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CMA Part 2
Financial Decision Making
Study Unit 1: Ethics, Fraud and Risk
Management
Introduction to the CMA Exam and Essays on the Exam
Ronald Schmidt, CMA, CFM
Patricia Burnett, CMA
Introduction to the CMA Prep-course
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Schedule of classes and topics
Instructional mode/format
Instructors
Resources outside of the lectures
– Instructor/Mentor
– Study material
ICMA Requirements for CMA Designation
• Become a member, pref. choosing your local chapter
• Request to take the exam, and register for an exam 12 months after
being admitted to the Certification Program
• Pass both parts in 3 years
• Satisfy the education requirements
• Satisfy the experience requirement
• Comply with the IMA’s Statement of Ethical Professional Practice
• Once you are a CMA
– Beginning the calendar year after successful completion of the CMA exam, 30
hours of CPE must be completed
– This course can help you achieve that
ICMA Requirements for CMA Designation
CMA Exam Prep
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Read the Study Units to be lectured on next
Take the two multiple-choice quizzes
Identify if missed questions were do to concept or strategy
Re-read the concepts missed
Share with us what you are having trouble with by no later than the Wednesday prior to
the lecture
Attend lecture and ask questions
Prepare a 20 question quiz on the lectured material using Gleim’s test bank
Identify any concepts still not clear and contact Instructor/Mentor to review
Practice Essays as much as possible throughout the course, completing ideally one per
week until the end of the course
Keep track of concepts which still seem difficulty or unclear and convey those to us
prior to the Cram Session
Exam
• It is recommended that you register for the exam as
early as possible.
– Exams are given at Prometrics Testing Centers
• Class (cram session) will conclude on Feb. 14th, which
will give you 2 weeks to take the exam
• DO NOT(!) plan a strategy that you will plan any “catchup” studying after our cram session
– You should progress through the course in an “even” a
manner possible – plan for a consistent study plan
Exam Format
Part 2 – Financial Decision Making
4 hours, 100 multiple-choice questions and two 30-minute essay scenarios
• Exam Content Specific Outline (CSO) includes:
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Financial Statement Analysis (25%)
Corporate Finance (25%)
Decision Analysis (25%)
Investment Decisions (20%)
Professional ethics (5%)
If you find you have weaknesses in any topic, reference Appendix C for the
appropriate sub-units.
Exam Format
• 3 Hours - 100 multiple choice questions = approx. 1.8 (we
recommend 1.5) minutes per question (on average).
– Find ways to “bank” time
– Look for short-cuts
– You will find that you most question do not seem “easy”, don’t
get discouraged
– You “earn” points for each question answered correctly
– Some questions are “test” questions that carry no point value.
You will not know which ones they are
– Extra time can be carried forward to the Essay portion
Exam Format
• 1 Hour - 2 Essay scenarios with up to 10 subparts
– You can’t go back to multiple-choice part once you
enter this portion of the exam
– Whatever you have typed on the screen will be
saved as your answer, irrespective if the timer
runs out on you
Exam Structure & Feedback
• Exam structure
– 3 hours of multiple choice questions ~ 75% of score
– 1 hour of essay questions ~ 25% of score
• Must earn at least 50% on multiple choice section
in order to advance to essay section
• Cannot return to the multiple choice section once
you’ve advanced to the essay section of the exam
Exam Strategy
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To pass the exam, you need:
Knowledge
Confidence
Effective Time Management
Commitment!
Day of the Exam
Relax “NO ONE HAS DIED FROM FAILING THE CMA EXAM”, there
is life beyond and we will help you pass it!!!!
Test Strategy
• Multiple Choice questions
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Answer in consecutive order
Try to ignore the answer choices (don’t get tricked)
Read the question carefully (sometimes before the scenario/data)
Determine the correct answer
Read the answer choices carefully and completely (most common
wrong answers are the alternative choices)
– Chose the best answer (there are correct and “more” answers)
– Guess if you have to (either educated, what you think the ICMA is
testing, or if you have not idea the same letter)
Most Common Reasons for Missing Questions
1. Misreading the requirement (stem) – Read the question first
2. Not understanding what is required
3. Making a math error – Try to not do calculations of paper first,
with the idea of “transferring” to the exam later. If you know
how to use your memory button(s) well on your calculator, use
it (i.e. save sub-calculations in your calculator).
4. Applying the wrong rule or concept
5. Being distracted by one or more of the answers – the most
common wrong answers are the incorrect alternatives
Most Common Reasons for Missing Questions
6.
Incorrectly eliminating answers from considerations – read all
answers first, some are more correct or complete then others
7. Not having any knowledge of the topic tested – don’t agonize
over it. If possible try to make an educated guess by eliminating
obvious wrong answers. If you guess, use the same letter each
time.
8. Employing bad intuition when guessing
Essays
• Remember, 2 essay questions with 3 to 6 parts
each!
• This section provides a great opportunity to earn
partial credit
– Be sure to show your work and assumptions
– You can scroll between questions and scenarios within
the essay section of the exam
• Helps to determine how much time you will need for
responses
Essay Questions
• Pay close attention to verbs
– E.g., if it says compare or contrast, don’t define something
• Read the entire question to understand all requirements
– You may have more than one requirement, for example:
“Define abc and interpret its applicability to xyz.”
• Grammar and writing skills
– Focus is on use of standard English, organization and clarity
– Graders are looking for effective writing skills
Essay Questions
• Be brief and to the point
– It’s ok to use bullet points!!!
• Do not leave a questions blank
– If short on time, at least write an outline of your main
points
• Graders are looking to give you points, not take them
away
– Make it as easy as possible for graders to give you points!
Essay Questions
• Type your responses into a text box
– Similar to MS Word, but with more simple
functionality
– Effective January 2013, the spreadsheet tool is no
longer being used on the CMA exam
• Be sure to use all of the time available to you
Essay
• There is a sample grading rubric for essay portion enclosed
in slide presentation. This is interesting because this shows
that the graders only give points for correct answers. They
don't deduct for wrong answers. Notice on rubric for the
second sample essay, there are multiple points that could
be earned for each question, but the total points for each
question is less than the sum for all the possible answers.
This means that there is more than one correct answer.
Once you get the maximum points for this part, the grader
moves on. You don't get more points for embellishing.
Essay
• Do not embellish. Be direct. Be simple. Use bullet points.
Show your work, including calculations. Use proper grammar
and English. Then move on to the next question.
• Practice answering essays online. This will get you used to
how to type calculations and make bullet points.
• Use ALL the time you have on your essay questions, even if
you pull time from your multiple choice section.
• The more you study, the better you will do. It is as simple as
that.
Sample Essay Question 1
A City owns and operates a community swimming pool. The pool is open each year for 90 days during
the summer months of June, July, and August. A daily admission is charged to patrons of the pool. By
law, 10% of all recreational and sporting fees must be remitted to a state tourism promotion fund. The
City Manager has set a goal that pool admission revenue, after subtracting the state fee and variable
costs, must be sufficient to cover the fixed costs. Variable costs are assumed to be 15% of gross
revenue. Fixed costs for the three-month period total $33,000. The following budget for the pool has
been prepared for the current year.
Adult admissions: 30 per day x 90 days x $5.00
Student admissions: 120 per day x 90 days x $2.50
Total revenue
State tourism fee
Net revenue
Variable costs
Fixed costs
Expected deficit $
$ 13,500
27,000
40,500
4,050
36,450
6,075
33,000
(2,625)
The City Manager is trying to determine what admission mix is necessary to
break even and what actions could be taken to eliminate the expected
deficit.
Essay Requirements (partial)
1. Given the anticipated mix of adult and
student admissions, how many total
admissions must the pool have in order to
break even for the season?
2. Regardless of the admissions mix, what is the
highest number of admissions that would be
necessary to break even for the season?
Sample Essay Response
Question 1:
Given the anticipated mix of adult and student admissions, how many total
admissions must the pool have in order to break even for the season?
Sample Response:
The contribution margin is 75% or $3.75 per adult admission, and $1.875 per student
admission. The mix is 20% adult (30 ÷ 150) and 80% student (120 ÷ 150).
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Calculate the weighted average contribution margin (WACM)
WACM = 0.20 ($3.75) + 0.80 ($1.875) = $2.25
The breakeven point in units is calculated as follows:
Fixed costs ÷ WACM
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Fixed costs = $33,000
WACM = $2.25
$33,000 ÷ $2.25 = 14,667 admissions per season
Sample Essay Response
Question 2:
Regardless of the admissions mix, what is the highest number of
admissions that would be necessary to break even for the season?
Sample Response:
To calculate the highest number of admissions to break even, you
would assume that all admissions are students. That’s because the
student admission price is the lowest of all admission prices.
– The breakeven point in units is calculated as follows:
• Fixed costs ÷ Contribution margin for students
– Fixed costs = $33,000
– Contribution margin for students = $1.875
– $33,000 ÷ $1.875 = 17,600 admissions per season
Ethics – Overview
CMA candidates need to be prepared to answer ethics questions
that will be integrated with any of the other topics, which can be
tested at all three levels of difficulty, requiring you:
• Recall aspects of the Foreign Corrupt Practices Act and
the IMA Statement of Management Accounting
• Evaluate and apply the different aspects as they relate
to typical business situations
• Memorize IMA’s Statement of Ethical Professional
Practice
Ethics – Overview
continued
• Questions can come in either multiple choice questions
or in essay format
• And require you not only to identify the nature of the
ethical dilemma but how to resolve it
• Tested from the perspective of both the individual and
organization in Part 2.
SU 1.1 – IMA’s Statement of Ethical
Professional Practice
• HFOR – The four overarching principles
– Honesty
– Fairness
– Objectivity
– Responsibility
SU 1.1 – IMA’s Statement of Ethical
Professional Practice
• CCIC – The statement contains four specific
standards
– Competence
– Confidentiality
– Integrity
– Credibility
SU 1.1 – IMA’s Statement of Ethical
Professional Practice
• Conflict of Interest
– Mitigate actual, and to avoid apparent, conflict of interest
– Examples – financial interest in suppliers, privileged info.
– Methods to control conflict of interest include:
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Code of Conduct
Full Financial disclosure
Prohibit financial ties to distributors
Adherence to strong ethical behavior
Etc…
SU 1.1 – IMA’s Statement of Ethical
Professional Practice
• Ethics on the exam
– You should essentially memorize the entire
content of the IMA Statement of Ethical
Professional Practice as shown on page 13 of the
book, including the section on Resolution of
Ethical Conflict on page 14
SU 1.1 – Ethics Question 1
In accordance with IMA’s Statement of Ethical Professional Practice, a
member who fails to perform professional duties in accordance with relevant
standards is acting contrary to which one of the following standards?
A
Competence.
B
Confidentiality.
C
Integrity.
D
Credibility.
SU 1.1 – Ethics Question 1 Answer
Correct Answer: A
One of the responsibilities of an IMA member under the competence standard is to “maintain an
appropriate level of professional expertise by continually developing knowledge and skills.” (S)he
must also “perform professional duties in accordance with relevant laws, regulations, and technical
standards.” The third requirement under this standard is to “provide decision support information
and recommendations that are accurate, clear, concise, and timely.”
Incorrect Answers:
The confidentiality standard concerns an IMA member’s responsibility not to disclose or use the firm’s
B
confidential information.
The integrity standard pertains to conflicts of interest, avoidance of acts discreditable to the profession, and
C
refraining from activities that prejudice the ability to carry out duties ethically.
Credibility is the fourth standard of IMA’s Statement of Ethical Professional Practice. It requires that
D
information be communicated “fairly and objectively,” and that all information that could reasonably
influence users be disclosed.
SU 1.1 – Ethics Question 2
If an IMA member discovers unethical conduct in his or her organization and
fails to act, (s)he will be in violation of which of IMA’s ethical standard(s)?
A
“Refrain from engaging in any conduct that would prejudice carrying out duties
correctly.”
B
“Communicate information fairly and objectively.”
C
“Disclose all relevant information that could reasonably be expected to influence
an intended user’s understanding of reporting analyses or recommendations.”
D
All of the answers are correct.
SU 1.1 – Ethics Question 2 Answer
Correct Answer: D
An IMA member displays his or her competence and credibility and maintains integrity
by taking the appropriate action within the organization to resolve an ethical problem.
All of these activities should be a part of an IMA member’s normal job processes.
Incorrect Answers:
A
Each standard is violated by an IMA member who fails to act upon discovering unethical
conduct.
B
Each standard is violated by an IMA member who fails to act upon discovering unethical
conduct.
C
Each standard is violated by an IMA member who fails to act upon discovering unethical
conduct.
SU 1.1 – Ethics Question 3
In which situation is an IMA member permitted to communicate confidential
information to individuals or authorities outside the firm?
A
There is an ethical conflict and the board has refused to take action.
B
Such communication is legally prescribed.
C
The IMA member knowingly communicates the information indirectly through a
subordinate.
D
An officer at the IMA member’s bank has requested information on a transaction
that could influence the firm’s stock price.
SU 1.1 – Ethics Question 3 Answer
Correct Answer: B
According to IMA’s Statement of Ethical Professional Practice, members are responsible
for observing the standard of confidentiality. Thus, the IMA member should “refrain from
disclosing confidential information acquired in the course of his or her work except when
authorized, unless legally obligated to do so.”
Incorrect Answers:
IMA’s Statement of Ethical Professional Practice states that “each member has a responsibility to
A
keep information confidential except when disclosure is authorized or legally required.”
The IMA member should “inform all relevant parties regarding appropriate use of confidential
C
information. Monitor subordinates’ activities to ensure compliance.”
D
The IMA member is required to “refrain from using confidential information for unethical or
illegal advantage.”
Study Tip
• Try to explain out loud a concept you are
trying to learn as though you are trying to
teach it to someone. A good place to do this
is in your car or in front of a mirror.
SU 1.2 – Corporate Ethics and Legislation
• The Foreign Corrupt Practices Act of 1977
(FCPA) contains two sets of provisions:
– Accounting
• Books and Records
• Internal Control
– Anti-Bribery
SU 1.2 – Corporate Ethics and Legislation
• Foreign Corrupt Practices Act of 1977 (FCPA)
– All public companies must comply
• Payments to foreign officials / politicians –Prohibited
• Payment to foreign business owners / corporate officers –
Not addressed
SU 1.2 – Corporate Ethics and Legislation
• Corrupt payments – For the purpose of inducing
someone to act or refrain to obtain or retain
business.
– Prohibits a mere offer or promise –even if not
consummated. Only minims gifts are acceptable.
– Known / should have known – influence of official.
SU 1.2 – Corporate Ethics and Legislation
• Violations subject to fines and imprisonment.
– Fines have to be paid by the person involved, Not 3rd
party
– Grease payments are allowed but not to Politicians.
Sarbanes-Oxley Act of 2002
• See “Background to Sarbanes-Oxley Act” on page 16
(Enron, Arthur Andersen…)
• Extensive responsibilities on issuers / auditors of
publicly traded securities.
– Sec 406(a) Senior financial officers Code of Ethics
• Reasonably necessary to promote
– Honest and ethical conduct
– Full, fair, accurate, timely, and understandable disclosure
– Compliance with governmental rules and regulations
• SOX does not define ethics.
SU 1.2 – Corporate Ethics and Legislation
Question 1
The Foreign Corrupt Practices Act prohibits
A
Bribes to all foreigners.
B
Small bribes to foreign officials that serve as facilitating or grease payments.
C
Bribery only by corporations and their representatives.
D
Bribes to foreign officials to influence official acts.
SU 1.2 – Corporate Ethics and Legislation
Question 1 Answer
Correct Answer: D
The Foreign Corrupt Practices Act (FCPA) prohibits any U.S. firm from making bribes to foreign
officials to influence official acts. The businesses subject to the FCPA include corporations,
partnerships, limited partnerships, business trusts, and unincorporated organizations. Violations of
the FCPA are federal felonies. The penalties are up to 5 years in prison or up to a $100,000 fine or
both for an officer, director, or shareholder who helps make the bribe.
Incorrect Answers:
A Bribes to all foreigners is not covered by the provisions in the FCPA.
Small bribes to foreign officials that serve as facilitating or grease payments is not covered by the provisions in
B
the FCPA.
C All U.S. firms are subject to the anti-bribery provisions.
SU 1.2 – Corporate Ethics and Legislation
Question 2
Firms subject to the reporting requirements of the Securities Exchange Act of 1934 are
required by the Foreign Corrupt Practices Act of 1977 to maintain satisfactory internal
control. The role of the independent auditor relative to this Act is to
A
Report clients with unsatisfactory internal control to the SEC.
B
Provide assurances to users as part of the traditional audit attest function that the client is in
compliance with the present legislation.
C
Express an opinion on the sufficiency of the client’s internal control to meet the
requirements of the Act.
D
Attest to the financial statements.
SU 1.2 – Corporate Ethics and Legislation
Question 2 Answer
Correct Answer: D
Whether a client is in conformity with the Foreign Corrupt Practices Act is a legal question. Auditors
cannot be expected to provide clients or users of the financial statements with legal advice. The role
of the auditor is to assess control risk in the course of an engagement to attest to the fair
presentation of the financial statements.
Incorrect Answers:
The auditor is not required to report violations of the Act to the SEC, although a duty to disclose outside the
A client may exist in some circumstances; e.g., the client’s failure to take remedial action regarding an illegal act
may constitute a disagreement that it must report on Form 8-K (AU 317).
B
The traditional attest function does not involve compliance auditing.
C
The FCPA contains no requirement that an auditor express an opinion on internal control.
Study Tip
• Try to find a little time every day to study,
whether it is reading or practicing quiz
questions. 1 hour per day M – F and the 4
hour lecture = 10 hrs. per week
• Passing the exam is a marathon not a sprint!
SU 1.3 – Corporate Responsibility for
Ethical Behavior
• The organization has a responsibility to foster a sense of
ethics
• A pervasive sense of ethical values can benefit and
organization
• A sense of ethics requires an ability to distinguish between
ethical and merely legal behavior
• “Leadership by example”, or tone at the top plays an
important role
SU 1.3 – Corporate Responsibility for
Ethical Behavior
• “Human capital” concept is an important component
to creating the right climate of “doing the right thing”
• Organizations culture
• Employee training
• Monitoring ethical compliance
– Human performance feedback loop
– Survey tools
– Reviews, 360’s, KPI’s
SU 1.3 – Corporate Responsibility for
Ethical Behavior
• Whistleblowing framework
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Confidential and independent
• Special challenges with international companies or trade
• Ethical behavior as a prerequisite to internal control
• Three tools to identify process controls related to ethical
and behavioral issues:
– Business Process Reengineering (BPR)
– Quality Management
– Continual Process Improvement (CPI)
SU 1.3 – Corporate Responsibility for
Ethical Behavior
• “Values and Ethics: From Inception to Practice”
• Have a comprehensive framework
– CEO & CFO “Get out of Jail card”
• Responsible to : Foster a sense of ethics
– Written code of Conduct and ethical behavior
• Pervasive sense of ethical values has benefits.
– White space vs. Gray area.
• Ethical and merely legal behavior
SU 1.3 – Corporate Responsibility for
Ethical Behavior Question 1
Which one of the following is a true statement regarding organizational
ethics?
A
B
C
D
As long as officer and employee behavior meet the requirements of the law, the
organization can be considered to have a functioning system of ethical behavior.
A strong sense of ethics on the part of employees who are in the best position to
appropriate cash and other assets is the most vital part of a functioning system of
ethical behavior.
If an organization has a strong code of ethical conduct in place, the role of
employee training can be downplayed.
Paying attention to “whistleblowers” plays a significant role in maintaining an
effective ethical atmosphere.
SU 1.3 – Corporate Responsibility for Ethical
Behavior Question 1 Answer
Correct Answer: D
“Values and Ethics: From Inception to Practice” states, in part, “A
whistleblowing framework (e.g., an ethics helpline) is an important
component in maintaining an ethical organizational culture. An
effective feedback system includes having a confidential framework for
employees to report possible violations of the organization’s code of
ethics and to receive advice on the ethical aspects of challenging
decisions. Statistics show that a large number of occupational fraud
cases are detected through an employee “hotline” or other reporting
method ... ” (IX. Measuring and Improving Ethical Compliance.)
SU 1.3 – Corporate Responsibility for Ethical
Behavior Question 1 Answer
Incorrect Answers:
A
A sense of ethics requires an ability to distinguish between ethical and merely legal behavior. “Values and Ethics:
From Inception to Practice” states, in part, “Many individuals at the center of corporate scandals [of the late
20th and early 21st Century] have professed the belief that they were innocent of any wrongdoing, including
Kenneth Lay of Enron or Conrad Black of Hollinger. The problem is that these individuals did not define their
behavior by what most of society would see as ‘reasonable,’ but rather they followed their own particular code –
in some cases, limiting the definition of ethical behavior to require compliance with the law and nothing
more.” (II. Introduction.)
B
“Values and Ethics: From Inception to Practice” states, in part, “Ethical behavior is not something that applies
to
someone else – every single individual is responsible for behaving ethically. Nowhere is this more important than
the demonstration of ethical behavior that managers and supervisors exhibit in the way they execute their dayto-day work...” This phenomenon is referred to as the “tone at the top.” (VI. Leadership by Example.)
C
Employee training is important to maintaining an ethical organizational culture. “Values and Ethics: From
Inception to Practice” states, in part, “Every existing member of staff should receive ongoing training, starting at
the board level and cascading down throughout the organization ... Ethics training for employees should focus
on
covering ethical concepts, the organization’s code, and compliance. To achieve this, training should include:
ethical concepts and thinking: What is ‘behind’ the issue of ethical action?; [and] the organization’s code of
ethics and any supporting ‘rules.’” (VIII. Practical Application: Converting Intent into Operational Reality.)
SU 1.3 – Corporate Responsibility for
Ethical Behavior Question 2
IMA’s Statement on Management Accounting, “Values and Ethics: From
Inception to Practice,” recommends a defined code of conduct and ethical
behavior for all organizations. One advantage of having such a code is that it
A
Provides employees with guidance for handling unfamiliar situations.
B
Ensures ethical behavior by all employees.
Shields the organization from liability in cases of loss of stockholder value due to
fraud.
Eases the investigative process performed by police and prosecutors in cases of
suspected fraud.
C
D
1.3 - Corporate Responsibility for Ethical
Behavior – Question 2 Answer
Correct Answer: A
“Values and Ethics: From Inception to Practice” states, in part, “... what does an employee do
when unplanned events occur? What reference does an individual look to for help in making
decisions? ... This is why it is important to have a defined set of organizational values and code of
ethics – they create the “touchstone” against which every unanticipated decision must be judged.
Failure to have every individual in the organization know and understand these values and ethical
code leads to inconsistency and, in the worst cases, unethical or fraudulent behavior.” (IV. Values,
Ethics, and Accounting.)
Incorrect Answers:
B A code of conduct cannot guarantee ethical behavior by employees.
C A code of conduct cannot guarantee that an organization will be shielded from liability in cases of fraud.
D A code of conduct does not ease law enforcement’s investigative process.
Study Tip
• You need to achieve an 80% on the quizzes you
attempt. If you have taken the quizzes twice and still
not achieved an 80%, create another 20 question
quiz from the test bank available, focusing (selecting)
on material that you are having difficulty with. In
different words “practice” what you don’t know
rather than what you do know.
SU 1.4 – Fraud and the Fraud Risk Model
• Types of Fraud
– Fraudulent Financial Reporting
• Mostly done by management
• Focus of external auditors, the PCAOB and the SEC
– Misappropriating of Assets
• Mostly done by employees (theft, embezzlement or
defalcation)
• Cause more internal problems then external problems
The Fraud Risk Model (Fraud Triangle)
SU 1.4 - The Fraud Risk Model
(Fraud Triangle)
• Opportunity – ability of a person not only to
commit and also conceal the fraud
– Absence of oversight, inadequate controls, lack of
enforcement
– The only thing that can be controlled by
management
SU 1.4 - The Fraud Risk Model
(Fraud Triangle)
• Rationalization – ability to justify actions as
consistent with his or her personal code of ethics
– Principles and integrity vary among individuals
– Rationalizations include:
•
•
•
•
•
Being underpaid or overworked
Everyone else is doing it
Rank has its privileges
See revenge
Nobody will get hurt
SU 1.4 - The Fraud Risk Model
(Fraud Triangle)
• Rationalization – most difficult to appraise
– Difficulty to get insight into another persons
ethical principles
– Believe that the perpetrator was an honest person
SU 1.4 - The Fraud Risk Model
(Fraud Triangle)
• Pressures (motivations)
– Need for cash
– Fraud and reward is not always so direct
• Maybe other than monetary
• Pressure to manipulate financial reporting if
compensation is tied to financial results
• Other include debt covenants, meeting
budgets/earnings targets/analyst forecast
The Fraud Risk Model (Fraud Triangle)
Pressures
Fraud Model as overlapping circles and
where you find the greatest risk
SU 1.4 – Fraud and the Fraud Risk Model
• Red Flags or Risk Factors indicating potential
fraud include:
–
–
–
–
–
–
Missing documents
Large amounts of cash on hand
Unexplained budget variances
Unwillingness to take vacation
Poor supervision
Complaints by customers
SU 1.4 – Fraud and the Fraud Risk Model
• Investigative Resources and Techniques
– Documents
• Search for evidence-related documents including other
locations such as trash bins, shredders, etc.
• Alert to alternate documents via erasure and forgery
– Handwritten signatures
– Photocopies
– Torn, smudged, faded documents
SU 1.4 – Fraud and the Fraud Risk Model
• Investigative Resources and Techniques
– Documents (cont.)
• Public searches of information
– Public records
– Social media
– Privacy concerns
• Commercial online services
SU 1.4 – Fraud and the Fraud Risk Model
• Investigative Resources and Techniques
– Documents (cont.)
• Electronic evidence
• Interview
– Care should be taken when drawing conclusions
SU 1.4 – Fraud and the Fraud Risk Model
Question 1
High risk of employee fraud is most likely when there is
pressure, rationalization, and
A
Opportunity.
B
Internal control.
C
Personal integrity.
D
Limited responsibility.
SU 1.4 – Fraud and the Fraud Risk Model
Question 1 Answer
Correct Answer: A
Opportunity creates risk of employee fraud.
Incorrect Answers:
B
Internal control mitigates the risk of employee fraud.
C
Personal integrity mitigates the risk of employee fraud.
D
Limited employee responsibility mitigates the risk of employee fraud.
SU 1.4 – Fraud and the Fraud Risk Model
Question 2
Rationalization of a fraud by an employee may be in the
form of all the following except
A Pressure from one’s spouse.
B Feelings of being underpaid.
C Belief in being overworked.
D Belief that rank has its privileges.
SU 1.4 – Fraud and the Fraud Risk Model
Question 2 Answer
Correct Answer: A
Pressure from one’s spouse is a motive for the misappropriation of
assets.
Incorrect Answers:
B
Feelings of being underpaid may be used by an employee to justify or rationalize
stealing.
C
Belief in being overworked may be used by an employee to justify or rationalize
stealing.
D
Belief that rank has its privileges may be used by an employee to justify or
rationalize stealing.
SU 1.4 – Fraud and the Fraud Risk Model
Question 3
Fraudulent financial reporting is most often committed by
A Management to deceive financial statement users.
B An auditor while performing an audit.
C Employees stealing assets.
D Customers.
SU 1.4 – Fraud and the Fraud Risk Model
Question 3 Answer
Correct Answer: A
Fraudulent financial reporting is committed by management in an
attempt to deceive financial statement users.
Incorrect Answers:
B Auditors are not responsible for financial reporting.
C Misappropriation of assets is most often committed by employees.
D Managers, not customers, are responsible for financial reporting.
SU 1.4 – Fraud and the Fraud Risk Model
Question 4
What is the most likely reason for management to overstate
expenses?
A To minimize tax liability.
B To earn a bonus.
C To maximize net income.
D To maximize cash on hand.
SU 1.4 – Fraud and the Fraud Risk Model
Question 4 Answer
Correct Answer: A
The most likely reason for management to understate income by
overstating expenses is to minimize tax liability.
Incorrect Answers:
B
Management may understate expenses to earn a bonus.
C
Management may understate expenses to maximize net income.
D Understating expenses has no direct effect on cash.
Study Tip
• Try to explain out loud a concept you are
trying to learn as though you are trying to
teach it to someone. A good place to do this
is in your car or in front of a mirror.
SU 1.5 – Addressing Fraud and Error
• Types of Controls
– Primary Controls
•
•
•
•
Preventive Controls
Detective Controls
Corrective Controls
Directive Controls
SU 1.5 – Addressing Fraud and Error
• Types of Controls
– Secondary Controls
• Compensatory (mitigative) controls may reduce risk (i.e.
segregation of duties)
• Complementary controls with other controls may
reduce risk to an acceptable level
SU 1.5 – Addressing Fraud and Error
• Segregation of Duties
• Independent checks and verification
– A Reconciliation between recorded amounts and assets
must be performed by
• someone unconnected with original transaction or
• without custody of the assets
• Safeguarding Controls
– Limiting access to assets to only authorized personnel (i.e.
lockbox system)
SU 1.5 – Addressing Fraud and Error
Question 1
The frequency of the comparison of recorded accountability with assets
(for the purpose of safeguarding assets) should be determined by
A The amount of assets independent of the cost of the comparison.
B The nature and amount of the asset and the cost of making the comparison.
C
The cost of the comparison and whether the susceptibility to loss results from
errors or fraud.
D The auditor in consultation with client management.
SU 1.5 – Addressing Fraud and Error
Question 1 Answer
Correct Answer: B
Assets should be compared with the recorded accountability as frequently as
the nature and amount of the assets require, within the limits of acceptable
costs of comparison. The costs of safeguarding assets should not exceed the
expected benefits.
Incorrect Answers:
A The costs of controls should be considered when making the comparison.
C
Whether the susceptibility to loss arises from errors or fraud should have little bearing on the
frequency of the comparison.
D Management, not the auditor, has responsibility for internal control.
SU 1.5 – Addressing Fraud and Error
Question 2
Internal controls may be preventive, detective, corrective, or
directive. Which of the following is preventive?
A Requiring two persons to open mail.
B Reconciling the accounts receivable subsidiary file with the control account.
C Using batch totals.
D Preparing bank reconciliations.
SU 1.5 – Addressing Fraud and Error
Question
2
Answer
Correct Answer: A
Preventive controls are designed to prevent an error or an irregularity. Detective
and corrective controls attempt to identify and correct errors or irregularities that
have already occurred. Preventive controls are usually more cost beneficial than
detective or corrective controls. Assigning two individuals to open mail is an
attempt to prevent misstatement of cash receipts.
Incorrect Answers:
B
Reconciling the subsidiary file with the master file may detect and lead to the correction of errors,
but the control does not prevent errors.
C
The use of batch totals may detect a missing or lost document but will not necessarily prevent a
document from becoming lost.
D Bank reconciliations disclose errors in the accounts but have no preventive effect.
SU 1.5 – Addressing Fraud and Error
Question 3
Segregation of duties is a fundamental concept in an effective system
of internal control. Nevertheless, the internal auditor must be aware
that this safeguard can be compromised through
A Lack of training of employees.
B
Collusion among employees.
C
Irregular employee reviews.
D Absence of internal auditing.
SU 1.5 – Addressing Fraud and Error
Question
3
Answer
Correct Answer: B
By segregating duties, organizations make it more difficult for one person to perpetrate
a fraud. When custody of the asset and recordkeeping for the asset are invested in
different persons, a fraud generally cannot be executed by one of the two parties.
However, if they collude, the internal control aspect of the segregation is nullified.
Incorrect Answers:
A
Lack of training by itself cannot negate effective separation of duties.
C
Irregular employee reviews may affect employee job performance, but they alone cannot negate
effective separation of duties.
D
While the absence of an internal audit activity may lessen the chances that an organization will
maintain effective internal control over the long run, by itself it cannot negate effective segregation
of duties.
Study Tip
• Always prepare for the next lecture first, as
opposed to catching up on material you are
behind on. There are plenty of weekends with
no classes that will allow you to catch up past
material. This way you are always prepared
for the next class and have identified (and
conveyed) what areas you need help with.
Sample Essay Question 2
SmallParts is a manufacturer of metal washers, screws, and other parts
required in the manufacture of various handmade craft and novelty
items. The firm has the ability to custom make virtually any small part,
provided the client is able to provide SmallParts with the dimensions
and tolerance required of the product. Because of its niche in the
market, SmallParts has over 1,000 clients. Unfortunately, many of its
small business clients eventually merge or cease operations. One of
the company’s biggest challenges is the return of shipped product.
Usually, this is because the small business client has ceased
operations. While most of the product is custom made, SmallParts has
found that much of it can be sold to other clients for adapted use. The
company’s accountant is reviewing the company’s internal controls
and financial accounting procedures, in particular, with respect to
inventory.
Sample Essay Question 2
Currently, SmallParts has one salesperson responsible for
marketing returned product. This salesperson has exclusive
and total control over the returned product including
arranging of sales terms, billing, and collection. The
salesperson receives the returned product and attempts to
find a client who may be able to adapt the product for the
client’s use. The inventory of returned product is not entered
in the accounting records, under the logic that the cost is
sunk. Revenue generated from its sale is classified as other
revenue on the SmallParts income statement.
Essay Requirements (partial)
1.
2.
3.
4.
Identify and describe the three objectives of a system of internal control.
Identify and explain three ways that the procedure for handling returned
product violates the internal control system of segregation of duties.
Identify and describe three ways that SmallParts can provide for better internal
control over its inventory of returned product.
The company accountant is concerned about SmallParts’ current procedure for
accounting for returned product and has turned to IMA’s Statement of Ethical
Professional Practice for guidance. Assume the company’s accountant identifies
a possible conflict of interest on the part of the salesperson responsible for the
returned product.
a)Identify the ethical principles that should guide the work of a management
accountant.
b)Identify and describe the standards that relate to this situation and explain
how they apply.
Sample Essay Response
Question 1: Identify and describe the three objectives of
a system of internal control.
Sample Response:
A good system of internal control is designed to provide
reasonable assurance regarding achievement of an
entity’s objectives involving effectiveness and efficiency
of operations, reliability of financial reporting, and
compliance with applicable laws and regulations.
Sample Essay Response
Question 2: Identify and explain three ways that the procedure for handling
returned product violates the internal control system of segregation of
duties.
Sample Response:
Segregation of duties requires that no one person have control over the
physical custody of an asset and the accounting for it. There is no evidence
to suggest SmallParts makes any effort to account for the value of returned
product, which may indeed be significant. The one salesperson seems to be
in charge of all aspects related to returned product, including authorizing the
returns, crediting the customers, receiving the returns, handling the physical
custody, finding new customers, concluding sales, shipping, billing, and
collecting. Most of these rules should be separated.
Sample Essay Question #2
(Information relative to Question 2 is red)
SmallParts is a manufacturer of metal washers, screws, and other parts required in the manufacture of
various handmade craft and novelty items. The firm has the ability to custom make virtually any small
part, provided the client is able to provide SmallParts with the dimensions and tolerance required of
the product. Because of its niche in the market, SmallParts has over 1,000 clients. Unfortunately, many
of its small business clients eventually merge or cease operations. One of the company’s biggest
challenges is the return of shipped product. Usually, this is because the small business client has
ceased operations. While most of the product is custom made, SmallParts has found that much of it
can be sold to other clients for adapted use. The company’s accountant is reviewing the company’s
internal controls and financial accounting procedures, in particular, with respect to inventory.
Currently, SmallParts has one salesperson responsible for marketing returned product. This
salesperson has exclusive and total control over the returned product including arranging of sales
terms, billing, and collection. The salesperson receives the returned product and attempts to find a
client who may be able to adapt the product for the client’s use. The inventory of returned product is
not entered in the accounting records, under the logic that the cost is sunk. Revenue generated from
its sale is classified as other revenue on the SmallParts income statement.
Sample Essay Response
Question 3: Identify and describe three ways that SmallParts
can provide for better internal control over its inventory of
returned product.
Sample Response:
Separate responsibilities and duties. While the salesman may
be assigned to work with customers who return products,
and find other customers for these products, other staff
should post credits to customer accounts following written
policy. The products should be received, inventoried, booked
and shipped just like regular products.
Sample Essay Response
Question 4: (Summarized)
a) Identify the ethical principles that should guide the work of a management accountant.
b) Identify and describe the standards that relate to this situation and explain how they apply.
Sample Response:
a)The Statement lists the following four ethical principles:
– Honesty, Fairness, Objectivity, Responsibility
b)Several standards from the Statement apply.
– Credibility: “Each practitioner has a responsibility to disclose deficiencies in internal controls.”
– Competence: duty to maintain an appropriate level of professional expertise relative to
standard procedure commonly used in the accounting of firms dealing with returned product
– Confidentiality: refrain from using this confidential information for unethical advantage, by
not informing firms of the lax controls and availability of steep discounts on returned product
– Integrity: mitigating any conflict of interest.
Small Parts Question
Item Description
Question 1
Reasonable Assurance
Effectiveness of operations
Efficiency of operationsi
Reliability of financial reporting
Other
Subtotal
Question 2
1 person should not control custody
& acctg.
Salesperson in charge of everything
No accounting for returned product
No tracking or returned product
Other
Subtotal
Maximum
Points
2
1/2
1/2
1/2
1/2
1/2
%
Correct
Score
0
0
0
0
0
0.00
2
1/2
1/2
1/2
1/2
1/2
0
0
0
0
0
0.00
Small Parts Question (continued)
Item Description
Question 3
Separate resp./segregation of duties
4 different ind. for ret. Prod. duties
Authority, recording, custody, reco.
Other
Subtotal
Maximum
Points
2
1/2
1/2
1/2
1/2
%
Correct
Score
0
0
0
0
0.00
SmallParts Question (continued)
Item Description
Maximum Points
6
a. Principles: max = 1
Honesty, Fairness, Objectivity, Responsibility
Two correct identifications
1/2
Four correct identifications
1
b. Standards max = 5
Competence
1/2
maintain appropriate level of prof competence
prepare complete & clear reports
1/2
perform in accord with laws, regs & tech stds
1/2
0
refrain from disclosing confidential info
1/2
refrain from using info unethically
1
Integrity
1/2
refrain from activity discrediting the profession
avoid actual or apparent conflicts of interest
refrain fr activity prejudice ability to carry out duties
refrain fr activity subverting attn of org objectives
Credibility/Objectivity
1/2
communicate info fairly and objectively
1/2
disclose fully all relevant info
1/2
other
1/2
TOTAL FOR ALL QUESTIONS:
12
% correct
Score Question #4
0
0
0
1/2
0
0
1/2
0 Confidentiality
0
0
0
1
1
1/2
1/2
0
0
0
0
0
0
0
0.00
Remember
•
•
The CMA exam uses essays to reflect a more "real-world" environment in which
candidates must apply the knowledge they have acquired. Essays are graded on
both writing skills and subject matter. Partial credit IS available for essays that have
some correct and some incorrect points. Finally, it is important to remember that
essays are not intended to test typing ability, so the time you allocated for essay
response is adequate to complete the questions even if you do not have the best
typing skills.
Answering multiple-choice questions is an effective method to study the material
for both the multiple-choice and essay sections of the exam. They are an excellent
diagnostic tool that will allow you to quickly identify your weak areas. Also, think
about what your answer would be if the question were not multiple-choice. When
reviewing the correct and incorrect answer explanations, your "essay answers"
should be somewhat equivalent to the detailed answer explanations.
Essay
• Roughly 75% of points come from multiple choice. Essay only accounts for
25% of points.
• There are two essay questions for each section of the CMA exam. Each
question will have 43-6 parts that must be answered.
• Be sure you skim all essay parts before begin answering. This will help you
survey how much time to spend on each question from the beginning.
Some will be easy, just asking for a definition. Some will require
calculations. Show all your work. Even if your answer is wrong, showing
your work will give you partial credit.
• Be sure to answer the question correctly. If the question asks you to
compare or contrast something, don't define it. That is not what they are
looking for.
CMA Part 2
Financial Decision Making
Cost of Capital - Defined
•
Corporations derive capital essentially from two sources: lenders and
shareholders. The total capital of a firm represents a combination of debt capital
and equity capital. These capital components are described next.
– Debt capital is that portion of total capital derived from the issuance of interest bearing
instruments such as notes, bonds, or loans.
– Equity capital is that portion of total capital derived from permanent investments by
shareholders, as either paid-in capital or retained earnings. A firm may issue new shares of
common or preferred stock, or it may choose to retain earnings instead of distributing them as
dividends.
•
Every activity a firm does to generate capital—either explicit or implicit—has a cost
associated with it. The overall cost of capital represents a proportional average of
the various components a firm uses for financing.
105
Cost of Capital – Defined (cont.)
The cost of capital should be considered in capital structure
decisions. Corporations can benefit from using the cost of
capital to benchmark investment decisions and to manage
working capital (e.g., receivables, inventories, and payables)
more efficiently. The cost of capital also can be valuable to use in
measuring and evaluating performance. For example, the actual
and expected return on capital or net assets may be compared
with the cost of capital associated with each.
106
SU 5.1 – Bonds
• Term structure of interest rates – relationship between yield to
maturity and time to maturity
– Types of slopes or “yield curves”
• The shape of the yield curve is closely scrutinized because it helps
to give an idea of future interest rate change and economic
activity.
• There are four main types of yield curve shapes:
–
–
–
–
Upward
Flat
Downward sloping
Humped
107
SU 5.1 – Bonds
• A normal yield curve (upward sloping) is one in which
longer maturity bonds have a higher yield compared to
shorter-term bonds due to the risks associated with
time.
• An inverted yield curve is one in which the shorterterm yields are higher than the longer-term yields,
which can be a sign of upcoming recession.
Continued
108
SU 5.1 – Bonds
• A flat (or humped) yield curve is one in which the
shorter- and longer-term yields are very close to each
other, which is also a predictor of an economic
transition.
• The slope of the yield curve is also seen as important:
the greater the slope, the greater the gap between
short- and long-term rates.
109
SU 5.1 – Bonds
– When plotting yield curves we hold the following
constant:
•
•
•
•
Default risk
Taxability
Callability
Sinking fund
Why?
110
SU 5.1 – Bonds
• Bonds are the principal form of long-term debt financing
for corporations and government.
• Features of Bonds
• Par Value = Maturity amount = Face Amount
• State rate = Coupon rate
• Indenture = Terms of the bond
• Issuing bonds takes time and money
• > Risk = > Return (yield)
• How can you mitigate some of the market required return?
111
SU 5.1 – Bonds
• Following are means to reduce the required rate of
return for bonds:
– Sinking Fund – payments to a segregated and
accumulate funds which will equal the maturity value
– Insured
– Secured
112
SU 5.1 – Bonds
• Advantages of Bonds
– Interest is tax deductible
– Retain corporate control
• Disadvantages of Bonds
–
–
–
–
–
Interest is considered legal obligation
Raises risk level and ultimately cost of capital
Raises risk profiles
Contractual requirements (e.g. required debt to equity)
Debt financing limits
113
SU 5.1 – Bonds
• Types of Bonds
– Maturity
• Term bond – single maturity
• Serial bond
– Valuation
• Variable rate
• Zero-coupon or deep-discount bonds
• Commodity-backed bonds
114
SU 5.1 – Bonds
• Types of Bonds
– Redemption Provisions
• Callable bonds – by the issuer
• Convertible bonds – into equities
– Securitization
• Mortgage bonds – specific
• Debentures – borrower’s general credit but not specific
collateral
115
SU 5.1 – Bonds
• Types of Bonds
– Ownership
• Registered bonds
• Bearer bonds
– Priority
• Subordinated debentures
• Second mortgage bonds
– Repayment Provisions
• Income bonds
• Revenue bonds
116
SU 5.1 – Bonds
• Bond Ratings – Moody’s, Standard and Poor’s,
and Fitch
– Investment grade – AAA; Insurance companies and
banks
– Non-investment grade – Junk bonds, sometimes used
for leveraged buy-outs
Higher rating = lower interest rate
117
SU 5.1 – Bonds
• Bond valuation and sales price
– Several components to determining the fair price of a
bond:
•
•
•
•
•
Risk
Duration
Face amount
Interest payment
Other features such as callable, convertibility
118
SU 5.1 – Bonds
• Bond Issuances - Bonds can be issued at par, at a discount, or at a premium.
If the stated rate of interest on the bond, which is used to determine interest
payments, is equal to the market rate of interest, which is the current interest paid on
similar investments in the market, and then the bonds are issued at par. Often this is
not the case. Because of timing issues, the stated rate printed on the bond is not the
same as the market rate. By the time the paperwork is complete, the market rate has
changed. Therefore, to make up for this, the price of the bond changes to make the
rate of return on the bond equal to the market rate. The actual selling price of a bond
represents a price that makes the return on the bond effectively the same as the
market rate of interest at the time the bond is sold.
119
SU 5.1 – Bonds
Stated versus Market rate
•
Bond Discount or Premium—bonds are sold for an amount different than the face
amount. Contract Rate vs. Market Rate
•
When contract rate and market rate are equal, bonds sell at par value;
•
When contract rate is above market rate, bonds sell at a premium (above par);
•
When the contract rate is below market rate, bonds sell at a discount (below par).
120
SU 5.1 – Bonds
Bonds are issued at PAR if the stated rate of interest is 8% and the market rate equals
8%. 10 year bonds and interest is paid annually.
JE:
JE
JE
Cash
1000
Bonds Payable
Interest Expense
Cash
Bond Payable
Cash
Bond Issuance
1000
60
60
1000
1000
Interest/yearly
Retirement at Maturity
121
SU 5.1 – Bonds
DISCOUNT
• The discount on bonds payable is the difference between the par (face) value of a
bond and its lower issuance price.
•
Entry to record issuance at a discount: debit Cash (issue price), debit Discount on
Bonds Payable (amount of discount), and credit Bonds Payable (par value).
•
Discount on Bonds Payable is a contra liability account; it is deducted from par
value to yield the carrying (book) value of the bonds payable.
122
SU 5.1 – Bonds
Bonds are issued at a DISCOUNT if the stated rate of interest is lower at 6% that the
market rate of 6.5%.The bond price is $920 (explained in later chapters). This means
the company receives $920 for the bond but repays $1000 at maturity. 6% interest is
equal to $60/year. This represents a return of 6.5%, which is calculated as follows:
$60 interest/$920 invested = 6.5%
Continued
123
SU 5.1 – Bonds
JE
Cash
$ 920
Issuance
Discount on Bonds Payable
80
Bonds Payable
1000
INTEREST EXPENSE = CASH PAID INTEREST + DISCOUNT
JE Interest Expense
$68
Discount on Bonds Pay
Cash
JE
Bond Payable
Cash
Interest/yearly
8
60
1000
Retirement at Maturity
1000
124
SU 5.1 – Bonds
PREMIUM
• Issuing Bonds at a Premium—sell bonds for more than par value.
• The premium on bonds payable is the difference between the par value of a bond
and its higher issuance price.
• Entry to record issuance at a premium: debit Cash (issue price), credit Premium on
Bonds Payable
• Premium on Bonds Payable is an adjunct liability account; it is added to par value
to yield the carrying (or book) value of the bonds payable. (amount of premium),
and credit Bonds Payable (par value).
125
SU 5.1 – Bonds
Bonds are issued as a PREMIUM if the stated rate of interest of 6% is higher than the
market rate is 5.5%. 10 year bond, annual interest payments.
The bond price is $1085. This means the company receives $1085 for the bond but
repays only $1000. The bondholders will still receive $60 interest payments each year.
(1000 * .06 = $60). This represents a return of 5.5% ($60 interest/$1085 invested).
Numbers May Be Rounded.
Continued
126
SU 5.1 – Bonds
JE Cash
$ 1085
Premium on Bonds Payable
Bonds Payable
JE
JE
Interest Expense
Premium on PB
Cash
Bond Payable
Cash
Issuance
85
1000
52
9
Interest/yearly
60
1000
Retire at Maturity
1000
127
SU 5.1 – Bonds
• Different tables necessary to calculate the
value of a bond.
– Present value of a $1
– Future value of a $1
– Present value of an ordinary annuity
– Present value of an annuity due
– Future value of an ordinary annuity
128
129
SU 5.1 – Bonds
See examples on page 128 and 129 of the
Gleim study book
130
SU 5.1 – Bonds
MATCH THE BOND WITH THE APPROPRIATE DISCRIPTION.
A. Convertible bonds
1. Bonds that all mature at the same time.
B. Premium on bonds
2. Interest rate investors are willing to pay for similar bonds of equal risk.
C. Callable bonds
3. Unsecured bonds backed only by the good faith of the borrower.
D. Callable bonds
4. Amount of a bond’s issue price over its maturity value.
E. Term bonds
5. Bonds that may be converted into the common stock of the issuing company at the
option of the investor.
F. Serial bonds
6. Amount of a bond’s maturity value over its issue price.
G. Discount on a bond
7. Interest rate that determines the amount of cash interest the borrower pays and the
investor receives.
H. Stated Interest Rate
8. Bonds in the same issuance that mature at different times.
I. Market Interest Rate
9. Bonds that the issuer may call or pay off at a specified price whenever the issuer wants.
J. Municipal Bonds
10. Bonds issued by a city, town, or school district for the purpose of school construction.
SU 5.1 – Bonds Question 1
All of the following may reduce the coupon rate
on a bond issued at par except a
A.
Sinking fund.
B.
Call provision.
C.
Change in rating from AA to AAA.
D.
Conversion option.
132
SU 5.1 – Bonds Question 1 Answer
Correct Answer: B
A bond issued at par may carry a lower coupon rate than other similar bonds
in the market if it has some feature that makes it more attractive to investors.
For example, a sinking fund reduces default risk. Hence, investors may require
a lower risk premium and be willing to accept a lower coupon rate. Other
features attractive to investors include covenants in the bond indenture that
restrict risky undertakings by the issuer and an option to convert the debt
instruments to equity securities. The opportunity to profit from appreciation
of the firm’s stock justifies a lower coupon rate. An improvement in a bond’s
rating from Aa to Aaa (the highest possible) also justifies reduction in the risk
premium and a lower coupon rate. However, a call provision is usually
undesirable to investors. The issuer may take advantage of a decline in
interest rates to recall the bond and stop paying interest before maturity.
133
SU 5.1 – Bonds Question 2
A company issued a 15-year, $1,000 par value bond. The
coupon rate on this bond is 9% annually, with interest being
paid each 6 months. The investor who purchased the bond
expects to earn a 12% nominal rate of return. The cash
proceeds received by the company from the investor totaled
A.
$619.43
B.
$793.43
C.
$875.38
D.
$950.75
134
135
136
SU 5.1 – Bonds Question 2 Answer
Correct Answer: B
The cash flows consist of interest of $45 every 6 months for 15
years (30 periods), and $1,000 at the end of the 30th interest
period. The 12% discount rate translates to 6% every 6 months.
Thus, the calculation is as follows:
Periodic interest
Maturity amount
Total proceeds
13.765(30 periods @ 6%) × $45 = $619.43
.174(6%) × $1,000 = 174.00
$793.43
137
SU 5.1 – Bonds Question 3
Which one of the following statements concerning debt instruments is correct?
A.
The coupon rate and yield of an outstanding long-term bond will change
over time as economic factors change.
B.
A 25-year bond with a coupon rate of 9% and 1 year to maturity has
more interest rate risk than a 10-year bond with a 9% coupon issued by
the same firm with 1 year to maturity.
C.
For long-term bonds, price sensitivity to a given change in interest rates
is greater the longer the maturity of the bond.
D.
A bond with 1 year to maturity would have more interest rate risk than a
bond with 15 years to maturity.
138
SU 5.1 – Bonds Question 3 Answer
Correct Answer: C
The longer a bond’s term, the more time there is for interest rate
volatility to affect a bond’s price, and thus the more sensitive is
its price to interest rate changes.
139