1

CHAPTER 1

INTRODUCTION

Risk management structure should be well thought-out, as well as a cultural fit

and sustainable. (Smiechewicz, 2001)

Uncertainty is not measurable. Risk is.

- Frank Knight,

Risk, Uncertainty and Profit (1921)

1.1 Introduction

Success in business, to a certain degree, requires owners and managers to take

calculated risks. The most successful business is usually managed by people
who know when to push forward and when to pull back, when to buy and when to
sell, when to stand firm and when to compromise. The successful company is
managed by people who understand what risk in business is, and how this risk
should be managed and mitigated.

Risk is an undeniable reality of doing business today, whether domestically or

globally. A successful entrepreneur does not fear risk, but strives to understand it,
to manage it, even to take advantage of it. As risk management tools and
techniques become more and more complex, however, companies require the
services of a Risk Management specialist.

A growing specialty in this field, globally, is that of international accounting risk

management. International accounting professionals can contribute to the
 2

success of their companies must have a strong grasp of financial risk

management techniques for multinational and multilateral business transactions
of great complexity.

Unfortunately, as the world of business becomes increasingly borderless, risk

management becomes, likewise, borderless, and thus more complicated. Risk
management strategies that make sense in a domestic environment do not
necessarily apply in the international arena, where business is exposed to the
additional risks associated with currency prices, exchange rates, and interest
rates, as well as more intangible issues of political and cultural risk. While not
necessarily absent in the domestic arena, each of these issues becomes both
more complex and more crucial once a company is active internationally.

In this context, it is imperative that the chief financial officers (CFOs) of these
companies be familiar with a variety of accounting tools and techniques with
which they can work to minimise their companies’ risk exposure. Financial risk
management in international accounting aims to minimise risk of loss from
unexpected changes in the prices of commodities and equities, or changes in
interest and inflation rates.

Intelligent risk management can help a company stabilise cash flows, reduce its
risk of insolvency, manage taxes better, and focus more effectively and efficiently
on its primary business risks. Effective risk management allows corporations and
their lenders to weather difficult situations and be able to survive the fall-out of
loan losses or corporate accounting scandals (Adler 2002). Intelligent risk
management at the level of international and multinational business operations
must take into account a myriad of factors, from the technical and the theoretical
to the political and practical.

An effective international accountant, such as a CFO of a multinational

corporation, must comprehend the immense complexity of financial risk
management. to recognize the relationships and correlations between various
risk management tools, techniques, and systems. These tools incorporate both
 3

qualitative and quantitative analysis and the efficacy of individual tools affect the
overall success of a company’s risk management program (Rahl & Lee 2000).

With the objective of contributing to the body of knowledge on which an effective

CFO of a multinational corporation must rely to properly fulfil his or her role; this
study explores the interplay of international accounting risk management tools
and techniques with elements of political and culture risk management. This
interplay makes international financial risk management a particularly challenging
and potentially rewarding field of study. Understanding this interplay is necessary
if companies are to protect themselves sufficiently and to compete in the
international world of business with success.
 4

1.2 Statement of problem

The problem at the core of this study is simple:

What does it take to manage risk for multinational firms with complex global
transactions and assets successfully?

The short answer, perhaps, is that it takes a great deal of expertise in financial
risk management. Financial risk management is a specialised area of
international accounting that requires specific training, tools and techniques, if
one is to be successful in mitigating risk for an international business. As such, in
this study, financial risk management was examined entirely from the perspective
of international accounting. The goal of this study is to show how risk mitigation
applies to firms with international holdings, assets, and transactions. The
study analysed the interplay of currency prices, exchange rates, and interest
rates with the technology of accounting systems, as well as the political and
cultural risks inherent in international operations.

At the end of the day, of course, risk is managed not by companies, but by
people. Risk management is usually the function of a company’s senior
accountants, who act as the “link” between a company’s business and financial
operations (Tunui 2002). Therefore, this study surveyed the risk management
practices of CFOs or other company accountants with risk management
responsibilities, and contrast the theory (or policy) of these practices with their
real-life application and practice.

The financial practices employed for risk management purposes by CFOs,

including diversification, asset allocation, and hedging was examined. For the
purposes of this study, diversification refers to the use of a combination of
dissimilar investments that offset each other. Asset allocation is defined as the
use of safe or low-risk investments to mitigate losses from high-risk holdings; and
 5

hedging comprises the use of financial contracts such as currency futures,

options or swaps to cancel out possible losses in transactions or holdings. These
practices were examined in light of their application to international business,
where accountants must cope with many more types and degrees of risk.

The areas of financial analysis that concern the firm’s long-term strategy, such as
investment risk, credit risk, and insurance risk were also reviewed. As
considered in this study, investment risk deals with issues such as market
analysis, portfolio management, asset price volatility; credit risk comprises both
individual and corporate exposure; and insurance risk covers property, product,
and business liabilities.
 6

1.3 Background and rationale of study

Financial risk management refers to the practices used by corporate finance

managers and accountants to limit and control uncertainty in the firm’s total
portfolio. Financial risk management aims to minimise the risk of loss from
unexpected changes in the price of currencies, interest rates, commodities, and
equities.

In the context of international accounting, financial risk management also

contains an element of political, legal and “culture” risk. These latter types of risk
comprise exposure to uncertainty in the outcomes of business transactions and
asset transfers that comes with most international business operations.

Risk management, because of its predominantly financial nature, is generally the

domain of a company’s accountants. Accountants are closely involved in the
analysis and evaluation of the financial effects of currency movements and
exchange rates, tax regimes and business laws, as well as risks of hostile
takeovers, expropriation and local economic downturns, which differ in every
country from Singapore and Malaysia to Japan, the United States and beyond.

Yet intelligent risk management requires more than a grasp of numbers and the
ability to calculate acceptable odds. For a multinational corporation, or even a
domestic company involved in exports or other supplier relationships with extra-
national parties, “firm-wide risk [can] not be represented by market and credit
functions alone” (Hoffman 2000). A risk management officer such as the CFO
must combine qualitative and quantitative risk management techniques to arrive
at a workable strategy for her company. She must also be able to asses the
effectiveness, efficacy, and applicability of each individual tool.

Intelligent and effective risk management is necessary to minimise against

perceived as well as actual risks—in fact, the perceived risks may harm the
company more than actual risks. When investors or shareholders, as well as the
 7

public, are comfortable with a company’s risk management practices as manifest

in its risk disclosures, the result is a decrease in market uncertainty and diversity
of opinion about the implications of the risk. That is, by employing trusted risk
management practices and by disclosing its risk management practices and
predictions, the firm to a large extent controls how firm value is affected by
changes in interest rates, foreign currency exchange rates, and commodity prices
(Linsmeier et al. 2002). Risk management practices that diversity of opinion
“should dampen trading volume sensitivity to changes in these underlying market
rates or prices” (Linsmeier et al. 2002, p. 343).

Risk management at the international level is a much-researched field.

Particularly as it is a newer and an expanding field, there is clearly a need for
more research, both qualitative and quantitative, into issues crucial to
international accounting. It is also a field that is evolving at an incredibly fast
pace. Global trends—including the overwhelming trend towards globalisation of
business and harmonisation of accounting practices and standards (Heppleston
2000)—rapid advances in technology, international political and economic events,
as well as the geopolitical realities of today’s world all impact risk management.

A great deal is written about specific risk management techniques and a great
deal is written about risk management models. Most of this discussion, however,
takes place at a very theoretical level. Those researchers engaged in empirical
research on specific companies or risk management strategies and practices
stress that more work in a similar vein is needed if CFOs and CEOs are to
possess reliable and valid data with which to address risk management for their
companies (inter alia, Linsmeier et al. 2002; Dhanani & Groves 2001; Mohanty
2001). There is a continuing need for more practical research that looks at
precisely how and why—and, most importantly, with what results—multinational
companies employ risk management techniques, how accountants understand,
and use, these tools, and how the different tools, strategies, and types of risk
interplay with and affect each other.
 8

Finally, as are shown in the literature review, there is a particular paucity of

studies in this field, which compare the theory of risk management to the actual
practice. One of the cornerstones of this study was the comparison of company’s
stated policies and objectives with its actual actions and results.

1.4 Purpose of study

The purpose of this study is twofold. On a theoretical level, a new model for risk
management strategy in the international accounting field is to be suggested.
Existing models were considered in Chapter 2: Literature Review, and their
strengths and weaknesses identified. The new model towards which would be
working was based on two assumptions.

The first assumption was that the effectiveness and efficacy of both individual risk
management tools and overall company risk mitigation strategies ultimately was
the result of the skills and capabilities of its risk mitigation officers—usually, CFOs
or other senior accounting professionals. The second assumption was that the
specialist in international accounting needs to familiarise herself with local
conditions, regulations and policies that impact each of these areas of finance—in
other words, that she needs to be conversant with more than numbers.

On a practical level, individuals active in this specialised area of international

accounting are provided with an accessible discussion of the tools, techniques,
approaches, and systems that should enable them to be successful in mitigating
risk for international businesses. They are the key individuals to companies’
ultimate success and financial performance; hence, it is the goal of this study to
marry practice and theory. To that end, companies’ actual actions and risk
management results were considered of more importance than their policies and
intentions.
 9

1.5 Contribution of study

Risk management has become an integral part of international business strategy

and accountants are using a variety of quantitative tools to measure and analyse
risk. Among the tasks of the CFO lies the responsibility for identifying and
addressing all types of risk, establishing support and control mechanisms for
dealing with it, and setting the course for the risk management team in terms of
its policies and objectives. This breadth of responsibilities requires that the
effective CFO be conversant with a variety of risk management practices and be
aware of their efficacy and appropriateness in specific situations.

The study considered a variety of risk management practices and areas of

financial analysis against the backdrop of a volatile global market in which
financial risk management must take into account political and cultural risks. The
study’s theoretical framework was rooted in the belief that the specialist in
international accounting needs to familiarize herself with local conditions,
regulations and policies that affect each of these areas of finance. She must also
bring to the table something more — a sensitive, comprehensive understanding of
the culture(s) in which the company is active and a familiarity with and ability to
analyse the political forces that may affect the company’s risk exposure.
Moreover, she must be able to translate her theoretical knowledge of these
concepts into practical policies and risk management strategies. Thus, the
contribution of this study is to equip the international accounting specialist with a
means of accessing and utilising this knowledge, through a discussion and
analysis of both the theoretical and the practical applications of risk management
techniques.
 10

1.6 Different types of risk

The first step in this process lies in identifying the different types of risk. For the
purposes of this study, risks were divided into two broad categories: general
financial risks experienced in the international arena and political/cultural risks.
The former category comprises interest rate and debt-related risk as well as
currency and exchange rate risk. These as well as the political risks are outlined
below. The purpose is to provide an overview of the many different types of risks
that multinational corporations faced. This list was not comprehensive, and
additional financial risks were discussed in the literature review.

1.6.1 Interest risk and debt-related risk

Interest rate risk is important in both domestic and international operations, but
multinational companies are more exposed to it. Interest rate risk is usually
defined as the degree of uncertainty for the rate of return from a bond or any
other convertible debt instrument or derivative. Interest rate risk is also concerned
with the changes in profits, cash flows, or valuation of the firm to changes in
interest rates. Viewed from the perspective of this definition, the firm should
analyse how its profit, cash outturns, and value change in response to changes in
interest rate levels.

Determining the risk in an interest-rate return is a complex process. The three

primary factors that are considered when calculating this risk;

(1) Risk of the bond issuer—i.e. is it a corporation or a government and what are
its risk management policies and thresholds,

(2) the liquidity of the bond—i.e., how easy is it to cash in; and
 11

(3) the level of income taxes applied to the bond in the region—e.g., is the interest
income taxable, untaxed, or tax deferred.

Associated with interest-rate risk are debt-related risks. Debt-related risk usually
takes the form of interest-rate risk for long-term debt instruments the company
issues, which by their term have greater risk exposure than short-term issues. In
general, “prices and returns for long-term bonds are more volatile than those for
shorter-term bonds” and can generate capital gains and losses creating
substantial differences between their real return and the yield to maturity known
at the time of the purchase (Mishkin 1995, p. 90).

1.6.2 Currency and exchange risk

Volatility in currency prices and exchange rates is of crucial importance to

multinational corporations. Their risk management officers must apprise
themselves of the risks in world currency and derivatives markets. The
corresponding rapid fluctuations in currency exchange and interest rates in the
international capital markets are amplified by the huge size of some of the
transactions these firms engage in. For example, should the corporate treasurer
of a large U.S. firm decide to transfer a very large amount of money from regular
dollar accounts to Eurodollar deposits in some non-American banking centre, e.g.
in Hong Kong, he or she may be able to instantly gain a substantial interest rate
advantage.

However, in doing so, the domestic dollar market is immediately reduced and the
Eurodollar market inflated, corresponding to the size of the money move. A $10
million deposit might not affect money rates in either realm, but it would affect
liquidity and interest rates within the selected banking circles involved, and these
effects would be felt all the way through the financial chain of related companies-
a fact financial officers need to be aware of.
 12

A sub-group of exchange rate risk is the so-called strategic exchange rate risk, a
risk resulting from long-term movements in exchange rates. This form of
exchange rate risk is frequently characterized as the most important form of
exchange risk (Dhanani & Groves 2001).

1.6.3 Other financial risks

Current risk-based capital standards account primarily for credit risk, interest rate
risk and market risks. However, non-credit risks, including asset concentrations
and liquidity risk, can significantly affect the performance of companies (Mohanty
2001). Indeed, several studies suggest that non-credit risks that lead to the
insolvency of banks and financial institutions (ibid.). The above discussed risks
are the primary concerns of most CFOS, but it is stressed they are not the only
ones. Moreover, in addition to these clearly monetary, financial and quantifiable
risks, multinational corporations have to deal with cultural and political risks.

1.6.4 Political and cultural risk

Political risk can be defined as the exposure to a change in the value of an

investment of cash position resultant upon government actions. Political risk, to a
certain degree, exists in virtually every country, and certainly exists in every
country in Asia (Wagner 2001). Areas of concern include currency
inconvertibility, political violence, and contract frustration.

Multinational companies doing business in political hotspots are concerned with

“ensuring smooth conversion and transfer of currency and having confidence that
government payment and performance obligations are honoured” (Wagner 2001;
see Appendix A1). Governments intervene in their national economies and, in so
doing, increase the level of political risks that the multinational firm faces. Political
 13

risks ranges from exposure to changes in tax legislation, through the impacts of
exchange controls to restrictions affecting operation and financing in a host
currency. Multinational Companies are concerned with the measurement and
management of political risk. There are various approaches to the measurement
of political risk – most of them are subjective in nature.

One of the factors that cannot be quantified about political risk is that it is to a
large part perception-driven (Wagner 2002). For example, in Southeast Asia,
Indonesia has been traditionally seen as the country with the highest political risk
in the region, as borne out by rates of political risk insurance. China, being a
country with a great dominance of trade in the region, is perceived as a much
safer place with minimum level of political risks, while Singapore and Malaysia
are generally “not even on the radar screen” of political risk analysts. However,
worldwide reporting of the arrest of 13-suspected terrorists in January 2002
increased Singapore’s political risk rating to the equivalent of the much more
potentially volatile South Korea (Wagner 2002; see Appendix A2).

Associated with political risk, is cultural risk. Cultural risk is perhaps best defined
as comprising the rules of engagement for business in a particular culture.
McDonald’s recent announcement that it is closing 135 of his franchises—most in
the Middle East—can be seen as cultural risk in action.
 14

1.7 Tools, techniques and technologies

Intelligent risk management helps a company stabilize cash flows, reduce risk of
insolvency, manage foreign taxes and focus on its primary business in each
country and market. It is particularly critical in Southeast Asia today, where
complex overseas operations are common for resident, host and guest firms
alike.

To keep track of the myriad details of a risk management system, managers now
rely upon a wide range of new tools and technologies-computer-based trading
systems, telecommunications technology, decision support systems that quantify
risk factors, and so on.

New computer-based tools are being introduced all the time, with recently
developed systems aimed at the specific needs of international accounts. The
technologies available to international accountants today quantify the financial
risks associated with interest-rate movements, volatile foreign-exchange rates
and erratic commodity-price movements. Many are effectively complete
methodology, software package and data set (Sessit 1999).

This study does not focus specifically on the use of specific systems or
technologies. However, it is important to consider which technologies
international accountants use because the relationship between system used and
strategy followed is a two-way one. Differences in risk management strategies
are associated largely with the types of tools—including systems—that are used.
While strategies should dictate the selection of tools, sometimes the availability of
certain systems dictates strategy. Differences among multinational corporations
regarding their concerns in choosing derivatives have been due to “driven to
some extent by differences in the accounting treatment internationally” (Lee et al.
2001).
 15

A recent study that surveyed the risk management practices of multinational

companies originating in the United Kingdom, the United States, and Asia Pacific,
found surprisingly little difference in these practices across the different regions.
Although a number of interregional differences in the organisation of risk
management were identified—for example, a greater emphasis on decentralized
structures in the Asia Pacific and less formal board control over risk management
in the United States—little variation was found in the methods of forecasting
exchange rates. The researchers found that the majority of the multinational
corporations, regardless of region, used a central risk management system (Lee
et al. 2001).

Centralization is in and of itself neither bad nor good—its efficiency and efficacy
are ultimately tested by the appropriateness of its systems. Centralization is
likely to continue to increase as rapid advances in computing and information
technology increase the pace of financial market globalization and
sophistication. It is imperative that the financial instruments used in international
accounting keep pace with these developments.

Effective instruments need to reflect the economic effects of entities’ investment

and risk management decisions so that the potential efficiency gains from
globalization can be fully realized and the risk of greater market volatility can be
ameliorated (Heppleston 2000, p. 4).

The nature of international operations frequently provides the tools that mitigate
the risks inherent in that nature. Currency risk is frequently managed using
foreign exchange derivatives. Recent evidence suggests that large companies’
use of foreign exchange derivatives increases with the level of foreign currency
exposure as well as with the degree of geographic concentration, which is
indicative of using less natural hedging (Makar, DeBruin & Huffman 1999). Basic
exchange rate risk mitigation is frequently offered by companies’ banks (Tunui
2002).
 16

Among the tools for addressing political risk is the purchase of political risk
insurance (PRI). Companies may choose to purchase PRI, or they may be
required to purchase it by their banks or financial institutions. Conservative by
nature, certain banks will not finance projects in regions perceived to have high
political risk without PRI—the banks’ own risk management technique (Wagner
2002). Rates of PRI purchase seem to be directly related to traumatic regional
and world events, such as the September 11, 2001 terrorist attacks on the United
States or the more recent events in Bali and Indonesia. At such times, as
demand potentially outstrips supply, prices for PRI are very high.

The above is merely a sampling of some of the tools available for risk mitigation.
These tools are both qualitative and quantitative in nature and their specific
efficacy and applicability were treated in further detail in Chapter 2. However,
tools are not enough. Evidence from China suggests that lack of adequate
supporting infrastructure, manifested in excessive earnings management (i.e.
ways of doing financial reporting in which managers intervene intentionally in the
financial reporting purposes to produce some private gains) and low quality
auditing, continues to affect the performance of Chinese companies. Even though
there are, utilization of sophisticated tools and attempts to comply with the
harmonized international accounting standards (Chen, Sun & Wang 2002).

Tools have to be used with care and they have to fit the background—financial,
economic, political, and cultural—in which they are operating.

What does the above mean for today’s international accounting professionals?
Simply, that there as many if not more risk management tools as there are risks
and business risk situations. An effective international accountant must know
which tool is appropriate for assessing which risk.