Impact Of Risk On Organizations: Why Manage Risk?

Posted in Risk Management on May 8, 2024
Impact Of Risk On Organizations

Impact of risk on organizations. Commonly, organizations focus on those risks that may result in a negative outcome, such as damage from a fire, losing a key customer, or an emerging new competitor. However, unpredictable events should also be considered, as these could have positive outcomes too, such as better-than-forecast weather, stronger staff retention trends, or improved tax rates.

Impact Of Risk On Organizations

Impact Of Risk On Organizations

Furthermore, events that are beneficial to the achievement of one objective could, at the same time, pose a challenge to the achievement of other objectives. For example, a product launch with higher-than-forecast demand has a positive effect on financial performance. However, it may also increase the risk to the supply chain, which could result in dissatisfied customers if the company cannot adequately supply market demand.

Some risks have minimal impact on an entity, and others have a larger impact. Enterprise risk management practices help an organization identify, prioritize, and focus on risks that may prevent the value from being created, preserved, and realized or that may erode existing value. However, just as important, it also helps the organization pursue potential opportunities.

It is, therefore, worth taking note that businesses and entrepreneurs must be willing to take risks to see results. Often, the risk they take is by investing their savings in the new business or ventures. These innovative entrepreneurs can often create much value for their business as long as their new ideas for goods or services are customer-focused. They understand that there is a risk of possible failure if the ideas do not turn into expectations, but it does not mean that businesses will not take risks.

In spite of a risky environment, new business ventures started by entrepreneurs can be based on a new idea or an innovative way of offering a service. They can also be a new location for an existing business idea or an attempt to adapt a good or service in ways that no one else has tried before. Indeed, people who have set up their own new business and have displayed skills of ‘entrepreneurship’ must have taken various risks at different stages of the business.

Organization’s Primary Objectives

An organization’s primary objectives include maximizing shareholders’ wealth, increasing profits and market share. Risks may affect these crucial objectives. If an organization lets risks go unmanaged, it may face potential financial, operational, legal, and reputational losses.

Risks affect a business’s activities, operations, and even financial reporting. Organizations must respond appropriately to fraud risks or suspected frauds identified during the examination of the financial system and reporting process. This is necessary because artificially inflated financial results do not mean that organizational objectives are achieved, and shareholders’ wealth is maximized. 

Therefore, risk management practices and measures are necessary to achieve the goals set by the Board of Directors. Management must take appropriate measures to build the required risk management model in the form of policies, procedures, and internal controls. Managing risk is also the responsibility of every employee of the organization because they all work together in different roles, with the common objective to achieve overall strategic objectives and goals. 

Organization’s Risk Appetite

An organization’s risk appetite, or the types and amount of risk it is willing to accept on a broad level in the pursuit of value, must be managed in terms of strategy and business objectives. The first expression of risk appetite is an entity’s mission and vision. Different strategies will expose an entity to different risks or different amounts of similar risks. Risk appetite guides the practices an organization is encouraged to pursue or not pursue. It sets the range of appropriate practices and guides risk-based decisions rather than specifying a limit. 

The management of an organization is in a unique position to influence employees down the line. However, there could be situations where management might not implement required processes and procedures to identify or assess and manage the risks in different processes and departments. An organization is also often in a unique position to perpetrate fraud because of its ability to manipulate accounting records and prepare fraudulent financial statements by overriding controls that otherwise appear to be operating effectively.

Although the level of risk of management override of controls will vary from organization to organization, the risk is nevertheless present in all organizations. Due to the unpredictable way in which such override could occur, the risk of material misstatement in financial statements could be material, leading to false impressions on the shareholders and investors.

Fraudulent Financial Reporting

Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. There are several techniques to committing fraud by overriding management controls. These include: recording fictitious journal entries, particularly close to the end of an accounting period, to manipulate operating results or achieve other objectives; inappropriately adjusting assumptions and changing judgments used to estimate account balances; omitting, advancing, or delaying recognition in the financial statements of events and transactions that have occurred during the reporting period.

Concealing or not disclosing, facts that could affect the amounts recorded in the financial statements; engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity; and altering records and terms related to significant and unusual transactions.

To achieve the objective of shareholders’ wealth maximization and to increase the market share with a good reputation, an organization must take measures to ensure organizational risks are continuously identified and assessed for appropriate management of identified risks. The Board of Directors and Senior Management must maintain an attitude of professional skepticism to promote and maintain the risk management culture at all levels. This is necessary because the impact of risks may be high leading to operational, reputational, and financial losses. 

Risk management measures are to be taken as a part of the organization’s strategy because the core of ERM is that the strategy and enterprise risk management practices should be aligned with each other. The strategy should not be developed in isolation of risk management practices because there may be elements in the strategy that may lead the organization to potential and significant operational and financial losses if the timely risk assessment processes are not performed for each component of the strategy.

Therefore, as a practice, the organization involves the risk management team in the process of setting the corporate strategy to have the assessment from a risk point of view. It becomes important for risk management professionals to consider the economic factors and the regulatory requirements applicable to the organization, which must be complied with during the execution of the strategy. 

Final Thoughts

Risks are also considered from the point of view of liquidity and working capital, for if the strategy is set without performing a liquidity risk assessment, the efforts to achieve the strategic objectives could result in a potential liquidity crisis. This could, in turn, lead to the liquidation of the organization. Therefore, the strategic objective must be aligned with existing and emerging risk assessments and scenarios.