Planning for uncertainty in the risk business

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The Independent Culture
Companies launching products or moving into unfamiliar markets are being advised to publish a `statement of risk'. It would give investors useful clues, and managers would also stand to gain from greater openness, says Roger Trapp

If asked to assess the risks of going mountain climbing, scuba diving or parachuting, most people would have little difficulty. Such activities would rank a fair way ahead of driving a car or riding a bicycle and a long way from something like watching television.

In fact, whether we are conscious of it or not, we weigh up such risks all the time in our daily lives. But when it comes to financial risks, companies seem to be much more circumspect. With the exception of derivatives and other financial instruments that have attracted a lot of interest in recent years, managers tend to gloss over the relative dangers of, say, launching new products or moving into emerging markets - other than to adapt the warning associated with the stock market and note that the value of investments can go down as well as up.

According to a report from the Institute of Chartered Accountants, such an approach does not go far enough. The paper, Financial Reporting of Risk: Proposals for a Statement of Business Risk, argues that the uncertainties inherent in business would be better reflected if companies published a "statement of business risk". This would identify key risks, describe the actions taken to manage them and report on how they are measured. But, in the interests of balance, the statement would cover the opportunities for gain rather than just exposure to loss.

On the face of it, such a move appears to be adding to a burden that many managers are already complaining is too heavy. But Robert Hodgkinson, the Arthur Andersen partner who chaired the steering group responsible for the report, believes companies could find the idea appealing because of the potential benefits it offers.

In a further sign that even accountants are starting to acknowledge the inadequacies of relying on purely financial measures, he points out that it could help to provide practical, forward-looking information of the sort that investors increasingly want. As the report, published last month, states, "The past is fine as a starting point for assessing likely future performance. However, investors and financial markets want information to assist them in their central activity of estimating the size, timing and certainty of future cash flows."

The most obvious response to such worries as well as concerns about the dangers of a short-term emphasis on recent profits and cash flows is to publish forecasts. But recognising that this is not likely to happen for some time, the steering group sees the business risk proposals as "a significant evolutionary step" along this road, because risk is an integral part of any useful reporting of forecasts and because reporting on risk helps investors in making their own forecasts.

Another benefit, argues the paper, which was prepared by a broad cross- section of accountants from public practice, business and academia, is that being open about risk could reduce the cost of capital, which can have a substantial effect on performance.

Finally, as the report stresses, "on the basis that `what gets reported gets managed', a company which adopts a more rigorous and consistent approach to reporting risk is likely to improve its own risk management process". Moreover, such a gain can feed others in that better risk management will enhance cash flow, reduce volatility and reinforce the positive effects on shareholder value that arise from lower interest costs and higher price/earnings ratios. "Robust and visible risk management will improve perceptions of management quality and hence strengthen a company," it concludes.

Mr Hodgkinson, who is also chairman of the institute's financial reporting committee, is aware that the proposals are "challenging", and therefore hopes that companies, investors, regulators and professional advisers will respond by 30 April.

In particular, he recognises that providing better information to capital markets could have "adverse commercial consequences for companies". But he adds that organisations need to decide "where the balance of advantage lies for their shareholders".

And in keeping with the Accounting Standards Board's approach of encouraging companies to disclose as much about potential influences on their performance as possible, he and his colleagues make a strong case for greater openness in this area.

Stressing that risk information contained in companies' prospectuses when they come to the stock market is not updated systematically or formally, he points out: "Currently, investors can use annual reports to learn about returns, but may be quite unaware of the riskiness and volatility of those returns when looking to the future."