iia advanced diploma past paper pack financial … · blakeley plc* is a budget airline operating...

Chartered Institute of Internal Auditors - Past paper pack

Past Paper Pack Chartered Institute of Internal Auditors 13 Abbeville Mews, 88 Clapham Park Road, London SW4 7BX February 2016

IIA Advanced Diploma Past Paper Pack Financial Management

M2 Tuesday 24 November 2015 Afternoon session Time allowed – 3 hours and 10 minutes DO NOT OPEN THIS PAPER UNTIL INSTRUCTED BY THE INVIGILATOR Candidate information and instructions There is one question in Part A and four questions in Part B. Answer the question in Part A and any three questions in Part B on the answer sheets provided. There are 100 marks available in this paper. Organisations marked with an asterisk, *, are fictitious. No similarity with any real organisation is intended nor should it be inferred. Start each question on a separate answer sheet. Do not identify yourself in answering any questions. Enter your candidate number, the paper number, the question number and the page number within the answer at the top of each answer sheet used. Any plans/notes that are made for each question should only be made on official IIA exam paper. Separate answer sheets should be used for each question plan. Clarity and logic of your answers, effective presentation and good use of English will be taken into account by the examiners when marking this paper.


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PART A There is one compulsory question in this section. QUESTION ONE Blakeley Plc* is a budget airline operating in Europe. Although it is a public company listed on the London Stock Exchange, much of the decision making is in the hands of the Chief Executive Officer (CEO) and Chief Operating Officer (COO). Shareholders are generally private individuals with little institutional investment or activist investors involvement. The Chair of the board has been ill over the last year and has only been able to attend occasional meetings. Board meetings have therefore been chaired by the Deputy Chair in his absence. The other board members generally trust the recommendations of the CEO and COO, largely because their past performance has led to the company achieving growth and success in its market sector. Competition in the industry has been severe over the last twelve months and the company is preparing to take some tough decisions to reduce its costs in order to remain viable. It has prepared the first draft of the budget for the next year. The following assumptions have been made in the preparation of the budget:

• Fuel prices will not rise above the current price (projected from oil at US$50 per barrel). The company has hedged fuel costs for the next six months

• Prices for flights will remain the same as in the past year with the only changes being for charges imposed by airports and countries for taxes, landing fees, etc

• The business will be able to run an additional 10% of flights, this being possible because it has taken over routes from another budget airline that has gone into liquidation. Blakeley paid a nominal £1 for these routes and the CEO estimated that this purchase is worth £5m in goodwill which the directors will include in the company accounts. The goodwill is to be written off over 10 years

• It will be possible to run the aircraft at an average of 95% capacity (90% in the last year was achieved)

• Flight staff costs will remain the same as last year • Head office and ground staff will be reduced by 50% which will save £10m, a

sum which is equivalent to the loss made in the previous year • To reward staff remaining with the airline, the previous plan to abandon a

share option scheme for all staff will be overturned and it will continue to operate. 90% of staff hold shares in the company

• All financing costs will remain the same and the company will be able to repay loans in line with the agreed repayment schedule as in the previous year

• As most customers make full payment in advance before flying and only 30% are corporate customers who are charged on account and pay after one month, revenue is to be recognised immediately a booking is made. This approach is new for the next budget year as previously, revenue was only recognised when cash was received

• The COO considers that the lives of the aircraft can be extended beyond the currently estimated economic life. Hence the depreciation charge for the next year’s budget has been reduced by half. The asset values are restated in the budget to reflect the extended life


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• Dividends will be maintained at the same rate as in the previous year as long as the draft budget is substantially implemented.

In view of the cost of the budgeting process, the directors have decided that although the draft budget should be discussed in order to obtain feedback from management, it should be adopted unless there is concern raised about an area which might lead to legal action against the company or something which would affect health and safety of staff and passengers. There will be no need for the budget committee to sign it off as has been practice in the past to reduce time spent on the budget process and ensure senior management and directors have more time to spend on the effective operations of the company. The COO has been in confidential talks with senior executives from three rival companies and although negotiations are at an early stage, it is considered that it may be possible to make informal agreements with other airlines to use spare capacity so that the occasional flight can be withdrawn to save operating costs. Hence, if there is spare capacity over a number of aircraft working on one route, all passengers from one airline will be placed on the aircraft of the other carriers. Projections, based on the previous three years, indicate that approximately 200 flights per year could be saved across the four airline companies. The effect of these discussions has not been included in the budget. The following are comparative budgets for the last year and the next year and the actual figures for the last year for Blakeley.

Budget/Actual figures to 31 Oct Budget

2015 £’m

Actual 2015 £’m

Draft Budget 2016

£’m Sales income 2,400 2,200 2,700 Fuel and consumables Employment costs Administration Sundries Finance costs

800 1,000

100 220 150

600 1,100

120 240 150

750 1,100

100 250 150

Profit/(Loss) for year 130 (10) 350 Dividends 60 60 60 Non-current assets (NCA) 900 990 1,080 Inventory Accounts receivable Bank

100 40

80

90 60

(20)

110 40

60 Total current assets 220 130 210 Total Assets 1,120 1,120 1,290 Equity Retained profits

500 150

500 10

500 300

650 510 800 Long-term finance 400 400 300 Total current liabilities 70 210 190 Total equity and liabilities 1,120 1,120 1,290


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a. Explain how the budget of a business relates to the overall planning process and management of the organization and analyse the advantages and disadvantages of a top-down budget compared with alternative approaches.

8 marks b. Evaluate the budget of Blakeley taking into consideration

any sensitivity factors that you identify and the degree of risk faced by the company and the three stakeholder groups: shareholders, employees and customers.

16 marks c. Referring to the information in the scenario, provide a briefing

for the board of Blakeley to: Demonstrate how fraud or other unethical behaviour by one or more individuals can mislead the representation of a business provided to stakeholders. Illustrate your answer with details from two named cases and identify any areas of fraud or unethical behaviour which could potentially arise at Blakeley.

16 marks SYLLABUS REFERENCE Section 4 - Ethics and creative accounting 4.1 the ethical implications for financial management and reporting that are involved in protecting the legitimate interests of the full range of stakeholders of an organisation 4.2 the impacts of these stakeholder pressures for the organisation’s strategic objectives in setting objectives and implementing strategy in order to achieve objectives 4.3 the main features of topical cases of fraud or other unethical behaviour, with particular emphasis on: • how the incident ultimately impacted stakeholders • the underlying internal features in the organisation that led to the problems, especially insofar as these relate to failures of controls • how the incident eventually came to light, particularly the role or potential role in this of internal audit 4.4 how financial accounts can be manipulated through either accounting or substantive methods in order to present a misleading picture to stakeholders through creative accounting and/or window-dressing and gaming behaviours Section 11 - Budgeting and budgetary control 11.1 how a budget and/or the financial element of a business plan relates to other aspects of the planning process and to other areas of management 11.2 evaluation of a proposed budget in terms of: • its consistency with the organisation’s objectives and strategy, and the potential for a satisfactory outcome • its internal logical consistency and external consistency with the known state of the market and the organisation’s context • the principal sensitivity factors • the degree of risk faced by the organisation and its stakeholders, and any downside protection in the event of failure 11.4 the risks involved in the budget-setting process, including: • budgetary slack • inter-departmental conflict


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• issues involved in setting appropriate standards and targets such as the tension between setting ‘stretch’ targets for motivation and the need for prudence in planning • the time and cost of the budgeting process 11.5 the alternative approaches that may be adopted in budget-setting and the multiple purposes that budgeting can aim to fulfil, and the making of recommendations on the most appropriate budgeting methodology for an organisation, including consideration of: • incremental and zero-based budgeting • top-down and bottom-up / participative • fixed-term and rolling budgets • deciding the appropriate extent of detailed control over budget-holders, and the use of ring-fencing 11.6 appropriate controls to ensure satisfactory implementation of the budget-setting process, including: • budget committee, manuals, guidelines • budget-setting timetables, and budget revisions • appropriate levels of authorisation • the extent of flexibility allowed for subsequent vireing and/or carrying forward unspent budgets to future periods 11.8 the implications of budgetary control for organisational behaviour, and for achieving an appropriate balance between trust, control and accountability MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part Remember/

Understand Apply/

Analyse Evaluate/

Create Total marks

a. Explanation - - relating budget to overall planning process and management 2 x 1 mark each

2

2

Explanation – Advantages/disadvantages of top down budgeting and comparison

Advantages - 3 x 1 mark Disadvantages 3 x 1 mark

6

6

b. Evaluation of budget and sensitivity factors – - company - shareholders - employees - customers 4 x 3 x 1 mark Evaluation of risk - company - shareholders - employees - customers 4 x 1 x 1 mark

4

12

16

c. Explanation – - of fraud/unethical behaviour on information to stakeholders

4

4

8


6

2 x 2 mark - illustration from cases

2 x 2 x 1 mark Evaluation –

- of information 2 x 2 marks

Explanation – - areas of fraud/unethical

behaviour 4 x 1 marks per point

2

2

4

8

Total

14

10

16

40

a. Relating the budget to planning and management

• Organisations have short, medium and long term plans. Budgets are usually for a year and these fit into the longer-term plans and short and medium term plans may fit into budgets. Budgets are a financial plan.

• Organisations have operational and strategic plans and these integrate with budgets.

• If plans are not co-ordinated, this risks plans and the budget being disjointed and inconsistent. This includes allowing for any changes in circumstance which may occur.

Comparative advantages and disadvantages of top-down budget and alternatives

• A top-down budget imposes a particular course of action which is appropriate when a business is relatively stable and homogeneous.

• It can be applied by lower levels of management if the senior management are aware of the operations of lower levels of the business. It can be appropriate in new organisations.

• If cash is limited, perhaps in a recession, strong control from the top may be preferred. Also it would be relevant in other circumstances where strong control is essential.

• However, a bottom up approach may be more relevant in a diverse organisation where senior management cannot be aware of lower level tasks

• A fast moving business environment also requires better understanding at lower levels of the organisation.

• It may be more motivational to allow lower level management to have greater control but that depends on the organisational culture.


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• Zero-based budgeting tends to be more participative because it requires input from lower level management and, hence, a top-down approach is difficult to apply. It would use a significant amount of senior management time to learn all that is required for zero based budgeting.

• Rolling budgets are updated regularly and a two-way communication between different levels of management is essential.

• Beyond budgeting is another option but a formal budgeting system involves greater understanding of levels of responsibility and authority.

b. Evaluation of the budget

• The budget information is a summary master budget based on the final accounts. More detailed information of different functions, for example, would be essential to have a better understanding of the profit and cash flows on a monthly basis. Control would be more easily implemented through monthly budgets.

• The comparison of budget and actual figures is useful. The addition of calculated variances would make the information clearer and easier to analyse. However, the changes can identified reasonably well.

• Some figures are 20 – 30% different between budget and actual and it may be possible to achieve a greater degree of accuracy in the future through analysis of past variances. Looking at the budget and actual profit/(loss) figures for the year to October 2015 the difference is significant which may cause doubts about the company’s budget process.

• The assumptions need to be made but each should be considered carefully to assess the likelihood of them being appropriate. For instance, if the cost of aviation fuel has been hedged for the next six months, the company can be reasonably certain that the amount is appropriate. However, prices of commodities can fluctuate considerably over time and the judgement of cost for the period 6 to 12 months into the budget will be difficult to assess in advance.

• Some assumptions are reliant on the co-operation of others and this co-operation may not be forthcoming. Each must be judged as appropriate.

• Shareholders will be interested in the security of their investment and probably capital growth and dividend income. Although they will not be party to the budget process, they will see the results in the final accounts each year.

• The risks they face are that (a) the company may not achieve its plans and the dividends will not continue to be paid and (b) the value of shares declines. As well as this arising from problems from operations, a significant impact on


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the company and their investment may occur from poor choices the impact of which fall on reputation. As the shareholders are a diverse group without the coherent management that often comes from an activist investor or institutions they are unlikely to be meeting regularly with the Board and senior management. This lack of communication will mean more surprises and probably more significant impact from problems which occur.

• Many employees are also shareholders so they may obtain more information about operations then outside shareholders and there is the risk that they take action, such as selling their shares on insider information.

• Employees will also be interested in maintaining their jobs/careers, a career structure and remuneration. If the company takes actions which are illegal they could lose their jobs and many could lose their investment too. In addition, they might find themselves having followed a strategy which leaves them open to legal action.

• Customers are interested in safety and flights which are inexpensive but efficient and which deliver them to their destinations in good time. If the company fails they could find themselves stranded in a foreign country without an immediate route home. The times of flights and destinations could also be changed if the talks of the COOs of the various companies come to fruition. There will also be confusion about the terms and conditions of service provided if they are moved from one company to another for flights.

• As the company also plans to reduce the number of ground crew, there is the potential of health and safety checks being rushed and danger to life of customers and employees and potential legal action against the company. Shareholder income would be reduced by legal costs as well as possible fines.

• Even if there are no accidents there could be more failures owing to mechanical problems which would affect all stakeholders adversely.

• External matters such as interest rates on loans could impact on business costs which would affect the profits of the organisations, probably adversely in view of current interest rates. And this could impact on the income of the shareholders and possibly employees. The company might try to counteract such increasing costs by reducing the service provided to customers.

• There is a risk involved in making arrangements with other airlines in that airlines outside the ‘group’ involved will take action themselves and/or industry regulators may see the action as anti-competitive and impose sanctions. This could affect the company’s reputation as well as directly affecting profitability.

• Finally by rushing the budget process and reducing oversight, there is the danger that the budget may prove to be incorrect with significant planning errors. As seen in 2015 a positive outcome in terms of profitability and a liquid


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organisation can turn into a loss and illiquidity in the actual figures. As the company has very limited reserves, it would find it difficult to survive more than a year or two of losses without having to reduce its operations significantly by selling aircrafts and laying off staff or seeking additional capital.

• There is little room for manoeuvre for the company in its attempts to alleviate the position from 2015 and not damage the interests of stakeholder groups. The pressurised situation could lead senior management into taking short-cuts which could be damaging and could end up in the liquidation of the company as well as legal action against individuals.

c. Fraud and unethical behaviour

• Fraud by individuals tends to undertaken to enrich themselves by stealing from the organisation. Or, action can be taken to cover up incompetence or even in as a way of ‘protecting’ an organisation which is heading for business failure.

• Unethical behaviour again can be to enhance the individual’s life, perhaps by ‘fiddling expenses’ or it can be unethical to benefit the business such as bribing government officials, regulators and others.

• Both fraud and unethical behaviour are likely to be hidden and not disclosed in the accounts. However, the income and profits are likely to be reduced by the action. Even if the business gains through extra contracts through bribery the amount received would not be as much as if bribery had not taken place.

• Enron is one example of fraud. It employed questionable accounting techniques which ensured that it was a leading US company and dominated its industry. Allegations of bribery and political corruption followed the company and eventually scandals caught up with the company and its directors. Even the huge accounting firm, Arthur Anderson, was embroiled in the scandals and both organisations failed.

• Worldcom is another classic example. The directors manipulated the accounts by including revenue expenditure as capital expenditure. This overstated profits. Once brought to light the company failed, employees lost their jobs and shareholders lost their investment.

• There are several examples in the assumptions applied to the accounts of Blakeley plc which could point to potential fraud or, at least unethical behaviour. This has been allowed to happen because of weakness in oversight and management. The CEO and COO have too much power in the company and others acquiesce rather than effectively question actions.

• The idea of adding to assets through the introduction of assets and revaluing the aircraft and other non-current assets makes the Statement of Financial


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Position look stronger. However, the adjustments are dubious. Goodwill arises on the purchase of one entity by another and not creating goodwill by buying aircraft routes. And although it is possible to reconsider asset lives it needs to be justified and the impact shown in the final accounts. This may occur but at the moment only the budget is seen

• The change in recognising income differently to show additional income in the accounts and budget appears to be manipulation of accounts and has some parallels with Worldcom.

• There also appears to be some pressurising of staff and management in the organisation which could be considered to be unethical behaviour.

Accept other suggestions. EXAMINERS’ COMMENTS This was the 40 mark compulsory question on the paper. The question focused on budgeting. Candidates were well prepared for the subject and all were able to explain budgeting and apply it to the scenario. However, the requirements to consider a variety of stakeholder groups and consider advantages, disadvantages, fraud and unethical behaviour seemed to be too prescriptive for many who did not adhere precisely to all aspects. Part (a) of the question was well answered and most candidates clearly identified and discussed advantages and disadvantages well. Those who did not adhere to the guidelines of advantages and disadvantages were given credit for distinguishing, to some extent, between differences. Part (b) tended to be written in a general way in about half of the answers. And the sensitivity factors were often offered within a wider analysis based on the scenario as opposed to a clear identification of matters which needed more focus. Nevertheless, most candidates were able to identify a range of risks. These were not always linked to the stakeholder groups. Candidates who clearly focused on the stakeholder groups found this a useful way of identifying specific risks and sensitivity factors. Most candidates were able to structure a briefing report well. And generally many were able to distinguish between fraud and unethical behaviour. The range of named cases and examples was very impressive. Some brought out Enron and Worldcom but others quoted Tesco, Barclays, other banks, Volkswagen and other car manufacturers and others. It is good to see how well candidates are keeping up with current events and that they were able to discuss the circumstances of each in some depth. Overall, candidates were well prepared and able to gain at least a quarter of the marks available from the basic of budgeting. The discipline of adhering to all the


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required aspects of each part of the question, however, did limit the ability of many candidates to score more than 70%+ of the available marks.


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PART B There are four questions in this section. Answer any three questions. QUESTION TWO Anytown Council* provides all the local government services in its area including waste collection, social services, libraries, highways maintenance, and housing. The Council is considering its investment strategy for the next year. There are requirements for a major road to service a new housing development (£15m), a new library (£4m) and new refuse collection vehicles to support the introduction of an improved waste collection scheme for residents (£2m). The Council has £8m capital to invest although it could borrow further monies at an interest rate of 5%. Road Project Library Project Refuse Vehicles

project Capital investment £15m £4m £2m Government grants £11m Nil £1m Revenue costs/(savings) £100k £50k (£900k) Note: if a project does not proceed the Council will lose the available government grant. You are asked to prepare a briefing note for the Council’s management board in which you:- a. Analyse the financial implications of the three options available to the

Council and assess the most appropriate course of action.

12 marks b. Discuss the qualitative factors to be included in reaching a final

decision.

8 marks SYLLABUS REFERENCE 9.1 systematic logical decision-making processes for the analysis of the options

available, related to an organisation’s strategic objectives, including the application of differential cost analysis to evaluate the options

9.2 how to distinguish those costs and revenues that are relevant for decision-making purposes from those that are irrelevant, in order to select the appropriate costs and revenues to include in a specific decision analysis, based on an understanding of: the specific decision and the resources that it will consume how that decision relates to the strategy and objectives of the organisation the extent to which relevant and reliable information is likely to be available from the accounting system

9.3 the qualitative factors that are likely to be relevant even if not easily quantifiable and how these may be integrated with the result of the quantitative analysis

MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part Remember/

Understand Apply/

Analyse Evaluate/

Create Total marks

a. Description/note

1

1


13

Analysis: 3 marks for each option Evaluate best option

9 2

9

2

b. 1 mark per factor Application in evaluation

4

4

4 4

Total 1 13 6 20 a. Financial evaluation Road Project Library

Project Refuse

Vehicles project

Capital investment £15m £4m £2m Government grants £11m Nil £1m Net cost to Council £4m £4m £1m Revenue costs/(savings) £100k £50k (£100k) Revenue return on capital investment Nil Nil 10% Amount of available capital = £8m To undertake all three projects the Council would invest in the road and the library with its own capital monies and borrow £1m for the refuse vehicles at an annual borrowing cost of £50k plus the payback of the loan over the useful life of the vehicles. However, the most financially attractive project is the refuse vehicles being the only project that has a psoitive revenue return on investment.

Potential for missing information from the analysis e.g. have all relevant cost differentials been considered

b. General points

• Awareness of the multifaceted dimensions of the decision making process Specific points

• For a Council, not just a financial decision i.e. roads would never be built purely from a financial return perspective, but they provide wider economic and community benefits

• Likelihood of changes in regulatory environment • Conditions attached to government grants • Attaching quantification to qualitative factors ; additional scenario planning

and attaching risk estimation and likelihood to outcomes EXAMINERS’ COMMENTS Candidates generally answered this question well which focused on decision making although it was the least popular question on the paper. In part a) poorer candidates scored lower where they did not attempt any calculations to come to a conclusion; thus they tended to 'discuss' rather than 'analyse'. Thus they often threw in qualitative factors into this discussion which were more appropriate for part (b).


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In part (b), the best marks were awarded for discussion of the qualitative factors; several weaker candidates just listed their factors. Proportionately however, this part was slightly better answered. QUESTION THREE You manage the treasury function of Brodie Plc*. The company is based in the UK and imports specialist medical equipment from worldwide manufacturers and also has a small manufacturing unit in the UK that produces surgical supplies for medical practices in the UK and Ireland. The company holds large amounts of cash and other financial assets to meet its short and longer term requirements. It must also be able to secure the raw materials it needs to make its products at competitive prices. The board of directors is conducting a review of the business and has asked you to provide a brief report outlining how the treasury function works and some of the main benefits it provides to the company. Provide a report to the board of directors in which you: a. Explain the role and responsibilities of the treasury management

function

5 marks b. Describe five types of investment that the treasury management

function may engage in, and evaluate how each are of value to the company.

15 marks SYLLABUS REFERENCE Section 7 – Financial Risk

7.1 - Treasury management: explain and evaluate the organisational processes for, and the risks associated with:

• cash management and the investment of temporary surplus cash • debtors, inventory and creditors management • the working capital cycle.

MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit.

Remember/ Understand

Apply/ Analyse

Evaluate/ Create

Total Marks

Part a Explanation of role of treasury function applying general knowledge to particular circumstances of question.

3

2

5

Part b Five types of investment relevant to this company

5

10

16


15

Total 3 7 10 20 Marks

1. From: The Treasury Manager To: The Board of Directors Date: xx/xx/xx Subject: Workings of the Treasury Department and the Ways it Benefits the Organisation

Introduction

You asked me to provide you with a report which outlines how the Treasury Department works, and which also covers some of the main benefits it provides to the organisation. I have divided this report into two sections, and trust that it will provide you with the all the information that you require at this stage.

(a) As Head of the Treasury Management function I have a wide range of responsibilities which I discharge personally or through the members of my Treasury Team. My Department provides a range of services to the organisation, which help to ensure that financial resources are managed effectively and in ways that meet both short and long term business requirements. These include the following:

• The day monitoring, forecasting and reporting of the company’s cash balances and the placement of funds.

• The provision of cash flow forecasts, current cash flow information and the impact on the effective management of liquidity, taking into account corporate debt charges, for example.

• The placement of, management of and accounting for, medium and long term investments and reporting on their performance.

• The provision of advice and forecasts on borrowing requirements. • Reporting on Treasury credit and risk management. • Overall management and reconciliation of corporate bank accounts. • Compliance with statutory requirements and corporate policies and

procedures. • Wider financial management and investment responsibilities, including

the monitoring of the performance of pensions funds and benefits schemes.

(b) There are a wide range of types of investment that the Treasury Management Function can engage in. I will outline the main types, which we can discuss in more depth if you wish:

• Short term cash holdings in bank current accounts. Their primary purpose is to be sufficient to meet immediate/short term cash requirements effectively.

• Medium/longer term cash holdings in higher interest accounts. The aim of these investments is to ensure that effective rates of return are


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secured, whilst cash needs can be met effectively when it is forecast that they will be required.

• Holdings in foreign currency accounts allow the organisation to benefit from certain currency movements, and to have cash in the correct currencies to meet payment requirements.

• Government Bonds/Securities provide secure returns with minimal risk of financial loss for clearly specified periods of time.

• Shareholdings allow the organisation to benefit from share price gains and the payments of dividends; there are considerable risks associated with holding this type of investment and these need to be reviewed regularly.

• Debentures allow the organisation to benefit from competitive rates of return on relatively secure investments in reliable companies.

• Corporate Bonds allow the organisation to benefit from competitive rates of return on relatively secure investments made in financially stable companies.

• Financial Futures help us to guard against/benefit from future market movements/availability.

• Options and Derivatives. These guard against /benefit from future market movements/availability.

• Commodities. These allow us to ensure the availability of, and the price to be paid for, commodities.

EXAMINERS’ COMMENTS This question focused on treasury management. In part a, candidates scored well and were able to identify the overall roles and responsibilities of Treasury and the most common activities. In part b the most successful candidates successfully identified appropriate Treasury related investments and evaluated them correctly. QUESTION FOUR You are head of internal audit at ABC*, a large multinational company, privately owned by Mr Manny Millions. The business has many successful but complex and often unrelated divisions which span both the manufacturing and service sectors. Manny wishes his young son Les to become involved in the business and, to that end, has made him a director, but Les lacks any real business experience. Manny has instructed you to become involved in educating Les and, as part of this, has asked you to prepare a memorandum for Les on activity based costing. Prepare a memorandum for Les in which you: a. Define activity based costing. 5 marks b. Evaluate the advantages and disadvantages of activity based costing

that organisations such as ABC are likely to experience in implementing it.

15 marks SYLLABUS REFERENCE Section 8.5 - the merits and demerits of activity based costing and the problems likely to be encountered in implementing this


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MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit.

Remember/ Understand

Apply/ Analyse

Evaluate/ Create

Total Marks

(a) Memorandum Headings: To, From, Subject and Date.

2 2

(a) Definition of ABC 3 3

(b) 5 merits / demerits of activity – based costing likely to be experienced by organizations such as ABC in implementing it. (up to the three marks for each valid point discussed.)

15 15

Total 20 Marks

(a) Activity – based costing is a costing methodology that identifies activities in an organisation and assigns the cost of each activity with resources to all products and services - according to the actual consumption by each. It assigns more of the indirect costs incurred by a business, or overheads, into direct costs than more traditional costing methods tend to do. ABC assists businesses in estimating the true cost elements of entire products, activities and services which supports decision-making. By helping businesses to better understand cost and profitability it is useful in aiding decisions on key business matters including pricing. (b) ABC Advantages:

• The traditional approach treats direct labour hours as the key driver of costs, however this is not always the case and ABC takes this reality into account.

• ABC claims to provide more accurate full costing information on product costs than other methods provide.

• Whilst – in common with the traditional approach to full costing- ABC uses historic costs, some argue that these are more accurate than current /actual costs because historic data may provide a better more stable long term guide to costs than current short term data which may not provide to be sufficiently typical.

• ABC may better motive staff as it is seen as a more accurate and fair way of analyzing business costs.

• ABC provides an accurate basis for determining how much to mark up costs to actual sales prices.

• ABC provides a more accurate basis for making critical decisions as to which projects to prioritize/accept/ reject.

ABC Disadvantages:

• Conducting the analysis of overheads required to undertake ABC is time - consuming and also costly.

• The benefits of implementing ABC may not justify the costs involved.


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• ABC, similar to the traditional approach full costing, does not assist in business decision- making (unlike marginal costing, for example).

• ABC – as traditional costing – relies on historic (past) costs rather than actual costs, which contributes significantly to it not effectively assisting current decision – making.

• ABC may be very intrusive into the activities of staff to gather the necessary data for accurate costing.

• ABC may damage worker relations /cooperation. EXAMINERS’ COMMENTS This was a relatively straightforward question on activity based costing and was well answered by most candidates. Some, however, failed to set out their answers in memorandum format, although this should be second nature to all well prepared students at this level. In part (a) most provided satisfactory definitions of activity based costing, although some focussed too much on specific characteristics or on how it compared and contrasted with other approaches to costing rather than providing an overarching definition. Part (b) was well answered by most with a good range of advantages and disadvantages evaluated effectively. Some, however, did not provide a sufficiently broad range of points or repeated points already made and consequently did not score as highly as might reasonably be expected on this question. QUESTION FIVE Easy Deals Ltd* is a supermarket chain operating across the UK. Increased interest by shareholders and the media on the validity of reported results and performance across this sector have raised the internal focus on ensuring that performance is being accurately reported, and risks in this area are being adequately managed. As head of internal audit at Easy Deals you are required to review the factors that could affect the three main categories of accounting ratios, and the risks of creative accounting or window dressing that may be associated with the reported results. As part of your preparation and scoping for this review to understand the processes and the potential risks you need to:- a. Identify the three main categories of ratios that measure

organisational performance and describe what can impact on these categories to make the analysis and comparisons less useful.

14 marks

b. Describe the impact of creative accounting and window dressing on

the reported figures and what safeguards should be in place to deter this type of activity.

6 marks SYLLABUS REFERENCE Section 5 – Financial analysis MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Risk of creative accounting or window dressing affecting reported results Reasons for creative accounting and/or window dressing;


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o To enhance reported organisational performance eg hide poor performance or smooth performance

o To avoid tax (lower profits = lower tax); o For personal gain eg bonuses, retain job or gain promotion; o To meet budgeted targets; o To hide variances of actual results (if poor) from expected results; o To encourage inward investment from investors and/or shareholders.

Safeguards over this area should be:

o The Board policy on ethical behaviour o Rigour of control systems o Strong audit committee who co-ord work of internal and external audit to

ensure comprehensive cover of financial systems; o Internal scrutiny processes of reported results and the associated narrative

before publication. The risk of distorted accounts due to creative accounting can be ascertained by establishing how strong the influence is to do this, and, establishing whether the organisation has the necessary safeguards in place . Mark Schemes are not definitive - valid points not listed will receive credit Question/Part Remember/

Understand Apply/

Analyse Evaluate/

Create Total marks

a. 3 categories of ratios Factors that impact on each category

2

4

4

4

2

12

b. Explain creative accounting and window dressing Safeguards

2

1

2

1

4 2

Total 9 7 4 20 Part a Identify 3 main categories of ratio and what makes comparisons less useful 3 categories of ratio that measure organisational performance:

Profitability ratios Liquidity ratios Efficiency ratios

Impacts that can make comparisons less useful: Profitability ratios


20

Several aspects impact on turnover that can make comparisons less useful; • Inflation; • Different sources of revenue; • Revenue recognition policy; • The effect on gross profit of the mix of sales products, selling prices and stock

valuation, and; • The effect on net profit of variations in the different expenses

Liquidity ratios Factors that can make comparisons less useful;

• The business may be seasonal or have seasonal trends; • Cash holdings may be low following a large purchase eg acquiring a fixed

asset; • Assumes that debts and/or stock can be turned in to cash quickly, and; • Safe liquidity levels vary between industries

Efficiency ratios Analysis and comparison may be less useful due to;

• Inventory (stock) can be affected by: o The organisations policy on stock holding; o The business may be seasonal; o It may be advantageous to bulk buy; o There may be large orders which necessitate temporarily high stock; o Some stock items may have long lead times;

• Debtor days best viewed as a trend; o Credit period may be a commercial necessity; o VAT can ‘muddy’ figures as it can be included in debtors but excluded

from sales, and; o The operation of credit control impacts on figures;

• Creditor days: o Taking longer credit may alienate suppliers; o Poor creditor payment performance can affect reputation; o Need to apply legislative requirements on payment terms to pay small

companies Accounting ratios can have merits and limitations in respect of:

o Their information content and the significance of the results reported; o Practical issues of feasibility, such as the accessibility of relevant data; o Reliability, and potential problems due to differences in accounting policies,

organisational structures and the nature of the specific organisations operations.

Part b Risk of creative accounting or window dressing affecting reported results Reasons for creative accounting and/or window dressing;

o To enhance reported organisational performance eg hide poor performance or smooth performance

o To avoid tax (lower profits = lower tax); o For personal gain eg bonuses, retain job or gain promotion; o To meet budgeted targets; o To hide variances of actual results (if poor) from expected results;


21

o To encourage inward investment from investors and/or shareholders. Safeguards over this area should be:

o The Board policy on ethical behaviour o Rigour of control systems o Strong audit committee who co-ord work of internal and external audit to

ensure comprehensive cover of financial systems; o Internal scrutiny processes of reported results and the associated narrative

before publication. The risk of distorted accounts due to creative accounting can be ascertained by establishing how strong the influence is to do this, and, establishing whether the organisation has the necessary safeguards in place. EXAMINERS’ COMMENTS This question was answered by most candidates who sat the paper. The majority of candidates scored half marks or more overall. Overall candidates achieved better marks on Part b than on Part a of the question. In some instances the level of the detail in the answers or the legibility of the script suggested that candidates were short of time to provide a full answer. Part a Part a of the question required the identification of the three main categories of ratios that measured organisational performance. Quality answers were able to distinguish the three categories of ratios as Profitability Liquidity and Efficiency whilst also recognising that Investment and Gearing ratios were less relevant to this question. Detailed listing of the ratios in each of these categories was not required but a number of candidates spent time on listing these. Marks could have been improved by a critique of what could impact on ratios to give a management and audit a better understanding of the value of the information they provided, and enable both strategic management and senior auditors to make informed decisions for any further action. Part b This part of the question was relatively straightforward and required candidates to describe creative accounting and window dressing and identify what safeguards should be in place. The question was generally well answered and the majority of candidates scored between half and full marks. A small percentage of candidates failed to answer part b of the question at all. It was unclear if this was due to misreading the question or lack of time to complete the answer.

END

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