Ending Wasteful Year-End Spending: On Optimal Budget Rules in Organizations

Abstract

What can organizations do to minimize wasteful year-end spending before the annual budget expires? I introduce a two-period model to derive the optimal budget roll-over and audit rules. A principal tasks an agent with using their budget to fulfill the organization's spending needs, which are private information of the agent. The agent can misuse funds for private benefit at the principal's expense. The optimal rules are to allow the agent to roll-over a share of the unused funds, but not necessarily the full share, in most cases to audit only sufficiently large spending, and to exert maximum punishment if fund misuse is detected. The shape of the optimal audit rule can change once fund roll-over is allowed, so the model has important implications for auditors. An extension with endogenous budget levels shows that strategically underfunding the agent can be optimal.

Keywords: Auditing, Budget Carry-Forward, Budget Roll-Over, Fund Misuse, Moral Hazard, Year-End Spending

JEL Classification: D82, G31, H50, H83