P3 CIMA Notes - Student - 2015

CIMA
Paper P3
Risk
Management
Notes
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ii
CONTENTS
Page
Chapter 1 Risk 1
Chapter 2 Risk management 11
Chapter 3 Internal control 27
Chapter 4 Risk and control of Information Systems 37
Chapter 5 Information strategy 45
Chapter 6 Management control systems 55
Chapter 7 Fraud 67
Chapter 8 Ethics 75
Chapter 9 Corporate governance 83
Chapter 10 Internal audit 97
Chapter 11 Financial risk 115
Chapter 12 Currency risk management 121
Chapter 13 Interest rate risk management 137
Chapter 14 Cost of capital and capital investment decisions 147
Chapter 15 Managing conflict, implementation and post completion 165
Appendix Tables 175
iii
iv
Chapter 1
Risk
Outcome
By the end of this session you should be able to:
 identify the types of risk facing an organisation
and answer questions relating to these areas.
The underpinning detail for this Chapter in your Notes can be found in
Chapter 1 of your Study Text
1
Chapter 1
Overview
Why incur risk?
What is risk?
RISK
CIMA risk Categories of

cycle risk
2
Risk
What is risk?
1.1 Definitions
 Risk is the chance that future events or results may not be as expected.
 ‘Risk is a condition in which there exists a quantifiable dispersion in the possible

outcomes from any activity.’ (CIMA official terminology)
 Risk can be defined as the combination of the probability of an event and its
consequences. (ISO Guide 73)
Note: some writers make a distinction between risk and uncertainty
1.2 Positive and negative aspects of risk
Can have:
 downside risk
 upside risk.
3
Chapter 1
Why incur risk?
2.1 Reasons why companies take risks
 To increase financial return - It is generally the case that firms must be willing
to take higher risks if they want to achieve higher returns:
 To gain competitive advantage - To generate higher returns a business may

have to take more risk in order to be competitive. Conversely, not accepting
risk tends to make a business less dynamic and implies a ‘follow the leader’
strategy.
4
Risk
CIMA’s risk management cycle
Establish risk management Business strategy

group and set goals
Identify risk areas
Review and Understand and

refine process assess scale of
and do it again risk
Information
for decision
making
Implementation Development of
and monitoring risk response
of controls strategy
Implement strategy and

allocate responsibilities
5
Chapter 1
Identify
Categories (or sources) of risk risk areas
4.1 Political, legal and regulatory risk
Risks that businesses face because of the regulatory regime that they operate in.
 Political risk Risk due to political instability
 Legal/litigation risk Risk that litigation will be brought against business
 Regulatory risk Risk of changes in regulation affecting business
 Compliance risk Risk of non-compliance with law resulting in fines,

penalties, etc.
4.2 Business risk
Risks that businesses face due to nature of operations and products.
 Strategic risk Risk that business strategies (e.g. acquisitions) will fail
Risk of failure of new products / loss of interest in

 Product risk
existing products
 Commodity
Risk of a rise in commodity prices (e.g. oil)
price risk
 Product reputation
Risk of change in product’s reputation or image
risk
Risk that business operations may be inefficient or

 Operational risk
business changes may fail
 Contractual Risk that the terms of a contract do not fully cover a

inadequacy risk business against all potential outcomes
6
Risk
4.3 Economic risk
Risks that changes in the economy might affect the business.
4.4 Financial risk
Risk of a change in a financial condition such as an exchange rate, interest rate,

credit rating of a customer or price of goods.
 Credit risk Risk of non-payment by customers
 Political risk Risk arising from actions taken by a government that

affect financial aspects of the business
 Currency risk Risk of fluctuations in the exchange rate
 Interest rate risk Risk that interest rates change
 Gearing risk Risk in the way a business is financed (debt v equity)
4.5 Technology risk
Risk that technology changes will occur that either present new opportunities to
businesses, or on the down-side make their existing processes obsolete or
inefficient.
4.6 Environmental risk
Risk that arises from changes in the environment such as climate change or natural
disasters.
4.7 Corporate reputation risk
Reputation risk is for many organisations a down-side risk as the better the
reputation of the business the more risk there is of losing that reputation.
7
Chapter 1
4.8 Fraud risk
Risk that is the vulnerability of an organisation to fraud.
4.9 Employee malfeasance risk
Risk that an organisation might be exposed to actions by employees that result in an

offence or crime (other than fraud).
4.10 Risks in international operations
International business are subject to additional risks factors relating to culture,

litigation, credit risk, items in transit and financial risks (especially currency).
Illustrations and further practice

Now try TYU questions
and Kit questions.
8
Risk
9
Chapter 1
You should now be able to answer these questions from the Study Text
and these from the Exam Practice Kit.
For further reading, visit the following Chapters from the Study Text.
10
Chapter 2
Risk management
Outcome
 identify the types of risk facing an organisation and recommend appropriate

responses
 evaluate senior management’s responsibility for risk
 evaluate alternative risk management tools
11
Chapter 2
Overview
What is risk
management?
ERM RISK MANAGEMENT
Risk strategies
Identifying risks
Quantifying risks
Risk Mapping
Risk Response
Risk Reporting
Roles and responsibilities
Evaluating strategies
12
Risk management
What is risk management?
1.1 Definitions
 ‘the process of understanding and managing the risks that the

organisation is inevitably subject to in attempting to achieve its
corporate objectives’
(CIMA Official Terminology)
1.2 Reconciling conformance and performance
 Conformance Avoiding downside risk
 Performance Benefitting from upside risk
Conformance Performance
Controlling threats or Maximising return

hazards or opportunity
Risk
Management
‘bad things do ‘good things might
happen’ not happen’
13
Chapter 2
Enterprise Risk Management (ERM)
2.1 What is ERM?
 'A process, effected by an entity’s 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'. (COSO 2003)
2.2 COSO ERM Framework
14
Risk management
2.3 Eight components:
 Internal environment.
 Objective setting.
 Event identification.
 Risk assessment.
 Risk response.
 Control activities.
 Information and communication.
 Monitoring.
2.4 Benefits of ERM
 Enhanced decision making by integrating risks.
 Improvement in investor confidence, and hence shareholder value.
 Focus of management attention on the most significant risks.
 A common language of risk management.
 Reduced cost of finance.

and Kit questions.
15
Chapter 2
Risk management strategy
3.1 Formulation of a risk strategy
 Risk appetite the amount of risk an organisation is willing to accept in

pursuit of value
 Risk capacity the amount of risk that the organisation can bear
 Risk attitude the overall approach to risk, in terms of the board being
risk averse or risk seeking
 Residual risk the risk that a business faces after its controls have
been considered
3.2 Features of a risk management strategy (CIMA and IFAC joint report)
 Statement of the organisation’s attitude to risk – the balance between risk and
the need to achieve objectives
 The risk appetite of the organisation
 The objectives of the risk management strategy
 Culture of the organisation in relation to risk
 Responsibilities of managers
 Reference should be made to the risk management systems the company uses
(i.e. its internal control systems)
 Performance criteria should be set so that the effectiveness of risk

management can be evaluated
16
Risk management
Identify risk
Identifying risks areas
4.1 Risk Identification
 Process controlled by risk committee.
 Risks recorded in a risk register.
 Various sources of information.
17
Chapter 2
Understand and
Quantifying risk assess scale of risk
5.1 Expected values
 Expected value (EV) = Σ (probability × outcome).
5.2 Volatility
 Simplest measure would be to look at the range of possible outcomes.
 Standard deviation is a measure of the average dispersion of outcomes around

the EV.
5.3 Value at risk (VaR)
 VaR assesses the scale of the likely loss in value of a portfolio in a specified
time period at a defined level of probability.
 'There is a 95% chance that the value of the portfolio will fall by less than
$10 million over the next week'.
 VaR = standard deviation × appropriate Z score from Normal distribution tables.
 Regulators require banks to use VaR as a measure of risk.
5.4 Regression and correlation analysis
 Regression coefficients show the significance of individual risk factors.
5.5 Simulation
 Allows many different factors/scenarios/assumptions to be modelled.

and Kit questions.
18
Risk management
19
Chapter 2
Understand and
Risk mapping assess scale of risk
6.1 Risk maps (also known as assurance maps)
 Prepared by the Board, the Risk Committee, the Audit Committee and senior
management from various departments.
 Can provide a framework for prioritising risks in the business.
Impact/consequence
Low High
High Further analysis

Highest priority
required?
Probability
/likelihood
Low Risks can probably Further analysis
be accepted required?
20
Risk management
Development of risk
Risk response response strategy
7.1 Objectives
 Exposure to severe risks is minimised.
 Unnecessary risks are avoided.
 Appropriate measures of control are taken.
 The balance between risk and return is appropriate.
7.2 Risk treatment (management) methods
 Avoid risk.
 Transfer risk.
 Pool risks.
 Diversification.
 Risk reduction.
 Hedging.
 Risk sharing.
21
Chapter 2
7.3 TARA
 Transfer Transfer risk wholly or in part to a third party – e.g. insurance.
 Avoid Many risks are unavoidable, so the only choice here may be
not to invest.
 Reduce Reduce or mitigate risks by limiting probability and /or impact,

especially of downside exposure.
 Accept Accept the risk and deal with the consequences.
Impact/consequence
Low High
High REDUCE AVOID
Probability
/likelihood
Low TRANSFER /
ACCEPT
SHARE

and Kit questions.
22
Risk management
Risk reporting
Risk reports now form part of UK annual reports.
8.1 Risk reporting
A risk reporting system would include:
 a systematic review of the risk forecast (at least annually)
 a review of the risk strategy and responses to significant risks
 a monitoring and feedback loop on action taken and assessments of significant

risks
 a system indicating material change to business circumstances, to provide an

‘early warning’
 the incorporation of audit work as part of the monitoring and information

gathering process.
8.2 Gross and net risk
Risk reports would show:
 Gross risk Assessment of risk before the application of any

controls, transfer or management responses
 Net (residual) risk Assessment of risk, taking into account the controls,
transfer and management responses
23
Chapter 2
Roles and responsibilities
9.1 Specific responsibilities
 Board of directors Ultimate responsibility for risk management
Define risk appetite
 Audit committee Responsible for reviewing internal control systems
Working with external / internal auditors
 Risk committee Direct responsibility for risk management
 Risk management Report to Board via audit /risk committees

group
Identify risks
Monitor effectiveness of overall process
 Internal audit Review of internal controls
Support management in risk management process
9.2 General responsibilities
 All employees Be aware of risks

Be audible
24
Risk management
Evaluating a risk management strategy
Risk Strategy
Evaluation
Has the strategy

Do the benefits
achieved its
outweigh the costs?
objectives?

and Kit questions.
25
Chapter 2
26
Chapter 3
Internal control systems
Outcome
 evaluate risk management strategies and internal control
27
Chapter 3
Overview
Definitions and
responsibilities
INTERNAL CONTROL SYSTEMS
Effective control Details of

systems control
Turnbull Report Examples

COSO Classification
Evaluation
28
Introduction
1.1 Definition of internal control systems
 'The whole system of controls, financial and otherwise, established

by the management in order to carry out the business of the
enterprise in an orderly and efficient manner, ensure adherence to
management policies, safeguard the assets, prevent and detect fraud
and error and secure as far as possible the completeness and
accuracy of the records’.
 a system for management to control certain risks and therefore help

businesses achieve their objectives.
1.2 Internal controls and risk management
 The need for a robust system of internal control and risk management is seen
as a major element of good corporate governance.
 The UK Corporate Governance Code requires the board of directors to review

the system of internal control in their organisation, and satisfy themselves that a
suitable system is in place.
 Since profits are, in part, the reward for successful risk taking in business, the
purpose of internal control is to help manage and control risk appropriately
rather than to eliminate it.
1.3 Responsibilities
 The board of directors is responsible for the company's system of internal

control.
 All employees have some responsibility for internal control as part of their
accountability for achieving objectives.
29
Chapter 3
The Turnbull Report (2005)
2.1 Elements of a sound system of internal control
 An internal control system encompasses the policies, processes, tasks,

behaviours and other aspects of a company that, taken together:
– facilitate its effective and efficient operation by enabling it to respond
appropriately to significant risks
– help ensure the quality of internal and external reporting
– help ensure compliance with applicable laws and regulations.
 The system of internal control will include:

– control activities
– information and communications processes
– processes for monitoring the continuing effectiveness of the system.
 The system of internal control should be:

– embedded within operations
– able to respond to changing risks
– includes procedures for reporting failings or weaknesses.
 A sound system of internal control reduces, but cannot eliminate, the possibility
of poor judgement in decision making, human error; control processes being
deliberately circumvented and the occurrence of unforeseeable circumstances.
 A sound system of internal control therefore provides reasonable, but not

absolute, assurance that a company will not be hindered in achieving its
business objectives by circumstances which may reasonably be foreseen.
30
COSO model of internal control
In 1992 COSO (Committee of Sponsoring Organisations) stated that effective internal

control systems consist of five integrated elements.
3.1 Control environment
 The control environment can be thought of as management's attitude, actions

and awareness of the need for internal controls – the ‘tone at the top’.
3.2 Risk assessment
 Need to identify and assess risks in respect of established objectives.
 Assessment should consider internal and external factors and distinguish

between controllable and uncontrollable risks.
3.3 Control activities (= internal controls)
 Once controllable risks have been identified, actual specific control activities
can be undertaken to reduce those risks.
3.4 Information and communication
 In order for managers to operate the internal controls, they need quality
information.
3.5 Monitoring
 If the system is not monitored it will be very difficult to assess whether it is out
of control and needs amendment.
 This element of an internal control system is associated with internal audit, as

well as general supervision.
31
Chapter 3
The detail of controls
4.1 Examples of controls
 Segregation of duties Separate (1) authorisation or initiation of the

transaction, (2) the handling of the asset and (3)
recording the transaction.
 Physical controls e.g. using a safe to hold cash
 Authorisation and e.g. spending limits

approval
 Management control Include top-level reviews and activity controls.
 Supervision Helps to ensure that individuals do the tasks they are

required to and perform them properly
 Organisational e.g. delegating authority, setting up responsibility

structure centres
 Arithmetic and e.g. double checking the figures in a sales invoice

accounting before sending it to a customer
 Personnel controls e.g. selection, induction and training of staff

and Kit questions.
32
Classification of controls
5.1 Financial controls
 These controls express financial targets and spending limits.
 Examples include budgetary control and controls over sales, purchases, payroll
and inventory cycles.
5.2 Non-financial qualitative controls
 These controls focus on targets against which performance can be measured

and monitored.
 Examples include balanced scorecard targets and TQM quality measures
 It is important that a feedback loop exists:
– performance target (standard) set
– actual result recorded
– compared with target
– control action taken (if required).
5.3 Non-financial quantitative controls
 These form the day to day controls over most employees in organisations.
 Examples include employee training, management control methods (such as

organisation structure, contracts of employment), physical controls and project
management.
33
Chapter 3
Evaluation of an internal control system
6.1 Costs
 Time of management involved in the design of the system.
 Implementation:
– costs of IT consultants to implement new software
– training all staff in new procedures.
 Maintenance of system:
– software upgrades
– monitoring and review.
6.2 Benefits
 The reduction of identified risks.
 Achievement of business objectives.

and Kit questions.
34
35
Chapter 3
36
Chapter 4
Risk and control of Information Systems
Outcome
 evaluate the essential features of internal control systems for identifying,

assessing and managing risks in the context of information systems
 advice managers of the risks in the development of strategies for information

systems that support the organisation's strategic requirements
37
Chapter 4
Overview
Risks Controls
RISK AND CONTROL OF

INFORMATION SYSTEMS
Systems Changeover
development methods
Development
controls
38
Risks
1.1 Risks to a computer system
Risks to information processing facilities may arise from:
 dissatisfied employees might deliberately modify or destroy information in the

system
 accidental mistakes could be made on input to the system
 inadequate security of the hardware or data
 faults in the hardware system.
1.2 Risks specific to networks:
 A hacker or industrial spy might break into the system.
 Viruses or malicious software could be introduced.
 File copying.
 File server security.
39
Chapter 4
Controls in an IS environment
2.1 Controls in an information systems environment
 General controls Personnel
 Appropriate use of systems and security Logical access

from loss of data
Facility
Business continuity
 Application controls Input
 Designed for the individual application to Processing

prevent, detect and correct processing
errors Output
 Software controls Reputable dealers
 Ensure that the software in use is Original disks

authorised
Licences
 Network controls Firewalls
 Arisen due to the growth in distributed Flow

processing and e-commerce
Data encryption
Virus protection
40
Systems Development
3.1 Systems Development Life Cycle (SDLC)
 Planning Feasibility study including goal setting, timing, duration and

budget
 Analysis Definition of project goals and analysis of user needs
 Design Features of system described in detail including screen

layouts, process layouts, business rules and
documentation. A prototype may be built
 Development Conversion of the design into a physical system including

the acquisition and installation of the hardware and
software
 Implementation The real code is written. Staff training. Testing for errors,
bugs and inoperability (Quality assurance);
 Review User acceptance testing, maintenance, post-

implementation review
3.2 Systems development risks
 Fails to satisfy user’s real requirements: the system was specified incorrectly.
 Do not provide the data processing or information for which they were
designed, or to the quality expected.
 The system was therefore designed and programmed incorrectly.
 They cost much more to develop and run than expected.
41
Chapter 4
Development Controls
4.1 Controls
Should be built in at all stages of the systems development life cycle and include:
 approval of outline system specification by the user/IT steering committee
 detailed system design documented using standard approaches
 programs written using programming standards and fully documented
 systems and program testing
 user testing
 development timetable and cost control using project management techniques
 implementation controls
 monitoring and audit of new systems.

and Kit questions.
42
Changeover methods
5.1 Changeover methods
 Direct Old system switched off and new system switched on
Cheap but risky
 Parallel Old and new systems run together for some time, until it is
felt safe to switch off the old.
Costly (duplication) but less risky
 Pilot One part of the business changes over first and then plans
rolled out to the rest of the business
Should reduce some risks as can learn from the pilot but
other locations may have different issues / problems
 Phased Introduce new system one part of the business at a time
Less risky but takes longer

and Kit questions.
43
Chapter 4
44
Chapter 5
Information strategy
Outcome
 advise managers of the risks in the development of strategies for information

systems that support the organisation's strategic requirements
45
Chapter 5
Overview
Developing
IS
Types
of IS INFORMATION STRATEGY
Steering Data
committees warehousing
and mining
Big Data
46
Developing an information strategy
1.1 Developing the information strategy
Mission Statement
Corporate Strategy
Business Objectives
Critical Success Factors
Key Performance
Indicators
Information to Proposals for

measure new systems or
performance modifications
Information needs
47
Chapter 5
1.2 Information strategy components
 Information Systems Division/SBU/function based

Strategy
Demand orientated
Business focused
 Information Technology Activity based

Strategy
Supply orientated
Technology focused
 Information Management Organisation based

Strategy
Relationships orientated
Management focused
1.3 Benefits of an information strategy
 Goal congruence between the information systems objectives and the

corporate objectives.
 Create and sustain competitive advantage.
 High levels of expenditure on information systems will focus on supporting key

aspects of the business.
 Developments in IT can be exploited at the most appropriate time.
 IT can be very expensive to get wrong.

and Kit questions.
48
Types of information system

System Purpose Features Example(s)
Transaction Captures and Batch, on-line or real Sales order processing
processing stores transaction time processing.
system data. Accounting system
Management Integrated system Data gathered from Databases

information for supporting TPS.
system operations and Reporting systems
decision-making. Predetermined output
format.
Enterprise Integration of Commercial software CRM
resource information across package installed on
planning the company. a Database Balanced scorecard
system Management performance reporting
System.
Decision Manipulation of User-friendly style Budgeting on a
support information to and assists with spreadsheet
system support decision- unstructured
making. problem.
Executive Present Highly visual and Executive performance
information selected/focused incorporate internal ‘dashboard’
system information for and external data.
senior executives.
Expert Present decision Modify its knowledge Tax advice
system options to ‘non- database in
expert’ users. accordance with its Legal advice
own results.
Selection of training
methods
Strategic Assist with Incorporates tools Significant investment
enterprise strategic decision- such as ABM. decisions
management making.
system Acquisition decisions
49
Chapter 5
50
Steering Committees
3.1 Steering Committee
Due to the strategic importance of IS/IT and the high level of spend that
many companies make in this area, steering committees are usually
established to decide on the provision of the information services.
3.2 Membership
Chair
Member of board
Senior managers Senior IT staff Senior finance

Key IT user Provide technical manager
departments input in committee Appraises costs/
3.3 Purpose of the steering committee
 Plan, monitor and control IS/IT/IM strategy.
 Identify and analyse IS/IT risk.
 Consider the competitive issues raised by IT.
 Ensure that IS/IT programmes achieve their specified objectives, in line with
organisational policy and objectives.
 Make resource decisions and IT funding decisions.
 Plan for future systems developments.
51
Chapter 5
Data warehousing and data mining
4.1 Data warehousing (as opposed to local databases)
Advantages Disadvantages
 Lower volumes of data held  New hardware and software

required
 Lower storage costs
 Training for staff
 Easy to amend data
 Existing data will need to be
 User confidence in up-to-date data analysed and cleansed
 Data management improved  Individual requirements may not

be met by central system
 Controls over data are improved
 Database failure is critical
 Consistency is achieved
 Response times may be slower
4.2 Data mining
Data mining is the process of analysing data from different perspectives and
summarising it into useful information.

and Kit questions.
52
Big data
5.1 Definition
Big Data is a term for the collection of data which is so large that it
becomes difficult to store and process using traditional techniques and
data processing applications.
5.2 Features of big data
The features of Big Data can be described by the 4Vs:
 Variety
 Veracity
 Variety
 Volume.
5.3 Benefits and drawbacks of Big Data
Benefits Drawbacks
 Drives innovation  Difficult to convert into useful

information
 Helps create competitive advantage  Lack of skills within the organisation
 Improves productivity  Data security and data protection

issues
53
Chapter 5
54
Chapter 6
Management control systems
Outcome
 recommend appropriate measures for the strategic control and direction of

various types of organisations
 recommend solutions for the risks of dysfunctional behaviour arising from the
associated models of performance measurement
55
Chapter 6
Overview
Organisations
Controls
as systems
MANAGEMENT CONTROL Strategic

SYSTEMS MA
Behavioural
Divisional PM
aspects
Beyond Transfer
budgeting pricing
56
Organisations as systems
1.1 Introduction
 An organisation is a social system, in which people combine

together to carry out the purpose(s) for which the organisation
exists.
1.2 Characteristics of systems
 A system is a set of interacting components that operate together to accomplish

a purpose. Essentially this consists of Input > process > output
 Companies are open systems – they react to their environment
 A system must have an objective – everything else is geared towards this
 Control - A system must be controlled to keep it stable or to allow it to change

safely. Control is dependent on receiving and processing information.
 Feedback control - 'The measurement of differences between planned outputs

and actual outputs achieved, and the modification of subsequent action and / or
plans to achieve future required results.'
– Negative feedback = feedback taken to reverse a deviation from

standard.
– Positive feedback = feedback taken to reinforce a deviation from

standard.
 Feedforward control - 'The forecasting of differences between actual and

planned outcomes and the implementation of actions before the event to
prevent such differences.'
57
Chapter 6
2.1 Management control systems
 The processes by which managers attempt to ensure that their

organisation adapts successfully to its changing environment.
2.2 Designing a management accounting control system
 Output requirements.
 Response required.
 Timing of information.
 Sources of information.
 Processing.
 Cost-benefit analysis.
2.3 Structure of management accounting control systems
Should consider:
 organisation structure
 responsibility accounting
 performance target setting
 behavioural implications.
58
Behavioural aspects of control systems
3.1 Principles of good performance management systems
 Effective control systems must incorporate a feedback loop
– set targets
– measure actual results
– compare actual with target
– control action taken.
 This will facilitate management by exception.
 When comparing actual and budget consider whether the budget should be
flexed.
 Targets should be neither too easy, nor too hard.
 Participation in target setting usually increases ownership and motivation but

can result in budget padding.
 Controllability – managers should only be assessed on factors under their

control.
 Targets should be linked to the type of business unit – e.g. profit centre.
 Targets should have a mixture of financial and non-financial performance

indicators.
 Targets should be linked to long term performance as well as short term.
59
Chapter 6
Beyond budgeting
4.1 Criticisms of traditional management accounting control systems
Traditional budgets based on fixed annual periods:
 encourage rigid planning and a lack of flexibility. This may not be appropriate in
a fast moving business environment
 are time consuming
 encourage managers and employees to meet only the lowest target rather
than attempting to beat the target set (this is inconsistent with a TQM approach)
 encourage managers and employees to achieve the budget even if this results
in undesirable action
 encourage managers and employees to spend what is in the budget, even if it

is not necessary, to guard against next year's budget
 reinforce the barriers between departments rather than encourage knowledge

sharing
 are seen as a mechanism for top-down control by senior management but

organisations should be empowering individuals on the frontline
 ignore key drivers of shareholder value by focusing on short term financial

performance
 produced inadequate variance reports leaving the 'how' and 'what'

unanswered
 emphasis on financial targets can result in important non-financial factors

being ignored
 targets may result in managers taking excessive risks.
60
4.2 The 'Beyond Budgeting' approach
 The manager sets their own 'stretch targets' (therefore takes more ownership).
 The manager is given full support to achieve the targets but carries sole
responsibility for meeting them.
 Targets are both strategic and financial.
 Monthly balanced scorecards are produced and measures are compared to

last year, other divisions and competitors.
 Performance reviews are called on an ad hoc basis when there is a blip in

performance. These reviews focus on action plans and possible improvements.
4.3 Advantages of the beyond budgeting approach:
 Managers are not punished for failing to reach the full target (improving
motivation).
 The use of the BSC promotes a balanced range of performance measures.
 Managers set their own targets increasing ownership.
 Reviews of action plans encourage feedback and learning.
 Beating internal and external competitors is motivational.
 Managers share a bonus pool that is based on share price or long-term

performance against a basket of competitors (encouraging teamwork and a
long-term perspective.

and Kit questions.
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Chapter 6
Divisional performance measures
5.1 Key principles
 Targets should be linked to the type of business unit – e.g. profit centre.
 Targets should encourage goal congruence – improving divisional

performance should not be in conflict with overall company performance.
5.2 Performance measures for investment centres
 Return on investment Simple to understand / calculate
Should be based on controllable profit
ROI can be boosted either by increasing profit OR

reducing capital employed
Can result in short termism
Danger that managers can boost divisional ROI at the

expense of company ROI
 Residual income Simple to understand / calculate
Should be based on controllable profit
Can result in short termism
Less risk of dysfunctional decision making
 EVATM NOPAT – Capital × WACC
Modified version of RI with large number of

adjustments
Good correlation with shareholder value
62
Transfer pricing
6.1 Objectives of transfer pricing
 Goal congruence TP can influence decisions
 Divisional autonomy Head office would rather not interfere in every

decision
 Performance
TP affects divisional performance
measurement
 Fair allocation of profits TP splits profits between seller (TP = income) and
between divisions buyer (TP = cost)
 Minimising global tax TP moves profit from one tax jurisdiction to another
 Recording movement of Basic accounting – otherwise transactions not

goods and services recognised
6.2 Typical methods of setting transfer prices
 Market price If one exists!
Usually results in goal congruence
May be adjusted for selling/buying costs
 Cost plus Which cost?
Actual cost may result in inefficiencies
 Negotiation One division may have more power
 Dual pricing Different TPs for seller/buyer
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Chapter 6
The Balanced Scorecard
This model aims to provide a broad range of financial and non-financial measures.
Financial
perspective –
how should we
appear to
shareholders?
Customer Internal business
perspective – process – what
how should we business
appear to our processes should
customers? we excel at?
Learning &
growth/
innovation – how
will sustain our
ability to change
and improve?

and Kit questions.
64
Strategic management accounting
8.1 Manufacturing methods
TRADITIONAL MODERN
 Standardisation of product Globalisation
 Long production runs Competition
 ‘Acceptable’ level of quality JIT and TQM
 Slow product development ‘Intelligent machines’
8.2 Modern management accounting techniques
SITUATION TECHNIQUE
 JIT and TQM environments Throughput accounting
Back flush accounting
Costs of quality
Non-financial performance indicators
 Large overhead costs Activity based costing (ABC)
Activity based budgeting (ABB)
 Focus on longer-term strategic Non-financial performance indicators

issues
Balanced scorecard
Strategic management accounting

(SMA)
65
Chapter 6
66
Chapter 7
Fraud
Outcome
 evaluate risk management strategies and internal controls in the context of

fraud management
67
Chapter 7
Overview
What is
fraud?
FRAUD
Prerequisites for Fraud risk

fraud management
strategies
68
Fraud
What is fraud?
1.1 Definitions
 Dishonestly obtaining an advantage, avoiding an obligation or causing a loss to

another party.
 Note: distinction made between fraud and errors (unintentional mistakes).
1.2 Examples of fraud
 Crimes against customers, e.g. pyramid schemes; selling counterfeit goods.
 Employee fraud against employers, e.g. falsifying expense claims.
 Crimes against investors, consumers and employees, e.g. FS fraud.
 Crimes against financial institutions, e.g. fraudulent insurance claims.
 Crimes against government, e.g. social security benefit claims fraud; tax
evasion.
 Crimes by professional criminals, e.g. money laundering; advance fee fraud.
 e-crime by people using computers, e.g. spamming, copyright crimes, hacking.
1.3 Prerequisites for fraud
 An ability to rationalise the fraudulent action and hence act with dishonesty.
 A perceived opportunity to commit fraud.
 A motive, incentive or pressure to commit fraud.
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Chapter 7
Fraud risk management strategy
2.1 Overview
70
Fraud
2.2 Fraud prevention
 Anti-fraud culture
 Risk awareness
 Whistleblowing
 Sound internal control systems
A fraud policy statement, effective recruitment policies and good internal controls
can minimise the risk of fraud.
2.3 Fraud detection
 Performing regular checks.
 Warning signals/fraud risk indicators:
– failures in internal control procedures
– lack of information provided to auditors
– unusual behaviour by individual staff members
– accounting difficulties.
 Whistleblowers.
71
Chapter 7
2.4 Fraud response
 Response plan:
– internal disciplinary action
– civil litigation
– criminal prosecution
– responsibilities.

and Kit questions.
72
Fraud
73
Chapter 7
74
Chapter 8
Ethics
Outcome
 evaluate the risks associated with corporate governance
75
Chapter 8
Overview
ETHICS
Business Personal
ethics ethics
Ethical principles
Threats and
safeguards
Conflict
resolution
76
Ethics
Introduction
1.1 What is ethics?
 Ethics can be defined as the ‘moral principles that govern a person’s behaviour
or the conducting of an activity’. (The Oxford English Dictionary)
1.2 Business ethics
 CSR, sustainability.
 Miss-selling, misleading advertising.
 Mistreatment of staff – e.g. discrimination, unfair dismissal.
 Bribery and corruption, especially of foreign government officials.
1.3 Personal ethics - use CIMA ethical code
 Conceptual framework – principles, threats, safeguards – see below.
1.4 Ethics as a source of risk
 Reputational damage.
 Fines/discipline.
 May affect chances of winning major contracts.
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Chapter 8
Ethical principles
A professional accountant shall comply with the following fundamental principles.
 Integrity to be straightforward and honest in all professional and

business relationships
 Objectivity to not allow bias, conflict of interest or undue influence

of others to override professional or business
judgments
 Professional to maintain professional knowledge and skill at the

competence and due level required to ensure that a client or employer
care receives competent professional services based on
current developments in practice, legislation and
techniques and act diligently and in accordance with
applicable technical and professional standards
 Confidentiality to respect the confidentiality of information acquired as

a result of professional and business relationships and,
therefore, not disclose any such information to third
parties without proper and specific authority, unless
there is a legal or professional right or duty to disclose,
nor use the information for the personal advantage of
the professional accountant or third parties.
 Professional to comply with relevant laws and regulations and avoid

behaviour any action that discredits the profession.
78
Ethics
Ethical threats
Threats fall into one or more of the following categories.
 Self-interest threat the threat that a financial or other interest will

inappropriately influence the professional accountant’s
judgment or behaviour
 Self-review threat the threat that a professional accountant will not

appropriately evaluate the results of a previous
judgment made or service performed by the
professional accountant, or by another individual within
the professional accountant’s firm or employing
organization, on which the accountant will rely when
forming a judgment as part of providing a current
service
 Advocacy threat the threat that a professional accountant will promote a

client’s or employer’s position to the point that the
professional accountant’s objectivity is compromised
 Familiarity threat the threat that due to a long or close relationship with a
client or employer, a professional accountant will be
too sympathetic to their interests or too accepting of
their work; and
 Intimidation threat the threat that a professional accountant will be

deterred from acting objectively because of actual or
perceived pressures, including attempts to exercise
undue influence over the professional accountant.
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Chapter 8
Ethical safeguards
4.1 Safeguards
 Safeguards are actions or other measures that may eliminate threats or reduce
them to an acceptable level.
4.2 Safeguards created by the profession, legislation or regulation
 Educational, training and experience requirements for entry into the profession.
 CPD requirements.
 Corporate governance regulations.
 Professional or regulatory monitoring and disciplinary procedures.
 External review by a legally empowered third party of the reports, returns,

communications or information produced by a professional accountant.
4.3 Safeguards in the work environment
 Firm-wide safeguards.
 Engagement-specific safeguards.

and Kit questions.
80
Ethics
Ethical conflict resolution
Step 1: Clarify the situation
 Ensure you are not acting on inaccurate or incomplete information
Step 2: Analysis
 What ethical issues are involved? Who is affected and how?
 Which fundamental ethical principles apply? How have they been

compromised, if at all, and to what extent?
 Is behaviour dictated by law (e.g. money laundering)?
 Does the organisation have internal policies that need to be followed?
Step 3: Alternatice courses of action
 Escalate concern internally, i.e. to direct management.
 Escalate issue further to your manager's boss, the Board or a non-executive

director (following any internal grievance or whistleblowing procedure).
 Seek advice from CIMA.
 Report externally to auditors or relevant trade/regulatory body.
 Remove yourself from the situation?
81
Chapter 8
82
Chapter 9
Corporate governance
Outcome
 evaluate the risks associated with corporate governance
83
Chapter 9
Overview
Introduction
SOX
CORPORATE
GOVERNANCE
Controls
Leadership Committees
Directors’ Audit
remuneration Committee
Nomination
Committee
Remuneration
Committee
84
Introduction
1.1 What is corporate governance?
 ‘The system by which companies are directed and controlled in the interest of
shareholders and others stakeholders’.
1.2 Importance of corporate governance:
 In most countries listed companies are required to comply.
 It is often built into stock exchange listing rules.
 Major influence on, and key part of, a company’s risk management strategy.
1.3 Limitations of corporate governance:
 It does not prevent company failure or collapse.
 It cannot prevent companies failing to achieve their objectives.
1.4 Principles-based or rules-based
 Principles-based approach – e.g. UK Corporate Governance Code (2010):
– Comply or explain.
 Rules-based approach – e.g. US Sarbanes-Oxley (SOX):
– Enforcement and documentation.
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Chapter 9
1.5 Corporate governance guidelines
Not all companies in the exam will be subject to the UK Corporate

Governance Code (2010) but it should be viewed as best practice.
UK Code covers the following five key areas:
 leadership
 effectiveness
 accountability
 remuneration
 relations with shareholders.
86
Leadership
2.1 General principles
 Chairman (who runs the board) and CEO (who runs the company) should be
separate individuals to prevent one individual having too much power.
 Balance between executive directors (EDs) and independent non-executive

directors (INEDs); generally at least 50% of the board should be INEDs.
 NED roles:
– strategy role: this recognises that NEDs have the right and responsibility
to contribute to strategic success, challenging strategy and offering advice
on direction.
– scrutinising role: NEDs are required to hold executive colleagues to

account for decisions taken and results obtained.
– risk role: NEDs ensure the company has an adequate system of internal
controls and systems of risk management in place.
– people role: NEDs oversee a range of responsibilities with regard to the

appointment and remuneration of executives and will be involved in
contractual and disciplinary issues.
 The board should communicate clearly and honestly with stakeholders,

particularly shareholders.
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Chapter 9
2.2 UK Corporate Governance Code – CEO, Chairman and EDs
 CEO and Chairman must be different individuals.
 The CEO cannot go on to be Chairman of the same company.
 Chairman should be independent on appointment.
 A full time ED can’t also take on more than 1 FTSE 100 NED role.
 A full time ED can’t also be the chairman of a FTSE 100 company.
 A significant portion of EDs’ pay should be performance related.
2.3 UK Corporate Governance Code – NEDs
 Appoint one independent non-executive director (INED) as the senior

independent director.
 A director may not be independent if they:

– were an employee within the last 5 years
– represent a significant shareholder
– have close family ties with Co.
– receive other pay or benefits in addition to a directors' fee
– had material business relationship with the Co. within the last 3 years
– have served on the board for more than 9 years.
 NEDs serving longer than 6 years should be subjected to a rigorous review.

and Kit questions.
88
Audit committee
There should be an audit committee to monitor the independence of the

external auditors
3.2 Typical roles and responsibilities
 To monitor the integrity of the financial statements of the company and any
formal announcements relating to the company’s financial performance.
 To review the company’s internal control and risk management systems.
 To review the effectiveness of the company’s internal audit function.
 To make recommendations re the appointment, reappointment and removal of

the external auditor, and to approve remuneration and terms of engagement.
 To review and monitor the external auditor’s independence and objectivity and
the effectiveness of the audit process.
 To develop and implement policy re non-audit services by the external auditor.
3.3 UK Corporate Governance Code
 Should be 100% INEDs.
 FTSE 350 – committee should have least 3 members.
 Smaller listed companies – should have at least 2 members.
 At least one member should have recent and relevant financial experience.
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Chapter 9
Nomination committee
4.1 Nomination committee
 There should be a nomination committee charged with ensuring the

board has the appropriate skills, knowledge and experience.
 Review regularly the structure, size, composition and balance of the board
 Consider the balance between executives and NEDs on the board.
 Ensure appropriate management of diversity to board composition.
 To reduce domination in executive selection by the CEO/chairman.
 Give full consideration to succession planning for directors.
 Prepare a description of the role and capabilities required for any particular
board appointment including that of the chairman.
 Identify and nominate board candidates to fill board.
 Make recommendations concerning the standing for reappointment of directors.
 Over 50% of the NC should be INEDs.
90
Remuneration committee
The executive directors' remuneration should be set by the remuneration

committee, so that EDs don't have the power to set their own pay.
 Setting the remuneration for EDs and the Chairman, including pension rights
and any compensation payments.
 Note: remuneration of NEDs should be determined by the Board or, where

permitted by the Articles, a separate committee.
 Should be 100% INEDs.
 FTSE 350 – committee should have least 3 members.
 Smaller listed companies – should have at least 2 members.

and Kit questions.
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Chapter 9
Directors’ remuneration
6.1 Behavioural impact
 Remuneration packages should be sufficient to attract, retain and motivate

directors of appropriate quality.
 However, they should also be designed to align the interests of directors with
those of the shareholders and to promote the long-term success of the
company – e.g. UK Code advises that share options should not granted with
exercise dates < 3 years.
6.2 Components of remuneration package
 Basic salary Determined by the experience of the director and the

market rate.
 Performance related Should be linked to measurable long-term performance

bonuses or enhanced shareholder value. Criteria should be risk
adjusted to prevent excessive risk taking.
 Benefits in kind Could include company cars, life assurance,

healthcare etc. Package offered to directors should not
be excessive compared to other employees
 Pensions The UK Corporate Governance Code states that, as a

general rule, only basic salary should be pensionable
 Share options Should align management and shareholder interests.

However, given there is no downside risk, directors
may proceed with high risk projects. Also risk that
directors may try to boost short term share price
leading up to the exercise date.
92
Governance and internal controls
7.1 Board responsibility
Board is responsible for:
 maintaining a sound system of internal control
 reviewing the effectiveness of internal controls
 reporting to shareholders that this review has been carried out.
7.2 Turnbull Report
The Turnbull Report requires that internal controls should be established using a risk-
based approach. Specifically a company should:
 establish business objectives
 identify associated key risks
 decide upon controls to address the risks
 set up a system to implement the required controls, including regular feedback
 review internal controls under the five headings identified by COSO.

and Kit questions.
93
Chapter 9
US Sarbanes-Oxley (SOX)
It is relevant to US companies, directors of subsidiaries of US listed

businesses and auditors who are working on US listed businesses.
8.1 Differences to UK Combined Code
 Enforcement.
 Documentation.
8.2 Key points of SOX
 Auditor Auditors restricted in extra services they can provide

independence
 Audit partner Senior partner must be changed every 5 years
 Restrictions on Directors prohibited from trading in shares at ‘sensitive

dealing times’
 Increased financial Reports to detail off-balance sheet finance

disclosures
 Certification of Must be vouched for by CEO and CFO

accuracy of FS
 Internal control report Annual report must include statement on internal

control systems
 Audit committee US stock exchanges are prohibited from listing any firm
that does not have an audit committee.
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95
Chapter 9
96
Chapter 10
Internal audit
Outcome
 evaluate the purposes and process of audit in the context of internal control
systems
 evaluate the effective planning and management of internal audit and internal
audit investigations
97
Chapter 10
Overview
Scope External v
Standards
internal
Need Introduction Types of

work
INTERNAL AUDIT
Audit process
Audit report
Audit of computer
systems
98
Internal audit
Introduction
1.1 Definition
 Internal audit is ‘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
effectiveness of other controls’. (CIMA)
1.2 Context – management review of controls (Turnbull)
 A review of internal controls should be an integral part of management’s role.
 The identification, evaluation and management of all key risks facing the
organisation.
 The effectiveness of internal control – financial, operational, compliance and

risk management controls.
 Communication to employees of risk objectives with targets and performance

indicators.
 The action to be taken if any weakness is found.
1.3 Internal audit vs. risk management
Internal Audit Risk Management
 Testing and evaluating controls  Own entire risk management

process
 Special investigations as
directed by management  Maintain risk register
 Support and assist senior  Lead in developing risk

management in projects, some response strategy
outside risk management arena
 Provide training and
 Contribute to risk identification development in risk
management matters
99
Chapter 10
100
Internal audit
The need for internal audit
2.1 Factors that affect the need for internal audit
 The scale, diversity and The larger, the more diverse and the more
complexity of the company’s complex a range of activities is, the more
activities there is to monitor (and the more opportunity
there is for certain things to go wrong).
 The number of employees As a proxy for size, the number of employees

signifies that larger organisations are more
likely to need internal audit to underpin
investor confidence than smaller concerns.
 Cost/benefit Management must be certain of the benefits

that will result from establishing internal audit
and they must obviously be seen to outweigh
the costs of the audit.
 Changes in the organisational Any internal (or external) modification is

structures, reporting processes capable of changing the complexity of
or underlying MIS operations and, accordingly, the risk.
 Changes in key risks The introduction of a new product, entering a

new market, a change in any of the
PEST/PESTEL factors or changes in the
industry might trigger the need for internal
audit.
 Problems with existing internal Any problems with existing systems clearly
control systems. signify the need for a tightening of systems
and increased monitoring.
 An increased number of System failures or similar events are a clear

unexplained or unacceptable demonstration of internal control weakness
events.
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Chapter 10
Scope of internal audit
Review accounting Economy, efficiency

and internal control & effectiveness
systems review of operations
Sample Scope of
Minimise risks
testing internal
audit
Compliance with Assist in carrying

laws, regulations or out external audit
internal policies procedures
Special
investigations

and Kit questions.
102
Internal audit
Standards of internal audit work
4.1 Attribute standards
 Independence Internal auditors should be Independent of executive

management. Head of internal audit report to senior
directors. Free from interference.
 Objectivity Internal auditors should be objective and avoid any

conflicts of interest.
 Professional care Internal auditors should exercise due professional care and
should have be competence to perform their tasks.
4.2 Performance standards
 Managing Establish risk-based plans to decide the priorities. Plans

internal audit should be reviewed at least annually and submitted for
board approval
 Risk Identify and evaluate significant risk exposures and

management contribute to the improvement of risk management and
control systems.
 Control Help maintain control system by evaluating the

effectiveness and efficiency of controls, and by promoting
continuous improvement
 Governance Assess the corporate governance process and make

recommendations
 Internal audit Identify, analyse, evaluate and record sufficient information

work to achieve the objectives of the engagement. Conclusions
should be based on suitable analysis and evaluation.
 Communicating Communicate the results of their engagement, including

results conclusions, recommendations and action plans.
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Chapter 10
Outsourcing internal audit
5.1 Advantages of outsourcing internal audit
 Greater focus on cost and efficiency of the internal audit function.
 Staff may be drawn from a broader range of expertise.
 Risk of staff turnover is passed to the outsourcing firm.
 Specialist skills may be more readily available.
 Costs of employing permanent staff are avoided.
 May improve independence.
 Access to new market place technologies.
Reduced management time in administering an in-house department.
5.2 Disadvantages of outsourcing internal audit
 Possible conflict of interest if provided by the external auditors.
 Pressure on the independence of the outsourced function.
 Risk of lack of knowledge and understanding of the organisation.
 The decision may be based on cost with the effectiveness of the function being
reduced.
 Flexibility and availability may not be as high as with an in-house function.
 Lack of control over standard of service.
 Risk of blurring of roles between internal and external audit.
104
Internal audit
Internal and external audit
6.1 External and Internal Audit
External Internal
Role required  Statute, for all limited  Management, usually in

by: companies larger organisations
Appointed by:  Shareholders or directors  Audit committee/CIA
Reports to:  Shareholder (primary  Audit committee/CIA

duty) and management
(professional
responsibility)
Reports on:  Financial statements  Internal controls mainly
Forms  True and fair view and  Adequacy of ICS

opinions on: proper presentation
Scope of  Unlimited, to fulfil statutory  Prescribed by

assignment: obligation management/audit
committee
6.2 Relationship of internal audit to external audit
External auditors should take into account the following when planning their audit:
 Status of internal audit within organisation.
 Scope of internal audit function.
 Whether management act on recommendations of internal audit.
 Technical competence of internal auditors.
 Objectives of internal audit.
 Due professional care demonstrated in internal audit work.
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Chapter 10
106
Internal audit
Types of internal audit work
7.1 Types of audit
 Compliance audit Compliance audits check the implementation of written

rules, regulations and procedures.
 Transactions A transactions audit involves the checking of a sample of

audit transactions against documentary evidence.
 Risk-based audit Plan audit tests so that more effort is directed towards the
most risky areas.
 Quality audit To establish whether quality objectives are being met.
 Post-completion An objective and independent appraisal of the measure of

audit success of a project.
 Value for money Whether proper arrangements have been made for
audit securing economy, efficiency and effectiveness (3Es) in
the use of resources
 Environmental Evaluation how well the company is safeguarding the

audit environment and meeting regulatory
 Social audit Looks at the company's contribution to society and the

community
 Management An objective and independent appraisal of the

(operational) effectiveness of managers and the corporate structure in
audit the achievement of the entities' objectives and policies
 Systems-based Audit of internal controls within an organisation

audit
107
Chapter 10

and Kit questions.
108
Internal audit
The audit process
8.1 Overall process
Agree the objectives of the audit
Plan the audit
Find out about systems and controls Planning
Confirm the operation of the system
Assess if controls are adequate
Test compliance with controls
Testing
Test application of controls
Review, report and recommend
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Chapter 10
8.2 Audit planning
 Objectives of the audit.
 Conduct of the audit.
 Resources and timing.
8.3 Audit risk
 Inherent risk The risk that an amount in the financial statements might
be stated as a materially incorrect amount, ignoring the
existence of existing internal controls.
 Control risk The risk that the existing controls are not sufficient to
prevent or detect a material misstatement.
 Detection risk The risk that the auditors’ substantive tests will not reveal
a materially incorrect amount in the financial statements, if
such an error exists.
8.4 Systems investigation and documentation - Ascertaining systems
 Flowcharts.
 Interviews.
 Systems documentation.
 Observation.
8.5 Types of audit testing
 Compliance testing Test of controls
 Substantive testing Test of balances or transactions
 Analytical review Examination of ratios, trends and changes in balances.

Can be used at planning, substantive testing and overall
review stages of an audit
110
Internal audit
The audit report
9.1 The audit report
 The objectives of the audit work.
 A summary of the process undertaken by the auditor.
 The results of tests carried out.
 The audit opinion (if an opinion is required).
 Recommendations for action.

and Kit questions.
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Chapter 10
Audit of computer systems
10.1 Problems of auditing computer systems
 Concentration of controls in the IT department.
 Lack of primary records.
 Encoded data.
 Loss of audit trail.
 Overwriting of data.
 Program controls.
10.2 Audit approaches
 Though the computer.
 Round the computer.
10.3 Computer-assisted audit techniques (CAATs)
Audit software
 Extract a sample according to specified criteria.
 Calculate ratios and select those outside the criteria.
 Check calculations (for example additions).
 Prepare reports (budget vs actual).
 Produce letters to send out to customers suppliers.
 Follow items through a computerised system.
 Search for underlying relationships and check for fraud.
Test data
 Live data = processed during a normal production run.
 Dead data = processed outside the normal cycle.
112
Internal audit
113
Chapter 10
114
Chapter 11
Financial risk
Outcome
 evaluate financial risks facing an organisation
115
Chapter 11
Overview
Introduction
FINANCIAL RISK
Types of
financial risk
116
Financial risk
Introduction
1.1 Definition of financial risk
 'A risk of a change in a financial condition such as an exchange rate,

interest rate, credit rating of a customer, or price of a good'.
1.2 To hedge or not?
Benefits of hedging Arguments against hedging
 Can provide certainty of cash  May harm interest of shareholders

flows with diversified portfolios
 Risk will be reduced  Significant transaction costs
 Reduction in probability of financial  Lack of expertise within the

collapse business
 May be perceived to be a more  Complexity of accounting and tax

attractive employer to risk-averse issues
managers
 For some risks, gains and losses
 May reduce taxes may cancel out in the long run.
1.3 Derivatives
 A derivative is a financial instrument whose value depends on the price of some

other financial asset or underlying factor (such as oil, gold, interest rates or
currencies).
 Derivatives can be used for hedging, speculation and/or arbitrage.
117
Chapter 11
Types of financial risk
2.1 Credit risk
Definition Management
Credit risk is the risk of non-payment or  Strong credit control procedures

late payment by debtors. Credit risk will
always exist in businesses that make  Insuring against the risk
credit sales and therefore it needs to be
managed.  Debt factoring without recourse
2.2 Political risk
The financial political risk is the risk  Entering into foreign joint ventures
arising from actions taken by a
government that affect financial aspects  Obtaining agreements and
of the business. contracts with overseas
government
 Using local financing
 Plans for ownership/part-ownership

by foreign country’s investors
118
Financial risk
2.3 Interest rate risk
Interest rate risk is the risk of gains or  Floating rate loans/investments

losses on assets and liabilities due to
changes in interest rates.  Fixed rate loans/investments
 Refinancing
See Chapter 13 for management.
2.4 Currency risk
Currency risk is the risk that arises from  Translation risk

possible future movements in an
exchange rate.  Transaction risk
 Economic risk
See Chapter 12 for management of transaction risk.

and Kit questions.
119
Chapter 11
120
Chapter 12
Currency risk management
Outcome
 advise on the effects of economic factors that affect future cash flows from
international operations
 evaluate appropriate methods for the identification and management of financial

risks associated with international operations
121
Chapter 12
Overview
Basics PPPT IRPT
Exchange
rates
Currency Risk
Management
Risk
management
Forward Swaps
contracts
MMH Options
Futures
122
Exchange rates – basics
1.1 Definition of an exchange rate
 An exchange rate is expressed in terms of the quantity of one

currency that can be exchanged for one unit of the other currency. It
can be thought of as the price of a currency.
1.2 How rates are quoted
Can have:
 direct quotes: one unit of foreign currency = its value in home currency
 indirect quotes: one unit of home currency = its value in foreign currency
 note: Spreads are quoted so the bank wins!
1.3 Reasons for forecasting exchange rates
 Foreign debtor and creditor balances.
 Working capital.
 Pricing.
 Investment appraisal.
 Consolidation of foreign subsidiaries.

and Kit questions.
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Chapter 12
Purchasing power parity theory (PPPT)
2.1 Purchasing power parity
 ‘Law of one price’.
 Country with higher inflation will suffer a fall in the value of their currency
1+ if
 Future spot rate = Current spot rate × , where i = inflation rates.
1+ ih
 Assumes rates are quoted as indirect quotes.
2.2 Limitations
 Future inflation rates may not be accurate.
 Speculation.
 Government intervention.

and Kit questions.
124
Interest rate parity theory (IRPT)
3.1 Interest rate parity
 Difference between spot and forward rates is equal to the differential between
interest rates available in the two currencies.
 Equivalently, both countries have the same real interest rate (Fisher Effect).
 Country with higher interest rates will suffer a fall in the value of their currency.
1+ if
 Forward rate = Current spot rate × , where i = money interest rates.
1+ ih
 Assumes rates are quoted as indirect quotes.
3.2 Limitations
 Controls on capital markets.
 Controls on currency trading.
 Government intervention.

and Kit questions.
125
Chapter 12
4.1 Types of risk exposure
 Transaction risk The risk of exchange rates changing before the

settlement date of a transaction.
 Economic risk The risk that long-term adverse movements in

exchange rates make the company less competitive
internationally.
 Translation risk The risk of exchange rate movements between one

year and the next causing fluctuations in values of
foreign currency assets and liabilities in consolidated
accounts.
Note: unrealised translation losses can affect

borrowing capacity.
4.2 Internal Methods
 Home currency Passes risk to other party
Unlikely to be commercially acceptable
 Leading/lagging Speed up / delay payment depending on expectations of

exchange rate movement
Problem predicting movements
 Matching/netting Match / net off transactions in the same currency
Easier if use foreign bank accounts (risk exposure on net

balance)
 Countertrade Avoid using currency and exchange products of equivalent

value
126
127
Chapter 12
Forward Contracts
5.1 Definition
A forward contract is a binding agreement to buy or sell a specific amount

of foreign currency at a given future date using an agreed forward rate.
5.2 Features and operation
 Forward contracts are a commitment, and as a result they have to be honoured

even if the rate in the contract is worse than the rate in the market.
 Forward contract rates are often quoted as an adjustment to the spot rate:
– add a discount ('add:dis')
– subtract a premium.
5.3 Advantages and disadvantages
ADVANTAGES DISADVANTAGES
 Simple  Contractual commitment
 Low transaction costs  Lose upside potential
 Fix the exchange rate  Forward markets banned in some

countries – e.g. China, Russia,
 Tailored India, Brazil

and Kit questions.
128
Money Market Hedges (MMH)
6.1 Basic ideas
 Avoid future (uncertain) exchange rate by making exchange now at (known)

spot rate.
 Use interest rates to create assets and liabilities that 'mirror' the future assets
and liabilities.
6.2 Operation
Future foreign CF? Payment Receipt
 Step 1: borrow Borrow in home currency Borrow in foreign currency
 Step 2: convert Convert to foreign currency Convert to home currency at

at spot spot
 Step 3: deposit Deposit foreign currency Deposit home currency
 Step 4: future Use deposit to pay supplier Receipt from customer

transaction date settles outstanding liability
129
Chapter 12
6.3 Calculations
 Always start with the future foreign cash flow.
 E.g. to hedge a payment in a foreign currency:
– calculate foreign deposit as the PV of the future payment
– then calculate how much home currency you need to borrow.
 E.g. to hedge a receipt in a foreign currency:
– calculate foreign borrowing as the PV of the future receipt
– then convert into home currency and place on deposit.
6.4 Advantages and disadvantages of MMH
 No currency risk  Complex
 Fairly low transaction costs  May be difficult to get overseas

loan
 Offer flexibility
 A company with a large overdraft
 May be able to use when forward may struggle to borrow funds now
contracts not available
6.5 Parities revisited
 IRPT implies that a forward contract and a MMH should give the same answer

and Kit questions.
130
Currency Futures
7.1 Features
 Standardised contracts to buy or sell standardised amounts of an underlying

asset at a pre-determined price in the future.
 In some respects futures sound similar to forward contracts except futures

contracts are rarely used to deliver. Instead a futures position is opened and,
later, closed out to leave a net gain or loss.
 The idea is that any gain or loss in the market is matched by a corresponding
loss or gain on the futures position, thus reducing the risk.
 Standard expiry dates – the last day of March, June, September and
December.
 All buyers and sellers are required to pay an initial margin (deposit) to the
exchange when they set up a position.
 Gains and losses are 'marked to market' on a daily basis and the initial margin
adjusted if necessary.
 Effectively fix’ the exchange rate  Foreign futures market must be

used for £ futures
 No transaction costs
 Require up front margin payments
 Tradable
 Not for precise tailored amounts
131
Chapter 12
7.3 Futures hedging calculations
1. Now – set up the hedge
 Buy or sell futures? Look at the currency of the contract
 Which expiry date? First contract to expire after future transaction
 How many contracts? Look at contract size. May need to round. May
need to convert currencies to match size and transaction
2. Contact the exchange and pay the initial margin.
3. Future transaction date – close out the futures position.
 Buy or sell? e.g. if originally contracted to sell, then close by buying
 Calculate gain or loss May need to convert between currencies using

the spot on the transaction date

and Kit questions.
132
Currency Options
8.1 Definition
 A currency option is a right, but not an obligation, to buy or sell a currency at

an exercise price on a future date.
 If there is a favourable movement in rates the company will allow the option to
lapse, to take advantage of the favourable movement. The right will only be
exercised to protect against an adverse movement.
 The writer of the option will charge a non-refundable premium for writing the
option.
 There are two types of option:
– a call option gives the holder the right to buy the underlying currency
– a put option gives the holder the right to sell the underlying currency.
 Offer the perfect hedge  Sterling currency options only

available in foreign markets
 Many choices of strike prices,
dates, premiums  High up front premium costs
 Can be allowed to lapse if not

required
133
Chapter 12
8.4 Options hedging calculations
1. Now – set up the hedge
 Call or put options? Look at the currency of the contract
 How many contracts? Look at contract size. May need to round. May
need to convert currencies to match transaction
 Which strike price? Many different ways of choosing – RTQ
2. Contact the exchange and pay the premium.
3. Future transaction date – compare the option price with the prevailing
spot rate and make decision – to exercise or allow to lapse?
4. Calculate CFs. The options may not match exactly with the future
transaction so extra exchanges may be necessary.

and Kit questions.
134
SWAPs
9.1 FOREX swaps
 Two parties agree to swap equivalent amounts of currency for a period and then
re-swap them at the end of the period at an agreed swap rate.
 The swap rate and amount of currency is agreed between the parties in
advance. Thus it is called a ‘fixed rate/fixed rate’ swap.
 The main objectives of a forex swap are:
– to hedge against forex risk, possibly for a longer period than is possible on
the forward market
– to access capital markets, in which it may be impossible to borrow directly.
 Forex swaps are especially useful when dealing with countries that have
exchange controls and/or volatile exchange rates.
9.2 Currency Swaps
 A currency swap allows the two counterparties to swap interest rate

commitments on borrowings in different currencies.
 In effect a currency swap has two elements:
– An exchange of principal in different currencies, which are swapped back

at the original spot rate
– An exchange of interest rates – the timing of these depends on the

individual contract.
135
Chapter 12
136
Chapter 13
Interest Rate Risk management
Outcome
 evaluate appropriate methods for the identification and management of financial

risks associated with debt finance
137
Chapter 13
Overview
Interest Rate Risk

Management
Risk
management
FRAs Swaps
IRGs Options
Futures
138
1.1 Types of risk exposure
 On existing loans or Exposed to changes in interest rates if existing loans

deposits and deposits have variable interest rates.
Can avoid by using fixed rates or using swaps
 On future loans or Even if we want to use fixed rates, we do not know

deposits what the rate will be when we need the loan / deposit.
1.2 Internal Methods
 Smoothing Company has a balance between its fixed rate and

floating rate borrowing.
Natural hedge against changes in interest rates.
 Matching The company matches its assets and liabilities to have

a common interest rate (e.g. loan and investment both
have floating rates).
 Netting The company aggregates all positions, both assets and

liabilities, to determine its net exposure.
1.3 External hedging techniques
Over-the-counter (OTC) Exchange traded

instruments instruments
 ‘Fixing’ instruments Forward rate agreements Interest rate futures

(FRAs)
 ‘Insurance’ Interest rate guarantees Interest rate options

instruments (IRG)
139
Chapter 13
Forward rate agreements (FRAs)
1.1 Definition
 An FRA is a forward contract on an interest rate for a notional future

short-term loan or deposit.
 The FRA does not replace taking out the loan (deposit) but rather the
combination of the loan (deposit) and the FRA result in a fixed effective
interest rate.
 If looking to borrow money then you need to buy an FRA.
 If looking to deposit money then you need to sell an FRA.
 A receipt or payment will be made at the start of the loan period that will
compensate for interest rate changes between the FRA and the market rate for
the loan.
 FRAs are normally for amounts greater than £1m.
 Terminology – '5v8 FRA', '5-8 FRA'.
 Quoted rates – use higher rate if borrowing, lower rate if depositing.

and Kit questions.
140
Interest rate guarantees (IRGs)
3.1 Basic ideas
 IRGS are options on FRAs.
 Treasurer has the choice whether to exercise or not.
3.2 Operation
1. Now – set up the IRG.
 Call or put options? Borrowing – would buy FRA, so need a call
Depositing – would sell FRA, so need a put
 Everything else (dates, sizes) bespoke as OTC.
2. Future transaction date.
 Compare the IRG (option) rate with the prevailing spot rate and make
decision – to exercise or allow to lapse?
 Calculate receipt on FRA if necessary.

and Kit questions.
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Chapter 13
Interest rate futures
4.1 Features
 Two types – short term interest rate futures (STIRs) and long term bond futures.
 In both cases the underlying asset can be viewed as buying or selling bonds
 'Price' = 100 – interest rate.

Size of loan Duration of loan
 Number of contracts = ×
Size of contract Duration of contract
4.2 Futures hedging calculations
1. Now – set up the hedge.
 Buy or sell futures? Borrow = sell, deposit = buy
 How many contracts? Look at contract size and duration.
2. Contact the exchange and pay the initial margin.
3. Future transaction date – close out the futures position.
 Buy or sell? e.g. if originally contracted to sell, then close by buying
 Calculate gain or loss.

and Kit questions.
142
143
Chapter 13
Traded interest rate options
5.1 Basic idea
 Traded interest rate options are options on STIRs – i.e. futures contracts.
5.2 Options hedging calculations
1. Now - set up the hedge
 Call or put options? Borrowing – would sell STIR, so need a put
Depositing – would buy STIR, so need a call
 How many contracts? Same as for futures.
 Which strike price? Many different ways of choosing - RTQ
2. Contact the exchange and pay the premium
3. Future transaction date
 Compare the option price with the prevailing spot rate and make
decision – to exercise or allow to lapse?
 Calculate gain on futures position (if exercised)
144
SWAPs
6.1 Definition
 An interest rate swap is an agreement whereby the parties agree to
swap a floating stream of interest payments for a fixed stream of
interest payments and via versa.
 There is no exchange of principal.
6.2 Reasons for using swaps

 As a way of managing fixed and floating rate debt profiles without having to
change underlying borrowing.
 To take advantage of unexpected increases or decreases in rates.
 To hedge against variations in interest rates.
 To benefit from ‘comparative advantage’.
6.3 SWAPs with intermediaries

 Bank offers two rates
– The ‘ask rate’ at which the bank is willing to receive a fixed interest cash
flow stream in exchange for paying LIBOR.
– The ‘bid rate’ that they are willing to pay in exchange for receiving LIBOR.
 The difference between these gives the bank’s profit margin and is usually at
least 2 basis points.

and Kit questions.
145
Chapter 13
146
Chapter 14
Cost of capital and capital investment
decisions
Outcome
 evaluate the risks arising from changes in the environment for capital
investment appraisal
 evaluate investment projects
147
Chapter 14
Overview
Recap of Real Certainty

CAPM
basic NPV options equivalents
Key models
Cost of capital and

investment decisions
Which
discount rate?
Co WACC APV
Risk
adjusted
WACC
148
Cost of capital and capital investment decisions
Introduction
1.1 Risk and investment appraisal
When looking at investment appraisal we are particularly concerned with

changes in business risk (what the project activity involves) and gearing
risk (how it will be financed).
Key questions:
 how to measure and evaluate the different risks involved
 how each method incorporates risks into the decision making process
 how to decide on which investment appraisal technique to use, based on the

risks
 how to implement the techniques specified.
1.2 Incorporating risk
All investment appraisals are based on estimates of likely project returns.
Uncertainty in the estimates can be dealt with using:
 sensitivity analysis
probabilities/expected values
 certainty equivalents
 risk-adjusted discount rates.
149
Chapter 14
Recap of discounted cash flows (P2)
2.1 Time value of money
 Key concept is the time value of money. This is expressed as a discount rate.
 Discount rate reflects:
– risk
– inflation
– cost of finance
– alternative investment opportunities.
2.2 The basics of discounting
Discount factor Single Tables are provided in

=1/ (1+r)n CF
the exam
MIRR
Annuity
factor=
Annuity Perpetuity
Discounting
MIRR MIRR
Tables are Perpetuity

provided in the factor = 1/r
exam
Perpetuity
with growth
Present value of a growing

perpetuity = CFt=1 × 1/ (r–g)
150
2.3 Net present value (NPV)
 Method: discount future cash flows to get their present value.
 NPV gives impact on shareholder wealth, so accept project if NPV > 0
2.4 Internal rate of return (IRR)
 IRR = discount rate. when NPV = 0
 IRR = breakeven cost of capital.
2.5 Expected values
 If forecasts are uncertain but probabilities can be attached to the possible

outcomes, expected values (EV) can be calculated.
 EV = (outcome 1 × probability 1) + (outcome 2 × probability 2) + ...
 However, there are limitations:
– EV is a long-run average, so less useful for one-off projects
– EV figure used (e.g. sales volume) may not be a possible outcome
– relying on EVs in isolation loses information about risk, so effectively

ignores risk preferences of investors (or assumes they are risk neutral)
– probabilities very difficult to estimate.
2.6 Sensitivity analysis
Sensitivity analysis can be used:
 to assess the impact on the NPV of a certain change in a particular input factor
 to consider by how much each input variable could change before the NPV of
the project became zero (and hence the project became unacceptable), and
hence to identify key estimates.
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Chapter 14
Certainty equivalents
3.1 Method
1. The cash flows of the project are estimated / calculated as per normal
2. Cash flows are adjusted downwards by multiplying by a certainty equivalent

factor. This in effect decreases the cash flow to reflect the level of uncertainty.
3. The cash flows are then discounted at the risk free rate.
Benefits of using certainty equivalents
 They are a very simple way of incorporating risk into an investment appraisal.
 They enable the decision maker to reduce the possible future cash flows to give
a worst possible scenario NPV.
 By using a risk-free rate for discounting, they avoid double counting risk.
 Avoids the need to estimate an appropriate discount rate which reflects the risk.
 The certainty equivalent approach distinguishes between risk and time.
 In practice the major problem is that the use of certainty equivalents is

subjective.

and Kit questions.
152
Real options
4.1 Basic idea
 The traditional NPV method tends to undervalue projects because it does not
consider the value of options associated with a project.
 Strategic NPV = traditional NPV + value of embedded real options.
4.2 Types of real option
 Abandonment options:
– financial put option
– the ability to ‘bail out’, should events turn out worse than expected.
 Timing options:
– financial call option
– 'wait and see options'.
 Strategic investment options:
– financial call option
– 'follow-on options'.
4.3 Valuing real options using Black-Scholes option pricing model
 Key variables are:
– present value of the future project cash flows
– outlay on additional investment (proceed of future sale)
– time until the opportunity disappears
– variability of project returns (measured as a standard deviation)
– risk-free rate of interest.
153
Chapter 14
154
The Capital Asset Pricing Model (CAPM)
5.1 Key elements of CAPM
 A methodology for measuring business risk.
 An equation for determining what level of required return is needed to

compensate for the measured level of risk.
5.2 Systematic and unsystematic risk
 As an investor increases the size of his/her portfolio, overall risk reduces.
Risk of
portfolio
(σ) Unsystematic
risk
Systematic
risk
Number of shares in portfolio
 If the investor has approximately 15–20 well-chosen shares in his portfolio, the
unsystematic risk will be eliminated and the investor is 'well-diversified'.
 Systematic risk is caused by general, macro-economic factors (e.g. recession,

interest rates, exchange rates). It cannot be diversified away.
 Unsystematic risk is caused by factors specific to the company or industry (e.g.

systems failure, R+D success, strikes).
155
Chapter 14
5.3 Systematic risk and betas
 A key concept with CAPM is that it only considers 'systematic risk', so

assumes the investor is well-diversified.
 Systematic risk is measured using beta factors.
 Beta = systematic risk of project ÷ typical level of systematic risk in the market:
– ß = 1 denotes average systematic risk
– ß > 1 for a riskier than average investment
– ß < 1 for a lower risk than average investment.
5.4 Required rate of return
 Required return = risk free rate + premium for systematic risk.
 Required return = risk free rate + ß × typical equity risk premium (ERP).
 Required return = Rf + ß × (Rm – Rf)
 The required return can often be interpreted as a cost of equity.
 If drawn as a graph, this shows the 'Securities Market Line'.
5.5 Criticisms of the CAPM model
 Single period model – e.g. Rf could change going forwards.
 Beta values are based on historic data.
 Market assumed to be perfectly efficient.
 No transaction costs.
156
Geared and ungeared betas
6.1 Two types of betas
 Ungeared ('asset') betas only incorporate systematic business risk.
 Geared ('equity') betas incorporate both systematic business risk and gearing
risk.
6.2 Estimating betas for projects (or unlisted companies)
 Many institutions calculate beta factors for listed companies by comparing

company performance with that of the stock market as a whole.
 This will typically give the company’s equity (geared) beta as it reflects all the
risks facing the shareholders, both systematic business risk and gearing risk.
 To get a project beta would involve the following steps.
1. Find a listed company with the same business activity as the project.
2. Take its equity beta and 'de-gear' it to give an asset beta.
3. Project asset beta = company asset beta as they have the same business
risk (but probably different gearing).
4. If required, 're-gear' the asset beta to incorporate project gearing to give a

project equity beta.
Note: You only need to know the concepts in P3 – the calculations

involved in de-gearing and re-gearing betas are tested in F3.
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Chapter 14
Which discount rate to use?
7.1 Basic ideas
 Any discount rate should reflect project business risk and project financial
gearing.
 Two key questions must thus be asked.
– Does the project have a different level of business risk to the company?
– Will the finance package chosen change the overall gearing level and
hence the gearing risk of the company? For example, using just equity or
just debt is likely to change the overall gearing level.
 There are four possible outcomes.

Project business risk
Same as company Different
Use existing Calculate a project-

Constant
gearing company WACC as specific risk-adjusted
Impact
of
a discount rate WACC
Project
finance
Change in Adjusted present Adjusted present

gearing value value
 Each of these is discussed below.
158
Using the company WACC
8.1 When is the company WACC relevant?
 The existing company WACC can only be used as a discount rate for project
appraisal if:
– The project has the same level of business risk as the company
– The project is financed to keep the company gearing constant
– In effect, the project looks like the company in miniature.
8.2 Further considerations
Some firms get by the above restrictions and use the company WACC anyway. This
is usually justified as follows.
 The small project argument – a small project would not change risk, ke, kd or
the WACC to change materially, so the WACC can be used.
 The pool of finance pool argument – It may not be practical to use a mixture
of debt and equity for every project. Suppose for this particular project we use
debt the above table states that we should be using APV as the gearing has
changed. However, the firm could argue that next time it will use equity and that
in the long run gearing will be kept constant. This argument may also be
expressed as saying that rather than looking at the specific finance for the
project, we should consider the firm having a 'pool' of finance that gets topped
up.

and Kit questions.
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Chapter 14
Using a risk adjusted WACC
9.1 When is a risk adjusted project WACC relevant?
 A project specific WACC if
– The project has a different level of business risk as the company – thus
the company Ke needs to be replaced with a project Ke.
– The project is financed to keep the company gearing constant – thus the
company kd and gearing ratio are still appropriate.
9.2 Method
1. Find a listed company in the same industry as the project.
2. Take the equity beta of the listed 'donor' company and 'de-gear' it.
3. 'Re-gear' this ungeared beta to reflect the company’s gearing level.
4. Insert this re-geared beta into CAPM to find a project Ke.
5. Combine this with the company’s cost of debt in the company.
160
Adjusted Present Value (APV)
10.1 When is APV relevant?
 APV must be used if the gearing ratio of the company changes as a result of the
project and its finance.
 Note: The main reason we cannot use a WACC is that we do not know the final
new gearing level – even if we know the finance to be issued, the gearing will
be affected by the project NPV (which we are trying to calculate!).
 APV is particularly recommended when there are complex funding

arrangements (e.g. subsidised loans).
10.2 Step 1: Base case NPV
 Ignore gearing! – discount project cash flows using a suitable, ungeared ke.
 Steps.
1. Find a listed company in the same industry as the project.
2. Take the equity beta of the listed 'donor' company and 'de-gear' it.
3. Insert this de-geared beta (do not re-gear!) into CAPM to find a project
Ke (do not re-gear!).
4. Use this ungeared Ke to calculate a project NPV.
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Chapter 14
10.3 Step 2: Present value of financing side effects
 These include the following.
Issue costs
PV of tax relief on interest, discounted at pre-tax cost of debt
PV of post-tax interest savings on subsidized loans
 Note: when calculating the tax relief on interest you should use the increase in
debt capacity of the firm, rather than the actual debt raised.
10.4 Step 3
 APV = 'Base case NPV' + PV of financing 'side-effects'.
 If APV > 0, then accept.

and Kit questions.
162
163
Chapter 14
164
Chapter 15
Managing conflict, implementation and
post completion
Outcome
 evaluate the outcomes of projects post-implementation
165
Chapter 15
Overview
Performance
measures
Managing conflict,
implementation and PCA
post completion
SDLC Project
implementation
166
Managing conflict, implementation and post completion
Introduction
1.1 Stakeholder objectives
With any business strategy or investment decision there are likely to be conflicting
stakeholder objectives. For example:
 spending extra to reduce the environmental impact of a project may be valued

by local government but may be at the expense of reduced profits for
shareholders
 paying higher wages and offering better healthcare may result in a more
satisfied workforce but does this necessarily result in higher profit for
shareholders?
 having night-time deliveries may improve responsiveness to customer needs

but at the expense of noise to the local community who live near the factory.
1.2 Investment metrics
 By using NPV as an investment metric, shareholder wealth objectives have

effectively been prioritised.
 It is often during the implementation phase that other stakeholders’ views come
back into focus.
1.3 Strategic implementation
 A system of control measures and indicators can help ensure that the strategy
is delivered and that the views of different stakeholders are incorporated.
167
Chapter 15
Performance and progress measures
2.1 Companies – typical measures
Financial Non-financial
 Profit  Market share
 Return on assets  Customer satisfaction
 CF  Quality measures
 Vale added  Risk measures
 Cost targets  Competitive position
2.2 Not for profit organisations
The strategic planning process can be more complex for NFPs since:
 multiple objectives, which are hard to prioritise
 objectives are more difficult to measure – usually non-financial
 influence/objectives of funding bodies
 recipients of the service are not the ones who pay for it.
Many NFPs therefore focus on the concept of value for money – the 3E’s model.
 Economy – focuses solely on inputs to the NFP.
 Efficiency – looks at the link between inputs and outputs.
 Effectiveness – looks solely at the outputs of the NFP.
168

and Kit questions.
169
Chapter 15
Systems development life cycle (SDLC)

The System Development Life Cycle (SDLC), or sometimes called the System
Project Life Cycle (SPLC), has six main stages.
 Planning – Feasibility study including goal setting, timing, duration and budget.
 Analysis – Definition of project goals and analysis of user needs.
 Design – Features of system described in detail including screen layouts,

process layouts, business rules and documentation. A prototype may be built.
 Development – Conversion of the design into a physical system including the

acquisition and installation of the hardware and software.
 Implementation – The real code is written. Staff training. Testing for errors,
bugs and inoperability (Quality assurance).
 Review – User acceptance testing, maintenance, post-implementation review.
170
Project implementation and control
There are several stages in the project implementation and control process, starting
with conceptual stage and running through to control.
4.1 Stage 1: Conceptual stage
 The aim of the conceptual stage is to finalise the design of the new product,
service or process before high costs are incurred in the development and
construction stages.
 Project team is brought together, under the control of the project manager.
 The team members will be allocated specific roles and responsibilities

depending on their skills.
4.2 Stage 2: Development stage
 Once the concept of the product, service or process has been well defined, the
development stage is where the project team needs to check that the concept
meets customer requirements.
 This can be achieved by trial product testing and subsequent consumer

feedback.
 Any problems noted at this stage of the process can be addressed and the
design can once again be amended before further costs are incurred.
171
Chapter 15
4.3 Stage 3: Construction and initial manufacturing/operating stage
 When the product, service or process has been developed, and any design
problems have been addressed, the next stage is where the new product,
service or process is launched.
 For a product, this stage will be where the large scale production begins,
making items based on the designs which were finalised during the
development stage.
 For a service or process, this is where the new service or process is

implemented.
 In the initial manufacturing/operating stage of the project, it will be critical for the
project team to control the new product, service or process by continual
product testing and product refinement (for products) or test runs and parallel
running (for services or processes).
4.4 Stage 4: Control stage
 The project team should continue monitoring the project, and comparing the
actual results against the original budget (time and cost).
 It will be the job of the project team at the control stage to keep considering
whether the project is likely to achieve its original objectives.

and Kit questions.
172
Post-completion audit (PCA)
5.1 Definition
 'An objective independent assessment of the success of a capital

project in relation to a plan.'
5.2 Scope and purpose
 To identify causes of variances from budget and general lessons to be learned.
 Often carried out by small teams, typically consisting of an accountant and an

engineer who have had some involvement in the project.
 Not common to find PCA as the responsibility of internal audit.
5.3 Benefits of post-completion auditing
 It improves the quality of decision making by providing a mechanism whereby

past experience can be made readily available to decision makers.
 It encourages greater realism in project appraisal by providing a mechanism

whereby past inaccuracies in forecasts are made public.
 It provides a means of improving control mechanisms by formally highlighting

areas where weaknesses have caused problems.
 It enables speedy modification of under-performing/over-performing projects by

identifying the reasons for the under or over performance.
 It increases the frequency of project termination for ‘bad projects’.
 It highlights reasons for successful projects which may be important in

achieving greater benefits from future projects.
173
Chapter 15
174
Appendix
Tables
175
Appendix
176
Tables
177
Appendix
178

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Chapter 2 Risk management 11

Chapter 3 Internal control 27

Chapter 4 Risk and control of Information Systems 37

Chapter 5 Information strategy 45

Chapter 6 Management control systems 55

Chapter 9 Corporate governance 83

Chapter 10 Internal audit 97

Chapter 11 Financial risk 115

Chapter 12 Currency risk management 121

Chapter 13 Interest rate risk management 137

Chapter 14 Cost of capital and capital investment decisions 147

Chapter 15 Managing conflict, implementation and post completion 165

Appendix Tables 175

By the end of this session you should be able to:

 identify the types of risk facing an organisation

and answer questions relating to these areas.

Why incur risk?

CIMA risk Categories of

 ‘Risk is a condition in which there exists a quantifiable dispersion in the possible

Note: some writers make a distinction between risk and uncertainty

1.2 Positive and negative aspects of risk

Why incur risk?

2.1 Reasons why companies take risks

 To gain competitive advantage - To generate higher returns a business may

CIMA’s risk management cycle

Establish risk management Business strategy

Identify risk areas

Review and Understand and

Implement strategy and

4.1 Political, legal and regulatory risk

 Political risk Risk due to political instability

 Legal/litigation risk Risk that litigation will be brought against business

 Regulatory risk Risk of changes in regulation affecting business

 Compliance risk Risk of non-compliance with law resulting in fines,

4.2 Business risk

Risks that businesses face due to nature of operations and products.

Risk of failure of new products / loss of interest in

Risk that business operations may be inefficient or

 Contractual Risk that the terms of a contract do not fully cover a

4.3 Economic risk

Risks that changes in the economy might affect the business.

4.4 Financial risk

Risk of a change in a financial condition such as an exchange rate, interest rate,

 Credit risk Risk of non-payment by customers

 Political risk Risk arising from actions taken by a government that

 Currency risk Risk of fluctuations in the exchange rate

 Interest rate risk Risk that interest rates change

 Gearing risk Risk in the way a business is financed (debt v equity)

4.5 Technology risk

4.6 Environmental risk

4.7 Corporate reputation risk

4.8 Fraud risk

Risk that is the vulnerability of an organisation to fraud.

4.9 Employee malfeasance risk

Risk that an organisation might be exposed to actions by employees that result in an

4.10 Risks in international operations

International business are subject to additional risks factors relating to culture,

Illustrations and further practice

and Kit questions.

and these from the Exam Practice Kit.

By the end of this session you should be able to:

 identify the types of risk facing an organisation and recommend appropriate