P1 student notes.pdf

8/19/2019 P1 student notes.pdf

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Student

Notes

ACCA Paper P1Professional Acccountant

For exams in December 2008

To be used with the BPP Study Text for exams in December 2008 and

June 2009 2008 edition)


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©

BPP Learning Media Ltd

2008

First edition 2008

ISBN 9780 7517 5713 2

British Library Cataloguing-in-Publication Data

A catalogue record for this book

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Introduction iii

C O N T

E N T S

chapter 1

SCOPE OF CORPORATE GOVERNANCEpage 1

chapter 2

APPROACHES TO CORPORATE GOVERNANCEpage 17

chapter 3CORPORATE GOVERNANCE PRACTICE AND

REPORTINGpage 33

chapter 4INTERNAL CONTROL SYSTEMS

page 49

chapter 5

INTERNAL ENVIRONMENT AND OBJECTIVE

SETTINGpage 63

chapter 6

EVENT IDENTIFICATION AND RISKASSESSMENT

page 77

chapter 7

RISK RESPONSE AND CONTROL

ACTIVITIESpage 87

chapter 8INFORMATION, COMMUNICATION AND

MONITORINGpage 95

chapter 9ETHICSpage 109

chapter 10

ETHICS AND PROFESSIONAL PRACTICE

page 119

chapter 11CORPORATE SOCIAL RESPONSIBILITYpage 133


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iv


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chapter 1

SCOPE OF

CORPORATE

GOVERNANCE

This chapter sets out the foundations of good corporate

governance, defining what corporate governance is andwhom good corporate governance serves. You mayneed to consider the conflicting interests of

stakeholders and how stakeholders can controlmanagers/directors. We also summarise major issues

in corporate governance.

DEFINITION

CONCEPTS

AGENCY

STAKEHOLDERS

MAIN ISSUES


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Definition Main issuesStakeholdersAgencyConcepts

Corporate governance is the system by which organisations are directed and controlled. It is a set ofrelationships between directors, shareholders and other stakeholders.

Risk managementand reduction

Appropriate controlsystems

Framework topursue strategy

Guards againstmisuse of resource

Spirit of codes Accountability tostakeholders

Corporate governance

D E F I N I T I O N


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1: Scope of corporate governance 3

Context

Good corporate governance enables investors to feel confident that their investment is well-

managed and will not be lost as a result of bad decisions, poor management control or greed of the

directors.

Learning example 1.1

10 years ago a fund manager invested $15m in the shares of CAET Corporation, a successful retail

clothing chain. Today the investment is worth only $3m.

What could have gone wrong at CAET Corporation?

What difference could having a better accounting function at CAET Corporation over the past 10

years have made?

Solution 1.1


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Fairness Take into account all stakeholders with legitimate interests

Transparency Openness, disclosure in financial statements, press releases, websites

Independence Need for independent non-executive directors who can monitor withoutconflicts of interest

Probity Truth-telling/not misleading

Responsibility Management responsible for organisation, means of corrective action andpenalising mismanagement

Accountability Directors answerable for consequences of actions, to shareholders andstakeholders (?)

Reputation Jeopardised by poor risk management/corporate governance, may impactcommercially

Judgement Taking decisions that enhance organisation’s prosperity

Integrity Straightforward dealing and completeness, basis of trust

C O N C

E P T S


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Agency Agency in corporate governanceAgency is acting on behalf of another (principal) indealing with others.

Agency costs are the monies and resourcesexpended by principal in monitoring agent.

Accountability

Fiduciary duty (trust and care)

Personal performance Obedience

Skill

No conflict of interest

Confidentiality

Handing over benefits

Agent’s responsibilities

Directors (agents) run company on behalf ofshareholders (principals).

Agency problem – how to prevent directors excessivelyrewarding themselves/underperforming.

Main solution is to link reward with companyperformance:

Profit related pay

Shares

Share option plans

Transaction costs theoryCompanies seek to keep business dealings in-house,managers act opportunistically in their own interests.

A G E N C Y


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Context

Directors and management are agents of shareholders (principals). The principal agent problem

refers to the difficulty faced by shareholders in ensuring that management don’t use the firm’s

money and assets for their own ends.


What would be the indicators of directors misusing their position as agents?

Solution 1.3


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Stakeholder theoryOrganisations have responsibilities to broadrange of stakeholders. Stockholder view thatcompany just responsible to shareholders is

wrong as modern corporations are very largeand social/political/legal impact is therefore great.

Instrumental view – mainly economicresponsibilities with aim of maximising profits

Normative view – ethical/philanthropicresponsibilities as well as economic/legal

StakeholdersStakeholders are groups or individuals whoseinterests are directly affected by the activities ofa firm or organisation.

Stakeholder power mappingLevel of interest

D

Power

Low High

Low

HighC

BA

A: minimal effortB: keep informed, as can influence more powerful stakeholdersC: keep satisfied

D: strategy must be acceptable

Corporate governance accommodates views Repositioning of stakeholders Identify change blockers/facilitators Assess legitimacy/urgency

Results of mapping

S

T A K E H O L D

E R S


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Context

Because firms affect people’s lives, some believe that management should accommodate the

interests of more than just shareholders when running companies.


The Board of a medium-sized private company is considering becoming fully listed on the stock

market. The family that presently holds 100% of share capital will have their holdings diluted down

to 30% as more shares are issued and capital is raised.

Classify the following using stakeholder mapping and justify your decision.

(a) Employees of the company

(b) The family that owns the shares at present

(c) The Stock Market's regulators

(d) Customers of the company

Solution 1.4


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StakeholdersDefinition Main issuesAgencyConcepts

Proximity to organisationInternal – employees/management

Connected – shareholders, customers, suppliers,lenders, trade unions, competitors

External – government, local government, public,

pressure groups, opinion leaders

Active and passive stakeholdersActive – seek to participate in organisation'sactivities (managers, shareholders, regulators,pressure groups)

Passive – don’t seek to participate in policy-making(shareholders, local communities, government)

Primary and secondary stakeholders

Narrow and wide stakeholders

Primary – need participation to continue as goingconcern (customers, suppliers, government)

Secondary – their ceasing to participate won’t affectcontinued existence (government, managers)

Narrow – most affected by organisation’s strategy(shareholders, employees, suppliers, major customers)

Wide – less affected by organisation’s strategy(government, less significant customers, community)

Voluntary and involuntary stakeholdersVoluntary – those who voluntarily have involvementwith the organisation – employees, customers,

suppliers, shareholders

Involuntary – engage with the organisation withoutchoosing to do so – neighbours, wider public

Knowledge of stakeholdersKnown – Existence known to organisation

Unknown – Existence unknown to organsiation(wildlife, communities affected by suppliers)

Legitimacy of stakeholders

Recognition of stakeholders

Legitimate – valid claims

Illegitimate – invalid claimsWho decides legitimacy?

On what basis?

Recognised – Managers consider interests and viewswhen deciding strategy

Unrecognised – Managers don't consider claims whendeciding strategy

S

T A K E H O L D

E R S


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Context

These are examples of stakeholders and the different ways to classify them.


The Board of a hotel company is considering acquiring land in an unspoiled area of great naturalbeauty to build a hotel and shopping complex, the first of its kind in the country.

Classify the affected stakeholders using the stakeholder power mapping matrix.

Tutor note. The value of this exercise will be in the application of ICE and what power and interest

each stakeholder has. A good approach is to draw up the matrix and fill it in from class suggestions.

The solution below is merely our suggestion.

Solution 1.5


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Secretary

Customers

Suppliers

Employees

Executive full-time managers, non-executive monitoring

Arranges board meetings, deals with documents and registers, general administration,reports to chairman

Impact of governance upon their position including their chances of becomingdirectors

Commitment, interest in pay and conditions, need to comply with control systems andadopt culture

Pay, prospects plus working conditions of members, concerned with poor boardcommunication, lax risk and control environment

Co-operation needed for just-in-time supply, poor payment record leads to creditrestriction and poor service

Increased expectations, power to shop elsewhere, ability to make views known, ethicalrequirements

Directors

Sub-board management

Trade unions

Independence required to supply confidence in information, need for audit committeeto reinforce position

Establish rules and standards, carry out inspections. May be enforcement costs orregulatory capture, domination of regulator by regulated

Establish overall control climate, influence investors through taxes, encourge privateshareholdings, provide subsidies and investment trusts

Companies raise money, investors transfer shares, provide regulatory framework forgovernance

Can influence prices, avoid speculative shares, want short-term profits, can influencecompanies through meetings and voting, able to take direct action if dissatisfied

External auditors

Regulators

Government

Stock exchanges

Institutional investors

S

T A K E H O L D

E R S


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Context

These are examples of stakeholders and why they are important to organisations.


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Duties of directorsCorporate governance guidelines reinforce legal andfiduciary duties to act in company’s best interests,use powers for proper purpose, avoid conflicts ofinterest and exercise duty of care.

Accounting and auditingGreater transparency and reliability of accounts,decreasing investor risks.Tougher auditing standardsand requirements for auditors to avoid conflicts ofinterest.

Board supervisionNeed for board to meet regularly to consider effectivelyorganisation’s activities, risks and control systems.

Directors’remuneration

Corporate social responsibility

Board compositionNeed to avoid domination by single individual/smallgroup of executive directors.

Builds on stakeholders’ debate, what responsibilitiesshould organisation and board fulfil.

Directors being paid undeserved and excessiveremuneration and bonuses. Allegations that directorshave been rewarded for making losses.

M A I N I

S S

U E S


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Context

These are the main techniques used to assure proper corporate governance. They will be examined

in detail in later chapter.


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Reinforcement

Using Chapter 1 of your Study Text

Expand notes on corporate governance concepts (Section 1.2), fiduciary

responsibility (Section 2.2) and stakeholders (Sections 3.10 – 3.26)

Attempt questions ‘Mendelow’s matrix’ and ‘Concepts’ in Chapter 1 Attempt Quick Quiz

Attempt Question 1 ‘Bonus schemes’ from Exam Question Bank at the back of

your Study Text


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chapter 2

APPROACHES

TO CORPORATE

GOVERNANCE

In this chapter we summarise the factors that haveinfluenced the ways corporate governance hasdeveloped. You may be asked about these in part (a) ofa question before you consider specific corporategovernance arrangements later in the question. Wealso give details of the major worldwide codes,

particularly those that have international impact.Corporate social responsibility is a major topic in thisexam, and the themes we cover will occur in manyquestions.

DEVELOPMENT OF GUIDANCE

BASIS OF GUIDANCE

MAJOR GOVERNANCE CODES

SARBANES-OXLEY

CONTRIBUTION OF CODES

CORPORATE SOCIAL RESPONSIBILITY


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Contributionof codes

Development ofguidance

Corporate socialresponsibility

Sarbanes-OxleyMajorgovernance codes

Basis ofguidance

Internationalisation

Governance development

Investor treatment Financial reportingweaknesses

Individual countrycharacteristics

Corporate scandals

Openness Integrity Accountability

Main goals

D E V E L O P M E N

T O F

G U I D A N C E


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2: Approaches to corporate governance 19

Context

Most codes and rules on corporate governance have developed since 1990. Understanding theregulations and differences between them can be helped by understanding the circumstances underwhich they developed.


Go to www.wikipedia.org and search the following terms. Make brief notes on the scandals, notingin particular the date, the name of the CEO and the financial practices that were concealed andwhich led to the scandal.

(a) Parmalat

(b) Enron

(c) II Robert Maxwell

Solution 2.1


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Basis ofguidance

Principles-based approachMost corporate governance codes have been drawn upon the basis of a principles-based approach with broadguidelines supplemented by limited specificrequirements. Danger may be that over-broad principlesare not strong enough.

Insider systemsMost companies listed on stock exchange are controlledby a few individuals.

Avoids inflexible rules

Less burdensome

Allows scope for development

Comply or explain

Emphasis on investor judgement

Advantages of principles

Outsider systemsShareholdings are widely dispersed, manager/ownerseparation.

Strong owner-manager linksLonger-term view

Discrimination v minorityLack of monitoring/governance

Robust governance regime

Hostile takeover threat constrains managementAgency problem

Short-term priorities

Advantages/Disadvantages

Insider Outsider

B A S I S O

F

G U I D A N C E


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Context

Corporate governance develops to keep pace with changes in firms’ behaviour and the economiccontexts that firms operate in. This leads some countries to prefer the certainty of a system basedon strict rules. Others prefer the adaptability and flexibility of codes based on principles.


Consider the advantages listed for principles-based approaches opposite. Use them to help you.

(a) List the disadvantages of rule-based approaches.

(b) Suggest advantages of rule-based approaches.

Solution 2.2


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Basis ofguidance




Cadbury reportReport aims to address weaknesses in director-auditorarrangements, particularly perception that auditorsoften capitulate to directors. Code of Best Practicecovers role of the board, audit, financial reporting andshareholder relations.

Combined CodeCode derives from Cadbury, Greenbury and Hampelreports, supplemented by:

Turnbull report – risk and internal control Smith report – audit committees Higgs report – non-executive directors

Hampel reportPrinciples-based approach, requiring companies tocomply with, or explain departure from, best practice.

King reportGreenbury reportNon-executive directors determine executive directors’remuneration and service contracts limited to one year.

South African report, advocating integrated approachto variety of stakeholders and importance of socialand environmental as well as economic activities.Report emphasises need for shareholder activism anddisclosure as regulatory measure.

OECD principles

Shareholder participation and voting on directors

Shareholder/stakeholder rights

Equitable treatment of all shareholders

Stakeholders rights protected

Timely/accurate disclosure of material matters

Board responsible for strategy and monitoring

Board should act with due diligence and in company’sbest interests

Principles

ICGN reportInternational Corporate Governance Network hasprovided practical guidance for boards to operateefficiently and compete for scarce capital.

Board’s role in strategy/monitoring emphasised

Directors need appropriate skills/experience

Directors show independent judgement

Directors fulfil fiduciary duties

Formal process of director evaluation

Shareholders’ voting rights protected Major changes require shareholder approval

Returns benchmarked v similar equity cos

Full disclosure of voting rights

Code of ethics

Need to manage stakeholder relationships productively

ICGN guidance

Organisation for Economic Co-operation andDevelopment produced non-binding principles toaddress the interests of global investors. Companiesshould work towards achieving principles, andprinciples are guidelines for individual countries todevelop own codes

M A

J O R

G O V E R N A N C E

C O

D E S


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Context

The Examiner may require you to cite particular codes as examples.


Explain the reasons for the growth of codes of corporate governance since 1990.

Solution 2.3


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Sarbanes-Oxley Contributionof codes



Majorgovernance codes

Basis ofguidance

Sarbanes-OxleyThe Sarbanes-Oxley Act was a response to thecollapse of Enron, one of America’s biggest companies.The Act is more prescriptive than codes in other jurisdictions, impacting on disclosures, audits, ethicsand directors’ share trading.

Lack of transparency in accounts Non-executive directors weak Lack of external audit scrutiny Directors’ use of inside information Dishonesty and law-breaking

Weaknesses at Enron

Corporate responsibilityChief executive/chief finance officer certify:

Appropriateness of accounts

Accounts fairly reflect operations and financialcondition

If accounts have to be restated, they forfeit theirbonuses.

Auditing requirementsThe non-audit services auditors can provide aresignificantly restricted and auditors are subject tovarious other rules:

Compulsory partner rotation

Retention of audit papers

Quality control standards

Review internal control systems

Audit committeesEvery listed company should have an auditcommittee consisting of independent directors, withmember(s) with financial expertise. Audit committeeshould be responsible for:

Appointment, compensation and oversight ofauditors

Discussing key accounting policies with auditors

Setting up complaints mechanisms

Internal control reportsAnnual accounts must contain internal control reportsthat:

State management responsibility for controlstructure/financial reporting procedures

Assess effectiveness of control structure/financialreporting procedures (with audit report)

State whether code of conduct for senior financialofficers has been adopted

Whistleblowing Off-balance sheet transactionsEmployees/auditors will be granted whistleblowing

protection if they disclose private employerinformation to parties involved in a fraud claim.

There should be appropriate disclosure of material off-

balance sheet transactions.

S A

R B A N E S - O

X L E Y


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Context

Sarbanes-Oxley Act 2002 is a statutory or rules-based framework of corporate governance that wasintroduced to stop a repeat of the abuses that came to light when Enron collapsed in November2001.


Compare the provisions of the Sarbanes-Oxley Act with the UK’s Combined Code and identify anyareas in which SOX has provisions not in the Combined Code.

Solution 2.4


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Basis ofguidance

Highlightedadvantages of good

governance

Emphasised keydangers

Providedbenchmarks

Promoted goodpractice

Emphasisedaccountability

Stressedtransparency

Contribution of codes

C O N T R I B U

T I O N O

F

C O

D E S


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Context

Having codes of corporate governance has raised investor awareness of the things to watch out forand to guard against in the behaviour of the boards they appoint.


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Basis ofguidance

Carroll’s modelFour levels of responsibilities:

Economic – shareholders/employees/customers

Legal – comply with laws Ethical – act in fair and just way Philanthropic – generosity to employees/

community

Collaboration time-consuming and expensive Culture clashes with certain stakeholders

Collaboration on some issues, conflict onothers

Lack of consensus between differentstakeholders

Problems with stakeholder view

CSR and stakeholdersBusinesses benefit from goodwill and other aspectsof society and therefore owe those particularlyaffected by their activities certain duties in return.

Significance of responsibilityLarge businesses in particular face expectations thatthey will act in a socially responsible fashion.

C O R P O R A T E

S O C I A L R

E S P O N S I B

I L I T Y


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Context

Most corporate governance seeks to protect the interests of the shareholder against poormanagement of businesses. Corporate Social Responsibility (CSR) considers management’sresponsibility for protecting and advancing the interests of the wider society.


Classify the following statements using the Carroll model.

(a) ‘We believe in giving something back to the community providing the firm can afford it’.

(b) ‘Our CSR statement is just something to attract the customers that care about those things’.

(c) ‘We are proud that our new factory, as well as cutting our costs, has allowed us to givedecent housing and education to families in a developing country’.

Solution 2.5


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Basis ofguidance

Ownership responsibilitiesBy buying shares, shareholders buy a responsibility toensure that company is managed in ways consistentwith public welfare. Ownership responsibilities of institu-tional shareholders have been stressed, institutionalshareholders’ large % shareholdings meaning theyshould be actively involved and pressure managers.

Shareholders with small % holdings aren’tinfluential

Shareholders can easily dispose of shares andthis loosens feelings of obligation

Ownership view problems

Objectives

Mission statements

Ethical codes

Governance codes

Stakeholder board representation

Corporate social reporting

Impact of CSR

C O R P O R A T E

S O C I A L R

E S P O N S I B

I L I T Y


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Context

This deals with the issue of whether firms should be run in just the selfish interests of the investorsor for society as a whole.


Cafédirect plc is a UK listed company that imports, roasts and distributes coffee beans, cocoa and

tea to consumers via conventional supermarkets and shops to rival the products from traditionalproviders like Nestle, General Foods and Kenco. Its website www.cafedirect.co.uk states:

In 2004, we successfully executed the UK’s biggest ethical public share issue to become a

publicly listed company, raising £5 million from 4,500 investors. The opportunity enabled ourgrower partners, consumers, employees and founders to own a share in the company and to bedirectly connected to each other.

Today we work with 39 grower organisations across 13 developing countries ,encompassing 264, 666 farmers and directly improving the lives of more than 1.4 million

people.

Cafédirect is the innovative result of Oxfam, Equal Exchange, Traidcraft, and Twin Trading’s

decision to bypass the conventional market and buy coffee direct from disadvantaged growers indeveloping countries. Since 2000 alone we have invested more than £3.3 million of our profits directly into the businesses and communities of our growers , and paid more than£13 million over and above market prices for our raw materials.

Assess Cafédirect from the perspective of wider ownership responsibilities.

Solution 2.6


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Reinforcement


Scan and note principles v rules, insider v outsider system (Section 1)

Learn detail of these codes (Section 2)

Learn the detail of Sarbanes-Oxley Act 2002 (Section 3)

Attempt Questions ‘Combined Code’ and ‘Writing a code’ in Chapter 2

Attempt Quick Quiz

Attempt Question 2 ‘Cedric Coffee’ from Exam Question Bank at the back of

your Study Text


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chapter 3

CORPORATE

GOVERNANCE

PRACTICE AND

REPORTING

Corporate governance practice is a key area in thissyllabus, and you can expect many questions onwhether an organisation is following good practice.

ROLE OF BOARD

BOARD MEMBERSHIP

NON-EXECUTIVE DIRECTORS

DIRECTORS' REMUNERATION

STAKEHOLDER RELATIONSHIPS

REPORTING


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ReportingRole of board Stakeholderrelationships


Non-executivedirectors

Boardmembership

Scope of board’s roleThe board should have a formal schedule of mattersreserved to it for decisions. Board is also responsiblefor overseeing strategy, monitor ing risk, controlsystems and management, and ensuring effectivecommunication.

Mergers and takeovers Acquisitions/disposals of major assets Investments Capital projects Loans/borrowing facilities Major foreign currency transactions

Matters for board decision

Legal responsibilities Avoidance of conflict of interest Time limits on appointments Limits on service contracts Departures from office Insider dealing

Legal and regulatory frameworks

Nomination of directorsNomination committee should oversee appointmentsand make recommendations to the board. Needs toconsider:

Executives/non-executives

Gaps in current board’s skills

Expanding board diversity

Continuity and succession planning

R

O L E

O F

B O

A R D


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3: Corporate governance practice and reporting 35

Context

The Board is the ‘controlling mind’ of the business. It is supposed to control the business rather

than control the day-to-day operations. For the governance of the business to be adequate the

Board must have the right members, the right to take important decisions, and to be aware of its

legal and regulatory duties.


Advise a director on their legal or regulatory duty in the following circumstances:

(a) He holds shares in the company but has seen a profit forecast that means profits and share

price will probably fall in the near future.

(b) He has taken up a non-executive directorship with one of the firm’s suppliers.

(c) He has been recently convicted of a serious criminal offence involving privately obtaining

bank loans by deception.

Solution 3.1


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CPD and appraisalsAll board members should have training coveringstrategy, management, legal responsibilities andcompany related issues.

There should be annual appraisals of the performanceof the whole board and of individual directors.

Performance against objectives Contribution to strategy/environment Response to problems Considering right matters Communication Effectiveness of board committees Quality of feedback Adequacy of decision-making

Board appraisal

Advantages of multi-tier boards

Supervisors/supervised separationDeters management fraudBetter links with stakeholders

Better use of non-executive time

Disadvantages of multi-tier boards

Lack of accountabilityDon’t receive information from managers

Supervisory board decision-making restrictedLess effective at questioning managers

Companies in some countries are run by two or moreboards, often with supervisory/management role split.

Multi-tier boards

R

O L E

O F

B O

A R D


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Context

This develops the issue of ensuring the effectiveness of the Board. Board effectiveness will be

influenced by how able the Board members are (CPD), how in-touch with the business they are

(unitary v multi-tier) and whether they are monitored (appraisal).


A recent report on European corporate governance states:

Germany's supervisory boards, normally made up of 20 non-executive directors, are required by

law and are meant to oversee a management board as part of a two-tier system to bring stability

and long-term perspective. In practice they have few foreigners on them – just 7% compared with

Switzerland's 45%. This leaves an elite group of German non-executive directors, often sitting on

each other's boards, to run most of Germany's top companies. They have the fewest meetings a

year and are paid the third-most in Europe. The main issues are all discussed and agreed by

shareholder representatives beforehand, reducing the effectiveness of meetings hugely.

Evaluate German Supervisory Boards using the headings of

(a) Principal agent problem

(b) Effectiveness of corporate governance(c) Board diversity

(d) Stakeholder representation

Solution 3.2


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Boardmembership

Board membershipCompanies need to consider optimumsize, balance of executive and non-executive directors, and diversity ofmembership.

Division of responsibilitiesNo one individual should have unfettered control. Ideally chairman andchief executive should be different people; if not there should be a strongindependent element on the board with a recognised senior member.

Board committeesBoard committees supervise specificareas, doesn’t absolve main boardfrom overall responsibilities. Key

committees: Nomination (this chapter)

Internal audit (Chapter 8)

Remuneration (this chapter)

Risk management (Chapter 5)

Strategic development

Investment analysis

Risk management

Recommendations toboard committees

Responsibilities of CEO

Running board

Accurate board information

Effective shareholdercommunication

New director induction

Board appraisal

Board development

Signing off accounts

Responsibilities of chairman

B O A R

D M

E M B E R

S H I P


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Context

Segregation of duties is a well-known internal control. This principle applies to Boards too.


Norman Meany is the Executive Chairman of a company that is about to seek a Stock Market listing.He also holds 30% of the issued shares. He founded the company 25 years ago to provide language

tuition and in the last 10 years has opened private schools. During this time he was the Managing

Director but, shortly before listing last year, changed to Chairman and appointed his deputy to the

role of CEO. The Company has a strategy to expand into other areas of education by acquisition

including running pre-school nurseries and professional training. There are 2 non-executive

directors on the 10 person board. One is a politician involved in education, whom the Chairman

believes may be helpful in getting education contracts, and the other is a partner with the firm’s

corporate lawyers.

Evaluate the corporate governance of this company.

Solution 3.3


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Boardmembership

Number of NEDsUSA/UK – Independent NEDs at least half of board,others – sufficient for views to carry weight.

Independence of NEDs No business/financial/other connection No share options/pensions Appointment for specified term Ability to take independent advice

Advantages of NEDs

External experience and knowledge

Wider perspectiveComfort for investors

Confidant/enablerBoard members but objective

Disadvantages of NEDs

Independence?

Restricted recruitmentDifficult to impose views

Can’t prevent problemsLimited time

Non-executive directors (NEDs)NEDs have no executive (managerial) responsibilities.They should provide balance and help to reduceconflict between executive directors and shareholders.Majority of NEDs should be independent.

Role:

Strategy Scrutiny

Risk management Board personnel

N O N - E X E C U T

I V E

D I R E C T O R S


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Context

Non-Executive Directors are required by most, codes of corporate governance around the world.

They are supposed to represent shareholders' long-term interests and also to bring extra skills and

knowledge to the Board.


Describe why the following might reduce the value of having NEDs on the Board.

(a) Board meetings are infrequent and the agenda and papers are circulated at the start of the

Board meeting by the Company Secretary.

(b) Two of the NEDs have retired from work and use the money they get from being NEDs to

supplement their pensions.

(c) One of the NEDs runs a specialist consultancy and has received additional fees from the

company for providing consultancy advice to the company.

(d) Most of the NEDs have been in their present roles since the company was listed 12 years

ago.

Solution 3.4


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Boardmembership

Service contractsIf service contracts are too long, premature terminationmay mean significant payments. Service contractsshouldn’t be > 12 months normally.

Remuneration committeeCommittee of independent NEDs determining:

Remuneration policy Specific remuneration packages

PrinciplesUK’s Greenbury committee suggests:

Directors’ remuneration set by independent boardmembers

Bonuses related to measurable performance/enhancedshareholder value

Full transparency in annual accounts

Remuneration statementConsider and disclose:

Remuneration policy

Arrangements for individual directors

Consider allowing members to vote on

remuneration statement in accounts.

Elements of remuneration packageBasic salary – in contract of employment

Performance-related bonuses – limited possiblyto maximum % of pay, shouldn’t be given fortransactions?

Shares – granted on condition can’t be sold

Share options – purchased at specified exerciseprice, encouragement to improve company’sperformance and hence share prices, options(and shares) to be held for certain length of time

Benefits-in-kind – is cost excessive and how

comparable are they with what employees aregiven

Pensions – best practice to make only basicsalary pensionable

Need to attract directors

Interests of stakeholders

Weighting and phasing of different parts of package

Director/manager differentials

Impact of director/manager resigning

Performance measures

Factors affecting remuneration levels

Variety of financial/non-financial measures

Focus on current performance

Avoid short-termism

Reward individual effort

Performance measures

D I

R E C T O R S ' R E M U N E R A

T I O N


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Context

The problem of ‘fat cat’ directors awarding themselves excessive pay rises, often while the share

price has been falling, has been seen as the most obvious abuse by directors of their position in the

principal agent problem.


Identify potential dysfunctional consequences of the following elements of remuneration for a 59

year old Sales Director (treat each separately)

(a) Bonuses are capped at 10% of his salary.

(b) Bonuses are paid for annual increase in sales volume.

(c) Annual pension will be equal to 70% of final year earnings, including bonuses.

(d) Share options at $1.50 are due to crystallise in 1 year’s time. Company’s share price is

presently $0.90.

Solution 3.5


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Boardmembership

Relationships with stakeholdersOECD stresses role of:

Employees

Creditors

Suppliers

Investors Government

Position of stakeholders should be:

Protected by law

Enhanced by participation (eg employees shareownership, profit-sharing arrangements, seat onboard)

Relationships with shareholdersDirectors should be held accountable by requiringthem to submit to regular re-election (every threeyears). Boards should consider relationships with allshareholders, particularly institutional shareholders.

Proxy votingMyners report addresses problems with administeringproxy votes and misuse of proxy votes. Recommends:

Clear agreements between beneficial owners andinvestment managers

Stock lending shouldn’t happen

Electronic voting

Poll (including proxies) for all general meetingresolutions

General meetings

Notice > 20 daysbefore

Businesspresentation

Question andanswer sessions

Shareholders vote onsubstantiallyseparate issues

Shareholders vote onreport and accounts

S T A K E H O L D E R R

E L A T I O N S

H I P S


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Context

The rights of shareholders are mainly exercised at General Meetings where they vote on

resolutions, appoint directors, and question the Board. They can only do this if the GMs are run in a

way that encourages and permits voting and scrutiny. Without these a crucial safeguard for

shareholders is lost.


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Boardmembership

Board composition, directors, NEDs, evaluationof board performance

Committee reports Relations with auditors and shareholders Review of internal controls

Going concern Sustainability reporting OFR

Major disclosures

ReportingLondon Stock Exchange requires:

Narrative statement of how principles inCombined Code have been applied

Statement of compliance/details of reasonsfor non-compliance

Voluntary disclosuresDisclosures above statutory/best practice minimum.Disclosures should follow certain principles:

Planned process

Transparency in disclosures made

Consultation with users

All relevant information considered

Disclosures subject to review

R E P O R

T I N G


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Context

The safeguard of ‘transparency’ requires that the Board discloses information on the Board’s

conduct and on the condition of the company to shareholders. Frameworks of corporate

governance, such as financial reporting standards and codes of corporate governance, lay down

provisions for reporting and disclosure.


The following is an extract from the statement of a UK company about its non-compliance with the

2007 Combined Code during part of its financial year.

For a period during the year the Company did not fully comply with the recommendations of the

Combined Code. In the period from 25 August to the date of this report:

(a) The Audit Committee did not have a Chairman and comprised only two Directors, neither of

whom have recent and relevant financial experience. However, Mr XXX acted as Chairman at

meetings and at least one of the Company's other independent Non-Executive Directors who have

recent and relevant financial experience was also in attendance at all meetings of the Committee.

This ensured that at least two independent Non-Executive Directors attended each meeting.

(b) The Remuneration Committee comprised only two Directors. However, at least one of theCompany's other independent Non-Executive Directors attended meetings of the Committee

thus ensuring at least three independent Non-Executive Directors attended each meeting.

(c) If the criteria for determining independence suggested by the Combined Code were applied,

less than half of each of the Board and Nomination Committee (in each case excluding the

Chairman) were independent. However, the Board's own view was that at least half of the

Board and Nomination Committee (excluding the Chairman) was independent, because it

regards Mr YYY as independent.

Discuss why each of these disclosures of non-compliance might cause investors concern.

What practical steps could be taken by shareholders or the stock market to force compliance with

the Combined Code?

Solution 3.6


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48

Reinforcement


Scan and note responsibilities of

– Directors (Sections 1.8 to 1.9.9)

–

The Chairman and the CEO (Section 2.2)– Non-executive directors (Sections 2.5 to 2.8)

Scan and note the elements of remuneration packages and the role of the

Remuneration Committee (Section 3)

Scan and note the issues surrounding proxy votes (Section 4.4)

Scan and note reporting requirements (Section 5.3)

Attempt question ‘Codes and corporate governance’ in Chapter 3

Attempt Quick Quiz

Attempt Q3 ‘Peter Postgate’ from Exam Question Bank at the back of your

Study Text


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49

chapter 4

INTERNAL

CONTROL

SYSTEMS

In this chapter we look at the key elements of sound

control systems. The overall environment and ethos oforganisation is as important as the specific procedures.The risks organisations face should have a significantimpact upon the control frameworks they adopt.

CONTROL SYSTEMS

NATURE OF RISKS

CONTROL FRAMEWORK

CONTROL LIMITATIONS

ENTERPRISE RISK MANAGEMENT


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Controlsystems

Enterprise riskmanagement

Controllimitations

Controlframework

Nature of risks

Elements of control systems

Cybernetic control system

Plan/Target/Objective – what system designed toachieve

Sensor – detects control system behaviour

Inputs/Processes/Outputs – main stages ofoperations

Comparator – compares actual behaviour with plan

Effector – enacts control action to change systembehaviour

Process of control within system.

Identification of system objectives Setting targets for system objectives Measuring system achievements/outputs Comparing achievements with targets Identifying corrective action Implementing corrective action

Objectives Nature/extent of

risks Acceptable risks Likelihood risks

materialise

Ability to reducerisks

Costs/benefits ofcontrols

Changes in riskconditions

Control systems and risks

Ease of targetachievement

Qualitative/ quantitativemeasures

Short/long-termmeasures

Consistency ofmeasures

Managementintervention

Automatic controlmechanisms

Reliance on socialrelationships

Characteristics of control systems

C O N

T R O L S Y S T E M S


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4: Internal control systems 51

Context

'Control' can be understood as ‘mechanisms to help ensure things go according to plan’. This

chapter introduces the main theories of control.


Consider a hospital.

(a) Identify how a cybernetic control system might be used to ensure that patients are given the

right medication.

(b) What control mechanisms exist in a hospital to ensure that patients receive adequate and

appropriate treatment?

Solution 4.1


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Controlsystems


Controllimitations

Controlframework

Nature of risks

Risk classificationRisks can be classified in various ways:Fundamental – affects society in generalParticular – individual in controlSpeculative – good or bad consequencesPure – only outcomes harmful

Risk and uncertaintyUncertainty means possible outcomes and/or chancesof each occurring are unknown.

Risk and corporate governanceCorporate governance reports aim to address

shareholder concerns that directors are notachieving adequate returns for risks incurred andprovide mechanisms for controlling directors whoare taking excessive risks. Directors’ responsibilityfor monitoring and disclosing risk management isstressed.

Predictability of cash flows Limitation of effects of bad events Increased shareholder confidence Weigh costs

Benefits of risk management

Risk and returnBusinesses may tolerate higher risk levels providedthey can receive a higher return. Value driver analysis

identifies risk-return links.

N A

T U R E

O F R

I S K S


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Context

During the last decade of the 20th Century the subject of risk became important to management

due to the recognition that complex technologies and global operations meant that business was

getting more prone to disasters. However the belief grew that that risk could be managed by

appropriate responses. Pressure grew on Boards to consider risks and to disclose them and the

strategies for dealing with them.


The Board of a listed company is considering investing funds into developing a capacity to offer

holidays on space stations orbiting the Earth.

Evaluate how shareholders might respond to this decision under the following circumstances (treat

each separately):

(a) Management is proposing selling-off most of the firm’s assets in stable industries like food

processing to raise funds to invest in this venture.

(b) Most of the shares are held in investment funds that specialise in investing in high technology

businesses.

(c) The project is a joint venture with over 100 other firms so the amount being invested is small

in comparison to the total assets of the firm and there is good evidence that the project will

yield very good returns.

(d) Most of the firm’s shares are held by pension funds.

Solution 4.2


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Controlsystems


Controllimitations

Controlframework

Nature of risks

CONTROL FRAMEWORK

Control proceduresControl environment

Facilitate effective and efficient operation

Appropriate response to risks (safeguarding of assets, liability management)

Ensure quality of reporting (maintenance of records, generation of relevantinformation)

Ensure compliance with laws and regulations

Embedded in operations

Form part of culture

Capable of quick response

Features of controls

C O N T R O L F R A M E W

O R K


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Context

This illustrates the principle that the control environment and procedures should be sufficient to

deal with the issues and risks in the business environment in which they operate.


Suggest control procedures for dealing with each of the following risks in a firm’s business

environment.

Most of the customers pay in cash

There is high staff turnover in the industry

Individual inventory items are of high value

A lot of firms in the industry have been sued by dissatisfied customers

There is a lot of dangerous machinery and chemicals involved in the process

Solution 4.3


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Control

systems


Controllimitations

Controlframework

Nature of risks

Costs > benefits Human error/Fraud Employee collusion

Managementbypass

Designed for routinetransactions

Depend on methodof data processing

LIMITATIONS OF CONTROLS

C O N T R O L L I M I T A T

I O N S

C O N T R O L L I M I T A T

I O N S


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Context

Controls are very often designed to reduce rather than eliminate the chances of risks

materialising. How effective controls are will often depend on the abilities, attitudes and honesty of

those operating controls. These are all factors connected with the internal environment and culture,

which will be covered in Chapter 5.


The board of Arlo has decided to outsource some of its manufacturing operations to a supplier

based on a different continent, in order to save costs. Arlo has always tightly controlled its

manufacturing processes that are located in its own country, with an emphasis on producing what

customers want, rigorous quality control and close monitoring of employees to ensure they produce

what is required.

Why might Arlo have difficulty maintaining the same level of control over the activities of its

overseas supplier?

Solution 4.4


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Controlsystems

Enterprise risk management

Controllimitations

Controlframework

Nature of risks

Enterprise risk management (ERM)ERM is framework suggested by COSO for dealingwith risk. It is a fundamental process, operated atorganisation level, that helps staff understand risks,responsibilities and authority levels. ERM should:

Apply in strategy setting

Apply in all areas and over whole organisation Identify events affecting entity Manage risk according to risk appetite Provide reasonable assurance Support organisational objectives

Align risk appetite and strategy Link growth, risk and return Choose best risk response Minimise surprises and losses Manage risks over whole organisation

Allows organisation to seize opportunities

ERM benefits

COSO’s Enterprise Risk Management framework

E N T E R

P R I S E

R I S K

M A N A G E M E N T


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Context

The ERM was developed in the US by the Committee Of Sponsoring Organisations (COSO) – the co-

ordinating body for professional accountants in the US. The model is popular and is being

implemented by businesses throughout the world that wish to attract funds from US investors.


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CIMA’s risk management cycle

E N T E R

P R I S E

R I S K

M A N A G E M E N T


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Context

CIMA is the UK-based Chartered Institute of Management Accountants. The risk management cycle

it has developed is an alternative set of steps from those outlined in COSO’s ERM.


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62

Reinforcement


Scan and note on control systems (Sections 1 to 4)

Attempt Questions ‘Risks’ and ‘Models’ in Chapter 4

Attempt Quick Quiz

Attempt Question 4 ‘New trainees’ from Exam Question Bank at the back of

your Study Text


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chapter 5

INTERNAL

ENVIRONMENT

AND

OBJECTIVE

SETTING

This chapter covers the underlying factors that help

determine how organisations respond to the risks theytake. These factors include attitudes to risk, theenvironment and culture, and the organisational

structure including responsibilities for dealing withrisks.

RISK ATTRIBUTES

STAKEHOLDERS AND RISKS

INTERNAL ENVIRONMENT

RISK MANAGEMENT RESPONSIBILITIES

OBJECTIVE SETTING


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Objectivesetting

Risk managementresponsibilites

Internalenvironment

Stakeholdersand risk

Risk attributes

Emotional satisfaction Risk/return Size

Structure Development Past experience

Organisational influencesShareholder requirementsPersonal views

Risk attributes

National influences

Government protection Fatalist (no control) Hierarchist (formal procedure) Individualist (wish to control) Egalitarian (sharing/transfer)

Cultural influences

R I

S K

A T T R I B U T E S


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5: Internal environment and objective setting 65

Context

This diagram seeks to answer the question ‘what influences the amount of risk that management is

willing to take?’. This is quite an academic topic but it is examinable.


AAA Group was a private UK company established 30 years ago by a high-profile and popular

entrepreneur, Mr X. During 30 years of growth AAA developed into a business that included

telephones and home media, airlines, rail transport, and financial services. Most shares were held

by Mr X although some were held by rich personal friends of his. At his retirement Mr X sold the

company to SSS, a US listed corporation, that owns railroads. The management of SSS has been

astonished to find a absence of risk management methods in AAA such as very few formal

budgetary systems, a willingness to invest considerable sums of money in business ideas with only

sparse business plans, and a history of failed business ideas amongst the small number of very

successful ventures.

Identify reasons for the different management attitudes to risk between AAA and SSS.

Solution 5.1


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Objectivesetting


Internalenvironment


Risk attributes

RISK

CO

NCERNS

Dividend impact Capital gain impact Dependent on their risk appetite Threat to repayment Security imposed Threat of other debts Job threats Health and safety worries Ability to take action Losses on sales Unwilling credit suppliers Disruption of relationships Delivery failures Lack of value Poor quality Poor employment policies Adverse impact on the environment

Debt providers

Wider community

Suppliers

Shareholders

Employees

Customers

S T A K E H O L D E R S A

N D R

I S K


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Context

Risk appetite was discussed in Chapter 4. Risk concerns of stakeholders is a connected topic.


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68

ObjectivesettingRisk managementresponsibilitesInternalenvironmentStakeholdersand riskRisk attributes

Internal/control environmentThe control environment is the attitude, awareness andactions of management in relation to internal controls,providing the background for the operation of othercontrols.

Risk management philosophy Risk appetite Integrity Ethics Organisational environment

Risk environment

Management’s philosophy and operating style Organisational structure Methods of imposing control Integrity, ethical values and competence

Elements of internal environment

Clear risk management strategies Culture/code of conduct/HRM/reward systems support

objectives and risk limitation Senior management commitment to competence,

integrity and trust Clear authority and responsibility Communication procedures Staff have knowledge, skills and tools

Strong internal environment

I N T E R N A L

E N V I R O N M E N T


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Context

The diagram makes clear that control environment means two things:

1 It is the overall framework that is a necessary support for the controls designed to counter

risks.

2 It may be the source of some controls, for example a professional culture provides control in

a professional practise such as accounting, law or medicine..


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ObjectivesettingRisk managementresponsibilitesInternalenvironmentStakeholdersand riskRisk attributes

Embedding risk awarenessRisk assessment should evolve into a consistent activityembedded across all processes, focus on:

Threats to shareholders/stakeholders (future growthopportunities/core business)

Consistent action-orientated risk assessment

Internal communications programme Training Involvement in risk identification Incentives Key personnel persuasion Infrastructure support

Changing risk culture Definitions and objectives

Regulatory requirements Links to strategic decision-making Key areas Risk classification Risk responsibilities Important controls Assurance reporting Training

Risk policy statement

Risk registerFormal collection of risk and response information.Register lists and prioritises risks, and specifiesresponsible individuals and action taken.

I N T E R N A L

E N V I R O N M E N T


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Context

Management cannot afford to hope that ‘risks never come true’. Neither can they hope to know

about every potential risk and ‘deal with it as it arises’. By then it would be too late. Therefore

cultivating risk awareness at all levels throughout the business, and plans and people to deal with

it, is essential. This section explains how to do it.


Suggest ways in which the Risk Committee of a large listed corporation with 100 shops might

embed risk awareness of matters such as customer safety, thefts of inventory, injuries at work and

loss of business due to competitive action.

Note: this question is not asking you for ways to eliminate the risks. It is asking you how

management can ensure these risks are noticed and reported by divisional managers and staff and

guarded against by them in their day-to-day activities.

Solution 5.2


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Objectivesetting


Internalenvironment


Risk attributes

Board

Senior managers

Internal audit

External audit

Line managers

Staff

Determines risk management strategy and monitors overall risks, setsand reviews internal control

Build on board’s overall framework, specifying risk managementmethods and co-ordinate responses

Audit risk management process/key risk area controls

Audit risk areas that impact materially on financial statements

Identify and evaluate risks in their areas, use performanceindicators for monitoring, implement responses

Follow risk management procedures, have good understanding,report dangers

Risk management committeeSpecialist committee of directors, separate fromaudit committee, responsible for monitoring andsupervising risk identification and management.

Can be staffed by executive directors Allows audit committee to concentrate on

financial risks

Risk management personnelRisk specialist – consultant called in to advise on particularaspects of risk management

Risk manager – employee with specific responsibility fordealing appropriately with risks

Risk management function – employees in largerorganisations

Determine risk managementstrategy/policy

Review reports on risk

Monitor overall exposure Monitor changes in circumstances Assess effectiveness of RM systems Review statement on internal control

Role of RM committee

Helping determine risk management strategies Champions of risk management Building risk awareness culture

Establishing risk policy and structures Developing and reviewing risk management processes Co-ordinating functional responses Preparing report for board/shareholders

Role of RM function

R I S K

M A N A G

E M E N T R E S P O N S I B I L

I T I E S


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Context

Risk management needs people to carry it out. This section introduces their roles and the roles of

the Risk Committee which, in some jurisdictions, is required by codes of corporate governance.


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Objectivesetting


Internalenvironment


Risk attributes

MissionA general objective, visionary, often unwritten andvery open-ended, without any time limit forachievement.

Strategic – high level goals, support mission Operational – effectiveness and efficiency Reporting – reliability Compliance – with applicable laws

COSO model

Profitability Market share Growth Cash flow Customer satisfaction Quality Added value

Corporate objectives

Objective setting and riskStrategic objectives and mission will influence riskmanagement.

However businesses should also determine risk appetite (willingness to take risks) and risk

strategy.These in turn should influence business objectives.Businesses should take a portfolio view of risks,looking at relevant risks over the whole organisation.

O B J E C T I V E

S E T

T I N G


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Context

Objective setting links in with the recommendation of corporate governance about the board

keeping control of the company and making sure that it takes decisions on key matters


What obstacles might prevent the board of a company from ensuring that there are effective links

between the objectives it sets and the management of its risks?

Solution 5.3


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Reinforcement


Scan and note risk and the organisation (Section 1)

Scan and note attitudes to risk of different stakeholders (Section 2)

Scan and note features of internal environment (Section 3)

Expand notes on embedding risk awareness and assessment (Session 4)

Scan and note risk management responsibilities (Section 5)

Scan and note different kinds of objectives (Section 6)

Attempt Questions ‘Organisational problems’ and ‘Risk culture’ in Chapter 5

Attempt Quick Quiz

Attempt Question 5, ‘Widmerpool’, from Exam Question Bank at the back of

your Study Text


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chapter 6

EVENT

IDENTIFICATION

AND RISK

ASSESSMENT

In this chapter we look at the risks that organisations

face. We draw various important distinctions betweendifferent kinds of risk, and emphasise the link betweenrisk and return. We also look at examples of the keyrisks that organisations have to counter.

STRATEGIC AND OPERATIONAL RISKS

TYPES OF RISKS

RISK ASSESSMENT


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Types of risksStrategic andoperational risks

Risk assessment

Strategic risksFundamental risks to organisation’s profits/existencearising from the sector it’s in and the nature of what itdoes. Strategic risks arise out of decisions aboutresources, products, acquisitions and investments.

Operational risksRisks of loss from failures in internal business andcontrol processes.

Stakeholders State of economy Nature of industries/markets Level of competition Availability/price of resources Flexibility of production Ability to innovate/R&D Stage of product life cycle

Factors affecting strategic risks IT failures Human error Loss of key staff Fraud Business interruptions Internal audit weaknesses

Examples

S

T R A T E G I C

A N D O

P E R

A T I O N A L R

I S K S


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6: Event identification and risk assessment 79

Context

Distinguishing a strategic from an operational risk is important for two reasons:

The origins of the risk will be different eg strategic risk usually results from decisions made

by the Board.

The ways to manage the risk will be different eg operational risk can be managed by

workplace procedures and backup systems.


A food and household goods store has been very successful in its home country and is now

considering expanding operations abroad, developing a home delivery service for food and larger

household goods and replacing cashiers with a technology that allows customers to check-out and

pay for their shopping electronically.

Identify additional risks arising from these management decisions and classify them into Strategic

and Operational (some risks may be both).

Solution 6.1


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Risk assessment

Financial risksThreats to organisation’s continued existence throughlack of available funds. Inappropriate gearing structure

Lack of long-term capital Fraud and misuse of funds

Currency, interest and market risk Credit and liquidity risks

Examples of financial risks

Environmental risksRisk of loss to business arising out of environmentaleffects of operations. Organisations could sufferfines, bad publicity, non-co-operation. Risks includepollution and disruption to local community throughtraffic organisation generates.

Legal and political risks

Legal risks include fines or threats of closedown, orincurring costs to fight legal actions.

Political risk is the risk that political action will affectposition and value of organisation. Examplesinclude quotas, tariffs, exchange controls andnationalisation.

Technological risksRisks of loss to the organisation through theinadequacies of, or disruption to, its IT systemsand resources.

Physical damages through fire/flood/adverse weather Human sabotage Accidental disruption Human error Malfunctioning hardware/software Dishonest use of systems Viruses and hacking

Examples of technological risks

Knowledge management risksRisks of losses due to failure to secure knowledgeresources adequately. Risks include abuse of intellectual

property, power failures leading to loss of information, lossof key staff.

Health and safety risksRisks include loss of employees’ time because ofinjury and having to pay compensation or legalcosts due to breaches. Risks arise because oflack of policy, poor culture, lack of emergencyprocedures, failure to deal with hazards.

T

Y P E S O

F R

I S K S


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Context

The remainder of this chapter introduces several sources of risk. Firms face these in different

combinations according to the business they do. There is no universally accepted categorisation of

risks. Some of the risks overlap the categories stated here.


A commercial bank offers banking services through branches, on-line and via call centres situated in

another country. It invests customers’ funds into investments to gain a return and lends funds to

borrowers at interest. Banks have been criticised for high account charges allegedly maintained by

an illegal cartel arrangement between them. Many customers like to withdraw cash from ‘hole on

the wall’ Automated Teller Machines (ATMs) which must be stocked daily with cash brought to the

branch by armoured security vehicle.

Identify the risks to which the bank is subject and classify them using the headings in the notes.

Solution 6.2


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Risk assessment

Fraud risksRisks of loss through fraudulent activities of employeesor managers. Fraud risks are often increased by poorcorporate governance procedures, allowing senior staffto commit fraud because mechanisms to challengetheir behaviour are ineffective.

Disruption risksRisk of disruption to operations caused by IT failures,employee problems, supplier loss, legal action.

Questionable managementintegrity/competence

Excessive financial reporting pressures

Poorly designed systems Unusual transactions or trends

Problems in obtaining sufficient appropriateaudit evidence

Problems with IT systems

Signs of fraud risks

Resource wastage risksRisks include incurring excessive costs (poorprocurement) or waste of employees’ time andresources.

Property risksRisks from damage, destruction or theft of property.Dangers include fire, wind, water leakage andvandalism.

Trading risks

Crystallisation of risks Poor customer service

Failure to innovate

Poor ethics

Poor reputation

Organisational risksRisks that members/employees of an organisationwill behave in ways detrimental to the organisation,eg failure to adapt to change.

Product risksRisks of financial loss due to producing a poor qualityproduct.

Need to compensate dissatisfied customers

Possible loss of sales

Need for expenditure on quality control procedures

Risks of disruption in the course of trade.

Physical – goods/documentation lost/stolen

Trade – customer refuses goods/cancels order

Liquidity – inability to finance activities Reputation risksRisk of loss of reputation arising from adverseconsequences of another risk.

T

Y P E S O

F R

I S K S


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Context

This identifies and explains further types of risk.


The bank described in Learning Example 6.2 above owns and operates branches in main cities andtowns. Its staff are members of a single trade union, the Union of Bank Workers. Some staff are trained

to offer financial advice on investments such as pensions and life assurance and the bank is regulated for

the conduct of investment business by the relevant government appointed bodies. Despite offering

incentives for using the on-line banking customers still seem to prefer conducting business (and

conversations) at branches and receiving bank statements thorough the post each month. Extensive

training has been given to staff under a group-wide ‘Work Smarter’ initiative to encourage them to

handle customers more quickly and to migrate them to paperless banking. The bank has been in the

news recently because it holds a lot of so-called ‘Third World Debt’ and the debtor nations are pressing

to have these debts set aside to enable them to retain capital for development.

Identify the risks to which the bank is subject and classify them using the headings in the notes.

Solution 6.3


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Risk assessment

Physical inspection

Enquiries

Brainstorming

Checklists

Benchmarking

Risk condition identification

Risk identificationNeed to know whether likely perils are present andbe aware of possibility of unlikely risks.

External events of economic conditions

Internal events eg human errors

Conditions resulting in risks

Trends and root causes

Event interdependencies

Event identification

Difficult to forecast financial effects of disaster,particularly to include all likely costs arising.Risk analysis

Risk profiling Risk quantificationUse likelihood/consequences matrix as basis forsetting priorities for risk management.

Need an idea of possible results or losses, togetherwith distributions and confidence limits.

Average or expected result or loss Frequency of losses Chances of losses

Largest predictable loss

Key calculations

Risk consolidationNeed to aggregate at organisation level risksidentified and quantified at corporate level.

R I

S K

A S S E S M E N T


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Context

This page includes the five steps of risk analysis. Codes of corporate governance now specify that

Boards must have a risk management process in place. This will be the subject of Chapter 7. But

the process draws on the risk analysis process here as one of its main steps.


You will need to use your own paper for this Learning example.

Consider the place that you are studying in and its risks.

(a) Identify at least 8 risks

(b) Assess the potential impacts of those risks if they were to crystallise and assign each one a

value between 0 and 10 with 10 reflecting a catastrophic impact

(c) Assess the likelihood of each risk and assign it a number between 0 and 10 with 10 meaning

‘it’s bound to happen one day’

(d) Map the risks on a likelihood/consequences matrix

Now compare your matrix with other students'.

Solution 6.4


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Reinforcement


Scan and note Sections 1 to 3

Attempt Questions ‘Health and safety’, ‘Procurement fraud’, ‘Managing risk’,

‘Significant risks’ and, ‘Risk management techniques’ in Chapter 6.

Attempt Quick Quiz

Attempt Question 6 ‘Pacific Group’ from Exam Question Bank at the back of

your Study Text


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chapter 7

RISK RESPONSE

AND CONTROL

ACTIVITIES

In this very important chapter, we deal with how risks

are managed, in particular how risks are reduced bycontrol activities.

RISK RESPONSES

CONTROL ACTIVITIES


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Risk responses

Controlactivities

Consequences

Low High

Low Accept

Cost of action/benefits

Transfer/Share

Insurance/contingency planning

High Reduce

Controls to limit riskoccurence/impact

Avoid

Immediate action required,possible abandonment of activities

Likelihood/Consequences matrix

Like

lihood

R I S K

R E S P O N

S E S


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7: Risk response and control activities 89

Context

The likelihood/consequences matrix was introduced in Chapter 6 as a risk profiling device. Here it

identifies appropriate risk management responses to treat each level of risk .

The four risk management strategies are extremely important.


ZAB is a listed company that sells cheap fashionable clothing to households in western Europe

through large stores in the main towns and cities.

Classify each of the following decisions into one of the four risk management strategies.

(a) Decision to rely on foreign manufacturers rather than make the clothes themselves in case of

bad sales in particular years.

(b) Signing up to the ethical trade initiative to avoid media criticism for selling the products of

exploited labour.

(c) Employment of security guards in stores to watch for customers stealing items.

(d) Decision to stock a wide range of designs but in small quantities if the firm’s buying teamdecide to stock product lines that are not popular with customers.

(e) Decision not to charge customers for plastic carrier bags despite these costing ZAB money to

buy and possibly incurring additional costs for recycling.

(f) Decision to take out short leases on shops when they first open in case they are not

successful.

(g) Offering staff contracts for only a minimum number of hours each week and supplementing

this with additional overtime hours in the busy seasons.

Solution 7.1


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90

Riskresponses

Controlactivities

Classification

Documents

P1 student notes.pdf