Archive for the ‘Accounting Risk’ category

Deciding “What Should We Do?” in the Risk Business

January 8, 2014


  1. How did we do?
  2. What should we do?




Let’s think about it just a little bit.













Capital Allocation – Different Questions

November 18, 2013

RISKVIEWS has been confused by the vehemence of some people about the topic of capital allocation.

Some people feel that capital MUST be allocated to facilitate proper management.

Other feel that capital MUST NEVER be allocated because it leads to incorrect decisions.

But RISKVIEWS suspect that they may be talking about two different questions.

Those who think that they MUST allocate capital are trying to answer the question “How DID we do?”

Those who think that they MUST NEVER allocate capital are focused on the question “What SHOULD we do?”

Of course, the two questions often get mixed up.  But one is about the past and the other one is about the future.  The problem that folks who object to capital allocation are afraid of is that if capital is allocated for the purposes of answering the “How DID we do?” question, then the same sort of allocation will be used to answer the “What SHOULD we do?” question.

And that IS a problem.  The “What SHOULD we do?” question needs to be answered with projections of the future.  Many decisions that are worth worrying about do not settle within a single year, so the projections need to be multi year.

But the problem that they are worried about is the problem of making a multi year decision with a single year projection.  Whether capital is allocated or not, that is a poor way to go.

Multi year decisions need multi year projections.  The multi year capital impact needs to be included.  That can be done with a cost of capital factor or be a carefully constructed model that reflects capital inflows and outflows and then implicitly charges a cost for capital held.   The multi year calculation usually needs to be discounted at an appropriate risk adjusted discount rate.

RISKVIEWS rule of thumb for selecting a discount rate is that all risks should be included ONCE and only ONCE in the entire calculation.  So if the calculation is a stochastic one that includes scenarios that reflect the possible adverse effects of a risk, then the discount rate should not also include a charge for that risk.  If your projection includes ALL possible risks, then a risk free rate is an appropriate discount.  Remember that the market charges a risk premium for its perception of emerging risks.  And for the risk of strategic failure.

So RISKVIEWS concludes that there is no harm from allocating capital.  There is a harm from making multi year decisions with a one year projection.  Whether or not capital is allocated.  And multi year decisions need to include the effect of capital usage.

Are you using Enron Accounting?

November 14, 2013

Over 10 years ago the high flying ENRON corporation came crashing down.

enronOne of the things that was responsible for their high flying and for the delayed recognition of their actual underlying troubles was their accounting. Arthur Andersen, their external auditors, went up in smoke 10 years ago also over related issues.

At its heart, Enron’s problems were caused by greed and a 65 multiplier.  Their stock was valued at 65 times earnings at its peak.  So a $1 increase in earnings meant a $65 increase in stock price.

And earnings were determined by accounting rules.

In Enron’s case, they were taking an approach to long term projects that fronted profits to an early stage in the life of the long term contract.  They often reported present value of all future profits from a new project when the project was contracted.  A long term energy delivery contract would have 5 or 10 years of future projected profits reported when the deal was closed.

This was called a mark to market approach.  But in fact it was almost always a mark to model.

But both systems can lead to risk management problems.  The fronted profits may or may not emerge. Some of these contract’s value were subsequently marketed down as market conditions changed in future years.  And in Enron’s case, the later adjustments became more and more on the down side because of optimistic original booking.  This then put pressure on management to find a larger and larger quantity of “new” deals where they could report large up front and possibly inflated pv of future profits.  Eventually it crashed like the ponzi scheme that it was.  They got too big.  They just couldn’t find enough new deals to paper over the losses from write downs adjustments to previously deals.

There are two other choices to accounting for long term transactions.  The profits could be recognized over the life of the deal or the profits can be recognized when the deal is completed.  That later approach seems so, so dated.  How 19th century. Let’s call these three types of accounting Type E, Type L and Type C.

But the risk manager needs to understand the accounting treatment of every deal that is not closed in the same accounting period that it is opened.

  • Type E accounting means that the company probably put up an asset for future profits.  The risk capital that should be associated with that asset may well be very high.  The firm is at high risk that that asset will not be worth what the books say.  Proponents of this approach say that all it takes to get this right is the correct discount rate.  With the right discount rate, the E approach is more or less the same as the L approach.  That discount rate is the rate that makes the activity break even at inception.
  • Type L accounting means that in some cases, the company is still setting up an asset, albeit small, at the inception of the deal, since in many cases there are either more expenses or less revenues at the outset of a long term project than there are over the life o the deal on the average.  That is the usual objective of Type L accounting, to make every year look like an “average” year on an expected basis.  This smoothing also carries some accounting risk, but much less than Type E.
  • Type C accounting means that profits are realized when cumulative revenues exceed cumulative expenses on the deal.  Deals that are expected to be profitable (and what company enters into long term deals that are not?) are usually reported as losers at the outset.  You could argue that this is just another discount rate applied to the future cashflows.  But this discount rate is infinite, making future cashflows worthless until they happen.

RISKVIEWS opinion is that one approach is not necessarily superior to another.  However, if the financial statement contains various projects that are not treating the future consistently, then there will be major distortions of perception about results.  That distortion is itself a major risk.

Marking Risks to Market

February 19, 2013

If financial statements are set to mark to market, why aren’t they marking uninsured risks to market?
Under all accounting systems, a business that buys no fire insurance will show a better result then a similar company who is buying insurance. Except in the year when they have a claim. The market price for their risk is an insurance premium.  But for some reason, risk has never been treated in this way.

If risk was market to market, then a firm that buys no insurance, or does not hedge a risk would not report a gain, they would need to put aside an amount at least equal to the insurance premium. That amount could be put into a fund and released when they have an event that would have generated an insurance claim.

Of course, to be mathematically correct, they would need to make adjustments to the insurance premiums. One to remove the profit margin/risk charge in the premium and another to reflect the fact that they are in effect creating an insurance pool with one participant which appropriately replaces the risk charge.
An insurance pool with one participant? That doesn’t make any sense. But that is what a business who is not buying insurance is doing. What then would be the correct premium, not loaded for profits, for an insurance pool of one? The pool would have to bare the cost of holding capital (or a contingent capital facility) for the entire maximum claim amount to the extent that amount exceeds the reserves (or the amount in the pool).
So if the cost of capital is 3%, and the claims rate is 1%, then the mark to market cost would be about 400% of expected claims at first, declining as the fund builds up.
Pretty expensive. But that would make the financial statement make sense on a mark to market basis for risk.
This approach could be applied to unhedged risks as well. The mark to market accounting is actually much too lenient on hedgable risks that are unhedged. The MTM accounting in effect allows those companies to reflect the cost of hedging even if they are not hedging. In fact, when they do not hedge, they are self insuring and need to reflect a much higher cost as described above.

Not managing risk is expensive, particularly to investors.  Investors deserve appropriate information on risk.  The longstanding accounting paradigm that ignors risk gives investors the exact wrong information and needs to be immediately corrected.

One of the main reasons that risk management is not already completely embedded in all firms is that they can get away with this scam on their investors, supported by their accounting statement.

Risk needs to be accounted for properly, especially when it is not managed.

Reliance on Risk Management

October 13, 2010

















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