Impact of Business Risks on Financial Statements of a Business

A business entity’s objective is usually stated as the objective of maximizing profits or wealth. However, business risks exist in every business, which could threaten the ability of the business entity to achieve its stated objective, and as such impact the financial statements.

Business risk is the risk that an adverse event or development can occur which could adversely affect the ability of a business to achieve its objectives. Any adverse event which can significantly affect a company’s business is expected to also affect its financial statements, including its going concern –that is the ability of the business to remain in operation in foreseeable future, such as the loss of a major customer or increase in the cost of key raw materials for production.

Business risk may arise from the external environment in which a company operates (which might include; low demand for a key products, proposed changes in laws and regulations by the government, effect of a new technology, changes in interest rates, changes in exchange rates, threats from existing or new competitors, and other environmental hazards), or from within the business (internal) processes (such as; weakness in internal control or accounting system, poor working capital management, excessive gearing level, poor management or inexperience personnel, poor customer services, lack of innovations or failure to invest in research and development, fraud or misappropriation of company assets and so on).

Other business risks identifiable to the financial statements include;

  • Bad debts or provision for doubtful debts may be wrongly stated; in other words, failure to make sufficient provisions or allowance for irrecoverable amounts as result of some doubts if amounts receivable for a period will actually be recovered, resulting in overstatement of profit and receivables. Although it may not be definite that certain amount is irrecoverable, recoverability of some receivables may be doubtful, such receivables are known as doubtful debts. Standards requires that a provision be made to recognize the potential loss arising from the possibility of incurring bad debts. The provision for doubtful debts reduces the receivable amount that the business estimates to recover in the future.
  • Inventories may be wrongly stated; where Net Realizable value is less than cost), which may result from the procedures a business adopted in inventory count or the timing of the physical inventory count. ; (IAS 2 – Inventory,  requires inventories to be measured at the lower of cost and net realizable value (NRV) and outlines acceptable methods of determining cost, including specific identification (in some cases), first-in first-out (FIFO) and weighted average cost.
  • Non-current Assets (Fixed Assets) may be wrongly stated; just as the provision for doubtful debts reduces the receivable amount that the business estimates to recover in the future, accumulated depreciation to which non-current assets are subjected, is deducted from the non-current asset cost account in Statement of Financial Position. However, there may be the risk that non-current assets are over stated in value when there is reason that impairment has occurred. IAS 16 – Property, Plant and Equipment requires Property, plant and equipment be initially measured at its cost, subsequently measured either using a cost or revaluation model, the determination of their carrying amounts, and the depreciation charges and impairment losses to be recognized in relation to them
  • Revenue and other income may be recognized wrongly; and not recognized in accordance with the requirements of IAS 18 – Revenue. In most cases, there is the risk that revenue will be over-stated as a result of the period in which revenue from the sale of goods, rendering of services, and for interest, royalties and dividends are recognized.

Revenue is defined as the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends). [IAS 18.7]. IAS 18 – Revenue requires that revenue be measured at the fair value of the consideration received or receivable and recognized when prescribed conditions are met, which depend on the nature of the revenue; that is; revenue should be recognized in the income statement when it meets the following criteria:

  • it is probable that any future economic benefit associated with the item of revenue will flow to the entity, and
  • the amount of revenue can be measured with reliability

When clients or customers make advanced payment for goods or services for instance, revenue should not be recognized until the goods or services have been provided, not when the payment is received.

  • Liabilities such as provisions may not have been adequately made in the financial statements when there are appropriate reasons to believe that such provisions should have been made to increase liabilities for a period and reduce profit.

Many of these business risks can never been exhausted here, what matters is when to identify these risks and properly deal with them, what is your risk management strategy? Is it effectively designed to reduce your identified business risks to acceptable level? How is your routine risk assessment report? How do you deal with identified risks in your business?

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Ways you can deal with identified business risks

Basic ways of dealing with or mitigating risks are not exceptional to only business risks, therefore, it can be applied to other known risks.

Risk mitigation is considered risk management strategy adopted to reduce adverse effects of risks. It involves having in place controls to reduce the likelihood or impact associated with the risks. “When mitigating risk, it’s important to develop a strategy that closely relates to and matches your company’s profile.” What are these risk management strategy?

  1. Risk Acceptance: this involves allowing the system to operate with identified risks especially areas of low risk exposure. High risks can also be accepted by the management, this risks are costly to mitigate and a common risk acceptance strategy option when the cost of risk management may outweigh the cost of the risk itself. In most cases, the probability of the risk events occurring is very low, therefore, businesses tend to accept the risks by not spending a lot of money avoiding them.
  2. Risk Avoidance: Risk avoidance is the opposite of risk acceptance. This involves removing the risk exposure areas of the system or the system itself to avoid the risk events whatsoever. Policies and procedures can be established which assist the business foresee and avoid high-risk situations.
  3. Risk Reduction/Limitation or Control: Assessment or analysis of risks can help a business identify and prioritize risks, then reduce the probability of occurrence or the severity of the consequences of an unwanted risk; or put in place effective controls for early detection before the occurrence of risk events. For instance, management decision to improve the design defect of a product line before a product launch; having detected some flaws. Risks can also be reduced through diversification. It is common for business to limit or reduce its risk exposure by taking some appropriate actions, understanding the risk that a system with a company files may fail prompts such a company to have system backups to reduce or limit the negative effects of system failure.
  4. Risk Transference: transference means to shift the burden of the risk consequence to another party or allowing another party to accept the risk on your behalf. A conventional way to transfer a risk is purchase of insurance. Contract terms with suppliers, vendors, contractors, etc. may provide a means to shift risk away from your organization. Companies without certain functions’ core competencies tend to outsource those functions such as accounting/bookkeeping, payroll service, customer service, Information Technology, etc. to reduce the overall financial impact of the risk events and focus more on their core competencies.

Each business risk has its uniqueness which must be considered in the risk management model of an organization to deal with identified risks. Understanding a set of clear risk mitigation plan in the entire organization is key for effective implementation. As simple as the risk management plan of an organization should be, there are a few essential such as:

  • Developing a clear list of identified individual risks
  • Arrange or rate each risk based on likelihood of occurrence and impact
  • Conduct an assessment of current processes and controls, and
  • Decide a plan of action.

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