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Project Risks
Introduction
Since every business focuses on making a profit on the activities that it operates, any aspect that may lead to degrowth of the company is usually eliminated. An example of the aspects that may lead an organization to a ditch is the poor planning and handling of risks. There are risks that befall firm out of unawareness. Such risks usually tamper with the progress of the company.
However, there are risks that a company may take to facilitate its financial progress. These risks usually revolve around the execution and management of company projects. Similarly, accounting aspects are also highly valued in an organization because transactions occur in an organization almost on a daily basis.
Through the accounting processes, a company is able to prepare the financial statements as well as its performance. Therefore, the various companies always ensure that the accounting methodology that they employ fulfills their interest, and any possible error is avoided.
This paper focuses on three types of project risks and also discusses the circumstances in which each of the risks is considerably favorable during financial budgeting. It also extends a look at the cash and accrual accounting methodologies and the companies of their best fit.
Project risks
Companies usually venture on the risks of projects in order to identify and also analyze these risks. The risks can only be handled when they are familiar and also their significance to the organization. The identification of the types of risks is very significant in an organization. The following are some of the examples of project risks;
Stand-alone risk
Stand-alone risk is a project risk incurred if it were operated as an independent project. This type of risk assumes that a project is operated in isolation; thus, it ignores possible portfolio effects. Besides, the stand-alone risk does not involve the firm’s diversification, among other projects.
In portfolio management, this type of risk is used to measure the risk of an individual asset that may not be reduced in accordance with diversification. In private investors, for instance, the stand-alone risk is used in predicting returns as expected at the start of the project. However, it is straightforward for an investor to lose the entire value because it is the only asset in the picture. Smaller businesses most use stand-alone risk.
On measurement, the stand-alone risk is measured by uncertainty amount, buying the notion, “greater uncertainty, greater the risk.” The project’s standard deviation (NPV) or rather a standard deviation is the measurement formula employed by this type of risk. Profitable measurements, in this case, involve IRR and MRR.
Within-firm risk
Within-firm risk is also known as corporate risk. It is the overall riskiness of business as per other projects of the firm, implying that diversification in included in the consideration.
The within-firm risk depends on a firm’s stand-alone risk, as well as the correlation of the project’s contributable return to the overall returns of the business.
In order to obtain within-risk measurements, a corporate beta is employed. Corporate beta is the regression line created by the realized difference between the project’s returns and the business’ overall returns.
Market risk
Market risk is the contribution a project has to the overall riskiness. This type of project risk depends on stand-alone risk as well as the correlation of the project’s returns to that of market portfolio returns. Market risk considered diversification as inherent in the portfolios of the stakeholders.
In order to measure market risk, market beta is used, which is a regression between the return of the project to the market portfolio. Examples of market risk include currency risk and monetary policy market risk.
Relevant situation
- Stand-alone risk relevancy
Each of the risks is relevant to different types of businesses. Stand-alone risk is most relevant to small but not-for-profit businesses. This is due to how it is characterized. That is, it entails an individual project entityexclusive of possible diversification.
Smaller businesses tend to run their operations through cash flows, predicting cash flows are very uncertain; thus, the stand-alone risk is relevant. Additionally, small business involves smaller budgeting compared to large businesses thereby, finds stand-alone risk favorable.
- Corporate or Within-firm relevancy
Corporate or within-firm, on the other hand, is most relevant to larger but not-for-profit businesses. Because it involves the contribution of a given project to the portfolio’s risk, it serves a suitable type of risk to equity investors. Most investors are willing to spend on the company’s project, given the return will be 11.5% or even more. Alternatively, it is relevant to investor-owned businesses because it affects bankruptcy potentiality.
- Market risk relevancy
Market risk is relevant mostly to investor-owned businesses. Examples of market risk include rate risk, commodity risk, equity risk, as well as currency risk. This explains why it is mostly applied by investor-owned businesses. Particularly, the monetary policy type of market risk is primarily relevant to fixed-income security businesses such as a bond.
In addition, market risk is applicable in exchange rate risk as it involves the exchange of currency between countries. Investors holding assets outside their country are subjected to currency risk type of market risk.
Effect of correlation
Dependencies are known to characterize related risks, that is, the influence of one risk to another. For instance, one risk may trigger the existence of the other, while another risk can be influenced by the consequences caused by a given risk. Correlation, on the other hand, involves the effect a change in one project is characterized by a change of another risk.
Most projects, as discovered, have returns that are highly correlated with either the market returns or overall business returns. As a result, it is important to note the effects of correlation observed by the various projects.
Correlation quantifies how a change in one project and how that given change is linked to another project related — for instance, a change in the price of steel, causing effects on any related project.
Correlation is used in risk assessment to determine consequences that may follow a given project. For example, a high labor cost may create a higher impact on time-related, among other projects.
In addition, correlation is used in predicting returns a project will have to a business. While lower correlation indicates a higher expectation of the project, higher correlated indicates higher risk hence lower return.Corporate risk, if negatively correlated oruncorrelated, the project will seemingly have a lower corporate risk.
For example, the correlation between accounting and market beta, which mostly ranges between 0.5 and 0.6, can be used to approximate market risk, cost of the capital as well as market beta.
Typically, labor and time-related need a correlation because they own a similar delay value, implying that cost items have to correlate for the benefits of the business involved.
- Cash and Accrual Basis Accounting
Finance treasurers’ may wonder what can be the most effective method for financial transactions and recording for transparency. For instance, when dealing with congregation finances, accessibility to financial data is the top primary interest.
Bookkeepers possessing appropriate methods of financial recordingsare able to understand the history of data and also can consistently perform new transactions. Presenting financial statements understandable manner is also an interest of all financial keepers that relies on the most appropriate.
Evaluating the needs of a business’s financial management, determining the most preferred method of accounting is vital. The choice of accounting method is mostly influenced by external factors such as external audits and loan covenants.
Consequently, cash basis accounting and the Accrual basis of accounting emerged to be the methods of accounting methods applied. While Cash serves short term account of assets, Accrual serves the long-term account transactions
In order for a business to own the best bookkeeping procedures as well as minimize the tax burden, knowledge on the differences and limitations on matters, cash, and accrual are critical. The difference between these two modes is a matter of time, as pointed by E.Miller and H.A Finney (1963).
- Cash Basis of Accounting
Pet Simmons (2018), the cash basis of accounting involves accounting procedures whereby expenses or income is recorded only when received. This implies that any revenue is not recorded until the cash is received, and any expenses are not recorded until the amount is settled.
Cash Basis of Accounting thus simplifies the daily processes of Accounting. This explains why the Cash Basis of Accounting cannot be employed by businesses that operate under inventory recording. Moreover, Cash Basis serves to provide possible options to postpone revenue as well as increases overall tax by accelerating expenses.
Disadvantages of Cash Basis of Accounting
However, the Cash Basis of Accounting has disadvantages. To begin with, it can misinterpret a company’s financials because it ignores transactions that are yet to receive payments. Consequently, it may produce a misleading financial image of a given organization now that there are limited records of financial transactions.
Secondly, revenue can only be reported once payment is received, which means, a business may end up paying taxes of the accumulated amount if the deductible expenses are kept until another year of Tax.
In addition, there is no attempt at matching expenses with revenue. This means that balance sheets or income statements may not be relevant documents to use in predicting the future of the business. This can deter the future of the business since loses and profits incurred are not keenly recorded. Relatively, predicting future income and financial position of the business becomes difficult or impossible.
Furthermore, the cash basis of accounting exposes a business to an Understate or overstate of net income. In accordance with this model, only cash transactions would be considered in determining net loss and income. Sometimes income is understated or overstated like in the case of a machinery purchase.
Last but not least, the cash basis of accounting encounters less bookkeeping, which to every business is very dangerous since financial data are supreme when it comes to future decision-making purposes.
- Accrual Basis of Accounting
Accrual Basis of Accounting involves the recording of expenses and income once they are earned. The mentioned method of accounting records receivables ofincome obtained from the goods and services offered by the business, regardless of when the money will be received.
Unlike Cash Basis of Accounting, all tracks of transactions are kept; thus, it is the best method of accounting since there is present income along with expenses that provides important financial data required by every business for predicting performances decision making purposes.
However, the Accrual method of Accounting is very complicated; thus, it requires advanced software and technical expertise. In addition, the Accrual method of Accounting is very expensive to use compared to the cash basis of accounting. Smaller businesses than rely on cash flow can find accrual model ineffective.
Comparison between Cash and Accrual basis of accounting in Summary
In summary, the accrual basis of accounting provides information about receipts and cash payments, while cash basis provides cash receipt payments only. Secondly, accrual basis recording is done as per debts and credit terms of payments, whereas a cash basis does not keep a record of credits and debts.
Additionally, the cash basis of accounting treats reveals fixed assets as an expense of the given year, unlike accrual basis, which shows the fixed asset’s budgets inclusive of their cost and depreciation calculated in accordance to their useful lives.
On revenue recognition, the two models operate as shown in the provided table;
| Accrual Basis of Accounting | Revenue recognition | Expenses recognition | |
| Accrual basis | Obtaining | Used | Accrual basis |
| Accrual basis | Billing | Commitment | Accrual basis |
| Accrual basis | Incorporation | Incorporation | Accrual basis |
| Accrual basis | Receipt | Payment | Accrual basis |
| Cash Basis of Accounting | Receipt | Payment | Cash Basis |
Effectiveness of Accrual Basis of Accounting over the Cash Model
Schaik(2004) says that the use of accrual methods of accounting compared to cash or traditional mode is more desirable since, in accrual accounting, it is easy to compare business’ success by analyzing expenditures against performance objectives.
In addition, Mrs. Baban Cristina, in his thesis, “From the accrual accounting model to cash model in the management of controlled resources, proposes that accrual method of accounting is appropriate for economic transactions in accounts when they occur, an exception of cash flow(Lucia,2010).
To mention, private sectors seek to provide the financial status of the business to its shareholders for decision making purposes; thus, accrual accounting is more appropriate (Tikal, 2010). Typically, the Accrual method provides all information regarding the financial status of an organization by keeping records of cash receipts, income, and records of every expense incurred by the business. This serves as a pillar of the better decision-making process by the business.
According to Land and Rocher (2011), the adoption of the accrual method of accounting in the public sector follows the advancement of technology on matters of information systems and the development of relevant skills for preparers or users.
In addition, the accrual basis of accounting has more power to assess and predicts business performance results since the management is at a place whereby they can control their activities more effectively (Kordestani and Iranshahy, 2010). They also pointed out that the accrual basis of accounting easily reflects the organization’s financial situation and abilities, as revealed by the detailed recorded financial transactions.
Besides, the Accrual method conforms to GAAP provisions (Generally Accepted Accounting Principle), as in the case of U..An implying that it shows a real fixture of an enterprise’s financial positions.
The discussed abilities served by accrual basis of accounting lacks on cash model whose concern is majorly cash payments hence is ineffective compared to the former.
References
Cunningham, B., Nikolai-HCP, L., Bazley, J., Kavanagh, M., & Simmons, S. (2018). Accounting: Information for Business Decisions. Cengage AU.
Cuzdriorean, D. D., Fekete, S., & Sucală, L. (2010). AN ATTEMPT AT MEASURING THE FISCAL INFLUENCE OVER ACCOUNTING OF ROMANIAN LISTED COMPANIES. Annales Universitatis Apulensis-Series Oeconomica, 12(1).
de Sousa, R. G., des de Vasconcelos, A. F., Caneca, R. L., & Katsumi Niyama, J. (2013). Accrual Basis Accounting in the Brazilian Public Sector: Empirical Research on the Usefulness of Accounting Information. Revista Contabilidade & Finanças-USP, 24(63).
Kordestani, G. H., & Iranshahy, A. (2010). Survey factors affecting of accrual accounting adoption in the public sector. Journal of Auditing Knowledge, 28, 10-21.
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