Chapter 1

Question 1

COSO (Committee of Sponsoring Organizations

Answer 1

• independent private sector initiative, initially established din mid-1980s to study factors that lead to fraudulent financial reporting
• AAA, AICPA, FEI, IIA, and IMA

Question 2

COSO Internal Control Framework

Answer 2

• framework used by company management and its board of directors to obtain an initial understanding of what constitutes an effective system of internal controls and to provide insight as to what internal controls are being properly applied within the organization
• confidence to stakeholders

Question 3

Internal Control

Answer 3

process that is designed and implemented by an organization’s management, board of directors, and other employees to provide reasonable assurance that the organization with achieve its operating, reporting, and compliance objectives

Question 4

COSO Application to Management and Board

Answer 4

• effectively applying internal controls within the overall organization, on a divisional unit level or at a functional level
• determining requirements of an effective system of internal control by ascertaining whether the components and principles exist and are function properly
• allowing judgement and flexibility in the design and implementation of the system of internal controls within all operational and functional areas
• identifying and analyzing risks and then developing acceptable actions to mitigate or minimize risk to acceptable levels
• eliminating redundant, ineffective, or inefficient controls
• extending internal control application beyond an organization’s financial reporting

Question 5

COSO Application to Stakeholders

Answer 5

• greater understating of what constitutes an effective system of internal controls
• greater confidence that management will be able to eliminate ineffective, redundant, or inefficient controls
• greater confidence that board has effective oversight of internal controls
• improved confidence that organization will achieve its stated objectives and will be capable of identifying, analyzing, and responding to risks affecting the organization

Question 6

Objective of COSO Framework

Answer 6

• Operations Objectives: relate to effectiveness and efficiency of an entity’s operations
  
  • includes financial and operational performance goals as well as ensuring that assets are adequately safeguarded against potential losses
• Reporting Objectives: pertain to reliability, timeliness, and transparency of an entity’s external and internal financial and nonfinancial reporting as established by regulators, accounting standard setters, and firm’s internal policies
• Compliance Objectives: ensure entity is adhering to all applicable laws and regulations

Question 7

COSO Components of Internal Controls

Answer 7

1. Control Environment
2. Risk Assessment
3. Information and Communication
4. Monitoring
5. Existing Control Activities

Question 8

Control Environment

Answer 8

• includes processes, structures, and standards that provide the foundation for an entity to establish a system of internal control
• established through “tone at the top”
• Principles:
  
  • Commitment to Ethics and Integrity
    
    • tone at tops, establishing standards of conduct, evaluating adherence to standards, and address deviations in timely manner
  • Board Independence and Oversight
    
    • independent from management and oversees development and performance of internal control
  • Organizational Structure
    
    • established by management
    • establishing reporting lines
    • defining, assigning, and limiting authorities and responsibilities
  • Commitment to Competence
    
    • hire, develop, and retain competent employees
  • Accountability
    
    • individuals held accountable for internal control responsibilities

Question 9

Risk Assessment

Answer 9

• identify and analysis of risks to achievement of objectives
• Principles:
  
  • Specify Objectives
    
    • identifying objectives that reflect management’s choices while complying with applicable accounting standards, laws, and regulations
  • Identify and Analyze Risk
    
    • to determine how the risks should be managed
    • analyzing internal and external factors
    • involving appropriate levels of management
    • determining how to respond
  • Consider Potential for Fraud
    
    • assessing incentive and pressures, opportunities and attitudes, and rationalizations
  • Identify and Assess Changes
    
    • changes that could significantly affect the system
    • external environment, business model and leadership

Question 10

Information and Communication

Answer 10

• support the identification, capture, and exchange of information in a timely and useful manner
• Principles:
  
  • Obtain and use Information
    
    • relevant, high-quality information to support the functioning of internal controls
    • identifying and defining information requirements within the internal control component level
  • Internally Communicate Information
    
    • necessary information to support the functioning of internal controls including relevant objectives and responsibilities
    • focus on flow of information up, down, and across organization using a variety of methods and channels
  • Communicate with External Parties
    
    • regarding matters that affect the functioning of internal controls
    • management having open, two-way external communication channels using variety of methods and channels

Question 11

Monitoring Activities

Answer 11

• process of assessing the quality of internal control performance over time by assessing the design and operation of controls on a timely basis and by taking necessary corrective actions
• Principles:
  
  • Ongoing and/or Separate Evaluations
    
    • selecting, developing, and performing to ascertain whether the components of internal controls are present and functioning
    • consider establishing baseline understanding
  • Communication of Deficiencies
    
    • evaluates and communicates internal control deficiencies in a timely manner to parties responsible for taking corrective action

Question 12

Existing Control Activities

Answer 12

• activities set forth by an entity’s policies and procedures to ensure that directives initiated by management mitigate risks are preformed
• may be detective or preventive in nature
• may be automated or manual
• require segregation of duties
• Principles:
  
  • Select and Develop Control Activities
  • Select and Develop Technology Controls
  • Deployment of Policies and Procedures

Question 13

Effective Internal Control

Answer 13

• framework indicates that an effective system of internal controls provides reasonable assurance that the entity’s objectives will be achieved
• all five components and 17 principles that are relevant be both present and functioning
• Present (Design): components and relevant principles are included in the design and implementation of the internal control system
• Function (Operating Effectively): components and relevant principles are currently operating as designed in the internal control systems
• integrated systems

Question 14

Ineffective Internal Control: COSO

Answer 14

• GAAP uses term “significant deficiency” and “material weakness”
• COSO uses “major deficiency”
• reduces likelihood that an organization can achieve its objectives

Question 15

Internal Control Framework Limitations

Answer 15

• Breakdowns in internal control due to errors or human failures
• Faulty or biased judgement used in decision making
• Issues relating to the suitability of the entity’s objectives
• external events beyond the control of the entity
• circumvention of controls through collusion
• management override of internal controls

Question 16

Using the COSO Framework Document

Answer 16

• Overall Assessment: supported by component evaluations
• Component Evaluation: supported by principal evaluations
• Principal Evaluations: serve as the source for isolating and defining internal control deficiencies
• Summary of Internal Control Deficiencies” summarize and impact the overall assessment

Question 17

Common Risk Using COSO

Answer 17

• Material Omission or Misstatement
  
  • vary due to:
    
    • industries, markets, and geographic areas
    • multiple regulatory environments with different standards
    • transactional environments with numerous contracts
    • active merger, acquisition, and divestiture environment
    • dynamic technological environment
    • high executive turnover
• Fraud
  
  • either by fraudulent financial reporting or misappropriation of assets
  • examples:
    
    • management bias in exercising judgement
    • degree of estimates and judgements underlying accounting and reporting
    • incentive for fraud
    • attitudes and rationalization by individuals
    • unusual transactions
    • vulnerability to management override
• Management Override
• Illegal Acts
  
  • violations of governments regulations that could have a material impact on financial statements
  • examples:
    
    • existence of investigations
    • reports of regulatory examiners
    • payments for unspecified services
    • delinquent tax returns

Question 18

Enterprise Risk Management (COSO)

Answer 18

• the culture, capabilities, and practice, integrated with strategy-setting and performance, that organizations rely on to manage risk in creating, preserving, and realizing value
• series of sequential yet intertwined components that drive an organization toward enhanced value
• developed to assist organizations in developing a comprehensive response to risk management
• defines risk as the possibility that events will occur and affect the achievement of strategy and business objectives
• underlying premise if that every entity exists to provide VALUE for stakeholders which involves risk
• management decisions will affect value development through creation, preservation, erosion, and realization
• Value Creation: when benefits of value exceed the cost of resources used
• Value Preservation: when ongoing operations efficiently and effectively sustain created benefits
• Value Erosion: faulty strategy and inefficient/ ineffective operation cause value to decline
• Value Realization: benefits created by organizations are received by stakeholder either monetary or nonmonetary forms

Question 19

Mission

Answer 19

represents core purpose of entity

why company exists

what it hopes to accomplish

Question 20

Vision

Answer 20

represents the aspirations of the entity and what it hopes to achieve over time

Question 21

Core Values

Answer 21

represent an organization’s beliefs and ideals about what is good or bad, acceptable or unacceptable

influence the behavior of organization

Question 22

Culture

Answer 22

• represents the collective thinking of the people within an organization
• plays important role in shaping decisions regarding risks

Question 23

Capabilities

Answer 23

• competitive advantage
• produces value for an entity
• exploitation of competitive advantage and adaption to change are embedded within ERM

Question 24

Practices

Answer 24

• ERM is an organizational practice continually applied to entire scope of activities of the business

Question 25

Risk Appetite

Answer 25

• represents the types and amounts of risk, on a broad level, an organization is willing to accept in pursuit of value
• range rather than specific limit
• provides guidance
• expressed first in mission and vision
• varies between products, business units, and timelines

Question 26

Risk Inventory

Answer 26

all risk that could impact entity

Question 27

Reasonable Expectation

Answer 27

amount of risk of having strategy and business objectives that is appropriate for an entity

realizing no one can predict with precision

Question 28

Business Context

Answer 28

• trends, events, relationships, and other factors that may influence, clarify, or change an entity’s current and future strategy and business objectives

Question 29

Risk Capacity

Answer 29

maximum amount of risk that an entity is able to absorb in the pursuit of strategy and business objectives

Question 30

Risk Profile

Answer 30

• composite view of the risk assumed at a particular level of the entity or aspect of the business that positions management to consider types, severity, and interdependencies of risks and how they may affect performance relative to strategy and business objective

Question 31

Portfolio View

Answer 31

• composite view of risk that entity faces which positions management and borad to consider the types, severity, and interdependencies of risk

Question 32

Organizational Sustainability

Answer 32

ability of an entity to withstand the impact of large-scale events

Question 33

Performance Management

Answer 33

• measurement of efforts to achieve or exceed the strategy and business objectives

Question 34

Components of Enterprise Risk Management

Answer 34

1. Governance and Culture
2. Strategy and Objective Setting
3. Performance
4. Review and Revision
5. Information, Communication, and Reporting (Ongoing)

Question 35

Governance and Culture

Answer 35

• Defines desired culture
• Exercises board oversight
• Demonstrates commitment to core values
• Attracts, develops, and retains capable individuals (employees)
• Establishes operating structure

Question 36

Strategy and Objective Setting

Answer 36

• Evaluates alternative strategies
• Formulates business objectives
• Analyzes business context
• Defines risk appetite

Question 37

Performance

Answer 37

• Develops portfolio view
• Assesses severity of risk
• Prioritizes risk
• Identifies risk (events)
• Implements risk responses

Question 38

Review & Revision

Answer 38

• Assesses substantial change
• Pursues improvement in ERM
• Reviews risk and performance

Question 39

Information, Communication, and Reporting (Ongoing)

Answer 39

• Leverage information and technology
• Communicates risk information
• Reports on risk, culture, and performance

Question 40

Implements Risk Responses

Answer 40

• Accept: no action taken to change severity of risk → within risk appetite
• Avoid: action is taken to remove risk → entity cannot devise a risk response that will mitigate the risk to objectives
• Pursue: action is taken that accepts increased risk to achieve improved performance → when management understands the nature and extent of any changes required
• Reduce: action is taken to reduce the severity of risk
• Share: action is taken to reduce the severity of risk through techniques such as outsourcing or insurance

Question 41

Sarbanes Oxley Act of 2002

Answer 41

• provisions for expanded disclosures by corporations and specific representations required by officers of public companies that must accompany the financial statements

Question 42

Title III of Sarbanes Oxley

Answer 42

• relates to establishment of an audit committee and the representations made by key corporate officers, typically the CFO or CEO

Question 43

Public Company Audit Committees (Title III)

Answer 43

• public companies are responsible for establishing an audit committee that is directly responsible for the appointment, compensation, and oversight of the work of the public accounting firm employed by that company
• auditor directly reports to audit committee
• responsible for resolving disputes between auditor and management
• Independence is a criteria:
  
  • audit committee members may not accept compensation from the issuer for consulting or advisory services
  • audit committee member may not be affiliated person of the issuer
• Must establish procedures to accept reports of complaints regarding audit, accounting, or internal control issues (whistle-blower hotlines)

Question 44

Corporate Responsibility for Financial Reports (Title III)

Answer 44

• CFO or CEO must sign certain representations regarding annual and quarterly reporting
• assertion that:
  
  • they have reviewed report
  • report does not contain untrue statements or omit material information
  • financial statements fairly present in all material respects the financial condition and results of operations
  • assume responsibility for internal controls
  • signing report assert that they have made the following disclosures to issuer’s auditors and the audit committee
    
    • significant deficiencies and material weaknesses in the design or operation of internal controls which might adversely affect financial statements
    • any fraud that involves management
  • any changes to internal controls

Question 45

Title IV (Enhanced Financial Disclosures)

Answer 45

• additional details regarding the financial statement, internal controls, and operations of audit committee
• Include:
  
  • all material correcting adjustments identified by the audit should be reflected in financial statements
  • should disclose all material off-balance sheet transactions:
    
    • operating leases
    • contingent obligations
    • relationships with unconsolidated subsidiaries
• Proforma should include:
  
  • no untrue statements
  • no omitted material information
  • reconciled with GAAP basis financial statement
• Disclose of SPEs (special purpose entities)
• Issuers are prohibited from making personal loans to directors or executive officers
• Disclosures for persons who have direct or indirect ownership of more than 10% of any class of most any equity security

Question 46

Section 404

Answer 46

• assessment of internal controls
• report is required to include:
  
  • statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting
  • an assessment, as of the end of the most recent fiscal year, of the effectiveness of the internal control structure and procedures for financial reporting
• auditor must attest to management’s assessment of internal control
• investment companies are exempt from this act
• must include the Code of Ethics for Senior Officers
• Disclosure of Audit Committee Financial Expert
  
  • at least one member of the audit committee needs to be a financial expert
  • knowledge of GAAP
  • experience in the preparation or auditing of financial statements for comparable issuers
  • Application of GAAP
  • Experience with internal controls
  • Understanding of audit committee functions

Question 47

Title VIII (Corporate and Criminal Fraud Accountability)

Answer 47

• Criminal Penalties for Altering Documents
  
  • fines and up to 20 years in prison
  • audit documents must be maintained for 7 years
    
    • fines and up to 10 years in prison
• Statute of Limitations for Securities Fraud
• No later than earlier of two years after the discovery of the facts constituting violation or five years after the violation
• Whistle-Blower Protection
• Criminal Penalties for Securities Fraud
  
  • an individual who knowingly executes, or attempts to execute, securities fraud will be fined and/or imprisoned for max of 25 years

Question 48

Title IX (White-Collar Crime Penalty Enforcement)

Answer 48

• Attempt and Conspiracy
  
  • individual who attempts (conspires) to commit any white-collar crime offense will be subject to same penalties as those who commit offense
  • mail & wire fraud = 20 years
  • violating ERISA = $100,000 &/or 10 years

Question 49

Title XI (Corporate Fraud Accountability)

Answer 49

• Tampering with Record or Impeding an Official Proceeding
  
  • fines and up to 20 years in prison
• Temporary Freeze Authority for SEC
  
  • if SEC determines it is likely that the issuer will be required to make penalty payments, the SEC may petition a federal district court to require the issuer to escrow payments in an interest-bearing account for 45 days
• Authority of the SEC to Prohibit Person from Serving as officer or Directors
• Retaliation Against Informants
  
  • fines and up to 10 years in prison

Question 50

Business Process Management

Answer 50

• process that reviews and oversees the organization’s approach to business process design and implementation
• may utilize software, tools, methodologies, or a combo approach to achieve objectives
• goal is to identify, document, model, assess, improve, optimize, and potentially automate or outsouce business processes

Question 51

Business Process Analysis

Answer 51

• methodology that looks at an organization’s business processes to improve its effectiveness and efficiency
• gain understanding of process
• evaluating what is occurring
• where the activity or information originates
• how information is exchanged and reported
• who are the parties involved
• helps to determine where value is added

Question 52

Business Process Automation

Answer 52

• looks to identify and automate business processes
• works to convert processes that are manual, repetitive, and recurring into systematic and automatic processes using automation technology

Question 53

Business Process Modeling Tools

Answer 53

• data flow diagrams
• flow charts
• system interface diagrams

Question 54

Impact of Business Process Management

Answer 54

• enhanced efficiencies in collecting, storing, processing, and analyzing information
• Improved accuracy in reporting
• Optimization of the supply chain for production and purchasing inventory
• greater customer service and retention
• automation of activities
• better decision making
• increased insights through analytics

Question 55

Key Business Processes

Answer 55

• Examples:
  
  • revenue
  • expenditure
  • human resources
  • payroll
  • manufacturing
  • financing
  • reporting processes

Question 56

Revenue Process

Answer 56

• recurring business activities surrounding the sale and delivery of goods and services including collection of payments from customers
• managing customer accounts and relationships
• exchanging information through invoice and payments
• Revenue Process Activities
  
  • sales order receipt and entry
  • Delivery of services or goods
  • Customer Billing
  • Payment Collections
• Key Documents:
  
  • Sales Order: document that lists the details of the customer order including the items or services ordered, quantity, prices, and agreed-upon timing and delivery terms
  • Pick Ticket: list provided to the warehouse or inventory function detailing items and quantities that should be picked and packaged and sent to the shipping department for an order
  • Packing Slip: document that details the items and their quantities and is included in the shipment for verification
  • Bill of Lading: document that accompanies a shipment that provides a contract concerning the allocation of responsibilities between the seller, carrier, and customer
  • Sales Invoice: document sent to customer detailing goods and services ordered along with the total cost of the order and payment instructions
  • Remittance Advice: notice of payment sent by the customer to the selling organization

Question 57

Expenditure Process

Answer 57

• made up of reoccurring business activities surrounding the purchase and subsequent payment for goods and services
• complements revenue cycle → customer side of revenue process
• Activities:
  
  • placing an order for goods/ services
  • Goods are delivered and/or services rendered
  • Receipt and approval of billing by performing a three-way match with the purchase order, receiving report, and vendor invoice
  • Bill Payment
• Common Documents:
  
  • Purchase Requisition: request generated by an individual or function requesting that goods and service be purchased by the purchasing function
  • Purchase Order: sent by the buyer to seller indicating the goods/ services desired, quantities and timing needs, and agreed-upon price
  • Receiving Report: indicates what goods or services were received, quantity received, timing of the receipt, and corresponding purchase order
  • Supplier Invoice: sent to organization from the supplier detailing goods and services ordered along with the total cost of the order and payment instructions
  • Voucher: contains purchase order, receiving report, and supplier invoice to verify that invoice matches what was ordered and received

Question 58

Human Resources & Payroll Processes

Answer 58

• recurring business activities that manage the employees
• HR Activities:
  
  • hiring employees
  • onboarding and training employees
  • establishing reporting structure
  • assigning employees to departments, functions, and jobs
  • monitoring, reviewing, and evaluating employee performance
  • responding to employee concerns
  • establishing and enforcing termination procedures
• Payroll Activities
  
  • establishing compensation plans
  • assigning and updating compensation
  • activity reports
  • third-party withholdings and rates
  • payroll disbursements

Question 59

Manufacturing

Answer 59

• made up of reoccurring business activities surrounding the design, development, and production of goods
• determining whether raw materials can be effectively and efficiently transformed into finished goods
• Activities:
  
  • Product design and engineering
  • product development
  • manufacturing forecasting and scheduling
  • manufacturing operations
  • manufacturing and fixed asset accounting and reporting

Question 60

Finance and Reporting

Answer 60

• made up of reoccurring business activities surrounding financial and management of an organization, including treasury functions, recording of transactions in general ledger, and ultimate create of financial statements
• Activities:
  
  • treasury function will manage the cash flow and financial activities of an organization
  • general ledger updates
  • financial statement managerial report generation
• Documents:
  
  • General Ledger: system utilized by an organization to record all journal activities that occur
  • Trail Balance: document that lists all of an organization’s accounts and their balances derived from the general ledger
  • Financial Statements
  • management Reports: forecasts, budgets, and balanced scorecards

Question 61

Business Process Controls

Answer 61

• Management and Policy Controls: defined policies and procedures that govern how the processes are performed, what safeguards should be adhered to, and how to address and escalate exceptions
• Segregation of Duties: each business process will have specific roles and functions that should be properly segreated to prohibit one position, or person, from having too much control or power over any given process
  
  • used to avoid fraud, errors, and waste
  • Custody of Assets: possession, receipt, or creation of assets at an organization
  • Record Keeping: data entry, recording transactions, preparing reconciliations, maintaining databases, and managing and modifying accounting records and reports
  • Authorization
  • segregation of duties surrounding granting access, authorization, and rights within information systems
  • Items to be segregated:
    
    • system use and users
    • system coding or programming
    • transaction and data entry
    • data custody and storage
    • authorization responsibility
    • monitoring and response

Question 62

Input Edit Checks

Answer 62

• aka Constraints
• preventive controls that assist in protecting integrity of information and only allowing complete transactions to be submitted for processing
• Examples:
  
  • Consistent Form: information gathered for each specific event is uniform
  • Completeness Check: verification that all required data has been input (prompting)
  • Reasonableness Test: verification of logic of input values where fields are dependent or relevant to each other
  • Field Check: designates character types that are allowed in the field
  • Size Check: limits the amount of characters input into field
  • Limit or Range Check: Limit checks establish either upper or lower limits for input data and range check establish both upper and lower limits
  • Sign Check: designates if a numeric value can be positive or negative
  • Referential Integrity (Validity Check): create a framework so values in data entered into a foreign key field must first be entered in a corresponding table with primary key
  • Closed-Loop Verification: retrieves and displays information related to the input to verify accuracy

Question 63

Processing Control

Answer 63

• put in place to help protect an organization against processed data from being incomplete or inaccurate
• Examples:
  
  • Data Matching: matching multiple items, such as purchase order, receiving reports, and vendor invoices, before processes are executed
  • Input Validation: If transactions or activities are processed in batches, it is important to determine if all items were processed and input correctly through use of validation techniques such as utilizing record counts and reconciling input totals to batch totals
  • Sequence Check: process of having prenumbered documents and verifying that no documents or transactions are missing
  • Cross-Footing: testing the sum of a column of row totals to the sum of a row of column totals to verify identical results

Question 64

Standing Data Controls

Answer 64

• term to describe master files or general data files that contain long-term data that does not change often
• may be referenced for vital activities
• Examples of Preventive Controls:
  
  • Access and Authorization Control: stored in safe location with prescribed access rights to authorized users who provide verification
  • Read-Only Rights:
  • Change Control: whenever changes are made to standing data they should be reviewed and approved by appropriate personnel prior to implementation
• Examples of Detection Controls:
  
  • Periodic Reconciliation of Changes to the Data: help to verify that any changes made to data follow the established polices and procedures, including appropriate review and approval
  • Review of Employee Access, Authorization, and Rights

Question 65

Spreadsheet Controls

Answer 65

• Preventive Controls:
  
  • Access and Authorization Controls: only allow access to those who need it for their job
  • Locked Cells: cells that contain complex or required formulas should be locked
  • Data Validation: establish validation requirements on input cells to allow only certain types of input (drop-down menus helpful)
  • Change Controls: changes should be tracked, reviewed, and approved by appropriate personnel prior
  • Regular Backups:
• Detective Controls:
  
  • Periodic Reconciliation of changes to spreadsheet structure
  • Review of employee access, authorization, and rights

Question 66

Supervisory and Monitoring Controls

Answer 66

• allow for review, monitoring, and oversight of business process activities by management
• Preventive Controls:
  
  • Organizational Charts: management should develop an organizational chart that describes the reporting structure of employees to management to establish a clear chain of command
  • Hiring Guidelines: Develop strict hiring guidelines so that only competent and capable employees are hired to perform key business processes
  • Supervision: management should verify that necessary business functions have proper supervision so that the business processes are conducted according to established policies and procedures
  • Formal Approval Control: should require proper authorization by management before execution
• Detective Controls:
  
  • Process Responsibility Reviews
  • Review of Key Performance Indicators
  • Budget and Forecast
  • Performance Reviews
  • Mandatory Job Rotation and/ or Vacations
  • Audits
  • Business Resiliency Control

Question 67

Reconciliations

Answer 67

detective controls that review changes in account balance due to business process activities or the difference in ledger accounts and value provided by third parties, such as banks

Question 68

Verification Controls

Answer 68

• procedures act as preventive controls that utilize some methodology to verify the identify of authorized users
• passwords, personal identification numbers, or physicals tokens

Question 69

Process Documentation Techniques

Answer 69

• a way to simplify the analysis of business processes is to create a detailed documentation of the process
• must first gain understanding of the process
• Types:
  
  • Process Narratives: written documents that tell the story of the process, each step described in detail, involved personnel and their roles, and what documents and information flow through the process
  • Data Flow Diagrams: document of logical flow of data through a process
    
    • focus on where data comes from, how it is transformed, and its final destination
    • components: data source, data flows, processes, journals, and data destinations
    • high level = context diagrams
  • Flowcharts: visual representations of how documents and information flow through a process
    
    • focus not only on logical flows of data through process but also provide insights into the form in the information takes and types of processes that are performed on data
    • use consistent set of symbols that represent various documents and processes throughout a workflow
  • System Interface Diagrams: demonstrates how users and function, both internal and external to an organization, interface with the organization’s systems
    
    • diagramming simple, logical relationships between functional areas (servers and offices)

Question 70

Benefits of Process Documentation

Answer 70

• different types of documentation allow for different forms of analysis
• goal to to communicate how the data processing cycle performs
• can have written or visual representations of dat input, processing, storage, and output
• Flowcharts identify risks

Question 71

Risks

Answer 71

• defined as the change of financial loss/ uncertainty

Question 72

Return

Answer 72

• defined as total gain or loss experienced on behalf of the owner of an asset over a given period of time

Question 73

Risk Preferences

Answer 73

• Risk-Indifferent Behavior: reflects an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return
• Risk-Adverse Behavior: reflects an attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return (most managers)
• Risk-Seeking Behavior: reflects an attitude toward risk in which an increase in the level of risk result in a decrease in management’s required rate of return

Question 74

Interest Rate Risk

Answer 74

• Yield Risk
• used in context of financial instruments and represents the exposure of the owner of the instrument to fluctuations in the value of the instrument in response to changes in interest rates

Question 75

Market/ Systematic/ Non-diversifiable Risk

Answer 75

• exposure of a security or firm to fluctuations in value as a result of operating within an economy
• inherent risk
• factors such as war, inflation, international incidents, and political events

Question 76

Unsystematic/ Firm-Specific/ Diversifiable Risk

Answer 76

• represents the portion of a firm’s or industry’s risk that is associated with random causes and can be eliminated through diversification
• strikes, lawsuits, regulatory actions, or loss of key accounts

Question 77

Credit Risk

Answer 77

• affect borrower
• includes company’s inability to secure financing or secure favorable credit terms as a result of poor credit rating

Question 78

Default Risk

Answer 78

• affect lenders
• creditors are exposed to default risk to the extent that it is possible that its debtors may no repay the principal or interest due on their indebtedness on a timely basis

Question 79

Liquidity Risk

Answer 79

• affects lenders (investors)
• exposed when their desire to sell their security but cannot do so ini a timely manner or when matieral price concessions have to be made to do so

Question 80

Price Risk

Answer 80

• represents exposure that investors have to a decline in the value of their individual securities or portfolios
• related to diversifiable risk

Question 81

State Interest Rate

Answer 81

• nominal inters rate that represents the rate of interest charged before any adjustments for compounding or market factors
• shown in the agreement of indebtedness (bond indenture or promissory note)

Question 82

Effective Interest Rate

Answer 82

• represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees related to loan origination
• computed by dividing the amount of interest paid based on the loan agreement by the net proceeds received

Question 83

Annual Percentage Rate

Answer 83

• interest represents a noncompound version of the effective annual percentage rate
• required for disclosure by federal regulations
• computed as the effective periodic interest rate times the number of period in a year
• amount paid relative to funds available

Question 84

Effective Annual Percentage Rate

Answer 84

• represents the stated interest rate adjusted for the number of compounding periods per year
• APR

Effective annual interest rate = { 1 + ( i / p)}^p - 1

i = stated interest rate

p = compounding periods per year

Question 85

Simple Interest (Amount)

Answer 85

• amount represented by interest paid only on the original amount of principal without regard to compounding

SI = Po (i)(n)

Po = Original principal

i = interest rate per time period

n = number of periods

Question 86

Compound Interest (Amount)

Answer 86

• amount represented by interest earnings or expenses that is based on the original principal plus any unpaid interest earnings or expense
• yields higher amount than simple

FVn = Po ( 1 + i )^n

Po = Original principal

i = interest rate

n = number of periods

Question 87

Required Rate of Return

Answer 87

• calculated adding the following risk premiums to the risk-free rate:
  
  • Maturity Risk Premium (MRP): compensation that investors demand for exposure to interest rate risk over time/ risk increases with the term to maturity
  • Purchasing Power Risk or Inflation Premium (IP): compensation investors require to bear the risk that price levels will change and affect values or the purchasing power of invested dollars (real estate)
  • Liquidity Risk Premium (LP): additional compensation demanded by lenders (investors) for the risk that an investment security (junk bond) cannot be sold on a short notice without making significant price concessions. (Liquidity = ability to quickly convert an asset to cash at fair market value)
  • Default Risk Premium (DRP): additional compensation demanded by lender (investors) for bearing the risk that the issuer of the security will fail to pay interest and/or principal due on timely basis

Question 88

Diversification

Answer 88

• diversifiable risks represents the portion of a single asset’s risk that is associated with random causes and can be eliminated through diversification
• process of building a portfolio of investments of different and offsetting risks
• reduces certain risks

Question 89

Mitigating Interest Rate Risk

Answer 89

• by investing in floating rate debt securities which do not change in value when interest rates change
• generate higher coupon payment when interest rates rise
• Derivatives such as forward rate agreements (FRAs) or interest rate swaps = invest pays a fixed interest rate and receives a floating interest rate

Question 90

Mitigating Market Risk

Answer 90

• no easy to mitigate
• cannot be done through diversification
• can invest in derivatives that provides gains to investor when market declines
• short selling = selling investment in hopes to buy it back at a lower price later

Question 91

Mitigating Unsystematic Risk

Answer 91

• can be minimized through diversification
• investor can have a broad portfolio of investments

Question 92

Mitigating Credit Risk

Answer 92

• managed through improvements in credit ratings
• conditions that effect are over economic outlook, industry conditions, cash flow measures, leverage, capital structure, liquidity, profitability
• understanding how to mitigate and control helps manage risk associated with

Question 93

Mitigating Default Risk

Answer 93

• as a lender, an entity may choose to lend only to borrows with low default risk
• as a lender, can adjust interest rates charged to better reflect the risk of each borrower

Question 94

Mitigating Liquidity Risk

Answer 94

• is higher for investments that do not have an active market (forward contracts, limited partnerships)
• allocate a greater percentage of capital to investments that trade on an active market such as equities, corporate bonds, future contracts and options

Question 95

Mitigating Price Risk

Answer 95

• minimized through diversification
• short selling or derivatives such as put options

Question 96

Trade Factor (relative Inflation Rates)

Answer 96

• when domestic inflation exceeds foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain purchasing power of their money

Question 97

Trade Factor (Relative Income Levels)

Answer 97

• as income increases in one country relative to another, exchange rates change as a result of increased demand for foreign currencies in the country in which income is increasing

Question 98

Trade Factor (Government Controls)

Answer 98

• various trade and exchange barriers that artificially suppress the natural forces of supply and demand affect exchange rates

Question 99

Financial Factors (Relative Interest Rates and Capital Flows)

Answer 99

• interest rates cause demand for currencies by motivating either domestic or foreign investment
• forces of supply and demand create changes in exchange rates as investor seek fixed returns
• directly affect by the volume of capital that is allowed to flow between countries

Question 100

Transaction Exposure

Answer 100

• helps to define exchange rate risk
• defined as the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of change in exchange rates
• measured in relation to currency variability or currency correlation
• Steps:
  
  • project foreign currency inflows and foreign currency outflows
  • estimate the variability risk associated with foreign currency

Question 101

Economic Exposure

Answer 101

• helps to define exchange rate risk
• defined as the potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rate
• defined through local currency appreciation or depreciation and is measure in relation to organization earnings and cash flows

Question 102

Currency Appreciation

Answer 102

• as domestic currency appreciates in value or becomes stronger, it becomes more expensive in terms of a foreign currency
• volume of outflows tends to decline as domestics exports become more expensive
• volume of inflows tend to increase as foreign imports become less expensive

Question 103

Currency Depreciation

Answer 103

• as domestic currency depreciated in value or becomes weaker, it becomes less expensive in terms of foreign currency
• volume of outflows tends to rise as domestic exports become more expensive
• volume of inflows tends to decline as foreign imports become more expensive

Question 104

Translation Exposure

Answer 104

• helps to define exchange rate risk
• risk that assets, liabilities, equity or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates
• defined by the degree of foreign involvement, location of foreign subsidiaries, and the accounting methods used and measured in relation to the effect on the organization’s earnings and comprehensive income
• Degree of Foreign Involvement: translation exposure increase as the proportion of foreign involvement by subsidiaries increases
• Locations of Foreign Investment: measurement of financial results of foreign investments frequently occur in the foreign currency in which the investee company operated
  
  • affected y the stability of foreign currency in comparison to the parent’s domestic currency

Question 105

Net Transaction Exposure

Answer 105

• amount of gain or loss that might result from either a favorable or unfavorable settle of a transaction
• consolidated entities consider prior to considering hedge strategies
• exposure on organization as a whole and not just its subsidiaries
• aggregate exposure
• Computation:
  
  • accumulate the inflows and outflows of foreign currencies in subsidiary
  • consolidate the effects on the subsidiary by currency type
  • compute net effect in total
• Adjusting Invoice Policies:
  
  • international companies may hedge transactions without complex instruments by timing the payment for imports with the collection from exports

Question 106

Selective Hedging

Answer 106

• hedging is a financial risk management technique in which an organization, seeking to mitigate the risk of fluctuations in value, acquires a financial instrument that behaves in the opposite manner from the hedged item
• process of reducing the uncertainty of future value of a transaction or position (asset, liability, income) by actively engaging in various derivate investments

Question 107

Mitigating Transaction Exposure: Future Hedging

Answer 107

• future hedge: entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a state date
  
  • denominated in standard amounts and tend to be used for smaller transactions
• Accounts Payable Application
  
  • denominated in a foreign currency represents a potential transaction exposure to exchange rate in the event that the domestic currency weakens relative to the foreign currency
  • more domestic currency will be required to purchase foreign currency → increase company’s cost
  • increases company’s cost of settling liability
  • futures hedge contract to buy the foreign currency at a specific prices at the time the accounts payable is due will mitigate the risk of a weakening domestic currency
• Accounts Receivable Application
  
  • denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that domestic currency strengthens in relation to the foreign currency
  • less domestic currency can be purchased with foreign currency received
  • futures hedge contract to sell the foreign currency received in satisfaction of the receivable at a specific price at the time the account receivable is due will mitigate risk of strengthening domestic currency

Question 108

Mitigating Transaction Exposure: Forward Hedge

Answer 108

• forward hedge is similar to future hedge in that it entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point
• large transactions between commercial banks and between businesses
• Accounts Payable Application
  
  • denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that foreign currency strengthens
  • forward hedge contract to buy foreign currency at a specific price a the time accounts payable are due for an entire subsidiary will mitigate risk of a weakening domestic currency
• Accounts Receivable Application
  
  • denominated in a foreign currency represent a potential transaction exposure to exchange rate risk in the event that the domestic currency strengthens
  • forward hedge contract to sell the foreign currency received in satisfaction of the receivables at a specific price at the time the accounts receivables are due or on the monthly cycle of a particular subsidiary will mitigate risk of a strengthening domestic currency

Question 109

Mitigating Transaction Exposure: Money Market Hedge

Answer 109

• uses international money markets to plan to meet future currency requirements
• uses domestic currency to purchase foreign currency at current spot rates and invest them in securities timed to mature at the same time as related payables
• Payables (excess Cash)
  
  • used to lock in exchange rates associated with foreign currency needed to satisfy payables when they come due
  • Steps:
    
    • determine amount of payable
    • determine amount of interest that can be earned prior to settling the payable
    • discount the amount of the payable to the net investment required
    • purchase the amount of foreign currency equal to the net investment required
• Payables (Borrowed Funds)
  
  • same as excess cash method except organization will borrow funds domestically and invest them internationally to satisfy the payable denominated in a foreign currency
• Receivables
  
  • involves factoring receivables with foreign bank loans
  • foreign currency amounts are borrowed in discounted amounts that are repaid in the ultimate maturity value of the receivable denominated in the foreign currency

Question 110

Mitigating Transaction Exposure: Currency Option Hedges

Answer 110

• same principles as forward hedge contract and money market hedge transactions
• difference is instead of requiring a commitment to a transactions, the currency option hedge give the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is more favorable
• Payables:
  
  • Call Option (an option to buy): currency option hedge used to mitigate transaction exposure associated with exchange rate risk of payables
  • business plans to buy a foreign currency at a low rate in anticipation of the foreign currency strengthening in comparison to domestic currency in order to ensure it can settle liability at the predicted value
  • option not obligation
  • option premiums are used to compute any net savings associated with options transactions, they are a sunk cost and not relevant to decision
• Receivables:
  
  • put option (option to sell): currency option hedge used to mitigate the transaction exposure associated with the exchange rate risk for receivables
  • business plans to sell a foreign currency at a higher rate, in anticipation of the foreign currency weakening in comparison to domestic currency, to ensure it can capitalize on the receivable collections at a stable or predictable value

Question 111

Mitigating Transaction Exposure: Long-Term Transaction

Answer 111

• Transaction Used:
  
  • Long-Term Forward Contracts:
    
    • same as any other forward contracts
    • set up to stabilize transaction exposure over long periods
  • Currency Swaps:
    
    • Types:
      
      • Two Firms: with coincidental needs for international currencies may agree to swap currencies collected in a future period at specified exchange rates
      • Financial Intermediaries: contacted to broker or to match firm with currency needs
      • Parallel Loan: two firms may mitigate their transaction exposure to long-term exchange rate loss by exchanging or swapping their domestic currencies for a foreign currency and simultaneously agreeing to re-exchange or repurchase their domestic currency at a later date

Question 112

Mitigating Transaction Exposure: Alternative Hedging Techniques

Answer 112

• Leading and Lagging: represent transaction between subsidiaries or a subsidiary and a parent
  
  • entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly wait until exchange rate is more favorable (legging)
• Cross-Hedging: involved hedging one instrument’s risk with a different instrument by taking a position in a related derivatives contract
  
  • often done when there is not derivatives contract for the instrument being hedged or when a suitable derivatives contract exists but the market is highly liquid
• Currency Diversification: diversify foreign currency holdings over time

Question 113

Economic Exposure

Answer 113

• defined by the degree to which cash flows of the business can be affected by fluctuations in exchange rates
• Techniques: (organizationally wide)
  
  • Restructuring:
    
    • sources of income and expenses to the consolidated entity
    • Decrease in Sales: company fearful of a depreciating foreign currency used by a foreign subsidiary met elect to reduce foreign sales to preserve cash flows
    • Increase in Expenses: company anticipating a depreciating foreign currency may elect to increase reliance on those suppliers to take advantage of paying for raw materials and supplies with cheaper currency.