Risk Management and the Tangled Web of Financial Control, Accounting and Technology

The general business press usually fails to distinguish between financial control professionals and experts concerned with financial statements, tax accounting, audits and other reports generated for outsiders. Financial control is far older than accounting, and is essentially technological, while financial accounting is essentially abstract.

These two branches of accounting have opposite relations to risk management. Financial control and cost accounting are essential for nearly all risk management. Risk managers need access to information about actual physical assets and real liabilities. They rely on competent controllers and cost accountants for basic data to evaluate and manage risk. Moreover, the technologies invented for financial control are needed for risk management as well.

The most important technology improving financial control — and hence risk management — today is blockchain. We’ll discuss this technological innovation at length in a moment, but first let’s examine the role of financial accounting and its relationship to risk management.

While financial statement, tax, regulatory and other forms of abstract accounting used for external reporting are undeniably valuable, they tend to create risk issues rather than resolve or help manage them. Converting everything to a numeraire requires valuation assumptions, and even if the valuations are accurate for arms-length transactions in normal markets, they can be fatally misleading if markets are illiquid or if transactions are not arms-length.

Filling statements with intangibles and plugs can cause problems when decision-makers treat them as real. Worst of all, these statements can only be prepared infrequently – often months past close. Risk managers need to know current reality, not an idealized guess about the past with transactions sorted by rule into before and after categories.

Blockchain: Pros and Cons

This brings us back to the importance of blockchain, distributed-ledger technology that has potential to solve ancient risk management problems.

Blockchains can be decentralized, getting past the problematic issue in financial accounting of consolidated financial statements. Large modern corporations are composed of hundreds or thousands of legal entities in multiple jurisdictions. Some are fully owned and controlled by the parent, some only partially owned or controlled. Moreover, many entities essential to the consolidated entity are deemed outside the consolidation.

This creates many opportunities for risk to accumulate unmonitored, especially for non-financial risk that is made invisible when everything is converted to a numeraire. Increasingly, consumers and regulators care about things like treatment of workers and environmental damage. These can be heavily influenced by upstream or downstream entities omitted from financial statements.

Blockchains allow multiple entities to maintain a reliable consolidated database, without mutual trust. This in turn allows risk managers to recast information for different views of an enterprise appropriate for different decisions; a risk manager could look at, say, regulations that refer to the entire lifecycle of production, or explore concerns about a regulated bank that is included in the consolidated statements of a non-financial company.

Blockchains also offer an immutable record, something that makes fraud much harder to hide. Multiple copies of the database — with enforced consistency — stop one individual or entity from making unauthorized changes or rewriting the past.

Aaron Brown

Blockchains can be very fast and can have a wide reach, with the Bitcoin blockhain, for example, processing transactions for millions of people all over the globe. That means they can offer close to real-time information, cryptographically proven and consistent. Blockchains can also prevent double-counting or omitted transactions.

Another valuable property is the composability of this technology. Blockchains can be easily integrated into other processes without the need for coordination — such as permissions, testing and interface agreements — with the blockchain operation itself. This greatly speeds development. Indeed, the last decade has seen an explosion of applications that allow seamless communication among blockchains.

Naturally, there are also some downsides. A blockchain will be more expensive and complicated than a conventional centralized database maintained by a trusted entity. For many specific risk management applications, moreover, there are better solutions – and, undoubtedly, superior innovations will appear in the future.

Financial Accounting: Innovations and Obstacles

Unlike financial control, financial accounting does not use extremely sophisticated technology today, but the profession has made significant advancements throughout history.

The first person who owned assets he could not see every day needed tools to keep track of them. One simple early technology was to make clay figures that represented the assets. More elaborate innovations were clay balls sealing figures inside to represent contracts; grids to move figures around to represent totals; pictures of assets rather than figures and words and numbers to further describe them; abacuses to count them; and notched sticks that could be split so that two parties had matched records.

Moving up to modern times, we have tools like cash registers, barcodes and scanners and video tracking. We call the people doing these tasks cost accountants, operations staff and bookkeepers, among other names.

Long after people developed ways to track assets and liabilities, some unknown person asked a question like, “Did the operation make a profit last year?” or perhaps, “How much gold can we demand in taxes without destroying this business?” These kinds of questions require abstractions.

All assets and liabilities must be converted to a numeraire — like shekels of silver. Further innovations were double entries and abstractions, such as depreciation, amortization and accruals, which helped align the periods in which revenues and expenses were recognized. Accountants also invented plugs like equity to balance assets and liabilities. None of this required physical technology, other than to record the results.

Today, aside from its technological limitations, financial accounting also struggles with staffing shortages, which partly stems from perceptions of the hardship of the profession. The poet Robert Frost once wrote:

 Never ask of money spent.                         

Where the spender thinks it went.                         

Nobody was ever meant                         

To remember or invent                         

What he did with every cent.                         

It is easy to understand Frost’s aversion to clear public disclosure: he was a Californian living in England trying to be the poet laureate of New England. He did live in that region long enough to drop out of school and go bankrupt — another reason for him to dislike accounting.

I was thinking about this when I ran across a recent Wall Street Journal editorial, “The Accountant Shortage Is Showing Up in Financial Statements.” It mentioned that more and larger public companies are disclosing material weaknesses in their internal control over financial reporting due to a lack of qualified accounting staff.  There is a reasonable possibility that material misstatements could occur more frequently, the article elaborated, because financial institutions cannot attract the quantity and quality of accounting personnel required to prevent or detect such errors on a timely basis.

The reasons for the shortage are well known and longstanding. Enrollment in undergraduate accounting majors has been declining for years, as have the numbers taking the Certified Public Accountancy exam. More people are leaving the profession every year — through retirement or changing fields — than are entering.

Parting Thoughts

Financial control is also suffering from staffing deficiencies. But the reasons for staff shortages in the two types of accounting are opposite.

Financial control from its earliest days has been a technology field, and technology is advancing. People with financial control and cost accounting skills are being hired for IT projects, and IT innovations are increasingly replacing internal human controllers. The same work is being done by many of the same people, but we now call fewer of them accountants.

These same IT advances are making financial accounting skills steadily less valuable. Of course, we’ll always need some expert accounting professors to think about what the rules should be for financial statements, taxes, regulations and other reports.

However, the need for armies of junior people to examine ledgers and accounts, validate entries and opine on policies and procedures is much diminished when all data are available in electronic forms and sophisticated algorithms (including artificial intelligence and machine learning) can do the checking far better, faster and cheaper than overworked college graduates studying for the CPA exam at night. Moreover, there is less need for experienced senior accounting and audit personnel to be deeply versed in the nuts-and-bolts of the work.

The erosion of financial accounting talent should not be a concern. If anything, less trust and reliance on the comforting fictions of financial accounting should reduce the danger in the world.

For the time being, risk managers can cheer the technological advances in the ancient human problem of financial control, rather than worry about the changing job titles of the people doing the work.

Aaron Brown worked on Wall Street since the early 1980s as a trader, portfolio manager, head of mortgage securities and risk manager for several global financial institutions. Most recently he served for 10 years as chief risk officer of the large hedge fund AQR Capital Management. He was named the 2011 GARP Risk Manager of the Year. His books on risk management include The Poker Face of Wall Street, Red-Blooded Risk, Financial Risk Management for Dummies and A World of Chance (with Reuven and Gabriel Brenner). He currently teaches finance and mathematics as an adjunct and writes columns for Bloomberg.