Reviewing and Post-Auditing an Accepted Project - Financial Management

A final important step in the capital budgeting process is the review of investment projects after they have been implemented. This can provide useful information on the effectiveness of the company’s selection process. The post -audit procedure consists of comparing actual cash flows from an accepted project with projected cash flows that were estimated when the project was adopted. Because projected cash flows contain an element of uncertainty, actual values would not be expected to match estimated values exactly.

Instead, a project review should be concerned with identifying systematic biases or errors in cash flow estimation on the part of individuals, departments, plants, or divisions and attempting to determine why these biases or errors exist. This type of analysis, when properly performed, can help a company’s decision makers better evaluate investment proposals submitted in the future.

The importance of the post-audit process has been highlighted in research by Brown and Miller.11 They observed that in the common situation where bad projects outnumber good ones, the simple procedure of making unbiased cash flow estimates and choosing projects with positive net present values will result in an upwardly biased acceptance rate for proposed projects (and returns that are, on average, below those that are expected) if there is uncertainty regarding future cash flows. In a situation such as this, the firm needs to correct for this potential bias when projects are being reviewed.

The information needed to make this necessary bias-eliminating correction can be gathered from careful project post-audits.

The importance of a good project review and tracking system is illustrated in the following example from Ameritech (merged with SBC Communications in 1999). Ameritech has a sophisticated tracking system that permits the company to identify the individual responsible for each estimate in a capital project proposal.

When the tracking system was announced and initiated, budgets had already been submitted for the coming year. Divisions were permitted to take back their budgets and resubmit them in light of the new tracking system. Seven hundred projects disappeared from the new budgets, and many others had reduced estimates of benefits!

Another objective of the project review process involves determining whether a project that has not lived up to expectations should be continued or abandoned. The decision to abandon a project requires the company to compare the cost of abandonment with any future cash flows that are expected over the project’s remaining life. These estimates of future cash flows will usually be more accurate after the project has been in service for a period of time.

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Financial Management Topics