Case Studies

Case Study 11 - Help Line Query on Ethics and the relationship to Budgeting

Industry: Unknown

Client: Unknown, external query, anonymous

Objective: To confirm the ethical nature of budget related activities.

Results:

The following query came through our website recently. The original query asked us to identify some possible ethical concerns around the preparation of budgets. Following I have copied the transcripts of the dialogue that followed and the advice provided:
"I think it is necessary to determine the context of the budget preparation before considering ethical issues. For example, if you were to prepare a financial budget in order to obtain a bank loan or attract investors, then clearly the accuracy and fairness of the budget, and its ethical basis, is of great import. Regardless of the fact that any financial institutions and investors would have to undertake their own due diligence, you would be expected to take an ethical approach and competently incorporate all known matters in the budget or any matters that you should have known as a reasonable business person.

Another key question is whether we are dealing with a financial budget or a quantitative budget for operational purposes, such as at a medical facility which budgets for the number and type of medicines required during a specific time period.

Secondly, you would have to review what approach is taken on developing the budget (I am going to discuss mostly financial budgets in this answer)

As budgets should be the end result of a thorough risk analysis and strategic planning exercise, the final result, a ground up budget, relates to the ethical foundation of the strategic or annual plan. For example, let's say that an organization's risk analysis has noted an environmental problem at a plant which needs to be fixed, but which is deliberately suppressed because the laws of the country where the plant operates are not enforced? Let's assume that the waste products of this plant are polluting waterways and have the potential to cause deformities in babies. Is it ethical to ignore the issue due to a legal factor, and thereby not reflect the investment required to set up environmental protection systems such as a waste reticulation plant?

An alternative view often noted is that budgets are simply augmented by a standard percentage based on last year's budget and actuals. I would call this type of approach most likely to be unethical because it actually inappropriately requests stakeholders to put aside funding on the basis of a deficient budget. An example is where a government department requests a budget from the Ministry of Finance not based on actual requirements but on the desire to maintain a certain financial momentum and scope, potentially for self aggrandizement of the head of that department. This could result in an annual spike in expenditure to "use up" the budget to ensure the next year's budgets are increased, and the attendant procurement problems that may arise, ranging from procurement fraud and inappropriate vendor and project selection, all matters related to ethics.

Budgets often drive Key Performance Indicators, as the logical next step after budget preparation and sign off is normally the setting of targets and KPI for executives of the organization. Let's assume that a CEO is likely to be paid a bonus of US$ 1 million on achieving a short term net profit target for the next year. This type of budget related issue is exemplified by a gas pipeline maintenance budget, a sub segment of the overall maintenance expense budget. By cutting costs and reducing the maintenance budget for the pipeline there will be short term gains and a consequent bonus for the CEO. But in the longer term the pipeline may well blow up causing immeasurable damage to the company. I have also seen the impact on accounting in this scenario where the CFO deliberately reclassified expenses to capital in order to meet certain challenging budgets set by the Board and in order for the senior executive team to qualify for their annual bonus.

Another good example of unconscionable operational budgeting may well be the case of Shell when it overstated its oil reserves/ budget of potential crude oil available for exploration, which happened some 10 years ago.

Lastly, if the budgets are to be prepared for a loan or grant application, or for the purpose of raising finances through an IPO, great care must be taken to ensure that the figures stack up. Ethical issues may arise where, for example, you are an external professional consultant preparing budgets, and where the client pressures you to manipulate revenues or expenses for the purpose of being able to get a bigger loan or investment, based on what are essentially false pretenses. An example is where I was recently requested to prepare a cash flow forecast for a manufacturing plant which wanted to avail itself of government funding focused on stimulating the manufacturing sector. The client, at the tender stage, was quite forthright about his intent to show the minimum gap between revenues and expenses, in order to present a "rosy" picture and obtain a multi million dollar soft loan. Needless to say, we were not interested in accepting this project."

The query and the subsequent questions and clarifications raised a few interesting points:

Ethics impact on every facet of business and correct standards need to be set correctly from the top. Based on the above description and examples, and further corroboration with the person who raised the issue with us, it turned out that the executive responsible for the request to re allocate general and administration expenses to direct costs in Production, was the General Manager of the manufacturing facility.

Pressure on maintaining an ethical approach to business is increasing due to the economic environment. The case points towards pressure being applied to re allocate general expenses to production budgets, as became clear in subsequent emails clarifying the situation. As identified above, there may be a multitude of reasons for this strategy, none of them acceptable in the context of managing a company in a transparent manner.

Lesson learnt:

Professional Advisory Services can usefully and anonymously be provided via email. This case confirmed it is quite possible to assist at a distance with questions about ethics and corporate governance. In fact, the anonymous nature of the process allows for clarity of facts.

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