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CIMA Managerial Case Study
Mock Exam 1
Portafone
Solutions
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Section 1
To: Leo Chan - Senior
From; Financial Manager
Re: Audit Reports Ethical Princi
an
‘Manager
les and Di
iplinary Process
Audit Report: Ethical Principles
Professional Behaviour
‘The willingness to use batteries before they were properly certified is a breach of
the principle of professional behaviour. Using batteries which are not certified or
falsely certified would be a conscious breach of the law governing health and
safety.
Effect on our reputation
We would risk discrediting the company and, by implication, our clients e.g.
network providers, by implicating them (albeit unwittingly) in this act. Part of the
success of Portafone is likely to be built upon our reputation for producing reliable
mobile phones as evidenced by our increasing sales.
We cannot afford for our reputation to be negatively impacted, especially since we
currently only manufacture mobile phones and therefore do not have any other
source of revenue.
Integrity
‘The use of batteries which are not certified would also breach the principle of
integrity. It is dishonest, both to use the batteries without signed-off safety
certification and to imply to clients that a batteries are fully certified,
Objectivity
‘The willingness to continue the employment of the employee with a criminal
conviction for fraud, in breach of the SLA’s commitment to clients such as network
providers breaches the principle of objectivity. We should not deceive stakeholders
even if we are doing so by omission of a material fact about a past error rather
than a deliberate decision to mislead,
Professional competence and due care
‘The failure to adequately vet the new employees also implies a breach of
professional competence and due care. As directors, it is perfectly acceptable to
delegate tasks to others, but directors always remain responsible, This situation
has arisen because of a corporate failure to implement an important check.
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Developing a soun ethical culture to help prevent fraud
Attitudes within an organisation often lay the foundation for a high or low fraud
risk environment. Where miner unethical practices may be overlooked (e.g. petty
theft, expenses frauds}, larger frauds committed by higher levels of management
may also be treated in a similar lenient fashion. Evidently this emphasises the
anger of not dealing with the issues highlighted by the audit report.
Risk of ignoring ethical issues
In this environment there may be a risk of total collapse of the organisation, either
through a single catastrophic fraud or through the combined weight of many
smaller frauds.
Long term benefits of high ethical standards
Organisations which have taken the time to consider where they stand on ethical
‘issues have come to realise that high ethical standards bring long term benefits as
customers, suppliers, employees and the community realise that they are dealing
with a trustworthy organisation,
Indeed we encourage our managers to engage with the wider community;
therefore we should already recognise the importance of being seen to bea
trustworthy organisation.
Consequences of dubious ethical practices
Some organisations have realised that dubious ethical or fraudulent practices can’
cause serious adverse consequences to the people and organisations concerned
when exposed. By not having robust ethical practices in place we risk damaging
our reputation,
Fraud risk and training
twill Be important for us to raise awareness through a formal education and
training programme as part of the averail risk management strategy, Particular
attention should be paid to those mangers and staff operating in high-risk areas,
such as procurement and bill paying and those with a role in the prevention and
detection of fraud and indeed those staff responsible for safety checks, including
“signing off” on safety checks.
Disciplinary Process
Accructal element of Human Resource Management is to have a robust control
system in place that encourages all employees to behave in an acceptable way. For
example within CIMAa’s framework of control, such a system will have two
elements.
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The two elements are, firstly, the control environment, where the organisation’s
overall philosophy is explained and expectations are set; secondly there are the
control procedures, where rules and guidelines are clearly defined. The control
procedures include both disciplinary and grievance procedures.
Control environment and procedures
These two elements have certain similarities, i.e. they both aim to encourage
acceptable behaviour. They are both designed to correct inappropriate behaviour
where necessary. They both require strict guidelines, so that people knaw exactly
what is expected of them. They both require an audit trail to ensure that fairness
has been applied in all cases. It is perhaps because of their similarities that the
two procedures can get confused.
Disciplinary Procedure.
Discipline can mean different things to different people. It can be thought of as
the use of pawer or authority to compel us to act in a certain way. Alternatively,
discipline can sometimes mean being punished for not doing something right and
this appears to be the view of some members of the audit committee in relation to
the alleged fraud by one employee in the sign-off of safety certificates for
batteries.
Establishing a framework
Disciptine is not all about punishing people for getting things wrong; it’s about
establishing a framework to help them get things right. In this case, the framework
is the disciplinary procedure, where guidelines are set, without appearing
dictatorial, to encourage staff to behave in an acceptable manner.
Clear documentation
‘The clearer the disciplinary procedure and the better it is understood, the more
likely it is that people will behave acceptably and ne corrective action will be
required. As with all rules and guidelines, it's important that the organisation
produces documentation that’s explicit about what is acceptable and what the
consequences are if the rules and guidelines are not followed.
Employer's role
Its not sufficient simply to make people aware of the procedure; the employer
has to ensure that all staff actually read and comprehend it. In this regard, many
organisations require their emplayees to study the documentation and then answer
a number of questions aimed at testing their understanding of the procedure.
In this particular case we need to be clear whether we provided the individual.
concerned with the appropriate documentation for their specific role. For example
did we provide full details of the ‘sign off" procedure for the testing of suppliers
batteries?
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‘Types of inappropriate behaviour
‘There are various types of behaviour that may be deemed inappropriate, ranging
from minor infringements to serious breaches. They include, persistently arriving
late for work and/or leaving early without approval, misusing company equipment,
pilfering company property, acting inappropriately in meetings with clients, failing
‘to comply with health and safety regulations, making threats to colleagues, and in
‘our specific case the allegation that an employee may have committed fraud.
Application of the
ary procedure
It's important that the disciplinary procedure can be applied to any form of
‘inappropriate behaviour that occurs, whether it’s trivial or grave. While specific
steps can vary between organisations, the following is a typical sequence of events
aimed at ensuring that a disciplinary matter is handled appropriatel
Informal discussion: This is an “off the record” meeting between the individual
‘concemed and their manager. It is often used to deal with minar breaches, with
‘the intention of tackling the problem before it becomes more serious.
‘Verbal warning: This will occur if the breaches continue after the informal
‘discussion. The manager must however record that a verbal warning has been
given.
‘Written warning: This will be invoked if the verbal warning has no effect. It will be
put on the employee's record. Some organisations give only one written warning
before moving on to the next step in the process, while others issue two.
‘Suspension: The employee will be removed from their duties, usually on full pay.
‘This step is intended as a temporary measure, often to give the individual time to
reflect on their misdemeanour’s and give their manager time to conduct
‘comprehensive investigation.
Demotion: This fs a more permanent sanction used in cases where the employee.
has not brought their behaviour up to an acceptable standard after all the
preceding steps.
Dismissal: The ultimate step in the process results in the termination of the
‘employee’s contract of employment. It is important to deal with a breach of
discipline at the appropriate stage to ensure fairness. In most cases, problems are
resolved at an early stage so that the final steps are not necessary.
However there may be instances where the process would start at one of the later
steps. For example in relation to the alleged fraud if after further investigation it
becomes clearer that fraud was carried out by this individual it may be appropriate
‘to suspend the individual on full pay until a more exhaustive inves
carried out.
ation is
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Right to appeal
Whatever action is taken, it must always be in line with the guidelines
documented. It is also important that the procedure sets out what the employee
would need to do if they should decide to exercise their right to appeal.
Benefits of disciplinary procedures
‘The benefits of having disciplinary procedures in place are that employees at all
levels know what steps will be taken in the event of the disciplinary procedure
being instigated and they should feel that there is a system in place that they can
trust.
For the employer, using the procedures appropriately should help to ensure it is
meeting its legal obligations as an employer to provide such procedures and
therefore should help to prevent the organisation's image from being tarnished.
Regards
Financial Manager
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Section 2
To: Leo Chan
From: Financial Manager
RE: Directors Performance / Remuneration and Executive Share Options
Directors Performance
Shareholder concerns
‘The shareholders are concerned by the fact that that the directors do not appear
to suffer any personal loss when Portafone runs into difficulties. In this case one
shareholder considers that the directors have made a serious error in not having an
alterative supplier.
Currently, the directors’ salaries are still paid regardless of the downturn in
revenue arising from the loss of business due to the media article and the recall of
4g smartphones,
Performance related pay: executive share options
Replacing part of the existing salary scheme with options would add a
performance-related element to directors’ remuneration. Share options allow the
directors to benefit from any increase in the share price provided the share’s
market value exceeds the exercise price.
That aligns the interests of the directors with those of the shareholders because
the options will expire worthless if the share price does not increase beyond the
exercise price,
Shareholders’ proposed model
‘The proposed model requires an increase in the share price of F51.10/3.10 = 35%
over four years. That requires an average increase of roughly 9% per annum
Achieving this size of increase in the share price would mean that Portafone would
have recovered from the current drop in share price due to the impact of the
recall of the 4g smartphones and associated drop in revenue.
Risks of proposed model
‘There could be a risk that the directors will become fixated on the option scheme
to the company’s detriment. For example, they could resist any attempt to remove
‘them from office because they do not wish to lose the value of any options that
will then expire.
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Growth of 9% per annum is quite high, so the directors could be motivated to
manipulate reports given that a consistent growth of 9% per annum could be
difficult to achieve through good management alone.
For example, directors could be motivated to try to manipulate the share price,
timed to coincide with the exercise date of a tranche of executive share options,
Non alignment of risks
‘The shareholders are concerned that the directors are unconcerned with the risks
faced by Portaphone. That may mean that options will not fully align their
interests because the directors will not participate fully in downside risks.
The value of the options will fall to zero if the share price is less than or equal to
the market price of the shares. Any further decline will cost the directors nothing
further.
Benefits of proposed executive share option model
If the directors hold large numbers of options then they will have a financial
incentive to maximise the share price. Provided the share price exceeds the
exercise price at the relevant date the directors can exercise their options and buy
shares for less than their market value, They will then either retain those shares as
an investment or resell them at a guaranteed capital gain.
If the share price does not rise during the vesting period then the directors will
receive Little or no value and so they have a direct financial interest in achieving
an increased share price.
Encouraging directors to accept shareholder risks
Any shareholder who wishes to achieve the best combination of risk and return
should hold a diversified portfolio. One implication of that is that the shareholders
are less concerned about total risk associated with any given investment in their
portfolio. The shareholders do not care about unsystematic risks because they can
protect themselves, but the directors do not have that luxury.
Shareholder and director interests
Each director has only one career and can only serve as an executive director for
‘one company at a time so diversification is impossible. An investment opportunity
that would be attractive to the shareholders because the potential returns are high
relative to systematic risks might be unacceptable te the directors because they
will be exposed to the total risks should it go wrong.
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For example, a new product that fails might have a very limited impact on
shareholder's total investment portfolios but could end the careers of the directors
who were responsible for recommending that it should proceed.
Conclusion
If shareholders really wish to align the director's interests with their own they
need to find some way to encourage the directors to accept the risks that they
‘would choose to accept for themselves. Unfortunately, there is no way to ensure
that will always happen. The best that the shareholders can do is to find a way to
encourage directors to take sensible risks and executive share options could
provide part of the answer and therefore could be seen as a sensible response,
Executive Share Options: Impact on Financial Statements
Basic features of Executive Share Options
An executive share option can be part of a manger’s remuneration package. The
detailed workings of any scheme are decided by the company itself, but the
general features involve the following aspects:
Allocation of Options and Striking Price
Each eligible manager is granted an allocation of options as part of their annual
remuneration. The number of options will generally be decided by the
remuneration committee. The options themselves will normally have a striking
price that is equal to or slightly higher than the share price at the date the options
are granted.
Vesting Period
‘There is invariably a vesting period of a few years that must pass before the
options can be exercised. If the manager resigns or leaves the company during that
period then the options will lapse. The options can normally be exercised on a
Specific date at the end of the vesting period.
Valuing share options
‘The preparation of the financial statements will be complicated by the need to
value the share options themselves. Generally, there are no identical financial
instruments that are traded in observable markets and so establishing the value of
these financial instruments will require some complex calculations based on
estimates. The reported profit figure will, therefore, be open to challenge because
of the range of outcomes that may be input in respect of the options.
Assumptions and uncertainties
Portafone will also have to determine the likelihood of board members remaining
with the company for long enough for their options to vest. That will inject a
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further set of assumptions and uncertainties associated with determining the
expense in the statement of profit or loss. The cost of preparing and auditing the
figures may increase because of the need to determine and audit these
assumptions and estimates.
In principle, replacing salary with an equivalent value in terms of share options
will do nothing to reported earnings. The risks being borne by the directors could,
however, lead to the directors negotiating a generous allocation of options that is,
worth more than the salary being foregone. That would increase costs in the short
term if the value attributed to the options at the grant date is significant.
Dilution of Earnings per share (EPS)
‘The further matter would be the dilution of EPS. If the directors exercise their
options then the number of shares in issue will increase and the directors will be
paying for them at a discounted price. The shareholders will have to factor the
impact of the dilutive effect of the options for their earnings per share. While any
increase in the share price will be welcomed, it will be shared with the directors
under the terms of the scheme.
Cash-settled share-based payment
A cash-settled share-based payment is made in cash, but the amount of cash is
based on the value of an equity instrument (such as ordinary shares). In this vay,
‘the payment is in cash, but the final amount is determined by share price, which
makes recognition and measurement more complex.
Equity-settled share-based payment
An equity-settled share-based payment is made without the medium of cash and
directly paid in shares or share options. This means that the staff or supplier will
receive payment for their services in the form of the equity of the business. Again,
this raises complexities g due to the nature of the payment.
Measurement
With cash settled amounts, if there is a vesting period for the rights, the cost will
be proportioned over the time period as is the case for equity based transactions,
but the liability will need to be re-calculated based on the fair value at the
reporting date. This is a change from equity settled transactions which just use the
grant fair value with no additional re-measuring.
Regards
Financial Manager
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Section 3 - Solution
Te: Leo Chan
From: Finance Manager
Re: Non-financial performance indicators and reducing costs
Hi Leo, please find my report attached below as requested. Let me know if you
need anything else.
Non-financial performance indicators
While the financial metrics we currently use offer us a good insight into our
financial performance they also have their share of limitations. They consist of
historical data only, whereas we need to be forward thinking. Financial metrics
can also be manipulated through selection of accounting policies and they offer
short term feedback only.
For this reason many companies, including those in the smartphone industry, as
demonstrated by the article about Foxconn, also employ non-financial indicators
(NFPI’s) which are designed to measure progress towards long term goals.
Advantages of NFPIs
Forward loo
e
NFPis are forward looking, giving management an idea of future performance of all
areas of the business and this is in contrast to financial indicators, which are
generally backward leoking and which generally only cover the business as a
whole.
Ease of understanding
NFPis are easily understood by all personnel. Non-financial managers will not
understand financial ratios but will understand things like customer satisfaction
and staff turnover very easily. This allows staff to see the progress the company is
making and as a result may make them feel more appreciated and dedicated.
Measures long term performance
NFPIs could give us a good indication of long term performance, as opposed to
financial indicators which are mostly focused on the short term. For example,
customer satisfaction helps indicate the level of returning customers longer term.
In addition, non-financial indicators cannot be easily manipulated through
accounting policies.
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