01 technical

accounting for
property, plant
and equipment
RELEVANT TO ACCA QUALIFICATION PAPER F7

The accounting for IAS 16, Property, Plant and Equipment is a How should the above information be accounted for in the
particularly important area of the Paper F7 syllabus. You can financial statements? (See page 5 for the solution to Example 1.)
almost guarantee that in every exam you will be required to
account for property, plant and equipment at least once. Example 2
This article is designed to outline the key areas of IAS 16, Construction of Deb and Ham’s new store began on 1 April 2009.
Property, Plant and Equipment that you may be required to attempt in The following costs were incurred on the construction:
the F7 exam.
$000
IAS 16, Property, Plant and Equipment overview Freehold land 4,500
There are essentially four key areas when accounting for Architect fees 620
property, plant and equipment that you must ensure that you are Site preparation 1,650
familiar with: Materials 7,800
¤ initial recognition Direct labour costs 11,200
¤ depreciation Legal fees 2,400
¤ revaluation General overheads 940
¤ derecognition (disposals).
The store was completed on 1 January 2010 and brought into use
Initial recognition following its grand opening on the 1 April 2010. Deb and Ham
The basic principle of IAS 16 is that items of property, plant and issued a $25m unsecured loan on 1 April 2009 to aid construction
equipment that qualify for recognition should initially be measured of the new store (which meets the definition of a qualifying asset
at cost. per IAS 23). The loan carried an interest rate of 8% per annum and
One of the easiest ways to remember this is that you should is repayable on 1 April 2012.
capitalise all costs to bring an asset to its present location and
condition for its intended use. Required
Commonly used examples of cost include: Calculate the amount to be included as property, plant and
¤ purchase price of an asset (less any trade discount) equipment in respect of the new store and state what impact the
¤ directly attributable costs such as: above information would have on the income statement (if any) for
– cost of site preparation the year ended 31 March 2010.
– initial delivery and handling costs (See page 5 for the solution to Example 2.)
– installation and testing costs
– professional fees Subsequent costs
¤ the initial estimate of dismantling and removing the asset and Once an item of PPE has been recognised and capitalised in the
restoring the site on which it is located, to its original condition financial statements, a company may incur further costs on that
(ie to the extent that it is recognised as a provision per IAS 37, asset in the future. IAS 16 requires that subsequent costs should be
Provisions, Contingent Assets and Liabilities) capitalised if:
¤ borrowing costs in accordance with IAS 23, Borrowing Costs. ¤ it is probable that future economic benefits associated with the
extra costs will flow to the entity
Example 1 ¤ the cost of the item can be reliably measured.
On 1 March 2008 Yucca acquired a machine from Plant under the
following terms: All other subsequent costs should be recognised as an expense in
$ the income statement in the period that they are incurred.
List price of machine 82,000
Import duty 1,500 Example 3
Delivery fees 2,050 On 1 March 2010 Yucca purchased an upgrade package from Plant
Electrical installation costs 9,500 at a cost of $18,000 for the machine it originally purchased in
Pre-production testing 4,900 2008 (Example 1). The upgrade took a total of two days where new
Purchase of a five-year maintenance contract with Plant 7,000 components were added to the machine. Yucca agreed to purchase
the package as the new components would lead to a reduction in
In addition to the above information Yucca was granted a trade production time per unit of 15%. This will enable Yucca to increase
discount of 10% on the initial list price of the asset and a production without the need to purchase a new machine.
settlement discount of 5% if payment for the machine was Should the additional expenditure be capitalised or expensed?
received within one month of purchase. Yucca paid for the plant on (See page 5 for the solution to Example 3.)
25 March 2008.
 student accountant issue 19/2010
02
Studying Paper F7?
Performance objectives 10 and 11 are relevant to this exam

A gain on revaluation is always recognised in equity, under a revaluation

reserve (unless the gain reverse’s revaluation losses on the same asset that
were previously recognised in the income statement – in this instance the gain
is to be shown in the income statement). The revaluation gain is known as an
unrealised gain which later becomes realised when the asset is disposed
of (derecognised).

Depreciation Example 6
Depreciation is defined in IAS 16 as being the systematic allocation A company purchased a property with an overall cost of $100m on
of the depreciable amount of an asset over its useful economic life. 1 April 2009. The property elements are made up as follows:
In other words, depreciation applies the accruals concept to the
capitalised cost of a non-current asset and matches this cost to the $000 Estimated life
period that it relates to. Land and buildings
(Land element $20,000) 65,000 50 years
Depreciation methods Fixtures and fittings 24,000 10 years
There are many methods of depreciating a non-current asset with Lifts 11,000 20 years
the most common being: 100,000
¤ Straight line
¤ % on cost or Calculate the annual depreciation charge for the property for
¤ Cost – residual value the year ended 31 March 2010. (See page 6 for the solution to
Useful economic life Example 6.)

¤ Reducing balance Revaluations

¤ % on carrying value This is an important topic in the exam and features regularly in
Question 2, so you should ensure that you are familiar with all
Example 4 aspects of revaluations.
An item of plant was purchased on 1 April 2008 for $200,000 and
is being depreciated at 25% on a reducing balance basis. IAS 16 rules
Prepare the extracts of the financial statements for the year IAS 16 permits the choice of two possible treatments in respect of
ended 31 March 2010. (See page 5 for the solution to Example 4.) property, plant and equipment:
¤ The cost model (carry an asset at cost less accumulated
Useful economic lives and residual values depreciation/impairments).
IAS 16 requires that these estimates be reviewed at the end of each ¤ The revaluation model (carry an asset at its fair value
reporting period. If either changes significantly, the change should at the revaluation date less subsequent accumulated
be accounted for over the useful economic life remaining. depreciation impairment).

Example 5 If the revaluation policy is adopted this should be applied to all

A machine was purchased on 1 April 2007 for $120,000. It was assets in the entire category, ie if you revalue a building, you must
estimated that the asset had a residual value of $20,000 and revalue all land and buildings in that class of asset. Revaluations
a useful economic life of 10 years at this date. On 1 April 2009 must also be carried out with sufficient regularity so that the
(two years later) the residual value was reassessed as being only carrying amount does not differ materially from that which would be
$15,000 and the useful economic life remaining was considered to determined using fair value at the reporting date.
be only five years.
How should the asset be accounted for in the years ending Accounting for a revaluation
31 March 2008/2009/2010? (See page 5 for the solution There are a series of accounting adjustments that must be
to Example 5.) undertaken when revaluing a non-current asset. These adjustments
are indicated below.
Component depreciation
If an asset comprises two or more major components with different The initial revaluation
economic lives, then each component should be accounted for You may find it useful in the exam to first determine if there
separately for depreciation purposes and depreciated over its own is a gain or loss on the revaluation with a simple calculation
useful economic life. to compare:

Carrying value of non-current asset at revaluation date X

Valuation of non-current asset X
Difference = gain or loss on revaluation X
03 technical

Revaluation gains Double entry:

A gain on revaluation is always recognised in equity, under a Dr Revaluation reserve
revaluation reserve (unless the gain reverse’s revaluation losses Cr Retained earnings
on the same asset that were previously recognised in the income
statement – in this instance the gain is to be shown in the income Be careful, in the exam a reserves transfer is only required if the
statement). examiner indicates that it is company policy to make a transfer to
The revaluation gain is known as an unrealised gain which later realised profits in respect of excess depreciation on revalued assets.
becomes realised when the asset is disposed of (derecognised). If this is not the case then a reserves transfer is not necessary.
This movement in reserves should also be disclosed in the
Double entry: statement of changes in equity.
Dr Non-current asset cost
(difference between valuation and original cost/valuation) Example 9
Dr Accumulated depreciation A company revalued its property on 1 April 2009 to $20m ($8m
(with any historical cost accumulated depreciation) for the land). The property originally cost $10m ($2m for the
Cr Revaluation reserve land) 10 years ago. The original useful economic life of 40 years is
(gain on revaluation) unchanged. The company’s policy is to make a transfer to realised
profits in respect of excess depreciation.
Example 7 How will the property be accounted for in the year ended
A company purchased a building on 1 April 2007 for $100,000. The 31 March 2010? (See page 6 for the solution to Example 9.)
asset had a useful economic life at that date of 40 years. On 1 April
2009 the company revalued the building to its current fair value of Exam focus
$120,000. In the exam make sure you pay attention to the date that the
What is the double entry to record the revaluation? (See page 6 revaluation takes place. If the revaluation takes place at the start of
for the solution to Example 7.) the year then the revaluation should be accounted for immediately
and depreciation should be charged in accordance with the
Revaluation losses rule above.
A revaluation loss should be charged against any related revaluation If however the revaluation takes place at the year-end then the
surplus to the extent that the decrease does not exceed the asset would be depreciated for a full 12 months first based on the
amount held in the revaluation reserve in respect of the same original depreciation of that asset. This will enable the carrying
asset. Any additional loss must be charged as an expense in the amount of the asset to be known at the revaluation date, at which
income statement. point the revaluation can be accounted for.
A further situation may arise if the examiner states that the
Double entry: revaluation takes place mid-way through the year. If this were to
Dr Revaluation reserve (to maximum of original gain) happen the carrying amount would need to be found at the date of
Dr Income statement (any residual loss) revaluation, and therefore the asset would be depreciated based
Cr Non-current asset (loss on revaluation) on the original depreciation for the period up until revaluation,
then the revaluation will take place and be accounted for. Once the
Example 8 asset has been revalued you will need to consider the last period
The carrying value of Zen’s property at the end of the year amounted of depreciation. This will be found based upon the revaluation rules
to $108,000. On this date the property was revalued and was deemed (depreciate the revalued amount over remaining useful economic
to have a fair value of $95,000. The balance on the revaluation reserve life). This will be the most complicated situation and you must
relating to the original gain of the property was $10,000. ensure that your working is clearly structured for this; ie depreciate
What is the double entry to record the revaluation? (See page 6 for first period based on old depreciation, revalue, then depreciate
for the solution to Example 8.) last period based on new depreciation rule for revalued assets.

Depreciation Example 10
The asset must continue to be depreciated following the revaluation. A company purchased a building on 1 April 2005 for $100,000
However, now that the asset has been revalued the depreciable at which point it was considered to have a useful economic life of
amount has changed. In simple terms the revalued amount should 40 years. At the year end 31 March 2010 the company decided to
be depreciated over the assets remaining useful economic life. revalue the building to its current value of $98,000.
How will the building be accounted for in the year ended 31
Reserves transfer March 2010? (See page 7 for the solution to Example 10.)
The depreciation charge on the revalued asset will be different to the
depreciation that would have been charged based on the historical
cost of the asset. As a result of this, IAS 16 permits a transfer to
be made of an amount equal to the excess depreciation from the
revaluation reserve to retained earnings.
 student accountant issue 19/2010
04

Example 11
At 1 April 2009 HD Ltd carried its office block in its financial Be careful, in the exam a reserves
statements at its original cost of $2 million less depreciation transfer is only required if the
of $400,000 (based on its original life of 50 years). HD Ltd
decided to revalue the office block on 1 October 2009 to its examiner indicates that it is company
current value of $2.2m. The useful economic life remaining policy to make a transfer to
was reassessed at the time of valuation and is considered to
be 40 years at this date. It is the company’s policy to charge realised profits in respect of excess
depreciation proportionally. depreciation on revalued assets. If
How will the office block be accounted for in the year ended
31 March 2010? (See page 7 for the solution to Example 11.) this is not the case then a
reserves transfer is not necessary.
Derecognition
Property, plant and equipment should be derecognised when it is This movement in reserves should also
no longer expected to generate future economic benefit or when it is be disclosed in the statement of
disposed of.
When property, plant and equipment is to be derecognised, a changes in equity.
gain or loss on disposal is to be calculated. This can be found by
comparing the difference between:

Carrying value X
Disposal proceeds X
Profit or loss on disposal X

Tip: When the disposal proceeds are greater than the carrying value
there is a profit on disposal and when the disposal proceeds are
less than the carrying value there is a loss on disposal.

Example 12
An asset that originally cost $16,000 and had accumulated
depreciation on it of $8,000 was disposed of during the year for
$5,000 cash.
How should the disposal be accounted for in the
financial statements?
(See page 7 for the solution to Example 12.)

Disposal of previously revalued assets

When an asset is disposed of that has previously been revalued,
a profit or loss on disposal is to be calculated (as above). Any
remaining surplus on the revaluation reserve is now considered to
be a ‘realised’ gain and therefore should be transferred to retained
earnings as:

Dr Revaluation reserve
Cr Retained earnings

In summary, it can be seen that accounting for property, plant

and equipment is an important topic that features regularly in the
Paper F7 exam. With most of what is examinable feeding though
from Paper F3 this should be a comfortable topic that you can
tackle well in the exam.

Bobbie-Anne Retallack is a content specialist at

Kaplan Publishing

See pages 5, 6 and 7 for solutions to all the examples illustrated

in this technical article.
05 technical

ias 16
solutions
Solution 1 ¤ Depreciation of the store. Even though the asset has not
In accordance with IAS 16, all costs required to bring an asset yet been brought into use, IAS 16 states depreciation of an asset
to its present location and condition for its intended use should begins when it is available for use, ie when it is in the location
be capitalised. Therefore, the initial purchase price of the asset and condition necessary for it to be capable of operating in
should be: the manner intended by management.
$
List price 82,000 Note: depreciation cannot be calculated in this question as
Less: trade discount (10%) (8,200) information surrounding useful economic life has not been provided
73,800 – this is for illustrative purposes only. Depreciation is covered later
Import duty 1,500 in this article.
Delivery fees 2,050
Electrical installation costs 9,500 Solution 3
Pre-production testing 4,900 The $18,000 should be capitalised as part of the cost of the
Total amount to be capitalised at 1 March 91,750 asset as the revenue earning capacity of the machine has
significantly increased, which could in turn lead to the inflow
The maintenance contract of $7,000 is an expense and therefore of  additional economic benefit and the cost of the upgrade can be
should be spread over a five-year period in accordance with the reliably measured.
accruals concept and taken to the income statement. If the
$7,000 has been paid in full, then some of this cost will represent Solution 4
a prepayment. Income statement extract
In addition the settlement discount received of $3,690 Depreciation expense
($73,800 x 5%) is to be shown as other income in the $37,500
income statement. Statement of financial position extract
Plant
Solution 2 (200,000 – 50,000 – 37,500)
This is an example of a self-constructed asset. All costs to get the $112,500
store to its present location and condition for its intended use should
be capitalised. All of the expenditure listed in the question, with the Working for depreciation:
exception of general overheads would qualify for capitalisation. 31/03/09 Cost 200,000
The interest on the loan should also be capitalised from Depreciation – 25% (50,000)
1 April 2009 as in accordance with IAS 23 it meets the definition Carrying value 150,000
of a qualifying asset. The recognition criteria for capitalisation
appears to be met ie activities to prepare the asset for its intended 31/03/10 Carrying value 150,000
use are in progress, expenditure for the asset is being incurred Depreciation – 25% (37,500)
and borrowing costs are being incurred. Capitalisation of the Carrying value 112,500
interest on the loan must cease when the asset is ready for use, ie
1 January 2010. At this point any remaining interest for the period Solution 5
should be charged as a finance cost in the income statement. 31 March 2008
At the date of acquisition the cost of the asset of $120,000 would
Property, plant and equipment be capitalised. The asset should then be depreciated for the years
Store: to 31 March 2008/2009 as:
$000
Freehold land 4,500 Cost – residual value = 120,000 – 20,000 = $
10,000 per annum
Architect fees 620 Useful economic life 10 years
Site preparation 1,650
Materials 7,800 Income statement extract 2008
Direct labour costs 11,200 Depreciation
Legal fees 2,400 $10,000
Borrowing costs Statement of financial position extract 2008
(25,000 x 8%) x 9 /12 1,500 Machine
Total to be capitalised 29,670 (120,000 – 10,000) $110,000

Income statement impact 31 March 2009

With regards to the income statement this should be charged with: Income statement extract 2009
¤ General overheads of $940,000 Depreciation $10,000
¤ Remaining interest for Jan–Mar which is now an expense Statement of financial position extract 2009
$500,000 (25,000 x 8% x 3/12) and; Machine
(120,000 – 20,000) $100,000
 student accountant issue 19/2010
06

31 March 2010 Solution 9

As the residual value and useful economic life estimates have Statement of comprehensive income extract for the year ended
changed during the year ended 2010, the depreciation charge will 31 March 2010
need to be recalculated. The carrying value will now be spread
according to the revised estimates. $000
Depreciation expense 400
Depreciation charge:
100,000 – 15,000 = $17,000 per annum Other comprehensive income:
5 years Revaluation gain 12,000

Income statement extract 2010 Statement of financial position extract as at 31 March 2010
Depreciation $17,000
Statement of financial position extract 2010 $000
Machine Non-current assets
(100,000 – 17,000) $83,000 Property
(20,000 – 400) 19,600
Solution 6
$000 Equity
Land and buildings Revaluation reserve
(65,000 – 20,000)/50 years)) 900 (12,000 – 200) 11,800
Fixtures and fittings
(24,000/10 years) 2,400 Statement of changes in equity extracts
Lifts
(11,000/20 years) 550 Revaluation reserve Retained earnings
Total property depreciation 3,850 $000 $000
Revaluation gain 12,000
Solution 7 Reserves transfer (200) 200
Gain on revaluation:
Carrying value of non-current asset at revaluation date Workings:
(100,000 – (100,000/40 years x 2 years)) 95,000 Gain on revaluation:
Valuation 120,000 $000
Gain on revaluation 25,000 Carrying value of non-current asset at revaluation date
(10,000 – ((10,000 – 2,000)/40 years x 10 years)) 8,000
Double entry: Valuation 20,000
Dr Building cost Gain on revaluation 12,000
(120,000 – 100,000) 20,000
Dr Accumulated depreciation Double entry:
(100,000/40 years x 2 years) 5,000 Dr Property
Cr Revaluation reserve 25,000 (20,000 – 10,000) 10,000
Dr Accumulated depreciation
Solution 8 ((10,000 – 2,000)/40 years x 10 years) 2,000
Loss on revaluation: Cr Revaluation reserve 12,000
Carrying value of non-current asset at revaluation date 108,000
Valuation 95,000 Depreciation charge for year to 31 March 2010:
Loss on revaluation 13,000 Dr depreciation expense
((20,000 – 8,000)/30 years) 400
Double entry: Cr Accumulated depreciation 400
Dr Revaluation reserve
(to maximum of original gain) 10,000 Reserves transfer:
Dr Income statement 3,000 Historical cost depreciation charge
Cr Non-current asset 13,000 ((10,000 – 2,000)/40 years) 200
Revaluation depreciation charge 400
The revaluation gain or loss must be disclosed in both the Excess depreciation to be transferred 200
statement of changes in equity and in other comprehensive income.
Dr Revaluation reserve 200
Cr Retained earnings 200
07 technical

Solution 10 Working paper:

Statement of comprehensive income extract 31 March 2010 Note: Revaluation takes place part way through the year and
therefore depreciation must first be charged for the period 1 April
Depreciation charge 2,500 09 – 30 September 09, then the revaluation can be recorded and
then depreciation needs to be charged for the period 1 October
Other comprehensive income: 2009 – 31 March 2010.
Revaluation gain 10,500
(W1) Depreciation 1 April–30 September 2009
Statement of financial position extract 31 March 2010 2,000,000 x 6/12 = $20,000
Building at valuation 98,000 50 years

Statement of changes in equity extract (W2) Revaluation

Revaluation The carrying value of the asset at 1 October 2009 can now be found
reserve and revalued.
Revaluation gain 10,500
Carrying value of non-current asset at revaluation date
Working paper: (2,000,000 – (400,000 – 20,000)) 1,580,000
Note: revaluation takes place at year end, therefore a full year of Valuation of non-current asset 2,200,000
depreciation must first be charged. Gain on revaluation 620,000

(W1) Depreciation year ended 31 March 2010 Double entry:

100,0000 = $2,500 Dr NCA cost (2,200,000 – 2,000,000) 200,000
40 years Dr Accumulated depreciation 420,000
Cr Revaluation reserve 620,000
(W2) Revaluation
The carrying value of the asset at 31 March 2010 can now be found (W3) Depreciation 1 October – 31 March 2010
and revalued. 2,200,000 x 6/12 = $27,500
40 years
Carrying value of non-current asset at revaluation date
(100,000 – (100,000/40 years x 5 years)) 87,500 Solution 12
Valuation of non-current asset 98,000 The asset and its associated depreciation should be removed from
Gain or loss on revaluation 10,500 the statement of financial position and a profit or loss on disposal
should be recorded in the income statement.
Double entry: The loss on disposal is:
Dr Accumulated depreciation 12,500
Cr NCA cost 2,500 Carrying value at disposal date
Cr Revaluation reserve 10,500 (16,000 – 8,000) 8,000
Disposal proceeds 5,000
Solution 11 Loss on disposal 3,000
Statement of comprehensive income extract 31 March 2010

Depreciation charge
(20,000 (W1) + 27,500 (W2) 47,500

Other comprehensive income:

Revaluation gain 620,000

Statement of financial position extract 31 March 2010

Office block (carrying value at 31 March):
Valuation 2,200,000
Depreciation (27,500)
Carrying value 2,172,500

Statement of changes in equity extract

Revaluation
reserve
Revaluation gain 620,000
01 technical

f5 examiner’s
approach
RELEVANT TO ACCA QUALIFICATION PAPER F5

I took over as the new Paper F5, My approach to exam writing Preparing for the exam
Performance Management examiner from My colleagues say that they can always The best preparation that you can still do
Geoff Cordwell and my first exam will be work out what is going on in my life by for the Paper F5 exam is to practise
sat by students in December 2010. There the content of my exam questions. If my as many past papers as possible. I may be
are numerous changes being made to both garden is being landscaped, there may a new examiner but the syllabus remains
Fundamental level papers and Professional well be a question based on a landscape the same. My beliefs about what Paper F5
level papers in the future, but these won’t gardening business. If I’ve spent days on aims to achieve are fundamentally the
come into effect until June 2011 exams. end sat at my computer writing, it may be same as my predecessor. It’s essentially
Prior to that, it will be necessary for me about computers! And so on... If you want a management accounting paper that
to write a lengthier article covering the to get an idea about my style, you should also requires you to interpret financial
changes to Paper F5 that are taking place look at some of my past questions for CAT information as you would in the real world.
at that point. Since there are no such Paper 10. I try to make questions original As a starting point, you need to walk into
changes coming into effect this year that and true to life, rather than focusing the exam with your metaphorical toolkit:
will affect December 2010’s paper, and purely on the traditional manufacturing your set of management accounting
since I am making no radical departures in environment, which only plays a small part techniques that you’ve learnt and practised
my approach to Paper F5 as compared to in the world of commerce now in many for the exam. Many of these have been
my predecessor, this article will be brief. parts of the world. introduced in Paper F2, Management
If you want a summary of the key areas I believe that exam questions should be Accounting, so if you were exempt from
of the current Paper F5 syllabus and the set out clearly in order to give candidates this exam, you still need to make sure that
format of the Paper F5 paper, you should the best opportunity to impart their you are comfortable with its subject matter.
refer back to Geoff Cordwell’s examiner’s knowledge and I try hard to present Part of the skill required in Paper F5 is that
approach article of January 2009 (www. information in a logical format, using sometimes, you won’t be told which tool you
accaglobal.com/students/acca/exams/f5/ structured notes where possible. Some may need to take out of the bag, metaphorically
exam_int/f5.pdf). argue that in the real world information is speaking. You may need to work that out.
not always accessed in such an ordered way. Then, you may have to go on and discuss
My background My response to that would be that, in the what you have done or what the information
First of all, let me tell you a little bit about real world, we can refer to textbooks and means. Sometimes it is inevitable that the
myself. I studied law at both degree and senior colleagues too, but we can’t in exams discussion follows the numbers, so you
professional level before going on to qualify unfortunately. I want to give candidates the need to make sure that you are able to do
as a Chartered Accountant with Coopers & best possible opportunity of passing the the numbers, but rest assured: where your
Lybrand (now known as Pricewaterhouse Paper F5 exam by being as prescriptive as discussion follows your numbers, you will be
Coopers) in 1998. I started teaching possible in my requirements. In my view, given credit for what you have written even if
straight after qualification, although I there is nothing worse than a candidate who your numbers were wrong.
had a brief period of working for KPMG, fails an exam not because they don’t know To all of you sitting the exam in
gaining invaluable further practical the syllabus but because they could not December, good luck. Having said that,
experience. Over the years I have taught a work out what was expected of them from luck should have little to do with it. Make
variety of subjects to trainee accountants the requirement. sure that you cover all key areas of the
at two of the leading training providers. I am very aware that for a significant syllabus in your revision; you can’t question
These subjects have ranged from law, tax, number of people sitting ACCA exams, spot. Also, refer to the advice given in the
financial accounting and auditing through to English is not their first language and this numerous articles written by both myself
management accounting subjects. I’ve also makes understanding the exam paper so and other writers in the Student Accountant
written material and delivered a number much more difficult. Such candidates archive, both on particular topics and on
of bespoke courses to non-accountants, should be commended; I studied French exam technique, in order to give you the
covering law, financial accounting and until I was 18 but I’m sure that I would best chance of passing.
management accounting. In 2003 I became struggle today to sit an exam paper in
an examiner for CAT Paper 1, Financial French (or even order food correctly in a Ann Irons is examiner for Paper F5
Accounting and CAT Paper 10, Managing French restaurant perhaps!). As with other
Finances. I relinquished the CAT Paper 1 examiners, I therefore try to be vigilant at all
role some years ago to bring my ACCA work times about the need for clarity of English, Paper F5 microsite
in line with my teaching, which by then was especially when writing requirements. Don’t Access the Paper F5
focusing mainly on management accounting be surprised to see requirements broken microsite at www.accaglobal.
subjects. In 2009, I accepted the role as down a little more than you are used to; I’m com/f5
Paper F5 examiner. trying to help you.

Make sure that you cover all key areas of the syllabus in your revision; you
can’t question spot. Also, refer to the advice given in the articles in the
Student Accountant archive, in order to give you the best chance of passing.
01 sample question

paper p5
sample question
RELEVANT TO PAPER P5

Armstrong Stores (Armstrong) is a listed business with a chain

of 126 general department stores in South Postland. The Appendix 1
company is known for the high quality of its products, mainly Financial data for Armstrong Stores
food and clothing. The majority of its goods are sourced from 2008 2009
trusted manufacturers and branded under the company’s own $m $m
‘Strongarm’ label. Operating profit 505.7 435.1
Currently, Armstrong faces a tough competitive environment with Interest 40.2 77.6
all the major players in its market trying to secure their positions. Profit before tax 465.5 357.5
Poor economic conditions worldwide have significantly affected Profit for the year 353.8 271.7
South Postland. Consumer spending is falling throughout the Average number of shares in issue 1,600m 1,600m
economy and there is no immediate likelihood of a resumption
of  growth. 2008 2009
Armstrong’s chief executive officer (CEO) has recently conducted Economic value added (EVA) $306m $110m
a strategic review of the business in the context of the current
economic recession. He has identified the following strategy as Stock market information
critical for Armstrong’s success: 2008 2009
¤ focus on key customers – those who are occasional shoppers but South Postland market index 1,115.2 724.9
not currently loyal to the business Retailing sector index 2,450.7 1,911.5
¤ ensure Armstrong’s offering addresses their needs Armstrong Stores
¤ cut out costs which do not address these customers’ priorities (average share price) $2.45 $2.08
¤ amend current processes to meet this new focus
¤ build for the future with a programme of
sustainable development.

The company now needs to address the impact of this new strategy
on its performance measurement systems. Armstrong uses a
balanced scorecard to assess its strategic performance and the
scorecard is used to connect the business strategy with its more
detailed performance measures. The CEO has asked you to consider
the implications of the new strategy for the performance measures
used by the business.
Currently, Armstrong uses Economic Value Added (EVA),
earnings per share (EPS) growth and share price performance
to monitor its financial performance. The company has supplied
data in Appendix 1 which the CEO wishes to see used to assess
the financial performance from the shareholders’ perspective. She
has asked that you explain the problems of capturing performance
with these particular metrics and also, how they may affect
management’s behaviour.
Finally, in order to aid refocusing the company, the CEO has
requested a report to the board comprehensively benchmarking
the current performance of Armstrong. The board need to have
benchmarking exercise explained and then the results described.
Appendix 2 contains data analysing Armstrong, its two main
competitors and statistics provided by the government of South
Postland. A junior analyst has already correctly completed the
preliminary calculation work for benchmarking in Appendix 3. The
CEO has requested a critical assessment of these different sources
as well as the comments on the results of the analysis.
 student accountant issue 19/2010
02
Studying Paper P5?
Performance objectives 12, 13 and 14 are relevant to this exam

Appendix 2
a) Comparative data
BS stores CS Stores Armstrong
2008 2009 2008 2009 2008 2009
Revenue:
– Food $m 1,542 1,538 2,100 1,978 1,985 2,025
– Clothing $m 1,234 1,222 2,723 2,610 2,450 2,475
Total $m 2,776 2,760 4,823 4,588 4,435 4,500
Profit for the year $m 142 127 294 193 354 272
No of stores 81 83 167 186 119 126
No of suppliers 3,400 3,100 4,200 4,200 4,122 4,468
No of warehouses 6 6 8 9 7 7

b) Government statistics

Market totals – Revenue 2008 2009

– Food Retail $m 12,403 12,656
– Clothing Retail $m 25,792 22,500

c) Armstrong data for 2009

Region by region
(South Postland is split into three large regions)

Acelon Baselon Caselon

Revenue:
– Food $m 648 810 567
– Clothing $m 792 1,114 569
Total $m 1,440 1,924 1,136
Profit for the year $m 87 111 73
No of stores 37 51 38
No of warehouses 2 3 2

armstrong now needs to address the impact of its new strategy on its
performance measurement systems. Armstrong uses a balanced scorecard
to assess its strategic performance and the scorecard is used to
connect the business strategy with its more detailed performance measures.
The CEO has asked you to consider the implications of the new strategy
for the performance measures used by the business.
03 sample question

Appendix 3
Junior analyst’s working papers
a) Comparative data

Change year on year BS stores CS Stores Armstrong

Revenue:
– Food –0.3% –5.8% 2.0%
– Clothing –1.0% –4.1% 1.0%
Total –0.6% –4.9% 1.5%
Profit for the year –10.3% –34.5% –23.2%
No of stores 2.5% 11.4% 5.9%
No of suppliers –8.8% 0.0% 8.4%
No of warehouses 0.0% 12.5% 0.0%

BS stores CS Stores Armstrong

2008 2009 2008 2009 2008 2009
Market share:
– Food 12.4% 12.2% 16.9% 15.6% 16.0% 16.0%
– Clothing 4.8% 5.4% 10.6% 11.6% 9.5% 11.0%

Revenue per shop $m 34.27 33.25 28.88 24.67 37.27 35.71

b) Regional data for Armstrong

Acelon Baselon Caselon Total

Revenue per shop $m 38.92 37.72 29.90 35.71
Profit margin 6.0% 5.8% 6.5% 6.0%

Required:
1 Describe the four perspectives of the balanced scorecard showing how the new strategy of the business as outlined by the CEO links
to the different perspectives. Illustrate your answer by suggesting appropriate performance measures for Armstrong for each of the
detailed points within the strategy. (8 marks)
2 a Assess the financial performance of the company using the three shareholder performance indicators. (5 marks)
b Critically evaluate the use of these performance metrics and how they may affect management’s behaviour. (6 marks)
3 Prepare a report to the board on a benchmarking exercise using the information given in the appendix:
a Evaluate the benefits and difficulties of benchmarking in this situation (4 marks)
b Evaluate the performance of Armstrong using the data given in the question. Indicate what further information would be useful
and conclude as to the performance of the company. (8 marks)

Professional marks for appropriateness of format, style and structure of the report. (3 marks)

Total: 34 marks

The indicators each have strengths and weaknesses. EVA is a widely used
indicator which aims to capture the increase in shareholder wealth that the
company generates. It uses amended traditional profit based information
in order to approximate the net present value method of appraising an
investment. Thus, EVA provides a clear focus on the major objective of most
commercial entities.
 student accountant issue 19/2010
04

1 The four perspectives of the balanced scorecard are: 2 a) Armstrong’s financial performance
¤ Financial – how do we optimally serve our The year on year performance of Armstrong has declined with
shareholders’ interests? earnings per share falling by 23%. Normally, this would imply
¤ Customer – how should we present ourselves to our customers? that the company would be heavily out of favour with investors.
¤ Internal business process – what processes are critical to However, the share price seems to have held up with a decline
achieving our customer and shareholder goals and how can we of only 15% compared to a fall in the sector of 22% and the
optimise these? market as a whole of 35%. The sector comparison is the more
¤ Learning and growth – how do we maintain our ability to relevant to the performance of Armstrong’s management as
change and grow? the main market index will contain data from manufacturing,
financial and other industries. Shareholders will be encouraged
The new strategy addresses these perspectives in different ways. by the implication that the market views Armstrong as one of
Ultimately all of the perspectives will have financial effects whether the better future prospects for investment.
in the short- or long-term interests of our shareholders. This view is substantiated by the positive EVA for 2009
($110m) which Armstrong generated. EVA has fallen by 64%
Focus on key customers – this directly addresses the customer from 2008 but it has remained positive and so the company
perspective and will require the collection of the profiles and continues to create value for its shareholders even in the poor
needs of these customers in order to generate market growth economic environment.
and so improve our financial position. Suitable performance b) Evaluating the financial metrics
measurement would segment our market (for example, by customer The indicators each have strengths and weaknesses. EVA is
age or gender) and identify our changing market share within a widely used indicator which aims to capture the increase
each segment. in shareholder wealth that the company generates. It uses
amended traditional profit based information in order to
Ensuring we meet key customer needs – again addresses the approximate the net present value method of appraising an
customer perspective but will also impact on the products/services investment. Thus, EVA provides a clear focus on the major
that Armstrong offers and so affect the process perspective. objective of most commercial entities. However, its calculation
Suitable performance measures from the customer perspective requires a large number of adjustments to the traditional
would be levels of repeat business and customer satisfaction and accounting figures, for example the need to calculate the
from the process perspective, Armstrong will measure its product economic rather than accounting depreciation, the need to
range and quality. Range would be measured against competitors distinguish between cash flow and accruals and to distinguish
while quality could be measured subjectively against competitors or between expense and investment. This makes the method less
internally by level of customer complaints or returns. easily understood than the two other measures currently used
by Armstrong.
Cost cutting – this connects to the process perspective as it EPS growth is important to shareholders as it relates to
seeks to focus the business on value added activities. Suitable dividend growth which is a fundamental variable used in the
performance measures would be efficiency savings generated by calculation of share value (Dividend valuation method). It is a
removing or reducing unnecessary processes/products. Armstrong widely used measure by equity analysts and so is a key driver
could possibly look to simplify its supply chain by cutting the of share prices. However, it is based on accounting profit and
number of suppliers with which it deals. only captures year on year change and so can be subject to
short-term manipulation if the trend over a number of years
Amend current processes to meet the new focus – clearly, this is not considered.
takes the process perspective and measurement of this objective Share price performance reflects the capital performance
will be by way of the achievement of goals in a specific change of  an investment but tends to be volatile and subject to
programme to assist the other objectives. significant fluctuations outside of the control of management.
It will be the figure that most shareholders turn to in order to get
Programme of sustainable development – this objective looks to a quick impression of their investment performance but it can
the future and this is the learning and growth perspective. Suitable lead to judgements being formed on the basis of that short-term
measures for this area would include the company’s carbon volatility which are more appropriate for speculators rather than
footprint (its CO2 output), the efficiency of energy use of the investors. The use of an average share price in this instance
business and the level of packaging waste generated. should help to ameliorate such problems but the averaging
method and time-period should be further investigated.
The impact of these metrics on management is intended
to focus their activities on improvement of financial
performance for shareholders. The danger of EPS growth
and share price is that these may be manipulated in the
short‑term in order to demonstrate improvement but at the
risk of impairing long-term performance. EVA partially tackles
this issue through its use of adjusted accounting figures (eg
depreciation) but suffers from lack of clarity in its calculation
compared to these other metrics.
05 sample question

Workings: It would be easier to obtain information from a company

(W1) which is not in direct competition with Armstrong but which
2008 2009 has similar functions such as purchasing and warehousing.
Economic value added (EVA) $306m $110m (down 64%) However, there are likely to be more significant differences in the
objectives and functions of the activities being compared and
(W2) so it may be harder to apply the lessons from the competitor
2008 2009 to Armstrong’s operations. Data has not been supplied to allow
EPS (profit for year/av no of shares) 0.221 0.170 (down 23%) this analysis in this case. Armstrong could seek out companies
which have industry awards in these functional areas and then
(W3) negotiate an information sharing agreement.
Stock market information b) Armstrong’s performance benchmarked
2008 2009 Comparing Armstrong to its competitors, it is clear that
Main market index 1,115.2 724.9 (down 30%) Armstrong has done well to increase its total revenues but this
Retailing sector index 2,450.7 1,911.5 (down 22%) has come at the cost of a significant fall in profit compared to
Armstrong Stores share price $2.45 $2.08 (down 15%) BS Stores. Armstrong should look into its pricing policy as it
may have been buying sales by offering heavy discounts and
3 these may not be sustainable in the long term. The CS Stores
To: Board of Armstrong Stores drop in profit is greatest of all but this may be explained by
From: A Accountant problems in the range or quality of its products. CS Stores
Date: Today opened 19 new stores in the period but there has been an
Subject: Benchmarking performance overall fall in revenue of 4.9%. Armstrong should analyse CS
offering to its customers in order to avoid making the same
This report describes the benefits and problems associated with mistakes. BS has increased profitability and this seems due to
benchmarking the company’s performance. Then, the performance a reduction in suppliers and presumably the overhead costs of
of Armstrong and its two main competitors is calculated managing those relationships. Armstrong should examine BS
and evaluated. Stores sourcing policy to see if it can simplify its supply chain in
a similar manner.
a) Benchmarking methods In terms of market share in food, Armstrong has maintained
Benchmarking is a business improvement technique. There its position against slight falls in its competitors. In clothing, all
are different types of benchmarking. Internal benchmarking the companies have made gains and this may indicate a trend
is where similar operations in different parts of the company to consolidation or failure of smaller stores of which Armstrong
under consideration are compared with each other and also may be able to take further advantage.
with an internally generated target. External benchmarking is In revenue per shop, Armstrong has outperformed its
where the company’s results are compared to those of other competitors, however, this may be due to Armstrong having a
companies. There are different types of external benchmarking: larger average store. This question could be answered by finding
one where competitors are used as comparators and another out the average store area for the three companies. Regionally,
where a company with similar operations (eg warehousing), the Caselon area stands out with poor revenue per shop and
which is not a direct competitor, is compared. The aim of it has an unusual mix of food and clothing compared to the
benchmarking is to identify where best practice lies and then to other regions where clothing predominates. Further work will
analyse what constitutes the best operational practice so this be needed to identify if this is due to a different range being
can be implemented across the business. offered by managers or if there are regional variations in
The main advantages and disadvantages concern the customer preferences.
availability of benchmark information and its applicability to the
business. Internal comparison between regions in Armstrong
will be easy but may not yield dramatic improvements as the
regions are probably already in relatively close contact. Any
improvements identified from this exercise should be easily
applicable as the systems will be broadly the same.
External benchmarking in this case means comparison
to competitors where the possibility of radical new ideas is
greater but the difficulty will lie in obtaining sufficiently detailed
information to identify the best practice business process. Of
course, it will be difficult to negotiate an information sharing
arrangement with a competitor due to the commercially
sensitive data being exchanged. However, there exist some
government schemes which require subscriber companies to
supply data and then provide them with anonymised industry
data in return.
 student accountant issue 19/2010
06

Conclusion
In conclusion, Armstrong appears to be performing well with
increased market share during the decline. The company must
guard against the danger of eroding margins too far.

Indicative marking schedule

Part 1
0.5 mark per explanation of each perspective, up to 2.
1.5 marks for comments discussing each of the performance
measures including the link to the new objectives, up to 6.

Total: 8 marks

Part 2
a) Comments: 1 mark per point up to maximum of 2 on EPS and
share price (together) and maximum of 1 on EVA.
(Maximum 3)

Workings:
1 mark for calculation of EPS and 0.5 each other calculation,
up to maximum of 2.

b) up to 2 marks on each metric and 2 marks on impact on
management behaviour (Maximum of 6)

Total: 11 marks

Part 3
a) 1 mark per point made; 2 for explaining benchmarking and 2 for
advantages/disadvantages (maximum 4)
b) 1 mark per point made up to 5 for analysing the computations,
1 mark per point made up to 3 for suggesting further work and
1 mark for a conclusion (maximum 8)

Professional marks (format, style and structure of report) are

available up to a maximum of 3.

Total: 15 marks

Total for question: 34 marks

01 technical

risk management
understanding why is as important
as understanding how
RELEVANT TO ACCA QUALIFICATION PAPER P4

The management of risk is a key area The return required by investors is the Taxation
within a number of ACCA papers, and sum of the risk free rate and a premium for Risk management may help in reducing the
exam questions related to this area are the risk they undertake. If investors hold amount of tax that a corporation pays by
common. It is vital that students are able well-diversified portfolios of investments reducing the volatility of the corporation’s
to apply risk management techniques, then they are only exposed to systematic earnings. Where a corporation faces taxation
such as using derivative instruments to risk as their exposure to firm-specific risk schedules that are progressive (that is the
hedge against risk, and offer advice and has been diversified away. Therefore, the risk corporation pays proportionally higher
recommendations as required by the premium of their required return is based amounts of tax as its profits increase), by
scenario in the question. It is also equally on the capital asset pricing model (CAPM). reducing the variability of that corporation’s
important that students understand why Research suggests companies with diverse earnings and thereby staying in the same
corporations manage risk in theory and in equity holdings do not increase value by low tax bracket will reduce the tax payable.
practice, because risk management costs diversifying company specific risk, as their According to academics, corporations
money but does it actually add more value equity holders have already achieved this could often find themselves in situations
to a corporation? This article explores the level of risk diversification. Moreover, risk where they face progressive tax functions,
circumstances where the management of management activity designed to transfer for example, when they have previous
risk may lead to an increase in the value of systematic risk would not provide additional losses which are not written off or, in the
a corporation. benefits to a corporation because, in perfect case of multinational corporations, due to
Risk, in this context, refers to the volatility markets, the benefits achieved from risk the taxation treaties which exist between
of returns (both positive and negative) management activity would at least equal the different countries. The amount of taxation
that can be quantified through statistical costs of undertaking such activity. Therefore, that can be saved depends upon the
measures such as probabilities, standard in a situation of perfect markets, it may be corporation’s individual circumstances.
deviations and correlations between argued that risk management activity is at
different returns. Its management is about best neutral or at worst detrimental because Insolvency and financial distress
decisions made to change the volatility of costs would either equal or be more than the A corporation may find itself in a situation
returns a corporation is exposed to, for benefits accrued. of being insolvent when it cannot meet
example changing a company’s exposure to Such an argument would not apply its financial obligations as they fall due.
floating interest rates by swapping them to to smaller companies which have Financial distress is a situation that is less
fixed rates for a fee. Since business is about concentrated, non-diversified equity severe than insolvency in that a corporation
generating higher returns by undertaking holdings. In this case the equity holders, can operate on a day-to-day basis, but it
risky projects, important management because they are exposed to both specific finds that these operations are difficult to
decisions revolve around which projects to and systematic risk, would benefit from conduct because the parties dealing with it
undertake, how they should be financed and risk diversification by the company. are concerned that it may become insolvent
whether the volatility of a project’s returns Therefore, whereas larger companies may in the future. When facing financial distress
(its risk) should be managed. not create value from risk management a corporation will incur additional costs,
The volatility of returns of a project activity, smaller companies can and should both direct and indirect, due to the situation
should be managed if it results in undertake risk management. However, it is facing.
increasing the value to a corporation. Given empirical research studies have found that The main indirect costs of financial
that the market value of a corporation is the risk management is undertaken mostly distress relate to the higher costs of
net present value (NPV) of its future cash by larger companies with diverse equity contracting with the corporation’s
flows discounted by the return required holdings and not by the smaller companies. stakeholders, such as customers, employees
by its investors, then higher market value The accepted reason for this is that the and suppliers. For example, customers may
can either be generated by increasing the costs related to risk management are large demand better warranty schemes or may be
future cash flows or by reducing investors’ and mostly fixed. Small companies simply reluctant to buy a product due to concerns
required rate of return (or both). A risk can not afford these costs nor can they about the corporation’s ability to fulfil its
management strategy that increases the benefit from the economies of scale that warranty; employees may demand higher
NPV at a lower comparative cost would large companies can. salaries; senior management may ask for
benefit the corporation. In addition to the ability of larger golden hellos before agreeing to work for the
companies to undertake risk management, corporation; and suppliers may be unwilling
market imperfections may provide the to offer favourable credit terms.
motivation for them to do so. Market
imperfections that exist in the real world,
as opposed to the perfect world conditions
assumed by finance or economic theory,
may provide opportunities to reduce
volatility in cash flows and thereby reduce
the costs imposed on a corporation.
The following discussion considers the
circumstances which may result in providing
such opportunities.
 student accountant issue 19/2010
02
Studying Paper P4?
Performance objectives 15 and 16 are relevant to this exam

Academics exploring this area postulate Therefore, when raising debt capital, a Capital structure and
that because stakeholders are subject corporation that is subject to low levels information asymmetry
to the corporation’s full risk, as opposed of financial distress would face higher Risk management can help a corporation
to only systematic risk, which is faced agency costs, with lenders imposing higher obtain an optimal capital structure of
by the corporation’s equity holders, the borrowing costs and more restrictive debt and equity to maximise its value.
stakeholders would demand greater covenants. Whereas debt holders get a fixed Since risk management stabilises the
compensation for their participation. Where return on their investment, any additional variability of cash inflows, this would
an organisation actively manages its risk benefit due to higher profits would go to the enable a corporation to take more debt
and prevents (or reduces the possibility of) equity holders. This would make the debt finance in its capital structure. Stable cash
situations of financial distress, it will find holders reluctant to allow the corporation flows indicate less risk and therefore debt
it easier to contract with its stakeholders to undertake risky projects or to lend holders would become more willing to lend
and at a lower cost. Hence, the more more finance to the corporation because to the corporation. Since debt is cheaper
volatile the cash flows of a corporation, they would not gain any benefit from the to finance than equity because of lower
the more likely the need to manage its risky projects. required rates of return and the tax shield,
risk in order to reduce the costs related to A corporation that faces high levels of taking on more debt should increase the
financial distress. financial distress would find it difficult to value of the corporation. Risk management
raise equity capital in order to undertake can help achieve this.
External funding and agency costs new investments. If corporations try to Academics have observed that managers
Another consequence of financial distress raise equity finance for relatively less risky would prefer to use internally generated
is the impact this may have on the projects then the profits earned from such funds rather than going to the external
corporation’s ability to undertake profitable projects would initially go to the debt markets for funds because it is cheaper
future investment. Financial distress may holders and the equity holders will gain only and less intrusive on the corporation. They
make the cost of external debt and equity residual profits. Therefore equity holders suggest that borrowing money from the
funding so expensive that a corporation would put pressure on the corporation and external markets, whether equity or debt,
and its management may be forced reject its management to reject good, low risk would involve parties who do not have the
profitable projects. Academics refer to this projects, which may have been acceptable complete information about the corporation.
as the under investment problem. to the bondholders. This information asymmetry would make the
Equity holders in effect hold a call option Therefore, risk management in reducing external sources of funds more expensive. If
on a corporation’s assets and debt holders financial distress by reducing the volatility risk management stabilises the cash flows
can be considered to have written the of the corporation’s cash inflows may help that the corporation receives from year to
option. In cases of low financial distress the management to obtain an optimal year, then this would enable managers to
the company may be considered to be mix of debt and equity, and to undertake plan when the necessary internal funds will
similar to an at-the-money option for its profitable projects. become available for future investments
equity holders, and, therefore, they would with greater accuracy. They will then be able
be more willing to undertake risky projects to align their investment policies with the
as they would benefit from any increase in availability of funding.
profitability, but the impact of any loss is
limited. In the case of substantial financial Manager behaviour towards
distress, the option could be considered to risk management
be well out-of-money. In this situation there In his seminal paper, Rene Stulz suggests
is little (or no) benefit to equity holders of that managers, whose performance reward
undertaking new projects, as the benefits of structure includes large equity stakes in a
these will pass to the debt holders initially. corporation, are more likely to reduce the
However, debt holders would be reluctant corporation’s risk, as opposed to managers
to lend to a severely distressed company in whose performance reward structure is
any case. based primarily on equity options. Managers
who hold concentrated equity stakes in a
corporation face increased levels of risk
when compared to other equity holders.
It is vital that students are able to apply risk As discussed previously, investors hold
well-diversified portfolios and face exposure
management techniques, such as using derivative to systematic risk only. But managers with
instruments to hedge against risk, and offer advice concentrated equity stakes would face
both systematic and unsystematic risk.
and recommendations as required by the scenario Therefore, they have a greater propensity to
in the question. It is also equally important reduce the unsystematic risk.
that students understand why corporations
manage risk in theory and in practice.
03 technical

the jury is still out on whether risk management actually does lead to
increased corporate value. There seem to be strong theoretical reasons
for managing risk, but empirical research has not proven the impact of risk
management activity on corporate value.

However, if investors do not reward Contrary to the behaviour of managers Hence the belief held among managers
corporations that are reducing unsystematic who hold concentrated equity stakes, is that the management of risk does
risk, because they have diversified this risk managers who own equity options, which create value, and certainly corporations
away themselves. And if a corporation’s will be converted into equity at a future and their senior managers seem to
managers use the corporation’s resources to date, will actively seek to increase the believe and act in a manner that it does.
reduce unsystematic risk, thereby reducing risk of a corporation rather than reduce However, the jury is still out on whether
the corporation’s value. Then it is worth it. Managers who hold equity options are risk management actually does lead to
exploring under what circumstances would interested in maximising the future price of increased corporate value. There seem to
equity investors allow managers to act to the equity. Therefore in order to maximise be strong theoretical reasons for managing
reduce unsystematic risk and whether such future profits and the price of the equity, risk, but empirical research has not proven
actions could actually result in the value of they will be more inclined to undertake the impact of risk management activity
the corporation increasing. risky projects (and less inclined to manage on corporate value.
Stulz argues that encouraging managers risk). Equity options, as a form of reward,
to hold concentrated equity positions but have been often criticised because they do Further reading
allowing them to reduce unsystematic risk not necessarily make managers behave in I would suggest that students read
at the same time, may enable them to act the best interests of the corporation or its the following academic books and
in the best interests of the corporation equity investors, but encourage them to act papers to supplement their knowledge
and the result may be an increase in the in an overly risky manner. and understanding.
corporate value. He explains that managers, A number of empirical studies looking ¤ Arnold, G, 2008. Corporate Financial
who do not have to worry about risks that at manager behaviour support the above Management. 4th ed. Harlow: Pearson.
are not under their control (because they discussion (see for example Tufano’s study ¤ Culp, C, 2002. The Revolution in Corporate
have hedged them away), would be able to published in 1996 in the Journal of  Finance). Risk Management: A Decade of Innovations
focus their time, expertise and experience in Process and Products. Journal of Applied
on the strategies and operations that they Testing the impact of Corporate Finance, 14(4), 8–26.
can control. This focus may result in the risk management ¤ Jensen, M, and Meckling, W, 1976. Theory
increase in the value of the corporation, In addition to the above, empirical of the Firm: Managerial Behaviour, Agency
although the impact of this increase in research studies have looked at the risk Costs and Ownership Structure. Journal of
value is not easily measurable or directly management policies and actions pursued Financial Economics, 3, 305–360.
attributable to risk management activity. by corporations and their impact on ¤ Myers, S, and Majluf, N, 1984. Corporate
As an aside, one could pose the question, corporate value. Although the studies have Financing and Investment Decisions when
why don’t managers, who are rewarded by provided varying results when studying each Firms have Information that Investors do not
equity, diversify the risk of concentrated area of market imperfections and their have. Journal of Financial Economics, 13,
equity investments themselves? They impact, the overarching conclusion from 187–221.
could sell equity in their own corporation these studies is that: corporations manage ¤ Smithson, C, 1998. Managing Financial
and replace it by buying equity in other their risks in the belief that this would Risk: A Guide to Derivative Products,
corporations. In this way they do not have to create or increase corporate value, although Financial Engineering and Value
hold concentrated equity positions and then a direct link between risk management and Maximization. New York: McGraw-Hill,
would be like the normal equity holders a corresponding increase in corporate value pp492–517.
facing only systematic risk. A research has not been established. ¤ Stulz, R, 1996. Rethinking Risk
study on wealth management, which looked Management. Journal of Applied
at concentrated equity positions and risk Corporate Finance, 9, 8–24.
management, found that senior managers ¤ Tufano, P, 1996. Who Manages Risk? An
are reluctant to reduce their concentrated Empirical Examination of Risk Management
equity positions because any attempt to sell Practices in the Gold Mining Industry.
the equity would send negative signals to Journal of Finance, 51, 1097–1137.
the markets, and cause their corporation’s
value to decrease unnecessarily. Shishir Malde is examiner for Paper P4