Accounting's Operational-Risk Missing Link

What do chemists and accountants have in common? Surprisingly, quite a lot. They are both data analysts and researchers whose core function is to manipulate and experiment with substances to produce compounds that allow humankind to evolve positively and safely.

For accountants, substances are the transactions registered in accounting systems that relate to all the contractual obligations entered into by a business, and the receipts and payments that emanate from them. Accountants are skilled in categorizing and manipulating transactions through devices such as depreciation, amortization, accruals, prepayments, allocations, valuations; and aggregating the outputs to produce accounting measures such as profit, equity, net interest income, unit cost, return on investment and many more. Accounting measures provide a common language for the interpretation of financial information and ensure that decisions and actions affecting the business are safe.

Unsafe Profits, Unexpected Losses

But what if reported profits are unsafe? The most toxic construct is a business that reports profits when, in fact, it is loss-making. The danger here is that investors, employees and the public purse are enriched through dividends, discretionary bonuses and income taxes in the misguided belief they are receiving their rightful share of the profits. This is a potentially life-threatening condition given the compounding negative impact on capital and liquidity through real losses masked as profits that are further depleted by unwarranted dividends, discretionary bonuses and income taxes. If uncorrected, bankruptcy is the inevitable outcome.

There are two main causes of unsafe profits. The first is the intentional falsification of accounting records that independent auditors fail to detect. The second is the unidentified and unreported accumulation of exposures to non-financial risks that, unlike financial exposures, have not yet found a common expression in the form of accounting measures.

Accounting for Non-Financial Risks

Banks' C-suite executives navigate their organizations through a minefield of non-financial risks in a global risk landscape that has evolved from simple and benign to complex and treacherous. Operational, cyber, model, conduct, geopolitical, reputational, legal and other risk types lurk in every corner of the global financial system.

The non-reporting in financial statements of expected future losses associated with accumulating non-financial risks can have catastrophic consequences. The day inevitably comes when accumulations of unreported risk exposures reach a tipping point, and the faÇade of a healthy financial performance and condition is suddenly unmasked through losses euphemistically termed “unexpected.” It's a CEO's and CFO's worst nightmare.

As we have seen from the subprime fiasco, the misguided or fraudulent activities of rogue traders, the JPMorgan London Whale, regulatory penalties due to compliance failures, compensation paid as a consequence of product mis-selling and numerous IT failures, such unexpected losses can severely dent, or even wipe out, a bank's capital.

It is sound accounting practice to adjust accounting profits for expected future losses associated with the exposures to risk created when making those profits. This is commensurate with the fundamental accounting principle that revenues and expenses should be recognized when they are incurred - the so-called accrual concept. If a firm creates a risk, it also creates a probability of loss. If that probability of loss can be reasonably calculated, it should be accounted for upon its creation.

Accounting provisions for expected credit losses have been required since 2018; there is no equivalent requirement to account for the expected losses associated with non-financial risks. This gap in GAAP (generally accepted accounting principles) needs to be fixed.

A Shift in Focus

Operational risk managers should ponder on how their work would be viewed if color-coded risk and control self-assessments (RCSAs) were to be translated into an expected loss accounting measure that is used to adjust profits. Boards and C-suite executives can choose whether or not to respond to a traffic light report; at best, they will ask for assurance that red and amber risks are being addressed, which they invariably get. But, if red and amber risks were to result in a charge to reported profits, corrective action becomes a corporate imperative, given the direct impact on the wallets of investors, employees and the public purse. The resulting shift in management's focus onto a risk mitigation and loss prevention agenda will inevitably be counterbalanced by the greater accountability and visibility of operational risk management.

The attributes of an effective accounting measure are that it fairly represents the object of the measure in monetary terms, is derived from and traceable to transactions registered in accounting systems, is immediately responsive to management actions or changes in operating conditions, complies with GAAP, is auditable and is directly comparable within and between business concerns. These attributes relative to non-financial risks are potentially available in a new and developing branch of accounting, “risk accounting.”

Academics have codified a theoretical risk accounting model that is currently undergoing viability testing. They acknowledge that its successful adoption requires accountants and risk managers to collaborate in a common endeavor aimed at taking the reporting of non-financial risks to the next level.

Peter Hughes (peter.j.hughes@durham.ac.uk) is chairman of the Risk Accounting Standards Board at serraq.org. He is a visiting fellow and advisory board member of the Durham University Business School's Centre for Banking, Institutions & Development (CBID). See his previous GARP Risk Intelligence article, Non-Financial Risks: Developments in Accounting.