Analysing Financial Performance (Corporate collapse)

Question 1

Financial Crisis

Answer 1

Any situation where one or more significant financial assets – such as stocks, real estate, or oil – suddenly (and usually unexpectedly) lose a substantial amount of their nominal value.

Question 2

Banking Crisis

Answer 2

A crisis occurs when the banking system—or a significant number of banks cannot perform its main functions and requires assistance.

Question 3

Currency crises

Answer 3

A sudden large depreciation in the exchange rate.

Question 4

Debt crises

Answer 4

A government that cannot pay its debt.

Question 5

Why do financial crises happen?

Answer 5

systemic failures
(is the risk that an event can trigger a loss of economic value or confidence in a substantial portion of the financial system that is serious enough to have significant adverse effects on the real economy.)

unanticipated or uncontrollable human behaviour,

incentives to take too much risk,

regulatory absence or failures,

or contagions that amount to a virus-like spread of problems from one institution or country to the next.

Question 6

Corporate Failure

Answer 6

Corporate failure occurs when a company cannot achieve a satisfactory return on capital over the longer term.

Question 7

Why do companies fail?

Answer 7

Failing to adapt to changes in the environment.
Complacency
risk-averse decision-making: select options of relatively limited impact
economies of production and administration: to retain shares by reducing price
limited opportunities for innovation and diversification
limited mental models: stop the company from changing quickly enough to keep up with environmental change.

Strategic drift
Strategic drift is a term devised by Johnson (1988) to describe a warning to those who champion the idea of strategy emerging as a series of logical, incremental steps. the rate of change in the marketplace speeds up, and the firm’s incrementalism approach is not enough to maintain its advantage, and it is left behind.

Question 8

Business Valuation Prediction

Answer 8

Valuation of a Business: is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

Market Value vs Book Value

Book Value: historical value and deprecation

Market Value: Assets resale value,

Market Capitalisation: the total value of all a company’s shares of stock. It is calculated by multiplying the price of a stock by its total number of outstanding shares

Stock market prediction: is the act of trying to determine the future value of company stock or other financial instrument traded on an exchange

Question 9

Fundamental Analysis VS Technical Analysis

Answer 9

Fundamental analysis looks to see whether an investment is overvalued or undervalued based on underlying economic conditions (fair value of the business). Fundamental analysis is based on the theory that share price can be derived from a rational analysis of future dividends.

Technical analysis (Chartist) assumes that a security’s price already reflects all publicly available information.

Question 10

Implications for Fundamental Analysis VS Technical Analysis

Answer 10

Fundamental analysis assumes stock price is equal to the value of expected future cash flow on the shares, discounted at the shareholders’ cost of capital. Therefore, the share price will be predictably provided that all investors have the same information about a company’s expected profits and dividends, and a known cost of capital.

Technical analysis believes past trading activity and price changes of security can be valuable indicators of the security’s future price movements. Professional analysts typically accept three general assumptions for the discipline:

everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock.

prices will exhibit trends regardless of the time frame being observed

history tends to repeat itself

Question 11

Efficient Market Hypothesis (EMH)

Answer 11

An inefficient market is one in which an asset’s prices do not accurately reflect its true value. In extreme cases, an inefficient market may even lead to market failure.

The theory behind share price movement can be explained by the three forms of the efficient market hypothesis (EMH):

Weak form: prices incorporate information about past prices movement and their implications;

Semi-strong form: incorporate past prices movement and all publicly available information;

Strong form: past prices movement and all information, including publicly available information and inside information; share price will respond to new development and events before they become public knowledge

The EMH refers to how well prices reflect all available information: how share prices react to new information about a company

Question 12

Investment Strategy

Answer 12

Passive investing is a buy-and-hold strategy adopted by people who believe in the efficient market hypothesis where investors seek to generate stable gains over a more extended period as fewer complexities are involved,

Active investing is a strategy adopted by people who believe the market is inefficient where investors use research, analysis, skill, and experience to discover market inefficiencies to generate a higher profit over a shorter period and exceed the benchmark returns.

Arbitrage investing: the process of simultaneous buying and selling of an asset from different platforms, exchanges or locations to cash in on the price difference

Speculative investing: the purchase of high-risk assets based on price fluctuations and “hunches” over solid fundamentals. It’s often compared to gambling (GameStop-Shorting Stock)

Momentum investing: investors buy assets with an upward price trend and sell them once they seem to have peaked.

Value investing: a long-term investment strategy of buying stocks that appear undervalued and seem to be trading for less than their intrinsic value

Question 12

Implications of the EMH

Answer 12

If markets are fully efficient, then no fundamentalortechnical analysis can help investors find anomalies and make an extra profit, even inside information can’t give a trader an advantage, and they can not exceed standard returns.

A semi-strong form of market efficiency theory accepts that individuals cannot beat the market by reading the newspaper or annual reports and investors can gain an advantage in trading only when they have access to any unknown private information unknown to the rest of the market.

Weak market efficiency indicates that the investor cannot make an excess profit by studying past share price movement and sees no or limited benefit to technical analysis to discover investment opportunities

Question 12

Tests of the different forms of EMH

Answer 12

Weak-form efficiency market hypothesis:
test the randomness of stock prices (serial correlations, pattern recognition);
test the invalidity of technical analysis, which tests the predictability of earnings.

Semi-strong form efficiency hypothesis:
Speed of adjustment of stock prices to new information (event studies)
Studies that consider whether investors can achieve above-average profits by trading on the basis of any publicly available information (fund management performance)

Strong form efficiency hypothesis:
it is not possible to make abnormal gains by studying any kind of information

Question 13

Principal-Agent Problem.

Answer 13

The separation between ownership and control (principal-agent) leads to potential principle-agency problems.

The different interests of principals and agents may become a source of conflict, as some agents may not perfectly act in the principal’s best interests.

The resulting miscommunication and disagreement may result in various problems and discord within companies.
Incompatible desires may drive a wedge between each stakeholder and cause inefficiencies and financial losses.

Agency theory attempts to explain and resolve disputes over priorities between principals and their agents.

Question 13

Principal-Agent Relationship

Answer 13

The principal-agent relationship is an arrangement in which one entity legally appoints another to act on its behalf. 1 In a principal-agent relationship, the agent acts on behalf of the principal and should not have a conflict of interest in carrying out the act.

Principal-agent relationships include shareholders and management, financial planners and their clients, lessees and lessors, investors and fund managers, employers and employees., and individuals and contractor.

An agency cost is a type of internal company expense, which comes from the actions of an agent acting on behalf of a principal

Question 14

Agency Theory

Answer 14

Agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents

Source of conflicts of interest

Homo economicus: a rational economic person is characterised by their infinite ability to make perfectly rational decisions, i.e. decisions that maximise their utility for monetary and non-monetary gains

Asymmetric Information: one party in a transaction is in possession of more information than the other. In certain transactions

Moral hazards: a party has not entered into a contract in good faith or has provided misleading information

Corporate policies to minimise conflicts of interest

Corporate governance: the system of rules, practices, and processes by which a firm is directed and controlled\

Performance measurement

Compensation;

Question 15

Assumptions: Homo Economicus

Answer 15

Classical Economics based on the ‘rational economic person’ assumption:
individuals motivated by self-interest tied to wealth maximisation,
challenges the view that accountants will be ‘objective’.

Question 16

Positive Accounting Theory

Answer 16

The Positive Accounting Theory seeks to explain and predict why accountants elect to adopt particular accounting methods in preference to others (Watts and Zimmerman, 1978, 1979, 1986).

Begin with a suitable sample of observations (e.g. of accounting practices), and enables prediction(s) to be made if the theory is a good explanation of that practice.
Past observations may suggest companies are more likely to engage in creative accounting if they are experiencing financial difficulties

If that is a good explanation of past practice, then it can be predicted that companies will be more likely to engage in creative accounting in the future if they are facing financial difficulties.

Question 17

Corporate Failure Forecasting

Answer 17

The theory of forecasting is based on the premise that current and past knowledge can be used to make predictions about the future. In particular, for time series, there is the belief that it is possible to identify patterns in historical values and successfully implement them in the process of predicting future values.

Question 18

Assessing the likelihood of failure

Answer 18

Quantitative information
Analysis of the company accounts to identity problems relating to key ratios such as liquidity, gearing and profitability

Other information in the published accounts such as:

Very large increase in intangible fixed assets

A worsening cash position is shown by the cash flow statement

Very large contingent liability
Important post-balance sheet events

Qualitative information
Information in the chairman’s report and the director’s report (including warning, evasions and changes in the composition of the board since last year)

Information in the press (about the industry and the company or its competitors)

Information about environmental or external matters such as changes in the market for the company’s products or service

Question 19

Financial Distress Prediction

Answer 19

The intention of a financial distress prediction system is to disclose the potential operational and financial risks of a company and to alert business owners and managers of such risks before any outbreak.

Question 20

Financial Distress Prediction Applications

Answer 20

External (To The Firm) Analytics
Lenders (e.g., Pricing)
Bond Investors
Long/Short Investment Strategy on Stocks
Security Analysts & Rating Agencies
Regulators & Government Agencies
Auditors – Going Concern
Advisors (e.g., Assessing Client’s Health)
M&A

Internal (To The Firm) & Research Analytics
To File or Not (e.g., General Motors)
Comparative Risk Profiles Over Time
Industrial Sector Assessment (e.g., Energy)
Purchasers, Suppliers Assessment
Accounts Receivables Management
Researchers – Scholarly Studies

Question 21

Evolution of Prediction of Financial Distress

Answer 21

Qualitative (Subjective): Expert’s judgment and experience (1800s)

Univariate (Accounting/Market Metric): Beaver (1960s), Dupont Analysis (1914);

Multivariate (Accounting/Market Metric): Multiple Discriminant analysis (MDA) (Z-Score, 1960’s)

Contingent Claims Approach (Balance Sheet/Market Metric) (1970s – Present)

Artificial Intelligence Systems: Expert Systems, Neural Networks, Machine Learning (1990s)

Question 22

Prediction of Financial Distress

Answer 22

Beaver (1966) used financial ratios with a univariate technique to predict financial failure. Beaver found that the cash flow to total debt ratio is the best predictor for five years preceding failure. ALL organisations with the ratio below 0.2 failed within 5 years, and those above 0.4 did not fail the next five years.

Beaver’s model may give inconsistent and confusing classification results for different ratios for the same firm (Altman 1968).

Altman developed the well-known Z score model with financial ratios based on multiple discriminant analysis (MDA). The results found that five financial ratios (Liquidity, Profitability, Efficiency, Leverage, and Solvency) are significant predictors in the corporate bankruptcy prediction model.

Question 23

The Z-score Model

Answer 23

First developed by Altman in 1968 as a measure of the probability of a company going bankrupt.

Altman’s Z-score Model is a numerical measurement that is used to predict the chances of bankruptcy.

Altman’s Z-score model combines five financial ratios to predict the probability of a company becoming insolvent in the next two years.

Question 24

Z-score constituent ratios

Answer 24

Working Capital/total assets (WC/TA) - Liquidity

Working Capital is the difference between the current assets and current liabilities as obtained from the balance sheet

Retained Earnings/total assets ( RE/TA) – Cumulative Profitability

Retained Earning is also known as the earned surplus
It represents the total amount of reinvested earnings and/or losses of a firm over its entire life-cycle
Can be obtained from the balance sheet

Earnings before interest and taxes/Total assets (EBIT/TA) - Efficiency

Measure of a corporation’s earning power from ongoing operations, by looking at the productivity of assets
Also known as Operating profit
Watched closely by creditors as it represents the total amount of cash that a corporation can use to pay off its creditors
Can be obtained for the Income statement

Market Value of Equity/Book Value of total liabilities (MVE/TL) –Gearing/Leverage

The market value of equity is the total market value of all of the stock, both preferred and common
The book value of liabilities is the total value of liabilities both long-term and current
The MVE/TL shows how much the firms’ assets can decline in value with increasing liabilities before the liabilities exceed the assets

Sales/Total Assets (S/TA) - Solvency

Also known as capital turnover ratio
Illustrates the sales-generating ability of the corporation’s assets by looking at the revenue-generating capability

Question 25

Z-Scores weighting

Answer 25

Working Capital/total assets (WC/TA) - Liquidity X 1.2

Retained Earnings/total assets ( RE/TA) – Cumulative Profitability X 1.4

Earnings before interest and taxes/Total assets (EBIT/TA) - Efficiency X 3.3

Market Value of Equity/Book Value of total liabilities (MVE/TL) –Gearing/Leverage X 0.6

Sales/Total Assets (S/TA) - Solvency X 1

Question 26

Z-Score indiactor

Answer 26

Less than 1.81 - companies with a Z score of below 1.81 are in danger and possibly heading towards bankruptcy

Between 1.81 and 2.99 - companies with scores between 1.81 and 2.99 need further investigation.

3 or above - companies with a score of 3 or above are financially sound.

Question 27

Additional Altman Z-Score Models

Answer 27

Private Firm Model (1968)
Non-U.S., Emerging Markets Models for Non-Financial Industrial Firms (1995), e.g., Latin America (1977, 1995), China (2010), etc.
Sovereign Risk Bottom-Up Model (2010)
SME Models for the U.S. (2007) & Europe

Question 28

Limitations of Altman’s Z-Score Model

Answer 28

Only Quantitative information is considered, and parameters like competition, market condition, and type of industry are completely discounted.

Z score work on Historical data i.e., it is a postmortem and not projected data.
Factors such as management style, approach & strategy are completely ignored.

Further analysis is required to fully understand the situation, e.g., cash flow projections, detailed cost information, and environmental review.

Scores are only good predictors in the short term.

Figures are open to manipulation.
The Z score model only gives guidance below the danger level of 1.81.

Further investigation is needed for those organisations with scores between 1.81 and 2.99.

Question 29

Weakness of quantitative models

Answer 29

Significant events can take place e between the end of the financial year and the publication of reports; especially when factors that led up to the collapse are essentially internal to the business and would never have become apparent in the published accounts (Baring merchant bank)

The information only looks at the past and takes no account of current and future situations

The underlying financial information may not be reliable.;

Disclosure requirements;

Figures are open to manipulation: creative, or even fraudulent accounting

Question 30

Information Systems

Answer 30

Information systems are a combination of planned procedures, suitably designed forms, an appropriate organisation structure and managers who are capable of using the output that is produced to assist them in the administration and use of available resources.

A modern organisation needs a wide range of systems to process, analyse and hold information. There are five main types of information processing systems:

Transaction processing systems (TPS)
Management information systems (MIS)
Decision support systems (DSS)
Executive information systems (EIS)
Expert systems (ES)

Question 31

Factors in Argenti’s Model

Answer 31

Defects Autocratic CEO
Passive board
Lack of budgetary control
Mistakes
Over-trading (expanding faster than
cash funding)
Gearing – high bank overdrafts/loans
Failure to large project jeopardise the
company
Symptoms
Deteriorating ratios
Creative accounting - sings of
window-dressing
Declining moral and declining quality

Question 32

Quantifying a Qualitative Judgement

Answer 32

The failure of a business organisation is seen as the culmination of a sequence starting with management defects that bring mistakes, which in turn produce symptoms.

The Argenti score attempts to quantify a qualitative judgement using a management-scoring approach to rate the risk of poor management causing corporate failure.

Question 33

Argenti’s A Model list and score (management defects) (Group A)

Answer 33

The Chief Executive is an autocratic (8)
The Chief Executive is also the chairman (4)
Passive Board of Directors (2)
Unbalanced Board – not presenting all business functions or overweight in one discipline (2)
Weak Finance Director (2)
Poor management depth (1)

Question 34

Argenti’s A Model list and score (Accounting defects) (Group A)

Answer 34

No budgets or budgetary controls (3)
No cash flow plans or not up to dated. (3)
No costing system, cost and contribution of each product or service are unknown.(4)
Poor response to change, old fashion products or services, obsolete production facilities, out of date marketing, old directors (15)

Question 35

Argenti’s A Model list and score (Management mistakes)(Group B)

Answer 35

High leverage, (15)
Over trading, Company expanding faster than funding. Capital base too small for level f activity or unbalanced for type and nature of the business. (15)
Big project has gone wrong or any obligation that the company cannot meet if something goes wrong. (15)

Question 36

Argenti’s A Model list and score (Symptoms of troubles)(Group C)

Answer 36

Financial analysis, such as Z-score, appears to indicate failure or difficulties. (4)
Creative accounting: Chief executive is the first to see signs to failure and in an attempt to hide it from creditors and the banks, accounts are ‘glassed over’ by, for instance, over valuing stocks, using lower depreciation etc. Skilled observers can spot these things. (4)
Any non-financial signs of problems, such as uncleaned and untidy offices, high staff turnover, low morale, rumours and so on. (3)
Terminal signs – at the end of the failure process, the financial and non-financial signs become so obvious that even the casual observer recognises them (1)

Question 37

Argenti’s A Model Indicators

Answer 37

<18 = Secure
>18 but <25 = grey area
>25 = Risk

Question 38

Basic Management Principles

Answer 38

1) Develop and communicate a strategy.
2) A unified sense of direction to which all members of the organisation relate. If you want to achieve plans, programmes and policies, then overall controls and costs controls must be established.
3) Exercise care in the selection of a Board of Directors and require that they actively participate in management.
4) Avoid the one-man rule.
5) Provide management depth.
6) Keep informed of change and react to change
7) Don’t overlook the customer and the customer’s new power.
8) Use but don’t misuse computers.
9) Do not engage in accounting manipulations.
10) Provide for an organisational structure that meets the needs of people.

Question 39

5 Cs of Credit

Answer 39

Character
Capacity
Capital
Collateral
Conditions

Question 40

Character

Answer 40

refers to the trustworthiness of the borrower

Question 41

Capacity

Answer 41

is a legal question, i.e., does the borrower have the legal capacity to borrow?

Question 42

Collateral

Answer 42

is also important as it is considered as a secondary source of assurance of payment.

However, during tight financial conditions, it is difficult to access collateral for the following reasons:

People know the reason for sale and hence bid the price down

Defaults on loans often occurs in poor economic conditions.

Consequently, lenders record losses, because the sale of the collateral does not cover the outstanding principal and interest

Question 43

Capital/Cash

Answer 43

Capital/Cash is the most important “C” is, because this is what repayment of loan is dependent upon. Much of the analysis is done to ensure that the borrower can generate sufficient cash flow as opposed to accounting profit to repay the loan

The ratios used are: Current ratio, inventory turnover ratio, net profit margin ratio and Debt to equity ratio.

Question 44

Conditions

Answer 44

Conditions refers to the economic conditions under which the borrower is operating. For a business borrower, conditions include the prospects of the company, the industry and the economy in general.

Question 45

Limitationsof qualitative models

Answer 45

Based on the subjective judgement of experts (also a strength).

Requires a large amount of financial and non-financial information (also a strength)
Results are only as good as inputs into them.

Ambiguities could arise when interpreting the credit criteria

The performance of such systems are very uneven. The success or failure of these systems rely on the experience of the lending officer

Question 46

What are ethical and legal issues in business?

Answer 46

Legal issues in business will arise when you are not in line with certain laws which are all clearly outlined by the government.

Employee issues; Intellectual property; Disagreements between shareholders; Disrespecting the competition (Antitrust Law)

Banking regulations require banks to satisfy specific capital requirements to protect depositors and promote the stability and efficiency of financial systems.

Insurance regulations require insurance companies to meet conditions for minimum financial health to protect insurance policyholders.

Relevant laws permit utility companies to earn only a reasonable return on their invested assets to ensure the continuity of supply and affordability of essential utilities

Ethical issues do not necessarily have a legal base. They are based on human ethics, values, and the concept of right and wrong.

Ethical issues involve rules or standards governing the conduct of members of a profession, while legal issues involve rules governing the conduct of persons within a community, state, or country.

Question 47

Basel Committee on Banking Supervision (BCBS)

Answer 47

published a series of regulations and guidance regarding regulatory capital, credit risks, market risks, liquidity and leverage, disclosure requirements

Question 48

Basel Accord (Basel I)

Answer 48

promotes the risk-weighted capital requirements. From a risk-based capital requirement perspective, bank assets with different risk categories should be matched with different amounts of required capital

Question 49

Basel II

Answer 49

The capital accord was amended by incorporating market risks in 1997 and updated with further modifications to the market risk in 2005

Question 50

Basel III

Answer 50

In 2011 it increased bank capitalisation, Pillar 3 of the Basel framework seeks to promote market discipline through regulatory disclosure requirements.

Question 51

Ethical Dilemma

Answer 51

Accounting issues
Production issues
Sales and marketing issues
Personnel (HRM) issues

Question 52

Accounting issues

Answer 52

Creative accounting to boost or suppress reported profits.

Directors’ pay arrangements - should directors continue to receive large pay packets even if the company is performing poorly?

Should bribes be paid to facilitate contracts, especially in countries where such payments are commonplace?

Insider trading, where for example directors may be tempted to buy shares in their company knowing that a favourable announcement about to be made should boost the share price.

Question 53

Production issues:

Answer 53

Should the company produce certain products at all, e.g. guns, pornography, tobacco, alcoholic drinks aimed at teenagers?

Should the company be concerned about the effects on the environment of its production processes?

Should the company test its products on animals?

Question 54

Sales and marketing issues:

Answer 54

Price fixing and anti-competitive behaviour may be overt and illegal or may be more subtle.

Is it ethical to target advertising at children, e.g. for fast food or for expensive toys at Christmas?

Should products be advertised by junk mail or spam email?

Question 55

Personnel (HRM) issues

Answer 55

Employees should not be favoured or discriminated against on the basis of gender, race, religion, age, disability, etc.

The contract of employment must offer a fair balance of power between employee and employer.

The workplace must be a safe and healthy place to operate in.

Question 56

Socially responsible investing (SRI)

Answer 56

also known as social investment, is an investment that is considered socially responsible due to the nature of the business the company conducts.

Question 57

ESG

Answer 57

environmental, social and corporate governance

ESG investing refers to a set of standards for a company’s behavior used by socially conscious investors to screen potential investments.

ESG is a framework that helps stakeholders understand how an organization is managing risks and opportunities related to environmental, social, and governance criteria (sustainability issues）

Question 58

Environmental Issues

Answer 58

Environmental criteria refer to an organization’s environmental impact(s) and risk management practices

direct and indirect greenhouse gas emissions

stewardship over nature resources, .energy use, natural resource conservation

waste generation, pollution,

treatment of animals,

firm’s overall resiliency against physical climate risks (like climate change, flooding, and fires),etc.

Question 58

Social Issues

Answer 58

Social criteria investigates the company’s relationships with its stakeholders.

Attitudes towards diversity, human rights, fighting slavery, consumer privacy protection as well as charity through CSR and volunteer programs.

Human Capital Management metrics (like fair wages and employee engagement metrics)

an organization’s impact on the communities in which it operates

Question 59

Governance Issues

Answer 59

Governance criteria refers to how a company is led and managed.

how leadership’s incentives are aligned to stakeholder expectations: Executive Compensation Scheme, Bribery and Corruption Policies

how to diversity board of directors

how shareholder rights are viewed,

How to promote transparency and accurate and transparent accounting methods.

Question 60

Principles for Responsible Investment (PRI)

Answer 60

The Principles for Responsible Investment (PRI) is an international organisation, supported by the United Nations (UN), that works to promote the incorporation of environmental, social, and corporate governance factors (ESG) into investment decision-making

The PRI works with signatories to identify key environmental, social and governance issues in the market, and coordinates engagements, publications, webinars, podcasts and events to address them.

Question 61

The Six Principles of PRI

Answer 61

We will incorporate ESG issues into investment analysis and decision-making processes.

We will be active owners and incorporate ESG issues into our ownership policies and practices.

We will seek appropriate disclosure on ESG issues by the entities in which we invest.

We will promote acceptance and implementation of the Principles within the investment industry.

We will work together to enhance our effectiveness in implementing the Principles.

We will each report on our activities and progress towards implementing the Principles.

Question 62

Corporate Governance

Answer 62

Corporate governance can be defined as the system by which companies are directed and controlled. It covers topics such as:

how power is divided between the board and the shareholders

the accountability of the board to the members of the company and other stakeholders

the rules and procedures for making decisions.

the provision of controls for companies.

Corporate governance provides the structure through which the company’s objectives are met, the means of attaining those objectives and monitoring performance.

Question 63

Internal Control Systems

Answer 63

Good corporate governance means that the board must identify and manage all risks for a company. Internal control and risk management are fundamental components of good corporate governance.

In terms of risk management, internal control systems span finance, operations, compliance and other areas, i.e. all the activities of the company

Controls attempt to ensure that risks, those factors which stop the achievement of company objectives, are minimised.

An internal control system comprises the whole network of systems established in an organisation to provide reasonable assurance that organisational objectives will be achieved.

Internal management control refers to the procedures and policies in place to ensure that company objectives are achieved.
The control procedures and policies provide detailed controls implemented within the company.

Question 64

Elements of an effective Internal Control System

Answer 64

Control Environment

Demonstrates commitment to integrity and ethical values
Exercises oversight responsibility
Establishes structure, authority and responsibility
Demonstrates commitment to competence
Enforces accountability

Risk Assessment

Specifies suitable objectives
Identifies and analyzes risk
Assesses fraud risk
Identifies and analyzes significant change

Control Activities

Selects and develops control activities Selects and develops general controls over technology
Deploys through policies and procedures

Information & Communication

Uses relevant information
Communicates internally
Communicates externally

Monitoring Activities

Conducts ongoing and/or separate evaluations
Evaluates and communicates deficiencies

Question 65

Three/Four Lines of Defense Model

Answer 65

The three/four lines of defense model provides guidance for effective risk management and governance by clarifying roles and duties . Each of the three lines plays a distinct role within the organization’s wider governance framework.

The first line of defense is primarily handled by front-line and mid-line managers who have day-to-day ownership and management of risk and control

The second line of defense includes various risk management and compliance functions put in place by management to help ensure controls and risk management processes implemented by the first line of defense are designed appropriately and operating as intended

The third line of defense is the internal auditors . The Institute of Internal Auditors (IIA) defines internal auditing as an “independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.

The fourth line of defense is the external audit can look at any aspects of a business’s processes and results that are relevant to the audit assignment.

Question 66

Second line of defence: Management review

Answer 66

The second line of defence relates to review by management or specialists that is separate from day-to-day operations. It includes risk and compliance reviews, financial controls over operational departments and oversight of operations by the board. It can also include quality control reviews that are additional to day-to-day quality checks.

A compliance department typically has five areas of responsibility —
Identification: identifies risks that an organization faces (comply with relevant laws and regulations and internal procedures)

Prevention: advises on how to avoid or address them and implements controls to protect the organization from those risks. (conduct training for employees.)

Monitoring and detection: monitors and reports on the effectiveness of controls in the management of the organisations risk exposure.

Resolution: resolves compliance issues as they arise and

Advisory: advised the business on rules and controls.

Question 67

Compliance Management System

Answer 67

In simple terms, a compliance management system, or CMS, is an interconnected system that helps manage compliance.

According to the regulators, a strong CMS must include these two key parts:
Board of Directors and Management Oversight: Communicate clear expectations, adopt clear policies, and define an appropriately staffed compliance function.

A Compliance Program: an organisation’s internal systems and procedures for helping to ensure that the organisation – and those working there – comply with legal requirements and internal policies and procedures.

Policies/procedures,

Training,

Monitoring, and

Consumer complaint response.

Every CMS is different because it’s customised to the unique needs of each institution and should be crafted to fit size, branches, employees, history, existing risk, business structure, and strategy, among other factors.

Question 68

The Five Pillars of an Anti-Money Laundry(AML) Compliance Program

Answer 68

The first pillar: implementation of effective internal controls through the establishment of internal policies and procedures

The second pillar requires the designation of a compliance (AML) officer responsible for managing the program.

The third pillar sets an expectation that appropriate periodic training for employees will be given; the focus of the training should be the programs and its controls, and the roles and responsibilities of employees within the program.

The fourth pillar requires independent testing of the program.

The fifth pillar include: risk-based procedures for conducting ongoing customer due diligence which include understanding the nature and purpose of customer relationships for the purpose of developing a customer risk profile; and conducting ongoing monitoring to identify and report suspicious transactions and, on a risk basis, to maintain and update customer information

Question 69

The Law of Torts

Answer 69

A tort is a type of civil wrong. It is a breach of a legal duty or an infringement of a legal right which gives rise to a claim for damages. As a tort is a breach of a legal duty, there is no liability unless the law recognises that the duty exists.
Types of Tort

Nuisance
The tort of nuisance allows a claimant to sue for most acts that interfere with their use and enjoyment of their land.

Trespass to Land
Trespass to land occurs where a person directly enters upon another’s land without permission, or remains upon the land, or places or projects any object upon the land

Trespass to Person
Generally, trespass to the person consists of three torts: assault, battery, and false imprisonment.

Negligence
Negligence is the breach of a legal duty to take care, which results in damage to another.

Question 70

Duty of Care

Answer 70

In the law of torts there is a legal obligation for individuals toadhere to a standard of reasonable care while performing any acts that could foreseeably harm others.

Tests to determining whether a duty of care exists.

Was the damage reasonably foreseeable by the defendant at the time of the act or omission?

Is there a neighbourhood principle or sufficient proximity (closeness) between the parties?

Should the law impose a duty of care between the parties i.e. is it fair and reasonable to do so?

Is there a matter of public policy which exists or requires that no duty of care should exist?

Lord Atkin defined those to whom we owe a duty of care in the neighbour principle:
‘You must take reasonable care to avoid acts or omissions which you ought reasonably foresee would be likely to injure your neighbour.’

He defined neighbours as ‘…persons who are so directly affected by my act that I ought reasonably to have them in contemplation’.

Duty of care refers to a fiduciary responsibility held by company directors which requires them to live up to a certain standard of care

Question 71

Breach of duty of care

Answer 71

The duty requires directors to make decisions in good faith and in a reasonably prudent manner.
The duty of care also applies to other roles within the financial industry, including accountants, auditors, and manufacturers.

Failure to uphold the duty of care may result in legal action by shareholders or clients.

In order for a claim a breach of duty of care to be successful, a claimant must not only prove that a duty of care existed, but that:

the duty was breached by the defendant. Establishing if there has indeed been a breach is a question of fact. Each case must be viewed separately on its own facts.

the defendant has not shown the required standard of care.

Failure to uphold the duty of care may result in legal action being brought by shareholders or clients for negligence.

Along with the duty of care, the other main fiduciary duty is the duty of loyalty; the duty of loyalty seeks to prevent directors from acting against the best interests of the corporation