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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

[email protected].

Senior Director (Examinations)

Chandana Bose

[email protected].

Senior Director

(Administration & Finance)

R N Pal

[email protected].

Director (Technical)

J. P. [email protected].

Joint Director (CEP)

D. Chandru

[email protected].

Joint Director (Membership)

Kaushik Banerjee

[email protected].

Joint Director (International Affairs)

S. C. Gupta

[email protected].

EDITOR

Sudhir Galande

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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

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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

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Accountants of India, whose permission

is necessary for reproduction in whole

or in part.

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Editorial


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 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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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

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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.

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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

Cover Feature

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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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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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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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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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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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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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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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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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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

feb2009.pdf

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