Traditional Budgeting as Foundation of Budgetary System with All Its Advantages and Disadvantages - Literature review Example

Budget Essay Name Institution Date Traditional Budgeting Introduction “The traditional budget is a rigid tool and should therefore be discarded in practice”. The scope and model of traditional budgetary system has raised questions of whether it should be abandoned or not. According to Dury (2011), budgeting is one of the concepts in corporate finance that are covered in best practices of financial management and that affect a business operation and decision making. This also includes accrual accounting, management and reporting. The traditional budgetary system adopts incremental approach. In this case, past year budget is adjusted by incorporating new information and assumptions of the current year. A unit in the organization can decide to put a forecast of 5% increase of previous year’s expenditure for current year due to projected increasing cost of labor and materials. This essay provides an analysis of rigidity of traditional budgeting in light of recent external pressures posed from capital markets. Traditional Budgeting The scope of budgetary process differs from organization to another depending on the type of budgetary module a company chooses to assume. Incremental budget approach puts more emphasis on previous economic result and integrates modulation of such approximations. Budget of subsequent years are then based on such approximations. Unlike incremental approach, rational approach is more concern on meeting the current set objectives using available alternatives. Instead of previous period’s budget bases budgeting basically involve estimating the current year’s turn out and for the following year (Rabin, 1992). Main goal of businesses is profit maximization and therefore, any selected investment should be in a position to attain maximum market value to a firm’s shares. The traditional capital budgeting is based on investment opportunities that are autonomous and of which internal rate of returns exceeds the company’s average cost in terms of its capital. Another way of attaining this is whether internal rate of return is more than net present values that should be positive compared to average cost of capital providing a suitable discount rate. Traditional capital budgeting assumes that inherent risk of the company will not change by either increasing or decreasing due to adoption of the investment opportunity (Tuttle & Litzenberger, 1968). Zero - Based Budgeting Due to the draw backs of traditional budgetary model, other forms of budgeting have been instituted to curb such weaknesses. The zero - based budgeting works better by providing an alternative to incremental approximated figures in consequent years. This kind of budget starts from a clear budget level of current year and period. This model adopts existing operations model where all operations including expenditure are accounted for and justified. Each activity must be useful to the organization and its general operations to be financed. Unlike incremental budgeting where alternative methods are created to spend, zero based budgeting requires that managers account for budgets they create and present. Analysis A strong financial management system of any organization unit is defined by efficiency and effectiveness. Apposite alignment of finances and expenditures ensure that effectiveness is achieved in budgeting. However, all these will not count if budgeting elements are not aligned with the organization’s strategies such that, the organization’s interests are prioritized. Key players in budgeting also need to understand what the organization’s expectations of performance are (Lynch & Martin, 1993). Budgeting in an organization is meant to aid in planning process and must therefore adhere and meet the objectives of the organization and the environment it operates in to its benefit. It stipulates and justifies amount of income needed by the organization. State governments charge their citizens fees and taxes at different levels so as to provide for public sector expenditure. Proposed budgets identify current levels of income and come up with projected income levels and match this with the expected expenditure levels for the next year. According to Otley (2001), government budget size will vary depending on planning services and can only spend funds that issue authorities provide. This enables the management to focus on specific issues that the organization has prioritized. Traditional or incremental budgetary approach takes into consideration the long term benefits by providing basis from previous year’s budget which zero based budgeting might leave out. When budgets are started at zero and built up to accommodate only current year’s operations, long term planning is likely to be overtaken by short term benefits. This is because planning process gives first priority to short term benefits then long term. With this, traditional budgeting model adheres to the provisions of financial reporting and accounting standards which focus on continuity of the business and long term benefits. Financial reporting is defined by national and international bodies within a country. Public and private partnerships and organizations are governed by reporting requirements provided by accounting bodies. In this case, organizations need to update changes in reporting standards and laws are as a result of complexity in business operations. Since budget is adjusted from previous years’ and fixed on basis of projected assumptions, this creates a lee way for corruption and misappropriation of funds. Especially in government sectors, there is usually no balance at the end of the year meaning all budgeted funds must are totally spent. Officers therefore strive to spend everything allocated to that particular year in budget before it ends. According to organizations applying the incremental approach departmental mangers are only allowed to apply for additional funds when they have spent entire funds allocated for previous year so as to maintain the budget level at par. According to (Bhimani et al, 2012), such misappropriation and embezzlement of funds is encouraged by traditional budgetary model that adopts incremental procedures. However, one of the advantages of incremental budgeting is that, it saves time in terms of planning for activities and allocation of costs from zero. Past year’s budget provides a basis for building up current budget and saves decision makers or managers the time of building a budget from scratch. Zero - based budgeting takes longer because of evaluations, new considerations, assumption and planning. Planners and decision makers set budget as zero unless stated otherwise and come up with appropriate ways to attain their goals. Although it might take lesser time than zero based budgeting, officers take a lot of time and resources in this process yet it is only updating procedures. This model involves use of spreadsheets which is having a number of shortcomings. This a high possibility of losing data and control issues in terms of spreadsheet version. the processes of creation of formulas can also be difficult hence inefficient (Van der Stede, 2000). Incremental budgeting in its nature provides an updated version of past data of budgets. In this case, efficiency might be compromised and previous year’s mistakes carried forward to subsequent years. Another is product related factors which can be attained through analysis of management accounting information incorporated during strategic business risk assessment. Resource allocation is one of the main decisions that managers must make to ensure efficiency and continuity of the business during strategic business risk assessment. This decision requires that updated information on resource availability such as financial, capital and human resources are provided. It is correct that management accounting provides information to people within the organization and is done to benefit decision makers. Low responsiveness to change in the traditional model affects its efficiency. Normally, budgets became obsolete after a short time that they have been created especially when implementation has started due to annual reporting. The review procedures are not as frequent enough to cater for these changes. Therefore some changes go unaccounted for. According to (), in most occurrences, it is almost impossible for 80% of organization units to review departmental budgets in real time. Structure of the money markets change in such a way that new systems need to be adopted to accommodate these changes. Creating a current year’s budget from previous years might affect implementation of such changes and their adoption into the new budgets. Over the past decades, the benefits of international diversification have been extended to stock portfolios. According to Allen (2013), investors of international stock markets consider themselves enjoying the substantially higher return with less risk than investment in single market. Risk-averse investors tend to avoid risk and would rather invest in markets with fewer risks and a lower return than in markets with high risks but possibly better returns. The aspect of risk brings about need for financial management in investment projects and business enterprises. Financial management involves all aspects of efficient and effective control including managerial finance, and corporate finance (Fisher 2012). Budgeting is one of the best financial practice concepts that involve identifying sources of fund and adequately allocating such resources to business activities. Starting from zero in budgeting is the most appropriate way of allocating funds to expenditures. From this, more budgets can be prepared based on goals and objectives of company projects. Allocation of resources is best done after there is an established budget so as to ensure cost effectiveness. Resources can then be allocated while taking into consideration organization’s interests. A budget cannot be complete with expenditures alone. Sources of funds to finance the expenditures are therefore taken into consideration. As much as short-term policies are a vital component of budget, long-term goals and strategies must be incorporated. Alignment of these strategies should be on priority basis according to organization goals. Analysis of individual activity to determine their cost effectiveness and feasibility to organization’s projected result is important. Budget preparation is governed by rules and regulations depending on state in which a business is established. According to Rabin (1992), decision makers must ensure that compliance to these regulations is attained when preparing budgets, doing reviews and submissions. Due to uncertainty in decision making procedures in capital markets, capital market budgeting proves to be untenable. Hennie and Brajovic (2009) state that, risk management is inevitable if organization profitability is to be attained. An effective risk management system will ensures that plans are put in place to prevent or mitigate any possible risks effectively and efficiently so that the impact is not severe on organization operations. Risks are continuous and cannot be entirely avoided therefore risk management system should be able to cope with the continuity. This includes taking into perspective factors like so as to develop appropriate strategies to identify and curb risks. Another aspect of budgeting and risk management that cannot be avoided is speculation of future occurrences and projection of possible mitigation strategies. Currently, countries’ governments provide regulations and legislative procedures that govern risk management within and outside businesses (Carpenter, 2012). Traditional budgeting does not consider organization priority although it considers authorization of expenditure. This budgeting model plays the role of motivating managers especially if the managers are involved in budgeting process. It creates ownership that brings about dedication. Activities need to be described and related costs highlighted for transparency. Transparency is the concept that traditional budgeting suppresses. According to Otley (2001), revenue budgets majorly consider amounts of income and respective expenditure while budgets based on line items consider nature of expenditure and income. Legally, a company or any organization for that matter is not supposed to spend without an approved budget indicating such expenditures and respective income sources. It therefore directs management and provides basis for measuring performance of all parties in the organization also known as a tool of performance appraisal. Prior period misstatements contribute to high chances of inherent risk assessment in a company. Insignificant errors made in previous periods might not be detected because of immateriality therefore not causing any change. However, these errors still exists to the current period ‘financial statements’ including the budget. Auditing does not consider an overstatement in a previous period to be compensated by an understatement in the current year so as to correct the error. Reliable and approved correction procedures must be followed. Financial accounting errors which carried forward to subsequent year as historical data in form of budgeting creates loop holes for inefficiency in investment decisions (Van der Stede, 2000). Capital markets encourage transparency that traditional budgeting might not provide on the expenditure side section where additional activities are created for spending allocated cash. Bodies like International Accounting Standards regulate the preparation and reporting of accounting information in public and private sectors. Since a wide range of parties use accounting information, transparency is important as it ensures information conveyed is true and clear. All organizations are expected to meet stipulated accounting principles while preparing and reporting financial information to shareholders. Stock Exchange Commission of the US government provides the accrual basis for preparation of accounts. Firms need to state methods they use in displaying such information. Transparency allows investors, stakeholders and analysts a chance to understand the operations of the firm. They are able to identify areas within the firm, that are less or more profitable. Due to such pressure of accountability on decision makers, they are propelled to improve performance and attain results that company owner’s desire. Since management accounting provides information required for decision making, it is updated. It applies current information which is focuses on the future of the company. If the decision concerns purchasing machinery, the management will require a recent cash statement indicating amounts available in cash and bank (Van der Stede, 2000). Without a well-defined cost and income structure, resource allocation decisions made by organization managers will be inefficient. Continuity of business majorly relies on appropriate allocation of available resources. Therefore decision makers’ base decisions on updated management accounting information such as budget. Mangers make decisions about changes implemented in the organization. These require a cost and benefit analysis of the changes to the organization and its daily operations including stakeholders’ interests. In case of a new technology, cost installation must be analyzed against benefits of the technology. Such information is used by the organization decision makers to analyze viability of the project. The commitment of management ensures a successful co-ordination on the part of other organization functions. Due to changing times, ways of management and technologies, the management needs to constantly improve the quality of their management system in order to catch up with the changes. Management accounting also helps managers in financial decision making on behalf of stakeholders of the company. Financial decision making is another important element of financial management. Major decisions made in relation to organization’s finances include financing of projects and operations, shareholders’ dividends and investments. According to Balakrishnan, et al (2008), investment decisions include methods of financing a given investment either by taking credit or lending or through placing shares on offer. The executive body in the organization should be considering stakeholders’ interests especially owners since they are the source of company’s capital and also in accordance with rules provided by the business so as to protect business finances. A better financial position is an assurance for sustainability and continuing growth. Conclusion Traditional budgeting remains to be the foundation of budgetary system with all its advantages and disadvantages. However, due to change in markets structures and business operations, the model is outdated. With zero based budgeting, organizations are in a better position to restructure cost strategies and sharpen their competitive tools. Since decision makers rely on such information to make capital investment decisions, unduly updated information may lead to unrealistic and irrational decisions due to the robustness of the market itself. In conclusion, based on theoretical argument and practical examples, traditional budgetary model should be abandoned. The model cannot cope with recent eternal pressures existent in capital markets. Bibliography Van der Stede, Wim, 2000, The relationship between two consequences of budgetary control, Accounting, Organizations and Society, 25, (2000), pp. 609-622. Ryan, B., 2007, Budgeting, the individual and the capital market: a case of fiscal stress. Accounting Forum, 31, (2007), pp. 384-397. Drury, C., 2011, Management and cost accounting. Andover: Cengage Learning. < https://www.cengagebrain.co.nz/content/9781408049044.pdf> Tuttle, D. L & Litzenberger, R. H., 1968, Cost and Management accounting. The Journal of Finance. < http://www.readcube.com/articles/10.1111%2Fj.1540-6261.1968.tb00818.x?r3_referer=wol&tracking_action=preview_click&show_checkout=1.> Capenter, J., 2012, The systematic risk assessment of UK building Regulations Class 3 structures. ICE - Structures and Buildings, Volume 166, Issue 2 Greuning, Hennie , and Bratanovic S. Brajovic. Analyzing Banking Risk: A Framework for Assessing Corporate Governance and Risk Management. Washington, D.C: World Bank, 2009. Print. Fisher, Gregg. S., 2012, Why Global diversification still makes sense. Forbes. Lynch, T.D., & Martin, L.L., 1993, Handbook of comparative public budgeting and financial management. New York: Marcel Dekker. (Dixson 336/L987h) Bhimani, A., Horngren, C. T., Datar, S. M and Rajan, M. V., 2012, Management and Cost Accounting. Prentice Hall. < http://www.amazon.co.uk/Management-Cost-Accounting-MyAccountingLab-Access/dp/0273762230> Rabin, J. (Ed.). 1992, Handbook of public budgeting. New York: Marcel Dekker. (Dixson 350.722/236) < http://www.dpmc.gov.au/accountability/budget/2009-10/pbs/naa.doc.> Otley, D., 2001, Extending the boundaries of management accounting research, British Accounting Review, 33, (2001), pp. 243-261. Read More