Financial Management Capability Model

Part I

Introduction

Background

The environment in which the federal government operates is rapidly changing. The effects of limited resources, downsizing and delayering are placing greater demands on government services to Canadians; the need for effective financial management may be greater than ever.

A long-standing strategic priority of the Office of the Auditor General has been to encourage better financial management in government and improve the understanding of the role it can and should play. Accordingly, in 1996 we began a study of the current and future financial management requirements of federal government departments and agencies. Its ultimate objective was to build a modern framework that would describe the key elements departments and agencies need to achieve effective financial management - a framework that would also provide a basis for assessing the current state of their financial management.

The result, the Financial Management Capability Model presented in this document sets out the Office of the Auditor General's expectations for financial management and is the basis on which future audits in this area will be conducted.

Objectives and Scope

This study focussed on financial management activities in departments and agencies.

In the course of the study we developed:

  • A clear and detailed definition of what we mean when we use the term financial management;
  • An audit approach and audit criteria that will permit the Office to assess the financial management capability of departments and agencies; and
  • A model that provides those who use it - either as an auditor or as a manager performing a self-assessment mode - a systematic method that can be used to assess financial management in government and provide organizations with a roadmap for improvement

Approach

In this document we begin by defining financial management and reviewing its objectives. It then presents the Financial Management Capability Model that describes the key elements needed for effective financial management.

We expect that the ideas in this document will evolve as a result of lessons learned in the course of applying and using it.

Financial Management

Objectives of Financial Management

All managers in government are entrusted with public resources to deliver programs and services. They have a responsibility to manage those resources with prudence and probity and due regard to economy, efficiency and effectiveness; they also must account for the way they have used the resources.

Financial management is an important component of what financial and program managers in departments and agencies do in delivering programs and services and exercising stewardship over the resources provided to them.

Essentially, the objectives of financial management are to:

  • ensure that managers have support for decision making;
  • ensure the availability of timely, relevant and reliable information, both financial and non-financial;
  • contribute to managing the risks to the organization;
  • help the organization make efficient, effective and economical use of resources;
  • enable managers to account for their use of resources;
  • establish a supportive control environment; and
  • enable the organization to comply with authorities and safeguard its assets.
Exhibit 1 elaborates on each of these objectives.

Defining Financial Management

Experience has shown that "financial management" has almost as many meanings as people who use the term. Indeed, the lack of clarity about what the term encompasses has probably contributed over the years to the difficulty of making progress in this area. Accordingly, we began our study by suggesting a definition of financial management in terms of the activities that we believe it includes.

In the private sector, financial management is often thought to include two areas of activity frequently covered by the terms "treasury" and "comptrollership". In government, the activities usually associated with the treasury function - debt management, investment and corporate budgeting - are carried out jointly by central agencies (the Department of Finance, Receiver General and the Treasury Board Secretariat). Our focus here is on only the financial management activities carried out by line departments and agencies.

Exhibit 2 sets out the key elements that constitute financial management and shows how they relate to the objectives of financial management.

Financial Management: Three Essential Elements

The following are the three essential elements of financial management:
  • Risk management and control. It is essential that an organization identify the risks it faces (anything that could interfere with its ability to achieve its established objectives); and that it establish a framework designed to manage and control those risks. An essential part of risk management and control is an environment that communicates the purpose, values and ethics of the organization.
  • Information. It is essential that the organization establish procedures to manage and protect the integrity of its data and to produce the type of information needed by managers to conduct their business and account for their responsibilities. The organization must also present this information when it is needed. This element includes management of information systems and financial and non-financial (operational and program) performance information.
  • Management of resources. This component of financial management focusses on managing and directing the organization's resources economically and efficiently to achieve corporate objectives. It includes strategic planning, analysis and support for decisions.
Clearly, financial management does not exist in isolation. Rather, it works in concert with other important components of the organization's management. Indeed, these three essential components of financial management overlap and relate to the other elements of management. Ultimately, an organization must have good management overall before it can have good financial management.

Principles of Financial Management

A number of principles underlie our Financial Management Capability Model:
  • Financial management is an integral component of an effective management framework that helps organizations achieve their objectives and account for the cost of doing so.
  • Management is responsible both for determining the financial management capability appropriate to the organization, and for establishing the processes and practices needed to achieve and maintain that capability.
  • Not every organization requires the same financial management capability. The appropriate level will be commensurate with the nature and complexity of the organization and the risks to which it may be exposed. We recognize that "no one size fits all".
  • Financial management activities must be cost-effective. In other words, the cost of maintaining controls should be commensurate with the risk the controls are intended to address.
  • Financial management is the responsibility of everyone in the organization. In carrying out their duties, all managers are responsible for considering the financial implications of their actions - for managing their resources in a cost-effective way.

The Financial Management Capability Model

Background

The Financial Management Capability Model (FMCM) is based on an adaptation of the Software Engineering Institute's "®Software Capability Maturity Model". The Institute developed the model as a tool for assessing an organization's ability to build software applications. We saw that this approach could be used to create a model for assessing the financial management capability of government departments.

® CMM and Capability Maturity Model are registered in the U.S. Patent and Trademark Office.

The FMCM is a framework that describes the key elements of effective financial management. It sets out a path that an organization can follow to develop progressively more sophisticated financial management practices, as needed. It shows the steps in progressing from a level of financial management typical of a start-up organization to the strong, effective, financial management capabilities associated with a more mature and complex organization.

In addition to its use in auditing, the Financial Management Capability Model also provides a tool that a government organization can use to:

  • determine its financial management requirements according to the nature, complexity and associated risks of its operations;
  • assess its existing financial management capabilities against the requirements it has determined; and
  • identify any gaps between those requirements and its existing financial management capabilities. Having identified these gaps, an organization can then address any significant ones and work toward developing the appropriate level of financial management capability.

Structure of the Financial Management Capability Model

The Financial Management Capability Model is a framework for strengthening financial management through many small evolutionary steps. The model illustrates the stages through which an organization can evolve as it defines, implements, measures, controls, and improves its financial management processes. These steps have been organized into five progressive "capability levels". Each level represents a well-defined stage toward developing a mature financial management regime.

The following are the five levels of the Financial Management Capability Model (see Exhibit 3).

  • Start-up
  • Control
  • Information
  • Managed
  • Optimizing
Each capability level consists of a cluster of "key process areas" (KPAs). When an organization has instituted all of the KPAs associated with a given level of financial management capability, it may be considered to have achieved that level. Note that each KPA has a purpose and one or more goals. Certain activities and results or outcomes are also associated with every KPA. Essentially, therefore, KPAs are the main building blocks that determine the financial management capability of an organization. They identify what must be in place at that capability level before the organization can advance to the next level.
The Start-Up Level
The Start-up Level describes the financial management characteristics of an organization that has not yet established its key policies and practices or its control framework. At this level, in the absence of established practices, the organization's ability to achieve its business or program objectives depends on the often-isolated efforts and accomplishments of individuals. In these circumstances there is no certainty that such accomplishments would be repeatable or sustainable.

This situation might exist if an organization has experienced dramatic changes in its operations - for example, if it has implemented a new program or policy, amalgamated with another department or relocated its operations. If it has not effectively managed the increased risks associated with the change, the organization could be at the Start-Up Level of financial management capability.

The lack of repeatable, sustainable practices of financial management and control means that any data produced may not be complete, accurate or reliable. Similarly, without an adequate control framework in place, assets may not be adequately protected or resources adequately controlled.

The key challenge the organization faces in progressing to Level 2 is to develop realistic, useful financial and operational business plans and to establish a basic control framework that allows it to monitor and control resources and safeguard and protect assets.

The Start-Up Level, unlike other levels in the Financial Management Capability Model, is not a stable environment in which it is desirable to remain.

The Control Level
At the Control Level (Level 2), the focus is on ensuring that adequate resources are available, assets are safeguarded, data are reliable, and operations are monitored and controlled and conducted with prudence and probity. Organizations at the Control Level are able to meet statutory and regulatory reporting requirements.

Organizations that have instituted the key process areas for this level have established a control framework that provides a stable environment and ensures that control practices are repeatable and sustainable. The control framework includes financial, operational and management controls. When these basic controls are operating as intended, they will help the organization to control or reduce risks and to produce complete and accurate financial and operational data.

With sound financial and operational data, the organization can carry out its basic stewardship responsibilities and meet its reporting obligations. The integrity of the data supports operational planning decisions and monitoring activities. It ensures that sufficient funds have been obtained to meet budget and cash-flow requirements, and it satisfies statutory and operational reporting requirements.

An organization at the Control Level will be able to answer "Yes" to the following key questions:

  • Do we have a control framework to ensure that our assets are safeguarded, our data are accurate and reliable, and our operations are conducted with prudence and probity?
  • Are transactions processed and controlled in accordance with applicable legislative and/or regulatory requirements?
The primary activities that the organization's Finance group performs at the Control Level involve the traditional accounting functions - processing transactions, bookkeeping and general accounting functions. Finance focusses on ensuring that controls over the financial systems are adequate to produce complete, accurate and timely financial data and to provide functional guidance to operational groups as required.

At the Control Level, operational managers play a role in achieving basic financial management capabilities. This involves establishing realistic financial plans based on expected results, and estimating the resources required to achieve those results. At Level 2, the data on which these plans are based are typically historical in nature, drawn from past experience. At this level, operational managers would also track actual progress and resource use against planned results.

At the Control Level, reliable historical data are available. However, they are not generally available as "information". Although ad hoc analysis can be carried out, the effort to collect information may be extensive and time-consuming because it may be fragmented, scattered and not easily accessible.

The Information Level
At the Information Level (Level 3), key process areas focus on integrating the organization's financial and non-financial systems, practices and procedures to provide information that can be used to manage resources with prudence and probity and in an efficient and economical manner.

At Level 3, an organization will be capable of both measuring and managing its risks, and can tailor management practices within its various operating units to manage and reduce risk cost-effectively. At Level 3, the organization will have information on the cost of producing a product of a given quality or delivering a service at a given level.

A key aspect of Level 3 is the changing role of Finance. The role begins to move away from performing only the traditional accounting functions to performing as a team player providing valuable support to operational managers. Finance works with operational managers to develop a financial structure that provides them with cost-effective controls and information which meets their day-to-day needs - for example, information on product costs.

At the Information Level, operational managers have a broader understanding of their financial management responsibilities. They also recognize their responsibility to contribute to the organization's financial management capabilities.

Critical to achieving this level of capability is a climate that institutionalizes financial management practices throughout the organization's culture. This would require that senior management explicitly demand and promote effective financial management and demonstrate its value. Such a culture is developed by formalizing financial management policies and practices across the organization and supplementing them with appropriate training - and a system of rewards, recognition and sanctions that reinforces the culture.

In addition to being able to answer "Yes" to the Control Level questions, an organization at the Information Level will be able to answer "Yes" to the question, "Do we have the financial management systems, practices and information that we need to measure and monitor the cost and quality of our outputs and the use of our resources?".

At the Information Level, organizational standards for all processes and activities have been established to allow for measurement and comparison between similar business units across the organization. These standard financial management practices can be tailored to each unit's nature and unique risks.

One of the key processes at the Information Level is to provide consistent and comparable financial and operational (non-financial) information and reports that meet the needs of managers. This information provides a basis for developing performance indicators, cost and quality measures and monitoring performance, to ensure that intended results are being achieved and to demonstrate accountability.

The Managed Level
At the Managed Level (Level 4), the organization uses the information developed at Level 3 to balance two competing objectives: using its resources economically and efficiently, and producing cost-effective results - for example, goods or services of acceptable quality. The organization understands the financial implications of the choices and trade-offs it makes between these objectives. Such information also allows the organization to better account for the way that it uses the resources entrusted to it.

An organization at the Managed Level can better manage its financial and operational performance because it has - and uses - the "right" information. It has information and analyses on the relative costs of different approaches to achieving its objectives. An organization with Level 4 capabilities uses that information and impact analyses to make informed decisions on cost versus quality and risk versus opportunities, or decisions on levels of service.

An organization with Level 4 financial management capabilities also has mechanisms for measuring the impact of variables such as cost, quality, productivity and degree of success in achieving its stated objectives. This capability flows from a history of having measured and managed organizational performance, which includes, for example:

  • managing the organization's information and knowledge resources as assets, so that information needed to make informed decisions is available (for example, by using simulations, historical trends and manipulating variables to see how they affect results);
  • defining the relationships among variables that affect cost, quality and level of service and understanding how they impact on the organization's desired results;
  • using information to make informed choices among competing objectives like cost, quality and schedule;
  • understanding the financial implications of decisions before making them, and monitoring their outcomes;
  • using quantitative information to control variances (for example, fluctuations or changes) in the organization's production or service delivery processes; and
  • using quantitative information to balance among competing business line objectives (for example, to reduce cost, increase productivity, improve quality, reduce risk, increase opportunities).
An organization at the Managed Level will be able to answer "Yes" to the question, "Do we know what it cost to achieve a given result, and did we follow the most cost-effective approach in achieving it?".
The Optimizing Level
An organization at the Optimizing Level (Level 5) uses information from inside and outside the organization to set and achieve strategic targets or objectives for improvement. Achieving these targets enables the organization to increase the value of its services or products to clients or consumers.

Thus, at the Optimizing Level the focus is on continuous improvement. The organization uses what it has learned from past experience to identify areas for future improvement. This involves:

  • developing prospective information to anticipate both internal and external changes that may affect the organization's performance (instead of reacting to changes) and making the necessary strategic or tactical decisions to manage their effects;
  • measuring the organization's performance against that of others in the same industry and setting strategic targets for improvement;
  • finding best practices and learning from other organizations (benchmarking); and
  • finding ways to minimize costs and maximize revenues, and to improve the quantity and quality of outputs, by introducing new technology or improving existing processes.
The key question that an organization at the Optimizing Level asks itself is, "How can we as an organization improve our performance?".

Achieving a Capability Level

Achieving Capability levels
Achieving a given capability level involves mastering the key process areas associated with it and ensuring that these key processes are institutionalized within the organization.

Mastering Key Process Areas

An organization can reach a given level or financial management capability by mastering all of the key process areas included in that level.

As illustrated in Exhibit 4, each KPA has certain goals. To achieve the goals in one or more key process areas, an organization must carry out certain activities. Typical activities include:

  • identifying requirements - such as the need for a certain control system - and developing plans and procedures to meet them;
  • carrying out those plans and procedures;
  • tracking and monitoring the work being done; and
  • correcting any problems that may arise.
In turn, these activities produce immediate outputs (for example, a control system) or longer-term outcomes (for example, careful management of the cost of products or services). Once an organization has done the necessary work and achieved the outputs or outcomes associated with a KPA, we can say that it has "mastered" that KPA: it has in place a basic building block that contributes to reaching a particular capability level.

Institutionalizing Key Process Areas

By itself, mastering one or more KPAs is not enough. It is also essential to "institutionalize" the KPA and all of the activities associated with mastering it. By institutionalizing, we mean weaving the KPA and related activities into the fabric or culture of an organization. Only in doing so will the organization make the KPA sustainable, repeatable and lasting.

Institutionalizing the KPA requires the "right" organizational climate. As indicated in Exhibit 5, some prerequisites or characteristics of such a climate are:

  • a commitment to master the KPAs associated with reaching a particular capability level;
  • the ability to carry out the necessary activities competently, for example, through training and development;
  • ongoing measurement and analysis of activities and progress toward goals; and
  • continuous verification to ensure that activities have been carried out in accordance with established policies and procedures.
Such a climate provides the support or foundation for reaching a financial management capability level appropriate to the organization.

Establishing Financial Management Requirements

We would expect that in determining and establishing the financial management capabilities their organization needs, managers would assess the nature of their operations and the risks they face. In this context, we consider risk to be any factor that may affect the organization's ability to achieve its objectives. Risks are identified through a process of first identifying potential hazards, then assessing the consequences to the organization should one occur, and finally determining the likelihood of the hazard's occurrence, given the control environment of the organization. Such a process is outlined in Exhibit 6.

As a first step, senior management would determine the organization's financial management requirements by defining its broad purpose and direction and assessing its risks (both financial and non-financial). The purpose of this assessment would be to determine three things:

  • what risks the organization faces and which of those must be controlled;
  • what financial and non-financial information the organization needs to meet internal and external accountability requirements; and
  • what financial and non-financial information management needs to fulfil its operational and policy responsibilities.
The second step would be for management to establish an overall management framework, based on the results of its assessment. This would include determining the financial management capabilities the organization needs, given the nature of its business and the inherent risks involved. This step would involve using the FM Capability Model to:
  • establish the financial management capability the organization needs;
  • assess the organization's existing capability level; and
  • provide guidance for closing any gap between the required and the existing levels of financial management capability.
Once financial management requirements have been established, management would identify any residual risks that exist and assess their acceptability. The existence of unacceptable residual risks would require management to reconsider its financial management requirements and the capabilities needed to meet them.

The third step would be for management to implement the financial management framework. This step involves monitoring processes and activities to ensure that financial management requirements and existing capabilities are still in balance and that they reflect the risks and needs of the organization. Any imbalance that this monitoring might reveal would have to be dealt with - for example, by modifying the risk analysis or financial management framework, as required.

Auditors of an organization as well as its senior management could use the framework outlined in Exhibit 6 to apply the Financial Management Capability Model. Auditors could use the Model to assess the audited organization's level of financial management capability relative to its requirements.

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