95129349 ACCA P1 Final Assessment Answers J12

ACCA

Paper P1

Governance, Risk and Ethics June 2012

Final Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the final assessment questions and submitted them for marking.

ACCA P1 GOVERNANCE, RISK AND ETHICS

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© Kaplan Financial Limited, 2012

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FINAL ASSESSMENT ANSWERS

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ANSWER 1

Key answer tips

This question spans a range of syllabus areas covering governance, risk and ethics. Ensure that you manage your time carefully to tackle all parts of the question.

Part (a) focuses on an important corporate governance topic of board structure, requiring application of theoretical points to this scenario. Stakeholders are a frequent exam topic, and the subject of two articles by the examiner. These are covered in part (b). Part (c) (ii) can be answered with knowledge from the examiner’s article on Risk and Environmental Auditing. Part (d) provides a small theoretical element in an otherwise ‘application’ question.

(a) Two-tier board structure

There are arguments for and against unitary and two-tier boards. Both have their ‘place’ depending on business cultures, size of business and a range of other factors.

Advantages of a two-tier board

Within a two-tier board structure there will be a management board, with responsibility for managing the business, and a supervisory board which appoints, supervises and advises members of the management board. This structure results in a clear separation between those that manage the company and those that own it, or must control it for the benefit of shareholders.

There is active involvement from major shareholders and stakeholders (such as banks and worker’s representatives) in the strategy and decisions of the business, which will minimise issues arising from the agency relationship and any associated agency costs.

The two boards will allow for independence of thought and open discussion, since the board meetings and their operations are separate.

The shareholder and stakeholder representatives have direct power over the management of the business through the right to appoint members of the management board.

Disadvantages of a two-tier board

One of the main features of a unitary board is the presence of independent non-executive directors (NEDs) working alongside executive directors, with an equal legal and executive status in law. The existence of the independent scrutiny that these NEDs bring to the board is something that is lacking in a two-tier board structure.

There is potential for confusion over authority between the separate boards and a resultant lack of accountability in a two-tier board structure.

The potential exists for the supervisory board to become isolated and distanced from the operational reality of the business through non-participation in management board meetings.

In practice there is a risk that management information may not be passed to the supervisory board, or that information may be restricted. This is particularly likely if relations become strained between members of the two boards.


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The involvement of multiple stakeholders in the decision making of the business may lead to slower decision making since many conflicting viewpoints will need to be discussed. The structure leads itself to additional bureaucracy with major decisions requiring discussion at both board meetings.

Case for the Baltic Pipe board remaining a two tier structure

The pipeline project requires significant international cooperation, since it will impact on many countries. For this reason it will be essential that national and regional governments are working with Baltic Pipe. The presence of senior political figures from a number of countries on the supervisory board ensures that their views and concerns are heard, and that their support for the project is guaranteed.

A further critical factor in the success of this project, and hence the company, will be the commitments from the major gas suppliers to utilise the pipeline and from the energy companies to purchase this gas supply. Again, having representatives of these companies on the supervisory board ensures that their interests are protected, or at least considered.

The significant technological challenges facing the company as they build these gas pipelines will necessitate a great amount of focus for the management board. The clear separation of responsibility present in a two-tier structure will permit this, allowing the supervisory board to continue to focus on shareholders' interests.

The management board, particularly the chief finance officer, Melanie Zubrowski, are engaged in raising the necessary finance to fund the construction of the pipeline. The potential for fraud, or inappropriate payments to directors, will be significantly reduced by the supervisory power of the upper board.

(b) Stakeholders of Baltic Pipe

There are many stakeholder groups who will be affected by, or can affect, Baltic Pipe. These include the following:

• The shareholders of the company are a major stakeholder. In this situation the shareholders are also the major customer of the pipeline (Gazco) and those who will utilise its services (the European energy companies). So protecting shareholder interests will ensure that a range of stakeholder interests are also considered.

• The Russian government will be affected by the project as the country earns significant income from the export of gas. In addition there will be employment opportunities in both the construction and operational phases for Russian residents, potentially in rural areas of high unemployment.

• The final consumers of energy in Europe who require a supply of gas, or any other method of generating power to meet their needs.

• The pipeline construction companies; the contract for construction will be significant for any company that wins the work even though the work is being split. The involvement in such a project will require innovative technology and significant investment in liaison and coordination with other companies.

• Wildlife in the seas will be affected by both the construction and operation of the pipelines. Their interests are likely to be represented by wildlife pressure groups.

• Banks; Baltic Pipe is aiming to raise approximately €5.6bn in debt finance (70% of €8bn) of which a significant amount is likely to come from banks and other financial institutions.


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Tutorial note

There are a number of other stakeholders that could have been identified here, and marks will be awarded for sensible suggestions. To assist in the second part of the question it is useful to consider those in different areas of the Mendelow matrix.

Influence of the stakeholders

In strategic analysis, the Mendelow framework is often used to attempt to understand the influence that each stakeholder has over an organisation’s objectives and/or strategy. The idea is to establish which stakeholders have the most influence by estimating each stakeholder’s individual power over, and interest in, the organisation’s affairs. The stakeholders with the highest combination of power and interest are likely to be those with the most actual influence over objectives.

Power is the stakeholder’s ability to influence objectives (how much they can), while interest is the stakeholder’s willingness (how much they care).

Influence = Power x Interest

Shareholders of Baltic Pipe

The shareholders of this company have a high degree of power over the business and its decisions. There are only four shareholders, each with significant holdings, so their views will all be heard. There is the likelihood that Gazco’s interests will dominate since it is the majority shareholder.

The interest of these shareholders is also very significant since they will be contributing 30% to the costs of the construction project, and all have significant interest in it on an ongoing operational basis.

This stakeholder group would be considered a ‘key player’ in the Mendelow framework.

Russian government

The Russian government’s power over this company is significant, but it will not be able to dominate decisions. The supervisory board has representatives of EU countries, and 49% of the shares are held by non-Russian organisations.

The interest of the Russian government is extremely high: eight per cent of GDP is earned through gas exports and it needs a secure means of exporting gas. The existing pipelines which cross former Soviet Bloc countries have encountered problems in recent years so this new project is extremely welcome.

Again the Russian government would be considered a ‘key player’ though its power is less than that of the shareholders.


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European consumers

The European consumers will have limited power to affect Baltic Pipe’s actions on an individual basis. As represented by their national governments and EU authorities their power can increase, but, as individuals, it remains low.

Consumers are unlikely to be particularly interested in where the energy they utilise comes from, as long as the supply is sufficient to meet their needs. This results in their current level of interest being low, but if the supply of power were limited or threatened, their interest in Baltic Pipe would increase significantly.

At present this stakeholder group requires minimal effort on the part of Baltic Pipe.

Construction companies

It will be essential for Baltic Pipe to appoint construction companies to build the pipeline who can work together as required by the project and deliver within the timescales and budgets set. As such the companies have a high degree of power over Baltic Pipe. Given that this construction is a highly specialised activity, it is likely that it will be hard for Baltic Pipe to replace a contractor for under performance. This will give the contractors a degree of power, but it is balanced by Baltic Pipe’s ability to withhold payment / charge penalties for failure.

The contracts for this work will be significant and will hence be highly sought after by the construction companies. As such their degree of interest in the decisions of Baltic Pipe will be high.

These companies will probably fall into the high interest / low power category, requiring Baltic Pipe to keep them informed.

Sea wildlife / pressure groups

Given the significant sums of money involved in this project and the high degree of political support for it, the power of wildlife pressure groups is likely to be low. It will only be through campaigning and raising public awareness that they may have any influence on the activities of Baltic Pipe.

The interest of the wildlife groups will be very high, since the construction of a pipe below the Baltic Sea will have a significant impact on the natural environment and its inhabitants.

This group will also need to be kept informed, so that their campaigning does not start to engender political interest.

Banks and other providers of debt finance

The providers of debt finance to Baltic Pipe have a significant degree of power over the company, since without this finance the pipelines cannot be built and so the business will fail.

The interest of these banks will simply be to have their interest payments met and loans repaid as agreed. Beyond that, they have little interest in the actions of the company, simply requiring the financing terms to be met.

This group fall into the Mendelow category that requires the company to ‘keep satisfied’, i.e. adhere to financing terms.


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Tutorial note

You may have differing views of the power and interest of stakeholders. As long as views are explained and justified marks will be awarded.

(c) Press statement

Baltic Pipe is delighted to announce the completion of the extensive research programme to gather technical and ecological data for the Baltic Sea. The resultant data is available for all to access and review. This constitutes one of the largest surveys of its kind, and it is hoped reflects Baltic Pipe’s commitment to environmental and wildlife issues.

To further demonstrate the company’s commitment to these matters Baltic Pipe are announcing additional environmental control measures that they are implementing within the business:

• analysis of the company’s environmental footprint, and

• introduction of a programme of environmental audit.

These measures are discussed in further detail below; definitions and explanations of the techniques are provided along with explanations of their introduction into Baltic Pipe.

Environmental footprint

The environmental footprint is the impact that a business’ activities have upon the environment in terms of resource consumption and pollution emissions. The use of the term ‘footprint’ with regard to the environment is intended to convey a meaning similar to its use in everyday language. In the same way that humans and animals leave physical footprints that show where they have been, so organisations such as Baltic Pipe leave evidence of their operations in the environment. They operate at a net cost to the environment.

Baltic Pipe’s environmental footprint

Utilising the results of the research, Baltic Pipe will be undertaking an exercise to analyse and quantify its environmental footprint. An initial assessment, referring to the definition provided above, is as follows:

Resource consumption

During the construction phase the company will require significant inputs of raw materials (such as sand, gravel and limestone to make concrete) and energy (to operate the equipment to construct the pipelines).

Once the pipelines are operational, there will be an energy cost associated with delivering the gas to Europe. Office premises and other buildings associated with running the business will be a drain on natural resources, requiring energy and water supplies.


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Pollution emissions

The construction phase will have an impact on the natural environment in the form of noise pollution from equipment, emissions from the machinery itself and the production of the energy necessary to power the machinery.

There will also be adverse impacts on the sea life, particularly fish stocks that may be affected by the activity along the seabed to lay the pipelines.

The impact once the pipelines are operational should be much less dramatic. The research data will enable Baltic Pipe to quantify the impact on sea life, since the surrounding water may change in temperature with the flow of gas along pipelines.

The supply of the environmental friendly fuel to Europe will lead to a net benefit to the environment above sea level, with a reduction in pollution emitted from the energy production.

Environmental audit

The introduction of an environmental audit once the pipelines are operational will enable Baltic Pipe to demonstrate its responsiveness to concerns raised by shareholders and other stakeholders regarding its environmental impact. The resultant environmental audit report will provide reassurance to all stakeholders, as well as demonstrating that the company has systems in place for the collection of data that can also be used in wider environmental reporting.

An environmental audit typically contains three elements: agreed metrics (what should be measured and how), performance measured against those metrics, and reporting on the levels of compliance or variance.

The metrics to be used in an environmental audit of Baltic Pipe may include the following:

• measures of pollution from pipeline equipment at ground level (pumping equipment),

• measures of impact on fish stocks within a given proximity of the pipelines, and

• energy consumption of the various company premises.

These are effectively quantitative measures of the organisation’s environmental footprint, as discussed above.

Given that the aim of environmental management is to reduce the footprint of the business, targets would be set against each of these measures, and compliance against these targets, along with the resultant variances, would be measured by the auditors and reported upon.

Baltic Pipe intends to commence work on deriving its environmental footprint during the construction phase immediately with an expectation that results will be published by the end of 2009. The environmental audit programme will not commence until the pipelines are in operation.

For any more information please contact the Baltic Pipe press office.


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(d) Risk and return

Reasons why management balance risk and return

Risk management can be thought of as the process of reducing the possibility of adverse consequences either by reducing the likelihood of an event or its impact. However, it is important to remember that there are two sides to risk: ‘downside risk, i.e. the adverse consequences, and ‘upside risk, the positive outcome.

Incurring an ‘acceptable’ amount of risk can lead to a business becoming more competitive, whereas not accepting risk tends to make a business less dynamic.

Historically, the focus of risk management has been on preventing loss. However, recently, organisations are viewing risk management in a different way, so that:

• risks are seen as opportunities to be seized.

• organisations are accepting some uncertainty in order to benefit from higher rewards associated with higher risk.

• risk management is being used to identify risks associated with new opportunities to increase the probability of positive outcomes and to maximise returns.

• effective risk management is being seen as a way of enhancing shareholder value by improving performance.

A business such as Baltic Pipe would not be successful were management not willing to take a certain degree of risk to generate a return. For example, the technological challenges that will be faced in construction of such massive pipelines are huge and there are numerous risks of events not materialising as had been expected, or budgeted for. However, the result is two pipelines with a 50 year life and already a guaranteed income stream for 22 years. Without taking the construction risk, this return would not be attainable.

Risk appetite

Risk appetite is the amount of risk that an organisation is willing to accept in the pursuit of value. It is directly related to an organisation’s strategy and may be expressed as the acceptable balance between growth, risk and return.

Risk appetite may be made explicit in organisational strategies, policies and procedures. Alternatively it may be implicit, needing to be derived from an analysis of organisational decisions taken.

Risk appetite can be considered to consist of two components:

The risk capacity which is an assessment of the amount of risk that an organisation is able to take, and withstand any adverse consequences of taking a risk such as failure of a business strategy.

The risk attitude which reflects the view of the business towards risk. Is it prepared to take high risks to seek high returns, or is it going to adopt a more risk averse stance? This does not take into account the amount of risk that the business can afford to take (this is the capacity) – it simply looks as a desire or opportunity to seek returns via risk.


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Marking scheme Marks (a) 1 mark for each relevant point made on advantages of two-tier boards

1 mark for each relevant point made on disadvantages of two-tier boards 1 mark for each relevant point made in applying advantages to Baltic Pipe (no marks for applying disadvantages, question requires a case FOR)

Up to 4 Up to 4 Up to 4

–––– Maximum 10 –––– (b) 1 mark for identifying, with brief explanation, any relevant stakeholder 1 mark for each point made assessing influence of stakeholder groups, up to

2 marks for each group

Up to 6 Up to 12

–––– Maximum 15 –––– (c) (i) 1 mark per point in definition of environmental footprint:

– resource consumption – pollution emissions – other relevant point

Up to 2

1 mark per point for discussion in the context of Baltic Pipe Up to 4 –––– Maximum 6 –––– (ii) 1 mark per point for explanation of what an environmental audit is Up to 2 1 mark per point for how it would be applied, with additional 1 mark for

application to Baltic Pipe: – metrics – targets and variances – report

Up to 4

–––– Maximum 6 –––– Professional marks available for:

– structure of statement (introduction and concluding sentences) – written in style of press statement – covers required areas, and without including irrelevant

information – logical flow of points and linkages between sections

Up to 4

–––– Maximum for part (c) 16 –––– (d) 1 mark for each relevant point regarding the balance of risk and return:

– upside risk as well as downside – acceptable risk – trade-off – any point made in application to Baltic Pipe Explanation of risk appetite Extending this to risk attitude and capacity (1 mark for each correct explanation)

Up to 5

Up to 2 Up to 2

–––– Maximum 9 –––– Total 50 ––––


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ANSWER 2

Key answer tips

This question covers the areas of internal control and audit. Note the requirement of part (a) is to critically evaluate, which incorporates good and bad points about the system.

You can earn several marks in part (b) for pure theory, but to get full marks you will need to apply to the scenario. Part (c), however, requires no application to the case of WCE.

(a) WC Engineering and a ‘sound’ system of internal control

Features of sound control systems

The Turnbull code employs the term ‘sound’ to indicate that it is insufficient to simply ‘have’ an internal control system. They can be effective and serve the aim of corporate governance or they can be ineffective and fail to support them. In order to reinforce ‘soundness’ or effectiveness, systems need to possess a number of features. The Turnbull guidance described three features of a ‘sound’ internal control system.

• The principles of internal control should be embedded within the organisation’s structures, procedures and culture. Internal control should not be seen as a stand-alone set of activities and by embedding it into the fabric of the organisation’s infrastructure, awareness of internal control issues becomes everybody’s business and this contributes to effectiveness.

• Internal control systems should be capable of responding quickly to evolving risks to the business arising from factors within the company and to changes in the business environment. Any change in the risk profile or environment of the organisation will necessitate a change in the system and a failure or slowness to respond may increase the vulnerability to internal or external trauma.

Sound internal control systems include procedures for reporting immediately to appropriate levels of management any significant control failings or weaknesses that are identified, together with details of corrective action being undertaken. Information flows to relevant levels of management capable and empowered to act on the information are essential in internal control systems. Any failure, frustration, distortion or obfuscation of information flows can compromise the system. For this reason, formal and relatively rigorous information channels are often instituted in organisations seeking to maximise the effectiveness of their internal control systems.

Tutorial note

Where a question refers to a sound system of controls you are required to discuss the three points covered above.

A requirement asking how to review the effectiveness of an internal control system would lead you to COSO’s 5 elements: control environment, risk assessment, control activities, information and communication and monitoring.



Shortcomings at WC Engineering

The case highlights a number of ways in which the internal control at WC Engineering fell short of that expected of a ‘sound’ internal control system.

First, and most importantly, the case suggests that the culture of WC Engineering did not support good internal control. Training is critical to ensuring that all operatives can carry out their jobs effectively, but based on the shift team leader’s comments about “sloppy training” it appears that WC Engineering do not place appropriate emphasis on this. The focus of the manager in question was on output, and seemingly at all costs. While having systems in place to support sound internal control, it is also important to have a culture that also places a high priority on it.

Second, there is evidence of that the control systems have not been updated to reflect the changing pattern of operations in the business. Rapid growth and expansion of product lines will have resulted in many new operatives and potentially new components being used. It may be that the procedures for both stores and training new operatives were adequate when the business was smaller, but have not been able to cope with the rapid expansion.

Third, there is evidence of a lack of reporting procedures at WC Engineering. Complaints about poor components have previously been ignored, and the shift team leader stated that his manager was not interested in taking action regarding his training concerns. If operatives and team leaders are unable to raise their concerns nothing can be done to resolve problems within the control systems.

Finally it appears that monitoring of the operations of the business, and hence identification of any problem areas does not appear to be working effectively. Issues with quality of components have been arising over the last few months with no apparent action being taken. The responsibility for ensuring the effective operations of any internal control system has to lie, in part, with the managers responsible for overseeing the operations of the business. Mistakes, rework, stoppages and delays should have led to these matters being investigated.

(b) Establishment of internal audit

There is an obvious cost involved in setting up internal audit in an organisation and so it is typical to ask what factors signify the need for internal audit before one is established. Several factors influence the need for internal audit:

• The scale, diversity and complexity of the company’s activities. The larger, the more diverse and the more complex a range of activities is, the more 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 considerations. Management must be certain of the benefits that will result from establishing internal audit and it must obviously be seen to outweigh the costs of doing so.

• Changes in the organisational structures, reporting processes or underlying information systems. Any internal (or external) change is capable of changing the complexity of operations and, accordingly, the risk.



• Changes in key risks could be internal or external in nature. 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 control systems. Any problems with existing systems clearly signify the need for a tightening of systems and increased monitoring.

• An increased number of unexplained or unacceptable events. System failures or similar events are a clear demonstration of internal control weakness.

Internal audit at WC Engineering

The situation at WC Engineering highlights a number of factors that would underpin its need to establish internal audit:

Firstly there has been growth in number of products, activities and (presumably) processes in recent times, thereby complicating the internal environment and introducing more opportunity for internal control failure.

Secondly, there have been problems with internal control systems such as the component quality causing delays and rework, and the mistakes made by new operatives.

Finally, there was an unacceptable event in the form of the Delta line stoppage that was attributed to poor training and control processes. As Jon Benedict described, this was ‘entirely avoidable’.

(c) Objectivity

Objectivity is a state or quality that implies detachment, lack of bias, not influenced by personal feelings, prejudices or emotions. It is a very important quality in corporate governance generally and especially important in all audit situations where, regardless of personal feeling, the auditor must carry out his or her task objectively and with the purpose of the audit uppermost in mind. The IFAC Code of Ethics explains objectivity in the following terms (Introduction, clause 16): ‘… fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity.’

Protection of professional objectivity

According to the King Report: ‘Internal audit is an independent objective assurance activity. It brings a disciplined approach to evaluate risk management, control and governance.’ To ensure that the internal audit function provides an objective assessment of control systems and their weaknesses, there should be measures in place to protect the independence of the internal audit department.

• The internal auditors should be independent of executive management and should not have any involvement in the activities or systems that they audit (avoid self-review)

• The head of internal audit should report directly to a senior director or the audit committee. Even if this is not the case, the head of internal audit should have direct access to the chairman of the board of directors, and to the audit committee, and should be accountable to the audit committee (Smith Guidance).

• The audit committee should approve the appointment and termination of appointment of the head of internal audit.



• (The latter two measures should help to protect the objectivity and independence of the head of internal audit, e.g. from undue influence from the finance director and/or CEO.)

• The independence of internal audit is enhanced by following accepted standards of internal audit work. Internal auditors can follow the same standards as external auditors. However, there are also International Standards for Internal Audit issued by the Internal Auditing Standards Board (IASB) of the Institute of Internal Auditors, such as attribute standards and performance standards.

Marking scheme Marks

(a) Description of ‘sound’ control systems – up to 2 marks for each relevant point

Up to 6

MUST be the three key points of:

– principles should be embedded

– system should respond to evolving risks

– procedures for reporting of control failings

Explanation of shortcomings at WC Engineering plc – 1 mark for each relevant point

Up to 6

––––

Maximum 10

––––

(b) 1 mark for each factor identified and briefly discussed Up to 7

Factor applied to WC Engineering – 1 mark for each relevant point Up to 5

––––

Maximum 10

––––

(c) Definition of objectivity Up to 2

Protection of professional objectivity / independence – 1 mark for each relevant point

Up to 4

––––

Maximum 5

––––

Total 25

––––



ANSWER 3

Key answer tips

(a) A good testing requirement here, asking you to stick within the boundaries of the requirement on ‘scope of regulation’ not just run a commentary on how bad the Governance at ABC is.

(b) A clear ‘comply or explain’ requirement

(c) Showing an understanding of the concept of ‘Insider trading’ is the key to this success here.

(a) Governance regulation

It is a certainty that a company such as ABC, will need to operate within a legal framework that inevitably includes legislation similar to the Companies Act 2006 in the UK. Beyond this there will be a wealth of regulation regarding competition (price fixing), health and safety and employee rights.

Stock exchange listing in this principles based regime suggests regulation through structures similar to the Corporate Governance Code with the UK. This includes detailed provisions regarding directorial duties including those discussed such as the need for committees. It might extend to the need for clarity in reporting, the need to review risks and controls as well as issues relating to director remuneration.

Listing also suggests regulation through the organisation controlling the stock exchange. In the UK this would be the Financial Services Authority authorising a model code for all members. In addition to coverage under the law, restrictions over the buying and selling of shares using insider information would be covered here.

The CFO is mentioned in the scenario. Governance regulation of a financial officer inevitably requires adherence to the IFAC code of ethics since virtually all professional finance officers come under its remit. This would question what the CFO should do if he found out about the use of inside information in order to gain advantage.

Although slightly tenuous since few details of the organisation are given, it might be suggested that other international standards such as ISO 9001 or ISO14001 may form the basis for internal regulation, control and governance of the company. The former has particular relevance to manufacturing, the latter depends on the need for environmental management systems in order to deal with potential environmental damage as a result of manufacturing operations.

Negative impact of governance regulation

Mr Toon points to the costs of governance in terms of structures such as committees. This cost includes the bureaucracy created through new reporting channels as well as the human costs involved remunerating NED’s. Any governance action needs to be administered and reported upon and so the greater the level of regulation the greater the bureaucracy and cost.

Costs have a negative effect on the ability to compete. The scenario makes it clear that it operates as a problem for smaller companies who have difficulty in absorbing these costs in comparison with their larger local competitors.



This negative impact on competitiveness can also be viewed in relation to overseas competitors. Such organisations may operate in a less stringent regulatory environment and so have a greater degree of flexibility and autonomy in operation and subsequently lower costs.

Governance cannot hope to cover all of the risks faced by investors and yet it may be charged with giving the false impression that it does. The existence of governance regulation can assist in reducing risk but does not assist in eliminating it. A failure to appreciate this point can lead investors to overestimate the safety of their investments or the robustness of the market itself. Historically this has been seen to be a significant issue.

However the extent of the negative impact of Governance regulation, must be measured with the positive impact on a company’s share price good governance can have and the fact that reducing risk is critical to the long term survival of a company such as ABC.

A related point is that governance is a reactive process. Improvements or additional rules only tend to come about due to evidence of failure from given corporate disasters. This being the case governance can be viewed as continually reducing the size of the hole in corporate regulation whilst at the same time recognising that tears in the fabric of governance keep arising elsewhere.

(b) Regulatory reaction to committee decision

The decision not to employ committee structures has no implication for the organisation in one sense. This is because the organisation operates within a principles based regime and so the need to comply with regulation is left to each individual company. They may decide not to adhere to most regulation without fearing sanction from the regulatory authority.

Principles based jurisdictions do however include the need to adequately disclose to shareholders the reasons why structures such as committees have not been used. This is why they are referred to as comply or explain regimes. Adequate information regarding this issue must be placed in the annual report.

Failure to do this would be considered to be a failure to adhere to the code and sanctions from the regulatory authority would follow. These sanctions would include penalties and fines and eventual delisting if remedial action is not forthcoming.

Any reprimand of this nature will inevitably affect market perceptions and will probably wipe out any share price gains that occurred through the release of the positive interim results.

(c) Possible outcomes to the agreement

It is a sad fact that the most likely outcome of the agreement between the two men is that they will commit a criminal act but will not be held accountable for it. If their crime is detected then they may be prosecuted under criminal law for insider trading should this type of legislation exists.

A lesser burden of proof, on the balance of probabilities rather than beyond all reasonable doubt, can be found in civil action taken through regulators in order to prove market abuse. Criminal action tends to suggest prison sentences, criminal action suggests fines. If it can be proven it is inevitable that Mr Toon would be removed as a director under relevant Company Act legislation and further disqualified from attaining a similar position for a period in the future, possibly 5 years.



As suggested, the most likely outcome is that both men make considerable amounts of money from the deal. However, with the advent of more sophisticated technologies to analyse trends and anomalies in the buying and selling of shares, there is greater likelihood today that they may be caught and punished.

Marking scheme Marks (a) Discuss scope of Governance

1 mark for each relevant point made Discuss the negative impact 2 mark for each relevant point made

Up to 5

Up to 10 –––– Maximum 15 –––– (b) Discuss likely regulatory action

1 mark for each relevant point made .

Up to 5 ––––

Maximum 5 (c) Discuss outcome of agreement

Define and explain ‘insider trading’ Apply to ABC

–––– 2 3

–––– Maximum 5 –––– Total 25

––––

ANSWER 4

Key answer tips

(a) There are a number of risks that could have been indentified from the scenario. The model answer only contains a selection. The marking scheme with reflect this open ended requirement by awarded one mark per valid point

(b) Strategies to manage risk = TARA

(c) Assessment of each risk should include reference to the Probability of consequence and potential impact, often referred to as the ‘Risk map’

(a) Identification of risks

Risk can defined as the possibility that events or results will turn out differently from that which is expected. There are a number of risks facing Hansen - SIX key risks are outlined below.

• The unexplained fall in gross profit in some stores may be indicative of fraud or other accounting irregularities. Low gross profit in itself may be caused by incorrect stock values or loss of sale income. Incorrect stock levels in turn may be caused by incorrect inventory counting or actual stealing of inventory by employees.

Similarly, loss of sales income could result from accounting errors or employees fraudulently removing cash from the business rather than recording it as a sale.



• Transferring data to head office at the end at each day may be inadequate for backup purposes. There is a risk that failure of computer systems during the day will result in loss of that day’s transaction data.

• Although inventory information is collected using the system, re-ordering of inventory takes a significant amount at time. Transferring data to head office for central purchasing may lead to some discounts on purchase, but the average 12–14 days before inventory is received at the store could result in the company running out of inventory (i.e. stockouts).

• The possibility of sunlight making some of Hansen’s products potentially dangerous may give rise to loss of sales, inventory recall and may even expose Hansen to legal action in the form of compensation for damages.

• The company is dependent on one market sector and vulnerable to competition in that sector. If the current trend for healthy outdoor activities declines, Hansen will suffer since most of its business is concentrated in this one sector.

• The most important social change is probably a change in fashion. Hansen has not changed its product designs for several years indicating some lack of investment in this area. Given that fashions tend to change frequently, Hansen may experience falling sales as customers seek new designs for their outdoor clothing.

(b) Risk management strategies

Tutorial note

This should be an easy four book work marks. Make sure you link Risk strategies with the TARA framework

There are four strategies for managing risk and these can be undertaken in sequence. In the first instance, the organisation should ask whether the risk, once recognised, can be transferred or avoided.

Transference means passing the risk on to another party which, in practice means an insurer or a business partner in another part of the supply chain (such as a supplier or a customer).

Avoidance means asking whether or not the organisation needs to engage in the activity or area in which the risk is incurred. In some cases it may be possible to restructure a process, or pull out of a market, and hence avoid a particular risk completely.

If it is decided that the risk cannot be transferred nor avoided, it might be asked whether or not something can be done to reduce or mitigate the risk. This might mean, for example, reducing the expected return in order to diversify the risk or re-engineer a process to bring about the reduction.

Finally, an organisation might accept or retain the risk, believing there to be no other feasible option. Such retention should be accepted when the risk characteristics are clearly known (the possible hazard, the probability of the risk materialising and the return expected as a consequence of bearing the risk).



(c) Risk analysis and strategies

Tutorial note

It helps here if you have planed your answer, and have realised when doing part a) you will need to refer back to the risks you have identified and assess them with a greater level of depth. Also the requirement asks you to recommend a strategy, so again careful planning would ensure a student thought carefully about how to best approach this 15 marks

By identifying and profiling the effect (impact or consequences) of a risk and the likelihood (probability) of occurrence Hansen can assess the risk and its significance to the business. This process, often referred to as risk mapping, will enable a decision to be made as to the appropriate strategy for a given risk.

• Accounting/cash irregularities

The potential impact on Hansen is loss of income either from inventory not being available for sale or cash not being recorded. The overall total amount is unlikely to be significant as employees would be concerned about being caught stealing.

However, the probability of occurrence is quite high for a business with cash and stock accessible to employees.

The risk can be reduced by introducing additional controls including the necessity of producing a receipt for each sale and the reconciliation of cash received to the till roll by the shop manager. Loss of inventory may be identified by more frequent checks in the stores or closed-circuit television.

• Systems backup

The potential impact on Hansen is relatively minor; details at one shop’s sales could be lost for part of one day. However, the cash from sales would still be available, limiting the actual loss.

The probability of this occurring would depend entirely on the robustness of the organisation’s computer systems. If they are up to date and appropriately maintained and protected, this will have a low likelihood.

To reduce this risk additional procedures could be implemented to back up transactions as they occur, using online links to head office. The relative cost of providing these links compared to the likelihood of error occurring will help Hansen decide whether to implement this solution.

• Delays in inventory ordering following head office collation

The potential impact on Hansen is immediate loss of sales, as customers cannot purchase the garments that they require. In the longer term, if running out of inventory becomes more frequent, customers may not visit the store because they believe inventory will not be available. They may choose to take their business to a competing store, or to purchase on line.



The probability of the loss of custom is quite high since customers will have a number of alternative methods of purchasing the items they require, and often require the goods straight away.

The risk can be avoided completely by letting the stores order goods directly from the manufacturer using an extension of the current electronic point of sale system. Costs incurred will relate to the provision of Internet access to the shops and possible increase in cost of goods supplied. However, this may be acceptable compared to overall loss of reputation.

• Products releasing toxic chemicals

The impact on Hansen is the possibility of having to reimburse customers and the loss of income from the product until the problems are resolved. The probability of this occurring is hard to gauge until further investigations have been undertaken into this claim.

There is a more significant impact if a claim for damages is made against Hansen as a result of these chemicals. The probability of a successful claim being made would be low since it is unlikely that chemicals released from an item of clothing could seriously harm an individual.

The risk can be reduced by Hansen taking the claim seriously and investigating its validity, rather than ignoring it. For the future, guarantees should be obtained from suppliers to confirm that products are safe and insurance taken out against possible claims from customers for damage or distress, thereby transferring the risk to the insurer.

• Market sector

The potential impact on Hansen largely depends on its ability to provide an appropriate selection of clothes. It is unlikely that demand for its products will fall to zero, so some sales will be expected. However, an increase in competition, or decline in business in that economic sector, may result in falling demand, and without some diversification, this will automatically affect the overall sales of Hansen.

The likelihood of this occurring can be better assessed by reviewing consumer spending patterns. Current trends indicate that the ‘healthy living’ sector will continue to be strong, but the introduction of competition into this sector is harder to predict.

To a large extent Hansen will have to accept the risk of a decline in the popularity of the sector as a whole since there is little that the business can do to influence overall consumer spending patterns and tastes. However, Hansen can minimise the impact of competition in the clothing market by diversifying into other areas. Given that the company sells outdoor clothes, then commencing sales of other outdoor goods such as footwear and camping equipment may be one way of diversifying risk.



• Fashion leading to a reduction in demand

Given that Hansen appears not to have updated its ranges for a number of years the likelihood that it will lose business due to being ‘out of date’ is quite high.

The impact on the business could be significant if competitors are keeping their products more in fashion, though it might be offset by the fact that the outdoor clothing ranges are rarely expected to be at the height of fashion. Ultimately the risk of loss of demand and business to competitors may undermine Hansen’s ability to continue in business.

This risk can be reduced by having a broad strategy to maintain and develop the brand of Hansen. The board must therefore allocate appropriate investment funds (R&D) to updating the products and introduce new products to maintain the company’s image.

Tutorial note

The strategies for the individual risks identified in the case are not the only appropriate responses and other strategies are equally valid providing they are supported with adequate explanation



Marking scheme Marks

(a) 1 mark for each risk identified and explained

(1/2 mark only for bullet points)

6

––––

Maximum 6

––––

(b) 1 mark for each strategy identified and explained

(½ mark just for identification of each strategy)

– Transfer

– Avoid

– Reduce

– Accept

(Note: no marks for other, or more general, strategies)

4

––––

Maximum 4

––––

(c) For each risk:

– 1 mark for assessment of impact (with reasons)

– 1 mark for assessment of likelihood (with reasons)

– 1 mark for strategy recommendation (with explanation)

(must state one of the TARA strategies with explanation)

up to maximum 3 marks for each risk

15

––––

Maximum 15

––––

Total 25

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95129349 ACCA P1 Final Assessment Answers J12

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