Enterprise Risk Management and Firm Performance

J. Account. Public Policy 28 (2009) 301–327 Contents lists available at ScienceDirect J. Account. Public Policy journal homepage: www.elsevier.com/locate/jaccpubpol Enterprise risk management and firm performance: A contingency perspective Lawrence A. Gordon a,*, Martin P. Loeb a, Chih-Yang Tseng b a Robert H. Smith School of Business, Van Munching Hall, University of Maryland, College Park, MD 20742-1815, United States b Department of Accounting, National Taiwan University, Taipei, Taiwan article info abstract Keywords: In recent years, a paradigm shift has occurred regarding the way Enterprise risk management organizations view risk management. Instead of looking at risk Firm performance management from a silo-based perspective, the trend is to take a Contingency theory holistic view of risk management. This holistic approach toward Management control systems managing an organization’s risk is commonly referred to as enterprise risk management (ERM). Indeed, there is growing support for the general argument that organizations will improve their performance by employing the ERM concept. The basic argument presented in this paper is that the relation between ERM and firm performance is contingent upon the appropriate match between ERM and the following five factors affecting a firm: environmental uncertainty, industry competition, firm size, firm complexity, and board of directors’ monitoring. Based on a sample of 112 US firms that disclose the implementation of their ERM activities within their 10Ks and 10Qs filed with the US Securities and Exchange Commission, empirical evidence confirms the above basic argument. The implication of these findings is that firms should con- sider the implementation of an ERM system in conjunction with contextual variables surrounding the firm. Ó 2009 Elsevier Inc. All rights reserved. 1. Introduction Managing risk is a fundamental concern in today’s dynamic global environment. In recent years, however, a paradigm shift has occurred regarding the way to view risk management. Instead of looking at risk management from a silo-based perspective, the trend is to take a holistic view of risk * Corresponding author. Tel.: +1 301 405 2255; fax: +1 301 314 9414. E-mail address: [email protected] (L.A. Gordon). 0278-4254/$ - see front matter Ó 2009 Elsevier Inc. All rights reserved. doi:10.1016/j.jaccpubpol.2009.06.006 302 L.A. Gordon et al. / J. Account. Public Policy 28 (2009) 301–327 management. This holistic approach toward managing an organization’s risk is commonly referred to as enterprise risk management (ERM). A general argument gaining momentum in the literature is that the implementation of an ERM system will improve firm performance (e.g., see Barton et al., 2002; Lam, 2003; Stulz, 1996, 2003; COSO, 2004; Nocco and Stulz, 2006; Hoyt and Liebenberg, 2009). The findings by Hoyt and Liebenberg (2009), for example, based on data from the insurance industry and using Tobin’s Q as the measure of performance, support this argument.1 The fact that many firms have adopted ERM (e.g., see Gates and Hexter, 2005) lends additional support to the view that ERM will improve firm performance. Nevertheless, empirical evidence confirming this relation between ERM and firm performance is quite limited and is not based on a robust measure of ERM. The primary objective of the study reported in this paper is to examine empirically the argument that ERM is related to firm performance. We argue that the ERM-firm performance relation is contingent upon the appropriate match between a firm’s ERM system and several key firm-specific factors. Based on the relevant literature, we identify five specific firm factors that are believed to have an im- pact on the ERM-firm performance relation. These factors are: (1) environmental uncertainty, (2) industry competition, (3) firm complexity, (4) firm size, and (5) board of directors’ monitoring. In pur- suing the above objective, we also develop an ERM index. To our knowledge, we are the first to develop such an index. The analyses presented in this paper are based on an empirical study of 112 US firms that disclose their ERM activities in their 10K and/or 10Q reports for 2005 with the US Security and Ex- change Commission (SEC). The findings from this study provide strong evidence that there is a positive relation between ERM and firm performance, but that this relation is contingent upon the appropriate match between a firm’s ERM system and the five factors noted above. These findings are robust to such concerns as the self-selection problem, the effectiveness of a newly constructed ERM Index, different measures for monitoring by the firm’s board of directors, and different measures of firm performance. The remainder of this paper will proceed as follows. In section two we develop the basic argument and research design underlying the empirical study discussed in this paper. The empirical study designed to test this argument is discussed in the third section of the paper. The fourth section of the paper presents the main results of the empirical study. The fifth section provides robust- ness checks for the main findings. The sixth section of the paper provides some concluding comments. 2. Basic argument and research design 2.1. Basic argument An increasing number of scholars view ERM as the fundamental paradigm for managing the port- folio of risks confronting organizations (e.g., see Lam, 2003; Liebenberg and Hoyt, 2003; Nocco and Stulz, 2006; Beasley et al., 2008; Hoyt and Liebenberg, 2009). Driving this trend is the belief that ERM offers companies a more comprehensive approach toward risk management than the traditional silo-based risk management perspective. By adopting a systematic and consistent approach (or process) to managing all of the risks confronting an organization, ERM is presumed to lower a firm’s over- all risk of failure and thus increase the performance and, in turn, the value of the organization. The presumed link between a holistic approach to risk management and an organization’s performance/ value is clearly noted in the following definition of ERM provided by the Casualty Actuarial Society Committee on Enterprise Risk Management (2003, p. 8): ERM is the discipline by which an organization in an industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization’s short- and long- term value to its stakeholders. 1 Exceptions to this argument, however, do exist. For example, see Pagach and Warr (2009). L.A. Gordon et al. / J. Account. Public Policy 28 (2009) 301–327 303 One of the most popular definitions of ERM used in the literature (e.g., see Beasley et al., 2005; Lin and Wu, 2006; Moeller, 2007) is the one provided by COSO2 (2004). COSO (2004, p. 2) defines ERM as: Enterprise risk management is a process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. According to COSO (2004), an organization’s ERM system should be geared toward achieving the following four objectives: (1) Strategy: high-level goals, aligned with and supporting the organization’s mission. (2) Operations: effective and efficient use of the organization’s resources. (3) Reporting: reli- ability of the organization’s reporting system. (4) Compliance: organizational compliance with appli- cable laws and regulations. The preceding four objectives of ERM specified by COSO (2004) expand upon, but clearly incor- porate, COSO’s (1992) narrower framework for internal control (IC). More to the point, COSO’s (2004) notion of ERM includes a strategy objective not included in its IC framework. Audit Standard No. 5 (AS No. 5), published by the Public Company Accounting Oversight Board (2007), also empha- sizes the importance of a broad view of risk management for firms listed with the US Security Ex- change Commission. In the UK, the 2005 report of the Financial Reporting Council (prepared by the Turnbull Review Group and widely known as the Turnbull Guidance), while setting out best practice on internal control for UK listed companies, focuses on the broad concept of an organization’s risk management. In developing its ERM framework, COSO (2004) recognizes that the appropriate ERM system will likely vary from firm to firm. In essence, COSO suggests a contingency perspective toward the appropriate ERM system for a particular organization. The fact that there is no universally ideal ERM system is, of course, intuitive and has been suggested elsewhere (e.g., The Financial Reporting Council’s Re- port, 2005; Beasley et al., 2005; Moeller, 2007; and AS No. 5). Furthermore, the contingency view of enterprise risk management systems is consistent with the literature that examines the more generic notion of management control systems3 (e.g., Gordon and Miller, 1976; Otley, 1980; Gordon and Narayanan, 1984; Merchant, 1984; Chenhall and Morris, 1986; Evans et al., 1986; Gordon and Smith, 1992; Mia and Chenhall, 1994; Shields, 1995; Chenhall and Langfield-Smith, 1998; Chenhall, 2003; Luft and Shields, 2003; Gerdin and Greve, 2004, 2008). The above notwithstanding, determining which are the key factors in the contingency relation between a firm’s ERM system and its performance is far from an exact science. In fact, there is no general theoretical framework or model that can predict the key factors influencing the relation between a firm’s ERM and its performance. However, based on the extant literature, there seems to be a parsimo- nious set of five factors that are critical to understanding the relation between ERM and firm performance. These five factors are: environmental uncertainty, industry competition, firm size, firm complexity, and board of directors’ monitoring.

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