Unit 6: Budgetary Control - Subjective Questions

Budgetary control is a system of planning and controlling business activities through the preparation of budgets and the comparison of actual results with budgeted results.

Objectives of budgetary control:

• To establish clear targets for different departments and functions.
• To coordinate the activities of various departments.
• To plan income, expenditure, production, sales, and cash requirements.
• To control costs by comparing actual performance with budgeted performance.
• To identify deviations and take corrective action promptly.
• To communicate management policies and objectives throughout the organisation.
• To evaluate the performance of departments and responsible managers.
• To ensure the optimum utilisation of financial, material, and human resources.
• To support managerial decision-making and future planning.

Thus, budgetary control converts organisational plans into measurable financial and operating targets.

Advantages of budgetary control:

• Planning: It requires management to plan future activities systematically.
• Coordination: It coordinates the activities of production, sales, purchasing, finance, and other departments.
• Cost control: It helps identify unnecessary expenditure and prevents wastage.
• Performance evaluation: Actual results can be compared with budgeted results to assess performance.
• Communication: Budgets communicate organisational objectives and responsibilities to employees.
• Resource utilisation: Scarce resources are allocated among competing activities in a rational manner.
• Early detection of problems: Variations from the budget highlight potential problems at an early stage.
• Motivation: Realistic budgets can motivate employees to achieve predetermined targets.
• Policy formulation: Budget information assists management in making operating and financial decisions.
• Profit improvement: Better planning and control can reduce costs and increase profitability.

Limitations of budgetary control:

• Budgets are based on estimates, and estimates may be affected by errors or uncertain business conditions.
• Preparing and administering budgets can be costly and time-consuming.
• A budget may become outdated when there are significant changes in prices, technology, demand, or government policy.
• Excessive emphasis on budget targets may encourage managers to focus on short-term results.
• Unrealistic budgets may reduce employee morale and motivation.
• Departmental managers may manipulate estimates to create easily achievable targets.
• Budgetary control cannot replace sound managerial judgement.
• Employees may resist budgets if they are imposed without participation or proper communication.
• Fixed budgets may be unsuitable when the level of activity changes significantly.
• Variance reports may identify deviations but do not automatically explain their causes or provide corrective action.

Therefore, budgets should be flexible, realistic, regularly reviewed, and supported by effective management.

A budget is a quantitative statement, usually expressed in monetary terms, prepared and approved before a defined period. It indicates the planned policy and activities to be followed during that period for achieving a specified objective.

Characteristics of a good budget:

• It should be based on clearly defined objectives.
• It should cover a specific future period.
• It should be expressed in quantitative and financial terms.
• It should be prepared using reliable and realistic estimates.
• It should be consistent with the organisation's overall plans.
• It should clearly specify responsibility for each activity.
• It should be flexible enough to respond to changes in operating conditions.
• It should be prepared with the participation of responsible managers.
• It should be communicated effectively to all concerned employees.
• It should be periodically reviewed and revised when necessary.

A good budget serves both as a planning instrument and as a basis for performance control.

Budgets may be classified in several ways:

1. Classification according to function:

• Sales budget: Forecasts the quantity and value of expected sales.
• Production budget: Specifies the quantity to be produced to meet sales and inventory requirements.
• Materials budget: Estimates material purchases and consumption.
• Labour budget: Estimates labour hours and labour cost.
• Overhead budget: Forecasts production, administration, and selling overheads.
• Cash budget: Estimates cash receipts, cash payments, and the resulting cash balance.
• Capital expenditure budget: Plans expenditure on long-term assets.
• Master budget: Summarises all functional budgets into an integrated plan.

2. Classification according to flexibility:

• Fixed budget: Prepared for one level of activity and remains unchanged regardless of actual activity.
• Flexible budget: Prepared for different levels of activity and changes according to the level achieved.

3. Classification according to time:

• Short-term budget: Usually prepared for a period up to one year.
• Long-term budget: Prepared for several years, generally for strategic planning.

4. Classification according to coverage:

• Partial budget: Covers only one activity or department.
• Comprehensive budget: Covers the organisation as a whole.

A flexible budget is generally more appropriate for industries where production or sales volume varies considerably.

A cash budget is a detailed estimate of cash receipts, cash payments, and the resulting cash balance during a specified future period.

Objectives of a cash budget:

• To estimate future cash receipts and payments.
• To determine periods of cash surplus or cash shortage.
• To plan borrowings and repayment of loans.
• To ensure that sufficient cash is available for day-to-day operations.
• To plan the temporary investment of surplus cash.
• To coordinate cash flows with sales, production, purchasing, and capital expenditure plans.

Uses of a cash budget:

• It helps maintain adequate liquidity.
• It assists in arranging bank overdrafts or other sources of finance.
• It prevents unnecessary borrowing and idle cash balances.
• It helps management schedule payments to suppliers, employees, lenders, and other parties.
• It supports decisions concerning capital expenditure and dividend payments.
• It provides a basis for controlling actual cash flows.
• It helps identify the timing of cash surpluses and shortages.

The cash budget is concerned with the timing of cash flows, not merely with accounting profit.

A cash budget normally contains the following components:

• Opening cash balance: Cash available at the beginning of the budget period.
• Cash receipts: Collections from cash sales, collection from credit customers, interest received, dividends received, sale of assets, issue of shares, loans, and other receipts.
• Cash payments: Payments for purchases, wages, salaries, overheads, selling and administrative expenses, taxes, interest, dividends, capital expenditure, loan repayment, and other obligations.
• Net cash flow: The difference between total cash receipts and total cash payments.

• Closing cash balance: The balance remaining after adding net cash flow to the opening balance.

• Financing section: It indicates the amount of borrowing required when the closing balance falls below the minimum desired cash balance, or the investment of surplus cash when the balance exceeds requirements.

The cash budget may be prepared monthly, quarterly, or annually depending on management's requirements.

Under the receipts and payments method, the cash budget is prepared by estimating all cash inflows and outflows for each budget period.

Procedure:

1. Determine the opening cash balance for the first period.
2. Estimate cash receipts, including cash sales, collections from debtors, loans, issue of shares, sale of assets, and other receipts.
3. Estimate cash payments, including purchases, wages, expenses, taxes, capital expenditure, interest, dividends, and loan repayments.
4. Calculate the net cash flow:

5. Add the net cash flow to the opening cash balance:

6. Treat the closing balance of one period as the opening balance of the next period.
7. Compare the closing balance with the minimum cash balance required.
8. Show additional borrowing if there is a shortage or temporary investment if there is a surplus.

A typical format is:

Credit transactions are not recorded as cash flows on the date of sale or purchase. They are included in the cash budget only when the related cash is expected to be received or paid.

Treatment of credit sales:

• Determine the collection pattern, such as the percentage collected in the month of sale and the balance collected in subsequent months.
• Apply the collection percentages to current and previous months' credit sales.
• Include only the amounts expected to be collected during the relevant budget period as cash receipts.

For example, if of credit sales are collected in the month of sale and in the following month:

Treatment of credit purchases:

• Determine the payment pattern, such as the percentage paid in the month of purchase and the balance paid in subsequent months.
• Include only the amounts expected to be paid during the relevant period as cash payments.
• Outstanding creditors from earlier periods must also be considered.

Thus, the cash budget reflects the timing of collections and payments rather than the timing of revenue and expense recognition.

A flexible budget is a budget designed to change according to the actual level of activity achieved. It is prepared for several levels of activity and is useful when output, sales, or capacity utilisation is uncertain.

Steps in preparing a flexible budget:

1. Select the relevant range of activity, such as , , and capacity.
2. Determine the cost behaviour of each item.
3. Classify costs into fixed, variable, and semi-variable costs.
4. Determine the variable cost per unit or the variable cost ratio.
5. Separate the fixed and variable portions of semi-variable costs.
6. Calculate the total cost at each level of activity.
7. Present the budget in a comparative format for the selected activity levels.

The basic calculation is:

For a semi-variable cost:

The resulting budget can be compared with actual costs at the actual level of activity.

At capacity, production is units.

Production at each capacity level:

• capacity: units
• capacity: units
• capacity: units

The formula is:

The cost per unit decreases as activity increases because the fixed cost is spread over a larger number of units.

A Cash Flow Statement is a statement showing the inflows and outflows of cash and cash equivalents during a particular accounting period. It explains the changes in the cash position of an enterprise by classifying cash flows into operating, investing, and financing activities.

Objectives:

• To identify the sources from which cash was generated.
• To show the purposes for which cash was used.
• To explain the movement between opening and closing cash balances.
• To assess the liquidity and short-term solvency of the enterprise.
• To evaluate the ability of the enterprise to generate future cash flows.
• To assess the capacity to pay dividends, interest, and loans.
• To distinguish cash generated from operations from cash obtained through external financing.

Uses:

• It assists management in cash planning and control.
• It helps investors evaluate the financial strength of an enterprise.
• It helps lenders assess the ability to repay borrowings.
• It improves comparison between enterprises by focusing on cash flows.
• It explains why accounting profit may differ from actual cash generated.
• It supports decisions relating to investment, financing, and working capital.

The statement provides information that complements the income statement and balance sheet.

Under AS-3 (Revised), Cash Flow Statements, cash flows are classified into three categories:

1. Cash flows from operating activities

These are cash flows arising from the principal revenue-producing activities of the enterprise. Examples include:

• Cash receipts from the sale of goods and rendering of services.
• Cash receipts from royalties, fees, commissions, and other operating revenues.
• Cash payments to suppliers of goods and services.
• Cash payments to employees.
• Cash payments of operating expenses and taxes, unless specifically classified as investing or financing activities.

2. Cash flows from investing activities

These relate to the acquisition and disposal of long-term assets and investments not included in cash equivalents. Examples include:

• Purchase and sale of property, plant, and equipment.
• Purchase and sale of intangible assets.
• Purchase and sale of shares, debentures, and other investments.
• Loans and advances made to other parties and their repayment.
• Interest and dividends received, where applicable under the standard's classification principles.

3. Cash flows from financing activities

These result in changes in the size and composition of the owner's capital and borrowings. Examples include:

• Proceeds from issuing shares or other equity instruments.
• Proceeds from issuing debentures, loans, notes, and other borrowings.
• Repayment of borrowings.
• Redemption of preference or equity shares.
• Payment of dividends and interest, according to the applicable classification policy.

This classification enables users to understand the operating, investment, and financing consequences of an enterprise's activities.

Cash and cash equivalents are related but distinct concepts.

An investment normally qualifies as a cash equivalent only when it is highly liquid, readily convertible into a known amount of cash, and subject to an insignificant risk of changes in value. Equity investments generally do not qualify unless they are, in substance, cash equivalents.

Under the indirect method, a typical reconciliation is:

Both methods ultimately report the same net cash flow from operating activities.

Under the indirect method, net profit or loss is adjusted to determine the net cash generated from operating activities.

Steps:

1. Start with net profit before tax and extraordinary items, or another appropriate operating profit figure as required by the reporting framework.
2. Add back non-cash expenses such as depreciation, amortisation, goodwill written off, and provisions.
3. Deduct non-operating incomes such as profit on sale of fixed assets, interest received, and dividends received when classified outside operating activities.
4. Add losses on sale of fixed assets or investments when they have been deducted in arriving at accounting profit.
5. Adjust for changes in working capital:
   • Increase in current assets is deducted.
   • Decrease in current assets is added.
   • Increase in current liabilities is added.
   • Decrease in current liabilities is deducted.
6. Deduct taxes paid, unless specifically classified otherwise.
7. Present investing and financing cash flows separately.
8. Reconcile opening cash and cash equivalents with closing cash and cash equivalents.

The basic expression is:

Under the indirect method, accounting profit is converted into operating cash flow by removing items that affect profit but do not represent operating cash receipts or payments.

Non-cash expenses:

• Depreciation is added back because it reduces accounting profit but does not involve a current cash outflow.
• Amortisation of intangible assets is added back for the same reason.
• Provision for doubtful debts and other non-cash provisions are generally added back, subject to the related cash treatment.

Non-operating incomes:

• Profit on sale of a fixed asset is deducted because the total sale proceeds are reported under investing activities.
• Interest received and dividends received are deducted from operating profit when classified under investing activities.

Non-operating losses:

• Loss on sale of a fixed asset is added back because the asset's sale proceeds are reported under investing activities.

The purpose of these adjustments is to avoid double counting and ensure that operating activities reflect cash generated from the principal revenue-producing activities.

For example:

Changes in working capital are adjusted because accounting profit is based on accrual accounting, whereas cash flow is based on actual cash movement.

Current assets:

• Increase in inventory: deduct, because cash has been used to purchase or produce additional inventory.
• Decrease in inventory: add, because inventory has been converted into sales or cash.
• Increase in trade receivables: deduct, because revenue has been recognised but cash has not yet been collected.
• Decrease in trade receivables: add, because cash has been collected from customers.
• Increase in prepaid expenses: deduct, because cash has been paid in advance.
• Decrease in prepaid expenses: add.

Current liabilities:

• Increase in trade payables: add, because expenses or purchases have been recognised without a corresponding cash payment.
• Decrease in trade payables: deduct, because cash has been paid to suppliers.
• Increase in outstanding expenses: add.
• Decrease in outstanding expenses: deduct.

The general rule is:

Using the indirect method:

Therefore: