Video: Probability of Risk

In this lesson, Nick Palazzolo, CPA, breaks down how to calculate the expected monetary value of risk, introducing a practical formula that combines the cost of potential damages with the probability of risk occurrence. Through engaging examples, he demonstrates how to apply this formula to real-world situations, such as assessing the financial impact of possible user errors in a company's order processing system. Nick simplifies complex risk assessment concepts, ensuring that grasping the expected annual losses and the role of probability in risk management is clear and straightforward. The lesson includes a step-by-step approach to quantitative risk evaluation, enhancing the ability to make informed decisions based on potential risks and their associated costs.

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Video Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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How do you quantify the risk? The probability that a risk will happen. So the damages from something happening, a risk event such as getting hacked or even a tornado happening or anything, right. Or an attack like physical on your company is the cost of the damages times the probability of risk. It's kind of like a weighted average weighted average cost of capital plus cost with no damages times the probability of no risk.

So let's say I'll show you in this example. Let's say it would cost $100 if the damage has happened, times the probability of that happening, plus the cost with no damages, which a lot of times it will be zero because it's just no damages. So there's no cost times the probability of no risk. All right, let's take a look at how this works. XYZ Company helps to manage its risk by utilizing risk analysis.

Good for you. XYZ Company reach a new project. A risk probability is estimated for Project A. The company has estimated a risk probability of 20%, or 0.2, that it will see significant damages. So you see right here, starting to fill out the formula, classic plug and chug. At least 20% is the probability of the risk.

Project A has a budget of 50,000, but we'll ignore it, and if the risk occurs, the cost will be 15,000. So right here the cost of the damages is 50,000. They're trying to get you to say that, oh, the whole project will be ruined.

So what's the expected monetary value of this event? 20% that it does happen, which means that there's 80% chance it won't happen. It's got to equal 100. Damages if it does happen are $15,000. What happens if it does not happen? $0 damages. Although there could

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