The Age of Compliance - Increasing Demands on Treasurers
This decade might well go down in treasury annals as the ‘decade of compliance’. Following a variety of financial collapses caused by multiple derivative disasters and dubious accounting practices, regulators have been prodigiously introducing a variety of compliance requirements and legislation.
The first was the introduction of new hedge accounting standards. For the past few years, most treasuries have been consumed by implementing and bedding down hedge accounting standard compliance. From AC 133, through AcG-13, FAS 133, IAS 39 to CICA 3865, the global accounting fraternity have kept treasurers extremely busy. Compliance with these standards can be analytically very demanding. For example, in many cases the use of a hypothetical derivative dramatically improves hedge effectiveness testing. However, the creation of these can be analytically challenging especially if your auditor requires the hypothetical derivative to have a zero value at inception of the hedge relationship.
Another example is the trend of using regression analysis as a hedge effectiveness testing methodology, as this has proven to be the most reliable method to ensure ongoing effectiveness. It is no small analytic feat to be able to generate sufficient sets of fair values or cash flows of hedged items and hedging instruments to derive the statistical calculations necessary to prove hedge effectiveness. The combination of complex calculations, large amounts of historic data required and the need to repeat testing at each reporting date puts this methodology beyond the realm of the spreadsheet. Another good example is the hedging of fuel and gas exposures with crude oil derivatives because of the better liquidity and pricing of those markets. This has introduced significant analytic demands on treasurers to satisfy hedge accounting compliance, particularly if options are used.
Hedge accounting has also resulted in the general movement of derivatives onto the balance sheet at fair value, which has led to far greater auditor scrutiny of financial instrument valuations. Today auditors either prefer or require non-counterparty valuations and treasurers have to be able to fully justify all valuations used. As a consequence, treasury staff have had to develop a much better understanding of the mechanics and drivers of instrument valuation, as well as the ability to identify the factors causing valuation variations between accounting periods and between different sources.
In general, compliance with hedge accounting has placed much greater pressure on treasurers to have better tools and systems to deliver and justify mark-to-markets and efficiently designate and effectiveness test hedge relationships.
Just as treasurers are weathering the hedge accounting storm, IFRS reporting companies are now being saddled with further compliance in the form of IFRS 7. This new standard came into effect for most regions on 1 January 2007. It requires enhanced disclosures of the financial instruments companies use, the financial risks they expose the company to and how the company goes about managing those risks.
Two aspects of IFRS 7 are further increasing the analytic demands placed on treasuries. In the first instance, enhanced credit risk disclosure could require more detailed analysis of a company’s counterparty risks. Best practice compliance for IFRS 7 suggests that credit risk should include potential credit calculations, possibly simulation based.
Secondly, companies are now required to disclose quantitative information about their exposure to market risks, such as interest rate, currency or commodity price risk. This can be presented either as a sensitivity analysis calculating the effect of shifts in market prices on the company’s profit and loss and equity, or using a multi-factor methodology such as value-at-risk. Using either of these presents analytic challenges for treasurers. For example, if a company has hedge relationships which are not 100% effective, treasurers will need to calculate the revised split between profit and loss and equity from the adjusted retrospective effectiveness numbers generated from the shift in market prices. Similarly, value-at-risk can be analytically demanding to ascertain.
The standard also requires disclosure if the company’s risk at balance date is materially different from that exposed to during the financial year. This will add to the analytic burden of treasuries as they will need to ensure they are comprehensively measuring their exposures to financial risk regularly throughout the financial year.
Compliance has also led to the need to ensure that treasuries can pass strict internal and external audit requirements regarding their use of treasury technology. Compliance with SOX and other standards has necessitated extensive reviews of treasury functions and the tools they use. Auditors have focused heavily on areas such as system security, dual approvals, reliability and robustness of deal capture systems and seamless market data integration.
The use of spreadsheets as ‘treasury systems’ is under more pressure than ever, particularly in mid-market companies which have traditionally been slow adopters of treasury management systems. The era of the spreadsheet being widely used as a central data store and for critical calculation tasks is ending.
With the demise of the spreadsheet there has also arisen an increasing focus on integration between systems and a general desire for true front-to-back office systems. Best practice compliance favours integrated systems which deliver all the analytics necessary for valuations, what-if analyses and risk management, as well as perform hedge accounting compliance, and traditional back-office functions such as deal capture, confirmations, settlements and cash flow tracking.
Another major trend compounding the need for better analytics in treasury is the birth of the ‘strategic treasurer’. The role of the corporate treasurers, with the increased complexity of global cash flow and risk management, coupled with an expanding range of capital and regulatory management options, is no longer simple. Treasurers now have responsibility for managing credit ratings, bank relationships and daily front through back office treasury operations, all while trying to model long term funding or investment requirements.
For example, there is increasing use of debt as a funding mechanism. However, extensive use of debt creates a strong need to be able to effectively manage the resulting interest rate risk and ensure that the debt can readily be serviced. The rapid growth of the syndicated loan market has increased the demand on treasurers to accurately track and monitor both facility drawdowns as well as the numerous fees associated with this funding mechanism.
If a treasurer can garner sufficient analytic experience and expertise they can expand their role as adviser to the business at a strategic level. This creates an opportunity for treasury to be seen as a strategic value-adding division rather than an administrative cost centre.
The last major trend driving enhanced analytic ability in treasuries is the uninterrupted global growth in the use of derivatives. Despite the introduction of the multitude of compliance standards and legislation, outstanding OTC derivative contracts grew from US$69.2 trillion at the end of 2001 to US$285.7 trillion in 2006, according to the International Swaps and Derivatives Association (ISDA). With proper controls in place, few people would argue against the value that derivatives are able to add to companies as risk transfer mechanisms. However, treasuries have a concomitant challenge to be able to properly measure, manage and report on this increasing derivative usage.
This combined demand for better analytic capability and auditor-friendly treasury management systems has significant implications for treasury technology. Treasurers should ensure they have access to excellent analytic functionality in integrated, robust and reliable systems. These systems should seamlessly combine deep front, middle and back office capabilities in a single system.
The demands of compliance and the need to be able to provide more detailed information to senior management and boards has driven a corresponding need for higher quality, more easily understood and flexible reporting. Treasurers should ensure that their systems provide reporting functionality which allows users to access any data stored or produced by the system in a completely user customisable manner, as well as produce high quality graphical output which is easy to understand and explain to senior management and other stakeholders. Having a powerful reporting capability in their systems is one of the best means for treasuries to raise their visibility and demonstrate value-add within their companies.
Treasuries should also ensure that their systems can easily and accurately value a wide range of instruments with seamless access to market data. These valuations should be accompanied by detailed output which facilitates their validation by auditors.
Lastly, treasuries should look for systems that can help satisfy these analytic requirements both now and into the future. In essence, treasurers are leveraging the analytic capability and expertise of system vendors which is embedded for external use in their software. They should consider the level and depth of technical support their vendors can provide as this is the key differentiating factor in the successful implementation and support of analytical software.