B1-B2
Title 11 - Corporate Fraud Accountability
• Tamper w/record or impede an official proceeding o No more than 20 years and fine • Temporary Freeze Authority by SEC o SEC determines issuer will have to make payment, freeze accounts • SEC prohibit person from serving as officer or director o If individual has violated securities rules/regulations
Internal Environment
"EBOCA + HRR" • Commitment to Ethics/Integrity • Board Oversight • Org. Structure • Commitment to Competence • Assignment of Authority/Responsibility • Human Resource Stds. • Risk Mgmt Philosophy • Risk Appetite
Control Environment
"EBOCA" Commitment to Ethics/Integrity Board independence and oversight Organizational structure Commitment to Competence Accountability
Components of ERM
"IS EAR AIM" • Internal Environment • Setting Objectives • Event Identification • Assessment of Risk • Risk Reponses • Control Activities • Info & Communication • Monitoring activities
Monitoring Activities
"Monitor SOD or grass won't grow" Separate and/or ongoing evaluation Reporting of deficiency
Info & Communication
"OIE" • Obtain info • Communicate (ext. and int)
Info & Communication
"OIE" • Obtain & use info • Internally communicate • Externally communicate
Objective Setting
"S+ORC" • Strategic Objs • Related Objs (ORC) • Select Objective (align with risk appetite) • Risk Appetite • Risk Response
Risk Assessment
"SAFR" • Specify Objectives • Identify and Analyze Risk • Consider Potential for Fraud • Identify and Assess Changes
Monitoring
"SOD" • Separate eval • Ongoing eval • Report deficiencies
Effective APR
(1+effective periodic rate)^(# periods) - 1
COSO 5 Components
(CRIME) Control Environment- Authority Risk Assessment - F/S misstated or fraud Info & Communication (FACT) o Fair, accurate, complete, & timely Monitoring - efficiency or deficiency Existing Control Activities o Policies to mitigate risk
ERM Objectives
(S + ORC) Strategic - high level goals designed to achieve mission • Operating, Reporting, and Compliance
Stated Interest Rate
(answer = rate stated)
Existing Control Activities
(or the CAT will P) • Select & develop control activities • Select & develop technology controls • Deployment of policies/procedures
Effective Interest Rate
(principal*stated annual rate)/# periods
COSO
17 principles based, private sector initiative to study what led to fraudulent reporting
COSO Framework Objective
ORC Operations - effective/efficient Reporting - reliability, timeliness, & transparency Compliance - follow rules/regulations
COSO Cube
Objectives, components, and org. structure
Compound Interest
Original principal*(1+interest rate)^(# periods)
Annual Percentage Rate (APR)
effective periodic rate*# of periods in a year
Required Rate of Return
• Calculated by adding risk premiums to the risk free rate
Mitigate Transaction Exposure: Forward Hedge
• Contract between business and commercial banks • Larger transactions • A/P o FC increases, more A/P, buy call or buy forward/future (depends on size) • A/R o FC decrease, loss on A/R, buy put or sell forward/future (depends on size)
Mitigating Unsystematic risk (Credit, default, liquidity, and price risk)
• Credit Risk o Ratio analysis to reduce cost of borrowing • Default risk o Change IR charged to reflect risk of each borrower • Liquidity Risk o Allocate greater % of capital to active markets • Price Risk o Diversification and short selling or derivatives
Factor Influencing Exchange Rates (trade and financing factors)
• Trade Factor o Relative inflation Rates Purchase foreign currency to maintain power of buying o Relative Income levels Increased demand for foreign currencies in the country in which income increases o Government controls Barriers that suppress the natural forces of supply and demand affect exchange rates • Financial factors o Relative Interest Rates & Capital flows Focus on supply and demand Currency w/ higher interest rate attracts investment thus more demand thus value goes up
Mitigate Currency Option Hedge
• Similar to forward hedge, but has the option not to o Currency Option Hedge: Payables Business has the option to purchase the security at the option price Risk FC up, AP up o Currency Option Hedge: AR Business has the option, not obligation to sell the collected amount of the foreign currency from the receivable at the option price Risk FC down, AR down
ERM Limitations
• Subject to human judgment • No guarantees • Collusion • Mgmt. override controls
Types of Risk (Diverse, nondiverse, IR, credit, default, liquidity, and price)
"DUNS" Unsystematic/firm-specific/diversifiable risk - firm or industry specific risk, non market Market/systematic/nondiversifiable risk - risk inherent within economy • Interest rate risk - IR up = value of fixed income down • Credit Risk - inability to secure financing or favorable terms due to poor Credit rating • Default risk- won't be able to pay principal/interest • Liquidity risk - want to sell and make it liquid (Cash) but have to make discounts to do so o GR- not publicly traded(real estate) • Price Risk - exposure that value of securities or portfolios will decline
Major Deficiency
• Significantly reduce the likelihood that an organization will achieve its objectives • Ineffective IC under COSO definition
Title 8 - Corporate & Criminal Fraud Accountability
• Criminal penalties for altering docs o Intent to impede investigation fined and/or imprisoned, up to 20 years o Auditors need to retain work papers for a period of 7 years Failure to do so, jail or a fine of up to 10 years • Statute of Limitations for Securities Fraud "2+5" o No later than the earlier of 2 years after the discovery or five years after the violation • Whistle Blower Protection o Can't be discharged, if they are they can receive Reinstatement of same employee status Back pay w. interest Compensation for special damages • Criminal penalities for securities fraud o Fined &/or imprisoned, no more than 20 years
Assessing Economic Exposure
• Degree to which cash flows of the business can be effected by the exchange rates fluctuating
Title 4 - Enhanced Financial Disclosures
• Disclosure in Periodic reports o Ensure that the application of GAAP reflect the transactionsare transparent • Conflict of interest provisions o Issuers can't make personal loans to directors or exec officers Exception: during ordinary course of business • Disclosure of transactions involving mgmt. & principal stockholders o Disclosure anyone with direct/indirect ownership of more than 10% ownership of any class of equity security • Mgmt assessment of IC o Statement that mgmt. is responsible for establish/monitor IC structure o Assessment as of the end of the most recent Fiscal Year of the issuer on effectiveness of IC o Auditor has to attest to mgmt's assessment of IC • Code of ethics for senior officers o Must disclose whether adopted code, or if no code they must say why so • Disclosure of Audit committee Financial Expert o One member of AC is financial expert o Knowledge of GAAP, etc. • Enhanced Review of Periodic Disclosures by Issuers o SEC required to review disclosures made by issuers on a regular/systematic basis
ERM Cube
• ERM Components, Objs., Entity and its Units
ERM (enterprise risk management)
• Enacted by BOD, mgmt. • Find events which impact the entity, and manage risk w/in risk appetite • Provide RA of achieving entity objectives
Title 3 - Corporate Responsibility
• Establish public company audit committee o Auditor reports to AC not BOD o AC are to be members of the issuer's BOD but are to be independent otherwise o Can't receive compensation from the issuer for advisory/consulting services o Procedures developed to accept reports of complaints regarding audit, accounting, or IC issues • Corp Responsibility for financial report o CEO/CFO sign saying the reports do not contain any untrue or omissions of info • Improper Influence on the conduct of audits o No officer, director, or any person can take action to not work with the authorities • Forfeiture of certain bonuses o CFO/CEO forgo bonuses on incentive based or equity based o Gains on sales of securities during 12 month period to pay for restatement
Risk Response
• Evaluate possible responses "ARSA" o Avoid, reduce, share, accept • Select response • Portfolio View (consider whole entity)
Event Identification
• Events • Influencing Factors • Event Identification Techniques • Event Interdepcenies • Event Categories • Distinguish Risks
Risk Assessment
• Inherent and residual risk • Establish likelihood and impact • Data Sources • Assessment techniques (benchmarking) • Event Relationships
Mitigate Market Risk/systematic risk = nondiversifiable
• Inherent in economy • Invest in derivatives that provide gains when market declines • Short selling, returns when market declines
Control Activities
• Integration w/ risk response • Types of control activities • Controls over Info system • Entity specific controls
Mitigate of Interest Rate Risk
• Investing in floating rate debt securities • Derivatives such as forward rate agreements or interest rate swaps (pay fixed, receive floating)
Mitigating Transaction Exposure: Alternative Hedging Techniques
• Leading and Lagging o Transactions between subsidy or a subsidy and a parent o Entity that is owed can bill in advance if exchange rate is good (lead) or wait till exchange rate is more favorable (lagging)
Mitigate Transaction Exposure: Long Term Contracts
• Long term Forward Contracts • OR Currency Swaps (2 firms agree to swap currency)
market risk premium, purchasing power risk or inflation premium, liquidity risk premium, default risk premium
• Maturity Risk Premium (MRP) - risk increases with term to maturity • Purchasing Power Risk or Inflation Premium (IP) • Liquidity Risk Premium (LP) - risk that security can't be sold on short notice without making significant price concessions • Default risk premium - risk that the issuer of the security will fail to pay interest and/or principal on timely basis
ERM effectiveness
• Present & Functioning • No material weaknesses
All 5 components and principles of COSO must be...
• Present - included in design • Functioning - operating as designed o All 5 components work together as an Integrated system to reduce to an acceptable level that an entity will not achieve objectives
IC Framework Limitations
• Provides reasonable assurance, but it doesn't prevent bad decisions or external events o Human failure o Collusion o Suitability of objectives o Faulty or biased judgment o Mgmt. override
Mitigate Transaction Exposure: Future Hedge
• Purchase or sell a particular number of currency units for a negotiated price on a stated date o Usually smaller transactions • A/P o currency weakens domestically, buy calls, buy future contracts o buy foreign currency to mitigate weakening domestic • A/R o Buy put options or sell future contracts o Strengthening domestic currency o Future hedge will sell foreign currency to mitigate risk of strengthening domestic currency
COSO Risk vs. Opportunity
• Risk- negative and affect achievement of objs. • Opportunity - positive, promote achievement of objs.
Measuring Specific Net Transaction Exposure
• Selective Hedging o Acquires financial instrument that acts in opposite manner of hedged item • Identify Net Transaction Exposure o AR>AP > net asset/ export o AP>AR = net liability / import
Risk Exposure categories (transaction, economic, and translation)
• Transaction Exposure o Company could get loss or gain based on settlement on transactions due to changes in exchange rates • Economic Exposure o Potential that the present value of an organization's cash flow could increase or decrease due to changes in exchange rates • Translation Exposure o A,L, & E or income of a consolidated entity will change as a result of exchange rates More risk as more foreign involvement by subsidy More stable exchange risk, less transaction and vice versa
Mitigate Transaction Exposure: Money Market Hedge
• Use international money markets to meet future currency requirements. A money market uses domestic currency to purchase foreign currency and invest in securities timed to mature at the same time as payable date • MMH: Payables (excess cash) o Lock an exchange rate with MMH to satisfy payables when needed • MMH: Payables (borrowed funds) o No excess cash, borrow funds domestically and invest internationally to satisfy the payable denominated in a foreign currency • MMH: Receivables o Factor receivables with foreign bank loans, mitigate FC decrease, hence AR decreases
Title 9 - White Collar Crime Penalty Enhancements
• Went from 5 to 20 years • Violate ERISA, from not more than 5k to not more than 100k, and 1 year to 10 years • Failure of Corporate officers to certify financial reports o Have to agree with SEC act of 1934 o Signed that info fairly presents the F/S o Signed by CEO/FO o Certify statement knowing it doesn't comply = $ 1 mil and/or 10 years max o Willfully certifies-$5mil and/or 20 years max
Risk Preferences
• risk indifferent- more risk doesn't mean more return • risk averse- increase risk = increase return • risk seeking- increase risk = decrease in return