapter 11: year of filing for Chapter 11. Y_audit opinion: year of the last audit opinion received. Time lag: difference between Y_Chapter 11 and Y_audit opinion.

In order to validate the results of our analysis, we built a matching sample composed of 42 randomly picked US listed financial companies that did not file for Chapter 11, namely, healthy firms. For each of them, we carried out the same procedure followed for Chapter 11 filing firms described above. Among the matching sample, we found two firms that received a qualified opinion in the time period (2002-2011) considered (for a total of three modified audit opinions) and all of them were GCOs. The remaining firms had unqualified opinions.

Statistical Analysis and Findings

The statistical analysis is composed of the following four steps: (1) Data preprocessing; (2) Logit regression analysis; (3) Support vector machine (SVM) analysis; (4) AdaBoost meta-classifier.

Data Preprocessing

As stated above, the sample is composed of 42 bankrupted firms and 42 healthy firms. For each of them, we considered 23 financial ratios. Being N = 84 the total number of firms and M = 23 the total number of financial ratios considered, we denote with xi,j, where i = 1, ..., N and j = 1, ..., M (the j-th financial ratio related to i-th firm) and with Ti, where i = 1, ..., N (the last year of available data for i-th firm). For each firm, we considered a time lag of four years, that is, for each xi,j, we built xt

i,j for ti = Ti-3, ..., Ti. Last available year Ti for healthy firms is assigned with a one-to-one criterion, that is, we replicated

Ti (i = 1, ..., 42) related to bankrupted firms and assigned each of them to a randomly picked healthy firm (Nicolaou, 2004).

Resulting data are combined in a matrix A composed by N rows and M × 4 columns.

Logit Regression Analysis

To answer RQ1, “Which ratios are mostly correlated with the issuance of a GCO?”, we used Logit regressions (Greene, 2003). Logit regressions allow us to highlight which financial ratios are more correlated with going concern issuance.

To avoid problems related to the strong multicollinearity of our data, we used a naïve multiple Logit regression approach (Fraser & Hite, 1990).

We regressed each column of matrix A versus a label vector yGC ∈ RN. Each element of yGC is denoted as yi,t. yi,t ∈ {0, 1} where 0 indicates that i-th firm did not receive a GCO at time t, and 1 indicates that i-th firm received a GCO at time t.

Table 5 shows which financial ratios are correlated with label vector. Statistical significance is evaluated with a Z-test (Sprinthall & Fisk, 1990).

Table 5 Logit Regression Results Financial ratio significant for going concern p-value β Std. error CFS T − 3 *** -1.02972483 0.33266128 CFS T *** -1.46053943 0.27517565 NIAC T *** -0.82577326 0.25009811 OI T − 2 *** -1.03995088 0.34864458 OI T − 1 ** -0.66209752 0.27696253 ROE T − 3 *** -0.85516301 0.32234961 ROA net income/total asset T ** -0.57712023 0.23119814 ROI EBIT/total asset T ** -0.57496468 0.23105093 ROS T *** -1.74405296 0.3020313 STD/total assets T ** 0.60696131 0.25856189 TD/total assets T ** 0.57593395 0.23112596 TSE/total assets T ** -0.57565295 0.23111892 ND/total assets T ** 0.57465455 0.23104341 OL/total assets T ** 0.57536804 0.23111189 Notes. *, **, and *** indicate significance at the levels of 0.05, 0.025, and 0.01, respectively. Signs of regression coefficients βs are coherent with expectancies, which could confirm the goodness of our analysis.

SVM Analysis

In order to deepen RQ1, we performed an analysis using SVMs. SVM is a popular classification tool initially proposed by Cortes and Vapnik (1995). For n-dimensional

data belonging to two different classes, in its easier formulation, an SVM builds a hyperplane which maximizes the distance between the two classes. Vectors closest to the hyperplane are called support vectors (Pedregosa, Varoquaux, Gramfort, Michel, Thirion, Grisel, & Duchesnay, 2011).

Using Scikit-Learn, we built a SVM for each feature of the sample assessed as statistically significant by Logit regression, namely for the 14 financial ratios showed in Table 5.

SVMs are trained using label vectors yGC defined above and yBR ∈ RN. As for yGC, each element of yBR is denoted with yBR

i,t. yBRi,t ∈ {0, 1} where 0 indicates that i-th firm did not go bankrupt at time T, and 1 indicates

that i-th firm went bankrupt at time T. We denoted with SVMGC the set of SVMs generated using yGC as a label vector and with SVMBR the set of

SVMs generated using yBR as a label vector. Both SVMGC and SVMBR are trained on the whole sample (42 healthy and 42 unhealthy firms).

Since the generated SVMs are unidimensional, the support vectors are reduced to scalars. The mean of support vectors generated by each SVM ∈ SVMGC, denoted with SVMGC

j for j = 1, …, 14, can be interpreted as

the threshold value used by the auditors to issue a GCO; whereas the mean of support vectors generated by each SVM ∈ SVMBR, denoted with SVMBR

j for j = 1, …, 14, can be interpreted as the threshold value under (above) which a firm will go (will not go) bankrupt.

The distances between SVMGCj and SVMBR

j for j = 1, …, 14 are normalized between 0 and 1, where a value close to 0 means a low distance whereas a value close to 1 indicates a great distance. Table 6 shows that such a distance is always very close to 0.

Table 6 Distances Between SVMGC and SVMBR Variable Distance between SVMGC and SVMBR CFS T − 3 0.000600252 CFS T 0.00036893 NIAC T 1.21E-008 OI T − 2 1.24E-007 OI T − 1 1.14E-007 ROE T − 3 0.000616039 ROA net income/total asset T 3.98174E-05 ROI EBIT/total asset T 4.3159E-05 ROS T 0.00046917 STD/total assets T 0.000226876 TD/total assets T 0.000165959 TSE/total assets T 4.85188E-05 ND/total assets T 0.000167887 OL/total assets T 6.79433E-05

AdaBoost Meta-Classifier

To answer our RQ2, “Are financial ratios useful in predicting the risk of bankruptcy?”, we appeal to an AdaBoost meta-algorithm. AdaBoost, which stands for adaptive boosting, has been first proposed by Freund and Schapire (1997). It is known for its predictive capability and it is widely considered as one of the best statistical classifiers (Wu, Kumar, Quinlan, Ghosh, Yang, Motoda, & Steinberg, 2008). The main idea behind AdaBoost is to combine multiple classifiers, called weak learners, in a unique classifier through their weighted linear combination.

Because of its excellent generalization ability, it is widely used in classification in several research fields. In this paper, we present an application of AdaBoost in the auditing subject, aimed to classify companies for which it is predictable to receive a GCO or an unqualified opinion. We trained M × 4 SVMs, one for each feature of the dataset, on 50% of the sample using as a label vector yBR. Built SVMs are used as weak learners in the AdaBoost. AdaBoost is trained on the same subsample used to train SVMs.

The predictive capability of AdaBoost is tested on the 50% of the sample not used to train the algorithm. Results show that AdaBoost is able to correctly classify 75% of submitted examples. Table 7 shows results in greater detail and proposes a comparison of AdaBoost with auditors’ bankrupt predictive capability.

Defining global performance as the ratio of correctly classified instances over the total number of instances submitted, AdaBoost outperforms auditors (75% versus 53.8%). More in detail, auditors perform better on healthy firms, wrongly classifying about 1% of instances versus a 12.5% error rate of AdaBoost classifier (Type 1 error).

About firms which filed for Chapter 11, AdaBoost strongly outperforms auditors. Its error rate (Type 2 error) is much lower than that of the auditors (38.1% versus 90.5%).

It is important to underline that results could be influenced by sample size and composition. In order to answer our RQ3, “Is the audit opinion helpful in predicting the risk of bankruptcy?”, in addition to the above mentioned global analysis (on both samples), we now focus our attention on only Chapter 11 filing firms that received a GCO. By means of such an analysis, we can observe that only 10 out of 42 firms (24%) received at least a GCO (see Table 4).

Interestingly, eight firms out of 10 received a GCO just one or a few years before the filing for Chapter 11; the remaining two firms received a GCO quite far from the filing for Chapter 11. Only for six firms, the auditors perceived a pervasive and systematic risk of bankruptcy, issuing GCOs for more than one year.

Table 7 Auditors and AdaBoost Performances Comparison5 Section 1 Auditors global performance 0.538 AdaBoost global performance 0.75 Section 2

Chapter 11 Non-Chapter 11 GCOs according to auditors 0.095 0.012a Unqualified according to auditors 0.905b 0.988 Section 3 Chapter 11 Non-Chapter 11 GCOs according to AdaBoost 0.619 0.125a Unqualified according to AdaBoost 0.381b 0.875 Notes. a: Type 1 error. b: Type 2 error.

Moreover, on 76% (32 firms out of 42) of the Chapter 11 filing firms, the audit firms commit the error of Type 2, as they did not issue a GCO for them. Other considerations could arise looking at Table 6. The distance between SVMGC

j and SVMBRj for each significant ratio is always very close to 0. This means that

for those ratios, the threshold values used by auditors are close to the threshold values useful to predict the risk of bankruptcy.

Conclusions

The present study reveals some interesting findings regarding the reliability of audit opinions as bankruptcy predictors. The percentage of Chapter 11 filing firms that received at least a GCO by audit firms is quite low (24%), and this evidence suggests that the reliability of auditors in predicting bankruptcy is quite low. In order to deepen this evidence and answer our research questions, we carried out some further investigations using statistical methods.

Regarding RQ1, we found, through a Logit regression model, the ratios deemed relevant by auditors for issuing or not a GCO. The financial ratios mostly correlated with the issuance of a GCO are: CFS, STD/total assets, TD/total assets, ND/total assets, OL/total assets, TSE/total assets, NIAC, OI, ROE, ROA, ROI, and ROS.

5 The elaboration in Table 7 is referred to the four years preceding the issuance of a GCO.

About RQ2, an AdaBoost meta-classifier shows that financial ratios could be useful in warning the risk of bankruptcy. AdaBoost, analyzing the financial ratios, is able to properly classify 75% of firms. These results allow us to better answer our RQ3, even if the reliability of audit opinions in predicting the risk of bankruptcy seems to be quite low, due to a high rate of Type 2 errors (76% only considering Chapter 11 firms and 46.2% considering both Chapter 11 and non-Chapter 11 firms). The results from SVM show that auditors take into consideration the right threshold values for each ratio. These evidences highlight that auditors are reluctant to issue a GCO, maybe to avoid self-fulfilling prophecy problems or to comply with the management plans for the future. The partial failure of the auditors in predicting the risk of bankruptcy could be due to the further information the auditors rely on, aside from financial and economic ratios, in supporting their audit opinions. The scant predictive ability of auditors might also be due to critical relationships with distressed clients, as suggested by some recent literature streams, or to the kind of responsibility that auditors feel to hold.

As from literature, scholars assert that auditors have both contrary information and mitigating factors regarding their client companies (Mutchler et al., 1997). Therefore, auditors may take into account different or further information regarding their clients. Moreover, SAS 59 requires auditors to consider management plans and evaluate if there is some likelihood that the adverse effects will be mitigated into the future for a reasonable period of time.

We are aware that a systemic analysis of annual report ratios and external factors, such as financial crisis and regulations, is necessary to better validate our results. We consider necessary, as well, that professional associations and academics clarify whether the external auditors have or not the responsibility to forecast the success or failure of the management’s business plans and to properly predict the risk of bankruptcy, especially for listed firms. Stakeholders rely on auditors’ opinions in performing their economic decision-making process and thus, when auditors fail to highlight a warning signal, strong concerns about the effectiveness of the audit opinion do arise.

Some limitations of our study could arise from the features of the sample, even if it represents the universe of US financial listed firms which filed for Chapter 11 between 2002 and 2011.

Suggestions for Future Researches

Further interesting researches could arise from our analysis. An interesting step forward could be attempted splitting the results for Big 4 and non-Big 4. The behavior of audit firms in issuing a GCO could be different according to the size of the audit firm and the reliability of their opinions as bankruptcy predictors could be different as well.

Because the risk of bankruptcy is an interesting matter for all the developed countries, an attractive research could be carried out extending the sample to other countries. The comparison could allow us to find out if auditors have the same predictive capabilities in each part of the world and if factors do exist that could affect the predictive capability of auditors (e.g., a more stringent regulation).

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Appendix A

Ratio6 Description CFS The sum of net income and all non-cash charges or credits/net sales or revenues

IDCSTI The change in cash and short-term investments from one year to the next. This item is available only when the statement of changes in financial position is based on cash and short-term investments

CD/total assets The total amount of a company’s long-term debt which can be converted into common or preferred stock at a set rate and a set date

STD and current portion of LTD/total assets

Portion of debt payable within one year including current portion of long-term debt and sinking fund requirements of preferred stock or debentures

TD/total assets All interest bearing and capitalized lease obligations. It is the sum of long- and short-term debts Total liabilities/total assets All short- and long-term obligations expected to be satisfied by the company

TSE/total asset The sum of preferred stock and common shareholders’ equity DI The investments sold during the accounting period of the company II The investments bought during the accounting period of the company

DO/total assets The earnings of a division or segment of business that the company wants to discontinue or dispose of in the near future. Discontinued operations are treated as an extraordinary charge or credit when the per share amount includes disposal

LTB/total assets The amount received by the company from the issuance of long-term debt (convertible and non-convertible), increase in capitalized lease obligations, and debt acquired from acquisitions

LTD/total assets All interest bearing financial obligations, excluding amounts due within one year. It is shown net of premium or discount

ND/total assets Total debt minus cash. Cash represents cash and due from banks for banks, cash for insurance companies, and cash and short-term investments for all other industries

OL/total assets All other liabilities of the bank besides total deposits, short- and long-term debts, provision for risks and charges and deferred taxes

RLTD Funds used to reduce long-term debt, capitalized lease obligations, and decrease in debt from the conversion of debentures into common stock

NIAC The net income the company uses to calculate its earnings per share. It is before extraordinary items

EBIT The earnings of a company before interest expense and income taxes. It is calculated by taking the pre-tax income and adding back interest expense on debt and subtracting interest capitalized

NS or revenues Gross sales and other operating revenue less discounts, returns, and allowances OI The difference between sales and total operating expenses

EE Portion of the earnings or losses of a subsidiary whose financial accounts are not consolidated with the controlling company’s assets

ROA Return on assets ROS Return on sales ROI Return on investment ROE Return on equity

6 All ratios and its measurement are taken from Thompson Reuters Datastream.

The Theoretical Perspectives and Managerial Implications of the

Balanced Scorecard (BSC) in the Italian Public Utilities

Francesco Agliata Second University of Naples, Capua, Italy

Maria Rosaria Petraglia University of Naples “Federico II”, Napoli, Italy

Danilo Tuccillo Second University of Naples, Capua, Italy

The present work aims to conduct a critical analysis of control systems and tools of performance assessment in

local public services companies, with a particular reference to the public transport sector. The interest in this issue

arises for various reasons, from the growing economic significance of the sector at a national level, measurable in

terms of production value and the number of operators involved, to the spread of outsourcing policies, liberalization

and privatization, and the use of the standard cost to establish the level of funding. In the field of public utilities,

until a few years ago, the concept of control was intended only in a “bureaucratic” sense as the capacity to fulfill

the formal obligations linked to the strong regulatory context, ignoring aspects that have become fundamental

today, such as economy, efficiency, and effectiveness of management. The approach used is deductive and the

study ends with the presentation of the possible implications of the use of standard cost and the presentation of an

application hypothesis of a balanced scorecard (BSC) for local public transport (LPT).

Keywords: control system, balanced scorecard (BSC), performance, public utilities

Introduction

The present work aims to conduct a critical analysis of control systems and tools of performance assessment in local public services companies, with a particular reference to the public transport sector.

The interest in this issue arises for various reasons, from the growing economic significance of the sector at the national level, measurable in terms of production value and the number of operators involved, to the spread of outsourcing policies, liberalization and privatization, and the use of the logic of standard cost to establish the level of funding.

In our country historically, the local public administration (PA) has at the same time the function to plan the supply, manage the service (usually through an external entity, a private company), and regulate the coverage of the costs not covered by the revenues. The concurrent pursuit of these tasks on behalf of public

Francesco Agliata, assistant professor in Accounting and Business Administration, Department of Economics, Second University of Naples. Email: f.agliata@unina.it.

Maria Rosaria Petraglia, Ph.D. student in Accounting and Business Administration, Department of Economics, Management, Institutions, University of Naples “Federico II”.

Danilo Tuccillo, assistant professor in Accounting and Business Administration, Department of Economics, Second University of Naples.

DAVID PUBLISHING

THEORETICAL PERSPECTIVES AND MANAGERIAL IMPLICATIONS OF THE BSC

bodies has so far prevented the development of industrial organization of the field of public utilities, the containment of production costs, and the achievement of satisfactory qualitative levels of service.

From such a perspective, this survey aims to focus on the definition of characteristics and factors of the competitiveness of public utilities and the study of management control in view of value creation. The possible changes in the use of new tools for management control will be analyzed and, in the light of recent regulatory changes regarding fiscal federalism, a new strategic connotation of standard cost will be shown; with a particular reference to the latter, it is conceivable a development of standard cost to assess in perspective of performance targets to be implemented in budgeting operations to benchmark for the funding of the essential service levels.

In the field of public utilities, until a few years ago, the concept of control was intended only in a “bureaucratic” sense as the capacity to fulfill the formal obligations linked to the strong regulatory context, ignoring aspects that have become fundamental today, such as economy, efficiency, and effectiveness of management.

The urgency for the improvement of performances leads to supporting the most popular tools of management with a multidimensional model of control combining the specificity of the companies considered by expanding the scope even towards strategic variables, not necessarily quantitative.

The approach used is deductive and it ends with the presentation of the possible implications of the use of standard cost and the presentation of an application hypothesis of a balanced scorecard (BSC) for local public transport (LPT).

Distinctive Characteristics of Public Utilities From the Business Perspective The concept of public utility refers to the output of business activity. The term “utilities” refers to all the

companies involved in the management and provision of public services for a certain community. According to Art. 112 TUEL (Testo Unico degli Enti Locali), local public services are those dealing with

“the production of goods and activities designed to achieve social purposes and promote the economic and social development of local communities1” (p. 1).

Studies in business management gave evidence that the key feature of public utilities companies is represented by the output of the production process regardless of the nature of the economic entity, balance of governance within the company, profit-making or not. Therefore, the term “public utilities” refers to different types of companies using different forms of management and control.2

Such companies represent a new paradigm for public sector companies, founded on administrative decentralization and the introduction of competitive market logic in the supply of public services in order to regain effectiveness and efficiency in public action, and for this reason, it can be said that the increased scientific interest in corporate management of public services is progressing parallel to the theoretical development of new public management.3

The absence of a precise definition of the concept of public utilities on behalf of the national legislation left a great deal of attention to the doctrinal interpretation on the issue. In this regard, it is possible to identify two main approaches: 1 It was observed that the statutory definition of local public services is extremely fluid and flexible (Ricci, 2006). 2 For a further close examination on the topic, please make reference to Ricci (2009), Mulazzani and Pozzoli (2005), Fici (2004), and Persiani (2003). 3 On this topic, please see the traditional studies of Hood (1991), Barzelay (1992), Osborne and Gaebler (1992), Mussari (1994), Pollitt and Bouckaert (2000), Hinna (2002), Anselmi (2003), and Borgonovi (2005).

(1) The first, subjectivist, which would categorize service as public in relation to any legal entity that assumes the responsibility of provision. In this way, only the services provided by the PA would be considered public;

(2) The second, objectivist, whereby it is believed that the public qualification of a service needs to descend from legal protection and from the granted right to use or access to the service.4

For the purpose of this study, it will be taken into consideration the objectivist approach for the cataloguing of public services.

Consequently, next to the companies operating under market conditions both in the supply of the inputs and in the provision of the outputs, there are companies aimed at satisfying the needs of more or less identified social groups.

The production process, however, has common features and what follows, then, will be referred to public utilities without further specification on its public or private nature5.

The production process can be traced back, in brief, to three phases: acquisition of production factors, processing and provision of products or services. These stages are not always easy to distinguish, since in the economic field, some may occur together, as in service companies where processing and provision, due to the impossibility to “store” services, are concurrent in fact. In any case, the output of the production process must have a higher economic value, or at least equal, to that of the inputs used in the process; when that does not occur, it does not mean that a part of the utility of resources employed in the production process has been lost and that there is no value creation but wealth destruction.

The value created by these companies, because of the role of public interest entrusted to them, is characterized by the presence of a large social component. The social character is identified in the fact that the service should be equally available to all the members of the community and set up with standardized characteristics within it. Consequently, such companies must create a real socio-economic value through production processes reconciling the need to optimize the use of available resources (mainly public) with that of ensuring a broad and generalized access to the services provided.6

To them is assigned the task of ensuring the provision of adequate quality to all those who require it. This constraint has a direct and immediate impact on the dimensioning of production capacity and production methods adopted. All these factors introduce a high degree of uncertainty on the performance of the production process.

The restriction imposed on the sizing of production capacity, which, at least in theory, should always be able to respond to peak demand, requires a continuous research of better conditions of use of this capacity; indeed, it is necessary to optimize the significant investments made, which in most cases have been financed with public resources, through the adoption of appropriate policies of production management. 4 On the difference between subjective and objective approaches, please see Dugato (2001), Pototschnig (1964), and Villata (2006). 5 Such nature, moreover, should be identified on the basis of parameters which should be clarified and according to which the conclusions might be different. For example, in the case of a joint-stock company wholly owned by public bodies, in reference to the owner, it would be qualified a public company; on the contrary, if it is considered the legal form with which the activity is engaged, then the nature of the company would be qualified as a private. 6 For the transport service, for example, the coverage of a certain route should be ensured even in the presence of a low number of users, because the right to mobility must be ensured even if it is below the break-even point. In terms of efficiency, this extension would be justified by the presence of a specific interest of public decision that these services are provided under certain levels and conditions regardless of the opportunity to improve the technical and allocative efficiency in their production. In general, the connotation of merit good could lead to a public preference for provision and use of service greater than that of solvent demand from the market which is due to the fact that the social objective may diverge from that of maximizing profits and also because the preferences of the public may differ from those of private individuals.

In the companies considered, therefore, the ability to create value must be conceived as the ability to provide a certain predefined level of services by implementing an efficient production process; in other words, if the objective of maximizing revenues cannot be pursued, the ability to create value must be proven through the effective and efficient use of resources according to the assigned objectives.

Furthermore, the project of the production process of a public service company able to generate value requires the knowledge and analysis of the elements founding it. Each service company is configured as a system, which includes processes of production (service operations), where the factors of production are processed or re-processed so as to create the constituent elements of the service and service delivery where, instead, it takes place the assembly of such elements and the “product” is transferred to the economy of the customer. Certain components of the system are visible to the customer; others remain hidden, enclosed in a production process, sometimes referred to as a technical core, of which the customer may even ignore its existence.

In the production system, it is detectable, thus, a visible and an invisible part. The invisible part of the customer is the system of internal organization, which includes the company’s traditional functions: finance, marketing, human resources management, etc..

A distinctive feature of public utility companies, in order to chain production, concerns the inability for them to “self-determine” the cost of the service provided. The motivation behind this limitation lies in the peculiar characteristics of the output produced, since it is provided a service of universal type, which is equally designed to the whole community and in the fact that the proceeds of sale of such services are defined on the basis of contract terms signed between the PA and the managing entity (through the so-called service contract).

Management and Control Critical Issues for Public Utilities

The system of public services, in general, is regulated by a government authority responsible for planning and funding of services within the territorial jurisdiction, while the management of the service is performed by an operator.

In the past, the sector has not been particularly considered by the scholars of management control, being rather more frequently the subject of interest on behalf of economists and jurists, involved in analyzing the best forms of management and the related regulation issues.7

Public utilities structurally denote significant economic and financial stability problems, the origins of this imbalance must be sought in the contractual terms of the service provision. Indeed, as previously stated, the utility companies stipulate a service contract8 with the PA regulating the provision of services, the fare system, investments, and monitoring.

The fare system determines the criteria through which the revenues for the manager companies can be calculated, through the determination of the so-called fare9. The determination of the fare by the PA represents one of the main problems of the sector in question since: It is essential to balance the economic and financial

7 There are, however, significant (and recent) studies conducted by business economists. See, for example, Giunta and Mulazzani (2010), Landriani (2010), Mulazzani and Pozzoli (2005), and Liberatore (2001). 8 The service contract is a tool available to the public authority entrusted to regulate relations with the companies managing (produce and provide) the service. The agreement regulates the mutual commitments and obligations (the activities related to the provision of services, the fare system, investments, and monitoring) between the trustee authority and manager, as well as the objectives of improving standards of service and the level of user satisfaction. 9 The fare is the price of a good or a service established by an authority, a body, or a public company.

demands of the companies that need to provide a quality service and meet standards of operating efficiency and the requirement to ensure accessibility, even in economic terms, for the benefit of all the users. Where fares were not able to remunerate the costs of production, the PA intervened by providing operating grants to cover such deficit.

Despite some attempts of reform, the objective of achieving a concrete introduction of competitive tools to access to market is yet far away: The use of tender procedures for the assignment of the service was introduced as a rule, but also in the period in which it has not been weakened by further legislative actions, it has assumed almost in every application only a formal nature because of the coincidence between service and owner of the company that has historically done it. In fact, it is unclear why a local authority should be available to achieve a greater efficiency and save on public transfers, to assign the service to a company different from that of its ownership, considering that thanks to this, it may acquire, for example, important electoral support among employees. The outcome of the tenders made has been, with very few exceptions and not surprisingly, to entrust again the service on the outgoing managers or to associations of companies in which the outgoing managers had a dominant role.

From this perspective, it is important for the research to be directed towards defining the characteristics and factors of competitiveness of these companies in order to understand the organizational implications of management control and facilitate the effective pursuit of the executive and operational objectives.

In light of the recent enactment of Act 42/2009 for the implementation of Art. 119 of our constitution on fiscal federalism, the standard cost plays a strategic role in the life of public utilities, as the main benchmark for the regulation of financial/contributory relationships, and not only, between the contracting authority and the service management company.

According to the traditional view of planning and management control of companies, the standard cost was connected to budgeting and it represented a landmark in the operations of monitoring based on the logic of feedback, through the tool of variances, allowing us to assess the ability of the company to carry out effectively its own strategic policies.

On the basis of the new guidelines, on the contrary, the standard cost seems to be the starting point in defining the action plans of public utilities. In fact, the determination of the standard cost would affect the calculation of fares and from it, moreover, it would depend the amount of contributions paid by the PA.

The expression “standard costs” usually refers to pre-determined costs, obtained by certain levels of efficiency and price that a company, producing goods or services, wants to achieve in the use of available resources and in relation to certain operating conditions.

Standard costs represent a benchmark to assess the performance of actual costs and provide information for possible reorganization processes. The process of defining standard cost cannot be separated, then, by the different operating conditions in which companies work and by the performance characterizing the respective activity.

In a sector characterized by a regime of “imperfect competition” (natural monopoly), the public body introduces a regulation using the standard cost to remedy the lack of competition. As regards the “natural monopoly”, in fact, a reference is made to “competition in the market” where prices tend to be oriented to the costs related to an average efficient management. Conversely, it is in a situation of “competition for the market” when fares are fixed and so are the service requirements for compensation to be determined based on an average efficient operator.

The use of the standard cost is hence motivated by the need to compensate for the absence of competition, in or for the market, thus facilitating the identification of a standard for the determination of a reasonable cost, meant as the cost that an operator average efficient should be implemented in a competitive environment.

It is, therefore, important to acquire meaningful data, relating to a wide population of companies operating in the specific field of investigation that is sufficiently representative of the specific operational situation at the national level.

As a result, benchmarking analysis becomes motivating to meet the growing need of management to give a greater efficiency to the process of planning and strategic control and face the competitive comparison. In fact, the benchmarking model in the sense of “control for comparison” allows us to indirectly measure the intensity of the company’s performance by comparing them with those of the best and most competitive companies (the so-called best-in-class) and makes a significant contribution to management in terms of both strategic planning and programming of the control (Bocchino, 1995).

Some Trends in the Management of LPT Companies

Assuming that the identification of any public utility company can be carried out through the classification of the output to be achieved, it can be noted that the scope of the public transport service is to guarantee the citizens’ essential right to mobility.

Over time, we have gone from conceiving the LPT service from a basic service—created for the purpose of mobility within the territory, sometimes relegated to a niche phenomenon aimed exclusively at the poorest or less affluent population groups (Asstra & Hermes, 2008)—to a balanced development and anti-congestion service of local traffic (such as Fraquelli, Piacenza, & Abrate, 2001).

In light of the above statement, the social function of the service provided can be identified even for the LPT sector, as well as its universal characteristic. It has to be highlighted the importance of a correct programming of the territorial plans (Capriello, 2006)10 of spreading of public transport as well as correlating the financial resources required to make the infrastructural investments, thus providing a service suited to the needs and proportioning the production capacity.11

Another problem specific to the LPT sector is the ownership of the assets provided by the PA to the managing companies. This was addressed by implementing a separation between the owners of the property and the management. This possibility derives mainly from the purpose of resolving any difficulties arising from the creation of natural monopoly situations, to which a series of shortage of increasing objectives to be achieved can be traced back, especially in terms of cost of labour, strongly affected by high rates of unionization.

With reference to this last aspect, it should be specified as in LPT a broad use of human factor is made and in comparison with the other sectors of public utilities, a relevant percentage of labour costs emerges; therefore, they are considered the main and crucial variable on which to act.12 10 The combination of the above mentioned social component and the identification of the territory directly influence the functional devolution, in politics and the administrative sector, from the central level to the regional one, in accordance with the principle of subsidiarity. 11 It is important to make the following observation on this issue, according to which the service originates only where production capacity is used by the citizen-user and up to this moment, we are in the presence of a possible and available potential as a result of sustaining fixed sunk costs, with a significant discrepancy, typically appearing between committed costs and investment costs. 12 It would be rather necessary to appreciate the link/dependency existing among productivity/corporate competitiveness in relation to labour costs, expanding the overall corporate vision of potential compared with different reference stakeholders (such as Fraquelli et al., 2001).

The main purpose of LPT companies lies in the will to increase the level of revenue through increasing the qualitative threshold of the service supplied, so as to increase the number of users of the public service.

On the other hand, the main objective for the PA would be to develop the LPT, to achieve a substantial improvement in the quality of life of the end users and as a consequence of the entire territorial community.13

To accommodate such different objectives, the organization and the entire cost structure should be rationalized implementing adequate self-financing policies and investing part of the revenue towards the growth and improvement of the service provided.

To this end, different strategic intervention solutions directly impacting LPT company management policies have been announced, such as the choice of fare integration.14

The LPT company is traditionally characterized by a strong imbalance between operating revenues and costs.15 Hence, the importance of an information tool, such as analytic accounting, of re-elaboration and re-classification of revenues/costs by destination rather than by nature, which in addition to responding to the information needs typical of private companies, intended to support an internal operating control system, becomes a cognitive tool also for the public corporation, in favour of the controlling subject, in view of the so-called analogous control operations.16

Basically, being an essential service with a strong social content, traceable to the community socio-economic development role through lower energy consumption and reduction of the causes of environmental pollution, the main cause of the economic imbalance can be found in the supply side, generally at a political price and the application of non-remunerating amounts, that is, insufficient to cover operating costs incurred to ensure the service itself. On the other hand, the inability to generate revenue sufficient to remunerate used production factors can be noticed and the inadequacy and incompatibility of the cost structure compared with the revenue are the two main causes of operating loss.17

These losses were compensated through providing non-repayable public funding or even through special assistance with an inevitable result of removing responsibility from the managing companies with regard to the achievable economic results.

It is, however, interesting to recognize the existence of other perspectives of investigation and intervention 13 On the topic of likely crucial issues on the direct government intervention in the management of services and the choice of monopoly, see Recktenwald (1985). 14 With the above mentioned European traffic revenue regulation policy, an immediate and main effect of a reductio ad unum of all public transport supplies is produced; with a similar layout, the user acquires the availability through a single ticket to use in the entire network according to his/her own needs. At any rate, a series of critical elements following specific substantial implementation are to be noted, such as: the selection of an appropriate methodology for allocation of revenues deriving from fare; the fear of partial or total loss—by companies involved in the integration process, sometimes through establishment of a special consortium—of identity and image in the territory and in relation to its users; the concern of a decrease of the amount of turnover caused by a favourable price to customers; and the pre-selection of an appropriate operating as well as managerial structure of rate integration. For a critical observation of the quantitative outcome of the specific experience of Unicocampania, please see Sannino (2006). 15 According to the economical aspect, LPT companies are experiencing a period of general crisis. The first empirical proof can be revealed in the peculiar circumstance of the 70s during which the revenue covered 70% of the costs; currently, revenue covers approximately 35% of the costs, even if the provision has grown in terms of lines and served kilometres, the actual users have constantly decreased. On this topic, please see Tuccillo, Pirozzi, Agliata, and Maglio (2010). 16 With a specific reference to cost analysis, it can be said that the main scopes are the following: monitoring of particularly relevant items such as the cost of personnel, request for contributions to cover losses divided depending on the type of service, analysis of convenience between production and outsourcing, identification of managerial accountability parameters, etc.. For a more detailed reading on the topic, please see Liberatore (2001). 17 After all, to entrust one operator to manage the service during the whole period of the concession means that it will be the only provider present on the market, covered from the risk that the revenue quotas are removed from it.

with a significant potential impact on LPT companies’ performance levels. For instance, the adoption of horizontally integrated strategies regarding service, implemented by means of

creating intermodal connections, or using other services considered collateral with the final scope to increase the amount of turnover through increasing the variety of the supply. This suggests the search for new markets, which go beyond the local area, trying to make the best use of the complementarity through using resources or which refer to economies of scope/scale, i.e., introduction of new categories of services with obtaining synergies.

Using aggregate operations, through the use of alliances and agreements, seems aimed at reaching positions of competitive advantage during the participation at tenders, using a variety of formulas such as that of the temporary association between enterprises (ATI) or of the consortium. In other terms, the objective is to equip with adequate requisites in order to better exploit the advantages which derive from the increased contractual power towards the PA following the drop in importance of existing competitors in the market. It must also be added the enlargement of competences that can be gained as a result of the combination of distinct experiences from the different actors involved, raising entry barriers to new competitors and the substantial attempt to neutralise derivable results from the reformation process.18

At the same time, as already stated, there is a tendency to increase the range of ancillary services to the main transport service (such as rental, maintenance, tourist services, school services, services for the disabled, etc.).19

A further tendency of the LPT company is to improve the quality of both the back and front offices. In that regard, of the utmost importance is the service contract, in the relation between the company and PA, to determine the default quality standard, to which a whole series of incentive or disincentive systems can be reconnected, i.e., the role of the Service Charter (Bortolotti & Maino, 2003),20 created as a regulatory/information mechanism about the relationship between the public utilities in question and the user community of the public transport service.

The Standard Cost in the LPT: First Remarks

In the reform project known as federalism, the review funding mechanisms that manage certain companies’ public services including the LPT sector is scheduled; the financing of these will no longer be based on historical expenditure but on the calculation of special standard costs for the delivered service.21

18 “If the growth of the considered dimensions of the effects on the experience curve linked to the action of learning economies, an advantage in terms of cost is achieved, then the consequence is that dimensional growth becomes an important strategic weapon even in the local public transport sector” (Mangia, 2005, p. 78). 19 As proof of these considerations, the results gathered and analysed by the Osservatorio Economico sui Servizi Pubblici Locali (Economic Observatory on Local Public Services) (Nomisma, 2009) are presented, showing the production values of 171 mono-service companies operating in LPT at a national level, composed as follows: revenue from sales (rates) with an incidence equalling to 69.9% of income, public contribution equalling to 10.9%, and other revenues equalling to 19.2% (Mulazzani & Pozzoli, 2005). 20 By way of example, the LPT company in the municipality of Rieti states that, “The Service Charter is a document that identifies the principles, rules, and quality standards of services in order to protect the needs of the citizens-users in compliance with the principles of effectiveness, efficiency, and cost-effectiveness. The Charter represents the company’s commitment towards customers and the users of the services. With this document, the company commits to ensure the provision of a service whose quality meets the standards laid down in the Charter itself” (Azienda Servizi Municipati Rieti Spa, Charter of Services on the Local Public Transport, 2011, p. 1). 21 It should be noted that the concept of (standard) cost is different from the expense. The first expresses the valuation of productive factors used in a specific period (e.g., one year) to perform certain functions and for the production of specific services. The second concept expresses the valuation of factors acquired during a specific period (e.g., one year) or of factors for which the body has purchase commitments for the same period. Naturally, the cost can be seen through financial-asset accounting, while the expense data can be recorded through a financial accounting system (which is the one typically used by central and local PAs).

The goal is to empower regional and local administrations, aimed at the economic and financial balance. In general terms, the accountability includes: (1) As regards costs, in terms of efficiency and functionality of service delivery choices, such as the

possibility of obtaining lower costs to the standard costs; (2) As regards revenue, the ability to balance transfers to the standard costs with taxes and/or fees charged

to users for the coverage of any difference between actual costs and standard costs. To this end, there are many interpretative uncertainties in the initial phase of the reform and doubts as to

the effectiveness of the reform itself. For example, it is acknowledged that public companies’ decision-making logic does not follow purely

economic motivations but relies mainly on political considerations as well as social choices that are potentially inconsistent, at least in the short term, with the parameters of efficiency.22 In addition to this political will, it is necessary to modify the existing balance in the relationships among local bodies, subsidiaries which manage local public service, and the local community.

With regard to the methods of standard cost determination, and specifically, the choice to refer to ideal or “normal” efficiency conditions, it must be said that LPT companies operate in very different territorial conditions, not only because of geography or population, but especially for socio-economic reasons.

In that sense, the key aspect is the identification of a sample on which the reference performance is to be tracked, and then to determine costs which are to be considered standard for all the other regions.

Another relevant aspect concerns the cost elements which are “subsidized”, either because they are or not included in the standard cost base calculation and those on the other hand which are borne by the local communities.

As it is known, different cost elements compose the cost of a service: (1) The production cost (or delivery), formed by special costs of production, i.e., directly referable to the

calculation. It expresses all production factors (staff, goods, services, etc.) which are part of the production of the product/service;23

(2) A portion of the common costs of the company (administration costs, overheads, etc.). Production costs should also include a portion of covering the cost of capital. Investments aimed at

creating and maintaining functional structural framework services (purchase of property and equipment, upgrading buildings, etc.) are, in fact, mainly financed through long-term debt; the inclusion of interest on debt in the standard costs highlights the intention that all or part of the cost of borrowing for investment is supported by the general public, rather than from local taxation. In addition, the inclusion of the cost of capital (also understood as the opportunity cost of equity capital) might arouse a greater interest by private enterprises in LPTs in the future.

Currently, the technique of direct costing per line is used in the LPT sector, concentrating on the comparison between traffic revenue (net or gross of the service contract contributions) and direct variable costs (maintenance, towing) to determine the gross contribution margin of the line; direct fixed costs should be 22 LPT companies, especially those in the south, have experienced occupational growth policies, which in the calculation of standard costs could imply significant initial difficulties especially in those areas where the objective was to sustain occupational levels. 23 Depreciation should be considered among the direct production costs, whose inclusion should allow the bodies to obtain financial resources to use for the substitution of technical fixed assets used for the provision of LPT services from the state (instead of from the local communities). Clearly, the inclusion of depreciation would make cost levels increasingly discretional.

subtracted from this (drivers, workshop or cleaning staff, warehouse depreciation), thus obtaining the semi-gross contribution margin per line. In order to achieve operating income, it is also necessary to subtract indirect fixed costs (coordination staff, workshop costs, warehouse, etc.) which are not split over the individual lines because of their non-flexibility.24

The determination of the standard cost should be weighted according to the type of service provided (urban, extra-urban), means used (rail, tyre), and some exogenous shocks to LPT companies such as traffic or even the risk of vandalism (Canzonetti, 2009).

According to the first point of view, urban and suburban transport should be distinguished. The first, carried out within the boundaries of a municipality, is characterized by the presence of a fairly circumscribed and dense network (i.e., with stops at relatively small distances). Since the route is moderately short, passenger vehicles are built in such a way so as to leave more space for standing room favouring a high load capacity. Fares are usually unique for the whole urban area and mostly independent of the length of the line.

A suburban transport network operates in a larger and less dense area and must respond to a demand focused on certain timeslots in which movement to and from the main urban centre concentrates; the frequency is lower than the urban transport and the supply of seats is increased depending on the length of routes and tariffs are differentiated according to the length of the route.25 This distinction is also reflected on the means of transport that include: trams, buses, underground, cable railway, and trains. In fact:

(1) Trams and buses have a much lower capacity compared with underground trains; (2) The commercial speed of underground trains is significantly higher than the average of surface

transport due to heavy traffic conditions. The latter, together with the electricity supply, allows underground trains to have a relatively lower

operating cost per unit of output; on the other hand, the construction, maintenance, or expansion of the underground network requires a financial commitment much higher than a surface line.

With regard to over-ground transport, there are significant differences among road transports, which guarantee greater flexibility in establishing baselines and in the use of vehicles and rail transport, more related to the available infrastructure and therefore characterized by greater management rigidity.

In general, the supply made by the companies operating in the LPT sector appears in part conditioned by exogenous factors (e.g., roads) in relation to the company’s decision-making sphere, or by public choices taken in the past (for example, the more or less extensive facilities of underground lines).

With regard to the main supply measures, these are represented by vehicles-km, which corresponds to the total number of km travelled in a year by all cars, and places-km supplied, which is obtained by multiplying the cars-km for the average capacity of the vehicles. Although the data on cars-km are widespread, it is not uniform

24 In line with the advanced direct costing concept, the contribution “gross” margin measures the capability of the line to produce revenue sufficient to cover, at least, the line’s direct variable costs. If the gross margin is negative, then the result is the incapability of the line to cover fixed costs generated in the short period, as for example, those of salaries and depreciation, whose amount does not depend on provision of service. Otherwise, if the gross contribution margin is positive, it would express the line’s capability to cover, in whole or in part, the direct fixed costs. For further readings, please see Aristeia (2003). 25 Even the cost of fuel and traction is different between urban and suburban services; generally, consumption for urban services is greater for the frequency of stops and the speed set by the urban network (traffic lights, pedestrians, and congestion). On the contrary, suburban services are carried out on a network with a higher commercial speed and with stops that are more distant, thus allowing lower consumption compared with the urban services. Furthermore, at a national level, companies may have, within the same type of service (urban and suburban), different consumptions, primarily due to the different structures of the network (e.g., frequency of stops) and the different geo-morphological characteristics of the network (e.g., mountainous areas or plains).

among companies, as it refers to units with different capabilities. On the other hand, places-km supplied takes into account the different carrying capacities of cars and, therefore, provides a higher degree of comparability among operators, provided that the capacity of the cars is calculated with homogeneous criteria. It must be remembered that cars-km and places-km are indicators that express the productive structure of the undertaking, regardless of the degree of exploitation of the service.26

Additional items to consider in the cost structure of LPT firms are technical-environmental variables which vary extremely and can significantly affect the size and dynamics of costs, for example, traffic congestion. The commercial speed, i.e., the ratio of cars-km and hours of service, represents an important factor in determining unit costs, which is what translates the cost per hour of exercise into cost-per-seat-kilometres supplied. Traffic congestion, the size (and respect) of the lanes, and the morphological and urban characteristics of different municipalities affect the time required and the number of vehicles needed for carrying out the service and therefore costs, particularly regarding personnel shifts, fuel consumption, and vehicle maintenance due to major stress. In addition, the use of means of public transport by citizens is often limited by the perceived risk of crime, another factor that is not controllable, at least partially, by the individual company.

Finally, it is important to highlight that the vision of using standard costs as an empowerment factor of regional governments prevails. The analysis should expand to the method of calculating costs, reaching to the dynamics of the proceeds (rates or taxes). In this sense, adopting net cost type contracts would be remarkable; with this type of contract, the handler receives an agreed fee ex ante and equal to the difference between operating costs and estimated traffic revenues, thereby increasing the risk to be borne by the operator, while the administration knows a priori the net burden of the provided service. This type of contract leads the service operator not only to cut costs but also to increase traffic revenues, countering the phenomenon of tax evasion.27

A Model of BSC in LPT

The BSC is a more advanced management control tool than traditional systems of enterprise monitoring, whereby they are restricted to use exclusively economic-financial parameters.

It starts from the assumption that company performance assessment methods through economic and financial indicators have become obsolete and they should be supplemented by the use of more significant future performance drivers; they usually appear as “non-monetary indicators” expressed in physical units (not uniquely classifiable), and constitute target-parameters for “strategic management”, intended in view of a “conversion of business strategy into actions”.

For measuring the degree of achievement of the strategic objectives, defined according to the typical four perspectives (economic-financial, the customer, internal processes, and learning and growth), the BSC uses a set of indicators divided into logical categories: the lead indicators (diagnostic indicators: cause) and the lag indicators (indicators of impact: effect). The first matches the performance drivers; the latter, rather, detects if the actions put in place by management have actually met the needs/expectations of the community. 26 The preference for the supply-oriented indicators, more than the demand-oriented, arises also in view of the normally wasted production capacity (sunk cost) of such companies. 27 In literature, at least three types of contracts are identified: (1) management contract, where both risks are borne by the principal entity. In fact, the operator receives a remuneration which is generally independent from the result achieved; (2) gross cost contract, on the basis of which the industrial risk is borne by the operator, while the commercial risk is borne by the principal entity. The operator receives a compensation based on the ex ante agreed costs and is paid for the production of a pre-established amount of service. This contract stimulates the company only from the cost aspect instead of from the revenue one, as the latter is managed and collected solely by the entity; and (3) the already mentioned net cost contract model.

A crucial aspect of implementing a BSC system lies in the choice of variables to be taken to reference; otherwise, a standard approach valid for every type of production activities cannot be implemented.

The main problem that arises, however, when an effort is made to identify an application hypothesis of BSC in the specific context of LPT, is connected to the particular nature of economic entities. On one hand, the LPT companies have elements typical of public companies, for example, the ownership of capital and, on the other hand, those of for profit, given the legal connotation of civil law.28 Hence, the two “souls” of the public service companies must be considered and combine the public and private needs (Kloot & Martin, 2000).

In this regard, it is necessary to build a strategic map—intended as the architecture required to make explicit the assumptions made by the company in accordance with the corporate strategy according to the BSC perspectives29—and only then define the multidimensional indicators integrated reporting.

Through the identification of the elements of the strategic relating to the four perspectives of Kaplan and Norton, a crucial element emerged, based on the fact that each action set up by LPT involves directly and indirectly the whole community and not just the service users. This means that the strategy set up by the company is not aimed at achieving economic results exclusively but also social results. In other words, to build the strategic map (Brusa, 2007) according to cause-and-effect relationships, the strategic goal remains unchanged but every aspect of community is influenced. This strategic vision implies that every decision the company makes has consequences on the community and the four perspectives do not seem to be sufficient to monitor this aspect. It is necessary to insert an additional perspective: the “community”.30

The perspective of the community arises from the vision of the LPT company as a subject dispensing a service aimed to meet the need of the society that considerably affects citizens, quality of life, and it also has a financial impact relating to the desire to reduce the cost of service, ensuring quality standards, through the promotion of improvement of processes and the reduction of evasion on behalf of users. In addition to this, there is a desire to increase the land areas covered by transport service allowing the provision of service to multiple users, and to increase the frequency of the service and its regularity. These issues affect the reliability of the LPT, thereby generating an improvement in the quality of life of users through both the reduction in the fleet of cars in circulation and the introduction of non-polluting vehicles, from an environmental and acoustic point of view (see Table 1).

In the financial perspective definition, it is fundamental to consider the main aspects of performance assessment (turnover, profitability, return on investment (ROI), etc.), more specifically, it is necessary to monitor the ability of the company’s autonomy. It is good to keep in mind that these companies place their production on the basis of a service contract agreed with the PA; being this the main “customer” of the company, it is necessary to monitor the possible degree of financial dependence. It will not be enough to control this aspect but support policies and promotion of the diversification of risk of loss of autonomy of the company itself must be implemented (see Table 2).

28 This is even more evident if we remember that the local bodies’ financial statements are written following the financial competence principle, conversely, the public transport company, as a joint-stock company must, on the other hand, follow a financial-asset type accounting (Marino, 2007). 29 In other words, the strategic map intends to describe the logical chain used in the cause-effect relationships among the different indicators chosen of the different perspectives. 30 Similarly, Sibilio Parri (2010) proposed to add a further perspective to the traditional ones, defined “institutional interests”.

Table 1 Community Perspective Objective Cause indicator Effect indicator

Containment of cost of service to promote a fare policy that manages to combine cost-effectiveness and socialization

Reduction of cost of service Cost of service coverage (%): Service revenue (fare) Total cost of service

Service cost reduction in critical areas: (1) Maintenance, repair, and operations (2) Operation (3) Human resources

Cost of service coverage (%): (1) Service revenue (price) Cost of maintenance (2) Service revenue (price) Operating cost (3) Service revenue (price) Cost of human resources

Reduction of evasion

Coverage of direct costs (%) (Legislative decree No. 422/1997): Revenues from transport tickets sold(Direct costs − infrastructure costs) Cover variable costs (a.v. and %): Revenues from transport tickets sold − variable costs

Increasing the supply of LPT service in some land areas

Percentage of land areas not served by LPT

Variation of the degree of coverage of the user areas (%)

Improving the quality of life Number of eco-friendly vehicles/total vehicle number

Level of polluting emissions (atmospheric and acoustic) in service delivery: Territorial area covered by the servicetotal area

Increasing the number of users

Number of new transport lines Activated lines (a.v. and %): Number of new lines activated/number oftotal lines

Number of transmission lines with increased journeys

Increase of the frequency of journeys made: Number of lines with increased routes/number of total lines

Improving the regularity of service Temporal regularity of transportation service

Implementation rate of scheduled service: Actual service level/scheduled service level

Table 2 Financial Perspective Objective Cause indicator Effect indicator

Management of public body financial dependency and increase in profitability

Increased revenue accessories (e.g.,sponsorships)

Dependency on public body (%): Government grants for current expenses/total operating revenues

Increased revenue from users Increase revenues (a.v. and %): Variation between revenue per year (n) and (n − 1)

Impact costs/revenues ROI − return on equity (ROE) − return on sales (ROS) − economic value added (EVA)

Achievement of budget results Degree of budget feasibility: (1) Budget costs/actual costs (2) Budget revenue/actual revenue

Empowerment of managers: Analysis of differences between budget and objective achieved

Moreover, the facts that the companies observed practice political prices and that the recognition of government grants is associated with their ability to pursue default results in compliance with the conditions laid down in the service contract must be taken into account. But in any case, the management objective of guaranteeing company survival through the pursuit of a sustainable economic and financial balance still remains a priority.

The user’s perspective, instead, is based on indicators which can be divided into two specific areas:

(1) Core measures: in order to measure the company’s ability to acquire and retain profitable customers; (2) Performance measures: in order to measure the company’s ability to meet customer expectations

(Fadda, 2004). In this respect, it can be observed that in private for-profit companies, the objective of ensuring adequate

dividends to shareholders appropriate to the level of risk when it was decided to participate in the business idea takes precedence. Conversely, in public companies, it can be said that the economic subject (the owners) coincides with the citizens who, having no profit, will be satisfied only if the quality of the service received is in line with their expectations, even taking into account the fare paid (cost of the ticket). From this comes the minor importance of core measures; in fact, the priority lies in the satisfaction of users’ expectations for which the LPT service was established (see Table 3).

Table 3 User’s Perspective Objective Cause indicator Effect indicator

Increasing user satisfaction to promote opportunities for dialogue with users to meet unmet needs: (1) Quality of service (comfort, staff, cleanliness, level of information for users, and timeliness of information); (2) Frequency of the transport service

Number of complaints by type (or frequency of service quality transport service): Number and frequency of information on services provided

Satisfaction of end-users: Quality service satisfaction surveys through questionnaires and online servicesExample (complaints): (1) Number of complaints/number of total users (2) Number of complaints reported/number of complaints received (3) Number of complaints resolved/ number of complaints received Analysis on the period number (e.g.,summer, Christmas time, strikes of the service staff, etc.) and typology

Increasing users’ loyalty level

Customer retention rate (a.v. and %): (Number of users at end ofperiod − number of new users acquired during period)/number of users at start of period

Level of customization services

To this the incidence of the political component in management decisions must be added; indeed, it is not always possible to find a logical and economic consistency in actions put in place by LPT companies (Niven, 2003).

For what concerns the estimation of quality of the output of the LPT, it must be said that in services, it is often difficult to identify and measure user needs and standard performance, mainly because it is defined by the user and each user is different from another (Esposito, Gentili, & Zini, 2000). In any case, the following reference to indicators measuring the degree of satisfaction of users can be assumed: passenger satisfaction indices (for quality of service, regularity of service, frequency of service, availability information, etc.), indices of quality level measurement perceived by the passenger, and the degree of impact on the level of satisfaction of ancillary services or personalized services provided.

With reference to the internal processes perspective, it is necessary to combine aspects of a production company, aimed at improving the management feature (through the reduction of costs and inefficiencies), with greater attention to improving the distribution of the service. Progress resulting from cost containment or reduction of inefficiencies translates into an effect on fees charged for the service and consequently generates positive effects on accessibility in economic terms (see Table 4).

Table 4 Internal Processes Perspective Objective Cause indicator Effect indicator

Improving maintenance process

Number of revisions of the planned vehicle fleet

Intensity rate of scheduled maintenance (a.v. and %): Scheduled maintenance interventions/maintenance interventions achieved

Number of subsequent failures

Intensity rate of fall maintenance (a.v. and%): Maintenance interventionsachieved/maintenance interventionsincluded in data sheet

Improving fleet reliability Staff rate employed in maintenance:Number of maintenance workers/vehicle fleet

Number of faults

Improving the process of building the operational programme

Service reliability rate: Delivered vehicle shifts/delivered vehicle shifts

Number of runs not carried out for lack of drivers

Optimizing the number of fleet vehicles Average vehicles used per day Fleet usage rate: Monthly peak of vehicle demand/number of fleet at the end of the month

Monitoring km travelled Number of “extra” runs due tobreakdowns

Programming rate km: Km planned/actual km

Km variation: Actual km − planned km Reducing lost km

Efficiency of the process, in the strict sense

Effective standards with private andpublic benchmarks

Cost coverage rate: (1) Total costs or costs of infrastructure/traveller seats or km (2) Total costs/number of travellers

Peculiar items relating to the management of an LPT company concern the programming feature, the number and the reliability of the means employed, and maintenance activities.

Table 5 Innovation and Learning Perspective Objective Cause indicator Effect indicator

Developing strategies to improve quantity of services provided New services provided to the users

Rate of usage of new services and satisfaction: Number of users using new services/number of total users

Development systems of internal and external communication with users

Construction of database and internal and external reports

Rate of circulation of information: Information requested/information provided

Technological innovation development Investment in advanced technologies to enhance the performance of vehicles and improve the quality of life

Investment rate in research and development (R&D): Investments in R&D/total investments

Developing networks and relationships with stakeholders

Projects in collaboration with other organizations

Growth rate of these collaborations: (1) Number of organizations with collaboration/number of organizations (2) Number of implemented projects

Developing skills and professional training

Number of training courses and work groups carried out

Degree of professional improvement and promotion of work groups: (1) Evaluation test results (2) Number of active staff in workgroups/total number of staff members

Promoting incentive schemes for the staff Number of oriented management policies to improve the business climate and the motivation of staff

Employee satisfaction: (1) Evaluation using anonymous questionnaires to employees (2) Number of participants to initiative/total number of staff members

Finally, from the innovation and learning perspective, it is considered appropriate to highlight the professional level of internal staff, using indicators that relate to the measurement of professional knowledge, increase satisfaction, participation in work groups, and membership projects promoted by the company. The growth point of view focuses on assessing the quality of services provided, internal and external communication, innovation, technology, and development of networks with stakeholders targeting both economic and financial results that achieve improvement for the community (internal and external) (see Table 5 above).

After the conclusion of this brief summary on global issues/features of a BSC system applicable to an LPT company, there is the presentation of a proposal possibly usable in companies with similar characteristics to those under examination. Below, there is the first strategic map built as described above (see Figure 1). The example of the proposed BSC is not exhaustive. Each perspective and aspect analysed could have been developed to further degree of detail, which for the purposes of research was not included.

Financialperspective

User perspective

Internal processes perspective

Innovation andlearning perspective Increasing staff

competenciesIncreasing

coordination ability

Increasing efficiency

Reducing production time

Reducing waiting lists

Increasing satisfaction

Increasing safety

Reducing costsIncreasing

income

Figure 1. Strategic map.

Conclusions

In the past, the public utilities sector was not particularly discussed by management control scholars, being rather more frequently a topic of interest of economists and lawyers, involved in analyzing the best forms of industry management and the related regulatory issues.

However, several elements, including one fundamental—the progressive reduction of public funds available to the industry—lead to a greater focus on the typical problems of management control.

For example, in light of the envisaged reforms in fiscal federalism, the standard cost seems conceived to have an increasingly important role in the measurement of efficiency, i.e., a cost considered adequate, as it is linked to the performance of an averagely efficient operator, operating in a standard competitive environment. Asides from future laws and without neglecting many operating difficulties encountered in determining the level of standard costs, it must be remembered that the standard costs help assess the economic gap between expected and actual outcome in the conduct of business activities and especially guide subsequent improvements. Therefore, it would be advisable to bring the analyzed companies closer to the “culture” of the standard costs, regardless of future legal provisions.31 31 On technical problems in determining standard costs for LPTs, please see Liberatore (2001).

Another aspect that has been highlighted is the opportunity to create a strategy map, i.e., a system of key elements for development, suitably summarized in a causal model, each of which shall be measured by one or more indicators which in turn form a system (the so-called BSC). Such a strategy map should act as a connecting element between strategy on one hand and budget/reporting on the other hand (Brusa, 2007). Obviously, it is important to focus the analysis on a limited number of key elements for the success of the reference business (those truly relevant for the implementation of the strategy) and that is actually possible to identify the causalities between them.

This is not, of course, a radically innovative approach but the adoption of a strategy map and of a BSC, especially in enterprises/PA has the advantage of forcing a reflection on the strategy pursued and on the actions to achieve it in practice.

Both the adoption of standard costs technique, and more importantly, the construction of a strategy map and the BSC require adequate investments in information technology (IT) enabling the management to have the required data in a timely and reliable manner. Clearly, the necessary investment in the upgrading of information systems must follow a prior and careful analysis of business strategy, critical success factors, and indicators by management; in other words, it should be clear (and this is not always the case in companies) that the management should request the information system to make the deemed necessary data available and that the management should not base its choices on information made available by information systems proposed by external IT consultants.

The design and implementation of an integrated information system must fulfil the choices of targets and indicators determined by company management at different levels of the organization.

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Global Financial Crisis: Systemic Failure and the Underlying

Knowledge Gap

Mir Obaidur Rahman United International University, Dhaka, Bangladesh

Recently, global financial crisis or meltdown rocked the international financial market. This havoc was the result of

the reckless use of financial derivatives that received spontaneous patronization from the financial whiz, but it is

strange to discover that those proponents of market economy embarked on policy that was purely Keynesian in

principle. The episode started in August 2007 with the collapse of subprime mortgage market and reached its

climax during August 2008. Central banks in many countries of the western world intervened in the market to

pump additional fund to give buoyancy in the credit market. The crisis encapsulated with the queer idea of financial

instruments and multiple origins related to subprime mortgage left its trail in both developed and developing

countries. Thus, an elaborate analysis of the causal link among various innovative instruments highlighting a

mismatch between academic doctrine and real-life perspective and the inadequacy of the institutional arrangements

supposed to tame the volatility of the market may be a useful guide to financial analysts and policy planners. The

purpose of this paper is to highlight systemic gaps in the meltdown and redefine the contour of macroeconomics

most appropriate to weather such catastrophe in the future.

Keywords: subprime mortgage, securitization, origin to distribution model, network theory

Introduction

Literatures on the recent financial crisis pointed out various factors behind the crisis (Colander, Föllmer, Haas, Goldberg, Juselius, Kirman, Lux, & Sloth, 2009; Crotty, 2009; Lawson, 2009; Capiro, Demirguc-Kunt, & Kane, 2010). Systemic may be an appropriate word to dub the recent global financial crisis, as this relates to failure of academics, policy planners, practitioners, and regulators. Indeed, many of them failed to comprehend the exact state of the economy and prescribe on appropriate policy to either tame or avert such a crisis. Academic failure manifests a wrong perception of the state of the economy by economists and financial analysts as pointed out by Nouriel Roubini, an economist at the Stern School of Business at the New York University, namely, the housing bubble in the United States of America (USA) would give way to a financial crisis and a recession. He was widely dismissed as an attention-seeking “Chicken Little” (Goodman, 2008). The period of the Great Moderation characterized by stable growth and low inflation witnessed in the major advanced economies since the early 1990s until mid 2006 did not augur any omen for the future. Robust global growth and low interest rates encouraged investors to seek higher returns, thus augmenting demand for riskier products generated mainly by financial institutions in the USA beguiling a very fundamental idea between real and nominal strands.

Mir Obaidur Rahman, professor, School of Business and Economics, United International University. Email: mirobaidurr7@gmail.com.

DAVID PUBLISHING

SYSTEMIC FAILURE AND THE UNDERLYING KNOWLEDGE GAP

The global financial crisis foretells that a genuine lack of perception between real and imaginary complex ideas may lead to a disaster that has wider ramifications. Surprisingly, the question bothered Queen Elizabeth II who asked “Why no economist had forecast the crisis” (White, 2009). The simple answer was though someone sounded warnings, policy makers attached to the financial institutions ignored the warnings; may be by the idea of “irrational exuberance” as propounded by Alan Greenspan, chairman (1987-2006) of the FED, in a speech on December 5, 1996 on the stock market performance. It is also interesting to scrutinize President Bush’s idea on the crisis at a closed Republican fund-raiser in Houston on July 18 that was published on July 23, 2008 in New York Times. “Wall Street got drunk—that’s one reason I asked you to turn off your TV cameras”, the president said. “It got drunk, and now it’s got a hangover. The question is, how long will it sober up and not try to do all these fancy financial instruments?”.

The hangover was in the form of a pile toxic debt riddled with an environment of uncertainty that revealed President Bush’s limited understanding of the financial crisis who considered it as a temporary phenomenon attributable to intoxication with “fancy financial instruments”, and in the very word of hangover.

Above illustrations manifest a misunderstanding on the functioning of the real economy. This premise was substantiated by the manifold increase of global financial asset against the real Gross Domestic Product (GDP). McKinsey’s Mapping Global Financial Markets (October 2008) put a staggering figure of global financial assets encapsulated in exotic derivatives worth US$196 trillion in 2007 from a paltry of US$12 trillion in 1980. A comparison between financial asset and the real GDP gives an awkward idea; while in 2000, only 11 countries had financial assets of more than 350% of GDP, and 25 countries reached that point by 2007. Moreover, the outstanding debts in USA grew from 20% of GDP in 1980 to 116% in 2007 (Blankenburg & Palma, 2009).

An understanding of the underlying reasons responsible for such an outcome may enrich our knowledge base and be a guide in monitoring future events. Thus, the purpose of this paper is to bring forth some pertinent issues of the financial crisis accessible to common mass and explore crucial areas of systemic failure. This paper is divided into four sections. The second section focuses on the amorphous derivative market emerged through securitization of mortgage deal and the extent of convolution in the process. The third section gives a perspective on the new macroeconomic foundations. Concluding observation is given in the fourth section.

Amorphous Mortgage-Backed Securities and the Wrong Perception of Structured Investment Vehicles

A financial crisis is not a regular phenomenon and generally occurs about once in a decade. The magnitude and the severity may be different in different cases. The Asian Financial Crisis of 1997 was a regional incident characterized by sudden reversals in capital flows that put the individual currency values in stress and also accentuated by loose monetary and fiscal policies. High ratio of short-term external debt to GDP, persistent current account deficit as a percentage of GDP, debt to GDP ratio, and overvaluation of currency were singled out as the major contributing variable (The Economist, 1996). The financial crisis of 2008 presents a different perspective: Factors responsible for the global financial crisis were quite different from the perspective of Asian financial crisis.

The crisis had its genesis in the subprime mortgage that reached its climax during August 2008 with several thousand foreclosures. The basic idea was on securitization based on pooling the mortgage deals very often not accessible to academicians and investors because of its complicated structure such as Collateralized Mortgage Obligations (CMO), Credit Default Swap (CDS), or Special Investment Vehicles (SIV).

“Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities” (Jobst, 2008, p. 48). This is an attempt to diffuse the risk of the assets they originate from the balance sheets to those of other financial institutions, such as banks, insurance companies, and hedge funds. CMO was first created in 1983 by investment banks and Wall Street firms, portions of which could be bought and sold. The owners are entitled to receive a corresponding share of payments from all the mortgage debtors in the package.

Subprime Mortgage and the Securitization Ordeal

Subprime mortgage is characterized by lending to clientele who are not eligible to get mortgage in prime market due to poor credit history or dubious distinction (impaired credit record). The enactment of Depository Institutions Deregulation and Monetary Control Act of 1980 wiped out the ceiling on interest rate and banks (particularly smaller savings & loan institutions (S&Ls)) could charge notably on mortgage. This waiver helped the share of subprime mortgage in total mortgage originations more than tripled between 2003 and 2006 (Goldstein, 2008). Moreover, the guideline for increasing home ownership for low- and moderate-income families opened avenues for independent mortgage brokers who were not generally supervised at the federal level like banks and thrift institutions. Subprime mortgages increased home ownership from 64% to 69% for the low- and moderate-income families (Gramlich, 2007).

There was frenzy even by government-sponsored institutions like Fannie Mae and Freddie Mac to put finance to those subprime borrowers. Both Fannie Mae and Freddie Mac purchased mortgage loans from banks and other institutions, bundled them into securities, and sold them to financial institutions and investors all over the world, held, or guaranteed more than $5 trillion in mortgage debt. Moreover, the real estate appraisers were captives of the mortgage companies, so they did not provide any independent check on credit worthiness. Thus, borrowing for home loans received a boost because of a very low interest rate for both short term and long term. It is worth noting that real short-term interest rates in the United States (US) were negative from roughly the third quarter of 2002 to the first quarter of 2005.

Low interest rate reflects both a low term premium and a low mortgage rate. Low term premium guarantees very low volatility in equity and bond markets and people will not have an expectation towards higher premium on long-term assets. So they may look for alternatives with more yields even with higher risk. Indeed, relatively low mortgage payments stoked the demand for housing market and inflated the housing price.

Investors were looking for outlets that ensure a higher return and they had it in the complex mortgage-backed securities even if they did not understand them. “Some of the purchasers of these securities did not understand what they were buying, the documentation was not very good, and these securities are very difficult to price because they have a complicated pay-off structure” (Goldstein, 2008, p. 3).

Two factors work in this mad drive. First, the independent rating agencies rated those mortgage-backed securities as AAA. The role of the credit rating agencies was rather dubious in this rating game. Surprisingly, one unit of the firm provided consultancy on how to design these products to fetch a higher return and another unit rated these products using the format as was prescribed by the design unit. So, it appeared that there was collusion in this naïve game. An example is Moody’s lion share in revenues during 2005 and 2006 from consulting on structured products. Indeed, independent credit assessment from the credit rating agencies was a major drawback that deceived the investors who primarily rely on rating agencies to fix their portfolio of investment. Secondly, monoline insurers blessed this structured product with enhanced creditworthiness to buy

insurance against default in the default swap market. Monoline insurers generally provide insurance for state municipal bonds when the state fails to honor the payment obligations. However, the temptation of rapidly growing complex mortgage-backed securities did work as an incentive for them to provide insurance against default in this market.

It is pertinent to see the networking in a conventional mortgage against the mortgage where it is difficult to trace the point of origin and the ultimate destination. The mortgage in the developing world is mainly conventional: one-to-one relationship between the borrower and the lender that is based on detailed eligibility check and adequate collateral coverage. On the other hand, mortgage deed in USA and in many other western countries spans beyond local borrowers and lenders popularly known as the originate-to-distribute business model. The idea encapsulates that the mortgage is likely to be sold to a third party who will package it with other mortgages and then issue some kind of mortgage-backed security. An in-built incentive structure worked also as a flaw in this model. Conventional mortgage focuses on a borrower’s ability to repay a loan. On the other hand, in subprime mortgage, banks focused on generating a high volume of loans thus booking as income the fees received to originate the mortgages. Thus, mortgage originators perform a perfunctory role in the process since someone else would be purchasing the mortgage. Instead of assessing borrowers’ ability to pay, lenders ended up focusing on collateral values, in effect anchoring on rising housing prices. Moreover, initial loan to valuation ratios on mortgages increased substantially during 2006, and explicit 100% financing became a more common phenomenon. An estimate shows that around 18% of mortgage originated in 2006 were in negative equity (Cagan, 2007).

There are two variants of securitization exercise: One so-called plain vanilla is very simple in nature and another could be very complex where those mortgage securities are also pooled with other kinds of asset-backed securities. The payments in these cases are split into various tranches (junior, mezzanine, and senior) and various ratings are given to those tranches. The philosophy was to augment the supply of mortgage finance and diffuse the risk to institutions capable to endure and thus enhance financial stability. The junior tranches are the most vulnerable and bear most the credit exposure but receive a higher return. There is a minor portfolio loss in senior tranches, because investors finance their purchases by borrowing and are very sensitive to changes in underlying asset values. This sensitivity was the initial source of problems in the subprime mortgage market in 2007. Thus, management of risks associated with these instruments poses significant challenges and in many cases has led to large exposures and concentrations that firms’ management failed to detect.

Methodically, this trail appears to be convincing but the academic failure stands in the weakest link in this chain, i.e., once the delinquency started to rise in the subprime market, the insurers did not have enough capital to handle defaults of this magnitude, and the credit premium that needs to be paid in the CDS market went way up and trading stopped. So, the promise of securitization did not work as per academic norm because of the complicated nature of origination and distribution model (Borio, 2008).

The academic failure is embedded in a simple paradigm that when a bank borrows from a depositor and lends it to household or business, the institution makes a provision for default loan but all that went out with deregulation and the enhanced scope of financial engineering. One of the important deregulations to mention in this context is the annulment by President Bill Clinton during 1993 of Glass-Steagall Act 1933 that had separated commercial banking from investment banking. This deregulatory measure allowed commercial banks to become large-scale issuers of mortgage-backed securities.

Another interesting aspect of these asset-backed securities is that these securities were put in off-balance sheets in special vehicles called SIV or conduits. The lenders thus faced a lower capital charge. A mismatch between borrowing and lending through these SIV, i.e., borrowing in a short term and investing in medium term with a maturity of seven years put a jolt in the system when delinquencies happened. People were a little bit cautious and thus were skeptical about the makeup of these securities and they lost confidence. The issuer of these off-balance sheet entities was faced with the dilemma of reputational risk, because the failure would reflect badly on the parent bank or investment bank. Therefore, they took these assets back on their balance sheets.

The Missing Link and the Ultimate Fall

At the outset, it was difficult to trace the link between the defaults in subprime mortgage market in USA and a massive default in broader credit markets that ultimately turned into a global turmoil of long duration. Mortgage market activity was not limited within USA; instead, non-USA financial institutions held mortgages on US properties and USA banks often maintained mortgage-banking subsidiaries in foreign countries incubating the contagion. The use of interest rate swaps to hedge mortgages in USA often involved a non-USA counterpart interested in swapping variable-rate payments in exchange for fixed-rate payments (Madura, 2008).

The contagion worked in two other ways: The first was the financial leverage, and the second was the massive global imbalance in the current account deficit of USA and substantial surplus in Asia, mainly in China. Financial leverage that takes asset on a whirl was a major contributing factor in the magnification of losses, but it is difficult to understand that instruments supposed to spread and diversify risks ended up in concentration of risks. Thus, the reckless use of these financial innovations with CMO/CDO and CDS has led to the crisis. Developed in the 1990s, these instruments proved to be fundamentally important in improving the pricing and distribution of credit risks. However, the past few years observed widespread and complex variations in its structure aided by advances in modeling techniques. “The sheer scale and variety of the use these innovations outstripped the capacity of even the most sophisticated dealers and investors to understand and manage the risks associated with them” (Cohen & Remolona, 2008, p. 3).

Massive imbalance in the current account portents a continuous savings and investment gap and the wrong alignment of currency value, Yuan, undervalued to the extent of 30% (Subramanian, 2010). These dual forces put substantial stress in the financial intermediation process and in-built flaws in the financial markets and instruments accentuated the crisis. Again, pursuance of an easy monetary policy in USA helped lower interest rate to fuel the crisis as compared with the Euro area and Japan; the deviation was much higher in USA as per Taylor Rule (Taylor, 2009). Moreover, an appreciation of the value of the asset particularly in housing and real estate through wealth effect accompanied by the low interest rate spurs consumption and investment. The availability of relatively cheaper goods and services from China and other emerging market economies worked as a conduit to promote price stability and pursuance of the accommodative monetary policy. It is interesting to note that many Americans came to treat their homes like an automated teller machine that never required a deposit.

Monetary accommodation may not be sustainable when inflationary pressure creeps up. Inflationary pressure puts pressure on interest rate. A rise in the interest rate pari passu raises the mortgage payments. Moreover, against the backdrop of a tight monetary policy, aggregate demand and output may be constrained, depressing house prices. USA housing prices nationwide went up about 90% between 1996 and 2005, 60% alone between just 2000 and 2005, and never experienced a fall in the 30-year run-up to the crisis, but the fall started in 2006 and it was just a nosedive, as given by the Shiller home price index.

Widespread defaulters in subprime mortgage led to losses by financial institutions and investors alike wiping off a significant fraction of their capital. The banking industry working in an optimistic environment never sensed a fall and the bank supervision never went beyond the mundane routine work such as excessive leverage, risk concentrations, and maturity mismatches whether on or off the balance sheet of the bank. Even many banks piled up loan on CDO based on subprime profile.

The entire model that was based on the assumption of low interest rate and upward trend in housing prices bids only a bright prospect of investment and return. But academic norm prescribed stress testing of any model when fundamental assumptions are changed. Such stress tests were based on the very optimistic data of the period of great moderation and thus failed to capture the reality (Haldane, 2009). It would have been more useful to test the model with default probabilities and see to what extent the model can endure the stress.

Fallacy in Macroeconomic Foundation

The legacy of the Keynesian Revolution permeated in the aftermath of the financial crisis in rescuing the ailing financial sector by central bankers all over the world for which they take pride to assert that they are all Keynesians. The Keynesian idea on expectation was rudimentary and the implausibility assumption of stickiness of wage and price with other economic variables ushered a new school, new classical school. New classical schools better dubbed as RatEx (rational expectation) were honored by the Nobel Prize of Robert Lucas for his contribution of policy ineffectiveness hypothesis. New classical schools assumed flexibility of wage and price. New Keynesian reintroduced the wage and price rigidities in the model.

Both Keynesian and new classical models failed to provide early warnings of the crisis. Macroeconomic stability requires fine tuning between aggregate demand and aggregate supply. Monitoring of aggregate demand is at the realm of financial institutions, notably the central bank and this brings the financial sector of the economy. Aggregate supply describing the production of goods and services brings the real sector. A mismatch between aggregate demand and aggregate supply forewarns the crisis, the pathology of which cannot be explained adequately by the available school of thoughts in macroeconomics such as Keynesian or new classical school when the web includes diversified agents with differences in information, motivation, knowledge, and strength. When wealth creation was bound up with manufacturing, exporting, and direct investment, it proceeded slowly. But now, it was possible through financial innovations to create wealth quickly. Consequently, increases in the asset value through loopholes in financial regulation and nurtured and nourished by a congenial environment invite bubble in the spectrum.

Rational expectation assumption in the new classical model begs individual expectations to be consistent with the structure of the model but actual expectations generally warrant empirical observation of the “expectations formation process of human actors, tends to be guided by heuristic devices and often by raw emotion” (Colander et al., 2009). Instead, the model based on rational expectation uses just simple extrapolation based on past data that ultimately failed to indicate the fall of the asset prices although recent events observed a fall in asset prices leading to financial crisis. Again, when rational expectation model with a representative agent is applied in the dynamic programming problems in macroeconomics, the plausibility of heterogeneity among economic actors is ruled out and opens the macro sphere equaling to micro sphere in all respects.

The development of macro framework from a microeconomic perspective requires a micro foundation of a macroeconomic model, which is absent from the curriculum of many economics programs. The approach is an interactive transaction model where agents at each point of the node with a preference map are given proper weight in interaction among the different actors since the issue of heterogeneity is important in such configuration. The assumption of representative agent in the basic structure is a major drawback of the current artifact of the macroeconomic model. Thus, origination and distribution model based on representative model failed to trace the link of delinquency in the current episode and as a result, the crisis spewed. Another pertinent aspect is the lack of psychological aspect in explaining the downturn in business cycle as pointed out by Colander et al. (2009):

The dynamic co-evolution of expectation and economic activity would allow one to study out of equilibrium and adaptive adjustments. Such dynamics could reveal the possibility of multiplicity and evolution of equilibria (e.g., with high or low employment) depending on agents expectation or even in the propagation of positive or negative “moods” among the population. This would capture the psychological component of the business cycle which, though prominent in many policy-oriented discussions, is never taken into consideration in contemporary macroeconomic models. (p. 9)

This academic gap could be salvaged through the network theory that can trace effectively events incorporating several heterogeneous agents, i.e., inter-bank linkages in a network format (Allen & Babus, 2009). The high degree of interdependencies in transactions such as exposures of risk in the interbank market, reconciliation of asset and liability side of their balance sheets, and holding similar portfolios or sharing the same mass of depositors with nodes representing diverse agents’ relative benefits and costs can be a useful representation of a financial system and can trace the linking point.

The application of the network theory in finance, especially the freeze on bank lending, is still in its infancy. Most literatures deal with the contagion and how the system exhibits resilience during contagion but “the actual contagion that occurred in the months following August 2007 came as something of a surprise” (Allen & Babus, 2009, p. 7). Thus, redefining the frontier of macroeconomics entails two crucial aspects: first, the treatment of micro anomaly as against the representative agent model in a comprehensive macro framework and the other is to identify the possibility of gridlocks, primarily due to breakdown of the payment systems (Freixas, Parigi, & Rochet, 2000).

A look at the Keynesian perspective with the assumption of stickiness in wage and price and the perfunctory treatment of uncertainty also constrain a neat analysis of the crisis. A more elaborate analysis is provided using the idea of “stages of credit growth, with the horizon of the credit getting ever shorter, culminating in what essentially Ponzi finance” (White, 2009, p. 17) where loans in the last stage of the boom are used to pay interest on previous loans. The chain breaks suddenly and the creditors focus on their own risks and look for imprudent behaviors of others. “The greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is in a deviation amplifying system” (Minsky, 1992, p. 7). The bust begins because of failure of production capacities with important implications for the real economy.

“The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made” (Keynes, 1964, p. 149). It would be unwise to treat the future as a replication of the past. When large changes are in the offing and expectation formation process is rather grey, then confidence in investment would be weak in the accumulation of risky assets. Powerful desktop computers and Ph.D. math available to economists of the current generation are apt to do more simulations from abstract concept divorcing from the real world environment.

Concluding Observation

Whether it is a static, comparatively static, or dynamic analysis, the existing macroeconomic model displays a stereotype decision—seldom incorporates a complex environment, dovetails changes in forecasting strategies, and more importantly, often excludes the social context that derives outcomes in asset and other markets. The model is often burdened with highly unrealistic restrictions to ensure stability and define a set time path. The perimeter of forecasting is also ill equipped to explain early indicators of system crisis and potential ways to prevent this malady from developing. Thus, the failure has a deep methodical root.

Macroeconomic policies, as we observe today, did not respond to increases in systemic risk. Moreover, the central bank policy focused mainly on price stability, very seldom on risks associated with high asset prices and increased leverage. And financial supervisors were preoccupied with the formal banking sector, not with the risks building in the shadow financial system. Monetary policy will be too blunt an instrument to deal with asset price and credit booms: The response has to be found mainly in prudential regulation. But that first line of defense has failed in the past and did so again recently. Therefore, there is a case for expanding the mandate of monetary policy to explicitly include macro-financial stability, not just price stability.

Future policy directives encompass two areas: regulation and a systemic check on growing imbalance. There were lapses by the financial regulators on many counts. Enforcement of the disclosure and transparency rules in the mortgage origination market was rather weak and FED’s failure in monitoring the concentration risks, i.e., the allocation of portfolio between housing and mortgage related loans. The role of the credit rating agencies in business was unethical. The transmission effect from the failure of one institution to another institution needs to be explored in a systemic way so that a domino effect in case of bail out in the wake of crisis may be contained. Basel II may be a more useful guide in looking into health of the banking institution. International financial institutions may monitor the macroeconomic health of the member countries to oversee the growing vulnerabilities from the contagion. Time series techniques may be useful to predict the deviations of financial or other prices from their long-run averages or a treatment of structural change may provide an indication of data going beyond the normal range, an indication of formation of bubble in the economy. Market discipline requires more transparent statements of the balance sheet of the financial institutions, especially the off-balance sheet exposure to financial risk.

A careful look of the financial crisis on the economy of less developed financial markets with required regulation and without any fancy derivatives displays rather a bright picture, though the pain is there because of contagion and reliance on export earnings and remittances flow. Bangladesh is a case in point. Mohammad Yunus, who won the Nobel Peace Prize in 2006, is optimistic about his business and beyond the travail, said that, “We have not been touched in any way by the financial crisis”. Microfinance institutions lend relatively small sums of money which the borrower can repay through weakly installments supported by group cohesiveness and peer pressure. He also said, on a visit to Japan, that, “The simple reason is because we are rooted to the real economy—we are not paper-based, paper-chasing banking. When we give a loan of $100, behind the $100 there are chickens, there are cows. It is not something imaginary” (The Economist, 2009, p. 1) and not with negative equity.

References Allen, F., & Babus, A. (2009). Networks in finance. In P. Kleindorfer, & J. Wind (Eds.), Network-based strategies and

competencies. Wharton School Publishing. Blankenburg, S., & Palma, J. G. (2009). Introduction: The global financial crisis. Cambridge Journal of Economics, 33(4),

531-538. Borio, C. (2008). Bank of international settlements. Working Paper 251. Cagan, C. L. (2007). Mortgage payment reset: The issue and the impact. First American Core Logic White Paper. Capiro, G., Demirguc-Kunt, A., & Kane, E. J. (2010). The 2007 meltdown in structured securitization: Searching for lessons not

scapegoats. The World Bank Research Observer, 25(1), 125-155. Cohen, B., & Remolona, E. (2008). The unfolding turmoil of 2007-2008: Lessons and responses. Conference Volume-2008,

Reserve Bank of Australia. Colander, D., Föllmer, H., Haas, A., Goldberg, M. D., Juselius, K., Kirman, A., Lux, T., & Sloth, B. (2009). The financial crisis

and the systemic failure of academic economics. Kiel Working Papers, Kiel Institute for the World Economy, No. 1489. Crotty, J. (2009). Structural causes of the global financial crisis: A critical assessment of the “new financial architecture”.

Cambridge Journal of Economics, 33(4), 563-580. Freixas, X., Parigi, B. M., & Rochet, J. C. (2000). Systemic risk, interbank relations, and liquidity provision by the central bank.

Journal of Money, Credit, and Banking, 32(3), 611-638. Goldstein, M. (2008). The subprime credit crisis: Origins, policy responses, and reforms. Peterson Institute for International

Economics. Goodman, P. S. (2008, July 19). Uncomfortable answers to questions on the economy. The New York Times. Gramlich, E. M. (2007). Subprime mortgage: America’s latest boom and bust. Washington, DC: The Urban Institute Press. Haldane, A. G. (2009). Why banks failed the stress test? Bank of England. Jobst, A. (2008). What is securitization? Finance and Development. International Monetary Fund, Washington, DC. Retrieved

from https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf Keynes, J. M. (1964). The general theory of employment, interest, and money. London: Macmillian. Lawson, T. (2009). The current economic crisis: Its nature and the course of academic economics. Cambridge Journal of

Economics, 33(4), 759-777. Madura, J. (2008). Financial markets and institutions (8th ed.). Ohio: Thomson. Minsky, H. P. (1992). The financial instability hypothesis. The Jerome Levy Economics Institute Working Paper No. 74. Subramanian, A. (2010). New PPP-based estimates of Renminbi undervaluation and policy implication. Peterson Institute for

International Economics, Policy Brief Number PB 10-8. Taylor, J. (2009). The financial crisis and the policy response: An empirical analysis of what went wrong. Working Paper 14631,

National Bureau of Economic Research. The Economist. (1996, August 24). Emerging Asia’s somber era (pp. 57-58). The Economist. (2009, March 19). Microfinance: Sub-par but not subprime (p. 1). Retrieved from

http/www.economist.com/node/13342261/print White, W. (2009). Modern macroeconomics is on the wrong track. Finance and Development, 46(4), 15-19.

Financial and Structural Stimuli for Regional Growth∗

Viktorija Šipilova Daugavpils University, Daugavpils, Latvia

The economies during the post-industrial era are returning to the classical meaning of manufacturing sector in the

process of balanced regional growth and are searching for stimuli for diversifying economic structure and

reindustrialization. Expansion of a new growth theory highlighted the necessity for the well-developed so-called

innovative manufacturing sector; however, stimuli for realizing the potential of this sector are limited due to relative

attractiveness of sectors with lower risks and faster returns especially in regions followers. Moreover, regional

success as a result of the previous development can hinder changes and stimulate economic agents to avoid regions

and sectors with high potential but weak performance. Generation of regional economic growth can be considered in

a framework of two kinds of stimuli as financial and structural. Financial capital as an important factor for supporting

structural change in economy helps to stay in harmony with the modern economy; however, existing sectoral

composition can be persistent to changes. Latvia is considered as a case study about issues on financial and structural

stimuli for regional growth because of the bright dominance of capital city region (high regional differentiation) and

typical post-industrial economic structure in parallel with an intention to actively participate in reindustrialization and

increase the innovativeness of economy. This article searches whether foreign investment stock in a company’s

equity capital provides a stimulus for an industrial change at a micro level (five regions and 12 manufacturing sectors

in accordance with statistical classification of economic activities NACE 2 Rev. (Nomenclature generale des

Activities economiques dans les Communuates Europeennes) two-digit level) and whether this change contributes to

the regional growth. Unbalanced regional growth as a result of reallocation of financial resources among sectors of

economic activity and differences in distribution of economic success at a sectoral level provide a useful foundation

for testing the impact of foreign direct investments (FDI) on changes in economic structure.

Keywords: financial stimulus, structural stimulus, regional growth, structural change, foreign direct investments

(FDI), Latvia

Introduction

The recent global economic downturn has stimulated a regional divergence (both at local and global levels) and has highlighted issues on unbalanced economic structure and preferences of the foreign direct investment (FDI) flows. Necessity to find a “correct” stimulus for growth requires an assessment which is based on acknowledgement of manufacturing and the so-called innovative manufacturing sector as a direction for further growth. Such an understanding makes the issues on structural composition of economy and resources necessary for its change interesting for research, especially for countries during the way towards prosperity. ∗ This work has been supported by the European Social Fund within the project “Support for the Implementation of Doctoral Studies at Daugavpils University, 2nd Stage”. Agreement No. 2012/004/1DP/1.1.2.1.2/11/IPIA/VIAA/011.

Viktorija Šipilova, Ph.D. candidate in Economics, researcher, the Institute of Social Research, Daugavpils University. Email: sipilova.viktorija@inbox.lv.

DAVID PUBLISHING

FINANCIAL AND STRUCTURAL STIMULI FOR REGIONAL GROWTH

This article presents the experience of a country with an unbalanced dispersion of economic growth among regions and sectors of economy and relative persistent post-industrial economic structure. The logic of this research is organized in a framework of an opposite understanding of the stimuli for growth: differing meaning of FDI in a growth process. FDI and structural composition of economy are focuses of this article.

Theoretical Understanding of Financial and Structural Stimuli for Growth

The recent global economic downturn highlighted the necessity for scientific and practical activities towards growth issues. Moreover, some authors indicate that the knowledge of previous generations, although, is not sufficient to understand the causes for economic growth today (see, for example, Kenny & Williams, 2001), consequent and ongoing changes of accents in models for economic growth indicate changes in dominant factors in the growth process. Issues on FDI and structural change are focuses of this article due to the absence of a univocal opinion concerning their effects on growth.

FDI is considered as an important stimulus for economic growth regardless of countries’ development stages. The logic of explanation can be found in endogenous growth theories which indicate that accumulation of human capital and technological externalities are necessary for growth, in turn, FDI can increase the existing stock of knowledge (see, for example, Barrowclough, 2007; Rodriguez, Gomez, & Ferreiro, 2007). Some authors, however, also indicate a pessimistic viewpoint concerning the positive effect of FDI on growth process (see, for example, Rodriguez et al., 2007), despite the findings that FDI can lead to the wide productivity gap between foreign and local firms (Rodriguez et al., 2007), and such a negative spillover could be softened by the fact that FDI flows can provide an access to global research and innovation network (Barrowclough, 2007).

Changes in the economic structure can be considered as both cause and factor for changeable economic growth (Quatraro, 2012). This, in turn, provides an interest for taking structural change into account for searching the stimuli for growth. The linkage between growth and economic structure is also actively debated from opposite viewpoints. This issue lost its central position in research since the neoclassical economic ideas dominate over the classical economics (Memedovic & Iapadre, 2010; Roberts & Setterfield, 2007), but economic development as a result of the economic growth is closely related to changes in production structure, because structural change means adaptation to changes stimulated by the technological progress (Silva & Teixeira, 2008). Moreover, empirical research findings in all times proved the significance of economic structure in development (Memedovic & Iapadre, 2010), because changes in favour of certain sectors of economy can stimulate economic growth (Janger, Hölzl, Kaniovski, Kutsam, Peneder, Reinstaller, Sieber, Stadler, & Unterlass, 2011).

Today, reallocation of labour force from low productivity sectors towards high productivity sectors is the main issue for countries which try to attain prosperity, and these countries sometimes are welcomed to make the emphasis on changes in production structure more than on technologies and also its acquisition. Modern economy requires understanding productivity, technologies, and production structure as driving forces for growth; therefore, changes in favour of the so-called innovative manufacturing sector take a leading position in the growth process (United Nations, 2006).

Taking into account the leading role of FDI in this article and the opposite viewpoint concerning the effect of FDI on growth, the author pays attention and combines arguments of the Harrod-Domar growth model and the Solow-Swan neoclassical growth model. In general, both models present opposite viewpoints related to the role of investments in growth process. The Harrod-Domar model highlighted the significance of investments in the growth rates worldwide, in turn, the Solow-Swan neoclassical growth model argued that growth is dependent not on investments, but on technological changes (see, for example, Kenny & Williams, 2001). Both viewpoints are presented in this article as an evaluation of the financial and structural stimuli.

Thus, this article unites the results of different models and provides the following logic of research: contribution of manufacturing sector (especially high-technology) to the economic growth and contribution of FDI to the sectoral change and thus to the growth also.

Data, Method, and the Logic of Research

Whether the sectors more significant for regional growth are also considered as crucial and attractive for FDI? The answer, in general, provides an insight into the potential of sectors to be at the fore of structural change in economy, thus becoming a stimulus for growth also, as well as indicates the possibility of FDI to be a crucial factor for growth.

This article considers financial and structural stimuli for regional growth in Latvia. Empirical presentation of the research issue operates with regional data on employment (Central Statistical Bureau of Latvia, 2014) and FDI in a company’s equity capital (Lursoft, 2014) by sectors of manufacturing at NACE 2 Rev. two-digit level1 in five regions2. Data on regional growth are presented by values of Gross Domestic Product (GDP) at the regional level. The structural composition of economy is illustrated by specialization calculated as location quotient (LQ) which is one of the most commonly used techniques for measurement of relative local representation of employment (see, for example, O’Donoghue & Townshend, 2005).

The logic of research is organized in accordance with the understanding that the existing economic structure could be influenced by FDI. Combination of argumentation of the Harrod-Domar model about significance of investments for growth (Kenny & Williams, 2001) and understanding the high meaning of structural change for modern economic growth (Memedovic & Iapadre, 2010) are applied in this article. The widely accepted and proven Solow-Swan neoclassical model for long-term growth depending on technological change (Kenny & Williams, 2001) is presented as special attention to the economic structure and the high-technology manufacturing sectors. Such an interaction can provide a stimulus for change or the other way round support the persistent economic structure. Interaction between regional growth and financial and structural stimuli is measured by using a non-parametric correlation analysis.

The author highlights that the experience of the Latvian economy can be useful for testing financial and structural stimuli due to high regional differentiation, as well as because of the relatively persistent dominance of post-industrial economic structure in Latvia. 1 C10-12: manufacture of food products, beverages, and tobacco products. C13-15: manufacture of textiles, wearing apparel, leather, and related products. C16-18: manufacture of wood, paper, printing, and reproduction. C20: manufacture of chemicals and chemical products. C21: manufacture of basic pharmaceutical products and pharmaceutical preparations. C22-23: manufacture of rubber and plastic products and other non-metallic mineral products. C24-25: manufacture of basic metals and fabricated metal products, except for machinery and equipment. C26: manufacture of computer, electronic, and optical products. C27: manufacture of electrical equipment. C28: manufacture of machinery and equipment n.e.c.. C29-30: manufacture of motor vehicles, trailers, semi-trailers, and of other transport equipment. C31-33: manufacture of furniture, jewelry, musical instruments, toys, and repair and installation of machinery and equipment. 2 Riga region, Kurzeme region, Zemgale region, Vidzeme region, and Latgale region.

Financial and Structural Stimuli for Regional Growth in Latvia

Regional uniqueness provided by the sectoral composition of economy can work as strong evidence of the regional economic identity, although regular structural change stimulated by requirements of modern economy should have a place for staying competitive. Regional growth, however, should rely on the processes of modifying the knowledge into the innovation in all sectors of economy, but as widely recognized practice indicates, higher value added produced as a result of innovative activities mostly can be observed in the so-called high-technology manufacturing sectors (such as “manufacture of basic pharmaceutical products and pharmaceutical preparations” (C21), “manufacture of computer, electronic, and optical products” (C26), and “manufacture of other transport equipment” (C30))3. Usually, performance of high-technology manufacturing determines the level of attractiveness of regional economy in processes of reallocation resources, because better performance in high-technology manufacturing can indicate relative readiness of regional economy to participate and overcome activities in economic sectors with higher financial risks (e.g., development of high-technology manufacturing is related to high financial and human investments and risks).

e f Figure 1. Regional economic structure and its changes, values of regional specialization (LQ) in Latvia by regions (2000-2011).

Source: own calculations based on the Central Statistical Bureau of Latvia (2014). 3 The author uses the sector “manufacture of motor vehicles, trailers, semi-trailers, and of other transport equipment” (C29-30) instead of “manufacture of other transport equipment” (C30) for empirical analysis due to lack of statistical data at the regional level.

Despite the facts that Latvia experiences high regional differentiation, Riga region is brightly ahead of other regions by performance of regional growth and Latvia’s sectoral composition is characterized as post-industrial with relative persistence to change, each region has its unique and well-developed economic structure which provides its regional economic identity. The focus of this article is related to the financial stimulus for structural change and thus for regional growth.

Calculated data on regional specialization and its changes indicate the dynamism in high-technology manufacturing sectors in the regions followers and the relative stability of this process in the region leader (see Figure 1). Specialization among regions differs and is more brightly expressed in high-technology manufacturing in the region leader, as well as is presented in the regions followers also. However, only Riga region specializes in the sector “manufacture of basic pharmaceutical products and pharmaceutical preparations” (C21). In general, a region leader has relatively stable specialization with similar values in all manufacturing sectors, except for sectors “manufacture of basic pharmaceutical products and pharmaceutical preparations” (C21), “manufacture of computer, electronic, and optical products” (C26) (in recent years), and “manufacture of machinery and equipment n.e.c.” (C28) (see Figure 1). Data calculated for high-technology manufacturing at the regional level indicate the successful performance of Riga region which can also partly explain more progressive regional growth.

Economic structure in regions followers is not stable but mostly is tended towards the increase of employment in manufacturing, however, differs among regions. Moreover, specialization outside Riga region is expressed by the lesser LQ values (see Figure 1). The consequent increase of employment as positive characteristics for regional growth can be observed in high-technology manufacturing, for example, in Zemgale and Latgale regions in sector “manufacture of motor vehicles, trailers, semi-trailers, and of other transport equipment” (C29-30), but at the same time, other high-technology manufacturing sectors show a decrease or are absent at all (e.g., sector “manufacture of basic pharmaceutical products and pharmaceutical preparations” (C21) is absent and sector “manufacture of computer, electronic, and optical products” (C26) shows a decrease tendency) (see Figure 1). In turn, Kurzeme and Vidzeme regions are characterized by dominance of low- and medium-technology sectors in economic structure. Moreover, high-technology manufacturing in these regions does not form specialization (see Figure 1). However, data of previous research indicate that “success” does not always correspond with regional specialization and active innovative activities can be found in sectors, which do not form regional specialization (Šipilova, 2014).

Detailed analysis of sectoral composition of economy at the regional level in manufacturing sectors is a base for understanding the processes of regional growth in Latvia. Further research is related to answering the questions: Whether such dynamism of economic structure has contributed to regional growth (as the structural stimulus) and whether such structural change was supported by the FDI flows (as the financial stimulus). An attempt to identify financial and structural stimuli for regional growth in Latvia by using an example of manufacturing sector and five regions is organized in Figures 2 and 3.

As the calculated data indicate, the regional growth in Latvia during the period analysed from 2000 to 2011 has a close linkage with the manufacturing sector and is widely diversified by manufacturing sub-sectors. The issue under consideration which could shed the light on the stimulus for regional growth is whether sectors significant for regional growth are also attractive for foreign investments.

Financial stimulus Structural stimulus Linkage between FDI and changes in economic structure

represented by manufacturing sub-sectors Linkage between GDP and changes in economic structure

represented by manufacturing sub-sectors Riga region

Kurzeme region

Zemgale region

Vidzeme region

Latgale region

Figure 2. Assessment of financial and structural stimuli for economic growth in Latvia by regions and manufacturing sub-sectors (NACE 2 Rev. two-digit level) in the period of 2000-2011 (non-parametric correlation coefficients).

Source: own calculations based on the Central Statistical Bureau of Latvia (2014) and Lursoft (2014).

Regional growth in Latvia was actively generated by the dynamics of economic structure within the manufacturing sector, and both high-technology and low- and medium-technology sectors have a close linkage with regional GDP depending on region. The data on FDI during the period analysed, however, illustrate that sectors significant for regional growth and sectors preferable for FDI can mismatch (see Figure 2). For example, despite the fact that Riga region specializes in high-technology manufacturing, FDI during the period analysed from 2000 to 2011 was attracted by low- and medium-technology manufacturing sectors more actively (see non-parametric correlation coefficients in Figure 2). The similar situation in regions followers can be observed: sectors with a significant contribution to regional growth not always receive an appropriate and sufficient amount of FDI (see, for example, data on Latgale, Vidzeme, and Kurzeme regions) (see Figure 2).

The data on Figure 3 combine information on financial and structural stimuli for regional growth in Latvia.

High regional differentiation in Latvia allocates regions as two poles: Riga region as the region leader and other regions (as the regions followers). Data on GDP in the group “other regions” indicate the relatively weaker performance of Latgale region. Thus, the results of the research presented in Figure 3 argue that the two poles by performance of regional growth as Riga region and Latgale region have a significant financial stimulus during the way towards prosperity.

The author’s calculations indicate that only Riga region and Latgale region present a close and statistically significant linkage between regional growth and foreign investments in the sectors, which are crucial for regional growth in these regions (see Figure 3). These sectors are “manufacture of machinery and equipment n.e.c.” (C28) in Riga region and “manufacture of electrical equipment” (C27) in Latgale region. Other regions demonstrate a significant structural stimulus for regional growth and a relatively weak financial stimulus for regional growth (see Figure 3).

Riga region Kurzeme region

C13-15 C28 C20 C31-33

0.368 -0.718** -0.484* -0.769** 0.187 0.657** 0.280 0.697**

Vidzeme region Latgale region

C10-12 C22-23 C16-18 C27

0.320 0.595** 0.405 -0.605** -0.373 0.625* 1.000* 0.479*

Zemgale region

C16-18 C24-25 C29-30 C31-33

0.295 0.758* -0.405 0.606** -0.426 0.831** 0.200 -0.606*

Manufacturing sectors (NACE 2 Rev. two-digit level) with the highest values of non-parametric correlation coefficients by financial and structural stimuli for growth, by regions in Latvia in the period of 2000-2011 (based on data of Figure 2). Note. * and **: Correlation is significant at the levels of 0.05 and 0.01 respectively.

Schematic regional map of distribution of financial and structural stimuli for growth in Latvia (based on data presented in Figure 2).

Schematic distribution of manufacturing sectors by kinds of stimulus for regional growth in Latvia in the period of 2000-2011.

Note. Source: own calculations based on the Central Statistical Bureau of Latvia (2014) and Lursoft (2014).

Figure 3. Regional and sectoral distribution of financial and structural stimuli for regional growth in Latvia.

The analysis applied in this article reveals that despite the close and statistically significant linkage between FDI and sectors important for regional growth, in general, the financial stimulus does not contribute to the growth process. This is indicated by the fact that despite active flows of FDI, Latgale region does not catch up the region leader and remains at the same development stage as other regions, which do not have a close linkage between FDI and regional growth. The presence of specialization in high-technology manufacturing is a crucial factor for regional growth to a larger extent which indicates the significance of the structural stimulus for growth.

Conclusions

As modern trends in economy reveal, searching for a “correct” stimulus for economic growth is closely related to performance of the manufacturing sector (especially of the so-called innovative manufacturing sector), processes of structural change in economy, and attraction of FDI for stimulating such changes also. However, different meanings of these factors in generation of economic growth exist. Therefore, this article was organized in the framework of two kinds of stimulus for growth as financial and structural, taking into account opposite viewpoints about significance of FDI and economic structure for growth. The experience of country with high regional differentiation and relatively persistent post-industrial economic structure was the base for searching the answer to the question whether the manufacturing sectors more significant for regional growth are also considered as crucial and attractive for FDI.

The author’s calculations have illustrated that regional growth in Latvia during the period from 2000 to 2011 was actively generated by the dynamics of economic structure within the manufacturing sector, although often with a mismatch among sectors significant for regional growth and attractive for FDI. Moreover, the author’s calculations indicated the growth performance of the two poles by level of economic development (Riga region and Latgale region). These regions presented a significant financial stimulus for growth. However, the regions follower was not able to move to a higher development stage by economic performance, despite the close and statistically significant linkage between regional growth and foreign investments in sectors crucial for regional growth. In general, the experience of regional growth in Latvia has highlighted that specialization in high-technology manufacturing is a crucial factor for regional growth to a larger extent than FDI flows and thus, structural stimulus was more significant for regional growth in Latvia than financial stimulus during the period analysed.

Research results indicate that regional growth in Latvia mostly is dependent on structural stimulus, especially by specialization in high-technology manufacturing sector. Financial stimulus is also significant, but yet does not provide a sufficient contribution to the process of convergence among regions.

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Corporate Sustainability and Ethical Codes Effectiveness*

Daniela M. Salvioni, Riccardo Astori, Raffaella Cassano University of Brescia, Brescia, Italy

In the last years, the issues regarding both sustainable development and business global responsibility

have qualified the corporate governance effectiveness. Many international institutions have intervened and

the companies, at least formally, have increased their attention to the interaction between stakeholder relationship

management and economic, social, and environmental responsibility. The numerous and frequent scandals

underline the discrepancy between the firms’ formal statements and the substantial behaviors. Most of the

companies, in the industrialized country, publish well-structured code of ethics and conduct, explicating

the strategic values assigned to the global responsibility. The research considers the capability of the code of

conduct to influence effectively the behaviors, in relation with the needs of transparency, sharing, coherent

individual behavior, and control. In relation to the importance conferred to the sustainable development by

the European Union (EU), the analysis examines listed companies with the greatest market capitalization

operating in the Great Britain, Germany, and Italy, in order to verify the firms’ behavioral uniformity and

the effectiveness of sustainability policies. The analysis shows that the codes of ethics seem to remain only formal

declarations. Conscious and rational governance not only transfers values and principles of sustainability

to the firm’s behaviors and its result system, but also goes beyond a mere diffusion and formalization of codes

of ethics and conducts. To achieve that, it is necessary to develop productive behaviors focused on the risk control

and on managing behaviors of all the organization’s members, in particular in reference to the stakeholder

relationship management. The codes of ethics, in fact, seem to assume a poor relevance for the corporate

sustainability promotion if a correct formal structure does not occur integrated with strategies and processes

which assure a constant workability. It requests especially: the ethic culture diffusion and sharing of related

values and principles; definition and integration of critical success dimensions in relation to economic,

environmental, and ecological responsibility; and identification of relevant ethical parameters and control of their

observance.

Keywords: sustainable development, management, internal control, risk management

Introduction and Literature Review

For a long time, the choices of corporate governance have privileged the profit maximization objective in order to satisfy the shareholders’ expectations (Friedman, 1962) revealing, therefore, significant dissimilarities among diverse groups of shareholders (for instance, among insider systems, majority and minority shareholders).

Daniela M. Salvioni, professor, Business and Administration, University of Brescia. Email: daniela.salvioni@unibs.it. Riccardo Astori, Ph.D., Business and Administration, University of Brescia. Raffaella Cassano, Ph.D., Business and Administration, University of Brescia.

DAVID PUBLISHING

CORPORATE SUSTAINABILITY AND ETHICAL CODES EFFECTIVENESS

More recently, a new approach towards the companies’ role in the society has emerged (Freeman, 1984; Evan & Freeman, 1988; Donaldson & Preston, 1995; Friedman & Miles, 2002; Freeman, Martin, & Parmar, 2007; Miles, 2012). It is not only due to persistent frauds and poor business management, but also due to evolution, all over the world, of new paradigms of sustainable development and shareholder relationship management (Steurer, Langer, Konrad, & Martinuzzi, 2005).

In fact, in the last years, the issues regarding both sustainable development and business global responsibility have qualified the corporate governance effectiveness (Salvioni & Astori, 2013). Many international institutions have intervened (see Table 1) and the companies, at least formally, have increased their attention to the interaction between stakeholder relationship management and economic, social, and environmental responsibility.

Table 1 The Sustainable Development and Its Evolution Year Evolution 1972 Stockholm—United Nations Conference on “the Human Environment” 1980 IUCN, “International Union for Conservation of Nature” Strategy

1983 World Commission on Environment and Development, created by the United Nations and headed by Gro Harlem Brunotland as the Chairman

1987 Brundtland Report: Our Common Future

1992 Rio de Janiero—Convention on Climate Change negotiated at the United Nations Conference on Environment and Development (subscribed in New York, May 9, 1992)

1994 Aalborg—The 1st European Conference on Sustainable Cities: Aalborg Card 1996 Lisbon—The 2nd European Conference on Sustainable Cities: Plan of Action: Card of Action 2000 Hannover—The 3rd European Conference on Sustainable Cities: Local Sustainability Plan for the 21st Century 2001 The 6th European Union (EU) Action Plan: Environment 2010: “Our Future, Our Choice” 2002 Johannesburg—World Summit on Sustainable Development: From Our Origins to the Future 2006 Bruxelles—European Sustainable Development Strategy: Seven Main Challenges 2007 Siviglia—The 5th European Conference on Sustainable Cities 2009 Copenhagen—The 15th United Nations Conference on Climate 2012 Rio de Jainero—The United Nations Conference on Sustainable Development Notes. Italy is home to some important moments for the establishment of sustainable development. In particular, we mention the stage in 1993 for the National Plan for Sustainable Development and 1999 for the Conference of Ferrara: The Establishment of the Italian Local Agenda 21 and the Establishment of the Service for Sustainable Development at the Ministry of the Environment.

Naturally, corporate sustainability does not mean a loss of importance in the creation of value and of adequate remuneration of risk capital contributors. On the contrary, it is appropriate to emphasize the interdependence among stakeholder relationship management, economic, social, and environmental responsibility, results (economic and otherwise), and capability of obtaining consensus and resources. It is evident, in fact, a governance approach that aims at increasing the shareholders’ abilities of creating values over time through the exploitation of opportunities and management of social and environmental risks, which companies currently have to compare with (Cassano & Gandini, 2008; Esty & Winston, 2008).

A company oriented to sustainable development is clearly aware of its responsibilities towards different stakeholders and adopts methods and tools of governance aimed at improving its economic, social, and green/ecologic performances. It is an approach based on a wide vision of responsibility and on a modern interpretation of the links between the long-lasting company success and the equal composition of all stakeholders’ interests (Salvioni, 2003; Salvioni & Bosetti, 2006).

The maintenance of a satisfactory level of effectiveness requires the development based on: assessment of stakeholders’ expectations and their alignment with corporate strategies; transfer of the top management orientation in business conduct; and verification of coherence among purposes, managerial objectives, and actual results, optimizing the performances and the relations.

On these bases, the codes of ethics and conduct are becoming more relevant (Schwartz, 2002; Valentine & Barnett, 2003; C. Stohl, M. Stohl, & Popova, 2009; Kaptein, 2004; 2011), informing stakeholders of the principles and values adopted for the corporate responsibility (Waddock, Bodwell, & Graves, 2002), and conditioning the top management’s decisions and the organization. Moreover, the firms seek to design all the business activities with respect to principles of stakeholders and protection of the environment and future generations. The codes of ethics, in fact, express the strategic value of global business responsibility. For these reasons, the effectiveness adoption requires transparency, sharing, coherence of individual behaviors, and control.

Aim of the Research

The rest of this paper aims to give testimony to corporate governance effectiveness in light of sustainable development. In fact, this article examines the code of ethics as a tool necessary for the corporate global responsibility implementation.

In particular, this paper focuses on three main questions: (1) What is the role of code of ethics for a proper management of the relationships with stakeholders and

how do they treat the issues of social and environmental responsibility? (2) What are the dimensions of sustainability mainly applied by the firms and what are the relationships

between formal aspects and substantial workability of code of ethics? (3) What are the processes and tools used to ease regular, coordinated, and efficient orientation to

sustainable development and what is necessary to generate effectively the sustainable value? In relation to the importance conferred to the sustainable development by the EU, the analysis examines

listed companies with the greatest market capitalization operating in different European countries, in order to verify the firms’ behavioral uniformity and the effectiveness of sustainability policies.

The following analysis shows some of the results of the research on sustainable development, risk management, and internal control, with intent to find the answers to the questions mentioned above. In particular, this paper analyzes 10 of the companies with the greatest market capitalization in the Great Britain, Germany, and Italy, studying the relationship between the code of ethics’ characteristics and the corporate scandals regarding the firms mentioned (see Table 2).

The logic that stands behind the choice of focusing on 10 companies with the greatest market capitalization springs from their leadership status on respective stock markets: big companies, subjected to stronger regulatory measures and market controls, which require transparency to stakeholders. The choice of three countries, on the other hand, allows pinpointing the major differences in prevailing corporate governance models. In particular:

(1) Great Britain, with the “outsider system”, which contemplates only the monistic model of corporate governance;

(2) Germany, with the “insider system”, which acknowledges only the dualistic vertical system (with partners and workers’ empowerment);

(3) Italy, with the “insider system”, which contemplates, since 2004, different corporate governance models, even if dualistic horizontal models are predominant.

In order to evaluate the effectiveness of communication to stakeholders from a global perspective, the analysis of the company was based on data and information published online in English. In particular, reference was made to the code of ethics and/or conduct, as well as the last report of corporate governance and the financial annual published report. For the scandals involving some of the firms examined, the reference point is the press and other available information sources.

Table 2 Companies Under Investigation (Capitalization Values on March 28, 2013)

Italy Germany Great Britain

Company Capitalization (MLN euro) Company Capitalization

(MLN euro) Company Capitalization (MLN euro)

Eni 64,079.67 SAP 74,891.49 BHP Billiton 154,466.74 Enel 24,019.68 Siemens 70,847.00 BP 135,192.71 UniCredit

19,373.13 Volkswagen

68,332.96 Royal Bank of

Scotland Group 132,908.05

Assicurazioni Generali

19,064.92 Bayer

66,545.61 HSBC Holdings

131,261.42

Intesa Sanpaolo

18,831.39 Basf

62,958.25 British American

Tobacco 103,195.87

Luxottica Group 18,594.11 Allianz 47,973.52 Vodafone Group 91,766.60 Tenaris 18,439.77 BMW 44,150.28 Unilever 78,839.37 Snam 12,065.86 Daimler 42,993.20 GlaxoSmithKline 74,526.41 Saipem 10,622.08 Deutsche Telekom 35,461.62 Rio Tinto 56,999.25 Telecom Italia 10,299.21 Deutsche Bank 28,253.49 SABMiller 52,036.33

Code of Ethics and Sustainable Development

The globalization of markets has brought: on one hand, the affirmation of the general principles of correctness in the company governance, often formalized in codes of ethics and conducts; and on the other hand, the affirmed importance of sharing these principles with own stakeholders and with dissemination and participation of the organization and of the main external partners.

With reference to the transparency of the codes, it is relevant that their edition on the company website is clear, precise, and comprehensive (see Table 3), in addition to the subscription by the main operating stakeholders.

Table 3 Level of Transparency on the Code of Ethics

Diffusion of the codes Italy (%) Germany (%) Great Britain (%) Edition of the code of ethics/ethics of behavior (in English) 100 100 90

The orientation of sustainable development also involves the declination of principles and rules of behavior with respect to compatible environmental performances and different kinds of social actors with whom the company interacts. In this regard, the analysis of the published codes highlighted the frequent presence of expressive variables of sustainability, even though with some qualitative differences between companies and countries (see Table 4).

Table 4 Level of Orientation to Sustainability

Environment and principal stakeholders Italy (%) Germany (%) Great Britain* (%) Environment 60 80 67 Shareholders 90 50 44 Management, employees, and associates 100 100 89 Suppliers and associates 90 60 67 Customers and consumers 90 70 78 Competitors 50 70 78 Local communities 70 60 78 Political organizations and unions 80 60 100 Authorities and public institutions 70 50 78 Note. * Data referred to the nine companies which have the code.

The enhancement of the ethic dimension of environment protection has increased in parallel with the affirmation of global responsibility, even though with significant differences related to the activity sector and the connected ecological impact. The adoption of a governance approach, based on rules which take sustainability into account, takes on a specific relevance with regard to the internal and external nets of relationships in order to facilitate the creation of virtuous circles among the stakeholders’ expectations, company behaviors, and corporate results.

Overall, the range of the stakeholder categories contemplated in ethic codes is quite large. This number is, however, sterile if we do not consider the specific dimensions which different principles are faced with, in relation to each category. In this sense, the link between standard privileged behaviors and relevant stakeholders’ classes is significant.

The role of the codes of ethics for the effectiveness of relationships with the stakeholders depends on the relevant behavior principles compared with the different social actors who interact with the company. In this regard, it is necessary to consider the standard behaviors for each category.

Shareholders

In the last 10 years, the EU has implemented intervention in order to promote corporate governance that protects shareholders’ rights, facilitate the relationships between shareholders and corporate governance boards, and protect the third parties. In particular, the EU has intervened on transparency promoting the improvement of the relationships with the stakeholders and firstly, with the shareholders.

The codes of ethics seem to reflect the European guidelines, provided that the standard behaviors which are privileged at the level of relationship with the stakeholders emphasize participation, transparency of information, and information symmetry (see Table 5).

The linkage among asset values, economic cycles, and default probabilities is discussed by several authors. Examples include the structural models of Merton (1974) and Moody’s KMV approach (Crosbie & Bohn, 2003) which incorporate asset value fluctuations and which are dealt with in depth in this paper. Jarrow (2001) incorporated equity prices into the estimation of default probabilities, where recovery rates and default probabilities are correlated and depend on the state of the macro economy.

Most of the codes contain the rules of managing the external communication which must be true, comprehensive, timely, and available. These features are not always cited in the codes of ethics, but they

sometimes relate references to truthfulness and/or timeliness of information. Substantially, it is common the reference to the need of respecting the rule that guides the treatment of price-sensitive information and market communication. Italian companies typically declare, in their code of ethics, to promote the participation of the shareholders in the company life.

Table 5 Standard Behaviors in Relationships With the Shareholders

Standard behavior Italy (%) Germany (%) Great Britain (%) Facilitate the participation 50 0 0 Transparency of information 70 60 78 Information symmetry and information management (insider trading, internal dealing, and market abuse)

Management and Employees

The standard behaviors in relationships with managers and employees mainly regard: healthcare and safety at work, promotion of human resources training, adoption of criteria for selection and carrier based on the logic of merit, the appreciation of the differences among people, and the prohibition of harassment and bullying/mobbing (see Table 6).

Table 6 Standard Behaviors in Relationships With Management and Employees

Standard behavior Italy (%) Germany (%) Great Britain (%) Healthcare and safety at work 90 80 78 Training promotion 40 10 22 Merit system criteria and carrier 90 30 44 Policy against discrimination 90 70 67 Policy against harassment and bullying 70 40 67

It is useful to consider that, as regards the involvement in the employees’ governance, Germany differs from Italy and England. It is a country where co-management exists, for which workers are involved in the mandate of governance. This situation shows a different relationship with the employees, which does not highlight relevant discrepancies in the standard behaviors.

In general, it is frequently the respect of the Universal Declaration of Human Rights rejecting child labor and highlighting the commitment to promoting better working conditions.

A company (Enel) also establishes the policy of intervention in the case of reorganization of work activities, safeguarding the value of human resources through training and/or professional retraining activities and uniform distribution, where possible, of reorganization of tasks.

Seventy percent of the United Kingdom (UK) societies (against 50% Italian and 20% German) pointed out the problem of alcohol and drug abuse. In some cases, the companies are willing to provide the necessary medical and psychological assistance, besides highlighting the negative effects on health and possible consequences in terms of sanctions, when the problem is reflected at the workplace.

Suppliers

Standard behaviors in relationships with suppliers tend to emphasize the criteria for selecting suppliers and the willingness to share their ethics within the supply chain (see Table 7).

Table 7 Standard Behaviors in Relationships With Suppliers

Standard behavior Italy (%) Germany (%) Great Britain (%) Criteria of selection of suppliers 90 50 56 Sharing of codes of ethics 60 40 67

As regards the choice of suppliers, the reference emphasizes the criteria of transparent, efficient, and effective selection, based on specific skills aimed at establishing and maintaining these long-term collaborations. In this regard, Enel also states the adoption of procedures that ensure the rotation of people responsible for supply.

Moreover, given the critical nature of their relationships with suppliers, some companies adopt specific codes. Customers and Consumers

Key principles in managing the relationships with customers are mainly related to the correctness of commercial policies, quality of products/services offered, as well as the completeness and accuracy of information provided (see Table 8).

Table 8 Standard Behaviors in Relationships With Customers and Consumers

Standard behavior Italy (%) Germany (%) Great Britain (%) Correctness of commercial policies 80 60 56 Quality of harmless products 50 20 11 Completeness and accuracy of product information 70 50 33

Competitors

Relationships with competitors are mentioned in 50% of the Italian codes, 70% of the German codes, and 67% of the UK codes (see Table 9).

Table 9 Standard Conducts/Behaviors in Relationships With Competitors

Standard behavior Italy (%) Germany (%) Great Britain (%) Fair competition 50 70 67

Relationships with competitors are often fairness-oriented and appreciate the competitive success through the merit of their results. It is often referred to anti-trust rules and prohibition to implement agreements with competitors for fixing prices or achieving goals otherwise not pursued. Sometimes, it is referred to policies that prohibit the abuse of dominant position, the imposition of restrictions to suppliers and customers at the expense of competition, as well as the realization of joints and acquisitions which may harm the image and reputation of the company.

Local Communities

Relationships with local communities are ruled in the codes of ethics, respecting the local rights and with an awareness of the existing relationships (see Table 10).

The involvement of local communities in business activities and the promotion of a relative consensus are possible through the companies’ willingness to promote the territory, even with philanthropic activities. In this regard, six out of 10 Italian societies declare it.

Table 10 Standard Behaviors in Relationships With Local Communities

Standard behavior Italy (%) Germany (%) Great Britain (%) Respect of local rights 60 30 60 Philanthropic activities 60 50 40

Political Organizations

Relationships with political organizations are often accepted in codes, especially in the Anglo-Saxon outsider systems (see Table 11).

Table 11 Standard Behaviors in Relationships With Political Organizations

Standard behavior Italy (%) Germany (%) Great Britain (%) Policy of distribution of donations to political parties 70 60 100

As regards the relationships with the political organizations, declarations about the behaviors of companies towards financing the parties are relevant. These declarations are commonly present, especially in the codes of ethics of UK companies, and tend to report the exclusion of the company from any form of financing the political parties. In some companies, however, financing the political party is accepted in compliance with specific and/or internal regulatory limits, not expressed in the codes of ethics. Most of the time, companies affirm the need to respect the worker’s political idea. Workers, according to their role, are precluded to express a political opinion which, even indirectly, can be traced to the company.

Authorities and Public Institutions

With reference to the relationships between companies and authorities and public institutions, the analysis of codes of ethics has marked the presence of declarations about the necessity of correctness, which must be maintained in the management of the relationship and of the transparency of information (see Table 12). This principle is often accompanied by the definition of possible nature of the relationship, mainly due to the need to bring own interests and those of category to the attention of the authorities, cooperating constructively for the development of legislation and regulation.

Table 12 Standard Behaviors in Relationships With Authorities and Public Institutions

Standard behavior Italy (%) Germany (%) Great Britain (%) Correctness in relationships 70 50 67 Competence reserved to specific functions 60 10 33

Six out of 10 Italian companies have also stated that the competence in managing these relationships is exclusively reserved to specific functions, precluding every unauthorized person to establish relationships with authorities and public institutions.

Rules of Conduct Transversal to the Different Categories of Stakeholders

The analysis of codes of ethics underlines even values and rules of conduct which are transversal to the different categories of stakeholders (see Table 13).

In this field, it may be considered: policies which regulate the exclusive use of corporate assets and protection of tangible and intangible assets of the company; anti-money laundering and anti-terrorism policies, which need constant attention and monitoring activities from all operators involved; the regulatory policies of conflicts of interests, sometimes also with examples of possible cases; anti-corruption policies, active and passive, which commonly prohibit giving or accepting gifts, donations and benefits, except modest value gifts; and the security policies of data and information, specifying privacy and storage requirements.

Table 13 Other Standard Behaviors

Standard behavior Italy (%) Germany (%) Great Britain (%) Policies of use and protection of the corporate assets 70 80 89 Anti-laundering policies 10 40 33 Anti-terrorism policies 10 20 22 Policies for regulating the conflicts of interests 100 100 100 Anti-corruption policies 80 100 100 Protection of privacy and security of information 100 100 89

Standard behaviors are flanked by instructions for the proper implementation of the code (see Table 14), reference point for risk management system, and internal control.

Table 14 The Implementation Details of Code Conditions

Detail of code conditions Italy (%) Germany (%) Great Britain (%) Promotion of the knowledge and diffusion of the codes of ethics 70 50 56 Details of the reference organization and supervision 90 90 78 Forecast of reporting system and complaint 80 80 100 Penalty system 70 90 78

Relationships Between Code of Ethics and Effective Sustainability

Typically, the best practices of corporate governance are distinguished by implementation of the code of ethics.

The code of ethics, in fact, regards corporate responsibility’s fundamental values and principles, consequently shared in order to integrate business activities with the interests of all the stakeholders. A firm is called to protect such interests and preserve the environmental resources for the future generations. The code of ethics, then, concerns a number of essential rules for the corporate sustainable development.

Our research, on one hand, confirms the ordinary character of code of ethics usage, on the other hand, spotlights the issue of numerous frauds and poor management in reference to the companies with the greatest market capitalization operating in the three European countries.

The main public information sources confirm the poor effectiveness of code of ethics, highlighting a discrepancy between the firms’ formal statements and substantial behaviors.

The tables below cite major corporate scandals articulated as follows: (1) Country where the firm is listed; (2) Corporate governance model; (3) Type of business.

The first one allows understanding the nature of the relationships among corporate behaviors, regulations, and “insider”/“outsider” models (see Table 15). In fact, the Anglo-Saxon countries differ by: the common law system (legal order according to which the law is developed by judges through decisions of courts or similar tribunals instead of by codes, laws, and rules developed by national authorities); a major openness of the market to the risk capital, which underlines shareholders’ controlling function (outsider system or market-oriented). In Germany and Italy, where the civil law is in force (laws and norms are subjected to codes) and the companies are characterized by shareholder concentration (insider system), the market has a poor power control, making the corporate governance systems of control extremely relevant (Astori & Bosetti, 2011).

Table 15 Corporate Scandals With Respect to the Country Where the Firm Is Listed

Country Companies involved Value (%) Great Britain BP-Shell, Glaxo, HSBC, RBS, Unilever, and Vodafone 60 (six out of 10) Germany Deutsche Bank, Siemens, and Volkswagen 30 (three out of 10) Italy Eni-Saipem, Intesa Sanpaolo, and UniCredit 30 (three out of 10)

A high scandal rate is particularly evident in the case of British companies. Although only the biggest 10 companies were analyzed, this study induces to a deep reflection regarding possible discordances between the stock market control and the affirmation of stakeholder relationship management (see Table 16).

In Italy, where the companies can choose among three different corporate governance models, it is useful underlying behavioral anomalies with reference to the governance model adopted (monistic, dualistic vertical, and dualistic horizontal).

Table 16 Corporate Scandals With Respect to the Corporate Governance System

Corporate governance model Companies involved Value (%) Monistic model BP-Shell, Glaxo, HSBC, RBS, Unilever, and Vodafone 54.54 (six out of 11) Dualistic vertical Deutsche Bank, Volkswagen, Intesa Sanpaolo, and Siemens 36 (four out of 11) Dualistic horizontal Eni-Saipem, UniCredit 25 (two out of 8)

In particular, 11 out of 30 companies analyzed adopt the monistic system of governance (10 listed in the UK and one in Italy). The dualistic vertical system, on the other hand, is present in 11 out of 30 companies (10 listed in Germany and one in Italy) and the dualistic horizontal system is present in eight out of 30 (all listed in Italy).

Figure 1 summarizes the information presented in Tables 15 and 16 in order to underline the relationship existing among the frequency of corporate scandals and the country of origin, the governance model, and legal systems.

This study shows that some industries are particularly exposed to the cases of corruption and irresponsible behaviors or, in other words, if, for some industries, such actions can have particularly negative consequences. Thus, Table 17 verifies the relationship between the industry of origin and corporate scandal rate (see Table 17).

As it was easily predictable, the banking industry reveals the highest scandal rate (100% of cases). The banking industry seems to be characterized by an evident discrepancy between the ethical and moral values declared and actual behaviors. This sector seems to be characterized by a high corruption rate and fiscal fraud cases, finalized to favor only few majority stakeholders.

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The analysis shows that the codes of ethics remain only formal declarations. Conscious and rational governance not only transfers values and principles of sustainability to the firm’s behaviors and its result system, but also goes beyond a mere diffusion and formalization of codes of ethics and conducts. To achieve that, it is necessary to develop productive behaviors focused on the risk control and managing behaviors of all the organization’s members, in particular in reference to the stakeholder relationship management (Cassano, Gandini, & Gennari, 2014).

The codes of ethics, in fact, seem to assume a poor relevance for the corporate sustainability promotion if a correct formal structure does not occur integrated with strategies and processes which assure a constant workability. It requests especially: the ethic culture diffusion and sharing of related values and principles; definition and integration of critical success dimensions in relation to economic, environmental, and ecological responsibility; and identification of relevant ethical parameters and control of their observance.

Conclusions

In most of the industrialized countries, frequently the firms adopt well-structured codes of ethics and conducts, without particular differences in reports and regard of different legal and market contexts and of diverse governance models. Typically, the differences stand in the workability of codes. It is often the case that the firms do not respect the global responsibility, favoring only specific classes of stakeholders or their sub-groups, also in relation to manufacturing delocalization processes.

In reference to the firms analyzed, although the codes of ethics are usually well-structured and based on the sustainability principles, the limiting character of codes falls back into a high scandal rate.

It becomes impossible, then, to affirm that the governance approach is by force based on the wide responsibility system or on the relationship between a durable success and a fair composition of stakeholders’ interests.

The codes of ethics reflect the strategic importance of global responsibility. Its role, then, is to promote and spread values and principles that generate behaviors fundamental for the sustainable value creation.

The codes of ethics, if well-structured, set principles and behavioral rules retained essential with respect to compatible environmental performances and different actors with whom the firm interacts. It is evident, however, that rarely does the ethical culture affect corporate behaviors. It is necessary, then, to actuate processes and tools that would systematically support the sustainability.

The operative effectiveness of codes requires, in fact, transparency, sharing, coherency of individual behaviors, and control. In particular, the exploitation of opportunities and economic, social, and environmental risk management require redesigning internal control systems, which for many years had privileged purely financial objectives.

The optimization of corporate potential in terms of sustainable value creation is significantly influenced by: strategic values of economic, social, and environmental responsibility integration; internal diffusion and sharing of sustainability-oriented values and principles; setup of integrated and complete risk management systems (Kaplan & Mikes, 2012; Salvioni, 2012); and introduction of operative procedures designed with an awareness of risk related to possible violations in the firm’s workability.

Risk management and internal control system: procure fundamental elements for the firm’s decision-making system; empower the intermediation between stakeholders’ expectations and managerial behaviors; encourage the firm to act in accordance with laws and internal regulations; and guarantee the completeness and transparency of disclosure (Salvioni, 2010).

An efficient governance and control system represents, for all the companies, a necessary condition for the risk minimization, in the long run.

The validity of internal risk and control management systems for a systematic, coordinated, and efficient sustainable development is conditioned by the ability to manage proactively the complexity which the firms have to struggle with. Thus, such a condition requires an integrated approach, which appraises the ethical culture and global responsibility at the corporate governance’s and the network’s level.

The internal control system, then, should represent an important tool activating responsible managerial behaviors: a necessary condition for the optimization of sustainable value creation processes. In this context, the codes of ethics represent a prerequisite of sustainability, necessary, but not sufficient, to guarantee the efficient realization. Barclays, for instance, after the Libor scandal, not only dismissed the top management and tried to recover after multi-million sanctions, but also decided to develop among its employees an ethical behavior spirit (numerous trainings were organized in order to make the staff rediscover values like respect, integration, service, excellence, and good administration) and to apply an awarding system for the ethical code observance.

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Human Resource Controlling and Human Resource Management:

Practice of Small and Medium-Sized Building

Companies in the Czech Republic

Filip Bušina

Moscow State University of Technology “STANKIN”, Moscow, Russia

Martin Šikýř

Czech Technical University in Prague, Prague, Czech Republic

The aim of this paper is to define the nature, present the possibilities, and discuss the problems of using human

resource controlling in small and medium-sized building companies. This paper is based on the assumption that

expedient human resource controlling is an effective human resource management tool that achieves the required

performance of employees and expected competitiveness of a building company. This paper uses the results of a

questionnaire survey conducted in November 2013 to analyze human resource management in building companies

in the Czech Republic and specify the organization and conditions of human resource management. Some

81 small (less than 50 employees) and 66 medium-sized (50-249 employees) building companies operating in the

Czech Republic took part in the questionnaire survey. The results of the questionnaire survey showed the lack of

concept and random nature of human resource management in most small and medium-sized building companies.

Of course, in terms of the present economic trend, it is above all important for small and medium-sized companies

to develop their adaptability to the building market and to be able to deal with a variety of construction works.

It is effective human resource management supported by expedient human resources that serves this purpose.

Keywords: human resource management, human resource controlling, building industry, small and medium-sized

companies

Introduction

The strategic importance of human resource management in the building industry stems not just from the

diversity of construction works in individual areas of building production (building construction, structural

engineering, and specialized construction), or demands of the working conditions in the building industry

(seasonal, sporadic, complex, responsible, and demanding nature of construction works, difficulty of the working

conditions, or the harm and risks of the working environment), but mostly from the difficult political, economic,

legal, social, cultural, technical, demographic, and natural conditions (Maloney, 1997), in which individual

building companies compete for their place on the building market.

Filip Bušina, Ph.D., MBA, Faculty of Economics and Management, Moscow State University of Technology “STANKIN”.

Email: filipbusina@seznam.cz. Martin Šikýř, Ph.D., Department of Engineering Education, Masaryk Institute of Advanced Studies, Czech Technical

University in Prague.

DAVID PUBLISHING

HUMAN RESOURCE CONTROLLING AND HUMAN RESOURCE MANAGEMENT

Based on the results of the Quarterly Analysis of the Czech Building Industry Q4/2013, which was drawn up

by CEEC Research (2013) based on data obtained from more than 100 personal and telephone conversations with

chief executive officers and members of the board of directors of the selected small, medium, and major building

companies operating in building and structural engineering in October and November 2013, the unfavorable

economic situation associated with a significant fall in the number and size of contracts in the last several years

has forced most building companies to reduce the number and change the structure of its employees working in

building, administrative, and management professions. In the interest of optimizing human resource costs and in

connection with the limitation of the number of own employees, individual building companies are more often

performing the required construction works through contractors above all the self-employed. But a number of

building companies are still dealing with the ongoing problem of a lack of suitable workers in narrowly

specialized professions, such as bricklayers, plumbers, tilers, carpenters, just as qualified site managers and cost

accountants. Every fourth building company (26%) confirmed a reduction in human resource costs in 2014.

Almost one fifth of the building companies (16%) have not been able to answer this question as yet and will

decide operatively depending on how things develop. This above all concerns small and medium-sized building

companies and a reduction in human resource costs will result in redundancies, reduction of wages, or

outsourcing of employees. In all cases, this concerns a major human resource decision that affects the effective

operation of an entire building company. But it is interesting that only two thirds (64%) of the addressed building

companies measure their efficiency. All major building companies confirmed that they measure their efficiency.

While only half of small and medium-sized building companies do so. Efficiency is measured either only at

company level as a whole (such as the year-on-year comparison of the development in turnover and profit,

performance per employee, margin trend, use of mechanization, observing the budget, etc.), or at individual

construction level (such as the profitability of the construction, observance of the budget and schedule, etc.).

However, a whole third of the building companies do not monitor their efficiency and this concerns solely small

and medium-sized building companies. Among the often presented reasons are the demands and lack of

objectivity of measurement just as lack of time, knowledge, and measuring tools.

The above shows a connection between human resource management and efficiency of building companies

and it is human resource management that is the area of management which distinguishes the successful building

companies from the unsuccessful ones (Brandenburg, Haas, & Byrom, 2006). It is also apparent that most small

and medium-sized building companies lack the necessary know-how for expedient and effective measurement of

their own productivity and efficiency, above all in relation to human resource management which significantly

affects the performance of each building company. A possible solution in terms of expedience and efficiency of

human resource management is the application of the main principles and procedures of human resource

controlling.

The aim of this paper is to define the nature, present the options, and discuss the problems of applying

human resource controlling in small and medium-sized building companies. This paper is based on the

assumption that expedient human resource controlling is an effective human resource management tool that

enables the required performance of employees and expected competitiveness of building companies. This paper

uses the results of the questionnaire survey carried out in November 2013 in order to analyze the safeguard of

human resource management in building companies in the Czech Republic and to specify the organization and

conditions of human resource management.

The necessary data were obtained by the Computer Assisted Telephone Interviewing (CATI) method using

questionnaire software from NIPO Software. The relevant data were provided by 81 small (less than

50 employees) and 66 medium-sized (50-249 employees) building companies operating in the Czech Republic.

The questionnaire contained a total of 19 questions with the choice of answers aimed at the total safeguard and

key tasks of human resource management, professional and qualification structure of employees,

and fundamental human resource activities related to recruitment, selection, appraisal, remuneration, training,

and development of employees. The results of the questionnaire were processed and evaluated using the

Microsoft Excel calculator to determine the relative frequencies and explanation of answers. The relative

frequencies of the answers were expressed using pie and bar graphs.

Human Resource Management

Human resource management represents theoretical starting points and practical approaches to management

and leadership of people in an organization. The general objective of human resource management is to ensure

that the organization is able through people to successfully meet its objectives (Armstrong, 2007). This objective

is met through individual human resource activities (planning, recruitment, selection, appraisal, remuneration, or

training of the people), which allows managers and human resource officers to systematically recruit, use, and

develop people to perform the required work and achieve the expected performance (Marchington & Wilkinson,

2005). In this context, it is evident that people represent the crucial source of any organization and a lot of

research has also shown the positive effect of various policies and procedures in human resource management on

the performance of people and the organization (Gerhart & Milkovich, 1990; Huselid, 1995; Rizov & Croucher,

2009).

The task of human resource management in a building company is to find the optimal way of performing the

required construction works and to achieve the expected strategic objectives of the building company

(sustainable development, long-term prosperity, constant competitiveness, etc.) with the help of people,

employees that work in the building company and look for ways of satisfying their own needs (prospective

employment, fair income, professional development, etc.). Of course, a precondition of success is the knowledge

of the application of individual human resource activities. Managers and human resource officers of the building

companies need to know which human resource activities need to be implemented and in what way and for what

purpose they have to implement such activities in order to be able to optimally manage other employees.

Concept of Human Resource Management

The results of the questionnaire survey confirmed that the overall approach of human resource management

in the addressed small and medium-sized building companies lacks concept and is random, focusing usually on

current problems associated with the necessary workforce and meeting the administrative obligations arising

from legislation.

Human resource management in an ordinary building company is ensured usually by managers, in some

building companies, usually in building companies with a greater number of employees, normally with the

support of human resource officers. In most small building companies, human resource management is ensured

by a different member of the company’s management such as the finance or economic director, or the executive

officer or owner. In medium-sized building companies, human resource management is divided among different

members of the company’s management and human resource officers (see Table 1).

Table 1

Organization of Human Resource Management Responsibility for human resource management Small (%) Medium-sized (%)

Human resource managers 12 14

Different management members 59 36

Human resource officers 6 35

Outsourcing 2 0

Different answers 2 15

Note. Source: Own elaborations.

At the end of October 2013, the addressed small and medium-sized building companies had, on average, 17

of their own employees (median 15, minimum 1, and maximum 47 of their own employees) and medium-sized

building companies had an average of 66 of their own employees (median 55, minimum 8, and maximum 218 of

their own employees). In terms of profession, in the addressed small and medium-sized building companies, there

was a predominance of construction workers, then technical and management professions, and finally

administrative and economic professions. In terms of education in the addressed small and medium-sized

building companies, the biggest share employees were those with primary and secondary school education.

Basic Human Resource Activities

The results of the questionnaire survey confirmed that the overall approach of human resource management

in the addressed small and medium-sized building companies lacks concept and is random, focusing usually on

current problems associated with the necessary workforce and meeting the administrative obligations arising

from legislation (see Table 2).

Table 2

Human Resource Activities Activity Small (%) Medium-sized (%)

Keeping human resource documentation 88 94

Ensuring safety and work hygiene 83 59

Creating a corporate culture 69 59

Recruiting and selecting employees 63 68

Assessing employee satisfaction 63 52

Strategic employee planning 53 64

Employee appraisal, remuneration, and education 52 58

Evaluating the efficiency of human resource activities 35 35

Note. Source: Own elaborations.

The initial problem of recruiting and selecting employees is the identification of potential sources of

employees in the company (e.g., employees downsized due to technical development, employees made redundant

in connection with organizational changes, employees interested in performing other work, etc.), and outside the

company (e.g., the unemployed registered at the labor office, employees of other companies, agency employees,

etc.). Cooperation with the labor office in recruiting employees was confirmed by 49% of small and 59% of

medium-sized building companies. Employees of other building companies are used to recruit employees by only

21% of small and 9% of medium-sized building companies. Agency employees are used to recruit employees by

only 9% of small and 2% of medium-sized building companies. Employees of other building companies are used

upon a mutual agreement and agency employees are used as required, especially seasonal when construction

workers are most frequently hired in this way.

As far as the appraisal is concerned of employees, an analysis and assessment of their skills, motivation,

results, and behaviors, in most small and medium-sized building companies, there is a predominance of an

“ad hoc” approach that stems from momentary needs, or reaction to the already existing problems, as the case

may be, which is a fundamental failure because the point of appraising employees is to address and not to prevent

problems.

Employees are remunerated in most small and medium-sized building companies for achieving results or as

a way of stimulating the performance of the work required. Various remuneration tools are used to remunerate

employees, especially a wage to perform work, extra pay for extraordinary conditions, or employee benefits

provided on the basis of an employee contract. In this context, 58% of small and 82% of medium-sized building

companies stated that they have an internal regulation for remunerating employees. In building companies, the

basis for the differentiation of employees’ wages tends to be the determination of the relative value of work and

the appropriate tariff wages of individual building professions, of course besides the traditional tariff systems,

modern performance remuneration is being asserted more in order to tie work performance and the related

employee remuneration into achieving individual and collective objectives.

Employee training in most small and medium-sized building companies is associated with the need to

adopt new legal and technical standards (stated 69% of small and 80% of medium-sized building companies).

Employee training associated with changes in techniques and technology is less common (stated 63% of small

and 44% of medium-sized building companies), just as training aimed at the long-term professional

development of employees (stated 60% of small and 61% of medium-sized building companies). Only 15% of

small and 20% of medium-sized building companies draw up plans of individual development for certain

professions.

As a result, it was confirmed that the addressed small and medium-sized building companies normally

do not implement a strategic and systematic approach to human resource management as most major building

companies which is perhaps natural given the significantly smaller number of employees. Of course, both

major and small and medium-sized building companies employ people of various professions who perform

various construction works in different working conditions. Moreover, small and medium-sized building

companies usually establish their successes on specialized professions, specialized experience, quality

work, and good references from customers which bring them the necessary building contracts. Under such

circumstances, it is more or less essential that the management of any building company (major, medium,

and small) implement a strategic and systematic approach to human resource management and ensure

individual human resource activities in accordance with human resource strategy and based on human resource

plans.

The basis of any attempt at an expedient change in the management of any building company must be an

attempt at an effective change in human resource management, philosophy, strategy, and a system of employee

management respectively, because it is employees who by their individual and collective approach decide the

way to carry out the required activities and achieve the expected objectives of the building company.

The successful fulfillment of the task of human resource management requires an effective tool for analyzing

and judging the expedience and efficiency of implementing individual human resource activities, their impact on

the performance of individual employees and the entire building company. Such a tool is the human resource

controlling.

Human Resource Controlling

Human resource controlling applies the concept, principles, and tools of controlling to human resource

management. The considered intention of the application of human resource controlling in the building industry

is to plan, analyze, and judge the development of decisive quantitative and qualitative human resource indicators

(such as the number of human resource officers in relation to the overall number of employees, professional

structure and qualification level of employees, revenues, costs, added value per employee, rate of fluctuation,

absenteeism and accident rate of employees, success in filling vacant jobs from internal and external sources of

employees, efficient use of funds for remuneration, training, and development of employees, etc.), whose optimal

fulfillment is in the interest of the effective attainment of the strategic objectives of the building company.

The final objective of the application of human resource controlling in the building industry is the creation and

implementation of an expedient and effective system of human resource activities (planning, recruitment,

selection, appraisal, remuneration, and training of employees), which will ensure the building company

economically and socially balanced performance of required construction works, attainment of the expected

objectives (profitability and competitiveness), and satisfaction of the needs of interested parties (owners,

employees, customers, contractors, consumers, the state, the public, etc.).

The concept of human resource controlling is based on the use of operative and strategic controlling

(Mikovcová, 2007):

(1) Operative controlling is oriented towards short-term and quantitative human resource indicators (such as

revenue, costs, added value per employee) and serves managers and human resource officers as an early warning

system at a deviation from the planned values;

(2) Strategic controlling is oriented towards long-term and qualitative human resource indicators (such

as a return on investment in remuneration, training and development of employees) and serves managers and

human resource officers as an evaluation and management of the expedience and efficiency of the human

resource management system, its added value for managers, human resource officers, employees, and

organization.

Among the main tools of human resource controlling are (Urban, 2004):

(1) Human resource statistics. Their purpose is to record the state and development of human resource

management in an organization, including human resource costs, for example;

(2) Human resource indicators. These are aggregate ratio quantities of a quantitative and qualitative nature

which enable comparison and orientation in the development of human resource management. Human resource

indicators can be arranged in groups according to individual human resource activities. Separate groups are

indicators of the efficiency of the human resource department;

(3) Human resource standards. These are target indicators of human resource management which are

based on the organization’s strategic objectives. They define the values of individual human resource

indicators which should never be exceeded. For example, a human resource standard means that every new

employee has his/her individual adaptation plans, every employee knows the most important objectives of the

organization, with each change in filling a job the employee’s added value will be analyzed, an appraisal

interview will be conducted with each employee every year about his work performance and personal

development, etc.;

(4) Human resource audit. This is designed to analyze and assess, in more detail, the individual quantitative

and qualitative results in human resource management. It is engaged in the analysis and assessment of the

contribution to human resource management (philosophy, strategy, and system of human resource activities) for

the activities of employees and function of the organization;

(5) Questioning employees. This serves to verify mostly qualitative results of human resource management

(motivation plans, employee satisfaction, human resource development, etc.). Data acquired from the questioning

serve as a basis for further decisions in human resource management.

Assuming the expedient setting of decisive quantitative and qualitative human resource indicators, human

resource controlling is an effective tool for analyzing, assessing, and regulating human resource management.

A certain problem of implementing human resource controlling is the risk that the appropriate conclusions will

not be deduced from individual results of the analysis and assessment of human resource management in an

organization, in other words, there will not be any effort in the organization to proceed with the appropriate

changes in the approach to human resource management in order to improve it. A critical factor of success in this

case appears to be the approach of individual managers to all levels of management of the organization

responsible for the daily management and leadership of employees towards the performance of the required work

and achievement of the expected objectives.

Conclusions

The results of the questionnaire survey, in which 81 small (less than 50 employees) and 66 medium-sized

(50-249 employees) building companies operating in the Czech Republic took part, showed that the

current approach of small and medium-sized building companies lacks concept and is random, oriented

mostly to satisfying momentary needs of the workforce and meeting administrative obligations that arise

from legislation. Although small and medium-sized building companies base their successes on specialized

professions, expertise, quality work, and good references from customers, most do not implement a strategic

and systematic approach to human resource management and do not provide human resource activities

in accordance with the human resource strategy and based on human resource plans. Many small

and medium-sized building companies lack expedient principles and effective human resource management

tools in planning, recruiting, selecting, appraising, remunerating, and training, which basically does not

enable the optimal evaluation of invested funds, use of available resources, and attainment of expected

results.

Likewise, most small and medium-sized building companies normally lack the required know-how for

expedient and effective measurement of own productivity and efficiency in relation to human resource

management which significantly affects the performance of every building company. A possible solution in terms

of expediency and efficiency of human resource management is the use of the concept, principles, and tools of

human resource controlling which focuses on planning, analyzing, and assessing the development of decisive

quantitative and qualitative human resource indicators whose optimal fulfillment is in the interest of effective

attainment of the strategic objectives of the building company. The final objective of the application of human

resource controlling is to create and implement an expedient and effective system of human resource activities

which will ensure for the building company an economically and socially balanced performance of the

required construction works, attainment of the expected objectives, and satisfaction of the needs of interested

parties.

References Armstrong, M. (2007). Řízení lidských zdrojů. Nejnovější trendy a postupy (Human resources management. Latest trends and

practices) (10th ed.). Praha: Grada Publishing. Brandenburg, S. G., Haas, C. T., & Byrom, K. (2006). Strategic management of human resources in construction. Journal of

Management in Engineering, 22(2), 89-96. CEEC Research. (2013). Kvartální analýza českého stavebnictví Q4/2013 (Quarterly analysis of the Czech building industry

Q4/2013). Retrieved from http://www.ceec.eu/research/ Gerhart, B., & Milkovich, G. (1990). Organizational differences in managerial compensation and financial performance. Academy

of Management Journal, 33(4), 663-691. Huselid, M. A. (1995). The impact of human resource management practices on turnover, productivity, and corporate financial

performance. Academy of Management Journal, 38(3), 635-672. Maloney, W. F. (1997). Strategic planning for human resource management in construction. Journal of Management in

Engineering, 13(3), 49-56. Marchington, M., & Wilkinson, A. (2005). Human resource management at work: People management and development (3rd ed.).

London: CIPD. Mikovcová, H. (2007). Controlling v praxi (Controlling in practice). Plzeň: Vydavatelství a nakladatelství Aleš Čeněk, s.r.o. Rizov, M., & Croucher, R. (2009). Human resource management and performance in European firms. Cambridge Journal of

Economics, 33(2), 253-272. Urban, J. (2004). Výkladový slovník řízení lidských zdrojů s anglickými ekvivalenty (Dictionary of human resource management

with English equivalents). Praha: ASPI.

JMAA 2014.9

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