acca p1 excellent file
TRANSCRIPT
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ACCA P1Professional Accountant
Arno ld Xu
Arno [email protected]
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Principals Agents
Views
-Capitalists
-Expedients
-Proponents ofsocial contract
-Socialecologists
Governance,IC, Audit,
ERM
Law, regulation, professional codes, professional values,personal ethics
Ethical theories, consequentialism, CMD
Stakeholders
-Shareholders
-Staff
-Lenders
-Customers
-Government
-Public
-Futuregenerations
Directors/accountants
National/localgovernment
Health authorities
Professional bodies
Schools/colleges
Duties
-Performance
-Competence
-Conflicts ofinterests
-Confidentiality
-Accountability
Power
Interests
Investments
Objectives
SOX, Combined Code
NED, AC, RC, NC
Risk Committee
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Safeguards
Governance,
IC, Audit,ERM
Risks
-Financial
-Operational
-Reputation
-Legal
Threats
-Self-interest
-Self-review
-Advocacy
-Familiarity
-Intimidation
Identify,Assess ,
Evaluate
ARTA
Integrity
Independence
Objectivity
Confidentiality
Competence
Risk CommitteeNED, AC, RC, NC
Law, regulation, professional codes, professional values,personal ethics
Ethical theories, consequentialism, CMD
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Introduction - Syllabus
A. Governance and respons ibil ity
1. The scope of governance
2. Agency relationships and theories
3. The board of directors
4. Board committees
5. Directors remuneration
6. Different approaches to corporate governance 7. Corporate governance and corporate social responsibility
8. Reporting & disclosure
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Introduction Examinable Models & theories
Corporate Governance
Agency theory (2 Define)
Transaction Costs theory (2 Explain & Analyze)
Stakeholder theory (2 Explain & Analyze)
Ethics
Relativisim & Absolutism ( 2 Explain & distinguish)
Kohlbergs stages of moral development (3 Explain)
Deontological and consequentialist (2 Describe &distinguish)
American Accounting Association model (2 - Apply)
Tuckers 5 question model-PLFRS (2 - Apply)
Gray, Owen and Adams 7 positions (2 Describe &evaluate) 6
Chapter 1
Corporate Governance
Concepts & Scope
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KNOWLEDGE CHECKLIST
Business organizations
Agency Theo ry & Transact ion Cost Theory
Agency theory
Agency relationship
Duties of agent
Accountability
Fiduciary duty
Agency cost
Alignment of interest
Close monitoring
Transaction cost theory
stakeholders
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KNOWLEDGE CHECKLIST
Corporate governance
Definition
Concepts
Fairness
Transparency
Independence
Probity
Responsibility & accountability
Integrity
Stakeholders
Relationship
Direct & control
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Corporate Governance Stakeholders 3
Stakeholder
Definition:
Any entity
Affect or be affected
Bi-directional
Power x interest = influence Source of risks
Debates over stakeholder
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Al l about s takeho lders
Stakeholdertheory
Instrumental Normative
Identification ofstakeholders
Stakeholdermapping
7 Positions CSR
Corporate CitizenSustainability
Reporting
Tuckers 5 Question
Institutional investors
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Chapter 2
Different Approaches
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KNOWLEDGE CHECKLIST Models of Business Ownership 2
Approaches to Corporate Governance Guidance 3
Principle vs. Rules based
Impetus for Corporate Governance Code 3
Investor (equity treatment)
Responsive
Major Corporate Governance Codes
Combined Code UK 2
Sarbanes-Oxley US 2
International 2
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Major Corporate Governance Codes 2
Principle Based:
UK Combined Code
OECD (CG concept)
ICGN (Ethics & stakeholders)
Rules based:
Sarbanes-Oxley Act
Other national codes
South Africa Kings report (CSR)
Singapore Code of Corporate Governance14
Chapter 3
Best Practices
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KNOWLEDGE CHECKLIST
Board composition & roles 3
Board structures 3
Directors Remuneration 3
Board committees 3
Communicating & Reporting
AGM 2
Proxy voting 3
Corporate Governance reporting 2
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Information & Professional Development of the Board 3
UK Combined Code
The board should be supplied in a timely manner withinformation in a form and of a quality appropriate to enable it todischarge its duties.
All directors should receive induction on joining the board andshould regularly update and refresh their skills and knowledge.
Information to th e Board
Responsibility:
Chairman
Management (provider)
Directors ( seek clarification )
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Induction programme
Contents
Company relationship
People
Products or services
Structure
Constitution
Assets, liab.,
Risks
KPI
Regulations
Meet
Visit
Build relationships
Meet auditor
Customer
Supplier
Shareholder18
Professional Development of the Board 3
Who is responsible?
chairman
CPD programme should be concentrate on
Role of the board
Obligations and entitlements of existing directors
Expected behaviour for effective board performance
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Performance of the Board 2
Board performance evaluation:
Key criteria:
L/T development instead of routine management matters
Who will evaluate?
by external 3rd parties ( e.g. auditors)
by NEDs (for evaluating performance of Chairman)
When
Once a year
Whom to report?
Shareholders
1.Formal, rigoro us
2.Board, committees, individual directors
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Performance of the Board 2
What are the crit eria?
For the Board
Board composition and meetings
The BOD is collectively responsible for success of thecompany
Measures:
Meetings (scheduled, unscheduled)
Attendance record
Updates of roles and responsibilities
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Performance of the Board 2
What are the criteria?
For the Board
Board balance and independence
ED and NED
Chairman Chief Executive Officer
Measures:
Age profile of the directors
Up to date CVs of directors
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Performance of the Board 2
What are the crit eria?
For the Board
Mission and strategy
Measures:
BSC: non-financial + financial targets
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Performance of the Board 2
What are the criteria?
For the Board
Board appointment and re-election
Formal, transparent procedure
Submitted for re-election at regular intervals
Measures:
NC, Length of tenure of each directors
Re-election interval (maximum 3 years)
Succession policy
Combined code:
All directors should be subject to election byshareholders at the firstAGM after theirappointment,
and to re-election thereafter at intervals ofnomore than three years.
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Performance of the Board 2
What are the crit eria?
For the Board
Directors' remuneration
Measures:
RC, composed by independent NEDs
Performance targets achieved > performance relatedpay
1. Combined Code:
2. Levels of remuneration for directors should be sufficientto attract, retain and motivate directors of the qualityrequired to run the company successfully but shouldnot be more than is necessary for purpose
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Performance of the Board 2
What are the criteria?
For the Board Information and pro fessional development
Info to the Board > timely and appropriate
All directors > induction training and CPD
Measures:
management a/c information > directors
Training courses
No. of new directors? Attendance?
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Performance of the Board 2
What are the crit eria?
For the Board
Accountab il it y
Balanced & understandable assessment of position and prospects inthe annual report and other public statements
Maintain a sound system of IC
Measures:
IC assessed ?
IA examines IC ?
AC (composition, meetings)
IC recommendations from EA
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Performance of the Board 2
What are the criteria?
For the Board
Communication
Dialogue with institutional shareholders
Use AGM to communicate with private investors andencourage their participation
Measures: Meet with major shareholders
Other communications?
Shareholders attendance at AGM
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Performance of the Board 2
What are the crit eria?
For the chairman
Effective leadership
Relationships and communications with shareholders
Relationships and communications within the board
Board agenda - enable board members to raise issues and
concerns Company secretary - used appropriately and maximum
value
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Performance of the Board 2Individual directors
Chairman & CEO
Separate appraisal carried out by NEDs
All di rec tors on the Board
Criteria:
independence > objective
preparedness > knowledge, relationship
practice > questioning, education
committee work > process, enthusiasm
development of the organization > suggestion, innovation
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Performance of the Board 2Board Meetings
Agenda:
Balance between L/T & S/T issues
Every director > opportunity to propose
Supportive information:
Informative, Risks and alternatives identified
Distributed in good time
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Legal & regulatory issues over the Board 2
Appointment
Removal
Rights
Responsibility
Remuneration
Directors
- Fees and expenses- Emoluments and
compensation forloss of office
Legal duties- Ski ll- Attend board meetings
-Delegation andcommunication
Conflict and disclosureof interests
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Time-limitedappointments
Removed ordisqualified
Not offering
himself forre-election
Resignation
CompanyDissolutionDeath
Legal & regulatory issues over the Board 2
Departure from office
writtennotice NEDs:
After 2 x 3 period > explain toSH
After 9 > annual re-election
By companys constitutionBy court
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Legal & regulatory issues over the Board 2
Insider dealing/trading
What is?
A criminal offence by using insider information to buy orsell shares in a stock market
A breach of agents duty
Insider information
Information that is specific and precise, Not yet been made public > if made public > significant
effect on share price
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BOARD STRUCTURE 3
Good board structure
1. Independence
2. Size
3. Committees and functions
4. Diversity
Division of responsibility in BOD
CEO
Chairman
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BOARD STRUCTURE 3
Bad board structure
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
UK Combined Code
There should be a clear division of responsibilities at the headof the company between the running of the board and theexecutive responsibility for the running of the companysbusiness. No one individual should have unfettered powers ofdecision.
A chief executive should not go on to be chairman of the samecompany. If exceptionally a board decides that a chiefexecutive should become chairman, the board should consultmajor shareholders in advance and should set out its reasonsto shareholders at the time of the appointment and in the nextannual report.
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
1.Different roles
Chairman: Head of the BOD
CEO: leading the management team
Pros for separation
Chairman (representative of Shareholders) manager role
No single person can do BOTHjob well
Can Board make CEO truly accountable for management?CEO is the head of board
Removes possibility of self-interest > act in the interest ofshareholders
NEDs report their concern over CEO to Chairman38
BOARD STRUCTURE 3
CHAIRMAN AND CEO
Possible Cons for separation
2 leaders > conflict
Greater power to the CEO
Motivating tools
What if CEO = Chairman ?
Strong independent element
E.g. senior independent NED
Available to shareholders to answer concerns that have notbe resolved through normal channels
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
Role of Chairman
Run the board and set its agenda
Information to board members
Effective communication with shareholders
Manage the board (meeting and NED)
Induction program for new directors
CPD of individual directors
Performance evaluation (directors and committees annually)
Encourage active engagement by all the members of theboard
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Accountabil ity of Board and CEO
Board
Shareholders
Executive
management
Financial marketsRegulatory bodies
Supervision of managementAnd stewardship of the company
Management of the company& stewardship of its operations
Other stakeholdersEmployee etc
Chairman
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
Role of CEO
Senior executive in charge of management team
Answerable Board
Responsibility:
UK Combined Code
Major Responsibilities of CEO
Business strategy and management
Investment and financing
Risk management
Board committees (recommendation)
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BOARD STRUCTURE 3
Role of NED
Who are they?
NEDs have no executive (managerial) responsibilities
non-executive director
Focuses on what they are not rather than what they are
Equivalent terms:
Outside director
Used in the US and elsewhere but NOT in the UK
independent director appears in Higgs Review
ALL NEDs could, or need to, be independent
UK Combined Code
The board should include a balance of ED and
NEDs (and in particular independent NEDs)such that no individual or small group ofindividuals can dominate the boards decisiontaking.
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BOARD STRUCTURE 3
Role of NED
SENIOR INDEPENDENT DIRECTOR
UK Combined Code
The board should appoint one of the independent NED to bethe senior independent director.
Be available to shareholders
When normal channels of chairman, chief executive orfinance director has failed
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BOARD STRUCTURE 3
Role of NED
SENIOR INDEPENDENT DIRECTOR
Debate over Senior Independent Director:
Pros:
Important > relationship b/w major shareholders and the board
Address shareholder concern
Chair meetings b/w NEDs where chairman does not attend
Unless being appointed as chairman > functions as Deputy Chair
Cons:
Unnecessary or divisive > shareholders may make use of own connectionswith NEDs, or contact the chairmen of board committees if they haveconcerns
Construct the case for having an independent Director onthe Board
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BOARD STRUCTURE 3
Role of NEDs
Strategy:
Constructively challenge and contribute to the development of strategy.
Performance (scrutiny)
Scrutinise the performance of management in meeting agreed goals andobjectives and monitor the reporting of performance.
Risk
Satisfy themselves that financial information is accurate and that financialcontrols and systems of risk management are robust and defensible.
People
Responsible for determining appropriate levels of remuneration ofexecutive directors and have a prime role in appointing, and wherenecessary removing, senior management and in succession planning
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BOARD STRUCTURE 3
Requirement & Provisions for NEDs in the Board
Numberof NEDs
UK Combined Code
At least half the board, excluding the chairman > independentNEDs
Smaller company > at least 2 independent NEDs
NYSE: Listed company > MAJORITY of NEDs ( > 50% of the board)
Singapore:
At least 1/3 > independent NEDs
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BOARD STRUCTURE 3
Pros & Cons for NEDs in the Board
Advantages
External experience and knowledge
Provide wider perspective
Comfort factor for 3rd parties (e.g. investors, creditors)
Well-suited roles played by NEDs
Dual nature of NEDs role
Full board members > same knowledge
Strong, independent element on the board
Compliance with relevant CG codes
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BOARD STRUCTURE 3
Pros & Cons for NEDs in the Board
Problems
Lack independence
Prejudice over recruitment of NEDs
High-calibre NEDs tends to work in best-run companies
Difficult to impose views on the board
Corrective roles may be beyond the capabilities of NEDs
Limited time to devote in company affair
May damage companys performance
Weakening board unity
Stifle entrepreneurship
Debate over CSR:
NED was for political reasons > represent others interest> not in best interest of shareholders
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BOARD STRUCTURE 3
Remuneration of NEDs
UK Combined Code
No share options to NEDs
In practice
Bonus scheme for NEDs could be problematic:
Too small > lack of motivation > observe bottom line
Too generous > conflict of interest > not act in the bestinterests of shareholders
Why?
Fear of challenging ED
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BOARD STRUCTURE 3
Remuneration of NEDs
Recommendations: Sufficient to attract high quality and motivated NEDs > shareholders
benefit
Payment:
Cash or shares
No share options
Linked to L/T performance rather than financial performance of currentperiod
Balanced performance measures
Encourage broader view of CG
Shareholders' prior approval of any bonus scheme
NEDs' bonuses > determined by Shareholder, NOT by ED
Incentive for NED to achieve specific objectives or tasks outside normalduties as NED
Paid immediately
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BOARD STRUCTURE 3
Supervisory board only non-executive members
Management board
Executive members only
Board of directorsExecutive &
non-executive members
Two-tier structureUnitary structure
Executive committee
committees committees
Supervisory boardComposition:Workers representativesShareholdersrepresentativesManagement boardComposition:-Appointed by SupervisoryBoard-Entirely of managers
Policy boards- L/T strategic issuesFunctional boards
-Main senior executives withfunctional roleMonocratic boards-Few responsibilities-More symbolic role
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Arguments for & against
Unitary Boards
Advantages:
Equal legal responsibility > NEDs involvement
Same meeting
Decision-making + information
More balanced decision > all directors involved
Presence of NEDs > scrutinizing and challenge > betterdecision-making
Enhance relationship between different types of directors
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Arguments for & against
Unitary Boards
Disadvantages:
Overloaded NEDs > manager + monitor
Time pressure for NEDs > meeting and understand
No EE in management board
Division b/w shareholders and directors > AGM only placefor shareholders
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Multi-tier Boards
Advantages:
Separation b/w monitors and those being monitored
Supervisory/policy board
Guard & Deterrent (similar to IA)
Stakeholders needs > by supervisory board
Shareholder involvement and EE participation (appointmentand supervision of directors)
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Multi-tier Boards
Disadvantages:
Confusion over authority > lack of accountability
Theorypractice
Management board may restrict info passed tosupervisory board
Independence of supervisory board
Representatives of shareholders > interfere
NED?
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BOARD STRUCTURE 3
Trends and futures
UK & US
Increasing criticism over two-tier board structure
Advocates on NEDs role in the board
Germany and Japan
Under pressure of globalisation of capital markets andcross-boarder M& A
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Board representation: Weight and influence ofdifferent stakeholders on the board
ExecutivedirectorsIn
depe
ndent
director
s
Shareholders employees
Executive
Directors
Chairman&CEO
Executive
directorsIn
depe
ndent
Dire
ctors
Nonex
ecutivech
airm
an
Indepe
ndent
director
s
Significant
shareholdersShareholders
employees
employees
United KingdomUS Continental Europe
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DIRECTORS REMUNERATION 3
Purpose & general guideline:
Adequate remuneration to attract individuals with sufficientcalibre
Motivate individuals to achieve performance levels
High-performing directors should be rewarded
> but how much is enough?
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DIRECTORS REMUNERATION 3
Setting o f Directors remuneration
By remuneration committee
Role
general policy on remuneration of executive directors
specific remuneration packages for each director
Composition
INDEPENDENCE (3 NEDs)
Staffed by NEDs > ED can NOT set on own salaries
3 No
no personal interest
no conflicts of interest
no day-to-day involvement in running the business60
DIRECTORS REMUNERATION 3
Remuneration Policy
pay scales
proportion of rewards
period for performance related payments become payable
proportion of performance related, balance b/w L/T & S/T
transparency of directors remuneration (pension rights)
Benchmarking with similar companies > applied with caution
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Problems:
Wrong measure applied
Myopia (short-term focus)
Remunerated with time delay ( reward for the past)
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Link variety of strategic goals and targets together
Profit based
EPS
Problem: S/T, manipulation, risk-taken
Market based
TSR
Problem:
Market fluctuation
Individual performance
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TSR
Total Shareholder Return
Capital Gain + Total Dividend over the period
Initial investment (Opening SP)
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Link variety of strategic goals and targets together
Internal based
Measures: financial + non-financial
Problems: Intangible
Benchmark
Compliance
Environmental
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Remuneration for different levels of directors
Loss of management (confidentiality)
Additional and basic
Flexibility
Difficult to distort
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Basicsalary
Performancerelated
Shares
Shareoptions
DIRECTORS REMUNERATION 3
Remuneration Package
1. UK Combined Code
2. Levels of remuneration should be sufficient to attract,retain and motivate directors of the quality required torun the company successfully, but a company shouldavoid paying more than is necessary for this purpose.
3. A significant proportion of executive directorsremuneration should be structured so as to linkrewards to corporate and individual performance.
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DIRECTORS REMUNERATION 3
Components
Basic salary
Determined by employment contract (experience, marketrate)
Not related to performance
Performance related bonuses
Cash bonus (may have a cap)
Transaction bonuses
Shares
Award shares and exercise after period of service
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DIRECTORS REMUNERATION 3
Components
Share options
a) What is
A right to purchase shares at a specified exercise price overa specified time period in the future
At the exercising day, if share price > exercise price, followexercise price
Initiatives and Problems
A mechanism to align interest of management with that of theshareholders
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DIRECTORS REMUNERATION 3
Share options
Conditional based on achievement of certain conditions
Market based:
Share price
Target share price relative to an index of market prices
Non-market based:
Revenue / Profits
Increase in EPS
Non-financial targets (IPO, number of EEs)
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DIRECTORS REMUNERATION 3
Share options
Initiatives and Problems
Vesting period
UK Combined Code:
Not less than 3 years
Encourage for longer holding period
Grants > in phase
Performance criteria
A matter of debate
Benchmark to a group of comparable companies
What will the directors do to protect own interests?
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DIRECTORS REMUNERATION 3
Benefits in kind
Transport, health provisions, life assurance, holidays,expenses, loans
Concerns:
Cost & benefit
Compared with EEs package
Loans
Abuse of loan (WorldCom case)
Loans to directors of listed companies > prohibited(some jurisdiction)
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DIRECTORS REMUNERATION 3
Pensions
Pension contributions
UK Combined Code
Only basic salary is pensionable
Pension consequences and associated cost need to beconsidered
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DIRECTORS REMUNERATION 3
Service Contracts & Termination Payments
Length of service contract
Most CG > less than 12 months
Compensation for terminating service contract
Continue to pay
Cease payment when directors finds new job
Paying shares
1.UK Combined Code:
2.The remuneration committee should carefully consider what compensationcommitments (including pension contributions and all other elements) theirdirectors terms of appointment would entail in the event of early termination.The aim should be to avoid rewarding poor performance. They should take arobust line on reducing compensation to reflect departing directorsobligations to mitigate loss.
3.Notice or contract periods should be set at one year or less. If it isnecessary to offer longer notice or contract periods to new directorsrecruited from outside, such periods should reduce to one year or less afterthe initial period.
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DIRECTORS REMUNERATION 3
Remuneration Disclosures
Annual report:
Remuneration policy
Arrangement for individual directors
Other disclosures
Duration of directors contracts
Notice periods and termination payments
Details of external remuneration consultants employed byRC
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DIRECTORS REMUNERATION 3
Voting on Remunerations
Shareholders
Approve remuneration policy > voting on remunerationstatement + remuneration packages
However
Legally binding contract b/w Co. & directors
Shareholders can not force a breach of contract
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BOARD COMMITTEES 3
Sub-board committees responsible for supervising specificaspects of governance.
Main board committees
Internal Audit Committee
Remuneration Committee
Nomination Committee
Risk Committee
Operation of committee system does not discharge theresponsibility of board on the specific areas
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COMMUNICATING & REPORTING 2
Board shareholders (institutional)
AGM > forum
Annual Report and Accounts
Shareholder has the right to appoint a agent (proxy) to act ontheir behalf at company meetings
Board should maintain a regular dialogue withshareholders, particularly institutional shareholders
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COMMUNICATING & REPORTING 2
AGM
Guidelines:
Company
Notice > 20 working days before meeting
Business presentation + Q&A session
Chair of key sub-committees > available to answer questions
Shareholders
Vote separately on EACH substantial separate issue (no bounding ofissues)
Propose a resolution at AGM relating to reports and accounts
Institutional investors
Provide details of their vote in the AGM
Eliminate impediments to cross-border voting
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CORPORATE GOVERNANCE REPORTING
Importance of Reporting
Reduce information asymmetry
Helps to address key difficulties of agencyrelationship
Principles vs. Compulsory
Principle based : London Stock Exchange
Compulsory: NYSE
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CORPORATE GOVERNANCE REPORTING
Whether complied throughoutthe accounting period
Non-compliance > explained
Narrative statement
LSE
Statement of compliance
how applied
explanations on detail
Supplementary Disclosures
balanced and detailed information
based on judgement
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CORPORATE GOVERNANCE REPORTING 2
Reporting Requirements
1. Explain responsibilities for preparing accounts
2. Report on going concern status
3. Information on BOD
4. Brief reports on
i. remuneration
ii. audit
i ii . nomination committees
5. Relations with auditors
6. Statement > reviewed effectiveness of IC, risk management
7. Statement > relations and dialogue with shareholders
8. Statement > company is a going concern
9. Substantiality report
10. Operating and financial review (OFR)82
CORPORATE GOVERNANCE REPORTING
Voluntary Disclosure 2
Any disclosure above mandated minimum
CEOs report
Social/environmental report
Additional risk or segmental data
General guidelines:
Transparent & planned process > communicated to everyoneresponsible for preparing the information
Consultation within business, shareholders and other key g roups
All relevant information > taken into account
Comprehensive, consistent and subject to review
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Q 1 Remuneration package
(a) As a consequence of the corporate governance codes, there isincreasing disclosure in the accounts of listed companies ofthe procedures for determining the remuneration of directors,and the actual remuneration.
The following statements are quoted from recent accounts:
'The (two) non-executive directors constitute the remunerationcommittee.'
'No member of the committee has a personal financial interest,other than as a shareholder, in the matters to be decided.There are no conflicts of Interest arising from crossdirectorships....'
'The Chairman has a service contract with a notice period ofthree years. This was originally drawn up in 20X2 and wasconsidered at that time to afford protection for the Groupagainst the loss of the services of a key executive. ....theBoard does not intend to seek to var the terms.'
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Q 1 Remuneration package
Answer:
'The (two) non-executive directors constitute the remunerationcommittee.
Membership:
Wholly by NEDs > ED cant decide on own salary
Number of NEDs
Significant number of NEDs (recommended)
At least 3 (Combined Code)
2 for small company
Reliance on NEDs
Overloaded > insufficient attention
Minimum number of NEDs at least 3
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Q 1 Remuneration package
Answer:
'No member of the committee has a personal financial interest,other than as a shareholder, in the matters to be decided.There are no conflicts of Interest arising from crossdirectorships....
Independence
All NEDs should be independent
No share option
No performance-related pay
No pension scheme
Cross-directorship
Agreement on set higher salary for each other
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Q 1 Remuneration package
'The Chairman has a service contract with a notice period of
three years. This was originally drawn up in 20X2 and wasconsidered at that time to afford protection for the Groupagainst the loss of the services of a key executive. ....theBoard does not intend to seek to vary the terms.
Answer:
Lengthy contract
Good: retain key management
Bad:
Financial disincentives to remove > high compensation costs
Shareholders right to remove directors > undermined
Service Contracts
Combined Code: for 1 year only
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Q 1 Remuneration package
(b) Required:
Analyze and explain the motivational effect on the ChiefExecutive of each elements of the remuneration package, andof the total package. (14 marks)
88
Q 1 Remuneration package
(b) Under contractual remuneration arrangements, the ChiefExecutive of X Group received in 20X6, as disclosed in theannual report and accounts:
Salary 516,000
Bonus 50,000
Employee profit-sharing scheme 8,000
Benefits 21,000
He has a three-year rolling contract. The Group contribution tohis pension scheme was 85,000.
The bonus is determined by the remuneration committee, and isnon-pensionable. It is based on the committee's assessment of theannual performance of the company and the individual's contributionthereto. The bonus may not exceed 25% of salary. Participation inthe employee profit-sharing scheme is limited to 8,000. Thebenefits relate to the use of a company car and accommodation.
89
Q 1 Remuneration package
In addition to the above, the contract provides that the ChiefExecutive can receive, as part of his remuneration package,the following.
(i) A conditional allocation of ordinary shares, which may beapproved annually by the Remuneration Committee, based ona percentage of salary not exceeding 50%.
Shares are held by trustees during the measurement period ofthree years.
Vesting (formal ownership and possession) of the shares issubject to a performance test at the end of the period. The testinvolves ranking the total shareholder return (TSR) againstthose of other top 100 companies (FT-SE 100).
(1) An upper quartile ranking will produce 100% vesting, alower quartile zero.
(2) The calculation of intermediate points is linear. 90
Q 1 Remuneration package
The shares required are purchased in the market. Conditionalallocations are expected to be at 50% of salary (the maximum).
(ii) Share options may be granted, at the market price at thedate of grant. The maximum share options granted in a three-year period can not exceed four times annual salary.
These can not be exercised for three years, and can beexercised only if the percentage growth of the TSR of thecompany equals or exceeds that of the average of the FT-SE100 companies.
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FTSE 350 Total Shareholder Return*
2. Imperial Tobacco 305.3%
3. Man Group 303.9%
4. Hit Entertainment 268.9%
5. Lonmin 259.2%
6. Grainger Trust 233.0%
7. RPS Group 230.3%
8. Enterprise Inns 230.1%
9. McCarthy & Stone 228.7%
10. Wimpey (George) 226.0%
11. Holiday Break 197.7%
12. PZ Cussons 179.0%
13. Interim Capital Group 178.0%
*Source: Datastream - Total Shareholder Return, period covering 5 years from Jan/98 Jan/03
1. Jardine Lloyd Thompson 376.9%
14. Persimmon 177.6%
15. BHP Billiton 171.9%
16. PZ Cussons A 168.8%
17. Inchcape 165.0%
18. Br iti sh Am eri can To bacco 162.8%
19. Gallaher Group 161.1%
20. Wembley Group 154.9%
21. Alba 154.1%
22. Signet Group 150.6%
23. Schroder Ventures 135.2%
24. Smith & Nephew 132.3%
25. Royal Bank of Scotland 128.5%
92
Q 1 Remuneration package
Answer:
Salary: 516,000 Substantial
Implication:
One of the highly-paid & highly sought-after directors
May increase in line with companys growth
Motivating
93
Q 1 Remuneration package
Answer:
Bonus: 25 % x 516,000 = 129,000
Relate to performance of Co.
Criteria ?
Assessment of Remuneration Committee
Implication:
Company politics > de-motivational ?
Based on annual performance > S/T view?
94
Q 1 Remuneration package
Answer:
Employee profit-sharing scheme 8,000 (Max)
Insignificant
However, average performance will get the bonus
Other benefits, pension contribution 85,000
Substantial
Unlikely linked to performance > limited motivation
95
Q 1 Remuneration package
Answer:
Conditional Allocation of Shares
50% of salary > significant
3 year time scale > related to TSR > not S/T focus
Motivational
However
Penalized by market?
If group perform well, but sector performed bad > CEOpenalized
96
Q 1 Remuneration package
Answer:
Share Option
Not exceeding 4 times of salary > lucrative
Strong motivational
However > based on market > out of control of CEO
Current position of the company?
Average > reasonable target
Low > mission impossible?
Recommendation:
Sliding scale approach instead of all or nothing
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97
Q 1 Remuneration package
Answer:
Total Package
Motivation depend on how CEO controls
Internal
External
Share grant + share option
Very lucrative
Encourage L/T perspective
However
Fixed proportion > substantial already
If CEO ambitious > higher performance
People are usually motivated by success itself
98
Chapter 4
Internal Control
Framework
99
Introduction - Syllabus
B Internal control and review
1. Management control systems in corporate governance
Propose
Assess
2. Internal control, audit and compliance in corporategovernance
Internal audit independence 2 - Assess 3. Internal control and reporting 2
4. Management information in audit and internal control
Communication of info 3
100
COSO- A process,- Effected by BOD, management and other personnel- reasonable assurance . achievement of objectives in thefollowing categories:
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with applicable laws and regulations
Purpose of Internal control system 2
101
Purpose of Internal control system 2
Importance of Internal Control
Achieve objectives
Underpin investor confidence
Risk awareness and control
Information on internal operations and compliance
Performance (expose and improve underperformed)
Reporting
Information for internal and external reporting
102
Purpose of Internal control system 2
Key stages involved in a Control System
1. Identification of system objectives
2. Setting targets for system objectives
3. Measuring achievements/outputs of the system
4. Comparing achievements with targets
5. Identifying what corrective action might benecessary
6. Implementing corrective action
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Importance of Internal control system 3
Turnbull Proposal
A company's system of internal control has a key role inthe management of risks that are significant to thefulfilment of its business objectives.
A sound system of internal control contributes tosafeguarding the shareholders' investment and thecompany's assets.
1. Internal controls should include all types of controlsincluding
Operational and compliance
Internal financial controls104
Importance of Internal control system 3
Turnbull Proposal
What is a Sound system of Internal Control
Embedded in operations and form part of its culture;
Capable of responding quickly to evolving risks
Within the company
In business environment
Procedures for reporting immediately to management
Significant control failings or weaknesses identified
+
Corrective action being undertaken
105
Importance of Internal control system 3
Combined Code Requirements on Internal Control
The board should maintain a sound system of internalcontrol to safeguard shareholders' investment and thecompany's assets.
The directors should, at least annually, conduct a reviewof the effectiveness of the group's system of internalcontrol and should report to shareholders that they havedone so.
The review should cover all material controls, includingfinancial, operational and compliance controls and riskmanagement systems.
106
Importance of Internal control system 3
Combined Code Requirements on Internal Control
For listed companies, the BOD should
Assess how the company has applied coderequirement to main a sound system of internalcontrol
Review effectiveness of internal control
Reporting on these matters to shareholders in theannual report and accounts
107
Importance of Internal control system 3
Roles and responsibilities over internal control
Board of Directors
Responsible for the company's system of internal control
Set policies
Seek regular assurance on effective operation
Ensure effectiveness of IC in managing risks
108
Importance of Internal control system 3
Roles and responsibilities over internal control
Management
Implementing ro le
Identify and evaluate the risks > consideration by the board
Design, operate and monitor IC
CEO- Ultimately responsible & assume "ownership" of the system
- Sets the "tone at the top" > control environment- Provide leadership and direction to senior managers- Review senior managers control over the business
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Importance of Internal control system 3
Roles and responsibilities over internal control
Senior Management
Assign responsibility > responsible personnel
All EEs
Some responsibility > accountability for achieving objectives
Collectively establish, operate and monitor
Produce information & communicate
Defined in everyone's JD
110
Importance of Internal control system 3
Roles and responsibilities over internal control
Internal Auditors
Evaluating
Monitoring
External parties
EA > NO responsibilities, NOR being part of IC
111
INTERNAL CONTROL FRAMEWORK 3
SOX Requirements on Internal Control
Statutory requirement
Sox 404
Audit and reporting of internal control systems
Management (CEO & CFO)
Understand IC
Evaluate effectiveness (design + operating)
Written assessment at Y/E on effectiveness > included in annual return External Auditor
Opinion on managements assessment
Test & Verify > assessment is correct
Express an opinion on F/S of the company
112
INTERNAL CONTROL FRAMEWORK 3
SOX Requirements on Internal Control
Statutory requirement
Sox 404
Audit and reporting of internal control systems
113
Sample Auditors Report - Microsoft In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial position of MicrosoftCorporation and subsidiaries as of June 30, 2007 and 2006, and theresults of their operations and their cash flows for each of the threeyears in the period ended June 30, 2007, in conformity withaccounting principles generally accepted in the United States of
America.
We have also audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), theeffectiveness of the Companys internal control over financialreporting as of June 30, 2007, based on the criteria established inInternal Control Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission and ourreport dated August 3, 2007, expressed an unqualified opinion onmanagement's assessment of the effectiveness of the Companysinternal control over financial reporting and an unqualified opinion onthe effectiveness of the Company's internal control over financialreporting.
DELOITTE & TOUCHE LLP 114
INTERNAL CONTROL FRAMEWORK 3
Internal Control Framework
Control Environment
ControlProcedures
Culture, infrastructure
+
Attitude of management
Detailed control in place
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INTERNAL CONTROL FRAMEWORK 3
COSO
1. Effectiveness and efficiency of Operations
2, Reliability of Financial reporting
3. Compliance with applicable laws and regulations
Key Concepts
Internal control is a process. It is a means to an end, not an end in itself.
Internal control is effected by people. Its not merely policy manuals andforms, but people at every level of an organization.
Internal control can be expected to provide only reasonable assurance,not absolute assurance, to an entitys management and board.
Internal control is geared to the achievement ofobjectives in one ormore separate but overlapping categories.
116
INTERNAL CONTROL FRAMEWORK 3
COSO
4 Objective Categories
Strategic development
Operations
Reporting
Compliance
5 components of internal control
Control Environment
Risk assessment
Control Activities
Information and Communication
Monitoring
Added
117
COSO ERM Framework
118
COSO
Control Environment
Sets the tone, influencing control consciousness
Foundation > discipline and structure
Control environment factors
Integrity
Ethical values and competence
Philosophy and operating style
Assigns authority and responsibility and organizes anddevelops its people
Attention and direction provided by the BOD
119
COSO
Control Environment
Importance of Control Environment
Strong control environment
Does not, by itself, ensure the effectiveness of theoverall IC system
Major influence only
- Establishment of business objectives
- Structuring of business activit ies
- The way business followed to deal with risks
120
COSO
Risk Assessment
Assessment of external and internal risks pertain to the entity
Identification and analysis of relevant risks to achievementof the objectives
Basis for determining how the risks should be managed
Risk assessment > ongoing
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COSO
Control Activities
Control activities occurthroughout the organization, atALL levels and in ALL functions
Typical activities (SOAPMAPS)
Supervision
Organization
Author izat ion
Personnel
Management
Ar ithmetical & Accounting
Physical
Segregation of duties
122
COSO
Information and Communication
Information must be identified, captured and communicated ina form and timeframe that enable people to carry out theirresponsibilities
Information:
IS reports
Operational, financial and compliance-related information
For planning and control of the business
Information sources:
Internally generated data
External events, activities and conditions necessary for informedbusiness decision-making and external reporting
123
Tactical
Strategic
Operational
Information & Communication
Planning
Controlling
124
COSO
Monitoring
A process that assesses the quality of the system'sperformance over time
Ongoing monitoring (in the course of operations)
Separate evaluations
Internal control deficiencies > upstream
Serious matters > top management & the board A combination of the two
125
COSO
Relationships:
All 5 components must be in place to achieve either one of 3objectives.
Advantages:
Focused on a wide concept of IC
Not just limited to financial control
126
COCO
COCO framework
Criteria of control
Canadian Institute of Chartered Accountants
Importance of feedback and continuous improvement incontrol systems learning process
Definition of Internal Control:
Internal Control is those elements of an organization(including its resources, systems, processes, culture,structure and tasks) that, taken together, support people inthe achievement of the objectives.
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127
PurposeA sense of direction.
What are we here for?
CommitmentA sense of identity
and values.
Do we want to doa good job?
CapabilityA sense of competence.
What action do we need totake?
Monitoring and
LearningA sense of evolution.
What Progress?
What Next?
ACTION
COCO
128
COMPONENTS OF INTERNAL CONTROL 3
Major Classifications:
Corporate, management, business process, transaction,
Administrative, accounting
Prevent, detect, correct
Discretionary and non-discretionary
Voluntary and mandated
Manual and automated
Application and general IS controls (Covered in F8)
Financial and non-financial
129
INTERNAL CONTROL AND RISK MANAGEMENT3
Turnbull Proposal
The board must further ensure that the system of internalcontrol is effective in managing those risks in the mannerwhich it has approved.
In determining its policies with regard to internal control, andthereby assessing what constitutes a sound system of internalcontrol in the particular circumstances of the company,
Factors to be considered by the Board
Nature and extent of the risks facing the company;
The extent and categories of risk which it regards asacceptable for the company to bear;
The likelihood of the risks concerned materialising;
The company's ability to reduce the incidence and impact onthe business of risks that do materialise; and
The costs of operating particular controls relative to the benefitthereby obtained in managing the related risks.
Risk management is ONGOING process!
130
Cost & benefits of internal control 2
Benefits & measurements:
Helps to achieve objectives
not ensure achievement (factors out of managementcontrol)
Helps to reduce fraud and errors
cant eliminate ( inherent limitation of internal control)
Helps to improve effectiveness and efficiency how to quantify
The Cost of implementing a specific control should NOTexceed the expected Benefit of the control.
131
Cost & benefits of internal control 2Cost
Tangible costs
salary, additional expenditures
Opportunity costs
management time spend on monitoring and supervision
Intangible co sts
Reduced flexibility, responsiveness, creativity
Does control stifle initiative?
132
Cost & benefits of internal control 2Practical Difficulties for Cost & Benefit analysis:
How to estimate potential monetary loss or gain in the event ofcontrol failure or absence
How to assess effect of control
E.g. how much a control can save?
Many benefits are non-monetary
E.g. improved morale or reputation
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133
Exam Questions on IC
Pilot Paper
- Sound system of internal control (optional Q)
Dec 07 (Q 1)
- Importance of internal control
- Recommendation of control procedures (application)
Jun 08 (Q1)
- IC over subcon (application)
134
Chapter 5
Internal Control - Internal Audit
No prior Exam Question on this area!
135
KNOWLEDGE CHECKLIST
Internal Audit
Need for Internal Audit function 1
Roles of Internal Audit 1
Independence of internal audit 3
Source of internal auditor
Relationship with external auditor
IIAs standards over internal auditor 3 Internal audit reports
Assess the performance of internal audit 3
Audi t Commit tee 2,3
Roles and functionsRelationship with IA & EA 2
Roles in internal control 3136
Need for Internal Audit function
Factors:
Scale, diversity and complexity of companys activities
Number of EE
Cost/benefit considerations
Changes in organizational structures, reporting process orunderlying IS
Changes in key risks Problems with internal control system
An increased number of unexplained or unacceptableevents
Combined Code:
Companies which do not have an internal auditfunction should from time to time review the need forone
137
Definition of internal audit 1
Appraisal or monitoring activity
Within an entity
Service to the entity
Examine & Report to management & directors
Accounting & internal control systems
UK APB
138
Typical Tasks 1
INTERNAL REVIEW
Internalaudit
Externalauditors/consultants
OR
Types of assignment Performed by
Operational
SystemsValue formoney
Financial
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Roles of Internal Audi t 1
Review of accounting and internal control system
Review design
Monitoring operation
Risk assessment
Detailed testing
Recommending cost effective improvements
Financial + non-financial controls
Examination of financial and operating information
Review of IS over financial and operation
Detailed testing of transactions, balances and procedures
140
Roles of Internal Audit 1
Review of 3Es of the operations
Review of Compliance with
Review controls over safeguarding of assets
Review of implementation of corporate objectives
Review effectiveness of planning
Relevance of standards and policies
CG procedures and operation of particular procedures
141
Roles of Internal Audit 1
Risk management Identification of significant risks (F, O) Monitoring overall risk management policy and risk
management strategies
Insuffici ent ERM
Effective ERM
Recommend
Audit & impr ove
142
Independence of internal audit 3
1. Independent of theactivities they audit
2. Independent reporting line
3. Objectivity (state of mind)
1. Independent mentalattitude
143
Independence of internal audit 3
Recommended Principles fo r Internal Auditor
Integrity
Objectivity
In gathering, evaluating, and communicating information
Balanced assessment
Impartial, unbiased attitude and avoid conflicts of interest
Confidentiality
Not disclose without appropriate authority > unlesswhistleblowing!
Competency
IA: ethics, public in terest, duty of agent
144
Independence of internal audit 3
Recommended Principles for Internal Audito r
Management o f IA
CIA
TOR (scope of work)
Planning, supervising, control
CPD
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Threats to Independence 3
Involvement in system design
Overfamiliarity
Close professional or personal relationship with managersand staff under audit
Reporting relationships
Independent of line management ( finance director)
Should report to board or AC
146
Threats to Independence 3
Dealing with threats to independence
No audits over previously worked department
No post-implementation audits on new systems ifinvolved in designing and implementation
Defined scope of responsibilities, unrestricted accessto records, assets and personnel
Rotation of staff over different audit areas
147
Independence of internal audit 3Consulting and safeguards
Problems:
Too much efforts onconsultancy projects
Involved in operationalconcerns >independence ?
Unrealistic expectation:
Reliance on IA forsolution
involvement ofoperational staffs
Safeguards
No management responsibility
Clearly defined TOR:
Resources
Prioritize
Additional resources
Include recommendation work on IC asIAs responsibility
Different staff Serious control weaknesses discovered in
consultancy > high risk > regular review
148
Sourcing Internal AuditInternal Auditor
Internal
Outsourced
Fresh perspective, experience
Independence > no operationalproblems
No prejudices and bias
No training cost or ongoing cost
More flexible > provided whenneeded
Problem:
Independence
Cost
Confidentiality
Staff change
149
Internal Audit Report
No formal reporting requirement
Standard Report Format
Executive Summary
Background
Objectives
Major outcomes
Key risks identified
Key action points
Summary of work left to do
Body of the Report
List of Findings
Potential impact of issues
Recommended approaches
Managements response
Agreed actions and deadlines 150
Assess the performance o f internal audi t 3
Assessment Cri ter ia
Professional proficiency Scope of work Performance of audit work Management of internal audit Independence of internal audit Authority of internal audit
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151
Assess the performance o f internal audi t 3
Quality control of IA
Internal Audit function should
Establish QC policies and procedures
All audits conducted in accordance with internal standards
Communicate > to IA
Factors affecting the policies
Size and nature of dept.
Geographic dispersion
Organization
Cost-benefit considerations
152
Assess the performance o f internal audi t 3
Quality control of IA
Responsibility
Chief audit executive (CAE)
Develop & maintain QA and improvement program
Continuously monitors its effectiveness
Internal External
153
Assess the performance o f internal audi t 3
Annual Rev iew o f Inter nal Audi t
By whom:
Board or
AC
Criteria:
Scope of work
Operational IC
Risk assessment and management process
Compliance with laws, regulations and policies
Safeguarding of assets
Reliability of information
Value for money
Organizations objectives and goalsSources of info: internal audit plan 154
Assess the performance o f internal audi t 3
Annual Review of In tern al Au dit
Criteria:
Author ity
TOR
IA reports > adequately considered & actions taken
Independence
Adequate safeguards
Reporting line
Removal of head of IA
No operational responsibility
No system design, installation and other operational taskby IA
155
Assess the performance o f internal audi t 3
Annual Rev iew of In ternal Audi t
Criteria:
Resources
Sufficient resources available for IA to carry out allnecessary work
Human
Hardware
Knowledge, skill and experience
156
Audi t Commit tee 2, 3
Composition:
Combined Code:
The board should establish an audit committee of at least three,or in the case of smaller companies two, members.
All members
Independent NED
The board should satisfy itself that at least one member ofthe audit committee has recent and relevant financialexperience
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157
Audi t Commit tee 2, 3
Appointm ent
Chairman of BOD member of audit committee
By board
Taking recommendation from NC (where there is one)
In consultation with the AC chairman
Period
Up to 3 years
Extendable by no more than 2 x additional 3 year periods,so long as members continue to be independent.
158
Audi t Commit tee 2, 3
Meetings of AC
Frequency and timing decided by
AC chairman
Company secretary
Frequency depend on role and responsibilities required > not lessthan 3 meetings
Timing:
Key dates within FR and audit cycle
Attendance
Only ACs chairman + members of committee
Non-members > subject to audit committees decision
Audit lead partner + FD
159
Audi t Commit tee 2, 3
Meetings of AC
Meet with EA & IA > at least annually
Chairman of AC should maintain close contact with key peopleinvolved in the companys governance
Board chairman
CEO, FD
EA lead partner Head of IA
160
Audi t Commit tee 2, 3
Resources
Remuneration
Component:
Remuneration paid to all NED
+
Further remuneration for the additional responsibilities
Skills, experience and training
1 x recent and relevant financial experience + professional qualification fromone of the professional accountancy bodies
Other member x experience of corporate financial matters
Induction programme for new member
CPD
Ongoing and timely training
161
Audi t Commit tee 2, 3
Relationship with the board
Board responsible for
Role and extent of work
Reporting line
TOR
Annual review of audit committees effectiveness
Disagreement with board
Allow adequate time for discussion
Unresolved > report to the shareholders in annual report
162
Audi t Commit tee 2, 3
Review annuala/c and IC
Monitor andrevieweffectiveness ofIA function,
App oin t/remov eCAE
Liaise with EA
whistleblowing
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163
Audi t Commit tee 2, 3
Communication with Shareholders
AnnualReport
AGM
Separate section for AC
Workof AC
Summary of role
Names and qualifications of allmembers
Number of meetings
Report on how AC has discharged itsresponsibilities
Non-audit services & safe uards
Chairman should answer
AC activities and
Matters within the scope of auditcommittees responsibilities.
164
Chapter 6
Risk Management
Identification of Risk
165
KNOWLEDGE CHECKLIST
Risk concept 2
Nature of risks
Risk & return
Risk and Corporate Governance 2
Strategic and Operational Risks 2
Business Risks 2
166
RISK CONCEPT
Nature of Risks
Definition:
A condition
in which there exists a possibility of deviation
From
a desired outcome that is expected or hoped for
167
RISK CONCEPTNature of Risks
Risk and Hazard
Risk is Probability
Likelihood that it will actually cause harm or injury
Hazard is Consequences
Something with the potential to cause harm orinjury
Relationship:
Risk is often used as generic term to coverHazard aswell.
168
RISK CONCEPTNature of Risks
Types of Risk
Speculative risks
Consequences >either good or harm
Example?
Business entity
Pure risks
Only consequence isharmful
Usually can be dealt withinsurance
Example?
Negative Risk
- Downside
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169
RISK CONCEPT
Risk & return
Risk management
Minimizing but not eliminate
Residual or remaining risk
Still be in presence > cost and benefit considerations
170
Different Attitudes to Risk
Definition
People have asymmetrical
views on risk
Types
Risk Seeking
Risk Neutral
Risk Averse
171
Different Attitudes to Risk
For a business
Profit is a reward for risk taking
Risk management
Avoid risks ( surprises)
Form integral part of business strategy
Enable business focusing on key value drivers
172
RISK AND CORPORATE GOVERNANCE
Links:
Risk taken shareholder return achieved
Risk taken directors remuneration
Should we link directors remuneration with risks taken?
Corporate Governance requirements :
Directors sh ould
Establish appropriate control mechanism to deals with risksorganization face
Monitor risks by regular review and a wider annual review
Disclose risk management processes in the accounts
173
Business strategy
Risk appetite
Risk attitude Risk capacity
Risk
strategy
Risks
Residual
risk
amount of risk willing to accept
overall approach torisk
risk averse
risk seeking
risk neutral
maximum risk abusiness canaccept
174
STRATEGIC AND OPERATIONAL RISKS
Strategic Risk
Fundamental and keydecisions that directorstake about the future ofthe organization
Business risk
Non-business risk
L/T financing
Operational risk
Risk of loss due to
People, processes,infrastructure ortechnology
operational impact,
Outside environment
Out of control of entity
Long term perspective
Internal environment
Controllable by entity
Day to day basis
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STRATEGIC AND OPERATIONAL RISKS
Strategic risk
Responsibility
BOD
Vision, info, skill
Risk management
Accept
New product in New mkt
Reduce in long run
Redesign
Avoid
High impact
Slim prospect
Operational risk
Responsibility
BOD>
Risk Committee>
Risk managementfunction>
Line MGR > EE
Risk management
Transfer
H (impact) L (probability)
Reduce
L (impact) H (probability) 176
STRATEGIC AND OPERATIONAL RISKS
Operational risk
Staff
Competence, labor
Technology
Fraud
Processes/procedure
Outsourcing
Language/translation
Security
Staff welfare
177
BUSINESS RISKS
Financial Risk
Risk that affect the entitys going concern status
Structure of finance, fraud and misuse of financial resources
Long term risks
Currency risk
Interest rate risk
Short-term risks Credit risk
Liquidity risk
178
BUSINESS RISKS
Financial Risk
Currency Risk
Possibility of loss or gain due to future changes in exchange rates
1. Transaction Risk
Exchange rate movements
2. Translation Risk
B/S values of foreign assets and liabilities > prevailingexchange rate at Y/E
3. Economic Risk
Intl competitiveness (imp & exp)
Hedging strategies
Internal
Domestic currency invoicing
Netting
Leading and lagging
External
Forward market hedges (buying or selling currency forward)
Money market hedge (exporter)
Borrow the foreign currency
Sell the foreign currency in the spot market
Lend the domestic currency
Futures or options
179
BUSINESS RISKS
Financial Risk
Interest Rate Risk
Risk of volatility in interest rate that may affect companys cost ofdebts
How to deal with the risk?
-Forward rate agreement
-Swaps:
- Reduce each partys financial risk
180
BUSINESS RISKS
Financial Risk (short-term)
Credit Risk
The risk that a counterparty may not pay amounts owed whenthey fall due.
How to management (exporter case):
Documentary credits
Bills of exchange
Export credit insurance
Export factoring and forfeiting
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BUSINESS RISKS
Financial Risk (short-term)
Liquidity Risk
Risk of loss due to a mismatch between cash inflows and outflows
182
BUSINESS RISKS
Financial Risk (short-term)
Finance providers Risk
Risks to the entity for providing finance for others
Risk of default on debt payment
Risk of low or no return on investment
Dividend
Capital gain
183
BUSINESS RISKS
Legal and Political Risk
Risks
Financial or other penalties
Compliance costs
Loss of reputation
Typical regulations:
Health and safety
Environmental legislation
Trade descriptions
Consumer protection
Data protection
Employment issues184
BUSINESS RISKS
Political Risk
The risk that there will be a change in the political framework ofthe country
Government policies:
Limitations on equity
Restrictions / interference with operations
Discriminatory taxation or tariffs
Non-tariff barrier
Profit repatriation
Wage fluctuations
Fiscal and monetary policies
185
BUSINESS RISKS
Political Risk
How to manage?
Avoidance
Insurance
Negotiate the environment
Structure the investment
R&D
Supplies of key components or materials
Global trademarks
Local stakeholders
186
BUSINESS RISKS
Country risk
Risk that a foreign currency will not be available to allowpayments due to be paid because of a lack of foreign currency orthe government rationing that which is available
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Tactical
Strategic
Operational
BUSINESS RISKS - Information
Planning
Controlling
Strategic
Tactical
Operational
188
Tactical
Strategic
Operational
Information Requirement
Planning
Controlling
ESS
DSS
ES
MIS
TPS
KWS
189
BUSINESS RISKS
Technological Risk
Physical damage risks
Fraud risk
Data and system integrity risk
Denial of service attack
Internet risk
190
BUSINESS RISKS
Health & Safety Risk
Environmental Risk
Fraud Risk
191
BUSINESS RISKS - Fraud risks
OpportunitiesWeak Board of DirectorsWeak Internal Controls
Att itudes /Rational izati onsLack of a Code of Conduct
Disregard for FinancialReporting
Incentives/PressuresTight Debt Covenants
Unrealistic AnalystExpectations
192
BUSINESS RISKS
Trading Risk
Risk with trading both internationally and domestically
Physical risk
Trade risk
Liquidity risk
Disruption risk
Cost and resource wastage risk
Product risk
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BUSINESS RISKS
Reputation risk
Loss of reputation as a result of the adverse consequences of another riskA genuine emerging issue after a series of accounting scandals
Affected stakeholders > power, interest
Poor customer service
Failure to innovate
Poor ethics
Non-cooperation from suppliers and customers
Inability to recruit high-quality staff
Fall in demand because of consumer boycotts
Increased public relation costs
Increased compliance cost
Loss of market value
194
Chapter 7
Risk Management - Risk Assessment
195
KNOWLEDGE CHECKLIST
Risk Analysis 2
Risk Identification
Risk Assessment
Risk Profiling
Risk Quantification
Risk Consolidation
Risk & Stakeholders 3
Role of the Board i n Risk Management 3
196
Risk Analysis 2
Risk analysis involves identifying , assessing, profili ng,
quantifying and consolidating risks.
Other terms may be used to describ e these stages
Identify
Assess
Profiling
Quantifying Consolidating
197
Control It
Share orTransfer It
Diversify orAvoid It
RiskManagement
ProcessLevel
ActivityLevel
Entity Level
RiskMonitoring
Identification
Measurement
Prioritization
RiskAss essment
Risk Analysis
198
Risk Analysis 2
1. Risk Identification
A continuous process to identify new risks and changes inexisting risks
Involves identifying risk conditions
Method:
Physical inspection
Enquiries (e.g. QC procedures)
Check documents, correspondence
Brainstorming sessions
Checklist
Benchmarking (internal and external)
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Risk Analysis 2
2. Risk Assessment
Understand the extent of impact of potential events
Assesses risks from 2 perspectives:
Likelihood
What is the likelihood of an incident occurring?
Impact
If an accident occurs, what would be the magnitude of itsconsequence?
200
Risk Analysis 2
3. Risk Profiling (Prioritisation)
Af ter evaluation o f
Likelihood of occurrence
Impact
Analyzed fur ther int o a pr ior it ized r isk l ist
Which risks need the most urgent attention
201
Low
High
High
I
M
P
A
CT
PROBABILITY
High Risk
Medium Risk
Medium Risk
Low Risk
Risk Analysis 2 Likelihood/consequence matrix
Loss of key customers Failure of computer
system
Loss of senior staff Loss of sales to competitor Loss of sales due to macro-
eco factors
Lost of low level staff Lost of unimportantsupplier
Can we quantify? 202
Risk Management Response to risks
Con t r ol
Sh a r e M it i g a t e & Co n t r o l
Accep t
High Risk
Medium Risk
Medium Risk
Low Risk
Low
High
High
I
M
P
A
CT
PROBABILITY
Strategicissues
203
Risk Analysis 23. Risk Profiling (Prioritisation)
Likelihood/consequence matrix
Qualitative way of assessing impact of risk
High Risks > more urgent attention > Strategic Decisions
Low Risks > less urgent
Attention:
Risk profile vary in different businesses
Risk can evolve due to environmental changes
204
Risk Analysis 23. Risk Profiling (Prioritisation)
CIMA
Factor affecting location of risk in a risk map
Strategic objective affected
Type of risk ( pure risk or speculative risk?)
Direct and indirect impact of risk
Likelihood of risk
Cost of responses
Organizations environment
Constraints within the organization
Organizations ability to respond to events
Analyze and lo cate the r isks in the map andgive reasons
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Question 14 Risk Map
Required
Prepare a 2 X 2 risk map, with one risk identified in eachquadrant of the map.
Explain your reasons for assessing the probability and impactof the risk as high or low in each case.
206
Question 14 Risk Map
BC Freight is a freight-forwarding business. It sends
containers of freight from Heathrow to airports around theworld. It specialises in consolidating the freight of differentshippers into a single container, to obtain the benefit of lowerfreight charges for large shipments. The prices that BCcharges its clients cover a share of the airline flight costs andinsurance, and provide a margin to cover its running costs andallow for profit. To make a satisfactory profit, BC needs to fillits containers to at least 75%, and at the moment is achievingan average' fill' of 78%.
International trade and commerce have been growing in thepast year, although at a slow rate.
BC's management is aware that airline flight costs are likely torise next year due to higher fuel costs, and because severalmajor airlines that have been suffering large losses will behoping to increase their prices.
207
Question 14 Risk Map
Step 1:
What are the risks?
A. Container not filled to B/E level
B. Increasing airline freight costs
C. Downturn in international trade
D. Some major airline may go out of business
208
Low
High
High
I
M
P
A
CT
Likelihood
High Risk
Medium Risk
Medium Risk
Low Risk
Step 2:Rank the impact and likelihood
Downturn ininternational trade
Container not filledto B/E level
Increasing airlinefreight costs
Major airline may goout of business
209
Risk Analysis 2
4. Risk Quantification
Risk can be further analyzed by quantifying
Consequences
Probability
Expected Value
EV = Probability of Occurrence x Impact
210
Risk Analysis 2
4. Risk Quantification
Risk can be further analyzed by quantifying
Consequences
Probability
Fire atoffice
(0.2)
Likelihood ofdamage
(0.8)
No alarm or sprinklersystem
80% of equipment maybe lost
$10,000
0.2 x 0.8 x$10,000
=
$1,600
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Risk Analysis 2
4. Risk Quantification
Results from quantification
Average or expected result or loss
( $1,600)
Frequency of losses
Predictable by studying available records
Confidence margin improved by including likely effects of changedcircumstances
Non-recurrence events > difficult to predict
Chances of losses
(0.16)
Largest predictable loss
($10,000)
No calculation r equired in EXAM!
212
Risk Analysis 2
4. Risk Quantification
Tools and techniques for quantifying risk:
Scenario planning
Sensitivity analysis
Decision trees
Computer simulations
Software packages
Analysis of existing data
213
Risk Analysis 2
5. Risk Consolidation
Divisional or subsidiary level > aggregated at corporate level
Group level risk > Board set up risk management system:
Identify changes in risks
Monitor risks regularly
Wider annual review (IC, ERM)
Categorization also helps to develop and implementcommon control for certain group of risks
Example?
Shared service
214
Examiners Definition of Risk Assessment
5 components in risk assessment stage:
1. Identify nature and extent of the risks facing the company
2. Decide whether risks are acceptable (Cost of control such riskand benefit to the business if risks are to be controlled)
3. Quantify risk by determining the likelihood (probability) of theidentified risks materialising
4. Examine businesss ability to reduce the impact of risks that domaterialise
5. Understanding of the costs of operating particular controls toreview and manage the related risks
Bad debtsControl?
L/C
Cash on delivery
Discount/factoring30% of AR >bad debts
Sufficient workingcapital?
Legal action?Cost:
Charges
Loss potentialcustomers
215
RISK & STAKEHOLDERS 3
Customers
Employees
Managers
Directors
Shareholders
Impact of Business RiskStakeholder
Identify stakeholders
Describe their claims
What are their actions & effects on business risks?
216
RISK & STAKEHOLDERS 3
Wider Community
Banks
Government
Supplier
Impact of Business RiskStakeholder
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ROLE OF THE BOARD IN RISK MANAGEMENT 3
Strategic level risk and attitude and approach to risk
Driving risk management and provide resources to managers
Ensure that risk management supports strategic objectives
Determine acceptable level of risk
Communication of risk management strategy throughoutorganisation and embedded in all activities
Reviews, identifies and monitors progress risk managementplans
Determine which risks will be accepted which cannot bemanaged, or which it is not cost effective to manage, i.e.residual risk
218
ROLE OF THE BOARD IN RISK MANAGEMENT 3
Turnbull Guidance
The board is responsible to develop internal control tomanagement risks facing the business
Factors to consider when determining policies on internalcontrol
Nature and extent of risks facing the company
Extent and categories of risk which it regards as acceptablefor the company to bear
The likelihood of the risks materializing
The companys ability to reduce the incidence and impacton the business of risks that do materialize
Cost and benefit consideration for operating particularcontrols
219
Chapter 8
Risk Management
Dealing with Risks
220
KNOWLEDGE CHECKLIST
Risk Management Systems 3
COSO ERM
Reducing Risk 2
Embedding risk awareness
Diversification
Risk Avoidance/retention/transference
Risk Avoidance & retention 2
Risk transference
Risk Attitude and Strategy 3
221
KNOWLEDGE CHECKLIST Risk Management Responsibilities 3
Role of Risk Committee
Risk Management Group
Role of Risk Manager
Risk Auditing
Others involved in Risk Management
Information on Internal Control & Risk 2
Information requirement of directors
Review of Internal Control
Reporting on Internal Control and Risk Management
222
KNOWLEDGE CHECKLIST
Controlling Risk
Targeting risk
Risk Manager
Risk Committee
Risk Audit
Risk Avoidance/Retention/Transfer
Reducing Risk
Embedding Risk
Diversification
Risk Avoidance
Risk Retention
Risk Transfer
Risk Attitude
Reporting on Internal Control & Risk
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RISK MANAGEMENT SYSTEMS
a process, effected by an entity's board of directors,
management and other personnel,applied in strategy setting and across the enterprise,
designed to identify potential events that may affect theentity,
and manage risks to be within its risk appetite,
to prov ide reasonable assurance regarding theachievement of entity ob jectives.
Source: COSO Enterpris e Risk Management Integrated Framework. 2004.
224
RISK MANAGEMENT SYSTEMS
Benefits/Purpose of ERM
Al ign ing (ri sk appet ite = st rateg y)
Enhancing risk response decisions
Framework for determine risk responses ARTA
Reducing operational surprises and losses
Identifying and managing multiple and cross-enterprise risks
Interrelated impacts > integrated responses
Seizing opportunities
Improving deployment of capital
Risk management helps an entity get to where it wantsto go and avoid pitfalls and surprises along the way.
225
RISK MANAGEMENT SYSTEMS
Fundamental concepts
A process > ongoing and flowing through an entity
Effected by people at every level
Applied in strategy setting
Applied across the enterprise > entity-level portfolio view of risk
Designed to identify > manage risk within its risk appetite
Reasonable assurance Geared to achievement of objectives in one or more separate
but overlapping categories
226
Internal Control Vs. ERM
RISK MANAGEMENT SYSTEMS
Internal Environment
Objective Setting
Event Identification
Risk Assessment
Risk Response
Control Activities
Information & Communication
Monitoring
Entity-Level
Division
BusinessUnit
Subsidiary
Internal Environment
Objective Setting
Risk Response
Event Identification
Strategic
227
RISK MANAGEMENT SYSTEMS
Entity objectives can be viewed in thecontext of four categories:
Strategic Operations Reporting Compliance8 components for
- Whole entity
- Each objective
- Individual unit228
RISK MANAGEMENT SYSTEMS
Internal Environment
Set the tone at the top
Philosophy regarding risk management.
Risk culture
Objective setting
Objectives = risk appetite
Event Identifi