Financial Management: Main Considerations and Characteristics

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Table of Contents

Introduction
Operational boundary and authorized limits
Main Considerations of FRS 17
Characteristics of FRS17
Financial risk areas and their relevance in FRS17
References

Introduction

Financial management refers to the process of planning for and allocating the organization’s financial resources with the objective of creating more wealth, generating more income or ensuring an adequate return on investment. Financial management as discussed by Henning et al (34), involves three main elements; financial planning, financial control and decision-making. The international accounting standards body considers financial management as a key factor in determining the success of any organization. Therefore, for the retirement benefits plan governed by FRS17 to succeed, proper financial management is key. The Greater Manchester Fire and Rescue Services puts a lot of premium on FRS17 since it govern how they maintain their employees’ pension funds accounts.

Operational boundary and authorized limits

Operational boundary in an organization relates to the level of operations in an organization when measured against the available resources. The value of the operational boundary in a given period is determined by calculating the value of external debts that have been used in the organization’s operations. These debts are often used for financing capital requirements, and a small amount on revenue requirements.

Authorized limits on the other hand are the boundaries set on the operational boundary to make a provision for the unanticipated cash flows. “This is determined by allowing a 5% upper and lower discrepancy on the operational boundary and the resultant figure is rounded up to the nearest £0.5 million” (Compton and John 21). This is however not the standard percentage since the management can change it if the need arises.

Arithmetically, the operational boundary and the authorized limits of Greater Manchester fire and rescue services are determined as follows:

Operational Boundary = £11.698M and the Authorised limit = £12.5M

So proportion of authorised limit used = operational boundary/authorised limit = 11.698/12.5 = 0.935

This gives the safety margin = 100% – 93.5% = 6.5%

The recommended safety margin is given as 5%

Therefore GMFRS is operating within the recommended safety margins

Main Considerations of FRS 17

Financial reporting standards are statements put forth by a governing body to guide organizations in preparing their financial reports so that they are consistent with the international standards. FRS 17, for example, is a guideline for employers in providing a complete report of the pension benefits earned by their employees irrespective of whether they have been disbursed or not. “The total liability brought about by this scheme is divided between the local government pension scheme and the fire service scheme which includes the firefighter’s pension scheme and the new fire fighters scheme” (Financial Management Association 10). The directors of the organization are faced with the responsibility of establishing a procedure to ensure that the finance department complies with FRS 17. They should also delegate some of these responsibilities to other people owing to the fact that they may not have the skills needed to carry out the valuation of assets and liability in conformity to FRS 17. They may also lack the right of access to some reports making it impossible for them to carry out financial reporting effectively.

FRS 17 defines retirement benefits to be inclusive all the benefits that accrue after retirement such as life insurance, health insurance and disability provision regardless of whether such arrangements are legislative, inherent or contractual as per the actions of the employers. Retirement benefits should also include the “post retirement benefits payable under a formal trust together with those payable pursuant to an informal agreement, such as a promise, a public statement or a similar commitment made by the employer” (Baker et al 3). In the management of the benefit schemes, FRS 17 maintains that the assets and liabilities of the scheme should be valued consistently. Any surplus should be considered as an asset and deficit as a liability in the report, and any additional disclosures should be mentioned in the statements.

FRS17 has been considered in the Greater Manchester fire and rescue services financial reports. “This organization has a liability of £925.7m and this is allocated between the local government pension scheme which gets £5.8m and the fire service scheme which gets £919.9m” (Financial management association 34). The liability that is allocated to the fire service is further divided in to the firefighters’ pension scheme of 1992 and the new firefighters’ scheme established in 1996.

In their financial statements, they have a separate division that only deals with the pension fund for the purpose of accountability. This is a requirement by the code of practice on local authority accounting 2007, which requires all the organizations to run a separate pension fund. This code specifies as well the amount of cash that should be deposited or withdrawn from the account at any given time. Besides this, there are other arrangements that have been put forth concerning the fire fighters pension fund account whose main purpose is to place the pensions under a plan referred to as the defined benefit schemes.

The fire service pension scheme is not a funded scheme and is governed by the management in agreement with the DCLG guidelines. This means that investment assets do not exist in this scheme hence FRS17 requires that the pension reserve and the liability be recognized in the financial statements (Income and expenditure account and the balance sheet). The local government pension scheme on the other hand requires that the assets of the organization should be attributed to the governing authority. All these assets together with the liabilities are posted on the balance sheet according to the guidelines specified by the actuarial society, which uses the projected unit procedure.

Any change experienced in the disposable pension’s liability should be evaluated into four elements. The first one is the current cost of service defined as the increase liabilities resulting from the cumulative years of service in relation to the current year as stated in the income and expenditure account as well as the revenue accounts of the services that have been rendered by the employee. The second element is the cost of past service defined as “the increase in liabilities arising from current year decisions whose effects relates to years of service earned in the past” (Micocci et al 45). The third element is the cost of interest and it refers to the anticipated increase in the liabilities’ present value in the current year. The forth element is the contribution made by the employer towards the pension fund on behalf of his employees. Appropriations are made by the governing body on the pensions reserve to ensure that notional credits and debits are eliminated and replaced with the debits for the cash paid to the pension fund and any other outstanding arrears.

Characteristics of FRS17

One of the major characteristics of FRS17 is that it is a defined benefit scheme. In such a scheme, the assets are stated as per their book value at the end of the specified period. These assets include, quoted securities, unquoted securities, unitized securities, tangible property, insurance policies and notional funding among others. The liabilities on the other hand are estimated based on the actuarial figures (Martin 45). Examples of these liabilities are promised benefits and constructive rules created in the public statements. Surpluses in this scheme are recorded in the balance sheet as assets while deficits are recorded as liabilities.

This feature of FRS17 is enshrined in the standards used in Greater Manchester in the sense that the financial management team ensures that proper balance sheet entries have been made concerning the pension funds surpluses and deficits. Their assets and liabilities are classified according to the general financial reporting standards described above (Henning et al 36). This is an indication that the organization is operating in line with the international accounting and finance standards.

Financial risk areas and their relevance in FRS17

Risks are a common occurrence in any field of operation and can be defined as the possibility of having a bad event happening when it was not anticipated for. The level of risks is usually measured using the probability method of finding the expected value, calculated as;

∑ (the possibility × the probability that it will occur).

When it is established that there is no possibility of the risk occurring, then the probability is zero. This is however not applicable in practice since risks occur every now and then. The main areas of risk in financial management include operational risks, market risks, financial risks, credit risks, quantitative risks and commodity risks (Financial Management Association 33).

Operational risks areas are those involved with human errors which occur in the daily practices. These risks are the most common type and are never intentional or anticipated. This makes it hard for the management to come up with ways of preventing them from happening. The only option therefore is to leave a provision to cater for such risks the moment they occur. In FRS17, operational risks can occur when the clerks accidentally enter the wrong amounts of pension fund received. This may amount to an imbalance of the whole account especially when the possibility of the risk occurring was never considered. Market risks areas involve risks such as changes in interest rates (Compton and John 21). This is the most unanticipated event which frequently affects the financial market. Changes in interest rates affect FRS17 by reducing the value of money such that the nominal amount of money in the pensions becomes less than its real value. This mostly affects the employees once they retire since the pension money they receive does not measure up to the present value of money.

A financial risk area is concerned with the defaulted payments which end up accumulating the interest such that they are declared to be bad debts. This risk affects FRS17 when the employers fail to pay the amount due to their employees’ pension funds and this amount accumulates over time. On retirement, the employees demand to be paid their pensions just to realize that there has been a deficit in their accounts. This however can be prevented by introducing a system of direct payment to the employees’ pension scheme. Credit risk involves the probability of defaulted payments from the creditors. This affects FRS17 in the event that the pension fund scheme may run out of funds to compensate the retirees owing to the unpaid debts (Financial management association 34).

Quantitative risk area is concerned with the efforts made to ascertain the numerical value of the possibility of various unfavourable financial situations to take care of the level of losses that may arise from such situations. This type of risk is applicable to FRS17 in the sense that this area of finance is prone to many errors owing to the fact that a lot of information is handled and this information dates back to many years back. This means that the database contains long term information that is very relevant and the loss thereof can be detrimental to the system. Finally is the commodity risk area which handles risks that are related to physical property (Compton and John 13). Loss of property can occur for many reasons one of them being fire outbreaks. In relation to FRS 17, this risk involves loosing the pension department’s property through theft, fire outbreaks or through any other destructive occurrence. This risk is considered the most serious one since it can bring about a permanent loss of data and information especially in the event where there were no backups.

FRS17 has accommodated the high risk areas in its accounts in that the risk is managed with regards to the general risk management policies. The most important thing when carrying out this process is to understand the sequential risk management procedures. A general quantification of risk is however difficult owing to the differences in risk perception in various departments. Irrespective of this, the general risk management process remains constant and it can be applied in any given situation. The first step that is considered is the establishment of the context using tools such as the SWOT analysis or the PESTEL analysis (Henning et al 45). Carrying out analysis using these tools brings out the possible risks facing the department and the financial manager is able to make an assessment of these risks.

After an assessment has been made on the risks, a profile is prepared and the risks are quantified in order to identify the possibility of their occurrence and the possible impact they may have on the operations of the department. The next step is to respond to these risks which include making decisions as to whether the risks should be avoided, reduced, transferred or accepted and this decision is implemented in the specific risk areas (Baker et al 3). The final step is monitoring and controlling the risks which is a continuous process involving making any necessary changes that may arise when the risk management plan is being implemented.

The financial managers in the pension schemes tackle financial risks by avoiding the hedging risks – the risks which are of little benefit to the organization. This ensures that any risk that is taken has returns equivalent to the magnitude of the risk. The risk should be in a position to produce greater value to the investors in the scheme since this is what will make it worth taking. Operational risk management is conducted in a pension scheme to ensure that operational losses are minimized and also to cut on auditing expenses. This also reduces the scheme’s vulnerability to the risks in future. Besides this, it enables the management to detect illegitimate activities early enough to be able to make corrections.

The financial managers working under FRS17 work with a number of factors that may lead to operational risks. These include external fraud such as hacking or robbery, internal frauds committed by the employees in the scheme as well as the risks occurring from business practices and from the management process (Micocci et al 42). They emphasize the risk management controls on the data entry department owing to the fact that most risks are experienced here. The risk management plan implemented by the management with regards to the credit risks is aimed at ensuring all the debts owing to the scheme are paid on time. This risk is considered with a lot of importance owing to the fact that it can lead to complete dissolution of the scheme. For them to be successful in this, they set the level of risk at a standard point beyond which the credit facilities are not offered anymore.

Market risk management is considered an important aspect in financial management under FRS17 since this is what addresses the concerns of the organization with the required risk structure. This is achieved by ensuring that any market related information that is relevant to the organization is accurate and genuine (Micocci et al 45). Finally is the quantitative risk management which is undertaken in the pensions department to ensure that the probability of occurrence of all the other risks is generally minimized. This works towards eliminating any possible hazards from the system and making sure that any type of risk that arises can be handled effectively. This plan is achieved using different kinds of tools. Some of the tools used are simulation, probability distribution, sensitivity analysis and decision diagram analysis.

References

Baker, August J, Dennis E. Logue, and Jack S. Rader. Managing Pension and Retirement Plans: A Guide for Employers, Administrators, and Other Fiduciaries. New York: Oxford University Press, 2005. Print.

Compton, Dennis, and John A. Granito. Managing Fire and Rescue Services. Municipal management series. Washington, D.C: International City/County Management Association, 2002. Print.

Financial Management Association. Financial Management. Atlanta, Ga: Financial Management Association international, 1972. Print.

Henning, Charles N, William Pigott, and Robert H. Scott. International Financial Management. McGraw-Hill series in finance. New York: McGraw-Hill, 1978. Print.

Martin, A. “The Impact of Frs17.” Pensions Management. (2001): 60-61. Print.

Micocci, Marco, Greg N. Gregoriou, and Giovanni B. Masala. Pension Fund Risk Management: Financial and Actuarial Modeling. Boca Raton, FL: Chapman & Hall/CRC, 2010. Print.

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