Risk Management: Definition, Types, and Future

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Table of Contents

Introduction
Definition
Types of Risk
Role of Accountants
Impact on Accounting Quality
Risk Management and Corporate Governance
Future of Risk Management
Biblical Worldview
Conclusion
References

Introduction

From the perspective of business accounting, risk management involves the assessment, evaluation, and mitigation of risk within the practices of an organization. Typically, risk management is seen as a strategic management concept, but within the context of modern businesses, accounting contributes strongly and is heavily invested in risk aversion. Enterprise risk management should be at the core of a professional accounting mindset, and to add value, accountants must be outward-looking risk experts that offer insight for their organizations when meeting their objectives or responding to uncertainty. Finance and accounting provide key quality information to management in a timely manner that can be used by managers at all levels for informed decision-making (Camilleri & Camilleri, 2017). Accounting is a tool for success, working with operating management to make conducive decisions, take on evaluated risks, and achieve enterprise strategic goals.

Definition

Risk management is a comprehensive process of identifying, analyzing, and mitigating/accepting the risk of uncertainty. Risk is quantifiable in both absolute and relative terms and becomes ultimately inseparable from return on investment. Despite risk being viewed in negative terms, it is necessary to achieve performance objectives. In its basic form in accounting, the risk is a deviation from the expected outcome (Camilleri & Camilleri, 2017). The deviation is either positive or negative, but it is generally accepted by financial professionals that increased returns come at greater risk and, in turn, come from increased volatility. Accountants consistently search for means to reduce volatility and risk through the use of various metrics such as standard deviation, distributions, and dispersions. Risk assessment is one of the key components of internal control in organizations, identifying areas of risk loss via accounting records and implementing adequate controls (Needles et al., 2014). Evaluating risk statistically and numerically allows for highly informed decision-making in regard to existing or potential risks.

Risk has traditionally been defined in terms of the chance of danger, loss, injury, or other negative consequences. In accounting, the risk is viewed from the perspective of decision trees, probability distributions, cost-volume-profit analysis, pricing models, cash flow models, and many other frameworks. Risk management allows one to methodically address risk, immediately attaching it to organizational activities and pursuing organizational objectives. Effective risk management consists of assessment, evaluation, treatment, and reporting. Meanwhile, the more in-depth enterprise risk management approach is aimed at aligning risk management with a business strategy and embedding a management culture into business operations (Collier et al., 2006).

Types of Risk

Risk is broken down into categories allowing for more effective and efficient comparison and evaluation. Risk will always be existent to some extent, so accountants must understand that some level of risk is viable, but tradeoffs and opportunity costs must be considered to either eliminate or maintain some risks. Therefore, it may be helpful to categorize risks, but different institutions may approach this differently.

Market risk – changing conditions in the marketplace where the organization operates, ranging from general market tendencies to specific company-specific elements.
Credit risk – stemming from the risk associated with credit extended to customers and/or suppliers, with the risk that either can default. The company must also ensure that it meets its own credit obligations in a timely manner.
Liquidity risk – this can include asset liquidity and operational funding liquidity. The company must have cash on hand to pay for basic expenses, balancing its assets and operational funding.
Operational risk – risk arising from daily business activities, ranging from crises and lawsuits to fraud and business models (Camilleri & Camilleri, 2017).

Role of Accountants

Accountants have an important role in helping organizations with internal controls and risk management processes. It is one of the core competencies of accountancy as a profession to oversee and improve internal control programs in an organization. They ensure that staff members are away of risk control language and standards, which must be met with all financial operations. Accountants virtually create the standards and then implement them in an organization (Needles et al., 2014). In a way, accountants are key strategic partners in decision-making management in risk management and consideration.

Accountants are most effective at risk management when they have an understanding of enterprise risk management (ERM) and applications of daily operations of a business. Companies with ERM strategies in place generally thrive better in risk and can focus on business continuity. A significant portion of companies is reactive to risks rather than proactive, and risk management is an activity that is best undertaken offensively before anyone is prepared. In order to do so competently, companies need accounting staff that can measure and manage risks accurately in all their forms. However, for ERM to work, it must be linked directly to company strategy and actions. Accountants have direct insight into a company’s finances and supply chains, so they work cross-functionally with other departments, such as H.R., I.T., sustainability, and others, to essentially evaluate financial and non-financial risks across the organization to construct a holistic risk framework (Thompson, 2020).

Impact on Accounting Quality

ERM gained significant attention and popularity in the midst of the 2008 crisis. It is believed to enhance a company’s ability to soften the impact of a major economic crisis as well as lead to an improved value relevance of account information for firms adopting ERM. Accounting quality is not a clearly defined term but generally implies that the value relevance of accounting information is considered and the ability of accounting information to reflect the true performance of an organization. Some common characteristics highlighted as vital to accounting quality are timeliness and timely loss recognition, accrual quality, earnings management, and discretionary accruals (Olayinka et al., 2019).

Accounting quality allows firms to reduce earnings management, minimize discretionary accrual, and offer great information on earnings. It is a vital measure of the value relevance of accounting for an organization seeking sustainable growth. ERM became popular around the world because it is meant to enhance the accuracy of corporate disclosure, improve the reliability of financial statements, develop stronger risk management, and enhance accounting quality. Therefore, accounting is directly interrelated with risk management and prevention in such systems. Accounting is vital for ERM function, while ERM seeks to enhance accounting processes by improving financial reporting quality and strengthening the internal processes of an organization (Olayinka et al., 2019).

Risk Management and Corporate Governance

Competent corporate governance is a result of an effective risk management system that creates a controlled environment. This is why much recent legislation around the world, including the Dodd-Frank Act in the U.S. in response to the 2008 financial crisis, requires effective risk management implemented in firms. Management accounting, under the concepts of risk and governance, has to be managerially actionable in order for their role and proficiency to be interpretable in logical and predictable terms. While risk management is the foundation of modern management control, management accounting is directly influencing corporate governance. For example, failure to provide accurate accounting reports and then use these reports inefficiently by risk management will have a negative impact on corporate governance. There is an inherent interdependence between risk management, managerial accounting, and corporate governance (Van der Poll & Mthiyane, 2018).

The design and utilization of strategic management accounting techniques are based on strategic information collection to address environmental uncertainties to support strategic decision-making. As part of the organizational structure, it is the role of the board as part of corporate governance to formulate a successful strategy, with managerial accounting reports enabling this task. Strategic management accounting is the basis for strategic positioning, which includes Porter’s competitive advantage and strategic cost exploration. Therefore, the usefulness of management accounts in risk management is paramount and is necessary for sustainability. However, if a firm chooses to ignore the strategic position, management accounting can then be used as a mitigation strategy. This once again demonstrates the triangle, side-by-side interdependence between corporate governance, risk management, and management accounting, and companies should recognize this interdependence (Van der Poll & Mthiyane, 2018).

Therefore, to understand how accounting systems influence risk management, it is important to view the firm as a governance coordinating mechanism for information provided to individuals. The objective is that the correct information is shared with targeted teams, departments, and individuals to whom they are relevant and enable them to undertake the tasks which fall under their responsibility. Effective information provision seeks to support efficient operations and primary concerns regarding risk management. Another important step is to extract meaning from the information, which requires expert judgment to interpret various calculative practices for risk assessment, such as the interpretation of uncertainty (Brookfield, 2018). Management accounting is a critical aspect of a company. However, even its elements can have certain challenges. For example, transparency, which is exalted as necessary for smooth governance, can be concerning. Evidence has shown that not all firms utilize management accounting in risk management for governance purposes. Some viewed M.A. statements but chose to ignore them; others presented manipulated healthy financial information, which was inaccurate, leading to collapse in both cases (Van der Poll & Mthiyane, 2018).

Multiple organizations adopt ERM to meet compliance regulations and virtually ignore the need to proceed with risks strategically. However, a comprehensive ERM approach is more effective. First, management accountants are asked to aid the organization in identifying risks and opportunities with events that have not yet occurred. Accounting is also asked to determine probabilities of occurrence and financial outcomes of these events, as well as justify why substantial investment controls of said risks are necessary even though there are chances they will never happen. Management accountants are familiar with regulatory standards, have direct lines to top executives, and usually have the experience for informed advising to decision-making parties. Management accountants play internal control roles in various ERM activities, and these activities may be aimed at multiple stages of risk management, from risk prevention itself, such as staff training, information on new software, etc., to actually resolving problems when confronted with consumers or regulators (analyzing costs of alternative ways of delivering repairs). Despite this, the profession still has no clear taxonomy regarding the role of management accountants in ERM activities (Bento et al., 2018).

While research and regulatory body of guidance and frameworks in ERM are becoming extensive, management accountants are still creating new territory regarding ERM practices. Management accountants have specialized experience and training on how to measure, report and analyze the financial and non-financial impact of decisions. Given leadership roles, management accountants can develop truly enterprise-focused ERM systems that are not dependent on functional silos but seek to permeate decision-making through the organization. This fits into the new paradigm of management accounting which calls to broaden its professional strategic scope and be better than a myopic view of planning and control, measuring the performance of the past and being able to make forward-predictive measurements about organizational sustainability and risk (Bento et al., 2018).

In a complex dynamic market environment, the effectiveness of risk mitigation may be difficult to pinpoint. The point of ERM is not to maximize profits but rather to create an equilibrium that is optimal and conditioned on its environment. The organization reaches a status quo where desired outcomes are reproduced from transactions undertaken that motivated the firm creation in the first place. Therefore, the issue adjusts from a static set of accounting-based budget targets to a process of equilibrium. Accounting and accounting technologies contribute immensely to organizational effectiveness and follow all other elements of organizational hierarchy closely (Brookfield, 2018). The key to remember is that information provision is always central to accounting technology and its role in effective risk mitigation.

Future of Risk Management

Currently, the financial industry is undergoing significant changes with the advent of blockchain and fintech technology. Blockchain is a disruptive element in currency, supply chains, and information-sharing practices. However, as with any new technology and practices, it will present additional risks. Accounting and ERM will be at the helm by addressing aspects of financial data integrity issues, financial reporting risks, and implications for external auditors. Firms that adopt blockchain will have to adjust their policies and accounting practices over internal controls and counterparty risk assessment. Both internal and external auditors will have to assess blockchain implementation primarily as a financial reporting risk (Smith & Castonguay, 2019).

Advancements in fintech are rapidly advancing, with up to a quarter of global financial institutions being at risk in the near future. The primary benefit of financial tech is eliminating elements of costly data entry and analysis. However, fintech has built-in logic and compliance with business models being built around data flow, greatly increasing transparency and reducing the time necessary to prepare for an audit example. As a result, accounting practices will shift dramatically as A.I. will be able to fulfill many manual human jobs currently ranging from data entry to selecting the right statistical sample in an audit. On the one hand, it will free up the human potential to focus on big data analysis and actually work with clients to improve business operations. On the other, it signifies an era of rapid change for accounting with changing standards, new issues, and most likely significantly new risks that the industry has not faced beforehand.

Biblical Worldview

Although a significant portion of the Bible concerns itself with faith and trust in the Lord, there are also calls to be prepared, to plan ahead, and to be rational with finances. In Luke 14:25-33, Jesus encourages followers to consider what it takes to follow him. Planning ahead is an important part of committing to any given thing. Jesus illustrates this through a short example, “For which of you, intending to build a tower, does not sit down first and count the cost, whether he has enough to finish – lest, after he has laid the foundation, and is not able to finish, all who see it begin to mock him saying, ‘This man began to build and was not able to finish’” (New International Version, 2011, Luke 14:28-30).

Making a blunt comparison in accounting, this would represent an imbalance between accounts payable and accounts receivable or a new project running out of funding prior to completion. These are risks that accountants consider and calculate in the long term prior to the project being financed even. They account for various risks such as increased costs with time, disrupted supply chains, passed deadlines, accrued costs, and others. As a result, management can make informed decisions based on this, to either postpone building ‘the tower’ or divert resources from other projects or find additional financing. The Christian worldview encourages us to have faith but also be prepared, approaching everything with preparation and responsibility. Risk management and planning for its mitigation are some of the critical elements from an accounting perspective.

Conclusion

Risk management is a key element of accounting, collaborating with organizational management to identify, evaluate, and mitigate deviations from the planned course of actions and finances. Deeply ingrained in enterprise risk management, accounting offers unique insights into organizational status, performance, and sustainability with up-to-date information provided to executives. This paper demonstrates the importance for organizations to invest in reactive risk management systems and accounting foundations in order to navigate and mitigate risks safely and effectively as part of competent governance and corporate sustainability.

References

Bento, R. F., Mertins, L., & White, L. F. (2018). Risk management and internal control: A study of management accounting practice. Advances in Management Accounting, 30, 1–25.

Brookfield, D. (2018). Risk and organizational effectiveness. Journal of Organizational Effectiveness: People and Performance, 5(2), 110–123.

Camilleri, E., & Camilleri, R. (2017). Accounting for financial instruments: A guide to valuation and risk management. Taylor and Francis.

Collier, P.M., Berry, A.J., & Burke, G.T. (2006). Risk and management accounting: best practice guidelines for enterprise-wide internal control procedures. Research Executive Summaries Series 2(11), 1-8.

Smith, S. S., & Castonguay, J. (2019). Blockchain and accounting governance: Emerging issues and considerations for accounting and assurance professionals. Journal of Emerging Technologies in Accounting, 17(1), 119–131.

Needles Jr., B.E., Powers, M., & Crosson, S.V. (2014). Principles of accounting (12th ed.). Cengage Learning.

New International Version Bible. (2011). BibleGateway.

Olayinka, E.A., Uwuigbe, U., Sylvester, E., Ranti Uwuigbe, O., & Osereme Amiolemen, O. (2019). Does enterprise risk management impact accounting quality? Evidence from the Nigerian financial institutions. Investment Management and Financial Innovations, 16(4), 16–27.

Thompson, J. (2020). How management accountants mitigate risk in an uncertain world. Forbes.

Van der Poll, H. M., & Mthiyane, Z. Z. F. (2018). The interdependence of risk management, corporate governance and management accounting. Southern African Business Review, 22.

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