STRATEGIC LEVEL MANAGEMENT ACCOUNTING PILLAR PAPER P3 RISK AND CONTROL STRATEGY

This is a Pilot Paper and is intended to be an indicative guide for tutors and students of the style and type of questions that are likely to appear in future examinations. It does not seek to cover the full range of the syllabus learning outcomes for this subject. Risk and Control Strategy will be a three hour paper with one compulsory section for 50 marks and one section with a choice of questions for 50 marks.

CONTENTS

Pilot Question Paper Section A: Case scenario Section B: Two scenario questions Indicative Maths Tables and Formulae Pages 2-3 Pages 4-8 Pages 9-11

Pilot Solutions

Pages 12-26

The Chartered Institute of Management Accountants 2004

P3 Risk and Control Strategy

1

SECTION A 50 MARKS ANSWER THIS QUESTION

Question One Crashcarts IT Consultancy is a 100 million turnover business listed on the Stock Exchange with a reputation for providing world class IT consultancy services to blue chip clients, predominantly in the retail sector. In 2000, Crashcarts acquired a new subsidiary for 2 million based on a P/E ratio of 8, which it renamed Crashcarts Call Centre. The call centre subsidiary leased all of its hardware, software and telecommunications equipment over a five-year term. The infrastructure provides the capacity to process three million orders and ten million line items per annum. In addition, maintenance contracts were signed for the full five-year period. These contracts include the provision of a daily backup facility in an off-site location. Crashcarts Call Centre provides two major services for its clients. First, it holds databases, primarily for large retail chains catalogue sales, connected in real time to clients inventory control systems. Second, its call centre operation allows its clients customers to place orders by telephone. The real-time system determines whether there is stock available and, if so, a shipment is requested. The sophisticated technology in use by the call centre also incorporates a secure payment facility for credit and debit card payments, details of which are transferred to the retail stores own computer system. The call centre charges each retail client a lump sum each year for the IT and communications infrastructure it provides. There is a 12 month contract in place for each client. In addition, Crashcarts earns a fixed sum for every order it processes, plus an additional amount for every line item. If items are not in stock, Crashcarts earns no processing fee. Crashcarts Call Centre is staffed by call centre operators (there were 70 in 2001 and 80 in each of 2002 and 2003). In addition, a management team, training staff and administrative personnel are employed. Like other call centres, there is a high turnover of call centre operators (over 100% per annum) and this requires an almost continuous process of staff training and detailed supervision and monitoring. A summary of Crashcarts Call Centres financial performance for the last three years: 2001 000 Revenue Contract fixed fee Order processing fees Line item processing fees Total revenue Expenses Office rent & expenses Operator salaries & salary-related costs Management, administration & training salaries IT & telecomms lease & maintenance expenses Other expenses Total expenses Operating profit P3 PILOT PAPER 400 2,500 600 3,500 2002 000 385 3,025 480 3,890 2003 000 385 3,450 390 4,225

200 1,550 1,020 300 150 3,220 280

205 1,920 1,070 310 200 3,705 185

210 2,180 1,120 330 220 4,060 165 2

Non-financial performance information for the same period is as follows: Number of incoming calls received Number of orders processed Order strike rate (orders/calls) Number of line items processed Average number of line items per order Number of retail clients Fixed contract income per client Income per order processed Income per line item processed Average number of orders per operator Number of operators required Actual number of operators employed 2001 1,200,000 1,000,000 833% 3,000,000 30 8 50,000 250 020 15,000 667 700 2002 1,300,000 1,100,000 846% 3,200,000 29 7 55,000 275 015 15,000 733 800 2003 1,350,000 1,150,000 852% 3,250,000 28 7 55,000 300 012 15,000 767 800

Required:
(a) Discuss the increase in importance of risk management to all businesses (with an emphasis on listed ones) over the last few years and the role of management accountants in risk management. (10 marks) Advise the Crashcarts Call Centre on methods for analysing its risks. (5 marks) (c) Apply appropriate methods to identify and quantify the major risks facing Crashcarts at both parent level and subsidiary level. (20 marks) Categorise the components of a management control system and recommend the main controls that would be appropriate for the Crashcarts Call Centre. (15 marks)

(b)

(d)

(Total = 50 marks)

End of Section A

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SECTION B 50 MARKS ANSWER TWO QUESTIONS

Question Two The Information Systems strategy within the MG organisation has been developed over a number of years. However, the basic approach has always remained unchanged. An IT budget is agreed by the board each year. The budget is normally 5% to 10% higher than the previous years to allow for increases in prices and upgrades to computer systems. Systems are upgraded in accordance with user requirements. Most users see IT systems as tools for recording day-to-day transactions and providing access to accounting and other information as necessary. There is no Enterprise Resource Planning System (ERPS) or Executive Information System (EIS). The board tends to rely on reports from junior managers to control the business. While these reports generally provide the information requested by the board, they are focused at a tactical level and do not contribute to strategy formulation or implementation.

Required:
(a) Compare and contrast Information Systems strategy, Information Technology strategy and Information Management strategy and explain how these contribute to the business. (10 marks) Advise the board on how an ERPS and EIS could provide benefits over and above those provided by transaction processing systems. (10 marks) Recommend to the board how it should go about improving its budgetary allocations for IT and how it should evaluate the benefits of ERPS and EIS. (5 marks) (Total = 25 marks)

(b)

(c)

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Question Three A listed services group with a UK Head Office and subsidiaries throughout the world reports in Sterling and shows the following liabilities in its notes to the accounts: Liabilities: All figures are in million Sterling $US Euro Total Maturity: All figures are in million Sterling $US Euro Total Total liabilities Floating rate liabilities 98 8 4 110 Maturing within 1 year 73 1 74 Fixed rate liabilities Weighted average interest rate Weighted average years for which rate is fixed 5

98 41 4 143 Total

33 33 Within 1-2 years 3 1 4

7.25%

Within 2-5 years 18 1 19

Over 5 years 4 41 1 46

98 41 4 143

Interest rates are currently about 5%.

Required:
(a) (i) (ii) (iii) Evaluate the main sources of financial risk for this group (assuming there are no offsetting assets that might provide a hedge against the liabilities). Quantify the transaction risk faced by the group if Sterling was to depreciate against the $US and Euro by 10%. Evaluate how transaction risk relates to translation risk and economic risk in this example. (13 marks)

(b)

Discuss the use of exchange traded and Over The Counter (OTC) derivatives for hedging and how they may be used to reduce the exchange rate and interest rate risks the group faces. Illustrate your answer by comparing and contrasting the main features of appropriate derivatives. (12 marks) (Total = 25 marks)

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Question Four ZX is a UK-based retailer and manufacturer that also owns a limited number of outlets in the USA, but is anxious to expand internationally via the use of franchising agreements. The enterprise plans to open five franchised shops in each of France, Italy, Germany, Belgium and Holland over the course of the next twelve months. ZX will provide loan finance to assist individuals wishing to purchase a franchise, the average cost of which will be 100,000. Loans will also be available (up to a maximum of 50% of the purchase price) to cover the cost of the franchisee acquiring suitable freehold or leasehold premises. The total sum required for the property loan facility is estimated by the treasurer of ZX to equal 48 million. The opportunity cost of capital in the UK is 10% per annum but, in recognition of the lower rates of interest available in the Eurozone, ZX will only charge the franchisees a fixed rate of 70% each year on all loans. Repayments will be made in equal Euro-denominated instalments. ZX charges commission to the franchisees at a rate of 1% of sales revenue, and also earns a net margin of 12% (of retail value) on the products supplied to the outlets from its UK manufacturing plant. Planned sales from the new European outlets equal 26 million over the next twelve months, but the enterprise recognises that its profits are dependent upon both sales revenue and the extent of loan defaults amongst franchisees (if any). Estimates of the likelihood of a range of scenarios are detailed below: Probability 01 03 04 02 Sales 10% below plan 20% below plan As per plan As per plan Number of loan defaults Two Four Zero One Comment Economic difficulties reduce sales and cause problems for some franchisees Severe economic problems lead to low sales and higher loan defaults Base case The weak German economy causes problems for one franchisee

Loan default is assumed to mean total write-off and ZX expects 80% of the new franchisees to take full advantage of the loan facilities offered to them. The current Euro : Sterling exchange rate is 13939/ and the Euro is expected to strengthen against Sterling by 5% over the next twelve months. In addition to the cash required to fund the foreign loan facility, a further 365 million of working capital will be required for the expansion project and the Treasury Department of ZX requires a minimum annualised return of 15% on all overseas projects.

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Required:
(a) Use the table of possible scenarios given above to calculate the expected Sterling value of the additional profit that ZX will earn if all the store openings are completed as planned and the foreign exchange rate forecast is fulfilled. (You should use the average exchange rate over the year for the calculation.) You should evaluate whether this profit yields the return required for international operations. (7 marks) (b) Discuss the risks that ZX might face in choosing to expand into Europe via the use of franchising. (8 marks) Evaluate methods of managing/minimising the risks involved in granting Euro denominated loans to the franchisees. (10 marks) (Total = 25 marks)

(c)

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Question Five You have recently been appointed as Head of the Internal Audit function for a large UK listed company that trades internationally, having worked within its finance function for two years prior to your new appointment. Your company has also appointed a new Chief Executive, headhunted from a large US corporation where she had held the post of Vice President, Finance.

Required:
As part of the new Chief Executives orientation programme, you have been asked to prepare a detailed report which provides key information on the principles of good corporate governance for UK listed companies. You should address the following in your report, remembering that her background is in US governance and procedures. (a) (b) (c) The role and responsibilities of the Board of Directors. (5 marks) The role and responsibilities of the audit committee. (10 marks) Disclosure of corporate governance arrangements. (10 marks) (Total = 25 marks)

End of Question Paper

Maths Tables and Formulae follow on pages 9-11

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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SOLUTIONS TO PILOT PAPER

Note: In some cases, these solutions are more substantial and wide ranging than would be expected of candidates under exam conditions. They provide background on theorists, frameworks and approaches to guide students and lecturers in their studies, preparation and revision.

SECTION A

Answer to Question One

Requirement (a)
The Turnbull report (ICAEW, 1999) recognised that profits were in part a reward for successful risk taking, and that the purpose of internal control was to help manage and control risk, rather than eliminate it. The report requires a risk-based approach to establishing a system of internal control and that all listed companies have an embedded internal control system that monitors important threats. Risks are defined as any events that might affect a listed companys performance, including environmental, ethical and social risks. For each risk, boards need to consider the risks and the extent to which they are acceptable, the likelihood of risk materialising and the ability of the organisation to reduce the incidence and impact of the risk. A major responsibility of the board is to review the effectiveness of internal control. It is required to make a statement on internal control, that is the process for identifying, evaluating and managing significant risks. Managements role is a delegated one from the board to ensure that internal controls are adequate but the ultimate responsibility lies with the board. It needs to ensure regulatory compliance. It also needs to manage risks (negative consequences) but also to ensure that opportunities are taken up (positive consequences, such as avoiding the risk of missed opportunities). To be effective, risk management should be embedded in the organisational culture. Management needs to put in place systems to identify, assess, monitor, manage and report risk and the management accountant has an important role to play in this process. Management accountants have a role in developing and maintaining management control systems that accommodate both strategic and budgetary (feed forward) and financial and non-financial performance control (feedback) mechanisms. While this typically emphasises a concern with variance (between plan and expectation, or between plan and actual result), management accountants can play a part in identifying risk, assessing the consequences of risk through the application of quantification and analytic techniques. They can also develop internal control systems to help manage risk and incorporate risk reporting into management information systems.

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Requirement (b)
There are various methods of identifying, evaluating and managing risk that Crashcarts could employ. Methods include using experience and judgement, brainstorming, scenario analysis, PEST/SWOT analysis, interviews and surveys, and statistical analysis. Some organisations use professional risk managers, either as internal consultants or as bought-in advisers. A common method is the Risk Register which lists each significant risk and the management action taken in relation to each risk. A simple but appropriate method for assessing risk is the likelihood/consequences matrix (see below). However, this simple version can be enhanced by Crashcarts using a 3x3 or larger matrix. The risks can be assessed by using probability techniques to assess likelihood and financial and non-financial performance information to quantify the consequences.

Requirement (c)
Methods for analysing risk The likelihood/consequences matrix is the simplest and most effective method to categorise risk and prioritise risk management. Consequences Low Spare operator capacity Likelihood High Staffing changes Low Reduced line items Out of stocks Reduced orders Failure of suppliers Systems failure High Loss of clients at end of 5 years

Quantification can be used to identify, for example, the impact of gaining/losing a customer, price changes, changes in the out-of-stock rate and so on. The impact of spare operator capacity and out of stocks on lost income is shown below: 2001 Spare capacity Number of operators Capacity (operators x orders) Actual number of orders Spare capacity (orders) Cost per order (Operator costs/order capacity) Cost of spare capacity 70 1,050,000 1,000,000 50,000 148 73,810 2002 80 1,200,000 1,100,000 100,000 160 160,000 2003 80 1,200,000 1,150,000 50,000 182 90,833

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Out of stocks Number of incoming calls received Number of orders processed Out of stocks orders Average number of line items per order Out of stocks line items Income per order processed Income per line item processed Lost income per order Lost income per line item Total lost income from out of stocks

1,200,000 1,000,000 200,000 30 600,000 250 020 500,000 120,000 620,000

1,300,000 1,100,000 200,000 29 581,818 275 015 550,000 87,273 637,273

1,350,000 1,150,000 200,000 28 565,217 300 012 600,000 67,826 667,826

Note: Different results may be presented as a result of rounding differences. Although both are risks, the financial consequences of out-of-stocks are much higher. The major risks facing the subsidiary are: The loss of clients and the inability to win replacement (in the event of loss) and/or new clients (increased business), particularly in an environment where call centre operations are increasingly being transferred to lower cost off-shore locations. The number of out-of-stock situations in its retail clients, which are causing substantial lost income, both to Crashcarts and to its retail clients, although there may be a need to increase staffing if the number of out of stocks was reduced. The question implies that lost orders are solely a result of the difference between calls received and orders placed.

Both of these represent significant lost opportunities. A further issue is the need to replace or update the technology after five years (or even before!)

The major risks facing the parent are: Reputation risk may face Crashcarts if the Call Centre subsidiary lets its clients down by not being able to provide its service, as it is heavily reliant on external suppliers to maintain its infrastructure. As an IT consultancy to the retail sector, Crashcarts may also face a reputation loss if its subsidiary is unsuccessful. Given the reducing profits of the subsidiary, Crashcarts may also face impairment of its goodwill, which may need to be reflected in its Balance Sheet under FRS 10. Fraud in the subsidiary is also a major risk, given the subsidiarys ability to obtain credit and debit card information from the retail stores customers.

The diversification into Call Centre operations presents a risk to the parent that needs to be assessed, monitored and managed. There is a need to protect shareholders investment (reputation, physical assets, profitability and so on) as well as interests of clients. The major risks to the subsidiary are not carried through to the parent as the consequences of failure of the subsidiary will not impact the parent significantly (goodwill is fairly minor in relation to group turnover), other than the reputation risk.

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Requirement (d)
Components of Management Control Systems (MCS) The main elements of an MCS are input, process, output, measurement, comparison to target, corrective action and predictive model (see diagram) Necessary conditions for control Inputs Process Information Implementation of action Predictive model of process Measure of output Outputs

Comparison

Determination of cause of deviation. Generation and evaluation of alternative corrective actions Objective

Source: Otley & Berry (1980) Management control can be considered in relation to both feedback (taking corrective action ex post) and feed forward (taking action ex ante). One feature of relevance to MCS design is the use of appropriate responsibility centres and the centralisation/decentralisation of responsibility to those centres. There is no information about the controls that Crashcarts exercises over the subsidiary but the main board and the audit committee need to oversee the subsidiarys operations and performance. Main controls: As risks or rather the causes of risk should drive controls, the main elements of the control system in Crashcarts should include (but not be limited to): number of clients (especially increases and potential losses); non-financial performance, especially key performance statistics on calls received, orders and line items processed; financial performance compared with target; client contract performance, contract review and client satisfaction; systems failure appears to be managed through maintenance agreements for all infrastructure; however supplier performance needs to be monitored; employment procedures, training, performance appraisal and monitoring of staff to reduce staff turnover and improve morale; strategic plan, budgets, targets, management reporting (financial and nonfinancial), expenditure authorisation; 15

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insurance; procedure manuals (for example access, password protection, data validation, virus protection, data back up, transaction audit trails and so on); health and safety (for example fire safety, ergonomics, stress-related illness and so on); use of risk consultants, internal audit, external audit; reporting to the main boards audit committee should take place; embed risk management in culture.

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SECTION B
Answer to Question Two

Requirement (a)
Information Systems (IS) strategy determines the information requirements of an organisation and provides an umbrella for different information technologies that may exist. The IS strategy follows the organisational business strategy and needs to ensure that the appropriate information is acquired, retained, shared and made available for use in strategy implementation in areas such as financial, non-financial, competitive, human resources and so on. Information Technology (IT) strategy defines the specific systems that are required to satisfy the information needs of the organisation, including the hardware, software, operating systems and so on. Each IT system must be capable of obtaining, processing, summarising and reporting the required information. The most sophisticated forms of IT system are the Enterprise Resource Planning System (ERPS) and Executive Information System (EIS). Information Management (IM) strategy is concerned with methods by which information is stored and available for access. This will consider methods of flat or relational database use, data warehousing, back-up facilities and so on. The IM strategy will ensure that information is being provided to users and that redundant information is not produced.

Requirement (b)
Transaction processing systems typically collect data from sales and purchase invoices, stock movements, payments and receipts, and so on in order to provide the information necessary for accounting systems (debtors, creditors, stock) and financial reports. They are largely oriented to line item reporting and profit reporting based on the organisational structure. They rarely provide profitability information by product/service groups, customers and so on. A more outward-focused approach may help the organisation to be more competitive, either by looking more broadly along its supply chain and/or by considering information available from the market place generally or from specific competitors. This is a strategic management accounting approach. The reports from junior managers suggest a lack of strategic planning and a lack of top management consideration of big picture matters. Applying Porter, for example, the organisation needs to determine whether its strategy is cost leadership, differentiation or focus, and how its IT can support that strategy. An ERP system helps to integrate data flow and access to information over the whole range of an organisations activities. ERP systems typically capture transaction data for accounting purposes, operational data, customer and supplier data which are then made available through data warehouses against which custom-designed reports can be produced. ERP system data can be used to update performance measures in a Balanced Scorecard system, can be used for activity-based costing, shareholder value, strategic planning, customer relationship management and supply chain management.

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Executive Information Systems (EIS) provide high level views of an organisation by aggregating data from various sources from within the organisation and from external sources. Ad hoc enquiries generate performance data and trend analysis for top level management. Ease of use is an important feature so that enquiries can be made without a detailed knowledge of the underlying data structures.

Requirement (c)
The IT budget is increased annually without any links to the services provided by IT. (Answers should mention activity-based or zero-based budgeting compared with incremental methods.) The introduction of ERPS and EIS would require a business case with all hardware, software, facilities and personnel costs identified, together with the benefits that could be achieved by the company from the information those systems would generate. Best practice for both IT budgets and for an ERPS/EIS business case would be to determine user requirements in the light of the organisational strategy and need for information (the IS strategy). User requirements should lead to the design of systems (hardware and software) needed to meet those requirements (IT strategy). The type of system and the risks faced would then determine system design and security considerations (the IM strategy). A best practice model such as Information Technology Infrastructure Library (ITIL) should be used in design, development, testing and management phases of any IT development.

Answer to Question Three

Requirement (a)
This group has a small proportion (23%) of fixed rate liabilities all $US - at average rates (725%) that are higher than current levels (5%). The group is also exposed to exchange rate fluctuations for these liabilities. Most liabilities (77%) are floating rate (110/143) and although most of these (98/110) are in Sterling, if interest rates increase the group will be subject to those fluctuations. As the group has subsidiaries around the world, it will be subject to exchange rate fluctuations, in relation to transaction, translation and economic risk. Interest rate risks arise as a result of borrowing over long time periods to invest in assets where a company either borrows at a fixed rate or a floating rate. The risk arises from differences between the rate at which interest is to be paid by the group relative to movements in market rates of interest. Exchange rate risks arise as a result of purchasing and selling goods and services across national borders and the relative mix of monies owed to, and owing by, a company in different currencies and the effect of changes in relative exchange rates between currencies. Depreciation by 10%: it is not necessary to know the exchange rates used in the Notes to the Accounts. At any exchange rate, if the devalues by 10%, the Sterling figure in the Accounts will be 90% of what it should be. Therefore, the new conversion will be (41 million + 4 million)/09 or 50 million. The transaction risk is therefore 5 million (50 million - 45 million) P3 PILOT PAPER 18

Transaction risk arises from transactions already entered into or for which there is likely to be a commitment in a foreign currency, as a result of exchange rate movements in the home countrys currency. This is typically for imports and exports, but also applies to borrowings in a foreign currency which requires interest and principal repayments. Transaction risk may be addressed by invoicing customers in the home currency or by hedging activity. The risks can be hedged by netting payments, by forward contracts, and so on. FRS 13 requires disclosure of derivatives and financial instruments in Notes to the Accounts. The Board needs to approve policy in relation to hedging. Translation risk arises because financial data denominated in one currency is expressed in another currency and is reflected in the movement of exchange rates between balance sheet dates, which distorts comparability. This typically happens when the accounts of foreign subsidiaries are consolidated into the home currency. It affects the balance sheet (assets and liabilities) and profit and loss account. This risk cannot be adequately addressed by hedging techniques. Economic risks are largely reflected in the worth of a business, based on the discounted cash flows payable to shareholders, which may reduce as a result of exchange rate movements, influencing the competitive position of the business. These risks are not reflected in Notes to the Accounts and are largely addressed by contingency planning and portfolio/diversification strategies although they can be minimised by using local agents or participating in joint ventures.

Requirement (b)
A derivative is an asset whose performance is based on the behaviour of an underlying asset (commonly called underlyings, for example shares, bonds, commodities, currencies, exchange rates). Derivative instruments include options, forward contracts, futures, forward rate agreements and swaps. Hedging protects assets against unfavourable movements in the underlying while retaining the ability to benefit from favourable movements. The instruments bought as a hedge tend to have oppositevalue movements to the underlying and are used to transfer risk. Exchange traded derivatives have lower credit risk, higher regulation, higher liquidity and the ability to reverse positions. However they are not always flexible. Over the counter derivatives are tailor made to allow perfect hedging but do suffer from low regulation, high credit risk and the inability to reverse a hedge. A forward contract is an agreement to undertake an exchange at a future date at a set price. This minimises the uncertainty of price fluctuations for both parties. Unlike options, both parties are committed to complete the transaction. The main forward markets are for foreign exchange. This is relevant in relation to the liability to repay a given, but unknown from the question, number of $US defined at the point in time in the past when dollars were borrowed, for this the current equivalent is 41 million. Forward rate agreements (FRA) are used for hedging interest rate risk. They are agreements about the future level of interest rates, and compensation is paid based on the difference between the rate of interest at a predetermined time and the level when the FRA was established. A cap is a hedging technique used to cover interest rate risk on long term borrowing, by which a borrower can benefit from interest rate falls but can limit exposure if interest rates rise. Cap compensates the purchaser if market interest rates rise above an agreed level. Floor compensates the purchaser should interest rates fall below an agreed level. Interest rate collar has both a cap and a floor. This is P3 PILOT PAPER 19

relevant in relation to the floating rate liabilities in $US (8 million) and Euros (4 million). A swap is an exchange of payment obligations to reduce exposure to interest rate changes, particularly over the longer term where a swap can run the lifetime of a loan. The swap could be an interest rate swap (for example between fixed and floating rate obligations) or currency swap where interest payments are in different currencies. Swaps reduce exposure to rising interest rates, enable the matching of interest rate assets with debts, and enable lower overall interest rates to be achieved when markets fluctuate. This is relevant in relation to the long term $US loan that has a fixed rate of interest of 725% and a swap may enable a reduction in that rate.

Answer to Question Four

Requirement (a)
Assuming that 80% of the franchisees take up the maximum loan facility, then the loans granted by ZX are equal to: (100,000) x 25 x 08 + 48 million Interest cost to ZX @ 10% per annum Interest received by ZX @ 70% per annum Net cost per annum The average loan per franchisee equals 68 million/25 or = = = = 68 million 068 million 0476 million 0204 million 272,000 026 million

Forecast revenue from sales commission if planned levels are achieved = Forecast net margin (12%) from supplying goods with a retail value of

26 million

Net profit if targets are fully met

= 312 million Total = 338 million = 338 - 0204 million = 3176 million

Adjusting for estimates under the different possible scenarios gives: 01 x [(09 x 338) million - 0204 million - (272,000 x 2)] plus 03 x [(08 x 338 million) - 0204 million - (272,000 x 4)] plus 04 x 3176 million plus 02 x [3.176 million - 272,000] Total expected profit P3 PILOT PAPER = = = = 02294 million 04236 million 12704 million = 05808 million

25042 million 20

The current exchange rate is 13939/ and this is forecast to move by 5% to 13242/. This gives an average exchange rate over the year of 13591/. The sterling value of the expected profit is thus: = 25042/13591 million = 18425 million Capital invested at the project launch equals 68 million + 365 million. Using the current exchange rate of 13939/, this gives 4878 million + 365 million, totalling 8528 million. The required return is 15%, that is 12792 million. In yielding 18425 million, the expansion therefore does meet the Treasurys requirements.

Requirement (b)
The risks that might arise from selecting this type of expansion are both financial and non-financial in nature, although it should also be recognised that franchising can also serve to reduce risks in comparison with those that might arise if expansion was via wholly owned subsidiary outlets. Franchising reduces risk by ensuring that it is the franchisees that bear the capital cost of the new shops. Consequently ZX requires minimal levels of additional capital to fund the expansion programme, despite the fact that it is offering loan funding to the franchisees. Nonetheless, the provision of these loans will give rise to two particular risks. The first is a credit risk, which is reflected in the anticipated default levels. This risk may be exacerbated because debt collection/credit regulations and procedures may differ across countries even within the European Union. The second is a foreign exchange risk because funds will have to be converted from Sterling to Euros, and the interest and capital repayments are also denominated in Euros. There are methods that may be used to manage the risks of the foreign loans, and will be discussed in the answer to requirement (c) of this question. ZX faces a potential risk in being unable to attract the desired number of franchisees because of cultural differences and an insufficiently powerful brand name. The most successful franchise operations are global in scope, but are linked to well-recognised brands, and the brand is used to ensure that the customer experience is common across the globe. European retailers may be less familiar with both the franchising concept and the ZX brand, and both of these threats pose a risk to the expansion plans. Unless the search for franchisees has been preceded by an extensive marketing campaign in the targeted countries, it is quite possible that fewer than twenty five suitable franchisees will be forthcoming. A further risk associated with this method of expansion is that of control. It is vital that the company image, product delivery and store layout/design are uniform and clearly recognisable. ZX faces the risk of finding that some franchisees know best and want to put their own individual stamp on the business. Controlling the supply of goods that are sold in each store is just part of the process of managing this type of risk. Other key requirements are good staff training schemes, standardised advertising, store displays and labelling and so on.

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In trying to move into five countries simultaneously, ZX is probably being rather ambitious. Despite the fact that all of the target markets are within the European Community, they are culturally quite distinct, and all are different from the UK and USA where ZX already has shops. The company therefore faces the risk of trying to cope with excessive diversity at the same time as rapid expansion and such complexity may prove very difficult to manage. From an operational perspective, the precise location of stores must also be carefully monitored to avoid them competing against one another for business. Germany is a large enough country for five shops to be geographically spread out, but it might not be possible to say the same of Belgium, for example. The company must also assess the impact of the expansion upon its UK operations. There is a risk that domestic operations will be ignored or sidelined in the search for growth, and if the company is dependent upon the UK for the bulk of its earnings, then care must be taken to minimise such risks. Additionally, the company should assess the relative merits of investing capital overseas rather than in the UK via a comparison of the rate of return earned in each location, and the respective risks associated with the different options. Rapid growth of UK franchise operations might be less risky and also more profitable.

Requirement (c)
The risks associated with the provision of the loans are of three types: credit risk, foreign exchange risk and interest rate risk. Each will be discussed in turn. Credit risk arises because, in providing loan finance to a third party, a company such as ZX cannot be certain that the counter-party will not default on the loan. The risk can be minimised or managed in a number of different ways. At the most basic level, ZX can ensure that its credit rating procedures are up to date and effective. For new business accounts such as those of the franchisees, it may be difficult to obtain good credit ratings and the only source of information may be basic references from credit reference agencies and banks. In such cases, ZX could protect its position, at least in part, by implementing its own credit scoring system and taking a charge over the assets of the new business in return for provision of the loan(s). A fixed charge over the property is probably the most suitable form of charge. Another method which can be used to reduce risk once the loans have been in place for some time, is to sell the loan book on to a third party. This is unlikely to be a practicable proposition in this case however, as the total value of the loans outstanding is rather small. The foreign exchange risk faced by ZX is threefold in nature. There is a transaction risk in the provision of the initial capital sum, and the payments received over the life of the loan, as well as a translation exposure in respect of the value of the loans outstanding at the end of each financial period. Lastly there is an economic exposure because the earning power of the company will be affected by long run trends in the Euro: Sterling exchange rate. The Euro is forecast to strengthen against Sterling and because the loans are classed as an asset on the balance sheet, if the exchange rate forecasts are correct, the value of the asset is potentially increasing over time, which might be thought of as reducing the companys risk. On the other hand, the value of any write-downs caused by changes in credit risk may also increase over time, thus increasing the likelihood of future earnings volatility.

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Both the translation and transaction risks arising from the loans could be minimised or reduced by creating a reverse exposure in the form of a Euro denominated liability. ZX could fund the loans to its franchisees by itself taking out a Euro denominated loan for the capital required. In this way, any changes in the exchange rate over time will result in equivalent changes in the balance sheet value of the associated asset and liability, thus cancelling one another out. At the same time, the Euro payments from franchisees can be used to fund the capital and interest payments on the borrowing by ZX. In this way, the company avoids the cost of regular transactions to convert Euro back into the home currency. The method would only create a perfect hedge, however, if ZX was able to borrow the exact sum of money at the interest rate of 7%, and there were no defaults by franchisees. In practice, this is very unlikely. An alternative way of reducing the foreign exchange risk would be for ZX to use EU based suppliers to provide the goods for sale in its European stores. This would reduce the forecast output at the UK manufacturing plant, and thus have an opportunity cost, but at the same time it would mean that ZX would have trade creditors that were calling for payment in Euros, and the monthly receipts from franchisees could be used for this purpose. It is unlikely that the transaction risk could be wholly eliminated in this way, but it could certainly be reduced. Any outstanding transaction exposure that remains after utilising the methods outlined above, can be hedged via the use of forward rate agreements, options or futures. Forward rate agreements enable a company to fix the exchange rate on a transaction at an agreed future date. This creates cash flow certainty, but there is a price to pay for the agreement, and it is also binding. An option allows a company to gain the right to buy/sell a foreign currency at an agreed exchange rate before a set expiry date. The option must be paid for up front, but if exchange rates move favourably, there is no further penalty for failure to exercise the option. Futures contracts are available in only a limited number of currencies, including the Euro, and contract sizes vary from currency to currency. A currency future represents a contract to buy or sell a fixed amount of a specified currency in the future for a price that is determined today. Futures are, therefore, very similar to forward contracts, but the market for them is much smaller because their appeal is limited by the use of the fixed contract amounts. Forward contracts can be tailored to suit the needs of the individual client, whereas if the transaction exposure does not exactly match contract sizes, use of the futures market will still leave some transaction exposure. In conclusion then, it is likely that ZX will be able to reduce, but not completely eliminate, its foreign exchange transaction exposure. ZXs economic exposure appears to be substantially increased by the expansion plan, because all of the target countries lie within the same currency zone. This means that the companys earnings will be more sensitive, longer term, to what is happening in the EU economies. The only way to minimise this risk is to diversify internationally through opening shops outside the European Union, but this may create other more significant risks instead. The interest rate risk faced by ZX is created by its decision to provide fixed rate loans to the franchisees, the price of which is based on European interest rates rather than those in the UK. ZX may, therefore, find that if interest rates rise, the cost of subsidising the foreign borrowers will increase, and so profits will fall. Interest rates and exchange rates tend to move approximately in line with one another, and so if the Euro is expected to strengthen relative to Sterling, then it is likely that European interest rates will remain below those in the UK. P3 PILOT PAPER 23

If, however, the UK economy is perceived to be strong, and the Bank of England chooses to increase UK rates in order to dampen demand, then the UK based opportunity cost of capital to ZX will rise, and the effective subsidy to borrowers will rise. One possible way in which ZX could reduce this interest rate risk is by tying the rate charged to UK interest rates. In other words, offering a variable rate rather than a fixed rate loan. This would, however, create an alternative form of interest rate exposure, because the company could now not benefit from a reduction in the subsidy if UK interest rates fell. The importance of the risk needs to be assessed in terms of the significance of the capital tied up in the loans, which could be regarded as a form of strategic investment by the company. For small loans, the cost of arranging interest rate hedges may far exceed the potential savings that they may generate. Ultimately, the decision on hedge/dont hedge is one for the Board of Directors, and will be dictated at least in part by their overall appetite for risk.

Answer to Question Five Report To: From: Re: Chief Executive Head of Internal Audit UK Corporate Governance

Requirement (a)
In the light of recent financial scandals in both the USA and Europe, regulations on corporate governance in the UK remain subject to ongoing review. The latest amendments to regulations were published in the form of a revised version of the Combined Code on Corporate Governance, issued in July 2003. This report is based largely upon the contents of that document, and assumes that the reader is familiar with US regulations, particularly recent changes such as the Sarbanes-Oxley Act, but has had less exposure to current UK requirements in respect of both control systems and disclosures in relation to corporate governance. The report deals with three main areas that are subject to regulation the role and responsibilities of the Board of Directors; the role and responsibilities of the audit committee and disclosure of corporate governance arrangements. The principles of good corporate governance that were laid down in the Combined Code can be broken down under a number of headings including financial reporting, internal control and disclosure. At the most fundamental level, the Board of Directors is required to present a balanced and understandable assessment of the companys position and prospects that confirms that the company is a going concern, or qualifies the statements accordingly. Insofar as the contents of the financial report are defined by a mix of company law and accounting regulation, compliance with the regulations is likely to (but not inevitably) result in satisfactory fulfilment of this requirement. It is important to note that this requirement extends beyond just the annual report into other interim and price sensitive reports, as required by regulators. In other words, good P3 PILOT PAPER 24

corporate governance means that financial information entering the public domain should be understandable and facilitate performance assessment by analysts. In relation to internal control, the Combined Code requires the board to maintain a sound control system and review, at least annually, the effectiveness of that control system. Financial, operational, compliance and risk management controls should all be included in the review. There is, however, no requirement for the board to report externally on the findings of this review. As part of the process of ensuring effective internal controls, the board is required to appoint an audit committee of at least three members, all of whom should be independent non-executive directors. The disclosure requirements of the Combined Code include a statement of compliance, together with details of board membership and responsibilities. The annual report must also contain acknowledgements by the board of their responsibility for preparation of the accounts, and confirmation that they have reviewed the effectiveness of the companys internal control system.

Requirement (b)
The audit committee is appointed by the board of directors and, in larger companies must have at least three members, all of whom should be independent non-executive directors. At least one individual should have both relevant and recent experience. Good corporate governance requires that the role and responsibility of the audit committee should be documented and include each of the following: Review the content of the financial statements and other public announcements in respect of the companys financial performance to ensure their integrity. Monitor the internal audit function and review its effectiveness. Where no such function is in place, the committee should annually review whether there is a need for one. Review both the internal control and risk management systems. Monitor the independence of the external auditors and satisfy itself in respect of their integrity and qualification to do the job. The committee should recommend to the shareholders, via the board, the reappointment or removal of the auditors as appropriate. Taking careful note of ethical guidelines, develop a policy in respect of the supply of non-audit services by the external audit firm, and report to the board any apparent conflicts of interest. Confirm the arrangements that are in place to ensure that members of staff in the company can report concerns in relation to financial improprieties in the organisation. The arrangements should ensure confidential investigation and follow up of any such complaints.

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Requirement (c)
A brief summary of the requirements was included in the answer to (a), but more detailed requirements include the following disclosures within the annual report: Details of members of the board (including non-executives), their collective responsibilities and the attendance records of individuals in respect of the board meetings; Names of the Chief Executive, Chairman, Deputy Chairman and senior independent director; Membership details in respect of the nomination, audit and remuneration committees, together with a description of the work of these committees; Terms of reference for each of the above committees; Information about how the board has ensured that they understand the views of major shareholders in respect of the business; A statement acknowledging their responsibility for preparation of the accounts; A statement that the Directors have undertaken a review of the effectiveness of the companys internal control system; Methods used to evaluate the performance of the board and its sub-committees; An explanation of the boards viewpoint in cases where is has chosen not to accept the audit committees recommendations in respect of reappointment or removal of the external auditors; Explanation of the non-audit services provided by the external auditor (where appropriate) and the steps taken to ensure that audit objectivity and independence is retained.

This report is a brief summary of the regulatory requirements, which differ in a number of ways from those applicable in the USA. If you wish to discuss any of the issues raised by this report in more detail, or would like to see examples of current UK reporting practice, please do not hesitate to contact me.

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

26 May 2005 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper, and if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read the question requirement before attempting the question concerned. The question requirements are contained in a dotted box. Answer the ONE compulsory question in Section A on pages 2 and 3. Answer TWO questions only from Section B are on pages 4 to 9. Maths Tables and Formulae are provided on pages 11 to 14. These pages are detachable for ease of reference. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER
The Chartered Institute of Management Accountants 2005

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One Company Overview
IDAN is a large banking and financial services group that is listed on both the London Stock Exchange and the New York Stock Exchange. The group has over 20 million customers throughout the world and operates in 35 countries on four continents. The IDAN Group is composed of a mix of retail and commercial businesses that include corporate and investment banking, private banking and commercial banking.

Trends within the Financial Services Sector

The Board of Directors of IDAN is aware that a number of trends within the sector will require the bank to substantially re-design a number of its operating and information systems and review the nature of the interface between the internal audit and risk management functions. Current issues that are having an impact on the financial services sector include: A new European Union law requiring banks to provide details of interest paid on personal savings accounts held by non-residents. A withholding tax of 15% is to be imposed on such income and details must be sent by the bank to the tax authorities in the EU country where the recipient resides. Forecast rises in interest rates over the next two years. The elimination within the UK of the use of personal signatures as the authorisation method for credit and debit card transactions and their replacement with personal identification (PIN) numbers. The increasing use, by personal customers, of both telephone and internet banking services. Over 40% of bill payments, standing order amendments and balance transfers by such customers were processed in this way during the last 12 months compared with 28% the previous year. A growth in the number of cases being sent to the financial ombudsman or the financial industry regulator relating to claims of mis-selling or incorrect advice on the part of financial services companies in the supply of a range of savings and investment products. As a result of threats of terrorist activity, money laundering legislation has been introduced or tightened in all of the countries in which IDAN has banking operations.

Analysis by Type of Business

(i) Net assets Corporate and investment banking Personal financial services Private Banking Commercial banking Year Ended 31 December 2004 31 December 2003 m m 15,824 12,286 9,250 6,400 2,320 1,755 9,364 11,186 29,805 38,580
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(ii) Profit on ordinary activities before tax Corporate and investment banking Personal financial services Private Banking Commercial banking

Year Ended 31 December 2004 31 December 2003 m m 3,416 2,949 2,427 1,684 116 85 3,558 3,356 8,276 9,315

(iii) Within the commercial banking portfolio, the allowance for credit losses equalled one per cent of the assets compared with two and a half per cent in personal financial services and private banking. (iv) Profits from Private Banking are viewed as being influenced by a range of factors including the state of the world economy and sentiment and performance in the equity markets. The current outlook for the global economy remains uncertain and depressed equity markets are expected to recover slowly over the coming financial year.

Required: (a)
Discuss the main categories of risk that are faced by a bank such as IDAN and the advantages of risk categorisation in the design of a risk management system. (10 marks) For every one of the six issues identified in the question, recommend the controls that might be introduced to minimise IDANs exposure to such risks. (15 marks) Compare and contrast the roles played by internal audit and risk management in organisations. Discuss the likely nature of the interaction between these two activities. (10 marks)

(b)

(c)

The performance of the Managing Directors of the four types of business within IDAN is evaluated on the basis of the profits of their individual businesses. It has now been suggested by the Board that the strategy of the group, future investment opportunities and the profitability of each business should be evaluated against a risk-adjusted hurdle rate.

Required: (d)
Critically discuss this suggestion by making reference to the information provided in the question. (15 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks)

End of Section A. Section B starts on the next page

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May 2005 3 P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two
BJP is an organisation involved in making business-to-business sales of industrial products. BJP employs a sales team of 40 representatives and assigns each a geographic territory that is quite large. Sales representatives search for new business and follow up sales leads to win new business, and maintain contact with the existing customer base. The sales representatives spend almost all their time travelling to visit clients. The only time when they are not doing this is on one day each month when they are required to attend their regional offices for a sales meeting. Sales representatives incur expenses. They have a mobile telephone, a fully maintained company car and a corporate credit card which can be used to pay for vehicle expenses, accommodation and meals and the cost of entertaining potential and existing clients. The performance appraisal system for each sales representative is based on the number and value of new clients and existing clients in their territory. All sales representatives are required to submit a weekly report to their regional managers which gives details of the new and existing clients that they have visited during that week. The regional managers do not get involved in the daily routines of sales representatives if they are generating sufficient sales. Consequently, sales representatives have a large amount of freedom. The Head Office Finance department, to whom regional managers have a reporting relationship, analyses the volume and value of business won by sales representatives and collects details of their expenses which are then reported back monthly to regional managers. At the last meeting of regional managers, the Head Office Finance department highlighted the increase in sales representatives expenses as a proportion of sales revenue over the last two years and instructed regional managers to improve their control over the work representatives carry out and the expenses they incur.

Required: (a)
Advise regional managers as to the risks facing BJP as a result of the lack of apparent control over sales representatives and their expenses and recommend the controls that should be implemented by regional managers to rectify this situation. (12 marks) Explain what an internal control system is, how it relates to the control environment and its likely costs, benefits and limitations. (8 marks) Recommend how analytic review could be used in the internal audit of BJPs sales representatives expenses. (5 marks) (Total for Question Two = 25 marks)

(b)

(c)

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Question Three
AMF is a market leading, high technology manufacturing organisation producing components for the computer industry. AMF has adopted a lean approach to all its functions and has already made a decision to implement a new enterprise resource planning system (ERPS) to support the management of its customers, suppliers, inventory, capacity planning, production scheduling, distribution and accounting functions. The Board of AMF is considering the outsourcing of the design, delivery, implementation and operation of the ERPS to a specialist contractor that has an excellent reputation within the computer industry. A team would be set up within AMF to manage the transition.

Required:
Write a formal report to the Board of AMF that: discusses the advantages and disadvantages of outsourcing the ERPS system as suggested above; (5 marks) identifies the main risks involved in outsourcing the ERPS and suggests how these risks might be mitigated through internal controls and internal audit; (10 marks) recommends the processes and controls that AMF should adopt to manage a project for successful transition to a chosen outsource supplier should that be the decision of the Board. (5 marks) (Total for Question Three= 25 marks including 5 marks for style, coherence and presentation of the report)

Section B continues on the next page

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May 2005 5 P3

Question Four
AL and Co. is a London-based building contractor, with an annual turnover of almost 15 million. The company employs 50 people, the majority of whom are skilled tradesmen or apprentices in the areas of plumbing, electrical work, plastering, carpentry, glazing and hard landscaping. AL and Co. specialises in renovation work for private clients by offering a fast all service facility that suits busy professional people seeking to renovate properties either for their own occupation or for investment purposes. As a result of the property boom, turnover has grown by over 30% in the last two years. Day-to-day management of the business is shared by two executive directors, one of whom manages the financial and legal aspects of the business (Director X), while the other is responsible for operational activities including work scheduling, agreeing quotes with the sales staff, and all procurement (Director Y). The two directors have a mutual respect and trust for one another and therefore do not check or verify each others work. As a medium sized company, AL and Co. is subject to an annual external audit, but it has no internal audit function and both its internal control and management accounting systems are very basic. Management accounting procedures record the costs of materials associated with all contracts via a job costing system, but other costs are not charged to individual contracts. The system is thus unable to identify whether any specific contract is profitable, and can only compute aggregate profit. One consequence of this system is that the company profitability depends on there being a close match between the actual time taken to complete jobs and the sales teams estimate of the times required: however, the time variances are neither calculated nor monitored. The systems have never been questioned or refined because, to date, an average gross markup of 25% has always been achieved. This margin has ensured that both directors earn high salaries which have risen year on year, and there has therefore been little incentive to improve controls and manage costs. Two staff are employed to issue written quotes in response to customer enquiries, with prices being calculated on the basis of estimated labour and material costs plus 25%. The quotes are reviewed by Director Y before they are sent to customers. All payments are due on completion of the work. In drafting the work schedules Director Y has full knowledge of which quotes are accepted by customers. Additionally, given his role of supervising procurement, he regularly gives administrative staff the names of new suppliers for inclusion in the accounting system. Six months ago, Director Y found himself over-committed financially, and devised a way of diverting company funds from AL and Co. for his own personal use. He began adding 10% to the figures quoted for all jobs requiring the use of more than three separate services (plastering, electrical etc), thereby raising the gross markup to 375% in such cases. The intention was to fraudulently redirect the additional income for his personal use. This was achieved by the submission to AL and Co., on the completion of a job, of an invoice (for the 10% additional charge) in the name of a fictitious supplier of small tools and consumables. Director Y would code the associated costs as variable overhead in the accounting system. The timing of the invoices could easily be matched to the job completion dates in view of his knowledge of work schedules, and he set up a separate bank account in the fictitious name to receive these payments. You are an accountant in AL and Co. and have been assigned responsibility for liaison with the external auditors. You find that you are unable to resolve their concerns about the escalation in variable overhead expenses over the course of the last year, most of which have been charged to a non-local suppliers account. You are having difficulty clarifying the precise nature of the expenses incurred because telephone calls to the business number always request that a message be left but no calls are ever returned. All other aspects of the audit are satisfactory.

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Required:
Write a report for the Directors of AL and Co. that: Details the inadequacies of the current internal control system within the company and possible changes that could be made to improve the system; (10 marks) Explains why the rise in variable overhead costs is a matter of concern from both an external audit and an internal control perspective, and thus requires immediate agreement on a co-ordinated response to investigate the possibility of fraud; (5 marks) Briefly explains the limits of the responsibility of external auditors to detect fraud; (5 marks) Explains why the company should prepare a fraud response plan, and outlines the issues to be considered in drafting such a plan. (5 marks) (Total for Question Four = 25 marks)

Section B continues on the next page

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May 2005 7 P3

Question Five
SDT plc is a UK based manufacturer of a wide range of printed circuit boards (PCBs) that are used in a variety of electrical products. SDT exports over 90% of its production to assembly plants owned by large multinational electronics companies all around the world. Two companies (A and B) require SDT to invoice them in a single currency, regardless of the export destination of the PCBs. The chosen currencies are the Japanese Yen (Company A) and the US$ (Company B) respectively. The remaining export sales all go to European customers and are invoiced in Euros. The variable cost and export price per unit PCB are shown below. Market Company A Company B Europe Unit variable cost () 275 480 625 Unit export sales price Yen 63250 US$ 102678 Euro 12033

Goods are supplied on 60 day credit terms. The following receipts for export sales are due in 60 days: Company A Company B Europe Yen 9,487,500 US$ 82,142 Euro 66,181

The foreign exchange rates to be used by SDT in evaluating its revenue from the export sales are as follows: Spot market 2 months forward 3 months forward 1 year forward Yen/ 198987-200787 197667-200032 196028-198432 188158-190992 US$/ 17620-17826 17550-17775 17440-17677 16950-17311 Euro/ 14603-14813 14504-14784 14410-14721 14076-14426

The Managing Director of SDT believes that the foreign exchange markets are efficient and so the likelihood that SDT will make foreign exchange gains is the same as the likelihood that it will make foreign exchange losses. Furthermore, any exchange risk is already diversified across three currencies, each from countries in very different economic regions of the world. The Managing Director has therefore recommended that the Treasury Department should not hedge any foreign exchange risks arising from export sales.

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May 2005

Required: (a)
Critically comment on the validity of the views and recommendations expressed by the Managing Director and explain how currency hedging might nevertheless be beneficial to SDT. (6 marks) Calculate the sterling value of the contribution earned from exports to each of the customers (A, B and Europe) assuming that SDT (i) (ii) hedges the risk in the forward market; (3 marks) does not hedge the risk and the relevant spot exchange rates in two months time are as follows: Two month spot Yen/ 20018-20263 US$/ 17650-17750 Euro/ 14600-14680 (3 marks) (iii) aims to maximise its contribution to sales ratio, calculate the average contribution to sales ratio in each of the above scenarios and advise SDT accordingly on whether to hedge its foreign exchange exposure. (3 marks) (Total for requirement (b) = 9 marks)

(b)

(c)

Comment on why (based on relative risk analysis) a company might seek to generate higher rates of return from export sales compared to domestic sales. (6 marks)

(d)

If the payment from Company B is received late, briefly explain what risk SDT is taking in hedging Bs payment in the forward market, and how this risk could be avoided? (4 marks) (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 11 to 14

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PRESENT VALUE TABLE

Present value of $1, that is (1+ r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

May 2005

13

P3

Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

P3

14

May 2005

[this page is blank]

May 2005

15

P3

Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

May 2005

Thursday Morning Session

P3

16

May 2005

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

General Comments Overall, performance was in line with expectations. Well prepared candidates were capable of obtaining very clear passes. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. There was a tendency for the choice in the optional section to be biased towards numerical rather than discursive questions. While candidates should always select the questions with which they feel most comfortable, those preparing for future diets should take care to ensure that they are capable of writing about and explaining the issues covered in the syllabus. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam SECTION A 50 MARKS ANSWER THIS QUESTION Question 1 (a) Discuss the main categories of risk that are faced by a bank such as IDAN and the advantages of risk categorisation in the design of a risk management system. (10 marks) For every one of the six issues identified in the question, recommend the controls that might be introduced to minimise IDANs exposure to such risks. (15 marks) Compare and contrast the roles played by internal audit and risk management in organisations. Discuss the likely nature of the interaction between these two activities. (10 marks) The performance of the Managing Directors of the four types of business within IDAN is evaluated on the basis of the profits of their individual businesses. It has now been suggested by the Board that the strategy of the group, future investment opportunities and the profitability of each business should be evaluated against a risk-adjusted hurdle rate. (d) Critically discuss this suggestion by making reference to the information provided in the question. (15 marks)

(b)

(c)

Rationale Question One is designed to test the candidates ability to categorise risk, recommend appropriate controls in relation to such risks, recognise the function of internal audit and risk management and how hurdle rates may be used in the risk-return trade-off. The syllabus topics being tested are mainly B (Risk and Internal Control), C (ii, internal audit) and D (Financial Risk). The question meets the learning outcomes by providing a case study in the financial services industry which identifies trends and performance data. Candidates are expected to apply their understanding of risk management, internal control and internal audit to a financial services case. Suggested Approach Part (a): Candidates need to think about the likely risks facing a bank. While standard risk classifications are a useful start, particular issues facing banks will include credit risk in relation to money lent, trading on the derivatives market, reputational risk and compliance risk. The importance of classifications (e.g. market, operational, reputation, etc.) then needs to be explained in terms of how risk management is more easily handled with categories of risk rather than individual risks. Part (b): For each of the six issues, 2-3 examples of controls should be recommended to address the risks. Part (c): Candidates need to explain the roles undertaken by (i) internal audit and (ii) risk management, showing similarities and differences. They then need to explain interaction how each influences and is influenced by the other. Part (d): To critically discuss the performance of each type of business would require the calculation of RONA for each of the two years for each type of business. Candidates then need to interpret these figures in the light of the scenario information to relate profitability to risks and hurdle rates.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Marking Guide Part (a) Discussion of main categories of risk Advantages of risk categorisation for control Max awarded for part (a) Part (b) For each of the six issues Max awarded for part (b) Part (c) Compare and discuss roles played by internal audit and risk management Discuss interaction Note that the question asks about the role of the respective functions in any organisation, but for illustrative purposes only the solution uses IDAN to explain the pertinent issues Part (d) Computation of RONA for each business 2 years = 8 calculations at mark each Commentary Examiners Comments

Marks 6 6 10 3 marks each 15 4 6

4 11

Part (a) was generally answered well, with candidates identifying the risks that faced IDAN and suggesting suitable categories of risk. Part (b) was also answered well, with answers generally being linked to the scenario and with appropriate controls being suggested. The better answers to part (c) appeared to be based on an understanding of the roles of internal audit and risk management. Far too many answers were, however, based on the regurgitation of definitions and lists from study texts. Answers to part (d) were generally weak, with little apparent understanding of the concept of the riskadjusted hurdle rate. Better answers highlighted the differences between the risks faced by the four business units. Common Errors The most common problem was the tendency to regurgitate material that may or may not have been directly relevant to the scenario. Questions are unlikely to reward lists of facts or points memorised from texts and candidates should concentrate on applying such material to the question as set. Weaker answers also frequently lacked depth. For example, answers to part (c) frequently made no attempt to discuss the interaction between internal audit and risk management, choosing instead to discuss each in turn. Many of the controls suggested in part (b) were either unrealistic or impractical. For example, it is unlikely that banks and their customers would find it cost-effective to require PIN numbers to be collected in person from branches rather than distributed by post. Very few answers to part (d) derived any figures from the information available from the scenario. For example, a comparison of Return on Net Assets yields some interesting issues.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY Question 2 (a) Advise regional managers as to the risks facing BJP as a result of the lack of apparent control over sales representatives and their expenses and recommend the controls that should be implemented by regional managers to rectify this situation. (12 marks) Explain what an internal control system is, how it relates to the control environment and its likely costs, benefits and limitations. (8 marks) Recommend how analytic review could be used in the internal audit of BJPs sales representatives expenses. (5 marks)

(b)

(c)

Rationale Question Two is designed to test the candidates ability to make recommendations in relation to internal controls, understand the costs and benefits of internal control and show how analytic review can be used in internal audit. The syllabus topics being tested are mainly C (Review and Audit of Control Systems) and B (Internal Control Systems). The question meets the learning outcomes by providing a scenario of an organisation that appears to have little control over sales representative expenses. Candidates are expected to apply their understanding of risks, internal controls and internal audit to the scenario. Suggested Approach In answering this question, candidates need to be aware of the need to think beyond traditional accounting. Part (a): Candidates need to identify risks in relation to the activities of sales representatives (i.e. how they spend their time); and the incurrence of costs. 3-4 examples of controls need to be provided in relation to each of sales representative activity, expenses, and general controls (personnel, training, discipline, etc.) Part (b): This calls for an explanation of what a control system is, the control environment and each of the costs, benefits and limitations of control systems. Part (c): Examples of analytic review should be provided in terms of how they could be used in internal audit.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Marking Guide Part (a) Risks arising out of the apparent lack of controls and recommendations for controls in respect of: Sales activities Expenses claims/recording General controls Max awarded for part (a) Part (b) Explanation of internal control system and its components Control environment Costs, benefits & limitations of internal controls Max awarded for part (b) Part (c) Concept of analytic review and how it may be used in BJP Examiners Comments

Marks

5 (max) 5 (max) 5 (max) 12 3 (max) 3 (max) 4 (max) 8 5

This question was generally answered well, apart from the common weakness in part (a) discussed below. It is satisfying that a large proportion of candidates applied themselves to the questions requirements. Common Errors Answers to part (a) were generally weak because many candidates concentrated on sales representatives expenses and missed the wider issues associated with the freedom granted to the sales representatives. In part (b) few candidates appeared to know what a control environment was, often attempting to repeat a definition and being unable to add anything else to their answer.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Question 3 Write a formal report to the Board of AMF that: discusses the advantages and disadvantages of outsourcing the ERPS system as suggested above; (5 marks) identifies the main risks involved in outsourcing the ERPS and suggests how these risks might be mitigated through internal controls and internal audit; (10 marks) recommends the processes and controls that AMF should adopt to manage a project for successful transition to a chosen outsource supplier should that be the decision of the Board. (5 marks) (Total for Question Three= 25 marks including 5 marks for style, coherence and presentation of the report) Rationale Question Three is designed to test the candidates ability in relation to risk in information systems in general and outsourcing of IT in particular and show how internal controls and internal audit can mitigate the risk. The syllabus topics being tested are mainly E (Risk and Control in Information Systems). The question meets the learning outcomes by providing a scenario in which an ERPS system is to be outsourced. Candidates are expected to apply their understanding of IT systems, risk and control and to write a report identifying the advantages and disadvantages of outsourcing, evaluating the main risks and recommending appropriate controls. Suggested Approach As this question allocates 5 marks for a formal report, it should contain an introduction, conclusion, main heading, and a structure with sub headings. There should also be a logical flow to the report. The question calls for both advantages and disadvantages of outsourcing to be discussed. The main risks of outsourcing should be identified and for each of those main risks, suggestions should be made as to how it may be mitigated, and recommendations made regarding the implementation process and controls for transition to an outsource supplier. Marking Guide Structure, style, coherence and presentation Discussion of advantages and disadvantages Identification of main risks and mitigation Processes and controls to achieve successful transition Marks 5 5 10 5

The Chartered Institute of Management Accountants

Page 6

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Examiners Comments This question rewarded candidates who had taken care to read its requirements carefully and apply themselves accordingly. Common Errors A large number of candidates failed to write a report, as requested. In many cases, answers started off in a report format but failed to continue in that style. Clearly, this cost some of the marks offered for presentation. Answers often dealt with general issues associated with outsourcing, rather than focussing on the specifics of the successful operation of the system as described in the question. The question clearly asked for a discussion of the transition to a chosen outsourcing company and yet many candidates wrote in some detail about how a company should be chosen.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Question 4 Write a report for the Directors of AL and Co. that: Details the inadequacies of the current internal control system within the company and possible changes that could be made to improve the system; (10 marks) Explains why the rise in variable overhead costs is a matter of concern from both an external audit and an internal control perspective, and thus requires immediate agreement on a co-ordinated response to investigate the possibility of fraud; (5 marks) Briefly explains the limits of the responsibility of external auditors to detect fraud; (5 marks) Explains why the company should prepare a fraud response plan, and outlines the issues to be considered in drafting such a plan. (5 marks)

Rationale Question Four seeks to test the candidates ability to identify shortcomings in internal controls systems, and the parties responsible for fraud management and detection. By placing the question in the context of a small sized business, the need for fraud control across all types and sizes of business is emphasised. The syllabus topics being tested range across both B (Risk and Internal Control) and C (Review and Audit of Control Systems). Candidates are expected to recognise that control of directors is central to fraud management and to identify mechanisms for improving internal controls, as well as understand the limited role of the external auditors in relation to fraud detection. The design of a fraud response plan forms the final part of the question. Suggested Approach While this question asks candidates to write a report, no marks are allocated for structure, style, etc but candidates are encouraged to structure their answer in this format. Candidates need to comment on the inadequacies in the existing internal control system both generally in terms of the responsibility of directors and specifically in relation to the scenario. Possible improvements to those controls should be suggested and candidates need to think beyond traditional accounting controls. Candidates need to explain why variable overhead costs may be of concern particularly in relation to the suggestion of fraud, but explain the limited responsibility external auditors have to detect fraud. The need for a fraud response plan and issues to be addressed in responding to fraud should be covered in the answer.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Marking Guide General commentary on lack of controls and directors responsibilities re internal control Specific inadequacies of AL & Co. internal controls and recommended changes Auditors information requirements re assurance Current lack of audit trail raising suspicions of fraud Specification of external auditors responsibilities re fraud The case for a fraud response plan Issues to be considered in establishing a plan

Marks 10 5 5 5

Examiners Comments This was the least popular of the optional questions. Those candidates who attempted it at all tended to write relatively brief and under-developed answers. Common Errors Answers frequently identified weaknesses, but failed to suggest satisfactory controls. An unrealistic burden was placed on the internal audit department. The discussion of the concerns raised by the variable overhead was frequently written only from an internal audit perspective rather than the external audit and internal control aspects as required by the question. Discussion of the limits of the ability of the external auditor to detect fraud and of the fraud response plan was generally superficial, with many candidates demonstrating very poor knowledge of fraud response plans.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Question 5 (a) Critically comment on the validity of the views and recommendations expressed by the Managing Director and explain how currency hedging might nevertheless be beneficial to SDT. (6 marks) Calculate the sterling value of the contribution earned from exports to each of the customers (A, B and Europe) assuming that SDT (i) (ii) hedges the risk in the forward market; (3 marks) does not hedge the risk and the relevant spot exchange rates in two months time are as follows: Two month spot Yen/ 20018-20263 US$/ 17650-17750 Euro/ 14600-14680 (3 marks) (iii) aims to maximise its contribution to sales ratio, calculate the average contribution to sales ratio in each of the above scenarios and advise SDT accordingly on whether to hedge its foreign exchange exposure. (3 marks) (Total for requirement (b) = 9 marks)

(b)

(c)

Comment on why (based on relative risk analysis) a company might seek to generate higher rates of return from export sales compared to domestic sales. (6 marks) If the payment from Company B is received late, briefly explain what risk SDT is taking in hedging Bs payment in the forward market, and how this risk could be avoided? (4 marks)

(d)

Rationale Question Five tests the candidates understanding of the management of financial risk (syllabus section D) and specifically currency risk. A little over one third of the marks go for computational exercises, with the remaining marks allocated for critical commentary on various issues related to foreign exchange risk. Candidates are expected to understand the pros and cons of currency hedging and be able to interpret spot and forward rate data to estimate revenue flows. Understanding of the limitations of forward contracts is also tested. Additionally, candidates are asked to comment upon the relative risk:return requirements for domestic versus overseas sales.

The Chartered Institute of Management Accountants

Page 10

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2005 Exam

Suggested Approach Part (a): Candidates should critically comment on the Managing Directors approach to the risk of foreign exchange losses and the benefits of hedging. Part (b): For each of the 3 sections, candidates should carry out the appropriate calculation, showing all workings clearly. Part (c): Candidates should consider the differences between sales in the home country and those to export markets to explain why higher returns may be looked for. Part (d): The risk facing the company should be explained and how this risk could be mitigated. Marking Guide Part (a) Critical commentary on MDs views in respect of market efficiency and how currency hedging may be beneficial Part (b) (i) Computation (ii) Computation (iii) Computation and advice Part (c) Comment on reasons why a higher return may be sought on export sales Part (d) Risk being taken Methods of mitigating the risk Examiners Comments This was by far the most popular optional question. The quality of answers was very variable, with weaker attempts failing to focus on the questions requirements in any great depth. Common Errors Answers to (a) frequently ignored the MDs comments and simply made general points about world events or hedging techniques. A large number of candidates managed to score full marks for part (b). However, a substantial minority calculated sales values or contribution per unit rather than total contribution as required. Answers to part (c) were either extremely good or extremely poor, with poor answers demonstrating no real understanding of the matter. Marks 6

3 3 3 6

The Chartered Institute of Management Accountants

Page 11

Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

24 November 2005 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper, and if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. Answer the ONE compulsory question in Section A on pages 2 and 3. Answer TWO questions only from Section B on pages 4 to 7. Maths Tables and Formulae are provided on pages 9 to 12. These pages are detachable for ease of reference. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER
The Chartered Institute of Management Accountants 2005

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One
VCF is a small listed company that designs and installs high technology computer numerical control capital equipment used by multinational manufacturing companies. VCF is located in one Pacific country, but almost 90% of its sales are exported. VCF has sales offices in Europe, Asia, the Pacific, Africa, and North and South America and employs about 300 staff around the world. VCF has annual sales of $200 million but the sales value of each piece of equipment sold is about $2 million so the sales volume is relatively low. Sales are always invoiced in the currency of the country where the equipment is being installed. The time between the order being taken and the final installation is usually several months. However, a deposit is taken when the order is placed and progress payments are made by the customer before shipment and upon delivery, with the final payment being made after installation of the equipment. The company has international patents covering its technology and invests heavily in research and development (R&D, about 15% of sales) and marketing costs to develop export markets (about 25% of sales). VCFs manufacturing operations are completely outsourced in its home country and the cost of sales is about 20%. The balance of costs is for installation, servicing and administration, amounting to about 15% of sales. Within each of these cost classifications the major expenses (other than direct costs) are salaries for staff, all of whom are paid well above the industry average, rental of premises in each location and travel costs. Area managers are located in each sales office and have responsibility for achieving sales, installing equipment and maintaining high levels of after-sales service and customer satisfaction. Although the head office is very small, most of the R&D staff are located in the home country, along with purchasing and logistics staff responsible for liaising with the outsource suppliers and a small accounting team that is primarily concerned with monthly management accounts and end of year financial statements. VCF has a majority shareholding held by Jack Viktor, an entrepreneur who admits to taking high risks, both personally and in business. The Board of four is effectively controlled by Viktor who is both Chairman and Chief Executive. The three other directors were appointed by Viktor. They are his wife, who has a marketing role in the business, and two non-executive directors, one an occasional consultant to VCF and the other a long-time family friend. Board meetings are held quarterly and are informal affairs, largely led by Viktors verbal review of sales activity. Viktor is a dominating individual who exercises a high degree of personal control, often bypassing his area managers. Because the company is controlled by him, Viktor is not especially concerned with short-term profits but with the long term. He emphasises two objectives: sales growth to generate increased market share and cash flow; and investment in R&D to ensure the long-term survival of VCF by maintaining patent protection and a technological lead over its competitors. Viktor is in daily contact with all his offices by telephone. He travels extensively around the world and has an excellent knowledge of VCFs competitors and customers. He uses a limited number of non-financial performance measures, primarily concerned with sales, market share, quality and customer satisfaction. Through his personal contact and his twin objectives, Viktor encourages a culture committed to growth, continual innovation, and high levels of customer satisfaction. This is reinforced by high salary levels, but Viktor readily dismisses those staff not committed to his objectives.

P3

November 2005

The company has experienced rapid growth over the last 10 years and is very profitable although cash flow is often tight. A high margin is achieved because VCF is able to charge its customers premium prices. The equipment sold by VCF enables faster production and better quality than its competitors can offer. Viktor has little time for traditional accounting. Product costing is not seen as valuable because the cost of sales is relatively low and most costs incurred by VCF, particular R&D and export marketing costs, are incurred a long time in advance of sales being made. R&D costs are not capitalised in VCFs balance sheet. Although budgets are used for expense control and monthly management accounts are produced, they have little relevance to Viktor who recognises the fluctuations in profit caused by the timing of sales of low volume but high value capital equipment. Viktor sees little value in comparing monthly profit figures against budgets because sales are erratic. However, Viktor depends heavily on a spreadsheet to manage VCFs cash flow by using sensitivity analysis against his sales and cash flow projections. Cash flow is a major business driver and is controlled tightly using the spreadsheet model. The major risks facing VCF have been identified by Viktor as: competitor infringement of patents, which VCF always meets by instituting legal actions; adverse movements in the exchange rate between the home country and VCFs export markets, which VCF treats as an acceptable risk given that historically, gains and losses have balanced each other out; the reduction in demand for his equipment due to economic recession; a failure of continued R&D investment to maintain technological leadership; and a failure to control costs.

Viktor considers that the last three of these risks are addressed by his policy of outsourcing manufacture and continuous personal contact with staff, customers and competitors.

Required: (a)
Identify and evaluate the existing controls within VCF (including those applied by Viktor). (20 marks) Write a report to the Board of VCF recommending improvements to the companys corporate governance, risk management strategy, and internal controls. Note: You should use examples from the case to illustrate your answer. (20 marks)

(b)

(c)

Identify the exchange risks faced by VCF and recommend the methods that could be used to manage those risks. (10 marks) (Total for Question One = 50 marks)

End of Section A. Section B starts on the next page

TURN OVER
November 2005 3 P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two
As a CIMA member, you have recently been appointed as the Head of Internal Audit for SPQ, a multinational listed company that carries out a large volume of internet sales to customers who place their orders using their home or work computers. You report to the Chief Executive, although you work closely with the Finance Director. You have direct access to the Chair of the Audit Committee whenever you consider it necessary. One of your internal audit teams has been conducting a review of IT security for a system which has been in operation for 18 months and which is integral to internet sales. The audit was included in the internal audit plan following a request by the Chief Accountant. Sample testing by the internal audit team has revealed several transactions over the last three months which have raised concerns about possible hacking or fraudulent access to the customer/order database. Each of these transactions has disappeared from the database after deliveries have been made, but without sales being recorded or funds collected from the customer. Each of the identified transactions was for a different customer and there seems to be no relationship between any of the transactions. You have received the draft report from the Internal Audit Manager responsible for this audit which suggests serious weaknesses in the design of the system. You have discussed this informally with senior managers who have told you that such a report will be politically very unpopular with the Chief Executive as he was significantly involved in the design and approval of the new system and insisted it be implemented earlier than the IT department considered was advisable. No post-implementation review of the system has taken place. You have been informally advised by several senior managers to lessen the criticism and work with the IT department to correct any deficiencies within the system and to produce a report to the Audit Committee that is less critical and merely identifies the need for some improvement. They suggest that these actions would avoid criticism of the Chief Executive by the Board of SPQ.

Required: (a) (b)

Explain the role of internal audit in internal control and risk management. (5 marks) Analyse the potential risks faced by SPQ that have been exposed by the review of IT security and recommend controls that should be implemented to reduce them. (8 marks)

(c)

Discuss the issues that need to be considered when planning an audit of activities and systems such as the one undertaken at SPQ. (5 marks)

(d)

Explain the ethical principles you should apply as the Head of Internal Audit for SPQ when reporting the results of this internal review and how any ethical conflicts should be resolved. (7 marks) (Total for Question Two = 25 marks)

P3

November 2005

Question Three
A large doctors practice, with six partners and two practice nurses has decided to increase its income by providing day surgery facilities. The existing building would be extended to provide room for the surgical unit and storage facilities for equipment and drugs. The aim is to offer patients the opportunity to have minor surgical procedures conducted by a doctor at their local practice, thus avoiding any unfamiliarity and possible delays to treatment that might result from referral to a hospital. Blood and samples taken during the surgery will be sent away to the local hospital for testing but the patient will get the results from their doctor at the practice. It is anticipated that the introduction of the day surgery facility will increase practice income by approximately 20 per cent.

Required: (a)
Identify the additional risks that the doctors practice may expect to face as a consequence of the introduction of the new facility, and explain how a model such as CIMAs risk management cycle might be used to understand and control such risks. (12 marks) Explain the meaning of the term risk appetite and discuss who should take responsibility for defining that appetite in the context of the scenario outlined above. (5 marks)

(b)

(c)

Critically discuss the role of systems based internal auditing in relation to the assessment of risk management procedures in any organisation. (8 marks) (Total for Question Three = 25 marks)

Section B continues on the next page

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November 2005 5 P3

Question Four

(a)

LXN is a large book retailer in France and as a result of recent rapid sales growth has decided to expand by opening six new branches in the south of France. The estimated set up cost per branch is 250,000 and LXN wishes to raise the required funding (plus an additional 20 per cent for increased working capital requirements) via borrowing. The Treasurer at LXN is concerned about interest rate risk however, and is unsure about whether to opt for a fixed or floating rate loan. LXNs Board of Directors has indicated that it wishes to maximise the companys use of opportunities to hedge interest rate risk.

LXN currently has 2,000 million of assets and the following long-term debt in its balance sheet: 15 million [(6% fixed rate) redeemable 2010] 18 million [( Sterling LIBOR plus 3%) redeemable 2007] All rates are quoted as an annual rate. The current exchange rate is /0684.

Required:
Discuss the factors that should be taken into account by the Treasurer of LXN when deciding whether to raise fixed rate or floating rate debt for the expansion project and whether to hedge the resulting interest rate exposure. (10 marks)

(b)

LXNs Treasurer has negotiated a fixed rate of 6% or a variable rate of Euro LIBOR plus 15% for the required borrowing. In addition, a counterparty (MGV) has offered to convert any new fixed rate debt that LXN takes on into synthetic floating rate debt via a swap arrangement in which the two companies will share the quality spread differential equally.

MGV, the counterparty, can borrow at a fixed rate of 72% or at a variable rate of Euro LIBOR plus 25%. Euro LIBOR is currently 5%. All rates are quoted as an annual rate.

Required:
(i) Briefly discuss the advantages and disadvantages of interest rate swaps as a tool for managing interest rate risk. (5 marks) Draw a diagram to illustrate how the transactions between LXN and MGV and the two lenders will operate if the swap is agreed. (4 marks) Calculate the interest rate terms payable by LXN. Evaluate the potential annual saving resulting from borrowing at a fixed rate and engaging in an interest rate swap, as against a straightforward floating rate loan. (6 marks) (Total for requirement (b) = 15 marks) (Total for Question Four = 25 marks)

(ii)

(iii)

P3

November 2005

Question Five

Required: (a)
Identify the key reasons for the emergence of corporate governance regulations around the world. (5 marks) Explain the core principles that underpin corporate governance regulations. (10 marks)

(b)

(c)

Discuss the role and responsibilities of audit committees as laid down in the Combined Code. (10 marks) (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 9 to 12

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November 2005

November 2005

P3

PRESENT VALUE TABLE

Present value of $1, that is (1+ r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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10

November 2005

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

November 2005

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P3

Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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13

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November 2005

15

P3

Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

November 2005

Thursday Morning Session

P3

16

November 2005

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

General Comments Overall, performance was in line with expectations. Well prepared candidates were capable of obtaining very clear passes. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. Generally one of the main problems was a failure to relate the answers to the situation portrayed in the question. Good marks were achieved by candidates who did this. There was a tendency for the choice in the optional section to be biased towards discursive rather than numerical questions. While candidates should always select the questions with which they feel most comfortable, those preparing for future diets should take care to ensure that they are capable of performing all the calculations which may be required in the syllabus. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam SECTION A 50 MARKS ANSWER THIS QUESTION Question 1

(a)

Identify and evaluate the existing controls within VCF (including those applied by Viktor). (20 marks)

(b)

Write a report to the Board of VCF recommending improvements to the companys corporate governance, risk management strategy, and internal controls. Note: You should use examples from the case to illustrate your answer. (20 marks)

(c)

Identify the exchange risks faced by VCF and recommend the methods that could be used to manage those risks. (10 marks) (Total for Question One = 50 marks)

Rationale Question One is designed to test the candidates ability to identify and evaluate a range of internal controls, including those that are financial and non-financial, qualitative as well as quantitative. The question further tests the candidates ability to recommend improvements to corporate governance, risk management strategy and internal controls. This requires the candidate to apply knowledge of best practice in these areas to the facts of the case. The syllabus topics being tested are widespread, covering A (i), (iii) & (iv), B (iv), (v) and (vii), C (v) and (vi), D (i), (ii) and (vi). The question meets the learning outcomes by providing a case study of a small multinational distribution organisation that is controlled by a dominant individual. Candidates are expected to apply their understanding of management control, risk and internal controls to this case.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Suggested Approach a) This question is about identifying the controls that are described in the scenario. This includes nonfinancial and qualitative controls, not just financial controls. The question asks candidates to identify and evaluate. Most marks are given for evaluation, for example the strengths and weaknesses of the main controls. It is not necessary to discuss risks in detail here, although a brief mention of the major risks may help candidates in their evaluation, i.e. do the controls actually address the key risks or not. In answering the question, candidates need to recognise the social controls exercised by Viktor. Answers need to be specific, i.e. clearly related to the case, not general. b) This question requires candidates to give equal emphasis to each of corporate governance (especially the role and function of the Board); risk management strategy; and internal controls. A good report is likely to utilise the evaluation in the answer to part (a) but needs to make specific recommendations for improvement. It is insufficient to identify weaknesses in existing governance, risk management strategy and internal controls. Recommendations need to be specific, e.g. establish a risk register and assess risks by considering their likelihood and impact, rather than general such as improve risk management procedures. Although marks are not allocated for a report format, a report format will help candidates focus on the important aspects of the case in making specific recommendations to the Board. c) Although using a general classification structure such as transaction, translation and economic risk may be helpful, candidates are expected to identify the particular exchange risks faced by VCF and recommend methods for managing those particular risks. For each of parts (a), (b) and (c), candidates are required to apply their knowledge to the facts of the case, and it is insufficient to merely repeat either facts from the case or material from the study packs. Marking Guide (a) Identify AND evaluate existing controls (b) Recommendations (up to 8 marks for each of corporate governance, risk management strategy and internal controls) (c) Identify AND recommendations (up to 4 marks for each risk) Marks 20 20 10

Examiners Comments This question was reasonably well done. The best scripts synthesised corporate governance frameworks with the specifics of the question whereas weaker answers listed these points without connecting them to the scenario. A failure to evaluate the controls in part (a) led to poorer marks than expected for this section. The candidates were expected to discuss the specific controls and problems in the scenario not any others. Candidates who only discussed hedging instruments in part (c) did not achieve high marks. Common Errors Part (a) Most candidates identified existing controls but then failed to evaluate them. Good marks could only be achieved by in depth evaluation of the existing controls. The controls also had to be related to the case. Part (b) This part was generally well done. Detailed recommendations were required for each area highlighted in the question and most candidates achieved this. Many candidates in discussing risk management merely re-iterated the text book PEST acronym without relating it to the question. Part (c) This part was slightly poorer with many candidates only discussing various hedging instruments; this approach did not achieve high marks. Some candidates failed to discuss the problems identified in the scenario and discussed translation risk in great detail even although it did not affect VCF greatly.

The Chartered Institute of Management Accountants

Page 3

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY Question 2

(a) (b)

Explain the role of internal audit in internal control and risk management. (5 marks) Analyse the potential risks faced by SPQ that have been exposed by the review of IT security and recommend controls that should be implemented to reduce them. (8 marks)

(c)

Discuss the issues that need to be considered when planning an audit of activities and systems such as the one undertaken at SPQ. (5 marks)

(d)

Explain the ethical principles you should apply as the Head of Internal Audit for SPQ when reporting the results of this internal review and how any ethical conflicts should be resolved. (7 marks) (Total for Question Two = 25 marks)

Rationale Question Two is designed to test the candidates ability to explain the role of internal audit and to analyse and discuss the risks exposed by the internal audit of security in a newly implemented computer system. The question further tests the candidates ability to apply CIMAs ethical guidelines to the case. The syllabus topics being tested are mainly B (i) and (iii), C (ii), (iv) & (vii), E (iv) & (v). The question meets the learning outcomes by providing a scenario in which the Head of Internal Audit has to address the risks of an inadequately designed IT system in which there are ethical issues surrounding how these risks and weaknesses are reported. Candidates are expected to apply their understanding of risks, internal control, internal audit and ethics to the scenario. Suggested Approach a) Candidates need to explain the role of internal audit in relation to internal control and risk management. It is insufficient to merely describe each of these, but to demonstrate an understanding of how internal audit is used in each of the internal control and risk management processes. This question can be answered in general terms, without regard to the scenario in the case. The question requires candidates to interpret the risks faced by SPQ in the scenario. Candidates are expected to recognise the three categories of possible risk emerging from the review described in the scenario: failures in the systems development process; network failures resulting in possible hacking; and fraud, whether by employees or customers. Candidates should then analyse (i.e. examine in detail) each of these categories of risk. Candidates need to demonstrate an understanding of audit planning generally, although the scenario may be helpful in illustrating the importance of audit planning. The question requires candidates to demonstrate an understanding of the principles found in CIMAs Ethical Guidelines, and then to apply those principles to the facts of the case.

b)

c) d)

The Chartered Institute of Management Accountants

Page 4

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Marking Guide (a) Role of internal audit (b) Up to 4 marks for analysis of each of the three major areas of risk (systems development, network/operations, & fraud) (c) Discussion of issues in planning an audit (d) Explanation of ethical principles AND application to case

Marks 5 8 5 7

Examiners Comments This was one of the most popular of the optional questions and was well done by a substantial number of the candidates. The main problem encountered was where candidates failed to apply their knowledge to the case. General essays on ethics got poor marks. Good answers specifically discussed the problems in the scenario. Common Errors Part (a) Some candidates merely described internal control and risk management and failed to explain the role of internal audit in each. Part (b) This part of the question was generally well done. Part (c) This part of the question was well done by most candidates although few attempted to apply audit planning to the case. Most candidates simply replicated text book answers. Part (d) This part was poorly done by a number of candidates. Many had very short bullet point answers and made no attempt to apply the ethical principles to the case.

The Chartered Institute of Management Accountants

Page 5

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Question 3

(a)

Identify the additional risks that the doctors practice may expect to face as a consequence of the introduction of the new facility, and explain how a model such as CIMAs risk management cycle might be used to understand and control such risks. (12 marks) Explain the meaning of the term risk appetite and discuss who should take responsibility for defining that appetite in the context of the scenario outlined above. (5 marks)

(b)

(c)

Critically discuss the role of systems based internal auditing in relation to the assessment of risk management procedures in any organisation. (8 marks) (Total for Question Three = 25 marks)

Rationale Question Three is designed to test the candidates ability to identify risks within a particular context, explain possible tools for their control, and discuss the appropriateness of systems based internal audits for monitoring risk controls. The syllabus topics being tested are mainly B (Risk and Internal Control) and C (ii) and (iv) on internal audit. The learning outcomes are achieved by the creation of a mini scenario of a doctors practice that is expanding into a new area of work that carries different risks. Candidates are thus required to apply their knowledge of risk identification, risk management and internal audit to a specific case. Suggested Approach a) The key requirement here is to apply core knowledge, and this requires both some reflective thought and a recognition that common sense will help in drafting an answer. One way of approaching this would be to list the various categories of risks that you know from reading textbooks and then think about which specific categories might be affected by the introduction of day surgery facilities. The problem with this method is that you can get caught up in the limitations of the categories that you have learned. An alternative approach, which is the one used in the suggested solution, would be to simply identify all the factors you can think of that would change and potentially create new risks as a result of the new facility. Discussion of the CIMA risk management cycle, or an equivalent model should be used to explain how risk management involves the use of a control loop, which ensures the continual review of new risks and the effectiveness with which they are managed. It is important to ensure that you apply the description/explanation to the scenario in the question a theoretically based application will lead to reduced marks. The requirement here is very clearly specified, and the definition does not have to be regurgitated word for word from a study text. Understanding the syllabus will mean that you can create your own definition. Responsibility for defining risk appetite ALWAYS rests with the senior management in an organisation e.g. Board of Directors, and so in this case it lies with the practice partners. This is not an answer that you can waffle your way through you either know about systems based auditing or you dont, although a bit of common sense should give you some hint of what it is about. You should explain the systems that are used in risk management and clearly specify how they might be audited. The explanation will highlight the different roles played by risk managers and internal audit in the control of risk.

b)

c)

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam Marking Guide (a) Additional Risks identified Explanation of risk management cycle and its application to the scenario (b) Explanation and discussion of the term risk appetite (c) Explanation of systems based audit Critical discussion in relation to risk management Marks 6 6 5 3 5

Examiners Comments This was by far the least popular of the optional questions and was not particularly well done. It was surprising how very few candidates mentioned the CIMA risk management cycle or appeared to know what it was. Many candidates failed to appreciate that the medium sized doctors practice only did minor surgery not general surgery, which led to some unrealistic answers. Part (c) caused candidates huge problems and very few had acceptable answers. Common Errors Part (a) Candidates did not read the question closely and some gave answers which were unrealistic. Lack of knowledge of the CIMA risk management cycle was a problem. Or knowledge of any other credible risk management model. Part (b) This question was well done. Part (c) This part was very poorly answered. Very poor level of knowledge on systems based auditing or any other alternative approaches. Very vague answers by the majority of candidates who did this question.

The Chartered Institute of Management Accountants

Page 7

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Question 4

(a)

Discuss the factors that should be taken into account by the Treasurer of LXN when deciding whether to raise fixed rate or floating rate debt for the expansion project and whether to hedge the resulting interest rate exposure. (10 marks)

(b)
(i) Briefly discuss the advantages and disadvantages of interest rate swaps as a tool for managing interest rate risk. (5 marks) Draw a diagram to illustrate how the transactions between LXN and MGV and the two lenders will operate if the swap is agreed. (4 marks) Calculate the interest rate terms payable by LXN. Evaluate the potential annual saving resulting from borrowing at a fixed rate and engaging in an interest rate swap, as against a straightforward floating rate loan. (6 marks) (Total for Question Four = 25 marks)

(ii)

(iii)

Rationale Question Four tests a candidates understanding of the tools that may be used to manage interest rate risk. Within the context of a scenario that contains information on a companys existing capital structure, the first part of the question requires discussion of the relative merits of using fixed or variable rate borrowing to fund an expansion project. The syllabus topic being tested is D (i) (Management of Financial Risk). The second part of the question, which also carried more marks, tests understanding of the use of swaps to manage interest rate risk. The syllabus topics being tested are D (ii) and (iii). The separate elements of the sub-question on interest rate swaps test both theoretical and application skills, including computation. Suggested Approach a) As with Question Three, the correct approach is to apply your knowledge to the specific context and avoid answering the question from a purely textbook perspective. List the issues that matter in comparing fixed versus floating rate debt, and deciding whether or not to hedge relative cost; risk; scale of the borrowing; interest rate forecasts etc and then discuss these in the specific context given in the question. Dont forget there are two elements to the question. The mark split between the different parts of (b) is small and so be careful about allocation of time. In particular do not spend too long on drawing the diagram for part (ii) as it carries the least marks. In (i) remember to identify disadvantages as well as advantages of swaps. In (iii) the quickest way of computing the saving is to firstly work out the new interest rate, and then simply multiply the sum borrowed by the incremental saving of 0.1%.

b)

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Page 8

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Marking Guide (a) Two marks for each factor identified AND discussed. (b) Advantages and disadvantages Diagram Net interest rates payable Resulting saving

Marks 10 5 4 4 2

Examiners Comments This question was the second least popular. Some excellent answers to this question and some dreadful ones. It was disappointing to note a lack of understanding of interest rate swaps. Some very poor attempts at calculations. There are very few numerical topics in the syllabus but it is important that candidates are prepared for these. Had this been a compulsory question the results would have been very variable. Common errors Part (a) Most candidates could identify factors which might influence the treasurers decision but did not discuss them in any detail. Higher marks could have been achieved with more focussed discussion. Part (b) Presentation of the diagram was generally poor. Many candidates could not perform the calculations required. There were some very poor attempts.

The Chartered Institute of Management Accountants

Page 9

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam

Question 5

(a)

Identify the key reasons for the emergence of corporate governance regulations around the world. (5 marks)

(b)

Explain the core principles that underpin corporate governance regulations. (10 marks)

(c)

Discuss the role and responsibilities of audit committees as laid down in the Combined Code. (10 marks) (Total for Question Five = 25 marks)

Rationale Question Five is a straightforward test of knowledge of corporate governance regulations and falls into syllabus section B (vii) on risk and internal control. Parts (a) and (b) of the question are phrased in a generic style that tests overall understanding of the reasons for the development of governance regulations and requires discussion of their link to risk management. Part (c) requires more detailed understanding of the UK regulations as laid down in the Combined Code with specific reference to the role of the audit committee. Suggested Approach a) Do not get bogged down in discussing the question from the angle of one specific geographical location the question takes a global perspective and so should your answer. The reasons behind tighter regulations lie in poor transparency and a need to renew shareholder confidence via greater accountability. b) The core principles can be divided into various categories that can be used as a framework for your answer there are the role and appointment of directors, and their remuneration arrangements; accountability and audit and relations with shareholders. c) Role and responsibilities are separate components in this question and both must be addressed in order to gain maximum marks. Your answer should make specific reference to the requirement for an audit committee under the Combined code, and detail its separate responsibilities in respect of both internal control and the external auditors. Marking Guide (a) Reasons for emergence of regulations (b) Core principles identification AND explanation in each case (c) Roles and responsibilities of the audit committee as per the Combined code marks for each point identified and discussed Examiners Comments This question was generally very well done. There were some excellent answers. Most candidates did very well particularly in part (c). Marks 5 10 10

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2005 Exam Common Errors Part (a) Some candidates only mentioned recent corporate scandals and did not get high marks as a wider answer was expected. Some discussion of other factors was required.

The Chartered Institute of Management Accountants

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

25 May 2006 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper, and if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. Answer the ONE compulsory question in Section A on pages 2 and 3. Answer TWO questions only from Section B on pages 4 to 7. Maths Tables and Formulae are provided on pages 9 to 12. These pages are detachable for ease of reference. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER
The Chartered Institute of Management Accountants 2006

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One
The GHI Group is a major listed travel company based in the UK, with a market capitalisation of 200 million, that specialises in the provision of budget-priced short and long haul package holidays targeted at the family market. The term package holiday means that all flights, accommodation and overseas transfers are organised and booked by the tour operator on behalf of the customer. The GHI Group encompasses a number of separate companies that include a charter airline, a chain of retail travel outlets, and several specialist tour operators who provide package holidays. Each subsidiary is expected to be profit generating, and each companys performance is measured by its residual income. The capital charges for each company are risk adjusted, and new investments are required to achieve a base hurdle rate of 10% before adjustment for risk. The package holiday market is highly competitive, with fewer than five main players all trying to gain market share in an environment in which margins are continually threatened. The key threats include rising fuel prices, last minute discounting and the growth of the self managed holiday, where individuals by-pass the travel retailers and use the Internet to book low cost flights and hotel rooms directly with the service providers. Also, customer requirements regarding product design and quality are continuously changing, thereby increasing the pressure on travel companies to devise appropriate strategies to maintain profitability. Sales of long haul packages to North America are relatively static, but the number of people travelling to South East Asian destinations has fallen substantially following the 2004 tsunami disaster. Africa, New Zealand, Australia and certain parts of the Caribbean are the only long haul growth areas, but such growth is from a small base. Sales within the European region are shifting in favour of Eastern Mediterranean destinations such as Cyprus and Turkey as the traditional resorts of Spain and the Balearic Islands fall out of favour. Short city breaks are also growing rapidly in popularity, reflecting higher spending power particularly amongst the over 50s. The shift in patterns of demand has created some problems for GHI in a number of Eastern Mediterranean resorts over the last two summer seasons. There are not many hotels that meet the specified quality standards, and consequently there is fierce competition amongst travel operators to reserve rooms in them. In 2002 GHI took out a three year contract (2003-2005 inclusive) for 10,000 beds in four major hotels over the peak holiday season of mid July end of August. The contract terms required GHI to pay a 20% refundable deposit at the start of each calendar year, in return for the right to cancel unwanted rooms without penalty at just one weeks notice. These contract terms were selected in preference to an alternative which required a 5% guarantee payment at the start of the calendar year, but with two weeks notice for all cancellations, and the payment of a flat fee of 20 per week per cancelled room. On three occasions in 2003, and six occasions in 2004, approximately 150 holidaymakers booked through GHI arrived at their hotels only to find that their rooms were already occupied by clients from a rival company. GHIs resort representative had severe problems relocating their customers, and over half of them were forced to move to inland hotels because all of the beach resorts were fully booked. The total compensation paid out by GHI to dissatisfied customers amounted to 135,000 in 2003 and 288,000 in 2004, and these payments were categorised as exceptional costs in the published accounts. The problems encountered by GHI received extensive coverage in the UK media, a popular television travel programme provided assistance to holidaymakers to compile compensation claims. As a result of all of this adverse publicity, GHI decided in early 2005 to invest 8 million
P3 2 May 2006

in purchasing two new hotels in the affected resorts. Sales forecasts indicate demand will grow at approximately 15% per year in the relevant resorts over the next five years. It is anticipated that the hotels will supply 70% of the groups accommodation requirements for the 2006 season. The package holidays to the GHI owned hotels will be sold as premium all-inclusive deals that include all food, soft drinks and local beers, wines and spirits. Such all-inclusive deals are not currently offered by other hotels in the target resorts.

Required: (a)
Identify and briefly discuss two risks that are likely to be faced by the GHI Group under each of the following categories: Financial Political Environmental Economic (16 marks)

(b)

Identify and evaluate risk impact upon GHIs financial statements and cash flow management of choosing to purchase its own overseas hotel properties as opposed to block booking rooms from local suppliers under the terms of the 2003 2005 contract. (15 marks) Identify and comment upon the changes in risks to GHI Group that might arise from the decision to sell premium all-inclusive deals, and suggest methods by which these risks might be monitored and controlled. (8 marks) Explain, using the investment in the new hotels as an example, how strategic decisions can simultaneously affect both performance measurement and capital allocation across a number of different companies within a group such as GHI. (6 marks)

(c)

(d)

(e)

List the tasks that the internal audit department of GHI should have performed to ensure that the risks associated with the new hotel purchases are managed effectively. You should assume that its involvement commenced immediately the strategic decision was made to purchase overseas property - in other words, prior to identification of target sites. (5 marks) (Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A. Section B starts on page 4

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May 2006 3 P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two

(a)

Warren Buffett, the stock market investor, views derivatives as a time bomb, but many corporate treasurers clearly perceive them as very useful tools for reducing risk.

Required:
Explain and discuss the reasons for such divergent viewpoints. (13 marks) The International Accounting Standard on Financial Instrument Recognition and Measurement (IAS 39) includes a fair value option that permits a company to designate certain types of financial instruments as ones to be measured at fair value on initial recognition, with changes in fair value recognised in profit or loss. The designation is irrevocable. Additionally, all financial assets and liabilities held for trading are measured at fair value with the associated changes in value passing through profit and loss. This method of accounting is defended on the grounds that it ensures that the disclosures better reflect the risks that are being taken, thereby improving the information available to the stock market.

Required: (b)
Explain the additional risks arising from these rules that may be faced by companies which choose to exercise the fair value option and/or regularly trade derivatives for profit. (5 marks)

(c)

An investor owns a portfolio of shares that has varied in value over the last twelve months between 15 million and 18 million. All stock is highly liquid and can be sold within one day. The daily profit and loss distribution is assumed to be normally distributed with a mean of zero and a standard deviation of 60,000.

Required:
(i) Explain the meaning of the term value at risk from the perspective of a fund manager. (4 marks) (ii) Calculate and comment upon the value at risk of the portfolio, assuming a 95% confidence level and a one day holding period. (3 marks) (Total for Question Two = 25 marks)

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May 2006

Question Three
LMN is a charity that provides low-cost housing for people on low incomes. The government has privatized much of the home building, maintenance and management in this sector. The sector is heavily regulated and receives some government money but there are significant funds borrowed from banks to invest in new housing developments, on the security of future rent receipts. Government agencies subsidise much of the rental cost for low-income residents. The board and senior management have identified the major risks to LMN as: having insufficient housing stock of a suitable type to meet the needs of local people on low incomes; making poor property investment decisions; having dissatisfied tenants due to inadequate property maintenance; failing to comply with the requirements of the regulator; having a poor credit rating with lenders; poor cost control; incurring bad debts for rental; and having vacant properties that are not earning income. LMN has produced a risk register as part of its risk management process. For each of more than 200 individual risks, the risk register identifies a description of the risk and the (high, medium or low) likelihood of the risk eventuating and the (high, medium or low) consequences for the organisation if the risk does eventuate. The management of LMN is carried out by professionally qualified housing executives with wide experience in property development, housing management and maintenance, and financial management. The board of LMN is composed of volunteers with wide experience and an interest in social welfare. The board is representative of the community, tenants and the local authority, any of whom may be shareholders (shareholdings are nominal and the company pays no dividends). The local authority has overall responsibility for housing and social welfare in the area. The audit committee of the board of LMN, which has responsibility for risk management as well as internal control, wants to move towards a system of internal controls that are more closely related to risks identified in the risk register.

Required:
For an organisation like LMN:

(a)

Discuss the purposes and importance of risk management and its relationship with the internal control system. (8 marks) Explain the importance of a management review of controls for the audit committee. (5 marks)

(b)

(c)

Discuss the principles of good corporate governance as they apply to the Boards role (i) (ii) in conducting a review of internal controls; and reporting on compliance. (12 marks)

Illustrate your answer with examples from the scenario. (Total for Question Three = 25 marks)

Section B continues on the next page

TURN OVER
May 2006 5 P3

Question Four
HIJ is a new company that provides professional services to small businesses. Apart from the Principal, a qualified accountant who owns 100% of the business, there are four professionally qualified and two support staff. The business model adopted by HIJ is to charge an annuallynegotiated fixed monthly retainer to its clients in return for advice and assistance in relation to budgeting, costing, cash management, receivables and inventory control, and monthly and annual management reporting. The work involves weekly visits to each client by a member of staff and a monthly review between HIJs Principal and the chief executive of the client company. In delivering its client services, HIJ makes extensive use of specialist accounting software. The Principal continually carries out marketing activity to identify and win new clients. This involves advertising, production of brochures and attending conferences, exhibitions, and various business events where potential clients may be located. The management of HIJ by its Principal is based on strict cost control, maximising the chargeable hours of staff and ensuring that the retainers charged are sufficient to cover the hours worked for each client over the financial year.

Required: (a)
Recommend management controls that would be appropriate for the Principal to have in place for HIJ. (12 marks) Discuss the need for various types of audit that are appropriate for HIJ. (8 marks)

(b)

(c)

Discuss the costs and benefits for HIJ that are likely to arise from a system of internal controls (5 marks) (Total for Question Four = 25 marks)

Section B continues on the opposite page

P3

May 2006

Question Five
CDE is a manufacturer of almost one hundred different automotive components that are sold in both large and small quantities on a just-in-time (JIT) basis to the major vehicle assemblers. Business is highly competitive and price sensitive. The company is listed on the stock exchange but CDEs share performance has not matched that of its main competitors. CDEs management accounting system uses a manufacturing resource planning (MRPII) system to control production scheduling, inventory movements and stock control, and labour and machine utilisation. The accounting department carries out a detailed annual budgeting exercise, determines standard costs for labour and materials, and allocates production overhead on the basis of machine utilisation. Strict accounting controls over labour and material costs are managed by the detailed recording of operator and machine timesheets and raw material movements, and by calculating and investigating all significant variances. While the information from the MRPII system is useful to management, there is an absence of integrated data about customer requirements and suppliers. Some information is contained within spreadsheets and databases held by the Sales and Purchasing departments respectively. One result of this lack of integration is that inventories are higher than they should be in a JIT environment. The managers of CDE (representing functional areas of sales, production, purchasing, finance and administration) believe that, while costs are strictly controlled, the cost of the accounting department is excessive and significant savings need to be made, even at the expense of data accuracy. Managers believe that there may not be optimum use of the production capacity to generate profits and cash flow and improve shareholder value. CDEs management wants to carry out sensitivity and other analyses of strategic alternatives, but this is difficult when the existing management accounting system is focused on control rather than on decision support.

Required: (a)
(i) (ii) Outline the different types of information system available to manufacturing firms like CDE; and Recommend with reasons the information system that would be appropriate to CDEs needs. (10 marks)

(b)

Given the business environment that CDE faces, and the desire of management to reduce the cost of accounting, (i) (ii) critically evaluate the relevance of the current management accounting system; and recommend how the system should be improved. (15 marks) (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 9 to 12

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May 2006 7 P3

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May 2006

May 2006

P3

PRESENT VALUE TABLE

Present value of $1, that is (1+ r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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10

May 2006

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

May 2006

Thursday Morning Session

P3

16

May 2006

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam

General Comments Overall, performance was poorer than expected. Well-prepared candidates were capable of obtaining very clear passes. Weaker candidates tended to not answer the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. There were fewer clear passes than expected in this paper. Generally one of the main problems was a failure to relate the answers to the situation portrayed in the question. High marks were achieved by candidates who did this. When information is given in the scenario candidates will be expected to use it to illustrate the main issues in their answer. Candidates should ensure they use the reading time to read the questions carefully. There was a tendency for the choice in the optional section to be biased towards more general risk management questions and for candidates to avoid the more specific questions. Very few candidates attempted Question Two but those who did tended to gain high marks, as they were well prepared for the topic. While candidates should always select the questions with which they feel most comfortable, those preparing for future diets should take care to ensure that they are capable of answering questions on all areas of the syllabus. Avoiding Question Two left candidates with little choice for the other optional questions. Please note that the marking guide included in this Post Exam Guide often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam SECTION A 50 MARKS ANSWER THIS QUESTION Question 1

(a)

Identify and briefly discuss two risks that are likely to be faced by the GHI Group under each of the following categories: Financial Political Environmental Economic (16 marks)

(b)

Identify and evaluate risk impact upon GHIs financial statements and cash flow management of choosing to purchase its own overseas hotel properties as opposed to block booking rooms from local suppliers under the terms of the 2003 -2005 contract. (15 marks) Identify and comment upon the changes in risks to GHI Group that might arise from the decision to sell premium all-inclusive deals, and suggest methods by which these risks might be monitored and controlled. (8 marks) Explain, using the investment in the new hotels as an example, how strategic decisions can simultaneously affect both performance measurement and capital allocation across a number of different companies within a group such as GHI. (6 marks)

(c)

(d)

(e)

List the tasks that the internal audit department of GHI should have performed to ensure that the risks associated with the new hotel purchases are managed effectively. You should assume that its involvement commenced immediately the strategic decision was made to purchase overseas property - in other words, prior to identification of target sites. (5 marks) (Total for Question One = 50 marks)

Rationale Question One tests a candidates ability to identify and evaluate the risk implications of strategic decisions. The decisions to switch from using local hoteliers to owning and managing company owned hotels, whilst simultaneously introducing new premium products both carry lots of potential risks of a financial and non-financial nature. The question also requires candidates to understand the inter group impact of such key decisions, particularly in relation to both performance measurement and capital allocation. The question requires application of knowledge rather than regurgitation of facts as is typical of all Section A questions to date. The main syllabus topics being tested are B (i) and (ii) which cover the identification of risks and their measurement and assessment. Part (b) specifically tests syllabus section D(i) on evaluation of financial risks, and the Review and Audit of Control Systems (syllabus section C) is tested in part (e) of the question.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam

Suggested Approach (a) The question guided candidates on possible risk categories to be used in this part of the answer and a lot of information was included in the question about specific types of risk. The use of categories to structure an answer helps avoid the risk of repetition and hence wasted time. The requirement was for only two risks in each category but this point was missed by many candidates. (b) The route to marks here was to note the significant key terms of financial statements and cash flow management. The question does not require repetition of part a) because it focuses specifically on the risks arising from the hotel purchase. Muddling the answer to include the premium packages does not gain any extra marks. Answers need to be very specific about which financial statement is being impacted and how. (c) As with (b) this question focuses on a specific issue, namely the introduction of the premium packages. Generic answers covering a whole range of risks will gain no additional marks. Additionally, care needs to be taken to offer solutions to the identified risks as well as commentary on them. (d) Easy marks can be collected by referring to the capital rationing that might impact on other divisions as a result of the investment decision, The main points to note are the interdependency of group performance and individual company performance and hence the potential need to review the whole performance measurement system. (e) Candidates need to show a good understanding of the role of the internal audit function, as opposed to the risk management function. The two roles are interrelated but different, and good answers will focus on the verification of control mechanisms not on control design. Marking Guide (a) Types of risks under various categories (b) Potential impact of hotel purchases on P & L, balance sheet and cash flow statements and management Marks 2 per relevant risk 1 mark for each risk plus bonus mark for linking to specified financial statement 4 4 3 3 5 ( max 2 for general discussion)

(c) New risks from product change ( premium packages) Methods of control (d)Explanation of interdependence Localised impact /risk changes (e) Internal audit tasks

Examiners Comments This question was reasonably well answered. One common failing was candidates not answering the exact question asked. Some general answers on risk were given particularly in parts (c) and (e). High marks were only awarded where the question was answered in full and related back to the scenario.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam Common Errors (a) (b) This part of the question was done well by most candidates. The suggested structure was used, however many candidates did not put the risks under the correct categories. Many candidates did not answer the requirement to relate their answer to the effect the decision to purchase hotels would have on the financial statements. As a result they failed to get high marks. Most candidates correctly identified a number of the risks but failed to mention how these could impact on the financial statements. Many candidates wasted valuable time performing calculations when none were required. Many candidates failed to focus on the risks of the premium package and merely listed generic risks of running a new hotel. Specific answers were required which related back to the scenario. Few candidates went into enough detail on the performance measurements required. Many candidates missed out this part of the question. The part of the question relating to the implications of the large capital investment on capital rationing throughout the group were answered in more detail, with many candidates getting reasonable marks. This was the section which was done least well in question 1. Many candidates did not restrict themselves to the risks, which would be most likely to occur before the project was undertaken. Many candidates wrote about risks that could occur after the hotels were opened. Many candidates also only wrote about controls they would design rather than verifying that risks were being properly managed.

(c) (d)

(e)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY Question 2

(a) (b)

Explain and discuss the reasons for such divergent viewpoints. (13 marks) Explain the additional risks arising from these rules that may be faced by companies which choose to exercise the fair value option and/or regularly trade derivatives for profit. (5 marks)

(c)
(i) Explain the meaning of the term value at risk from the perspective of a fund manager. (4 marks) (ii) Calculate and comment upon the value at risk of the portfolio, assuming a 95% confidence level and a one day holding period. (3 marks) (Total for Question Two = 25 marks)

Rationale Question Two covers a range of topics that fall within Section D of the syllabus - Managing Financial Risk. The focus is on derivatives because a number of recent corporate scandals have brought this issue to the attention of the media. Candidates need to understand that derivatives are a very useful tool for reducing financial risk, but failure to control their use can also be very dangerous. Part (b) tests a candidates understanding of the financial reporting risks that may result from trading derivatives rather than just using them as a hedging tool. Understanding of the costs and benefits of a specific control system (syllabus section B (vi)) Value at Risk- is tested in the final part of this question, which also tests numerical understanding of this risk measure. Suggested Approach (a) A good answer will clearly explain what is meant by the term derivative, and include simple definitions. This will be followed by a well balanced explanation and discussion of the alternative perspectives. Derivatives are widely used tools to manage and reduce risk, but their price volatility and gearing element means that they are inherently risky when used for trading. The discussion should reach a conclusion that both points of view are valid and that without both speculators and hedgers the liquidity of derivatives markets would be very low. Some marks could be gained for simply using the information given in the question that changes in fair value are recognised in profit and loss. A good answer required understanding of the methods used to obtain fair value, and the potential volatility of such values which will impact profits even when unrealised. (i) This was not a question to guess at as although widely used, Value at Risk is a highly specific concept. The term fund manager is important in framing an answer as many funds need continual growth in value but changes in fair value could impede this. (ii) There are two requirements here- to calculate and comment upon, both of which earn marks. The calculation required knowledge of the number of standard deviations required for 95% confidence limit and needed use of the tables. The comment requires consideration of the size of the VaR relative to the value of the portfolio and a decision on whether it is large enough to worry about.

(b)

(c)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam Marking Guide (a) Alternative types of derivatives and their uses Equal split of marks for discussion of each viewpoint (b) Risks from IAS 39 rules (c) (i) Explanation of VaR (ii) Calculation and commentary Marks 3 10 5 4 3

Examiners Comments This was the least popular of all the optional questions. Clearly many candidates had not learned this area of the syllabus. Common Errors This was the least popular of all the questions and was done by very few candidates. (a) This part was done very well by most candidates. Some candidates however only discussed derivatives from a hedging perspective and did not mention speculation; these candidates did not attain high marks. It was essential that both perspectives were discussed to fully answer the question. This part was very poorly answered. Several marks could be gained by using information in the scenario. Many candidates did not seem to understand the role of derivatives except for hedging. Candidates did not appear to have much knowledge of the financial reporting requirements for derivatives. Many candidates missed out this part of the question. This was a straightforward calculation and was done very badly. Some revision of this whole topic would benefit candidates in the future.

(b)

(c)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam

Question 3 For an organisation like LMN:

(a)

Discuss the purposes and importance of risk management and its relationship with the internal control system. (8 marks) Explain the importance of a management review of controls for the audit committee. (5 marks)

(b)

(c)

Discuss the principles of good corporate governance as they apply to the Boards role (i) (ii) in conducting a review of internal controls; and reporting on compliance. (12 marks)

Illustrate your answer with examples from the scenario. (Total for Question Three = 25 marks)

Rationale Question Three is designed to test the candidates ability to identify the purposes of risk management and how risk management relates to internal controls. The question also requires candidates to demonstrate their knowledge of a management review of controls undertaken for the audit committee. Finally, the question requires candidates to demonstrate the principles of corporate governance in relation to the Boards role in reviewing internal controls and reporting on compliance. The syllabus topics being tested are mainly B (iii) (Risk and Internal Control); Management review of controls C (i) and the role of governance in relation to controls C (vi). The learning outcomes are achieved through the scenario of a charity in which the major risks have already been identified. Candidates are required to apply their knowledge of risk management and internal controls to this scenario. Suggested Approach (a) The question requires candidates to break down the requirements and address each in turn, by discussing examining in detail the three elements in the question. First, the purposes of risk management. This is about risk identification and assessment in order to determine appropriate risk responses. Second, the importance of risk management improving the ability to respond to risks and to achieve its objectives. Third, the relationship between risk management and internal controls, particularly that internal controls should be developed as an outcome of the risk management process. (b) Candidates need to show that they understand that management review of controls is a process carried out by management to self-evaluate the organisations control system and how this is one of the pieces of evidence, supplemented by audit reports and other independent sources, to enable the Board to evaluate the effectiveness of the internal controls. (c) Candidates need to show an understanding of the principles of good corporate governance as it relates to the Boards review of internal controls, through an Audit Committee. This involves an assessment of risks and their significance, and how effective controls are in relation to those risks. The second part of the question is in relation to the annual requirement for the Board to report to shareholders that they have reviewed controls and the issues that they have taken into account in that review.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam Marking Guide (a) Purpose and importance of risk management, and relationship between risk management and internal control (b) Management review of controls for Audit Committee (c) (i) Review of internal control (ii) Report on compliance Marks 8 5 8 4

Examiners Comments This was the most popular of the optional questions and was not done particularly well. Some candidates appeared to have difficulty applying Corporate Governance principles to an organisation which was not a listed company. The main problem was that candidates did not relate their answer back to the scenario. Common Errors This question is a good example of candidates not answering what was asked. Candidates should make full use of reading time to ensure they understand what is being asked. When there is a scenario, candidates should usually try and relate their answer to the information given. (a) (b) This part was done well by most candidates. The most common error was for candidates to discuss the role and structure of the audit committee rather than answer the question. The question required candidates to comment on the importance of self-evaluation of management internal controls by management. The audit committee has a role to play in this but general comments on the structure and other roles of the audit committee were not rewarded. The most common error was for candidates not to take account of information in the scenario. The charity was a stakeholder organisation and was not a listed company. Many candidates simply wrote everything they knew about Corporate Governance and internal control. This strategy was not rewarded. The answer should have been related back to the circumstances of the charity.

(c)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam

Question 4

(a)

Recommend management controls that would be appropriate for the Principal to have in place for HIJ. (12 marks) Discuss the need for various types of audit that are appropriate for HIJ. (8 marks)

(b)

(c)

Discuss the costs and benefits for HIJ that are likely to arise from a system of internal controls (5 marks) (Total for Question Four = 25 marks)

Rationale Question Four tests a candidates ability to apply management controls to a small professional services firm controlled by a single Principal. Candidates need to understand the different types of audit that may be appropriate for this firm and be able to compare the costs and benefits of a system of internal control. The syllabus topics being tested are A (i) (Recommend appropriate management control systems); a plan for the audit of organisational activities C (iii) and the costs and benefits of internal controls B (vi). Suggested Approach (a) As in scenario questions relating to controls in previous examinations, candidates are expected to recommend controls that are financial, non-financial but quantitative and qualitative. Specific examples of controls under each of these three headings should be given by candidates. (b) Candidates should demonstrate a broader understanding of audit, particularly as it applies to a small business. Examples could include cost audits, internal audits, management audits, etc. The need for each type of audit should be discussed in terms of the risks facing the business described in the scenario. (c) Candidates should identify both costs and benefits of an internal control system, which when applied to the scenario will include opportunity costs (for example, management time, loss of income, etc.) whilst candidates should recognise that many internal controls are simply good business practice. Marking Guide (a) 4 marks for each of financial, quantitative and qualitative controls (b) Need for various types of audit (c) Costs and benefits of internal controls Marks 12 8 5

Examiners Comments Again candidates had difficulty in applying their knowledge to the scenario. This was a very small organisation run by a qualified accountant with several other qualified accountants on the staff. Many candidates suggested they required an internal audit department. Others went to the other extreme and suggested all stationery invoices of over 2 should be checked by the Principal and signed by the company accountant. Clearly neither is appropriate. Reading the scenario and planning a sensible answer bearing in mind the organisation in the question, would be a huge benefit to candidates.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam (a) Some candidates did not discuss management controls but went into great detail on the need for receipts to be checked and for mileage checks. Otherwise, this part of the question was well done by the majority of candidates. Many candidates did not relate their answer to the scenario. They just listed many types of audit and wrote about them. A good answer would have related the need for various types of audit back to the scenario and discussed those in terms of the risks facing that particular type of business. Clearly an internal audit department is neither feasible nor necessary. Financial audit is not a requirement unless the organisation is a limited company and of a reasonable size. Careful reading of the scenario and an answer plan would help candidates with these questions. This part of the question was answered well by most candidates.

(b)

(c)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam

Question 5

(a)

(i) (ii)

Outline the different types of information system available to manufacturing firms like CDE; and Recommend with reasons the information system that would be appropriate to CDEs needs. (10 marks)

(b)

Given the business environment that CDE faces, and the desire of management to reduce the cost of accounting, (i) (ii) critically evaluate the relevance of the current management accounting system; and recommend how the system should be improved. (15 marks) (Total for Question Five = 25 marks)

Rationale Question Five provides the scenario of a manufacturer and candidates are required to outline different kinds of information systems that are available and recommend the most suitable to meet the needs of the company identified in the scenario. In the second part of the question, candidates are required to critically evaluate the relevance of the management accounting system described in the scenario and recommend improvements to that system. The syllabus topics being tested are evaluation of strategies to support management controls E (i) and the evaluation of IT systems appropriate to an organisations needs E (ii). Suggested Approach (a) Candidates should first briefly list the different types of information system, such as transaction processing, MIS, ERPS, SEM and EIS then recommend, with reasons, the most suitable given the scenario. (b) Candidates should demonstrate an understanding of the business environment in the scenario by evaluating showing the value of the current system, that is, its strengths and weaknesses. In doing so, the second part of this question gives candidates the opportunity to recommend, with reasons, how the system should be improved. In both cases, recommendations should address managements desire to reduce the cost of accounting. Answers could address budgeting, overhead allocation, costing, variance analysis, backflushing, etc. Marking Guide (a) Different information systems Recommendation of most appropriate (b) Evaluation of current system and recommendations (1 mark per point) Marks 6 4 Max 15

Examiners Comments This question was also poorly answered. Part (a) was reasonable with many candidates listing sensible information systems; however the second part of this was poor. Many candidates did not give reasons for their choice of the most appropriate system and did not achieve a high mark. Part (b) was also poor as candidates failed to address the cost of accounting. Again, careful reading of the scenario pays dividends.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2006 Exam Common Errors (a) While most candidates listed several types of information system many failed to give sensible reasons for choosing one particular system. This section was not very well done. Many candidates failed to critically evaluate the present system and did not mention ways of reducing the high cost of accounting. (b) Some knowledge of strategic management accounting was expected. Usually when the question requires recommendations to be made it suggests there are some problems with the existing system. Many candidates were in favour of the existing system and saw no need to change.

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

23 November 2006 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper, and if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. Answer the ONE compulsory question in Section A on pages 2 and 3. Answer TWO questions only from Section B on pages 4 to 7. Maths Tables and Formulae are provided on pages 9 to 12. These pages are detachable for ease of reference. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER
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P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One
BLU is a stock market listed manufacturing company that has historically invested in computer numerical control (CNC) equipment to manufacture a range of electronic components for the telecommunications industry. BLUs strategic objective is to increase shareholder value through an annual increase in sales revenue of 15% and an annual increase in after-tax profits of 17.5%, both of which have been achieved over the past three years. This objective is strongly promoted within BLU and senior management bonuses are linked to the achievement of those targets. In early 2006, the following financial justification was presented to the Board of Directors of BLU to support a proposal for capital investment in new CNC manufacturing equipment: Projected cash flows for new equipment 2007 all figures in 000 Additional sales income 12,000 Additional variable costs 3,600 Additional fixed costs 1,500 Additional operating profit 6,900 Less taxation Additional operating cash flow 6,900 Less additional working capital 1,000 Additional cash flow 5,900 Cost of capital Present value of future cash flows Less capital cost of new equipment Net present value 15% 19,398 17,500 1,898

2008 13,000 3,900 1,500 7,600 2,070 5,530 300 5,230

2009 14,000 4,200 1,500 8,300 2,280 6,020 400 5,620

2010 15,000 4,500 1,500 9,000 2,490 6,510 500 6,010

2011 16,000 4,800 1,500 9,700 2,700 7,000 600 6,400

It is company policy to evaluate investments over the first five years only. In March 2006, the Board approved the capital investment as it met its minimum criterion of a positive NPV using a cost of capital of 15%. There was one other project that was competing for funds at that time. This was for a new distribution system. However, this project was rejected by the Board because the NPV was lower than that of the CNC equipment. Later in 2006, the audit committee asked a firm of consultants to review BLUs capital investment approval process and the information system that informs that process. As part of the first stage of the consultants review, a draft report has been received by the Board that describes the process but as yet does not make any recommendations. The following are extracts from the consultants draft report: BLU has a Market Research Department that looks at economic, industry and competitive factors affecting the market demand for its products in order to forecast market growth and likely market share during BLUs strategic planning horizon of five years. As part of its assessment, the Market Research Department asks the Sales Department to liaise with its largest customers to determine their likely requirements. The Sales Department forecasts sales based on its own knowledge of its market, including information from existing customers and its plan to win new customers. Having collated the available information, the Market Research Department provides the Production Department with annually updated forecasts of market demand for the next five years.
P3 2 November 2006

 The Production Department compares the Market Research Departments forecasts with its production capacity based on past experience of volumes, product mix, and cycle times. The Production Department then determines the capacity gap over the next five years, which it defines as the difference between the capacity required to satisfy forecasts of market demand and its existing practical capacity. Based on the capacity gap, the Production Department conducts a search for new CNC manufacturing equipment that will satisfy projected sales. A range of alternative suppliers is considered and prices for the equipment are compared, after which the Production Department identifies the supplier and the equipment deemed most suitable to bridge the capacity gap. The capital costs of new equipment and the capacity of this new equipment are calculated by the Production Department. The Finance Department accepts the forecasts of market demand from the Market Research Department and the cost and capacity information from the Production Department. It then uses historical cost information to update standard costs of labour and materials, with advice from the Human Resources and Purchasing Departments respectively about likely increases in the price of labour and materials. The Finance Department makes its own assessments about the additional working capital requirement. The Finance Department then completes a discounted cash flow calculation to assess the investment in new capital equipment, which is then presented to the Board of Directors as part of the annual budget cycle. BLU uses a cost of capital of 15% for the assessment of new capital expenditure proposals. This is the benchmark figure used by the Board, which has been in use for several years. Proposals that show a positive net present value are likely to be approved and where there are competing proposals for limited capital funds, the project with the highest NPV is usually selected. The Boards capital investment approval criteria are well known by BLUs managers.

Required:
Note: No calculations are required to answer this question.

(a)

Analyse the risks facing BLU in relation to (i) its investment appraisal and approval process; and (ii) the information system feeding that process. (20 marks)

(b)

Explain how, as an internal auditor, you would plan an audit of BLUs existing capital investment process (and the information system feeding that process), highlighting those elements of the process that you would pay particular attention to under a risk-based approach. (10 marks) Recommend to the Board of BLU the internal controls that should be introduced to improve BLUs capital investment process (including the information system feeding that process) and explain the benefits of your recommended controls. (20 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks) TURN OVER

(c)

November 2006

P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two
STU is a large distribution business which provides logistical support to large retail chains. A significant problem currently faced by STU is the number of legacy systems1 in use throughout the organisation. The various legacy systems, each of which tends to be used by a single business function, hold data that is inconsistent with other systems, leading to an inconsistent approach to decision making across the business. The problem is made worse by many managers having developed their own PC-based databases and spreadsheets because of the lack of suitable information produced by the legacy systems. STUs Board of Directors has recently approved the feasibility study presented by the Finance Director for the in-house development of a new Strategic Enterprise Management (SEM) system. The SEM system will use real-time data entry to collect transaction data from remote sites to maintain a data warehouse storing all business information which can then be accessed by various analytical tools to support strategic decision making. The SEM system will be developed and implemented over a three year period within a budget approved by the Board. Three phases have been identified: design of the new system; development of the software; and delivery of the finished system into business units. The Board considers that designing, developing and delivering the SEM system will be crucial to business growth plans in a competitive environment.
1

Note: A legacy system is a computer system which continues to be used because the information it provides is critical to a business. However, the high cost of replacing or redesigning the system has led to it being retained by the business. It is typically an older design, is not compatible with more up-to-date software, and because of its age, provides information that is not as complete or reliable as it should be.

Required: (a)
Assuming that you are STUs Head of Internal Audit, recommend the actions that should be taken in connection with the design, development and delivery of the SEM system. (13 marks) Advise the audit committee of STU about (i) (ii) possible approaches to auditing computer systems; and the controls that should exist in an IT environment. (12 marks) (Total for Question Two = 25 Marks)

(b)

Section B continues on the opposite page

P3

November 2006

Question Three
The following information relates to two companies based in the United States of America, both of which are listed on the New York stock exchange. Each company had an annual turnover of approximately $800 million in 2005. Company A This company sells into a mix of business-to-business and end-user markets across a total of 15 countries in North America and Europe. Business-to-business sales predominate and 40% of turnover comes from two key European customers. Manufacturing, assembly and delivery is managed geographically rather than by product type, via three separate subsidiaries with their own CEO based in Canada, France and the UK respectively. Research and all Treasury operations for the arrangement of loan finance and hedging of foreign exchange risk are both fully centralised. The company has a diverse shareholder base that includes two major pension funds, one of which has a representative entitled to be present as an observer at the board meetings of Company A. Company B This company operates in the same product market as Company A, but earns most of its income from end user sales, many of which are initiated by on-line direct orders. 80% of the internet sales originate in the United States of America. Companys Bs largest single customer, a Canadian company, represents 15% of its annual sales revenue, but no other customer exceeds 1% of total sales. Research and sales facilities are based at the US headquarters, but manufacturing and assembly is all undertaken by separate subsidiaries in China, where the company also has a joint venture business that manages all the global distribution. Treasury operations are fully decentralised, but run as cost rather than profit centres. The company was started ten years ago, and the Board of Directors remains dominated by members of the founding family. The CEO and the Finance Director are husband and wife, and together own 35% of the companys shares.

Required:
Using the information contained in the above scenario to develop your arguments, answer each of the following questions:

(a)

Discuss how decisions about company structure, market types and location can impact upon the risk profile of a company. (12 marks)

(b)

Compare and contrast the risks associated with the differing approaches to the Treasury function adopted by the two companies in the above scenario. (4 marks) For either Company A or Company B as described in the scenario, taking into account its current structure and size, recommend one example of each of financial, non-financial quantitative, and non-financial qualitative controls that may be useful tools in monitoring exposure to either strategic or operational risks. You should briefly justify your choices. (9 marks) (Total for Question Three = 25 marks)

(c)

TURN OVER
November 2006 5 P3

Question Four
MNO is a UK based company that has delivered goods, invoiced at $1,800,000 US dollars to a customer in Singapore. Payment is due in three months time, that is, in February 2007. The finance director of MNO is concerned about the potential exchange risk resulting from the transaction and wishes to hedge the risk in either the futures or the options market. The current spot rate is $1695/. A three month futures contract is quoted at $1690/, and the contract size for $/ futures contracts is 62,500. A three month put option is available at a price of $1675.

Required: (a)
Assuming that the spot rate and the futures rate turn out to be the same in February 2007, indicating that there is no basis risk, identify the lowest cost way of hedging the exchange rate risk (using either futures or options) where the exchange rate at the time of payment is: (i) $1665/ (ii) $1720/ Note: Your answer should show all the calculations used to reach your answer, including the extent (if any) of the uncovered risk. (10 marks)

(b)

Briefly discuss the problems of using futures contracts to hedge exchange rate risks. (6 marks) Identify and explain the key reasons why small versus large companies may differ in terms of both the extent of foreign exchange and interest rate hedging that is undertaken, and the tools used by management for such purposes. (9 marks) (Total for Question Four = 25 marks)

(c)

Section B continues on the opposite page

P3

November 2006

Question Five

Required:
Write a report advising the Board of Directors of a stock market listed company on: the key responsibilities of Board members in relation to ensuring the effectiveness of internal controls; the methods used to assess such effectiveness; and the regulations that govern the reporting to the stock market of the results of internal control reviews.

An indicative mark allocation for the three points above are 5, 10 and 5 marks respectively. (Total for Question Five = 25 marks) (includes 5 marks for report format and style)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 9 to 12

TURN OVER
November 2006 7 P3

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November 2006

November 2006

P3

PRESENT VALUE TABLE

Present value of $1, that is (1+ r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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November 2006

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

November 2006

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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November 2006

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November 2006

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Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

November 2006

Thursday Morning Session

P3

16

November 2006

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

General Comments Overall, performance was in line with expectations. Well prepared candidates were capable of obtaining very clear passes, it was pleasing to see some candidates achieve exceptionally good marks. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. Generally one of the main problems was a failure to relate the answers to the situation portrayed in the question. Good marks were achieved by candidates who did this. There were no questions noticeably avoided by candidates. Candidates should always select the questions with which they feel most comfortable, however those preparing for future diets should take care to ensure that they are capable of answering questions on all areas of the syllabus. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam SECTION A 50 MARKS ANSWER THIS QUESTION

Question 1

(a)

Analyse the risks facing BLU in relation to (i) its investment appraisal and approval process; and (ii) the information system feeding that process. (20 marks)

(b)

Explain how, as an internal auditor, you would plan an audit of BLUs existing capital investment process (and the information system feeding that process), highlighting those elements of the process that you would pay particular attention to under a risk-based approach. (10 marks) Recommend to the Board of BLU the internal controls that should be introduced to improve BLUs capital investment process (including the information system feeding that process) and explain the benefits of your recommended controls. (20 marks) (Total for Question One = 50 marks)

(c)

Rationale Question One is a manufacturing scenario and is designed to test the candidates ability to look behind the numbers in a capital investment proposal and to recognise that, despite the apparent accuracy implied by a net present value calculation, the assumptions leading to the estimates of future cash flows may be very questionable. The question requires no calculations, but is one where candidates are expected to interpret the numbers and to think about the risks in the capital investment process and the information system that produces the forecast cash flows. The question goes on to ask candidates to plan an internal audit of the capital investment process, based on the risks identified in response to the first part of the question. Finally, candidates are expected to recommend internal controls to improve the capital investment process, and to explain the benefits of those controls. The learning outcomes tested are mainly B (i) and B (v) in relation to risks and internal control, C (iii) for an internal audit plan, A (iv) in relation to control systems generally, and E (iv) which is specific to information systems. This is a good example of a scenario that cuts across four of the five syllabus areas.

Suggested Approach Requirement (a) requires candidates to identify the risks. Each element of the scenario needs to be considered in terms of the risks. Risks relating to both the investment appraisal process and the information system should be identified and as in previous examinations these risks should not be limited to accounting or financial ones. The risks are largely concerned with the subjectivity of the forecasts, the use of historic information and the unquestioning acceptance of information and assumptions. Requirement (b) requires candidates, based on the assessment of risks, to plan an internal audit on the basis of those risks. This would involve scoping the audit with the specific approach taken consistent with the risks identified in (a). Requirement (c) then requires candidates to recommend internal controls that are consistent with the risks identified, so again these would primarily focus on improving forecasts, introducing more objective methods and questioning the assumptions used in both the capital investment process and the information system feeding that process. Part (c) also requires candidates to explain the benefits of the recommended controls. The benefits must relate to how the controls are likely to reduce the risks. NOTE: Answers are not sufficient to pass if they are lists of generic risks, audit approaches and internal controls. The answers MUST be related to the scenario.
The Chartered Institute of Management Accountants Page 2

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Marking Guide 1 (a) Identifying risks of information system Identifying risks for capital investment approval process 1 (b) Scoping the audit with marks for each element identified in the audit plan 1 (c) Identifying internal controls Identifying benefits of each control

Marks 10 10 10 10 10

Examiners Comments Candidates must use the reading time to make sure they understand what is being asked. The questions are quite specific and general answers will get poor marks. The answers should always relate to the scenario. Part (a) was generally done well by most candidates. Part (b) was done poorly by many candidates. Some candidates appeared to misinterpret the question and went into great detail about examining invoices and checking arithmetic. This was not what was required. The approach to the internal audit was what was required. Many candidates did not mention scoping the audit and others did not relate the answer to the scenario. Part (c) was not answered well either, with a number of candidates identifying the internal controls but not mentioning the benefits of the controls. Common Errors Part (b) Not relating the planning of the audit to the scenario was the most common error. Generic answers relating to audit planning did not get high marks. Some candidates answered as if it was external audit and again did not achieve high marks. Part (c) Again this answer had to refer to the scenario. A generic answer got poor marks. While the internal controls would normally relate to the risks identified in part (a), an answer which repeated the answer to part a, did not get high marks.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY

Question 2

(a)

Assuming that you are STUs Head of Internal Audit, recommend the actions that should be taken in connection with the design, development and delivery of the SEM system. (13 marks) Advise the audit committee of STU about (i) (ii) possible approaches to auditing computer systems; and the controls that should exist in an IT environment. (12 marks) (Total for Question Two = 25 Marks)

(b)

Rationale Question Two is a scenario of a distribution business implementing a strategic enterprise management (SEM) system. This is designed to test candidates ability to understand the role of internal audit and internal controls in the design, development and delivery of a new IT system and candidates are expected to make recommendations in relation to a project management structure to ensure that the design, development and delivery of the SEM is effective. The question also requires candidates to advise the audit committee about approaches to the audit of computer systems and the controls that are particularly relevant to an IT environment. The learning outcomes tested are mainly E (iv) and (v) in relation to improving the control and audit of information systems and C (iii) a plan for the audit.

Suggested Approach Requirement (a) expects candidates to recommend actions in relation to a computer system involving the design, development and delivery. It would be almost impossible to satisfactorily answer this question without a project management-type approach that covers each of these stages, including design acceptance through steering committees, management support for the project, resourcing, quality control, risk management, approval and testing, etc. Whilst many elements of project planning will be generic, answers must be related to the scenario. Requirement (b) asks candidates to advise about possible approaches to auditing computer systems and controls in an IT environment. Answers need to be related specifically to IT systems hence computer security, data entry, control self assessment, embedded audit etc. would all be appropriate. In terms of controls, IT system controls should encompass personnel, physical, input/process/output, network and business continuity, etc. As with all such questions, it is important to give reasons to support your advice.

Marking Guide 2 (a) Marks allocated for each action identified 2 (b) Approaches to auditing computer systems with reasons Controls in an IT environment with reasons

Marks 13 6 6

Examiners Comments This question was answered well by most candidates.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam Common Errors Part (a) - Some candidates did not relate their answer to the scenario. Part (b) - Some candidates did not relate their answer to an IT environment. To gain high marks answers should have specifically concentrated on auditing and IT. Some candidates only discussed general approaches to audit and got poor marks. The reasons for these controls should have been discussed in depth, again many candidates failed to discuss controls in any detail.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Question 3 Using the information contained in the above scenario to develop your arguments, answer each of the following questions:

(a)

Discuss how decisions about company structure, market types and location can impact upon the risk profile of a company. (12 marks)

(b)

Compare and contrast the risks associated with the differing approaches to the Treasury function adopted by the two companies in the above scenario. (4 marks) For either Company A or Company B as described in the scenario, taking into account its current structure and size, recommend one example of each of financial, non-financial quantitative, and non-financial qualitative controls that may be useful tools in monitoring exposure to either strategic or operational risks. You should briefly justify your choices. (9 marks) (Total for Question Three = 25 marks)

(c)

Rationale Question Three is a question about two US listed companies that have different structures, strategies and markets. The question is intended to test candidates understanding of how decisions about corporate strategy work to influence decisions on structure and marketing. All of these issues will in turn influence the design of performance management systems and risk exposure. Other elements of the question require consideration of the relative risks of centralisation versus de-centralisation of the treasury function, and recommendations of a range of financial and non financial controls suitable for managing the risks identified in the company scenarios. The learning outcomes being tested in this question are B (i) and (ii) in relation to risk identification and assessment, A (ii) which tests evaluation of controls, and C (v) on recommendations of actions to improve controls.

Suggested Approach Part (a) requires discussion of the impact of different types of structures, strategies, markets and location upon a companys risk profile. The question does not ask for discussion of the specific risk profile of each company in the scenario, but for generic comment on each issue. For example the issue of market types could be discussed by reference back to the fact that Company A operates in markets that are diversified both by customer type and location, but risk is increased by dependence upon two key customers. The issues of market type, relative significance of particular customers and access to markets are all relevant here. Part (b) requires straightforward discussion of the pros and cons of centralising the treasury function. This does not simply mean writing down two directly opposite perspectives eg more efficient versus less efficient. To gain full marks four separate issues have to be discussed. Part (c) requires the candidate to select just ONE of the scenario companies and suggest ONE control in each category, with brief justification. Attention should be given to the need for both qualitative and quantitative non-financial controls, and answers need to include specific suggestions. Comments such as profit monitoring are insufficiently precise to gain a pass mark on this section.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Marking Guide Link between structure and strategy Company structure impact on risk Market types and location linked to risk profile (max of 3 marks if not linked to risk) Centralised ( pros and cons) De- centralised (pros and cons) Each type of control 1 mark for identification and 2 for discussion Examiners Comments This question was answered reasonably well by most candidates. Common Errors

Marks 2 4 6 2 2 Max 3 each

Part (a) The link to strategy should have been clearly made in the answer. Some candidates ignored this completely. Part (b) Some candidates only mentioned opposites for pros and cons. This meant that only half the marks were available to them. Part (c) This part of the question was well answered.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Question 4

(a)

Assuming that the spot rate and the futures rate turn out to be the same in February 2007, indicating that there is no basis risk, identify the lowest cost way of hedging the exchange rate risk (using either futures or options) where the exchange rate at the time of payment is: (i) $1665/ (ii) $1720/ Note: Your answer should show all the calculations used to reach your answer, including the extent (if any) of the uncovered risk. (10 marks)

(b) (c)

Briefly discuss the problems of using futures contracts to hedge exchange rate risks. (6 marks) Identify and explain the key reasons why small versus large companies may differ in terms of both the extent of foreign exchange and interest rate hedging that is undertaken, and the tools used by management for such purposes. (9 marks) (Total for Question Four = 25 marks)

Rationale Question Four tests understanding of the techniques available for managing foreign exchange risk via the use of either futures contracts or options. The questions tests both numerical and discursive knowledge of the topic, and also the factors that may influence a companys decision to hedge foreign exchange risk, including company size. The syllabus topics being tested all fall within Part D of the syllabus, which covers management of financial risk. The learning outcomes being tested are (vi), requiring recommendation of currency risk management strategies, (iii) which requires evaluation of alternative risk management approaches and (ii) on identification and evaluation of alternative approaches to financial risk management. It is recognised that there is strong overlap between (ii) and (iii).

Suggested Approach Part (a) requires the completion of calculations relating to BOTH options and futures transactions, including the computation of the size of the option premium. The futures element should be approached by assessing the required number of contracts, the amount left unhedged and then calculation of the outcome at the given exchange rate. The options calculation must include a conclusion on the efficacy of exercising or not exercising the option. Part (b) requires explanation of the problems of using futures contracts, and includes issues such as minimum contract size, inflexibility of both timing and value, and the cash flow implications of margin payments. Part (c) asks for discussion of the reasons why small and large firms differ in their approaches to both foreign exchange and interest rate hedging. The question is open to slightly different interpretations insofar as it could be read as asking why the tools used differ according to company size. Alternatively it could be read as asking simply for some detail on hedging tools. In the marking process both approaches were given full credit.

The Chartered Institute of Management Accountants

Page 8

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Marking Guide Options calculations Futures contract number - unhedged amount - Outcomes ( 2 per case) Problems of hedging using currency futures - 2 marks per point as Solution, but must discuss) Tools used for hedging Differences between small and large companies

Marks 4 1 1 4 6 Max 3 6

Examiners Comments Few candidates used the correct rates in all sections of the question in part (a). This was disappointing. Very few candidates attempted to calculate the premium on the option. Common Errors Part (a) Very few candidates achieved the high marks expected in this question. Some revision of this area of the syllabus is recommended. The premium on the option was tricky to calculate but few candidates made any attempt to do so. Many candidates adopted the approach of just using all the rates in the hope one would be correct, this approach got few marks. Part (b) This part was done well by most candidates. Part (c) Candidates were unclear as to the most appropriate methods of hedging for small and large companies.

The Chartered Institute of Management Accountants

Page 9

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam

Question 5

Write a report advising the Board of Directors of a stock market listed company on: the key responsibilities of Board members in relation to ensuring the effectiveness of internal controls; the methods used to assess such effectiveness; and the regulations that govern the reporting to the stock market of the results of internal control reviews.

An indicative mark allocation for the three points above are 5, 10 and 5 marks respectively. (Total for Question Five = 25 marks) (includes 5 marks for report format and style)

Rationale Question Five provides candidates with a chance to display their knowledge of governance regulations in relation to board of director responsibilities regarding internal controls. The question covers responsibilities in the areas of ensuring control effectiveness, methods used to assess effectiveness and the reporting of internal control reviews to the stock market. The suggested solution is drafted from the perspective of a UK listed company, but other international contexts are acceptable. The question tests basic knowledge rather than the application of knowledge to a particular scenario. The learning outcomes being tested in this question are from Section C of the syllabus, namely C (i), which requires understanding of the importance of management review of controls, and C (vi) and C (vii) which cover the principles of good corporate governance for listed companies and the importance of ethical principles in reporting on internal reviews.

Suggested Approach The key to a good mark in answering this question is to take care over the wording which is very precise. The question requires discussion of issues relating to the effectiveness of internal controls, and it is not on the general issue of what is meant by internal control, or broader aspects of corporate governance. Key responsibilities requires discussion of the boards role in appointing an audit committee and establishing an internal audit function to assess control effectiveness. The part on methods requires discussion of the way in which internal control is managed, and its relationship to the Audit Committee and Board of Directors. In reporting on regulations it is not adequate to simply mention the existence of the Combined Code and Sarbanes Oxley. The question requires discussion of the requirement to report on the completion of an internal control review.

Marking Guide Report format and style Key responsibilities Discussion of internal audit and audit committee roles re effectiveness Discussion of the regulations on what has to be reported re internal control effectiveness

Marks 5 5 10 5

Examiners Comments It was pleasing to see so many candidates getting good marks for the report format and style. However the candidates strayed from what was asked in the question.

The Chartered Institute of Management Accountants

Page 10

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2006 Exam Common Errors Many candidates did not discuss the effectiveness of internal control. This was the key requirement of the question. Many candidates discussed internal audit and audit committees in detail, but this did not answer the question. Marks were generally poorer than expected for this question Again candidates must read the questions carefully and make sure they answer what is asked.

The Chartered Institute of Management Accountants

Page 11

Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

24 May 2007 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 and 3. Answer TWO questions only from Section B on pages 4 to 11. Maths Tables and Formulae are provided on pages 13 to 16. These pages are detachable for ease of reference. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER
The Chartered Institute of Management Accountants 2007

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One
ACB is a stock exchange listed company that designs and assembles small passenger aircraft which it sells to regional airlines throughout the world. ACB is highly regarded by its airline customers for the quality of its aircraft. ACB is also recognised for meeting contractual commitments through on-time delivery. The company generates profits before interest and taxes of about 5% of sales. However, due to the depressed nature of the airline industry and competition from foreign manufacturers, the company has modest growth targets. About 60 aircraft are delivered each year. Competitive Advantage The companys competitive advantage is its ability to take a standard aircraft design and customise it to the varying needs of its customers. This includes, for example, changes in engine size, passenger capacity, configuration, and electronic equipment. The cycle time from signed order to delivery is about 18 months. Pricing and Sales Terms ACB sets the price of its completed aircraft in the customers currency. The fixed price is converted to ACBs home currency using exchange rates applicable at the time contracts are signed. Progress payments are made on order and throughout the production process, but the balance of approximately 60% of the selling price of the aircraft is made on delivery to the airline. Any delivery delays are classed as a breach of ACBs contract for which it incurs significant financial penalties. Production and Supply Chain The manufacture of all the aircraft components has been subcontracted to about 200 suppliers located across several continents. The cost of purchased components constitutes 70% of the final aircraft selling price. Suppliers are selected on the basis of quality, reliability and cost. Contracts with each supplier include prices established in the suppliers currency and incorporate price increases and anticipated efficiency savings over the next two years. This enables accurate forecasting of material costs by ACB. As each component is produced to satisfy the differing requirements of each aircraft, any delay in receipt of any component will delay final assembly. A distribution company has the contract to transport all components to ACBs factory and a combination of bar-coding and satellite tracking technology enables the precise location of all components to be tracked from despatch through to receipt by ACB. There are five major production operations at ACBs factory: four relate to component assembly and one to final assembly. The four component assembly operations are fuselage, wings, engines, and electronics. All four component assemblies are brought together in a large hangar where the final aircraft assembly takes place. ACB operates its factory on a just-in-time (JIT) basis to minimise inventory. Production scheduling for each of the four component assembly operations must be integrated so that the final assembly can take place on schedule. IT Support ACB uses a sophisticated enterprise resource planning system (ERPS) to manage its supply chain, purchase ordering, production scheduling, accounting and performance management, and customer relationship management. The company also relies on an electronic data interchange (EDI) system to track component purchase orders from their despatch by suppliers to receipt at ACBs factory. Quality Control Aircraft manufacture is highly regulated with stringent quality control and safety requirements. ACB has always maintained the highest standards. The governments Aircraft Inspection
P3 2 May 2007

Agency makes regular inspections of component and final assembly quality in order to ensure annual re-licensing of ACB as an aircraft manufacturer. Costing & Pricing The cost of each aircraft is estimated from a bill of materials for components and a labour routing, both of which take into account the customisation of each aircraft. Price negotiations follow the cost estimation process and discounts are given for quantity and the significance of the customer to ACB in terms of past and anticipated sales. Overhead costs are traced to products through an activity-based costing system, based on cost drivers established for eight significant business processes. Profits are calculated for each aircraft and each order (which may be for several aircraft) and customer profitability analysis is used to support future sales efforts. Risk Management and Governance The company has a Risk Management Group at senior management level that maintains a register of major risks, carries out risk assessments in terms of their likelihood and consequences, identifies appropriate risk responses, and reports to each meeting of the Audit Committee. IT risks and foreign currency exposures require highly specialised attention and responsibility for these risks is delegated to the IT Department and Treasury Department respectively. The ERPS and EDI systems are managed by the in-house IT department which has longserving and highly skilled staff who have developed comprehensive operating procedures and business continuity plans. ACBs Treasury department primarily uses matching techniques to offset foreign exchange exposures in each currency but does use forward contracts where exposures in some currencies are deemed unacceptable. The Board of Directors emphasises strategy and monitors sales and delivery performance. It aims to ensure that sales are spread evenly over different regions so as not to be disproportionately affected by political or economic changes. The general approach to risk management is to have a portfolio of customers, products and suppliers, so as to minimise sensitivity to any one factor that might jeopardise the companys success. The Board reviews assessments made by the Aircraft Inspection Agency and is actively involved in rectifying any problems identified. The companys Audit Committee, composed of independent directors, monitors the risk assessments made by managers, ensures that internal controls are adequate and approves the companys internal audit plan each year. The Audit Committee also monitors all monthly financial performance information while the internal audit function spends a considerable proportion of its resources ensuring that financial performance information produced by the ERPS is accurate for management decision-making and financial reporting purposes.

Required: (a)
State the recommended components of any organisations risk management strategy and evaluate ACBs approach to risk management in terms of those components. (12 marks) Identify the major categories of risk facing ACB and evaluate the controls adopted by ACB in relation to each category. (28 marks) Risk treatment (or risk response) is an important component of risk management strategy. Explain what is meant by risk treatment and its benefits to a Board of Directors. (10 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks)
3 P3

(b)

(c)

May 2007

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two
The PKG High School has 900 pupils, 40 teachers, 10 support staff and a budget of $3 million per annum, 85% of which represents salary and salary-related costs. The Local Authority1 for PKGs area is responsible for 34 schools, of which six are high schools. The Local Authority allocates government funding for education to schools based on the number of pupils. It ensures that the government-approved curriculum is taught in all schools in its area with the aim of achieving government targets. All schools, including PKG, are subject to an independent financial audit as well as a scrutiny of their educational provision by the Local Authority, and reports of both are presented to the school Governing Body. The number of pupils determines the approximate number of teachers, based on class sizes of approximately 30 pupils. The salary costs for teachers are determined nationally and pay scales mean that more experienced teachers receive higher salaries. In addition, some teachers receive school-specific responsibility allowances. PKG is managed on a day-to-day basis by the Head Teacher. The governance of each school is carried out by a Governing Body comprising the Head Teacher, elected representatives of parents of pupils, and members appointed by the Local Authority. The principles of good corporate governance apply to school Governing Bodies which are accountable to parents and the Local Authority for the performance of the school. The Governing Body holds the Head Teacher accountable for day-to-day school management, but on certain matters such as building maintenance the Head Teacher will seek expert advice from the Local Authority. The Governing Body meets quarterly and has as its main responsibilities budgetary management, appointment of staff, and educational standards. The main control mechanisms exercised by the Governing Body include scrutiny of a year-to-date financial report, a quarterly non-financial performance report, teacher recruitment and approval of all purchases over $1,000. The Head Teacher has expenditure authority below this level. The financial report (which is updated monthly) is presented to each meeting of the Governing Body. It shows the Local Authoritys budget allocation to the school for the year, the expenditure incurred for each month and the year to date, and any unspent balances. Although there is no external financial reporting requirement for the school, the Local Authority will not allow any school to overspend its budget allocation in any financial year. PKGs budget allocation is only just sufficient to provide adequate educational facilities. Additional funds are always required for teaching resources, building maintenance, and to upgrade computer equipment. The only flexibility the school has in budget management is to limit responsibility allowances and delay teacher recruitment. This increases pupil-contact time for individual teachers however, and forces teachers to undertake preparation, marking and administration after school hours.

NOTE: A Local Authority (or council) carries out services for the local community and levies local taxes (or council tax) to fund most of its operations. Many of the Local Authority functions are regulated by central government and considerable funding also comes from that source. The range of Local Authority services include education, community health, refuse collection, and maintenance of footpaths and public parks.
4 May 2007

P3

Required: (a)
Explain why the review and audit of control systems is important for the Governing Body of a school such as PKG. (5 marks) Evaluate the effectiveness of the Governing Bodys control over PKG High School and recommend ways in which it might be improved. (20 marks) (Total for Question Two = 25 marks)

(b)

Section B continues on the next page

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May 2007 5 P3

Question Three
Under international accounting conventions, the rules on accounting for employee benefits are based upon the principle that the cost of providing such benefits should be recognised in the period in which the benefit is earned by the employee, rather than when it is paid or payable. The rules laid down in International Accounting Standard 19 (IAS 19), Employee Benefits apply to a wide range of employee benefits of which the most common form is pensions. A significant number of pension plans are classed as defined benefit plans, under which the pension payable by the organisation on the retirement of an employee is linked to his/her salary. The salary used for the calculation of the benefit may be either an average or a final salary, although final salary is still the most common. Under IAS 19, a companys balance sheet must record the present value of the future benefits payable, net of the value of the pension fund assets. The discount rate used to arrive at a present value for the liabilities is equal to the interest rate payable on AA rated corporate bonds. The valuations are carried out by actuaries, who are required to make a number of assumptions about current economic conditions, life expectancy, the rate of salary increase over time, and the expected rate of return on the pension fund assets. In the UK, the requirement to put the value of the pension funds net assets or liabilities on the face of the balance sheet has resulted in a number of companies reporting pension fund deficits in excess of 1 billion and has led to concerns over a pensions crisis.

Required: (a)
A company has a pension fund deficit equal to ten per cent of its market capitalisation. Explain and discuss the nature of the risks posed to both the company and its current employees by the existence of such a substantial pension fund deficit. (10 marks) The Finance Director of a UK listed company is concerned about the sensitivity of the companys pension fund deficit to changes in life expectancy. If the companys advising actuaries use the most up-to-date life expectancy table, the companys pension deficit will increase by 30%, to approximately 60% of its market capitalisation. The Head of Financial Reporting is therefore considering requesting the actuaries to continue using tables which are now deemed out of date.

Required: (b)
(i) Discuss the proposal to request the actuaries to use out-of-date tables. (8 marks) (ii) Identify the internal and external financial reporting controls that could be used to prevent the manipulation of the liability valuation in the manner suggested by the Head of Financial Reporting. (7 marks) (Total for Question Three = 25 marks)
P3 6 May 2007

Section B continues on the next page

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May 2007 7 P3

Question Four
You work in the new product development division of a USA based global consumer electronics company. You are employed as the accountant responsible for costing and project appraisal of all new product proposals. All costs and revenues are based on information provided by the electronic engineers and marketing staff responsible for each individual project. It is assumed that all development is fully completed prior to initial marketing, and so no redesign costs are allowed once a product is launched. The rapid rate of technological change within the industry has led the company to assume a maximum product life of seven years. The tables below give details of the company-wide incremental cash flows for two new consumer products. All cash flows are assumed to occur at the year end. Regulatory constraints mean that the company cannot invest in both developments. The company-wide hurdle rate for capital investments is 75% per year but the Finance Director is considering introducing risk-adjusted rates, which would give a discount rate of 85% per year for Product 1 and 10% per year for Product 2. The net present values generated by each of the products, using both the standard hurdle rate and the risk-adjusted hurdle rates, are also given in the tables. Product 1 would be manufactured and assembled in China and transferred to company-owned retail outlets in the USA. Product 2 would be assembled in the Czech Republic from components shipped in from Taiwan and then sold to third party distributors across Western Europe. Product 1 Year(s) Annual Sales Revenue $ Million (based on ex factory prices) Nil Nil 280 420 Design and Development Costs $ Million 200 400 Annual manufacturing and distribution costs $ Million Nil Nil 120 180

NPV at 75% p.a. NPV at 85% p.a. Product 2

1 2 3 4-7 $244 million $217 million Year(s)

NPV at 75% p.a. NPV at 10% p.a.

1 2 3 4-6 $430 million ($45 million)

Annual Sales Revenue $ Million (based on ex factory prices) Nil 1,250 2,000 3,500

Design and Development Costs $ Million 6,400 Nil Nil Nil

Annual manufacturing and distribution costs $ Million Nil 600 750 1,200

P3

May 2007

Required: (a)
Recommend three ways of improving your companys internal control systems to ensure better management of risks throughout the product life cycle. (10 marks)

(b)

Prepare a memo for your Head of Division recommending which product your company should support. You should clearly explain and justify your recommendations in the context of risk management. (15 marks) (Total for Question Four = 25 marks)

Section B continues on the next page

TURN OVER
May 2007 9 P3

Question Five
You are the newly appointed treasurer of VQR Ltd, a medium sized importing and exporting company based in Singapore. The company imports goods from Australia and New Zealand and exports these goods to the United States. A subsidiary company, based in Sydney, Australia, is partly financed by an Australian dollar denominated floating rate bank loan. VQR uses the forward or money markets to hedge its foreign currency risk. Most customers are allowed, and take, three months credit. You need to respond to the points raised in the following memo from your Chief Executive Officer:

From: CEO To: Treasurer Date: 24th May 2007 I have been reading the financial section of the local business press and note the following in respect of interest rates and other economic data: Exchange rates Spot 1 month forward Annual inter-bank offer rate Singapore$/US$ 1565 1562 Singapore 344% USA 538% Australian$/US$ 1311 1312 Australia 62%

Annual inflation for Singapore over the next twelve months is forecast at 05%, compared with forecast rates of 13% for Australia and 186% for the USA. I have a number of questions: (i) As interest rates are higher in the USA than here in Singapore, surely the US dollar should be trading forward at a premium to the Singapore dollar, not a discount? The newspaper did not quote a 3 month forward rate. We have recently sold goods to a customer in the USA to the value of US$ 3 million. What 3 month forward rate of exchange is implied by the information we do have, and therefore what will be the receipt in Singapore dollars in three months time? Can we save money by buying Australian dollars on the spot market as and when we need them to pay for imports, rather than taking out forward contracts, and are there any disadvantages to this strategy? Would it be in our interest to borrow Singapore dollars and use the proceeds to pay off our Australian dollar loan given that rates of interest in Australia are higher than those in Singapore?

(ii)

(iii)

(iv)

Please respond to these questions by the close of today.

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10

May 2007

Required:
Produce a response to the CEO. Note: Your response should include a brief explanation of theories and appropriate calculations to support your discussion. Five marks will be allocated for explanation of appropriate theories. The balance of twenty marks is for application of those theories and relevant calculations. (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 13 to 16

TURN OVER
May 2007 11 P3

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May 2007

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PRESENT VALUE TABLE

Present value of $1, that is (1+ r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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May 2007

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE
1 KNOWLEDGE What you are expected to know.

VERBS USED
List State Define Describe Distinguish Explain Identify Illustrate

DEFINITION
Make a list of Express, fully or clearly, the details of/facts of Give the exact meaning of Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning of Recognise, establish or select after consideration Use an example to describe or explain something To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence To counsel, inform or notify To appraise or assess the value of To advise on a course of action

2 COMPREHENSION What you are expected to understand.

3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise Compare and contrast Construct Discuss Interpret Produce

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

May 2007

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P3

Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

May 2007

Thursday Morning Session

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20

May 2007

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

General Comments Overall, performance was comparable to previous diets. Well prepared candidates were capable of obtaining very clear passes, it was pleasing to see some candidates achieve exceptionally good marks. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. Generally one of the main problems was a failure to relate the answers to the situation portrayed in the question. Good marks were achieved by candidates who did this. Question 3 was noticeably avoided by candidates. Candidates should always select the questions with which they feel most comfortable, however those preparing for future diets should take care to ensure that they are capable of answering questions on all areas of the syllabus. The same is true of Question 5, many candidates made very poor attempts at the calculations. It is important to cover the whole syllabus when revising. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question or sub-question and so there is no advantage to be gained from over-developing the answer to one question/sub-question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam SECTION A 50 MARKS ANSWER THIS QUESTION

Question 1

(a)

State the recommended components of any organisations risk management strategy and evaluate ACBs approach to risk management in terms of those components. (12 marks) Identify the major categories of risk facing ACB and evaluate the controls adopted by ACB in relation to each category. (28 marks) Risk treatment (or risk response) is an important component of risk management strategy. Explain what is meant by risk treatment and its benefits to a Board of Directors. (10 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks)

(b)

(c)

Rationale This case study brings together many aspects of the Risk and Control syllabus. Focused on risk management, the setting is an aircraft assembly operation that relies extensively on information technology, is heavily reliant on its supply chain management, has foreign exchange exposure and uses lean accounting techniques. The case is designed to test the candidates ability to apply learning from across different syllabus areas. The main syllabus areas covered are A (ii) Evaluate the control of activities and resources within the organisation; B (i) Define and identify risks facing an organisation; B (iv) Evaluate risk management strategies; D (i) Identify and evaluate financial risks facing an organisation; and E (iii) Evaluate benefits and risks in the structuring and organisation of the IS/ IT function and its integration with the rest of the business.

Suggested Approach Requirement (a) requires candidates to state the components of a risk management strategy and apply those elements against the scenario to evaluate the companys approach. As a minimum, candidates should recognise risk appetite, risk assessment, treatment, responsibility and reporting/monitoring processes as they have been applied by the company. Requirement (b) requires candidates to identify the main categories of risk facing the company and evaluate the companys controls in relation to those risks. As well as the conventional cost control, economic and exchange rate risks, candidates should identify the less obvious reputation, IT and supply chain risks faced by the company. The question also requires candidates to evaluate the controls used in the company in terms of whether they effectively treat risks. Requirement (c) requires candidates to demonstrate their understanding of how an organisations risk appetite influences its assessment of likelihood and consequences of risks and the cost/benefit of different risk treatments including avoidance, reduction, sharing and acceptance of risk. Candidates also have to identify the benefits of risk treatment to Boards, in terms of assessing how well they have met their governance responsibilities for risk management.

The Chartered Institute of Management Accountants

Page 2

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

Marking Guide 1 (a) Components of risk management strategy Evaluate companys approach 1 (b) Identify major categories of risk Evaluate controls in relation to risk 1 (c) Explain risk treatment Benefits of risk treatment

Marks 5 7 14 14 5 5

Examiners Comments Part (a) This part of the question was poorly answered by some candidates. Many candidates missed out the review and monitoring stages and only discussed identification and assessment. Part (b) This part of the question was done well by most candidates, there was a tendency to write about every risk possible and not have a well structured answer. Candidates who related their answer closely to the scenario achieved high marks. Part (c) This part was well done by the majority of candidates. However more detail was required in many answers. Common Errors Part (a) was poorly answered in some cases as the later stages of risk management were largely ignored. There was a tendency in part (b) to ignore the scenario. Answers should always relate to the scenario wherever possible. Many candidates wasted time by discussing risks which were not apparent from the scenario. Generally many candidates achieved very high marks in this section of question 1. In part (c) more detail would have improved the answers. In some cases a bullet point list of risk treatments was given with very little elaboration. This approach got very few marks.

The Chartered Institute of Management Accountants

Page 3

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY

Question 2

(a)

Explain why the review and audit of control systems is important for the Governing Body of a school such as PKG. (5 marks) Evaluate the effectiveness of the Governing Bodys control over PKG High School and recommend ways in which it might be improved. (20 marks) (Total for Question Two = 25 marks)

(b)

Rationale Question Two largely concerns the review and audit of control systems. It uses the setting of a government-funded school to test candidate understanding of how a governing body can evaluate the effectiveness of controls. The question also tests an understanding of the role of different types of audit. The syllabus areas covered are C The review and audit of control systems, in particular C (v) Recommend action to improve the efficiency, effectiveness and control of activities, and C (ii) Evaluate the process of internal audit.

Suggested Approach Requirement (a) expects candidates to explain the importance of the review and audit of controls. This requires a risk-based approach that identifies the major risks and then applies controls to mitigate those risks. Importantly, the risks and controls should not be limited to financial ones but should include operational risks. Requirement (b) asks candidates to evaluate the effectiveness of the governing body in terms of the controls over the schools operations and to recommend improvements to those controls. Again, this should not be limited to financial issues. Candidates should consider a broad range of controls including strategic planning; the adequacy of annual reports; financial reporting; expenditure approval; staff recruitment; and other personnel controls

Marking Guide 2 (a) Importance of review and audit of controls 2 (b) Effectiveness of control evaluation of existing controls Recommendations for control improvements

Marks 5 10 10

Examiners Comments This was the most popular of the optional questions and was also the most poorly answered question. Candidates did not seem able to relate corporate governance to the scenario.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam Common Errors Part (a) This question was done poorly as candidates tended to write about corporate governance in limited companies rather than relating it to the scenario. Part (b) was also poor as the candidates did not pick up the main points in the scenario. The control exerted by the headmaster was a major issue as was the lack of frequency of information. Many candidates did not discuss these issues in any detail.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

Question 3

(a)

A company has a pension fund deficit equal to ten per cent of its market capitalisation. Explain and discuss the nature of the risks posed to both the company and its current employees by the existence of such a substantial pension fund deficit. (10 marks)

(b)
(i) Discuss the proposal to request the actuaries to use out-of-date tables. (8 marks) (ii) Identify the internal and external financial reporting controls that could be used to prevent the manipulation of the liability valuation in the manner suggested by the Head of Financial Reporting. (7 marks) (Total for Question Three = 25 marks)

Rationale Question Three tests a candidates understanding of the potential risks arising from a companys provision of pension benefits for its employees. Under IAS 19, a companys balance sheet must record the present value of the future benefits payable, net of the value of the pension fund assets. As a result, any deficit on the fund is made transparent, but may consequently affect the companys cash flows, financial position and share price. The issue of the ethics of trying to manage the deficit downwards is also addressed in this question. The syllabus topics being tested are B(i) Define and identify risks facing an organisation; C (vii) - Discuss the importance of exercising ethical principles in conducting and reporting on internal reviews and A(i) evaluate and recommend appropriate control systems for the management of organisations.

Suggested Approach The question is divided into three sections, all of which carry similar marks and so in attempting this question good time management is essential to ensure all parts are answered. Part (a) requires explanation and discussion of the risks facing both a company and its employees when there is a high pension fund deficit on the balance sheet. From the company perspective, this requires consideration of the risks to current and future operating capacity, access to finance and shareholder value. From the perspective of the pension fund member, the main risks to be considered are in terms of both current and future income, but also morale and career opportunities with the existing employer. Both elements within part (b) address an ethical issue associated with the reporting of a pension fund deficit which makes it essential to refer to a basic principle of financial reporting, namely the concept of true and fair. Reference, but not detailed knowledge of, the CIMA ethical guidelines is important here. In suggesting the controls that may be helpful in preventing manipulation of the liability valuation maximum marks required reference to BOTH internal and external controls.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

Marking Guide 3 (a) Risks to the Company 3 (a) Risks to employees 3(b) (i) Unethical and in conflict with accounting principles Reference to professional ethical guidelines 3(b) (ii) Internal controls External controls

Marks 5 5 6 2 4 3 25

Examiners Comments This was the least popular of the optional questions. Where candidates chose this question it was very well answered. Common Errors All parts of this question were answered well by the majority of candidates.

Question 4

(a)

Recommend three ways of improving your companys internal control systems to ensure better management of risks throughout the product life cycle. (10 marks)

(b)

Prepare a memo for your Head of Division recommending which product your company should support. You should clearly explain and justify your recommendations in the context of risk management. (15 marks) (Total for Question Four = 25 marks)

Rationale Question Four provides the scenario of a need to choose between investment in two alternative new products, which are perceived as carrying different levels of risk. The question tests ability to interpret cash flow and NPV information and use risk management principles to reach a decision on the best option. Identification of suitable controls to effectively manage product development risks also forms part of the question. The syllabus topics being tested in the first part of the question are A(iii), A (iv) and B (v), Recommend ways in which the problems associated with control systems can be avoided or solved ;Evaluate the appropriateness of an organisations management accounting control systems and make recommendations for improvements and Evaluate the essential features of internal control systems for identifying, assessing and managing risks. Part (b) tests syllabus section D (iii) Evaluate the effects of alternative methods of risk management and make recommendations accordingly.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

Suggested Approach This question builds directly upon knowledge gained in Paper 2 but creates new investment risks by its incorporation of an international scenario. Part (a) should be approached by starting with a definition of the product life cycle because this provided the framework for the control system. The scenario tests ability to apply general principles of control to a specific situation and so mimics the sort of problems that may be faced in the workplace. In answering the question therefore, it is vital to not reproduce a rote list of typical controls, but to use the information in the question to illustrate your argument on the need for improvement. Part (b), although it asks for a recommendation on which product to support, does not require lots of numerical work. Instead, the emphasis in answering the question should be on interpretation. Using the correct memo format will also gain a mark. Most importantly, the criteria for the choice of product is based on relative risks and NOT financial returns.

Marking Guide 4(a) Definition of product life cycle Each suggested control 1-3 marks depending upon level of comment 4(b) Memo format Risk impact of factors influencing the choice Case for use of risk adjusted rates to drive strategies Recommendation

Marks 1 9 1 10 3 1 25

Examiners Comments Reasonable marks were achieved for this question. It was heartening to see that most candidates had well structured answers. Common errors Part (a) was answered poorly with candidates failing to relate their answers to the product life cycle. Candidates should always relate their answers to the scenario. Part (b) was answered well.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2007 Exam

Question 5 Produce a response to the CEO. Note: Your response should include a brief explanation of theories and appropriate calculations to support your discussion. Five marks will be allocated for explanation of appropriate theories. The balance of twenty marks is for application of those theories and relevant calculations. (Total for Question Five = 25 marks)

Rationale Question Five requires understanding of exchange rate theory and an ability to apply that theory to calculate forward exchange rates. The question does not require detailed numerical calculations but is instead focused on underlying understanding of the principles that underpin exchange rate determination. The syllabus topics being tested are D(iv) Calculate the impact of differential inflation rates on forecast exchange rates; D (v) Explain exchange rate theory and D (vi) Recommend currency risk management strategies.

Suggested Approach This question tested understanding of basic principles of foreign exchange risk management using a combination of both narrative and computational arguments. The format of the question meant that the best approach was to begin with an explanation of the underlying theories of exchange rates determination and relative inflation rates. Following on from this, it was easiest to deal with each point of the memo in turn, in order to ensure that all issues had been covered. Using the memo format gained a mark.

Marking Guide PPP theory Interest rate theory

Relevant calculations of forward and cross rates Relevant commentary Memo format

Marks 3 3 Max 5 for theory 8 10 1 25

Examiners Comments This question was straightforward and yet was badly answered. Memo formats were excellent. Candidates had difficulty with the fairly standard calculations. Candidates should ensure they cover all areas of the syllabus when revising. Common Errors The calculations were poorly done, this is an area where many candidates would benefit from revision. Candidates used the wrong exchange rate and failed to calculate the 3 month forward rate correctly. These calculations are quite straightforward so it was disappointing to see such poor attempts. The written explanations, in many cases, were also poor.

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

22 November 2007 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 to 5. The question requirements are on page 5, which is detachable for ease of reference. Answer TWO questions only from Section B on pages 8 to 12. Maths Tables and Formulae are provided on pages 13 to 16. These pages are detachable for ease of reference. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

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The Chartered Institute of Management Accountants 2007

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION
Question One
The NOP Group is one of the worlds largest clothing retailers and had a turnover in excess of 2,000 million for the year ended 30 September 2007. The groups clothes are sold in Europe, East Asia, North America and Australia and New Zealand. The clothes are made for NOP by a number of approved contractors in China, Sri Lanka, Thailand and India. The clothes are designed by employees of NOP at the companys headquarters in London, England. The designers base their ideas on what has attracted them when they have attended the previews of the latest styles at the fashion shows presented by the worlds leading fashion houses. NOP operates to a four month lead time which runs from the start of the design process through to the first appearance of the new styles in the retail stores. NOPs clothes are targeted at the mid to high priced sector of the market and are sold under several brand names. NOP tries to match brands to differing customer profiles, and in doing so recognises that its customers ages are an important factor. Within the 18-25 year customer age group, brands are uni-sex. NOP operates across four geographic business units, with each managed as a profit centre. The group has differing arrangements for its retail outlets across the world, as shown below: Business Unit Europe (UK, France, Italy) USA and Canada Asia (Japan, Thailand, China, Singapore) Australia and New Zealand Outlet Arrangement Group owned shops Franchise agreements Joint ventures with department stores Joint venture with a distributor

The Group is a signatory to an ethical code of conduct (see extracts in the additional information below) which has been developed for use within the clothing sector, and it produces a separate social and environmental report which it views as complementary to its annual report. As part of its environmental protection policy, NOP has also declared a commitment not to send waste to landfill sites from 2008 onwards and will make arrangements for all company waste to be recycled. The Groups Treasurer regards NOP as highly exposed to currency risk, and therefore requires that all open positions with an equivalent value in excess of 100,000 are hedged. Responsibility for hedging arrangements lies with the Finance Director of each of NOPs four regional business units. Capital gearing is kept at a low level compared to NOPs competitors, and the market value of debt equalled just 30% of the market value of equity at the balance sheet date of 30th September 2007. The Group Directors remuneration, as detailed in Note 3 below, is linked to medium term financial targets. The Groups shares are listed on both the London and the New York stock exchanges. NOPs share price has fallen by 15% over the last six weeks, compared with an average fall of 10% for the general retail sector, and 8% for fashion retailers. A meeting of the Board of Directors has been called to address the problem. The Group Finance Director thinks that a share price recovery could be stimulated by a well targeted cost cutting exercise. The production and transportation costs being charged by suppliers are considered too high, as they amount to 75% of the cost of goods sold. Initial
P3 2 November 2007

estimates suggest that there is scope to reduce each of these costs by around 5%. Profit is further eroded by high employee costs, especially in Europe, where they equal 18% of sales, compared to an industry average of 12%. The Group Finance Director believes that increasing the proportion of part-time sales staff could bring employee costs in line with the industry average. The Group Marketing Director proposes an alternative solution, as he believes that a new advertising campaign would stop the decline in the share price. The campaign would focus on the groups most glamorous product ranges and would use international film stars to promote the clothes. The average gross margin on all clothes sales across the group varies significantly. For some products in the UK and Japan it is 45%, but it is as low as 6% for some products in Thailand and Singapore. The glamour ranges earn an average gross margin of 22% and sales of these ranges account for 15% of group revenue, but it is thought that the advertising campaign could significantly boost global sales of these high mark-up products with no accompanying sales loss elsewhere. Additional Information 1. Extracts from key financial statistics for the preceding two years: 2005 million 2,400 480 72 (350) 24 15% 465 pence 680 2006 million 3,120 625 50 180 22 15% 490 pence 782

Sales* Gross Profit (excluding joint ventures) Distribution costs Profit/loss from joint ventures Net Interest payable Dividend yield on year end share price UK Share Price (year end) Price index for UK retail shares (Base 100 in 1997)

The current (November 2007) share price is 480 pence *Sales are split across the regions as follows: Europe 60%; USA & Canada 20%; Asia 12%; Australia and New Zealand 8% 2. The Ethical Code of Conduct covers conditions and terms of employment within NOP and in NOPs suppliers, and includes the following requirements: Payment of the legal minimum level of wages (or industry average) whichever is higher; No use of forced labour, and freedom for employees to join a trade union and/or engage in collective bargaining; Safe and hygienic working conditions; A commitment not to use child labour, that is, aged below 15; Working hours kept to normal national levels or local industry standards.

The question continues, with its requirements, on page 5, which is detachable for ease of reference

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3.

Remuneration of Group Executive Directors

In addition to a fixed, market based salary, plus pension and health scheme benefits, group directors are entitled to performance related pay. The performance related pay usually represents over 50% of each directors annual remuneration and is based upon the following terms: A variable bonus is payable if performance meets or exceeds pre-determined annual targets for NOPs profit before tax. Achieving target performance earns the directors a bonus of 55% of their annual salary, and this rises to a maximum of 150% for performance more than 20% above the target level. Half of the variable bonus is granted in cash, and the rest is paid in shares, which must be held for a minimum of three years. Remuneration of business unit directors and other senior managers

4.

In common with the executive directors, other senior managers in NOP are paid partly on the basis of performance. Senior staff can earn bonuses paid in shares, which carry no minimum holding period requirement. The bonus rates are dependent upon performance relative to earnings per share growth targets set by the Board of Directors and in recent years have ranged between 50% and 220% of annual salary.

Required: (a)
Discuss the extent to which each of the following characteristics of NOP creates potential risks for the companys shareholders: (i) (ii) (iii) (iv) (v) Branding and marketing strategy; Design and procurement strategy; Remuneration of senior management and executive directors; Corporate Treasury function; Social and environmental policies. (30 marks)

(b)

Prepare a report to be presented at the board meeting that:

Explains why the principle of risk ownership at board of director level is a vital form of control, especially in extremely large companies such as NOP; (5 marks) Discusses the relative merits of the Finance Directors and the Marketing Directors proposals. (Your discussion should be from a risk management perspective, and should therefore focus on the risks created by the share price fall and the impact of each proposal on the groups overall risk profile.) (15 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks)

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November 2007 5 P3

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November 2007

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November 2007

P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY
Question Two
X is a small company based in England. The company had the choice of launching a new product in either England or France but lack of funding meant that it could not do both. The company bases its decisions on Expected Net Present Value (ENPV) and current exchange rates. As a result of this methodology, and the details shown below, it was decided to launch in England (with an ENPV of 28,392) and not France (with an ENPV of 25,560). England Probability Launch Costs 145,000 120,000 Annual Cash Flows 65,000 42,000 24,000 01 09 04 04 02 Launch Costs 190,000 Annual Cash Flows 90,000 70,000 30,000 France Probability 10

05 02 03

The annual cash flows are based on contribution margins of 10% for England and 20% for France where it is expected that sales volumes will be lower. It is thought that the product will sell for four years only. The monetary values are expressed in the home currency of the company and have been converted (where necessary) at the current exchange rate of 147/1. The company has discounted the cash flows using a cost of capital of 10% per year.

Required: (a)
It has now been forecast that the Euro is likely to strengthen against sterling by 5% in each of the next four years. Calculate and briefly comment upon the revised Expected Net Present Value if the product is launched in France. (5 marks)

(b)

Identify the different risks associated with each launch option and discuss how these may be managed by the company. (8 marks) (Total for requirements (a) and (b) = 13 marks)

P3

November 2007

(c)

Company X wishes to raise a 500,000 fixed rate bank loan to fund the product launch and additional capital investments. Company X is able to obtain fixed rate finance at 85% or a variable rate loan at LIBOR + 05%. Using its bank as an intermediary, Company X has been offered a swap arrangement with HTM, a smaller company that wishes to borrow at a fixed rate. HTM has been quoted a rate of 105% for a fixed rate loan or LIBOR + 11% for a floating rate loan. The bank charge for arranging a swap is 02% of the principal, and it is assumed that the net benefits will be shared equally between Company X and HTM.

Required:
(i) Briefly discuss the potential benefits and hazards of interest rate swaps as a tool for managing interest rate risk. (6 marks) Show the transactions involved, the bank charges and the interest terms payable if X and HTM agree to the swap. (6 marks) (Total for requirement (c) = 12 marks) (Total for Question Two = 25 marks)

(ii)

Section B continues on the next page

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November 2007 9 P3

Question Three
VWS is a company manufacturing and selling a wide range of industrial products to a large number of businesses throughout the country. VWS is a significant local employer, with 2,500 people working out of several locations around the region, all linked by a networked computer system. VWS purchases numerous components from 750 local and regional suppliers, receiving these components into a central warehouse. The company carries about 10,000 different inventory items, placing 25,000 orders with its suppliers each year. The Accounts Payable Department of VWS has six staff who process all supplier invoices through the companys computer system and make payment to suppliers by cheque or electronic remittance.

Required: (a)
Discuss the purposes and value of an internal control system for Accounts Payable to a company like VWS. (10 marks) Identify the information systems controls that should be in place for Accounts Payable in a company like VWS. (10 marks) Explain the risk of fraud in a computerised Accounts Payable system for a company like VWS and how that risk can be mitigated. (5 marks) (Total for Question Three = 25 marks)

(b)

(c)

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November 2007

Question Four
EWC is a large company in an unregulated sector of the telecommunications industry. It has ambitious plans for sales growth and increased profitability. In support of these goals, senior management has established a flat management structure. Budget targets place employees under considerable pressure but success in achieving and surpassing sales and profitability targets is rewarded by bonuses and share options. Employees who do not achieve their targets do not remain with the company for long. Performance targets exist for expanding EWCs customer base, sales value and profitability per customer, and geographic and product-based expansion. EWC zealously pursues cost reduction with continual efforts to drive down suppliers prices. The company aims to eliminate any wasteful practices in management and administration. EWC considers any expenditure that does not lead directly to sales growth to be wasteful and the company minimises its corporate policies and procedures. As a result, EWC has tended to overlook unscrupulous practices in its employees dealings with customers, competitors and suppliers in the pursuit of its goals. The company is unlisted and reports its profits to shareholders once per year.

Required: (a)
Identify the major types of risk facing EWC that arise from its style of management. Give reasons to support your answer. (10 marks)

(b)

Explain the significance of the control environment in EWC. (5 marks)

(c)

From the perspective of a newly appointed non-executive director, evaluate the financial, non-financial quantitative, and qualitative controls in EWC in the context of EWCs goals and the risks facing EWC. (10 marks) (Total for Question Four = 25 marks)

Section B continues on the next page

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November 2007 11 P3

Question Five

Required: Effective internal control, internal audit, audit committee and corporate governance are
all inter-related. Discuss this statement with reference to:

(a)

How internal audit should contribute to the effectiveness of internal control; (7 marks)

(b)

How an audit committee should contribute to the effectiveness of internal audit; (9 marks)

(c)

The role of an audit committee in promoting good corporate governance. (9 marks) (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 13 to 16

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November 2007

13

P3

PRESENT VALUE TABLE

Present value of $1, that is (1 + r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

November 2007

15

P3

Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

P3

16

November 2007

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P3

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November 2007

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE
1 KNOWLEDGE What you are expected to know.

VERBS USED
List State Define

DEFINITION
Make a list of Express, fully or clearly, the details of/facts of Give the exact meaning of

2 COMPREHENSION What you are expected to understand.

Describe Distinguish Explain Identify Illustrate

Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning of Recognise, establish or select after consideration Use an example to describe or explain something

3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate

To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table

4 ANALYSIS How you are expected to analyse the detail of what you have learned.

Analyse Categorise Compare and contrast Construct Discuss Interpret Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence

5 EVALUATION How you are expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

November 2007

19

P3

Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

November 2007

Thursday Morning Session

P3

20

November 2007

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

General Comments Overall, performance was poorer than expected. Well-prepared candidates, however, were capable of obtaining very clear passes. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. There were fewer clear passes than expected in this paper. Generally one of the main problems was a failure to relate the answers to the situation portrayed in the question. Candidates who did this achieved high marks. When information is given in the scenario, candidates are expected to use it to illustrate the main issues in their answer. Using the reading time wisely can be of huge benefit. Candidates should always plan their answers and ensure they read the questions carefully before starting the paper. Candidates who answer the specific question asked will achieve high marks. Candidates waste valuable time if they fail to be specific in their answer, as only the points which answer the question will gain marks. There was evidence of time pressure in a number of scripts. This can be avoided by use of an answer plan and by using the reading time to plan answers. At the strategic level, candidates are expected to use knowledge gained at the managerial level to inform their answers. It would have been useful had candidates used the knowledge gained in P5 integrated management, in particular, when answering Q1. This is one of many examples of where prior knowledge of previous subjects is expected. There was no question noticeably avoided by candidates. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam SECTION A 50 MARKS ANSWER THIS QUESTION

Question 1

(a)

Discuss the extent to which each of the following characteristics of NOP creates potential risks for the companys shareholders: (i) (ii) (iii) (iv) (v) Branding and marketing strategy; Design and procurement strategy; Remuneration of senior management and executive directors; Corporate Treasury function; Social and environmental policies. (30 marks)

(b)

Prepare a report to be presented at the board meeting that:

Explains why the principle of risk ownership at board of director level is a vital form of control, especially in extremely large companies such as NOP; (5 marks) Discusses the relative merits of the Finance Directors and the Marketing Directors proposals. (Your discussion should be from a risk management perspective, and should therefore focus on the risks created by the share price fall and the impact of each proposal on the groups overall risk profile.) (15 marks)

(Total for Question One = 50 marks) (Total for Section A = 50 marks) Rationale Question One is a case study of a UK based global clothing retailer which is dual listed in both London and New York. The question expects candidates to apply the theoretical principles of good risk management to a specific scenario and thus tests higher level learning skills. The first part of the question requires evaluation of the risks created for shareholders across a broad range of business areas, from branding through to social and environmental policy. The second part relates to the need for director involvement in risk management via ownership of specific risks and the evaluation, from a risk management perspective, of two alternative strategies to encourage a share price recovery. The question is focused on the risk and internal control section of the syllabus. Part (a) addresses the syllabus area B (i) Define and identify risks facing an organisation, whilst part (b) of the question covers syllabus sections B(iv) Evaluate risk management strategies and B (vii) Discuss the principles of good corporate governance for listed companies, particularly as regards the need for internal controls.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Suggested Approach (a) This question asked candidates to comment on potential risks for the companys shareholders. A lot of information was included in the scenario about specific areas to think about. The use of categories to structure an answer helps to avoid the risk of repetition and hence wasted time. Business knowledge gained from reading the financial press would have been useful when answering this question. Comments on areas outside the categories specifically asked for in the question were not rewarded. (b) In the first part of the question the route to marks was to note the significant key term of risk ownership. Many candidates did not mention this in their answer at all. The question was specific and general answers about the control environment were not a requirement of the question. This approach would not gain many marks. Answers needed to be very specific about risk ownership. As with the first part of the question, this second part focuses on a specific issue, namely the effect of the Finance Directors and the Marketing Directors proposals on the risks created by the share price fall and the impact on the groups overall risk. Generic answers covering a whole range of risks which are unrelated to the proposals gain no additional marks and answers which did not discuss the share price fall would not be complete.

Marking Guide Part (a) Branding and marketing Design and procurement Remuneration Corporate treasury Social and environmental Total Part (a) Part (b) Risk ownership Relative merits of finance directors proposal Relative merits of marketing directors proposal Conclusion Total Part (b) Total for Question 1 Examiners Comments

Marks 9 6 6 6 4 30 max

5 max 9 max 6 max 2 max 20 max 50

This question was very badly answered by both home and overseas candidates. Candidates showed a very poor level of appreciation of the risks involved in the scenario. Much of the knowledge required to answer this question could have been gained by reading the business news over the last year. Large multinational companies have faced problems with branding and procurement and many have received poor publicity over environmental issues and child labour. It would have been helpful for candidates to think about difficulties faced by consumers in the clothing industry to answer the branding and marketing and design parts of the question. Very few candidates mentioned the issues of sizing or culture, which were easy points to make. Even thinking from a practical view of the issues of ensuring comparable quality across a world-wide market would have been very useful when answering the question. The level of general business knowledge demonstrated by candidates was very disappointing. Marks were low compared to usual for question one. This meant that candidates had to achieve good marks in the other two questions to pass.

The Chartered Institute of Management Accountants

Page 3

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam Common Errors Part (a) was done badly by many candidates. The sections on branding and marketing strategy and design and procurement were very poor. Few candidates managed to address these risks in any depth. General business knowledge demonstrated was poor and knowledge of business news was also poor. There have been numerous accounts in the press on the problems of Marks and Spencer, which could have been used to inform candidates answers. Candidates did not use knowledge gained in the managerial level P5 Integrated Management, which would have improved their answers. Social and environmental strategy was a little better with candidates showing some appreciation of the problems; again reading the business press would have really helped candidates. Many large well known companies have had widely publicised difficulties over child labour and poor working conditions in the last few years. Part (b) was also poor as many candidates failed to answer the first part on risk ownership at all and then failed to discuss the effects of the proposals on the share price fall. The question specifically asked candidates to comment on the effect on the share price fall and it was surprising how many candidates failed to mention this in their answer.

The Chartered Institute of Management Accountants

Page 4

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY

Question 2

(a)

It has now been forecast that the Euro is likely to strengthen against sterling by 5% in each of the next four years. Calculate and briefly comment upon the revised Expected Net Present Value if the product is launched in France. (5 marks)

(b)

Identify the different risks associated with each launch option and discuss how these may be managed by the company. (8 marks)

(c)
(i) Briefly discuss the potential benefits and hazards of interest rate swaps as a tool for managing interest rate risk. (6 marks) Show the transactions involved, the bank charges and the interest terms payable if X and HTM agree to the swap. (6 marks) (Total for requirement (c) = 12 marks) (Total for Question Two = 25 marks) Rationale Question Two tests candidates understanding of discounted cash flow analysis in an international context, where exchange rate movements may impact upon the NPV. The first part of the question requires calculation of a revised expected NPV if the company opts to change the country in which it launches a new product. The second part of the question broadens the requirement to test knowledge of the wider risk implications of strategies which are domestically versus internationally focused. In other words, candidates are expected to recognise that risk cannot be defined in purely monetary terms, and company planning must also take into account the risks arising from levels of market concentration, lack of local knowledge etc. The final part of the question requires candidates to discuss the specific benefits and hazards of interest rate swaps as a tool for managing interest rate risk and to then to undertake and interest rate swap calculation. The syllabus area covered by the question is that relating to the management of financial risk. The calculation element in the first part of the question covers syllabus area D (i) Identify and evaluate financial risks facing an organisation. The requirement to discuss how the risks might change and how these should be managed i.e. the second part of the question, covers syllabus areas D (ii) and D (iii) Identify and evaluate appropriate methods for managing financial risks, and Evaluate the effects of alternative methods of risk management and make recommendations accordingly.

(ii)

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Page 5

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Suggested Approach Part (a) The first task is to calculate the effect on the exchange rate of the Euro strengthening against sterling over the next four years then to calculate the Expected Net present Value. This should be straightforward. A brief comment on the result is also required. Part (b) There are a number of risks associated with each option such as the risk that the expected cash flows may not be achieved or that the exchange rate may not be as expected for the next four years. There are also difficulties in starting a new business in a foreign country, the culture is different and the product may not be received as well as expected. A brief comment on how these risks could be managed is also required, market research for example. It would be helpful to break the risks down into sections such as exchange rate risk , business risk , political risk etc and to use the same headings when considering ways of managing the risk. Part (c)(i) This is a very straightforward question, which could be answered from a textbook. A sentence on each hazard and each benefit is all that is required. Part (c)(ii) This question just required a straightforward interest rate swap calculation. The question suggested that both companies would like a fixed rate loan. This is not possible, as there would be no advantage to one of the companies in this. This means that in order for a swap to be carried out one of the companies has to accept a floating rate loan. There is a comparative advantage to both companies and so the swap is possible.

Marking Guide Part (a) NPV and cash flow Commentary Total Part (a) Part (b) Types of risk Limitations of NPV methodology Total Part (b) Part (c)(i) Advantages of interest rate swaps Disadvantages of interest rate swaps Total Part (c)(i) Part (c)(ii) Calculations Total for Question 2 Examiners Comments Many candidates did very well in this question.

Marks 3 3 5 max

6 max 4 max 8 max

5 3 6 max

6 max 25

Most candidates who selected this question demonstrated a good knowledge of interest rate swaps, which was heartening. The few candidates who demonstrated that there would be no advantage to the companies in carrying out a fixed to fixed rate swap and did not go on to suggest one should accept a floating rate were not penalised, and were given reasonable marks. Most candidates however calculated the fixed/ flexible rate swap extremely well and achieved high marks for this question.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam Common Errors Part (a) The calculations in this part of the question were carried out very well. The most common error was where candidates got weakening and strengthening confused. Some calculated this the wrong way and showed the forecast as if the Euro was weakening against sterling rather than strengthening. Many candidates did not then go on to comment on the results and did not get as many marks as they could have for part (a). Part (b) was done reasonably well in parts, however, very few candidates noted the problems of launching a product in a new market in a different country but covered other aspects of the question well. Part (c) This question was answered well by many candidates. Many candidates did not calculate the bank charges. This was a very easy mark and was missed by over 50% of candidates. The interest rate swap was done well. Many candidates noted that a fixed to fixed interest rate swap was not possible as there was no advantage to both companies in doing so. These candidates were all given reasonable marks. The candidates who carried out the calculations for a fixed to floating rate swap usually did so correctly. There was a huge improvement in candidates knowledge in this diet compared to that shown on a similar question, which appeared in a previous diet.

The Chartered Institute of Management Accountants

Page 7

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Question 3

(a)

Discuss the purposes and value of an internal control system for Accounts Payable to a company like VWS. (10 marks) Identify the information systems controls that should be in place for Accounts Payable in a company like VWS. (10 marks) Explain the risk of fraud in a computerised Accounts Payable system for a company like VWS and how that risk can be mitigated. (5 marks) (Total for Question Three = 25 marks)

(b)

(c)

Rationale Question Three focuses on internal controls in a fairly traditional Accounts Payable function. The brief scenario is largely about the flow of inventory from purchasing and receipt to payment in a manufacturing/distribution company with multiple branches. The first part of the question relates to the purposes and value of internal controls for accounts payable generally, with an emphasis on authorising and paying suppliers. The second part relates to specific IS controls for accounts payable (personnel, access, processing, network, business continuity, etc.) and the third part to the risk of fraud and controls to mitigate fraud. The syllabus areas covered are B (iii) Discuss the purposes and importance of internal control and risk management; B (v) Evaluate the essential features of internal control systems for identifying, assessing and managing risks; and E (iv) Evaluate and recommend improvements to the controls of information systems.

Suggested Approach Part (a) The route to success in this part is to think of the purposes and value of internal control systems and then to relate these specifically to accounts payable. Marks are available for generic purposes but to gain the highest marks, candidates must discuss specific controls which relate to the question scenario. Listing all the purposes and value of internal control systems in general will not gain more marks. Part (b) As in Part (a) the question is looking for controls that are specific to accounts payable. General controls will gain a few marks but candidates must be specific and answer the question to achieve a high mark. Part (c) As in the 2 previous parts the answers must be specific to accounts payable.

Marking Guide Part (a) Importance of internal controls general Importance of internal controls accounts payable Total Part (a)

Marks

6 4 10

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam Part (b) Controls general Controls accounts payable Total Part (b) Part (c) Relating risk of fraud to accounts payable Total for Question 3 Examiners Comments Parts (a) and (b) were poorly done by many candidates. However Part (c) was done extremely well. Candidates failed to address the problem in relation to accounts payable, which was what the question asked. There were several marks available for general controls but to gain high marks candidates had to relate their answer to accounts payable. Common Errors In Parts (a) and (b) candidates showed a disappointing knowledge of accounts payable systems. Marks were allocated for general IT and accounting controls, but several were for points specific to accounts payable. The answers were very vague and lacked depth. Candidates just tended to write everything they knew about general controls, this did not gain high marks. Part (c) was done very well.

6 4 10

5 25

The Chartered Institute of Management Accountants

Page 9

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Question 4

(a)

Identify the major types of risk facing EWC that arise from its style of management. Give reasons to support your answer. (10 marks)

(b)

Explain the significance of the control environment in EWC. (5 marks)

(c)

From the perspective of a newly appointed non-executive director, evaluate the financial, non-financial quantitative, and qualitative controls in EWC in the context of EWCs goals and the risks facing EWC. (10 marks) (Total for Question Four = 25 marks)

Rationale Question Four concerns a telecommunications company with a rather unhealthy approach to budget targets, cost reduction, minimal policies and overlooking unscrupulous practices in the relentless pursuit of sales growth. The question asks candidates to identify the major reputational, business/operational and financial reporting risks flowing from this approach to business, the significance of the control environment, and from the perspective of a newly appointed director, an evaluation of the companys controls given the risks it faces. Importantly, this last part of the question expects candidates to address financial, other quantitative and qualitative controls. The syllabus areas covered are A (ii) evaluate the control of activities; B (i) identifying risks; and B (v) Evaluate the essential features of internal control systems identifying, assessing and managing risks .

Suggested Approach Part (a) It is helpful to have a structure in mind when answering these type of questions. An answer plan is the first step in achieving a good structured answer, which will achieve high marks. The route to success with this part of the question is to carefully think about the main risks facing EWC. These are reputation risk, business/operational risk and financial reporting risk. Remember that the question asks for risks that arise from EWCs style of management. Marks are available for all of these categories of risk. Generic answers, which give a list of all possible risks to any business, would not achieve high marks. The next step is to give good reasons why EWCs style of management gives rise to those particular risks. Part (b) The significance of the control environment in EWC is huge. There are many poor working practices evident from the scenario which has an effect on the control environment. A good answer would demonstrate how the lack of good systems and the poor management style have led to a poor control environment. It is this poor control environment which increases many of the risks in Part (a). Part (c) This is a straightforward question which should be laid out well. A short paragraph evaluating each type of control in relation to the goals and risks facing EWC is all that is required. Identifying the controls is not sufficient.

The Chartered Institute of Management Accountants

Page 10

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Marking Guide Part (a) Identify major risks: Reputational Business Reporting General comment on risks Part (b) Significance of control environment Culture and values Context for internal control procedures Relate to EWC culture (singleminded pursuit of growth and profit) Part (c) Evaluation of controls financial non-financial quantitative qualitative Relate controls to EWC goals and risks Address role of NED in monitoring Total for Question 4 Examiners Comments Candidates performance in this question was generally reasonable. Most candidates did very well in Part (a) and managed to identify most of the risks facing EWC. Answers to parts (b) and (c) were poorer.

Marks

3 3 3 1

2 2 1

2 2 2 2 2 25

Part (b) was very disappointing as the level of knowledge that was demonstrated about the control environment was very poor. Part (c) asked candidates to evaluate the financial, non-financial quantitative and qualitative controls in EWC. Many candidates attempted to identify the controls but that was all. Some attempt at evaluation was required to get a high mark. Common errors Part (a) was done well by most candidates. Many candidates failed to mention the problems created by having unscrupulous working practices in Part (b). This was important and it was disappointing to note that candidates did not make the link between the control environment and poor working practices. It was also surprising how many candidates still have trouble understanding what the control environment is. Part (c) was done well by some candidates although candidates failed to evaluate controls in all three areas in any depth. They also failed to identify any qualitative controls. Many candidates simply wrote balanced scorecard, which did not achieve any marks. Some discussion was required. This has been asked in several previous diets and it is disappointing to note that candidates still do badly in this type of question. Merely identifying the controls was not enough to get a high mark.

The Chartered Institute of Management Accountants

Page 11

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Question 5 Effective internal control, internal audit, audit committee and corporate governance are all interrelated. Discuss this statement with reference to:

(a)

How internal audit should contribute to the effectiveness of internal control; (7 marks)

(b)

How an audit committee should contribute to the effectiveness of internal audit; (9 marks)

(c)

The role of an audit committee in promoting good corporate governance. (9 marks) (Total for Question Five = 25 marks)

Rationale Question Five is an essay-style question not based on a scenario. However, it requires candidates to identify the inter-relationships between internal audit and internal control, the audit committee and internal audit, and the audit committee and corporate governance. In answering this question, it is not sufficient for candidates to merely repeat what they know about each, but to identify the contribution of each to the other. The syllabus areas covered are B (vii) Discuss the principles of good corporate governance for listed companies, particularly as regards the need for internal controls; C (ii) Evaluate the process of internal audit; C (v) improving control; and C (vi) Discuss the principles of good corporate governance for listed companies, for conducting reviews of internal controls and reporting on compliance.

Suggested Approach The question is very specific. For Part (a) the answer to this question should make a very clear link between internal audit and the effectiveness of internal control. The route to success in this question is to think of the role of internal audit and then to only discuss the parts of it that relate to the effectiveness of internal control. Answers, which just discussed the role of internal audit in general terms, will not achieve a high mark. For Part (b) the answer should make a clear link between the audit committee and its contribution to the effectiveness of internal control. Generic answers on the role of the audit committee will not be rewarded. For parts b and c candidates should think of the role of the audit committee and then think which parts of its role promote effective internal control and good corporate governance. There is some overlap in (b) and (c) but candidates should not just write everything they know about the audit committee in both parts. Part (c) asks for the role of the audit committee in promoting good corporate governance. As in Parts (a) and (b) generic answers will not gain a high mark. The question is quite specific and answers should also be specific.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2007 Exam

Marking Guide Part (a) IA contribution to internal control effectiveness: Risk based internal auditing Managers responsibility for adequacy of controls and possible conflict of interest Risk Management (RM) informs priorities for IA plan RM itself is audited Total Part (a) Part (b) Audit committee (AC) contribution to internal audit (IA) effectiveness: Function of IA (independent and objective assurance) IA Charter, Head of IA, resources IA plan based on risk assessments, approved by AC as addressing main risks AC ensures recommendations implemented AC monitors and reviews IA effectiveness Total Part (b) Part (c) Audit committee contribution to corporate governance: Define corporate governance Define audit committee Roles of audit committee especially in relation to risk management & internal controls Reliance on external audit Benefits: reduced risk, improved performance, access to capital markets, stakeholder confidence, transparency and accountability etc. Total Part (c) Total for Question 5 Examiners Comments

Marks

2 2 2 2 7 max

2 2 2 2 2 9 max

1 1 2 2 3 9 max 25

This question was done poorly by many candidates. Many candidates just listed the roles of the audit committee and made no attempt to link them to corporate governance or the effectiveness of internal audit. Common Errors Part (a) was done reasonably well by many candidates which was heartening. Answers to part (b) and (c) were disappointing. Many candidates failed to answer what was asked in the question. Many candidates wrote everything they could think about on the roles of the audit committee in both parts of the question. This approach did not get high marks. The links to internal audit and corporate governance were the crux of the question and if the links were not made low marks were awarded. It is vital that candidates read the question carefully and tailor their answers to the specific requirements of the question. Make good use of the reading time and structure the answer well. Candidates will find an answer plan is very helpful.

The Chartered Institute of Management Accountants

Page 13

Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

22 May 2008 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 to 5. The question requirements are on page 5, which is detachable for ease of reference. Answer TWO questions only from Section B on pages 8 to 12. Maths Tables and Formulae are provided on pages 13 to 16. These pages are detachable for ease of reference. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

TURN OVER

The Chartered Institute of Management Accountants 2008

P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE

Question One
MFT is a publicly listed company, which operates a chain of 74 restaurants throughout the country. The company has built a reputation for quality dining at affordable prices. The business model operated by MFT is to maximise the number of customers within each restaurants seating capacity and to maximise the amount of money spent by each customer on food and alcohol. Restaurant management Each restaurant has a manager. Many of these managers have been with MFT for a long time and are well known to senior management. MFTs Head Office allows managers considerable autonomy in the management of their restaurants. The restaurant manager decides on the menu for his or her restaurant, orders food and alcohol from Head Office and promotes the restaurant locally. Pricing is the responsibility of each restaurant manager. Price variations depend on location, competition and menu. Each restaurant operates a paper-based, order-taking system. One copy of the order is passed to the kitchen; the other is priced and given to the customer at the end of the meal. About 80% of customers pay their bill by credit card and about 20% pay in cash. The restaurant manager must control costs by balancing staff levels with customer demand. The manager must also minimise food wastage, for example by promoting daily specials. A market research consultancy carries out annual customer satisfaction and brand recognition surveys for each restaurant. Central support MFTs Head Office is responsible for strategic planning, financial management, and legal and governance issues. It also provides marketing support for each restaurant and purchases all food and alcohol through central purchasing arrangements. Sub-contractors are used to deliver fresh food to each restaurant daily. Alcohol is delivered direct by suppliers. Food and alcohol can be signed for by any employee when the deliveries are made to restaurants. Alcohol is stored in a locked storeroom. Financial management MFT exercises strict financial and reporting controls. Each day, restaurant managers must report the value of sales to Head Office and deposit cash receipts to a central bank account. Each week, restaurant managers must report the number of customers served each day and submit an inventory of unsold food and alcohol to Head Office. The cost of food and alcohol is charged to each restaurant. Staff salaries, based on manual time records, are paid by Head Office into employee bank accounts. Incidental expenses are paid by restaurant managers using a corporate credit card. This permits local payments for advertising, menu printing and so on. The rental and utility costs for each restaurant are paid by Head Office. A weekly profit statement showing the performance of the restaurant is sent from Head Office to the restaurant manager. Accompanying the report is a comparison against the budget for that restaurant and the average results for all restaurants. Information received by each restaurant manager includes income, gross and operating profits, seating capacity utilisation and spend

P3

May 2008

per customer. MFT defines gross profit as that which is controllable by the restaurant manager, after deducting the cost of food and alcohol, staff salaries and local payments. The non-controllable expenses of rent and utilities and allocated corporate costs are deducted to arrive at operating profit. The restaurant manager is paid a bonus based on the gross profit earned by his or her restaurant. Restaurant profitability The gross profit for MFT as a whole is 35% of sales income, but there is considerable variation between the 74 restaurants. The performance of 5 to 7 restaurants is of concern. The average sales mix comprises approximately 70% food and 30% alcohol. The gross profit is approximately 30% on food and 50% on alcohol. No restaurant spends more than 1% of sales on local purchases. Audit and Control MFTs internal auditor designed the management control and reporting system used by the company. The internal auditor takes a systems approach to auditing and ensures that the weekly management reporting and end-of-year financial reporting is accurate and on time. MFT has recently received the management letter from its external auditors following the completion of the year-end statutory audit. The auditors have identified a number of risks and have made the following suggestions: 1. There is considerable variation in spend per customer and gross profit margins between individual restaurants. This may be the result of poor restaurant management and/or malpractice. Internal audit should spend more time on checks on individual restaurants that are under-performing compared to the company average. This would allow improvements to be made by utilising best practice from better-performing restaurants. The manual order-taking process has potential for errors in terms of the kitchen fulfilling an order and in pricing. There is also the possibility that the proceeds of bills paid in cash will not be paid into MFTs bank account. MFT should consider a computerised ordertaking system in all of its restaurants to eliminate errors, mis-pricing and cash losses. Inventory may be taken by staff for personal use. As most of the value of inventory is alcohol, the suggested computerised order-taking system would also provide a perpetual inventory for alcohol, resulting in more physical control and better management information. Employee time records may not be accurate and employees may be claiming for working longer hours than they have actually worked. MFT should consider an automated time recording system whereby employees enter a code when starting and finishing work. The customer satisfaction and brand awareness survey shows considerable customer dissatisfaction and a negative brand perception in a few areas in which MFT has restaurants. Management should identify the causes and rectify this situation. Restaurant managers may use their corporate credit cards improperly, for example to make personal purchases or to purchase local food and alcohol contrary to corporate guidelines. Credit cards could be replaced with a small petty cash float to eliminate this possibility. There is a risk of short-delivery of food and alcohol by sub-contractors and suppliers when any employee can sign for the delivery, as the quantities and condition may not be checked. This can lead to significant stock losses. All deliveries should be checked as to quality and quantity by the restaurant manager.

2.

3.

4.

5.

6.

7.

The Question requirements are on page 5, which is detachable for ease of reference
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Required: (a)
(i) Construct a 2x2 likelihood/consequences matrix according to whether they are high, medium and low. (4 marks) Explain, with examples, an appropriate response for each of the risk categories. (4 marks) Apply the matrix to categorise each of the seven risks identified by MFTs auditors and state your reasons. (11 marks) (Total for Part (a) = 19 marks)

(ii)

(iii)

(b)

As the sole internal auditor within MFT, write a report recommending to the Audit Committee which of the external auditors suggestions should be adopted and which should be rejected. Give reasons to support your recommendations. (26 marks including 5 marks for report style)

(c)

Explain the ethical issue faced by the internal auditor when responding to the external auditors report. (5 marks) (Total for Question One = 50 marks)

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[Section B starts on the next page]

TURN OVER May 2008 7 P3

SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY

Question Two
CSX is a distribution company, which buys and sells small electronic components. The company has sales of $200 million per annum on which it achieves a profit of $12 million. Central Warehouse Department The company has a large Central Warehouse Department employing 100 staff over 2 shifts. The warehouse contains 30,000 different components, which are of high value and are readily saleable. Technological change is commonplace and components can become obsolete with little warning. Twice a year, the Purchasing Manager authorises the disposal of obsolete inventory. Inventory control is carried out through a computer system that has been used by the company for the last ten years. Purchasing and receiving Inventory is ordered using manual purchase orders based on tender prices. Goods received into the Central Warehouse are recorded on a manual Goods Received Note which is the source document for computer data entry. Data entry is done by clerical staff employed within the Central Warehouse. Customer orders Orders from customers are entered into the computer by clerical staff in the Sales Department. The computer checks inventory availability and produces a Picking List which is used by Central Warehouse staff to assemble the order. Frequently, there are differences between the computer inventory record and what is physically in the store. The Picking List (showing the actual quantities ready to be delivered) is used by clerical staff to update the computer records in the Central Warehouse. A combined Delivery Note/Invoice is then printed to accompany the goods. Accounting At the end of each financial year, a physical check of inventory is carried out which results in a significant write-off. To allow for these losses, the monthly operating statements to the Board of Directors include a 2% contingency, added to each months cost of sales. Internal Audit Department The companys Internal Audit Department has been asked by the Board to look at the problem of inventory losses. Managers in the Central Warehouse believe that inventory losses are the result of inaccurate data entry, the old and unreliable nature of the computer system and the large number of small inventory items which are easily lost, or which warehouse staff throw away if they are obsolete or damaged.

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May 2008

Required: (a)
Explain the risks faced by CSX in relation to its inventory control system and recommend specific improvements to the systems internal controls. (15 marks) Recommend (without being specific to the CSX scenario) the tests or techniques, both manual and computerised, that internal auditors can use in assessing the adequacy of inventory controls. (10 marks) (Total for Question Two = 25 marks)

(b)

Section B continues on the next page

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Question Three
LXY is a company, which has a five-year contract to operate buses in and out of the city bus station in Danon, France. The station has 60 bus piers and an average of 90 buses per hour leave Danon for local and national destinations. Services operate between 06.00 and 22.00 daily. All buses are operated solely by the driver, who loads and unloads luggage and checks that all passengers have a valid ticket. LXY only permits travel with a pre-paid ticket. Local buses provide a suburban service to areas within a 20 kilometre radius of Danon. The national services cover distances of up to 500 kilometres and so drivers are frequently required to stay overnight at certain destinations before covering the return service the following day.

Required: (a)
You have recently been appointed Head of Risk and Internal Audit at LXY. (i) Identify, with a brief justification, three categories which may be used to classify and manage the risks faced by LXY. (3 marks) For ONE of the categories that you have selected in (i) above, identify three possible risks and recommend appropriate tools for their control. (9 marks) (Total for Part (a) = 12 marks)

(ii)

(b)

A caf owner in Danon has approached LXY with a proposal to provide food and drink facilities on board long-distance bus services. Identify the additional risks that need to be considered by LXY in the evaluation of the proposal, and how they might be managed. (4 marks)

(c)

Many companies are too small to justify the existence of separate risk management and internal audit functions. Briefly explain the distinctive roles performed by each of these functions and recommend ways of maintaining their separate effectiveness within a combined department. (9 marks) (Total for Question Three = 25 marks)

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Question Four
A foreign exchange dealer working in a London-based investment bank wishes to take advantage of arbitrage opportunities in the international money markets. The following data is available relating to interest rates and exchange rates for Australia and the USA: US$/ AUS$/ Spot 20254 23180 6 Month Forward 23602 19971 The effective six-month Australian dollar interest rate is 332% and the equivalent US $ rate is 368%. These rates apply to both borrowing and lending. Assume that in six months time the actual exchange rate between sterling and Australian dollars is Aus$ 232/. The dealer is authorised to buy or sell up to US$5 million per transaction. The costs for this type of currency trading are charged in sterling at a rate of 3,000 per transaction. Note: Each currency conversion counts as one transaction.

Required: (a)
Calculate the spot and six-month forward cross rates between the Australian and US dollar. (4 marks) Explain the meaning of the term arbitrage profit and explain why such profits may be available in the scenario outlined above. (No illustrative calculations are required). (6 marks) Calculate the profit available to the dealer from exploiting the opportunity shown above, clearly showing all of your calculations. (10 marks) Explain the importance of trading limits and value at risk as tools for managing the risks within a financial trading operation. (5 marks) (Total for Question Four = 25 marks)

(b)

(c)

(d)

Section B continues on the next page

TURN OVER

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Question Five

(a)

With specific reference to risk management: (i) Define and discuss the role of the Treasury function within an organisation; and (6 marks) (ii) Discuss the arguments for and against operating a Treasury function as a profit centre. (6 marks) (Total for Part (a) = 12 marks)

(b)

Explain the factors a Board of Directors should consider when deciding what to include in the section entitled Risk Exposure and Control Systems, in their companys report. (13 marks) (Total for Question Five = 25 marks)

End of question paper Maths Tables and Formulae are on pages 13-16

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May 2008

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PRESENT VALUE TABLE

Present value of $1, that is (1 + r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE
1 KNOWLEDGE What you are expected to know.

VERBS USED
List State Define

DEFINITION
Make a list of Express, fully or clearly, the details of/facts of Give the exact meaning of

2 COMPREHENSION What you are expected to understand.

Describe Distinguish Explain Identify Illustrate

Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning of Recognise, establish or select after consideration Use an example to describe or explain something

3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate

To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise Compare and contrast Construct Discuss Interpret Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

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Management Accounting Pillar

Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

May 2008

Thursday Morning Session

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

General Comments Overall, performance was reasonable. Well-prepared candidates were capable of obtaining very clear passes. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. Generally, where candidates did not achieve a pass, the main problem was a failure to relate the answers to the situation portrayed in the question. Candidates who did this achieved high marks. When information is given in the scenario candidates are expected to use it to illustrate the main issues in their answer. Using the reading time wisely can be of huge benefit; candidates should always plan their answers and ensure they read the questions carefully before starting the paper. Candidates who answer the specific question asked could achieve high marks. Candidates waste valuable time if they fail to be specific in their answer, as only the points which answer the question will get marks. One of the main problems with candidates scripts this diet was a complete failure to answer what was asked. There was evidence of time pressure in a number of scripts; this can be avoided by use of an answer plan and by using the reading time to plan answers. At the Strategic level candidates are expected to use knowledge gained at the Managerial level to inform their answers. It would have been useful had candidates used the knowledge gained in P5 integrated management, in particular, when answering Q1. This is one of many examples of where prior knowledge of previous subjects is expected. Questions 4 and 5 were not as popular as the other three questions. It is very important that candidates prepare for the exam by learning all parts of the syllabus. Numerical questions will always be a part of this exam and it narrows down candidates choice if the numerical topics have not been studied. Question 4 was very badly done, few candidates made a reasonable attempt at part (c). Question 5 (b) was very poorly done as candidates did not answer the question. The question asked what factors should be taken into account when deciding what to include in the section of the report, not what should be included. This is another instance where candidate have not read the question properly. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

Page 1

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam SECTION A 50 MARKS ANSWER THIS QUESTION

Question 1 (a) (i) Construct a 2x2 likelihood/consequences matrix according to whether they are high, medium and low. (4 marks) Explain, with examples, an appropriate response for each of the risk categories. (4 marks) Apply the matrix to categorise each of the seven risks identified by MFTs auditors and state your reasons. (11 marks) (Total for Part (a) = 19 marks) (b) As the sole internal auditor within MFT, write a report recommending to the Audit Committee which of the external auditors suggestions should be adopted and which should be rejected. Give reasons to support your recommendations. (26 marks including 5 marks for report style) (c) Explain the ethical issue faced by the internal auditor when responding to the external auditors report. (5 marks) (Total for Question One = 50 marks) Rationale This case study is set in a restaurant chain where auditors have identified various risks and have recommended improvements to overcome internal control weaknesses. The question requires candidates to relate the already identified risks to a likelihood/consequences matrix, and in doing so to make judgements about the severity of risks and the need for the recommended internal controls. Candidates are asked to write a report, for which marks are awarded. There is also an ethical dimension to the scenario as the report candidates are asked to produce is from the perspective of the accountant who designed the existing internal controls. The main syllabus areas covered are B (ii) measuring and assessing risk; B (iv) evaluating risk management strategies; B (vi) the costs and benefits of controls; and the ethical issue is part of syllabus outcome C (vii).

(ii)

(iii)

Suggested Approach Candidates should first construct a 2x2 likelihood/consequences matrix and allocate each risk and the risk response to areas of high, medium and low risk on the matrix. Candidates should then adopt a report format to address each of the auditors recommendations. Candidates must give reasons to support their argument as to whether the audit recommendations should be implemented or rejected. Candidates should note that merely accepting the audit recommendations for computerised systems without consideration of the costs and benefits of doing so is not likely to be a soundly based answer to the question. Candidates should then apply CIMAs Code of Ethics to the scenario to explain how their role of internal auditor may not be an objective assessment of the external auditors recommendations.

The Chartered Institute of Management Accountants

Page 2

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Marking Guide (a) Constructing a matrix and making judgements about relative risk and response, broken down as follows: Matrix Risk responses with examples Placing of the 7 risks on matrix and discussion of reasons for placing in that position - 2 marks per risk to a max of 11 marks (b) For each of the seven audit recommendations, assessment of risk; the most appropriate risk response; and the cost/benefit of the external auditors suggestions: 3 marks for discussion of each point raised by the auditor Format Ethical issues and objectivity

Marks

4 marks 4 marks 11 marks

21 marks 5 marks 5 Marks

(c)

Examiners Comments This question was done reasonably well by most candidates. Part (a) was straightforward and generous marks were available for the diagram and for placing the risks into the most likely position. This should have led to candidates achieving very high marks for this section. Many candidates did, but some had poor results for this part of the question. Reading the question carefully was the key to a high mark. Many of the risks could have been in a number of different positions on the diagram so a good explanation justifying the position was very important. Part (b) was well done by most candidates. Part (c) was very poor. CIMA has a section of its website devoted to ethics and it would be helpful if candidates read this in preparation for the next diet of exams. It was disappointing to see how few candidates gave a satisfactory answer to this part of the question. Common Errors Part (a) This part of the question was done reasonably. Some candidates did not appear to understand the requirements of the question and did not achieve a high mark for this part of the question. The attempts at the matrix were poor and many candidates just mentioned where the risks would be placed on the matrix and did not justify their decision. Many of the risks could have been placed in a variety of positions and the justification by the candidates was vital in deciding whether their decision was worth any marks. Marks were not awarded unless the candidates discussed the reasons for the risks being in that particular position on the matrix. Part (b) This part of the question was done well by many candidates. Part (c) This part was very poorly done by most candidates. This was disappointing given the emphasis on ethics by all the professional accounting bodies in the last few years. Candidates tended just to repeat words like integrity and honesty rather than answer the question. The main problem was that the internal auditor was the sole internal auditor and was responsible for ensuring that there were adequate internal controls in the system. He would find it difficult to be objective. Few candidates answered this correctly.

The Chartered Institute of Management Accountants

Page 3

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY

Question 2 (a) Explain the risks faced by CSX in relation to its inventory control system and recommend specific improvements to the systems internal controls. (15 marks) Recommend (without being specific to the CSX scenario) the tests or techniques, both manual and computerised, that internal auditors can use in assessing the adequacy of inventory controls. (10 marks) (Total for Question Two = 25 marks)

(b)

Rationale Question Two is a distribution scenario with particular problems in relation to inventory control which is carried out using an older computer system. Candidates are asked to identify the relevant risks and to recommend appropriate internal controls consistent with those risks. Candidates are also asked to recommend the kinds of tests that internal auditors could adopt in testing for the adequacy of inventory controls, both in terms of manual systems and in the particular context of an IT system. The syllabus areas covered are A (iv) Evaluate the appropriateness of an organisations management accounting control systems and make the recommendations for improvements; B (i) Define and identify risks facing an organisation; C (i) Explain the importance of management review of controls; and C (iii) Produce a plan for the audit of various organisational activities including management, accounting and information systems. The IT elements of the scenario relate to syllabus items E (iv) Evaluate and recommend improvements to the control of information systems, and E (v) Evaluate specific problems and opportunities associated with the audit and control of systems which use information technology.

Suggested Approach Candidates need to read the scenario carefully and identify the specific risks identified in the scenario. For each risk so identified, candidates need to make recommendations for internal control improvements that address those risks. Candidates then need to identify the internal control improvements that are necessary to mitigate weaknesses in the internal control system. This could either be done generally, e.g. through input, processing and output controls or by listing specific audit tests relating to inventory control

Marking Guide (a) Identify the risks of the inventory control system and recommend specific improvements to internal controls: 1 mark for each risk and 1 mark for each suggested improvement to the internal control for each risk to a maximum of 15 (b) Identify the tests or techniques, both manual and computerised, that internal auditors can use in assessing the adequacy of inventory controls: 3 marks for each test or technique to a maximum of 10 marks

Marks

15 marks

10 marks

Examiners Comments This question was a very popular question and was done very well by the majority of candidates. Part (a) was very well done but part (b) was disappointing. Candidates showed a low level of knowledge of the tests and techniques used by internal auditors. Again reading the question carefully was the key. Instead of discussing tests and techniques of internal auditors many candidates just listed internal controls. This approach did not get any marks.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam Common Errors Part (a) this part was done very well by most candidates. Part (b) this part was done very poorly with many candidates just listing internal controls rather than possible audit tests. Many candidates duplicated what they had said in part (a) but just added some comments suggesting the auditor should check whether the control was in place. A list of suggested tests and techniques was all that was required, marks were given for broad suggestions and also for detailed tests specific to inventory. This should have been a straightforward question for a well prepared candidate. Marks were disappointing in some cases. This is an area which future candidates would benefit from studying further.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Question 3 (a) You have recently been appointed Head of Risk and Internal Audit at LXY. (i) Identify, with a brief justification, three categories which may be used to classify and manage the risks faced by LXY. (3 marks) For ONE of the categories that you have selected in (i) above, identify three possible risks and recommend appropriate tools for their control. (9 marks) (Total for Part (a) = 12 marks) (b) A caf owner in Danon has approached LXY with a proposal to provide food and drink facilities on board long-distance bus services. Identify the additional risks that need to be considered by LXY in the evaluation of the proposal, and how they might be managed. (4 marks) (c) Many companies are too small to justify the existence of separate risk management and internal audit functions. Briefly explain the distinctive roles performed by each of these functions and recommend ways of maintaining their separate effectiveness within a combined department. (9 marks) (Total for Question Three = 25 marks)

(ii)

Rationale Question Three describes a bus operating company which is exposed to a very broad range of risks. Candidates are asked to select a categorisation system for the management of risks, in addition to identifying relevant tools of control. There is also a requirement to comment upon the respective roles played by risk management and internal audit in a generic context. The syllabus areas covered are B (i) Define and identify risks facing an organisation; B (ii) Explain ways of measuring and assessing risks facing an organisation, including the organisations ability to bear such risks; and B (vii) Discuss the principles of good corporate governance for listed companies, particularly as regards the need for internal controls.

Suggested Approach It is important for candidates to draft an answer that relates directly to the scenario, and so in answering part (a) the categories selected need to be appropriate to the context. Part (b) raises issues relating to the risks arising from lack of direct control of an operation in addition to the obvious health and safety concerns. In answering (c) candidates need to note that the requirement contains two distinct elements, and focusing on one only will earn limited marks.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Marking Guide (a) Identification of suitable risk categories Identification of related risks and appropriate controls for one of the categories: up to 3 marks for discussing each of 3 risks (b) (c) Identify the risks of allowing food and drink to be sold on board the bus services Explanation of respective roles and recommendation of tools for control: explanation of roles - 1 mark per relevant point tools for control - 2 marks for discussion of each tool.

Marks 3 marks

9 marks 4 marks

max 9 marks

Examiners Comments Generally candidates scored high marks for this question. Parts (a) and (b) were done well, the question allowed for a wide variety of risks to be selected by candidates and most candidates did achieve high marks. Part (c) was less well done as candidates could not suggest reasonable ways of maintaining separate effectiveness. Common Errors Part (a) and (b) were done well by candidates. A huge variety of risks were suggested by candidates and all reasonable suggestions gained marks. Part (c) was poor. Candidates could describe the separate roles of risk management and internal audit but had difficulty in suggesting ways of maintaining separate effectiveness. Again this was straightforward and a well prepared candidate should have achieved high marks.

Question 4 (a) Calculate the spot and six-month forward cross rates between the Australian and US dollar. (4 marks) Explain the meaning of the term arbitrage profit and explain why such profits may be available in the scenario outlined above. (No illustrative calculations are required). (6 marks) Calculate the profit available to the dealer from exploiting the opportunity shown above, clearly showing all of your calculations. (10 marks) Explain the importance of trading limits and value at risk as tools for managing the risks within a financial trading operation. (5 marks) (Total for Question Four = 25 marks)

(b)

(c)

(d)

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Rationale Question Four required an understanding of exchange rate theory and hedging techniques in order to apply that knowledge to identify an arbitrage opportunity. In addition to calculating cross rates, candidates are required to explain the concept of arbitrage, identify the relevant opportunity, and calculate the resulting profit. General comment upon specific risk control tools makes up the remainder of the question. The whole question falls into syllabus area D - Management of Financial Risk, and in particular D (iii) Evaluate the effects of alternative methods of risk management and make recommendations accordingly; D (iv) Calculate the impact of differential inflation rates on forecast exchange rates and D (v) Explain exchange rate theory.

Suggested Approach Parts (a) and (b) require simple explanations or calculations to earn ten marks, and so it is suggested that these are tackled first. In answering (c), candidates need to look carefully at the rates given in the question, to get an initial sense of where potential profit might be made. This should be done by applying basic exchange rate theory to show the mismatch between forward exchange rates and current interest rate differentials. In part (d) candidates need to answer both elements of the question to gain maximum marks.

Marking Guide (a) Spot and forward cross rates: 2 marks for each (b) Explanation of arbitrage profit : 6 marks (c) Calculation of profit available: 1 mark for each part of calculation (d) Explanation of trading limits and VaR Max of 3 marks for discussion of VaR + max of 3 marks for discussion of trading limits

Marks 4 marks 6 marks 10 marks

5 marks max

Examiners comments Parts (a) and (b) were done well by most candidates but parts (c) and (d) were poor. It was very disappointing to see so few candidates attempt this question and how poor some of the attempts at part (c) were. Common errors Part (a) was done well. Part (b) many candidates confused speculation with arbitrage. Arbitrage is very specific and takes advantage of very short windows of opportunity to make money in the markets. There is very little speculation involved as arbitrageurs are almost certain that if they act quickly enough they will make money, before the markets adjust. Candidates who just discussed speculation achieved low marks. Part (c) This part was very poorly done. A handful of candidates got this right. It was clear that candidates had not learned this part of the syllabus and did this question out of desperation. It is wise to cover all aspects of the syllabus when revising. There is always a numerical element in this paper and assuming that the question can be avoided is not a good study technique. Many candidates made very poor attempts and others simply missed part (c) out altogether. Starting off correctly was essential as was choosing the correct rates. Part (d) was also poor. Many candidates explained trading limits and did not comment on value at risk, this suggests a lack of revision of this area. It also meant that few candidates passed this part of the question as they were only completing half the question.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Question 5 (a) With specific reference to risk management: (i) Define and discuss the role of the Treasury function within an organisation; and (6 marks) (ii) Discuss the arguments for and against operating a Treasury function as a profit centre. (6 marks) (Total for Part (a) = 12 marks) (b) Explain the factors a Board of Directors should consider when deciding what to include in the section entitled Risk Exposure and Control Systems, in their companys report. (13 marks) (Total for Question Five = 25 marks)

Rationale Question Five combines aspects of Treasury management and financial reporting in one question. The first part requires candidates to define the role of Treasury and understand the issues to be considered in operating it as a profit centre. The second part of the question requires understanding of the issues underlying decisions to report risk information in the annual report. The syllabus areas covered are B (vi) Evaluate the costs and benefits of a particular internal control system and C (vi) Discuss the principles of good corporate governance for listed companies, for conducting reviews of internal controls and reporting on compliance.

Suggested Approach Candidates should define and discuss both the investment and funding roles played by treasury in addition to its function in hedging financial risks. The answer should be framed in the context of the risks that are being managed, or are potentially created, by treasury activities. Part (ii) of (a) reflects this emphasis in requiring discussion of the case for and against treasury being run as a profit centre. Candidates should comment on the risk appetite implied by choosing for or against a profit centre approach. Candidates need to write ONLY about external risk reporting in answering part (b). Comments on internal reporting practice would earn no marks. Additionally, the answer should focus not on the content but on the factors to consider in writing the report. These include the commercial sensitivity of the relevant information, as well as the extent to which it is understandable by the average user of the financial statements.

Marking Guide (a) Role of the Treasury function - 1 marks per relevant point Case for/against a profit centre - max 3 marks for and 3 marks against (b) Factors to take into account in producing a narrative report on risk and control Max of 2 marks for discussion of each factor

Marks 6 marks 6 marks max 13 marks

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide May 2008 Exam

Examiners Comments Part (a) was done very well by most candidates. This question has been asked before and candidates had clearly taken note and revised this area. It is always gratifying to see candidates achieving high marks. Part (b) was poor with few candidates producing a reasonable attempt. Failing to read the question properly was the main problem. Common Errors Part (a) was done well by most candidates. Part (b) was done very badly. The most common error was that candidates did not answer what was asked. The question asked what factors should be taken into account when writing the report, not what should go into the report. Many candidates wrote a list of what should be included in the report and did not comment on the factors affecting the decision of what was reported. Reading the question is very important. Candidates will not be awarded marks unless they answer what is asked.

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting Risk and Control Strategy

20 November 2008 Thursday Morning Session
Instructions to candidates
You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or subquestions). The question requirements are contained in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 to 5. The question requirements are on page 5, which is detachable for ease of reference. Answer TWO questions only from Section B on pages 8 to 11. Maths Tables and Formulae are provided on pages 13 to 16. These pages are detachable for ease of reference. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

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P3 Risk and Control Strategy

SECTION A 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE
Question One
PLM: Background, organisational structure and financial controls PLM is one of the worlds largest manufacturers of energy saving products for use in construction. The group specialises in the manufacture of timber framed sections and of insulated panels, both being used in domestic and commercial construction. The insulated panels take the form of a sandwich of outer layers of wooden board with a polystyrene core, and so PLM is very dependent on access to timber supplies for the manufacture of both of its products. PLM owns manufacturing plants and distribution centres in various locations around the world. The group is largely based in Europe, and has its headquarters and Research and Development Unit in Germany, as well as manufacturing sites in Germany, Scotland and Poland. The European manufacturing operations are supported by distribution centres located in each of Germany, France and Scotland. An additional manufacturing plant and two distribution centres are located in Canada, to serve both the Canadian and US markets. PLM sells to customers located in 15 different countries in Europe and North America. The control structure in PLM is regionally rather than product based. Manufacturing and distribution centres are managed in combination as regional profit centres, whilst the Research and Development Unit is treated as a cost centre. For example, the Director of Operations for Western Europe is responsible for a single profit centre that covers the German and Scottish manufacturing plants together with the distribution centres in Germany, France and Scotland. Similarly, the Director of Operations for North America is responsible for a profit centre that includes all of the Canadian manufacturing and distribution centres. The Polish manufacturing plant is a separate profit centre managed by a UK based Director. Profit centre results are calculated before inclusion of the impact of any foreign exchange or interest rate movements. Product Development The Board of Directors regards new product development as vital to the continued success of the business, and 5% of group profit is allocated to Research and Development. All new products have to obtain certification on their suitability for purpose and compliance with health and safety and building regulations. Certification is granted by an internationally approved body such as the UK based Building Research Establishment, but obtaining certification can take up to three years to complete. Environmental Issues PLMs timber based products appeal to customers because of the fact that timber is a renewable building material. There is, however, growing consumer concern about illegal logging and global depletion of major forestry resources. In response to these concerns, PLMs strategic plan states that it aims, by 2010, to have 75% of timber supplies sourced from sustainable woodland. The timber used for both the timber framed sections and the insulated panels is primarily softwood which, in forestry terms, is fast growing. Trees reach the necessary level of maturity in approximately 20 years. Reliable market forecasts suggest that demand for sustainably produced timber is growing faster than its supply, and that severe competition for this resource will emerge over the next five to eight years.

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A number of international schemes have developed with the aim of providing customer assurance on the sustainability of a timber source. PLM uses suppliers which are registered under a number of different such schemes including the Forestry Stewardship Council, Sustainable Forestry Initiative, and the Canadian Standards Association. Consumers, however, appear to be poorly informed about the different assurance systems and are unable to clearly distinguish between genuine and rogue assurance schemes. Market Conditions The business has expanded very rapidly since 2000 as a result of a growing awareness amongst architects of the need to use environmentally friendly building systems, combined with the potential of both product types to halve construction times. In the 1980s and 1990s there was a degree of mistrust within the industry about the use of timber frame construction techniques, and in Europe there were only a small number of contractors who were knowledgeable and experienced in their use. In contrast, the Canadian market for the product has been well established since the 1950s. Insulated panels have also been in widespread use in North America for many years, but PLM was the first company to introduce this building system into Europe in 1998. Since then a number of competitors have entered the European market, some of which provide customers with on site installation services as well as acting purely as panel manufacturers. An important reason for the market appeal of the panels lies in the fact that they offer very high levels of insulation, and the European market has expanded hugely following the introduction of strict new regulations on the energy efficiency of new buildings. The MD is aware of the impact of the 2007 credit crunch and has taken that into account when preparing the 2008-9 budget by suggesting that there will be zero sales growth. The customer base for both timber framed sections and the insulated panels is highly concentrated. For timber framed sections, 40% of global revenue is earned in Canada, whilst 80% of PLMs substantial European revenue from the sale of the insulated panels comes from ten main construction companies. Retention of key customers is pursued by PLM through its policy of guaranteeing delivery, anywhere in the world, of all orders in excess of 05 million, within six weeks of the order being received. As a result, there are times when PLM is manufacturing in Canada for delivery in Europe and vice versa. Sales Mix and Profit Margins Year ended 30 June Sales: Global North America UK France Germany Other countries Global Ratio of timber frame to panel sales (by value) Average profit margin on panels Average profit margin on timber framed sections

2006 m 350 150 45 10 60 85 60 : 40 95% 125%

2007 m 420 175 65 10 70 100 52 : 48 90% 140%

The question, including the requirements, continues on page 5, which is detachable for ease of reference

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Question One continued

Risk Management in PLM Overall responsibility for risk management systems within PLM rests with a senior manager (ranked immediately below Board level) who holds the title of Group Risk Controller. He was appointed five years ago, after promotion following 20 years service as PLMs Head of Group Insurance. He works closely with the Head of Internal Audit, although their respective roles are not clearly defined and documented and they jointly report monthly to the Audit Committee and the Finance Director. The Board of Directors approach to risk management is to either avoid risk or transfer it. One consequence of this policy is that the insurance bill for the group is extremely high in comparison to its peers. The existing risk averse culture also means that all overseas customers are billed in Euros, and the Treasury unit is barred from using derivative financial instruments, even for hedging purposes, because they are too risky. The Group Risk Controller of PLM is due to retire in July 2009, and in its most recent review of internal controls within PLM the Audit Committee recommended that the Board of Directors should work with the new appointee to undertake a major review of current risk management practice within PLM.

Required:
Using the information provided in the above scenario you are required to:

(a)

Discuss the extent to which each of the following aspects of the operational and business environment of PLM creates potential risks for the groups shareholders: (i) (ii) (iii) (iv) (v) Product development Environmental issues Market conditions Sales mix and profit margins Financial controls (20 marks)

(b)

Recommend, with reasons, a risk management control system that could be used by PLM as a mechanism for recording, prioritising and managing the groups risks. (20 marks) Explain why the role of the Group Risk Controller extends beyond issues of insurance and conformance and is also concerned with performance against strategic objectives. (10 marks) (Total for Question One = 50 marks)

(c)

(Total for Section A = 50 marks)

Section B begins on page 8

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SECTION B 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS ONLY

Question Two

Required: (a)
The shift towards fair value accounting has potentially increased the financial risks faced by companies that own high volumes of financial assets. (i) Discuss the above statement. (6 marks) (ii) Explain the tools that might be used to monitor such risks. (4 marks) (Total for requirement (a) = 10 marks)

(b)
KRL plc is a UK based transport company that specialises in large scale business to business contracts, delivering items from original manufacturers to assembly plants across the whole of Western Europe. Fuel is one of the companys main costs, and the Treasurer has decided to purchase oil futures to try and protect the company from the risk of rising fuel prices. The aim is to use any gains on the futures price to offset any increase in costs resulting from a fuel price rise. KRL forecasts that it will consume approximately 158,000 US gallons of fuel over the three month period to 1 March 2009 at an average cost of 545 per gallon. Crude oil futures are traded in the market in units of 1,000 US barrels (42,000 gallons) and on 1 December 2008 the price for delivery in three months time is US $11600 per barrel. The current spot rate is US$ = 0504. Assume that on 1 March 2009 the spot exchange rate is US$ = 051 and KRL is able to close out its contracts at a value of US$11892 per barrel.

Required:
(i) Calculate, ignoring transaction costs, the profit or loss arising from the decision to use futures contracts to hedge fuel costs. (10 marks) Discuss the risks associated with hedging fuel prices via the purchase of crude oil futures. (5 marks) (Total for requirement (b) = 15 marks) (Total for Question Two = 25 marks)

(ii)

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Question Three
FDS is a large diversified company whose information technology and information management activities are carried out by a shared service centre. FDS25 is one of many business units operating as an investment centre within FDS. FDS25 has developed a new business strategy which requires a major new investment in information technology to support its business strategy. FDS25 needs to implement the new system as quickly as possible and within budget in order to meet its objectives.

Required: (a)
Recommend the controls that could be implemented by a business unit like FDS25 to mitigate against risk at each stage of information system design and implementation. (15 marks)

(b)

From the perspective of FDS25, identify the risk management advantages and disadvantages of each of (i) (ii) utilising the shared service centre; and outsourcing

for the design and implementation of a new information system. (10 marks) (Total for Question Three = 25 marks)

Section B continues on the next page

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Question Four
HFD is a registered charity with 100 employees and 250 volunteers providing in-home care for elderly persons who are unable to fully take care of themselves. The company structure has no shareholders in a practical sense although a small number of issued shares are held by the sponsors who established the charity many years previously. HFD is governed by a sevenmember Board of Directors. The Chief Executive Officer (CEO) chairs the Board which comprises the Chief Financial Officer (CFO) and five independent, unpaid non-executive directors who were appointed by the CEO based on past business relationships. You are one of the independent members of HFDs Board. The CEO/Chair sets the Board agendas, distributes Board papers in advance of meetings and briefs Board members in relation to each agenda item. At each of its quarterly meetings the Board reviews the financial reports of the charity in some detail and the CFO answers questions. Other issues that regularly appear as agenda items include new government funding initiatives for the client group, and the results of proposals that have been submitted to funding agencies, of which about 25% are successful. There is rarely any discussion of operational matters relating to the charity as the CEO believes these are outside the directors experience and the executive management team is more than capable of managing the delivery of the in-home care services. The Board has no separate audit committee but relies on the annual management letter from the external auditors to provide assurance that financial controls are operating effectively. The external auditors were appointed by the CEO many years previously. HFDs Board believes that the companys corporate governance could be improved by following the principles applicable to listed companies.

Required: (a)
Recommend how HFDs board should be restructured to comply with the principles of good corporate governance. (16 marks) Explain the aspects of CIMAs ethical principles and the conceptual framework underlying those principles which you would consider relevant to continuing in your role as an independent member of HFDs board. (9 marks) (Total for Question Four = 25 marks)

(b)

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Question Five
SRN is a small listed clothing retailer operating a chain of 18 stores in suburban shopping centres together with a city-based Head Office. Orders for stock are placed centrally by Head Office and are delivered to Head Office by suppliers. Details of goods received are entered by Head Office employees to the companys computer system. The goods are then despatched to the retail locations. There are typically between two and three full-time employees in each store (one of whom is the store manager) plus part-time employees during the busiest periods. They are responsible for display and sales. All sales are processed using the electronic point of sale (EPOS) terminals which have the facility for cash, and debit and credit card sales. Cash sales are banked daily by store employees and each day Head Office reconciles bank deposits with the EPOS reports for each store. Sales through the EPOS terminals automatically reduce stock levels and support Head Office purchasing and stock replenishment decisions. A physical stocktake is carried out by store employees six monthly. Usually the stocktakes reveal stock shortfalls for almost half the stores. Store employees attribute this to theft. Prices are set initially by Head Office as a standard mark-up on the purchase cost. This price is automatically displayed on the EPOS terminals. However, employees have the authority to discount prices based on the length of time stock has been in their store and the need to ensure constant stock rotation. Sales revenue and price discounts are monitored weekly by Head Office to ensure that sales levels and margins are on target and that excessive discounting does not take place. Sales, gross profits and net profits are reported quarterly for each store. A Head Office manager visits each store once per week, typically on the same day and at the same time, so that store employees can discuss any problems with the Head Office manager.

Required: (a)
Identify the risks of fraud and theft faced by SRN in relation to its employees. (6 marks)

(b)

Recommend (with reasons) the policies and internal controls that SRN could implement to prevent employee fraud and theft. In making your recommendations, you should consider both (i) working conditions and the role of the Human Resource function; and (ii) operational internal controls. (19 marks) (Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths Tables and Formulae are on pages 13-16
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PRESENT VALUE TABLE

Present value of $1, that is (1 + r ) payment or receipt.
Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
n

where r = interest rate; n = number of periods until

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312 Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1+ r ) n r

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818

9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129

10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

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Formulae
Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV =
1 1 1 r [1 + r ] n

Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =
1 r

Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =
1 r g

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LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE
1 KNOWLEDGE What you are expected to know.

VERBS USED
List State Define

DEFINITION
Make a list of Express, fully or clearly, the details of/facts of Give the exact meaning of

2 COMPREHENSION What you are expected to understand.

Describe Distinguish Explain Identify Illustrate

Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning of Recognise, establish or select after consideration Use an example to describe or explain something

3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate

To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table

4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise Compare and contrast Construct Discuss Interpret Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence

5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

November 2008

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Management Accounting Pillar Strategic Level Paper

P3 Management Accounting - Risk and Control Strategy

November 2008

Thursday Morning Session

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November 2008

Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

General Comments Overall, performance was poorer than expected. Well-prepared candidates were capable of obtaining clear passes. Weaker candidates tended to avoid the requirements of the question, either through a failure to grasp what was required or as an attempt to obtain marks for repetition of memorised facts and information. Generally, where candidates did not achieve a pass, the main problem was a failure to relate the answers to the situation portrayed in the question. Candidates who did this achieved high marks. When information is given in the scenario candidates are expected to use it to illustrate the main issues in their answer. Using the reading time wisely can be of huge benefit; candidates should always plan their answers and ensure they read the questions carefully before starting the paper. Candidates who answer the specific question asked could achieve high marks. Candidates waste valuable time if they fail to be specific in their answer, as only the points which answer the question will get marks. One of the main problems with candidates scripts this diet was a complete failure to answer what was asked. There was evidence of time pressure in a number of scripts; this can be avoided by use of an answer plan and by using the reading time to plan answers. One of the main problems in this sitting was that candidates failed Question 1 which was the 50 mark compulsory question. All parts of Question 1 were done badly but part (c) was especially poor. Part (c) was done badly by all candidates. Questions 2 and 4 were not as popular as the other three questions. It is very important that candidates prepare for the exam by learning all parts of the syllabus. Numerical questions will always be a part of this exam and it narrows down candidates choice if the numerical topics have not been studied. Question 2 was very badly done, few candidates made a reasonable attempt at part 2(b)(i) and part (a)(i) was also very poor. Question 4 (b) was very poorly done as candidates struggled to think of the ethical issues which could be involved in the scenario. Note that the attached marking scheme often makes more marks available than indicated on the question paper. This reflects the fact that questions at this level can often be approached in more than one way and that there is no single perfect answer. In applying this marking scheme, marks are always restricted to the total offered by the question and so there is no advantage to be gained from over-developing the answer to one question at the expense of another that may appear more difficult.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

SECTION A 50 MARKS ANSWER THIS QUESTION

Question 1 Using the information provided in the above scenario you are required to:

(a)

Discuss the extent to which each of the following aspects of the operational and business environment of PLM creates potential risks for the groups shareholders: (i) (ii) (iii) (iv) (v) Product development Environmental issues Market conditions Sales mix and profit margins Financial controls (20 marks)

(b)

Recommend, with reasons, a risk management control system that could be used by PLM as a mechanism for recording, prioritising and managing the groups risks. (20 marks) Explain why the role of the Group Risk Controller extends beyond issues of insurance and conformance and is also concerned with performance against strategic objectives. (10 marks) (Total for Question One = 50 marks)

(c)

Rationale This case study is set in manufacturing company that supplies products for use in environmentally friendly construction. Although based in Europe, the group has both manufacturing plants and distribution centres around the world, which are managed as either cost or profit centres. The Group Risk Controller is risk averse, and the business faces challenges in terms of maintaining long term access to supplies and also ensuring sales growth. The first part of the question requires candidates to use the information provided in the scenario to discuss the extent to which specific aspects of the business, such as product development and market conditions, create potential risks for the groups shareholders. Candidates are also asked to recommend a risk management control system that could be implemented by the case study business to record, prioritise and manage the groups risks. The last part of the question tests candidates understanding of the role of a risk controller by asking them to explain why risk management is concerned with performance against objectives as well as insurance and conformance. The syllabus areas covered are B (i)define and identify risks facing an organisation, B (ii) explain ways of measuring and assessing risks facing an organisation, including the organisations ability to bear such risks, and C(v)Recommend action to improve the efficiency, effectiveness and control of activities.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Suggested Approach Part (a) Candidates should read the scenario carefully then work through each of the aspects that is asked about in turn. The question asks the extent to which each of the aspect creates risks for the shareholders, it is important that this is addressed in the answer. Part (b) Candidates are asked to recommend with reasons a risk management control system. In the answer, go through each stage in the risk management control system and write about it then give reasons for having that stage. This is a very straightforward question. Part (c) Candidates are being asked what other aspect of risk is the risk controller interested in. He is interested in insurance to transfer the risk and conformance with internal control systems to cut down the risk but he is also interested in meeting the companys strategic objectives. In order to make profits some risk may be necessary, how does the controller deal with this is what is being asked.

Marking Guide 1(a)

Five issues with a maximum of 4 marks available for discussion of each one. Product Development : Environmental Issues: Market conditions: Sales Mix and profit margins: Financial Controls:

Marks Max of 4 marks for each issue.

1(b)

Identification of the key components of a risk management system Detailed discussion of system for risk assessment Detailed discussion of system for risk reporting. Comment on frequency (1 mark) and risk ownership (1 mark) essential to gain max score. Risk response Residual risk reporting

Max 2 for each recommendation. 12 max for recommend with no reasons i.e. a list of points.

1(c)

Definition of the role of risk management Discussion of downside risks and conformance Discussion of upside risks and strategic objectives Explanation of how risk management and performance are linked

2 3 3 2

Examiners Comments The answers to Question 1 were very mixed. Part (a) was done reasonably well by many candidates. Part (b) which should have been very straightforward was in fact done poorly by a number of candidates and part (c) was universally very poor.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam Common Errors In part (a) the main problem was that candidates did not discuss how the issues could create risks for the groups shareholders. The candidates did discuss some of the risks but then did not go on to answer the next part of the question. This meant that candidates only achieved half the available marks. The answers were also very general and not detailed enough. Part (b) should have been very straightforward but many candidates did not give any reasons for the risk management control system suggested. Very few candidates mentioned residual risk reporting which would form an important part of such a system in any organisation. Many candidates did not discuss risk assessment or risk response in any depth and so could not be rewarded with a good mark. The answers to this part of the question were very disappointing. Part (c) was very poor. Very few candidates passed this part of the question. Candidates did not seem to know what was being asked. Few candidates mentioned upside risk at all and therefore could not get marks.

SECTION B 50 MARKS ANSWER TWO QUESTIONS ONLY

Question 2

(a)

The shift towards fair value accounting has potentially increased the financial risks faced by companies that own high volumes of financial assets. (i) Discuss the above statement. (6 marks) (ii) Explain the tools that might be used to monitor such risks. (4 marks) (Total for requirement (a) = 10 marks)

(b)
(i) Calculate, ignoring transaction costs, the profit or loss arising from the decision to use futures contracts to hedge fuel costs. (10 marks) (ii) Discuss the risks associated with hedging fuel prices via the purchase of crude oil futures. (5 marks) (Total for requirement (b) = 15 marks) (Total for Question Two = 25 marks)

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Rationale Question Two covers two different aspects relating to the management of financial risk. Part (a) requires candidates to discuss the impact of fair value accounting on the financial risk level of a company that holds high levels of financial assets, and to explain the tools that might be used to monitor financial risk exposure. The question does not require detailed knowledge of the financial accounting rules, but does require knowledge of the relative risks of different types of financial asset, and the potential for volatility in their values arising from the use of fair value accounting. Media coverage of such issues has been very extensive over the last six months. In explaining the tools for management of financial risk, candidates need to display an understanding that different asset types require the application of different tools of control. The syllabus areas covered in part (a) are Section D (i)Identify and evaluate financial risks facing an organisation, and part (b) covers Section D (ii) Identify and evaluate appropriate methods for managing financial risks. Suggested Approach This question is broken down into 4 parts which should have made it easier to answer. Candidates should have discussed fair value accounting and the volatility in asset values and how the financial statements might be affected by this. The next part required candidates to discuss the tools that could be used to monitor the resultant financial risk. This should have included Value at Risk (VAR), scenario planning and sensitivity analysis. The next part is a calculation of the profits which could be gained by hedging against a possible price increase in fuel. This should have started with a calculation of the number of contracts needed to make the hedge and then a calculation of the possible profits. The final part of the question is a discussion of the risks associated with the hedging strategy.

Marking Guide 2(a) (i)

Marks Examples of types of financial asset Explanation of levels of fair value accounting Main risk is market risk Possible tools for control (1 mark for identification and up to a max of 2 marks for each) Sterling cost per gallon of the future Number of contracts purchased Sterling costs of the futures purchase Profit on sale of the contracts Overall principle Mismatch between crude and refined price movements Foreign exchange risk Fixed contract dates Fixed contract size 2 3 1 4

2(a) (ii)

2 (b) (i)

2 2 2 2 2 2 1 1 1

2 (b) (ii)

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Examiners Comments This question was by far the least popular question. Fair value accounting is a reasonably topical issue and yet many candidates did not seem to have any idea what it was. The next part was done very poorly and should have been fairly straightforward as it was asking candidates to demonstrate their knowledge and not to apply it. The candidates could have quoted the paragraph from the study text and achieved a high mark. The calculation was done very badly starting with the calculation of the number of contracts required for the hedge. Candidates who persisted and finished the question usually did well in the final part. Common Errors Part (a) (i) was poor, very few candidates had any idea of the financial risks which fair value accounting could increase. This was disappointing given that interest in fair value has increased over the past few years and it is a topical issue in accounting. Part (a) (ii) was also very poor. Few candidates mentioned Value at Risk, scenario planning or sensitivity analysis which formed the basis of the examiners answer. Many candidates missed out this part of the question which lost valuable marks. Part (b) (i) was done poorly. Candidates should try to learn the calculations in this subject. There are not many and they are examined at each diet. Most candidates calculated the number of contracts needed for the hedge based on volume which was incorrect. Had they gone on and done the rest of the calculation correctly they would still have passed the question. Many candidates just gave up after calculating the number of contracts. Part (b) (ii) was done reasonably well. Most candidates knew some of the main points and achieved a reasonable mark for this part of the question.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Question 3

(a)

Recommend the controls that could be implemented by a business unit like FDS25 to mitigate against risk at each stage of information system design and implementation. (15 marks)

(b)

From the perspective of FDS25, identify the risk management advantages and disadvantages of each of (i) utilising the shared service centre; and (ii) outsourcing for the design and implementation of a new information system. (10 marks) (Total for Question Three = 25 marks)

Rationale Question Three is a business unit of a diversified company which needs to introduce new business systems. Candidates are asked to recommend the controls that could mitigate risk in system design and implementation. Candidates are also asked to compare a shared services centre with outsourcing of the design and implementation process. The question requires candidates to relate the scenario to a commonly accepted standard such as the Systems Development Lifecycle. Candidates should also be able to compare and contrast the advantages and disadvantages of shared service centres with outsourcing. The syllabus areas covered are A (iv) improving management accounting and control; B (ii) and B (iv) risk assessment.

Suggested Approach Candidates had to go through the various stages involved in project planning and recommend controls at each stage. In the next part of the question candidates had to discuss the advantages and disadvantages of shared service centres and outsourcing.

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Marking Guide 3(a) Any controls in relation to the following 6 areas: Feasibility study Systems analysis Systems design Implementation (incl. testing and conversion) Operation & maintenance (incl. post-impl review) Steering committee

Marks 1 mark per point

Max 15 marks 3(b) Identification of risk 2 marks for risks of not satisfying functionality, cost and time 1 mark for each advantage of SSCs 1 mark for each disadvantage of SSCs 1 mark for each advantage of outsourcing 1 mark for each disadvantage of outsourcing

Max 5 marks for SSC Max 5 marks for outsourcing Total 10 marks

Examiners Comments This question was popular with candidates and many candidates achieved a high mark for this question. One of the problems noted was that candidates could have laid out the answer to part (b) in a more logical way. Some candidates did use a table for this which worked well. This made it easy to see the points the candidates were making in relation to the two alternatives. Some revision of this area would help as some candidates did not seem to know what a shared service centre was. Many candidates did achieve a good mark for this question. Common Errors Part (a) Some candidates did not read the question and did not mention controls but just went through the various stages of project management. The majority of candidates did well in this question. Part (b) This part was done well by the majority of candidates. Those who did badly often stated the risks and benefits of outsourcing were the opposite of those for the shared service centre. This approach did not achieve a high mark. Some candidates had a poor layout which made it difficult to see whether they were referring to outsourcing or the shared service centre. This was problematic where it was not clear that the candidate understood what a shared service centre was.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Question 4

(a)

Recommend how HFDs board should be restructured to comply with the principles of good corporate governance. (16 marks) Explain the aspects of CIMAs ethical principles and the conceptual framework underlying those principles which you would consider relevant to continuing in your role as an independent member of HFDs board. (9 marks) (Total for Question Four = 25 marks)

(b)

Rationale Question Four contains the scenario of a charity and the role of governance in that charity. Candidates are asked to recommend improvements to governance through restructuring the Board. Candidates are also asked to relate CIMAs ethical principles and the conceptual framework underlying those principles to the hypothetical situation of their role as an independent Board member. Candidates should be able to relate the scenario to the applicable elements of good governance as identified in the Combined Code on Corporate Governance, as well as explain the applicable ethical principles. The syllabus areas covered are B (vii) principles of corporate governance, and C (vii) CIMA ethical principles

Suggested Approach There were several areas where the charity had weak corporate governance. The candidates had to discuss ways that the board could be restructured to improve corporate governance. Recommend does not just mean identify areas of weakness but also explain how the restructuring would help. Part (b) called for a discussion of which ethical principles you should consider when carrying out your role as an independent member of the board. The candidate should have selected which principles were relevant and then discussed them in depth.

Marking Guide 4(a)

2 marks for each recommendation in relation to principles of corporate governance

Marks Max 2 for each point max 16 Max 3 for each issue related to scenario max 9

4(b)

Explaining any 3 ethical issues related to scenario

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Examiners Comments Part (a) was done quite well by many candidates. Most candidates could identify areas where restructuring of the board was needed to comply with corporate governance guidelines. Some candidates did not go on to explain why the restructuring was required. Part (b) was done very poorly. A CIMA member should always follow the ethical principles even when not acting as an accountant. Any areas considered relevant by the candidate could be discussed in this part. Integrity, confidentiality, objectivity and due care were the ones most likely to be of relevance. Common Errors The most common error was candidates not explaining why they were suggesting restructuring. These candidates could only achieve half marks. In part (b) some candidates had very weak answers. Some missed this part out altogether. Some candidates just discussed all the ethical principles and did not even mention the scenario; this did not achieve a high mark. Candidates should always relate their answer to the scenario. The scenario is there to test candidates' application of knowledge. The ethics question was done badly in the previous diet also. Some revision of the ethics part of the syllabus would be advisable.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam

Question 5

(a)

Identify the risks of fraud and theft faced by SRN in relation to its employees. (6 marks)

(b)

Recommend (with reasons) the policies and internal controls that SRN could implement to prevent employee fraud and theft. In making your recommendations, you should consider both (i) (ii) working conditions and the role of the Human Resource function; and operational internal controls. (19 marks)

(Total for Question Five = 25 marks)

Rationale Question Five is based on a retail chain where there is a risk of fraud and theft. Candidates are asked to identify the risks of employee fraud and recommend policies and controls to prevent employee fraud and theft. This question requires an understanding of the role of the Human Resources function in supporting an anti-fraud culture as well as the specific internal controls to reduce fraud. The syllabus areas covered are A (i) management control systems; B (i) identifying risks; and E (ii) IT systems.

Suggested Approach There were a number of risks of fraud and theft which could have been mentioned. Candidates are only asked to identify these so no explanation is required. A brief discussion of risks of fraud and theft is all that is required. In part (b) candidates are required to discuss the recommendations in relation to two aspects of the business. Candidates should have made recommendations in relation to both of these or they would not achieve a good mark. They are also required to give reasons for the recommendation. There are many issues that could be discussed so there is plenty of scope to get a high mark.

Marking Guide 5 (a) 5(b) (i) and (ii)

2 marks for each type of fraud Discussion of anti-fraud culture, risk awareness, whistle-blowing policy and sound internal controls Marks for each of pre-requisites of fraud: dishonesty of employees, reducing opportunities for fraud, and reducing the motive for fraud and controls

Marks max 6 amrks Up to 2 marks for each point (1 for description and 1 for reason)

Examiners Comments This question was very well done by many candidates. This was the most popular of the optional questions.

The Chartered Institute of Management Accountants

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Paper P3 Management Accounting Risk and Control Strategy Post Exam Guide November 2008 Exam Common Errors Most of the candidates who chose this question scored a high mark.

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