ACCA P1 EXAM NOTES
Part 1: Framework
Chapter 1: Introduction of CG (Corporate Governance)
Segregation of the ownership and control
-Shareholders are the owner of the company
-Control usually delegated to director
-Interest of shareholders and directors may conflict
-Directors may not act in the best interest of the
shareholder
Corporate Governance
Largely concerned with governing the relationship
between shareholders and directors
Definition:
Impact on organization:
Stakeholder;
Issues and scope of
A system by which organizations
-Duties of directors and
Internal:
governance
are directed and controlled
function of the board
-Directors
public, private and
-Composition and balance
-Company secretary
NGO sectors
of the board and board
-Managers
-Influenced
committee
-Employee
size, ownership, model
-Employee
and
Purpose and objectives:
-Monitor those who control the
assets owned by investors
-Contribute
corporate
to
improved
performance
and
accountability in creating long
term shareholder value
-Reliability
reporting
of
financial
and
external
auditing
External:
-Directors’
remuneration
and rewards
-Risk
representative
-Auditor
-Regulator
management
and
-Shareholder
internal control system
-Stock exchange
-Right and responsibilities
-Government
of shareholders
Key points:
1.
Definition of CG- B 49&F 4
2.
Underlying concepts of CG- B 49&F 7
3.
Major areas of CG- B 67-70 & F10-11
1
on
by
objectives
organization
the
of
Chapter 2: Agency relationship and theories
Agency relationship and theories
Transaction costs and stakeholder
Agency theory
theories and economic theory
Definition:
Relationship
Examine duties and
CG:
by
conflict that occur
Key function of CG
perform a task on their
between parties who
to
behalf, agents become
have an agency
principal
protect
with
Agent Accountability:
the
agent
accountable
principal
relationship between
shareholder
and
director
Key concept:
Agent
Principal
Agency
Agency cost
Accountability
Fiduciary
Responsibility
Shareholder
Key points:
1.
Agency theory: B 52&F 25 F27-F29
2.
Transaction theory: B55&F30 F31
3.
Stakeholder theory: B55&F32
undertaking
2
to
to
the
Chapter 3: Board of directors, Board of Committee & Remuneration
Board of directors:
Board of directors
Unitary
Board structure
Single board
Two boards
ED
NED
Management
Supervisory
board
board
ED
NED
Roles and responsibilities:
Characteristic and composition:
Induction program:
-Act in good faith in the interests of the
-Balance of ED and NED
Gives incoming director:
company as a whole
-Not be dominated by a single
-An understanding of nature of
-Display a certain amount of skills and
powerful individual
the company, its business and
exercise reasonable care
-Role of chairman and the CEO
the market in which it operates
-Ensure company maintains full and
should be separated
-A link with company’s people
accurate accounting records
-Understanding of company’s
-Produce and present annual accounts
main relationship
Legal and regulatory framework:
Chairman:
CPD:
-
Appointment and retirement
-Runs the board
Companies
-
Service contract
-Ensures that the board sets and
resources for developing and
-
Removal
implements the company’s direction
refreshing the knowledge and
-
Disqualification
and strategy effectively
skill of director
-
Conflicts of interest
-Acts
-
Insider dealing
representative
as
company’s
need
lead
Executive Director (ED):
Non Executive Director (NED):
-Members of a board of directors who are also
-Members of a board of directors who do not
senior managers of the company
form part of the executive management team
-Usually paid as full time employee for their work
-Not full time employee of the company or
they act in any other way
CEO:
-Runs the company
-Take the responsibility for the performance of the
company as determined by the board’s strategy
-Report to chairman
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to
provide
Independence:
-Require certain detachment from the company
-Should be independent in judgment
Key points:
1.
Role of board: P104 &F 58
2.
Board structure:
Advantages and disadvantages of unitary board and two-tier board B119-120 & F 60-61
3.
Composition of the board
Combined code requirement: F63
-Board should meet regularly and the results of the meeting included in the annual report as a high level statement
of the operation.
-The annual report should identify attendance and name of chairman, CEO, senior independent, others and
committee nature and membership.
-The chairman should hold separate meeting with NED and NED should meet to discuss chairman’s performance.
-Any unresolved meeting concerns should be recorded in board meetings. If NED resigns they must notify
chairman of concerns.
-The company should arrange appropriate insurance cover in respect of legal action against directors.
4. Functions of NED B 115-117&F 65-66
5. Threats to independence of the NED B 117-B118 &F 67
Independence can be judged as:
-Not being an employee of the company within last 5 years
-Not having material business relationship with the company in last 3 years
-Not receiving any remuneration except a director’s fee (including share option)
-Not having any family ties with the firm
-Not holding cross directorships with other director
-Not being an significant shareholder
-Not having served on the board for over nine years
-The board should consist of half independent excluding the chair
-One NED should be the senior independent director who is directly available to shareholders if they have
concerns which cannot be dealt with through the appropriate channel of chairman, CEO or finance director.
6. Role of chairman and CEO B112-114F 69-70
7. Directors induction and CPD B106& F73-75
8. Legal duty B109-111& F 78-83
-Retirement
-Service contract
-Removal
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-Disqualification
-Conflicts of interest
-Insider dealing
Board committee
Audit committee
Remuneration
Nomination
committee
committee
100%
Risk committee
100%
NED
NED
Pay & Benefits of
Majority NED
Majority NED
Structure of board
Company risk
ED
exposure
Key points:
1.
Role and responsibilities of different committees B115&F93-F97
2.
Remuneration: B123-B124 & F100-P102
Chapter 4: Different approaches to corporate governance
Cadbury
Greenbury
Hampel
Multiple jurisdictions
-OECD principle
-ICGN principle
Higgs
Combined code
Turnbull
Smith
Auditor independence
Audit committee
Auditors are restricted in the additional
Company must have an audit committee-will be
service they can provide to the client
disallowed from trading if it does not have one
US stock exchange regulations
Required under the Act-very
Audit committee
SOX
similar to UK regulation
Annual report must include
statements concerning the internal
control system in the company
Increased financial disclosures
Financial report to detail off
balance sheet financing
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Key points:
1. Development of the code: B 81-85 & F40-42
2. SOX: B88-89 & F45
Chapter 5: Corporate governance, social responsibility and disclosure
CG is how an organization is governed in pursuit
of its objective and includes:
-how it behaves in relation to its environment
-how it interests its shareholder
CSR (Corporate social responsibility)
Stakeholders
Is how an organization manages the impact of
Of an organization have different objectives which
their operations on the wider environment,
need to be managed in terms of organizational strategy.
including consideration for stakeholder group
Shareholders are particularly important stakeholders to
the company.
Shareholder
Are company owners and entitled to information
from the directors. Usually in the form of
-Annual report
Reporting and disclosure
-General meeting
-Voluntary
-Mandatory
General meeting
Best practice
Guidance provided by the
combined code
Proxy voting
Key points:
1. CSR: B90-91 & F115-116
2. Mandatory and voluntary disclosure: B127-129 & F128-130
3. General meeting: B125 & F134
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4. Proxy voting: B126 & F135
Chapter 6: Management control systems in corporate governance
Internal management control
Key process concerned with management of
risks and achievement of objective
Internal control system
Roles and responsibility
Relevance to corporate governance
-Board of directors
-Internal
-Executive management
management
components
control
are
of
good
and
risk
fundamental
corporate
governance
-CG has key links to risks and
internal control
Objectives and functions
Internal control
-Ensure goals and objectives of the
Individual components of
organization are met
an
-Ensure
reliable
financial
and
internal
system
management reporting
-Ensure compliance with laws
-Protect organization’s reputation
Elements:
-Risk assessment
-Control environment
-Information and communication
-Monitoring
-Control activities
Key points:
1.
Definition of IC: B136&F140
2.
Objective of IC: BF145
3.
Elements of IC: B136&F155
Internal control Method F158-161
S Segregation of duties
P Physical
A Authorization and approval
O Organization
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control
A Arithmetic and accuracy
P Personnel
S Segregation of duties
Most transactions can be broken down into three separate duties:
1. Authorization
2. Handling of the asset
3. Recording of the transaction
For example: making the purchase, making the payment and recoding the purchase and payment in the accounts
P Physical
It aims to protect physical assets against theft and unauthorized access and use. They include:
1.
using a safe to hold cash and valuable document
2.
using secure entry system to buildings and areas of a building
3.
dual custody of valuable assets
4.
periodic inventory checks
5.
hiring security guards and using closed circuit TV(CCTV)
A Authorization and approval
For spending items, an organization needs establish authorization limits.
O Organization
It refers to the controls provided by the organization’s structure, such as:
1.
the separation of an organization’s activities and operations into department or responsibility center, with a
clear division responsibility
2.
delegating the authority
3.
establishing the reporting line
4.
coordinating the activities of different departments
A Arithmetic and accuracy
Controls are provided by:
1.
Recording transactions properly in the accounting system
2.
Being able to trace each transaction through the accounting records
3.
Double checking
P Personnel
1. Suitable individuals are appointed
2. Suitable induction and training
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Chapter 7: Internal control, audit compliance and reporting in CG
Internal control
-Monitoring, testing and reporting on the
effectiveness of control
Internal audit
External audit
-Perform an important function in testing and
Performs a statutory function
reporting on internal control
Audit committee
Reporting to shareholders
Function and importance
Have responsibility for review
Is important CG requirement
-Review of accounting and internal control
and monitoring of internal
system
controls and audit
-Detailed testing
-Review of operations
Internal Audit
-Review of implementation of corporate policy
Perform an important function
in testing and reporting on
internal controls
Threats to independence
Importance
Self interest
If
Self review
independent, work may
Advocacy
be biased and therefore
Intimidation
not reliable
Familiarity
Key points:
1.
Function and importance of the internal audit B 152-153&F166-167
2.
Performance standard for IA: B158-159 & F172-173
3.
Threats to independence of auditors B155-156 &F175-179
4.
Audit committee and internal control B163 B165& F 181-185
5.
Audit committee and internal audit & external audit B164 &F187 F189
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auditors
are
not
Chapter 8: Risk management, assessment and risk management
Risk
Management
Categorization
perception of risk
risk
of
Measurement of
Controlling risk
risk
Key points:
1.
Risk category: B177-187 & F220-222 F226-227
2.
Risk analysis: B192-195 F217
3.
Impact on the stakeholders: B196-297&F228-229
4.
Role of board: B198 B224 & F234
5.
Role of risk management committee B224-225&F250
6.
Role of risk manager B228
7.
Reduction of risk: B231-234& F259-262
Chapter 9 Ethic theories and professional ethic
Codes of ethics
Ethic theory
Corporate ethic
Professional Ethic
-Kohlberg theory
Application of values to
Codes
-Tucker’s model
business behaviors
ACCA Code
-Integrity
-Objectivity
-Professional competence
-Confidentiality
-Professional behavior
Threats to the auditor’s
independence
-Self interest
-Self review
-Familiarity
-Intimidation
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Conflicts of interest
1. Kohlberg theory: B263-264&F280-283
2. Tucker’s model: B292
-Profitable
-Legal
-Fair
-Right
-Sustainable
3. ACCA codes: B290&F331-332
4. Conflicts of interest: B302-303 & F334-335
5. Threats to independence: B294-302 & F337-343
II. How to organize your answer
– Adequacy of answer plan
– Structured answer
– Inclusion of significant facts
– Information given not repeated
– Relevant content
– Inferences made
– Commercial awareness
– Higher skills demonstrated
– Professional commentary
III Sample question and answer:
Business risk and risk management
1. Azure, a limited liability company, was incorporated in Sepiana on 1 April 2004. In May, the company exercised
an exclusive right granted by the government of Pewta to provide twice weekly direct flights between Lyme, the
capital of Pewta, and Darke, the capital of Sepiana.
The introduction of this service has been well advertised as ‘efficient and timely’ in national newspapers. The
journey time between Sepiana and Pewta is expected to be significantly reduced, so encouraging tourism and
business development opportunities in Sepiana.
Azure operates a refurbished 35-year-old aircraft which is leased from an international airline and registered with
the Pewtan Aviation Administration (the PAA). The PAA requires that engines be overhauled every two years.
Engine overhauls are expected to put the aircraft out of commission for several weeks.
The aircraft is configured to carry 15 First Class, 50 Business Class and 76 Economy Class passengers. The
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aircraft has a generous hold capacity for Sepiana’s numerous horticultural growers (e.g. of cocoa, tea and fruit) and
general cargo.
The six hour journey offers an in-flight movie, a meal, hot and cold drinks and tax-free shopping. All meals are
prepared in Lyme under a contract with an airport catering company. Passengers are invited to complete a
‘satisfaction’ questionnaire which is included with the in-flight entertainment and shopping guide. Responses
received show that passengers are generally least satisfied with the quality of the food – especially on the Darke to
Lyme flight.
Azure employs 10 full-time cabin crew attendants who are trained in air-stewardship including passenger safety in
the event of accident and illness. Flight personnel (the captain and co-pilots) are provided under a contract with the
international airline from which the aircraft is leased. At the end of each flight the captain completes a timesheet
detailing the crew and actual flight time.
Ticket sales are made by Azure and travel agents in Sepiana and Pewta. On a number of occasions Economy
seating has been over-booked. Customers who have been affected by this have been accommodated in Business
Class as there is much less demand for this, and even less for First Class. Ticket prices for each class depend on
many factors, for example, whether the tickets are refundable/non-refundable, exchangeable/non-exchangeable,
single or return, mid-week or weekend, and the time of booking.
Azure’s insurance cover includes passenger liability, freight/baggage and compensation insurance. Premiums for
passenger liability insurance are determined on the basis of passenger miles flown.
Required:
(a) Identify and explain the business risks facing Azure.
(b) Describe how the risks identified in (a) could be managed and maintained at an acceptable level by Azure.
(a) Business risks
(b) Processes for managing
Rights to operate
All terms and operations of the right to operate,
Accept at the present level (as one that has to be
Which provide the assurance is a going
borne) but bear in mind (e.g. when making strategic
Concern. For example, twice-weekly flights
decisions) the impact that management’s actions
May be a guranteed minimum
could have on any renewal of the rights.
Terms and conditions attached to the rights may
Relevant terms and conditions should be
threaten Azure’s operational existence if, for
communicated to all staff so they are clear about the
example, there are any circumstances under
importance of their areas of responsibility.
which the rights could be withdrawn. For
example, if the standard of service falls below a
minimum specified level.
Competition
Although at the moment there appears to be none (as
-Monitor the progress of applications for flights to
the rights are exclusive), any competition in the future
destinations which could provide transit to Lyme.
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could reduce profitability (e.g. if the right was to
-Reduce the risk by increasing the reliability and
become non-exclusive or an indirect service between
reputation of Azure’s service, improving comfort etc
Sepiana and Lyme should be established).
(e.g. by increasing leg room and
providing air-conditioned lounges).
Age of aircraft
The age of the aircraft (35 years) is likely to have a
Azure should manage its cash flows and
bearing on fuel consumption and other costs (e.g.
borrowing capability (e.g. bank loan facility) to carry
repairs and maintenance).
out ongoing operating repairs as and when needed.
Engine overhaul
If the lease is a finance lease it is likely that Azure will
As above, Azure should budget its financial
have to bear the costs of the overhaul – which may
resources to meet the costs of the overhaul, the timing
have a detrimental effect on cash flows.
of which can be planned for.
The service would need to be suspended while the
The lease agreement with the airline should
engine is being overhauled unless an alternative is
provide that an equivalent aircraft be available.
planned for.
Leased asset
Azure operates with just one leased asset which
-Azure should enter into a contractual arrangement
may be withdrawn from service:
(e.g. may be included within the terms of an operating
– in the interests of passenger safety (e.g. in the event
lease) for a replacement aircraft in the event that the
of mechanical failure);
aircraft be grounded.
– for major overhaul;
-Azure should carry adequate insurance cover for
– if Azure defaults on the lease payments.
remedying
and/or
providing
compensation
to
customers for significant disruptions to the
scheduled service.
Fuel prices
Increases in fuel prices (a major operational cost) will
-Fuel surcharges should be included in the flights’
reduce profitability.
price structure so that significant increases can be
passed on to the customers.
-Hedging against the effect of energy price (and
exchange rate) risks through forward contracts.
Weather
Weather conditions may delay or cancel flights.
Manage the impact of the risk/modify the business
activity. For example, as any form of travel may be
hazardous if weather conditions are so bad as to
disrupt
the
flight
schedule
There
should
be
air-conditioned facilities in which travelers can relax
before their journey.
Horticultural cargo
Certain produce may be prohibited from import
-Contracts with growers should clearly state items
(e.g. due to the risk of spread of disease).
-Azure ’ s operational controls should include
verification checks on produce carried.
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Growers may seek to hold Azure liable for:
Azure should have adequate insurance cover
– produce which perishes (e.g. if successive
against claims for damaged/lost cargo.
flights are cancelled);
– impounded goods.
Economy
With significantly less demand for Business Class than
Keep demand for the classes of tickets under review
for Economy (which gets over-booked) and review and
and respond to the excess of supply over demand for
respond to the excess of supply over even less for First
Economy seating. For example:
Class, the service is operating at demand for Economy
– charge higher prices for economy on peak
seating (and demand well below capacity (economy is
flights;
only 54% of seating capacity)
–offer larger discounts for advance bookings on First
Azure may not be recouping fixed operating costs in
and Business Class seats;
the long run – making the service
– introduce a loyalty scheme for frequent users
uneconomical.
which offers ‘preferred customer’ seat
upgrades.
Service levels
Azure ’ s schedule is described as ‘ efficient and
Azure should benchmark the timeliness of its service,
timely’. If the level of service delivered does not meet
against a comparable airline service operating under
expectations it is unlikely that a regular customer base
similar weather conditions.
will be established.
On-board services
Passengers are expressing dissatisfaction with
meals
Azure should consider:
provided, especially on the ‘return’ flight from Darke.
– changing caterer in Lyme;
The food prepared in Lyme may be stale or
–a contract with a caterer in Darke;
contaminated by the time it is served.
– expert advice (e.g. of a chef) on preserving
Passengers may be deterred from using this flight the
quality of meals for long-haul flights.
if they are subject to the risk of illness.
Passenger safety
Penalties for non-compliance with safety regulations
Staff training should be on-going with regular safety
(e.g. maintenance checks on life safety drill procedures
drill procedures.
(e.g. in evacuation
jackets, etc) may be incurred if inspection logs are not
kept.
Azure may face lawsuit for personal injury and illness
Safety procedures must be demonstrated before Azure
may face lawsuits for personal injury or take-off on
every flight and passengers referred to illness (e.g.
deep vein thrombosis – ‘dvt’), safety information,
including how to reduce the risk, provided with each
seat.
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Air stewards/Cabin crew safety
Azure will have difficulty recruiting and maintaining
Flight personnel rotas should ensure, for example,
the services of appropriately qualified cabin crew if it
– pilots take ‘ground leave’ between flights;
does not have sufficient regard for their health and
their health and safety.
safety.
– there is adequate ‘cover’ when crew are sick
or taking leave.
Emergency
A serious accident (e.g. fire), collision or breakdown
Accept at the present level, but taking all practicable
may threaten operations in both short and longer-term.
safety checks now implemented in the airline industry
to ensure that Azure is not exposed to preventable
risks. For example:
– x-ray screening of checked-in baggage;
–
security screening
of cabin
baggage
and
passengers, etc.
Flight personnel
Azure may not be able to service the flight in the event
The agreement with the airline should indemnify
of non-supply of flight personnel by the international
Azure for all costs and losses incurred if flights are
airline (e.g. due to strike action).
cancelled or disrupted due to non-availability of flight
personnel.
Flight tickets
Tickets are sold by more than one party (Azure and
Strict controls must be exercised over:
travel agents) and at more than one location. lso,
–
unused tickets;
pricing is complex, with a range of tariffs depending on
–
ticket pricing;
many factors. This increases the risk that
–
real-time reservations
– revenue may be lost if passengers are undercharged
–
ticket refund and exchange transactions.
or ticket sales unrecorded; and
– flights may be over-booked, with consequent loss
of customer goodwill.
The configuration of the aircraft does not
currently
Commence negotiations with the international
meet the current demand profile of passengers and
airline for an amendment to the current lease
under the terms an operating lease may not be
and terms allowing flexibility in the seating
changeable.
arrangements.
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2. Hydrasports, a limited liability company and national leisure group, has sixteen centres around the country and a
head office. Facilities at each centre are of a standard design which incorporates a heated swimming pool, sauna,
air-conditioned gym and fitness studio with supervised childcare. Each centre is managed on a day-to-day basis, by
a centre manager, in accordance with company policies. The centre manager is also responsible for preparing and
submitting monthly accounting returns to head office.
Each centre is required to have a licence from the local authority to operate. Licences are granted for periods
between two and five years and are renewable subject to satisfactory reports from local authority inspectors. The
average annual cost of a licence is $900.
Members pay a $100 joining fee, plus either $50 per month for ‘peak’ membership or $30 per month for ‘off-peak’,
payable quarterly in advance. All fees are stated to be non-refundable.
The centre at Verne was closed from July to September 2003 after a chemical spill in the sauna caused a serious
accident. Although the centre was re-opened, Hydrasports has recommended to all centre managers that sauna
facilities be suspended until further notice.
In response to complaints to the local authorities about its childcare facilities, Hydrasports has issued centre
managers with revised guidelines for minimum levels of supervision. Centre managers are finding it difficult to
meet the new guidelines and have suggested that childcare facilities should be withdrawn.
Staff lateness is a recurring problem and a major cause of ‘early bird’ customer dissatisfaction with sessions which
are scheduled to start at 07.00. New employees are generally attracted to the industry in the short-term for its
non-cash benefits, including free use of the facilities – but leave when they require increased financial rewards.
Training staff to be qualified life-guards is costly and time-consuming and retention rates are poor. Turnover of
centre managers is also high, due to the constraints imposed on them by company policy.
Three of the centres are expected to have run at a loss for the year to 31 December 2003 due to falling membership.
Hydrasports has invested heavily in a hydrotherapy pool at one of these centres, with the aim of attracting retired
members with more leisure time. The building contractor has already billed twice as much and taken three times as
long as budgeted for the work. The pool is now expected to open in February 2004.
Cash flow difficulties in the current year have put back the planned replacement of gym equipment for most of the
centres.
Insurance premiums for liability to employees and the public have increased by nearly 45%. Hydrasports has met
the additional expense by reducing its insurance cover on its plant and equipment from a replacement cost basis to
a net realisable value basis.
Required:
(i) Identify and explain the business risks which should be assessed by the management of Hydrasports.
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(ii) Explain how each of the business risks identified in (i) may be linked to financial statement risk.
Answer:
(i) Business risks
(ii) Financial statement risk
The standard design of facilities increases operational
The carrying amount of the associated non-current
risk as any difficulties encountered in one facility will
assets (i.e. equipment, fixtures and fittings) is likely to
be compounded by the number of other facilities
be overstated as they are likely to be impaired if they
(potentially all) which are similarly affected. This is
are not in use.
illustrated by the in use closure of the saunas.
Centralised control through company policy is
Management circumvention or override of control
resulting in inefficient and ineffective operations as
procedures laid down by head office may result in
managers cannot respond on a timely basis to local
system weaknesses. If errors arising are not detected
needs.
and corrected the risk of misstatement in the financial
statements is increased.
Business reporting risk is likely to be increased by
-Information processing risk is increased as accounting
centre managers preparing monthly accounting returns.
information flowing into the financial statements may
Operational risk may be increased if centre managers
not be properly captured, input, processed or output by
cannot fulfil their day-to-day responsibilities (e.g.
the centre managers.
relating centre managers. to customer satisfaction,
- Inherent risk, of errors arising, in monthly ‘branch’
human resources, health and safety).
returns is high.
Advanced payments contribute to business reporting
-Revenue may be overstated if an accurate cutoff is not
and financial (cash flow) risk. Cash received must be
achieved. In particular, there is an estimate risk in
available to meet the costs of providing future
determining the amount of deferred income at the
services.
balance sheet date.
- An error of principle may also arise if Hydrasports’
revenue recognition policy does not comply with IAS
18 ‘Revenue’.
Hydrasports cannot operate a centre if a licence is
An error of principle arises if licences are not
suspended, withdrawn or not renewed (e.g. through
capitalised as intangible assets (but instead written off
failing a local authority inspection or failing to apply
as expenses when incurred).
for renewal).
Closure may result in customers finding alternative
Failure risk (i.e. that Hydrasports will not continue to
facilities with permanent loss of fee revenue.
operate as a going concern) is increased.
‘ Early bird ’ customers disatisfaction similarly
This creates disclosure risk if the disclosures relating
increases operational risk.
to going concern as the basis of accounting do not
meet the requirements of IAS 1 ‘Presentation of
Financial Statements’.
Serious accidents may prompt investigation by local
-If licences are withdrawn, the intangible asset
authority – resulting in penalties, fines and/or
(amounts prepaid) should be written off to the extent
withdrawal of licence to operate.
that monies are not refundable.
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- The likelihood of contingent (if not actual) liabilities
increases disclosure risk.
Although fees are non-refundable, suspension of a
Provisions may be understated at 31 December 2003 if
facility (e.g. sauna) may result in customers asking for
Hydrasports has a legal obligation to refund fees
partial refund. In particular Hydrasports may have an
where it has failed to provide services.
obligation to refund fees paid in advance when centres
are closed (e.g. the Verne centre from July–September
2003).
Permanent loss of customers requiring childcare
Disclosure risk is (again) increased if fines/penalties
facilities increases operating risk. Compliance risk is
arising are material and not disclosed.
increased if the new guidelines are not met.
Similarly, inability to retain lifeguards increases
operational risk that pools cannot open (due to health
and safety regulations). Compliance risk is increased
by the possibility that pools may be operated without a
lifeguard being on duty.
High staff turnover indicates increased operational risk
Staff costs may be overstated as the risk that payments
(poor human resource management, inefficiency in
may be made to leavers is increased.
working practices, reduced capacity, etc).
Limitations on centre managers’ levels of authority
Any lack of integrity may increase the risk of
may not be commensurate with their responsibilities.
management and/or employee fraud, illegal acts and
Empowerment risk arises if managers are not properly
unauthorised use of company assets. In particular the
led (and if they, in turn, do not properly lead their
assertion of existence of assets may be at risk
centre staff).
(resulting in overstatement).
More centres may become loss-making if the reasons
Loss-making centres should be tested for impairment
for falling membership are not addressed.
as cash-generating units.
The
hydrotherapy
pool
cannot
operate
until
The value of the asset in construction should be
construction is completed and completion may be
written down if it is impaired (even though it has not
threatened by cash flow difficulties.
yet been brought into use).
Cash flow difficulties increase liquidity/financial risk.
See above reference to going concern and disclosure
risk.
Obsolete gym equipment increases operational risk as
-Depreciation may be overstated if Hydrasports
customer satisfaction decreases and health and safety
continues
risks are increased.
fully-depreciated assets.
to
calculate
depreciation
on
- Disclosures for capital commitments (e.g. to replace
equipment) in the financial statements may be
inappropriate if Hydrasports does not have funds to
finance such commitments.
- See above reference to going concern and disclosure
risk.
The reduction in insurance cover reduces the
See above reference to going concern and disclosure
recoverable amount of assets in the event of loss
risk.
through fire (for example). Inability to replace
18
lost/damaged assets increases operational risk (see
obsolete gym equipment
above).
Operational risk is increased if the substantial increase
Disclosure risk is increased in relation to contingent
in liability insurance premiums is a reflection of an
assets (for reimbursement under insurance policies).
increase in the level of claims being made.
3. The principal activity of Bateleur Zoo Gardens (BZG) is the conservation of animals. Approximately 80% of the
zoo’s income comes from admission fees, money spent in the food and retail outlets and animal sponsorship. The
remainder comprises donations and investment income.
Admission fees include day visitor entrance fees (‘gate’) and annual membership fees. Day tickets may be
pre-booked by credit card using a telephone booking ‘hotline’ and via the zoo’s website. Reduced fees are
available (e.g. to students, senior citizens and families).
Animal sponsorships, which last for one year, make a significant contribution to the cost of specialist diets,
enclosure maintenance and veterinary care. Animal sponsors benefit from the advertisement of their names at the
sponsored animal’s enclosure.
BZG’s management has identified the following applicable risks that require further consideration and are to be
actively managed:
(i) Reduction in admission income through failure to invest in new exhibits and breeding programs to attract
visitors;
(ii) Animal sponsorships may not be invoiced due to incomplete data transfer between the sponsoring and
invoicing departments;
(iii) Corporate sponsorships may not be charged for at approved rates – either in error or due to arrangements with
the companies. In particular, the sponsoring department may not notify the invoicing department of reciprocal
arrangements, whereby sponsoring companies provide BZG with advertising (e.g. in company magazines and
annual reports);
(iv) Cash received at the entrance gate ticket offices (‘kiosks’) may not be passed to cashiers in the accounts
department (e.g. through theft);
(v) The ticket booking and issuing system may not be available;
(vi) Donations of animals to the collection (e.g. from Customs and Excise seizures and rare breeds enthusiasts)
may not be recorded.
Required:
(a) Describe suitable internal controls to manage each of the applicable risks identified.
(b) Explain the financial statement risks arising from the applicable risks.
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Answer:
(i) Lack of investment
■ Monthly review and monitoring of:
– admission fees;
– number of day visitors;
– annual memberships taken out (analysed between new and renewed);
– lapsed membership;
– sponsorship waiting lists (animals without sponsors and sponsors waiting for suitable animals).
■ Approval of annual budgets which plan for adequate investment to attract visitors.
■ Monthly comparison of actual expenditure on new exhibits and breeding programs against budget
– to see the extent to which the expected level of investment in development is being made.
(ii) Incomplete data transfer
■ Monthly reconciliations of actual (invoiced) sponsorship income to that expected (based on number of
sponsorships, by type, per sponsor department records) and investigation of shortfalls.
■ Monitoring of instances of incomplete/inaccurate data transfer – how identified, reason for occurrence,
amounts involved, how rectified.
(iii) Non-charges
■ Monitoring of sponsorship income generated (i.e. actual) to that available (e.g. projected), by class of animal,
and investigation of shortfalls.
■ Comparison of BZG’s advertising expenditure against budget (to identify potential for unrecorded costs).
(iv) Misappropriated cash
■ Two people could ‘man’ each ticket kiosk at all times. A duty log should be kept (date, time, staff member).
■ The kiosks must not be left unattended while cash is held there.
■ All cash received from visitors should be counted and recorded and a receipt given.
■ Cash and a copy of the receipts should be transferred, securely, to cashiers.
■ The existence of CCTV at the kiosks should be made evident, to act as a deterrent.
■ Daily reconciliation of cash takings to ‘gate’ (i.e. number of day visitors) and investigation of any apparent
shortfall.
■ A separate admission gate after the kiosk checks that entrants have been issued a ticket.
■ An auditable cash register system to control cash drawers at ticket booths. Transactions must be traceable in
multiple forms of tender (cash, credit card).
■ Multiple cash drawer inserts enabling quick and easy shift changes. An automated audit trail of all movements
in and out of each drawer.
(v) Systems not available
■ Back up/recovery/contingency plans must be in place to ensure that BZG can take bookings and issue tickets
even when the electronic system is not available.
■ In particular, the back up system should be tested periodically to ensure that credit card bookings can be taken
and correct discounts processed for concessionary tickets and group bookings.
■ Preventive arrangements to ensure that any ‘down time’ is kept to a minimum. For example, acquiring highly
reliable systems components and frequent housekeeping/maintenance.
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(vi) Unrecorded donations
■ Periodic inspection of animals and comparison with book records (e.g. fixed asset register for larger species
and inventory records for smaller species).
■ Comparing new animals identified by veterinary records to additions to inventory records (or asset register).
(b) Financial statement risks
(i) A going concern (‘failure’) risk arises from lack of investment. Any significant doubts about going concern
must be suitably disclosed in the notes to the financial statements. Disclosure risk arises if the requirements of IAS
1 ‘Presentation of Financial Statements’ are not met.
(i) A reduction in admission income may result in asset impairment. BZG’s management should perform
impairment tests on the carrying amount of the larger exhibits, in accordance with IAS 36 ‘Impairment of Assets’.
■ Income may be materially understated due to:
(ii) incomplete data transfer resulting in invoices not being raised;
(iii) unrecorded sponsorships arising from advertising arrangements.
Tutorial note: It is unlikely that income would be overstated as companies would dispute the rates if they were
overcharged for sponsorships.
(iii) BZG’s advertising costs will be understated if their barter for sponsorships is not recorded. If material, there is
a risk of non-compliance with financial reporting requirements (SIC 31 ‘Revenue – Barter Transactions Involving
Advertising Services’).
(iv) Cash asset/admission income will be understated in respect of cash which does not reach the accounts
department. If some of this cash is not stolen but rather appropriated for use in the business (e.g. in meeting
day-to-day cash expenses) then costs would be understated also. The financial statement risk is greater if income is
‘lost’ through unticketed entry (as it will be more difficult to quantify than if misappropriation occurs after tickets
have been issued).
(v) There may be no financial statement risk. For example, if BZG were to admit people for free there would be no
admission fees to be recorded for that day. Alternatively, in the absence of an adequate back up system, the risk of
unrecorded cash/income identified in (iv) may be exacerbated.
(vi) Assets (and reserves) will be understated if donated animals are not initially recognised at fair value (IAS 16
‘Property, Plant and Equipment’).
Professional and ethical issue
Sample question and answer:
1.You are a training manager in Hawk Associates, a firm of Chartered Certified Accountants. The firm has suffered
a reduction in fee income due to increasing restrictions on the provision of non-audit services to audit clients. The
following proposals for obtaining professional work are to be discussed at a forthcoming in-house seminar:
(a) ‘Cold calling’ (i.e. approaching directly to seek new business) the chief executive officers of local businesses
and offering them free second opinions.
(b) Placing an advertisement in a national accountancy magazine that includes the following:
‘If you have an asset on which a large chargeable gain is expected to arise when you dispose of it,you should be
interested in the best tax planning advice. However your gains might arise, there are techniques you can apply.
21
Hawk Associates can ensure that you consider all the alternative fact presentations so that you minimise the
amount of tax you might have to pay. No tax saving – no fee!’
(c) Displaying business cards alongside those of local tradesmen and service providers in supermarkets and
libraries. The cards would read:
‘Hawk ACCA Associates For PROFESSIONAL Accountancy, Audit, Business Consultancy and Taxation
Services Competitive rates. Money back guarantees.’
Required:
Comment on the suitability of each of the above proposals in terms of the ethical and other professional issues that
they raise.
Answer:
(a) ‘Cold calling’
Tutorial note: Recognising that there are three issues to address (i.e. ‘cold calling’, ‘free’ and ‘second opinions’) is
likely to earn more marks than focusing on just one.
■ Until relatively recently ‘cold calling’ has been largely prohibited throughout the profession (and still is in
some countries e.g. Hong Kong). Therefore the ‘direct’ approach may not be suitable.
■ Where ‘cold-calling’ restrictions have been relaxed it may still only be permitted for existing business clients
(i.e. to offer them additional services), the direct approach to non-business clients being prohibited. This inhibits
competition.
■ Although the practice may be viewed as ‘a bit grubby and commercial’ it is now generally regarded as an
accepted modern business practice. Along with other professional bodies, ACCA removed its prohibition on ‘cold
calling’ in 2002.
■ Whilst Hawk is permitted to ‘cold call’, the fundamental ethical principles must be adhered to. Whilst
solicitation which is decent, honest and truthful may be acceptable, cold calling which amounts to harassment is
not.
■ Offering a service for ‘free’ is not prohibited provided that the client is not misled about future levels of fees.
■ There are strict ethical rules regarding ‘second opinions’ (on accounting treatments). Practitioners are advised
NOT to provide second opinions, when requested, without following a procedure of contacting the incumbent
auditor/accountant. Therefore to be offering second opinions clearly goes against ethical guidelines – as the
practice is to be discouraged.
(b) Tax planning
■ Advertising is generally allowed subject to the observance of the fundamental principles of ethical codes (e.g.
IFAC’s ‘Code of Ethics for Professional Accountants’, ACCA’s ‘Rules of Professional Conduct’).
■ Although direct advertising (i.e. on television, radio, cinema) is prohibited in many jurisdictions (e.g. Hong
Kong), an advertisement in a national accountancy magazine is generally permitted.
■ Where advertising is permitted, the minimum requirements are that it be decent, honest, truthful and in good
taste. These criteria may not be met in this proposal as:
– expectations of favourable results (lower tax liabilities) may be unjustifiable (or created deceptively);
22
– ‘techniques you can apply’ may imply an ability to influence taxation authorities;
– ‘the best’ is likely to be a self-laudatory statement and not based on verifiable facts;
– ‘the best’ may also be making an unjustifiable comparison with other professional accountants in public
practice;
– ‘the best tax planning advice’ may be an unjustifiable claim of expertise or specialism in the field of tax.
■ ‘Can ensure …’ and the assertion of ‘all’ may not be supportable claims, therefore the advertisement is not
honest in these respects.
■ There is a ‘fine line’ between tax avoidance and tax evasion and ‘techniques you can apply’ and ‘alternative
fact presentations’ may lean toward the latter and so not be in keeping with the integrity of the profession.
■ The assertion of being able to ‘minimise the amount of tax’ may expose Hawk Associates to litigation. The
engagement risk associated with taking on this work would be high and so should carry commensurately high fees.
■ The ‘no tax saving – no fee’ offer does not compensate for the risk associated with undertaking the work
advertised.
■ Contingency fees, whereby no fee will be charged unless a specific result is obtained, are prohibited by IFAC
(unless otherwise permitted by statute of member body).
(c) Business cards
■ Business cards may be considered a form of stationery and should be of an acceptable professional standard
and comply with legal and member body requirements concerning names of partners, principals, professional
descriptions, designatory letters, etc.
■ Whilst placing such an advertisement where a target audience might reasonably be expected to exist (e.g. in an
Institute of Directors or Business Men’s Club), displaying it alongside ‘local tradesmen’ may appear to belittle the
status of professional accountants.
■ An advertisement the size of a business card would be sufficient to provide a name and contact details and in
this respect is suitable. However, the danger of giving a misleading impression is pronounced when there is such
limited space for information.
■ However, the tone of the advertisement may discredit the ACCA name. It is also unsuitable that it seeks to take
unfair advantage of the ACCA name. Although the ACCA mark can be used by Hawk Associates on letterheads
and stationery (for example) it cannot be used in any way which confuses it with the firm.
■ The emphasis on ‘professional’ may be unsuitable as it could suggest that there are other than professional
accounting, audit (etc) services to be had.
■ Offering a range of non-audit services in the same sentence as ‘audit’ may mislead interested persons picking
up the card into thinking that Hawk can provide them together. This conflicts with the fact that Hawk is restricted
in providing non-audit services to audit clients.
■ There is no basis for asserting ‘competitive rates’.
■ It is unlikely that any professional would offer ‘money back’. In the event of dispute (e.g. over fees), the matter
would be taken to arbitration (with their member body) if a satisfactory arrangement could not be reached with the
client.
■ A tradesman may guarantee the quality of his work – and that it can be made good in the event that the
customer is not satisfied. However, an auditor cannot guarantee a particular outcome for the work undertaken (e.g.
reported profit or tax payable). Most certainly an auditor cannot guarantee the truth and fairness of the financial
statements in giving an audit opinion.
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2. You are an audit manager of Kloser, a firm of Chartered Certified Accountants. You are assigning staff to the
final audit of Isthmus, a company listed on a stock exchange, for the year to 31 December 2002. You are aware of
the following matters:
(1) Isthmus has recently issued a profits warning. The company has announced that the significant synergies
expected from the acquisition of Vanaka, a former competitor company, have not materialised. Moreover, it has
emerged that certain of Vanaka’s assets are significantly impaired. Your firm’s corporate finance department,
assisted by two audit trainees, carried out due diligence work on behalf of Isthmus before the purchase of Vanaka
was completed in December 2001.
(2) Mercedes, the assistant manager assigned to the interim audit of Isthmus, has since inherited 5,000 $1 shares in
Isthmus. Mercedes has told you that she has no intention of selling the shares until the share price recovers from
the fall to $1·95 which followed the profit warning.
(3) Anthony, an audit senior, has been assigned to the audits of Isthmus since joining the firm nearly three years
ago. He has confided to you that his father owned 1,001 shares in Isthmus but sold them only days before the
profits warning at a share price of $7·95. You are assured that Anthony did not previously know that his father had
the shares.
Required:
Comment on the ethical and other professional issues raised by the above matters and their implications, if any, for
staffing the final audit of Isthmus for the year to 31 December 2002.
(1) Profits warning
Ethical and professional issues
■ The profit warning increases the inherent risk of this assignment. As more work may be needed than for the
prior year (e.g. on Vanaka’s impaired assets), additional staff may need to be assigned to the audit.
■ An ‘advocacy threat’ may occur if a dispute (potential legal action) arises between Isthmus and Kloser. For
example, if the due diligence work should have recognised the significant impairments.
■ Kloser should undertake a review of the due diligence work and audit for the year-ended 31 December 2001 to
ensure there were no findings which should have alerted them to the problems in Vanaka which precipitated the
profit warning.
■ A ‘self-review threat’ may arise in that the prior year-end audit, which followed the purchase, may have lacked
objectivity. For example, the involvement of the corporate finance department in due diligence may have resulted
in less audit work
being carried out on Vanaka’s assets and operating results than would otherwise have been performed.
■ If Kloser was negligent in undertaking the due diligence work (e.g. because assets were impaired at the time of
acquisition and/or the assumptions underlying the expected synergies were unrealistic/hypothetical), to whom will
Kloser be liable? To whom was the due diligence work reported? (Isthmus, Isthmus’s shareholders, providers of
finance for the acquisition?)
24
Tutorial note: To illustrate that these ‘model’ answers are not exhaustive consider, for example, that credit was
given to candidates who argued that the trainees’ involvement in the audit would be beneficial (to Kloser and/or
Isthmus).
Implications for staffing
As a safeguard for the provision of the other service (due diligence) the audit personnel seconded to the corporate
finance department may not have participated in the audit for the year ended 31 December 2001. Any such ‘bar’
should continue.
If the secondees are involved in the audit, appropriate safeguards would include not assigningthem to the audit
areas most closely associated with due diligence and close monitoring and review of their work.
More senior/better quality/experienced staff should be assigned to the audit (than would have been necessary had
the profit warning not been issued).
(2) Shares inherited
Ethical and professional issues
■ A ‘self-interest threat’ has arisen as Mercedes has a direct financial interest in Isthmus (i.e. she controls the
shares). In particular, in wishing the share price to increase Mercedes might be in a position to overlook
unrecorded liabilities and losses discovered during the conduct of the audit (say).
■ Even though Mercedes may have independence of mind and be known to act with the utmost integrity, she
cannot have independence in appearance.
■ This inadvertent violation (i.e. through inheritance) of an independence principle does not impair the
independence of Kloser or the audit team providing:
– Kloser’s established policies and procedures have resulted in Mercedes having reported promptly her
inheritance of the shares;
– Kloser promptly advises Mercedes that the shares should be disposed of; and
– the disposal occurs at the earliest practical date, or she is removed.
■ Mercedes does not intend to dispose of the shares quickly as she is waiting for the share price to recover.
■ It is unlikely that Kloser would consider offering her adequate compensation for an earlier disposal (the loss in
share value since the fall being 5,000 × ($7·95 – $1·95) = $30,000).
■ Although IFAC’s Independence statement requires Mercedes’ removal from the audit team, Kloser may require
stricter safeguards and prohibit all professional staff from holding direct financial interests. Mercedes may
therefore be asked to choose between staying with the firm or disposing of the shares at the earliest practical date.
■ If any work has been done by Mercedes on the audit of Isthmus since she inherited the shares (e.g. in
reviewing interim audit work or planning the year-end or final audit visits) that work should be re-reviewed by
another professional accountant.
Implications for staffing
This threat is so significant that Mercedes should be removed from the audit team unless she disposes of the shares
before she undertakes any further tasks relating to the audit of Isthmus.
25
3) Dealing in shares
Ethical and professional issues
■ A self-interest threat would have arisen only if Anthony had known that a close family member (a parent) had
shares in Isthmus (but he did not). A self-interest threat cannot now arise as his father has disposed of the shares.
■ Providing Anthony did not knowingly prompt his father to sell the shares, he has not committed a criminal act
(e.g. of insider dealing).
Tutorial note: If he committed such an act he should be instantly dismissed by the firm and any professional body
under which he is registered (e.g. ACCA) notified for disciplinary action.
■ However, if he in some way communicated (e.g. in a careless remark) something that prompted his father to
sell the shares, he may be in breach of his duty of confidentiality. This should be investigated and appropriate
action taken (e.g. he may be cautioned or given a written warning).
■ If he unknowingly gave his father price sensitive information, then his father may be guilty of insider dealing
(or similar) for having acted on it.
Implications for staffing
Unless there is any reason to suppose that Anthony has acted improperly (e.g. if he has delayed disclosing the
matter) there is no reason why he should not continue his position in the audit team.
However, if his father were to come under suspicion of insider dealing then Anthony should be withdrawn from
this assignment.
Overall
Given the high profile attaching to this listed client it would be timely to have all members assigned to the audit
team renew their written declarations of independence and confidentiality.
26