17.
How do accountants manage risk and uncertainty?

17.1 Risk and uncertainty

It is said that there are only two things in life that are certain. They are claimed to be death and taxation.

We make this point for two reasons. The first is to demonstrate that certainty is not commonplace in our world. The second is to demonstrate that the basis for any claim that a person makes has always to be examined if its true nature is to be understood.

There are two attributes of our everyday activities. The first is that there is risk about their outcomes, and the second is that their outcomes cannot be known for sure, meaning that they are uncertain.

The conditions of risk and uncertainty have been known to mathematics for a very long time, but it seems that these ideas were introduced into economic thinking by almost certainly the greatest economic thinker of the twentieth century, John Maynard Keynes, or Lord Keynes as he was at the end of his life. From a UK perspective, a significant achievement was to work out how to fund both of the twentieth-century World Wars on behalf of the UK government. From an economic perspective, his revolutionary thinking during the 1920s and 1930s shaped much of what was called the ‘post-war economic consensus’ that dominated economic policy in Europe, the USA and elsewhere from 1945 to about 1980.

One of the books that he wrote during this period was his Treatise on Probability.¹ It was in this book that Keynes first began to consider the difference between activities with certain, risky or uncertain outcomes.

It is important to say that certain outcomes do exist in economic activity, and so in accounting. As Keynes made clear, if all transactions were to take place in a moment, then neither risk or uncertainty need trouble us. For example, if a reporting entity makes a sale in exchange for cash, then the outcome of that transaction is certain, presuming that no right of return is granted. No professional judgement as to how to record this transaction is required; it then becomes a straightforward technical issue to identify the debit and credit that record it in the right place, and there is no more judgement required than that.

Complications involving consideration of both risk and uncertainty can only arise in accounting if we undertake transactions that are intended to have economic consequences in the future. When that happens, those consequences are either risky or uncertain. An activity with a risky outcome is one to which probabilities of success can be attributed. This, in turn, requires that the accountant can foresee all the possible outcomes that might arise from undertaking the action and then, secondly, can attribute reasonable probabilities of likelihoods, expressed in percentage terms, to each of these outcomes occurring. An example might be the provision for doubtful debts.

In contrast to a risky activity, an uncertain course of action is one where the potential outcomes of the activity cannot be known. It is therefore impossible to determine the likelihood of any one outcome arising because a complete set of outcomes cannot be identified. This means that it is, in turn, impossible to attribute a probability of the event happening, even to those which might be known.

17.2 The practical application of the concepts of risk and uncertainty in economics and accounting

This division between what is either risky or uncertain, because it involves the ability to allocate probabilities to defined set of outcomes, appears to create a very clear divide between the two groups if the terms are used in their strict mathematical sense. However, Keynes did refreshingly suggest that this strict division might be inappropriate when these two concepts were used in an economic environment. He suggested that in these situations more commonplace or everyday interpretations should be used. In other words, he accepted that uncertainty (which is the issue with which he and we should be most concerned) might be almost as rare as certainty is, since it requires that there be an absolute absence of knowledge about the potential outcomes of an activity, but that in reality we claim outcomes are uncertain because we have no way of realistically predicting which of those outcomes might occur. Our uncertainty can then relate, when considering an economic activity, to our inability to forecast likelihoods of outcomes rather than outcomes themselves. While Keynes did not talk about accounting when making that suggestion, it seems fair to apply his insight to accounting.

This then lets us define the difference between certainty, risk and uncertainty in most situations that an accountant will encounter.

• Certainty exists when the outcome of an activity is known.
• Risk exists in a situation where the potential outcomes of an activity are known and reasonable probabilities of them occurring can be attributed to each outcome.
• Uncertainty exists when, even if the likely outcomes of an activity are known, there is considerable reasonable doubt as to which outcome might happen based on currently available information.

The future life of an asset is not known. For example, it might be destroyed in an accident. It could be stolen. It might be rendered obsolete. Spare parts might cease to be available for it. In practice, the life of most fixed assets owned by a company is uncertain.

The amount that might be paid by a customer to whom goods are sold on credit depends on:

• whether they decided to settle early to claim a discount for doing so
• whether they dispute the quality of the goods supplied and seek either to return them or claim a discount as a consequence
• whether they become insolvent before settlement is due.

In practice, a probability based on the reporting entity’s own experience can predict the likelihood of each of these events happening. As such, while the payment to be made by such a customer when viewed individually is risky, an overall level of risk of non-payment across all the sums due to the reporting entity can be estimated with some accuracy.

However, if particular situations arise, for example an economic downturn or a particularly high concentration of sales with one customer, past experience may not be a good guide to what might happen with regard to customer payments. The accountant might then need to consider those amounts that will be paid as uncertain and reappraise the likely net value of sums owing to the company from customers.

17.3 How the accountant manages risk and uncertainty

There are no right or wrong answers to the reflection immediately preceding this section. What it points out instead is that even with regard to quite simple things, such as the expected life of our mobile phone, we have to exercise considerable judgement when it comes to managing the uncertainty that inevitably exists around that subject.

We usually presume that risk and uncertainty only exist about events that might have consequences in the future. This is not always true, for reasons noted in Section 17.2, but for the moment let us assume that this is the case.

Before discussing management of risk and uncertainty in detail, let us consider some overarching principles of this management.

Prudence

When considering these issues, the concept of prudence is especially important. This concept was omitted from the International Financial Reporting Standards Conceptual Framework for many years but was reintroduced to it in 2018 in the aftermath of the Global Financial Crisis of 2008, because many commentators suggested that the financial statements of many banks were insufficiently prudent when it came to loss provisions on loans made in the years running up to that time. Chapter 2 of the IFRS Framework now defines prudence ‘as the exercise of caution when making judgements under conditions of uncertainty’, which places it firmly in the middle of the issues being discussed here.

These words are not deeply illuminating in themselves, and that is at least in part because some commentators were not persuaded in 2018 of the need for the inclusion of prudence in the IFRS Conceptual Framework, despite the fact that it has been considered an essential quality of accounting decision-making for more than a century.

That said, the practical interpretation of the concept of prudence is clear. It is that if there is a choice between:

• two bases for reporting income, then the one that reports the lower figure should be used
• reporting two figures for expenditure, then the higher figure should be used
• two bases for valuing the worth of an asset, then that which reports the lower figure should be used
• two bases for estimating the value of a liability, then that which discloses the higher figure should be used.

These choices show why some claim that the concept of prudence introduces a bias in financial reporting towards the under-declaration of profit in the present period even if that means that there is risk that a resulting, compensating, over-declaration of profit might be required in a later period.

The resulting possibility that prudence creates within a reporting entity that is not concerned about the public perception of its financial statements is that it does provide an opportunity for a company to under-declare profits at a point of time with a potential resulting risk that tax might be underpaid as a consequence. Tax authorities around the world take different approaches to managing this risk, but any company that over-exercises prudence for this reason does create the risk, or even uncertainty, of a tax audit by their tax authority, resulting in the consequent likelihood of an upward restatement of their tax liabilities. Such tax audits are usually expensive and time-consuming to manage. The key point is that supposedly prudent financial reporting should not itself introduce volatility into financial reporting by the successive under- and over-statement of profit that would not otherwise be present.

That said, there is a consensus, now reinforced by the IFRS Conceptual Framework, that professional accountants should be prudent when making their judgements. This means is that when they decide to adopt a prudent course of action, they should document the fact that this decision has been required and record:

• the nature of the decision that they took
• the possible courses of action that they considered available to them
• the available evidence to inform the decision
• their estimate of the risks and uncertainties in the matter, and how they determined them
• the decision criteria that they chose to use, and why they dismissed alternatives
• the consequent calculations that they undertook
• how those calculations are reported within the financial statements
• what disclosures might be required with regard to this matter, particularly if the consequence of the prudent decision is likely to be material to a decision made by a foreseeable user of the financial statements who does, as a consequence, need to be informed.

These documents then form a part of the accountant’s working papers that support the financial statements that they have prepared. If the report entity is subject to audit, these papers would have to be made available to that auditor for them to appraise the reasonableness of the assumptions that the accountant has made. Therefore, it is vital that an accountant develops the necessary discipline in recording their decision-making in conditions of risk and uncertainty if they are to properly fulfil their professional duties.

The way in which the issue of prudence impacts the accounting management of risk and uncertainty is explained in the following question and reflection.

Worked example: Prudence in action

Suppose an organisation makes a sale on its usual credit terms with the value of the good sold amounting to £100. The reporting entity knows that on average 97% of its customers eventually settle invoices. The other 3% either raise dispute which results in non-payment, or become insolvent before collection of the debt can be recorded. Are the accounting consequences of this transaction risky or uncertain, and how must it be recorded in the financial statements taking into consideration the fact that unpaid debts are treated as bad debts in the income statement of the organisation?

Answer

The likely value to be recovered from this sale is £97, which is the £100 invoice value less the 3% probability that it will not be paid.

There are two ways to record this sale:

• The sale could be recorded when made as having a gross value of £100 with £3 of potential bad debt being recorded at the same time, leaving £97 as the value to be recovered shown on the balance sheet. This presentation would be true and fair and reflect the actual risks within the transaction. The problem with this approach is that it is very unlikely that the sum of £97 will be paid. Either £100 or nothing are the most likely payments of this debt. So, if payment of £100 is received then the previously recorded bad debt would have to be reversed. Alternatively, when it is understood that nothing is to be paid, an additional £97 of bad debt would need to be recorded. These entries are cumbersome to record and time-consuming to put in place.
• Alternatively, and much more commonplace, is the recording of the debt at its full £100 value, with a provision being included in the accounts at each period end to reflect the 3% likelihood that some of the outstanding debts would not be paid. In other words, if total debt at that time was £12,000, then £360 of this sum will be provided for as a bad debt, with charge being made to the income statement for this potential cost, and the trade receivables on the statement of financial position being recorded as £11,660, which is the sum of £12,000 gross less the provision made. This presentation in the accounts would also be considered true and fair, unless it was known by the time that the accounts were prepared that the £100 would not be paid, when it would need what is called a specific provision to be made to write it off as a bad debt.
• As is apparent, the accountant of the reporting entity involved undertakes a lot of judgement. If the accounts are to be properly documented, the entries made would all need to be supported by notes as described above.

Worked example: Provisioning for losses

A fashion retailer has heavily invested in its summer range. Sales of the summer range are heavily dependent on a good, dry summer, with regular high temperatures.

The reporting entity has a year-end reporting date before the end of the summer season.

The summer turns out to be wet and miserable. The likelihood that the fashion range will succeed depends on:

• whether there might be a good late summer season because of improvements in the weather
• whether the range could be successfully sold at discounted prices in end-of-season sales, incurring a loss as a result
• whether the retailer can exercise the option to return excess unsold stock to manufacturers, either under the terms of their contracts, or because they can create other claims to justify return, for example, relating to the quality of the goods, whether that is a real issue or not, and notwithstanding the ethics involved.

Considerable quantities of this fashion range are held in stock at the period-end date, still awaiting sale. How should these matters be reflected in the retailer’s period-end accounts?

Answer

Most accountants would consider the scenario described as a difficult situation, but prudence helps resolve the situation.

The reporting entity did not, of course, have any control over the weather. Similarly, it has no control over the prospect of there being a late summer season during which some, or all, of the product that looks to be of doubtful value at the period-end date might be sold. Precisely because the company has no control over these outcomes it is operating in a situation of accounting uncertainty which it can only seek to mitigate by trying to turn it into a risky situation by undertaking one of the two potential courses of action that might remain open to it, or a combination of both of them.

The accountant must decide when the decision that gave rise to the loss occurred. Since the design of the summer fashion range and the orders for the products – the events that in combination have created the risk of loss – must have both taken place before the period-end date, prudence requires that any loss should be included in the account to that period-end date.

Next, the accountant must ask how much might be recovered from sales of items left in stock at the period-end date, also taking into consideration any cost incurred in selling them. No one can make an objective decision on this issue. As all retailers know, the outcome of discounted sales periods can never be known in advance. If, for example, the weather is really good at the time that this discounting takes place, all the products in question might sell out and there might be none for the retailer to try to return. Alternatively, discounting might be of little benefit when the summer season is already over, and the retailer might be left with considerable quantities of goods to try to return, with the risk that this might seriously prejudice its future relationship with its suppliers. An accountant would have to take all these factors into consideration and then estimate the possible losses that might arise, knowing that no precise answer will ever be possible and that a best estimate is the most that can be hoped for.

The basis for all these decisions will have to be recorded as described above, and the retailer’s accountant might well then be left with the prospect of arguing their case with their auditors, who might form an entirely different opinion, and require that provision for losses be made, regardless of what the accountant thinks. Both will be guided by the prudence principle but may make different judgements as a consequence.

Provisions

Sometimes it is necessary for a set of financial statements to recognise that a reporting entity faces a situation where the future outcome of current or past events can, at best, only be approximately estimated. When this happens disclosures might be required in the financial statements.

The first of these potential disclosures is described as a provision. The International Accounting Standard 37 describes a provision as ‘a liability of uncertain timing or amount’. The liability in question may be a legal obligation – due by law or because of a contract – or a constructive obligation, by which the company accepts that it will have to settle the sum in question whether law requires it or not. An example of a constructive obligation is the costs of managing the transition to a net-zero position to ensure the ability to trade in the future.

Worked example: Provisions

Suppose that you are the accountant for a mining company. The company has accepted a legal obligation to restore the landscape of the land from which it is extracting minerals at the time that it ceases to do so.

At your reporting entity’s period and date no one knows when your company’s mine might cease operating. Nor is the potential scale of the mine at the time of ceasing operations known. What the potential cost of making good the landscape might be at that time is incapable of precise estimation because too many variables exist (time, work to be undertaken, cost, changes in the value of money overtime, and so on). However, the liability to make good the land that has been spoiled by the mining operation to the period-end date does clearly exist and must be recognised if the accruals concept of accounting is to be properly applied to your entity’s financial statements. How should this situation be managed?

Answer

In a situation such as this, the requirement to document the decision-making process that the accountant uses in the way noted previously in this unit is appropriate. It would, however, be expected that the accountant:

• emphasise the uncertainty in their calculations
• undertake such calculations on a range of different bases to see what the potential range of outcomes might be
• make prudent provision for the outcome which looks like most likely, but which might, in that circumstance, not be the costliest
• include this provision as a liability in the financial statements of their reporting entity, also recording any change in that provision arising during the period as a cost, or potential gain if that provision has reduced for any reason
• make full narrative disclosure of the reason why this provision has occurred, what cost it represents and what it is expected to cover, and how, at least in broad terms, it has been best estimated.

Without such disclosure the financial statements might be materially misleading.

17.4 Contingent liabilities

Provisions have to be estimated and disclosed if the situation to which they relate is risky – in other words, if the circumstance to which they relate will definitely arise, even if the outcome is uncertain because the potential cost of that outcome is subject to considerable doubt.

There are other circumstances in which a company can face potential costs whose likelihood is itself uncertain. For example, a company faces a major legal action which might impose substantial cost on it. In circumstances like these, the amount of judgement required as to whether any cost needs to be included in the accounts is even greater than where a provision is necessary. That is because while a provision relates to an outcome that is likely to happen, this second scenario relates to a situation where the outcome might never arise. For example, in the situation described, the legal claim against the company might fail and all the reporting entity’s defence costs might be recovered from the claimant.

In this situation, the reporting entity has a duty when preparing its accounts to follow the whole decision-making process noted previously in this unit to determine whether it needs to make disclosure about this matter in its financial statements.

The difference between this situation and that relating to a provision for a situation that is known will arise, but with uncertain cost, is that if there is an uncertain outcome which regard to a claim against the company, then it has the option of not making a provision for the costs that are being claimed against it on the grounds that it thinks they will not be payable, for example, because they think they will win the legal claim case in question.

To determine what, if any, provision needs to be made in such circumstance the entire decision-making process previously noted in this unit will have to be followed by the accountants to the reporting entity. The important point to note is that even if accountants to the reporting entity decide that a provision is not required, the risk that it creates might still be material to the understanding of the financial statements by any potential user. In that case the reporting entity is required to disclose its existence. They do so by describing it as a contingent liability.

Contingent liabilities are referred to only in the narrative notes to the accounts, and no actual entries are made in the numerical financial statements themselves. Instead, a narrative note explains the potential extent of the claim against the company for the costs that they have decided not to provide. As with a provision, sufficient information must be disclosed about a contingent liability so that a potential user can decide if they wish to accept the risk of engaging with the company, knowing that this liability might arise in the future, although the company itself thinks that is unlikely.

An example from oil and gas company, Total Energies can be found in the notes on provisions and other non-current liabilities.

17.5 Risk and uncertainty relating to past periods

It is usually assumed that risk and uncertainty might relate to future periods, but this is not always the case. If judgements made about risky and uncertain situations in past periods prove to be materially inaccurate it can be necessary for financial statements to be restated.

For example, taking the mining example above, if in the current period new legislation was passed by the country in which the mine is located that both makes its future operation economically impossible and significantly increases the cost of restoring the landscape to its pre-mining state over the sums included in the financial statements of prior periods, then those financial statements will have been proved, in retrospect, to have been materially inaccurate. This will be both about the likely value of the investment in the mine and with regard to the cost of remedial work required when the mine closes. As a result, significant additional provisions will be required in the financial statements to write off the investment involved, and to increase the provision for reinstatement of the land.

In this case, the accountant must ask whether this additional cost should be reflected in the accounts for the current period, or whether to restate the comparative figures reported alongside those accounts to note that errors of judgement were made on asset lives and remedial costs when they were prepared. This restatement could only be justified if the risk of the new legislation was known when the accounts were prepared but was not considered then. If that was the case, a restatement of those prior-year accounts might be appropriate, with the restatement including those provisions. The consequences of making such changes would have to be fully disclosed in the financial statements for the current period, explaining what the impact of that restatement might be both in that prior period and in the current one.

17.6 Summary

• There are very few transactions with consequences arising after a period-end date that are free of risk and uncertainty.
• Situations involving uncertainty necessarily require the exercise of considerable judgement by any accountant involved in preparing financial statements.
• Accounting is not just a matter of adding things up.