Cities, counties, and other local government agencies are increasingly adopting long-term financial forecasting as a critical component of their financial management practices. Too many governments have found out the hard way what can happen in the absence of a realistic forecast model, one that projects and quantifies the impact of potential revenue shortfalls and increased liabilities well into the future. Forecasts can be used to create a strategic context for evaluating the annual budget, to establish a baseline for measuring the long-term effects of decisions, to test the economic effects of best-case and worst-case funding scenarios, and to establish a baseline projection of revenues, expenditures, and future cash flows and fund balances.
An effective forecast model is not a budget, nor is it a Soviet-style "5-year plan" that remains static and sits on a shelf. It is also not an absolute prediction of the future. Instead, a forecast model projects a range of possible outcomes, based on a set of known variables and assumptions. As with a weather forecast, a financial forecast is always subject to revision based on new information, and an effective budgeting and planning process provides a consistent routine for updating the forecast. If prepared and managed properly, a forecast can also help public officials evaluate the financial effects of proposed initiatives, and it can help educate constituents about an organization's present and potential financial capabilities. In particular, forecast models that include well-designed charts and tables can be used as visual aids in public presentations about the organization's finances, helping elected officials, citizens, and other stakeholders gain a better understanding of financial issues.
Baseline forecasts are based on recurring revenues and expenditures, projected at least five years into the future. It is recommended they be projected much further out, as far as 20 years, depending on known commitments and liabilities such as employee benefit and debt obligations. Proposed new revenues and expenditures that the organization has not committed to can be included in the forecast model as "optional" variables, the future effects of which can be measured against the baseline forecast.
Local governments typically use one or a mixture of three techniques for forecasting revenues and expenditures: expert judgment and analysis, deterministic forecasting, and econometric modeling. The methods used depend on the type of revenue being forecasted and the availability of historical and current economic data, along with other factors that drive the revenue.
Expert judgment and analysis can be used when data are limited. This method relies on simple trend analysis and requires alternative scenarios to measure the broadest range of probable outcomes. For example, a forecast of fines and forfeitures might be based on historical trends but modified to account for expected inflation-assuming fines are adjusted according to the Consumer Price Index (CPI)--and population growth.
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An organization should develop alternative favorable and unfavorable (or best- and worst-case) scenarios in a way that represents the broadest range of possible forecast outcomes. The primary purpose for creating alternative scenarios is to support sensitivity analysis, which attempts to identify what area of uncertainty makes the most difference in the forecast. Sensitivity analysis allows for "what-if" testing of various assumptions and outcomes, and their likely impact on the organization's finances. Quantifying unfavorable scenarios, in particular, allows a local government or agency to make contingency plans that can be implemented earlier and more thoughtfully than the reactionary measures that would likely be put in place after the day of revenues-hort-fall reckoning occurs. …