One way to think about contract risk is that there are two veins: the likelihood of a breach and the impact of a breach. When a breach of contract occurs, it often requires significant of time, information-gathering, and negotiations in order to prosecute or defend the action. The lost opportunity cost associated with a breach of contract dispute is in addition to actual costs due to lawyer fees, court cost and other litigation related expenses. Therefore, it is to entities advantage to minimize the risk and costs associated with breach of contract.
There are risks involved in every agreement for performance of services. On the buyer’s side there is the risk of nonperformance – meaning the buyer does not receive the services bargained for under the contract. On the seller’s side there is a risk of nonpayment – meaning the seller does not receive payment for services rendered. This article focuses on the risk of nonpayment and how to most effectively minimize such risks.
Unless the agreement you have with the other party requires all payment upfront – the contractor accepts some form a credit risks when he or she agrees to provide services to the buyer. Credit risks is defined as the probability that a party will fail to meet his or her obligations in accordance with the agreed upon terms. The level of inherent risk (level of risk before considering controls) that a service provider faces with respect to nonpayment for services may depend on a number of factors – but the largest factor will be the parties involved.
Inherent Risks – First step is to identify what is the inherent risk involved when you are contemplating entering into a relationship with the other party. What can go wrong with this relationship? What could impede your business objectives if you engage with this entity or organization? You need to go through this exercise to better appreciate the risk involved. Without acknowledging the inherent risk it is difficult to create effective controls to mitigate risks. Again, inherent risks is the level of risk prior to assessing the effectiveness of controls. It shows the level of risk that exists if no controls are present.
It is impossible to control for every risk, especially since certain risk remain unknown. Therefore, after we assess the risk – we may skew our controls toward those risks that are most probable and with the potential for the greatest lost. The greater the risk- the more controls that may need to be implemented.