ACCA P1 EXAM NOTES

Part 1: Framework
Chapter 1: Introduction of CG (Corporate Governance)
Segregation of the ownership and control
-Shareholders are the owner of the company
-Control usually delegated to director
-Interest of shareholders and directors may conflict
-Directors may not act in the best interest of the
shareholder

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

Definition:
A system by which organizations
are directed and controlled

Purpose and objectives:

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

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

Key points:
1.

Definition of CG- B 49&F 4

2.

Underlying concepts of CG- B 49&F 7

3.

Major areas of CG- B 67-70 & F10-11

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

Issues and scope of

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

Chapter 2: Agency relationship and theories

Agency relationship and theories

Transaction costs and stakeholder

theories and economic theory

Agency theory

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

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

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

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

Key points:
1.

Agency theory: B 52&F 25 F27-F29

2.

Transaction theory: B55&F30 F31

3.

Stakeholder theory: B55&F32

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

Board of directors:
Board of directors

ED

Unitary

Board structure

Single board

Two boards

NED

Management
board

Supervisory board

ED

NED

Roles and responsibilities:

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

Characteristic and composition:

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

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

Legal and regulatory framework:

Appointment and retirement
Service contract
Removal
Disqualification
Conflicts of interest
Insider dealing

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

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

Executive Director (ED):

-Members of a board of directors who are also
senior managers of the company
-Usually paid as full time employee for their work

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

Non Executive Director (NED):

-Members of a board of directors who do not
form part of the executive management team
-Not full time employee of the company or
they act in any other way

Independence:
-Require certain detachment from the company
-Should be independent in judgment
Key points:
1.

Role of board: P104 &F 58

2.

Board structure:
Advantages and disadvantages of unitary board and two-tier board B119-120 & F 60-61

3.

Composition of the board

Combined code requirement: F63

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

-Disqualification
-Conflicts of interest
-Insider dealing
Board committee

Audit committee

100%

Remuneration
committee

Nomination
committee

Risk committee

100%

NED

NED

Pay & Benefits of

ED

Majority NED

Majority NED

Structure of board

Company risk
exposure

Key points:
1.

Role and responsibilities of different committees B115&F93-F97

2.

Remuneration: B123-B124 & F100-P102

Chapter 4: Different approaches to corporate governance

Cadbury

Greenbury

Hampel

Combined code

Turnbull

Multiple jurisdictions
-OECD principle
-ICGN principle

Higgs
Smith

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

US stock exchange regulations

Required under the Act-very
similar to UK regulation

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

SOX

Increased financial disclosures

Financial report to detail off
balance sheet financing
5

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

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

Chapter 5: Corporate governance, social responsibility and disclosure

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

CSR (Corporate social responsibility)

Is how an organization manages the impact of
their operations on the wider environment,
including consideration for stakeholder group

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

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

Best practice
Guidance provided by the
combined code

General meeting

Proxy voting

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

4. Proxy voting: B126 & F135

Chapter 6: Management control systems in corporate governance

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

Roles and responsibility

-Board of directors
-Executive management

Internal control system

Objectives and functions

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

Internal control
Individual components of
an internal control system

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

Key points:
1.

Definition of IC: B136&F140

2.

Objective of IC: BF145

3.

Elements of IC: B136&F155

Internal control Method F158-161

S Segregation of duties
P Physical
A Authorization and approval
O Organization

Relevance to corporate governance

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

A Arithmetic and accuracy

P Personnel
S Segregation of duties
Most transactions can be broken down into three separate duties:
1. Authorization
2. Handling of the asset
3. Recording of the transaction
For example: making the purchase, making the payment and recoding the purchase and payment in the accounts
P Physical
It aims to protect physical assets against theft and unauthorized access and use. They include:
1.

using a safe to hold cash and valuable document

2.

using secure entry system to buildings and areas of a building

3.

dual custody of valuable assets

4.

periodic inventory checks

5.

hiring security guards and using closed circuit TV(CCTV)

A Authorization and approval

For spending items, an organization needs establish authorization limits.
O Organization
It refers to the controls provided by the organizations structure, such as:
1.

the separation of an organizations activities and operations into department or responsibility center, with a
clear division responsibility

2.

delegating the authority

3.

establishing the reporting line

4.

coordinating the activities of different departments

A Arithmetic and accuracy

Controls are provided by:
1.

Recording transactions properly in the accounting system

2.

Being able to trace each transaction through the accounting records

3.

Double checking

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

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

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

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

External audit
Performs a statutory function

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

Function and importance

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

Reporting to shareholders
Is important CG requirement

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

Threats to independence
Self interest
Self review
Advocacy
Intimidation
Familiarity

Key points:
1.

Function and importance of the internal audit B 152-153&F166-167

2.

Performance standard for IA: B158-159 & F172-173

3.

Threats to independence of auditors B155-156 &F175-179

4.

Audit committee and internal control B163 B165& F 181-185

5.

Audit committee and internal audit & external audit B164 &F187 F189

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

Chapter 8: Risk management, assessment and risk management

Risk

Management
perception of risk

Categorization
risk

of

Measurement of
risk

Controlling risk

Key points:
1.

Risk category: B177-187 & F220-222 F226-227

2.

Risk analysis: B192-195 F217

3.

Impact on the stakeholders: B196-297&F228-229

4.

Role of board: B198 B224 & F234

5.

Role of risk management committee B224-225&F250

6.

Role of risk manager B228

7.

Reduction of risk: B231-234& F259-262

Chapter 9 Ethic theories and professional ethic

Codes of ethics

Ethic theory
-Kohlberg theory
-Tuckers model

Corporate ethic
Application of values to
business behaviors

Professional Ethic
Codes

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

Threats to the auditors

independence
-Self interest
-Self review
-Familiarity
-Intimidation

10

Conflicts of interest

1. Kohlberg theory: B263-264&F280-283

2. Tuckers model: B292
-Profitable
-Legal
-Fair
-Right
-Sustainable

3. ACCA codes: B290&F331-332

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

Professional commentary

III Sample question and answer:

Business risk and risk management

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

11

aircraft has a generous hold capacity for Sepianas numerous horticultural growers (e.g. of cocoa, tea and fruit) and
general cargo.
The six hour journey offers an in-flight movie, a meal, hot and cold drinks and tax-free shopping. All meals are
prepared in Lyme under a contract with an airport catering company. Passengers are invited to complete a
satisfaction questionnaire which is included with the in-flight entertainment and shopping guide. Responses
received show that passengers are generally least satisfied with the quality of the food especially on the Darke to
Lyme flight.
Azure employs 10 full-time cabin crew attendants who are trained in air-stewardship including passenger safety in
the event of accident and illness. Flight personnel (the captain and co-pilots) are provided under a contract with the
international airline from which the aircraft is leased. At the end of each flight the captain completes a timesheet
detailing the crew and actual flight time.
Ticket sales are made by Azure and travel agents in Sepiana and Pewta. On a number of occasions Economy
seating has been over-booked. Customers who have been affected by this have been accommodated in Business
Class as there is much less demand for this, and even less for First Class. Ticket prices for each class depend on
many factors, for example, whether the tickets are refundable/non-refundable, exchangeable/non-exchangeable,
single or return, mid-week or weekend, and the time of booking.
Azures insurance cover includes passenger liability, freight/baggage and compensation insurance. Premiums for
passenger liability insurance are determined on the basis of passenger miles flown.
Required:
(a) Identify and explain the business risks facing Azure.
(b) Describe how the risks identified in (a) could be managed and maintained at an acceptable level by Azure.
(a) Business risks

(b) Processes for managing

Rights to operate
Accept at the present level (as one that has to be
borne) but bear in mind (e.g. when making strategic
decisions) the impact that managements actions could
May be a guranteed minimum

have on any renewal of the rights.

Terms and conditions attached to the rights may

Relevant terms and conditions should be

threaten Azures operational existence if, for

communicated to all staff so they are clear about the

example, there are any circumstances under

importance of their areas of responsibility.

which the rights could be withdrawn. For

example, if the standard of service falls below a
minimum specified level.
Competition
Although at the moment there appears to be none (as

-Monitor the progress of applications for flights to

12

the rights are exclusive), any competition in the future

destinations which could provide transit to Lyme.

could reduce profitability (e.g. if the right was to

-Reduce the risk by increasing the reliability and

become non-exclusive or an indirect service between

reputation of Azures service, improving comfort etc

Sepiana and Lyme should be established).

(e.g. by increasing leg room and

providing air-conditioned lounges).

Age of aircraft
The age of the aircraft (35 years) is likely to have a

Azure should manage its cash flows and

bearing on fuel consumption and other costs (e.g.

borrowing capability (e.g. bank loan facility) to carry

repairs and maintenance).

out ongoing operating repairs as and when needed.

Engine overhaul
If the lease is a finance lease it is likely that Azure will

As above, Azure should budget its financial

have to bear the costs of the overhaul which may

resources to meet the costs of the overhaul, the timing

have a detrimental effect on cash flows.

of which can be planned for.

The service would need to be suspended while the

The lease agreement with the airline should

engine is being overhauled unless an alternative is

provide that an equivalent aircraft be available.

planned for.
Leased asset
Azure operates with just one leased asset which

-Azure should enter into a contractual arrangement

may be withdrawn from service:

(e.g. may be included within the terms of an operating

in the interests of passenger safety (e.g. in the event

lease) for a replacement aircraft in the event that the

of mechanical failure);

aircraft be grounded.

for major overhaul;

-Azure should carry adequate insurance cover for

if Azure defaults on the lease payments.

remedying

and/or

providing

compensation

to

customers for significant disruptions to the

scheduled service.
Fuel prices
Increases in fuel prices (a major operational cost) will

-Fuel surcharges should be included in the flights

reduce profitability.

price structure so that significant increases can be

passed on to the customers.
-Hedging against the effect of energy price (and
exchange rate) risks through forward contracts.

Weather
Weather conditions may delay or cancel flights.

Manage the impact of the risk/modify the business

activity. For example, as any form of travel may be
hazardous if weather conditions are so bad as to
disrupt the flight schedule There should be airconditioned facilities in which travelers can relax
before their journey.

Horticultural cargo
Certain produce may be prohibited from import

-Contracts with growers should clearly state items

(e.g. due to the risk of spread of disease).

-Azures

13

operational

controls

should

include

verification checks on produce carried.

Growers may seek to hold Azure liable for:

Azure should have adequate insurance cover

produce which perishes (e.g. if successive

against claims for damaged/lost cargo.

flights are cancelled);

impounded goods.
Economy
With significantly less demand for Business Class than

Keep demand for the classes of tickets under review

for Economy (which gets over-booked) and review and

and respond to the excess of supply over demand for

respond to the excess of supply over even less for First

Economy seating. For example:

Class, the service is operating at demand for Economy

charge higher prices for economy on peak

seating (and demand well below capacity (economy is

flights;

only 54% of seating capacity)

offer larger discounts for advance bookings on First

Azure may not be recouping fixed operating costs in

and Business Class seats;

the long run making the service

introduce a loyalty scheme for frequent users

uneconomical.

which offers preferred customer seat

upgrades.

Service levels
Azures schedule is described as efficient and

Azure should benchmark the timeliness of its service,

timely. If the level of service delivered does not meet

against a comparable airline service operating under

expectations it is unlikely that a regular customer base

similar weather conditions.

will be established.
On-board services
Passengers are expressing dissatisfaction with meals

Azure should consider:

provided, especially on the return flight from Darke.

changing caterer in Lyme;

The food prepared in Lyme may be stale or

a contract with a caterer in Darke;

contaminated by the time it is served.

expert advice (e.g. of a chef) on preserving

Passengers may be deterred from using this flight the

quality of meals for long-haul flights.
if they are subject to the risk of illness.
Passenger safety
Penalties for non-compliance with safety regulations

Staff training should be on-going with regular safety

(e.g. maintenance checks on life safety drill procedures

drill procedures.

(e.g. in evacuation
jackets, etc) may be incurred if inspection logs are not
kept.
Azure may face lawsuit for personal injury and illness

Safety procedures must be demonstrated before Azure

may face lawsuits for personal injury or take-off on
every flight and passengers referred to illness (e.g.
deep vein thrombosis dvt), safety information,

14

including how to reduce the risk, provided with each

seat.
Air stewards/Cabin crew safety
Azure will have difficulty recruiting and maintaining

Flight personnel rotas should ensure, for example,

the services of appropriately qualified cabin crew if it

pilots take ground leave between flights;

does not have sufficient regard for their health and

their health and safety.

safety.

there is adequate cover when crew are sick

or taking leave.

Emergency
A serious accident (e.g. fire), collision or breakdown

Accept at the present level, but taking all practicable

may threaten operations in both short and longer-term.

safety checks now implemented in the airline industry

to ensure that Azure is not exposed to preventable
risks. For example:
x-ray screening of checked-in baggage;

security screening

of

cabin

baggage

and

passengers, etc.
Flight personnel
Azure may not be able to service the flight in the event

The agreement with the airline should indemnify

of non-supply of flight personnel by the international

Azure for all costs and losses incurred if flights are

airline (e.g. due to strike action).

cancelled or disrupted due to non-availability of flight

personnel.

Flight tickets
Tickets are sold by more than one party (Azure and

Strict controls must be exercised over:

travel agents) and at more than one location. lso,

unused tickets;

pricing is complex, with a range of tariffs depending on

ticket pricing;

many factors. This increases the risk that

real-time reservations

revenue may be lost if passengers are undercharged

ticket refund and exchange transactions.

or ticket sales unrecorded; and

flights may be over-booked, with consequent loss of
customer goodwill.
The configuration of the aircraft does not currently

Commence negotiations with the international

meet the current demand profile of passengers and

airline for an amendment to the current lease

under the terms an operating lease may not be

and terms allowing flexibility in the seating

changeable.

arrangements.

15

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

16

Required:
(i) Identify and explain the business risks which should be assessed by the management of Hydrasports.
(ii) Explain how each of the business risks identified in (i) may be linked to financial statement risk.
Answer:
(i) Business risks

(ii) Financial statement risk

The standard design of facilities increases operational

The carrying amount of the associated non-current

risk as any difficulties encountered in one facility will

assets (i.e. equipment, fixtures and fittings) is likely to

be compounded by the number of other facilities

be overstated as they are likely to be impaired if they

(potentially all) which are similarly affected. This is

are not in use.

illustrated by the in use closure of the saunas.

Centralised control through company policy is

Management circumvention or override of control

resulting in inefficient and ineffective operations as

procedures laid down by head office may result in

managers cannot respond on a timely basis to local

system weaknesses. If errors arising are not detected

needs.

and corrected the risk of misstatement in the financial

statements is increased.

Business reporting risk is likely to be increased by

-Information processing risk is increased as accounting

centre managers preparing monthly accounting returns.

information flowing into the financial statements may

Operational risk may be increased if centre managers

not be properly captured, input, processed or output by

cannot fulfil their day-to-day responsibilities (e.g.

the centre managers.

relating centre managers. to customer satisfaction,

- Inherent risk, of errors arising, in monthly

human resources, health and safety).

branch returns is high.

Advanced payments contribute to business reporting

-Revenue may be overstated if an accurate cutoff is not

and financial (cash flow) risk. Cash received must be

achieved. In particular, there is an estimate risk in

available to meet the costs of providing future

determining the amount of deferred income at the

services.

balance sheet date.

- An error of principle may also arise if Hydrasports
revenue recognition policy does not comply with IAS
18 Revenue.

Hydrasports cannot operate a centre if a licence is

An error of principle arises if licences are not

suspended, withdrawn or not renewed (e.g. through

capitalised as intangible assets (but instead written off

failing a local authority inspection or failing to apply

as expenses when incurred).

for renewal).
Closure may result in customers finding alternative

Failure risk (i.e. that Hydrasports will not continue to

facilities with permanent loss of fee revenue.

operate as a going concern) is increased.

Early bird customers disatisfaction similarly

This creates disclosure risk if the disclosures relating

increases operational risk.

to going concern as the basis of accounting do not

17

meet the requirements of IAS 1 Presentation of

Financial Statements.
Serious accidents may prompt investigation by local

-If licences are withdrawn, the intangible asset

authority resulting in penalties, fines and/or

(amounts prepaid) should be written off to the extent

withdrawal of licence to operate.

that monies are not refundable.

- The likelihood of contingent (if not actual) liabilities
increases disclosure risk.

Although fees are non-refundable, suspension of a

Provisions may be understated at 31 December 2003 if

facility (e.g. sauna) may result in customers asking for

Hydrasports has a legal obligation to refund fees where

partial refund. In particular Hydrasports may have an

it has failed to provide services.

obligation to refund fees paid in advance when centres

are closed (e.g. the Verne centre from JulySeptember
2003).
Permanent loss of customers requiring childcare

Disclosure risk is (again) increased if fines/penalties

facilities increases operating risk. Compliance risk is

arising are material and not disclosed.

increased if the new guidelines are not met.

Similarly, inability to retain lifeguards increases
operational risk that pools cannot open (due to health
and safety regulations). Compliance risk is increased
by the possibility that pools may be operated without a
lifeguard being on duty.
High staff turnover indicates increased operational risk

Staff costs may be overstated as the risk that payments

(poor human resource management, inefficiency in

may be made to leavers is increased.

working practices, reduced capacity, etc).

Limitations on centre managers levels of authority

Any lack of integrity may increase the risk of

may not be commensurate with their responsibilities.

management and/or employee fraud, illegal acts and

Empowerment risk arises if managers are not properly

unauthorised use of company assets. In particular the

led (and if they, in turn, do not properly lead their

assertion of existence of assets may be at risk

centre staff).

(resulting in overstatement).

More centres may become loss-making if the reasons

Loss-making centres should be tested for impairment

for falling membership are not addressed.

as cash-generating units.

The

hydrotherapy

pool

cannot

operate

until

The value of the asset in construction should be written

construction is completed and completion may be

down if it is impaired (even though it has not yet been

threatened by cash flow difficulties.

brought into use).

Cash flow difficulties increase liquidity/financial risk.

See above reference to going concern and disclosure

risk.

Obsolete gym equipment increases operational risk as

-Depreciation may be overstated if Hydrasports

customer satisfaction decreases and health and safety

continues

risks are increased.

depreciated assets.

to

calculate

depreciation

on

fully-

- Disclosures for capital commitments (e.g. to replace

equipment) in the financial statements may be
inappropriate if Hydrasports does not have funds to
finance such commitments.

18

- See above reference to going concern and disclosure

risk.
The reduction in insurance cover reduces the

See above reference to going concern and disclosure

recoverable amount of assets in the event of loss

risk.

through fire (for example). Inability to replace

lost/damaged assets increases operational risk (see
obsolete gym equipment
above).
Operational risk is increased if the substantial increase

Disclosure risk is increased in relation to contingent

in liability insurance premiums is a reflection of an

assets (for reimbursement under insurance policies).

increase in the level of claims being made.

3. The principal activity of Bateleur Zoo Gardens (BZG) is the conservation of animals. Approximately 80% of the
zoos income comes from admission fees, money spent in the food and retail outlets and animal sponsorship. The
remainder comprises donations and investment income.
Admission fees include day visitor entrance fees (gate) and annual membership fees. Day tickets may be prebooked by credit card using a telephone booking hotline and via the zoos website. Reduced fees are available
(e.g. to students, senior citizens and families).
Animal sponsorships, which last for one year, make a significant contribution to the cost of specialist diets,
enclosure maintenance and veterinary care. Animal sponsors benefit from the advertisement of their names at the
sponsored animals enclosure.
BZGs management has identified the following applicable risks that require further consideration and are to be
actively managed:
(i) Reduction in admission income through failure to invest in new exhibits and breeding programs to attract
visitors;
(ii) Animal sponsorships may not be invoiced due to incomplete data transfer between the sponsoring and
invoicing departments;
(iii) Corporate sponsorships may not be charged for at approved rates either in error or due to arrangements with
the companies. In particular, the sponsoring department may not notify the invoicing department of reciprocal
arrangements, whereby sponsoring companies provide BZG with advertising (e.g. in company magazines and
annual reports);
(iv) Cash received at the entrance gate ticket offices (kiosks) may not be passed to cashiers in the accounts
department (e.g. through theft);
(v) The ticket booking and issuing system may not be available;
(vi) Donations of animals to the collection (e.g. from Customs and Excise seizures and rare breeds enthusiasts)
may not be recorded.
Required:

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

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

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(v) Systems not available

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

21

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

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

23

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

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

24

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

25

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

26