ACCA P1 EXAM NOTES

Part 1: Framework Chapter 1: Introduction of CG (Corporate Governance)

Segregation of the ownership and control -Shareholders are the owner of the company -Control usually delegated to director -Interest of shareholders and directors may conflict -Directors may not act in the best interest of the shareholder

Corporate Governance Largely concerned with governing the relationship between shareholders and directors

Definition: A system by which organizations are directed and controlled

Purpose and objectives: -Monitor those who control the assets owned by investors -Contribute to improved corporate performance and accountability in creating long term shareholder value

Impact on organization: -Duties of directors and function of the board -Composition and balance of the board and board committee -Reliability of financial reporting and external auditing -Directors remuneration and rewards -Risk management and internal control system -Right and responsibilities of shareholders

Stakeholder; Internal: -Directors -Company secretary -Managers -Employee -Employee representative External: -Auditor -Regulator -Shareholder -Stock exchange -Government

Issues and scope of governance on public, private and NGO sectors -Influenced by the size, ownership, model and objectives of organization

Key points: 1. 2. 3. Definition of CG- B 49&F 4 Underlying concepts of CG- B 49&F 7 Major areas of CG- B 67-70 & F10-11

Chapter 2: Agency relationship and theories

Agency relationship and theories

Agency theory

Transaction costs and stakeholder theories and economic theory

Definition: Examine duties and conflict that occur between parties who have an agency

Relationship with CG: Key function of CG to protect the principal agent relationship between shareholder and director

Agent Accountability: by undertaking to perform a task on their behalf, agents become accountable to the principal

Key concept: Agent Principal Agency Agency cost Accountability Fiduciary Responsibility Shareholder

Key points: 1. 2. 3. Agency theory: B 52&F 25 F27-F29 Transaction theory: B55&F30 F31 Stakeholder theory: B55&F32

Chapter 3: Board of directors, Board of Committee & Remuneration

Board of directors: Board of directors

Unitary

Board structure

Single board

Two boards

ED

NED

Management board

Supervisory board

ED

NED

Roles and responsibilities: -Act in good faith in the interests of the company as a whole -Display a certain amount of skills and exercise reasonable care -Ensure company maintains full and accurate accounting records -Produce and present annual accounts

Characteristic and composition: -Balance of ED and NED -Not be dominated by a single powerful individual -Role of chairman and the CEO should be separated

Induction program: Gives incoming director: -An understanding of nature of the company, its business and the market in which it operates -A link with companys people -Understanding of companys main relationship

Legal and regulatory framework: Appointment and retirement Service contract Removal Disqualification Conflicts of interest Insider dealing

Chairman: -Runs the board -Ensures that the board sets and implements the companys direction and strategy effectively -Acts as companys lead representative

CPD: Companies need to provide resources for developing and refreshing the knowledge and skill of director

Executive Director (ED): -Members of a board of directors who are also senior managers of the company -Usually paid as full time employee for their work

Non Executive Director (NED): -Members of a board of directors who do not form part of the executive management team -Not full time employee of the company or they act in any other way

CEO: -Runs the company -Take the responsibility for the performance of the company as determined by the boards strategy -Report to chairman 3

Independence: -Require certain detachment from the company -Should be independent in judgment Key points: 1. 2. Role of board: P104 &F 58 Board structure: Advantages and disadvantages of unitary board and two-tier board B119-120 & F 60-61 3. Composition of the board

Combined code requirement: F63 -Board should meet regularly and the results of the meeting included in the annual report as a high level statement of the operation. -The annual report should identify attendance and name of chairman, CEO, senior independent, others and committee nature and membership. -The chairman should hold separate meeting with NED and NED should meet to discuss chairmans performance. -Any unresolved meeting concerns should be recorded in board meetings. If NED resigns they must notify chairman of concerns. -The company should arrange appropriate insurance cover in respect of legal action against directors. 4. Functions of NED B 115-117&F 65-66 5. Threats to independence of the NED B 117-B118 &F 67 Independence can be judged as: -Not being an employee of the company within last 5 years -Not having material business relationship with the company in last 3 years -Not receiving any remuneration except a directors fee (including share option) -Not having any family ties with the firm -Not holding cross directorships with other director -Not being an significant shareholder -Not having served on the board for over nine years -The board should consist of half independent excluding the chair -One NED should be the senior independent director who is directly available to shareholders if they have concerns which cannot be dealt with through the appropriate channel of chairman, CEO or finance director. 6. Role of chairman and CEO B112-114F 69-70 7. Directors induction and CPD B106& F73-75 8. Legal duty B109-111& F 78-83 -Retirement -Service contract -Removal

-Disqualification -Conflicts of interest -Insider dealing Board committee

Audit committee

Remuneration committee

Nomination committee

Risk committee

100% NED

100% NED Majority NED Majority NED

Pay & Benefits of ED

Structure of board

Company risk exposure

Key points: 1. 2. Role and responsibilities of different committees B115&F93-F97 Remuneration: B123-B124 & F100-P102

Chapter 4: Different approaches to corporate governance

Cadbury

Greenbury

Hampel

Multiple jurisdictions -OECD principle -ICGN principle

Higgs Combined code Smith Turnbull

Auditor independence Auditors are restricted in the additional service they can provide to the client

Audit committee Company must have an audit committee-will be disallowed from trading if it does not have one

US stock exchange regulations Required under the Act-very similar to UK regulation

SOX

Audit committee Annual report must include statements concerning the internal control system in the company

Increased financial disclosures Financial report to detail off balance sheet financing 5

Key points: 1. Development of the code: B 81-85 & F40-42 2. SOX: B88-89 & F45

Chapter 5: Corporate governance, social responsibility and disclosure

CG is how an organization is governed in pursuit of its objective and includes: -how it behaves in relation to its environment -how it interests its shareholder

CSR (Corporate social responsibility) Is how an organization manages the impact of their operations on the wider environment, including consideration for stakeholder group

Stakeholders Of an organization have different objectives which need to be managed in terms of organizational strategy. Shareholders are particularly important stakeholders to the company.

Shareholder Are company owners and entitled to information from the directors. Usually in the form of -Annual report -General meeting Reporting and disclosure -Voluntary -Mandatory

Best practice Guidance provided by the combined code

General meeting

Proxy voting

Key points: 1. CSR: B90-91 & F115-116 2. Mandatory and voluntary disclosure: B127-129 & F128-130 3. General meeting: B125 & F134

4. Proxy voting: B126 & F135

Chapter 6: Management control systems in corporate governance

Internal management control Key process concerned with management of risks and achievement of objective

Roles and responsibility -Board of directors -Executive management

Internal control system

Relevance to corporate governance -Internal control and risk management are fundamental components of good corporate governance -CG has key links to risks and internal control

Objectives and functions -Ensure goals and objectives of the organization are met -Ensure reliable financial and management reporting -Ensure compliance with laws -Protect organizations reputation

Internal control Individual components of an internal control system

Elements: -Risk assessment -Control environment -Information and communication -Monitoring -Control activities

Key points: 1. 2. 3. Definition of IC: B136&F140 Objective of IC: BF145 Elements of IC: B136&F155

Internal control Method F158-161 S Segregation of duties P Physical A Authorization and approval O Organization

A Arithmetic and accuracy P Personnel S Segregation of duties Most transactions can be broken down into three separate duties: 1. Authorization 2. Handling of the asset 3. Recording of the transaction For example: making the purchase, making the payment and recoding the purchase and payment in the accounts P Physical It aims to protect physical assets against theft and unauthorized access and use. They include: 1. 2. 3. 4. 5. using a safe to hold cash and valuable document using secure entry system to buildings and areas of a building dual custody of valuable assets periodic inventory checks hiring security guards and using closed circuit TV(CCTV)

A Authorization and approval For spending items, an organization needs establish authorization limits. O Organization It refers to the controls provided by the organizations structure, such as: 1. 2. 3. 4. the separation of an organizations activities and operations into department or responsibility center, with a clear division responsibility delegating the authority establishing the reporting line coordinating the activities of different departments

A Arithmetic and accuracy Controls are provided by: 1. 2. 3. Recording transactions properly in the accounting system Being able to trace each transaction through the accounting records Double checking

P Personnel 1. Suitable individuals are appointed 2. Suitable induction and training

Chapter 7: Internal control, audit compliance and reporting in CG

Internal control -Monitoring, testing and reporting on the effectiveness of control

Internal audit -Perform an important function in testing and reporting on internal control

External audit Performs a statutory function

Function and importance -Review of accounting and internal control system -Detailed testing -Review of operations -Review of implementation of corporate policy

Audit committee Have responsibility for review and monitoring of internal controls and audit

Reporting to shareholders Is important CG requirement

Internal Audit Perform an important function in testing and reporting on internal controls

Threats to independence Self interest Self review Advocacy Intimidation Familiarity

Importance If auditors are not independent, work may be biased and therefore not reliable

Key points: 1. 2. 3. 4. 5. Function and importance of the internal audit B 152-153&F166-167 Performance standard for IA: B158-159 & F172-173 Threats to independence of auditors B155-156 &F175-179 Audit committee and internal control B163 B165& F 181-185 Audit committee and internal audit & external audit B164 &F187 F189

Chapter 8: Risk management, assessment and risk management

Risk

Management perception of risk

Categorization risk

of

Measurement of risk

Controlling risk

Key points: 1. 2. 3. 4. 5. 6. 7. Risk category: B177-187 & F220-222 F226-227 Risk analysis: B192-195 F217 Impact on the stakeholders: B196-297&F228-229 Role of board: B198 B224 & F234 Role of risk management committee B224-225&F250 Role of risk manager B228 Reduction of risk: B231-234& F259-262

Chapter 9 Ethic theories and professional ethic

Codes of ethics

Ethic theory -Kohlberg theory -Tuckers model

Corporate ethic Application of values to business behaviors

Professional Ethic Codes

ACCA Code -Integrity -Objectivity -Professional competence -Confidentiality -Professional behavior

Threats to the auditors independence -Self interest -Self review -Familiarity -Intimidation

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Conflicts of interest

1. Kohlberg theory: B263-264&F280-283 2. Tuckers model: B292

-Profitable -Legal -Fair -Right -Sustainable

3. ACCA codes: B290&F331-332 4. Conflicts of interest: B302-303 & F334-335 5. Threats to independence: B294-302 & F337-343
II. How to organize your answer Adequacy of answer plan Structured answer Inclusion of significant facts Information given not repeated Relevant content Inferences made Commercial awareness Higher skills demonstrated Professional commentary

III Sample question and answer: Business risk and risk management

1. Azure, a limited liability company, was incorporated in Sepiana on 1 April 2004. In May, the company exercised an exclusive right granted by the government of Pewta to provide twice weekly direct flights between Lyme, the capital of Pewta, and Darke, the capital of Sepiana. The introduction of this service has been well advertised as efficient and timely in national newspapers. The journey time between Sepiana and Pewta is expected to be significantly reduced, so encouraging tourism and business development opportunities in Sepiana. Azure operates a refurbished 35-year-old aircraft which is leased from an international airline and registered with the Pewtan Aviation Administration (the PAA). The PAA requires that engines be overhauled every two years. Engine overhauls are expected to put the aircraft out of commission for several weeks. The aircraft is configured to carry 15 First Class, 50 Business Class and 76 Economy Class passengers. The

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aircraft has a generous hold capacity for Sepianas numerous horticultural growers (e.g. of cocoa, tea and fruit) and general cargo. The six hour journey offers an in-flight movie, a meal, hot and cold drinks and tax-free shopping. All meals are prepared in Lyme under a contract with an airport catering company. Passengers are invited to complete a satisfaction questionnaire which is included with the in-flight entertainment and shopping guide. Responses received show that passengers are generally least satisfied with the quality of the food especially on the Darke to Lyme flight. Azure employs 10 full-time cabin crew attendants who are trained in air-stewardship including passenger safety in the event of accident and illness. Flight personnel (the captain and co-pilots) are provided under a contract with the international airline from which the aircraft is leased. At the end of each flight the captain completes a timesheet detailing the crew and actual flight time. Ticket sales are made by Azure and travel agents in Sepiana and Pewta. On a number of occasions Economy seating has been over-booked. Customers who have been affected by this have been accommodated in Business Class as there is much less demand for this, and even less for First Class. Ticket prices for each class depend on many factors, for example, whether the tickets are refundable/non-refundable, exchangeable/non-exchangeable, single or return, mid-week or weekend, and the time of booking. Azures insurance cover includes passenger liability, freight/baggage and compensation insurance. Premiums for passenger liability insurance are determined on the basis of passenger miles flown. Required: (a) Identify and explain the business risks facing Azure. (b) Describe how the risks identified in (a) could be managed and maintained at an acceptable level by Azure. (a) Business risks Rights to operate Accept at the present level (as one that has to be borne) but bear in mind (e.g. when making strategic decisions) the impact that managements actions could May be a guranteed minimum Terms and conditions attached to the rights may threaten Azures operational existence if, for example, there are any circumstances under which the rights could be withdrawn. For example, if the standard of service falls below a minimum specified level. Competition Although at the moment there appears to be none (as -Monitor the progress of applications for flights to have on any renewal of the rights. Relevant terms and conditions should be communicated to all staff so they are clear about the importance of their areas of responsibility. (b) Processes for managing

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the rights are exclusive), any competition in the future could reduce profitability (e.g. if the right was to become non-exclusive or an indirect service between Sepiana and Lyme should be established).

destinations which could provide transit to Lyme. -Reduce the risk by increasing the reliability and reputation of Azures service, improving comfort etc (e.g. by increasing leg room and providing air-conditioned lounges).

Age of aircraft The age of the aircraft (35 years) is likely to have a bearing on fuel consumption and other costs (e.g. repairs and maintenance). Engine overhaul If the lease is a finance lease it is likely that Azure will have to bear the costs of the overhaul which may have a detrimental effect on cash flows. The service would need to be suspended while the engine is being overhauled unless an alternative is planned for. Leased asset Azure operates with just one leased asset which may be withdrawn from service: in the interests of passenger safety (e.g. in the event of mechanical failure); for major overhaul; if Azure defaults on the lease payments. -Azure should enter into a contractual arrangement (e.g. may be included within the terms of an operating lease) for a replacement aircraft in the event that the aircraft be grounded. -Azure should carry adequate insurance cover for remedying and/or providing compensation to customers for significant disruptions to the scheduled service. Fuel prices Increases in fuel prices (a major operational cost) will reduce profitability. -Fuel surcharges should be included in the flights price structure so that significant increases can be passed on to the customers. -Hedging against the effect of energy price (and exchange rate) risks through forward contracts. Weather Weather conditions may delay or cancel flights. Manage the impact of the risk/modify the business activity. For example, as any form of travel may be hazardous if weather conditions are so bad as to disrupt the flight schedule There should be airconditioned facilities in which travelers can relax before their journey. Horticultural cargo Certain produce may be prohibited from import (e.g. due to the risk of spread of disease). -Contracts with growers should clearly state items -Azures operational controls should include As above, Azure should budget its financial resources to meet the costs of the overhaul, the timing of which can be planned for. The lease agreement with the airline should provide that an equivalent aircraft be available. Azure should manage its cash flows and borrowing capability (e.g. bank loan facility) to carry out ongoing operating repairs as and when needed.

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verification checks on produce carried. Growers may seek to hold Azure liable for: produce which perishes (e.g. if successive flights are cancelled); impounded goods. Economy With significantly less demand for Business Class than for Economy (which gets over-booked) and review and respond to the excess of supply over even less for First Class, the service is operating at demand for Economy seating (and demand well below capacity (economy is only 54% of seating capacity) Azure may not be recouping fixed operating costs in the long run making the service uneconomical. Keep demand for the classes of tickets under review and respond to the excess of supply over demand for Economy seating. For example: charge higher prices for economy on peak flights; offer larger discounts for advance bookings on First and Business Class seats; introduce a loyalty scheme for frequent users which offers preferred customer seat upgrades. Service levels Azures schedule is described as efficient and timely. If the level of service delivered does not meet expectations it is unlikely that a regular customer base will be established. On-board services Passengers are expressing dissatisfaction with meals provided, especially on the return flight from Darke. The food prepared in Lyme may be stale or contaminated by the time it is served. Passengers may be deterred from using this flight the quality of meals for long-haul flights. if they are subject to the risk of illness. Passenger safety Penalties for non-compliance with safety regulations (e.g. maintenance checks on life safety drill procedures (e.g. in evacuation jackets, etc) may be incurred if inspection logs are not kept. Azure may face lawsuit for personal injury and illness Safety procedures must be demonstrated before Azure may face lawsuits for personal injury or take-off on every flight and passengers referred to illness (e.g. deep vein thrombosis dvt), safety information, Staff training should be on-going with regular safety drill procedures. Azure should consider: changing caterer in Lyme; a contract with a caterer in Darke; expert advice (e.g. of a chef) on preserving Azure should benchmark the timeliness of its service, against a comparable airline service operating under similar weather conditions. Azure should have adequate insurance cover against claims for damaged/lost cargo.

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including how to reduce the risk, provided with each seat. Air stewards/Cabin crew safety Azure will have difficulty recruiting and maintaining the services of appropriately qualified cabin crew if it does not have sufficient regard for their health and safety. Emergency A serious accident (e.g. fire), collision or breakdown may threaten operations in both short and longer-term. Accept at the present level, but taking all practicable safety checks now implemented in the airline industry to ensure that Azure is not exposed to preventable risks. For example: x-ray screening of checked-in baggage; security screening of cabin baggage and passengers, etc. Flight personnel Azure may not be able to service the flight in the event of non-supply of flight personnel by the international airline (e.g. due to strike action). The agreement with the airline should indemnify Azure for all costs and losses incurred if flights are cancelled or disrupted due to non-availability of flight personnel. Flight tickets Tickets are sold by more than one party (Azure and travel agents) and at more than one location. lso, pricing is complex, with a range of tariffs depending on many factors. This increases the risk that revenue may be lost if passengers are undercharged or ticket sales unrecorded; and flights may be over-booked, with consequent loss of customer goodwill. The configuration of the aircraft does not currently meet the current demand profile of passengers and under the terms an operating lease may not be changeable. Commence negotiations with the international airline for an amendment to the current lease and terms allowing flexibility in the seating arrangements. Strict controls must be exercised over: unused tickets; ticket pricing; real-time reservations ticket refund and exchange transactions. Flight personnel rotas should ensure, for example, pilots take ground leave between flights; their health and safety. there is adequate cover when crew are sick or taking leave.

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2. Hydrasports, a limited liability company and national leisure group, has sixteen centres around the country and a head office. Facilities at each centre are of a standard design which incorporates a heated swimming pool, sauna, air-conditioned gym and fitness studio with supervised childcare. Each centre is managed on a day-to-day basis, by a centre manager, in accordance with company policies. The centre manager is also responsible for preparing and submitting monthly accounting returns to head office. Each centre is required to have a licence from the local authority to operate. Licences are granted for periods between two and five years and are renewable subject to satisfactory reports from local authority inspectors. The average annual cost of a licence is $900. Members pay a $100 joining fee, plus either $50 per month for peak membership or $30 per month for offpeak, payable quarterly in advance. All fees are stated to be non-refundable. The centre at Verne was closed from July to September 2003 after a chemical spill in the sauna caused a serious accident. Although the centre was re-opened, Hydrasports has recommended to all centre managers that sauna facilities be suspended until further notice. In response to complaints to the local authorities about its childcare facilities, Hydrasports has issued centre managers with revised guidelines for minimum levels of supervision. Centre managers are finding it difficult to meet the new guidelines and have suggested that childcare facilities should be withdrawn. Staff lateness is a recurring problem and a major cause of early bird customer dissatisfaction with sessions which are scheduled to start at 07.00. New employees are generally attracted to the industry in the short-term for its noncash benefits, including free use of the facilities but leave when they require increased financial rewards. Training staff to be qualified life-guards is costly and time-consuming and retention rates are poor. Turnover of centre managers is also high, due to the constraints imposed on them by company policy. Three of the centres are expected to have run at a loss for the year to 31 December 2003 due to falling membership. Hydrasports has invested heavily in a hydrotherapy pool at one of these centres, with the aim of attracting retired members with more leisure time. The building contractor has already billed twice as much and taken three times as long as budgeted for the work. The pool is now expected to open in February 2004. Cash flow difficulties in the current year have put back the planned replacement of gym equipment for most of the centres. Insurance premiums for liability to employees and the public have increased by nearly 45%. Hydrasports has met the additional expense by reducing its insurance cover on its plant and equipment from a replacement cost basis to a net realisable value basis.

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Required: (i) Identify and explain the business risks which should be assessed by the management of Hydrasports. (ii) Explain how each of the business risks identified in (i) may be linked to financial statement risk. Answer: (i) Business risks The standard design of facilities increases operational risk as any difficulties encountered in one facility will be compounded by the number of other facilities (potentially all) which are similarly affected. This is illustrated by the in use closure of the saunas. Centralised control through company policy is resulting in inefficient and ineffective operations as managers cannot respond on a timely basis to local needs. Business reporting risk is likely to be increased by centre managers preparing monthly accounting returns. Operational risk may be increased if centre managers cannot fulfil their day-to-day responsibilities (e.g. relating centre managers. to customer satisfaction, human resources, health and safety). Advanced payments contribute to business reporting and financial (cash flow) risk. Cash received must be available to meet the costs of providing future services. Management circumvention or override of control procedures laid down by head office may result in system weaknesses. If errors arising are not detected and corrected the risk of misstatement in the financial statements is increased. -Information processing risk is increased as accounting information flowing into the financial statements may not be properly captured, input, processed or output by the centre managers. - Inherent risk, of errors arising, in monthly branch returns is high. -Revenue may be overstated if an accurate cutoff is not achieved. In particular, there is an estimate risk in determining the amount of deferred income at the balance sheet date. - An error of principle may also arise if Hydrasports revenue recognition policy does not comply with IAS 18 Revenue. (ii) Financial statement risk The carrying amount of the associated non-current assets (i.e. equipment, fixtures and fittings) is likely to be overstated as they are likely to be impaired if they are not in use.

Hydrasports cannot operate a centre if a licence is suspended, withdrawn or not renewed (e.g. through failing a local authority inspection or failing to apply for renewal). Closure may result in customers finding alternative facilities with permanent loss of fee revenue. Early bird customers disatisfaction similarly increases operational risk.

An error of principle arises if licences are not capitalised as intangible assets (but instead written off as expenses when incurred). Failure risk (i.e. that Hydrasports will not continue to operate as a going concern) is increased. This creates disclosure risk if the disclosures relating to going concern as the basis of accounting do not

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meet the requirements of IAS 1 Presentation of Financial Statements. Serious accidents may prompt investigation by local authority resulting in penalties, fines and/or withdrawal of licence to operate. -If licences are withdrawn, the intangible asset (amounts prepaid) should be written off to the extent that monies are not refundable. - The likelihood of contingent (if not actual) liabilities increases disclosure risk. Although fees are non-refundable, suspension of a facility (e.g. sauna) may result in customers asking for partial refund. In particular Hydrasports may have an obligation to refund fees paid in advance when centres are closed (e.g. the Verne centre from JulySeptember 2003). Permanent loss of customers requiring childcare facilities increases operating risk. Compliance risk is increased if the new guidelines are not met. Similarly, inability to retain lifeguards increases operational risk that pools cannot open (due to health and safety regulations). Compliance risk is increased by the possibility that pools may be operated without a lifeguard being on duty. High staff turnover indicates increased operational risk (poor human resource management, inefficiency in working practices, reduced capacity, etc). Limitations on centre managers levels of authority may not be commensurate with their responsibilities. Empowerment risk arises if managers are not properly led (and if they, in turn, do not properly lead their centre staff). More centres may become loss-making if the reasons for falling membership are not addressed. The hydrotherapy pool cannot operate until construction is completed and completion may be threatened by cash flow difficulties. Cash flow difficulties increase liquidity/financial risk. Obsolete gym equipment increases operational risk as customer satisfaction decreases and health and safety risks are increased. Any lack of integrity may increase the risk of management and/or employee fraud, illegal acts and unauthorised use of company assets. In particular the assertion of existence of assets may be at risk (resulting in overstatement). Loss-making centres should be tested for impairment as cash-generating units. The value of the asset in construction should be written down if it is impaired (even though it has not yet been brought into use). See above reference to going concern and disclosure risk. -Depreciation may be overstated if Hydrasports continues to calculate depreciation on fullydepreciated assets. - Disclosures for capital commitments (e.g. to replace equipment) in the financial statements may be inappropriate if Hydrasports does not have funds to finance such commitments. Staff costs may be overstated as the risk that payments may be made to leavers is increased. Disclosure risk is (again) increased if fines/penalties arising are material and not disclosed. Provisions may be understated at 31 December 2003 if Hydrasports has a legal obligation to refund fees where it has failed to provide services.

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- See above reference to going concern and disclosure risk. The reduction in insurance cover reduces the recoverable amount of assets in the event of loss through fire (for example). Inability to replace lost/damaged assets increases operational risk (see obsolete gym equipment above). Operational risk is increased if the substantial increase in liability insurance premiums is a reflection of an increase in the level of claims being made. 3. The principal activity of Bateleur Zoo Gardens (BZG) is the conservation of animals. Approximately 80% of the zoos income comes from admission fees, money spent in the food and retail outlets and animal sponsorship. The remainder comprises donations and investment income. Admission fees include day visitor entrance fees (gate) and annual membership fees. Day tickets may be prebooked by credit card using a telephone booking hotline and via the zoos website. Reduced fees are available (e.g. to students, senior citizens and families). Animal sponsorships, which last for one year, make a significant contribution to the cost of specialist diets, enclosure maintenance and veterinary care. Animal sponsors benefit from the advertisement of their names at the sponsored animals enclosure. BZGs management has identified the following applicable risks that require further consideration and are to be actively managed: (i) Reduction in admission income through failure to invest in new exhibits and breeding programs to attract visitors; (ii) Animal sponsorships may not be invoiced due to incomplete data transfer between the sponsoring and invoicing departments; (iii) Corporate sponsorships may not be charged for at approved rates either in error or due to arrangements with the companies. In particular, the sponsoring department may not notify the invoicing department of reciprocal arrangements, whereby sponsoring companies provide BZG with advertising (e.g. in company magazines and annual reports); (iv) Cash received at the entrance gate ticket offices (kiosks) may not be passed to cashiers in the accounts department (e.g. through theft); (v) The ticket booking and issuing system may not be available; (vi) Donations of animals to the collection (e.g. from Customs and Excise seizures and rare breeds enthusiasts) may not be recorded. Required: Disclosure risk is increased in relation to contingent assets (for reimbursement under insurance policies). See above reference to going concern and disclosure risk.

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(a) Describe suitable internal controls to manage each of the applicable risks identified. (b) Explain the financial statement risks arising from the applicable risks.

Answer: (i) Lack of investment Monthly review and monitoring of: admission fees; number of day visitors; annual memberships taken out (analysed between new and renewed); lapsed membership; sponsorship waiting lists (animals without sponsors and sponsors waiting for suitable animals). Approval of annual budgets which plan for adequate investment to attract visitors. Monthly comparison of actual expenditure on new exhibits and breeding programs against budget to see the extent to which the expected level of investment in development is being made. (ii) Incomplete data transfer Monthly reconciliations of actual (invoiced) sponsorship income to that expected (based on number of sponsorships, by type, per sponsor department records) and investigation of shortfalls. Monitoring of instances of incomplete/inaccurate data transfer how identified, reason for occurrence, amounts involved, how rectified. (iii) Non-charges Monitoring of sponsorship income generated (i.e. actual) to that available (e.g. projected), by class of animal, and investigation of shortfalls. Comparison of BZGs advertising expenditure against budget (to identify potential for unrecorded costs). (iv) Misappropriated cash Two people could man each ticket kiosk at all times. A duty log should be kept (date, time, staff member). The kiosks must not be left unattended while cash is held there. All cash received from visitors should be counted and recorded and a receipt given. Cash and a copy of the receipts should be transferred, securely, to cashiers. The existence of CCTV at the kiosks should be made evident, to act as a deterrent. Daily reconciliation of cash takings to gate (i.e. number of day visitors) and investigation of any apparent shortfall. A separate admission gate after the kiosk checks that entrants have been issued a ticket. An auditable cash register system to control cash drawers at ticket booths. Transactions must be traceable in multiple forms of tender (cash, credit card). Multiple cash drawer inserts enabling quick and easy shift changes. An automated audit trail of all movements in and out of each drawer.

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(v) Systems not available Back up/recovery/contingency plans must be in place to ensure that BZG can take bookings and issue tickets even when the electronic system is not available. In particular, the back up system should be tested periodically to ensure that credit card bookings can be taken and correct discounts processed for concessionary tickets and group bookings. Preventive arrangements to ensure that any down time is kept to a minimum. For example, acquiring highly reliable systems components and frequent housekeeping/maintenance. (vi) Unrecorded donations Periodic inspection of animals and comparison with book records (e.g. fixed asset register for larger species and inventory records for smaller species). Comparing new animals identified by veterinary records to additions to inventory records (or asset register). (b) Financial statement risks (i) A going concern (failure) risk arises from lack of investment. Any significant doubts about going concern must be suitably disclosed in the notes to the financial statements. Disclosure risk arises if the requirements of IAS 1 Presentation of Financial Statements are not met. (i) A reduction in admission income may result in asset impairment. BZGs management should perform impairment tests on the carrying amount of the larger exhibits, in accordance with IAS 36 Impairment of Assets. Income may be materially understated due to: (ii) incomplete data transfer resulting in invoices not being raised; (iii) unrecorded sponsorships arising from advertising arrangements. Tutorial note: It is unlikely that income would be overstated as companies would dispute the rates if they were overcharged for sponsorships. (iii) BZGs advertising costs will be understated if their barter for sponsorships is not recorded. If material, there is a risk of non-compliance with financial reporting requirements (SIC 31 Revenue Barter Transactions Involving Advertising Services). (iv) Cash asset/admission income will be understated in respect of cash which does not reach the accounts department. If some of this cash is not stolen but rather appropriated for use in the business (e.g. in meeting day-today cash expenses) then costs would be understated also. The financial statement risk is greater if income is lost through unticketed entry (as it will be more difficult to quantify than if misappropriation occurs after tickets have been issued). (v) There may be no financial statement risk. For example, if BZG were to admit people for free there would be no admission fees to be recorded for that day. Alternatively, in the absence of an adequate back up system, the risk of unrecorded cash/income identified in (iv) may be exacerbated. (vi) Assets (and reserves) will be understated if donated animals are not initially recognised at fair value (IAS 16 Property, Plant and Equipment). Professional and ethical issue Sample question and answer: 1.You are a training manager in Hawk Associates, a firm of Chartered Certified Accountants. The firm has suffered a reduction in fee income due to increasing restrictions on the provision of non-audit services to audit clients. The following proposals for obtaining professional work are to be discussed at a forthcoming in-house seminar:

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(a) Cold calling (i.e. approaching directly to seek new business) the chief executive officers of local businesses and offering them free second opinions. (b) Placing an advertisement in a national accountancy magazine that includes the following: If you have an asset on which a large chargeable gain is expected to arise when you dispose of it,you should be interested in the best tax planning advice. However your gains might arise, there are techniques you can apply. Hawk Associates can ensure that you consider all the alternative fact presentations so that you minimise the amount of tax you might have to pay. No tax saving no fee! (c) Displaying business cards alongside those of local tradesmen and service providers in supermarkets and libraries. The cards would read: Hawk ACCA Associates For PROFESSIONAL Accountancy, Audit, Business Consultancy and Taxation Services Competitive rates. Money back guarantees. Required: Comment on the suitability of each of the above proposals in terms of the ethical and other professional issues that they raise. Answer: (a) Cold calling Tutorial note: Recognising that there are three issues to address (i.e. cold calling, free and second opinions) is likely to earn more marks than focusing on just one. Until relatively recently cold calling has been largely prohibited throughout the profession (and still is in some countries e.g. Hong Kong). Therefore the direct approach may not be suitable. Where cold-calling restrictions have been relaxed it may still only be permitted for existing business clients (i.e. to offer them additional services), the direct approach to non-business clients being prohibited. This inhibits competition. Although the practice may be viewed as a bit grubby and commercial it is now generally regarded as an accepted modern business practice. Along with other professional bodies, ACCA removed its prohibition on cold calling in 2002. Whilst Hawk is permitted to cold call, the fundamental ethical principles must be adhered to. Whilst solicitation which is decent, honest and truthful may be acceptable, cold calling which amounts to harassment is not. Offering a service for free is not prohibited provided that the client is not misled about future levels of fees. There are strict ethical rules regarding second opinions (on accounting treatments). Practitioners are advised NOT to provide second opinions, when requested, without following a procedure of contacting the incumbent auditor/accountant. Therefore to be offering second opinions clearly goes against ethical guidelines as the practice is to be discouraged. (b) Tax planning

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 Advertising is generally allowed subject to the observance of the fundamental principles of ethical codes (e.g. IFACs Code of Ethics for Professional Accountants, ACCAs Rules of Professional Conduct). Although direct advertising (i.e. on television, radio, cinema) is prohibited in many jurisdictions (e.g. Hong Kong), an advertisement in a national accountancy magazine is generally permitted. Where advertising is permitted, the minimum requirements are that it be decent, honest, truthful and in good taste. These criteria may not be met in this proposal as: expectations of favourable results (lower tax liabilities) may be unjustifiable (or created deceptively); techniques you can apply may imply an ability to influence taxation authorities; the best is likely to be a self-laudatory statement and not based on verifiable facts; the best may also be making an unjustifiable comparison with other professional accountants in public practice; the best tax planning advice may be an unjustifiable claim of expertise or specialism in the field of tax. Can ensure and the assertion of all may not be supportable claims, therefore the advertisement is not honest in these respects. There is a fine line between tax avoidance and tax evasion and techniques you can apply and alternative fact presentations may lean toward the latter and so not be in keeping with the integrity of the profession. The assertion of being able to minimise the amount of tax may expose Hawk Associates to litigation. The engagement risk associated with taking on this work would be high and so should carry commensurately high fees. The no tax saving no fee offer does not compensate for the risk associated with undertaking the work advertised. Contingency fees, whereby no fee will be charged unless a specific result is obtained, are prohibited by IFAC (unless otherwise permitted by statute of member body). (c) Business cards Business cards may be considered a form of stationery and should be of an acceptable professional standard and comply with legal and member body requirements concerning names of partners, principals, professional descriptions, designatory letters, etc. Whilst placing such an advertisement where a target audience might reasonably be expected to exist (e.g. in an Institute of Directors or Business Mens Club), displaying it alongside local tradesmen may appear to belittle the status of professional accountants. An advertisement the size of a business card would be sufficient to provide a name and contact details and in this respect is suitable. However, the danger of giving a misleading impression is pronounced when there is such limited space for information. However, the tone of the advertisement may discredit the ACCA name. It is also unsuitable that it seeks to take unfair advantage of the ACCA name. Although the ACCA mark can be used by Hawk Associates on letterheads and stationery (for example) it cannot be used in any way which confuses it with the firm. The emphasis on professional may be unsuitable as it could suggest that there are other than professional accounting, audit (etc) services to be had. Offering a range of non-audit services in the same sentence as audit may mislead interested persons picking up the card into thinking that Hawk can provide them together. This conflicts with the fact that Hawk is restricted in providing non-audit services to audit clients. There is no basis for asserting competitive rates. It is unlikely that any professional would offer money back. In the event of dispute (e.g. over fees), the matter would be taken to arbitration (with their member body) if a satisfactory arrangement could not be reached with the client.

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 A tradesman may guarantee the quality of his work and that it can be made good in the event that the customer is not satisfied. However, an auditor cannot guarantee a particular outcome for the work undertaken (e.g. reported profit or tax payable). Most certainly an auditor cannot guarantee the truth and fairness of the financial statements in giving an audit opinion.

2. You are an audit manager of Kloser, a firm of Chartered Certified Accountants. You are assigning staff to the final audit of Isthmus, a company listed on a stock exchange, for the year to 31 December 2002. You are aware of the following matters: (1) Isthmus has recently issued a profits warning. The company has announced that the significant synergies expected from the acquisition of Vanaka, a former competitor company, have not materialised. Moreover, it has emerged that certain of Vanakas assets are significantly impaired. Your firms corporate finance department, assisted by two audit trainees, carried out due diligence work on behalf of Isthmus before the purchase of Vanaka was completed in December 2001. (2) Mercedes, the assistant manager assigned to the interim audit of Isthmus, has since inherited 5,000 $1 shares in Isthmus. Mercedes has told you that she has no intention of selling the shares until the share price recovers from the fall to $195 which followed the profit warning. (3) Anthony, an audit senior, has been assigned to the audits of Isthmus since joining the firm nearly three years ago. He has confided to you that his father owned 1,001 shares in Isthmus but sold them only days before the profits warning at a share price of $795. You are assured that Anthony did not previously know that his father had the shares. Required: Comment on the ethical and other professional issues raised by the above matters and their implications, if any, for staffing the final audit of Isthmus for the year to 31 December 2002. (1) Profits warning Ethical and professional issues The profit warning increases the inherent risk of this assignment. As more work may be needed than for the prior year (e.g. on Vanakas impaired assets), additional staff may need to be assigned to the audit. An advocacy threat may occur if a dispute (potential legal action) arises between Isthmus and Kloser. For example, if the due diligence work should have recognised the significant impairments. Kloser should undertake a review of the due diligence work and audit for the year-ended 31 December 2001 to ensure there were no findings which should have alerted them to the problems in Vanaka which precipitated the profit warning. A self-review threat may arise in that the prior year-end audit, which followed the purchase, may have lacked objectivity. For example, the involvement of the corporate finance department in due diligence may have resulted

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in less audit work being carried out on Vanakas assets and operating results than would otherwise have been performed. If Kloser was negligent in undertaking the due diligence work (e.g. because assets were impaired at the time of acquisition and/or the assumptions underlying the expected synergies were unrealistic/hypothetical), to whom will Kloser be liable? To whom was the due diligence work reported? (Isthmus, Isthmuss shareholders, providers of finance for the acquisition?) Tutorial note: To illustrate that these model answers are not exhaustive consider, for example, that credit was given to candidates who argued that the trainees involvement in the audit would be beneficial (to Kloser and/or Isthmus). Implications for staffing As a safeguard for the provision of the other service (due diligence) the audit personnel seconded to the corporate finance department may not have participated in the audit for the year ended 31 December 2001. Any such bar should continue. If the secondees are involved in the audit, appropriate safeguards would include not assigningthem to the audit areas most closely associated with due diligence and close monitoring and review of their work. More senior/better quality/experienced staff should be assigned to the audit (than would have been necessary had the profit warning not been issued). (2) Shares inherited Ethical and professional issues A self-interest threat has arisen as Mercedes has a direct financial interest in Isthmus (i.e. she controls the shares). In particular, in wishing the share price to increase Mercedes might be in a position to overlook unrecorded liabilities and losses discovered during the conduct of the audit (say). Even though Mercedes may have independence of mind and be known to act with the utmost integrity, she cannot have independence in appearance. This inadvertent violation (i.e. through inheritance) of an independence principle does not impair the independence of Kloser or the audit team providing: Klosers established policies and procedures have resulted in Mercedes having reported promptly her inheritance of the shares; Kloser promptly advises Mercedes that the shares should be disposed of; and the disposal occurs at the earliest practical date, or she is removed. Mercedes does not intend to dispose of the shares quickly as she is waiting for the share price to recover. It is unlikely that Kloser would consider offering her adequate compensation for an earlier disposal (the loss in share value since the fall being 5,000 ($795 $195) = $30,000). Although IFACs Independence statement requires Mercedes removal from the audit team, Kloser may require stricter safeguards and prohibit all professional staff from holding direct financial interests. Mercedes may therefore be asked to choose between staying with the firm or disposing of the shares at the earliest practical date. If any work has been done by Mercedes on the audit of Isthmus since she inherited the shares (e.g. in reviewing interim audit work or planning the year-end or final audit visits) that work should be re-reviewed by another

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professional accountant. Implications for staffing This threat is so significant that Mercedes should be removed from the audit team unless she disposes of the shares before she undertakes any further tasks relating to the audit of Isthmus. 3) Dealing in shares Ethical and professional issues A self-interest threat would have arisen only if Anthony had known that a close family member (a parent) had shares in Isthmus (but he did not). A self-interest threat cannot now arise as his father has disposed of the shares. Providing Anthony did not knowingly prompt his father to sell the shares, he has not committed a criminal act (e.g. of insider dealing). Tutorial note: If he committed such an act he should be instantly dismissed by the firm and any professional body under which he is registered (e.g. ACCA) notified for disciplinary action. However, if he in some way communicated (e.g. in a careless remark) something that prompted his father to sell the shares, he may be in breach of his duty of confidentiality. This should be investigated and appropriate action taken (e.g. he may be cautioned or given a written warning). If he unknowingly gave his father price sensitive information, then his father may be guilty of insider dealing (or similar) for having acted on it. Implications for staffing Unless there is any reason to suppose that Anthony has acted improperly (e.g. if he has delayed disclosing the matter) there is no reason why he should not continue his position in the audit team. However, if his father were to come under suspicion of insider dealing then Anthony should be withdrawn from this assignment. Overall Given the high profile attaching to this listed client it would be timely to have all members assigned to the audit team renew their written declarations of independence and confidentiality.

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