BEC - B1: Internal Control Frameworks

Question 1

Why did COSO prepare the Internal Control Integrated Framework?

Answer 1

-In 1992, COSO issued “internal control - integrated framework” in order to assist organizations in developing assessments of the effectiveness of internatl controls. It was not related to anything from Congress or the SEC, and was not issued specifically in order to “compliment the ERM”. The ERM literature was developed in 2004, 12 years later.

Question 2

Which of the following is not a critical step of the “monitoring internal control” component of the COSO framework?

• assessing and reporting the results
• designing and executing monitoring procedures that are prioritized based on risks
• increasing the reliability of financial reporting and compliance with laws and regs
• establishing a foundation for monitoring

Answer 2

(c) is not a correct answer. (c) increasing the reliaiblity of reporting and compliance with laws is congruent with “effective financial reporting and control”, not monitoring.

Question 3

Corporation sets up a compliance program with ethics training and a hotline for anonymous reporting. What value of COSO are they emphasizing?

• Sound integrity and ethical values are developed and understood and set the standard of conduct for financial reporting?
• Management and employees are assigned appropriate levels of authority to facilitate effective IC over financial reporting?
• Management’s philosohpy and operating style support achieving effective internal control over financial reporting?

Answer 3

• (a) is the correct one.
• Sound integrity and ethical values go hand in hand with a corporate compliance program developed throughout different levels of the organization.

Question 4

Which is correct regarding the sequence of “event identification” and “objective development” within an orgainzation?

• Event identification occurs after the development of objectives
• Event identification occurs before the development of objectives

Answer 4

• Event identification occurs after the development of objectives. The organization must first set its objectieves, and then events will either positively or negatively affect the achievement of these objectives
• Negative events (risks) can ONLY be identified within the context of the objectives of the organization

Question 5

What are the five principles of the performance component of the COSO ERM?

Answer 5

• VAPIR:
• develops portfolio VIEW
• ASSESSES severity of risk
• PRIORITIZES risk
• IDENTIFIES risks
• implements risk RESPONSES

Question 6

The ability of a firm / entity to withstand the impact of large-scale events refers to its:

Answer 6

Organizational stability.

NOT:

• risk inventory - all the risk that could possibly impact an entity
• risk profile - the composite view of the risk assumed in a specific situation, and how management develops a strategy in response to that risk
• risk capacity - the maximum amount of risk that an entity is able to absorb in the pursuit of strategy and business objectives

Question 7

What’s the relationship between inherent risk and residual risk?

Answer 7

• Inherent risk is the risk if management does nothing to alter the likelihood/impact of a negative event.
• Residual risk is the risk leftover to an organization after management takes actions to reduce the inherent risk.

Question 8

What is the relationship between risk appetite and residual risks? In relation to when an organization will not operate beyond its limits… ?

Answer 8

• An organization will not operate beyond the limits of its risk appetite.
• When risk appetite has been exceeded, that means the combined likelihood and impact of negative events SIGNIFICANTLY exceeds residual risks.

Question 9

Sarbox of 2002 requires that officers of a corporation be held accountable to a code of ethics. According to Sarbox, codifications of ethical standards should include all of the following except:

• Honest and ethical conduct
• Compliance with laws, rules and regs
• Prompt internal reporting of code provisions, accountability for adherence to the code
• Full, fair accurate timely disclosure in periodic F/S

Answer 9

-C is the correct answer.
Although the SEC proposed standards for codes of ethics to include both internal reporting and accountability for adherance, Sarbox does not have this requirement specifically

-The Act specifically requires that the code provide for honest and ethical conduct, compliance with laws, and full, fair, accurate, timely disclosure in periodic financial statements

Question 10

Conflict of interest provisions prevent which of the following for an issuer:

• loaning to director (personal loan) not in the ordinary course of business
• giving a director perquisite compensation
• having a director with 10% ownership of any form of equity
• having a director with 10% ownership of common stock

Answer 10

Disclosures are required for perquisite and 10% ownership. However, issuers are generally prohibited (you cannot) from making loans to directors or executives.

Question 11

Which organization was established by Sarbox in 2002 to control the auditing profession?

Answer 11

PCAOB. It was created by Congress through Sarbox in 2002.

Question 12

How do we calculate effective annualized percentage cost of financing?

Answer 12

Finance charge / loan proceeds

(finance charge = interest charged - any interest earned on mandatory checking accounts)

(loan proceeds = amount from the loan that the company actually has use of)

Question 13

How do we calculate annual percentage rate on debt (“annual percentage rate of interest”)?

Answer 13

Finance charge / net proceeds

(charge = interest charged)

(net proceeds = what you have able to invest)

Question 14

Which of the following has a higher interest rate risk? Which has a higher credit risk?

• Short term financing
• Long term financing

Answer 14

Short term financing has a higher interest rate risk, and a higher credit risk as well.

Short term financing results in lower interest rates, but higher risk on those rates because rates will fluctuate more dramatically for short term issues than long term ones.

Long term financing has lower credit risk (obviously) because you have more time to figure out how to repay the loan.

Question 15

The required rate of return is generally computed as the RF rate of return plus a number of adjustments. Which of the following is not one of those adjustments?

• Maturity risk premium
• Credit risk premium
• Default risk premium
• Purchasing power risk premium

Answer 15

Credit risk premium is not one of the risk adjustments related to rate of return. Credit risk is related to the ability to obtain credit, not grant credit.

• Maturity risk premium (“interest rate risk”) is the compensation investors demand for bearing risk. Increases with the term to maturity.
• Default risk premium is additional compensation demanded for bearing the risk that an issuer of a security will fail to pay interest, or repay the principal
• Purchasing power risk premium (“inflation premium”) is the compensation required to deal with the potential for changing price levels

Question 16

Which of the following is not a derivative?

• interest rate futures
• fixed interest five year note payable
• agreement to buy PPE in 6 months at a price determined today
• contract to buy commodities in 6 months at a price determined today

Answer 16

• Fixed interest five year note payable is not a derivative. This is a debt instrument whose value changes are not reliant upon external factors.
• Derivatives are financial contracts which derive value from the perforamnce of another asset or financial contract

Question 17

How do we calculate the effective interest rate if a borrowing is in the form of a discounted note?

Answer 17

Effective interest rate = interest charge / net proceeds (reduced by interest charge)

(Say interest 9% on a loan of 100,000… 9% / 91% = effective rate)

Question 18

Which factors are inherent in a firm’s operations if it utilizes only equity financing?

Answer 18

Business risk. Equity financing is issuing equity in order to raise capital. Means you’re not issuing debt, which rules out answer options like financial risk (“default risk”), interest rate risk, and marginal risk - which is more related to incremental changes in risk

Question 19

Where do we include “transaction costs” in the equation to calculate EAR?

Answer 19

• Transaction costs are included in the numerator - they affect the “finance charge” to obtain a loan
• They are not included in the denominator, that would be like double-counting the charges. You still obtain / receive the same net proceeds. Just have to pay an additional finance charge (in the numerator) in order to obtain them

Question 20

What is another label or term for non-diversifiable risk?

Answer 20

Systematic (Market) Risk

“Unsystematic” risks, “non-market” risks, and “firm-specific” risks are sometimes used as synonyms for diversifiable risks.

Question 21

Which component of the internal control integrated framework addresses an entity’s financial reporting objectives?

Answer 21

-Risk Assessment. Goes hand in hand with risks and fraud risk.

Question 22

Pursuant to SARBOX, an accountant who destroys documents to impede an investigation by a U.S. agency can be:

Answer 22

-Fined and/or imprisoned not more than 20 years.

Anyone who destroys docs can get up to 20 years and imprisonment, or both.

Question 23

The existence of a corporate compliance program is evidence of which of the following:

• BOD understands and exercises oversight responsibility related to financial reporting and related internal control
• Management and employees are assigned appropriate levels of authority and responsibility to facilitate ICFR
• Sound integrity and ethical values are developed and understood and set the standard of conduct for ICFR
• Management’s philosophy and operating style support achieving effective ICFR

Answer 23

• No. Board oversight relates more to overall leadership
• No. Delegation relates to the organization’s assignment of duties, rather than the specifics of ethical behavior and reporting issues.
• Yes. The existence of a compliance program that includes both ethics training and a hotline is evidence of the “development of ethical values” and “ensuring that those values are understood and taken seriously”
• No. Management’s operating style relates more to “work ethic and commitment to ICFR”, rather than the specifics of ethical behavior.