In the world of financial accounting controls, the concepts of planning, budgeting, and variance monitoring are intimately related. Each is one of the legs of a three-legged stool that defines organizational structure and control. Each leg is fundamental to the success of the organization's raison d'être.
As we will see, the risk management process also can be described as a three-legged stool. Effective risk management processes also have planning, budgeting, and variance monitoring dimensions. It is intuitive that there should exist such a close correspondence between the models that support risk management and those that support financial accounting controls. Remember that risk is the cost of returns—the shadow price of returns. Hence, behind every number in a financial plan or budget there must exist a corresponding risk dimension. This duality suggests that risk management can be described, organized, and implemented using an approach that is already commonly used in the world of financial controls—namely, planning, budgeting, and monitoring.
For a moment, let's focus on the world of financial accounting to explore this point further. Consider how the "financial controls stool" is constructed. The first leg of this stool is a strategic plan or vision that describes earnings targets (e.g., return on equity, earnings per share, etc.) and other goals for the organization (e.g., revenue diversification objectives, geographic location, new product development, market penetration standards, etc.). The strategic plan is a policy statement that broadly articulates bright lines that define points of organizational success or failure.
Once a plan exists, the second leg of the financial controls stool—a financial budget—is created to give form to the plan. The financial budget articulates how assets are to be expended to achieve earnings and other objectives of the plan. The budget represents a financial asset allocation plan that, in the opinion of management, should be followed to best position the organization to achieve the goals laid out in the strategic plan. The budget—a statement of expected revenues and expenses by activity—is a numeric blueprint that quantifies how the strategic plan's broad vision is to be implemented.
The strategic plan and financial budget both presuppose scarcity. In a world of unlimited resources, there is clearly no need for either a budget or a plan. Any mistake could easily be rectified. In a world of scarcity, however, it is apparent that a variance monitoring process—the third leg of the stool—helps ensure that scarce resources are spent wisely in accordance with the guidance offered by the plan and the budget. Monitoring exists because material variances from financial budget put the long-term strategic plan at risk.
In the world of risk management, these same three elements of control—planning, budgeting, and monitoring—apply as well. Although this paper focuses primarily on risk monitoring, it is useful to step back and provide a more complete context for risk monitoring.
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