Non-standard FX Operating Procedures
When it comes to foreign currency volatility, corporate finance organisations today are faced with managing risk on an ever-changing playing field that is fraught with many challenges. In an increasingly global marketplace, where cross-border trade has quadrupled over the last 20 years, the stakes for managing foreign exchange (FX) risk has only become higher. And, in a regulatory environment that has been stirred up by a recent spate of financial scandals, the rules of the game have become staggeringly complex, increasing the compliance burden on corporate accounting and financial reporting departments. But that’s just where the challenges begin – because the combined effects of these factors have led to an avalanche of operational issues within the majority of multinational companies that have transformed FX risk from what was once regarded as a departmental-level issue into a bona fide risk to the enterprise.
The focus on compliance and reporting that we associate with FASB and Sarbanes-Oxley (SOX) translates into a shift in resources and focus away from treasury, the traditional stewards for corporate risk management, to the controller’s organisation. Take away those resources, then factor in all the demands that an insatiable appetite for corporate growth through mergers and acquisitions (and the resulting burden on treasury) and you begin to understand why employee turnover within treasury has reached unprecedented levels. Taken as a whole, the stress that these factors place on the people, processes and systems organisations rely on to protect corporate value from foreign currency volatility amounts to a perfect storm.
From one perspective, the risk of currency fluctuations is one of the easier financial risks to manage. Exchange-traded options, currency swaps or forward contracts can all lock in exchange rates to protect balance sheets and cash flows from the effects of currency swings. So, even while the dollar leads the way in today’s limbo dance of currency fluctuations, there are common methods and mechanisms available to deal with the problem.
At the same time, it’s easy enough to assume that given the enormous capital expenditures companies have made in implementing SAP, Oracle and/or other ERP systems, as well as financial consolidation and reporting tools, treasury workstations and sophisticated trading platforms, that the process of quantifying a company’s FX exposure and making well-informed decisions to eliminate exposures shouldn’t pose a significant problem for most corporations. Today, that assumption has been put to the test and the majority of companies in the US and overseas have failed to demonstrate an ability to accurately anticipate (or explain) FX gains/losses, or to adequately protect corporate value from foreign currency fluctuations.
So, why has the FX risk suddenly emerged as an enterprise risk and why has it become a top issue for CEOs, CFOs and boards of directors? The reason is because significant, unexpected FX gains and losses are showing up in corporate income statements. In the US, the weakness of the dollar has meant that FX exposure management issues have shown up as unexpected gains related to FX. In Canada and Europe, the US dollar’s weakness has revealed itself in the form of unanticipated FX-related losses that have shown a spotlight on an operational risk that had otherwise been ignored.
As former Microsoft CFO, John Connors, often remarks, “Foreign exchange is the toughest job in finance.” The FX problems that have suddenly surfaced in the executive suite aren’t simply the result of vast market forces and they weren’t created overnight. Rather, today’s market volatility has exposed fundamental problems with the underlying transaction data that companies use to calculate and manage FX exposure – problems that can be tied to people, processes and systems throughout the enterprise that qualify FX as an operational risk.
In a recent survey conducted by FiREapps of 100 multinational companies with revenues ranging from US$20m to US$40bn per annum, the majority of treasurers, foreign exchange managers and controllers who expressed confidence in the currency risk management policies within their companies communicated deep concerns that these policies weren’t being followed properly. Even more distressing was their lack of confidence in their ability to define and quantify the true currency exposure faced by their firms. In other words, good policies were being overlooked and the problem of bad data was being ignored.
One major factor that leads to unreliable transaction data for managing foreign currency exposures is a lack of visibility into the process and a related lack of understanding of how certain accounting procedures can impact the company’s ability to manage foreign currency exposure. Let’s take a look at some of the people and processes that lead to operational FX risks.
In many cases, one contributor to transaction currency data problems is manual accounting processes that lead to persistent, systemic errors. There are two major sources of accounting issues related to foreign currency exposure: improper recording and relief of a transaction, and improper, unilateral recording of intercompany transactions.
Often, these problems can show up in regional offices, where a foreign currency transaction is converted on the fly and entered into the general ledger in the local currency of the office, rather than in the currency of the transaction. Back at corporate headquarters, this exposure never surfaces and cannot be managed by corporate treasury. In addition, the foreign currency gain/loss associated with this transaction exposure is not realised incrementally in conjunction with the process of account revaluation. Rather, it is realised all at once, when the transaction is cleared or settled.
Another prevalent issue is the clearing and reconciliation of multi-currency account balances in local currency instead of transaction currency. This results in invalid transaction currency balances and invalid relationships between the transaction currency and local currency within the accounting system. Because revaluation processes are based upon transaction currency balances, invalid transaction currency balances can lead to invalid unrealised FX gain/loss calculations and posted results when revaluation occurs during period-end processing.
These accounting issues are evidence of a process breakdown usually attributed to employee training in the area of transaction entry. Detecting these issues requires a disciplined analytic review of the monthly foreign currency FX gain/loss for entities within the enterprise, given the foreign currency exposure relationships within the entities and changes in foreign currency rates for during the month. Resolving the issue will include more rigorous training to ensure that proper accounting procedures are followed, and that the impact of flawed practices are understood.
When it comes to FX, treasury is a customer of accounting and, to a lesser extent, IT. Accounting maintains the accounting systems and data that treasurers rely on to calculate an FX exposure and make decisions to mitigate risk. IT supports and aids in the administration of the ERP and G/L systems that manage this data.
There are three basic issues that lie within the realm of accounting, related to a firm’s ability to assess the impact of currency revaluation and re-measurement on its financial statements:
Set-up of the revaluation environment within a multinational company is complicated. Initial set-up requires an understanding of the requirement to revalue monetary asset and liability accounts as prescribed by FAS 52. It also requires the ability to configure a combination of systematic and manual processes across the accounting enterprise to accomplish the requirement.
Failure to properly set-up or to maintain multicurrency accounting systems to revalue accounts often points to a fundamental disconnect between the domain knowledge of the treasurer and the controller and a lack of coordinated efforts. A treasurer who has no visibility to the underlying remeasurement/revaluation rules is forced to assume that the data they receive from accounting is accurate. A controller who does not fully understand the remeasurement process and the configuration rules within their ERP system may not be able to identify and resolve issues without assistance from the treasurer.
Once the treasurer has received a transaction currency exposure data, it’s their job to calculate the company’s FX exposure. Research shows that 95% of firms rely on little of no automation when it comes to aggregating and reporting exposure data. The tool of choice in most cases is Microsoft Excel. The potential for problems here should be obvious. From data entry errors to propagated formula errors, spreadsheets are ill equipped to deal with the complexities of analysing foreign currency exposures.
Another problem with spreadsheet-driven processes is that they are largely dependent upon the knowledge/expertise of the person who created the spreadsheet. And experience should tell anyone in treasury that this is a liability.
FX managers are often faced with performing a very challenging role with little prior experience. Our research indicates that over 65% of FX managers possessed no prior experience with managing FX when starting in their role. In many cases, they aren’t given a lot of time to mature within the role either. Many treasury departments view the FX manager role as a training opportunity with the expectation that the practitioners will move up in the organisation to take on broader responsibilities.
In cases where firms have unexpectedly lost the foreign exchange manager due to turnover, it has generally taken close to two-quarters to recover from the loss. Again, that’s because so many processes relied on individual knowledge and spreadsheets, rather than on a system that embeds knowledge into the process.
Talk to any CFO, controller or treasurer about FX and you’ll find a common theme that emerges: an overall lack of cross-functional coordination and collaboration with regard to activities that impact foreign currency exposure. While treasury may be regarded as the process owner, in reality they maintain control of, and have authority over, only one piece of the puzzle. Different functional groups within an organisation contribute to foreign currency exposures and their management process. The FX gain/loss line on the corporate income statement is the ultimate product of these efforts. Responsibility and accountability for that number resides with the chief financial officer. As such, it is the CFO who assumes responsibility and accountability for the process, and must ensure coordination among the contributing functional groups to ensure that this result is both accurate and acceptable within company policies. The only way to ensure the kind of cross-functional coordination required to properly manage the foreign currency exposure management process is to elevate awareness and priority of the issue throughout the enterprise.
Multinational companies who have tackled this issue head on acknowledged foreign currency exposure management as an operational risk. As a result, they assigned the proper level of oversight, accountability and resources to the entire process. At a strategic level, the role of the FX business process evolved into a strategic responsibility for addressing and maintaining currency risk management decisions, processes and policies. This meant empowering that individual or team to coordinate tactical activities across multiple disciplines, communicate effectively with finance, accounting, tax and operations representatives from around the globe, and ultimately maintain visibility into the foreign currency exposure management process from data to exposure across the enterprise in a systematic and institutionalised framework.