Introduction to Finance

17.10
Keeping Managers Honest
ETHICAL
We have reviewed the fi fth stage of the capital budgeting process—the follow-up, 
sometimes called the audit or control phase. In this stage, a fi rm’s fi nancial analysts track the 
spending and results of the fi rm’s current capital budgeting projects. 
Many fi rms review spending during the implementation stage of approved projects. 
Quarterly reports are often required in which the manager overseeing the project summar-
izes spending to date, compares it to budgeted amounts, and explains diff erences between 
the two. Such oversight during the implementation stage allows top managers to foresee 
cost overruns. Some fi rms require projects that are expected to exceed their budgets by a 
certain dollar amount or percentage to fi le new appropriation requests to secure the addi-
tional funds. Implementation audits allow managers to learn about potential trouble areas 
so future proposals can account for them in their initial analysis; implementation audits also 
give top management information on which managers generally provide the best estimates 
of project costs.
Besides implementation control, fi rms should compare forecasted cash fl ows to perform-
ance after the project has been completed. This provides data regarding the accuracy over time 
of cash fl ow forecasts, thus, permitting the fi rm to discover what went right with the project, 
what went wrong, and why. Audits force management to discover and justify any major devi-
ations of actual performance from forecasted performance. Specifi c reasons for deviations 
from a budget are needed for the experience to be helpful to all involved.
An eff ective control system will record the names of the persons who make the estim-
ates so top management can evaluate business units and managers on the accuracy of their 
estimates. Such a system pinpoints personal responsibility. If, for example, a department head 
estimates a proposed expenditure would allow the department to reduce personnel by 10 per-
cent, the department head can be questioned if the proposed cuts do not come to pass. Such a 
system will control intra-fi rm agency problems by reducing “padding”; that is, overestimat-
ing the benefi ts of favorite or convenient project proposals. This increases the incentives for 
department heads to manage in ways that help the fi rm achieve its goals. Despite this, some 
research indicates psychological factors that led to biases which overestimate cash fl ows and