Accounting Best Practices, Fifth Edition

5–14. Incorporate Risk Analysis into Budget Modeling

Most budgets include only a single scenario, where a single mix of assumptions culminate in a single estimate of revenue and expenses. Examples of key assumptions are the inflation rate, the price of energy, the impact of a lawsuit, and the entry into the market of a low-priced competitor. Usually, these assumptions are based on what actually happened during the preceding year. Unfortunately, reality can diverge sharply from an assumption, resulting in an extremely inaccurate budget model.

Though it is impossible to predetermine every possible variation in assumptions, the budget model can at least be structured so that a wide range of assumption values can be entered into it, to see what impact they will have on the company’s financial results. This type of risk analysis calls for the use of a flex budget, as described in a preceding best practice, since a flex budget will automatically change many of its numerical values as a result of a change in an assumption.

To the extent possible, try to cluster all assumptions on a single page of the budget model, where they will be more readily accessible for modeling and viewing activities. Once all risk analysis has been conducted with the budget model, include the results of this experimentation in a separate budget report, and forward it to the management team for review. Managers can use it to determine if further action is needed to mitigate the impact of changes in certain assumptions. ...