Corporate Finance
A Fresh Approach to Budgeting
"If management sets the targets and makes people's jobs depend on meeting them, people will do whatever is needed to hit the targets, including destroying the company to get there."
— W. Edwards Deming
FROM:
SEP-OCT 2004 ISSUE | BY
JEFF BUCKSTEIN
Some public companies will do whatever is necessary to report meeting budget targets, even if it means adopting questionable accounting practices. A bias to produce figures that will satisfy targets at the expense of providing accurate information is called gaming, a practice that is being tracked closely as part of an ongoing academic study called
Beyond Budgeting or Budgeting Reconsidered.
Authors Murray Lindsay, CMA, professor of management accounting and control at the Richard Ivey School of Business at the University of Western Ontario in London, and Theresa Libby, CA, a professor of accounting at Wilfrid Laurier University in Waterloo, Ont., have found solid evidence that gaming exists.
The Canadian portion of the study, which involved just over 300 responses from certified management accountants in senior positions with
for-profit firms across Canada, will be followed up by field research, along with a similar survey among U.S. professional accountants this fall.
To date, a significant number of survey respondents have indicated that gaming activities occasionally occur in their companies. Some examples: shifting funds between accounts; using unspent money at
year-end to avoid losing it; deferring expenses to boost profits; negotiating easier targets; and taking a big financial hit in order to better match financial results with budgeted figures. Even more alarming, some respondents reported such behaviours are detrimental to the
long-run performance of their business units.
"We certainly see no shortage of situations where people in organizations play games in order to achieve bonuses, variable compensation programs, promotions — what have it, when they're based on things like hitting fixed targets," claims Mitchell Max, CA, the Toronto-based director of financial services for the Beyond Budgeting Round Table (BBRT), an independent, international research collaborative.
When budgets — particularly those treated as fixed performance contracts — are used the wrong way, they encourage gaming, which can in turn dilute the ethical climate within an organization.
Once a company has established and met its earnings targets, management and employees are often reluctant to better them. "We see this quite frequently," says Max. "You get situations where the bonus stops after a certain level, and there's no benefit to overachieving. People will then tend to defer earnings to future periods."
But could ethical lapses originating from deficient budgeting practices have contributed to recent corporate failures?
Budgeting for Market Pressures?
While many accountants agree that gaming practices exist, some are reluctant to draw a direct correlation between shortcomings of budgeting techniques and the corporate malfeasance responsible for bringing down prominent companies in recent years.
But their failures were not indicative of general business practice, notes Andre Falzon, CGA, Toronto-based vice-president and controller of Barrick Gold Corporation, which is listed on the Toronto, New York, London, and Swiss stock exchanges. Falzon concedes that the budgeting process has changed somewhat as companies providing guidance to the market about issues such as predicted earnings are now more cautious. Additional public scrutiny means companies now generally tend to do a bit more risk analysis, he says.
Sandy Campbell, FCGA, senior vice-president and chief financial officer of WestJet Airlines Ltd. in Calgary, also finds it hard to attach a strong correlation between problems associated with the budget process and the more extreme cases of corporate malfeasance.
"A company would be foolhardy to base its business decisions or budgeting on what the investment community was expecting. There's no requirement to do that," Campbell says, adding that once a company falls onto that slippery slope, it can't get off.
But is it really budgets that create pressures in the market or, as some have suggested, is the dilemma created the other way around, with market pressures the genesis for high financial expectations?
The obvious answer appears to be market pressures. "A lot of people would say it's because of the street requiring firms to show increases every quarter," says Lindsay. "I think it would be wrong to put the blame at the foot of budgeting, although in the right environment budgeting can certainly exacerbate a bad situation," he points out.
Top Down or Bottom Up?
The BBRT claims that one of the most serious problems with contemporary budgeting is the existence of a traditional, top-down process whereby fixed, inflexible budgeting goals are pushed down to subordinates.
As a result, the BBRT is promoting the need to create a more dynamic environment within organizations whereby if a department or division needs more resources from the centre, they are able to get them, but at a price, says Max. "We've been trying to restore the level of accountability that says the end user is paying based on their real use of services. This creates a culture that says, 'I'm going to use it effectively.'"
Campbell argues, however, that the budgeting process has already become more democratic and has been so since the early to
mid-90s, in large part because of advances in accounting software and technology. These have made it possible for managers on the front lines to adjust figures with lightning speed, and then filter those numbers back up to the executives.
"Whereas it used to be a bunch of accountants who did the number crunching in conjunction with senior management, today front line managers and decision makers are ultimately responsible for their capital and operating budgets, and that's as it should be," Campbell says. WestJet, which became a public company in 1999, has always opted for a more participative,
bottom-up approach to budgeting, he points out.
Barrick Gold is also a long-time subscriber to the
bottom-up approach, with regional business units or operating segments submitting their budgets to head office for review. "Basically, we would not push a budget to them unless they accepted it. We stress that they're the ones eventually accountable for it. I can't speak for how other companies operate, but it's hard to believe in this day and age that kind of
top-down approach really works," Falzon says.
It does, though, according to Wai Ki, CGA, corporate
vice-president of Shaw Communications Inc., in Calgary. He points out that executives at his company, which is listed on both the Toronto and
New York stock exchanges, not only continue to use a top-down approach to budgeting, they have found this to be an effective means of allowing managers at various levels to pull together in order to achieve the company's goals.
Ki also downplays any positive impact that technology, in and of itself, has had on the budgeting process. "I think technology has, to some degree, brought companies to the point where they're not stepping back and looking at the big picture regarding the purpose of the budgeting process," he says. "Sometimes they're so wrapped up in the details and complexities of the model they lose sight of their goal."
Failing to Satisfy
Another problem with budgets, asserts Max, is that they have a tendency to be ineffective control mechanisms. While budgets protect spending above a certain level, they also often serve to limit an organization's potential. "People will tend to limit the growth of the company by moving away from riskier investments to stick with things that are tried and true," he says.
This charge fits into another key assertion of the BBRT — that budgeted figures tend to be too rigid. In fact, the survey carried out by Lindsay and Libby found that while the bulk of respondents indicated their firms continued to use budgets for various control purposes, almost half did not revise those figures once they were established. Moreover, adaptability to market change ranked very low among a series of questions related to how firms rely on budgets to deal with various issues, including profit planning, allocating and authorizing resources, and motivation and performance evaluation, among others.
"The BBRT is arguing that the budget is antithetical to adapting to market changes taking place, and these results would seem to support that," Lindsay says. Nearly half of respondents said they were considering abandoning using budgets as a control tool over the next
two years, which would seem to suggest all is not well with budgeting from a control standpoint, he adds.
Critics of those charges assert that too much weight is being given to the budgeting process. Budgets alone can't stifle risk taking or innovation or prevent companies from responding quickly to new developments. That can only happen, they argue, if the organization's culture stresses that kind of mentality.
"In some companies, there is old fashioned thinking that budgeted figures are the law they must stick with at all costs," says Campbell. "That's very dangerous. You can miss opportunities or end up spending for something that you don't need," he stresses.
Ki emphasizes the importance of organizational culture. "I think good managers will always think outside the box, stretch boundaries, and look for opportunities with a certain amount of risk," he says, adding, "Organizations which embrace that will ultimately be more successful."
A Limited Reporting Tool
According to Max, finance department personnel "spend a tremendous amount of effort building and analyzing variances to insane levels of detail without real value." So rather than adhering to rigid budget forecasts that only warrant attention when negative variances subsequently arise, management should develop more innovative ways of forecasting, including a means of identifying key performance drivers of the business, he suggests.
The BBRT claims leading public companies have, in fact, already begun to place more emphasis on continuous planning, relative measurement, and adaptive control to supplement the budget process. "We are seeing organizations trying to move towards providing ranges of estimates to get out of having the analysts just blindly take the numbers given, followed by the companies slavishly trying to meet those numbers. That's the cycle we think is damaging," Max says.
The BBRT also asserts that the process of trying to attain internal goals is sometimes divorced from the need to maximize shareholder value. "This is when people say 'the street expects us to deliver x amount so if we don't we're going to get punished.' But if the street expects you to deliver x and your competitor delivers
20 per cent more, is the street going to care whether you've met your commitments or not? Not really. Relative performance is the only thing that really matters," says Max.
While acknowledging that flaws such as gaming practices were a problem in some companies, some accountants also cite other reasons behind recent corporate failures. Deficiencies in areas like corporate governance probably contributed more to such downfalls, they believe. But serious breakdowns in corporate governance don't represent general business practice and the number of companies that failed as a result of questionable actions "represents a pretty small percentage of our universe," says Falzon.
Whether or not one agrees that current budgeting processes are flawed, the BBRT is encouraging fresh thinking on old issues and is sparking stimulating discussion that goes beyond budgeting.
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Jeff Buckstein, CGA, is a freelance business writer living in Ottawa.