FINANCIAL PLANNING SYSTEM

Software that helps the user evaluate alternatives. It allows for the creation of a data model, which is a
series of data elements in equation form; for example, gross profit = gross sales - cost of goods sold.
Different values can be plugged into the elements, and the impact of various options can be assessed
(what

if?).

A financial planning system is a step above a spreadsheet by providing additional analysis tools; however,
increasingly, these capabilities are being built into spreadsheets. For example, sensitivity analysis assigns
a range of values to a data element, which causes that data to be highlighted if it ever exceeds that range.
Eugene Oregon's Financial Advisors and Retirement Planners-EXAMPLE
Our mission is simple - We want to know each client and have a thorough understanding of their needs so
we can tailor a unique comprehensive plan and investment strategy that brings focus to their financial
goals.
Sound financial planning requires making the right moves at the right times. At Future Planning Systems
our mission is to make sure each client begins with a plan that takes into consideration their own goals,
objectives and risk tolerance before building a portfolio to appropriate diversification.

We believe you will find it rewarding when a more proactive approach to your personal financial situation
is used. We're here to help you add to your knowledge about asset portfolio allocation, management,
investing, retirement, estate planning and to make specific recommendations on how to best preserve your
wealth.

A decision-support system that allows the financial planner or manager to examine and evaluate many
alternatives before making final decisions, and which employs the use of a model, usually a matrix of
data elements which is constructed as a series of equations.

Financial planning
1. In general usage, a financial plan is a series of steps or goals used by an individual or business,
the progressive and cumulative attainment of which are designed to accomplish a financial goal
or set of circumstances, e.g. elimination of debt, retirement preparedness, etc. ...
Financial planning is the task of determining how a business will afford to achieve its strategic goals and
objectives. Usually, a company creates a Financial Plan immediately after the vision and objectives have
been set. The Financial Plan[1] describes each of the activities, resources, equipment and materials that are
needed to achieve these objectives, as well as the timeframes involved.
The Financial Planning activity involves the following tasks;

Assess the business environment

Confirm the business vision and objectives

Identify the types of resources needed to achieve these objectives

Quantify the amount of resource (labor, equipment, materials)

Calculate the total cost of each type of resource

Summarize the costs to create a budget

Identify any risks and issues with the budget set

Performing Financial Planning is critical to the success of any organization. It provides the Business Plan
with rigor, by confirming that the objectives set are achievable from a financial point of view. It also
helps the CEO to set financial targets for the organization, and reward staff for meeting objectives within
the budget set.
The role of financial planning includes three categories:
1. Strategic role of financial management
2. Objectives of financial management
3. The planning cycle
When drafting a financial plan, the company should establish the planning horizon,[2] which is the time
period of the plan, whether it be on a short-term (usually 12 months) or long-term (25 years) basis. Also,
the individual projects and investment proposals of each operational unit within the company should be
totaled and treated as one large project. This process is called aggregation.[3]

THE

FINANCIAL

PLANNING

PROCESS

Most people want to handle their finances so that they get full satisfaction from each
available dollar. Typical financial goals include such things as a new car, a larger home,
advanced career training, extended travel, and self-sufficiency during working and retirement
years.

To achieve these and other goals, people need to identify and set priorities. Financial and
personal satisfaction are the result of an organized process that is commonly referred to as
personal money management or personal financial planning.

Personal financial planning is the process of managing your money to achieve personal
economic satisfaction. This planning process allows you to control your financial situation.
Every person, family, or household has a unique financial position, and any financial activity
therefore must also be carefully planned to meet specific needs and goals.

A comprehensive financial plan can enhance the quality of your life and increase your
satisfaction by reducing uncertainty about your future needs and resources. The specific
advantages of personal financial planning include

Increased effectiveness in obtaining, using, and protecting your financial resources

throughout your lifetime.

Increased control of your financial affairs by avoiding excessive debt, bankruptcy, and
dependence on others for economic security.

Improved personal relationships resulting from well-planned and effectively communicated

financial decisions.

A sense of freedom from financial worries obtained by looking to the future, anticipating
expenses, and achieving your personal economic goals.

We all make hundreds of decisions each day. Most of these decisions are quite simple and have
few consequences. Some are complex and have long-term effects on our personal and financial
situations. The financial planning process is a logical, six-step procedure:

(1) determining your current financial situation

(2) developing financial goals

(3) identifying alternative courses of action

(4) evaluating alternatives

(5) creating and implementing a financial action plan, and

(6) reevaluating and revising the plan.

Step 1: Determine Your Current Financial Situation

In this first step of the financial planning process, you will determine your current financial
situation with regard to income, savings, living expenses, and debts. Preparing a list of
current asset and debt balances and amounts spent for various items gives you a foundation
for financial planning activities.

Step 2: Develop Financial Goals

You should periodically analyze your financial values and goals. This involves identifying
how you feel about money and why you feel that way. The purpose of this analysis is to
differentiate your needs from your wants.

Specific financial goals are vital to financial planning. Others can suggest financial goals for
you; however, you must decide which goals to pursue. Your financial goals can range from
spending all of your current income to developing an extensive savings and investment
program for your future financial security.

Step 3: Identify Alternative Courses of Action

Developing alternatives is crucial for making good decisions. Although many factors will
influence the available alternatives, possible courses of action usually fall into these
categories:

Continue the same course of action.

Expand the current situation.

Change the current situation.

Take a new course of action.

Not all of these categories will apply to every decision situation; however, they do represent
possible courses of action.

Creativity in decision making is vital to effective choices. Considering all of the possible

alternatives will help you make more effective and satisfying decisions.
Step 4: Evaluate Alternatives

You need to evaluate possible courses of action, taking into consideration your life situation,
personal values, and current economic conditions.

Consequences of Choices. Every decision closes off alternatives. For example, a decision to
invest in stock may mean you cannot take a vacation. A decision to go to school full time
may mean you cannot work full time. Opportunity cost is what you give up by making a
choice. This cost, commonly referred to as the trade-off of a decision, cannot always be
measured in dollars.

Decision making will be an ongoing part of your personal and financial situation. Thus, you
will need to consider the lost opportunities that will result from your decisions.

Evaluating Risk

Uncertainty is a part of every decision. Selecting a college major and choosing a career field
involve risk. What if you dont like working in this field or cannot obtain employment in it?

Other decisions involve a very low degree of risk, such as putting money in a savings account
or purchasing items that cost only a few dollars. Your chances of losing something of great
value are low in these situations.

In many financial decisions, identifying and evaluating risk is difficult. The best way to
consider risk is to gather information based on your experience and the experiences of others
and to use financial planning information sources.

Financial Planning Information Sources

Relevant information is required at each stage of the decision-making process. Changing

personal, social, and economic conditions will require that you continually supplement and
update your knowledge.

Step 5: Create and Implement a Financial Action Plan

In this step of the financial planning process, you develop an action plan. This requires
choosing ways to achieve your goals. As you achieve your immediate or short-term goals, the

goals next in priority will come into focus.

To implement your financial action plan, you may need assistance from others. For example,
you may use the services of an insurance agent to purchase property insurance or the services
of an investment broker to purchase stocks, bonds, or mutual funds.

Step 6: Reevaluate and Revise Your Plan

Financial planning is a dynamic process that does not end when you take a particular action.
You need to regularly assess your financial decisions. Changing personal, social, and
economic factors may require more frequent assessments.

When life events affect your financial needs, this financial planning process will provide a
vehicle for adapting to those changes. Regularly reviewing this decision-making process will
help you make priority adjustments that will bring your financial goals and activities in line
with your current life situation.

PROGRAMME

BUDGETING

AND

PLANNING

PROGRAMMING

BUDGETING

SYSTEMS
Programme budgeting,developed by U.S. president Lyndon Johnson, is the budgeting system that,
contrary to conventional budgeting, describes and gives the detailed costs of every activity or
programme that is to be carried out in a budget.
Objectives, outputs and expected results are described fully as are their necessary resource costs, for
example, raw materials, equipment and staff. The sum of all activities or programmes constitute the
Programme Budget. Thus, when looking at a Programme Budget, one can easily find out what
precisely will be carried out, at what cost and with what expected results in considerable detail.

TOPIC 4
Zero-based budgeting
Zero-based budgeting is an approach to planning and decision-making which reverses the working
process of traditional budgeting. In traditional incremental budgeting (Historic Budgeting),

departmental managers justify only variances versus past years, based on the assumption that the
"baseline" is automatically approved. By contrast, in zero-based budgeting, every line item of the
budget must be approved, rather than only changes.[1] During the review process, no reference is
made to the previous level of expenditure. Zero-based budgeting requires the budget request be reevaluated thoroughly, starting from the zero-base. This process is independent of whether the total
budget or specific line items are increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to describe "zero-sum
budgeting", the practice of budgeting every unit of income received, and then adjusting some part of
the budget downward for every other part that needs to be adjusted upward. 7 Zero based budgeting
also refers to the identification of a task or tasks and then funding resources to complete the task
independent of current resourcing.

Advantages
1. Efficient allocation of resources, as it is based on needs and benefits rather than history.
2. Drives managers to find cost effective ways to improve operations.
3. Detects inflated budgets.
4. Increases staff motivation by providing greater initiative and responsibility in decisionmaking.
5. Increases communication and coordination within the organization.
6. Identifies and eliminates wasteful and obsolete operations.
7. Identifies opportunities for outsourcing.
8. Forces cost centers to identify their mission and their relationship to overall goals.
9. Helps in identifying areas of wasteful expenditure, and if desired, can also be used for
suggesting alternative courses of action.
Disadvantages
1. More time-consuming than incremental budgeting.
2. Justifying every line item can be problematic for departments with intangible outputs.
3. Requires specific training, due to increased complexity vs. incremental budgeting.

4. In a large organization, the amount of information backing up the budgeting process may be
overwhelming

According to Sarant, ZBB is a technique which complements and links to existing planning,
budgeting and review processes. It identifies alternative and efficient methods of utilizing limited
resources . It is a flexible management approach which provides a credible rationale for reallocating
resources by focusing on a systematic review and justification of the funding and performance levels
of current programs.
A method of budgeting in which all expenses must be justified for each new period. Zero-based
budgeting starts from a "zero base" and every function within an organization is analyzed for its
needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of
whether the budget is higher or lower than the previous one.
ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to
specific functional areas of the organization, where costs can be first grouped, then measured against
previous results and current expectations.
Components of a public sector ZBB analysis
In general there are three components that make up public sector ZBB:
1. Identify three alternate funding levels for each decision unit (Traditionally, this has been a
zero-base level, a current funding level and an enhanced service level.);
2. Determine the impact of these funding levels on program (decision unit) operations using
program performance metrics; and
3. Rank the program decision packages for the three funding levels.
The process was also specifically intended to involve both program staff and budget staff in the
process. In many cases, program staffers were asked to look for alternative service delivery models
that could deliver services more efficiently at lower funding level.
The US General Accounting Office (GAO) reviewed past performance budgeting initiatives in 1997
and found that ZBBs main focus was on optimizing accomplishments available at alternative

budgetary levels. Under ZBB agencies were expected to:

Set priorities based on the program results that could be achieved at alternative spending levels, one
of which was to be below current funding.
1. In developing budget proposals, these alternatives were to be ranked against each other
sequentially from the lowest level organizations up through the department and without
reference to a past budgetary base.
2. In concept, ZBB sought a clear and precise link between budgetary resources and program
results. [6]
Further, ZBB illustrated the usefulness of:
1. Defining and presenting alternative funding levels; and
2. Expanded participation of program managers in the budget process.
Performance measures
Performance measures are a key component of the ZBB process. At the core, ZBB requires quality
measures that can be used to analyze the impact of alternative funding scenarios on program
operations and outcomes. Without quality measures ZBB simply will not work because decision
packages cannot be ranked. To perform a ZBB analysis alternative decision packages are prepared
and ranked, thus allowing marginal utility and comparative analysis. [11]
Traditionally, a ZBB analysis focused on three types of measures. They (federal agency program
staff) were to identify the key indicators to be used in measuring performance and results. These
should be measures of:
1. effectiveness,
2. efficiency, and
3. Workload for each decision unit.(ELABORATE EACH.

Impact of ZBB on Government Operations

According to the GAO:

Agencies believed that inadequate time had been allowed to implement the new initiative. The
requirement to compress planning and budgeting functions within the timeframes of the budget cycle
had proven especially difficult, affecting program managers ability to identify alternative approaches
to accomplishing agency objectives. Some agency officials also believed that the performance
information needed for ZBB analysis was lacking. [13]
According to the National Conference of State Legislatures:[14]
In its original sense, ZBB meant that no past decisions are taken for granted. Every previous budget
decision is up for review. Existing and proposed programs are on an equal footing, and the traditional
state practice of altering almost all existing budget lines by small amounts every year or two would
be swept away. No state government has ever found this feasible. Even Georgia, where Governor
Jimmy Carter introduced ZBB to state budgeting in 1971, employed a much modified form.
State programs are not, in practice, amenable to such a radical annual re-examination. Statutes,
obligations to local governments, requirements of the federal government, and other past decisions
have many times created state funding commitments that are almost impossible to change very much
in the short run. Education funding levels are determined in many states partly by state and federal
judicial decisions and state constitutional provisions, as well as by statutes. Federal mandates require
that state Medicaid funding meet a specific minimum level if Medicaid is to exist at all in a state.
Federal law affects environmental program spending, and both state and federal courts help determine
state spending on prisons. Much state spending, therefore, cannot usefully be subjected to the kind of
fundamental re-examination that ZBB in its original form envisions.
To the extent that ZBB has encouraged governors and legislators to take a hard look at the impact of
incremental changes in state spending, it produced a significant improvement in state budgeting. But
in its classic form--begin all budget evaluations from zero--ZBB is as unworkable as it ever was

TOPIC 5

COMMITMENT ACCOUNTING
Commitment s are an intrinsic part of the expenditure planning and the budgetary control
processes. Commitment accounting involves the recording of obligations to make some future
payments at the time they are foreseen, not at the time services are rendered and billings are
received. Such obligations may represent contractual liabilities of a department, as is the case when
purchase orders or contracts for goods or services are issued. Alternatively, they may represent
conditional liabilities, as is the case when an arrangement is made that may require the spending of
funds if conditions specified in the arrangement are met.
.
Definitions
an obligation arising from an existing contract, agreement or legislative enactment
Commitment

or regulation that will become an actual liability upon the fulfillment of specified
conditions. 1 A purchase order typically initiates a Commitment .

Continuing
Commitments

are those that will require a series of payments or settlement actions over an
indeterminate period. An example is the obligation to make monthly payments
for telephone service.2

Pre-

to separate funds from the free balance of a budget in order to reserve the funds

encumbrance

for the current fiscal year for a particular purpose. Typically, a Preencumbrance is
initiated by a written requisition

The budget represents the legal embodiment of government policy. Commitment Accounting
precedes the traditional accounting cycle and typically contains the following elements:

Draft budget plan consists of budget estimates that have yet to be approved.

Budget consists of budget at the line item level.

Appropriations, allotments or warrants consist of budgetary information that authorizes

spending. These can be combinations of short and long term allotments.

Commitments represent the start of a spending process through the generation of a Purchase
Requisition. A commitment sets aside an estimate amount from the budget. This prevents
other commitments that could exceed the budget.

Obligations represents a legal obligation with a supplier through the generation of a

Purchase Order. The obligation can be at a different amount that the estimate. The original
commitment is de-committed. The commitment is replaced by the obligation. (The
government may elect not to enter into a contract. The entire amount is de-committed and
made available in the budget.)

Payments actual payments made. The payment de-obligates and replaces the obligated
amount with the actual amount that could be different.

Budget transfers and virements that change the budget amounts to reflect changes in need or
government financial position. For example, the government may recognize that there will be
revenue

shortfalls

and

adjusts

the

expenditure

budget.

Or

new

priorities

require transferring budget to different programs.

Commitment accounting requires many steps prior to affecting the General Ledger. Government
financial management systems must track the status of all of these steps to ensure that the budget will
not be overspent. The available budget for spending is often referred to as the free balance where:
free balance = budget (commitments + obligations + actuals)
The status of budgets, commitments and obligations provide government decision-makers with trend
information that can predict budget variances.

The purpose of commitment accounting is to allow the accounting department to have a

chance to plan the cash flow and be aware of invoices that are coming in or going out for
products not yet shipped.

Allows for tracking "commitments" on both purchase orders and sales orders.

In a common organization that deals with selling articles they have normally large purchase

orders and many small sales orders, so from a cash flow point of view the purchase orders are
usually the most important ones to monitor.

Commitment posts in the account are of a special type "Commitment". This means that they
will not show with the normal reports with are "Actual" figures.

CommitmentAccounting "Also known as Encumbrance Accounting or Invoice Matching,

Commitment Accounting allows the posting of expenses before the creation or collection of the
underlying documents such as invoices, purchase orders, etc., and before those committed funds
are

paid

out.

This allows the financial records to reflect the allocation of budgetary resources when they are
committed instead of when they are paid out, providing financial information earlier than budget
to

actual

reports

and

preventing

budget

overruns.

Typical continuing commitments would include wages and salaries for employees and monthly
utility payments, and typical specific commitments might include the verbal agreement (and
subsequent

written

agreement)

to

hire

band

for

an

event."

"Commitment accounting identifies and reserves funds for future payment obligations.
Commitment accounting is required to ensure that departments anticipate their expenditures so as
not to exceed appropriation ceilings. Commitment accounting means the accounting entries are
made and the appropriation is charged when a contract is entered into or when an order is placed
for goods or services. The entries record the amount to be reserved out of the unencumbered
balance remaining in an appropriation in order to honour the commitment

MAKE NOTES ON BENEFITS AND LIMITATIONS OF COMMITMENT ACCOUNTING

TOPIC 6

BUDGETING
Budgeting is the process of setting financial goals, forecasting future financial resources and
needs, monitoring and controlling income and expenditures, and evaluating progress toward
achieving the financial goal.

Government budgeting is the critical exercise of allocating revenues and borrowed funds to
attain the economic and socia l goals of the country. It also entails the management of
government expenditures in such a way that will create the most economic impact from the
production and delivery of goods and services while supporting a healthy fiscal position.

In large corporations, budgeting is a collective process in which operating units prepare their plans in
conformity with corporate goals published by top management. Each unit plan is intended to
contribute to the achievement of the corporate goals. Unit managers prepare projections of sales,
operating costs, overhead costs, and capital requirements. They calculate operating profits and returns
on the investment they intend to use. The budget itself is the projection of these values for the next
calendar or fiscal year. As part of this process, each unit presents its plans and budget to a reviewing
upper management panel and may, thereafter, make whatever changes result from instructions from
or negotiations with the higher level. Texts presenting, documenting, and defending the rationales
underlying the numbers are usually part of the planning document. Approved budgets then become
the road-map for operations in the coming year. Ideally monthly or quarterly budget reviews track
performance against the budget. As part of such reviews, changes to the budget may be approved. At
year-end

managers

are

judged

by

their

performance

against

the

budget.

Many small businesses try to operate without a formal budget. Even some businesses that have a
budget seldom consult it, meaning they are not gaining the business advantages that they could be
through budgeting. For startup entrepreneurs, a budget is like a roadmap that can help them set goals
and assess the validity of their business concept. For established small businesses, a budget can be
used to take the pulse of the business, determining how the business is performing through the years,
and helping identify possible future investments. By regularly consulting a budget, business leaders
can compare actual figures and catch potential business shortfalls or other problems early. Budgets

can also be instrumental in winning over investors, convincing banks your business is a good loan
risk,

or

bringing

on

new

partners

or

customers.

While budgets are developed bottom up, managers must strive to meet top-down business goals (e.g.,
"Annual growth in after-tax profits of 39 percent."). Because performance is measured based on
meeting or exceeding positive projections (of sales, returns, and profits) and meeting or coming in
below negative projections (fixed and variable costs and capital expenditures) managers have strong
incentives for projecting the lowest possible "positive" and the highest possible "negative" results.
The more successful they are in understating sales and profits and overestimating costs, the higher the
likelihood of "meeting the budget." Top management's incentives, by contrast, are to do the opposite.
Therefore

the

budgeting

process

is

inherently

marked

by

potential

conflict.

Such difficulties can be, and usually are, mitigated by rational policies, good will on both sides, and
straight forward implementation. Projections should be as realistic and quantifiable as possible. If
projections are out of line with historical patterns, up or down, management must question the
planning. Thus, for instance, a sharply rising projection of costs must have some real-world
justification. Overly ambitious revenue projections must also be questioned. Conversely, managers
must resist pressures sharply to raise revenue targets unless tangible changes in the market or
compensating raises in sales expenditures are present. If the negotiating levels are honest and
realistic, the right projections will result. Ideally, operating units should not be measured on activities
over which they lack full control. An operation which does not operate its own debt collection, for
example, should not be measured on how rapidly invoices are collected. Since budgets are often at
least 50 percent guess-work, formal budgetary review at reasonable intervals and realistic
adjustments based on actual events must be part of a well-functioning process. All too often, the
spring

BENEFITS

budgeting

event

is

AND

rapidly

forgotten.

COSTS

The single-most potential benefit of formal budgeting lies in ensuring that responsible managers take
time each year (and then at fixed intervals throughout the year) in thinking about their operation by
looking at all of its aspects. Budgeting creates a comprehensive picture of the future and makes both
opportunities and barriers conscious. This foreknowledge then helps guide day-to-day activities.

The chief cost of the budget process is time. In some corporations the process takes on a life of its

own and becomes a convoluted exercise of excessive complexity which, moreover, prevents unit
managers from doing any thinking: their time is consumed in efforts to comply with a vast array of
requirements dictated from above. Much of the negative attitude that has developed concerning this
activity has its roots in unnecessary bureaucratic impositions on the one hand and unreliability
because of rapid change a few months out.
TYPES

OF

BUDGETS

The two dominant forms of budgeting are traditional and zero-based. Business planning is usually a
combination of the two. Traditional budgeting is based on a review of historical performance and
then the projection of such findings to the future with modifications. If inflation is high, for instance,
cost trends of the last several years are projected forward but with adjustments both for inflation and
for projected growth or decline in business activity. Historical sales patterns, using established trends
in sales growth, are projected; new sales from planned new product introductions are then added.
Zero-based budgeting is the creation of a completely new budget from the ground upas if no
history existed. When using this method, the operation must justify and document every item of
expenditure and income anew. Brand-new operations will utilize zero-based methods.
In government planning, but only very rarely in business, performance budgeting is used as a third
alternative. Under this method, the budget is fixed at the outset. The planning activity is to determine
exactly what activities will be carried out using the allocated funds. Performance budgeting is
sometimes used in the corporate setting when the advertising budget is arbitrarily set as such-andsuch a percent to projected sales. The advertising function then uses performance budgeting to
allocate

the

budget

to

various

products

and

media.

For the small business, different types of budgets can be drafted to monitor various financial aspects
of

the

business.

Operational budget - An operational budget is the most common type of budget used. It forecasts
and tries to pretty closely predict yearly revenue and expenses for a business. This budget can be
updated with actual figures on a monthly basis and then you can revise your figures for the year, if
needed.
Cash flow budget - A cash flow budget details the amount of cash you collect and pay out. This is

generally tallied on a monthly basis, but some businesses tabulate this weekly. In this budget, you
track your sales and other receivables from income sources and contrast those against how much you
pay to suppliers and in expenses. A positive cash flow is essential to grow your business.
Capital budget - The capital budget helps you figure out how much money you need to put in place
new equipment or procedures to launch new products or increase production or services. This budget
estimates the value of capital purchases you need for your business to grow and increase revenues

OBJECTIVES OF A BUDGET

Provide structure. A budget is especially useful for giving a company guidance regarding the
direction in which it is supposed to be going. Thus, it forms the basis for planning what to do
next. A CEO would be well advised to impose a budget on a company that does not have a
good sense of direction. Of course, a budget will not provide much structure if the CEO
promptly files away the budget and does not review it again until the next year. A budget
only provides a significant amount of structure when management refers to it constantly, and
judges employee performance based on the expectations outlined within it.

Predict cash flows. A budget is extremely useful in companies that are growing rapidly, that
have seasonal sales, or which have irregular sales patterns. These companies have a difficult
time estimating how much cash they are likely to have in the near term, which results in
periodic cash-related crises. A budget is useful for predicting cash flows, but yields
increasingly unreliable results further into the future. Thus, providing a view of cash flows is
only a reasonable budgeting objective if it covers the next few months of the budget.

Allocate resources. Some companies use the budgeting process as a tool for deciding where
to allocate funds to various activities, such as fixed asset purchases. Though a valid objective,
it should be combined with capacity constraint analysis (which is more of an industrial
engineering function than a financial function) to determine where resources should really be
allocated.

Model scenarios. If a company is faced with a number of possible paths down which it
budgets, each based on different scenarios, to estimate the financial results of each strategic
direction. Though useful, this objective can result in highly unlikely results if management
lets itself become overly optimistic in inputting assumptions into the budget model.

Measure performance. A common objective in creating a budget is to use it as the basis for

judging employee performance, through the use of variances from the budget. This is a
treacherous objective, since employees attempt to modify the budget to make their personal
objectives easier to achieve (known as budgetary slack).
Conversely, budgeting may not be of much use for a well-established business that has a consistent
track record of performance. In this case, a better approach may be to manage the organization from a
rolling forecast that is updated on a regular basis. Doing so reduces the work associated with financial
predictions, and also allows the business to shift its operational focus on short notice.

BUDGET PREPERATION PROCESS

A. ESTABLISH THE OBJECTIVES OF BUDGET PREPERATION
During budget preparation, trade-offs and prioritization among programs must be
made to ensure that the budget fits government policies and priorities. Next, the most costeffective variants must be selected. Finally, means of increasing operational efficiency in
government must be sought. None of these can be accomplished unless financial
constraints are built into the process from the very start. Accordingly, the budget formulation
process has four major dimensions:

Setting up the fiscal targets and the level of expenditures compatible with
these targets. This is the objective of preparing the macro-economic
framework.

Formulating expenditure policies.

Allocating resources in conformity with both policies and fiscal targets. This

is the main objective of the core processes of budget preparation.

Addressing operational efficiency and performance issues

can travel, you can create a set of

B. DEVELOPMENT OF MEDIUM-TERM PERSPECTIVE FOR BUDGETING

The need to address all three objectives of public expenditure managementfiscal

discipline, strategic resource allocation, and operational efficiency. This calls for a link
between policy and budgeting and for a perspective
beyond the immediate future.Of course, the future is inherently uncertain, and the more so
the longer the period considered. The general trade-off is between policy relevance and
certainty. At one extreme, government budgeting for just the following week would suffer
the least uncertainty but also be almost irrelevant as an instrument of policy. At the other
extreme, budgeting for a period of too many years would provide a broad context butcarry
much greater uncertainty as well.
In practice, multiyear means medium-term,i.e., a perspective covering three to five years
including the budget year. Clearly, the feasibility in practice of a multiyear perspective is
greater when revenues are predictable and the mechanisms for controlling expenditure welldeveloped. (The U.K., for example, has recently moved beyond a multiyear perspective to
an outright three-year budget for most budgetary accounts.) These conditions do not exist in
many developing countries.
3
, The dilemma is that a multiyear perspective is especially important in those countries
where a clear sense of policy direction is a must for sustainable development, and public
managers are often in sore need of some predictability and flexibility.
4
The dilemma that a multiyear perspective is especially needed where it is least
feasible cannot be resolved easily, but must not be ignored. On the one hand, to try and
extend the time horizon of the budget process under conditions of severe
revenue uncertainty and weak expenditure control would merely lead to frequent
changes in ceilings and appropriations, quickly degenerate into a formalistic exercise, and
discredit the approach itself, thus compromising later attempts at improvement.
On the other hand, to remain wedded to narrow short-term management of public
expenditure would preclude a move to improved linkage between policies and expenditures.
In practice, therefore, efforts should constantly be exerted to improve revenue forecasting
(through such means as relieving administrative or political pressures for overoptimistic
forecasts), and strengthen the linkages between policy formulation and expenditure, as well
as the expenditure control mechanisms themselves. As and when these efforts yield
progress, the time horizon for budget preparation can and should be lengthened. Because
revenue-forecasting improvements and the strengthening of policy-expenditure links and
expenditure control mechanisms are important in any event, efforts to achieve these can

yield the double benefit of improving the short-term budget process at the same time as they
permit expanding the budget time horizon to take account of developmental priorities.
Therefore, although in almost all countries government budgets are prepared on an annual
cycle, to be formulated well they must take into account events outside the annual cycle, in
particular the macroeconomic realities, the expected revenues, the longer-term costs of
programs, and government policies. Wildavsky (1986) sums up the arguments against
isolated annual budgeting as follows:
short-sightedness, because only the next years expenditures are reviewed;
overspending, because huge disbursements in future years are hidden;
conservatism, because incremental changes do not open up large future vistas;
and parochialism, because programs tend to be viewed in isolation rather than
in comparison to their future costs in relation to expected revenue.
Specifically, the annual budget must reflect three paramount multiannual
considerations:
The future recurrent costs of capital expenditures;
The funding needs of entitlement programs (for example debt service and
transfer payments) where expenditure levels may change, even though
basic policy remains the same;
Contingencies that may result in future spending requirements (for
example government loan guarantees (see chapter 2).

A medium-term outlook is necessary because the time span of an annual budget is too short
for the purpose of adjusting expenditure priorities and uncertainties become too great over
the longer term. At the time the budget is formulated, most of the expenditures of the budget
year have already been committed.

The expenditure implications of such a policy change stretch over several years, and the
policy therefore can hardly be implemented through a blinkered focus on the annual budget.
Medium-term spending projections are also necessary to demonstrate to the administration
and the public the desired direction of change. In the absence of a medium-term program,
rapid spending adjustments to reflect changing circumstances will tend to be across-theboard and ad hoc, focused on inputs and activities that can be cut in the short term. (Often,
these are important public investment expenditures, and one of the typical outcomes of

annual budgeting under constrained circumstances is to define public investment in effect

as a mere residual.) If the expenditure adjustments are not policy-based, they will not be
sustained. By illuminating the expenditure implications of current policy decisions on future
years budgets, medium-term spending projections enable governments to evaluate costeffectiveness and to determine whether they are attempting more than they can afford.

Finally, in purely annual budgeting, the link between sectoral policies and budget
allocations is often weak. Sector politicians announce policies, but the budget often fails to
provide the necessary resources.
However, two pitfalls should be avoided. First, a multiyear expenditure approach can itself
be an occasion to develop an evasion strategy, by pushing expenditure off to the out-years.
Second, it could lead to claims for increased expenditures from line ministries, since new
programs are easily transformed into entitlements as soon as they are included in the
projections. To avoid these two pitfalls, many developed
countries have limited the scope of their multiyear expenditures estimates to the cost of
existing programs, without making room for new programs.
6

Three variants of medium-term year expenditure programming can be considered:

A mere technical projection of the forward costs of ongoing programs
(including, of course, the recurrent costs of investments).
A stringent planning approach, consisting of: (i) programming savings in
nonpriority sectors over the planned period, to leave room for higherpriority programs; but (ii) including in the multiyear program ongoing
programs and only those new programs that are included in the annual
budget currently under preparation or for which financing is certain

The feasibility of implementing these different approaches and their linkages with the annual
budget depends on the capacity and institutional context of the specific country. However,
the annual budget should always be placed into some kind of multiyear perspective, even
where formal multiyear expenditure programming is not feasible. For this purpose two
activities are a must: (i) systematic estimates of the forward costs of ongoing programs,
when reviewing the annual budget requests from
line ministries; (ii) aggregate expenditure estimates consistent with the medium-term

macroeconomic framework (see section C). It is often objected that estimating forward costs
is difficult, especially for recurrent costs of new public investment projects. This is true, but
irrelevant, for without such estimates budgeting is reduced to a shortsighted and parochial
exercise.

C. DEVELOPMENT OF THE MACROECONOMIC AND POLICY CONTEXT

This includes;
1. Macroeconomic framework and fiscal targets

Importance of a macroeconomic framework.

The starting points for expenditure programming are: (i) a realistic assessment of
resources likely to be available to the government; and (ii) the establishment of fiscal
objectives. (There follows, of course, significant iteration between the two, until the desired
relationship between resources and objectives is reached.)

As noted earlier, the capacity to translate policy priorities into the budget, and then to ensure
conformity of actual expenditures with the budget, depends in large part onthe soundness of
macroeconomic projections and revenue forecasts. Overestimating revenues leads to poor
budget formulation and therefore poor budget execution. (As mentioned earlier, this may
sometimes be a deliberate ploy to evade the responsibility for weak budget management
and discipline.)
The preparation of a macroeconomic framework is therefore an essential element in the
budget preparation process. Macroeconomic
Projections are not simple forecasts of trends of macroeconomic variables. Projections are
based on a definition of targets and instruments, in areas such as monetary policy, fiscal
policy, exchange rate and trade policy, external debt policy, regulation and promotion of
private-sector activities, and reform of public enterprises. For example, the policy objective
of reducing inflation normally corresponds to targets such as the level of the deficit, and the
specific instruments can include tax measures and credit policy measures, among
others.

2.Fiscal targets and indicators

The establishment of explicit fiscal targets gives a framework for budget formulation,allows
the government to state clearly its fiscal policy and the legislative and the public to monitor
the implementation of government policy, and, ultimately, makes government politically as
well as financially accountable. Fiscal targets and indicators should cover three areas:
current fiscal position (e.g., fiscal deficit), fiscal sustainability (e.g., debt-, tax-, or
expenditure-to-GDP ratios), and vulnerability (e.g., analysis of the composition of the foreign
debt).

The summary indicator of fiscal position used most commonly is the overall
Budget deficit on a cash basis,defined as the difference between actual expenditure
payments and collected revenues (on a cash basis) plus grants (cash or in kind).
The cash deficit is by definition equal to the government borrowing requirements (from
domestic or foreign sources) and is thus integrally linked to the money supply and inflation
targets and prospects. The deficit is therefore a major policy target to ensure that the budget
will be financed in a noninflationary way and without crowding out private investment, while
keeping the growth of public debt under control. The cash deficit must always be included in
the set of fiscal targets. The cash deficit does not take into account payment arrears and
floating debt. In countries that face arrears problems the deficit on a cash basis plus net
increase of arrears is also an important indicator, and is very similar (but not necessarily
identical) to the deficit on a commitment basis,
i.e., the difference between annual expenditure commitments and cash revenues and
grants.
16
Therefore, when using the deficit on a commitment basis as fiscal
indicator, it is necessary to specify what transactions are included in the expenditures
on a commitment basis. This indicator would be meaningless if it includes multiyear
commitments and commitments that are merely reservations of appropriations. Moreover, to
estimate arrears more accurately, orders not yet delivered should be separated from actual
expenditures (accrued expenditures, or expenditures at the
verification stage).

An assessment of fiscal vulnerability is also needed, especially in countries that

benefit from short-term capital inflows. Especially relevant to Asian countries affected by the
financial crisis that began in 1997; such an assessment could be based on the analysis of

the maturity of government debt, the volume of usable foreign exchange reserves, etc.
There is no question that the standard deficit measures may indicate a healthy fiscal
situation which is in reality fragile.
3.Preparation of a macroeconomic framework
A macroeconomic framework typically includes projections of the balance of
payments, the real sector (i.e., production), the fiscal accounts, and the monetary
sector. It is a tool for checking the consistency of assumptions or projections
concerning economic growth, the fiscal deficit, the balance of payments, the
exchange rate, inflation, credit growth and the share of the private and public sectorson
external borrowing policies, etc.
Preparing a macroeconomic framework is always an iterative exercise. A set of initial
objectives must be defined to establish a preliminary baseline scenario, but the final
framework requires a progressive reconciliation and convergence of all objectives and
targets. Considering only one target (e.g., the fiscal deficit) in this iterative exercise risks
defining other important targets as de facto residuals.
General government should be considered when preparing the fiscal
projections and defining the fiscal targets, but the fiscal targets should also be broken down
between central and local government. In some decentralized systems, by law a fiscal target
cannot be directly imposed on subnational and local government. In those cases, it is
necessary to assess the feasibility of achieving it by means of the different instruments
under the control of the central government (such as grants, control of borrowing). However,
the constraints on running fiscal deficits are typically much tighter on subnational entities
than they are on central government. The main reason is the central governments capacity
to regulate money supply.
The following are considered;

a)Fiscal projections- should cover the consolidated account of the general government and
quasi-fiscal operations by the banking system. Future expenditures related to contingent
liabilities as a result of government guarantees should be assessed.
In any case, forecasting revenues should be based on detailed analyses and
forecasts by individual tax rather than on the aggregate outputs of a macroeconomic model.
The problems revealed by the projections (e.g., lack of consistency between

economic growth targets and monetary policy) must be discussed among the
agencies involved in macroeconomic management. The preliminary baseline scenario gives
the macroeconomic information needed for preparing sectoral and detailed projections, but
these projections usually lead in turn to revising the baseline scenario.
Such iterations should continue until overall consistency is achieved for the
macroeconomic framework as a whole. The iteration process is not only necessary for
sound macroeconomic and expenditure programming, but is also an invaluable capacitybuilding tool, to improve the awareness and understanding of involved agenciesand
therefore their cooperation in formulating a realistic budget and implementing it correctly.
The preparation of a macroeconomic framework should be a permanent activity. The
framework needs to be prepared at the start of each budget cycle to give adequate
guidelines to the line ministries. As noted, it must then be updated throughout the further
stages of budget preparation, also to take into account intervening changes in the economic
environment. During budget execution, too, macroeconomic projections require frequent
updating to assess the impact of exogenous changes or of possible slippage in budget
execution.

The importance of good data cannot be underestimated. Without reliable information, the
macroeconomic framework is literally not worth the paper it is written on. This includes the
collection of economic data and the monitoring of developments in economic conditions
(both of which are generally undertaken by statistics bureaus) as well as the monitoring and
consideration of changes in laws and regulations that affect revenue, expenditure, financing
and other financial operations of the government.

b) Aggregate expenditure estimates

Typically, a macroeconomic framework is at a very aggregate level on the
expenditure side, and shows total government wages, other goods and services,
interest, total transfers, and capital expenditures (by source of financing).
Assumptions and underlying policy objectives therefore concern the broad economic
categories of expenditures, rather than the allocation of resources among sectors.
Moreover, transfers or entitlements are not reviewed in sufficient detail and
assumptions on future developments are not compared with continuing commitments. Thus,
when elaborating a fiscal framework on the basis of the overall macroeconomic framework,
estimates of the impact of the assumptions and the aggregate fiscal targets on the

composition of expenditure, by sector or economic category, are required to assess whether

the fiscal targets are realistic and sustainable, and to determine the conditions to meeting
these targets.
Therefore, the preparation of aggregate expenditure estimates could help in
assessing the sustainability of expenditure policy, and thus improve the budget
preparation process (notably when defining expenditure ceilings for the various
sectors). These estimates could cover: (i) the forward costs of large investment
projects; (ii) projections for the more important entitlements; and (iii) aggregate
projections of other expenditures, by function and broad economic category.

c).Consolidating the fiscal commitments

i)Making the macroeconomic projections public.
While the iterative process leading to a realistic and consistent macroeconomic
framework must remain confidential in many of its key aspects, when the framework is
completed it must be made public. The legislature and the population at large have a right to
know clearly the government policy objective and targets, not only to increase transparency
and accountability, but also to reach a consensus within civil society.
While such a consensus may take additional time, and require difficult debates, it will also
be an invaluable foundation for the robust and effective implementation of the policy and
financial program. A good example is provided by the government of Hong Kong, China,
which annexes its medium-term forecast to the annual budget speech

The Medium Range Forecast (MRF) is a projection of expenditure and revenue for the
forecast period based on forecasting assumptions and budgetary criteria. To derive the
MRF, a number of computer-based models that reflect a wide range of assumptions about
the factors determining each of the components of governments revenue and expenditure
were used. As summary is shown here, a fuller description is in Annex VII.
Assumptions relating to developing expenditure and revenue forecast over the mediumterm period are the following:
estimated cash flow of capital projects
forecast completion dates of capital projects and their related recurrent consequences in
terms of staffing and running costs
estimated cash flow arising from new commitments resulting from policy initiatives

 the expected pattern of demand for individual services

the trend in yield from individual revenue sources

In addition to these assumptions, there are a number of criteria against which the results of
forecasts are tested for overall acceptability in terms of budgetary policy:
Maintain adequate reserves in the long-term
Expenditure growth should not exceed the assumed trend growth in GDP
Contain capital expenditure growth within overall expenditure guidelines
Revenue projections reflect new measures introduced in this years budget

ii) Develop Binding fiscal targets

Several countries have laws and rules that restrict the fiscal policy of government
(fiscal rules).

For example, an earlier golden rule stipulated that public borrowing must not exceed
investment (thus mandating a current budget balance or surplus). In some cases, the overall
budget must be balanced by law (as in subnational government in federal countries). In the
European Union, the Maastricht Treaty stipulates specific fiscal convergence criteria,
concerning both the ratio of the fiscal deficit to GDP and the debt/GDP ratio. (The former
has been by far the more important criterion.) One frequent criticism of such rules is that
they favor creative accounting and encourage nontransparent fiscal practices. When they
are effectively enforced, nondiscretionary rules can also prevent governments from
adjusting their budgets to the economic cycle.

More important than specifying ex-ante targets and general criteria is to ensure that
institutional arrangements and processes favor coherence among resource
constraints, fiscal objectives, and expenditure programs. This broader issue involves the
mechanisms for policy formulation, the budget preparation process, the role of the Ministry
of Finance in budgeting, and the development of appropriate instruments for reviewing
expenditures within a longer period than the annual budget.

D.POLICY FORMULATION

a.Importance of policy formulation

The budget preparation process is a powerful tool for coherence. The budget is both an
instrument of economic and financial management and an implicit policy
statement, as it sets relative levels of spending for different programs and activities.
However, policy decision making is complex and involves different actors in and outside the
government. It is a technocratic illusion to embed all policy formulation within the budget
process (as to some extent was the ambition of the PPBS;
However, a coherent articulation should be sought between the policy
agenda (which should take into account economic and fiscal realities) and the budget(which
should accurately reflect the government's policy priorities).
The budget process should both take into account policies already formulated and be the
main instrument for making these policies explicit and operational. However,policies must
be defined outside the pressure of the budget process. Making policy through the budget
would lead to a focus only on short-term issues and thus to bad policy, since the policy
debate would be invariably dominated by immediate financial considerations. (This is
frequently the unfortunate outcome in developing countries with weak capacity faced with
financial difficulties.) In earlier times, medium-term development plans were intended as the
instrument for setting up government strategy. However, these plans were rigid, invariant,
and usually out of sync with financial realities. Paradoxically, therefore, they indirectly led in
practice to the same dominance of short-term financial considerations.

b.The policy-budget link

A bridge between the policy making process and the budget process is essential to make
policy a breathing reality rather than a statement of wishes. For this purpose at least two
clear rules must be established.
The resource implications of a policy change should be identified, even if very
roughly, before a policy decision is taken. Any entity proposing new policies must
quantify their effects on public expenditure, including the impact both on its own
spending and on the spending of other government departments.
The Ministry of Finance should be consulted in good time about all proposals involving
expenditure before they go into ministerial committee or to the center of the government and
certainly before any public announcements are made.
Within the budget formulation process, close cooperation between the Ministry of
Finance and the center of government is required, at both the political and the

technical level. The role of the center is to ensure that the budget is prepared along the lines
defined; to arbitrate or smooth over conflicts between the Ministry of Finance and line
ministries; and to assure that the relevant stakeholders are appropriately involved in the
budget process. (This is a major challenge, which can only be mentioned here but requires
care and commitment on a sustained basis.) An interministerial committee is needed to
tackle crosscutting issues and review especially sensitive issues. And, most importantly,
each entity involved in the budget process must perform its own role in a responsible
fashion, and be given the means and capacity to do so.

c.Reaching out: The importance of listening

Consultations can strengthen legislative scrutiny of government strategy and the
budget. Legislative hearings through committees and subcommittees, particularly
outside the pressure environment of the annual budget, can provide an effective
mechanism for consulting widely on the appropriateness of policies (issues related to the
role of the legislature are discussed in chapter 5) .
The government should try to get feedback on its policies and budget execution from the
civil society. Consultative boards, grouping representatives from various sectors in society,
could discuss government expenditure policy. On crucial policy issues government can set
up ad hoc groups. Preparing evaluation studies and disseminating them, conducting
surveys, etc. provides information tostakeholders and the civil society and helps the
government receive reliable feedback. User surveys and/or meetings with stakeholders and
customers when preparing agencies strategic plans or preparing programs can enhance
their effectiveness. Finally, and most concretely, in countries with weak budget execution
and monitoring mechanisms, only mechanisms for eliciting feedback from far-flung citizens
can be effective in revealing such malpractices as ghost schools, shoddy infrastructure,
incomplete projects, thefts, and waste. Such mechanisms are often resented by the
executive branch, but should be seen by governments (and external donors) as remarkably
cost-effective monitoring devices, and encouraged and supported as such.
However, although these consultations must have an influence on budget decisions, a direct
and mechanical linkage to the budget should be avoided. As noted, the budget preparation
process needs to be organized along strict rules so that the budget can be prepared in a
timely manner while avoiding excessive pressure from particular interests and lobbies.
Participation, like accountability, is a relative, not absolute, concept.

E.RESOURCE ALLOCATION AND OPERATIONAL EFFICIENCY

As stressed earlier, budget preparation is an iterative process between the Ministry of
Finance and spending ministries. Therefore, it is a combination of a top-down approach,
with the Ministry of Finance giving guidelines or communicating instructions to spending
ministries, and a bottom-up approach, with spending ministries presenting requests for
budget allocation to the Ministry of Finance. Either approach followed in isolation would
have adverse effects:[A budget created from the bottom-up may lead to excessive
spending and instability, if not carefully organized and subject to pre- established limits. By
contrast, a highly centralized exercise introduces rigidities and loses the vision of those who
are close to the service recipients (Petrei, 1998, p. 399).
The articulation of the top-down and bottom-up approach is crucial since it determines how
priorities and fiscal targets will be taken into account over the budget preparation process.
This includes;

a)Top-down approach
As previewed earlier, the starting points for budget preparation are a clear definition of fiscal
targets and a strategic framework consisting of a comprehensive set of objectives and
priorities. Thereafter, strong coordination of the budget preparation is required to achieve
the necessary iteration and to avoid major departures from the initial framework.
Giving a hard constraint to line ministries from the start of budget preparation favors a shift
from a needs mentality to an "availability" mentality. Moreover, to translate strategic
choices and policies into programs, line ministries require clear indications on available
resources. Finally, a hard constraint increases the de facto authority and autonomy of the
line ministries, weakening the claim of the Ministry of Finance to a role in determining the
internal composition of the line ministries budget. (The same is true of each line ministry
vis--vis its subordinate agencies.)
This calls for notifying spending agencies of the initial budget ceilings and preferably in
absolute terms, or at least through the provision of accurate and complete parameters.
These ceilings may be defined either at the very beginning of the dialogue between the
Ministry of Finance and the line ministries, or after a first iteration when line ministries
communicate their preliminary requests. In practice, two variants are found in countries that
have good financial discipline. In some, line ministries are notified of the sectoral ceilings at
the very start of the budget preparation process.

The institution responsible for overall financial management should coordinate the setting of
the sectoral ceilings to ensure that they fit the aggregate expenditure consistent with the
macroeconomic framework.

2.Bottom-up approach
Line ministries are responsible for preparing their requests within the spending limits
provided. Depending on the severity of the fiscal constraint and the organization of the
budget preparation process, additional requests from line ministries could be allowed for
new programs. However, the principal request should be consistent with the notified ceilings
or guidelines, and costs of programs included in the additional requests should be clear and
fully adequate for proper implementation, without any underestimation. Naturally, no request
for new programs should be entertained without a clear demonstration of its purpose and,
where appropriate an estimate of the demand for the services to be provided.
Line ministries budget requests should clearly distinguish: (i) the amount necessary to
continue current activities and programs; and (ii) proposals and costing for new programs.
Before deciding to launch any new expenditure program it is necessary to assess its forward
budget impact. This is particularly important for development projects and entitlement
programs, which may generate recurrent costs or increased expenditures in the future. This
assessment is required whether or not a formal exercise of multiyear expenditure
programming is carried out. For this purpose, requests must show systematically the
forward annual costs of multiyear or entitlement programs, and the Ministry of Finance
should take into account the forward fiscal impact of these programs when scrutinizing the
budgetary requests from line ministries.
Estimates of future costs related to multiyear commitments could be annexed to the overall
budget document. These estimates would facilitate the preparation of the initial ceilings for
the next budget. In addition to their budget requests, the submission from the line ministries
should include: (i) a brief policy statement spelling out the sector policies and expected
outcomes; (ii) where applicable, realistic and relevant performance indicators, including
results from the previous period and expected performance for the future; (iii) a statement of
how the objectives will be achieved; (iv) proposals for achieving savings and boosting
efficiency; and (v) clear measures for implementing the proposals effectively.
Line ministries must coordinate the preparation of the budget of their subordinate
agencies and give them appropriate directives.

3.Negotiation
Once it receives the requests of line ministries, the Ministry of Finance reviews their
conformity with overall government policy, and compliance with the spending limits; reviews
performance issues; and takes into account changes in the macroeconomic environment
since the start of budget preparation. Almost always, these reviews lead the Ministry of
Finance to suggest modifications in the line ministries budget requests.
Negotiation follows.Formal negotiation between the Ministry of Finance and line ministries
can take the form of a budgetary conference. Professional staff from the Ministry of Finance
and line ministries should also hold informal meetings to avoid misunderstandings and
minimize conflicts. Major differences of opinion will normally be referred to the center of
government, depending largely on the relative balance of administrative and political power
between the Ministry of Finance and the specific line ministry concerned.

4.Preparing expenditure ceilings

In preparing the sectoral expenditure ceilings, the following elements must be taken into
account:
Macroeconomic objectives and fiscal targets;
The results of the review of ongoing programs for the sector; The impact of ongoing
expenditure programs on the next budget, and their degree of rigidity (notably expenditures
related to continuing commitments, such as entitlements);
The strategy of the government concerning possible shifts in the intersectoral
distribution of expenditure, and the amount of resources that could be allocated to new
policies as well as service demand projections where appropriate.
Preparing these initial ceilings is largely an incremental/decremental exercise.
Budgets are never prepared from scratch. Debt servicing, multiyear commitments for
investment; pensions and other entitlements; rigidities in civil service regulations; and the
simple reality that government cannot stop at once all funding for its schools, health centers
or the army, etc, limit possible annual shifts to perhaps 5-10 percent of total expenditures. In
theory, this percentage could be higher in developing countries than in developed countries
(where the share of entitlements is higher). But in practice, because of earlier
overcommitments the room to maneuver is often even lower in developing countries. If one
excludes emergency or crisis situations, when preparing the budget the government should
focus on new policies, savings on questionable programs, and means of increasing the
efficiency of other ongoing programs. It is clear, once again, that any significant policy shift

requires a perspective longer than one year and some advance programming, in whatever
form that is appropriate and feasible in the specific country. It includes;

a. A subceiling for capital expenditure

As discussed earlier, a separate budget preparation process for capital and current
expenditure (dual budgeting) presents problems, but a separate
presentation is desirable. Aside from that question, however, should separate ceilings for
capital and current expenditures be set at the start of the budget preparation process. The
answer depends on the sector concerned.
Obviously, if only a global ceiling is set, line ministries would be able to make trade- offs
between their current spending and their capital spending, and if separate ceilings are set,
the distribution between current and capital spending is fixed for each sector. In certain
sectors, such as primary education, it is generally preferable to leave the choice between
current and capital spending partly to line ministries, since both current and capital
expenditures are developmental, and line ministries presumably know better than the
Ministry of Finance what would be the most efficient allocation of resources within their
sector. However, in some cases, the sector budget depends largely on the decision of
whether or not to launch a large investment project. For example, the budget of a Ministry of
Higher Education would largely depend on the decision whether to construct a new
university. Because such large investment projects are a government policy issue, not only
a sectoral policy issue, separate ceilings would be appropriate in these cases. Depending
on circumstances and fiscal policy issues, separate subceilings may also be needed for
other expenditure items, such as personnel expenditures and subsidies.
b.Efficiency dividends
In recent years, Australia demanded from each spending unit, efficiency dividends,i.e.,
required savings in their ongoing activities (around 1.5 percent annually). On the surface,
this practice may look like the typical (and undesirable) across-the-board cuts made by the
Ministry of Finance when finalizing the budget. However, there are two major differences: (i)
efficiency dividends are notified early in the process and within a coherent multiyear
expenditure framework; and (ii) the allocation of savings among activities and expenditure
items is entirely the responsibility of the spending agencies, which alleviates the arbitrary
nature of the approach. Savings measures are much more likely to be implemented within
the ministry when the line ministry itself is arguing for them rather than when they are set by

the central agencies, with the knowledge and skills of the program agency being devoted to
criticism and obfuscation.

And, where evaluation capacity is weak, the risk that the efficiency dividends are achieved
by diminishing service or program quality are very real. However, this practice may be an
invaluable aid to introducing greater performance orientation in a complacent administrative
system, and triggering more structural improvements.

5. multiyear estimates in budget preparation

A possible interrelation between the preparation of multiyear estimates and the
preparation of the annual budget is presented in figure 6. When launching budget
preparation, the multiyear estimates prepared the previous year are used to assess
constraints related to existing policy commitments. This assessment and estimate of the
financial constraints give the basis for estimating initial expenditure ceilings that frame the
preparation of sector requests. Then, the multiyear expenditure program is updated and
rolled over when preparing the budget. This process ensures both that the initial ceilings are
prepared appropriately and that forward costs of programs are taken into account when
preparing the budget.

F. MONITORING AND EVALUATION

Line ministries should take ownership of the implementation process. They should be accountable
on how expenditure is dispensed. There should be an oversight body to review the spending
behavior of ministries for effective performance.

CAPITAL BUGETS AND PROGAMS IN PUBLIC FINANCE

BOROWING AND DEBT MANAGEMENT

Basic Principles of Local Government Borrowing
1.3. Debt Management

Before long term borrowing is undertaken, it is recommended that each local government has in place
a

debt

management

strategy

and

written

debt

policy.

Any decision to fund local government investment needs through borrowing has to be accompanied
by debt management capability and capacity at the local level. In the immediate future, it is
imperative that debt management capacity and capability should be enhanced as local borrowing also
bears substantial financial risks for local governments (e.g. when debt repayment exceeds the
financial

capacities

of

local

budgets).

Debt management may be defined as the process of providing for the payment of interest and
principal payments on existing debt, and the planning for incurrence of new debt at a level which will
optimize borrowing costs and not weaken the financial position of the local government. Estimating
the impact of the current and future debt burden on the local budget in future years is also part of the
debt

management

process.

The financial position of a debtor determines its maximum borrowing capacity as well as the cost of
borrowing. Thus, the maximum indebtedness capacity of a local government varies in time,
depending on economic and market conditions.

What to consider in the national legislation?

The financial framework of local governments plays a key role in the sustainable
development of local credit markets. The design of intergovernmental fiscal structure together
with the accounting system and reporting procedures are important factors that are taken into
consideration by financial institutions when assessing the opportunity to finance local

governments. By establishing the general structure of local revenues and expenditures, the
intergovernmental fiscal framework determines in broad terms the borrowing capacity of local
governments from within a country. Financial institutions need readable, credible, transparent
and comparable financial documents and reports as an input in the credit risk analysis of local
governments. This can only be achieved if local governments adhere to national accounting
standards, which accurately reflect the true financial position of local governments.
Authorisation process of local borrowing should ensure that (i) all legal aspects related to local
indebtedness are met, (ii) there is a real necessity to pursue external financing which benefits
the local economy, (iii) the financial stability of the local government is not threatened by the
future debt repayment. The central government's involvement in the authorisation process
should be limited to the control of the legal aspects related to local borrowing. Limits to local
indebtedness should be clearly stiplulated in legislation on local public debt and should include
at least the purpose of borrowing and maximum debt thresholds. Short term borrowing should
be pursued only to cover temporary liquidity shortages while long-term borrowing is
warranted to finance capital expenditures.

Which debt instrument is suitable?

There are two major types of debt instruments available to finance municipal capital
expenditures: (i) loans and (ii) bonds. Loans are granted by a financial institution (e.g.
commercial bank) directly to the local government. Applying for a loan is less complex than the
procedures required for bond issuance. From this point of view, loans are more advantageous
to small and medium size municipalities seeking external financing. Many international
financial institutions have dedicated programs aimed at supporting and financing local
governments' infrastructure projects, especially in the emerging markets. The financing occurs
either directly or indirectly, via intermediated loans to local banks in target countries. The
terms and conditions of such loans are more favorable to the local governments than in case of
typical commercial banking loans. Bonds are the preferred form of financing for large capital
investment projects which require long term financing. Bonds are issued by local governments
either directly or via financial intermediaries (e.g. funds, banks) to institutional or individual
investors. The cost of borrowing using bonds is usually lower than in case of a loan. There are
two types of municipal bonds. A. General obligation bonds are secured by the local
governments' revenues stream. Such bonds are used to finance investments in public goods

(public safety, streets and bridges, public parks and open space, public buildings etc.). B.
Revenue bonds are backed by the stream of revenues generated by the project, financed from
the bond sale. Revenue bonds are not backed by the taxing power of the local government.
Typical projects financed by revenue bonds include: municipally-owned airports, water and
sewer systems, electric utilities, athletic and sport facilities and limited access highways

Debt instruments can be broadly classified in two categories: (i) loans and (ii) bonds.

In case of loans, debtors deal directly with lenders (e.g. banks, pension funds or insurance companies)
i.e. borrower negotiates terms of the loan directly with the lender. The due diligence process (risk
assessment

and

monitoring)

of

the

borrower

is

performed

by

the

creditor.

Bonds represent a different kind of financial intermediation. They are sold directly or via financial
intermediaries (e.g. funds, banks) to institutional or individual investors. In 37 case of bonds, due
diligence is the responsibility of credit rating agencies (or financial intermediaries). Based on their
analysis, investors decide under what conditions (i.e. required yield) they are willing to buy the
bonds.

Loans have been more popular as a debt financing instrument of local governments across Western
Europe, where they financed municipal investment throughout the 20th century. Bonds are
characteristic for the U.S. market, laying the foundation of municipal credit market development in
North

America.

In its early stages, local government credit markets may start with either of the two models but
usually end up with both models serving different segments of the market. The same legal framework
should be applied to all types of debt instruments without discrimination. Competition between
banks, a bond market and other available financing instruments can help keep the costs of capital as
low as possible for municipal borrowers and increase the flow of information about credit quality in
between market stakeholders.
Improving Financial Management Performance
Adequate, accurate and timely financial information on local governments' operations benefits
both investors and local governments. A uniform financial reporting format, which suites both local/
central governments' and investors' requirements, should be a top priority for national regulators, as a

precondition for improved financial management performance. Local governments' annual reports
should include at least an administrative report, a balance-sheet and income statement as well as a
cash-flow analysis (if accounting system is accrual based). Public disclosure of financial reports
should be mandatory. Independent audits should be conducted on a regularly basis. Local
governments could also improve their financial management performance by applying for an external
credit rating. By obtaining the credit rating, the local government will better understand what the
main determinants of its creditworthiness are and can decide what changes are needed to improve its
credit risk profile and thereby reduce its borrowing costs.

How to manage the credit?

Local governments can tap external resources using a wide range of borrowing instruments.
However, each instrument is suited to finance only certain types of activities. Short term financing
instruments include: (i) working capital credit line local government draws funds from the credit
line, on which they pay interest, to finance temporary revenue shortages; principal is usually rolled
over, (ii) bridge loans are a special type of short term loan where financing for a capital investment
project is provided for a transitory period until the main (long term) financing is obtained. Medium
and long-term borrowing should be pursued by local governments when financing capital investment
projects. Long-term borrowing to cover current expenditures is usually prohibited by law and must be
avoided

anyway.

Planning the structure of a financing package should be in line with a local governments debt
management and capital investment strategy. When negotiating with the financial institution(s), local
governments have to think at maturity, grace period, interest rates, fees, drawdown (loan
disbursement), refinancing etc. After securing the financing package local governments have to
generate enough revenues to pay for debt service and also allow for additional lending or direct
investment. Unfortunately, when things do not go as planned, local communities must deal with loan
restructuring

and

sometimes

default.

Restructuring of a loan should be contemplated as an option when local governments enter a period
of financial distress. Restructuring should be foreseen, whenever this is possible, from the beginning
when the financing contract is signed with the bank. Restructuring of a bank loan usually involves the
following elements: (i) refinancing, (ii) maturity extension, (iii) reshaping the debt service schedule

to match the clients projected cash-flows, (iv) writing off a portion of the debt (haircut).

Debt Policy

Any local government planning to issue a debt should adopt a written debt policy. A formal debt
policy is essential to effective financial management. Debt policies are written guidelines and
restrictions establishing maximum debt thresholds, the type of debt to be issued and at the same time
documenting the issuance process. Such policy helps establish limits and provide general direction to
local government executive officials in the planning and issuance of debt. A carefully crafted and
consistently applied debt policy signals lenders and rating agencies that the local government is
committed

to

sound

and

sustainable

financial

management.

The policy must be developed within the framework of existing laws and based on projections of the
local government's future condition. It anticipates future financing needs and limitations that the
policy imposes. Specifically, it should address the following questions:
What are acceptable levels of short and long term debt? Debt issuance involves a trade-off. In
exchange for funds for current capital improvements, future spending is limited. The degree to which
a local government is willing to make these trade-offs depend on the urgency of its capital needs, its
expected rate of growth, economic trends, and the stability of its overall finances.
What are acceptable purposes for which debt can be issued? Does the investment have a life-span
which equals at least the duration of the debt-repayment schedule?
To what extent and for what purposes will the local government use general obligation debt vs.
revenue debt3?
What covenants, pledges, or securities is the local government willing to give, in order to make
borrowing possible and/or lower the cost of borrowing (interest rates)?
How will the local government make sure that it is borrowing under competitive conditions (i.e.

obtain the lowest possible cost)?

Furthermore a debt policy: 1) establishes maximum debt thresholds and ensures proper procedures
are in place to keep debt within limits; 2) communicates to citizens the importance placed on
financial management and to investors that the local government is being prudent with its resources;
3) communicates to the financial community that the local government is prudent and has a policy
basis for debt.
How to Finance Capital Items? Current Revenue or Debt Financing?

When considering what resources are available to fund capital investments, it is most important to
consider all possible financial alternatives. A wide range of sources are possible, for example current
revenues, grants from central governments or the EU (or other donors), private sector investments
(PPP).

Long-term

debt

is

only

one

option

out

of

many.

Local governments rarely maintain cash surpluses large enough to pay for the entire cost of big
capital projects. They can either finance a capital project from own resources, by accumulating
savings in their current account budget (pay-as-you-go financing) or by tapping credit markets (payas-you-use

financing1).

Borrowing allows a local entity to carry out more ambitious investments than otherwise would be
possible. In principle, it also promotes intergenerational equity by having the future generations of
citizens

which

will

benefit

from

facility's

services

pay

for

its

construction.

However borrowing is not always an appropriate financing strategy. Borrowing to cover current
expenditures or account deficits has just the opposite effects. It shifts the costs to future generations,
while

today's

taxpayers

enjoy

the

benefits.

Many municipalities practice a combination of Pay-as-you-use and Pay-as-you-go policies.

There are mixed views as to whether long-term debt financing is a superior method of capital
financing than pay-as-you-go. There are advantages and disadvantages to both approaches,
municipalities need to consider the merits of both methods to guide their future financing in

accordance with a long term plan. In doing so, municipalities should establish parameters to guide the
financing of their capital budgets, and develop policies to implement these guidelines.

"Pay-as-you-go" financing is normally useful for low cost repair and maintenance projects or the
purchase of equipment with short useful life. "Pay-as-you-use" is appropriate for capital
improvements

with

high

cost

and

long

useful

life.

Pay-as-you-go financing has important advantages over pay-as-you-go financing schemes:

lets municipalities build more projects sooner;
allows for greater inter-generational equity, and
spreads out capital expenditures over time.

Many capital investments that municipalities can undertake yield benefits in the form of economic
development. Even the so-called social investments such as water and wastewater systems and
education contribute to the local economic development. When projects are built sooner, people
benefit

earlier.

When

projects

are

deferred,

the

benefits

are

postponed

as

well.

When considering debt financing as an alternative to finance an investment project, the risks
associated to borrowing have to be well understood in terms of their potential impact on local budget
in the future. For a borrower, the main risks of a plain vanilla loan are related to the dynamics of
interest rate and exchange rate (if the loan is denominated in foreign currency). If the loan is
originated at variable interest rate, then an increase in reference interest rate would be reflected into a
higher debt service. Volatility of exchange rate has also to be considered when evaluating the
possibility to borrow in hard currency (e.g. euro, U.S. dollar). During the recent financial and
economic crisis, emerging market exchange rates from almost all Territories covered by NALAS
members. have depreciated significantly. This led to an increase in debt burden of unhedged foreign
currency borrowers (e.g. local governments, households) and a deterioration of their financial
position.

Background, Issues and Challenges

The prospect of improving municipal credit worthiness and increasing local governments' ability
to access and use credits (loans and bonds) as an additional source for local infrastructure investment
has been discussed extensively in the public sector over the past several years in almost all territories
covered by NALAS members. However, local credit markets are still in their infancy.
Every fiscal decentralization effort includes a legislative reform agenda that guides the further
refinement of the national policy framework. The frameworks vary across countries in their
comprehensibility but also in terms of their maturity (see chapter 2). In general fiscal decentralization
processes in South Eastern Europe (SEE) have opened up the opportunity for local governments to
use various instruments of borrowing to finance their local investment financing needs.

Issues and challenges

There are large policy issues about the role of credit markets in meeting municipal infrastructure
finance

requirements.

According to the results of our survey, in all Territories covered by NALAS members. the primary
obstacle to the use of municipal credit has been largely on the demand side, i.e. the municipalities'
readiness to borrow. Moreover, according to the national legislation related to municipal finance and
municipal borrowing, local governments were prohibited from taking on debt until recently (Moldova
2003, Serbia and Montenegro 2005, Albania and Macedonia 2008, Kosovo 2009). On supply side,
i.e. within financial institutions, funds for lending to local government were theoretically available.
However, (i) the weak financial position of local governments coupled (ii) with a low experience of
banks in assessing the credit worthiness of municipalities restricted the development of local credit
markets.

Although the supply side of the municipal credit market in SEE countries appears to have sufficient
liquidity and capacity to actively enter into transactions, the demand side of the market is currently
limited to larger municipalities with sound financial position. Therefore, to enable municipal credit
market development, the ongoing fiscal decentralization programs must strengthen local government
financing capacities. To this end, creating and enforcing adequate legislation, building and supporting

financial management capacity at local level are critical for the success of decentralisation process.

Municipal debt legislation that comprehensively addresses all key elements in an internally consistent
manner would substantially benefit the development of municipal credit markets in this region. The
existing frameworks in all respective countries provide to some extent clear principles and guidelines
required for market development. Clear debt rules, stable revenues and expenditures assignments and
objectively allocated transfers should be the governing principles of the local debt legislation
framework.

There are some important distinctions between various debt instruments utilized in financing of local
government capital investment projects. Among the most popular are bank loans and municipal
bonds. Variations of these instruments are widely known and utilized in other countries in Central
and Western Europe, USA and Canada. A basic legal framework can and should apply to all types of
debt

instruments.

A properly structured and competitive market for local borrowing instruments can help keep the costs
of capital as low as possible for municipal borrowers. Furthermore, the availability of a local credit
market helps municipalities to play a larger role in selecting and implementing capital investments.

The development of a domestic credit market for local governments is conditional upon the existence
of a public finance system that assigns significant decision-making power, autonomy, responsibilities
and

corresponding

financial

resources

to

local

governments.

Transparency and disclosure are also key elements upon which the development of local credit
market depends. In order to assess credit worthiness of local governments, credit institutions need
adequate, accurate and timely information related to local governments' financial performance and
condition..

International financial institutions (IFI) including World Bank, EBRD, European Investment Bank
and KfW, are becoming more active in the region, especially in the municipal sector. Credit
enhancement mechanisms and guarantee funds established with donor or international lenders'
support

will

significantly

improve

local

governments'

access

to

external

financing..

Following the financial and economic crisis, many commercial banks started to diversify their credit

portfolios by investing into sectors with higher resilience to economic downturns. In this context,
lending to local governments is becoming increasingly attractive for financial institutions..

The establishment of state-funded development funds for regional/municipal investments could

represent another solution to increase local governments' external financing sources. Examples of
such funds from the region include: the Slovenian Environment Fund, the Slovenian Regional
Development Fund, the State Development Fund in Serbia, the Agency for Regional Development in
Macedonia, the Investment development Fund of Montenegro, Fund of Social Investments in
Moldova..

Implementing Public Debt Management Guidelinesrecent experiences.

The World Bank and the IMF followed up on the Issuance of the Guidelines with a pilot program of
diagnosis and technical cooperation that involved countries: Bulgaria, Colombia, Costa Rica, Croatia,
Indonesia, Kenya, Lebanon, Nicaragua, Pakistan, Sri Lanka, Tunisia, and

Zambia. Based on an

assessment of the extent to which these countries had strengthened their public debt management
practices, a report was issued in 2007.
The report noted that while significant progress has been made in the structure of debt and in the
transparency and governance of debt management functions, weaknesses remain in managing risks, and
formulating medium term strategies.

Improving the debt structure

Longer maturity profile

Less reliance on foreign currency debt

More fixed-rate issues

Use of debt exchanges or swaps to change debt profile (Colombia, Mexico,

Tunisia, Uruguay)

Developing and publishing debt management strategy

Middle income countries (Brazil, Bulgaria, Colombia, Costa Rica, Czech

Republic, Hungary, Indonesia, Peru, Poland, Mexico, Turkey)

Low income countries (Tanzania, Papua New Guinea)

Improving governance framework

Public debt management consolidated in one unit (Colombia, Indonesia,

Uruguay)

Set up of semi-autonomous debt management offices (Hungary, Nigeria)

Creation of coordination committees to monitor debt management(Nicaragua)

Improving transparency and communication with the market

Developing domestic public debt markets

Introducing primary dealers (Colombia, Turkey)

Strengthening legislation and regulation (Kenya, Nicaragua)

Countries, however, faced problems in a number of areas:

DEBT PROBLEMS

Incomplete credit policies and strategies

Strategies do not include domestic debt(Tanzania, Papua New Guinea) or take into account contingent
liabilities (few countries do)

Fragmented responsibilities

Different agencies in charge of foreign and domestic debt or of fiscal and quasifiscal debt (Chile, Costa Rica, Guatemala, Nicaragua)

Lack of Medium Term Debt Strategy

Many developing countries lack such a strategy

Publication of those strategies is rare

Insufficient linkage to debt sustainability

GENERAL OBJECTIVES OF DEBT MANAGEMENT

Objective of debt is to finance govt financing requirements at the least cost worth a prudent
degree of risk

Develop explicit debt mgt strategy to enhance transparency

Appropriate strategy sought to balance between the cost of debt and the risk of default

Institutionbalize the prodn of debt strategy through government regulations

OTHER GUIDELINES TO EFFECTIVE DEBT MANAGEMENT

Strong coordination between monetary and fiscal authorities

Transparency and accountability

Strong legal institutional framework

Robust debt management policy and strategy

Good risk management framework

OTHER PITFALLS OF DEBT MANAGEMENT

Lack of coordination between monetary and fiscal authorities

Zero Transparency and accountability

Poor legal institutional framework

nonexistent debt management policy and strategy

poor risk management framework

Excessively unhedged forex dealings

Too much authority to incur debt- no control

Poor capital markets for trading

Misrepoting of contigent liabilities

CORPORATE RESTRUCTURING LAST TOPIC

Corporate restructuring is the process of redesigning one or more aspects of a company. The
process of reorganizing a company may be implemented due to a number of different factors,
such as positioning the company to be more competitive, survive a currently adverse economic
climate, or poise the corporation to move in an entirely new direction. Here are some examples
of why corporate restructuring may take place and what it can mean for the company.
Restructuring a corporate entity is often a necessity when the company has grown to the point
that the original structure can no longer efficiently manage the output and general interests of the
company. For example, a corporate restructuring may call for spinning off some departments
into subsidiaries as a means of creating a more effective management model as well as taking
advantage of tax breaks that would allow the corporation to divert more revenue to the
production process. In this scenario, the restructuring is seen as a positive sign of growth of the
company and is often welcome by those who wish to see the corporation gain a larger market
share.
However, financial restructuring may take place in response to a drop in sales, due to a sluggish
economy or temporary concerns about the economy in general. When this happens, the
corporation may need to reorder finances as a means of keeping the company operational
through this rough time. Costs may be cut by combining divisions or departments, reassigning
responsibilities and eliminating personnel, or scaling back production at various facilities owned
by the company. With this type of corporate restructuring, the focus is on survival in a difficult
market rather than on expanding the company to meet growing consumer demand.
Corporate restructuring may take place as a result of the acquisition of the company by new
owners. The acquisition may be in the form of a leveraged buyout, a hostile takeover, or a
merger of some type that keeps the company intact as a subsidiary of the controlling corporation.
When the restructuring is due to a hostile takeover, corporate raiders often implement a
dismantling of the company, selling off properties and other assets in order to make a profit from
the buyout. What remains after this restructuring may be a smaller entity that can continue to
function, albeit not at the level possible before the takeover took place.
In general, the idea of corporate restructuring is to allow the company to continue functioning in
some manner. Even when corporate raiders break up the company and leave behind a shell of the
original structure, there is still usually the hope that what remains can function well enough for a
new buyer to purchase the diminished corporation and return it to profitability.

Reasons Why You Should Consider Restructuring

There are several reasons you may have to reorganize the operations and other structures of the
organization. Restructuring a company can improve efficiency, keep technology up to date, or
implement strategic or governance changes made by, or mandated to, company owners.

1. Changed Nature of Business

In todays business environment, the only constant is change. Companies that refuse to change
with the times face the risk of their product line becoming obsolete. Because of this, businesses
experiment with new products, explore new markets, and reach out to new groups of customers
on a continuous basis. Businesses seek to diversify into new areas to increase sales, optimize
their capacity, and conversely shed off divisions that do not add much value, to concentrate on
core competencies instead.
All such initiatives require restructuring. For instance, expansion to an overseas market may
require changes in the staff profile to better connect with the international market, and changes in
work policies and routines to ensure compliance with export regulations. Starting a new product
line may require changes in the system of work, hiring new experts familiar in the business line
and placing them in positions of authority, and other interventions. Hiving off unprofitable or
unneeded business lines may require changes to retain specific components of such divisions that
the main business may wish to retain.

2. Downsizing

One common reason for restructuring a company is to downsize the workforce. The changing
nature of economy may force the business to adopt new strategies or alter their product mix,
making staff redundant. Similarly, cutthroat competition and pressure on margins from
competitors who adopt a low price strategy may force the company to adopt lean techniques, just
in time inventory, and other measures to cut input costs and achieve process efficiency.
In such situations, the organization will need to redo job descriptions, rework its team, group,
and communication structures and reporting relationships to ensure that the remaining workforce
does the job well. Very often, downsizing-induced restructuring leads to a flatter organizational
structure, and broader job descriptions and duties.

3. New Work Methods

Traditional organizational systems and controls cater to standard 9 AM to 5 PM office or factory

based work. Newer methods of work, especially outsourcing, telecommuting, and flex time
require new systems, policies, and structures in place, besides a change in culture, and such
requirements may trigger organizational restructuring.

The presence of telecommuting employees, temporary employees, and outsourcing work may
require a drastic overhaul of performance management parameters, compensation and benefits
administration, and other vital systems. The newer work methods may, for instance, require
placing emphasis on the results rather than the methods, flexible reporting relationships, and a
strong communication policy.

4. New Management Methods

Traditional management science recommends highly centralized operations, and the top
management adopting a command and control style. The new behavioral approach to
management considers human resources a key driver of strategic advantage, and focuses on
empowering the workforce and providing considerate leeway to line managers in conducting
day-to-day operations. The top management intervenes only to set strategy and ensure
compliance; strategic business units receive autonomy in functioning.
Traditional management structures were bureaucratic and hierarchical. Of late, management
experts see wisdom in flatter organizations with wider roles and responsibilities for each member
of the team. Job flexibility, enlargement and enrichment are key features of such new structures,
but successful implementation requires changes in the communication and reporting structures of
the organization. While new organizations can start with such new paradigms, old organizations
have to restructure themselves to keep up with these best practices to remain competitive.

5. Quality Management

Competitive pressures force most companies to have a serious look at the quality of their
products and services, and adopt quality interventions such as Six Sigma and Total Quality
Management. Implementing new quality standards may require changes in the organization.
Most of the new quality applications strive to imbibe quality in the actual work process rather
than maintain a separate quality control department to accept or reject output based on quality
specifications.
In many cases, an organizational level audit precedes quality interventions, and such audits
highlight inefficiencies in the organizational structure that may impede quality in the first place.
For instance, reducing waste may require eliminating certain processes, and thereby reallocation
of personnel undertaking such activities.

6. Technology

Innovations in technology, work processes, materials and other factors that influence the
business, may require restructuring to keep up with the times. For instance, enterprise resource
planning that links all systems and procedures of an organizational by leveraging the power of
information technology may initially require a complete overhaul of the systems and procedures
first.
Such technology-centric change may be part of a business process engineering exercise that
involves redesigning the business processes to maximize potential and value added, while

minimizing everything else. Failure to do so may result in the company systems and procedures
turning obsolete and discordant with the times.

7. Mergers and Acquisitions

In todays corporate world, where survival of the fittest is the maxim, mergers and acquisitions
are commonplace and any merger or acquisition invariably heralds a restructuring exercise. The
reasons for such restructuring accompanying mergers and acquisitions are many. Some of the
common reasons are:
o
o
o

Reconciling the systems and procedures of the merged organizations to ensure that the new
entity has consistency of approach.
Eliminating duplication of work or systems, such as two human resource or finance
departments.
Incorporating the preferences of the new owners, and more.

Joint ventures may also require formation of matrix teams, special task forces, or a new
subsidiary.

8. Finance Related Issues

Very often, small and medium scale businesses have informal structures and reporting
relationships, and an ad-hoc style of decision-making. When such companies grow and want to
raise fresh funds, venture capitalists and regulations might demand a more professional set up,
with formal written-down structures and policies. A listed company may undertake a
restructuring exercise to improve its efficiency and unlock hidden value, and thereby show more
profits to attract fresh investors.
Bankruptcy may force the business to shed excess flab such as workforce, land, or other
resources, sell some business lines to raise cash, and become lean and mean, to attract bail-outs
or some other rescue package. Companies may try to restructure out of court to avoid the high
costs of a formal bankruptcy.

9. Buy Outs

At times, the restructuring exercise may be the result of the whims and fancies of the owners. For
instance, the company may have a new owner who wants to stamp his or her personal authority
and style onto the business. Restructuring allows the new owner to:
o
o
o

Reshuffle key personnel and provide power to trusted lieutenants.

Start with a clean state and thereby exert greater control.
Preempt any inefficiencies that caused the previous owner to sell-out, and more.

With or without ownership change acting as a trigger, company owners may appoint a
management consultant to review the company and suggest macro-level changes, as a routine
exercise.

10. Statutory and Legal Compliance

At times, restructuring may be a forced exercise, to conform to some legal or statutory

requirements. For instance, the government may mandate financial and healthcare institutions
that deal with sensitive personal data to monitor their computer networks. A new bill may require
that private computer networks adopt the same security measures that government networks
adopt, to gain immunity from liability lawsuits in the eventuality of cyber attacks.
Any organizational restructuring is basically a change initiative. Success depends on managing
resistance to change by convincing the remaining workforce of the need for change and the
possible benefits, an effective communication system to lend clarity to the change process, and
effective leadership.
OTHERS

Changes in ownership of the firm

Business bankruptcy

Financial crisis regime

Types of Corporate Restructuring

Corporate Restructuring means any change in the business capacity or portfolio that is
carried out by inorganic route or any change in the capital structure of a company that is
not in the ordinary course of its business or any change in the ownership of a company or
control over its management or a combination of any two or all of the above.
Types of Corporate Restructuring

Mergers / Amalgamation
Acquisition and Takeover
Divestiture
Demerger (spin off / split up / split off)

Reduction of Capital
Joint Ventures
Buy back of Securities

Merger / Amalgamation: A merger is a combination of two or more businesses into one

business. Laws in India use the term amalgamation for merger. Amalgamation is the
merger of one or more companies with another or the merger of two or more companies to
form a new company, in such a way that all assets and liabilities of the amalgamating
companies become assets and liabilities of the amalgamated company.

Merger through Absorption:- An absorption is a combination of two or more companies into

an existing company. All companies except one lose their identity in such a merger. For
example, absorption of Tata Fertilisers Ltd (TFL) by Tata Chemicals Ltd. (TCL).
Merger through Consolidation:- A consolidation is a combination of two or more companies
into a new company. In this form of merger, all companies are legally dissolved and a new
entity is created. Here, the acquired company transfers its assets, liabilities and shares to the
acquiring company for cash or exchange of shares. For example, merger of Hindustan
Computers Ltd, Hindustan Instruments Ltd, Indian Software Company Ltd and Indian
Reprographics Ltd into an entirely new company called HCL Ltd.

Acquisitions and Takeovers: An acquisition may be defined as an act of acquiring effective

control by one company over assets or management of another company without any
combination of companies. Thus, in an acquisition two or more companies may remain
independent, separate legal entities, but there may be a change in control of the companies.
When an acquisition is forced or unwilling, it is called a takeover.
Divestiture: Divestiture means an out sale of all or substantially all the assets of the
company or any of its business undertakings / divisions, usually for cash (or for a
combination of cash and debt) and not against equity shares. In short, divestiture means
sale of assets, but not in a piecemeal manner. Divestiture is normally used to mobilize
resources for core business or businesses of the company by realizing value of non-core
business assets.
Demerger:Demerger is a form of corporate restructuring in which an entitys business
operations are segregated into one or more components.
Demerger can take three forms:

Spin-off
Split-up
Split-off

Reduction of Capital: Reduction of Capital is a process by which a company is allowed to

extinguish or reduce liability on any of its shares in respect of share capital not paid up, or
is allowed to cancel any paid-up share capital which is post or is allowed to pay-off any
paid up capital which is in excess of its requirements.

Joint Venture: Joint Venture is an arrangement in which two or more companies (called
joint venture partners) contribute to the equity capital of a new company (called joint
venture) in pre-decided proportion. For e.g. Maruti Suzuki
Buy back of Securities: When a company is holding excess cash, which it does not require
in the medium term (say three to five years); it is prudent for the company to return this
excess cash to its shareholders. Buy-back of securities is one of the methods used to return
the excess cash to its shareholders.

Corporate Restructuring Increasing your Business Efficiency

To be successful on a long term basis it is essential that companies can respond to fluctuations in the
economy and endure dips in income. In some instances, companies may need to change their business
processes and working methods in order to operate as efficiently as possible. Corporate restructuring
enables businesses to do this, reduce costs, increase profits and allow companies to avoid closure and
insolvency in some instances.

Corporate Restructuring increasing your business efficiency

To be successful on a long term basis it is essential that companies can respond to fluctuations in
the economy and endure dips in income. In some instances, companies may need to change their
business processes and working methods in order to operate as efficiently as possible. Corporate
restructuring enables businesses to do this, reduce costs, increase profits and allow companies to
avoid closure and insolvency in some instances.
Unfortunately, there are a number of factors than can have a negative effect on a business and
subsequently reduce income. An increase in tax liability, recession, negative media attention and
increased competition are just some of the factors that can reduce a companys cash flow.
Ideally, companies are able to survive temporary cash flow reductions but this is not always
possible. Issues such as, a floundering economy or an unavoidable increase in production costs
can leave businesses facing long term income loss which can have a profoundly negative and
sometimes catastrophic effect on the business. It is essential that businesses react quickly and
effectively to such issues. By undergoing corporate restructuring they ensure the business is
equipped to survive such changes and can increase profits in both the short and long term or
return the business to profitability.
The options available to businesses considering corporate restructuring are vast and very much
dependent on the industry, nature of the business and specific issues the company is facing. The
merging of departments, disposal of company assets or reduction in workforce may be necessary
step to keep a company functioning and can all be conducted during a period of corporate
restructuring.
By accessing the services of corporate restructuring specialists, businesses can seek advice
regarding how best to restructure the company. In addition to providing a range of viable options
and calculating the associated risks, corporate restructuring experts can assist with the

implementation of changes to the business and provide additional resources to staff during the
period of corporate restructuring.
Its even possible for businesses to begin a cycle of corporate restructuring before any income is
lost or before damage occurs to the business. For example, if upcoming legislative changes are
going to place additional burdens on the company and ultimately reduce income or increase
costs, a strategic corporate restructuring plan can enable the business to implement changes prior
to the enactment of new regulations and avoid any loss or harm to the business. The quicker a
business responds to unwanted or enforced change, the more chance it has of surviving and
increasing profits as it does so.
Whilst many companies undergo corporate restructuring following a period of reduced trading or
income, business also often seek to the assistance of corporate restructuring specialists during
time of growth or expansion. Even before trading begins, many business owners plan for
projected growth and assess potential routes for expansion. When growth occurs, the original
business structure may not cope with increased production and require remodelling. The use of
corporate restructuring services can enable the business to assess all viable options and
implement the changes in an effective and efficient manner.
As businesses are constantly subject to external and internal change, it is essential that they are
adaptable in order to survive on a long term basis. Whether the business is expanding or
economising, corporate restructuring allows a business to respond accordingly and become as
profitable as the market allows. Although some corporate restructuring methods, such as
downsizing or reducing workforce, can be difficult, they are sometimes the only method of
ensuring the business is able to continue to function and return to profitability. It is essential that
businesses welcome corporate restructuring methods both in times of difficulty and prosperity in
order to function at their optimum level and maximise economic success
CHALLENGES OF CORPORATE RESTRUCTURING

Difficult in how to prioritize policy goals and objectives

Weak macro-economic framework

Identification of unviable corporations from viable ones is complicated by the overall

performance of the corporate sector

Problem of how to dispose off the assets of a liquidated corporation

Delays in assets disposal ties up economic resources and impedes restructuring strategies.

Long delays in implementing bankruptcy reforms slow down restructuring efforts.

Economic and political constraints

No clear valuation criteria

Assignment.2
The current turbulent debate on the government wage bill is generating a lot of concern. The current
wage bill now stands at 13% of GDP or an equivalent of 53% of total government expenditure . As a
consultant you have been approached to provide tangible long-term solutions to this heated debate in
the next ONE week to the ministry of National treasury. (20MARKS)

THE END.