Risk Accounting: An Accounting Based Approach to Measuring Enterprise Risk and Risk Appetite

40 Pages Posted: 22 Oct 2012 Last revised: 29 Jul 2013

See all articles by Kiran Fernandes

Kiran Fernandes

Durham University Business School

Allan D. Grody

Financial InterGroup; New York University (NYU) - Leonard N. Stern School of Business

Peter J. Hughes

Durham Business School - Centre for Banking, Institutions & Development

Oliver Phillips

University of York - The York Management School

Steve Toms

University of Leeds - Leeds University Business School (LUBS); University of Leeds - Division of Accounting and Finance

Date Written: July 1, 2013

Abstract

The resetting of the risk management agenda through successive capital accords has had little impact on the ability of many firms to prevent losses which raises concerns as to whether the risk calculation methods applied in the calibration of regulatory capital are fit for purpose. This has been the focus of recent public comment by global regulators, central bankers and industry commentators who suggest that excessively complex and flawed capital adequacy rules that rely on risk modeling techniques such as Value-at-Risk (VaR) were a contributing factor in the financial crisis.

We argue that the disclosure of an enterprise’s financial condition and the concomitant determination of its capital adequacy must be a function of accounting rather than financial modeling. We further argue that if accounting is to fulfill this core function, the current practice of basing accounting on fair values must be adapted such that accounting is based on the risk exposures inherent in approved transactions. In this paper we demonstrate how this may be achieved by adding risk information to the existing management information that is attached to transactions upon their registration in accounting systems. The incremental risk information enables a calculation of risk-weighted transaction values that are accounted for using a new risk abstraction - the Risk Unit (RU). In this way a comprehensive risk management system is created that is tied to the financials of the enterprise.

We further demonstrate how risk accounting aligned with management accounting can produce a system of integrated risk and management reporting by, for example, group, organisation unit, product, customer and geography which, in turn, enables the risk appetite setting process to become an integral part of the enterprise’s financial planning and budgeting cycle.

Over time, risk accounting outputs can be correlated with expected and actual losses thereby imparting a monetary value to the RU abstraction which can be used in the determination of regulatory capital requirements, the computation of risk adjusted return on capital (RAROC) and adjusting the betas in the capital asset pricing model (CAPM) thus bridging accounting with economic theory and risk management concepts.

Keywords: Risk measurement, Risk management, Operational risk, Enterprise risk, Risk appetite

JEL Classification: D81, E10, F02, F23, G2, G38, L2, M4

Suggested Citation

Fernandes, Kiran and Grody, Allan D. and Hughes, Peter J. and Phillips, Oliver and Toms, Steve, Risk Accounting: An Accounting Based Approach to Measuring Enterprise Risk and Risk Appetite (July 1, 2013). Available at SSRN: https://ssrn.com/abstract=2165034 or http://dx.doi.org/10.2139/ssrn.2165034

Kiran Fernandes

Durham University Business School ( email )

Durham, Durham DH1 5BN
United Kingdom

Allan D. Grody (Contact Author)

Financial InterGroup ( email )

169 East 69th Street
New York, NY 10012
United States
9174143608 (Phone)
212-585-4397 (Fax)

New York University (NYU) - Leonard N. Stern School of Business ( email )

Suite 9-160
New York, NY
United States

Peter J. Hughes

Durham Business School - Centre for Banking, Institutions & Development ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

Oliver Phillips

University of York - The York Management School ( email )

Sally Baldwin Buildings
Heslington
York, North Yorkshire YO10 5DD
United Kingdom

Steve Toms

University of Leeds - Leeds University Business School (LUBS) ( email )

Leeds LS2 9JT
United Kingdom

University of Leeds - Division of Accounting and Finance ( email )

Leeds LS2 9JT
United Kingdom

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