A change in the financial headwinds has to affect risk disclosures, particularly in the environment where effective risk management has emerged as an important priority for businesses. The absence of such adjustments may suggest that companies’ analysis of possible adverse events and their probable consequences may be inadequate; it may also be pointing to the inefficiency of risk communicating strategies utilized by companies. In either case, deficiencies in collecting and providing quality enterprise risk management (ERM) information diminishes a company’s competitive advantage and its ability to create value for shareholders.
Bringing these concerns into sharp focus, a new study by the CGA-AGRC examined the effect of the 2008 financial crisis on risk disclosures and concluded that the crisis did not prompt a shift in the risk disclosures of major non-financial Canadian firms. Quite the opposite: Investors examining changes in risks faced by non-financial companies would have been at a loss to anticipate the decline in market values that occurred in that period.
ERM considers all risks within a coordinated and strategic framework which strives to create, protect and enhance shareholder value by managing the uncertainties surrounding the achievement of organizational objectives. ERM input provided through the disclosure process helps reduce the information asymmetry between management and investors and is a critical factor in any business decision whether made by management or external stakeholders. The importance of ERM information in the decision process determines the need for the disclosure to be high-quality, sound and reliable.
Regulatory requirements instruct companies to disclose important trends and risks that have affected the financial statements and those that are reasonably likely to affect them in the future. This should be done by not only providing information on the nature and likelihood of each risk but also on how its materialization could affect the company’s business and financial performance. In particular, companies are required to disclose exposure to financial and market risks and their risk management strategies.
The 2008 financial crisis provided a unique opportunity to evaluate the changes in enterprise risk disclosures. Professors Michael Maingot, CGA, CA, FCA, Tony Quon and Daniel Zéghal, FCGA of the Telfer School of Management, University of Ottawa examined how the financial crisis affected risk disclosures of Canadian companies listed on the S&P TSX Composite Index. This was done through a content analysis of 2007 and 2008 annual reports that examined changes in risk exposure, risk consequences and risk management disclosures within three major categories of risk: financial, business and operational risk.
Risk disclosures provided few harbingers of crisis
The research findings suggest that:
- The upturn in the number of risk disclosures was only minor as the total number of disclosures increased by 3.6 per cent from 2007 to 2008. This pattern of increase applied to all three aspects of risk – risk exposure, risk consequences and risk management. For credit risk, the increase was the greatest.
- The average level of risk (as disclosed by companies) increased very slightly (from 4.46 to 4.48; half way between “probable” and “certain” risks). This increase came primarily from companies operating in consumer discretionary, energy and telecom sectors. The average level of risk consequences (as it appears in the disclosure documents) stayed unchanged at a “moderate” level.
- The types of risks judged to be most ‘certain’ were foreign exchange, interest rate, and economic risks. Economic risk was the only one among those to rise in level, but only marginally. This may be understandable as an ‘almost certain’ risk exposure leaves little room for an increase.
- Among the factors that affected a broad range of sectors, the level of risk consequences disclosed by companies grew noticeably only for economic and credit risk, but nevertheless these adjustments were fairly marginal.
- Financial risks, operational and environmental risks were most likely to be actively managed. From 2007 to 2008, the average levels of risk management increased the most for credit, foreign exchange and economic risks, but declined the most for supplier risk.
Room for improvement exists
While disclosures of only two types of risks – financial and market risks – are specifically identified as required in the regulatory requirement, it is in the shareholders’ and public interest that all important risks faced by the reporting company are disclosed. The largely unaffected nature of ERM information disclosure observed among major non-financial Canadian companies may suggest that companies’ risk management remained unchanged despite the change in the external conditions brought upon by the 2008 financial crisis. As this is a rather unlikely scenario, a room for improvement may be identified in meeting the requirements and needs of risk disclosure.
Risk management is a crucial element of a company’s existence and development, and should be conducted in a sound, efficient and effective manner. It is critically important for investors and other external users of ERM information to have reliable data and analysis. Policy makers are encouraged to accord particular attention to the quality of risk disclosures.
The study authors were Michael Maingot, CGA, CA, FCA, Tony Quon and Daniel Zéghal, FCGA; their research titled “The Effect of the Financial Crisis on Enterprise Risk Management Disclosures” was published in the International Journal of Risk Assessment and Management, 2012 Vol.16, No.4, pp.227 – 247.
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CGA-Canada | Last Updated: January 23, 2013