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Project Risks and Capital Budgeting Decisions

Capital budgeting is described as the planning procedure that an organization utilizes to determine the investments worth pursuing. Therefore, in the context of capital budgeting, project risk is referred to as uncertainty regarding the profitability of a project. If the potential of a chosen activity has an unknown implication on the forecasted cash flow profitability, then there is the possibility of a threat. The two main techniques through which project risk is incorporated into capital budgeting comprise the risk-adjusted discount rate and the certainty equivalent method (Gapenski & Reiter, 2016). Similar to other investments, threats primarily influence a project’s required rate of return (discount rate). To determine the possibility of a risk, companies might use historical data to get an outline of the riskiness of the proposed investment. Nevertheless, there are instances where it is challenging to acquire past information; therefore, the managers have to rely on subjective judgments, which is often the case in capital budgeting (Gapenski & Reiter, 2016). Several types of risks are considered when performing financial planning. Each addresses the sphere in which some kind of volatility could forcibly interfere with the organization’s managers; hence, they depend on the situation at hand. However, they are majorly categorized into stand-alone, corporate, and market or beta risk.

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Stand-alone risk presumes that a project will be operated in isolation, thus nullifying the existence of essential portfolio effects, such as firm and shareholder diversification. Therefore, this suggests that stand-alone risk is only applicable to small-non-profit enterprises, which often exist as independent entities (Gapenski & Reiter, 2016). Such risks can be overcome by eliminating the specific unit in which the risk is associated. Stand-alone risks have to be given keen consideration because, as a limited asset, investors perceive to see a high return if the value of the asset increases, as it is the only asset. It is evaluated based on the degree of uncertainty that is, the higher the uncertainty, the greater the risk. It is quantitated in terms of the standard deviation of the net present value (NPV), or the coefficient of variation of NPV that illustrates how much risk is associated with an investment relative to the amount of expected return (Gapenski & Reiter, 2016). However, other measures might be used to get stand-alone estimates and they comprise the internal rate of return (IRR) and modified internal rate of return (MIRR).

On the other hand, corporate or the within-firm risk is regarded as the overall riskiness of a project that considers the organization’s other assets (diversification within the company); hence, it reflects the effect of the project on the corporate’s earnings stability (Gapenski & Reiter, 2016). Computationally, it is referred to as the standard deviation of the company’s return on equity. Essentially, the corporate risk is most relevant to large non-profit enterprises. Moreover, since it is connected to non-owner stakeholders and impacts bankruptcy potential, it can be perceived to also be relevant in the realm of investor-owned companies. It is important to note that is reliant on a project’s stand-alone risk (standard deviation of NPV), and the correlation of the project’s returns to that of the rest of the firm (Gapenski & Reiter, 2016). If a project is negatively correlated to the overall return of the company, then it holds significant diversification benefits. Lastly, it is conceptually quantitated to the project’s corporate beta, that is, the slope of the regression line developed when plotting a line graph of the rate of returns on a project against the firm’s overall returns.

Finally, market risk is the riskiness of a project with regards to the total riskiness (standard deviation) of a well-diversified investment portfolio. In other words, it factors the stockholders’ other assets. Therefore, it depends on the stand-alone risk (standard deviation) as well as the correlation of the project’s returns to the returns of the stock portfolio (Gapenski & Reiter, 2016). Unlike other before-mentioned threats, it is perceived as a systematic risk that can be substantially minimized as it encompasses factors that can be diversified. It is most relevant in the case of investor-owned firms (Gapenski & Reiter, 2016). The project’s market beta conceptually measures market risk, that is, the slope of the regression line developed when plotting a line graph of project returns against the market returns.

Since the primary objective of the managers is to increase shareholder maximization, theoretically, market risk is considered to be most relevant to capital budgeting. Nonetheless, customers, employees, creditors, and suppliers are impacted by the total risk of a firm, which is the corporate version. Therefore, this risk is also deemed relevant. However, despite holding a relatively limited relevance to capital budgeting, the stand-alone risk is the only one that is easiest to measure and most intuitive. As a result, businesses explicitly concentrate on this risk when making capital budgeting decisions (Gapenski & Reiter, 2016). Nevertheless, this focus does not imply poor decisions since many core projects have returns that are highly correlated with the overall returns in the firms and with market returns. Hence, in other words, stand-alone risk reflects both corporate and market risk.

In conclusion, during the screening and selection of investment projects, the management has to determine the future cash flows for every project, the level of risk that might arise from the cash flows, and the contribution of each project towards the maximization of the owner’s returns. Since future cash flows are developed from a subjective perspective, they hold uncertainty. Therefore, the management has to incorporate risk into project analysis to determine ventures, which are of high profitability. This is aided by the employment of risk analysis methodologies, such as scenario, simulation, and decision tree analysis. Nevertheless, unlike market and corporate risks, it is only the stand-alone risk that is applicable in real-life situations, otherwise, the rest only hold theoretical relevance.

The Cash Accounting and Accrual Accounting Methodology

Modern financial accounting has stemmed up from the long conventional method of registering receipts and cash payments (single-entry bookkeeping). This was followed by the double-entry accounting that was more inclined to resources rather than profits (Biswas et al., 2015). Therefore, since no cost accounting technique could be used in the valuation of assets and examine depreciation, there lacked a clear distinction between income and capital. The two modern primary methods of accounting include cash accounting and accrual accounting. This paper aims to compare and contrast the two accounting methodologies and illustrate their efficiency in different types of business environments.

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Cash Accounting Method

The cash accounting method, also known as treasury accounting, is essential in the evaluation of the real property of a firm as it seeks to recognize the overall business through the lens of the treasury. Treasury in this context refers to cash and related cash equivalents. The firm managers must scrutinize the cash flow via the prism of flows acquired from the main operation, with the cash out allocated for financing and investment activities (Biswas et al., 2015). However, the cash accounting method is restricted as the possibility of an entity gaining profit is limited to the extent of the cash. Hence, it is essential to utilize a technique that considers assets, liabilities, and receipt payments in the results of a company, and this is where accrual accounting comes in.

Advantages of Cash Accounting

The cash basis method is more straightforward; hence, making the record-keeping process to be easier. It is suitable for tracking cash flow (money coming in and going out) since it does not include receivables and payables. In addition, because it is not compliant with the Generally Accepted Accounting Principles (GAAP), business owners do not have to pay income taxes about cash that has not yet been received. Therefore, this helps to improve cash flow and ensure that the companies have funds available for tax payments.

Disadvantages of Cash Accounting

Despite its advantage of simplifying the record-keeping process, financial statements prepared by this method are sometimes not a true reflection of the business’ performance within a given accounting period. This is because the revenues and expenses associated with a single transaction can be reported in different periods (Biswas et al., 2015). Moreover, the advantage of the reduction in tax expenses also has its limitations. Since firms are required to report the payment once received, they end up incurring tax on the gross amount if the deductible expenses are not published until the succeeding tax year. Third, expenses are often unmatched by the revenues; thus, the balance sheets and income statements may not give a clear overview of the overall business activities. Consequentially, this leads to the last disadvantage, which is that it will be challenging to predict future income or financial position.

Accrual Accounting Method

Cash has to be recognized as a principal indicator of a firm’s short-term and long-term management, and at the same time providing information concerning the risk of bankruptcy, financial stability, and signs of vulnerability, among others. In European accounting, the concept of accrual basis is intertwined with a principle that is foundational to the creation of financial statements – the principle of the independence of the fiscal year (Biswas et al., 2015). It states that businesses should report their profits, revenues, and the associated costs of their activities over a standard period. This financial data is often presented in the statement of cash flows. It is essential to note that in the end, the results of both the accrual and cash accounting methods are almost similar.

Advantages of the Accrual Basis

Unlike the cash basis method that gives a short-term overview of the business’s financial performance, the accrual basis provides a long-term financial summary. This is because the latter shows how much money was earned and spent while considering payables and receivables. Furthermore, since it factors several accounting factors, it gives an accurate financial picture.

Disadvantages of the Accrual Basis

It requires more intensive bookkeeping; hence, small business owners regard it as more technical and expensive to implement. Moreover, since it considers the money that has yet to be received, it gives an inaccurate portrayal of a firm’s short-term financial situation.

Comparing and Contrasting the Cash Accounting and Accrual Accounting Methodologies

Comparing the characteristics of the two accounting methodologies is centered on accounting recognition of revenue and expenses. In the cash method, revenue is recognized in the period in which the payment has been received, and the expenses in the duration in which payment has been made (Biswas et al., 2015). On the other hand, in the accrual method, the revenue denotes the effect of the accomplished business activities on the effort provided by expenses. According to GAAP principles guiding the preparation of financial statements, income is described as the increase in economic benefits over a specific accounting period, and this can be in the form of asset growth and debt reduction, which increase equity as well as the shareholders’ contributions (Biswas et al., 2015).

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Moreover, the accrual basis depends on four moments of recognition of revenue and expense accounts, for instance, revenues being recognized at the base rate of considering expenditure incurred in consumption of resources (wages and materials and supplies, among others). Second is the revenue recognized at the moment of billing when it is generating receivables from the recipients of the goods and services. The third moment is when both the revenue and expenses are integrated into the results of the end financial period. Lastly, the fourth moment is shared between the two methodologies, which is, receipt payment. However, the disparity is that on a cash basis income infers to only receiving cash while expense refers to payment. Alternatively, on the accrual basis, not every cash receipt is regarded as revenue, and the same applies to expenditure. Overall, the primary difference between the two methodologies is the timing of the operational logs. The record-keeping time on the cash basis is less than that of the accrual basis.

Cash Accounting Accrual Accounting
Accounting of income and expenses only when a payment or receipt is made. Accounting of income and expenses is performed independent of the cash flow.
It is non-compliant to the GAAP requirements. It is compliant to the GAAP requirements.
Lack of cash flows is associated with the absence of accounting records, which means that there is no method of tracking inventory. Any basic generation of revenue and expenditure is reflected in the accounting records.
It gives the difference between funding, operational activities and investment. Both the expenses and income are categorized as financial, extraordinary and exploitative.
Contains information only regarding receipts, and payments of cash and cash equivalents. Similar to cash accounting, it provides information concerning receipts, and payments of cash and cash receipts.
It is required in the restatements for the creation of financial statements. The financial statements for given accounting periods are prepared in a comprehensive manner by following a series of logical steps with regards to relevant legal provisions.
It provides the management with information regarding profit. It enables the management to evaluate the quality appreciation by establishing thing the variation between net cash and net profit.

Conclusion

In conclusion, the selection of either of the accounting methods is dependent on the size of the business, the business goals, availability of resources, and the firm’s financial requirements. Therefore, the cash accounting method is more popular among small firms, sole proprietorships, and start-ups. On the other hand, accrual accounting is more applicable in instances where businesses earn gross revenue of more than $25 million over a three-year duration, or when firms sell products or purchase them on credit. Therefore, the best accounting strategy is that which utilizes a hybrid approach.

References

Gapenski, L.C., & Reiter, K.L. (2016). Healthcare finance: An introduction to accounting and financial management. Health Administration Press.

Biswas, R., Rahman, M., & Rahman, R. (2015). Effectiveness of accrual basis accounting as compared to cash basis accounting in financial reporting. International Journal of Multidisciplinary Research and Development, 2(10), 467-473. Web.

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