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Risk and Black Swans

accapr —  25 March 2014 — Leave a comment

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Simon Constant-Glemas, VP Corporate and UK Country Controller at Shell

There are few industries more risky (in terms of the obvious risks, at least) than the oil and gas sector. These companies typically work in dangerous environments, often in unstable regions (in terms of both geography and politics) and are subject to the unpredictable variances of commodity prices and exchange rates. As a result, risk reporting is both a critical and contentious subject for the oil and gas sector, as was brutally illustrated by BP’s Deepwater Horizon disaster in the Gulf of Mexico in 2010.

The disaster focused everyone’s mind on risk and risk reporting, particularly in the extractive industries. There has definitely been an increased focus around risk since Deepwater Horizon, because it was such a significant event. That and the financial crisis have made everyone more risk-aware.

I am aware of investors’ desire for more information about risks, but a more considered approach should be taken. Addressing all possible risks in a risk report would be counterproductive – more comprehensive risk reporting doesn’t mean better risk reporting. We employ more than 100,000 people in 70 countries, so any risk that’s applicable to a large multinational would apply to us. It is much better to provide a concise overview of the key risks inherent in the business that are most likely to prevent the achievement of its objectives.

One area where risk reporting might be constrained is where disclosure could be perceived to damage competitive advantage. I don’t think competitive advantage is an issue – you can strike a balance between referencing risk and not giving away critical information. We need to be careful sometimes about things like risks around a particular transaction but the vast majority of the time some information will be in the public domain already and so, if necessary, a more generic reference can be made. Suggestions that companies should try to quantify the potential impact of major accidents and events, though, are more difficult to address.

The fundamental question is whether a risk report can ever helpfully highlight the risks of rare but catastrophic events – analysts argue that an attempt to quantify the financial impact of a disaster on the Deepwater Horizon scale would be useful but understandably, this is something that organisations themselves are reluctant to do.

It’s the Black Swan effect – it rarely happens but when it does, the impact is massive. The difficult conversations about Black Swan events do take place within a company, but specifically disclosing all of the details in a risk report is another thing altogether. If you put a dark lens on everything and, for instance, try to quantify what the financial impact of a very rare disaster could be, you could scare away a lot of investors.

The nature of black swan events means that it is difficult to think about what the impact of an event could possibly be, let alone put a reliable figure on it, but I strongly believe that a thorough consideration of everything that could possibly go wrong is an important part of good risk management, even if the full details are not disclosed publicly. I do wonder if enough thinking goes on around rare events – I suspect that not enough people considered the probability of the entire inter-bank lending system grinding to a halt overnight before the financial crisis happened.

The main problem discussing Black Swan events in a risk report is that the context of probability is difficult to get across. Ideally a risk report should contain enough detail to start the necessary conversation between stakeholder and management. The quality element of risk reporting comes down to the conversation about risk that takes place, and that conversation should start with the risk report. A detailed discussion about risk is more likely to come out in a discussion between the CEO or finance director and analysts and other stakeholders – the annual report is not really the place to go into that sort of detail.

It is these conversations that are the most valuable to stakeholders, and also why more frequent risk reporting would not be particularly helpful. A certain amount of risk is strategic and it would feel more like crisis management if risk reporting was carried out more frequently than it is today. The crystallisation of an emerging risk or emergence of a new risk would certainly warrant disclosure but risk reporting should not be confused with robust and timely management information.

There are parallels to be drawn here with the increased regulation faced by multinationals since the financial crisis. There has been a huge increase in it since the financial crisis and the question is whether that drives better risk management or not. There have certainly been unintended consequences – at Shell we are captured by criteria that are not intended for us, simply because we are large. In my view it has the potential to distract organisations from good risk management.

My main concern is the raft of new regulatory requirements could result in organisations seeing risk reporting as just another tick-boxing exercise, rather than driving better risk management. We have to be careful that we’re not reporting on risk in order to satisfy a process, but that risk management is used effectively as a way to differentiate the business. In the past risk management was focused on mitigation, but today it is part of adding value to the organisation.

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By Eric Tracey, investor, Governance for Owners

An integrated and individual approach to risk reporting is the key to helping investors make the right decisions.

When I read about a company’s strategy and objectives I want to read about risk as well. You can have higher and lower risk strategies depending on what you are trying to do but risk is inherent: what you want to see is how two companies that do ostensibly similar things are going about, or might go about, them in a way that is different, and that’s what you want to understand.

I want to read about what the directors are really worrying about – not something that is just made up for the annual report.

The great challenge in all reporting is that it gets taken over by advisers. They either make it all very bland or alternatively put everything in but the kitchen sink, in which case it becomes completely useless. That’s the biggest threat to good risk reporting.

Risk reporting should contain a certain amount of policy, but it’s more about what’s changed than what carries on from year-to -year.

What you want people do each year is not to quite start from a blank sheet of paper, but it’s important to say this is what we’ve done this year. Reporting needs to be in the past tense – if it just becomes a whole series of policy statements then it frankly becomes pretty meaningless.

I am also not impressed when issues of commercial sensitivity are used as a barrier to risk reporting.

It’s a fantastic smokescreen to hide all sorts of things and I don’t give it much credence at all. You ought to be able to describe your risks to the business without giving away something that you should keep secret. It’s precisely because it’s sensitive that something should be reported to shareholders.

Where the law limits what can be said, looking forward, there is still a lot that can be said about the company’s approach to risk and who is managing it.

If I saw something that said risk is the responsibility of the audit and risk committee, I’d be more wary than if a company told me that risk is the primary responsibility of the CEO and the management team. Those would be quite different statements.

Similarly a company’s risk appetite can be better communicated by talking about what the company actually does and is revealed in the decisions the company makes. It is reflected in the exposures taken, and whether you are comfortable with them and if the return you are getting is acceptable.

What’s important is that this risk appetite and approach is reflected right through the business all the way up.

In good companies that’s what they try to do – they say, this is how we do what we do, this is how we approach risk, now let’s write that story. So you don’t have these enormous exposures that the board is not fully aware of, which is clearly what happened in the financial crash, when there would have been people somewhere in the banks who understood the risks.

I want to get a clear understanding of regulatory risks and how these are shaped by the various financial control authorities around the world.  More standardisation of the reporting of risk around the world would in theory be a good thing, but the perfect should not be the enemy of the good.

While you can’t object to standardised international reporting, you don’t want to say you want everyone to be in the same place before you do anything.

As far as frequency goes, I am fine with ‘proper annual reporting’. If you do anything other than that you can overload people with information so that they can’t cope or use it in any way. You need to know what’s going on but the shareholder can’t cope if it’s every quarter or every six months – that’s too often and encourages short-termism.

Risk is the “core of capitalism” and developing an adequate understanding of it is an “interesting challenge.”

Does the growth of risk reporting make organisations more risk averse? Possibly, but it’s not necessarily a bad thing. You can have an adequate discussion of risk without beating the hell out of any entrepreneurial spirits.

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An ongoing tension in the debate around risk reporting is the gap between what investors want from a risk report and what companies feel is appropriate to disclose. The arguments are familiar: investors want a full and frank discussion of the risks the company faces; however companies say that providing any more detail than they currently do would require them to disclose commercially sensitive information.

In the first of a series of blogs on risk reporting, Jane Fuller, journalist and financial analyst, says this is a poor excuse for not being completely transparent.

I think it’s used too much as an excuse and it tends to infantilise the role of investors. Companies are effectively saying that they don’t want to frighten the horses.

I have been closely involved in responding to the initiatives developed by the IASB (the International Accounting Standards Board), the UK’s Financial Reporting Council and others since the financial crisis, which have collectively attempted to improve the risk reporting of financial institutions.

I feel that risk reporting in general still has some way to go, although guidance such as that from the Enhanced Disclosure Task Force of the Financial Stability Board has helped. The momentum towards better risk reporting has increased since 2008 – I have had more discussions about how to improve risk reporting since then. Moving things forward with purpose will require a change in attitude.

One of my major concerns about current risk reporting, and one that has been identified by CFA UK, is that risk reports rarely get to the fundamentals of what an identified risk would mean in practice i.e. the oil spill from BP’s Deepwater Horizon rig in the Gulf of Mexico in 2010. The group’s risk reports before the accident might have mentioned safety risks repeatedly, but there would have been little to help analysts in terms of what a rare accident might mean when looking at the financial impact it has.

BP could have said, for example, that accidents rarely happen but if one does, it will be very expensive for us and this is how we would mitigate the impact. Or a pharmaceutical company could disclose its general risk of litigation and say that while it happens on rare occasions, if it does happen the risk is considerable, perhaps illustrating this by disclosing the biggest payouts in the sector in the past.

This approach might cause migraines in many a boardroom but it would result in a far more useful discussion about risk. The main barrier to better risk reporting is companies’ reluctance to be frank. At the moment risk reporting is a process-driven exercise, which describes what they have looked at and the risk-management process, and that is a long way from a truly frank discussion.

The second problem is that risk reports have a management bias – a bias towards putting a gloss on everything. There is not enough challenging going on, from boards or auditors or investors, about the ‘what ifs’ – what if this went wrong? The reaction of some companies seems to be “don’t worry your little head about it.”

Ideally I would like to see risk reports that prioritise the major risks faced by the company, as well as identifying any emerging risks. A few banks, notably Barclays and HSBC, have experimented with this approach since the financial crisis and the results have been interesting.

This suggests that there is some scope for shortening risk reporting in the voluminous discussions and boilerplate lists sometimes produced. Some investors like the very detailed risk reporting you get in a prospectus. I’ve seen risk reports that run to pages and pages, Personally, I would like to see see risks prioritised, without losing too much detail. I would rather have 20 pages of risk disclosures and use my own brain than very few. If there is too much narrowing down of the reported risks it is more likely that something will be left out.

I don’t favour frequent or real-time risk reporting. It has to be a stand-back exercise and for that reason, I am generally happy with annual reporting. A focused, standalone interim report, which states the top risks and how the company is handling them, as well as any new risks that have emerged, might be a good addition, but risk reporting twice a year is enough.

The various initiatives designed to improve risk-based disclosures – such as the IAASB’s proposals on material misstatement – have had some impact. But even if the quality of risk reports improves, any sensible investor would see the report as just one element in making a decision. A risk report is the management’s perspective, after all. To get the full picture you need to look more broadly than that. You ask yourself if there is other evidence that you can collect that would shed more light.

It’s a timely reminder that to see the best view, you need to stand back.

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By Jason Piper, technical manager, tax and business law, ACCA

What is it that stakeholders or investors in a company want to know? (I’m choosing to consider the terms as interchangeable for now – if I’ve invested something in a company, be it time, money or emotional capital, then I have a stake in it.)

Broadly, they want to know that the company is “well run”. They might have different reasons for wanting to know that, or even subtly different definitions of it, but whether they want to see a financial return, know that the company isn’t harming the environment in production of their goods, or simply that they’ll still be around and paying wages in 2 years’ time, good management will be key.

A range of recent research has revealed an interesting new proxy for detailed reports on specific ranges of measures in assessing management quality – management diversity, and specifically gender diversity at board level. Research in the US has shown a link between the presence of women on Boards, and a significantly reduced likelihood of financial restatement, and that such diversity has a greater impact on corporate financial behaviour than prescriptive rules and regulations on audit review and independence of board members.

Now that sounds like good news for those seeking to justify mandatory targets for gender diversity at board level, and compulsory reporting of the relevant statistics, and to some extent it is. But board diversity has to be pursued for the right reasons – and if the imposition of quotas results in tokenism and a ‘box ticking’ approach to reaching targets then the worry is that no good will be done. And of course businesses may exist which are perfectly well run by an all male, or all female, board; simply reporting on the board’s makeup does not necessarily indicate its efficacy.

While details of, for example, the demographic breakdown of management may be of some interest, it is more fundamental to the continued existence of the entity – and so of more direct concern to its stakeholders – that management have correctly identified and addressed the essential financial issues facing the company. And that surely is what is key for any stakeholder in a company – for once the company has been chosen as the business form, financial performance is key to the continued existence of the entity. If it fails to stack the numbers up then it won’t matter how environmentally friendly or socially worthy its aims are, creditors will pull the plug. In the UK at least, even if the creditors don’t do the job, the directors will be committing an offence if they don’t close the company down. Solvency is the key fundamental to continued life of the company, and while knowing that half the board are women will give you a statistical probability (for now, while it is still a matter of choice) that the business is better run than most, it is only an indirect indicator and less reliable than commentary on the methodology behind the company’s assertion of its overall general financial health. We should surely be concerned that without an understanding of how the underlying going concern/liquidity/solvency position of the company has been established, the financial statements may be of limited overall value to stakeholders. A company’s compliance with quotas regarding management diversity is less important to its survival, and the protection of creditors, than their financial effectiveness. The importance of understanding the basis of any report is key. For example, the preparation of accounts on a ‘statement of affairs basis’ as opposed to a ‘going concern’ basis will often be significantly less positive, since the inclusion of all contingent and future liabilities (in particular redundancy costs) will often result in a net negative balance sheet. On a related note of course the lack of regulation around preparers of company financial statements could also be a cause for concern. If the financial statements are a principal element of the safeguards for creditors, is it necessarily appropriate that they can be prepared by someone with no financial knowledge or qualifications, or is there a risk that this devalues the reliance which can (or ought) to be placed on them?

The inclusion of information, or data, for no good reason does not in fact improve stakeholders understanding of a business, and may distract from the key information. By all means we should promote diversity, as the evidence shows it improves performance. But if we must prioritise the disclosures a company must make, and the indicators by which it will be measured, should we not focus on the source of success (financial soundness) and disclose it directly, rather than relying on proxies such as board diversity?

By Ian Welch, head of policy, ACCA

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ACCA has consistently stated that the view of investors should be at the heart of standard-setting and financial policymaking. Too often their voice is not heard as rules are being made or proposals formulated.

But who exactly are the investors? How have their asset allocations and investment strategies changed since the Global Financial Crisis (GFC)? And, of most direct interest to accountants, what do they want from corporate reporting?
ACCA is undertaking a four-stage project examining the UK and Ireland investor landscape, post-GFC and the first two reports, based on interviews with key players and a survey of 300 investors carried out concurrently, reveal trends of far greater international application.

The increase in short-termism is one clear trend. The traditional domination of markets by pension funds and insurance companies has been eroded both by greater international ownership of companies, and by the emergence of other players such as hedge funds and private equity firms, with shorter-term investment horizons. And even the traditional players have switched much of their investment from equities to bonds, as a result of the GFC.

Added to this , the vastly increasing proportion (estimated by some to be 80%) of trades that takes place via computer in nano-seconds has left a question mark on who the owners of companies actually are – and how companies can meaningfully engage with investors who hold shares for a very short time. We have already seen international policymakers, such as the G20 and EU, responding with measures to enhance long-term finance and address the ‘ownership vacuum’. More is needed, it seems.

Low interest rates are another key trend. Central bank activism, leading to loose monetary policy, historically low interest rates and currency wars throughout Europe and the US has been a major response by the authorities to the GFC. This has had a clear effect on investors, making them search for yields in riskier investments.

Perhaps inevitably, the greater pressures on investors has seen a constant demand for more information and transparency -and the proliferation of new technologies such as mobile and social media has led to massively more corporate information being available, much of it on a real-time basis. But how much it is useful, and how do investors prevent themselves being overwhelmed?

Intriguingly our research revealed a dichotomy – and one which leaves policymakers with much to ponder. Three-quarters of investors say that, that the quarterly report remains a valuable input to their investment decision-making. Yet, at the same time, almost half of investors believe mandatory quarterly reporting should be abandoned, with almost two-thirds believing the increase in information has encouraged “hyper-investment” and taken up excessive amounts of management time.

This suggests a “tragedy of the commons” effect, whereby individual investors want to consume quarterly reporting for their own self-interest, despite recognizing that this focus on shortening time horizons is damaging for the overall market’s long-term interests.

Fully 45% said they had little use for the annual report – and worryingly, two-thirds said their faith in company reporting had declined since the GFC. Almost half that believe management has too much discretion in the financial numbers they report. While perhaps not surprising, these are nonetheless chastening findings for standard-setters and policy-makers to reflect on.

Is there any good news for the profession? Yes for auditors – much maligned of late – as external assurance of company figures seemed to be their main source of credibility. And investors claimed that they would be prepared to pay more to have additional information available contemporaneously as long as it was externally verified. This would put pressure on the audit profession – but it should consider it carefully as a way of regaining the initiative following recent critical political and regulatory inquiries on audit.

There is much here for many other parties to chew over, and ACCA will be following this up with a series of events designed to bring key players together to thrash it out, before releasing stages 3 and 4 in this research series, which will look at the ‘real-time’ issue in greater depth and investigate corporate reaction.

But for now, accounting standard-setters and regulators must consider the criticism of standards and the annual report. Policy- makers must wrestle with the quarterly reporting conundrum. And the investors themselves must consider how to get their voice more clearly heard when policy decisions that affect them are being made. If they really are prepared to pay more for a wider audit, then now would be a good time to let that be clearly known.

This post first featured in The Accountant, June 2013