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PRESIDENT
Kunal Banerjee
email : [email protected]
VICE PRESIDENT
A. S. Durga Prasad
email : [email protected]
CENTRAL COUNCIL MEMBERS
Chandra Wadhwa, V. C. Kothari,
A. N. Raman, S. R. Bhargave,
Somnath Mukherjee, G. N. Venkataraman,
Hari Krishan Goel, Dr. Sanjiban
Bandyopadhyaya, M. Gopalakrishnan,
Suresh Chandra Mohanty, Ashwin
G. Dalwadi, Balwinder Singh,
B. M. Sharma
GOVERNMENT NOMINEES
S. C. Vasudeva, R. K. Jain,P. K. Sharma, Jaikant Singh,
T. S. Rangan
CHIEF EXECUTIVE OFFICER
Sudhir Galande
Senior Director (Examinations)
Chandana Bose
Senior Director
(Administration & Finance)
R N Pal
Director (Technical)
J. P. [email protected].
Joint Director (CEP)
D. Chandru
Joint Director (Membership)
Kaushik Banerjee
Joint Director (International Affairs)
S. C. Gupta
EDITOR
Sudhir Galande
Editorial Office & Headquarters
12, Sudder Street, Kolkata-700 016
Phone : (033) 2252-1031/34/35,
Fax : (033) 2252-1602/1492
Website : www.icwai.org.
Delhi Office
ICWAI Bhawan
3, Institutional Area, Lodi Road
New Delhi-110003
Phone : (011) 24622156, 24618645,
24641230, 24641231, 24641232,
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Fax: (011) 24622156, 24631532,
24618645
TheManagem entAccountant
Official Organ of The Institute of Cost and Works Accountants of India
Volume 44 No. 2 February 2009
the management accountant, February, 2009 89
Editorial 91
President’s Communique 92
Cover Features
Measurement and Management of
Risk
by Dr. V. Gangadhar &
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
Dr. G. Naresh Reddy 94
Risk Reporting : An Essence of Risk
Management
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○
by Subhajit Ghosh 99
Operational Risk : An Important Issue
in Modern Banking
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ by Soumya Mukherjee 107Enterprise Risk Management (ERM)
by Adithya Bhat 112
Accounting Issues
IAS 17 : Leases - A Closer Look
by K. S. Muthupandian 115
Outsourcing
Outsourcing - an opportunity
by P. Subramanian 121
Emerging IssuesEmployee Governance
by R. Soundara Rajan &
Chitra Rajan 123
Finance
Non-Performing Assets
Management of Non-banking
Financial Companies : An
Introspection
by Jafor Ali Akhan 132
Issues & Concerns
Behavioral Finance – A Discussion on
Individual Investors’ Biases
by Dr. M. Bhatt H.S. 138
Finance & Accountancy
Intellectual Property and its
Pervasiveness in Industry, Trade and
Commerce
by Avik Ranjan Roy 142
Golden Jubilee Commemorative
Address 128
Legal Updates 144
E-mail Ids 164Regional Conference at Chandigarh168
IDEALS
THE INSTITUTE STANDS FOR
to develop the Cost and Management
Accountancy profession to develop
the body of members and properly
equip them for functions to ensure
sound professional ethics to keep
abreast of new developments.
The views expressed by contributors or
reviewers in this Journal do not
necessarily reflect the opinion of The
Institute of Cost and Works Accountants
of India nor can the Institute by any
way be held responsible for them. The
contents of this journal are the copyright
of The Institute of Cost and Works
Accountants of India, whose permission
is necessary for reproduction in whole
or in part.
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The Management Accountant
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“ICWAI Professionals would ethically drive
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through competencies drawn f rom the
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the management accountant, February, 2009 90
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Editorial
the management accountant, February, 2009 91
It’s a risky businessReaders will observe that ever since the financial
tsunami erupted, we have been carrying in each edition
of the journal, issues on which this global crisis has a
bearing - the likely impact of the financial upheaval on
the outsourcing sector (September issue); the effect
the slump will have on the globe’s efforts to tackle
climate change (October issue); the emergence of the
Micro Finance Institutions (MFIs) as an alternative
source to provide affordable credit with the drying up
of formal credit channels (November issue); the raging
debates over new accountancy norms (December
issue) and the increasing need towards Human Resource
Accounting (January issue). Inclusion of such articles
on different sectors of the economy that have current
relevance has been widely received and appreciated by
our readers. This has encouraged us to continue with
the practice of highlighting another area badly hit by
the financial crisis.
In this issue we focus on risk management. Risk
Management is an elite word in financial literature yet
much maligned against the backdrop of frequent crises.
Risk in financial parlance means the possibility of lowerearnings or downright loss. We are also aware that “no
risk, no return”. Hence, risk is an inseparable way of
doing business. Financial risk can either be ignored (if
it is small vis-à-vis return) or it can be avoided (by not
undertaking that business venture at all) or removed
and in the most likely case the impact mitigated. Risk
management would thus imply putting mechanisms and
measures in place to accept/ limit/ transfer this risk
that can emerge from any source- business operations,
fluctuations in market variables, possibility of default
in funds lent/ invested, external events etc. Risk
management architecture encompasses risk identification, risk measurement (through sensitivity,
simulation models), risk monitoring (through VaR
models), risk mitigation (e.g. derivatives) and Board
oversight in the form of policy formulation, execution
and independent audit.
The characterizing feature of the financial world in recent
times has been the quantum jump in innovations relating
to risk management. Greater financial integration
among countries, more intense competition between
the financial players, development in the field of IT
which enabled the emergence of sophisticated risk
modeling techniques to measure and monitor risks,
greater regulation which spawned the need to
circumvent the stringent rules- all these have played a
role in the development and refinement of risk
management.
Many would blame the sub prime crisis to risk
management as they feel conventional business got lost
in the esoteric world of risk management. Yet it must
be remembered that the crisis occurred due to the lack
of prudent risk management practices rather thanbecause of its existence. Evidently, risk management
practices were flouted/ ignored at every level of the
sub prime crisis. The lenders of the housing loans
acquired substantial credit risk both at the origination
(loans sanctioned without proper due diligence) and
post disbursal stages (by securitisation). Investment
banks in a bid to be ahead in the competition had over
leveraged themselves and thus exposed themselves to
risk arising from insufficient capital. Entities, both
financial and non financial were subjected to market
risk on account of huge exposures to complex derivative
products. Further, internal risk management practiceslike watertight segregation of risk origination and risk
audit were not followed leading to operational risk. All
these underscore the need for risk management instead
of vilifying it.
Risk management, as a concept is not new, even to
Indian business. When a banker appraises a prospective
borrower before sanctioning a loan, he is in effect
guarding against credit risk. When a farmer enters into
a contract with the local mandi today to sell his crop
three months later at a price determined today, the
farmer is basically protecting himself from possible
market risk. The risk management literature in its
present avatar is essentially a systematic approach to
curtail one’s losses and stabilize one’s profits. The Basel
Accord is an example of a comprehensive risk
management policy document for adoption by the
banking world.
It is hoped that the articles on the cover feature will aid
in the understanding and familiarity with risk
management concepts. This will equip our Cost
Accountants towards further progress and development
in this area.
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92 the management accountant, February, 2009
My dear Professional Colleagues,
We are living in turbulent times. Even before recovering from the global financial crisis,
we are confronted with more challenges, which are equally damaging albeit on a more
local scale. The Madoff scandal in US and back home in India the Satyam episode are
two such events, which have succeeded in denting the already sagging confidence
among the business community. Both are examples of greed and failure and inadequacy
of corporate governance and underscore the indispensability of ethics, proper regulation,
independent audit and above all effective checks and balancing with business
performance in a public organisation. The current situation arising out of serious lapses
in Corporate Governance in India drives home the point which we have been advocating
regarding Enterprise Governance. Corporate governance is about how companies are
directed and controlled. It is focused on conformance with regulations. This conformance
is of course necessary – but a governance structure should also support an organization’s
efforts to improve performance. It has to come out of a check-list mentality which leads to governance in name and not
in spirit. There is an urgent need to move from compliance governance to business governance which also happens to
be the considered view of the International Federation of Accountants (IFAC) (Report on Financial Reporting Supply
Chain).
In our view, this governance structure has to expand its horizon to include a system that ensures optimal utilisation of
resources for the benefit of shareholders while meeting societal expectations.There has to be a shift from compliance
or rule based governance to a performance management framework with enterprise governance in mind. To
achieve this IFAC has recommended suitable performance management systems for the functioning of the audit
committee. The Expert Group constituted to review the mechanism of cost accounting records and cost audit has also
recommended this shift of the framework of cost audit from being compliance or rule based governance to a performance
management framework with enterprise governance in mind. These recommendations acquire great significance in the
current context of governance failure. The Ministry should get the report examined at the earliest so that the issues of enterprise governance and corporate competitiveness are addressed, to avoid repetition of another corporate financial
catastrophe.
SEBI has desired a second audit of all the listed companies. We feel that such an audit should be conducted by a firm
of Cost Accountants who have greater capabilities to focus on input-output structures in an enterprise and find
justification and correctness of the declared profits. Such an opinion is also echoed in the IFAC survey on the
Financial Reporting Supply Chain. Many developed countries have Accounting Oversight Boards to regulate the
statutory services of accounting professionals. An independent Regulatory body may be considered in India to
regulate the services of statutory auditors of companies.
The month of January was very eventful for the Institute. January 15, 2009 was a red letter day for our Institute when
Bharat Ratna Dr. A.P.J. Abdul Kalam addressed the members at Pune and delivered the Golden Jubilee Commemorative
Address marking the 50th year of enactment of the Cost and Works Accountants Act. The key message of Dr. Kalam
to the professionals was “Promote Profit with Integrity – Work with integrity and Succeed with integrity”. You can
also find the speech in the web sites of Dr. Kalam as well as of the Institute.
Formal announcement of the Certificate Course in Accounting Technicians was held at New Delhi on January 9, 2009.
The details of the Memorandum of Understanding between our Institute and the Chartered Institute of Management
Accountants, UK were also announced at the same function. I am happy to inform you that a final passed ICWAI
candidate will be able to take direct admission for the Strategic Level Examination of CIMA after passing CIMA
Professional Gateway Examination (CPGA). The MoU with CIMA, UK heralds an era of opening up of globalization for
the Indian students and an opportunity to attain International accounting qualification at a fast pace. Ms. Tam Kam
Peng. Head of Alliances & Learning Partnerships, CIMA attended the function. The modalities regarding the CPGA
are appearing in our website. Members interested in getting the CIMA qualification can refer to the site of the Institute
for further details.
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the management accountant, February, 2009 93
The National Institute of Securities Markets (Established by Securities and Exchange Board of India) organized
executive education programme in Mumbai for training of auditors of broking firms. Shri A. S. Durga Prasad, VicePresident attended the programme and addressed the Inaugural function on January 9, 2009. Shri Durga Prasad alsohad discussions with SEBI officials regarding scope and areas where cost and management accountants can extendtheir services to SEBI to enable SEBI to perform their regulatory functions in a more effective manner.
As a part of the ongoing Silver Jubilee Celebrations of SAFA, our Institute organized a Seminar on Target Costing atNew Delhi on January 17, 2009 along with CII-TCM Division and Automotive Components Manufacturers Associationas Technical Partners. Shri Jitesh Khosla, Joint Secretary, MCA inaugurated the Seminar which was very well attended.The Institute is also planning to hold chain seminars on Enterprise Governance in collaboration with CIMA, UK,seminars on Audit of Stock Brokers as mandated by SEBI as well as seminars in all the four regions on Ethics and
Practices for Professional Accountants, which is the need of the hour.
The Northern India Regional Council and Chandigarh Chapter organized the NIRC Regional Cost Convention atChandigarh during January 3-4, 2009. I take this opportunity of congratulating the organizers for a very successful
convention, which was inaugurated by Shri Randeep Singh Surjewala, Minister for Power & PWD, Govt. of Haryana.Shri P. K. Bansal, Union Minister of State for Finance, Govt. of India presided over the function.
The Golden Jubilee National Convention was organised by the Western India Regional Council and Pune Chapter of Cost Accountants at Pune during January 29-31, 2009. The Convention was preceded by a Students’ Convention,Practitioners’ Meet and Lady Cost Accountants’ Meet on January 28, 2009. The technical sessions of the Convention
were very lively with intense participation of the delegates and participants. The Plenary Session was followed by ameet of Industrialists discussing the role of cost and management accountants in making India Inc. globally competitive.I congratulate the WIRC and Pune Chapter for a very successful organisation of the Convention, which was attendedby a large number of delegates across the country, all the regional councils and representatives of Chapters fromacross the country.
The SAFA Assembly was held at Pokhara, Nepal on January 25-26, 2009, which elected Mr. Sheikh A Hafiz of ICA
Bangladesh as President and Mr. Komal Chitracar of ICA Nepal as Vice President of SAFA for the year 2009.As part of the continuing knowledge initiatives, ICWAI organised a highly informative two-day session on International
Financial Reporting Standards (IFRS), the most important development towards convergence of global accountingstandards. Dr T.P.Ghosh, an expert in this field delivered the lectures on January 12 and 13, 2009. The programme wasattended by a wide cross section of practicing accountants, professionals, coprorates and students alike.
I am glad to inform you that we have released the final cost accounting standard on materials. Other Exposure draftshave also been released and are available on the Institute’s website. I request all our members to send their observationsand suggestions on the exposure drafts to the Technical Directorate to make the standards more meaningful andcomprehensive.
We have also released Management Accounting Guidelines on Internal Audit and Guidelines on Valuation for CaptiveConsumption for the help and benefit of the members and the industry at large.
In this month’s journal we focus on the vast and dynamic area of risk management. Our members are likely to benefitfrom the articles on risk management as a driver of growth.
With warm regards
Yours sincerely,
Kunal Banerjee
President
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94 the management accountant, February, 2009
Measurement andManagement of Risk
Risk is all-pervasive. The philosophy of treating risk has gained wide popularity
because it is not just a threat but also a powerful device to combat fierce
competition and ultimately to learn how to grow and survive amid all adversities.
There should be always a trade-off between return and risk. In the present era of
globalization and changing global environment risk measurement and
management is also one of the important functions of the financial manager. The
risk will influence in a greater way for its all future operations. Therefore, we
made an attempt to analyze different types of risk, methods for risk measurement
and the steps involved in the management of risk of a business firm.
Dr. V. Gangadhar*
Dr. G. Naresh Reddy**
*Convener, ICET-2006 and Professor of
Commerce and Business Management,
Kakatiya University, Warangal -506009.
**Lecturer, Department of Commerce and
Business Management, University Arts &
Science College, Kakatiya University,
Warangal -506 001.
Introduction
Risk Management encompasses
a wide variety of different types
of risk in any corporate
enterprise - market, credit, liquidity,
event and operational. Five key forces
are changing the way that senior
managers in major companies round theworld view their future - new
technologies, globalization, non - bank
competition, deregulation and the
opening up of previously protected
markets.1 The true measure of a
business’s success is the rate at which
it can improve its range of products/
services and the way it produces and
delivers them. Risk measurement and
management is also one of the important
functions of the financial manager. In
the changing global environment his
decisions are affected by risk in a
perceptible way. Therefore, we made an
attempt to examine the different types
of risk, its measurement and
management in a business business firm.
Meaning
Risk : There are many definitions
of risk; they depend on the specific
application and situational contexts. In
general, every risk (indicator) is
proportional to the expected losseswhich can be caused by a risky event
and to the probability of this event.
James C. Van Home has defined the risk
as “the variability in the expected
earnings of a company”. Therefore, the
differentiation of risk definitions
depends on the losses context, their
assessment and measurement, as well
as, when the losses are clear and
invariable, for example a human life, the
risk assessment is focused on the
probability of the event, eventfrequency and its circumstances. We try
to define the term risk in the point of
view of engineers, financial managers
and statisticians.
Engineering definition of Risk, an example:
Probability of Accident Consequence in Lost Money
Risk =Events Per Time Period Per Event
1Yen Yee Chong and Evelynmay Brown: Managing Project Risk, Prentice Hall,
Pearson Education Limited, London, First Edition, Year 2000.
Financial definition of Risk: “The
chance that an investment’s actual
return will be different than expected.This includes the possibility of losing
some or all of the original investment. It
is usually measured by calculating the
standard deviation of the historical
returns or average returns of a specific
investment”. Risk in finance, as defined
by Ron Dembo, is quite general methods
to assess risk as an expected after-the-
fact level of regret. Such methods have
been successful in limiting interest rate
risk in financial markets. Financial
markets are considered to be a proving
ground for general methods of risk
assessment. A fundamental idea in
finance is the relationship between risk
and return. The greater the amount of
risk that an investor is willing to take
on, the greater the potential return. The
reason for this is that investors need to
be compensated for taking an additional
risk”.
Statistical definition of Risk: It is
mapped to the probability of some eventwhich is seen as undesirable. Usually
the probability of that event and some
assessment of its expected harm must
be combined into a believable scenario
(an outcome) which combines the set
of risk, regret and reward probabilities
into an expected value for that outcome.
Thus, in statistical decision theory, the
risk function of an estimator 6 (x) for a
parameter 6, calculated from some
observables x; is defined as the
expectation value of the loss functionL,
dx)(x/ (x)),(L(x)),R( θ∫ ×δθ∫ =δθWhere : (x) = Estimator; = the
Parameter of the Estimator
Cover Feature
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the management accountant, February, 2009 95
Risk Measurement: In the wordsof William Shockley measurement is a
comparison to a standard. The processof measurement involves estimating theratio of the magnitude of a quantity tothe magnitude of a unit of the same type(length, time, mass, etc.). Ameasurement is the result of such aprocess, expressed as the product of areal number and a unit, where the realnumber is the estimated ratio. It is truethat only quantifiable and identifiablerisks are managed in terms of providinghedge cover or insurance. It is pertinentthat enterprises identify its key risks
and the volume of exposure, before itcould decide on the type of hedgingand its timings, to optimize risk-returnpayoff. Range, Standard Deviation, Co-efficient of Variation and otherEconometric tools are used for themeasurement of risk.
Risk Management: is the processof identifying, analyzing and evaluatingthe risk and selecting the best possiblemethods for handling it. There is nostandard approach for risk management.However, there are some common
elements of successful risk managementefforts: (i) Recognition of the risk is theresponsibility of a programmemanagement, (ii) The risk managementprocess includes planning for risk management, continuously identifyingand analyzing programme events,assessing the likelihood of theiroccurrence and consequences,incorporating handling actions tocontrol risk events and monitoring aprogramme’s progress towards meetingprogramme goals. In an ideal risk management, a prioritization process isfollowed whereby the risks with thegreatest loss and the greatestprobability of occurring are handledfirst, and risks with lower probability of occurrence and lower loss are handledlater. In practice the process can be verydifficult, and balancing between riskswith a high probability of occurrencebut lower loss vs. a risk with high lossbut lower probability of occurrence canoften be mishandled. Risk managementfaces a difficulty in allocating resources
properly. This is the idea of opportunitycost. Resources spent on risk
management could be instead spent onmore profitable activities. Again, idealrisk management spends the leastamount of resources in the processwhile reducing the negative effects of risks as much as possible.
Objectives: The main objectives of the study are:
a. To explain the concept of risk, risk measurement and risk management.
b. To discuss the different types of risk.
c. To analyze the techniques of risk measurement.
d. To suggest the steps involved in therisk management process.
e. To present the summary of thestudy.
Types of Risk:
Number of factors will influence therisk and depending upon the cause, therisk can be broadly classified into thefollowing three major types:
1. Strategic Risks,
2. Operational Risks and
3. Investment Risks.
Strategic Risks: These risks are theissues which require companies to think on a large scale. These risks have amajor impact on the company’s costs,prices, products and sales. Some of thesolutions which companies bring tobear such risks are shown in thefollowing table:
Operational Risks: These risks canbe categorized according to theiroccurrence. Some occur at suppliers,others at the point of production, in the
distribution chain or when the productSTRATEGIC RISKS
Have an impact upon theStrategic Risks
company’sSolutions can be found in
Strategic Planning of
Government and Costs Markets and Products
Economic Factors Empowerment
Customers Prices Quality Management
Competitors Products Customer Care
New Technology Sales Investment Innovation
Cost Reduction
is consumed. Operations risk stemsfrom a variety of sources.
Broadly speaking, these are processrisk, people risk, technology risk anddisasters. Each of these categories mustbe investigated to identify the risk elements, assign a probability of occurrence, consequences if the eventdid happen and thus arrive at theweightage assigned to that risk.Operational hazards classified by timeare presented in the following table:
Some of the Important OperationalRisks are Presented in Brief:
Process Risks: this stem from thedesign of the process and the extent of manual or human element in the stepsof the process. A common risk isincorrect data capture. Since datacapture is often the very first step in aprocess, an error there hasconsequences in all the succeedingsteps and rectifying the error in turninvolves many stages of rollback. Datacapture can easily be classified as a risk with a high probability of occurrenceand with costly consequences, thusmaking it a high weightage risk.
People Risk: this risk is rarelyconsidered as a formal risk. At the back of his mind, a manager is probably awarethat there is excessive dependency onone person, but this also means that heis too busy to train someone else. Aformal identification of key persons anda strategy to contain that risk isessential. Likewise, formal processdocumentation, recruitment, induction,ongoing training and motivationpolicies are very important to mitigate
those HR risks.
Cover Feature
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96 the management accountant, February, 2009
Operational Risks
Suppliers Process and
Internal Risks Distribution Customers Competitors
Interruption of Fire Counterfeiting Payment Problems Competitor Activity
Supplies
Poor Quality Pollution Tampering Changing
Supplies Fraud Needs Product
Computers Liability
Accidents
Labor
Disputes
Terrorism,
Kidnap and Ransom
Technology Risks: the financialindustry is the leading user of technology worldwide. Even in India,banks, brokerages, exchanges andmutual funds are aggressive users of the latest technology. As technologybecomes a key part of the process, itsmaintenance and performance becomesa key risk factor. The risks associatedwith the hardware side of technologyare somewhat easier to contain, becausethey involve in simple monetary costsin redundancies. Hardware and
networking skills are somewhat at apremium, but these are generic skills andcan be had at a cost. The risk associatedwith the application side is far moreinsidious and difficult to manage.Application technology is invariablycustomized to that particular businessneed.
Investment Risks:
Every investment involvesuncertainties that make futureinvestment returns risky. Some of thesources of uncertainty that contribute
to investment risks are aggregated into2(a) Interest Rate Risk (b) PurchasingPower Risk (c) Bull-Bear Market Risk (d) Default Risk (e) Liquidity Risk (f)Callability Risk (g) Convertibility Risk (h) Political Risk (i) Industry Risk (j)Currency Risks (k) Portfolio Risk and(1) Country Risk.
Interest Rate Risk: It is defined asthe potential variability of return causedby changes in the market interest rates.The degree of interest rate risk is relatedto the length of time to maturity of the
security. If the maturity period is long,the market value of the security mayfluctuate widely. Further, the marketactivity and investor perceptionschange with the change in the interestrates and interest rates also dependupon the nature of instruments such asbonds, debentures, loans and maturityperiod, credit worthiness of the securityissues, etc.
Purchasing Power Risk: This is thevariability of return an investor suffersbecause of inflation. It is closely related
to interest rate risk, since interest ratesgenerally rise when inflation occurs.Purchasing power risk is more relevantin case of fixed income securities;shares are regarded as hedge againstinflation. It is the risk that the real rateof return on security may be less thanthe nominal return. There is always achance that the purchasing power of invested money will decline or that thereal return will decline due to inflation.The return expected by investor willchange due to change in real value of
returns. Cost push inflation is causedby rise in the costs due to rise in theinput costs. Push and pull forces operateto increase prices due to inadequatesupplies and raising demand.
Bull-Bear Market Risk: It arisesfrom the variability in market returnsresulting from the operators of bull andbear market forces. When a security
2 Jack Clark Francis: “Investment Analysis
and Management”, Me Graw-Hill
International Editions, Fifth Edition, p. .3.
index rises fairly consistently from a lowpoint, called a peak, for a period of time,this upward trend is called a bull market.The bull market ends when the marketindex reaches a peak and starts adownward trend. The period duringwhich the market declines sharplyindicating a trough trend and theposition is called as a bear market.
Default Risk: Is that portion of aninvestment’s total risk that results fromchanges in the financial integrity of theinvestment. It is a failure of the borrower
to pay the interest and principal amountwithin the stipulated period of time. Thedefault risk has the capital risk andincome risk as its components. It meansnot only failure to pay, but also delay inpayment.
Liquidity Risk: Is that portion of an asset’s total variability of returnwhich results from price discounts givenor sales commissions paid in order tosell the asset without delay. It is asituation wherein it may not possible tosell the asset. Assets are disposed off
at great inconvenience and cost in termsof money and time. Any asset that canbe bought and sold quickly is said tobe liquid. Failure to realize with minimumdiscount to its value of an asset is calledliquidity risk.
Callability Risk: It is that portionof a security’s total variability of returnsthat derives from the possibility that theissue may be called as the callability risk.Callability risk commands a risk premiumthat comes in the form of a slightlyhigher average rate of return. This
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the management accountant, February, 2009 97
additional return should increase as therisk that the issue will be called creases.
Convertibility Risk: It is thatportion of the total variability of returnfrom a convertible bond or a convertiblepreferred stock that reflects thepossibility that the investment may beconverted into the issuer’s commonstock at a time or under terms harmfulto the investor’s best interests.
Political Risk: It arises from theexploitation of a politically weak groupfor the benefit of a politically stronggroup. With efforts of various groupsto improve their relative positionsincrease the variability of return fromthe affected assets. Regardless of whether the changes that cause politicalrisk are sought by political or byeconomic interests, the resultingvariability of returns is called politicalrisk if it accomplished throughlegislative, judicial or administrativebranches of the government.
Industry Risk: It is that portion of an investment’s total variability of return caused by events that affect the
products and firms that make uponindustry. The stage of the industry’s lifecycle, international tariffs and/or quotason the product produced by anindustry.
Currency Risks: These areassociated with internationalinvestments not denominated in thehome currency of the portfoliomanager’s beneficiaries. These risksinvolve the international payment of cash. Currency risks on a global basismay be close to unsystematic, meaning
that they are uncorrelated acrosseconomies and are not priced.
Portfolio Risk: Portfolio managersattempt to maximize returns given anacceptable level of risk. Industrypractitioners describe five differentportfolio management risks as: interestrate risk, liquidity risk, credit risk,operating risk and currency risk.
Country Risk: It involves thepossibility of losses due to countryspecific economic, political or socialevents or because of company specific
characteristics, therefore all politicalrisks are country risk but all country
risks are not political risks. A sovereignrisk involves the possibility of losseson private claims as well as on directinvestment. Sovereign risk is importantto banks whereas country risk importantto MNCs.
Risk Measurement:
Risk refers to variability. A varietyof measures have been used to capturedifferent facets of risk. Among themmore important ones are - Range,Standard Deviation, Co-efficient of Variation and Semi-Variance. Apart fromthis, we also use - Sensitivity Analysis,Breakeven Analysis, SimulationAnalysis, Decision Tree Analysis,Value at Risk Analysis and Cash Flowat Risk Analysis.
Sensitivity Analysis: With the helpof sensitivity analysis it is possible toshow the profitability of a project alterswith different values assigned to thevariables needed for the computation(unit sales price, unit costs, and salesvolume). This analysis is frequently
used if, although the simple anddiscounted methods of evaluation donot show a satisfactory profitability, animprovement is felt to be possible bychanging some of the variables.
Break-even Analysis: The financialmanager is interested to know how muchhe should be produced and sold at aminimum to ensure is called break-evenanalysis and the minimum quantity atwhich loss is avoided is called thebreakeven point.
Simulation Analysis: The decision
maker would like to know the likelihoodof occurrences. This information can begenerated by simulation analysis whichmay be used for developing theprobability profile of a criterion of meritby randomly combining values of variables which have a bearing on thechosen criterion.
Decision Tree Analysis: It is auseful tool where sequential decisionmaking in the face of risk is involved.This analysis is having the fourimportant steps. They are (i) identifying
the problem and alternatives, (ii)delineating the decision tree, (iii)
specifying probabilities and monetaryoutcomes and (iv) evaluating variousdecision alternatives.
Value at Risk Analysis (VAR): It isone of the proven and the most usedmeasures of risks by financialinstitutions. VAR measure the likelychange in marked to market value of aportfolio, at specified time periods withcertain confidence.
Cash Flow at Risk Analysis(C-far):
is specifically developed for non-financial organizations with cash flowas variable. The following two featuresof non-financial organization hadresulted in the development of C-farmodel. Firstly, certain assets of non-financial organization could beaccurately valued at market prices.Secondly, the risk free and continuousfuture cash flows represent the valueof any non-financial organization.Hence, cash flows are taken as proxyfor measuring risks. Cash flow at risk measures the deviation of cash flows
from the expected volume. In otherwords, it gives an idea as to how muchof cash flows the portfolio might lose ina given time with given probability.
Risk Management:
Risk Management is the process of identifying assets at risk, assigningappropriate values, identifying threatsto those assets, measuring or assessingrisk and then developing strategies tomanage the risk (see the Chart-1). In theRisk Management the following stepsare to be taken up to minimize the risk.
Step-1: Identification of Assets atRisk: The first step in the risk management process is to identify theassets in support of critical businessoperations. The assets could fall underdifferent groups which are physical/ tangible and conceptual assets.
Step-2: Valuation of Assets: Theassets so identified and grouped in theprevious step are to be valued,categorized into different classes, suchas critical and essential.
Step-3: Identifying the Threats:
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98 the management accountant, February, 2009
Threats can be defined as anything thatcontributes to the interruption or
destruction of any service/product.Various threats can be grouped intoenvironmental, internal and externalthreats.
Step-4: Risk Assessment: Theprocess of Risk Assessment includesnot only assessment as to theprobability of occurrence but also theassessment as to the potential severityof loss, if risk materializes. This willassist in determining the appropriaterisk mitigation strategy, the residual risk and investment required to mitigate the
risk.Step-5: Developing Strategies for
Risk Management: Once risks havebeen identified and assessed, thestrategies to manage the risk fall intoone or more of these four majorcategories:
i) Risk Avoidance: Not doing anactivity that involves risk and losing outon the potential gain that accepting therisk might have provided.
ii) Risk Mitigation/Reduction:
Implementing controls to protectinfrastructure and to reduce the severityof the loss.
iii) Risk Reduction/Acceptance:
Formally acknowledging that the risk exists and monitoring it. In somecases it may not be possible to takeimmediate action to avoid/mitigate therisk. All risks that are not avoided ortransferred are retained by default.
iv) Risk Transfer: Causing anotherparty to accept the risk i.e. sharing risk with partners or insurance coverage.
Summary:Risk measurement and management
is also one of the important functionsof the financial manager. In thechanging global environment hisdecisions are affected in a big way. Risk is the chance of future that can beforeseen. Risk is classified into variouscategories, like strategic risk,operational risk and investment risk. Forthe measurement of risk variousmethods are applied. By using thesemethods, the financial manager has to
CHART-1: RISK MANAGEMENT PROCESS:
take a decision for investment or someother purpose. The management of risk is an important aspect for thecontinuation of business in the long-run. Finally, the profit or the future cashinflows are depending on the presentdecision which influence for a future
course of action.
References:
A.K. Seth: International Financial
Management, Galgotia Publishing
Company, New Delhi.
Frank H. Knight: Risk Uncertainty and
Profit, University of Chicago Press,
Chicago and London.
James C. Van Home: Financial
Management and Policy, Prentice-Hall
of India Private Limited, New Delhi.
Keith Redhead: Financial Derivatives,
Prentice-Hall of India Private Limited,
New Delhi.
Kit Sadgrove: The Complete Guide to
Business Risk Management, Jaico
Publishing House, Mumbai.
N.D. Vohra and B.R. Bagri: Futures and
Options, Tata Me Graw-Hill Publishing
Company Limited, New Delhi. Prakash G Apte: International Finance,
Tata Me Graw-Hill Publishing
Company Limited, New Delhi.
Prof. V. Gangadhar: Investment
Management, Anmol Publications
Private Limited, New Delhi.
R.K. Mittal: Portfolio and Risk
Management, Rajat Publications, Delhi.
Yen Yee Chong & Evelyn May Brown:
Managing Project Risk, Pearson
Education Limited, London.
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Risk Reporting: An Essenceof Risk ManagementSubhajit Ghosh*
*Lecturer, Accounting & Finance
Department of Commerce St. Xavier’s
College, Kolkata
Corporate risk communication is important for the well functioning of companies
and long term trust can be generated by rationalizing and monitoring risks. But
risk management is impossible without risk reporting. Proper risk reporting
can successfully predict the volatility, sensitivity and fluctuations in future
market. Risk reporting which is the essence of successful decision-making depends
on disclosure incentives. The main object of this paper is to realize the essence of
risk reporting and to show how important role mandatory risk reporting
disclosure under specific accounting standard can play to prevent corporatecollapses.
Introduction & Background
The decision making process
involves consideration for risk
and return. As higher risk tends
to higher return, corporate managers
take unnecessary risks. In order to
monitor and minimize the risk there
should be a ‘risk management
framework’ and thus the concept of ‘risk
reporting’ has gained importance. ‘Risk
reporting’ is a decision support systemwhich aims to provide risk information
in the form of risks assumed, their
effects on future cash flows and profits
and effects of various corporate actions
on the risk profile of the firm. As any
managerial activity is impossible
without information, risk management
process is also impossible without risk
reporting. Risk reporting is reporting of
all anticipated risks, their classification,
effects and consequences. Risk arises
when expected cash flow differs fromactual cash flow. When the probability
of realizing cash is on the lower side, it
creates a risky situation. Risk reporting
is expected to describe all these
probabilities of future anticipated cash
flows. So risk reporting can be defined
as probabilistic forecast disclosure. So
risk reporting is futuristic and subjective
reporting. Financial reporting is
reporting of actual and verifiable
information. On the other hand elements
of variability and reliability may be
missing to some extent in risk reporting
as it reports future risks and
probabilities.
There’s no doubt that risk reporting
is key to helping risk management to
add value to organizations. It’s a
question every amateur philosopher haspondered: “If a tree falls in the forest
and no one is there to hear it, does it
make a sound?” Similarly, risk
professionals may well have found
themselves asking: “If a risk is managed
and no one is told, is it actually being
managed?” Of all the major
developments in risk management in the
past few years one element that in many
cases, stands between success and
failure is risk reporting. Perhaps the most
key application for risk reporting, interms of risk professionals, is
demonstrating the value that risk
management can bring to an
organization and ensuring that those at
the top understand and value risk. With
senior executives and boards
increasingly looking to realize return on
investment, risk reporting is becoming
increasingly important.
Risk reporting can unearth excessive
controls and smarter resource
allocation. Effective risk reporting,
particularly KPI [key performance
indicator] reporting linked to risks, might
show where controls are excessive in apart of the business and may be scaled
back to enable those resources to be
utilized in other parts of the business
where controls may be less adequate.
Effective risk reporting may show where
risks appear to be concentrated in
certain parts of the business and
resources can be allocated to those
areas. It’s also crucial to ensure that risk
reporting is not a one-way street. While,
ostensibly risk reporting is designed to
enable senior executives and the boardof directors to make informed business
decisions on the basis of accurate risk
information, it should also be linked back
to those ‘at the coalface’. When risk
reports are linked back to the business
and actually assist the business in
managing its resources, reducing its
expenses and enabling risk taking in a
controlled environment then effective
risk reporting is critical to the risk
management and operational process.
With this backdrop an attempt has
been made to analyze the role of risk
reporting to realize the volatility,
sensitivity and fluctuations in future
market essential to prevent corporate
collapses. The next section provides an
insight into the identification,
classification and importance of risk
reporting. The third section develops
the basis for ideal risk reporting. The
fourth section explains the role of risk
reporting to reduce the gap between
accounting and economic valuation.
The fifth section deals with therelevance of risk reporting in accounting
standard keeping in mind the Indian
scenario. The sixth section concludes
the paper.
Importance, Identification &
Classification of Risk Reporting
Importance of Risk Reporting: A
transparent and fair risk reporting
system is essential for a company as it
is bound to disclose all material risks
that it faces and its risk management
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100 the management accountant, February, 2009
practices. Risk reporting has gained
importance after collapse of Enron
followed by other major corporatefailures. Risk reporting can hold
managers accountable for what they do.
If corporate boards are insistent, they
can hold the bull by the horns and make
the managers more responsible. There
must be a justification for what
corporate managers do and don’t do.
So risk reporting has the following
importance:
It can assist the board to discharge
its responsibilities as the company
can go for higher profit at lower risk. It helps in decision making at all
level.
It can help the investors to evaluate
market situations and to build
optimum portfolio of securities.
Lenders can be assisted in their
lending operations and policy
decisions.
It can help a company in getting
better credit rating and assess to
cheaper sources of finance.
It reduces information asymmetry
between managers and investors
leading to reduced agency cost.
Lower agency cost can reduce the
cost of capital and can increase the
basket of profitable investment
opportunities available to a firm.
It can create a niche for the company
and can act as trendsetters for
others.
Identification of Risks:
The process of identifying the risksof an organization is an important
exercise. The key persons of the
organization are expected to raise their
awareness about the risks in their day-
to-day operations. Peter Drucker has
classified risks into four broad
categories:
(a) risk that is built into the very nature
of the business and cannot be
avoided.
(b) risk one can afford to take.
(c) risk one can afford not to take.
(d) Risk one cannot afford not to take.
Traditionally risks are classified as
hazard risk, financial risk, operational
risk and strategic risk. Hazard risks are
related to natural hazards, accidents, fire,
earthquake etc. Financial risks are
concerned with volatility in interest and
exchange rates, asset liability mismatch
etc. Operational risks are associated
with systems, process and people and
covers areas like succession planning,
failure of research and development
facilities, non-compliance of regulatory
provisions etc. Strategic risks arise frominability to adjust to changes in the
environment arising from merger or
acquisition, competition threats etc.
Indian companies have reported various
risks faced by them and most common
of these are financial risks related to
volatility in interest and foreign
exchange rates. Every type of risk arises
either from external factors like exchange
rate fluctuations, political environment,
competitive environment, inflation,
immigration regulations, technologyobsolescence etc. or from internalfactors like liquidity and leverage,contractual compliances, intellectual
property management, integration andcollaboration, human resourcemanagement etc.
Classification of Risk Reporting:
Risk reporting can be internal andexternal or voluntary and mandatory.
Internally the corporate board andother higher authorities expect a detailed
analysis of corporate risks and theireffects. Such information can be utilizedas risk monitoring and decision making
mechanism. Internal risk reporting ismandatory. On the other hand external
reporting is done to inform the
stakeholders about the risk faced by theentity, steps taken to mitigate andcontrol the risk and the mechanisms
adopted to facilitate decision making atindividual and institution level. Externalrisk reporting can be voluntary or
mandatory. Many feel that voluntary risk
reports do not yield desirable reports
and it is poor because:
A manager is not under any legalcompulsion to disclose all the
details.
He/she is not informed about all
risks.
Lacks incentive to know or identify
all the risk factors.
Does not believe in what is being
disclosed to him.
Believes that they are only half-
truths.
Users are not serious users.
Assumes that the users lack sufficient skills to understand what
is being disclosed.
In view of all these, it can be saidthat risk reporting should be mademandatory. However, empirical evidence
shows that even under a mandatoryrisk-reporting regime, comprehensiverisk reporting is rather vague providing
dissatisfying information content.
Developing the basis for ideal Risk
Reporting
The information that investors likeequity or debt holders, wish to have
about the financial performance of a firmcan guide their decision-making. Theywould surely wish to form a view about
the firm’s past and current profitability,solvency and liquidity at a given pointin time. No doubt, they would also like
to develop a picture of the risk profile
of those attributes over time and henceof their potential future evolution. And
they would presumably also wish to geta sense of how reliable or accurate thosemeasures are. Combined, these three
elements would provide the raw materialto inform views about expected returnsproperly adjusted for risk and for the
inevitable uncertainties that surround
measurement. Three types of information correspond to the key
categories into which the ideal set canbe divided namely: first-momentinformation, risk information and
measurement error information.
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the management accountant, February, 2009 101
First-moment information
describes income, the balance sheet and
cash flows at a point in time. It is by farthe type of information with the longest
tradition in accounting; it is, in fact, the
type with which accounting has often
been identified. In historical cost
accounting, much of this information is
of a contemporaneous or backward-
looking nature. However, even
according to this valuation principle, it
would inevitably include forward-
looking elements too, whenever the
valuation of an item is based on
expectations about the future. This istrue (implicitly) at inception, when the
transaction occurs. But it can also be
true in subsequent periods, whenever
the value of an item is adjusted based
on some estimate of future cash flows,
and the earnings figure is seen as the
period-to-period change in those
estimates. For example, loan loss
provisions are based on future
discounted cash flows. More generally,
forward looking elements are inherent
in accruals adjustments. By contrast, theforward-looking component is intrinsic,
for instance, fair value accounting. It is
implicit to the extent that market values
embody such expectations. It is explicit
whenever “models” are used to derive
fair values.
Risk information is fundamentally
forward-looking. Future profits, future
cash flows and future valuations are
intrinsically uncertain. Risk information
is designed to capture the prospective
range of outcomes or statisticaldispersion for the variables of interest
as measured at a particular point in time.
More specifically, to the extent that the
behaviour of these variables can be
represented by probability distri-
butions, risk information would ideally
provide the best estimate of the
corresponding (unconditional)
probability distributions. Value-at-risk
or cash-flow-at-risk measures, for
example, are summary statistics of such
estimated probability distributions of
future outcomes. But one should
include in this category also information
that is not so easily captured byprobability measures, such as the
outcome of stress tests and sensitivity
analyses. Importantly, any such
directional information, which indicates
whether firms are long or short specific
risk factors, could also help to assess
the potential co-variation in
performance measures across firms,
particularly relevant to allow investors
to assess the degree of diversification
in their portfolios.
Me asuremen t er ror informationdesignates the margin of error or
uncertainty that surrounds the
measurement of the variables of interest,
including those that quantify risk. The
need for this type of information arises
whenever these variables have to be
estimated. For instance, measurement
error would be zero for first-moment
information concerning items that were
valued at observable market prices and
for which a deep and liquid market
existed. But it would be positive if, say,such items were traded in illiquid
markets, since a number of assumptions
would need to be made to arrive at such
estimates.
Measurement error information is even
less developed, although significant
improvements have been made or
proposed more recently. Firms generally
provide estimates of first-moment and
risk information as if they had no
The Ideal Information Set (Table 1)
Financial Characteristic Illustrations Availability
First-moment information Income statement Very high
Balance sheet statement
Cash flow statement
Risk information Earning-at-risk and Medium
value-at-risk
Portfolio stress test
Measurement Error Sensitivity analysis to Low
parameter values
Comparison of outcomes with
previous estimates
uncertainty attached to them. One
important long-standing exception to
this common practice is that sometimesfirms have disclosed additional
information about the assumptions that
underlie the estimates, possibly
accompanied by sensitivity analysis. In
addition, the disclosure of a comparison
of previous forecasts with actual
outcomes remains very unsystematic.
While the broad thrust of the steps
taken in recent years towards greater
disclosure of risk and measurement error
information is very welcome, arguably
the state of affairs still falls short of whatis desirable and feasible. There are a
number of reasons for this:
First, unless it is assumed that market
participants somehow “see through”
the information provided in financial
statements and reach for any missing
elements, the information disclosed
does not as yet seem sufficient to form
a proper view of the potential benefits
and risks of investing in a firm.
Second, the changing composition of
the investor base lends further supportto the need to go beyond first-moment
information. It has sometimes been
argued that the emphasis on first-
moment information is a natural result
of the focus on the needs of equity
holders.
Third, historical experience suggests
that a key objection to the disclosure of
information, namely proprietary
concerns, can easily be exaggerated. In
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102 the management accountant, February, 2009
particular, the set of what has been
regarded as private information has
steadily been shrinking. For instance,information was initially limited to the
balance sheet rather than earnings; and
when earnings information became
public, revenue information was
originally regarded as proprietary.
Fourth, measurement technology
has already proceeded to a point that
additional meaningful information could
be supplied, at relatively low cost.
Advances in measurement technology
over the last 30 years or so have been
enormous.
Fifth, the process of edging closer
towards the ideal information set should
be seen as evolutionary and as tailored
to the characteristics of reporting
entities. It should be seen as
evolutionary because it is important
that progress be made at a measured
pace consistent with the developments
in, and the spreading of, risk
measurement technology. Finally, and
more generally, valuations are
fundamentally affected by risk anduncertainties and by attitudes towards
risk, as captured by risk premia.
Therefore, first-moment, risk and
measurement error information are
inextricably linked. The quality of first-
moment information itself is dependent
on the quality of risk and measurement
error information. As an accounting
framework for first-moment information,
which incorporates more forward-
looking elements, is developed, the
importance of risk and measurementerror information will inevitably become
more obvious.
Risk Reporting and the gap between
Accounting and Economic valuations
It is now time to explore in more
detail the factors that can lead to a gap
between accounting valuations, on the
one hand, and underlying economic
valuations, on the other, and how this
gap might be narrowed. Greater
consistency with sound risk
management can help to bridge the
divide.
The most controversial issuesgiving rise to tensions between the
accounting standard setters, risk
managers and prudential supervisors
often arise precisely for the same
reasons. We can consider the following
implications:
First, the definitions of assets and
liabilities may not necessarily include
all the cash flows that the firm (or the
“market”) considers when making
decisions; typically, in fact, they are more
restrictive. Examples: intangibles,growth options, and, more generally,
cash flows associated with anticipated,
but as yet not contracted, income
streams. Depending on the
predictability of such cash flows, the
firm may understandably wish to take
them into account in its business and
hedging decisions. Accounting
standard setters, however, may not find
it consistent with their framework.
Second, even if the asset/liability
meets the relevant accountingdefinition, it might not meet the
standards for recognition on the
balance sheet. Failure to recognize
internally generated intangibles is a clear
case in point. In this case, the results
are analogous to those where the
accounting definitions do not
correspond to those effectively
employed in the running of the business.
Finally, in “economic” and
“reported” values, a gap may arise from
the use of different valuation principlesfor different items in the balance sheet.
The most common source of such
mismatches is the current mix of
historical and fair value principles
applied to the accounts.
Factors for such discrepancies: One
factor may simply be the piecemeal
evolution of the accounting standards,
particularly relevant in relation to
aspects of the coexistence of different
measurement attributes, such as
historical and fair-value elements.
A second factor relates to specific
aspects of the definitions. For instance,
an entity should have a sufficientdegree of “control” over the cash flows
associated with an asset before the item
is deemed to meet the definition of an
asset and “past transactions and
events” have to be clearly associated
with its control. More fundamentally
perhaps, a third factor relates to the
degree of verifiability of the cash flows
associated with the assets (liabilities).
Indeed, issues of control or the stress
on the relevance of “past transactions
and events” may arguably at least partlybe traced to difficulties in verifying the
corresponding cash flows, especially
when future cash flows are involved.
The gap between accounting and
closer approximations to underlying
economic valuations can clearly distort
the accounts and, in a world of imperfect
and costly information, also economic
behaviour.
A second, even more widespread,
concern is that the mismatch can result
in “artificial” volatility in net worth andincome measures, i.e, volatility that in
some sense does not reflect “underlying
economic volatility”. On the one hand,
this artificial volatility could distort the
behaviour of investors, unnecessarily
increasing financing costs. In some
sense, the firm would be perceived as
“artificially risky”. On the other hand, it
could encourage inappropriate hedging
practices, as the firm came under
pressure to hedge the volatility in the
accounting numbers as opposed to theone that might be closer to the
underlying economic volatility
associated with the economic substance
of the transactions. The complex
apparatus of hedge accounting is
precisely aimed at limiting the effects of
the mismatches on the volatility of the
balance sheet and the income
statements arising from mixed-attribute
accounting. This measured volatility
would still exist, but would be smaller, if
only entity-specific and fair values
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the management accountant, February, 2009 103
coexisted in the same framework,
because of the different inputs. The
accounting standard seems to be goingin this direction. But the volatility would
not be eliminated completely even in a
full fair value arrangement.
Revealing illustrations of the
potential tensions between accounting
and firms’ perspectives on valuation
and volatility arising from definitional
and recognition issues include the
treatment of demand deposits, which
has attracted much attention in recent
years. For the purposes of business
planning and risk management, financialinstitutions have been accustomed to
treat the corresponding instruments on
the basis of their behavioural
(“expected”), as opposed to
contractual, maturity, with this
(statistically) expected maturity being
estimated with reference to historical
patterns. This has obvious implications
for the hedging of interest rate risk, as
actual maturities are much longer than
contractual ones, especially if the latter
are interpreted as the shortest time
interval within which the withdrawal/
cancellation option can be exercised.
Let’s consider the case of demand
deposits. The accountant would treat
the deposits individually. And would
consider each deposit as the
outstanding balance at a point in time,
with potential future additions and
withdrawals even by the same
depositor representing new, future
transactions over which the institution
has no control. As such, thesetransactions would be excluded from
consideration, as not meeting the
definition of an outstanding asset/
liability. The corresponding expected
maturity of the deposit would then be
very short, days, weeks or months rather
than years. In contrast, the perspective
of the firm is entirely different. Even for
a single deposit account, it would
consider the average balance as being
the relevant criterion. Moreover, it
would tend to focus on the whole stock
of deposits at a point in time across all
deposit holders, normally even
offsetting the transactions of newdepositors against those done by old
depositors. The resulting expected
maturity of the deposit base would be
quite long, typically years. In fact, banks
regard such core deposits as one of the
most stable sources of funds at their
disposal.
This suggests that it would be
desirable to seek to close the gap
between the way these issues are dealt
with in the accounting and in the
internal running of the firm. It seems tous that the economic substance of the
transactions is closer to the latter than
to the former. The risk is that prudent
economic hedging may be discouraged
at the expense of uneconomic hedging
aimed exclusively at accounting
numbers and that, more generally,
information signals may be distorted.
How exactly this could be done is not
clear. The possible solutions do depend
on detailed interpretations of definitions
and concepts and also on potential
knock-on effects on other parts of the
accounting framework. But the general
direction is clear: paying closer
attention to consistency with sound
risk management practices and risk
reporting holds useful clues about how
to narrow the gap. It is clearly unrealistic
to expect that the needs of accounting
and risk management could be fully
reconciled. Tensions are bound to
remain as a result of differences in the
objectives and “degrees of freedom” in
the two disciplines. Questions of whatcan and cannot be recognized as assets
and liabilities, based on criteria such as
the verifiability of the corresponding
Accounting Risk Management
Unit of analysis Individual basis Portfolio basis
Future changes in balance Excluded Included (statistical basis)
Maturity Very short Long (behavioural)
Impact of a rise in market Zero (face value) Fall (profit)
rates on valuation
Narrowing the Gap: Demand Deposits (Table 2)
amounts, are an obvious example. Even
so, there seems to be considerable
scope for a narrowing of the gapbetween the two perspectives. It is
desirable to strengthen efforts to this
end.
Risk reporting and consistency of
Accounting Standards:
Though risk reporting is gaining
importance in the edge of global
integration of business and stock
markets, emergence of derivatives and
other risk products, increasing
corporate failures still there is no
specific accounting standard issuedeither by the IASB or by the FASB. Each
of these agencies has risk reporting
disclosure requirements under specific
accounting standards. Among various
IASs and IFRSs issued by the IASB,
the IFRS-7 on “Financial Instruments:
Disclosures” covers the disclosure of
nature and extent of risks arising from
financial instruments. Similarly IFRS-4
on “Insurance Contracts” prescribes the
disclosure requirements in insurance
contracts. An insurer should discloseinformation relating to company’s risk
management policies and objectives,
insurance risk, interest rate and credit
risk, exposure to interest rate or market
risk under embedded derivatives that
are contained in a host of insurance
contracts. IAS-1 encourages
enterprises to present, outside financial
statements, a financial review by
management, which should describe and
explain the main features of the
enterprise’s financial performance and
financial position as well as principle
uncertainties it faces. IAS-21
encourages the disclosure of an
enterprise’s foreign currency risk
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104 the management accountant, February, 2009
management policies. IAS-37 requires
the information is provided about risks
for which provisions have beenrecognized in the balance sheet. For
each class of provision an enterprise
should provide a brief description of the
nature of the obligation and the
expected timing of resulting outflows
of economic benefits as well as
uncertainties about the amount or
timing of those outflows.
In India, ICAI, like IASB, is yet to
pronounce an independent accounting
standard on risk reporting. Like IFRSs
and IASs, the Indian Accounting
Standards very cursorily deal with some
of the risk aspects. AS-11 (Revised) on
“The effects of changes in foreign
exchange rates” and exposure draft on
“Presentation of financial instruments”
deal with risk reporting only to a little
extent. AS-11 expects companies to
disclose their foreign exchange risk
management policies and framework.
The German Accounting Standards
Board issued GAS-5 on “Risk Reporting” in 2000, which was
applicable from 31st December 2000. The
standard is applicable to all parent
organizations, which are either limited
liability companies or enterprises
equivalent to such companies and to
enterprises, which are required to
present consolidated financial
statements. The standard prescribes
that information should be presented
in a self contained section of the group
management report.Risk reporting is based on following
criterion:
Criterion I – Reliance on Principles-
Based Accounting Standards:
In general, the principles-based
IFRS framework seems particularly well-
tailored to international implementation.
Legal, tax and regulatory environments
differ from one country or economic
area to another, so that the flexibility
provided by a principles-based
approach seems highly suitable.
Although the trend towards increasing
financial integration reduces thosepeculiarities, principles-based
standards fit better to this type of
situation. The IFRSs set out general
principles, which include examples or
application guidance, but without
presuming to capture every kind of
operation in a specific rule. Hence,
accountants and auditors are left room
for judgement and adaptation under the
IFRSs. However, the IFRS framework
appears to be relatively prescriptive, i.e.
much closer to a rules-based approach,
in the specific area of financial
instruments (i.e. IAS 39). Indeed, if
hedge accounting is taken as an
example, institutions need to comply
with a strict set of requirements. Given
the possibility of deferring or bringing
profits or losses forward, it is
understandable that the IASB has come
to the conclusion that this discretion
be governed by stricter and detailed
rules. Nevertheless, there is some
inconsistency with the global
principles-based approach, which could
also create complex implementation
issues.
Criterion II – Use of Reliable and
Relevant Values:
For instruments or operations that
have a short time horizon and that are
traded in active, deep and liquid
markets, historical cost is close to
meaningless and the reliability and
relevance of market or model values isnot questioned. These market values
are easily determined from observable
market prices, which should incorporate
all relevant information, or from widely
accepted models that mainly use
observable market inputs. Hence, in this
context, market or model values do,
indeed, provide appropriate signals for
economic decisions. However, concerns
arise upon departure from that stylised
set of assumptions. Moreover, liquidity
may also vary over time, depending on
current economic conditions.
Unexpected or sudden developmentscould also rapidly affect the liquidity of
operations within an economic sector.
In a nutshell, “marking-to-market”
values are not always a synonym for
“fair” values. Limitations or difficulties
can arise when valuing, for example, (i)
“tailored” or complex products that
cannot be priced through generally
accepted models or that require
unobservable inputs for pricing, or (ii)
long term financial instruments that are
extremely sensitive to the underlying
parameters, i.e. cases where a marginal
change in one of the model’s parameters
results in a material change in the value.
IFRS 7 (Financial Instruments:
Disclosures) may partially address this
issue as firms have to disclose the
consequences of probable changes in
the parameters, but the bottom-line
figures will remain subject to this pricing
fragility.
Criterion III – Recognition of theAllocation and Magnitude of Risks:
The IFRSs should improve the
information pertaining to the financial
position of the bank, as the accounting
standards require a more comprehensive
recognition of risks in the balance sheet.
Indeed, all derivatives will have to be
reported in the balance sheet at their
fair value. This is a significant and highly
welcomed improvement over the rules
previously existing in most European
countries, where derivatives not heldfor trading were kept off-balance-sheet
at cost, thus concealing the effective
risks incurred. The IFRS rules for de-
recognition and consolidation could
also have a favourable impact as they
seem adequately to reflect effective risk
exposures in most situations. Indeed,
the IFRS approach for de-recognition
mixes a risk-and-reward approach,
which tends to precisely track the
economic allocation of risks, with a
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the management accountant, February, 2009 105
control-oriented approach, while giving
precedence to economic substance over
the legal form. Such rules could beregarded as particularly helpful both in
a context where risk transfers are
developing between banks, on the one
hand, and insurance companies, mutual
funds, hedge funds and pension funds,
on the other, and with a view to the
potential financial stability implications
if unidentified risks were to emerge.
Criterion IV – Provision of Comparable
Financial Statements:
The adoption of commonaccounting standards in Europe as such
means a major improvement in the
comparability of financial statements. In
principle, the introduction of the IFRSs
provides a substantial increase in
comparability and transparency. An
analysis of the current situation in
Europe, however, leads to the
observation that this benefit has not
been fully reaped, as implementation of
the IFRSs appears, discussions with
market participants showed differencesin the implementation of the IFRSs, in
particular on account of strong domestic
accounting cultures and divergent
positions among external auditors
across jurisdictions. In this context, the
IFRSs should not cover provisions, nor
should their implementation create
ambiguities that could jeopardize the
objective of enhanced comparability.
However, certain provisions of the
IFRSs, notably IAS 39, considers
financial instruments that are effectivelyexposed to credit risk, thus excluding
other financial instruments such as
government bonds from the argument.
For the purpose of measurement, IAS
39 groups financial instruments into
four categories that are based on
management intent. The intent behind
management’s holding an instrument is
also used as the determining factor in
existing local European rules. It is thus
an accepted accounting convention
that different values can appear in the
balance sheet for similar financial
instruments, depending on the natureof, or intent behind, their use. It is also
consistent with the objective that
accounting should be aligned to sound
risk management practices. However,
some aspects of IAS 39 may raise
concerns about comparability insofar as
it permits identical or similar positions
that are managed in the same way to be
accounted for differently.
Criterion V – Alignment of Accounting
Rules with Sound Risk Management
Practices:
When comparing international
accounting rules with sound risk
management practices, three main
issues arise regarding trading,
provisioning and hedging. With regard
to trading, marking-to-market or
marking-to-model measurements, when
appropriately calculated, provide senior
managers and, eventually, stakeholders
with very useful early warning signals
on exposures. The immediate impact onprofitability is generally a strong
incentive to adequately manage
exposures. This anticipatory effect can
be considered a sound risk management
tool on an individual basis. Where
provisioning is concerned, accounting
should ideally incorporate a pro-active
approach that is comparable to sound
credit risk management, which tries to
identify expected collective losses as
soon as possible, in particular those that
may be embedded in loans and relate tosectoral, geographical or even global
monetary and other economic
developments, be they existing or
anticipated. With regard to hedge
accounting, the IFRSs should reflect the
economic substance of the
transactions. Despite improvements
introduced to IAS 39 (Financial
Instruments: Recognition and
Measurement) that bring hedge
accounting closer to the risk
management methods used by credit
institutions.
Criterion VI – Promotion of a Forward-
Looking Recognition of Risks:
Two issues could be considered in
this context: (i) the forward-looking
nature of “fair” value accounting and
(ii) the incorporation of forward-looking
elements in the provisioning of
instruments measured at amortized cost.
Fair value accounting could be regarded
as forward-looking by nature, given that
expectations regarding the future
performance of assets and liabilitiesshould, in theory, be reflected in market
valuations. Indeed, fair value leads to
the revaluation of an asset when there
is a change in its market price or (in the
absence of a market for the asset) in the
present value of the future stream of
cash flows to be generated by the asset.
Risk Reporting Disclosure: The Indian
Scenario
In spite of making it compulsory for
all listed companies in India to disclose
(in their report of Board of Directors)
the risks faced and the adequacy of risk
management processes in their
organizations, the quality of such
disclosures are not satisfactory. Except
for some of the leading software
development companies, not many
Indian Companies have recognized the
importance of integrated risk
management. Most of the companies
are adopting defensive approach to
minimize the negative impact of risk.
Even in banks and financial institutions,
where success largely depends on
striking a balance between enhancing
profits and managing risk, the attention
to risk identification, measurement and
monitoring is not adequate. This is
evident from the quality of their risk
reporting and disclosures. Mathe-
matical modeling and sensitivity
analysis, which indicate how much the
company will be affected by risk
exposure, is missing in the disclosures.
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the management accountant, February, 2009 107
Operational Risk: AnImportant Issue inModern BankingOperational risk of banks is really a tough task to quantify and the non-
availability of data due to operational loss makes the task tougher. The revised
accord for regulating banking risk, known as BASEL-II, has given a new
dimension to the measurement procedure of this risk. This paper focuses on the
problems