All businesses and financial institutions are subject to various methods of 'control'. These ensure that the business continues to operate effectively, but also ethically, legally and viably. These controls can come in the form of social control, administrative control and self-exercised control (Hopwood, 1974). Sometimes, these controls operate by regulating the way in which activities are conducted - the mechanisms of operation, but sometimes control is exercised by assessing outcomes and ensuring that these are in line with recommended limits. Financial accounting is therefore often seen as playing a key role in assessing performance and monitoring outcomes to ensure they are in line with pre-established dimensions. In the case of financial organisations that engage in lending practices, these control limits are not only generated internally, but also imposed through regulation within the industry - in the form of Basel II requirements. These dictate how much capital a bank must maintain in line with the amount of risk that the bank is carrying. This level of risk is one of the 'outcomes' of operations that must be assessed by financial accountants. However, the efficacy of these risk models (and by extension, general quantitative mechanisms of assessment and control) is sometimes questioned. This essay will examine the paper forwarded by Wahlstrom, which addresses the requirement in the financial industry to calculate risk using quantitative accounting models. It will then take the lessons learnt from Wahlstrom's paper and apply them in a more general sense, examining not only the calculation of risk, but the calculation of a wide range of financially related business outcomes. The essay will identify that there are a number of issues with relying exclusively on quantitative models of measurement, and therefore presents a potential framework that accommodates a more holistic assessment of business performance. This model allows businesses to exercise more effective controls and show accountability in a wider range of areas.
Underpinning Wahlstrom's argument is the idea that perceptions of management and control systems are just as important as the physical construction of those systems. A model that shows itself to accurately measure and control risk will only be effective if those applying it have confidence in its efficacy and believe in the underlying ideology that numerical measurement is the most effective tool for risk management. His study engages with a number of bank workers in order to identify how they perceive the requirements of the Basel II guidelines. His findings indicate that there is a division in perception between those who engage directly with risk management activities, and those who activities are based around operational action. Those who operate within the risk management arena perceived the Basel II requirements positively; they believed that using quantitative risk measurement techniques was beneficial for financial institutions, because it allowed them to align their capital stores with their actual level of risk. This in turn freed up capital for investment, which in turn could generate profit. They therefore stated that they would have implemented (or had already been implementing) quantitative risk management models regardless of the Basel requirements. However, they none-the-less perceived Basel II to be positive and necessary, since it provided added incentive for other institutions that were not yet engaging in suitable quantitative measurement practices (this incentive comes in the form of a reduced minimum capital store imposed by governing legislation). They believed that Basel II imposed centralisation and uniformity across the industry, and that this would positively benefit the operations of all organisations.
Conversely, those who were engaged in operational activities did not perceive the Basel requirements in such a positive light. It should be noted that none of the respondents criticised the general underpinning theory of implementing Basel II, and all felt that having a system of quantitative control was important. However, the degree to which this was felt by operational staff was less extreme than the support given for quantitative controls by those more closely engaged in risk management. Wahlstrom further identified that existing views regarding the benefits of centralisation would affect the opinions held on quantitative control measures, and in particular the Basel II regulations. He identified that those who worked within decentralised banks were more critical of Basel II, due to the fact that it promoted uniformity and centralisation. In contrast, those who were used to operating in an environment that favoured centralisation felt more comfortable with the requirements that were forwarded under the Basel II guidelines.
There were a number of reasons why Basel II was criticised. One of the first one was a perceived gap in knowledge between risk identifiers and operational managers. Wahlstrom identified that those engaged in operational management were often very senior, and could be as much as 30 years older than the more recent recruits in risk management departments. As such, the senior managers viewed the activities of risk managers with some scepticism, believing that their knowledge was finance was purely theoretical and did not ground itself upon real world market and business knowledge. As such, it could be said that their concern was with the degree to which Basel II could be implemented properly, rather than a problem with the guidelines themselves. However, this focus on a need for real world knowledge highlights that fact that those not engaged directly with risk management activities valued real knowledge more, and undervalued quantitative measurement when compared to their risk management counterparts.
Something that this highlights regarding the Basel II requirements are that they are too complex, and therefore inaccessible to those who are not trained specifically within risk management disciplines. Arguably, if Basel II were more accessible to and better understood by operational managers, then they would feel more comfortable with the use of numbers as a management and control tool. Furthermore, a lack of understanding regarding how the numbers were generated meant that operational managers felt frustrated at the fact that the Basel II requirements were extremely resource intensive, but there was no real understanding of how or why those resources had to be used.
A further practical criticism of the Basel II requirement for risk measurement was that when these figures were used to determine practice, it often resulted in banks pursuing very similar paths. This uniformity of practice across the industry, as opposed to just within a particular organisation, was viewed as negative for the market in general. The example of standardised mortgage practices was given. Concern was also raised regarding the power that Basel II gave to supervisory bodies, who could raise or lower the capital requirements of a bank depending on the economic circumstances. Operational managers did not trust the supervisory bodies to make the right decisions; they expressed the belief that in times of financial crisis, the bodies would raise the minimum level of required capital. As a result, banks would have fewer funds available for investment, and this would in turn perpetuate and worsen an already negative financial climate.
As well as promoting uniformity, the Basel II requirements were also viewed by operational managers as promoting and favouring banks that had adopted centralised structures. This was partly attributable the perceived high cost of creating quantitative models, meaning that one model would be developed centrally and then used throughout the organisation.
As can be seen, the majority of these criticisms are aimed at specific elements of the Basel II requirements, and do not directly attack the principle of using numbers as the basis of risk identification, and thus as a control mechanism and determiner of strategic direction. None-the-less, some scepticism is shown towards the concept of quantitative measurement and control, particularly by those engaged in operations based activities. Wahlstrom, in his identification of the academic failures of Basel II, identifies that quantifying risk use calculation methods may not be the most suitable method of identifying and allocating risk. He states that the 'superiority' that is usually accorded to risk quantifying practices may occur due to the perpetuation of the view by academics, and not necessarily because of any inherent superiority. He identifies that this has occurred because previously, finance was taught by real world practitioners, but now the teaching of finance is often conducted by academics who have a lesser understanding of the real world issues involved in finance. As a result, their development of models is either 'inward looking' (ie, designed to impress fellow academics rather than promoting good practice) (Lee, 1995) or simply fails to grasp the necessary real world issues that will contribute to an effective and applicable measurement model.
Wahlstrom also identifies that a social perception of the value of quantitative mechanisms has led to their promulgation in business. He identifies that there is an inherent 'appeal' in the use of numbers as a mechanism of control, but states that this 'appeal' may be misplaced.
Wahlstrom's report on Basel II provides some important insights into the more general world of accounting. The points that Wahlstrom has made regarding the calculation and control of risk can be applied to wider accounting practices. The first, and most significant lesson to be taken from Wahlstrom's article is that accounting (ie, control through numbers) is not the only method of exercising control or accountability, nor is it necessarily the most appropriate or effective. This is true for a number of reasons. The first of these is that often, the models that accounting bases its practice on has been determined by academics who do not have the promotion of effective business practice as their central motivation. Furthermore, accounting models and control through numbers can promote uniformity and centralisation, which can have a negative effect for the market or for the business itself. The final reason that numerical models may not be the most effect method of management and control are because they have not been empirically tested to identify how effective they truly are. These models are often perceived as superior, but testing of this assertion has been severely lacking in the academic literature.
The second important message to be taken from Wahlstrom's study is that the efficacy of accounting practices as a method of control is likely to be viewed differently based on the background of the individual. Those who are trained in the use of quantitative data as a measurement and control device will generally perceive quantitative accounting models to have more value than those who are not trained in financial accounting practices. Accounting models therefore need to be open and accessible in order that there value may be more easily identified by operational managers. Furthermore, operational managers should be encouraged to develop an understanding of accounting practices, whilst accountants should be encouraged to understand that numbers are not necessarily superior in determining future action. In developing this understanding, both parties are able to 'bridge the knowledge gap' that currently exists, and as a result their activities will be more coordinated and will 'pull in the same direction'.
The question to be asked is - are Wahlstrom's 'lessons' particular to the role of management accountancy in the banking industry, or do they have wider application in other business contexts? This idea of harmonising accounting management and control with traditional management and control is not exclusively forwarded by Wahlstrom. Indeed, there has been a wide range of literature that promotes the idea of a 'new' model of accounting management practice, which incorporates non-financial metrics in an assessment of performance, and the deployment of control mechanisms.
How then can these more modern theories of the role of accountancy management (typified by Wahlstrom's theories) be accommodated in a practical model of management and control? It should be stressed that Wahlstrom is by no means denying the place of accountancy measurement and control in an overall management system - therefore they must still be incorporated to a degree. However, financial metrics should not be afforded exclusive importance; instead they should be made accessible to managers outside of the accounting sector, and should afford equal importance to non-financial measures and control methods. There are a number of different accounting management tools and frameworks that can be used to monitor activities (whether this would be risk or some other factor), control operations and offer accountability. These include target costing, product life cycle costing, customer profitability analysis and backflush accounting (Bhimani, 2008). Each of the methodologies places a differing level of significance on the use of numerical models to assess and control future performance. One potential framework that can be altered to accommodate various levels of accounting measurement and control is the 'balanced score card' methodology (Kaplan and Norton, 1996). The balanced scorecard uses financial metrics as only one of four metrics that monitor and control overall operations; the others are customer, internal business process and learning and growth. Bhimani et al (2008) identify that this model of accounting management has the advantage of evaluating both short run and long run performance. The authors state that using purely financial metrics as a device for control leads to short term thinking and action, whereas operational indicators can give a greater picture of the long term direction that a company is taking.
Furthermore, the model has the potential to mitigate or eliminate many of the problems that were identified by Wahlstrom as being a part of purely numerical control models. Businesses reduce the risk that their practices will emulate each other so closely because they must base control mechanisms on a wider range of factors. However, the central advantage of the balanced score card is that it helps to bridge the gap between operational managers and accounting managers, instead bringing their perspectives in a complimentary fashion. It ensures that businesses do not focus exclusively on monetary performance and cost reduction, instead, they learn to control other important variables. Drury (2004) identifies that the ability of the balanced scorecard to adopt a more holistic approach to business control means that accounting management can take a 'strategic' approach to the control mechanisms that it exercises. He states that the balanced scorecard constitutes 'an integrated framework of performance measurement that can be used to clarify, communicate and manage strategy implementation'.
This essay has clearly identified that despite Wahlstrom's focus on risk calculation and control, there are a number of lessons to be taken from the paper that relate to the wider use of quantitative models in accountancy management. These lessons relate to two central ideas. The first of these is that quantitative models have been promoted throughout the industry as the ultimate form of measurement and control, but exclusive reliance on these metrics may be misguided. Furthermore, there is a discrepancy between different groups of managers regarding the place of quantitative metrics and control devices. Those who are closely engaged in their use generally find them to be important, whilst managers who focus on the operational side of an organisation are generally sceptical regarding the value of quantitative methods of assessment. They find them resource intensive, confusing and lacking in 'real-world grounding'. For this reason, the balanced score card is forwarded as a potential device that will harmonise the differing opinions of various management groups, and adopt a holistic view of business operations that allows for more complete accountability, and more effective controls.
- Bhimani, Horngren, Datar and Foster (2008) Management and cost accounting, Pearson
- Drury (2004) Management and Cost Accounting, Cengage learning
- Hopwood (1974) Accounting and human behaviour, Prentice Hall
- Kaplan and Norton (1996) Using the balanced scorecard as a strategic management system, Harvard Business Review Jan - Feb pp.75-85
- Lee (1995) Shaping the US academic accounting research profession: the American Accounting Association and social construction, Critical Perspectives of Accounting 6, 241-261.
- Wahlstrom (2009) Risk management versus operational action: Basel II in a Swedish Context, Management Accounting Research, 20, 53-68