Risk Management

1. Risk Management Management Level – Paper P2 Advanced Management Accounting Lecture - 29 Vidya Rajawasam ACMA CGMA MBA

2. Risk Management In the previous lectures we have discussed • Definition of risk • Risk and Return • Benefits of taking risks • Risk types • Sources and impact of risks

3. Risk Management In this lecture we will discuss • Introduction to risk management • Managing risks • Risk management process • Reduction and mitigation • Enterprise risk management

4. Risk Management Risk management is a key element of any management accounting role. The ability to identify risks before they arise, and then plan a strategy to deal with them is paramount. The consequences of not doing this could be business failure. A discussion of the nature of risk and identifying risks is discussed in detail in this lecture.

5. Risk Management Management needs to manage and monitor risk on an ongoing basis for a number of reasons: • To identify new risks that may affect the company so an appropriate risk management strategy can be determined.

6. Risk Management • To identify changes to existing or known risks so amendments to the risk management strategy can be made. For example, where there is an increased likelihood of occurrence of a known risk, strategy may be amended from ignoring the risk to possibly insuring against it. • To ensure that the best use is made of opportunities.

7. Risk Management Managing the upside of risk Historically, the focus of risk management has been on preventing loss. However, recently, organisations are viewing risk management in a different way, so that: • risks are seen as opportunities to be seized • organisations are accepting some uncertainty in order to benefit from higher rewards associated with higher risk

8. Risk Management Managing the upside of risk • risk management is being used to identify risks associated with new opportunities to increase the probability of positive outcomes and to maximize returns • effective risk management is being seen as a way of enhancing shareholder value by improving performance.

9. Risk Management Managing the upside of risk Risk management is therefore the process of reducing the possibility of adverse consequences either by reducing the likelihood of an event or its impact, or taking advantage of the upside risk. It is a method of controlling risks.

10. Risk Management Risk Management Process The organization’s Management is responsible for establishing a risk management system in an organisation. The process of establishing a risk management system is summarized in the following diagram:

11. Risk Management Risk Management Process

12. Risk Management Risk Management Process

13. Risk Management TARA (or SARA) Strategies for managing risks can be explained as TARA (or SARA): Transference (or Sharing), Avoidance, Reduction or Acceptance. Transference In some circumstances, risk can be transferred wholly or in part to a third party, so that if an adverse event occurs, the third party suffers all or most of the loss.

14. Risk Management Transference A common example of risk transfer is insurance. Businesses arrange a wide range of insurance policies for protection against possible losses. This strategy is also sometimes referred to as sharing. Risk sharing - An organisation might transfer its exposures to strategic risk by sharing the risk with a joint venture partner or franchisees.

15. Risk Management Avoidance An organisation might choose to avoid a risk altogether. However, since risks are unavoidable in business ventures, they can be avoided only by not investing (or withdrawing from the business area completely). The same applies to not-for-profit organisations: risk is unavoidable in the activities they undertake

16. Risk Management Reduction/mitigation A third strategy is to reduce the risk, either by limiting exposure in a particular area or attempting to decrease the adverse effects should that risk actually crystallize. Other examples of risk reduction include: Risk minimization. This is where controls are implemented that may not prevent the risk occurring but will reduce its impact if it were to arise.

17. Risk Management Risk pooling. When risks are pooled, the risks from many different transactions of items are pooled together. Each individual transaction or item has its potential upside and its downside. For example, each transaction might make a loss or a profit by treating them all as part of the same pool. The risks tend to cancel each other out, and are lower for the pool as a whole than for each item individually.

18. Risk Management Risk pooling An example of risk reduction through pooling is evident in the investment strategies of investors in equities and bonds. An investment in shares of one company could be very risky, but by pooling shares of many different companies into a single portfolio, risks can be reduced (and the risk of the portfolio as a whole can be limited to the unavoidable risks of investing in the stock market).

19. Risk Management TARA (or SARA)

20. Risk Management Review MCQs The reasons for managing and monitoring of risks are? • The procedures Prevents shareholders selling their own stake. • Identification of new risks that may affect the company. • Enhancing the shareholder value by improving performance. • Non of the above

21. Risk Management Review MCQs The reasons for managing and monitoring of risks are? • The procedures Prevents shareholders selling their own stake. • Identification of new risks that may affect the company. • Enhancing the shareholder value by improving performance. • Non of the above

22. Risk Management Review MCQs An example of risk transference is ? • Issue of new shares • Insurance • Sale and buy back. • Non of the above.

23. Risk Management Review MCQs An example of risk transference is ? • Issue of new shares • Insurance • Sale and buy back. • Non of the above.

24. Risk Management Reduction/mitigation Reducing Financial Risk - Hedging techniques. Risks in a situation are hedged by establishing an opposite position, so that if the situation results in a loss, the position created as a hedge will provide an offsetting gain. Hedging is used to manage exposures to financial risks, frequently using derivatives such as futures, swaps and options.

25. Risk Management Reducing Financial Risk - Hedging techniques. With hedging, however, it often happens that if the situation for which the hedge has been created shows a gain, there will be an offsetting loss on the hedge position. In other words, with hedging, the hedge neutralizes or reduces the risk, but: • restricts or prevents the possibility of gains from the 'upside risk'

26. Risk Management Reducing Financial Risk - Hedging techniques. • as well as restricting or preventing losses from the downside risk. Neutralizing price risk with a forward contract In some situations, it is possible to neutralize or eliminate the risk from an unfavorable movement in a price by fixing the price in advance.

27. Risk Management Reducing Financial Risk - Hedging techniques. For example, in negotiating a long-term contract with a contractor, the customer might try to negotiate a fixed price contract, to eliminate price risk (uncertainty about what the eventual price will be and the risk that it might be much higher than expected). The contractor, on the other hand, will try to negotiate reasonable price increases in the contract.

28. Risk Management Reducing Financial Risk - Hedging techniques. The end result could be a contract with a fixed price as a basis but with agreed price variation clauses. Fixed price contracts for future transactions are commonly used for the purchase or sale of one currency in exchange for another (forward exchange contracts).

29. Risk Management Acceptance The final strategy is to simply accept that the risk may occur and decide to deal with the consequences in that particularly situation. The strategy is appropriate normally where the adverse effect is minimal. For example, there is nearly always a risk of rain; unless the business activity cannot take place when it rains then the risk of rain occurring is not normally insured against.

30. Risk Management Risk mapping and risk management strategies Risk maps can provide a useful framework to determine an appropriate risk management strategy.

31. Risk Management Risk mapping and risk management strategies

32. Risk Management Enterprise Risk Management (ERM) Enterprise Risk Management (ERM) can be defined as the: process effected by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.

33. Risk Management Principles of ERM The key principles of ERM include: • consideration of risk management in the context of business strategy • risk management is everyone's responsibility, with the tone set from the top • the creation of a risk aware culture • a comprehensive and holistic approach to risk management

34. Risk Management Principles of ERM • consideration of a broad range of risks (strategic, financial, operational and compliance) • a focused risk management strategy, led by the board (embedding risk within an organization's culture ). • Risk management has transformed from a 'department focused' approach to a holistic, co-ordinated and integrated process which manages risk throughout the organisation.

35. Risk Management Principles of ERM Drivers for this transformation include globalization, the increased complexity of doing business, regulatory compliance/corporate governance developments, and greater accountability for the board and senior management to increase shareholder value. ding.

36. Risk Management Principles of ERM These drivers mean that an organisation and its board must have a thorough understanding of the key risks affecting the organisation and what is being done to manage them. ERM offers a framework to provide this understanding.

37. Risk Management COSO ERM framework matrix The COSO (the Committee of Sponsoring Organisations, COSO, 2004) ERM framework is represented as a three dimensional matrix in the form of a cube which reflects the relationships between objectives, components and different organizational levels. .

38. Risk Management COSO ERM framework matrix .

39. Risk Management The eight components are closely aligned to the risk management process, and also reflect elements from the COSO view of an effective internal control system: • Internal environment: This is the tone of the organisation, including the risk management philosophy and risk appetite. • Objective setting: Objectives should be aligned with the organization's mission and need to be consistent with the organization's defined risk appetite.

40. Risk Management • Event identification: These are internal and external events (both positive and negative) which impact upon the achievement of an entity's objectives and must be identified. • Risk assessment: Risks are analysed to consider their likelihood and impact as a basis for determining how they should be managed. • Risk response: Management selects risk response(s) to avoid, accept, reduce or share risk. The intention is to develop a set of actions to align risks with the entity's risk tolerances and risk appetite

41. Risk Management • Control activities: Policies and procedures help ensure the risk responses are effectively carried out. • Information and communication: The relevant information is identified, captured and communicated in a form and time frame that enables people to carry out their responsibilities. • Monitoring: The entire ERM process is monitored and modifications made as necessary.

42. Risk Management Review MCQs The principles of Enterprise risk management are? • Focusing on short term operational risks. • Consideration of risk management in the context of business strategy • Focuses on shareholder communication. • Non of the above.

43. Risk Management Review MCQs The principles of Enterprise risk management are? • Focusing on short term operational risks. • Consideration of risk management in the context of business strategy • Focuses on shareholder communication. • Non of the above.

44. Risk Management Review MCQs The components of enterprise risk management (ERM) are? • Identification of risks. • There is a lot of confusion with regard to its application. • Risk assessment • Non of the above.

45. Risk Management Review MCQs The components of enterprise risk management (ERM) are? • Identification of risks. • There is a lot of confusion with regard to its application. • Risk assessment • Non of the above.

46. Uncertainty and risk in decision making Lecture Summary We have discussed the • Introduction to risk management • Managing risks • Risk management process • Reduction and mitigation • Enterprise risk management

47. Risk Management Management Level – Paper P2 Advanced Management Accounting Lecture - 29 Vidya Rajawasam ACMA CGMA MBA