Project Risks

Posted: July 9th, 2021

In all types of business decisions, risk is always inherent. In capital budgeting, where a lot of the decisions made involve costs and benefits that extend for long periods of time where several things may change, risk is inherent in every decision. All the investments that may be considered for inclusion in an organization’s capital budgeting have the same risk as the investments that are already existing. Capital budgeting is part of project management, as the success of any project depends on the capital budget. The analysis of risk is one of the most important and complex aspects of capital budgeting. There are various sources of risks in projects. These include international risk sources, project-specific risk sources, competitive risk, and market risk (Chandra, 2011). Management of risk in projects is one of the most important areas that all project managers should be competent in.

Risk, in both capital budgeting and project management, may be defined as any condition or event that is unexpected and that has an effect on the outcomes of a project if it occurs. The process of identifying, conducting an assessment, and prioritizing risks, after which resources are applied in a coordinated and economical manner to monitor, minimize, and control the possibility and effect of unplanned for events is known as risk management (Carbone & Tippett, 2004). Proper management of risks in projects depends on a wide range of organizational factors and the clear division of project team roles and responsibilities. The management of project risk involves six major steps, as follows:

1. Planning for risk
2. Identifying the risk
3. Conducting qualitative analysis of risk
4. Conducting quantitative analysis of risk
5. Planning of responses
6. Monitoring and control.

All the risks that are related to capital budgeting can be analyzed from three different perspectives, which are also referred to as the different types of project risks: stand-alone risk, firm risk or corporate risk, and market risk (Chandra, 2011).

Stand-Alone Risk

This risk perspective assumes that a company’s project intends to pursue one organizational area that is different from all the other areas of the company. This type of risk is calculated by the variability of one project or organizational area and does not consider how the relevant risk of the single project may affect the total risk for the company. It refers to the risk of a project if it was operated in an independent manner and is measured through the coefficient of variation (Chandra, 2011). It may be associated with only one of the operating units of an organization, a department or division, or an asset, rather than being associated with a larger and diversified portfolio. A stand-alone risk approach usually ignores the diversification among projects and firms, focusing on only a single unit, project, or asset. For this reason, the stand-alone risk would not exist if the activities and operations in the single area or division were to stop or if the single asset would cease to exist.

In capital budgeting and project management, the financial assets of a company may either be examined in a portfolio context or on a stand-alone context where each financial asset is treated in isolation (Carbone & Tippett, 2004). The portfolio context examines all the investments and assets when calculating or evaluating risk. In the stand-alone context, however, the risk is calculated with the assumption that a single asset or investment under review is the only source of risk and value that investors have to gain or lose. Therefore, stand-alone risk only measures the risk or danger that is associated with a single asset or investment. It is important since it allows companies to determine the risk of a project as an independent entity. The owners of a company or the investors may evaluate the risk associated with an asset or investment in order to compare and contrast their value against the risk involved, which helps in the prediction of the expected ROI. Stand-alone risks need to be carefully evaluated because when it comes to an investment, the investors stand to gain high returns in value if the investment grows since it is the only investment, but may also lose the whole value of the project or investment, because it is the only investment.

Firm or Corporate Risk

With firm risk, the assumption is that any project that an organization conducts or pursues does not exist as a single entity but is incorporated with other entities that belong to the company. Corporate risk recognizes the relationship and diversification that exists between projects and assets of a company (Carbone & Tippett, 2004). Therefore, the total uncertainty of a project is interrelated with the risks of other projects of the company. Corporate risk is measured by the potential impact that a project may have on the revenues of a company. It considers the total risk of a project in relation to the other projects of the company and is a function of the deviation and a project’s current value, as well as the project’s correlation with the returns on other projects of the company. Corporate risk usually reflects a project’s impact or effect on the stability of the total earnings of the company. The main difference between stand-alone risk and corporate risk is that corporate risk recognizes the diversification that exists within the company and the interrelationship between projects, whereas stand-alone risk ignores this interrelation.

Market Risk

Under this risk evaluation approach, project risk is looked at through the eyes of a stockholder. In this perspective, project risk is not only considered from a company’s point of view, but also from the stockholder’s portfolio. It considers the total risk that a project poses to an investor that is well-diversified and is measured by the effect that the project may have on a company’s beta. Market risk considers both the stockholder and the corporate diversification (Chandra, 2011). Its key purpose or aim is to identify the total risk in projects and investment in order to respond to risk and maximize the wealth of the stockholder or shareholder.

All the forms of project risks are important to capital budgeting (Carbone & Tippett, 2004). However, market risk is the most relevant risk when it comes to capital projects. This is because the main goal or objective of management is to maximize the shareholders or investors wealth. Through the identification of the total market risk, including the corporate and the stockholder diversification, the management is able to respond effectively to the risk and ensure stakeholder wealth maximization. Nevertheless, firm risk, which is also referred to as corporate risk, affects various stakeholders including customers, creditors, suppliers, and employees. Therefore, corporate risk cannot be ignored in capital budgeting (Carbone & Tippett, 2004). Most organizations and project teams focus on stand-alone risk during capital budgeting since it is the easiest to measure. While this does not always lead to poor capital budgeting decision making, it is not theoretically correct to ignore corporate risk and market risk during capital budgeting.

The three types or forms of project risk are usually correlated to a great extent. For instance, many of the projects that companies or organizations undertake are usually part of the core business operations, which means that stand-alone risk has a high correlation with the corporate risk. In addition, the corporate risk is highly likely to be correlated with market risk. This correlation between the different types of project risks is very important since all risk assessments end up being interrelated, which is advantageous when it comes to total risk assessment and facilitation of good capital budget decision making.

Accounting Methodology

There are various methods of accounting that different companies use. Accounting methods refer to the basic guidelines and rules under which companies maintain their financial records and develop all their financial reports. The maintenance of financial records and the development of financial reports are very important in company management and adherence to laws and regulations. There are two major methods of accounting that are used by companies and other organizations for record-keeping: the accrual basis and the cash basis (Goel, 2016). Business owners and managers have to make a decision on which accounting method best suits their businesses depending on factors such as the business’ sales volume, the legal form of the business, whether the business extends credit to its customers, the tax requirements set by the Internal Revenue Service (IRS), and whether the business organization maintains inventory.

While recordkeeping is necessary for tax purposes and for adherence with legal regulations, the information obtained from financial recordkeeping is very useful to business owners and managers as it enables them to assess the financial situation of a company or business organization, enabling them to make good and informed decisions. Despite the accounting method selected for use by a business organization, the organization may change to the other method later. However, the process of transitioning from one accounting method to the other can be complicated and may take a lot of time. For this reason, it is very important that an organization or a business owner to make a proper decision on which of the two methods is most appropriate for them based on suitability. Business organizations may either handle their own financial statements and records or hire an outside organization or professional to do it for them. Nevertheless, it is important that they understand the difference between the two accounting methods.

The key difference between the two accounting methods lies in the timing of when the purchases and sales of a business are recorded in the accounts or financial records (Reichard & Van Helden, 2016). The cash accounting method is a method that recognizes expenses and revenues immediately, whereas the accrual accounting method focuses on the anticipated expenses and revenues of a company or business (Goel, 2016). This means that while the cash accounting method recognizes expenses and revenues when money changes hands, the accrual method of accounting recognizes expenses when they are billed (not paid) and revenues when they are earned. Each of the two methods of accounting has its benefits, merits, and disadvantages, and the bottom line of a business organization is affected by the accounting method that is selected. A business may use one accounting method for its daily financial records and the other for its year-end financial reports or tax returns. Businesses that have no inventory mostly use the cash basis method of accounting.

Cash Basis Accounting

In this method of accounting, the financial records are prepared using real-time cash flow. All the revenues or incomes are recorded after the funds are received rather than when they are earned. The expenses of the business are recorded in the accounting records as soon as they are paid, rather than when they are incurred. This method of accounting does not, therefore, recognize any accounts payable or accounts receivable. Through the use of the cash basis method of accounting, it becomes possible for a business to defer its taxable income by delaying billing to ensure that payment is not received in the present or the current fiscal year. It also becomes possible for a business organization to accelerate its expenses by ensuring that they are paid as soon as the bills are received (before the due dates).

Small enterprises and other businesses choose to use the cash basis method of accounting since it is easy to maintain (Reichard & Van Helden, 2016). With this accounting method, determining when transactions occurred or have occurred is very easy – either the cash is in the bank or out of the bank. In addition, with this method, there is no need for the tracking of payables or receivables. Through the use of the cash accounting method, it is easy to track the amount of cash that a business actually has at any particular time since the accountant can simply look at the bank balance and determine the number of resources available. Another advantage of the cash basis accounting method is that the income of a business is not taxed until it is in the bank account, as the transactions of the business are only recorded when the cash is paid or received.

The main disadvantage of this accounting method is that it does not have control for accounts payable and accounts receivable, especially those that are long-term. For this reason, the cash basis accounting method tends to give a narrow view of the finances of a business (Tickell, 2010). Moreover, the cash-based accounting method may overstate the financial state of a business that has huge amounts of accounts payables that exceed the cash at hand and the revenue streams of the business. Investors may conclude that a business is making a profit while the business is actually losing money.

Accrual Based Accounting

The accrual-based method of accounting involves the recording of expenses and revenues of a company when they are earned, regardless of whether they have been paid for or not. This method of accounting is more commonly used than the cash-based method since it gives a more realistic idea of the expenses and incomes of a company during a specific period of time (Tickell, 2010). It, therefore, provides investors and managers with a long-term picture of the financial situation of a business. The main disadvantage of accrual-based accounting is that it does not provide the awareness of the cash flow of a business. As such, a business entity may appear to be highly profitable under accrual-based accounting, while in reality, it may have bank accounts that are empty. It is very important that cash flow is well-monitored in businesses that use accrual-based accounting in order to avoid this problem.

As discussed, the main difference between the two methods of accounting relates to how the cash going out of and coming into a business is recorded (Reichard & Van Helden, 2016). At any particular time period, the accounts of a business entity will show different figures depending on the selected accounting method or the accounting method that was used to prepare the financial accounts. Nevertheless, any differences that appear in the accounts as a result of the use of different accounting methods will diminish over time after all the revenues and expenses have been recorded. The choice of the appropriate accounting method ultimately depends on the decision of the managers or business owners and factors that are relevant to accounting. Understanding the differences that exist between the two accounting methods, as well as the various advantages and disadvantages of each method, is important as it enables one to accurately interpret financial information and records and enables investors to accurately estimate the financial position of a business.

References

Carbone, T. A., & Tippett, D. D. (2004). Project risk management using the project risk FMEA. Engineering Management Journal, 16(4), 28-35.

Chandra, P. (2011). Financial management. Tata McGraw-Hill Education.

Goel, D. (2016). The earnings management motivation: Accrual accounting vs. cash accounting. Australasian Accounting, Business and Finance Journal, 10(3), 48-66.

Reichard, C., & Van Helden, J. (2016). Why cash-based budgeting still prevails in an era of accrual-based reporting in the public sector. Accounting Finance & Governance Review, 23(1-2), 43-65.

Tickell, G. (2010). Cash To Accrual Accounting: One Nations Dilemma. International Business & Economics Research Journal (IBER), 9(11).