Risk is an unavoidable part of doing business, but it can be managed through comprehensive assessment and management. In fact, the majority of internal and external threats companies face can be addressed and mitigated through risk advisory best practices. But it can be difficult to measure your risk exposure and use that information to position yourself for success.
The best way to prevent risk – and reap the full benefits of effective risk and opportunity management – is to hire an advisor (like Centri). This blog is designed to help you make the right choice by answering the question “why is risk advisory important for businesses?” We’ll also review internal controls and explore their interconnected relationship with business risk management.
What is Business Risk?
Simply put, business risks are preventable internal (strategic) or external threats that affect whether you achieve your organizational objectives. Risks exist in every decision your business makes and are inseparable from desirable performance and outcomes. And while it’s virtually impossible to determine your exact risk exposure, you can take certain measures to anticipate potential losses.
There are a wide variety of business risks, and they vary depending on your specific industry. A few of the most common risks include:
- New competitors
- Market volatility
- Data breaches
- Employee theft
- Legal liabilities
- Product recalls
- Project failures
While there’s no one “right” way of calculating and analyzing risk, there are several different ways to approach business risk management, which we’ll explore in the next section.
What is Business Risk Management?
Protecting your business starts with risk management, which is the process of identifying the most critical internal and external threats to your organization. Every business should have a solid risk management plan that details current risk levels and how to mitigate worst-case scenarios.
One of the most important risk advisory best practices is striking a balance between protecting your organization while also facilitating continuous growth. This requires implementing international methodologies and governance, like Committee of Sponsoring Organizations of the Treadway Commission (COSO) internal controls and enterprise risk management.
What Do Business Risk Advisors Do?
Business risk management is handled by a highly-trained risk advisory group, which is responsible for completing comprehensive risk assessments that determine whether a specific action is worthwhile. This involves examining the underlying risk(s) of a decision and the likelihood of adverse outcomes.
After making their assessment, business risk advisory professionals present different approaches that can be used to assess the risk and reward tradeoff of a potential opportunity. Creating these strategies requires a deep understanding of everything from option theory and financial instruments to trading markets and risk management theory.
How to Minimize Risk in Business
Are you looking for specific examples of how to mitigate financial risk in business? There are two primary analytical methods: quantitative and qualitative.
Quantitative Risk Analysis
One of the best ways to manage risk in business is through quantitative analysis, which uses simulations or statistics to assign risks specific numerical values. These assumed values are fed into a risk model, which generates a range of outputs. The results are analyzed by risk managers, who use the data to identify business opportunities and mitigate negative outcomes.
Qualitative Risk Analysis
Rather than using numerical values and quantitative ratings, qualitative risk analysis involves a written explanation of potential uncertainties. These reports also include an evaluation of the impact of negative outcomes and mitigation plans if adverse events do occur. Qualitative risk tools include cause and effect diagrams, SWOT analyses, and decision matrices.
Three Lines of Defense (3LOD) Model of Business Risk Management
Created by the Institute of Internal Auditors (IAA), the three lines of defense (3LOD) model provides a framework for identifying, combatting, and mitigating business risks and threats. The 3LOD model defines roles and responsibilities throughout an organization and uses them to establish and enforce accountability.
With the 3LOD model, your board of directors is responsible for risk oversight, while senior management establishes a business-wide risk culture. We’ll explain each line of defense in the sub-sections below.
First Line of Defense: Operational Management
Responsible for owning and mitigating risks, operational managers oversee day-to-day business dealings. They’re also responsible for implementing and executing internal controls, along with making enhancements and taking corrective measures (when necessary).
Second Line of Defense: Internal Monitoring & Compliance
Compliance and quality control functions are responsible for the design and implementation of proper controls. These tasks are typically handled by financial controllership, quality control teams, and compliance, who may also have responsibilities within the first line of defense.
Third Line of Defense: Internal Audit
Internal auditors provide impartial assurance to the first two lines of defense to ensure that risks are handled appropriately while still meeting operational objectives. Third-line personnel should have a direct relationship with the board of directors, while still maintaining a connection with management in financial and/or legal capacities.
What Are Internal Controls?
Internal controls are regulations and procedures that businesses implement to ensure the integrity of their financial information, prevent fraud, and promote managerial accountability. A comprehensive set of internal controls should include items like reconciliation, documentation, security, authorization, and separation of duties.
Environmental, Social, & Governance (ESG) Criteria
As the number of ethics-focused investors continues to increase, many businesses are adding environmental, social, and governance (ESG) criteria to their internal controls. Investors use these to determine whether a company’s values align with their own. Here’s a closer look at each principle:
- Environmental criteria examine a company’s energy use, natural resource conservation, pollution, waste, and treatment of animals.
- Social criteria examine how a company handles its relationships with employees, customers, and the larger community.
- Governance criteria examine a company’s leadership, internal controls, audits, shareholder rights, and executive pay.
Why Do Internal Controls Matter?
Strong internal controls are essential to business risk management and significantly increase the likelihood that you’ll achieve your goals. They also increase efficiency and enhance compliance while streamlining operations and helping prevent fraud. Ultimately, control effectiveness in risk management improves the accuracy and timeliness of your financial reporting, which benefits your entire organization.
How to Create Effective Internal Controls
Building a comprehensive set of internal controls involves strategy alignment, standardizing policies and procedures, process documentation, and establishing roles and responsibilities. Your internal controls should incorporate risk advisory best practices while always remaining focused on your core business objectives.
The most effective internal controls are strategically segregated to avoid potential conflicts and reduce the risk of financial fraud. You should also make sure the control owner possesses the experience and skills necessary to fulfill their role within that line of defense.
Types of Internal Controls
Creating good internal controls involves implementing rules that are both preventative and detective. We’ll take an in-depth look at each of these below.
Preventative Internal Controls
These procedures use comprehensive documentation and authorization practices to keep errors and fraud from happening in the first place. They include:
- Limiting physical access to equipment, inventory, and cash
- Separation of duties
- Authorization of invoices
- Verification of expenses
Detective Internal Controls
These backup procedures are designed to detect negative outcomes and risks missed by the first line of defense. They include:
- Internal audits
- External audits
How Are Internal Controls Enforced?
Reputable internal controls are enforced through internal and external audits, which you’ll learn about below. You’ll also find information about SOC 1, which is a specific type of external audit.
Internal audits involve a thorough evaluation of a business’s internal controls, including its accounting practices and corporate management. They’re designed to ensure regulatory compliance, along with accurate and timely financial reporting. Internal audits also help maintain maximum efficiency by uncovering and correcting issues before companies undergo external audits.
The passage of the Sarbanes-Oxley (SOX) Act in 2002 exponentially increased the importance of internal audits. According to this legislation, management teams are legally responsible for the accuracy of their company’s financial statements. Along with protecting investors, SOX (and internal audit support) have significantly improved the reliability of public accounting disclosures.
These audits are performed by impartial third parties and are designed to evaluate a company’s accounting procedures and internal controls. Ultimately, the opinions of external auditors provide investors and other businesses with confidence in the subject’s financials. External auditors also have the ability to be completely candid with no risk of negatively affecting internal relationships.
System & Organization Controls (SOC) 1 Audits
If you offer services to other businesses, their auditors may require assurance that your internal controls are efficient and effective. These take the form of SOC 1 audits, which focus on how your internal controls are relevant to your customer’s financial statements. You’ll need to provide a description of relevant internal controls and how they’re designed to achieve business objectives.