Literature Review On Budgeting: Advantages, Disadvantages And Capital Budgeting Practices

You are required to prepare a report about your findings from the literature research, and discuss how it has helped your understanding of your chosen topic. The report should cover the following:

1. An explanation of the selected management accounting
2. An explanation of the purpose of the two studies and what research question(s) they set out to explore about the
3. A discussion about the similarities and differences in the findings of the two studies.
4. Provide four (4) specific outcomes or lessons learned from the two studies’ research findings that will be useful for management accountants in Australian companies to learn from, and justify your answer [i.e. provide 2 outcomes from eachstudy].

Types of Budgets Used by Organizations

In today’s world, Budget is a commonly used term, be it in the corporate environment or in the household. To state in simple words, a budget is nothing but just a tool used for managing the finance. It helps in planning the expenses and income for a given period so that a person can inculcate a habit of savings and thrift. In the absence of a pre-defined budget, a person will not be able to save money systematically and even if does, he will not be able to manage his savings and as a result will watch it pass away from his hands. Creation of a budget in a way curbs the mindless spending of people. So we can say that budgeting is a step of creating a plan in order to spend your money right. There are various tools of budgeting for the purpose of determining a budget (Bena, et al., 2017). These involves providing an estimation of expenditures and revenues; enabling the actual business operation against the estimation and the establishment of various cost constraints. Budgeting is of great significance for the smooth operation of the business of any and every organization. If an organization does not plan a budget then it ends up playing a host to various problems relating to finance. Every organization, irrespective of its size and years of operation, needs to plan a fair and effective budget, failing which there ought to be various financial problems which the organization should prepare itself to face. There are various types of budgets used in different types of organizations. These are: sales budget to estimate the amount of future sales for obtaining the goals of a company in respect of sales; Production budget which determines the estimation of the quantity of units required to be produced by the company in order to the goals set in respect of sales (Clarke, 2013). It also estimates the various cost involved with the production process; Capital budget which determines the net present value of the costs involved in the long term investments of a company like plant, machinery, replacement of plants etc.; Cash Budget estimates the total cash expenditure and cash receipts for a given period. All the cash inflows and outflows are included in this budget; Marketing Budget which predicts the  funds required for the promotion and other related expenditures of the product produced by the company; Project Budget that shows the cost which is associated with a particular project of the company; Revenue Budget shows the revenues of the government and the expenditures related to these revenues after netting off; Expenditure budget includes all the expenditures incurred by the company; Flexibility budget is created for the estimation of fixed costs as well as the variable rate for every activity for determination of the variable cost; Performance budget is created to evaluate the performance of the company; Appropriation budget is used for establishing the maximum amount for a specified expenditure as decided by the management; lastly the Zero based budget is created when the resources are limited and is needed to be apportioned very carefully. We have discussed all the possible types of budget above, however for the given assignment our main focus will be on the capital budget. Based on two journals the discussion will be done below in this report. We have also discussed the various advantages and disadvantages of budgeting in this assignment prior to discussing the journals (Visinescu, et al., 2017).

Capital Budgeting Practices in Australia

Budgeting is important in every segment of business and every sector of an industry. The main advantages it has are discussed in brief here. These advantages are as follows:

1. It helps in having control over the money. With the preparation of a budget an organization is able to control the money by estimating and planning the amount to spend and the amount which is required to be saved. This prevents the circumstances of lack of funds as the organization will be able to estimate the expenditure beforehand.
2. It helps in focusing on the goals related to money. By limiting the amount of unnecessary spending on goods and services which are not required and focus on contributing to the achievement of financial objectives of the company, it is very helpful in case of the companies whose resources are limited(Naci & Hasan, 2012).
3. Budgeting helps you in keeping a track of your money. The cash budget discloses the amount of cash inflows and outflows which helps the organization in planning. With the help of budgeting an organization can avoid the situation where it has to wonder where the money was actually spent. It also enables an organization in decision making process relating its debts as well as investing prospects.
4. With the help of budgeting, an organization is able to organize properly its savings and expenditure. By preparing budgets an organization can divides its savings and expenditure into various categories and evaluate the proportion of savings and expenditures allocated to each category. This makes it easier for the organization to make any required adjustments(Raghupathi & Wu, 2018).
5. An organization will be able to decide which part of the money will be used in which manner in advance. This makes forecasting the future needs and requirements of money easier for the organization.

Even though, budgeting has various advantages as mentioned above, there are certain drawbacks faced by budgeting. These disadvantages are being pointed below:

1. Budgeting faces the issues relating to inaccuracy. Budgets are prepared on the basis of various assumptions relating to the expenditures and incomes. All these assumptions are based on the market trends and scenarios which were prevailing when the budgets were prepared. These are also prepared with the help of estimations relating to the future depending on the information and data available at time of preparation. Any change in the economic behaviour on the basis of which these budgets were prepared will affect the costs and expenditures significantly(Fay & Negangard, 2017).
2. The process of preparing a budget is in fact expensive as well as time consuming. An organization has to employ extra manpower for the collection of data and the preparation of budget. This adds up to the costing of a company and also the time of the management as they have to oversee the budget finally prepared is reliable or not.
3. The budgets sometimes leads to excessive spending by the managers as some managers are of the view that the funds which are apportioned to the departments are required to expended. They believe that if they fail to spend the funds which are apportioned to them, then the amount of apportionment to their department in the next period will be reduced by the amount not spent by them in the current year. This leads to unnecessary spending by the managers(Choy, 2018).
4. The methods used for the allocation of expenses amongst the department at the time of preparation of the budget might cause issues and strife among the various departments. The allocation of expenses is the responsibility of the management. It is practically very cumbersome to take under consideration the suggestion of each and every department regarding the allocation of costs and expenses amongst them. Hence, this creates a lot of controversies in the organization among different departments.

For the preparation of this assignment we have taken under consideration and studies two journals relating to budgeting. There are various kind of budgets prepared by an organization, we have done this assignment by taking journals on capital budgeting. The two journals are, firstly, “Cost of Capital Estimation and Capital Budgeting Practice in Australia” by Giang Truong, Graham Partington and Maurice Peat; secondly, “Improved Capital Budgeting Decision Making: Evidence From Canada” by Karim Bennouna, Geoffrey G. Meredith and Teresa Marchant (Jefferson, 2017).

The first journal is the analysis of  the practices of capital budgeting by the Australian companies listed in the Australian Exchange, while the other journal analyzes the improved decision making process on capital budgeting in Canada. Both the journals are discussed below in detail.

In the first journal, the authors have put emphasis on the use of capital budgeting in corporate finance and how the development of capital asset discounting model (CAPM) has affected the practice in Australia. The various issues are the extent of use of real options analysis instead of discounted cash flow technique; using discount rates of varying time; the inputs used by the companies while applying CAPM; what are the differences, in relation to the cost of capital, between the regulatory practices and Australian corporate. The authors have further discussed the various surveys done to reveal the growing recognition of the discounting cash flow (DCF) technique and also the reliance place on the discounting rate which is considered to be the weighted average cost of capital (Dumay & Baard, 2017). These surveys were done by MacMohan (1981), Lilleyman (1984) and Hobbes (1991). The recent international surveys conducted by Kester et al. (1999) on the Asian pacific countries which included  various Australian companies as well has disclosed that almost 73% of the companies which were surveyed followed CAPM. There were various other surveys which were conducted to review the importance of CAPM in various countries. The other areas which were looked upon were the evaluation of the effects tax credits imputation. The surveyor has selected 488 firms which were included in the All Ordinaries Index in August 2004 as the interested population. The main focus of the survey was on the practice of capital budgeting by the Australian companies so the companies outside the boundaries of Australia were excluded from the survey. The survey included 20 questions and the response rate was 24.4 % and on the basis of revenue the average size of the respondents was $ 1.32 billion. The survey was inclined towards the large firms as they were likely more participative in the survey. According to the survey on the evaluation of the techniques used by the Australian companies, it was observed that the net present value techniques were used by 82 numbers of companies which was 94 % of total responses and while 11 companies forming 13% of the responses followed other techniques. The authors have observed on the basis of various surveys that many companies did not place full reliance on the single capital budgeting technique instead they were using various other techniques along with it (Linden & Freeman, 2017). The techniques which topped the list of techniques were NPV, IRR and Payback. The most popular method use in the estimation of the cost of capital was the capital asset pricing model (CAPM). The authors have also presented various tables and charts for the analysis of the above techniques used in capital budgeting. The authors have also emphasized on the adjustments for Dividend Imputation Credits, which was not done by the majority of the companies investigated. Nonetheless, the surveys discussed in the journals and briefed as above are considered important for the updating of our knowledge and practice.

Capital Budgeting Practices in Canada

The authors of the second journal have emphasized on the evaluation of the techniques used currently in capital budget decision making in Canada. The authors have discussed the various trends in the capital budgeting decision making process. There has been a long gap between the studies done on the capital budgeting decision making process, which is around 50 years. Discounting cash flows are not being involved in the various investment analysis methods by the Canadian firms (Raiborn, et al., 2016). The authors have also pointed on the proper utilization of the DCF technique since adoption of the same is the first step towards the effectiveness of capital budgeting. The determination of cash flows was not proper in the analysis of the capital investment by the Canadian firms. Moreover, the basis of the DCF technique should be the cash flows and not accounting income. The firms are expecting recognition of inflation in the capital budgeting decision making process. In the calculation of DCF cost of capital has been considered as a key parameter. The firms generally make wrong decision by choosing a single cost of funds. For the calculation of the cost of capital the weights taken should be based on the market values of the firm’s capital structure rather than on the book values. However, in case of Canada there is no research investigating about the weights used for the calculation of WACC. It has been observed that many large firms in Canada and US as well have to face difficulty relating to separation of divisional cost of capital. For the effective decisions in respect of capital investment, risk analysis is of great importance apart from the DCF techniques, estimates of discount rate and proper cash flows. The literature also provides for various recommendations about the administration apart from the use of proper financial techniques. The authors have also discussed various surveys conducted in Canada presented in the forms of tables and charts in great detail (Truong, et al., 2008). There were 17 firms which did not use the DCF techniques out of the total number of 88 firms surveyed in Canada. Nonetheless, the outcomes of these surveys have various limitations. The survey was restricted to small number of the large firms in Canada because they apply DCF method in capital budgeting technique. The managers of the companies considers internal rate of return (IRR) as the key model of capital decision making in spite of the drawbacks faced in using this model because it gauges the value of investment in the terms of percentage, which makes it easy for them to compare various capital budgeting projects. For the evaluation of risks, we have observed that most of the firms in Canada uses sensitivity analysis as the risk analysis tool, the percentage of the firms using the sensitivity analysis being 92.8 % and those using scenario analysis as the risk analysis toll being 85.3 %, while risk adjusted discount rate is being used by 76.8% firms as risk analysis tool. There has been a considerable increase in the sensitive analysis and risk adjusted discount rate in the current period as compared to the past research.

Advantages of Budgeting

We have observed certain similarities between the above journals. These similarities are stated below:

1. The authors of both the journals put emphasis on the capital budgeting technique and different methods of applying the same.
2. According to both the journals, the most widely use technique in the Capital budgeting is the DCF technique.

There were certain differences between the above journals as well. These differences are stated as follows:

1. The first journal discuss the capital budgeting decision making in case of Australian companies while the second journal was on the discussion about the improvement in the capital budgeting technique in Canada(Bennuona, et al., 2010).
2. In the first journal, primary emphasis was given on the estimation of cost of capital while in the second journal the discussion was about enhancement in the capital budgeting decision making.

From the first journal we have learned the following points which are discussed below:

1. The companies usually follow more than one technique instead of single capital budgeting technique. Also in case of project evaluation the companies uses other techniques like internal rate of return (IRR) and payback method apart from the usual net present value (NPV) method.
2. The weighted average cost of capital (WACC) is commonly used as the discounting rate by most of the companies across the boundaries. CAPM is used widely as the asset pricing model for the estimation of the cost of capital.
3. The real options technique has also come up as a popular technique for the evaluation of projects. Although the users of this technique are substantially minor and considered as unimportant(Kewell & Linsley, 2017).
4. We have observed that while the companies acknowledges time varying as the nature of risk, however in their risk evaluation techniques they use fixed discount rate.

In case of the second journal, there were several points which grabbed our attention and we would like to discuss the same. These points are mentioned as follows:

1. The discounting cash flow technique has been considered as the most recommended technique of investment decision making process, which has also become the standard technique. The employment of the non DCF techniques has decreased but is still adopted by some firms.
2. Although the DCF techniques have been used widely but the improvement in this technique has been restrained. There were many areas requiring more improvement in investment decision making process(Zhou, 2018).
3. There were certain limitations which were observed like the confinement to one country. However, this research has enhanced the knowledge relating to the capital investment. This study helps in improving the usual problems faced in the use of DCF techniques.

References

Bena, J., Ferraira, M., Matos, P. & Pires, P., 2017. Are foreign investors locusts? The long-term effects of foreign institutional ownership. Journal of Financial Economics, pp. 21-35.

Bennuona, K., Meredith, G. & Marchant, T., 2010. Improved capital budgeting decision making: Evidence from Canada. Emerald Management Division, 48(2), pp. 225-247.

Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis. Ecological Economics, p. 145.

Clarke, J., 2013. Australian Contract Law. [Online]
[Accessed 8th August 2016].

Dumay, J. & Baard, V., 2017. An introduction to interventionist research in accounting.. The Routledge Companion to Qualitative Accounting Research Methods, p. 265.

Fay, R. & Negangard, E., 2017. Manual journal entry testing : Data analytics and the risk of fraud. Journal of Accounting Education, Volume 38, pp. 37-49.

Jefferson, M., 2017. Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland. Technological Forecasting and Social Change, pp. 353-354.

Kewell, B. & Linsley, P., 2017. Risk tools and risk technologies.. The Routledge Companion to Accounting and Risk, 15.

Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making. Business Ethics Quarterly, 27(3), pp. 353-379.

Naci, T. & Hasan, O., 2012. The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System. Journal of Applied Management Accounting Research, 10(2), pp. 43-55.

Raghupathi, W. & Wu, S., 2018. The Strategic Association Between Information and Communication Technologies and Sustainability: A Country-Level Study. IGI Global, disseminator of knowledge, p. 26.

Raiborn, C., Butler, J. & Martin, K., 2016. The internal audit function: A prerequisite for Good Governance. Journal of Corporate Accounting and Finance, 28(2), pp. 10-21.

Truong, G., Partington, G. & M, P., 2008. Cost of Capital Estimation and Capital Budgeting Practice in Australia. Australian Journal of Management, 33(1), pp. 95-121.

Visinescu, L., Jones, M. & Sidorova, A., 2017. Improving Decision Quality: The Role of Business Intelligence. Journal of Computer Information Systems, 57(1), pp. 58-66.

Zhou, C. &. P. A., 2018. Developing creativity and learning design by information and communication technology (ICT) in developing contexts. Encyclopedia of Information Science and Technology, pp. 4178-4188.