Accounting risk

Accounting risk is the risk that inappropriate accounting information causes suboptimal
decisions to be made and may be due to inappropriate policy, faulty interpretation
of policy, or plain error. We can distinguish accounting risk from fraud,
which is deliberate manipulation of reported numbers, although the faulty interpretation
of policy in a computer system can facilitate fraud, as would appear to have
happened at Kidder Peabody in1994.
Salomon Brothers recorded a USD250 million hit as due to accounting errors in
1994, but most errors which are discovered are wrapped up in other results for the
same reasons that frauds are unless they are really enormous – management judges
the costs from loss to reputation to be too high. Merger provisions are an obvious
dumping ground. Most of the problems discussed in this chapter are unresolved at
many institutions today due to lack of understanding.
Dealing with accounting risk is not something that concerns only the financial
reporting function – decisions which need to be made on accounting matters affect
valuation and risk-reporting systems, interbook dealing mechanisms, and the relationship
of Treasury to trading businesses. Senior management needs to understand
the issues and make consistent decisions.
There is continual tension in most trading organizations between traders and
trading management who want to show profits as high as possible, and the risk,
control, and accounting departments, who are charged by senior management with
ensuring that what is reported is ‘true’.
Most risk information is concerned with looking at what may happen in the future.
Accounting is showing what has already happened. While traders are typically
focused purely on the future, the past does matter. One has to judge performance
based on what has already happened, rather than just on what is promised for the
future. Anything other than the net profit number is generally more relevant for
management and the control functions than for traders.
Direct losses from accounting risk typically happen when a large profit is reported
for a business and significant bonuses are paid out to the personnel involved before
it is discovered that the actual result was a much smaller profit or even a loss. In
addition, extra capital and resources may be diverted to an area which is apparently
highly profitable with the aim of increasing the business’s overall return on capital.
However, if the profitability is not real, the extra costs incurred can decrease the
business’s overall profit. As these losses are dispersed across an organization they
do not receive the same publicity as trading mistakes. Such risks are magnified
where the instruments traded have long lives, so that several years’ bonuses may
have been paid before any losses are recognized. The risk of profits being understated
is generally much lower, because those responsible for generating them will be keen
to show that they have done a good job, and will investigate with great diligence any
problems with the accounting producing unflattering numbers.
Indirect losses from the discovery and disclosure of accounting errors arise only
for those rare mistakes which are too large to hide. The additional losses come from
the associated poor publicity which may cause a downgrade in reputation. This can
result in increased costs for debt and for personnel. Regulators may require expensive
modification to systems and procedures to reduce what they see as the risk of
repetition. In addition, announcements of such failings can lead to the loss of jobs
for multiple levels of management.
In many large trading organizations the daily and monthly accounting functions
have become extremely fragmented, and it is very difficult to see a complete picture
of all the assets and liabilities of the organization. Especially in organizations which
have merged, or expanded into areas of business removed from their original areas,
there is often inconsistency of approach, which may result in substantial distortion
of the overall results. There is often a tendency for individual business lines within
an organization to paint the best possible picture of their own activities. Considerable
discipline is required from head office to ensure that the overall accounts are valid.
In many trading organizations the accounting function is held in low regard. As a
result, many of the people who are best at understanding the policy complications
which arise in accounting find that they are better rewarded in other functions.
These individuals may therefore act in an economically rational manner and move
to another function. The resulting shortage of thinkers in the accounting function
can increase the risk of problems arising.
Many non-accountants find it astonishing that there could be more than one
answer to the question ‘How much profit have we made?’. This is a very reasonable
attitude. This chapter seeks to explain some examples of where accountants commonly
tangle themselves, sometimes unnecessarily.
The main focus in this chapter is on the risks that arise from choice and interpretation
of policy in accounting performed for internal reporting in organizations for
whom the provision or use of financial instruments is the main business. These are
the organizations which knowingly take on risk, either making a margin while
matching with an offsetting risk, or gaining an excess return by holding the risk.
This is the main area which affects risk managers and is illustrated by several
common areas in which problems arise. FX, funding, and internal consistency are
areas where many accountants in banks will be well used to seeing multiple arguments.
We then briefly consider external reporting by such organizations, and the
additional complexities for internal and external reporting by ‘end-users’ – the
organizations which use financial instruments to reduce their risks.