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Capital Budgeting And Public Financial Management

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Capital Budgeting And Public Financial Management

  1. 1. By Ngoie Joel Nshisso<br />International Business<br />Ph.D. program<br />Northcentral University<br />June 2008<br />Capital Budgeting and Public Financial Management: <br />Why the Democratic Republic of Congo can’t improve its economy<br />Now a day, budgeting is a common and required practice for businesses and public sectors. Even families use budgeting as part of their planning for major acquisitions like a house or automobile. They use consultant or software that observes budget principles to achieve the expected result. <br />Before to show the importance of capital budgeting and the role it plays in the public financial management, this research will briefly explain the fundamental concept of budget, the difference between the budget and the capital budget. Before to draw the conclusion, this research will show the relationship between capital budgeting and public financial management, and analyze some data of the Democratic Republic of Congo in comparison to Belgium in order to understand the tenure of the first named country to the capital budgeting and public financial management.<br /> In simple words, a budget is a financial tool that allocates revenues and expense to divisions or departments. The goal of the budget is to obtain a certain amount of net income from a forecasted or anticipated volume of revenues which can be sales, taxes, memberships or any other acceptable revenues. The budget plays the role of benchmark for companies and public sectors. Without a budget, it is impossible to know whether the actual results of the company or public sector are successful or if they fit in to the overall business plan. <br />Budget procures considerable benefits to the company. It allows for coordination of all departments of a company; provides a starting point for taking action to control costs and to correct practices that are causing cost overruns and develop a standard by which to measure the performance of managers.<br />The budget last in general one year and contains in most part the operating incomes and expenses that vanish in assets to the end of the period. As implied by (Bernard 2006) “these assets constitute a capital because of a stock of accumulated goods especially at a specified time and in contrast to income received during a specified period”. Because, business and public sector are there to stay for long time, as far as the profit or the funds make it possible, decision can be made to purchase items that immobilize money for more than one year. This can be the example of warehouse, machines or buildings. Such items are budgeted under different consideration and fall in the category that financial management specialists term as capital budgeting. <br />In essence, “capital budgeting is the decision process that managers use to identify those projects that add to the firm’s value, and as such it is perhaps the most important task faced by financial managers and their staff. First, a firm’s capital budgeting decisions define its strategic direction because moves into products, services, or markets must be preceded by capital expenditures. Second, the results of capital budgeting decisions continue for many years, reducing flexibility. Third, poor capital budgeting can have serious financial consequences” (Eugene & Michael 2008). <br />Just as businesses observe financial management in relation to budget and capital budgeting, the public sector with respect to good management practices, in order to render services to the community and to be a good steward of tax money, follows rules to establish budget or purchase item of considerable value beyond the day to day operation. This activity of the public sector is called by some authors and specialist under the name of public financial management.<br />A good analysis of different countries economy shows differences between infrastructures (roads, public buildings, parks and recreation centers), gross domestic product and wealth. This difference leads to the classification of developed and developing countries. The importance of the public sector in the economy will never be overstated by statement like the following: “public investment is an important potential contributor to economic growth and achievement of social development objectives. In addition to the level of investment and the sectoral allocation, the capital budgeting process is an important determinant of the quality of investment projects and their implementation. Recent years have seen renewed attention to capital investment for economic growth and development. In particular, much attention has been given to finding fiscal space for increasing capital investment” (Bill 2008). In this declaration, it is clear that the investment and the implementation of the capital budgeting are among the keys to success in public financial management. <br />According to “the size of expenditure, the long-term costs and the benefit, the importance for public service delivery and economic development, countries develop and implement processes to deal with capital or investment spending. Those processes are in accord with the financial management and further they respect the criteria set by institution like international monetary fund (Joseph 2007). The question is why some countries, especially those in developing word like the Democratic Republic of Congo have a low participation of public sector in the development of their economy?<br />The response can be found in the analysis of Capital Asset Condition and Maintenance that discover that “rather than only examining funding, it is important to examine other aspects of capital spending performance, such as condition of facilities and adequacy of maintenance spending. These are important inputs and outputs of the capital budgeting process, and affect both decision-making and efficiency of capital spending. A central or sector ministry registry of current assets and their physical condition is a useful tool to support budget formulation, execution, and management. Many countries do not have such registries, and they can demand much human capital to maintain current data. Even where no central registry of capital assets and their condition exists, countries may have information on asset depreciation and years of service. These can give some indication of potential investment needs. But, they are relatively crude measures telling more about facility age than current condition, and not a satisfactory way to estimate maintenance costs or need for various types of capital investment. The absence of better data should raise serious questions of whether more investment in a sector is justified, or would be properly maintained and serve its full useful life” (Bill 2008).<br />The following table gives some general data for the Congo Democratic Republic. For comparison purpose, data for Belgium will be also given. Congo Democratic Republic is a developing country and Belgium is a developed one. The first country was colonized by the second one and has historic ties.<br />According to the CIA statistics, the data for Belgium is for year 2007 while the available one for Congo Democratic Republic is prior to year 2000. Any estimation of Additional funds needed using the formula: AFN = (A*/S0) ΔS - (L*/S0) ΔS - MS1 (RR) to purchase capital items for the public sectors for this country will be based on inaccurate balance sheet and income statement. <br />Data is an important ingredient to the capital budgeting because it provide the base for the evaluation of current assets to project additional funds needed (AFN) and to opt for with capital budgeting decision methods among the six well known, that are: “payback and discounted payback, Net present value (NPV), Internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI)” (Eugene & Michael 2008).<br />A close look at the table above it is obvious to notice that developed country (Belgium) keeps and renews data after each period where developing country (Congo DRC) don’t have necessary data to base its capital budgeting upon. Beside data, there are other elements that contribute to good or poor capital budgeting such as: “(1) Comprehensiveness: all revenue and expenditure, and all government agencies, are included in the budget; all government agencies are integrated into the public expenditure management system. (2) Accuracy: actual transactions and flows are recorded. (3) Annularity: the budget covers a defined period of time (e.g., one year). (4) Authoritativeness: spending is carried out only as authorized by law and (5) Transparency: information on spending is publicly available, on a timely basis, in an understandable or common format” (Bill 2008).<br /><ul><li>Within the over-all budgeting process, robust capital budgeting elements need not be overly technical or sophisticated.  Traditional capital budgeting has three distinct phases: planning, budgeting, and implementation. A fourth not commonly included in capital budgeting discussions, post audit is also an import step in assuring process and information integrity. </li></ul>The planning phase is often considered the most important because of the long-lived nature of the assets. Whether undertaking government-wide strategic capital planning, ministry planning, or program planning, the planning exercise needs to be kept within the over-all expenditure ceilings or envelopes to help insure more realism in the planning process, and in a multi-year framework to take into account the inter-temporal nature of decisions. Capital planning is not divorced from strategic planning, where strategic planning sets the goals and objectives for government, ministries, and programs. Then capital planning fits as part of consideration of what mix of capital and recurrent spending best meets those needs within available resources. The planning phase should provide the type of investments and size or number of investments (if not specific investments) needed. <br />The budgeting phase entails selecting specific projects to include in the budget, and may entail trade-offs between specific investments given available resources and government’s relative priorities. It includes identifying specific financing sources.<br />Implementation is self-explanatory, and entails government monitoring and oversight of the work for quality, time-lines, etc. The bulk of this work is in programs or ministries. Procurement is a critical step in the process, and care must be taken to assure that costs do not rapidly escalate after contracts signing, and that unit costs are within competitive ranges.<br />Post - audit of financial and physical records helps insure weaknesses in the process are identified and can be corrected.  <br />In conclusion, capital budgeting processes in the public sector can be extremely time-consuming and expensive if not properly designed. There is frequently a tendency to require elaborate studies and cost-benefit analysis for all proposed projects, regardless of importance, feasibility, likelihood of being adopted, etc. A better system would seek to use strategic planning and priority-setting to help screen ideas before necessitating more detailed analysis. Much of the planning and budgeting process is a filtering process to arrive at an optimal set of investments with respect to government objectives and available resources. <br /><ul><li>A foundation of a robust capital budgeting process is a good inventory of existing capital assets. Basic information needs to be readily available and up to date. The inventory should identify each asset, the ministry owning it, the program it supports, the date it entered service and original construction cost, annual maintenance and repair expense history, current condition, current replacement cost, and similar data. Current asset condition needs a simple but consistent framework for summarizing condition, and should be updated annually.
  2. 2. Asset condition assessment is likely to be the most labor-intensive task in the capital budget process, but is essential to know if the asset is in need of replacement. The condition can be assesses by the owning agency or ministry, by a central agent contracted to a private firm, or contracted to a university or non-profit organization.</li></ul>References:<br />Bernard, M. (2006). Management decision. The Emerald Research journal, 9, 43<br />Bill, D. (2008). Capital Budgeting and Public Financial Management. Retrieved May 26, 2008<br /> from http://blog-pfm.imf.org/pfmblog/2008/02/capital-budgeti.html<br />Career Press. (2007). Business Finance. 3 Tice road, Franklin Lakes, NJ 07417<br />CIA Factbook. (2008). Congo democratic republic. Retrieved June 20, 2008 from<br /> https://www.cia.gov/library/publications/the-world-factbook/geos/cg.html<br />CIA Factbook. (2008). Belgium. Retrieved June 20, 2008 from <br />https://www.cia.gov/library/publications/the-world-factbook/geos/be.html<br />Craig, R. H. (2008). Management malpractice. Platinum press, 57 little field street, <br />avon MA 02322<br />Eugene, F.B., & Michael, C.E. (2008). Financial management. Thomson higher education, 5191<br /> Natorp Boulevard, Mason, OH 45040<br />Geoffrey, A. M. (2008). Living on the fault line: managing for shareholder value in any <br />Economy. HarperCollins publishers, Inc, 10 east 53rd street, New York, NY <br />10022<br />Joseph E. S. (2007). Globalization and its discontents: IMF’s other agenda. W.W. Norton & <br />company, Inc., 500 fifth avenue, New York, N.Y. 10110<br />