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The accounting for IAS 16, Property, Plant and Equipmentis aparticularly important area of the Paper F7 syllabus. You canalmost guarantee that in every exam you will be required toaccount for property, plant and equipment at least once.

This article is designed to outline the key areas of IAS 16,Property, Plant and Equipmentthat you may be required to attempt inthe F7 exam.

IAS 16, ProPrty, PlAt Ad IPmt ovrvIwThere are essentially four key areas when accounting forproperty, plant and equipment that you must ensure that you arefamiliar with: initial recognitiondepreciation revaluationderecognition (disposals).

IItIAl rcogItIoThe basic principle of IAS 16 is that items of property, plant andequipment that qualify for recognition should initially be measuredat cost.

One of the easiest ways to remember this is that you shouldcapitalise all costs to bring an asset to its present location andcondition for its intended use.

Commonly used examples of cost include:purchase price of an asset (less any trade discount)directly attributable costs such as:

cost of site preparation initial delivery and handling costs installation and testing costs professional fees

the initial estimate of dismantling and removing the asset andrestoring the site on which it is located, to its original condition(ie to the extent that it is recognised as a provision per IAS 37,Provisions, Contingent Assets and Liabilities)

borrowing costs in accordance with IAS 23, Borrowing Costs.

xAmPl 1On 1 March 2008 Yucca acquired a machine from Plant under thefollowing terms:

$List price of machine 82,000Import duty 1,500Delivery fees 2,050Electrical installation costs 9,500Pre-production testing 4,900Purchase of a five-year maintenance contract with Plant 7,000

In addition to the above information Yucca was granted a tradediscount of 10% on the initial list price of the asset and asettlement discount of 5% if payment for the machine wasreceived within one month of purchase. Yucca paid for the plant on25 March 2008.

How should the above information be accounted for in thefinancial statements? (See page 5 for the solution to Example 1.)

xAmPl 2Construction of Deb and Hams new store began on 1 April 2009.The following costs were incurred on the construction:

$000Freehold land 4,500Architect fees 620Site preparation 1,650Materials 7,800Direct labour costs 11,200Legal fees 2,400General overheads 940

The store was completed on 1 January 2010 and brought into usefollowing its grand opening on the 1 April 2010. Deb and Hamissued a $25m unsecured loan on 1 April 2009 to aid constructionof the new store (which meets the definition of a qualifying assetper IAS 23). The loan carried an interest rate of 8% per annum andis repayable on 1 April 2012.

RequiredCalculate the amount to be included as property, plant andequipment in respect of the new store and state what impact theabove information would have on the income statement (if any) forthe year ended 31 March 2010.

(See page 5 for the solution to Example 2.)

Subsequen ss

Once an item of PPE has been recognised and capitalised in thefinancial statements, a company may incur further costs on thatasset in the future. IAS 16 requires that subsequent costs should becapitalised if: it is probable that future economic benefits associated with the

extra costs will flow to the entity the cost of the item can be reliably measured.

All other subsequent costs should be recognised as an expense inthe income statement in the period that they are incurred.

xAmPl 3On 1 March 2010 Yucca purchased an upgrade package from Plantat a cost of $18,000 for the machine it originally purchased in2008 (Example 1). The upgrade took a total of two days where newcomponents were added to the machine. Yucca agreed to purchase

the package as the new components would lead to a reduction inproduction time per unit of 15%. This will enable Yucca to increaseproduction without the need to purchase a new machine.

Should the additional expenditure be capitalised or expensed?(See page 5 for the solution to Example 3.)

rlvAt to AccA AlIFIcAtIo PAPr F7

accounting for

property, plantand equipment

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xAmPl 6A company purchased a property with an overall cost of $100m on1 April 2009. The property elements are made up as follows:

$000 Estimated lifeLand and buildings(Land element $20,000) 65,000 50 yearsFixtures and fittings 24,000 10 yearsLifts 11,000 20 years

100,000

Calculate the annual depreciation charge for the property forthe year ended 31 March 2010. (See page 6 for the solution toExample 6.)

rvAlAtIoS

This is an important topic in the exam and features regularly inQuestion 2, so you should ensure that you are familiar with allaspects of revaluations.

IAS 16 uesIAS 16 permits the choice of two possible treatments in respect ofproperty, plant and equipment:The cost model (carry an asset at cost less accumulated

depreciation/impairments).The revaluation model (carry an asset at its fair value

at the revaluation date less subsequent accumulateddepreciation impairment).

If the revaluation policy is adopted this should be applied to allassets in the entire category, ie if you revalue a building, you mustrevalue all land and buildings in that class of asset. Revaluationsmust also be carried out with sufficient regularity so that thecarrying amount does not differ materially from that which would bedetermined using fair value at the reporting date.

AccotIg For A rvAlAtIoThere are a series of accounting adjustments that must beundertaken when revaluing a non-current asset. These adjustmentsare indicated below.

the iniia eauainYou may find it useful in the exam to first determine if thereis a gain or loss on the revaluation with a simple calculationto compare:

Carrying value of non-current asset at revaluation date X

Valuation of non-current asset XDifference = gain or loss on revaluation X

depeiainDepreciation is defined in IAS 16 as being the systematic allocationof the depreciable amount of an asset over its useful economic life.

In other words, depreciation applies the accruals concept to thecapitalised cost of a non-current asset and matches this cost to theperiod that it relates to.

depeiain ehsThere are many methods of depreciating a non-current asset withthe most common being: Straight line

% on cost or Cost residual value Useful economic life

Reducing balance

% on carrying value

xAmPl 4An item of plant was purchased on 1 April 2008 for $200,000 andis being depreciated at 25% on a reducing balance basis.

Prepare the extracts of the financial statements for the yearended 31 March 2010. (See page 5 for the solution to Example 4.)

sefu eni ies an esiua auesIAS 16 requires that these estimates be reviewed at the end of eachreporting period. If either changes significantly, the change shouldbe accounted for over the useful economic life remaining.

xAmPl 5A machine was purchased on 1 April 2007 for $120,000. It wasestimated that the asset had a residual value of $20,000 anda useful economic life of 10 years at this date. On 1 April 2009(two years later) the residual value was reassessed as being only$15,000 and the useful economic life remaining was considered tobe only five years.

How should the asset be accounted for in the years ending31 March 2008/2009/2010? (See page 5 for the solutionto Example 5.)

cpnen epeiainIf an asset comprises two or more major components with differenteconomic lives, then each component should be accounted forseparately for depreciation purposes and depreciated over its ownuseful economic life.

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020202Stdt AccotAt issue19/2010 02Studying Paper F7?

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Double entry:Dr Revaluation reserveCr Retained earnings

Be careful, in the exam a reserves transfer is only required if theexaminer indicates that it is company policy to make a transfer torealised profits in respect of excess depreciation on revalued assets.If this is not the case then a reserves transfer is not necessary.

This movement in reserves should also be disclosed in thestatement of changes in equity.

xAmPl 9A company revalued its property on 1 April 2009 to $20m ($8mfor the land). The property originally cost $10m ($2m for theland) 10 years ago. The original useful economic life of 40 years isunchanged. The companys policy is to make a transfer to realisedprofits in respect of excess depreciation.

How will the property be accounted for in the year ended31 March 2010? (See page 6 for the solution to Example 9.)

xAm FocS

In the exam make sure you pay attention to the date that therevaluation takes place. If the revaluation takes place at the start ofthe year then the revaluation should be accounted for immediatelyand depreciation should be charged in accordance with therule above.

If however the revaluation takes place at the year-end then theasset would be depreciated for a full 12 months first based on theoriginal depreciation of that asset. This will enable the carryingamount of the asset to be known at the revaluation date, at whichpoint the revaluation can be accounted for.

A further situation may arise if the examiner states that therevaluation takes place mid-way through the year. If this were tohappen the carrying amount would need to be found at the date ofrevaluation, and therefore the asset would be depreciated basedon the original depreciation for the period up until revaluation,then the revaluation will take place and be accounted for. Once theasset has been revalued you will need to consider the last periodof depreciation. This will be found based upon the revaluation rules(depreciate the revalued amount over remaining useful economiclife). This will be the most complicated situation and you mustensure that your working is clearly structured for this; ie depreciatefor first period based on old depreciation, revalue, then depreciatelast period based on new depreciation rule for revalued assets.

xAmPl 10A company purchased a building on 1 April 2005 for $100,000at which point it was considered to have a useful economic life of40 years. At the year end 31 March 2010 the company decided torevalue the building to its current value of $98,000.

How will the building be accounted for in the year ended 31March 2010? (See page 7 for the solution to Example 10.)

reauain ainsA gain on revaluation is always recognised in equity, under arevaluation reserve (unless the gain reverses revaluation losseson the same asset that were previously recognised in the incomestatement in this instance the gain is to be shown in the incomestatement).

The revaluation gain is known as an unrealised gain which laterbecomes realised when the asset is disposed of (derecognised).

Double entry:Dr Non-current asset cost

(difference between valuation and original cost/valuation)Dr Accumulated depreciation

(with any historical cost accumulated depreciation)Cr Revaluation reserve

(gain on revaluation)

xAmPl 7A company purchased a building on 1 April 2007 for $100,000. Theasset had a useful economic life at that date of 40 years. On 1 April2009 the company revalued the building to its current fair value of

$120,000.What is the double entry to record the revaluation? (See page 6

for the solution to Example 7.)

reauain ssesA revaluation loss should be charged against any related revaluationsurplus to the extent that the decrease does not exceed theamount held in the revaluation reserve in respect of the sameasset. Any additional loss must be charged as an expense in theincome statement.

Double entry:Dr Revaluation reserve (to maximum of original gain)Dr Income statement (any residual loss)Cr Non-current asset (loss on revaluation)

xAmPl 8The carrying value of Zens property at the end of the year amountedto $108,000. On this date the property was revalued and was deemedto have a fair value of $95,000. The balance on the revaluation reserverelating to the original gain of the property was $10,000.

What is the double entry to record the revaluation? (See page 6for the solution to Example 8.)

depeiainThe asset must continue to be depreciated following the revaluation.However, now that the asset has been revalued the depreciableamount has changed. In simple terms the revalued amount shouldbe depreciated over the assets remaining useful economic life.

resees ansfe

The depreciation charge on the revalued asset will be different to thedepreciation that would have been charged based on the historicalcost of the asset. As a result of this, IAS 16 permits a transfer tobe made of an amount equal to the excess depreciation from therevaluation reserve to retained earnings.

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cArFl, I t xAm A rSrvStrASFr IS oly rIrd IF txAmIr IdIcAtS tAt It IS comPAy

PolIcy to mAk A trASFr torAlISd ProFItS I rSPct oF xcSSdPrcIAtIo o rvAld ASStS. IFtIS IS ot t cAS t ArSrvS trASFr IS ot cSSAry.tIS movmt I rSrvS Sold AlSo dIScloSd I t StAtmt oFcAgS I Ity.

xAmPl 11At 1 April 2009 HD Ltd carried its office block in its financialstatements at its original cost of $2 million less depreciationof $400,000 (based on its original life of 50 years). HD Ltddecided to revalue the office block on 1 October 2009 to itscurrent value of $2.2m. The useful economic life remainingwas reassessed at the time of valuation and is considered tobe 40 years at this date. It is the companys policy to chargedepreciation proportionally.

How will the office block be accounted for in the year ended31 March 2010? (See page 7 for the solution to Example 11.)

deeniinProperty, plant and equipment should be derecognised when it isno longer expected to generate future economic benefit or when it isdisposed of.

When property, plant and equipment is to be derecognised, again or loss on disposal is to be calculated. This can be found bycomparing the difference between:

Carrying value X

Disposal proceeds XProfit or loss on disposal X

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

xAmPl 12An asset that originally cost $16,000 and had accumulateddepreciation on it of $8,000 was disposed of during the year for$5,000 cash.

How should the disposal be accounted for in thefinancial statements?(See page 7 for the solution to Example 12.)

dispsa f peius eaue assesWhen an asset is disposed of that has previously been revalued,a profit or loss on disposal is to be calculated (as above). Anyremaining surplus on the revaluation reserve is now considered tobe a realised gain and therefore should be transferred to retainedearnings as:

Dr Revaluation reserveCr Retained earnings

In summary, it can be seen that accounting for property, plantand equipment is an important topic that features regularly in thePaper F7 exam. With most of what is examinable feeding thoughfrom Paper F3 this should be a comfortable topic that you cantackle well in the exam.

Bobbie-Anne Retallack is a content specialist atKaplan Publishing

See pages 5, 6 and 7 for solutions to all the examples illustratedin this technical article.

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Depreciation of the store. Even though the asset has notyet been brought into use, IAS 16 states depreciation of an assetbegins when it is available for use, ie when it is in the locationand condition necessary for it to be capable of operating inthe manner intended by management.

Note: depreciation cannot be calculated in this question asinformation surrounding useful economic life has not been provided this is for illustrative purposes only. Depreciation is covered laterin this article.

SoltIo 3The $18,000 should be capitalised as part of the cost of theasset as the revenue earning capacity of the machine hassignificantly increased, which could in turn lead to the inflowof additional economic benefit and the cost of the upgrade can bereliably measured.

SoltIo 4Income statement extractDepreciation expense

$37,500Statement of financial position extractPlant(200,000 50,000 37,500)

$112,500

Working for depreciation:31/03/09 Cost 200,000

Depreciation 25% (50,000)Carrying value 150,000

31/03/10 Carrying value 150,000Depreciation 25% (37,500)Carrying value 112,500

SoltIo 531 March 2008At the date of acquisition the cost of the asset of $120,000 wouldbe capitalised. The asset should then be depreciated for the yearsto 31 March 2008/2009 as:

Cost residual value = 120,000 20,000 = $10,000 per annumUseful economic life 10 years

Income statement extract 2008Depreciation

$10,000Statement of financial position extract 2008Machine(120,000 10,000) $110,000

31 March 2009Income statement extract 2009Depreciation $10,000Statement of financial position extract 2009Machine(120,000 20,000) $100,000

SoltIo 1In accordance with IAS 16, all costs required to bring an assetto its present location and condition for its intended use shouldbe capitalised. Therefore, the initial purchase price of the assetshould be: $List price 82,000Less: trade discount (10%) (8,200)

73,800Import duty 1,500Delivery fees 2,050Electrical installation costs 9,500Pre-production testing 4,900Total amount to be capitalised at 1 March 91,750

The maintenance contract of $7,000 is an expense and thereforeshould be spread over a five-year period in accordance with theaccruals concept and taken to the income statement. If the$7,000 has been paid in full, then some of this cost will representa prepayment.

In addition the settlement discount received of $3,690

($73,800 x 5%) is to be shown as other income in theincome statement.

SoltIo 2This is an example of a self-constructed asset. All costs to get thestore to its present location and condition for its intended use shouldbe capitalised. All of the expenditure listed in the question, with theexception of general overheads would qualify for capitalisation.

The interest on the loan should also be capitalised from1 April 2009 as in accordance with IAS 23 it meets the definitionof a qualifying asset. The recognition criteria for capitalisationappears to be met ie activities to prepare the asset for its intendeduse are in progress, expenditure for the asset is being incurredand borrowing costs are being incurred. Capitalisation of theinterest on the loan must cease when the asset is ready for use, ie1 January 2010. At this point any remaining interest for the periodshould be charged as a finance cost in the income statement.

Property, plant and equipmentStore: $000Freehold land 4,500Architect fees 620Site preparation 1,650Materials 7,800Direct labour costs 11,200Legal fees 2,400Borrowing costs(25,000 x 8%) x 9 /12 1,500Total to be capitalised 29,670

Income statement impactWith regards to the income statement this should be charged with:General overheads of $940,000Remaining interest for JanMar which is now an expense

$500,000 (25,000 x 8% x 3/12) and;

ias 16solutions

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31 March 2010As the residual value and useful economic life estimates havechanged during the year ended 2010, the depreciation charge willneed to be recalculated. The carrying value will now be spreadaccording to the revised estimates.

Depreciation charge:100,000 15,000 = $17,000 per annum

5 years

Income statement extract 2010Depreciation $17,000Statement of financial position extract 2010Machine(100,000 17,000) $83,000

SoltIo 6 $000

Land and buildings(65,000 20,000)/50 years)) 900Fixtures and fittings

(24,000/10 years) 2,400Lifts(11,000/20 years) 550Total property depreciation 3,850

SoltIo 7Gain on revaluation:Carrying value of non-current asset at revaluation date(100,000 (100,000/40 years x 2 years)) 95,000Valuation 120,000Gain on revaluation 25,000

Double entry:Dr Building cost(120,000 100,000) 20,000Dr Accumulated depreciation(100,000/40 years x 2 years) 5,000Cr Revaluation reserve 25,000

SoltIo 8Loss on revaluation:Carrying value of non-current asset at revaluation date 108,000Valuation 95,000Loss on revaluation 13,000

Double entry:Dr Revaluation reserve(to maximum of original gain) 10,000Dr Income statement 3,000Cr Non-current asset 13,000

The revaluation gain or loss must be disclosed in both thestatement of changes in equity and in other comprehensive income.

SoltIo 9Statement of comprehensive income extract for the year ended31 March 2010

$000Depreciation expense 400

Other comprehensive income:Revaluation gain 12,000

Statement of financial position extract as at 31 March 2010

$000Non-current assetsProperty(20,000 400) 19,600EquityRevaluation reserve(12,000 200) 11,800

Statement of changes in equity extracts

Revaluation reserve Retained earnings$000 $000

Revaluation gain 12,000Reserves transfer (200) 200

Workings:Gain on revaluation:

$000Carrying value of non-current asset at revaluation date(10,000 ((10,000 2,000)/40 years x 10 years)) 8,000Valuation 20,000Gain on revaluation 12,000

Double entry:Dr Property(20,000 10,000) 10,000Dr Accumulated depreciation((10,000 2,000)/40 years x 10 years) 2,000Cr Revaluation reserve 12,000

Depreciation charge for year to 31 March 2010:Dr depreciation expense((20,000 8,000)/30 years) 400Cr Accumulated depreciation 400

Reserves transfer:Historical cost depreciation charge((10,000 2,000)/40 years) 200Revaluation depreciation charge 400

Excess depreciation to be transferred 200

Dr Revaluation reserve 200Cr Retained earnings 200

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Working paper:Note: Revaluation takes place part way through the year andtherefore depreciation must first be charged for the period 1 April09 30 September 09, then the revaluation can be recorded andthen depreciation needs to be charged for the period 1 October2009 31 March 2010.

(W1) Depreciation 1 April30 September 20092,000,000 x 6/12 = $20,00050 years

(W2) RevaluationThe carrying value of the asset at 1 October 2009 can now be foundand revalued.

Carrying value of non-current asset at revaluation date(2,000,000 (400,000 20,000)) 1,580,000Valuation of non-current asset 2,200,000Gain on revaluation 620,000

Double entry:

Dr NCA cost (2,200,000 2,000,000) 200,000Dr Accumulated depreciation 420,000Cr Revaluation reserve 620,000

(W3) Depreciation 1 October 31 March 20102,200,000 x 6/12 = $27,50040 years

SoltIo 12The asset and its associated depreciation should be removed fromthe statement of financial position and a profit or loss on disposalshould be recorded in the income statement.

The loss on disposal is:

Carrying value at disposal date(16,000 8,000) 8,000Disposal proceeds 5,000Loss on disposal 3,000

SoltIo 10Statement of comprehensive income extract 31 March 2010

Depreciation charge 2,500

Other comprehensive income:Revaluation gain 10,500

Statement of financial position extract 31 March 2010Building at valuation 98,000

Statement of changes in equity extractRevaluation

reserveRevaluation gain 10,500

Working paper:Note: revaluation takes place at year end, therefore a full year ofdepreciation must first be charged.

(W1) Depreciation year ended 31 March 2010

100,0000 = $2,50040 years

(W2) RevaluationThe carrying value of the asset at 31 March 2010 can now be foundand revalued.

Carrying value of non-current asset at revaluation date(100,000 (100,000/40 years x 5 years)) 87,500Valuation of non-current asset 98,000Gain or loss on revaluation 10,500

Double entry:Dr Accumulated depreciation 12,500Cr NCA cost 2,500Cr Revaluation reserve 10,500

SoltIo 11Statement 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 2010Office block (carrying value at 31 March):Valuation 2,200,000Depreciation (27,500)Carrying value 2,172,500

Statement of changes in equity extractRevaluation

reserveRevaluation gain 620,000

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I took over as the new Paper F5,Performance Managementexaminer fromGeoff Cordwell and my first exam will besat by students in December 2010. Thereare numerous changes being made to bothFundamental level papers and Professionallevel papers in the future, but these wontcome into effect until June 2011 exams.Prior to that, it will be necessary for meto write a lengthier article covering thechanges to Paper F5 that are taking placeat that point. Since there are no suchchanges coming into effect this year thatwill affect December 2010s paper, andsince I am making no radical departures inmy approach to Paper F5 as compared tomy predecessor, this article will be brief.If you want a summary of the key areasof the current Paper F5 syllabus and theformat of the Paper F5 paper, you shouldrefer back to Geoff Cordwells examiners

approach article of January 2009 (www.accaglobal.com/students/acca/exams/f5/exam_int/f5.pdf).

My bakgroundFirst of all, let me tell you a little bit aboutmyself. I studied law at both degree andprofessional level before going on to qualifyas a Chartered Accountant with Coopers &Lybrand (now known as PricewaterhouseCoopers) in 1998. I started teachingstraight after qualification, although Ihad a brief period of working for KPMG,gaining invaluable further practicalexperience. Over the years I have taught avariety of subjects to trainee accountantsat two of the leading training providers.These subjects have ranged from law, tax,financial accounting and auditing through tomanagement accounting subjects. Ive alsowritten material and delivered a numberof bespoke courses to non-accountants,covering law, financial accounting andmanagement accounting. In 2003 I becamean examiner for CAT Paper 1, FinancialAccounting and CAT Paper 10, ManagingFinances. I relinquished the CAT Paper 1role some years ago to bring my ACCA workin line with my teaching, which by then wasfocusing mainly on management accountingsubjects. In 2009, I accepted the role as

Paper F5 examiner.

My approah to xaM writingMy colleagues say that they can alwayswork out what is going on in my life bythe content of my exam questions. If mygarden is being landscaped, there maywell be a question based on a landscapegardening business. If Ive spent days onend sat at my computer writing, it may beabout computers! And so on... If you wantto get an idea about my style, you shouldlook at some of my past questions for CATPaper 10. I try to make questions originaland true to life, rather than focusingpurely on the traditional manufacturingenvironment, which only plays a small partin the world of commerce now in manyparts of the world.

I believe that exam questions should beset out clearly in order to give candidatesthe best opportunity to impart theirknowledge and I try hard to present

information in a logical format, usingstructured notes where possible. Some mayargue that in the real world information isnot always accessed in such an ordered way.My response to that would be that, in thereal world, we can refer to textbooks andsenior colleagues too, but we cant in examsunfortunately. I want to give candidates thebest possible opportunity of passing thePaper F5 exam by being as prescriptive aspossible in my requirements. In my view,there is nothing worse than a candidate whofails an exam not because they dont knowthe syllabus but because they could notwork out what was expected of them fromthe requirement.

I am very aware that for a significantnumber of people sitting ACCA exams,English is not their first language and thismakes understanding the exam paper somuch more difficult. Such candidatesshould be commended; I studied Frenchuntil I was 18 but Im sure that I wouldstruggle today to sit an exam paper inFrench (or even order food correctly in aFrench restaurant perhaps!). As with otherexaminers, I therefore try to be vigilant at alltimes about the need for clarity of English,especially when writing requirements. Dontbe surprised to see requirements brokendown a little more than you are used to; Im

trying to help you.

Mak sur that you ovr all ky aras of th syllabus in your rvision; youant qustion spot. also, rfr to th advi givn in th artils in thstudent accountantarhiv, in ordr to giv you th bst han of passing.

prparing for th xaMThe best preparation that you can still dofor the Paper F5 exam is to practiseas many past papers as possible. I may bea new examiner but the syllabus remainsthe same. My beliefs about what Paper F5aims to achieve are fundamentally thesame as my predecessor. Its essentiallya management accounting paper thatalso requires you to interpret financialinformation as you would in the real world.As a starting point, you need to walk intothe exam with your metaphorical toolkit:your set of management accountingtechniques that youve learnt and practisedfor the exam. Many of these have beenintroduced in Paper F2, ManagementAccounting, so if you were exempt fromthis exam, you still need to make sure thatyou are comfortable with its subject matter.Part of the skill required in Paper F5 is that

sometimes, you wont be told which tool youneed to take out of the bag, metaphoricallyspeaking. You may need to work that out.Then, you may have to go on and discusswhat you have done or what the informationmeans. Sometimes it is inevitable that thediscussion follows the numbers, so youneed to make sure that you are able to dothe numbers, but rest assured: where yourdiscussion follows your numbers, you will begiven credit for what you have written even ifyour numbers were wrong.

To all of you sitting the exam inDecember, good luck. Having said that,luck should have little to do with it. Makesure that you cover all key areas of thesyllabus in your revision; you cant questionspot. Also, refer to the advice given in thenumerous articles written by both myselfand other writers in the Student Accountantarchive, both on particular topics and onexam technique, in order to give you thebest chance of passing.

Ann Irons is examiner for Paper F5

PaPer F5 microsite

acce e pe f5mce .cc.cm/5

01 thnial01 thnial

rlvant to aa qualifiation papr f5

f5 examiners

approach

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Armstrong Stores (Armstrong) is a listed business with a chainof 126 general department stores in South Postland. Thecompany is known for the high quality of its products, mainlyfood and clothing. The majority of its goods are sourced fromtrusted manufacturers and branded under the companys ownStrongarm label.

Currently, Armstrong faces a tough competitive environment withall the major players in its market trying to secure their positions.Poor economic conditions worldwide have significantly affectedSouth Postland. Consumer spending is falling throughout theeconomy and there is no immediate likelihood of a resumptionof growth.

Armstrongs chief executive officer (CEO) has recently conducteda strategic review of the business in the context of the currenteconomic recession. He has identified the following strategy ascritical for Armstrongs success: focus on key customers those who are occasional shoppers but

not currently loyal to the business ensure Armstrongs offering addresses their needs cut out costs which do not address these customers priorities amend current processes to meet this new focus

build for the future with a programme ofsustainable development.

The company now needs to address the impact of this new strategyon its performance measurement systems. Armstrong uses abalanced scorecard to assess its strategic performance and thescorecard is used to connect the business strategy with its moredetailed performance measures. The CEO has asked you to considerthe implications of the new strategy for the performance measuresused by the business.

Currently, Armstrong uses Economic Value Added (EVA),earnings per share (EPS) growth and share price performanceto monitor its financial performance. The company has supplieddata in Appendix 1 which the CEO wishes to see used to assessthe financial performance from the shareholders perspective. Shehas asked that you explain the problems of capturing performancewith these particular metrics and also, how they may affectmanagements behaviour.

Finally, in order to aid refocusing the company, the CEO hasrequested a report to the board comprehensively benchmarkingthe current performance of Armstrong. The board need to havebenchmarking exercise explained and then the results described.Appendix 2 contains data analysing Armstrong, its two maincompetitors and statistics provided by the government of SouthPostland. A junior analyst has already correctly completed thepreliminary calculation work for benchmarking in Appendix 3. TheCEO has requested a critical assessment of these different sourcesas well as the comments on the results of the analysis.

RELEVANT TO PAPER P5

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sample question

APPENdix 1Financial data for Armstrong Stores 2008 2009

$m $mOperating profit 505.7 435.1Interest 40.2 77.6Profit before tax 465.5 357.5Profit for the year 353.8 271.7Average number of shares in issue 1,600m 1,600m

2008 2009Economic value added (EVA) $306m $110m

Stock market information2008 2009

South Postland market index 1,115.2 724.9Retailing sector index 2,450.7 1,911.5Armstrong Stores(average share price) $2.45 $2.08

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ARmsTRONg NOw NEEds TO AddREss ThE imPAcT Of iTs NEw sTRATEgy ON iTsPERfORmANcE mEAsuREmENT sysTEms. ARmsTRONg usEs A bALANcEd scOREcARdTO AssEss iTs sTRATEgic PERfORmANcE ANd ThE scOREcARd is usEd TOcONNEcT ThE busiNEss sTRATEgy wiTh iTs mORE dETAiLEd PERfORmANcE mEAsuREs.ThE cEO hAs AskEd yOu TO cONsidER ThE imPLicATiONs Of ThE NEw sTRATEgyfOR ThE PERfORmANcE mEAsuREs usEd by ThE busiNEss.

APPENdix 2a) Comparative data BS stores CS Stores Armstrong

2008 2009 2008 2009 2008 2009Revenue: 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 2,475Total $m 2,776 2,760 4,823 4,588 4,435 4,500Profit for the year $m 142 127 294 193 354 272No of stores 81 83 167 186 119 126No of suppliers 3,400 3,100 4,200 4,200 4,122 4,468No 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 CaselonRevenue: Food $m 648 810 567 Clothing $m 792 1,114 569Total $m 1,440 1,924 1,136Profit for the year $m 87 111 73No of stores 37 51 38No of warehouses 2 3 2

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1 The four perspectives of the balanced scorecard are: Financial how do we optimally serve our

shareholders interests?Customer how should we present ourselves to our customers? Internal business process what processes are critical to

achieving our customer and shareholder goals and how can weoptimise these?

Learning and growth how do we maintain our ability tochange and grow?

The new strategy addresses these perspectives in different ways.Ultimately all of the perspectives will have financial effects whetherin the short- or long-term interests of our shareholders.

Focus on key customers this directly addresses the customerperspective and will require the collection of the profiles andneeds of these customers in order to generate market growthand so improve our financial position. Suitable performancemeasurement would segment our market (for example, by customerage or gender) and identify our changing market share withineach segment.

Ensuring we meet key customer needs again addresses thecustomer perspective but will also impact on the products/servicesthat Armstrong offers and so affect the process perspective.Suitable performance measures from the customer perspectivewould be levels of repeat business and customer satisfaction andfrom the process perspective, Armstrong will measure its productrange and quality. Range would be measured against competitorswhile quality could be measured subjectively against competitors orinternally by level of customer complaints or returns.

Cost cutting this connects to the process perspective as itseeks to focus the business on value added activities. Suitableperformance measures would be efficiency savings generated byremoving or reducing unnecessary processes/products. Armstrongcould possibly look to simplify its supply chain by cutting thenumber of suppliers with which it deals.

Amend current processes to meet the new focus clearly, thistakes the process perspective and measurement of this objectivewill be by way of the achievement of goals in a specific changeprogramme to assist the other objectives.

Programme of sustainable development this objective looks tothe future and this is the learning and growth perspective. Suitablemeasures for this area would include the companys carbonfootprint (its CO

2output), the efficiency of energy use of the

business and the level of packaging waste generated.

2 a) Armstrongs nancial performanceThe year on year performance of Armstrong has declined withearnings per share falling by 23%. Normally, this would implythat the company would be heavily out of favour with investors.However, the share price seems to have held up with a declineof only 15% compared to a fall in the sector of 22% and themarket as a whole of 35%. The sector comparison is the morerelevant to the performance of Armstrongs management asthe main market index will contain data from manufacturing,financial and other industries. Shareholders will be encouragedby the implication that the market views Armstrong as one ofthe better future prospects for investment.

This view is substantiated by the positive EVA for 2009($110m) which Armstrong generated. EVA has fallen by 64%from 2008 but it has remained positive and so the companycontinues to create value for its shareholders even in the pooreconomic environment.

b) Evaluating the financial metricsThe indicators each have strengths and weaknesses. EVA isa widely used indicator which aims to capture the increasein shareholder wealth that the company generates. It uses

amended traditional profit based information in order toapproximate the net present value method of appraising aninvestment. Thus, EVA provides a clear focus on the majorobjective of most commercial entities. However, its calculationrequires a large number of adjustments to the traditionalaccounting figures, for example the need to calculate theeconomic rather than accounting depreciation, the need todistinguish between cash flow and accruals and to distinguishbetween expense and investment. This makes the method lesseasily understood than the two other measures currently usedby Armstrong.

EPS growth is important to shareholders as it relates todividend growth which is a fundamental variable used in thecalculation of share value (Dividend valuation method). It is awidely used measure by equity analysts and so is a key driverof share prices. However, it is based on accounting profit andonly captures year on year change and so can be subject toshort-term manipulation if the trend over a number of yearsis not considered.

Share price performance reflects the capital performanceof an investment but tends to be volatile and subject tosignificant fluctuations outside of the control of management.It will be the figure that most shareholders turn to in order to geta quick impression of their investment performance but it canlead to judgements being formed on the basis of that short-termvolatility which are more appropriate for speculators rather thaninvestors. The use of an average share price in this instanceshould help to ameliorate such problems but the averagingmethod and time-period should be further investigated.

The impact of these metrics on management is intendedto focus their activities on improvement of financial

performance for shareholders. The danger of EPS growthand share price is that these may be manipulated in theshort-term in order to demonstrate improvement but at therisk of impairing long-term performance. EVA partially tacklesthis issue through its use of adjusted accounting figures (egdepreciation) but suffers from lack of clarity in its calculationcompared to these other metrics.

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Workings:(W1)

2008 2009Economic value added (EVA) $306m $110m (down 64%)

(W2)2008 2009

EPS (profit for year/av no of shares) 0.221 0.170 (down 23%)

(W3)Stock market information

2008 2009Main market index 1,115.2 724.9 (down 30%)Retailing sector index 2,450.7 1,911.5 (down 22%)Armstrong Stores share price $2.45 $2.08 (down 15%)

3To: Board of Armstrong StoresFrom: A AccountantDate: TodaySubject: Benchmarking performance

This report describes the benefits and problems associated withbenchmarking the companys performance. Then, the performanceof Armstrong and its two main competitors is calculatedand evaluated.

a) Benchmarking methodsBenchmarking is a business improvement technique. Thereare different types of benchmarking. Internal benchmarkingis where similar operations in different parts of the companyunder consideration are compared with each other and alsowith an internally generated target. External benchmarking iswhere the companys results are compared to those of othercompanies. There are different types of external benchmarking:one where competitors are used as comparators and anotherwhere a company with similar operations (eg warehousing),which is not a direct competitor, is compared. The aim ofbenchmarking is to identify where best practice lies and then toanalyse what constitutes the best operational practice so thiscan be implemented across the business.

The main advantages and disadvantages concern theavailability of benchmark information and its applicability to thebusiness. Internal comparison between regions in Armstrongwill be easy but may not yield dramatic improvements as theregions are probably already in relatively close contact. Anyimprovements identified from this exercise should be easilyapplicable as the systems will be broadly the same.

External benchmarking in this case means comparisonto competitors where the possibility of radical new ideas isgreater but the difficulty will lie in obtaining sufficiently detailedinformation to identify the best practice business process. Of

course, it will be difficult to negotiate an information sharingarrangement with a competitor due to the commerciallysensitive data being exchanged. However, there exist somegovernment schemes which require subscriber companies tosupply data and then provide them with anonymised industrydata in return.

It would be easier to obtain information from a companywhich is not in direct competition with Armstrong but whichhas similar functions such as purchasing and warehousing.However, there are likely to be more significant differences in theobjectives and functions of the activities being compared andso it may be harder to apply the lessons from the competitorto Armstrongs operations. Data has not been supplied to allowthis analysis in this case. Armstrong could seek out companieswhich have industry awards in these functional areas and thennegotiate an information sharing agreement.

b) Armstrongs performance benchmarkedComparing Armstrong to its competitors, it is clear thatArmstrong has done well to increase its total revenues but thishas come at the cost of a significant fall in profit compared toBS Stores. Armstrong should look into its pricing policy as itmay have been buying sales by offering heavy discounts andthese may not be sustainable in the long term. The CS Storesdrop in profit is greatest of all but this may be explained byproblems in the range or quality of its products. CS Storesopened 19 new stores in the period but there has been anoverall fall in revenue of 4.9%. Armstrong should analyse CS

offering to its customers in order to avoid making the samemistakes. BS has increased profitability and this seems due toa reduction in suppliers and presumably the overhead costs ofmanaging those relationships. Armstrong should examine BSStores sourcing policy to see if it can simplify its supply chain ina similar manner.

In terms of market share in food, Armstrong has maintainedits position against slight falls in its competitors. In clothing, allthe companies have made gains and this may indicate a trendto consolidation or failure of smaller stores of which Armstrongmay be able to take further advantage.

In revenue per shop, Armstrong has outperformed itscompetitors, however, this may be due to Armstrong having alarger average store. This question could be answered by findingout the average store area for the three companies. Regionally,the Caselon area stands out with poor revenue per shop andit has an unusual mix of food and clothing compared to theother regions where clothing predominates. Further work willbe needed to identify if this is due to a different range beingoffered by managers or if there are regional variations incustomer preferences.

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cONcLusiONIn conclusion, Armstrong appears to be performing well withincreased market share during the decline. The company mustguard against the danger of eroding margins too far.

iNdicATiVE mARkiNg schEduLEPart 10.5 mark per explanation of each perspective, up to 2.1.5 marks for comments discussing each of the performancemeasures including the link to the new objectives, up to 6.

Total: 8 marks

Part 2a) 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 3a) 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 and1 mark for a conclusion (maximum 8)

Professional marks (format, style and structure of report) areavailable up to a maximum of 3.

Total: 15 marks

Total for question: 34 marks

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risk managementunderstanding why is as importantas understanding how

The management of risk is a key areawithin a number of ACCA papers, andexam questions related to this area arecommon. It is vital that students are ableto apply risk management techniques,such as using derivative instruments tohedge against risk, and offer advice andrecommendations as required by thescenario in the question. It is also equallyimportant that students understand whycorporations manage risk in theory and inpractice, because risk management costsmoney but does it actually add more valueto a corporation? This article explores thecircumstances where the management ofrisk may lead to an increase in the value ofa corporation.

Risk, in this context, refers to the volatilityof returns (both positive and negative)that can be quantified through statisticalmeasures such as probabilities, standard

deviations and correlations betweendifferent returns. Its management is aboutdecisions made to change the volatility ofreturns a corporation is exposed to, forexample changing a companys exposure tofloating interest rates by swapping them tofixed rates for a fee. Since business is aboutgenerating higher returns by undertakingrisky projects, important managementdecisions revolve around which projects toundertake, how they should be financed andwhether the volatility of a projects returns(its risk) should be managed.

The volatility of returns of a projectshould be managed if it results inincreasing the value to a corporation. Giventhat the market value of a corporation is thenet present value (NPV) of its future cashflows discounted by the return requiredby its investors, then higher market valuecan either be generated by increasing thefuture cash flows or by reducing investorsrequired rate of return (or both). A riskmanagement strategy that increases theNPV at a lower comparative cost wouldbenefit the corporation.

The return required by investors is thesum of the risk free rate and a premium forthe risk they undertake. If investors holdwell-diversified portfolios of investmentsthen they are only exposed to systematicrisk as their exposure to firm-specific riskhas been diversified away. Therefore, the riskpremium of their required return is basedon the capital asset pricing model (CAPM).Research suggests companies with diverseequity holdings do not increase value bydiversifying company specific risk, as theirequity holders have already achieved thislevel of risk diversification. Moreover, riskmanagement activity designed to transfersystematic risk would not provide additionalbenefits to a corporation because, in perfectmarkets, the benefits achieved from riskmanagement activity would at least equal thecosts of undertaking such activity. Therefore,in a situation of perfect markets, it may be

argued that risk management activity is atbest neutral or at worst detrimental becausecosts would either equal or be more than thebenefits accrued.

Such an argument would not applyto smaller companies which haveconcentrated, non-diversified equityholdings. In this case the equity holders,because they are exposed to both specificand systematic risk, would benefit fromrisk diversification by the company.Therefore, whereas larger companies maynot create value from risk managementactivity, smaller companies can and shouldundertake risk management. However,empirical research studies have found thatrisk management is undertaken mostlyby larger companies with diverse equityholdings and not by the smaller companies.The accepted reason for this is that thecosts related to risk management are largeand mostly fixed. Small companies simplycan not afford these costs nor can theybenefit from the economies of scale thatlarge companies can.

In addition to the ability of largercompanies to undertake risk management,market imperfections may provide themotivation for them to do so. Marketimperfections that exist in the real world,as opposed to the perfect world conditions

assumed by finance or economic theory,may provide opportunities to reducevolatility in cash flows and thereby reducethe costs imposed on a corporation.The following discussion considers thecircumstances which may result in providingsuch opportunities.

TaxaTionRisk management may help in reducing theamount of tax that a corporation pays byreducing the volatility of the corporationsearnings. Where a corporation faces taxationschedules that are progressive (that is thecorporation pays proportionally higheramounts of tax as its profits increase), byreducing the variability of that corporationsearnings and thereby staying in the samelow tax bracket will reduce the tax payable.

According to academics, corporationscould often find themselves in situationswhere they face progressive tax functions,for example, when they have previouslosses which are not written off or, in thecase of multinational corporations, due tothe taxation treaties which exist betweendifferent countries. The amount of taxationthat can be saved depends upon thecorporations individual circumstances.

insolvncy and inancial disTssA corporation may find itself in a situationof being insolvent when it cannot meetits financial obligations as they fall due.Financial distress is a situation that is lesssevere than insolvency in that a corporationcan operate on a day-to-day basis, but itfinds that these operations are difficult toconduct because the parties dealing with itare concerned that it may become insolventin the future. When facing financial distressa corporation will incur additional costs,both direct and indirect, due to the situationit is facing.

The main indirect costs of financialdistress relate to the higher costs ofcontracting with the corporationsstakeholders, such as customers, employeesand suppliers. For example, customers maydemand better warranty schemes or may bereluctant to buy a product due to concernsabout the corporations ability to fulfil itswarranty; employees may demand highersalaries; senior management may ask forgolden hellos before agreeing to work for thecorporation; and suppliers may be unwillingto offer favourable credit terms.

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Academics exploring this area postulatethat because stakeholders are subjectto the corporations full risk, as opposedto only systematic risk, which is facedby the corporations equity holders, thestakeholders would demand greatercompensation for their participation. Wherean organisation actively manages its riskand prevents (or reduces the possibility of)situations of financial distress, it will findit easier to contract with its stakeholdersand at a lower cost. Hence, the morevolatile the cash flows of a corporation,the more likely the need to manage itsrisk in order to reduce the costs related tofinancial distress.

xTnal Unding and agncy cosTsAnother consequence of financial distressis the impact this may have on thecorporations ability to undertake profitable

future investment. Financial distress maymake the cost of external debt and equityfunding so expensive that a corporationand its management may be forced rejectprofitable projects. Academics refer to thisas the under investment problem.

Equity holders in effect hold a call optionon a corporations assets and debt holderscan be considered to have written theoption. In cases of low financial distressthe company may be considered to besimilar to an at-the-money option for itsequity holders, and, therefore, they wouldbe more willing to undertake risky projectsas they would benefit from any increase inprofitability, but the impact of any loss islimited. In the case of substantial financialdistress, the option could be considered tobe well out-of-money. In this situation thereis little (or no) benefit to equity holders ofundertaking new projects, as the benefits ofthese will pass to the debt holders initially.However, debt holders would be reluctantto lend to a severely distressed company inany case.

Therefore, when raising debt capital, acorporation that is subject to low levelsof financial distress would face higheragency costs, with lenders imposing higherborrowing costs and more restrictivecovenants. Whereas debt holders get a fixedreturn on their investment, any additionalbenefit due to higher profits would go to theequity holders. This would make the debtholders reluctant to allow the corporationto undertake risky projects or to lendmore finance to the corporation becausethey would not gain any benefit from therisky projects.

A corporation that faces high levels offinancial distress would find it difficult toraise equity capital in order to undertakenew investments. If corporations try toraise equity finance for relatively less riskyprojects then the profits earned from suchprojects would initially go to the debt

holders and the equity holders will gain onlyresidual profits. Therefore equity holderswould put pressure on the corporation andits management to reject good, low riskprojects, which may have been acceptableto the bondholders.

Therefore, risk management in reducingfinancial distress by reducing the volatilityof the corporations cash inflows may helpthe management to obtain an optimalmix of debt and equity, and to undertakeprofitable projects.

caPiTal sTUcTU andinomaTion asymmTyRisk management can help a corporationobtain an optimal capital structure ofdebt and equity to maximise its value.Since risk management stabilises thevariability of cash inflows, this wouldenable a corporation to take more debtfinance in its capital structure. Stable cashflows indicate less risk and therefore debtholders would become more willing to lendto the corporation. Since debt is cheaperto finance than equity because of lowerrequired rates of return and the tax shield,taking on more debt should increase thevalue of the corporation. Risk managementcan help achieve this.

Academics have observed that managerswould prefer to use internally generatedfunds rather than going to the externalmarkets for funds because it is cheaper

and less intrusive on the corporation. Theysuggest that borrowing money from theexternal markets, whether equity or debt,would involve parties who do not have thecomplete information about the corporation.This information asymmetry would make theexternal sources of funds more expensive. Ifrisk management stabilises the cash flowsthat the corporation receives from year toyear, then this would enable managers toplan when the necessary internal funds willbecome available for future investmentswith greater accuracy. They will then be ableto align their investment policies with theavailability of funding.

manag bhavioU Towadsisk managmnTIn his seminal paper, Rene Stulz suggeststhat managers, whose performance rewardstructure includes large equity stakes in acorporation, are more likely to reduce thecorporations risk, as opposed to managerswhose performance reward structure isbased primarily on equity options. Managerswho hold concentrated equity stakes in acorporation face increased levels of riskwhen compared to other equity holders.As discussed previously, investors holdwell-diversified portfolios and face exposureto systematic risk only. But managers with

concentrated equity stakes would faceboth systematic and unsystematic risk.Therefore, they have a greater propensity toreduce the unsystematic risk.

iT is viTal ThaT sTUdnTs a abl To aPPly iskmanagmnT TchniQUs, sUch as Using divaTiv

insTUmnTs To hdg againsT isk, and o advicand commndaTions as QUid by Th scnaioin Th QUsTion. iT is also QUally imPoTanTThaT sTUdnTs UndsTand why coPoaTionsmanag isk in Thoy and in PacTic.

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However, if investors do not rewardcorporations that are reducing unsystematicrisk, because they have diversified this riskaway themselves. And if a corporationsmanagers use the corporations resources toreduce unsystematic risk, thereby reducingthe corporations value. Then it is worthexploring under what circumstances wouldequity investors allow managers to act toreduce unsystematic risk and whether suchactions could actually result in the value ofthe corporation increasing.

Stulz argues that encouraging managersto hold concentrated equity positions butallowing them to reduce unsystematic riskat the same time, may enable them to actin the best interests of the corporationand the result may be an increase in thecorporate value. He explains that managers,who do not have to worry about risks thatare not under their control (because they

have hedged them away), would be able tofocus their time, expertise and experienceon the strategies and operations that theycan control. This focus may result in theincrease in the value of the corporation,although the impact of this increase invalue is not easily measurable or directlyattributable to risk management activity.

As an aside, one could pose the question,why dont managers, who are rewarded byequity, diversify the risk of concentratedequity investments themselves? Theycould sell equity in their own corporationand replace it by buying equity in othercorporations. In this way they do not have tohold concentrated equity positions and thenwould be like the normal equity holdersfacing only systematic risk. A researchstudy on wealth management, which lookedat concentrated equity positions and riskmanagement, found that senior managersare reluctant to reduce their concentratedequity positions because any attempt to sellthe equity would send negative signals tothe markets, and cause their corporationsvalue to decrease unnecessarily.

Contrary to the behaviour of managerswho hold concentrated equity stakes,managers who own equity options, whichwill be converted into equity at a futuredate, will actively seek to increase therisk of a corporation rather than reduceit. Managers who hold equity options areinterested in maximising the future price ofthe equity. Therefore in order to maximisefuture profits and the price of the equity,they will be more inclined to undertakerisky projects (and less inclined to managerisk). Equity options, as a form of reward,have been often criticised because they donot necessarily make managers behave inthe best interests of the corporation or itsequity investors, but encourage them to actin an overly risky manner.

A number of empirical studies lookingat manager behaviour support the abovediscussion (see for example Tufanos study

published in 1996 in the Journal of Finance).

TsTing Th imPacT oisk managmnTIn addition to the above, empiricalresearch studies have looked at the riskmanagement policies and actions pursuedby corporations and their impact oncorporate value. Although the studies haveprovided varying results when studying eacharea of market imperfections and theirimpact, the overarching conclusion fromthese studies is that: corporations managetheir risks in the belief that this wouldcreate or increase corporate value, althougha direct link between risk management anda corresponding increase in corporate valuehas not been established.

Th jUy is sTill oUT on whTh isk managmnT acTUally dos lad Toincasd coPoaT valU. Th sm To b sTong ThoTical asonso managing isk, bUT mPiical sach has noT Povn Th imPacT o iskmanagmnT acTiviTy on coPoaT valU.

Hence the belief held among managersis that the management of risk doescreate value, and certainly corporationsand their senior managers seem tobelieve and act in a manner that it does.However, the jury is still out on whetherrisk management actually does lead toincreased corporate value. There seem tobe strong theoretical reasons for managingrisk, but empirical research has not proventhe impact of risk management activityon corporate value.

UTh adingI would suggest that students readthe following academic books andpapers to supplement their knowledgeand understanding. Arnold, G, 2008. Corporate Financial

Management. 4th ed. Harlow: Pearson. Culp, C, 2002. The Revolution in Corporate

Risk Management: A Decade of Innovationsin Process and Products. Journal of AppliedCorporate Finance, 14(4), 826.

Jensen, M, and Meckling, W, 1976. Theoryof the Firm: Managerial Behaviour, AgencyCosts and Ownership Structure. Journal ofFinancial Economics, 3, 305360.

Myers, S, and Majluf, N, 1984. CorporateFinancing and Investment Decisions whenFirms have Information that Investors do nothave. Journal of Financial Economics, 13,187221.

Smithson, C, 1998. Managing FinancialRisk: A Guide to Derivative Products,Financial Engineering and ValueMaximization. New York: McGraw-Hill,pp492517.

Stulz, R, 1996. Rethinking RiskManagement. Journal of AppliedCorporate Finance, 9, 824.

Tufano, P, 1996. Who Manages Risk? AnEmpirical Examination of Risk ManagementPractices in the Gold Mining Industry.Journal of Finance, 51, 10971137.

Shishir Malde is examiner for Paper P4

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