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P3 Risk


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2016 Examinations CIMA P3 1

1. The types of risk facing an organisation! 3

2. Responses to risk! 9

3. Enterprise risk management! 17

4. Some quantitative techniques! 27

5. Business unit/divisional performance measurement and transfer pricing! 39

6. Corporate governance! 49

7. Professional Ethics! 55

8. Information technology! 59

9. Financial risk: business risk and gearing risk! 73

10. Foreign currency risk and its management! 85

11. Hedging techniques for interest rate risk! 99

12. Performance management! 111

13. Auditing and fraud! 121

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2016 Examinations CIMA P3 2

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2016 Examinations CIMA P3 3

Chapter 1

1. What is risk?
Risk is a condition in which there exists a quantifiable dispersion in the possible outcomes from
any activity. It can be classified in a number of ways.
CIMA Official Terminology, 2005

The key word in this definition is quantifiable. Both the probabilities that a particular
outcome occurs and its impact must be known. If the probabilities of different outcomes
occurring are not known then we are working under conditions of uncertainty, not risk.

Note that the strict definition of risk allows for good outcomes as well as bad

For example, insurance companies mostly deal with risk. For example, they maintain detailed
statistics of the following:
The chance of a 20 year-old driver having an accident;
The chance of a house burning down
The chance of a burglary
The chance that someone who is 70 dying within the next 10 years

Risk is often expressed in terms of a combination of the consequences of an event (including

changes in circumstances) and the associated likelihood ( of occurrence.

If probabilities, or the chance of an event occurring are not known (uncertainty) then
organisations and individuals are working much more in the dark.

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2. Types of risk
Risk can be categorised using the following terms:
Pure risk: this is where there is the chance of loss but no chance of a gain. It is also
known as downside risk. Often when risk is mentioned, this is the type of risk they
mean, but remember that, strictly risk is the spread of all results, good and bad.
Examples of pure risk include: fire destroying a factory, an IT system being hacked, an

employee being injured at work and fraudulent transactions by an employee.

Speculative risk: this is where there can be both good and bad outcomes. It might
occasionally be called two-way risk. Examples include developing a new product,
entering a new market, buying a more advanced machine and developing a new web-
site. Each of these good go well or badly.
Upside risk: the possibility of making a gain.

3. Conformance and performance

Risks are an inevitable wen running a business or other organisation. If a business were
unable to take any risks it would not buy inventory (in case it wouldnt sell), it would not
extend credit (in case of bad debts), and it would not employ anyone in case they were no
good. The same applied in not-for-profit organisations such as a hospital (where surgeons
would not operate in case the patient dies) or schools (where sports would be banned in case
a pupil were injured).

Favourable outcomes for the organisation and its stakeholders are not available unless risks
are undertaken. The key is the balance between the risk and the organisations performance.

takes advantages
controls the
of opportunities to
downside risk
increase returns

IFAC: seek to balance conformance and performance. Compliance is necessary to avoid

failure, but it does not produce success.

Higher risks are needed if you are to produce higher returns. Compliance with rules,
regulations and controls does not of itself make an organisation successful. However, poor
conformance with controls and risk management strategies can certainly lead to
organisational failure.

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A simple matrix can be used to illustrate the point:

Low High

Routine Avoid

Identify and develop Cautiously examine


Examples could be:

Routine: extending moderate credit to a new customer. The maximum write-off of a
debt would be small and the customer will provide some income.
Avoid: entering a joint venture with a company that has a poor reputation. Returns
might be small compared with the risk of the companys goodwill being tarnished.
Identify and develop: support of a well-known charity or sporting event to improve the
companys reputation. This could create a very large increase in competitive advantage
and the risk would be low provided the third party were carefully chosen
Examine cautiously: opening operations in a new country. There are considerable risks
that the expansion might fail, but is it is successful the rewards could be huge.

4. Categorisation of risks
There are many ways in which risks can be categorised. In many ways this isnt important for
its own sake but the categories can act a checklists when trying to identify and anticipate

One categorisation is strategic, operational, reporting and compliance risks:

Strategic risks: these arise from long term effects such as those relating to the nature
and type of business, changes in competitive and legal environments, poor long-term
decisions being made. For example, a supermarket which did not respond to the
growing popularity of on-line shopping would have opened itself to a long-term
decline in profits.
Operational risks: short-term, day-to-day problems. For example, a machine
breaking down, a key employee leaving, a fire breaking out in the warehouse or a fraud
Reporting risks: risks arising because internal and external reporting are not reliable.
For example, management accounts containing errors can lead to incorrect analysis and
Compliance risks: the risks arising form not complying with rules and regulations.
Penalties, loss or reputation and removal of operating licenses can all result.

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Some major risks are set out below, just to give you an idea of the wide variety of risks that
organisations might have to deal with. Each type of risk has one example given:
Environmental: the release of dangerous chemicals into the local river.
Economic: interest rates being increased so that consumer demand is suppressed.
Competitor: a competitor launches a fantastic product.
Product: you launch a poor product

Commodity: the supply and price of raw materials change adversely.

Political, cultural and legal: your product, for example cigarettes, becoming illegal or
Financial (currency, interest rate, market risk, reporting): you are exporting and the
buyers currency weakens before you are paid.
Investment: a subsidiary is bought but it turns out that it isnt as good as you thought it
would be.
IT: hacking and release of customer details
Knowledge management: techniques and know-how arent captured and recorded so
that when employees move-on they leave little behind.
Property: Fire, flood
Health and safety risks: injury to employees and fines by regulators.
Trading risks: irrecoverable debts.
Resource risks: increasing difficulty recruiting the right people
Organisational risks: the organisation is too moribund and too slow to respond to
developments in the market.
Inadequate system risks: management information inaccurate and out-of-date.
Fraud risks: theft of cash or inventory.
Probity risks (unethical behaviour): an employee acts unethically and the companys
reputation is damaged.
Reputational risks: products get a name for being unreliable so the companys
reputation is damaged.

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5. How much risk should an organisation take on?

Risk appetite is the term given to describe the amount of risk an organisation is willing to
accept in pursuit of value.

Risk appetite is determined by two factors:

Stakeholders attitude to risk

Risk capacity, which is the amount of risk that the organisation can bear.

Taking a personal example:

Some people are risk seekers and like to gamble; others are risk averse. So, if betting on a
horse race, the risk seekers might be attracted to gamble on the high odds 100 to 1 horse. The
risk averse person would tend not to consider that sort of gamble. They have different
attitudes to risk.

However, lets say both people has $100,000 in the bank and were being asked to bet $100.
Even the risk averse person might be tempted to go for 100 to 1 odds. In this situation they
have high risk capacity because losing $100 is of little consequence. But what if each person
had only $100 in the bank? Theres a fair chance that neither would bet $100 because the
consequences of losing are so serious: they have very low risk capacity.

So, overall their appetite for risk (ie their appetite for the gamble) depends on their own
attitudes plus the risk capacity.

6. Potential advantages of risk management

More predictable cash flows
Well-run systems (eg greater efficiency because routine maintenance is used to prevent
the risk of machine breakdown).
Limitation of the impact of disaster (eg, stand-by arrangements are in place to take over
Greater confidence amongst investors, employees, customers, suppliers and partners.
Better matching to risk appetite of shareholders.

Remember organisations should obtain an acceptable balance between risk and return.

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Chapter 2

1. A framework for risk management the CIMA risk

management cycle

Establish risk
management group
and set goals
Identify risk areas

Review and refine Understand and assess

process and repeat scale of risk
Information for
decision making

Implement and Develop risk response

monitor controls strategy
Implement strategy
and allocate

The framework is logical and easy to understand.

Establish a risk management group and set goals

Ultimately risk management is the responsibility of the board (or, more broadly, those
charged with governance). However, like many functions in organisations the board is
likely to delegate responsibility to a sub-group of suitable specialists. The board should
set goals which reflect the risk appetite of the organisation. For example, if the
organisation is an airline, the board would set goals of Zero accidents but it might be
prepared to tolerate a degree of risk of bad publicity from over-booking flights.

Identify risk areas

It is important not to be complacent about risks. Some will be obvious and well-known
but others might be undiscovered until something goes wrong. We will see later in this
Chapter methods that might help to discover potential risks.

Understand and assess the scale of the risk

Not all risks are equal. Some risks that are discovered might be judged a being of little
consequence; others could be of major significance. Techniques will be covered later.

Develop a risk response strategy

Having identified and assessed the risks decisions have to be made about what to do
about them. The TARA approach will be explained later.

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Implement strategy and allocate responsibilities

Simply identifying risks and working out suitable responses will not reduce risk: proper
actions have to be specified must to be consistently carried out. For example, ensuring
that the safety of machines is monitored or that customer credit limits are regularly
reviewed. Individuals have to be put in charge of risk management strategies and
procedures and must be held accountable for failures.

Implement and monitor controls

Controls must then be implemented. For example, setting out dates by which risks have
to be addressed, ensuring that inspections are done at regular intervals or by sending
staff on training courses. It is very important to document risk reduction strategies and
how those strategies are realised.

Review and refine the process and repeat

Of course, the solutions implemented to deal with identified risks are unlikely to work
perfectly the first time. They will often need to be improved. But it is also very important
to realise that nothing stand still: risks will be evolving all the time and the organisation
must keep them under constant review to ensure that all are properly addressed.

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2. Identifying risk areas

The trick is to use every method at your disposal to identify risks. Throw the net as widely as
you can at this stage. Later, risks might be dismissed as being of little importance, but it is
important that as many as possible potential risks are initially considered.

Methods include:

Physical inspection and observation (for example, that safety equipment is still used on
Inspect documents (for example, the accident log book).
Internal audit. Internal auditors are employees of the company (usually) who examine
and report on the organisation systems of internal control. Not only do they report on
financial controls but they can also be required to examine systems such as quality
control accident reporting and so on.
Outside consultants brought in to audit procedures (for example, security consultants
to advise on IT security).
Observation of competitors procedures (question why they carry out operations in a
particular way).
Enquiries (for example, ask employees, customers and suppliers about problems).
Brainstorming (wide-ranging discussions to anticipate potential problems).
Checklists (for example, use a checklist to evaluate how a job went and consider action
where there had been problems).
Benchmarking (falling short of targets can imply that things are going wrong).
External events (for example, be alert for economic events that could affect the
Internal events (for example, high staff turnover can indicate problems with
employments conditions).
Leading event indicators (for example, if a customer takes longer and longer to pay
each month then there would appear to be a risk of non-payment).
Escalation triggers (for example, if you are late filing a tax return twice, then the third
default could be very serious).
Event interdependencies (for example, a major customer going into liquidation could
cause excess inventory problems).

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3. Understand and assess the scale of the risk

The scale of the risk depends on:

(1) The likelihood that the event will occur; and

(2) The impact of the event.

Of course, these will be estimates, particularly the probability of an event occurring. However,
precise figures are not needed, just an idea of whether they are high or low. Nevertheless
you will see some mathematical techniques that can be used to quantify events.

A very standard tool to assess the scale of the risk is a risk map (or assurance map):

Low High
Complete breakdown of IT
Loss of a mobile phone

Flight disruption because

Routine sta turnover
of bad weather

Note that there is nothing absolute about the categorisation of these risks. For example, the
chance of flight disruption has been assessed as high, but that depends on the airports used.
Similarly, the loss of a mobile has been categorised as being of low impact but this wouldnt
be correct if that mobile was the only place where important contact data is held.

The severity of the risk can be estimated by methods such as:

Calculation of average/expected loss, largest predictable loss
Exposure of physical assets: total loss, repair, decrease in value
Exposure of financial assets
Exposure of human assets (injury, death, staff leaving)

Obviously, great attention should be given to risks in the bottom right hand quadrant (high/
high) whereas those risks in the top left quadrant are less important.

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4. Risk response
The risk responses can be remembered by the TARA approach:

Transfer Methods of transferring risk include insurance, sub-contracting operations or

joint ventures (partial transferring). Insurance is, for example, used to protect
against risk in motoring accidents. Individuals do not have bad accidents

often, but if they do the consequences can be very severe.

Avoid The risk has been assessed as being so serious that all possibility of the event
occurring should be avoided.

Reduce Take steps to mitigate the risk. For example, instead of installing a new
computer system in every branch over one weekend, run a pilot operation
then gradually extend.

Accept Dont do anything about the risk. Its just part of everyday business

(You might occasionally see these approaches referred to as the 4Ts: Transfer, terminate,
treat, tolerate).

The four responses can be mapped onto the risk map diagram a follows:

Low High
Complete breakdown of IT
Loss of a mobile phone
Frequency/ TRANSFER
Flight disruption because of
Routine sta turnover
bad weather

So, phones are lost (or stolen) from time to time and most people live with that risk (though
insurance is always a possibility and might be taken out foe very expensive hones).

The complete breakdown of an IT system could be dealt with by outsourcing the system so
the supplier shoulders the risk.

Routine staff turnover has costs associated with it (recruitment and training) so better
employment policies might be worthwhile to reduce the cost and disruption.

Flights to an airport with very bad weather or safety records might simply be abandoned
because they cause more trouble than they are worth.

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5. Gross and net risks

It is important to know these terms:

Gross risk = the risk before any mitigation (reduction) procedures. Gross risk is sometimes
referred to as inherent risk.

Net risk = the residual risk after reduction and mitigation.

The gross risk is initially dependent on:

The asset: what you are trying to protect. For example, property, cash, people,
reputation and so on.
The threat: what you are trying to protect against. For example, destruction of
property, theft of cash, injury to people, damage to reputation.
The vulnerability: weaknesses or gaps that can be exploited. For example, no fire
alarms, cash not banked, no hand rails on stairs, poor PR.

The gross risk can be reduced to a lower net risk, or residual risk by reducing any of these
variables through the application of counter-values or counter-measures.

Management must then decide whether the residual risk is within the organisations
risk appetite.

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Asset: the inventory in warehouse; threat: fire; vulnerability: full of inflammable material

Counter values could be:

Asset: reduce the amount of inventory

Threat: impose no-smoking rules (if not already present),

Vulnerability: install smoke detectors and a fire suppression system that is suitable for the
type of inventory stored.

Asset: valuable sales manager; threat: moves to a competitor; vulnerability: enticing offers
from competitors.

Counter values could be:

Asset: divide sales over two managers (each person is half as valuable).

Threat: impose contracts that require 3 6 months notice to make moving more difficult

Vulnerability: offer good pay, conditions and prospects.

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6. The risk register

Identified risks, their probability of occurrence, impact and responses to them should be
entered into a risk register. Typical contents of a risk register are:
Description of the risk
Date identified

Its estimated likelihood of occurrence before mitigation

Its likely impact before mitigation
Pre-mitigation rating
The risk owner (who is responsible for dealing with the risk
Detailed response strategy to the risk (TARA)
Its estimated likelihood of occurrence after mitigation
Its likely impact before mitigation after mitigation
Post mitigation rating
Date by when response should be implemented
Date response implemented
Signed off by risk owner

The board and risk management committee should take an active interest in the risk register
to ensure that identified risks have been satisfactorily dealt with.

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Chapter 3

1. Introduction

Enterprise Risk Management (ERM) can be defined as the:

... process effected by an entitys board of directors, management and other personnel, applied in
strategy setting and across the enterprise, designed to identify potential events that may affect the
entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the
achievement of entity objectives.
Enterprise Risk Management Integrated Framework,
the Committee of Sponsoring Organisations, COSO, 2004

The CIMA Official Terminology uses the COSO (Committee of Sponsoring Organisations)

Think of ERM as a development and formalisation of the approaches already described.

2. The COSO framework for ERM

The following diagram sets out the COSO framework for ERM:

Across the top of the cube are all the categories of risk that an enterprise can suffer from:
strategic, operations, reporting and compliance. These have already been discussed.

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Down the side, going into the paper the enterprise is considered at various levels of
operation: the whole entity (think of group level); divisional level (Eg European, USA and
Asian divisions); then business units (such as cars and commercial vehicles); finally
subsidiaries (for example, different marques of car).

Some risks will be felt at entity level for example, the Volkswagen exhaust emission scandal.
Other risks will be more limited - for example, one make and model of vehicle that has to be
recalled for repair, or a subsidiary dealing with consumer finance for new vehicles not

complying with lending regulations.

Risk consolidation is the process of aggregating divisional/subsidiary risks at the corporate

level. Some risks can be handled together and be subject to a common approach, or they
might even substantially cancel.

For example, many organisations will organise insurance at the group level to cover injury to
employees anywhere in the group. This approach will usually be cheaper than insuring small
groups of employees separately.

Similarly, if one subsidiary is exporting and receiving US$, whilst another is importing and
spends US$, the net exposure to US$ currency movement might be very low and can be
ignored at the group level.

Down the front of the cube are the elements of a risk management approach:

Internal environment
This can be regarded as the outlook and culture of the organisation, including its
enthusiasm for risk management and its risk appetite.

For example, some organisations are a bit happy-go-lucky when it comes to risk
management whereas others are extremely strict and want things to be done by the

Objective setting
Objectives must exist before management can identify potential events aecting their
achievement. Enterprise risk management ensures that management has in place a
process to set objectives and that the chosen objectives support and align with the
entitys mission and are consistent with its risk appetite.

For example, the objectives of a military operation might be to capture a town and to
do that, certain risks will be experienced and have to be assessed and evaluated.

The objectives of a research and development department in a business will establish

the risks that it suers (such as a development failing to work).

The objectives of a marketing department will, again be quite dierent, and will be
judged against their risks such as the failure of a marketing campaign (or too much
uptake on special oers!)

Event identification
As discussed earlier, there are internal and external events (both positive and negative)
which aect the achievement of an entitys objectives and must be identified.

Risk assessment

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As already discussed, risks are analysed to consider their likelihood and impact as a
basis for determining how they should be managed.

Risk response
Management selects risk response(s) to transfer, avoid, reduce or accept risk (TARA).

The aim is to align risks with the entitys risk tolerance and risk appetite. Risk tolerance
is the acceptable variation in outcome compared to an original objective. In setting risk

tolerance, management considers the relative importance of the related objective. So, if
an objective is particularly important, risk tolerances might be higher to recognise that
achieving something really worthwhile is worth accepting more risk.

Control activities
Policies, procedures and control methods help to ensure risk responses are properly
carried out. Examples of control activities include authorisation of transactions,
reconciliations, segregation of duties (splitting a transaction so that several people are
involved), physical controls (such as locking away valuable inventory), the comparison
of actual results to budgets. IT controls can also be very important.

Information and communication

Information that monitors or identifies risks must be identified, recorded and
communicated quickly enough and in a way that lets people carry out their
responsibilities by making decisions. For example, if a products sales are lower than
expected, this information must be available quickly enough to change prices, alter the
advertising campaign or to withdraw the product.

The entire ERM process must be monitored and modifications made as necessary, to
improve current methodologies and to adapt to emerging risks, so that the system stays

3. Risk reports
UK quoted companies are now required to include risk reports as part of their annual reports.
This informs shareholders and others about the organisations main risks and what the
company is doing about them.

Here is an extract from Unilevers 2015 report and financial statements:

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4. Principal Risk Factors

Our business is subject to risks and uncertainties. On the following pages we have identified
the risks that we regard as the most relevant to our business. These are the risks that we see
as most material to Unilevers business and performance at this time.

There may be other risks that could emerge in the future. We have also commented below on
certain mitigating actions that we believe help us to manage these risks. However, we may

not be successful in deploying some or all of these mitigating actions.

If the circumstances in these risks occur or are not successfully mitigated, our cash flow,
operating results, financial position, business and reputation could be materially adversely
affected. In addition, risks and uncertainties could cause actual results to vary from those
described, which may include forward-looking statements, or could affect our ability to meet
our targets or be detrimental to our profitability or reputation.


BRAND PREFERENCE We continuously monitor external market
trends and collate consumer, customer and
As a branded goods business, Unilevers shopper insight in order to develop category
success depends on the value and and brand strategies.
relevance of our brands and products to
consumers around the world and on our Our strategy focuses on investing in markets
ability to innovate and remain and segments which we identify as
competitive. attractive because we have already built, or
are confident that we can build, competitive
Consumer tastes, preferences and advantage.
behaviours are constantly changing and
Unilevers ability to anticipate and respond Our Research and Development function
to these changes and to continue to actively searches for ways in which to
dierentiate our brands and products is vital translate the trends in consumer preference
to our business. and taste into new technologies for
incorporation into future products.
We are dependent on creating innovative
products that continue to meet the needs of Our innovation management process
our consumers. If we are unable to innovate deploys tools, technologies and resources to
eectively, Unilevers sales or margins could convert category strategies into projects and
be materially adversely aected. category plans, develop products and
relevant brand communication and
successfully roll out new products to our

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SUPPLY CHAIN We have contingency plans designed to

enable us to secure alternative key material
Our business depends on purchasing supplies at short notice, to transfer or share
materials, ecient manufacturing and production between manufacturing sites
the timely distribution of products to our and to use substitute materials in our
customers. product formulations and recipes.

Our supply chain network is exposed These contingency plans also extend to an
topotentially adverse events such as ability to intervene directly to support a key
physical disruptions, environmental and supplier should it for any reason find itself in
industrial accidents or bankruptcy of a key diculty or be at risk of negatively aecting
supplier which could impact our ability to a Unilever product.
deliver orders to our customers.
We have policies and procedures designed
The cost of our products can be significantly to ensure the health and safety ofour
aected by the cost of the underlying employees and the products in our facilities,
commodities and materials from which they and to deal withmajor incidents including
are made. Fluctuations in these costs cannot business continuity and disaster recovery.
always be passed on to the consumer
through pricing. Commodity price risk is actively managed
through forward buying oftraded
commodities and other hedging
mechanisms. Trends are monitored and
modelled regularly and integrated into our
forecasting process.

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SAFE AND HIGH QUALITY PRODUCTS Our product quality processes and controls
are comprehensive, from product design to
The quality and safety of our products are customer shelf. They are verified annually,
of paramount importance for our brands and regularly monitored through
and our reputation. performance indicators that drive
continuous improvement activities. Our key
The risk that raw materials are accidentally suppliers are externally certified and the
or maliciously contaminated throughout the quality of material received is regularly

supply chain or that other product defects monitored to ensure that it meets the
occur due to human error, equipment failure rigorous quality standards that our products
or other factors cannot be excluded. require.

In the event of an incident relating to the

safety of our consumers or the quality of our
products, incident management teams are
activated in the aected markets under the
direction of our product quality, science, and
communication experts, to ensure timely
and eective market place action.

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5. Environmental, social, and ethical issues of risk

Organisations have an effect on their environment and the human stakeholder with whom
they interact. These effects can often produce ethical dilemmas that organisations have to
deal with.

Examples of environmental issues

BP and the Deepwater Horizon oil spill in the Gulf of Mexico
VW and car emission misreporting
Release of dangerous chemicals into water supplies

Everyone is wise with hindsight and no-one in the organisations concerned would have
wanted these events to happen (though someone in VW was responsible for incorrect

However, as always, there is a balance to be struck between risk and performance. Quite
obviously there would be no oil spills if no company drilled for oil. BP had safety procedures
in place but either they were inadequate or BP suffered exceptional bad luck. Not only did the
company have to pay huge fines and compensation (about $60Bn) but it suffered severe
reputational damage.

Unilevers risk report also contains a section on sustainability:

SUSTAINABILITY The Unilever Sustainable Living Plan sets

clear long-term commitments to improve
The success of our business depends health and well-being, reduce
on finding sustainable solutions to environmental impact and enhance
support long-term growth. livelihoods. Underpinning these are targets
in areas such as hygiene, nutrition,
Unilevers vision to accelerate growth in the sustainable sourcing, fairness in the
business while reducing our environmental workplace, opportunities for women and
footprint and increasing our positive social inclusive business as well as greenhouse gas
impact will require more sustainable ways of emissions, water and waste. These targets
doing business. This means reducing our and more sustainable ways of operating are
environmental footprint while increasing being integrated into Unilevers day-to-day
the positive social benefits of Unilevers business.
activities. We are dependent on the eorts
of partners and various certification bodies Progress towards the Unilever Sustainable
to achieve our sustainability goals. There can Living Plan is monitored by the Unilever
be no assurance that sustainable business Leadership Executive and the Boards. The
solutions will be developed and failure to do Unilever Sustainable Living Plan Council,
so could limit Unilevers growth and profit comprising six external specialists in
potential and damage our corporate sustainability, guides and critiques the
reputation development of our strategy.

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Examples of social issues

Use of Facebook, Twitter to troll and bully.
Capture of big data to analyse consumer habits
Discrimination or lack of diversity in the workplace

Companies suffer reputation risk if their products or information gathering cause damage.
The unauthorised release of data can cause financial damage to customers.

Poor recruitment policies leave companies open to accusations of discrimination and this can
cause both reputational damage and can lead to legal claims.

Poor diversity policies can cause poor business results as products, services and employees
no longer match up to what customers expect.

Ethical issues

For example, a pharmaceutical company is developing a new drug. Some of the ethical issues
arising from this are:

Safeguarding the volunteers on whom the drug is tested

How much testing should be done before the drug is marketed? The more testing the greater
the delay in releasing a drug very effective in treating a disease but, balancing that, more
testing means less chance of undiscovered side effects.

What price should the drug be sold at? A high price might please shareholders and could
enable more money to be spent on research and development of more drugs. However, a
high price would mean that some patients and health services could not afford the drug.
Should different prices be charged for the same drug in different countries depending on the
countrys wealth? Poor ethical choices present risks, particularly reputational and compliance.

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Chapter 4

1. Introduction

This chapter looks at some techniques which can be used to assess the probability or effect of
a risk event.

Methods covered are:

Expected values
Value at risk
Sensitivity analysis
Risk adjusted discount rates
Certainty equivalents
Linear regression
Simulation modelling

2. Expected values
Here is a simple expected values example. The expected value outcome is the sum of
individual outcome weighted by the probability of each occurring. So here there are two
states of the world (such as the economy doing well or poorly) and two once-off projects the
company could invest in.

State of the P Project A Project B P x income of P x income of

world income ($) income ($) Project A Project B
I 0.6 2,000 4,000 1,200 2,400
II 0.4 10,000 6,500 4,000 2,600
5,200 5,000

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The conventional advice as to which project to invest in would be to invest in Project A as it

has the higher expected value. However, you need to be careful about a number of factors:

(1) How have the probabilities been assessed? This must be very dicult in practice. Think
about how inaccurate opinion polls are at predicting election results.

(2) For a once-o projected the expected value is often (as here) not expected. The
expected incomes are $2,000 or $10,000 for Project A and $4,000 or $6,500 for Project B

(3) Expected values conceal risk. Say that each project cost $3,800. There is no prospect (as
far as is estimated) of Project B making a loss whereas Project A has a better than evens
chance of earning only $2,000 so that it would then make a loss of $1,800 which could
be fatal for the company.

Because risk is concealed in expected values it is perhaps not the best tool to use for project

3. Sensitivity to probability assumptions

Just consider Project A above. Although the expected value is positive, it could result in the
project making a loss if the probabilities had been incorrectly calculated. We can work out
how the probabilities would need to change for the project to break even.

Instead of using the probability estimates of 0.6 and 0.4, let them be p and 1 p (note that
they must add back to 1 to ensure all outcomes have been included). Project A can now be
represented as:

State of the P Project A P x income of Project A

world income ($)
I p 2,000 2,000p
II 1-p 10,000 10,000 10,000p
10,000 8,000p

If the project is to break=-even, the expected value of the outcome will equal to its cost of

So, 3,800 = 10,000 -8,000p

8,000p = 10,000 3,800 = 6,200

P = 0.775

So if the probability of state of the world I occurring rose from 0.6 to 0.775, Project A would
break even in present value terms. If the probability rose further, Project As expected value
would be less than the cost of the project.

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4. Value at risk introduction

In your exam it is assumed that results from an investment or the value of a share portfolio
has a mean (average) value but that results vary around that mean following a normal
distribution curve. This will allow estimates to be made of the likelihood of possible

Normal curves have the following general shape:

Small standard deviation,

Large standard deviation,


If the possible results are closely clustered around the mean the standard deviation of the
distribution is small; if the results are very spread out, the standard deviation of the
distribution is large.

So if the mean daily value of a share is $30 and the standard deviation of its value is $1 the
share is rarely valued very far from $30. If, however, the standard deviation were $10, then the
shares value would be very volatile, often worth more than, say, $40 and less than say $20.

Because all normal curves are of the same basic shape, they can be described using a set of
tables, as set out below.

The area under the curve holds all possible results and the table gives the proportion of those
results between the mean and Z standard deviations above (or below) the mean

Note, Z is the distance above or below the mean expressed as a number of standard
deviations, so for a value x, Z is:


So, if the mean height of a population was 178 cm with a standard deviation of 4cm, we can
work out what proportion of the population is 178 181 cm tall.

181 178
Z= = 0.75

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Look up the table value for Z = 0.75 by going down the left hand column until you get to 0.7,
then across until you get to 0.05 and the table figure is 0.2734. That means 27.34% of the
population is in the height range 178 181 cm tall. Because the curve is symmetrical, the
same proportion of people would be 175 178 cm tall.


Z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224

0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621

1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441

1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817

2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952

2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990

The use of the tables can be turned round to answer a question such as in what height range
are the 20% of who are people just taller than the mean. This means that the shaded area in
the diagram shown as part of the table has to be 0.2 as that represents the 20% of people just
taller than the mean.

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To solve this go to the body of the table and look for 0.2. You will see that this is
somewhere between Z = 0.52 and 0.53 (areas = 0.1985 and 0.2019). In fact, 20% seems almost
mid-way, so Z would be estimated at 0.525.

Using the formula at the top of the table:

x 178
Z= 0.525 = = 0.75


x 178 = 4 x 0.525 = 2.1.

Therefore the 20% of people just taller than the mean of 178 cm will be in the height range
178 180.1 cm.

5. Value at risk share values

What talking about value at risk, the commonest criterion is to work out the amount you
could lose over a period so that there is only a 5% chance of losing more. This can be
represented as follows on the curve:

45% 50%


We are looking for where the cut-off is to leave only the 5% lowest values.

Lets say that a shareholding has a mean value of $80,000 and the daily has a standard
deviation of $5,000. The shareholding could easily have a value of $81,000, $78,000 and so on
but you would have had some bad luck if tomorrows value were only $60,000. However, that
low value would be possible.

So, below what value would only 5% or results lie?

5% splits the left hand side of the curve into 5%/45%, or 0.05/0.45. The normal curve tables
give the area under the curve from the mean down or the mean up so would indicate the Z
value for an area of 0.45.

Looking at the body of the tables for an area of 0.45, you will see that Z = 1.645 (mid-way
between 1.64 and 1.65).

80,000 x (Z is the distance below the mean as a number of standard

Z = 1.645 =
5,000 deviations)

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5,000 x 1.645 = 80,000 x

x = 80,000 5,000 x 1.645 = $71,775.

So, there is only a 5% chance that after one day the shares will be worth less than $71,775.
There is a 95% chance that the shares will be worth more than that.

Another way of expressing that is to say that we are 95% confident that the shares will not be

worth less than $71,775.

The value at risk (VAR) at the 95% confidence level is the maximum you stand to lose with a
95% confidence, so that figure is:

80,000 71,775 = $8,225

Alternatively, the value at risk is simply 1.645 x $5,000 = $8,225

If you were asked to calculate the VAR to the 99% confidence level, then you are splitting the
curve into 0.01, 0.49, 0.50 areas

49% 50%



The 49% (or 0.49) area needs to be found in the body of the tables (remember tables only
give the area from the mean up or down) and the Z value for 0.49 is about 2.33.

80,000 x (Z is the distance below the mean as a number of standard

Z = 2.33 =
5,000 deviations)

5,000 x 2.33 = 80,000 x

x = 80,000 5,000 x 2.33 = 68,350

So, there is only a 1% chance of the shares being worth less than $68,350.

The value at risk to the 99% confidence level is 80,000 68,350 = $11,650

This means that there is only a 1% chance of the shares losing more than $11,650 in the
course of a day.

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6. Value at risk for several periods

The example above dealt with variations in share value over the course of a day and the
standard deviation of $5,000 was for one day. But, what if we wanted to work out similar
statistics for, say, a period of 10 consecutive days?

What we need now is a standard deviation for share value for 10 days.

The rule is (really you just have to learn this) is:

period = day n

where n is the number of days in the period.

So, is the standard deviation of share value for 1 day is $5,000, for 10 days it would be:

$5,000 x 10 = 5,000 x 3.1623 = 15,881.

So the value at risk to the 95% confidence level over 10 days would be:

1.645 x $15,881 = $26,124

Obviously, the value at risk over ten days must be greater than over just one day as there
could be a sequence of 10 days of bad luck.

7. Sensitivity analysis
Sensitivity analysis examines how a decision might change if one variable at a time is
changed. It is usually measured with respect to where a project or opportunity hits break-
even point.

You might first have coma across the principle in contribution analysis:

Unit cost card $ $

Selling price 120
Material 30
Labour 22
Variable overhead 28
Fixed overhead 15
Profit 25
Based on budgeted output of 10,000

Budgeted fixed costs = $15 x 10,000 = $150,000

Contribution per unit = 120 30 22 18 = $50

Break even point = $150,000/$50 = 3,000 units.

So, the actual output could fall from its budgeted level of 10,000 units to 3,000 before a loss
starts to be made. The margin of safety (or sensitivity to volume) is 7,000 units or 70%.

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Sensitivity is often used to assess net present value calculations. Look at this example:

Here is a project appraised at a discount rate of 10%. Sales volume is estimated at 1,000 units per
Time $ 10% discount factor DCF $

0 Cost (130,000) 1 (130,000)

14 Sales 1,000@$100 = $100,000 3.17 317,000
1 -4 Marginal costs 1,000@$60 = ($60,000) 3.17 (190,200)
4 Scrap 25,000 0.683 17,075
NPV 13,875
The NPV is positive so the conventional advice would be to accept the project. However, the
sensitivity of this recommendation to the various assumptions should be examined. This is done by
seeing how far an assumption can change before the NPV = 0. Each assumption has to be assessed
Examine the sensitivity of the solution to:
(a) Initial cost
(b) Selling price
(c) Sales volume
(d) Scrap value
(e) Discount rate

(a) If the NPV is to be zero, the cost must rise by $13,875 to extinguish the NPV.
Sensitivity = 13,875/130,000 = 10.7%
(b) Selling price aects the revenue figure. If its PV of $317,000 falls 13,875 then NPV = 0.
Sensitivity = 13,875/317,000 = 4.4%
(c) Sales volume aects both revenue and marginal costs: 317,000 190,200 = 126,800
Sensitivity = 13,875/126,800 = 10.9%
(d) The PV of the scrap value must fall by $13,875 to produce a zero NPV.
Sensitivity = 13,875/17,075 = 82%
(e) To work out the sensitivity to the discount rate, the IRR has to be calculated. So, NPV at 20%:

Time $ 20% discount factor DCF $

0 Cost (130,000) 1 (130,000)
14 Sales 1,000@$100 = $100,000 2.59 259,000
1 -4 Marginal costs 1,000@$60 = ($60,000) 2.59 (155,400)
4 Scrap 25,000 0.482 12,050
NPV (14,350

By interpolation
IRR = 10 + (20 10) x13,875/(13,875 + 14,350) = 14.9, or around 15%

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So, the NPV is very sensitive to the selling price, which only needs to fall by about 4.4% before the
project just breaks even. Not only is 4.4% small, but the selling price is probably dicult to
The cost could rise by about 10%. Not a large over-run, but at least cost is easier to predict and
control than future flows.
Scrap value could fall by 82% - a large fall, but it will usually be dicult to predict the scrap amount.

The discount rate can rise from 10% to 15% (50%) and that would probably be judged unlikely.

Sensitivity analysis allow only one variable to be changed at a time. In fact some
changes might well be linked.
It also say nothing about how likely a variable is to change. We have said that the
project is very sensitive to selling price (4.4%), but if the selling prices had been already
agreed for a four year contract, that 4.4% drop is unlikely to happen.

8. Risk adjusted discount rates

If a projects cash flows are perceived as being particularly either because they are simply
difficult to predict or the project is inherently risky then a higher discount rate can be applied.
This will more severely discount the more distant cash flows which is just what you want
because those are the flows that are least certain.

This subject is covered in more detail in a later chapter.

9. Certainty equivalents
Another way to account for future inflows being uncertain is to reduce them to their
certainty equivalent, which can be defined as:

the guaranteed amount of money that an individual would view as equally desirable as a
risky asset.

So, the flows being received at each of times 1, 2, 3 might be reduced to 90%, 75% and 60%
of their face values to account for further off flows being less certain.

There is no set way to reduce future flows. For example, for a particular project the reductions
might be to 80%, 70% and 50%

The resulting cash flows would then be discounted the risk free discount rate. Do not reduce
the flows to their certainty equivalence AND use a risk adjusted discount rate as that would
be double counting.

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10. Linear regression

Linear regression is a method of fitting the best possible straight line through a set of points.

In business, typically the line would connect points showing:

Cost and volume
Selling price and sales volume

Hours worked and units produced

The predictions that might be made can be used by organisations to plan better and this will
reduce risk. For example, if a company is think of reducing its selling price, it needs to have an
idea of the volume of goods that will sell otherwise it risks not being able to meet demand
and of alienating customers.

Linear regression will give constants which fit a line of the type:

y = ax + b


y is the dependent variable (cost, hours, volume sold)

x is the independent variable (units made, selling price).

The constant a, for example, could be the additional cost for each additional unit made; b
would be the cost even if no units were made (the fixed cost).

However, be warned: linear regression will give the best line it can through any set of points.

For example, if you numbered the days in the year 1 365 and you noted the day each person
was born and the amount of money they had in their bank account, linear regression would
suggest the best relationship it could between these variables. Obviously there would not
actually be a good relationship.

To test the relationship you must calculate the coefficient of correlation (r), or the coefficient
of determination (r2). r can vary between:

r = +1, meaning perfect positive correlation where all points lie on the line and as one
variable increases, so does the other.

r = -1, meaning perfect negative correlation where all points lie on the line and as one
variable increases, the other decreases.

r = 0 means no correlation.

If r = 0.7, r2 = 0.49 or about 50%. This means that 50% of the change in one variable is
explained by the change in the other.

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You should be aware of the following before you rely on any prediction based on linear
If r2 is low, then one variable is not well-associated with the other, so any predictions are
liable to be poor.
The more points (readings) the better: simply more evidence for the association.
Extrapolation (predicting outside the range examined) is dangerous as we have no
direct evidence of what happens in other regions. For example, costs might suddenly

Other known influences (such as inflation) should be removed before the analysis.
Even good correlation does no prove cause and effect: both variables might have
moved together under the influence of another variable.

11. Simulation modelling

Simulation attempts to model the possible results from a project by using ranges of values
and random numbers to generate typical series of events. It is best carried out using a

For example:

A company is considering a 6 year project, in volatile economic conditions. It is thought that

growth or decline in the market from one year to the next will depend on the growth or
decline that happened in the previous year:

If the market grows 10% in one year, there is a 75% chance that it will grow 10% the following
year and a 25% chance that it will decline 10%. Similarly, decline of 10% in one year gives a
75% chance of 10% decline the next and a 25% chance of 10% growth.

To set up the simulation ranges of numbers are assigned to mimic the probabilities:
If there is growth one year then for the next year: 00 75 = further growth; 76 99 =
If there is a decline one year then for the next year: 00 75 = further decline; 76 99

Lets start with sales of 1000 units and assume that the previous year showed growth.
Random numbers are then generated. For example: 63, 41, 5, 67, 98, 37, 74, 3, 12, 34 , 95
and so on

Random number 63 41 85 67 98 37 74 83 12 95

Growth/decline +/- 10% G G D D G G G D D G

Sales 1100 1210 1089 980 1078 1186 1305 1175 1057 1163

This allows typical trading patterns to be examined and would allow the company to see
what might happen if it had several years of decline in a row.

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Chapter 5


1. The meaning of divisionalisation

Divisionalisation is where a business is split and managers of business units are given a
degree of autonomy over decision-making i.e. they are given the authority to make decision
without reference to senior management. In effect, they are allowed to run their part of the
business almost as though it were their own company.

Divisionalisation can be on the basis of:

Geography (eg North American and European divisions)
Products (commercial vehicles and motor cars)
Customers (business to business and business to consumer)
Activities (component manufacturing and assembly and sales)

Inevitably when a business is split into a number of business units, managers want to
measure and compare the performance of each division. If goods pass from one division to
another, transfer prices must be set.

2. Advantages of divisionalisation:
Specialism in product/country/customer.
Greater motivation for managers.
Allows divisions to be profit centres (motivating and promotes eciency).
Allows performances between divisions to be compared.
Clearer objectives for managers (concentrate on one area of the business only).
Usually accompanied by decentralisation, so potentially better decisions.

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3. Problems and risks with divisionalisation:

Coordination diculties. The divisions might act in ways that hurt the group. This is
known as dysfunctional decision-making. For example, one division could stop making
a component that is vital to another divisions operations.
Requires transfer prices to be established. Wring transfer prices can cause dysfunctional
Diculties in fair comparison of divisions. Once again, transfer prices could distort

performance appraisal.
Potential duplication of some services.

4. Divisional performance measurement

4.1. Return on Investment (ROI)

ROI is defined as: Controllable division profit as a percentage of divisional investment

It is equivalent to Return on Capital Employed and this is one of the reasons that it is very
popular in practice as a divisional performance measure.Exam

Example 1
Vallpineda plc has several divisions.The Isabel division is currently making a profit of $82,000 p.a. on
investment of $500,000. Vallpineda has a target return of 15%
The manager of Isabel is considering a new investment which will require additional investment of
$100,000 and will generate additional profit of $16,000 each year
(a) Calculate whether or not the new investment is attractive to the company as a whole.
(b) Calculate the ROI of the division, with and without the new investment and hence
determine whether or not the manager would decide to accept the new investment.

The investment earns a rate of $16,000/$100,000 = 16%. As this is greater than the groups target
rate of return (15%), the group would want Isabel to take on the new investment.
Isabel currently earns an ROI or 82/500 = 16.4%. As this is above the groups required return of 15%,
the manager of Isabel would feel safe.
If Isabel took on the new investment, the new ROI would be (82 + 16)/(500,000 + 100,000) = 16.3%.
Although this ROI is still above the required return of 15%, it is lower than it would have been had
the investment been turned down ie Isabels ROI has fallen from 16.4% to 16.3%. There is therefore
no incentive for the manager of Isabel to take on the new investment. Why would you if the
performance measure on which you are judged falls from 16.4% to 16.3%?

This is an example of dysfunctional decision making and this can occur with investment
decisions based on ROI. The group would like the investment to be taken on, but the
divisional manager would reject it.

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4.2. Residual Income (RI)

Instead of using a percentage measure, as with ROI, the Residual Income approach assesses
the managers on absolute profit. However, in order to take account of the capital investment,
notional (imputed or pretend) interest is deducted from the Income Statement figure profit
figure. The notional interest is charged at the cost of capital. The balance remaining is known
as residual income.

Example 2
Figures as above for Vallpineda and Isabel but assume that the manager is assessed on the
divisions Residual Income and that maximisation of residual income drives decisions.

Currently Isabels residual income is: $82,000 0.15 x $500,000 = $7,000
With the new project: $82,000 + $16,000 0.15 $(500,000 + 100,000) = $8,000
Therefore, taking on the new project will increase the residual income of Isabel and this should
make Isabels manager accept the project. That decision is congruent with what the group would
want to happen.

4.3. ROI vs RI

Note that both RI and ROI will favour divisions with older assets because those divisions will:
Probably have bought the assets more cheaply than new divisions which buy at inflated
The assets are more heavily depreciated so that the capital employed figures is less in
the division with older assets and this aects both the denominator in ROI and the
notional interest charge in RI

Both methods can also suer from distortions because of assets leased on operating leases
and also if head oce accounts for some divisional assets (for example HO holding all

In practice, ROI is more popular than RI, although that RI is technically superior as it
encourages managers to make the correct investment decisions.

Pros and cons of ROI:

It seems familiar most managers will know about return on capital calculations.
Easy: compare ROI with a company target.
Encourages maximisation of ROI which might be how congruent with shareholders
judge the company.
Good for comparing divisions of dierent sizes


Decisions will not necessarily maximise shareholder wealth.

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Pros and cons of RI:

RI maximisation tends to be congruent with decisions that maximise shareholder

Dierent notional interest rates can be set for investment of dierent risk.


A less familiar calculation and concept

Not good at comparing divisions of dierent sizes. (Larger RIs might simply mean
bigger division).

5. Economic Value Added

Economic value added (EVA) is a performance metric that is very similar in approach to
Residual Income, and is defined as being:

EVA = Net operating profit after tax WACC x book value of capital employed

EVA is a trade-marked technique, developed by consultants called Stern Stewart and Co.

The principle behind it is that a business is only really creating value if its profit is in excess of
the required minimum rate of return that shareholders and debt holders could get by
investing in other securities of comparable risk.

The capital employed is the opening capital employed, adjusted for the items set out below.

However, EVA makes certain adjustments because certain types of expenditure which appear
in the statements of profit and loss under ISAs and IFRSs are NOT regarded as expenses when
using EVA and cash accounting is regarded as more reliable than accruals accounting).

The major adjustments are:

Add back to profits:

Expenditure on building for the future (e.g. research expenditure, marketing
expenditure and sta training):
Non-cash expenses
Goodwill written o
Depreciation: add back book depreciation and deduct economic depreciation. If
economic depreciation is not given, assume it is the same as book depreciation and that
there is no net adjustment.
Interest on debt capital: Add back to net profit after adjusting for any tax relief. (Treat
the debt as part of capital employed)

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Adjustment to statement of financial position

Non capitalised leases
Research etc now capitalised
Goodwill written o

6. Potential problems with EVA

It is dicult to use EVA to compare firms or divisions because it is an absolute measure
and takes no account of the relative size of the business.
Because EVA is a year-to-year measure, it could be improved in the short term but to the
detriment of the business in the long term.
Economic depreciation is dicult to calculate and conflicts with generally accepted
accounting principles.
Other factors that could be important but are not included in the accounts are ignored.
EVA is a short-term measure whereas performance measures should focus on the
longer- term forecasts. Ideally economic income would be used (by discounting
estimated future cash flows) but even ignoring the complexity of this, the person
responsible for estimating it would very often be the person being measured, which
could lead to bias.

7. Transfer pricing Introduction

The ideal transfer price should be:

Perceived as fair to both divisions and therefore good for performance measurement
and management.
Provide profits for both divisions because profits are motivating.
Promote goal congruence so that divisions volunteer to do what is good for the group.
Promote autonomy ie minimise head oce interference.

The reason for having a transfer price is to be able to make each division profit accountable. If,
in the previous example, there was no transfer price and goods were transferred free of
charge between the division, then the overall profit for the company would be unchanged.
However, Division A would only be reporting costs, and Division B would be reporting an
enormous profit. The problem would be compounded if Division A was selling the same
product externally as well as transferring to Division B.

8. Cost-plus transfer pricing

A very common way in practice of determining a transfer price is for the company to have a
policy that all goods are transferred at the cost to the supplying division plus a fixed
percentage. This is easy to calculate though gives no incentive for the transferring division to
save costs. Cost plus means more profit as costs rise!

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9. Cost-plus transfer pricing

This method has the great advantage of being perceived as fair by both divisions. It the
divisions were on their own and having to buy or sell from outside suppliers/customers then
the market price would be what they have to charge or pay.

However, it can only work if there is a market for the intermediate product. Adjustments
should also be made if it costs less to transfer internally than externally, for example,

packaging might be simpler on internal transfers.

The market price approach can also lead to dysfunctional decisions. Consider the following,
where Division A makes components and transfers them to Division B for the external market
price of the components, $120. Division B sells them to the public for $250.

$ Division A Division B
Transfer-in costs - 120
Own costs 80 100
Total costs 80 220
Profit 40 30
Transfer price/sale price 120 250

Now assume that the company can make more units than are demanded at the selling price
of $250, and a potential customer approaches Division B, the end-selling division, saying that
they will by all surplus capacity for $200/unit.

Division B will turn down that offer because it perceives marginal cost per unit = $220 but it
would only earn marginal revenue of $200.

However, from the groups viewpoint, marginal cost to the group = $180 (80 + 100) so the
offer would be worthwhile as it makes a positive contribution.

So, even though the transfer price has been set objectively at the market value of the items
transferred it can lead to dysfunctional decisions.

10. Other practical approaches of transfer pricing

Marginal cost: condemns selling divisions to making losses because fixed costs are not
covered. However, promotes goal congruent decisions
Marginal cost plus lump sum: during the year marginal costs are used (goal
congruence). At the end of the period an additional lump sum is transferred between
transferee and transferor to account for profits.
Dual prices: transferee transfers at a markup (so makes a profit); transferee buys in at
marginal cost (so can make correct decisions for goal congruence)

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11. Sensible transfer pricing to achieve goal congruence.

You might be asked to suggest sensible transfer prices. (As we will illustrate, you will normally
be asked to state a range rather than one specific price.)

There are rule that can be applied. However, it is dangerous to simply learn a rule without
fully understanding the logic. We will therefore build up the rules using a series of small
examples, and then state the rules at the end.

Example 1
Division A has costs of $20 p.u., and transfer goods to Division B which has additional costs of $8
p.u. . Division B sells externally at $30 p.u.
Determine a sensible range for the transfer price to achieve goal congruence.

$ Division A Division B
Transfer-in costs - ?
Own costs 20 8
Total costs 20 ?
Profit ? ?
Transfer price/sale price ? 30
The group can make: 30 20 8 = 2 per unit, so the group will want the Divisions to trade.
If they are going to trade, both must want to, so:
Division A must be offered a transfer out price of no less than $20, otherwise it would be making a
negative contribution. Division A determines the minimum transfer price.
Division B, after its own costs, is left with net marginal revenue of $22 (ie 30 8).
If the price it had to pay to Division A were greater than $22 it would not trade. Division B
determines the Maximum transfer price.
Therefore a viable range of transfer prices if $20 - $22. Anything outside that range would mean
that on or other of the divisions would not trade.

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Example 2
Division A has costs of $15 p.u., and transfers goods to Division B which has additional costs of $10
p.u.. Division B sells externally at $35 p.u.
A can sell part-finished units externally for $20 p.u.. There is limited demand externally from A, and
A has unlimited production capacity.

Determine a sensible range for the transfer price to achieve goal congruence.


$ Division A Division B
Transfer-in costs - ?
Own costs 15 10
Total costs 15 ?
Profit ? ?
Transfer price/sale price ? 35
And/or Division A can sell outside at $20
The Group wants goods to pass from Division A to Division B because that way the groups will
make $35 - $15 - $10 = $10/unit.
Division A will be happy to sell outside at a price of $20/unit because that earns it $5/unit.
However, because Division As production capacity is unlimited and the outside market for Division
As product is limited, Division B and the Group can do everything they want: Division A can sell as
much as the outside market demands and can also sell to Division B.
The only thing to worry about is ensuring that Division A and Division B will trade with each other.
So Division A must be offered at least $15, and Division B must have to pay no more than $25 (ie
$35 - $10).
Therefore, the range of transfer prices is $15 to $25.

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Example 3
As above, but there is now unlimited external demand from the external market for the
intermediate product that Division A makes A, but Division A has limited production capacity.
Determine a sensible range for the transfer price to achieve goal congruence.

Division A has limited production capacity so cannot supply the outside market fully and also
transfer to division B.
The Group wants to ensure that goods are transferred to Division B and sold on because that route
generates a contribution per unit of $35 - $10 - $15 = $10. However, if Division A had decided to
transfer goods to the external market for $20, the Group would earn only $20 - $15 = $5.
So, to make Division A decide to transfer to Division B, the transfer price offered must be at least
$20, ie at least as good as what it could earn externally.
The viable range of transfer prices is therefore $20 to $25
[Note the minimum transfer price can also be described as the marginal cost to Division A of
production plus the opportunity cost of transferring internally rather than externally:
$15 + ($20 - $15) = $20 [as before]

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Example 4
Division A has costs of $8 p.u., and transfers goods to Division B which has additional costs of $4
p.u..Division B sells externally at $20 p.u.
Determine a sensible range for the transfer price to achieve goal congruence, if Division B
can buy part-finished goods externally for:

(i) $14 p.u.

(ii) $18 p.u.

$ Division A Division B
Transfer-in costs - ? And/or Division B can buy from
outside at (i) 14 or $(ii) $18
Own costs 8 4
Total costs 8 ?
Profit ? ?
Transfer price/sale price ? 20
The group will prefer Division B to buy form Division A as $8 (in-house costs) < $14 (buy-in costs).
So the transfer price must be in the range $8 (to make Division A make and sell) to $14 (to make
Division B buy from Division A rather than outside.
Division B would not dream of buying for outside at $18 as that is greater than its net marginal
revenue of $16 (ie 20 4). SO the viable range of transfer prices is simply $8 - $16.

12. International considerations

When transfers occur between different countries, then there are additional factors to take
into account. These include the following:
Taxation in the dierent countries
Import taris
Exchange controls
Anti-dumping legislation
Competitive pressures
Repatriation of funds

In practice, most countries tax laws will include rules about transfer pricing.

Usually they encourage a transfer price at market value to ensure that both countries receive
a fair share of the profits. However, it is not always easy to establish what is a fair market

A transfer price at full cost is usually acceptable to tax authorities, but transfer prices at
variable cost are unlikely to be acceptable.

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Chapter 6

1. Why corporate governance is needed

Corporate governance is a system by which companies are directed and controlled.

The problem is that although the shareholders own companies, the day-to-day management
and direction of companies is given to the Board of Directors. In large companies, many
shareholders are relatively passive and the Board of Directors are given more or less free rein
to make whatever decisions they wish.

Auditing was instituted so at least once a year, when the accounts were presented to the
members of the company, the auditors would examine the accounts and give some
expression of opinion to the members of the company as to whether the accounts were true
and fair. Without that assurance the members of the company really would have a little idea
as to whether or not the accounts were worth relying on. The auditors therefore examine the
financial statements and this adds credibility to those statements, the shareholders have a
much better idea of the performance of the directors and the company.

Appoint independent

Measure credibility
Financial Statements

Prepare FS

Shareholders Directors

Own Manage

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Note that shareholders appoint the independent auditors, they also appoint the directors.
The problem is however that once directors were appointed, shareholders often didnt take
much further interests in what the directors were doing. Scandals such as Enron, Worldcom in
the early 2000s and perhaps banking problems in 2008 showed that this hands-off approach
was entirely inadequate and additional safeguards have been instituted to try to ensure that
directors act in the best interests of the members of the company.

2. Principles of corporate governance

The Organization of Economic Cooperation Development (OECD) has put forward some
principles of corporate governance.
Corporate governance frameworks should protect shareholders rights, ensuring fair
treatment of all shareholders, particularly minority and foreign shareholders. For
example all shareholders should have access to the same information.
The corporate governance framework should also recognise the rights of all
stakeholders, not just shareholders, and should encourage active cooperation between
the entities and stakeholders in creating wealth, jobs and sustainability of financially
sound entities.
There should be disclosure and transparency.
The corporate governance framework should ensure that timely accurate information is
made available in all material matters.
Responsibility of the board is also covered, and the corporate the corporate governance
framework should ensure the strategic guidance of the entity, effective monitoring of
management by the board and the boards accountability to the entity and their
shareholders. In particular the board should set its own objectives, monitor its own
performance and have its own performance assessed.

3. The UK Corporate Governance Code

The OECD principles are put into effect in a variety of ways in different countries. The UK
Corporate Governance Code can be referred to as an example of best practice.

The code states that the purpose of corporate governance is to facilitate effective
entrepreneurial and prudent management that can deliver long-term success of the
company. It then goes on to list the main principles of the code:

Main principles

Relations with shareholders

Comply or explain

The code has no force in law and is enforced on listed companies through the Stock
Exchange. Listed companies are expected comply or explain and this approach is the
trademark of corporate governance in the UK. Listed companies have to state that they have

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complied with the code or else explain to shareholders why they havent. This allows some
flexibility and non-compliance might be acceptable in some circumstances.


Every company should be headed by an effective board which is collectively

responsible for the long-term success of the company.
There should be a clear division between the running of the board and the executive

responsibility for the running of the companys business. No one individual should have
unfettered powers of decision. This means that the roles of CEO and Chairman should
not be performed by one person as that concentrates too much power in that person.
The chairman is responsible for leadership of the board
Non-executive directors (NEDs) must be appointed to the board and they should
constructively challenge and help develop proposals on strategy. NEDs sit in at board
meeting and have full voting rights, but do not have day-to day executive or managerial
responsibility. Their function is to monitor, advise and warn the executive directors.


The board should have an appropriate balance of skills, experience, independence and
knowledge. In large companies NEDS should be at least 50% of the board; in small
companies there should be at least 2 NEDS.
New directors should be appointed by a Nomination Committee to ensure a formal,
rigorous and transparent procedure for their appointment. The Nomination Committee
consists of NEDs. This provision is to prevent directors appointing their friends and
colleagues to the board and ensures that the best people for the job are considered and
All directors should be able to allocate sufficient time to company business
There should be induction on joining the board and a programme to update and
refresh directors skills and knowledge.
The board should be supplied in a timely manner with necessary information
The board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors.
All directors should be submitted for re-election at regular intervals
The board should present a balanced and u


The board should present a balanced and understandable assessment of the companys
position and prospects.
The board is responsible for determining the significant risks and should maintain
sound risk management and internal control systems.
The board should establish formal and transparent arrangements for applying the
corporate reporting, risk management and internal control principles, and for
maintaining an appropriate relationship with the companys auditor. This means that an
Audit Committee (NEDs again) should be established to liaise with both internal and
external auditors. Before audit committees, the finance director liaised with auditors,
but this was not satisfactory because the finance director was often the person
responsible for accounting problems. Therefore auditors were often reporting problems

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to the person who caused them. The directors are responsible for establishing an
internal control system and must review the need for internal audit.


Levels of remuneration should be sufficient to attract, retain and motivate directors of

sufficient quality but avoid paying more than is necessary.
A significant proportion of executive directors remuneration should be structured so as

to link rewards to corporate and individual performance. In other words, profit related
pay is encouraged. Directors should not receive high pay irrespective of company
There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors. No
director should be involved in deciding his or her own remuneration. This means that a
Remuneration Committee (NEDs) should be formed to fix directors remuneration.

Note the point that a significant proportion of executive directors remuneration should be
related to the profit or other success of the company. A long term relationship is really whats
wanted so that directors cannot manipulate profits in the short term to manufacture bonuses
for themselves.

Share option schemes can be very effective methods of remuneration. For example, if the
current share price is $8, offer share options at $15, available after four years (the vesting
period). If, after four years, the share price has risen above $15, directors will exercise their
options to buy at $15 as this will produce a profit for them. If the share price were only $12,
the options would not be exercised. Therefore, the scheme encourages directors to act in a
way that increases the long-term share price of the company precisely what the
shareholders would want then to do.

Relations with shareholders

One of the problems with achieving good corporate was encouraging shareholders to take an
active interest in the company. Too often they did not fully participate at AGMs and would
wave through motions. This passive attitude might well have been encouraged by directors
to move power towards them and away from members.

The code therefore specifies:

There should be a dialogue with shareholders based on the mutual understanding of

objectives. The board as a whole has responsibility for ensuring that a satisfactory
dialogue with shareholders takes place.
The board should use the AGM to communicate with investors and to encourage their

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4. The role of the audit committee

The audit committee is now very important part of corporate governance.

Review of internal audit

Financial Statements Review of internal control

Special investigations
Liaison with external auditors:
Scope of external audit
Forum to link directors/auditors
Deal with auditors reservations
Obtain information for auditors.

The committee should be dominated by non-executive directors. The functions are as follows:
They will review the work of internal audit. Companies dont have to be an internal
audit department, but corporate governance rules now stated management should
keep the need for internal audit on the review.
The audit committee will review the system of internal control. Corporate governance
now imposes on management the requirement that they implement a system of
internal control.
From time to time the audit committee may launch special investigations. For example,
if a fraud had been discovered within the organization the audit committee may ask for
a report on how it happened and how to prevent it in the future.
Liaison with external auditors. It used to be that external auditors would communicate
almost exclusively with the finance director, but of course the finance director may not
be sufficiently independent of the finance function and the system of internal control.
Now, the audit committee will set the scope for the external audit. They act as a forum
to link directors and auditors. Auditors will typically write to the audit committee about
any problems they may be having on the audit or obtaining all the information they
require. If the auditors are worried in someway about the financial statements they will
raise those concerns with the audit committee.
If the auditors cant find information in any other way and feel perhaps they are being
obstructed, they can go to the audit committee and explain the problem and the audit
committee can try to investigate on their behalf.
Liaise on the process of appointing auditors and setting their fees. (Note that the
external auditors are appointed by members in general meeting, but the audit
committee is likely to make recommendations.)

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Chapter 7

1. Introduction

The CIMA Code of Ethics for Professional Accountants is based on The CIMA Code of Ethics is
based on the IFAC Handbook of the Code of Ethics for Professional Accountants, of the
International Ethics Standards Board of Accountants (IESBA).

If a member cannot resolve an ethical issue by following this Code by consulting the ethics
information on CIMAs website or by seeking guidance from CIMAs ethics helpline, he or she
should seek legal advice as to both his or her legal rights and any obligations he or she may

The Code of Ethics sets out certain fundamental principles about how its members should
behave. It also recognises how its members could be subject to certain threats which would
compromise their behaviour and suggests ways in which members can safeguard themselves
against the operation of those threats.

The guide applies to all members of CIMA working in industry, commerce and public practice.
It also applies to all CIMA students. Note that its operation is not restricted to auditors and
covers CIMA members working in industry and commerce.

The ethical framework recognises that there are:

Ethical principles to be followed

These are subject to risks
Accountants should use safeguards to avoid or to respond to risks.

2. Fundamental principles
The fundamental principles are as follows:
First, integrity. This means that members should be honest, straightforward. If they see
something is amiss, they should say so; they shouldnt try to conceal it; they shouldnt
turn a blind eye; they shouldnt try to be ambiguous, they should state things plainly.
Secondly, objectivity, members should be influenced by the facts and the facts only.
They must avoid bias, conflict of interest and undue influence.
Third, members should exercise professional competence and due care. They must
keep themselves up-to-date with legislation and recent developments. They shouldnt
take on work which they are not qualified for or for which they have no skills. They must
be diligent, they must be careful.
Fourth, confidentiality. Members, particularly perhaps those who are auditors, have
accessed information which is highly confidential and which is indeed price sensitive.
That information must be held confidentially. Members should not disclose confidential
information unless they have a legal or professional duty to do so. An example of a legal
duty to disclose information can arise if a member thinks that a client or the person they

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are working for is involved in money laundering. Many countries have very strong
regulations nowadays that money laundering suspects should be reported to the
Finally, members should show professional behaviour. They should comply with the
law and they should avoid any actions which discredit the profession. So, for example,
when they are trying to advertise their services they shouldnt say that other members
are bad or poor. They should confine themselves to promoting what they are good at;
they shouldnt rubbish other professionals.

3. Threats to professional ethics

Threats to professional ethics arise from
Self review

Note also management threats where the auditor performs managerial functions for the
client. Not listed by the IESBA, but covered under several of the above, such as self-interest
and familiarity.

Where such threats exist, the CIMA member must put in place safeguards that eliminate them
or reduce them to clearly insignificant levels. Safeguards apply at three levels: safeguards in
the work environment, safeguards that increase the risk of detection, and specific safeguards
to deal with particular cases. If he is unable to implement fully adequate safeguards, then the
member must not carry out the work.

Some of the following threats are likely to apply predominately to members in public
practice, but many apply to all types of employment

3.1. Self-interest threats

Self-interest threats are the following:

Financial: For example, if an auditor own shares in the client or employer. The member
could be accused of wanting the company profits to look good, so that the share price
rises thereby enriching the member.
Close business relationships are also threats. For example, if a partner retired from an
audit partnership and then immediately went to work for a client, they could be
accused for having lined themselves up for a job and to do that they perhaps did not do
their audit rigorously. A period of at least two years should pass before an ex-partner
takes up an appointment with a client. Having a partner on the client board is also
Close family and personal relationships between the CIMA member and owners or
directors of the company they are working with create the possibility of suggestions
that the members work has been neither objective nor independent, and that the
accountant did not show the proper degree of integrity.
Loans and guarantees to the CIMA member should be looked at carefully. If the other
party is a bank and it makes a loan on a normal business terms, for example a mortgage,

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this would normally be regarded as acceptable. Certainly no loans or financial

relationships should exist between a client and the member if it is not normal business
for the client to make loans.
Overdue fees, for example, for consultancy work, put the CIMA member some risk as
there is a possibility that client will never pay those fees. This could lead to accusations
any work performed (such as preparing a cash-flow forecast) will try to ensure that the
company survives so that the fee will be paid. If there are overdue fees the member
should not make the situation worse and should not incur any more chargeable time

until those fees have been settled.

Contingent fees are obviously dangerous. A contingent fee, for example, would be
where the CIMA member is paid is paid a small fee if a report being prepared is
unfavourable, but a large fee if it is favourable.
High percentage fees. If the auditor earns a high percentage of total income from one
audit client, then the auditor will rely too much on that client and cant afford to lose
them. This can give the client too much leverage over the auditor. Generally any singly
ordinary audit client should not contribute more than 15% of recurring fee income to
the auditor. The 15% is reduced to 10% for public interest companies such as quoted
Low-balling refers to the practice of quoting a very low audit fee to a client and then
hope that profits would be made another work awarded by the client. This means really
that the audit does not pay for itself so how, therefore, could a proper audit be done?
Winning an audit is a competitive business and the audit fee is an important factor to
clients. However, an auditor could find it difficult to claim that a proper audit has been
carried out if a loss was made on the audit. Fees should be profitable for the auditor.
Recruiting staff on behalf of a client should not be done. The danger here is that if
members of staff are recruited by the auditor, particularly financial staff, then
subsequently the auditor might be reluctant to criticise the performance of those staff
members as the advice they gave on recruitment looks bad. Similar considerations
should be taken into account when the auditor performs any management function for
the client.

3.2. Self review threats

Self review threats arise when an auditor does work for a client and that work may then be
subject to checking during the subsequent audit. For example, if the auditor prepares the
financial statements, and then has to audit them, or the auditor performs internal audit
services and then has to check that the system of internal control is operating properly.
Auditors could obviously be reluctant to criticise the work which their own firms have earlier
undertaken, and this could interfere with independence and objectivity. Generally auditors
must be very careful when undertaking such work. Certainly it is common for auditors to do
other work, what is important that the work is done by an entirely different team from the
audit firm.

Really, checking your own work is a waste of time.

3.3. Advocacy threats

Arise if promoting a position or opinion to the point that subsequent objectivity is

compromised. An example would be where you represent a company at a meeting with a
bank to raise a loan.

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3.4. Familiarity threats

Familiarity threats arise because of the close relationship between members and a client or
employer so that independence is compromised. The close relationship can arise by
friendship, family or through business connections. There is no general definition of whats
meant by close relationships, but if you were a consultant and your brother was the Finance
Director of a client firm then there probably is a close relationship! If however the finance
director was a remote cousin of yours, there might not be a close relationship. Note that there

does not have to be any family or legal relationship: friendship can threaten independence
and integrity.

3.5. Intimidation threats

The final groups of threats are intimidation threats. These can deter CIMA members from
acting properly. Examples could be threatened litigation, blackmail, bad staff assessments, no
promotion, or there might even be physical intimidation, though it is to be hoped that that is
rare. Blackmail could be more subtly applied and might relate back for example to a period
where the CIMA member was not acting in accordance with the required ethical standards.

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Chapter 8

1. Types of processing systems

1.1. Levels of management and their information needs

Information processing systems have to support staff at all levels, but there are quite different
information needs at different levels:

Corporate /
Strategic Level

Business / Management

Operational Control

Corporate/strategic level needs information which tends to be:

Forward-looking (at this high level of management, people should be planning for the
future) and historical.
Often has to deal with estimates
Often not to the last degree of accuracy perhaps dealing with the nearest $1m.
Outward-looking (how are competitors, countries economies and technologies
Supports unstructured decision-making ie where there is no definitive way at arriving at
the right answer. For example, should we open an operation in Brazil?
Non-routine/ad hoc

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Operation control level deals with information which tends to be:

Very accurate
Supports structured decisions such as dont accept an order if over a customers credit


In the middle, information for business and management control

Moderately forward looking (for example, will the division reach this years budget?)
Semi-structured decisions (such as should we manufacture more stock?)
Reasonably accurate.

The types of processing system available include:

Transaction processing systems (TPS)

The first business computer applications were for recording transactions such as wages
and salaries processing, the production of sales invoices and receivables ledger
accounting. These systems are known as transaction processing systems and they
automate existing operations allowing greater accuracy, more speed and cheaper

Management information systems (MIS)

Once transactions are recorded in a computer it is easy to analyse those transactions to
produce information that could be useful for management and IT operations then
became known as management information systems. For example, once the sales
ledger is computerised it is easy to produce aged receivables listings.

The systems could also be programmed to make simple decisions such comparing
inventory levels to production plans to enable automatic stock ordering or approving
new orders by comparing credit limits to customer balance and new order value. The
simple decisions are known as programmable or structured decisions, meaning that
there is a well-defined way of getting to the correct answer. MIS primarily allows
companies to keep their costs down, helping them to move towards cost leadership,
through a combination of automation and rationalisation.

Decision support systems (DSS)

Not all decisions are structured. For example, there is no definitively correct way to draft
next years budget or to decide on the selling price of a new product. DSS help
managers to make decisions.

A good example is seen in the use of spreadsheets where financial models created on
spreadsheets allow managers to try out what if? experiments where they try out
dierent combinations of assumptions and try to home in on a credible answer.

More sophisticated DSS systems can combine, for example, computer aided design and
computer aided manufacturing systems to enable new products to be brought to
market more quickly. Data warehousing (recording historical transaction data) and data
mining (trawling through that data to learn more about customers preferences and

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buying patterns). Both of these techniques can help with dierentiation and focus

Executive information systems (EIS)

These are aimed at senior managers and they have a particular emphasis on giving
access to external information that is needed for operational and strategic planning (eg
through the internet and access to external databases). Executive information systems
also emphasise flexibility so that executives can see company data in a wide variety of

ways and they can drill down top greater detail when needed.

Databases are by far the preferred way to hold data. Databases allow a wide range of
users and applications to use the data flexibly and to update it. Each user can be given a
unique, personalised and relevant view of the data which they can easily search and
manipulate. Centralising data into databases means that data is held once only so is
easier to update and everyone sees a consistent version.

Access to databases needs to be carefully controlled and backups are immensely

important. If the database is damages, all an organisations data could be lost.

Expert systems
These were an attempt to capture an experts skills so that expert decisions could be
made automatically. They are used where there are complex programmed (structured)
decisions to be made such as working out pension entitlements and options.

The increasing reliance on computers by all levels within a company requires careful
design of the information technology (IT) infrastructure. IT usually refers to the
hardware: computers, connections, disk storage.

2. Physical arrangements

2.1. Networks

Only the very smallest of businesses will have stand-alone computers ie computers not
connected to other computers. Even in small businesses employees need to share data and
very soon after personal computers were invented networks of computers were introduced.

There are two main types:

Local area network (LAN): Here the network extends over only a relatively small area,
such as an office, a university campus or a hospital. The small area means that these
networks use specially installed wiring to connect the machines.
Wide area networks (WAN): Here the network can extend between several cities and
countries. Each office would have its LAN, but that connects to LANs in other offices and
countries using commercial, public communications systems. At one time this would
have been done by the organisation leasing telephone lines for their private use to
transmit data from office to office. However, this is expensive and inflexible and the
common system now used is known as a virtual private network (VPN)

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2.2. Virtual private networks

VPNs allow data to be transmitted securely over the internet between any two locations.
Information will pass over many different circuits and connections but the system gives the
impression that you are operating over a dedicated, private communications link: hence the
name: virtual private network. For example, an employee working from home or a hotel can
access the company system as though being in the office. Because data is being transmitted
over public systems it is particularly vulnerable to interception and it is very important that

adequate security measures are in place to safeguard the data.

There are three essential steps in the security measures:

(1) Access control and authentication this ensures that unauthorized users do not access
the system. Typically this will be accomplished through a log-in procedure.

(2) Confidentiality this ensures that data cannot be intercepted and read by a third party
whilst being transmitted. This is achieved using encryption.

(3) Data integrity this ensures that the data has not been altered or distorted whilst in
transit. To ensure this, the message could have special check digits added to ensure that
the data complies with a mathematical rule.

2.3. Centralised and decentralised (distributed) architectures

Consider an office local area network. There are three main ways in which the data and
processing can be arranged: centralised, decentralised (distributed) and hybrid.

Centralised systems.

In these systems there is a powerful central computer which holds the data and which carries
out the processing.

The main advantages of such systems are:

Security: all data can be stored in a secure data centre so that, for example, access to the
data and back-up routines are easier to control.
One copy of the data: all users see the same version of the data.
Lower capital and operational costs: minimal hardware is needed at each sites. There is
also less administrative overhead.
The central computer can be very powerful: this will suit in processing-intensive
They allow a centralised approach to management. For example, a chain of shops needs
to keep track of inventory in each shop and to transfer it as needed. There is little point
in a shop that is running low ordering more if another branch has a surplus.

The main disadvantages of such systems are:

Highly dependent on links to the centralised processing facility. If that machine fails or
communication is disrupted then all users are affected.
Processing speed: will decrease as more users log-on
Lack of flexibility: local offices are dependent on suitable software and data being
loaded centrally.

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Decentralised (distributed) systems.

In these systems, each user has local processing power and will hold data locally.

The main advantages of such systems are:

Resilience: if one machine breaks down, others are unaffected.

Easy expansion: simply add another computer.

Flexibility: local users can decide which programs and software should be installed to
meet local needs.
They are more useful where each location can operate reasonably separately from

The main disadvantages are:

More difficult to control: data storage and processing are in many locations and correct
access, processing and back-up of data are more difficult to enforce.
Multiple versions of data: user might have their own version of data that should be
Potentially higher costs: each local computer has to have sufficient processing power
and each location might require an IT expert.

2.4. Cloud computing.

This is relatively new approach but one that is growing in popularity. There is only one copy
of the software on the server within a web-based interface. Users log into the web system and
their processing is then carried out on the server or a cloud of servers. It appears to each user
that they have a local version of the software, but what they are really seeing is the program
operating in the server. As more processing is needed more cloud resources can be used and
this gives users great flexibility.

Client machines can be thin-clients (ie not powerful) as they do not have to store much data
and software nor do they have to carry out much processing. Hardware, software and
maintenance costs are greatly reduced, though the system is vulnerable to service disruption.

It can be particularly useful where a companys processing needs are very volatile. For
example, a design or engineering company might need very high computing power only
when rendering (ie producing detailed graphics) work. Much of the time processing needs
are small. Therefore, instead of having a large computer of its own, the design companys
work is hosted by a cloud-based computer (whose use is shared). That computer will be
powerful enough to deal with intensive processing as needed. Also, designers can work at
home, for example, on laptops. The relatively low powered laptop provides the interface but
the bulk of the processing is done elsewhere.

Obviously there are risks arising from:

Loss of communications with the cloud machine

Communications that are too slow
Confidential data is being held on a third party machine and being transmitted over
public communications systems.

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3. Controls in IT systems

3.1. Risks

IT poses particular risks to organisations internal control and information systems and
organisations must try to safeguard their data and IT systems otherwise problems can lead to
their operations being severely disrupted and subsequently to lost sales, increased costs,
incorrect decisions and reputational damage. Some security breaches might leave an

organisation open to prosecution.

Risks include:

Reliance on systems or programs that are inaccurately processing data, processing

inaccurate data so that they report inaccurate, misleading results.
Unauthorised access to data leading to destruction of data, improper changes to data,
or inaccurate recording of transactions.
Particular risks may arise where multiple users access a common database on which
everyone in the organisation relies. The data could be incorrectly amended and all users
will be affected.
The possibility of IT personnel gaining access privileges beyond those necessary to
perform their assigned duties.
Human error.
Physical damage, such as fire or water damage.
Industrial espionage
Unauthorised changes to data in master files. For example, changing a selling prices or
credit limit.
Unauthorised changes to systems or programs so that they no longer operate correctly
and reliably.
Failure to make necessary changes to systems or programs to keep them up-to-date
and in line with legal and business requirements.
Potential loss of data or inability to access data as required. This could prevent, for
example, the processing of internet sales.

3.2. General controls

Controls in computer systems can be categorised as general controls and application


General controls: these are policies and procedures that relate to the computer environment
and which are therefore relevant to all applications. They support the effective functioning of
application controls by helping to ensure the continued proper operation of information

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General IT controls that maintain the integrity of information and security of data
commonly include controls over the following:

Data centre and network operations. A data centre is a central repository of data and it
is important that controls there include back-up procedures, anti-virus software and
firewalls to prevent hackers gaining access. Organisations should also have disaster
recovery plans in place to minimise damage caused by events such as floods, fire and
terrorist activities.

System software acquisition, change and maintenance. System software refers to

operating systems, such as Windows or Apples OS. These systems often undergo
updates as problems and vulnerabilities are identified and it is important for updates to
be implemented promptly.
Application system acquisition, development, and maintenance. Applications systems
are programs that carry out specific operations needed by the company such as
calculating wages and invoices and forecasting inventory usage. Just as much damage
can be done by the incorrect operation of software as by inputting incorrect data. For
example, think of the damage that could be done if sales analyses were incorrectly
calculated and presented. Management could be led to withdraw products that are, in
fact, very popular. All software amendments must be carefully specified and tested
before implementation.
Access security. Physical access to file servers should be carefully controlled. This is
where the company keeps it data and it is essential that this is safeguarded: data will
usually endow companies with competitive advantage. Access to processing should
also be restricted, typically through using log-on procedures and passwords.

3.3. Application controls:

Application controls are manual or automated procedures that typically operate at a business
process level, such as the processing of sales orders, wages and payments to suppliers.

These controls help ensure that transactions are authorised, and are completely and
accurately recorded, processed and reported. Examples include:
Edit checks of input data. For example, range tests can be applied to reject data outside
an allowed range; format checks ensure that data is input in the correct format (credit
card numbers should be 12 digits long; dependency checks where one piece of data
implies something about another (you have probably had a travel booking rejected
because you inadvertently had a return date earlier than the outward date); check
digits, where a number, such as an account number, is specially constructed to comply
with mathematical rules.
Numerical sequence checks to ensure that all accountable documents have been
Drop down menus which constrain choices and ensure only allowable entries can be
Batch total checks.

On-line, real time systems can pose particular risks because any number of employees could
be authorised to process certain transactions. Anonymity raises the prospect of both
carelessness and fraud so it is important to be able to trace all transactions to their originator.
This can be done by tagging each transactions with the identity of the person responsible.

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Cyber-espionage is also a growing threat. Governments, competitors and criminals attempt

to steal intellectual property or information about customers and contracts. Quite obviously
the theft of valuable know-how will undermine a companys competitive advantage and it is
essential that for organisations to defend themselves as far as possible against these threats.

4. Big data
There are many definition the term big data but most suggest something like the following:

Extremely large collections of data (data sets) that may be analysed to reveal patterns,
trends, and associations, especially relating to human behaviour and interactions.

In addition, many definitions also state that the data sets are so large that conventional
methods of storing and processing the data will not work.

In 2001 Doug Laney, an analyst with Gartner (a large US IT consultancy company) stated that
big data has the following characteristics, known as the 3Vs:

These characteristics, and sometimes additional ones, have been generally adopted as
essential qualities of big data.

disparate non-uniform data of dierent sizes, sources, shape,
arriving irregularly, some from internal sources and some from
external sources, some structured, but much of it is unstructured

of big data

Velocity: Volume:
data arrives continually and a very large amount of data. More than
often has to be processed very can be easily handled by a single
quickly to yield useful results computer, spreadsheet or conventional
database system

The commonest fourth V that is sometimes added is veracity: Is the data true? Can its
accuracy be relied upon?

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4.1. Volume

The volume of big data held by large companies such as Walmart (supermarkets), Apple and
eBay is measured in multiple petabytes. Whats a petabyte? Its 1015 bytes (characters) of
information. A typical disc on a personal computer (PC) holds 109 bytes (a gigabyte), so the
big data depositories of these companies hold at least the data that could typically be held on
1 million PCs, perhaps even 10 to 20 million PCs.

These numbers probably mean little even when converted into equivalent PCs. It is more

instructive to list some of the types of data that large companies will typically store.
Via loyalty cards being swiped at checkouts: details of all purchases you make,
when, where, how you pay, use of coupons.
Via websites: every product you have every looked at, every page you have visited,
every product you have ever bought. (To paraphrase a Sting song Every click you
make Ill be watching you.)

Social media (such as Facebook and Twitter)

Friends and contacts, postings made, your location when postings are made,
photographs (that can be scanned for identification), any other data you might choose
to reveal to the universe.

Mobile phone companies

Numbers you ring, texts you send (which can be automatically scanned for key words),
every location your phone has ever been whilst switched on (to an accuracy of a few
metres), your browsing habits. Voice mails.

Internet providers and browser providers

Every site and every page you visit. Information about all downloads and all emails
(again these are routinely scanned to provide insights into your interests). Search terms
you enter.

Banking systems
Every receipt, payment, credit card payment information (amount, date, retailer,
location), location of ATM machines used.

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4.2. Variety

Some of the variety of information can be seen from the examples listed above. In particular,
the following types of information are held:

Browsing activities: sites, pages visited, membership of sites, downloads, searches

Financial transactions

Buying habits
Reaction to ads on the internet or to advertising emails
Geographical information
Information about social and business contacts
Numerical information
Graphical information (such as photographs)
Oral information (such as voice mails)
Technical information, such as jet engine vibration and temperature analysis

This data can be both structured and unstructured:

Structured data: this data is stored within defined fields (numerical, text, date etc) often with
defined lengths, within a defined record, in a file of similar records. Structured data requires a
model of the types and format of business data that will be recorded and how the data will be
stored, processed and accessed. This is called a data model. Designing the model defines and
limits the data that can be collected and stored, and the processing that can be performed on

An example of structured data is found in banking systems, which record the receipts and
payments from your current account: date, amount, receipt/payment, short explanations
such as payee or source of the money.

Structured data is easily accessible by well-established database structured query languages.

Unstructured data: refers to information that does not have a pre-defined data-model. It
comes in all shapes and sizes and this variety and irregularities make it difficult to store it in a
way that will allow it to be analysed, searched or otherwise used. An often quoted statistic is
that 80% of business data is unstructured, residing it in word processor documents,
spreadsheets, PowerPoint files, audio, video, social media interactions and map data.

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4.3. Velocity

Information must be provided quickly enough to be of use in decision making. For example,
in the above store scenario, there would be little use in obtaining the price-comparison
information and texting customers once they had left the store. If facial recognition is going
to be used by shops and hotels, it has to be more-or less instant so that guests can be
welcomed by name.

You will understand that the volume and variety conspire against the third, velocity. Methods

have to be found to process huge quantities of non-uniform, awkward data in real-time.

4.4. Software for big data

The processing of big data is generally known as big data analytics and includes:
Data mining: analysing data to identify patterns and establish relationships such as
associations (where several events are connected), sequences (where one event leads to
another) and correlations.
Predictive analytics: a type of data mining which aims to predict future events. For
example, the chance of someone being persuaded to upgrade a flight.
Text analytics: scanning text such as emails and word processing documents to
extract useful information. It could simply be looking for key-words that indicate an
interest in a product or place.
Voice analytics: as above with audio.
Statistical analytics: used to identify trends, correlations and changes in behaviour.

The analytical findings can lead to:

Better marketing
Better customer service and relationship management
Increased customer loyalty
Increased competitive strength
Increased operational efficiency
The discovery of new sources of revenue.

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4.5. Dangers of big data

Despite the examples of the use of big data in commerce, particularly for marketing and
customer relationship management, there are some potential dangers and drawbacks.
Cost: It is expensive to establish the hardware and analytical software
needed, though these costs are continually falling.
Regulation: Some countries and cultures worry about the amount of

information that is being collected and have passed laws governing its collection,
storage and use. Breaking a law can have serious reputational and punitive
Loss and theft of data: Apart from the consequences arising from regulatory breaches
as mentioned above, companies might find themselves open to civil legal action if data
were stolen and individuals suffered as a consequence.
Incorrect data (veracity): If the data held is incorrect or out of date incorrect
conclusions are likely. Even if the data is correct, some correlations might be spurious
leading to false positive results.
Employee monitoring: data collection methods allow employees to be monitored in
detail every second of the day. Some companies place sensors in name badges so that
employee movements and interactions at work can be monitored. The badged monitor
to whom each employee talks and in what tone of voice. Stress levels can be measured
from voice analysis also. Obviously, this information could be used to reduce stress
levels and to facilitate better interactions but you will easily see how it could easily be
used to put employees under severe pressure.

5. Data Protection Act implements Directive 95/46/EC

One of the important European laws concerns data protection. The Data Protection Act in the
UK relates to personal data. We are not talking here about data relating to companies: we are
talking about data relating to people.

The act sets out certain principles:

Data shall be processed fairly and lawfully.

It can only be obtained for one or more specified and lawful purposes.
It mustnt be excessive to whats required.
It must be accurate and kept up-to-date.
It mustnt be kept for longer than necessary.
Personal data shall be processed only in accordance with the rights of data subjects. The
data subject is a person about whom the data is held and that person has certain rights.
For example they have a right to see the data and they have a right to insist that its
corrected. The people holding the data have to register with a government body and
there they have to say what data is held, why it is held and to whom it might be
Appropriate measures shall be taken against unauthorised and unlawful processing and
also care has to be taken over the accidental loss or damage to personal data.
Finally, personal data must not be transferred to a country or territory outside the
European Economic Area unless there is similar legislation giving similar protection in
that area.

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6. Disaster planning
Many organisations are so reliant on the continued availability of IT that to be without it for
even a short time can be very damaging. Of course more serious incidents could make an IT
system unavailable for long times can be disastrous.

June 2015, Computer Weekly

Royal Bank of Scotland (RBS) customers suered at the hands of another IT problem as
hundreds of thousands of payments failed to reach their accounts. About 600,000 payments
including tax credits and disability living allowance did not arrive when expected.

RBS has been subject to costly IT problems in recent years. In 2012 customers were locked out
of their accounts for days, as a result of a glitch in the CA-7 batch process scheduler, which
froze 12 million accounts. Customers were left unable to access funds for a week or more as
RBS, NatWest and Ulster Bank manually updated account balances.

RBS was fined 56m by the Financial Conduct Authority (FCA) and the Prudential Regulation
Authority (PRA) as a result.

Companies should have disaster plans that will first offer some protection against problems
but which will then allow the companys IT system to be up and running (at least the most
vital elements of the system) a soon as possible.

Typical contents of a disaster plan are:

Minimise physical risks; take regular backups of data
Contingency planning: standby procedures, recovery procedures, personnel
Define responsibilities of sta members. Remember, normal working will have
been disrupted.
Risk assessment where is most attention needed? Where are we most
Prioritise which elements of the system are the most vital to get back?
Back-ups and stand-by arrangements if the computer is damaged, a standby
machine (hardware duplication) will be able to pick up the processing. It should
be located at a remote site.
Communication with sta and customers. A disaster can undermine confidence so
good PR is essential.
Business continuity planning. How will the business be carried on until normal service is

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Chapter 9

1. Financial risk introduction

Equity shareholders suffer risk from two sources:
Business risk arising from the type of business their company is in. For example a
supermarket company is likely to enjoy much more stable earnings that a house-
building company. Everyone needs to eat, even in poor economic times, but house
purchases will be postponed unless people are reasonably optimistic.
Gearing risk. This risk arises because a company has borrowed. The interest on the
borrowings has to be paid and this increases the volatility of the earnings available for
shareholders. This is explained in more detail below.

When deciding what return is needed from a company, shareholders have to take both types
of risk into account. They will always demand higher returns as risk (from whatever source)

2. Illustration of gearing risk

Here are two companies, U Co which is ungeared (ie, no borrowing) and G Co which is
geared. They have exactly the same assets and carry on the same activities, so their earnings
before interest are the same:

$000 U Co G Co
Earnings 1,000 1,000
Interest (400)
1,000 600
Tax @25% (250) (150)
Available for dividends 750 450

Now, we will see what happens if earning go up 50% or down 50%

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Starting position Increase 50% Decrease 50%

$000 U Co G Co U Co G Co U Co G Co
Earnings 1,000 1,000 1,500 1,500 500 500
Interest - (400) - (400) - (400)
1,000 600 1,500 1,100 500 100
Tax @25% (250) (150) (375) (275) (125) (25)
Available for dividends 750 450 1,125 825 375 75

+ 83% -83%

In the ungeared company, U Co, as earnings rise or fall be 50% so do the amounts available
for dividends.

In the geared company, however, as earnings rise or fall 50% the amounts available for
dividends vary by 83%.

Therefore, income volatility (or risk) is magnified in the geared company. Thats why the term
gearing is used. On a bicycle, if you are in a high gear one turn of the pedals has a large effect
on the wheels.

In the USA, the term leverage is used instead of gearing, and when using a lever, moving one
end a small amount will move the other end a lot.

3. How to account for business risk

In this paper you account for business risk and link it to equity shareholders returns by using
the capital asset pricing model (CAPM). This model states that:

Required return (cost of equity) = Risk free return + (Return from the market risk free rate)

or Ke = Rf + (Rm Rf)

The risk free rate is typically what you could get putting your money on deposit in the bank. If
an investment is not risk free then the required return must be higher than that rate.

is a measure of the systematic risk of the investment. This is explained further below. The
higher is the higher the required return.

Rm is the return you can get from the market as a whole. The (Rm Rf) represents a premium
that is required over the risk free rate to compensate investors for the additional risk.

Rm Rf is sometimes known as the market risk premium.

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4. Systematic and unsystematic risk

Unsystematic risk is risk that arises form random events affecting one share only. For
example, one pharmaceutical launches a blockbuster drug and that share only will enjoy
improved returns.

Systematic risk is risk that rises from large events, national and international, that affects all
shares, though to differing degrees. For example, the banking crisis of 2008 affected all


Unsystematic risk is handled by diversifying it away. This means that by the time you hold
about 30 different investments the random good news in one share is probably cancelled out
by the random bad news in another share you hold. For example, the goods news helping
your shares in the pharmaceutical company is likely to be offset by bad news in your shares in,
say, an airline.

CAPM deals only with systematic risk and this means that any investor who is going to use
this approach must be well-diversified.

The value is a measure of systematic risk, and can be interpreted as:

= 1 the investment has the same systematic risk as the market.

> 1 the investment is more volatile than the market; it has more systematic risk. The
required return will be greater than the return form the market.

< 1 the investment is more stable than the market; it has less systematic risk. The required
return will be lower than the return form the market.

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Example 1
Risk free rate = 5%; market return = 14%
What returns should be required from investments whose beta values are
(i) 1
(ii) 2

(iii) 0.5

Ke = Rf + (Rm Rf)
(i) Ke = 5 + 1(14 5) = 14% (The return required from an investment with the same risk as the
market is simply the market return)
(ii) Ke = 5 + 2(14 5) = 23% (The return required from an investment with twice the risk as the
market. A higher return than that given by the market is required)
(iii) Ke = 5 + 0.5(14 5) = 9.5% (The return required from an investment with half the risk as
the market. A lower return than that given by the market is required).

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5. Taking gearing into account

If there is risk caused by gearing as well as risk caused by the type of business that is being
undertaken the required return of the equity shareholders will be greater. This can be
accounted for by using a higher to work out the cost of equity.

Before going on, we must get some terminology straight:

In an ungeared company the is known as the asset because the risk arises purely
from the business assets and business activities. It can be useful to refer to this as the
ungeared .
In a geared company the is known as the equity because the risk arises from both
business and gearing and that determines what the equity shareholder require. It can
be useful to refer to this as the geared .

The asset (ungeared) and equity (geared) are linked by the following formula:

a =
(ve + vd (1 T ))

a = the asset (ungeared )

e = the equity (geared )

Ve = the market value of equity

Vd = the market value of debt

T = tax rate

Notice that the formula must mean that a is less than e reflecting the fact that the
systematic risk must be lower in an ungeared company than in the equivalent geared

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Example 2
An ungeared company has a of 0.8.
What is the equity-holders required rate of return in an equivalent company that was
financed by $4m equity and $3m debt where the tax rate is 30%?

The risk free rate is 4% and the return from the market is 15%.

First, work out the appropriate value for the geared company:
a =
(ve + vd (1 T ))
0.8 = = 0.6557 e
( 4 + 3(1 0.3))
e = 0.8 / 0.6557 = 1.22

[Check: the equity (geared should be higher than the ungeared ]

Ke = Rf + (Rm Rf)
Ke = 4 + 1.22(15 4) = 17.42%
[Note the required return in the ungeared company would be: 4 + 0.8(15 4) = 12.8%].

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6. Risk adjusted discount rates

If a company is going to use its existing cost of capital as a discount rate when appraising a
new project then two conditions must be met:

(1) The nature of the project must be the same as existing activities. If the new project is in
dierent business area then the cost of capital relevant to that project will be dierent
(dierent business = dierent risk = dierent cost of capital).

(2) The gearing of the company must not change (dierent gearing = dierent risk =
dierent cost of capital).

CAPM can let us deal with the first problem because CAPM allows a specific discount rate to
be calculated that is appropriate for the type of risk associated with the new project. This is
known as the risk adjusted discount rate.

Example 3
An all equity company has a cost of equity of 18%. The risk free rate is 4%.
The company is in the food production industry and it has a of 0.8, but the new project is very
dierent to existing activities: goods haulage. A listed goods haulage company has a of 1.2.
What discount rate should be used to appraise the new haulage project?

From the companys current statistics:
Cost of equity = Risk free rate + (return from the market - risk free rate)
18% = 4% + 0.8 (return from the market risk free rate)
Return from the market - risk free rate = (18% - 4%)/0.8 = 17.5.
The discount rate appropriate to a haulage project or haulage business that is all equity financed is
Required return = 4 + 1.2 x 17.5 = 25%
Check: the new project has a high , so the required rate of return must also be higher.

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7. Project financed by a mix of debt and equity: adjusted

present values.
Financing the project by a mix of debt and equity will potentially alter the gearing and this
will alter the appropriate cost of capital and therefore the net present value of the project.

Loan finance offers companies a uniquely low source of finance. It is low because:

(1) It is less risky to supply loan capital than equity. Loans are often secured on valuable
assets; companies know that they must pay interest on time if they are avoid defaulting,
whereas dividends are discretionary; if the company is wound up, creditors rank before
equity shareholders.

(2) Loan interest gets tax relief but dividends do not.

Point (2) is very important. Tax relief is equivalent to a borrower paying the interest then
having the government contribute to the cost of capital. Tax relief is just as valuable as a
grant coming from the government and the benefit of this must be taken into account
when appraising a project: the technique used to do this is known as the adjusted
present value.

The technique is used when:

Funding includes a subsidised loan (including when tax relief is given on interest
Debt capacity has increased
Comparison of different capital structure


Evaluate project as though all equity financed

Adjust for the beneficial effect of the finance used: the finance costs are discounted at
the pre-tax cost of the finance. This will mean that the present value of the tax shield is
calculated at the pre-tax cost of debt.

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Example 4
Time 0 Invest 100M
Times 1 5 Earn 60M pa pre-tax
Tax = 30%, paid at the end of each year. Cost of equity (ungeared) = 20%
Pre-tax cost of debt = 5%

Calculate the gain to the shareholders if the project is financed:

(a) Entirely by equity
(b) 70% equity and 30% irredeemable debt
(c) 70% equity and 30% from debt redeemable in 5 years time.

Financed entirely by equity
NPV = -100 + 60 x 0.7 x 2.991 (5 yr, 20% cumulative factor) = 25.622m
Financed entirely 70% equity and 30% irredeemable debt
Adjusted present value = Base case NPV (all equity) + PV of the tax shield.
The present value of the tax shield is: Interest x tax rate x cumulative discount factor at 5%. The
cumulative discount factor at 5% for a perpetuity is 1/0.05 ie 1/r, where r is the discount rate as a
APV = 25.622m + $30m x 5% x 0.3/0.05 = 25.622 + 9 = 34.622m
Financed by 70% equity and 30% from debt redeemable in 5 years time
Now tax is saved for only 5 years. The 5 year 5% cumulative discount factor is 4.329, so:
APV = 25.622m + $30 x 5% x 0.3 x 4.329 = 25.622 + 1.948 = $27.57m

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The company also benefits if its debt capacity is increased because of the project and its

Debt capacity is the ability of the company to raise loans.

Example 5
An all equity project lasts for 6 years and increases debt capacity by $4M pa at the risk free rate of

5%. Tax at 30% is paid 1 year in arrears.

What is the value of the increase in debt capacity?

The project and the debt capacity increase last for time 1 6, but the potential benefit comes
through the tax relief on the increase in the debt capacity and that will be for times 2 7.
The PV of the increase in debt capacity is:
$4m x 5% x 0.3 x (5.786 0.9520) = $0.29m
5%, yrs 1 7 , 5%, yr 1

Sometimes the loan might be subsidised in other ways, not just tax relief and the benefit of this
cheap access to finance should also be taken into account.

Example 6
A project costing $12M project lasts for 5 years and will financed by debt.
The company normally borrows at 8%, but a development loan from the government will cost 6%.
Risk free rate of interest = 3%. Tax is payable 1 year in arrears at 30%.

Tax shield on interest paid $12 x 0.06 x 0.3 = 0.216
Saving on interest $12 x 0.02 = 0.240
Less: PV of tax relief lost $12 x 0.02 x 0.3 =(0.072)
Advantage arising from the subsidised finance is therefore: $0.384 x [5.417 0.971] = 1.707

Note the third line of the column of figures relating to the PV of tax relief lost. It might look as
though the government has saved the company 2% by giving a subsidised loan, but if the
interest is reduced by 2%, so is the tax relief.

Finally, we consider issue costs. For example, a company might need $2m to finance a project
but this is after issue cots. The loan needed would therefore have to be for $2m plus issue costs.

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Issue costs can be expected to enjoy tax relief.

Example 7
$6m is needed to spend on the project and must be available after issue costs of 2% are deducted.
Issue costs are payable immediately.
Assume the loan is at 6%, tax is 25% payable at the end of each year and the loan is in perpetuity.

$6m is after issue costs of 2% so must represent 98% of the amount raised.
Therefore, amount raised is $6m/0.98 = $6.12m
PV of tax shield on interest = $6.12m x 6% x 0.25/0.06 = $1.53
However, to obtain this benefit, issue costs are paid at time 0 and tax relief on those costs is
enjoyed one year later
Issue costs less tax relief = $0.12m 0.12 x 0.25 x 0.943 = 0.092
Therefore, the net benefit is $1.438m

8. Real options
A real optionis the right, but not the obligation, to undertake certain business decision, such

a capital project.

Real options provide additional flexibility to the investor. This must always be worthwhile to
investors and so should add value to any project for which they are available. Therefore:

Real options PV = Traditional NPV + real option value.

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Chapter 10

1. Introduction
Increasingly, many businesses have dealings in foreign currencies and, unless exchange rates
are fixed with respect to one another, this introduces risk.

Exchange rates move up and down for all sorts of reasons, such as:
Political uncertainty
Economic prospects of the country
Demand for the currency

Many of these factors are unpredictable, but there are three calculations that can be
performed to predict certain exchange rates and also to predict a countrys exchange rate.

2. Interest rate parity

The different interest rates in countries can be used to predict the forward exchange rate.
The forward exchange rate is the rate you would be quoted now for changing currency at a
specific date in the future.

For example, say that the UK interest rate is 4% and the US $ rate is 6% and that the current
exchange rate (the spot rate) is US$ 1.4 = 1.00

An investor might therefore see a way to make money by borrowing, say 1,000 at 4% in the
UK, changing this into $1,400 and investing at 6% in the US. There seems to be a 2% margin in
doing this.

However, the investor would not be sure of making money unless he or she knew how many
they would get back at the end of the period. If the US$ at weakened to say 1 = $2, the
investor might lose a lot of money. To prevent that, the investor could agree now a rate (a
forward rate) at which to change back the US $ at the end of the period.

The forward rate must be a rate that means the investor would break-even (otherwise there
would be the odd situation where people could make money, risk free, by simply borrowing
and investing).

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So, looking at a period of a year:

Borrow 1,000 add 1 years interest @ 4% Amount owing becomes 1,040

Convert into US$ at 1.40$/

Invest $1,400 add 1 years interest @ 6% Amount available becomes $1,484

Interest rate parity theory says that the 1 year forward exchange rate is therefore 1,484/1,040

= 1.427 $/

After, say two more years, interest would have accrued for three years and the forward
exchange rate would be given by:

1,400 x (1.06)3/1,000 x(1.04)3 = 1.4823 $/.

3. Purchasing power parity

In theory, this predict future spot rates.

The approach says that money obtains its value with reference to what it can buy. Therefore
an exchange rate links what an item costs in two different currencies.

So if an item cost 1,000 in the UK and $1,500 in the US, then 1,000 must have the same
value as $1,500 and the exchange rate is therefore $1.5/.

After a year, the purchase prices will have risen in each country by their inflation rates. Say
that in the UK inflation is 2% and in the US it is 3.5%. Then in a year, the product will cost:

(1) In the UK: 1,000 x 1.02 = 1,020

(2) In the US: 1,500 x 1.035 = $1,552.50

These amounts must be worth the same because they buy the same item. Therefore the
exchange rate in 1 year is predicted to be:

1,552.5/1,020 = 1.522.

In four years the exchange rate would be predicted to be:

1,500 x (1.035)4 /1,000 x (1.02)4 = 1.59 $/

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4. International Fisher effect

This theory says that the real rate of interest is the same in every country and the interest
rates quoted on bank accounts (the nominal or money rate) is a combination of this rate (the
real rate) and the inflation rate.

1 + Nominal Rate = (1 + Real Rate) x (1 + Inflation Rate)

Say a country had in inflation rate of 2.5% and a nominal interest rate of 5%. If another
country had an inflation rate of 6%, then we can predict its nominal rate of interest as follows:

1 + 0.05 = (1 + Real Rate) x (1 + 0.025)

1 + Real Rate = 1.05/1.025 = 1.02439

The nominal rate in the other country is therefore given by:

1 + Nominal Rate = (1.02439) x (1 + 0.06) = 1.08585

The nominal rate is therefore 8.585%

Remember, the nominal rate is higher when inflation is higher because money on deposit has
to increase by inflation just to stand still with respect to inflation, then investors expect a real
rate of interest on top ie they expect to be able to buy more even after inflation.

5. Cross rates
Cross rates allow you to work out the exchange rate between to currencies when their rate
with respect to a third currency are known

For example, on 3 May 2016, published exchange rates were:

US$/ = 1.45

/ = 1.26

We can therefore work out /US$ as follows:

Look at what you want ie /US$

/US$ = / x /US$

/US$ = 1/(US$/)

So, /US$ = 1.26 x 1/1.45 = 0.87

The published rate was indeed 0.87

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6. Types of currency risk

There are three types of currency risk:

6.1. Economic risk.

The source of economic risk is the change in the competitive strength of imports and exports.
For example, if a company is exporting (lets say from the UK to a Eurozone country) and the

euro weakens from say / 1.1 to / 1.3 (getting more euros per pound sterling implies that
the euro is less valuable, so weaker) any exports from the UK will be more expensive when
priced in euros. So goods where the UK price is 100 will cost 130 instead of 130, making
those goods less competitive in the European market.

Similarly, goods imported from Europe will be cheaper in sterling than they had been, so
those goods will have become more competitive in the UK market. Note that a company can
therefore experience economic risk even if it has no overt dealings with overseas countries. If
competing imports can become cheaper you are suffering risk arising from currency rate

Doing something to mitigate economic risk can be difficult especially for small companies
with limited overseas dealings. In general, the following approaches might provide some
Try to export or import from more than one currency zone and hope that they dont all
move together, or at least to the same extent. For example, over the three months 14
January 2010 to 14 June 2010 the /US$ exchange rate moved from about /$ 0.6867 to
/$ 0.8164. This means that had weakened relative to the US $ (or US $ strengthening
relative to the by 19%). This would make it less competitive for US manufactures to
export to a Eurozone country. In the same period the /$ exchange rate moved from
0.6263 /$ to 0.6783 /$, a strengthening of the $ relative to of only about 8%. Trade
from the US to the UK would not have been so badly affected.
Make your goods in the country you are selling them in. Although raw materials might
still be imported and affected by exchange rates, other expenses such as wages are in
the local currency and not subject to exchange rate movements.

6.2. Translation risk.

This affects companies with foreign subsidiaries. If the subsidiary is in a country whose
currency weakens, the subsidiarys assets will be less valuable in the consolidated accounts.
Usually, this effect is of little real importance to the holding company because it does not
affect its day-to day cash flows. However, it would be important if the holding company
wanted to sell the subsidiary and remit the proceeds. It also becomes important if the
subsidiary pays dividends. However, the term translation risk is usually reserved for
consolidation effects.

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It can be partially overcome by funding the foreign subsidiary using a foreign loan. For
example, take a US subsidiary that has been set up by its holding company providing equity
finance. Its statement of financial position would look something like:

$ million
Non-current assets 1.5
Current assets 0.5

Equity 2.0

If the $ weakens then all of the $2 million total assets become less valuable.

However if the subsidiary were set up using 50% equity and 50% dollar borrowings, its
balance sheet would look like:

$ million
Non-current assets 1.5
Current assets 0.5

$ Loan 1.0
Equity 1.0

The holding companys investment is only $1 million and the companys net assets in US$ are
only $1 million. If the $ weakens the only the net $1 million becomes less valuable.

6.3. Transaction risk.

This arises when a company is importing or exporting. If the exchange rate moves between
agreeing the contract in a foreign currency and paying or receiving the cash, the amount of
home currency paid or received will alter, making those future cash flows uncertain.

For example, in June a UK company agrees to sell an export to Australia for 100,000 Australian
$, payable in three months. The exchange rate at the date of the contract is
AUD/ 1.80 meaning that there are 1.80 AUD for every .

Confusingly, this could also be written as

1/AUD 1.80, where the key is noticing that it is 1, meaning 1 - 1.8AUD.

So the company is expecting to receive 100,000/1.8 = 55,556. If, however, the Australian $
weakened over the three months to become worth only 1/AUD 2.00, then the amount that
would be received would be worth only 50,000. Of course, if the Australian $ strengthened
over the three months more than 55,556 would be received.

It is important to note in the following discussions that transaction risk management is not
concerned with achieving the most favourable cash flow: it is aimed at achieving a definite
cash flow as only then can proper planning be undertaken.

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7. Dealing with transaction risks

Assuming that the business does not want to tolerate exchange rate risks (and that could be a
reasonable choice for small transactions), transaction risk can be treated in the following

(1) Invoice. Arrange for the contract and the invoice to be in your own currency. This will
shift all exchange risk from you onto the other party. Of course, who bears the risk will

be a matter of negotiation, along with price and other payment terms. If you are very
keen to get a sale to a foreign customer you might have to invoice in their currency.

(2) Netting. If you owe your Japanese supplier 1 million , and another Japanese company
owes your Japanese subsidiary 1.1 million , then by netting o group currency flows
your net exposure is only for 0.1 million . This will really only work eectively when
there are many sales and purchases in the foreign currency. It would not be feasible if
the transactions were separated by many months. Bilateral netting is where two
companies in the same group cooperate as explained above; multilateral netting is
where many companies in the group liaise with the groups treasury department to
achieve netting where possible.

(3) Matching. If you have a sales transaction with one foreign customer then, a purchase
transaction with another (but both parties operating with the same foreign currency)
then this can be eciently dealt with by opening a foreign currency bank account. For
1 November: should receive $2 million from US customer

15 November: must pay $1.9 million to US supplier.

Deposit the $2 million in a US $ bank account and simply pay the supplier from that.
That leaves only US $0.1 million of exposure to currency fluctuations.

Usually for matching to work well, either specific matches are spotted (as above) or
there have to be many import and export transactions to give opportunities for
matching. Matching would not be feasible if you received $2 million in November, but
didnt have to pay $1.9 million until the following May. There arent many businesses
that can simply keep money in a foreign currency bank account for months on end.

(4) Leading and lagging. Lets imagine you are planning to go to Spain and you believe that
the euro will strengthen against your own currency. It might be wise for you to change
your spending money into euros now. That would be leading because you are
changing your money in advance of when you really need to. Of course, the euro might
weaken and then youll want to kick yourself, but remember: managing transaction risk
is not about maximising your income or minimising your expenditure, it is about
knowing for certain what the transaction will cost in your own currency.
Lets say, however, you believe that the euro is going to weaken. Then you would not
change your money until the last possible moment. That would be lagging, delaying
the transaction. Note however that this does not reduce your risk. The euro could
suddenly strengthen and your holiday would turn out to be unexpectedly expensive.
Lagging does not reduce risk because you still do not know your costs. Lagging is
simply taking a gamble that your hunch about the weakening euro is correct.

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(5) Forward exchange contracts. A forward exchange contract is a binding agreement to

sell (deliver) or buy an agreed amount of currency at a specified time in the future at an
agreed exchange rate (the forward rate).
In practice there are various ways in which the relationship between a current exchange
rate (spot rate) and the forward rate can be described. Sometimes it is given as an
adjustment to be made to the spot rate or the forward rates might be quoted directly.
However, for each of spot and forward there is always a pair of rates given. For example:

Spot / 1.2025 0.03 ie 1.2028 and 1.2022

3 month forward rate / 1.2020 0.06 ie 1.2026 and 1.2014
One of each pair is used if you are going to change sterling to euros. So 100 sterling
would be changed now for either 120.28 or 120.22. Guess which rate the bank will
give you! You will always be given the exchange rate which leaves you less well o, so
here you will be given a rate of 1.2022, if changing to euros now, or 1.2014 if using a
forward contract. Once you have decided which direction one of the rates is for, the
other rate is used when converting the other way. So:

to to
Spot / 1.2028 1.2022
3 month forward rate / 1.2026 1.2014
So, lets assume you are a manufacturer in Italy, exporting to the UK. You have agreed
that the sale is worth 500,000, to be received in three months and wish to hedge
(reduce your risk) against currency movements.

In three months you will want to change to and you can enter a binding agreement
with a bank that in three months you will deliver 500,000 and that the bank will give
you 500,000 x 1.2014 = 600,700 in return. That rate and the number of euros you
receive is now guaranteed irrespective of what the spot rate is at the time. Of course if
the had strengthened against the (say to / = 1.5) you might feel aggrieved as you
could have then received 750,000, but income maximisation is not the point of
hedging: its point is to provide certainty and you can now put 600,700 into your cash
flow forecast with confidence.

However, there remains here one lingering risk: what happens if the sale falls through
after arranging the forward contract. We are not necessarily talking about a bad debt
here as you might not have sent the goods, but you have still entered a binding
contract to deliver 500,000 to your bank in three months time. The bank will expect
you to fulfil that commitment, and so what you might have to do is go to the bank,
exchange enough for 500,000, then immediately use that to meet your forward
contract, receiving 600,700 back. This process is known as closing out, and you could
win or lose on it depending on the spot rate at the time.

There is one other way that forward rates might be given and this is as an adjustment to
the spot rates.

For example:

Spot rate / 1.2501 1.2631

3 month forward margin 0.3c 0.4c pm
Here pm appears after the margin. This means SUBTRACT the margin. Note that the
margin is in cents.

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If dis had been after the margin, this means a discount and this would be ADDED to the
spot rate.

Note premium and discount appear to have the reverse meanings to normal. ADD a

So in this example, the three month forward rate would be:

Spot rate / 1.2501 1.2631

3 month forward margin 0.0030 0.0040 pm

1.2471 1.2591
Forward contracts are known as over the counter arrangements. You have to meet
with your bank and set up the contract on an individual basis/

(6) Money market hedging. Lets say that you were a UK manufacturer exporting to the US
so that in three months you are due to receive $2 million. You would suer no currency
risk if that $2 million could be used then to settle a $2 million liability; that would be
matching the currency inflow and outflow. However, you dont have a $2 million liability
to settle then so create one that can soak up the US $. You can create a $ liability by
borrowing $ now and then repaying that in three months with the $ receipt. So the plan

Interest on the $
loan will accrue for
three months
Borrow $ now $2 million liability

Convert at
spot rate

Available now $2 million from customer

To work out how many $ need to be borrowed now, you need to know $ interest rates.
For example, the US$ 3 month interest rate might be quoted as:

0.54% 0.66%

It is important to understand that, although this might be described as a 3 month rate

it is always quoted as an annualised rate. One rate is what you would earn interest at on
a deposit, and the other the rate you would pay on a loan. Again, no prizes for guessing
which is which: you will always be charged more than you earn. On the dollar loan we
will be charged 0.66% pa for three months and the loan has to grow to become $2
million in that time. So, If X is borrowed now and three months of interest is added:

X(1 + 0.66%/4) = 2,000,000

X = $1,996,705

This can be changed now from $ to at the current spot rate, say $/ 1.4701, to give

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This amount of sterling is certain: we have it now and it does not matter what
happens to the exchange rate in the future. Ticking away in the background is the US$
loan which will amount to $2 million in three months and which can then be repaid by
the $2 million we hope to receive from our customer. That is the hedging process
finished because exchange rate risk has been eliminated

Why might this somewhat complicated process be used instead of a simple forward
contract? Well, one advantage is that we have our money now rather than having to

wait three months for it. If we have the money now we can use it now or at least place
it in a sterling deposit account for three months. This raises an important issue when we
come to compare amounts received under forward contracts and money market
hedges. If these amounts are received at dierent times they cannot be directly
compared, because receiving money earlier is better than receiving it later. To compare
amounts under both methods we should see what the amount received now would
become if deposited for three months. So, if the sterling 3 month deposit rate were
1.2%, then placing 1,358,210 on deposit for three months would result in:

1,358,210 (1 + 1.2%/4) = 1,362,285

It is this amount that should be compared to any proceeds under a forward contract.

The example above dealt with hedging the receipt of an amount of foreign currency in
the future. If foreign currency has to be paid in the future, then what the company can
do is change money into sucient foreign currency now and place it on deposit so that
it will grow to be the required amount by the right time. Because the money is changed
now at the spot rate, the transaction is immune from future changes in the exchange

Money market hedging is also an over-the counter operation.

8. Further methods of exchange risk hedging

There are two other methods of exchange risk hedging which you are required to know. They
involve the use of derivatives: financial instruments whose value derives from the value of
something else like an exchange rate.

8.1. Currency futures.

Simply think of futures contracts as items you can buy and sell on the futures market and
whose price will closely follow the exchange rate.
Currency futures are standardised contracts for the sale or purchase at a set future date
of a set quantity of currency.
Contracts have a market price and they can be bought and sold on the futures market.
The market prices follows the exchange rate approximately.
Losses or profits can be made on futures trading

To hedge: do the same to the futures now [Buy/sell] as you would do to the currency in the

Lets say that a US exporter is expecting to receive 5 million in three months and that the
current exchange rate is $/1.24. Assume that that is also the price of $/ futures. The US
exporter will fear that the exchange rate will weaken over the three months, say to $/1.10

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(that is fewer dollars for a euro). If that happened then the market price of the future would
decline too, to around 1.1. The exporter could arrange to make a compensating profit on
buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore any loss made on
the main the currency transaction is offset by the profit made on the futures contract.

This approach allows hedging to be carried out using a market mechanism rather than
entering into individual tailored contracts that the forward contracts and money market
hedges required. However, this mechanism does not offer anything fundamentally new.

Here are some more examples:

Example 1
Weetwood Co is in the US and needs 5m on 30 September Spot today (1/8) is: $/ 1.5134 1.5352.
September $/ futures are available. The price today is 1.5423. The spot and the futures prices both
increase by 0.04 as at 30/9.
Remember, do to futures now (buy/sell) that you will do to the currency later.

If exchanged at spot rate 5m would cost 5m x 1.5352 7.676
If exchanged at rate at 30/9, $5m would cost 5m x 1.5752 (ie 1.5352 +0.4) 7.876
Loss on underlying transaction (0.200)
Profit on futures contract (buy now at 1.5423, sell on 30/9 at 1.5823) $5m x
(1.5823 1.5423)
Net gain/loss NIL
Note: if the exchange rate had moved the other way, the profit on the exchange rate would be
oset by a loss on the futures contract.

Example 2
Weetwood Co is in the US and will receive 10m on 30/9. Spot today (1/8) is: $/ 1.5134 1.5352.
September $/ futures are available. The price today is 1.5423. The spot and the futures prices both
increase by 0.04 as at 30/9.
Remember, do to futures now (buy/sell) that you will do to the currency later.

If exchanged at spot rate 10m would cost 10m x 1.5134 15,134

If exchanged at rate at 30/9, 10 would give 10m x 1.5534 (ie 1.5134 + 0.04) 15,534
Gain on underlying transaction 0.200
Loss on futures contract (sell now at 1.5423, buy on 30/9 at 1.5823) $5m x
(1.5823 1.5423)
Net gain/loss NIL

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Practical points relating to futures

All futures are priced in US $, eg US $/ or US $/

Contracts are standard sizes: = 62,500; = 125,000; Japanese Yen = 12.5m
All contracts of standard maturity
A tick is the smallest movement of a contract price and is 0.0001 of the contract
Value of tick = 0.0001 x contract size ( contract, tick = $12.50 NB priced in $).

Choose nearest whole number of contracts.

Choose first expiry contract date after the transaction
To enter the contract, have to pay a margin up-front (like a deposit).

Example 3
1/6: UK company agrees to sell goods to the US for $500,000, to be settled 30/11
1/6: spot rate $/ = 1.5732 1.5745.
Sterling futures: contract size 62,500;
Tick size = $6.25. Prices are as shown in the table:

Settlement date Price S/

Jun 1.5480
Sept 1.5245
Dec 1.5136

Assume spot rate on 30/11 is 1. 71 1. 75 and the futures price then is 1.6997.
Show how the transaction could be hedged by setting up a futures contract.

We lose if 1.5745 rises as $500,000 will yield fewer .
Therefore, to compensate, buy futures now, sell later. (Note: always consider from a US viewpoint
as these are $ futures. We need to buy , the foreign currency, so buy futures now.)
Contract size = 62,500; tick = $6.25
December futures (1st expiry date after the transaction): $500,000/1.5136 = 330,338;
330,338/62,500 = 5.3, say 5.
We are told to assume spot rate on 30/11 is 1. 41 1. 75 and the futures price is 1.5723.
Futures price has moved by 0.1861 (1.5136 up to 1.6997) an increase of 1861 ticks
1861 x 5 contracts x $6.25 = $58,156 profit
Receive $500,000 + $58,156 = $558,156
This will be converted to $558,156/1.75 = 296,197.
Note that if we could have converted at the spot rate on 1/6, we would have received
This will produce sterling of $518,344/1. 75 = 317,561

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The hedge is not perfect because:

The number and value of contract is not an exact fit to the transaction
There is basis risk, meaning that futures prices do not stay perfectly in line with spot

8.2. Options

Options are radically different. They give the holder the right, but not the obligation, to buy or
sell a given amount of currency at a fixed exchange rate (the exercise price) in the future. (If
you remember, forward contracts were binding.)

The right to sell a currency at a set rate is a put option (think: you put something up for sale);
the right to buy the currency at a set rate is a call option.

Suppose a UK exporter is expecting to be paid US$ 1 million for a piece of machinery to be

delivered in 90 days. If the strengthens against the US$ the UK firm will lose money, as it will
receive fewer for the US$ 1million. However, if the weakens against the US$, then the UK
company will gain additional money. Say that the current rate is $/ 1.40 and that the
exporter will get particularly concerned if the rate moved beyond $/1.50. The company can
buy call options at an exercise price of $/ = 1.50, giving it the right to buy at $1.50/. If
the dollar weakens beyond $/$1.50, the company can exercise the option thereby
guaranteeing at least 666,667. If the US$ stays stronger or even strengthens to say $/1.20,
the company can let the option lapse (ignore it) and convert at 1.20, to give 833,333.

This seems too good to be true as the exporter is insulated from large losses but can still
make gains. But theres nothing for nothing in the world of finance and to buy the options the
exporter has to pay an up-front, non-returnable premium. Options can be regarded just like
an insurance policy on your house. If your house doesnt burn down you dont call on the
insurance, but neither do you get the premium back. If there is a disaster the insurance
should prevent massive losses.

Options are also useful if you are not sure about a cash flow. For example, say you are bidding
for a contract with a foreign customer. You dont know if you will win or not, so dont know if
you will have foreign earnings, but want to make sure that your bid price will not be eroded
by currency movements. In those circumstances, and option can be taken out: used if
necessary or ignored if you do not win the contract or currency movements are favourable.

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A company is importing goods costing $200,000 from the US. The current exchange rate is /$ 0.75
payment to be made in 3 months. The company buys a three month option for 4000 at an
exercise price of /$ 0.77. What will the total cost of the import be if the exchange rate is:
/$ 0.70?

/$ 0.80?

$200,000 would cost 140,000 (200,000 x 0.7) using the spot rate or 154,000 (200,000 x 0.77) if the
option is exercised. Therefore, allow option to lapse. Total cost of goods = 144,000 (140,000 +
$200,000 would cost 160,000 (200,000 x 0.8) using the spot rate or 154,000 (200,000 x 0.77) if the
option is exercised. Therefore, exercise the option. Total cost of goods = 158,000 (154,000 +

8.3. Option pricing

There are two elements to the price of an option:

Intrinsic value
Time value

The intrinsic value is determined by the exercise price compared to the current price of the
underlying asset.

For example: a put option allowing you to sell an asset at $5 when the current market price of
the asset is $4, gives an intrinsic value of $1.

Similarly: a call option at an exercise price of $7 when the actual purchase price if $10 gives an
intrinsic value of $3.

In the two examples above, the option would be said to be in the money. A put option at an
exercise price of $6 when the market price is $7 is out of the money and has no intrinsic

The time value related to the length of time that the option lasts and therefore what
protection it might offer against adverse price movements. Think of how you would be
prepared to pay more for an insurance policy if:
The period of the insurance increased; and/or
The volatility of the underlying security increased (greater volatility implies more
protection is given by the option).

In addition the value of a call option increases if general interest rates increase because the
call option allows you to safely defer purchase and to keep your money earning interest for

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Chapter 11

1. Introduction
Risk arises for businesses when they do not know what is going to happen in the future, so
obviously there is risk attached to many business decisions and activities.

Interest rate risk arises when businesses do not know:

how much interest they might have to pay on borrowings, either already made or


how much interest they might earn on deposits, either already made or planned.

If the business does not know its future interest payments or earnings, then it cannot
complete a cash flow forecast accurately. It will have less confidence in its project appraisal
decisions because changes in interest rates will alter the weighted average cost of capital and
the outcome of net present value calculations.

There is, of course, always a risk that if a business had committed itself to variable rate
borrowings when interest rates were low, a rise in interest rates might not be sustainable by
the business and that liquidation becomes a possibility.

Note carefully that the primary aim of interest rate management (and indeed currency rate
management) is not to guarantee a business the best possible outcome, such as the lowest
interest rate it would ever have to pay. The primary aim is to limit the uncertainty for the
business so that it can plan with greater confidence.

2. Traditional and basic approaches

2.1. Matching and smoothing

When taking out a loan or depositing money, businesses will often have a choice of variable
or fixed rates of interest. Variable rates are sometimes known as floating rates and they are
usually set with reference to a benchmark such as LIBOR, the London Interbank Offered Rate.
For example, LIBOR +3%.

If fixed rates are available then there is no risk from interest rate increases: a $2 million loan at
a fixed interest rate of 5% per year will cost $100,000 per year. Although a fixed interest loan
would protect a business from interest rates rises, it will not allow the business to benefit
from interest rates decreases and a business could find itself locked into high interest costs
and thereby losing competitive advantage.

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Similarly if a fixed rate deposit were made a business could be locked into disappointing


In this simple approach to interest rate risk management the loans or deposits are simply
divided so that some are fixed rate and some are variable rate. Looking at borrowings, if
interest rates rise, only the variable rate loans will cost more and this will have less effect than

if all borrowings had been at variable rate. Deposits can be similarly smoothed.

There is no particular science about this. The business would look at what it could afford, its
assessment of interest rate movements and divide its loans or deposits as it thought best.


This approach requires a business to have both borrowed and deposited money. The closer
the two the amounts the better.

For example, lets say that the deposit rate of interest is LIBOR + 1% and the borrowing rate is
LIBOR + 4%, and that $500,000 is deposited and $520,000 borrowed. Assume that LIBOR is
currently 3%.


Annual interest paid = $520,000 x (3 + 4)/100 = $36,400

Annual interest received = $500,000 (3 + 1)/100 = $20,000

Net cost = $16,400

Now assume that LIBOR rises by 2% to 5%

New interest amounts:

Annual interest paid = $520,000 x (5 + 4)/100 = $46,800

Annual interest received = $500,000 (5 + 1)/100 = $30,000

Net cost = $16,800

The increase in interest paid has been almost exactly offset by the increase in interest
received. The extra $400 relates to the mismatch of the borrowing and deposit of $20,000 x
increase in LIBOR of 2% = $20,000 x 2/100 = $400.

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3. Asset and liability management

This relates to the periods for which loans (liabilities) and deposits (assets) last. The issues
raised are not confined to variable rate arrangements because a company can face difficulties
where amounts subject to fixed interest rates or earnings mature at different times.

Say, for example, that a company borrows using a ten-year mortgage on a new property at a
fixed rate of 6% per year. The property is then let for five years at a rent that yields 8% per

year. All is well for five years but then a new lease has to be arranged. If rental yields have
fallen to 5% per year, the company will start to lose money.

It would have been wiser to match the loan period to the lease period so that the company
could benefit from lower interest rates if they occur.

4. Forward rate agreements (FRA)

These arrangements effectively allow a business to borrow or deposit funds as though it had
agreed a rate which will apply for a period of time. The period could, for example start in 3
months time and last for 9 months after that. Such an FRA would be termed a 3 12
agreement because is starts in 3 months and ends after 12 months. Note that both parts of
the timing definition start from the current time.

The loans or deposits can be with one financial institution and the FRA can be with an entirely
different one, but the net outcome should provide the business with a target, fixed rate of
interest. This is achieved by compensating amounts either being paid to or received from the
supplier of the FRA, depending on how interest rates have moved.

Technically, if you are borrowing, you buy an FRA; if you are depositing money you would sell
an FRA.

FRAs are over the counter instruments

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Example 1
Nero Plcs cash flow forecast shows that it will have to borrow $2 million from Goodfellows Bank in
4 months time for a period of 3 months. The company fears that by the time the loan is taken out,
interest rates will have risen. The current interest rate is 5% and this is oered by Helpy Bank on the
required FRA.

What FRA is needed?

Show the cash flows if the interest rate has risen to 6.5% when the loan is taken out
Show the cash flows if the interest rate has fallen to 4% when the loan is taken out

(i) The FRA needed would be a 4 7 FRA at 5%
(ii) The interest rate has risen to 6.5%:

Interest on loan paid to Goodfellows bank = $2 million x 6.5/100 x 3/12 = (32,500)

Paid to Nero under FRA by Helpy Bank = $2 million x (6.5 5)/100 x 3/12 = 7,500

Net cost of the loan (25,000)

(iii) The interest rate has fallen to 4%:

Interest on loan paid to Goodfellows bank = $2 million x 4/100 x 3/12 = (20,000)

Paid to Nero under FRA to Helpy Bank= $2 million x (4 5)/100 x 3/12 = (5,000)

Net cost of the loan (25,000)

(a) In both cases the eective rate of interest on the loan is 5%, the FRA agreed rate:
$2 million x 5/100 x 3/12 = $25,000.
(b) In part (iii) when interest rates have fallen, Nero Plc would no doubt wish that it hadnt
entered the FRA so that it wouldnt have to pay Helpy Bank $5,000. However, the purpose of
the FRA is to provide certainty, not to guarantee the lowest possible cost of borrowing and
$5,000 will have to be paid to Helpy Bank.

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5. Interest rate derivatives

The interest rate derivatives that will be discussed are:

Interest rate futures

Interest rate options
Interest rate caps, floors and collars

5.1. Interest rate futures

Futures contracts are of fixed sizes and for given durations. They give their owners the right to
earn interest at a given rate, or the obligation to pay interest at a given rate.

Selling a future creates the obligation to borrow money and the obligation to pay interest

Buying a future creates the obligation to deposit money and the right to receive interest.

Interest rate futures can be bought and sold on exchanges such as LIFFE, the London
International Financial Futures Exchange.

The price of futures contracts depends on the prevailing rate of interest and it is crucial to
understand that as interest rates rise, the market price of futures contracts falls. In fact, the
price of a futures contract is 100 the interest rate.

Think about that and it will make sense: say that a particular futures contract allows
borrowers and lenders to pay or receive interest at 5%, which is the current market rate of
interest available. Now imagine that the market rate of interest rises to 6%. The futures
contract has become less attractive to buy because depositors can earn 6% at the market rate
but only 5% under the futures contract. The price of the futures must fall.

Similarly, borrowers will now have to pay 6% but if they sell the future contract they have to
pay at only 5%, so the market will have many sellers and this reduces the selling price until a
buyer-seller equilibrium price is reached.
A rise in interest rates reduces futures prices.
A fall in interest rates increases futures prices.

Remember: price of the futures contract = 100 interest rate.

Interest rate option contracts are for fixed amounts (typically 500,000) last for only 3
months. So to obtain cover for a 3m loan for 6 months the number of contracts needed
would be

3m/0.5m x 6 months/3 months = 12 contracts.

In practice, futures price movements do not move perfectly with interest rates so there are
some imperfections in the mechanism. This is known as basis risk.

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The approach used with futures to hedge interest rates depends on two parallel transactions:
Borrow/deposit at the market rates
Buy and sell futures in such a way that any gain that the profit or loss on the futures
deals compensates for the loss or gain on the interest payments.

Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest

The depositor fears interest rates falling as this will reduce income.

If interest rates fall, futures prices will rise, so buy futures now (at the relatively low price) and
sell later (at the higher price). The gain on futures can be used to offset the lower interest

Of course, if interest rates rise the deposit will earn more, but a loss will be made on the
futures (bought at a relatively high price then sold at a lower price).

As with FRAs, the objective is not to produce the best possible outcome but to produce an
outcome where the interest earned plus the profit or loss on the futures deals is stable.

Borrowing and paying interest

The borrower fears interest rates rising as this will increase expense.

If interest rates rise, futures prices will fall, so sell futures now (at the relatively high price) and
buy later (at the lower price). The gain on futures can be used to offset the lower interest

Students are often puzzled by how you can sell something before you have bought it. Simply
remember that you dont have to deliver the contract when you sell it: it is a contract to be
fulfilled in the future and it can be completed by buying in the future.

Of course, if interest rates fall the loan will cost less, but a loss will be made on the futures
(sold at a relatively low price then bought at a higher price).

Once again, the aim is stability of the combined cash flows.


The summary rule for interest rate futures is:

Depositing: buy futures then sell
Borrowing: sell futures then buy

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Example 2
Today is 3 October, and interest rates are 8% p.a. X plc will wish to borrow $6M for 6 months
starting on 1 January. 3 month January interest rate futures are available at 92.00.
Show how interest rate futures may be used to hedge the risk, and calculate the outcome on
1 January.
(Assume that on 1 January interest rates have changed to 10% and the futures price to 90.00)

Sell futures amount = 6M x 6/3 =$12M
On 1 January:
Loan interest: $6M 10% = 300,000
Profit on futures: 12M (92 90)/400 (60,000)
Net payment $240,000
The net payment is equivalent to 8% x $6m x 6/12.
Note: 92 90 = movement on the futures price, but strictly there are percentages.
Just as 5% = 0.05, 92 = 0.92.

The contracts last for only three months so the interest gain/loss is for of a year. (Earlier we
had used 6/3 to account for 6 months coverage).

So the profit on futures will be 12M x (92% - 90%)/4 or 12M x (92 - 90)/400.

5.2. Interest rate options

Interest rate options allow businesses to protect themselves against adverse interest rate
movements whilst allowing them to benefit from favourable movements. They are also
known as interest rate guarantees. Options are like insurance policies:

(1) You pay a premium to take out the protection. This is non-returnable whether or not
you make use of the protection.

(2) If interest rates move in an unfavourable direction you can call on the insurance.

(3) If interest rates move favourable you ignore the insurance.

Options are taken on interest rate futures and they give the right, but not the obligation,
either to buy the futures or sell the futures at an agreed price at an agreed date.

Interest rate option contracts are for fixed amounts (typically 500,000) last for only 3
months. So to obtain cover for a 3m loan for 6 months the number of contracts needed
would be

3m/0.5m x 6 months/3 months = 12 contracts.

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Using options when borrowing

As explained above, if using simple futures the business would sell futures now then buy

When using options, the borrower takes out an option to sell a future at todays price (or
another agreed price). Lets say that price is 95. An option to sell is known as a put option
(think about putting something up for sale).

If interest rates rise the futures price will fall, lets say to 93. Therefore the borrower will buy at
93 and will then choose to exercise the option by exercising their right to sell at 95. The gain
on the options is used to offset the extra interest that has to be paid.

If interest rates fall the futures price will rise, lets say to 97. Obviously, the borrower would
not buy at 97 then exercise the option to sell at 95, so the option is allowed to lapse and the
business will simply benefit from the lower interest rate.

Using options when depositing

As explained above, if using simple futures the business would buy futures now then sell

When using options, the investor takes out an option to buy at todays price (or another
agreed price). Lets say that price is 95. An option to buy is known as a call option.

If interest rates fall the futures price will rise, lets say to 97. The investor would therefore sell
at 97 then exercise the option to buy at 95. The gain on the options is used to offset the
lower interest that has been earned.

If interest rates rise the futures price will fall, lets say to 93. Obviously the investor would not
sell futures at 93 and exercise the option by insisting on their right to sell at 95. The option is
allowed to lapse and the investor enjoys extra income form the higher interest rate.

Options therefore give borrowers and lenders a way of guaranteeing minimum income or
maximum costs whilst leaving the door open to the possibility of higher income or lower
costs. These heads I win, tails you lose benefits have to be paid for and a non-returnable
premium has to be paid up front to acquire the options.

Example 3
Today is 3 October, and interest rates are 8% p.a. X plc will wish to borrow $6M for 6 months
starting on 1 January. 3 months January interest rate futures are available at 92.00.

Show how interest rate futures may be used to hedge the risk, and calculate the outcome on
1 January.
(Assume that on 1 January interest rates have changed to 10% and the futures price to 90.00)

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5.3. Interest rate caps, floors and collars

Interest rate cap:

A cap involves using interest rate futures options to set a maximum interest rate for
borrowers. If the actual interest rate is lower, the option is allowed to lapse. This is simply the
explanation above of using an option when borrowing and the borrower would buy a put

Interest rate floors:

A floor involves using interest rate futures options to set a minimum interest rate for
investors. If the actual interest rate is higher the investor will let the option lapse. This is
simply the explanation above of using options wen depositing and the investor would buy a
call option.

Interest rate collar:

A collar involves using interest rate options to confine the interest paid or earned within a
pre-determined range. A borrower would buy a cap (buy a put) and sell a floor (sell a call),
thereby offsetting the cost of buying a cap against the premium received by selling a floor.
Note this is the first time we have dealt with selling an option: previously we have bought
puts or calls.

Selling the call option allows the other party to insist on receiving interest at a minimum rate.
If actual rates are lower than this, we will end up having to pay that person interest hence a
floor is set for us as borrowers.

A depositor would buy a floor and sell a cap.

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6. Interest rate swaps

In interest rate swaps: two parties agree to exchange interest payments with each other over
an agreed period.
There have to be advantages to both parties.
The advantages usually arise because the parties are offered different terms for fixed
and floating rate loans and these differences can be exploited.

For example:

Company A can borrow at a fixed rate of 8% or at a variable rate of LIBOR + 2%

Company B can borrow at a fixed rate of 9% or at a variable rate of LIBOR + 5%.

Company A wants to have a fixed rate loan and Company B wants a variable rate loan.

Show how both companies can borrow from an interest rate swap.

If each company borrows the type of loan it wants, Company A will borrow fixed at 8% and
Company B will borrow variable at LIBOR + 5%.

The total interest bill will be: LIBOR + 5% + 8% = LIBOR + 13%

If they borrow in the ways they dont want, Company A will borrow variable at LIBOR + 2%
and Company B will borrow fixed at 9%.

The total interest bill will be: LIBOR + 2% + 9% = LIBOR + 11%.

There is therefore a 2% difference that the companies should be able to exploit by borrowing
in the ways they dont want then swapping the interest rate payments so that they pay fixed/
variable as they wish.

They can split the 2% advantage in whatever way they want to. In the following solution it
has been assumed that they enjoy 1% each, so at the end of the swap, Company A will be
paying fixed rate interest but at 8 1 = 7%, and Company B will be paying variable rate
interest but at LIBOR + 4%.

Company A Company B
Borrow in the way that will open up the advantage (LIBOR + 2%) (9%)
Swap the variable rate LIBOR + 2% (LIBOR + 2%)
Swap a fixed rate (7%) 7%
(7%) (LIBOR + 4%)

In practice there are many ways in which the swap could take place, but the key is to ensure
that each party ends up better than they would have if borrowing what they wanted directly.

In this example, two companies cooperated without any intermediary. In practice, this
matchmaking can be difficult to bring off as each company needs to find another it trusts
with complementary needs. Instead, swaps are often arranges directly with a bank, or
through a bank which will either pay or accept LIBOR in exchange for fixed interest. The bank
will take a cut.

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For example:

Company A: Fixed rate 10%, or LIBOR + 1% [prefers to borrow fixed]

Company B: Fixed rate 9% or LIBOR + 0.5% [prefers to borrow variable]

If they borrow in the way they prefer the total interest bill will be: 10% + LIBOR + 0.5% =
LIBOR + 10.5%

If they borrow the other way, the total interest bill will be: LIBOR + 1% + 9% = LIBOR + 10%.

So there is 0.5% to play for.

Instead of swapping directly they go through a bank that will pay LIBOR to Company A in
exchange for 8.8% fixed, and will accept LIBOR from Company B in exchange 8.6% interest.

Note that with regard to the bank, the LIBOR in and out have cancelled, but the bank receives
8.8% from Company A and pays only 8.6% to Company B, thus making a profit.

The position can be shown as:

8.8% 8.6%
Company A Company B
Borrows LIBOR +1% LIBOR LIBOR Borrows fixed 9%

The final position is:

Company A pays: LIBOR + 1% + 8.85 LIBOR = 9.80 [better than direct fixed borrowing of

Company B pays: 9% + LIBOR - 8.6% = LIBOR + 0.4% [better than direct variable borrowing of
LIBOR + 0.5%]

Between them the companies save (10 9.8) + (0.5 0.4) = 0.3

The bank earns 0.2%

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Chapter 12

1. Introduction

Performance: A task or operation seen in terms of how successfully it is performed

The task could be to make profits, increase share price, curing patients in a hospital,
clear household rubbish. An organisations primary tasks can often be found in the
organisations mission statement For example a car manufacturers primary task is to
produce cars profitably. Although that might be its primary tasks the task of making
profits always rests on subsidiary tasks such as good design, low cost per unit, quality,
flexibility, successful marketing and so on. Many of these are non-financial

Management: The process of dealing with or controlling things or people

Implicit in the idea of controlling something (like a bicycle) is knowing where it is now,
knowing where you need to go and how to manoeuvre it to reach your destination.

2. Features of a modern performance measurement system

Performance measurement is fundamental to both the concept of performance (what is
meant by successful performance?) and its management (assessment of current position, and
where we need to be). It is essential to good performance measurement that suitable
performance measures are set.

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The expected features of modern performance measurement systems are.

Feature Explanation

They should measure the effectiveness For example: a local council will have
of the business and its processes in objectives for street cleaning and waste
meeting the organisations objectives disposal so as to provide a safe and pleasant
in order to link to the overall strategy; environment for the local population.

Performance in these areas should be

measured to maximize the chance of the
objectives being met.

They should measure the efficiency of For example: although the council, above,
resource utilisation within the might keep its streets spotless it would also
organisation; have a responsibility to achieve this in a
cost-eective way by ensuring that tasks are
performed eciently.

They should contain internal and For example: the performance of dierent
external measures of performance; cleaning teams can be compared. In
addition it is important to compare
(benchmark) the councils performance to
that of other councils so that meaningful
targets are set.

They should comprise a mix of For example: running costs, % of rubbish

financial and non-financial bins not emptied as scheduled, householder
(quantitative and qualitative) methods; satisfaction ratings.

They will require to make clear the For example: should rubbish bins be
different dimensions of performance emptied weekly or only every fortnight?
so that judgements on trade-offs Costs saves and loss of amenity must be
between them are explicit (e.g. quality compared to allow a rational decision to be
and cost); made.

They will link to the targets set for For example: a monthly employee bonus
employee motivation; based on % of rubbish bins emptied on

They should cover both the short-term For example: short term there will be cost
and long-term performance of the constraints; long term the council might
organisation; want to attract more people to the area to
boost the economy. Attracting new people
will partly depend on providing a clean
environment and good council services.

They should be flexible in order to For example: there will be short term
respond to changes in the business disruption over public holidays or periods of
environment. very bad weather. Long term, if industry
grows in the area, measures might have to
be divided to cover both domestic waste
and industrial waste.

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There are a number of potential pitfalls on the design of performance measurement


Not enough performance measures are set. Often directors and employees will be
judged on the basis of performance measure results. It has been said that Whatever you
measure you change and employees will tend to concentrate on achieving the required
performance where it is measured. The corollary is that Whatever you dont measure
you dont change and the danger is that employees will ignore areas of behaviour and

performance which are not assessed.

Too many performance measures, especially where they are not ranked by importance.
Performance measures have to be measured, calculated, reported to management and
discrepancies explained or excuses invented. Trying to juggle too many measures can
divert time from more important tasks and there is a danger that employees
concentrate on the easier but more trivial measures than on the more difficult but vital
targets. It is essential to identify the really important measures and the identification of
critical success factors (CSF) can achieve this. CSFs must be achieved if the organisation
is going to succeed.
The wrong performance measures. For example, applying strict cost measures in an
organisation where luxury products and services are sold is likely to detract from the
organisations success.
Too tight/too loose performance measures. For example, performance indicators that
are too difficult to attain can lead to a loss of employee motivation, gaming and to the
misrepresentation of data. A performance measure that is too loose can pull down
performance. It is important that measures are set at challenging yet attainable levels
and it is here that benchmarking exercises can help. Internal benchmarking generally
sets measures based on previous periods measures or set measures with respect to
other branches or divisions. However these internal benchmarks can lead to
complacency as many organisations have to compete with others and benchmarks
should be aligned to competitors performance.
Hit and run performance indicators. By this I mean that a performance indicator is set
then it is assumed that things will look after themselves. The performance indicator
needs a management framework if it is to be at all effective.

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3. Control systems

3.1. Introduction

Control systems are necessary throughout an organisation to monitor performance so that

corrective action may be taken where appropriate.

An example is a budgetary control system, where costs might be compared against budget

and action taken to attempt to correct any over-spends.

Another example is a quality control system, where production is compared against pre-
defined standards, and again appropriate action is taken when the quality deviates from the

All control systems operate in the same basic way, and you should be aware of the diagram
below and the terminology.






3.2. Feedback/feedforward control

Feedback control is where the outputs of a process are measured and information is then
provided regarding corrective action, after the outputs have been produced.

Variance analysis is an example of this. At the end of (say) each month, variances are
calculated. If there is an overspend in January, then attempts will be made to correct the
problem for the future. It is however too late to do anything about January

It is vital that any feedback needed is applied sufficiently quickly to prevent further
deterioration in performance. Delays can creep in at any stage:
Delay in collecting data
Delay in carrying out comparisons (eg delays in producing variance analyses)
Delay in managers reading the reports, deciding what to do and effecting change.

IT systems can be of great help in reducing delays in control systems because the data can
often be collated and reported in real time.

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Feed forward control is where a problem is identified in advance and corrective action
taken before the problem occurs.

An example of this is one use of the budgeting process. If a budget is prepared for the coming
year and forecasts an unacceptably low profit, then ways will be looked for of changing plans
to increase the profit. For example, increasing selling prices or cutting cost

3.3. Negative/positive feedback

Negative feedback is where the control mechanism reduces the problem, and is what we
would desire to achieve. For example if actual costs are above budgeted costs, negative
feedback would be applied

Positive feedback however, is where the departure from the plan is to be encouraged.
For example, if sales are ahead of budget the organisation would try to encourage that

4. Information for performance management

4.1. Introduction

Information can be classified as follows:


Non-financial Financial

Quantitative Qualitative

Examples are:
Financial: sales, profits, costs, GP%, return on capital employed
Non-financial quantitative: percentage of product rejects, volume of sales, number of
Non-financial qualitative: reputation, effectiveness, customer satisfaction, staff morale.

The information provided must match the performance drivers of the organisations success.
In particular, non-financial performance is a very important determinant of the long term
success of any enterprise. For a business, short term financial performance can often be
improved by reducing quality, innovation and training. However, a business pursuing these
approaches is likely to suffer financially in the long term. It is not so much that a business is
interested in making high quality products for their own sake, but if the business positions
itself as a high quality manufacturer it must deliver high quality and, therefore, quality needs
to be monitored. If the business were known as a cheap and cheerful supplier, the
measurement of quality would be much less important but costs per unit would become
more important. It is a common theme of questions for reports to display only financial
information; this allows the opportunity for candidates to criticise the lack of relevant non-
financial information.

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4.2. Budgets in performance management

The functions of a budget are:

Planning and control


Particular difficulties can arise when using budgets to evaluate performance:

Time consuming and costly to put together
Constrains responsiveness, flexibility and change
Rarely strategically focussed
Concentrate on cost reduction, not value creation
Strengthen vertical control and command reflect emerging network structures
Encourage gaming and perverse behaviour.
Developed and updated too infrequently
Based on unsupported assumptions and guesses
Reinforce departmental barriers
Make people feel undervalued.

4.3. Beyond budgeting

Measuring success against the competition.
The target setting based on external benchmarks.
Motivation through challenges and delegating responsibility
Empowerment of operational managers by giving them the means to act
independently (access to resources).
The resource utilisation process is based on direct local access to resources through
internal markets
Organization based on customer-oriented teams
Creation of a single truth in the organization

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5. The balanced scorecard (Kaplan and Norton)

The balanced looks at performance over four perspectives:
Financial perspective
Customer perspective
Internal business perspective

Innovation and learning perspective

The perspectives form a hierarchy:

Financial performance is easy to measure, but those measurements do not tell you how
goods performance was attained. The source of good performance can be thought of as
happy, loyal customers who are willing to pay goods prices.

The customer perspective looks at how well we are regarded by customers. Measures include
sales growth, repeat orders, growth of new customer, customer surveys.

The internal business perspective looks at what the organisation is doing so that customers
are delighted and operations are carried out efficiently. There will be delighted, loyal
customers, and delighted if the organisation does well what it purports to do whatever that
is. So if customers require fast delivery, then delivery times have to have targets and actual
delivery performance has to be measured. If customers wan low prices, our operations must
deliver that and we must measure success there. If customers want fantastic quality, then that
has to be measured.

The organisation might currently be the best one around, but nothing stands still.
Competitors will be trying to out-do us and improve their internal business perspectives.
Therefore organisations cannot rest on their laurels: continual improvement is needed and
this is what the innovation and learning perspective addresses. Measurements could include
new products brought to market, patents filed, staff gaining qualifications, improvements in
the performance of products.

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6. Factors relevant when designing performance

measurement systems

6.1. Mission statements

These define the important aspects of performance that sum up the purpose of the
organisation. See the article The design of reports for performance management.

6.2. Stakeholder analysis

Recognises that different stakeholders have different views on what constitutes good
performance. Sometimes what stakeholders want is different to what the mission statement
suggests as the purpose of the organisation. This is a particular problem when key-players are
at odds with the organisations mission. For example, a hospital would probably mention
high quality patient care in its mission statement. One of the measures that could be used to
assess that could be how long patients have to wait for treatment. Say that currently the
hospital had essential staff present only at weekends and that no elective procedures were
planned then. To improve the use of facilities and to allow patients to be seen more quickly
the hospital now wants to introduce full facilities seven days a week. This plan could cause
strong resistance from staff, particularly if the staff belonged to a powerful trade union and
were thus key players. Lets say that staff require large pay rises to work more flexibly. So
there is a conflict: the mission statements implies that seven day working is desirable, but key
player stakeholders desire more pay.

6.3. Company structure

Different structures inevitably affect both performance and its management. Tall narrow
structures are rather out of fashion but might be required in high risk industries where close
supervision is needed to avoid catastrophe. In fast changing environments, however, wide
flat structures will more readily allow flexibility, information sharing and fast decision-making
on which the organisations performance might depend. If success depends on flexibility and
fast response to customer requirements then there should be an attempt to measure
performance there. As businesses become larger, many choose a divisionalised structure to
allow specialisation and concentration on different parts of the business: manufacturing/
selling, European market/Asian market/North American market, product type A/product type
B. Divisional performance measures, such as return on investment and residual income then
become relevant

6.4. Information technology

What systems and information are required to maximise performance and to measure
performance? How could new technologies help performance? Remember that sophisticated
new technology does not guarantee better performance as costs can easily outweigh
benefits. If IT is vital to a business then down time and query response time are relevant as
might be a measure of system usability. Back-up procedures and recovery times should be
tested to ensure that proper performance is achieved.

As noted above, IT can allow performance to be measured in real-time so that adjustments

can be quickly made.

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6.5. Human resource management

What type of people should be recruited, how are they to be motivated, appraised and
rewarded to maximise the chance of good organisational performance? Again, you always
have to question whether or not recruiting better qualified people, paying them more
generously and giving better working conditions will improve performance. There are, of
course ethical issues raised by poor working conditions, but all organisations whether profit-
seeking or not have to watch their wage bills. Performance measures are needed to, for

example, monitor training, performance, job satisfaction, recruitment and retention. In

addition, considerable effort has to be given to considering how employees remuneration
should be linked to performance.

It is also important to set targets to individuals which are effective in generating the proper
behaviours and performances. It is suggested that key performance indicators should comply
with the following:
Ownership: refers to the idea that KPIs will be taken more seriously if you have a say in
setting targets. You will be more committed and will better understand why that KPI is
Achievability: if KPIs are frequently and obviously not achievable then motivation is
harmed. Why would you put in extra effort to try to achieve a target (and bonus) if you
believe failure is inevitable.
Fairness. Everyone should be set similarly challenging objectives and it is essential that
allowance should be made for uncontrollable events. Managers should not be
penalised for events that are completely outside everyones control (for example, a
natural disaster) or which is someone elses fault

Employee rewards should be set up to encourage employees to achieve the KPI targets:
Clarity: exactly how does performance translate into a reward?
Motivation: the reward must be both desirable and must be perceived as achievable if it
is to be motivating.
Controllable: achievement of the KPI giving rise to the reward should be something the
manager can influence and control.

6.6. Quality

Increasingly quality is seen as key to sustained good performance whether you are talking
about a profit-seeking organisation, not-for profit hospital or school. However, high quality is
not an absolute goal. Performance measures are needed to ensure that products and services
achieve the quality levels set as being appropriate to the organisation.

Quality can be analysed as follows:

Prevention costs
Appraisal costs
Internal failure costs
External failure costs.

The most convincing argument for setting up a quality control system is to imagine no quality
control at all. All failures would then happen when goods arrived with customers (external

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failure costs) and this cost is very high indeed (replace unit, poor reputation, perhaps damage
at customers premises).

External failure could largely be prevented by testing completed units in-house before
despatch.Failure at this point would be less expensive, but a whole unit needs to be
examined and repaired.

If units were tested and appraised as they were being made then repairs would be easier to
carry out or if the unit had to be scrapped at least less work would have been done on it.

Best (and cheapest) of all is to concentrate quality control on prevention: good design, good
suppliers and components, good training of staff.

The money spent on prevention will be much less than having to spend it on quality further
along the chain.
Prevention and appraisal costs are known as costs of conformance (improving quality)
Internal and external failure costs are known as costs of non-conformance (allowing for
poor quality).

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Chapter 13

1. Introduction to auditing

External audit:
A periodic examination of the books of account and records of an entity carried out by an
independent third party (the auditor), to ensure that they have been properly maintained, are
accurate and comply with established concepts, principles, accounting standards, legal
requirements and give a true and fair view of the financial state of the entity.
(CIMAs Management Accounting Ocial Terminology)

Internal audit:
An independent appraisal activity established within an organisation as a service to it. It is a control
which functions by examining and evaluating the adequacy and eectiveness of other controls; a
management tool which analyses the eectiveness of all parts of an entitys operations and
(CIMAs Management Accounting Ocial Terminology)

CIMA members and the P exam are primarily focussed on internal audit.

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2. Internal audit types of assignment

Transactions audit: tracing transactions through the system, often from start to finish, to
see if they are treated correctly.
Systems audit: an information technology or information systems audit, is an
examination of the management controls within an Information technology (IT)
Risk-based audits: an internal audit which is primarily focused on the

inherentriskinvolved in the activities or system and provide assurance thatriskis being

managed by the organisation to the definedriskappetite level.
Accounting systems audit: ensuring, for example, that the proper accounting controls
are being applied consistently.
Operational audits: a systematic review of effectiveness, efficiency and economy of
operation.For example, examining how customer complaints are dealt with.
Value for money and best value. Usually associated with public or non-profit
organisations. Its purpose is to assess the effectiveness and efficiency of its use of public
Management audits: analysis and assessment of competencies, abilities and capabilities
of a company's management in order to evaluate their effectiveness, especially
regarding the strategic objectives and the implementation of the policies of the
Social and environmental audits: Asocial and environmental auditlooks at factors such
as a company's record of charitable giving, volunteer activity, energy use, recycling
waste, diversity in recruitment, non-discrimination in appointments, the standard of the
work environment, workers remuneration to evaluate the social and
environmentalimpact the company is having.
Special assignments such as investigating a case of fraud
Assisting the external auditors.

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3. Comparison of internal and external audit

Internal audit External audit

Reports to Management must have a Shareholders

clear route to the board
though day-to-day reporting
to the audit committee.

Appointed by Management Shareholders

Power from Management Statute allows external
auditors to insist on seeing all
documents and to be given
full explanations.
Employed by Company (unless outsourced) External firm
Coverage All categories of risk and Financial statements: true
investigation and fair view
Responsibility for A major function of internal Will report to management
improving the organisation audit on internal control

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4. The audit risk model

Risk of material misstatement

AR = x DR


Audit Risk

Control risk

Inherent Risk Detection Risk

Sampling Risk Non-sampling Risk

The audit risk model sets out the current, risk-based, approach to auditing.

Audit risk is the risk that the auditor comes to a wrong conclusion about a figure in the
financial statements or the accounting system. For example, the auditor, whether internal or
external, concludes that an amount is correct when, in fact, it is wrong.

For that to happen, three problems must have occurred:

Inherent risk: this is the risk that an error is made in the first place before the
application of any controls of checks. Inherent risk is increased by factors such as:
Inexperienced sta
Time pressure
Complex transactions
Figures requiring a high degree of estimation
Pressure to perform well eg to make results look good.
Control risk: this is the risk that the organisations system of internal control does not
prevent or detect the error. For example, a junior employee might have committed an
error (inherent risk), but good supervision and checking of that persons work should
detect and correct the error.
If both of these occur, then a wrong figure is in the financial statements or in the
accounting records.

Detection risk: this is the last line of defence and this refers to work the auditor does. If
the auditor performs a lot of work, detection risk will be low as there is a good chance
that the audit work detects the problem. If the auditor does relatively little work, then
the chance of picking up an error will be low.
Auditors cant alter inherent risk or control risk in the short term (though they should
certainly be able to influence control risk in the long term). Therefore, to keep the audit
risk low (and this is essential), if the auditor perceives high inherent and control risk, a

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large amount of audit work will have to be performed. If, however, the auditor
perceives inherent and control risk to be low, the auditor will perform much less audit
work yet still achieve a reasonable degree of assurance about the figures in the
accounting system.

Detection risk depends on:

Sampling risk if a sample is too small then errors might not be found. This risk is
decreased by increasing sample sizes.

Non-sampling risk typically because the auditors are too inexperienced, badly
supervised and their work poorly reviewed. Samples could be 100% but if the
auditor didnt know what he or she was looking for detection risk will be very

5. Audit planning
The first step in any audit is to plan: what are the main risks? How will they be addressed?
How many auditors do we need and with what experience? How long will it take? How many
locations do we need to visit?

Risk can be assessed by:

Knowledge of the business. For example, a jewellery business will have high risk in inventory
(small, high-valued items).
Talking to staff. For example, they might tell the auditor of an accounting problems or
that the new IT system was giving problems.
Analytical procedures. Compare this periods results with last periods and with budgets.
If, for example, receivables collection periods have increased form 34 days to 56 days
the auditors need to know why. Is it a deliberate change to terms? Has the credit control
department become sloppy? Is it an error? Is there a large unrecoverable amount that
should perhaps be written off?

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6. Internal control systems

Most auditing relies on testing the system of internal control. This is the system put in place
to prevent or detect errors. Typical controls are:
Segregation of duties: split up the stages of a transaction so that one person doesnt
carry out every step. This helps to stop fraud and also means that several minds are
involved in ensuring the transaction is correct.

Physical: for example, lock cash and inventory away.

Authorisation and approval: for example, overtime claims are signed by managers as
Management and supervision: managers and supervisors keep an eye on whats going
Organisation: for example, ensuring that the sales team cant decide on sales prices to
boost demand and their commissions.
Arithmetic and accounting: reperform calculations. Carry out reconciliations.

Internal control systems should be set out in a procedures manual and internal auditors will
Are the procedures adequate?
Are the procedures being carried out as they should be?

Examples of poor internal control include:

Not cancelling suppliers invoices when posted/paid (they could go round the system
Employees self-certifying time sheets and expense claim forms
Ability of junior staff to write off debts (or to carry out other journal entries).
Not ensuring that cash receipts are promptly banked
Not establishing credit limits for customers and not following up slow payers
Not approving orders for material so that too much of the wrong type can be ordered

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7. Collecting audit evidence

Auditors collect evidence in the following ways (AEIOU):
Analytical procedures ratios and comparisons as explained above.
Enquiry and confirmation: for example, ask employees how they carry out certain
operations. Write to customers and ask how much they think they owe.

Inspection: for example, inspect orders to ensure they have been properly authorised
Observation: for example, watch operations in the receiving bay to ensure that
personnel count and inspect the goods delivered.
RecalcUlation and reperformance. For example, redo a bank reconciliation to ensure
that it was carried out correctly.

8. Computer assisted audit techniques

8.1. Introduction

Even very small businesses will usually maintain their computer records on computer. There
are many advantages to this, not least that trial balances will usually balance and control
accounts will reconcile to the underlying detailed records. However, the absence of as many
hand-written data and documents data can make auditing more difficult. For example, it can
be difficult to test whether a computer is carrying out a procedure correctly and it can be
more difficult to see and examine the information and records than in a manual system.

Computer Assisted Audit Techniques (CAAT) have been developed to assist the auditor when
the client maintains computerised records.

8.2. Types of CAAT audit software

Audit software (or audit programs) is software developed and used by auditors. Audit
software allows clients accounting data files to be read and examined.

Auditors audit Reads Clients accounting

software data

The processes carried out by the auditors software commonly include:

Adding up the records. For example, inventory values and receivables balances. The
totals are the amounts that should appear in the statement of financial position.
Performing calculations for analytical reviews.
Identifying and printing details of unusual items for further investigation, such as credit
balances on a receivables ledger or negative inventory balances.
Picking samples. For example, that audit software can be programmed to create a
stratified sample or a pure random sample.
Picking all items with particular characteristics, such as all sales orders approved by a
certain employee.

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Once it is set up, audit software can quickly, efficiently and economically examine every item
on a data file. This which would often be difficult or impossible if attempted manually. It can
greatly speed up audit completion and reduce costs.

8.3. Types of CAAT test data

Test data is auditors data that is operated on by clients program. It is used to test the
workings and resilience of programs.

Is processed by
Auditors Test data Clients programs

The results produced by client programs are compared with predictions of what should
happen and any discrepancies are investigated.

Test data is designed to:

Test that calculations are carried out correctly by client software. For example, enter
time sheet data of 50 hours worked and ensure that the correct wages and tax are
Test that programmed controls and procedures are carried out correctly. For example, if
a clients system should reject orders from customer over their credit limit, test that such
orders are indeed rejected by entering an order that should be rejected. Another
example of a programmed control would be testing that only staff members who are
allocated certain privileges can log-on and change someones salary: log-on with what
should be inadequate rights and ensure that you cannot change a salary.
Test how resilient software is against input errors. For example, test what happens if an
account number is entered incorrectly, or a negative amount of stock id ordered, or an
impossible date is entered.

Test data might be the only way in which certain controls can be verified. For example, a
company web-site might properly reject an order from a customer, but there might be no
permanent record available to the auditors to verify that this control is happening.

8.4. Problems with CAAT techniques

Technical/set-up problems. Initially, additional time and technical expertise will be
needed to set up audit software and test data properly. The time and expenses of this
should be repaid in subsequent years.
Clients or departments can be reluctant to let auditors interfere with their computer
records. This is more of a problem with test data where deliberately false transactions
are processed to test the system. The normal way round this is for the auditor to use a
copy of the system and to process their test data against that. This technique is known
as dead test data. There is a risk, of course, that the programs being used are different
to the copies being used by the auditor.

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9. The internal audit report

At the end of the audit process, internal auditors will issue a report that will detail:
Deficiencies in the internal control systems design
Incidents where the internal control system was not complied with
Errors discovered

Often the reports will be in the format:

Details about the nature of The possible eects of these Suggestions as to how to fix
the internal control deficiencies and departures the problems
deficiency and departures
from the specified internal
control procedures

10. Responsibilities, status and outsourcing

10.1. Responsibilities for internal control

Note that directors are responsible for:

Maintaining sound risk management and internal control systems
Setting the control environment (a culture where there is an appreciation of the
benefits and importance of controls, internal control procedures and their operation
The effectiveness of these elements should be regularly reviewed.
Keeping the needs for internal audit under regular review
Listed companies must report on internal control in their annual reports.

10.2. Status and qualifications

Internal auditors should be:


Although ultimately they report to the board this will often be through the audit committee.
Even then, because of the employer/employee relationship it might be difficult for internal
auditors to criticise internal controls set up by the finance director.

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10.3. Outsourcing internal audit

It is increasingly common for the internal audit function to be outsourced (ie internal audit
functions are externally supplied). Advantages and disadvantages of this are as follows:

Advantages Disadvantages
No recruitment, stang or training worries Less knowledge and expertise about the

Specialist services will be available from Cost external providers will charge quite
large external suppliers that might be high hourly rates.
dicult to provide in-house eg forensic

Flexibility to carry out special There can be ethical complications if

investigations that are urgent external auditors are used in an internal
audit function
Quicker to set up initially

Appropriate amounts of time can be spent.

A company might not be large enough to
keep an internal audit team fully employed
(and a team is needed to provide mutual
Greater independence

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2016 Examinations CIMA P3 131

11. Fraud

11.1. Introduction

Fraud is an intentional act involving deception to gain unjust or illegal advantage.

There are two types:

Fraudulent financial reporting. For example, overstating profits to generate high

directors bonuses, boost the share price or to achieve a good sale price for the
Misappropriation of assets. For example theft of cash or inventory.

Managers and those charges with governance are responsible for the prevention or detection
of fraud. Auditors should always be aware of an organisations susceptibility to fraud.

11.2. The pre-conditions for fraud:

Three conditions or risk factors are necessary for fraud to be committed:


Risk factor Examples relating to fraudulent Examples relating to the

financial reporting misappropriation of assets.
Incentive Pressure from shareholders to Personal financial pressure
perform Greed
Fear of losing job
Dislike of the employer (Ill get
Incentives related to my own back!)
Opportunity Poor internal control Poor internal control
Poor corporate governance eg a High-value portable inventory
dominant chief executive who is Cash-based business
also chairman
Poor supervision
Results dependent on many
estimates and a high degree of
Attitude Poor ethics Poor ethics
Poor morale Dislike of the employer
Excessively aggressive targets Other employees behaviour (and
you become convinced that the
fiddle is normal and therefore

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11.3. An anti-fraud strategy

An anti-fraud strategy has three elements:


CIMA shows that these interrelate as follows:

(Fraud risk management: a guide to good practice, CIMA)

Deterrence is the result of prevention (too difficult to get to the inventory to steal it),
detection (you will be subject to random searches as you leave the factory), response (you will
definitely be prosecuted).

Surrounding these specific anti-fraud strategies there are:

Legislation: for example, what types of actions (such as insider trading) are illegal?
Risk management: an awareness by the organisations senior managers and directors
of where the main dangers of fraud lie and then suitable controls being put in place.
Corporate governance. For example, non-executive directors providing independent
advice about behaviour. Audit committee being available to support internal audit and
Ethical culture: for example, making it clear that shady practices are wrong and will
not be tolerated by the company. Training in ethical behaviour will be important

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11.4. Whistleblowing

Whistleblowing is defined as making a disclosure that is in the public interest.

Many frauds are known about or suspected by people who are not involved in the
dishonesty. The challenge for management is to encourage these innocent people to speak
out and to demonstrate that it is very much in their own interest to do so. Reporting
mechanisms are a very important element of risk management and fraud deterrence.

There can be many conflicting emotions influencing the potential whistleblower:

working group/family loyalties
fear of consequences
suspicion rather than proof.

The organisations anti-fraud culture and reporting processes can be a major influence on the
whistleblower, as it is often fear of the consequences that has the impact. To the
whistleblower the impact of speaking out can be traumatic, ranging from being dismissed to
being shunned by other employees. Confidential reporting mechanism might help.

In the UK, whistleblowers (employees, trainees, agency workers) are protected by law if they
a criminal offence, eg fraud
someones health and safety is in danger
risk or actual damage to the environment
a miscarriage of justice
the company is breaking the law, eg doesnt have the right insurance
you believe someone is covering up wrongdoing

Personal grievances (eg bullying, harassment, discrimination) arent covered by

whistleblowing law, unless your particular case is in the public interest.

To enjoy legal protection, disclosures by whistleblowers must actually be in the public

interest. Therefore, to be protected by the law the whistleblower must:
have made the disclosure in good faith in other words you must be disclosing the
information because it is in the public interest and is clearly wrong
reasonably believe that the information is substantially true
reasonably believe you are making the disclosure to the right prescribed person.

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