The Fundamentals of Budgeting

Budgeting involves developing and implementing a plan for an organisation’s activities and comparing the plan against actual performance. The activities involved in budgeting include: 

• Estimating and forecasting
• Planning
• Preparation of the budget documents
• Distribution of budget documents and implementation of the budget
• Review of budget expectations against actual performance¹

Budgeting provides a systematic way of reviewing objectives, coordinating future activities and setting realistic targets. It is an effective management tool and serves the following purposes: 

• Establishes the work program for the financial year
• Provides a set of standards against which business performance can be measured and monitored
• Defines and provides an understanding of each staff member’s specific role
• Identifies potential trouble spots, e.g. cash flow shortages
• Builds good relationships and develops morale in the workplace¹

Budgeting in an organisation aims to achieve the following:    

• Provide an organisation with guidance on which direction it is going
• Predict cash flows, especially for organisations that are growing rapidly 
• Serve as a tool for deciding fund allocations within the business
• Develop a system to provide regular feedback on financial performance
• Identify variances between budgets and actual results

There are many limitations to budgeting in some of the key areas, including the following:

• Budgets are only as good as the assumptions or estimates on which they are based. There is always uncertainty in predicting future events, and the quality of the estimates will be critical to using the budget as a control document.
• The budget process may be expensive initially and during its operation, concerning monetary costs and staff time. Therefore, management will need to monitor the situation to ensure the benefits exceed the costs of installing a budgetary system.
• Preparation of the budget is no guarantee of success. Other factors include the performance of staff members and management and the operating and economic environment.
• The budget must be delivered promptly to the relevant people for appropriate action to be taken for implementation.
• Variances between budget and actual figures need to be identified and addressed, with improvements implemented promptly.
• The targets should not be too challenging, e.g. setting high or unrealistic statistics. 

The budget process should be communicated to all staff members and used as a motivating tool to boost morale and commitment in the organisation.1

The Generally Accepted Accounting Principles (GAAP)

Regarding accounting, certain globally recognised principles and practices must be adhered to by businesses of all sizes. The most commonly used system for tracking a company's financial position and performance is known as the Generally Accepted Accounting Principles, or GAAP. This system has been developed over many years and is now used in over 150 countries.

Under GAAP, businesses must calculate their financial results following specific standards. This includes recording revenue and expenses at the correct time and using appropriate valuation methods for assets and liabilities. In addition, GAAP prescribes certain rules around how items should be reported in financial statements to ensure fairness and consistency across different companies.

The generally accepted accounting principles (GAAP) encompass a broad range of subjects, including presenting financial statements, liabilities, assets, equity, income and expenses, business combinations, foreign currency, derivatives and hedging, and non-monetary activities.

While following GAAP is not compulsory for all businesses, it is generally seen as the gold standard for accounting.

Corporate governance

Corporate governance (CG) is the system by which a company is directed and controlled. CG principles and recommendations aim to protect the interests of all stakeholders, including shareholders, employees, customers and the community.

Several Acts and Regulations govern CG in Australia, including the Corporations Act 2001 (Cth), ASX Listing Rules and ASIC Regulatory Guide 128: Corporate Governance Principles and Recommendations (RG 128).

The key principles of CG are accountability, integrity, fairness, disclosure and consultation. These are underpinned by five core values: responsibility, accountability, transparency, good faith and due care.

CG applies to all companies listed on the Australian Securities Exchange (ASX) regardless of size or sector.

Using your current work environment, or one you have recently worked in, consider the Generally Accepted Accounting Principles (GAAP):

Read further information and answer the following questions.

Make and keep notes for your future reference, as this information will support your assessment and professional practice.

Choose five principles of accounting from the list below and define them in your own words. Then, if you wish to improve your learning, feel free to define all 10.

1. Economic Entity Principles
2. Monetary Unit Principle
3. Period Principle
4. Cost Principle
5. Full Disclosure Principle
6. Going Concern Principle
7. Matching Principle
8. Revenue Recognition Principle
9. Materiality Principle
10. Conservatism Principle

Using your current work environment, or one you have recently worked in, consider the Ten Principles of GAAP. Then, define each of them in your own words. 

1. Principle of Regularity
2. Principle of Consistency
3. Principle of Sincerity
4. Principle of Permanence Of Method
5. Principle of Non-compensation
6. Principle of prudence
7. Principle of Continuity
8. Principle of Periodicity
9. Principle of Full Disclosure
10. Principle of Utmost Good Faith

Communicating financial information

When writing or presenting for a business, it is important to take the time to understand the organisation's requirements, review its style guide, and use the proper terminology, language, and grammar so you can produce a document that is easy to read and understand.

It is important to ensure correct spelling, grammar, terminology, and conventions are followed to produce accurate, clear, and concise business reports. For example, check the standard abbreviations used in the business. In addition, it is important to use the correct terms, as incorrect terms may lead to confusion. 

Spell checking and proofreading are important steps in the writing process and should not be skipped. If you are not confident checking a document for grammar mistakes, spelling errors, and typos, many tools are available to help proofread documents, including spell checkers and grammar checkers. Spell checkers are used to finding misspelled words, while grammar checkers can identify incorrect grammar usage. These tools can be helpful but should not be relied on completely. Having someone else read your document is always a good idea to catch any mistakes the tools may have missed.

The financial information you prepare will be viewed by diverse audiences, including employees, directors, shareholders, and government regulators. Therefore, the information must be written clearly and concisely to ensure everyone understands it. 

Financial information will also need to be presented in graphical forms to make it easier to understand. Preparing logically structured financial information will ensure the company and its stakeholders receive the most accurate and up-to-date information possible.

Further Reading  

Read more information on business reporting standards.

By this stage in your career, you should already be adept at creating graphs and charts from financial information using spreadsheets like Microsoft Excel, but for some great tips on presenting financial information, watch this short 3.5-minute video.

When planning for the future, it is important to consider all possible costs and revenue streams. It is also necessary to account for ethical and organisational requirements to make accurate projections. For example, a company may need to provide estimates for future cash flow, costs and revenues according to environmental regulations or compliance with specific industry standards. These estimates should be realistic and supported by verifiable evidence. Source documentation can help to ensure that projections are accurate and reliable. 

The Institute of Chartered Accountants in Australia (ICAA) and The International Ethics Standards Board for Accountants (IESBA) 

The Institute of Chartered Accountants in Australia (ICAA) strongly emphasises members’ responsibilities to act with integrity and in the best interests of clients. 

Read

Codes of Ethics & Professional Standards for Members 2022 

The International Ethics Standards Board for Accountants (IESBA) sets high-quality, internationally appropriate ethics standards for professional accountants, including auditor independence requirements.

The IESBA Code of Ethics consists of five fundamental principles that govern the ethical conduct of professional accountants. The five principles are:

• Integrity: Be straightforward and honest in all professional and business relationships:
• Objectivity: Don’t allow bias, conflicts of interest, or the undue influence of others to compromise sound judgement
• Professional Behaviour: Comply with all laws and regulations and don’t act in a way that could discredit the profession
• Confidentiality: Respect the confidentiality of information acquired because of professional and business relationships, subject to applicable laws
• Professional Competence & Due Care: Always apply an appropriate level of professional knowledge, skill, and diligence

Internal processes affect budgeting and cash flow forecasts, with external factors impacting effective financial planning in the short and long term. 

All assumptions made in the forecasting process must be realistic. All assumptions should be documented and supported by source documentation. This enables assumptions to be checked and easily changed if circumstances change.

Examples of the source of data might include:   

• Financial institution statement
• Invoices and receipts
• Order and supplier documentation
• Taxation and statutory returns

Sources of information that can be used might include:   

• Business plan
• Operational plan
• Historical business data

All cash, expenditure, and revenue items must be defined before preparing the budget to ensure the accuracy of the data compiled for budget preparation. 

The following are some general income, revenue and expenditure items that may need to be considered when preparing a budget. Still, it is important to refer to organisational and operational requirements for each specific budget.

Cash items   

Cash items, such as salaries and other operating expenses, are paid out of the budgeted amount.

Noncash items   

Noncash items, such as salaries and other operating expenses, are paid out of the budgeted amount.

Revenue items   

Revenue items are those that bring in money, such as rent or sales income. Revenue and income items can include: 

• Sale Revenue: Income earned in the ordinary course of business activities of the entity; including sales of products and services 
• Gains: Income that does not arise from the core operations of the entity, such as gain on a re-valuation of company assets

Expenditure items   

Expenditure items are those that go towards the purchase of capital assets, such as land or a building. Revenue items are those that go towards the purchase of capital assets, such as land or a building. The difference between the budgeted and actual is called a variance. Variances are not a problem if they are within budget limits. Expenditure items can include:    

• Wages
• Repairs and maintenance
• Rent
• Postage and printing 
• Stationery 
• Legal and insurance
• Motor vehicle costs 
• Service and bank fees 
• Advertising and marketing 
• Utilities

Variance    

The difference between the budgeted and actual is called a variance. Variances are not a problem if they are within budget limits. 

However, not all cash, expenditure and revenue items are relevant to budgeting. For example, depreciation is an expense item, but it is not relevant to budgeting as it does not impact the amount of cash available. Similarly, interest payments on debt are revenue items, but they are not relevant to budgeting as they do not affect the bottom line.

Before a budget can be prepared, it is important to identify and include any milestones and performance indicators used to monitor financial performance. By identifying milestones and performance indicators in budgets, businesses can better understand how they are doing financially and make necessary adjustments. 

Milestones

Milestones are established to guide the progress towards targets and overall objectives. In addition, milestones are used to monitor the effectiveness of budgets and forecasts and to keep track of the income and expenses of a project within the set period.

The types of milestones will vary but could include a review period, timeframes for completion of reports, implementation of new programs, etc. The milestone is the confirmation that an initiative has been achieved. They do not measure the actual performance. When preparing budgets and forecasts, the milestone could be scheduled payment dates or monthly, quarterly, and yearly reports.

Completing reports for specified periods and projects within agreed timeframes

Most business owners know they must complete reports for specified periods and projects within agreed timeframes. The consequences of not doing so can be significant, with missed deadlines often resulting in financial penalties and other adverse consequences. A failure to meet deadlines can also impact a business's reputation and prospects. Therefore, businesses should aim to complete all required reports before the due date. Sometimes, this may not be possible, but it is important to submit reports as soon as they are ready rather than waiting until the last minute. This allows time for any corrections or amendments that may be required. 

Time management is essential for meeting deadlines, and businesses should ensure that staff are aware of reporting periods and project timelines. Schedules should be created and adhered to as closely as possible, with regular reviews to ensure that progress is on track. 

When working with clients, it is important to provide complete reports for specified periods and projects within agreed timeframes; this allows you, your staff, and the client to plan and budget their work schedule accordingly. 

Meeting deadlines also demonstrate that your business is efficient and capable of meeting commitments. Failing to meet deadlines can result in lost business, tarnished reputation, and penalties from governing bodies such as the Tax office. 

There are a few key things that can help you stay on track when it comes to meeting deadlines: 

1. Create a schedule and stick to it; 
2. Delegate tasks as needed; 
3. Prioritise tasks according to importance; 
4. Use effective time management techniques;
5. Stay organised. When deadlines are looming, it is easy for stress levels to increase.

Further Reading

For more Important financial dates for your calendar

Further Reading  

It's also wise to regularly confirm dates directly with the Australian taxation office via their website. The "Due Dates By Topic" page offers a handy way to view key lodgement and payment dates by topic. Here you will find dates for:

Due dates by topic 2022

Performance indicators

Performance indicators are core metrics used by businesses to monitor their progress. Some of the more common performance indicators which are applied to measuring the financial performance of an organisation include: 

• Gross margins – Net sales less cost of goods sold. The gross margin will highlight the revenue earned from ales before any deductions, such as expenses, are made. 
• Net profits – This represents the financial position once all expenses have been subtracted. This type of indicator is often relied on to make decisions on the future of the business, including the need for additional finance.  
• Current ratio – This measures the business's ability to pay its debts and is a measure of short-term liquidity. 
• Debt to equity ratio – The debt-to-equity ratio assesses your business's total debt relative to the amount of money invested by the owners up until now and the amount of income that continues to be earned over time. The debt-to-equity ratio of your company is one of the important things the bank looks at to determine your suitability for a larger loan.

The milestones and performance indicators must be established during the planning stage of developing the budgets to ensure that the appropriate measures can be taken to assess performance. KPIs manage business spending and assist with future forecasts if KPI is based on the operating trends of the business.  

Operating trends and Seasonal indicators

Budget planning will also require a review of operating trends, and this is usually obtained by collecting information from multiple periods and analysing the data for patterns. Additionally, breaking annual budgets into seasonal periods according to operating trends can help track progress and performance. Budgets are typically built around seasonal periods, with the most important revenue and expense drivers typically factored in. Operating trends are also considered to project future results.

Seasonal indicators show how business activity changes from month to month or quarter to quarter. They can help businesses budget their expenses and plan for future growth. Some common seasonal indicators include retail sales, spending on travel and tourism, and business activity in sectors such as manufacturing and construction. By tracking these indicators, businesses can see how the economy is doing and make decisions about where to invest their money.

In business, trend analysis is typically used in two ways, which are as follows:

When used internally (the revenue and cost analysis function), trend analysis is one of the most useful management tools. The following are examples of this type of usage:

• Examine revenue patterns to see if sales are declining for certain products, customers, or sales regions.
• Examine expense report claims for evidence of fraudulent claims.
• Examine expense line items to see any unusual expenditures in a reporting period that require additional investigation.
• Extend revenue and expense line items into the future for budgeting purposes to estimate future results.

When trend analysis is used to predict the future, remember that the factors formerly impacting a data point may no longer be doing so to the same extent. This means that the extrapolation of a historical time series will not necessarily yield a valid prediction of the future. Thus, a considerable amount of additional research should accompany trend analysis when using it to make predictions.

Effective budgeting requires you to record and keep track of all financial transactions – what goes into the account and what is taken out must be documented. This method of recordkeeping is referred to as double-entry bookkeeping. 

Enhance your understanding by watching the following 3.34-minute video.

Double-entry bookkeeping is based on the following principles:

• Dual effect principle: Every transaction involves two (2) parties – debit and credit. According to the double-entry accounting principle, every debit of some amount creates corresponding credit, or every credit creates the corresponding debit for the same amount.
• Separate entity principle: The business and the business owner are considered as two (2) separate entities. This means that the business and business owners' transactions must be recorded separately to identify whether an expense or income is for the business or for the owner.
• Accounting equation: The accounting equation is the basis of the accounting process in double-entry bookkeeping. It includes the following equation.

Assets=Liabilities
Assets=Liabilities+Capital
Profit increases the capital, while drawings (money taken by the business owner) will reduce it.
Assets-Liabilities= Capital+Profit-Drawings
Accrual accounting method    

Enhance your understanding by watching the following 1.50-minute video.

In the accrual accounting method, transactions and events are recorded in the periods they occur rather than in the period when cash is received or paid. For example, income is recorded before receiving the actual payment, and expense is recorded on the purchase date, despite the business not yet releasing payment.

For example, if a business purchases office supplies on 22 November and pays on 24 November, the transaction is recorded on 22 November. However, if its client orders a product from them on 24 November and the payment is received on 3 December, the transaction is recorded on 24 November.

Accrual accounting has two (2) key principles:   

• The revenue recognition rule: The revenue recognition rule determines which period incoming cash flows need to be recognised as revenue. According to this rule, revenues are earned when the product is delivered or the service has been rendered, regardless of which period the customer pays the firm.
• The matching principle: The matching principle tells which period an outgoing cash flow needs to be expensed. According to this principle, cash outflows should be booked as an expense in the period they help generate revenue.

Due to ever-changing economic conditions, it is important for organisations to monitor their budget processes and make necessary changes periodically. In addition, organisational policies and procedures should be aligned with accounting principles and practices to ensure accurate and timely reporting. By doing so, management can make sound financial decisions that will benefit the organisation in the long run.

Periodically monitoring organisational policies and procedures and accounting principles and practices is important for ensuring everything is running smoothly. This can help identify potential issues early on, so they can be addressed before they become bigger problems. 

By taking a proactive approach to reviewing processes, organisations can ensure that their employees follow the correct procedures and that their financial statements are accurate. 

Several steps can be taken to review processes effectively. The key is embedding regular reviews into everyday procedures, attaching responsibilities for those reviews, and implementing required changes to specific job roles.