With Pedro Frías
Since the very beginning of my involvement in risk management, one of the issues that interested me the most is the effect of the risk management principles in accounting and control. Accountants and auditors are supposed to ensure the consistency of information to third parties, but, after a discussion on risk mapping, how can we think information is consistent if a complete risk map is not included in the auditors’ report? On the other hand, most firms will not be wiling to do a full disclosure of the output of the risk management committee, for it is extremely sensitive information. This implies a potentially interesting issue for accountants. In an attempt to go deeper in the study of this issue, I asked my longtime friend and colleague Pedro Frías to join me in this post. Pedro, one of the brightest minds in accounting that I came across, has been doing some thinking about this topic. This post is reflecting some of these shared thoughts.
Let’s assume that risk management keeps growing fast and stable as a management trend and its practices will stay for good in the ambiguous practice of management. Then we can imagine a pervasive trend to embody the risk perspective in every formal management and information system, like it is actually emerging in every organization.
In the last fifteen years, two seminal documents were issued to contribute to the raise of risk management’s rank for firm’s external duties: (i) the “Principles of Corporate Governance” of OECD, and (ii) the “Enterprise Risk Management — Integrated Framework” of COSO In both papers there were explicit mentions to the board’s responsibility of the risk assessment, managing and reporting process. The OECD paper points out the time’s imperative: “disclosure about the system for monitoring and managing risk is increasingly regarded as good practice”.
As of today we mostly find some narrative – and somehow generic – description of the firm’s main risks in the management report section of the annual reports of most listed firms. But the risk issue presents some additional and deeper complexities when related to the firms’ primary financial statements: balance sheet, income statement, stockholder’s equity statement, cash flow statement and relates notes. How should we expect accounting to reflect the risk issues in the financial statements? Are accountants prepared to lead the process towards an adequate reflection of the risks and opportunities faced by a firm? Can accountants depart from their old “bean-counter” image?
The road leading to this change is not paved, and the change is likely to be slow. The recent issue of “The Conceptual Framework for Financial Reporting” (IASB 2010), does not include the Management Report or Commentary (i.e. the place in which the main risks are listed) in the primary financial statements enumeration. This leads us to question, in which financial statement should we include the risks considerations? And which are the foundations in which we should ground this analysis?
There are several paths that can lead us to the improve the way we address these topics in financial reporting: 1) revisiting the going concern principle, 2) changing the scope of the forward-looking information that must be included in the financial statements, 3) improving the impairment test, and/or 4) accounting for identified risks like “contingent liabilities”. We offer a brief discussion on each of these paths below. It is obviously not intended to be an exhaustive treatment of each idea, but can be regarded as a kick off that can be discussed in more detail.
Going-concern Principle
This cornerstone accounting principle, is often under-valued by the users of financial statements. Going concern means that if there are doubts about the firm´s continuity the conceptual framework basis should be changed. This principle provides an excellent opportunity for including the principles of risk management into the accounting framework. In the 1989 version of IASB Conceptual Framework the going-concern view was as simple as: “the assumption that an entity is a going concern and will continue in operation for the foreseeable future.” Today the concept is evolving, so we find new ideas like: “When management is aware, in making its assessment, of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, the entity shall disclose those uncertainties. …In assessing whether the going concern assumption is appropriate, management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period.” Obviously, revisiting and reforming the going concern principle, provides a powerful tool to accountants to include the major enterprise risks in their reports.
Forward-looking Information
The International Accounting Standards Board (IASB) is actually running an ambitious project to modify his Conceptual Framework. Their preliminary drafts stem out their purpose of maintaining financial information based in past information. In their draft agenda papers (available at the IFRS website) they are proposing: “Given that financial statements reflect a reporting period, to be relevant the information they contain must arise from past and current conditions, transactions and events. By limiting the notes to the financial statements to information arising from past and current conditions, transactions and events, this discussion paper proposes to limit the type of forward-looking information presented in financial statements. Forward-looking information is information about the future (eg information about prospects and plans) that may later be presented as historical information (ie results).” For the accountants this is a logical way to focus in their main purpose: to properly inform about financial performance of firms and dealing with relevant and verifiable information. Should it be reviewed? How can this be improved?
Improving Impairment Tests
The current accounting standards –IAS 36- Impairment of Assets– prescribe annual tests to reasonably assure that the asset’s value-in-use is greater than the asset´s book value. For the most volatile assets (like intangibles and dedicated physical fixed assets) these tests must include the specific risk exposure they face. But, as of today, these tests are performed with spreadsheets and projections that are not adequately challenged and disclosed, so, in practice they are almost worthless. This offers a valuable opportunity for improving the way accounting is considering and disclosing risk and for addressing risk management practices in a more comprehensive way.
Contingent liabilities
Nowadays, a contingent liability is recorded only if its materialization is probable and if it can be reliably measured. It is mandatory, however, to add the other possible liabilities in a note to the financial statements. But, in order to achieve a more integrated view of the enterprise’s risks, we wonder how accounting standards should accompany the management imperative duty of reporting contingencies in the same line of their management risk’s practices according to what regulators are requiring nowadays. How can we achieve this? Should we need some new sort of SOX act to turn top management accountable for this matter? Should we include downside risk only? How large should these risks be in order to have mandatory disclosure?
In our view, accounting, as a profession, would be at risk if it does not manage to incorporate the new risk practices into their statements in a proper way. Accounting has an opportunity, however, if starts developing these proposed multiple paths, which certainly constitute a challenge, but represent also an interesting opportunity for a sustainable improvement.
