Following detailed scrutiny and approval of an annual budget (usually prepared and proposed by management), active monitoring of actual income and expenditure against the approved budget is likely to be a dominant board meeting activity. Indeed, in many organisations, the budget is often the only kind of plan that gets any real board attention.
This budget-centred approach to a board’s basic responsibility for organisation direction and control tends to reflect tradition and habit as much as conscious thought and deliberate choice. Unfortunately, it has many weaknesses. Broadly, it sees boards being primarily engaged in reactive financial management at the expense of proactive financial governance. In applying their time and attention to the wrong (operational) end of the telescope, too many boards are distracted from the job they should be doing to create a framework within which more detailed financial planning can be done. By this neglect they make it far more difficult for their managers to prepare the operational budgets they need.
A more balanced approach is needed—one in which board and management play two distinctly different but complementary (and, as it turns out, sequential) roles. But, first, let’s look at a range of shortcomings in the traditional board approach to budget direction and control.
Typical shortcomings
The traditional line-by-line budget approval process is an open invitation to directors who are natural micromanagers to nit-pick what is in front of them. Others find it difficult to distinguish between substantial amounts in the budget worthy of board attention and the equivalent of minor rounding errors. Both types of directors divert their boards from more important discussion topics and frustrate fellow directors and senior executives alike.
A typical draft budget is structured by operational units and/or functions. This is a direct invitation for boards to focus on operational activities (eg, manufacturing, marketing, policy advice, staff training, asset management, etc). This dictates a concern for inputs when the board’s focus should be on resourcing the achievement of desired outcomes. Most budgets are presented in a way that makes it difficult, if not impossible, for a board to judge whether a draft budget is likely to support the achievement of the outcomes it has specified.
Boards typically approve a budget, but budget ownership (and accountability) is seldom clear. If a board intervenes and changes a management-proposed budget, whose budget is it—the board’s or the chief executive’s? If it is the board’s, where is the ownership and accountability of those who must ‘land’ the budget?
It is seldom clear what board ‘approval’ of a budget means in practice. Later, it often becomes apparent that individual board members have quite different interpretations of just what that approval amounted to: the budget’s general shape but not its detail? every number in the document? perhaps something in between?
For managers, has the board’s ‘approval’ fixed the numbers so that any change (eg, reallocation between line items) requires formal board approval? And, if that is not the case, how much discretion does the chief executive and management team have as the year unfolds to adapt and make sensible financial decisions in response to a changing operating environment?
By approving a budget, a board sets up a kind of performance contract. When boards also tie variable chief executive remuneration to ‘hitting the numbers’ it is hugely tempting for the chief executive (and other budget managers) to game the budget process to achieve the most personally beneficial results. As history has shown, opportunities for ‘creative accounting’ are many and varied.
The very notion of a board approving the budget in terms of specific numbers is fundamentally flawed. In most organisations, managers simply do not have enough control over income and expenditure to hit budget numbers on the nail. Often it makes little sense to even try. Trading conditions usually turn out better or worse than predicted when the budget was approved. Ideally, managers have the flexibility to adjust as conditions unfold without having to go back to their board to approve frequent budget adjustments.
Accountability within a board can also be compromised. Detailed scrutiny of a draft budget is often delegated to the most financially literate board members, possibly via an audit and risk or finance committee, or even to a single board member (eg, the ‘Treasurer’). This does free up other board members but also enables them to opt out of their collective responsibility for the organisation’s financial well-being.
These and other shortcomings point to the usual process of approving and subsequently applying ‘the budget’ being little more than the random result of a contest between individual inclinations and preferences, both at board and management levels.
There is a better way
As in most areas of corporate endeavour, governance and management roles and processes differ but should complement each other and must often also be performed in the right order. One thing budget-setting problems have in common is a lack of prior board agreement about criteria against which budget proposals can be judged. Effective financial governance requires a board to set out its thinking on what the financial planning (budgeting) process should both achieve and avoid before budget preparation (essentially a management process) begins.
Any board policy statements relevant to setting and approving budgets are seldom in full sight. So, few boards get past the actual numbers to any rigorous prior consideration of the values and principles that, if enunciated and consistently applied, would give the board more effective financial control and give managers a greater sense of responsibility for planning and making prudent financial decisions.
This requires a different concept of the exercise of a board’s fiscal responsibility. The board’s traditional, but often superficial, preoccupation with budget numbers, should be replaced by deep thought about the values that should be reflected in budget planning and budget monitoring. In other words, to the board’s budget policy.
To govern financial planning rather than just randomly questioning and sometimes altering the numbers put to them for approval, boards must be clear which aspects of financial planning require their direction and control. These should be expressed in terms of a budget policy based on what the board values in terms of the management of the organisation’s financial condition.
Management should not be expected to develop a strategic plan without the board determining corporate purpose, desired corporate outcomes and priorities. And neither should management be expected to develop a budget without guidance as to the policy objectives it must reflect.
Boards should always speak to management with one voice so chief executives are not faced with as many ‘masters’ as there are directors. Therefore, the policy-making process is also essential to align board members’ views and to define and signal its appetite for financial risk.
If the board leaves a policy vacuum around financial planning, it is open to individual board members to critique the detail of a budget and demand satisfaction of their own preferences. Settling budget contentions then becomes a lottery because there is no recourse to budget approval criteria that are well thought through and specified in advance.
What should a board-expressed budget policy contain?
A budget policy need not set out the board’s values on all areas of expenditure—just the matters with enough governance-level significance to merit both the attention of and control by the board. This means it can focus specifically on what would render budget content unacceptable.
Two budgeting features should cover most, if not all, of the board’s financial planning values and concerns. First: resources are allocated towards the results the board expects the organisation to achieve. Second: planned expenditure is prudent.
On neither matter should a board leave its views to management’s imagination.
In a general sense, the policy should speak first to the board’s concern about the proportionality of expenditure in relation to the achievement of intended results.
It is surprising how many organisations show little or no connection between budget allocations and what the strategic plan says is important. Because traditional budget preparation tends to be a ‘bottom-up’ process, it can lock in patterns of expenditure that quickly fall out of alignment with what the organisation needs, or says it wants to achieve.
While the idea of ‘zero-based budgeting’ was popular some years ago, the reality in any sizeable organisation is that what is put up for approval is the previous year’s budget, with minor modifications. When a draft budget is being compiled, operating units are highly motivated to at least hold onto what they had last year. So, boards need to give far more direction on budget priorities. Budgeting needs to be as much top-down as bottom-up.
Regardless of the level of detail it contains, a traditional budget structured around the kind of expense categories relevant to management (eg, marketing, travel, office expenses, etc) is of little use at board level. As noted earlier, presenting that kind of budget will do little more than draw some board members into second-guessing low-level operational trade-offs and prompt the rest of the board to go online to find something more interesting to occupy their minds.
A board’s budget policy direction should insist that any proposed budget adequately resources the board’s ‘change agenda’.[1] The subsequent review of the budget proposal will focus on the level of adequacy of that resourcing.
It may take some time for a board to fully define what it means by such terms as ‘adequacy’. Early efforts by boards to develop budget-related policy will inevitably be somewhat iterative.
Budget policy should not relate only to the board’s change agenda. A standard board budget policy could state, for example, that the chief executive must not plan to commit any expenditure that is inconsistent with the fulfilment of the organisation’s purpose, or the achievement of board-specified outcomes. This is an example of the potential for quite a simple policy pronouncement to have a significant impact. It is also another signal, should a board need it, that it should get on with the job of defining purpose and outcomes and any other ‘ends’-related matters. Without that framing of desired results, there is no way a board can tell whether planned expenditure is likely to be properly incurred or not.
Rather than locking in specific numbers, a board should expect financial planning (and desired financial outcomes) to be defined in terms of expected relationships or ratios. A desired level of solvency, for example, can be specified in the form of the margin the board expects to see maintained between current assets and current liabilities. Many not-for-profit entities have very lumpy cash flow. How low is the board prepared to see the margin drop, even though the planned end-of-year result may still be achieved comfortably? Is it prepared, for example, to permit management to draw on reserves to cover short-term cash flow deficits? This then points to the need for the board to also have a clearly stated policy on the purpose and use of financial reserves.
Rather than a specific end-of-year profit or ‘surplus’ number, a board’s policy objective can be specified in terms of the desired end-of-year relationship between total revenues and total expenses. This emphasises that it is not the number that matters but the attributes of the number. Since the board’s budget policy criteria remain constant while actual numbers vary during the year this gives the chief executive what might be termed ‘bounded freedom’. Knowing that—regardless of actual revenue—the board expects to achieve a minimum surplus of income over expenditure of 10% is a clear direction to management to budget and manage expenses accordingly. There is no real need then for chief executives to consult their boards or even get their approval on changing budget detail through the year as long as they can deliver the end-of-year surplus target.
The need to progressively refine its policy underlines that policy review and policy adjustment is a continuous task for any board. If a board has not yet made clear which circumstances would cause it not to approve a budget, then it has not yet expressed its values adequately and the policy needs further articulation.
In the end, the aim is that the chief executive has a budget that the board does not need to approve beyond attesting that that it complies with the board’s budget policy. That will mean that the board has set the criteria for chief executive’s financial planning sufficiently clearly that it can assess whether the chief executive’s budget intentions meet the board’s expectations.
Boards also need further policy that relates to their direction and control of the ongoing financial condition of their organisations, but that is a subject for another time.
[1] One of the biggest risks to any board's leadership is to be bogged down in 'business as usual'. In the short to medium term, BAU takes care of itself. It is important, therefore, for a board to have a clear sense of a few key initiatives that will produce significant progress towards the achievement of its priorities. We refer to those priorities and the associated initiatives as the board's 'change agenda'.
