ACC-Treasury-Management-Module-3-4 (PDF)

**AMANDO COPE COLLEGE** *A.A. Berces St., Baranghawon, Tabaco City* *Albay Philippines 4511* *Tel. No. (052) 487-4455* *E-mail: * **\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_** Course Instru...

**AMANDO COPE COLLEGE** *A.A. Berces St., Baranghawon, Tabaco City* *Albay Philippines 4511* *Tel. No. (052) 487-4455* *E-mail: * **\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_** Course Instructor: Gerald B. Bequio, LPT, MBA Course Code: ELEC 4 Course Title: Treasury Management Credit Units: 3 Pre-Requisite: None Time Duration 54 hours Semestral Term: Second Semester School Year: 2020-2021 Time: 6:00 -- 7:30 Days: W Th **MODULE 3 & 4** **TREASURY OPERATIONS AND CONTROLS** Treasury operations are exposed to particular risks such as fraud, error and failures of markets and systems. They are particularly susceptible because of the large amounts of money involved, their ability to make payments and the potential complexity surrounding their activities. Internal controls Treasury functions vary in their composition and scope and in how different organizations allocate tasks. For these reasons, when considering operational controls it is generally better to emphasize underlying principles rather than the detail of specific controls and reporting systems. Control procedures in treasury generally cover the following areas: Segregation of duties is designed to prevent fraud and detect errors. It is an essential approach that means no transaction or payment, internal or external, is ever carried out without at least one other person knowing about it. In a treasury's activities, this becomes a general principle so that those executing and recording transactions must not confirm or settle those transactions. **Counterparty risk** Counterparty risk is the risk to each party to a contract that the counterparty will not meet its contractual obligations, where counterparty is the other party to a financial transaction. Counterparty risk arising from exposure to banks and other financial counterparties is often much larger than credit risk from an organization's sales. Before the global financial crisis, some organizations paid scant attention to this, regarding banks as safe institutions. Times have changed: organizations are holding more cash, and banks' credit (from the corporate perspective) has become weaker. Counterparty risk with financial institutions does not arise from deposits alone. It can be found in many other places including: The legal entity (and in some cases the branch involved) must undertake counterparty credit analysis. In addition to using overall ratings reports, including ratings outlooks, the treasury function should look at the individual credit ratings of domestic and foreign counterparties, as well as those assumed to be seeking government support. It is also important for treasurers to make a considered assessment of governments' ability and willingness to support their banks. However, ratings should not be relied upon exclusively as they can be slow to change and may effectively lag behind market events. For treasury activities, the importance is growing of the technology that organizations use for automating processes, performing calculations, communicating with internal and external partners, monitoring risk and generating compliance reports. **Straight-through processing (STP)** The effectiveness of transaction processing is usually determined by the degree to which it facilitates straight-through processing (STP). Straight-through processing is the efficient, secure and instantaneous flow of information: Within systems in the treasury department, such as the electronic confirmation-matching system that automatically updates deal-confirmation status in the treasury management system (TMS) With other internal systems, such as the automatic posting into the general ledger system of journal entries created in the TMS With other parts of the business, such as the capture of foreign exchange (FX) transactional risk by forecast FX transactions reported from subsidiaries With external parties, such as cash balances reported from banks or mandatory derivative trade reporting/reconciliation. **Treasury management systems** For large organizations, all treasury transactions should be recorded and managed within a treasury management system (TMS), which forms the heart of most corporate treasury technology infrastructures. While spreadsheets are commonly used for broad forecasting roles, proper risk management techniques are available in dedicated systems. TMS: Facilitates the processing and management of specialist information Provides secure information through workflow controls Defines user rights, ensuring the segregation of duties Provides an audit trail Produces treasury reports and accounts for treasury transactions, which under International Financial Reporting Standards (IFRS) and equivalent local standards may be complex. These issues are important for a number of reasons: The amounts of money handled by treasuries are always large relative to the size of transactions typically handled elsewhere in an organization. This means the potential cost of even a relatively minor incident of error or fraud can be material, even fatal, for the business. Treasury needs reliable information to help make decisions on risk management, liquidity and funding, the financing of investment and acquisitions, structuring debt and more. Corporate governance is on the agenda of every CFO and treasurer, and may to some extent be externally imposed. For example, the US Sarbanes-Oxley legislation requires rigorous operational controls, which are only achievable with specialist technology. The TMS will often need to be supplemented by or interfaced with additional systems covering payments, market information or other specialist tools. **TREASURY AND FINANCING RISKS** Treasury and financing transactions are subject to a number of risks and consequences that are important for management and Boards to understand. Many markets have become more difficult and expensive to operate in since the 2008 global financial crisis. Greater risk awareness within organizations means that businesses take long-term views in planning business development. Treasury must therefore ensure that management understands the risks or consequences of treasury transactions. Key treasury and financing risks include interest rate risks, foreign-exchange risks related to transactions, and risks associated with the translation of assets and liabilities denominated in foreign currency that are consolidated into group financial statements. **Interest rate risk** If interest rates rise, borrowers will pay more interest. If they fall, depositors will earn less. However, there are more facets than this to interest rate risk, as described below: **Risk Type** **Description** --------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Risk over future interest payments or receipts. Borrowers will pay more and investors will receive more if interest rates rise. Economic risks -- linkage between business performance and interest rates If a business does well in a high interest rate environment, its risk to rising interest rates is lower. Such a rise may be beneficial for the business overall if its commercial improvement is greater than the effect on the organization's costs of debt. Organizations with high leverage face high exposure to interest rate risk A high level of exposure must be managed to prevent it from swamping the organization. Normally, market interest rates that are fixed for longer periods are higher than those fixed for shorter periods (the yield curve). If an economy slows, the government or central bank may reduce the interest rate to stimulate activity. This means a business may be somewhat protected against economic downturn. Organizations with a naturally high leverage structure, such as property companies and those financed by private equity, will usually have a high proportion of fixed-rate debt. Generally their revenue streams, such as rental income, are also reasonably fixed. This matching between debt and income reduces their exposure to interest rates. Borrowers with steady amounts of debt will generally find it cheaper in the long run to adopt a fully floating interest rate approach. This is mainly because longer-term (fixed) rates include inflation, a liquidity premium and, arguably, a maturity premium. Because many organizations can generally raise prices with moderate inflation, paying a premium by fixing seems wasted expense. For some organizations, the objective may be to minimize the chance of a financial covenant being breached, making interest cost a secondary issue. This is achieved by managing the fixed/floating ratio of debt. Since bond finance is usually at fixed rates and bank finance is usually at floating rates, it is possible to enter into interest rate swaps to reach the chosen ratio. Economic foreign-exchange risk, or strategic foreign-exchange risk Economic foreign-exchange risk is the risk of a change taking place in the value of an organization due to varying exchange rates. It is the aggregate of the present values of all types of foreign-exchange risks. The largest component is sometimes called 'strategic foreign-exchange' risk, which arises from any consequential changes in the organization's competitive position. Factors affecting economic foreign-exchange risk include: The organization's market position and its ability to control sales and cost prices Markets, such as aerospace, which are effectively denominated in a particular currency (in this case USD) Businesses concentrated in particular geographies, as opposed to truly global businesses. (The specifics of an individual organization mean that economic foreign-exchange risk usually differs materially between organizations.) Economic risk goes to the heart of a business strategy and an organization's underlying competitiveness. The response to economic risk is therefore based around the business strategy itself, and the risk can rarely if ever be avoided. The risk to the organization needs to be properly measured, considered and responded to with a view to containing or reducing that risk, using means such as facilitating contingency plans for business operations. In principle, the nature of the risk might properly be responded to with instruments designed for the purpose, such as financial options. However, given the very long terms and the large sums involved, costs are usually prohibitive. **Currency/commodity transaction risk** Pre-transaction risk Pre-transaction risk arises when an organization has to commit to a price before actually entering into transactions or commercial agreements. It can also occur where volumes to be shipped are uncertain, under call-off contracts or contracts with cancellation or partial cancellation clauses, for example, or when tendering for a construction contract. This contingent risk is ultimately best managed with a contingent risk-transfer product, such as an option. Alternatively, companies may hedge proportions of the forecast cost or revenue using foreign exchange (FX) forwards (agreements conveying the right to buy or sell FX at a set price at a predetermined time). For example, when the German auto industry cancelled call-off orders early in the recent European financial crisis, it left central European suppliers with outstanding outright currency contracts that were cripplingly expensive to cancel. If options had been in place, they could have been exercised if in the money, or allowed to expire if out of the money. That is why companies commonly use a proportion of options, partially to hedge or transfer such risks. Options have certain important characteristics: They provide the option buyer (the holder) with the right (but not the obligation) to exercise the option if the price of the underlying asset meets or exceeds a certain price -- the 'strike price'. Once purchased, they provide protection against adverse price movements while allowing the holder to benefit from favorable movements. Purchased options can never be a liability for the holder. There is an up-front cost to buying options (the premium) which can seem expensive. They can be seen as speculative if used for cash flows that are in fact certain. For most organizations, selling options is speculation, as they place a potentially unlimited liability on the seller. Options can be combined, usually offsetting the cost of a purchased option with the proceeds from selling an option. This reduces the up-front cost in return for a reduced benefit. There is no standardized name convention for such combinations, so such instruments should only be entered into after a thorough evaluation of the possible outcomes for the corporate customer. The potentially unlimited pay out under the sold option may negate the effectiveness of such a hedge. **Foreign-exchange transaction risk** Transaction risk is the risk that changes in FX rates may make committed cash flows in a foreign currency worth less or cost more than expected. Examples of its causes can include sales or purchases made or contracts entered into in a foreign currency. Like other risks, transaction risk can either be avoided altogether (by buying or selling goods and services only in local currency), or accepted, reduced or transferred. Some exposures can be reduced or avoided by netting against opposite exposures within the organization or another group subsidiary. Others can be transferred to a third party. The relevant external hedge is often a forward contract, usually used in foreign exchange. Another option is a future, usually used for commodity risk, which transfers the risk to the hedge counterparty. External hedging with forward contracts and futures provides a degree of certainty for periods, depending on the organizational policy, that can extend to several years. While hedging can smooth out some of the market volatility in rates/prices, if there is a permanent and significant change to market rates it only buys time before the impact is felt. In the long run, the organization may still have to adjust its business model by changing its geographic sales patterns or the currency of its input costs. This might even mean relocating its manufacturing location. Leaving a non-trivial FX exposure un-hedged can itself be seen as speculation. This applies to foreign exchange (FX), as much as commodity risk. **Foreign-exchange translation risk** Foreign-exchange translation risk results from exchange differences that arise when consolidating foreign currency assets and liabilities into the group financial statements. This is not a cash exposure but an accounting issue, and it is therefore often not hedged by the organization. This is the approach that shareholders generally expect when investing in an international group. Accounting standards, however, tend to point managers towards 'net investment hedges'. These are where an organization borrows or enters into a derivative to hedge against movements in the value of the accounting net assets of an overseas entity. However, this hedge of accounting net worth may bear little relation to the economic risks/value in such investments. In fact, the hedge may actually increase risk by introducing a cash flow from the hedge that is not balanced by an offsetting cash flow from the foreign investment. Translation exposure can nevertheless affect credit ratios and cash flow measurements that may be relevant to debt covenants. The measures and ratios that can be affected by movements in exchange rates include: Net worth or enterprise value Gearing Net debt/EBITDA Interest cover Cash flow (and measures involving cash flow). The risk of covenant default is often the measure adopted in the management of foreign exchange translation risk. It can be assessed by modelling various 'what if' scenarios applied to the business plan. The response to such a risk is usually to adjust the amount of debt by currency, so that the debt is more evenly balanced against earnings or net worth by currency. **FINANCIAL RISK MANAGEMENT AND RISK REPORTING** Corporate finance theory suggests that the value of an organization can be increased if its risk (the uncertainty of returns) is reduced. Risk management approach ISO standard 31000-2009 defines risk as the 'effect of uncertainty on objectives'. Risk can present opportunities for or threats to objectives. An uncertainly that does not affect objectives cannot be a risk to those objectives. **Key questions to consider** Management accountants must be aware of the overall approach of the organization to financial risk management, and be able to answer the following questions: Has the organization properly articulated its management approach to threats and opportunities? Hence, is there capacity to take certain risks? If so, is there an appetite? How much of this appetite can be delegated to the treasury function? **Approach to risk management** Risk tolerance The amount and type of risk an organization is willing to accept in pursuit of its business objectives. Risk appetite An organization's readiness to bear the risk after risk treatment in order to achieve its objectives. Risk budget The amount of risk that an organization plans to retain, following all planned steps to reduce the risk for the organization. Risk policy Predetermined actions the organization will take, or have in reserve, to deal with the various situations that might arise. Risk policy should cover commercial as well as treasury approaches to exposure management. The policy should identify and reflect the risk appetite and risk tolerances of the organization, making it explicit that a risk management system has been designed to provide reasonable assurance of achieving business objectives. It should assign accountability for managing risks and reporting results on the system's effectiveness to executive management. **Risk management vs speculation** 'Speculation' is the act of deliberately taking on risk or hedging a risk that you do not have. Opportunities consistent with the business strategy, commonly within strict limits (such as credit risk or liquidity risk in investing surplus funds) are acceptable. Anything else (inconsistent with the business strategy) is speculation. It should therefore be prohibited in corporate treasury as elsewhere. Deliberate or inadvertent inaction is also considered speculation when policy would call for action. It too should be prohibited or strictly controlled within limits. For example, treasury operations might be entitled to disregard foreign-exchange positions passed to them if they are accepted as small and not of market size. This approach does not prohibit the taking of financial risk. For example, increasing levels of debt (leverage) that make the financial structure riskier is a widely accepted approach to increasing shareholder returns. But such leverage should be decreased if either the business or its financing becomes more risky. (We have seen this happen widely since the global financial crisis.) Risk management framework Once a budgetary approach to treasury has been established, a risk management framework provides a mechanism to develop an overall approach to financial risks across the entire organization. It does so by creating the means to discuss, compare, evaluate and respond to these risks. It can be seen as a series of successive phases. **Enterprise Risk Management (ERM) Process** +-----------------------------------+-----------------------------------+ | **Phase** | **Description** | +===================================+===================================+ | Identify risk | Identification and classification | | | of the financial risk exposures | | | threatening an organization's | | | objectives, including where they | | | come from | +-----------------------------------+-----------------------------------+ | Assess risk | An assessment of the likelihood | | | of each financial risk occurring | | | and of its potential impact on | | | business objectives. It also | | | includes the prioritization of | | | those significant risks for | | | further analysis, evaluation and | | | management. Using a risk map or | | | probability/ impact matrix is a | | | useful way of assessing risks | | | systematically. The assessment | | | aims to establish the probability | | | and extent of potential loss (or | | | gain), both for single risks and | | | groups of risks combined, and to | | | involve consideration of | | | non-calculable risks (events). | | | Evaluation techniques include | | | scenario analysis, sensitivity | | | analysis, Value at Risk, | | | statistics, and maximum loss. For | | | some risks, such as political | | | risk, there can be no statistical | | | approach. In these cases, | | | non-statistical evaluation such | | | as scenario analysis or stress | | | testing is key. | +-----------------------------------+-----------------------------------+ | Plan response strategy | After assessing the risks, | | | organizations should plan their | | | risk responses. Each | | | organization's corporate | | | objectives, risk appetite and | | | risk sources are unique, leading | | | to a different risk set and risk | | | responses. Risk responses can be | | | categorized into four classes: | | | | | | Avoid or transfer the risk if | | | investors do not expect the | | | organization to take it. | | | | | | Accept (retain) and monitor the | | | risk if the threat is immaterial | | | or the opportunity attractive. | | | | | | Reduce threats (their | | | probability or impact) by | | | internal action such as internal | | | controls, diversification or | | | contingency plans. | | | | | | Transfer risks to a third party | | | via insurance, derivatives or the | | | use of subcontractors. | | | Organizations use risk policy | | | statements to document risk | | | responses (see Treasury policy). | +-----------------------------------+-----------------------------------+ | Implement mitigation strategy | A key element of ensuring that a | | | plan is transformed into a live | | | risk management system is making | | | individuals responsible for every | | | risk. | +-----------------------------------+-----------------------------------+ | Risk reporting | Reporting helps ensure that risks | | | are being managed as agreed and | | | that information is fed back in | | | to the risk management process. | | | (See Risk reporting). | +-----------------------------------+-----------------------------------+ **Risk heat maps** A risk heat map is a tool used to present the results of a risk assessment process visually and in a meaningful and concise way. They can also rank impacts on the basis of what is material in financial terms, or in relation to the achievement of strategic objectives. Organizations generally map risks on a heat map using a 'residual risk' basis that considers the extent to which risks are mitigated or reduced by internal controls or other risk response strategies. **Risk reporting** Responsibility for the management of financial risk is often delegated to those responsible for treasury activities. These treasury activities must be included in the organization's management information as well as, where material, to the market. For each financial risk, there should be some measure of the risk and risk reduction. Regular reports should: Inform management of financial exposures outstanding both before and after any hedging Demonstrate that treasury activity is within the policy authorized by the Board Promote the concept of analysis and performance-measurement in treasury Create a feedback mechanism that leads to improvements in efficiency and control. Best-practice reporting should focus on accuracy, completeness, timeliness and materiality. Best-practice reporting should focus on accuracy, completeness, timeliness and materiality. **Financial risk reporting** **Policy/risk area** **Typical risk management report(s)** **Frequency and/or period of report** --------------------------------------- --------------------------------------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------------------------- Liquidity management Identification and classification of the financial risk exposures threatening an organization's objectives, including where they come from. Weekly out to 30 days and monthly out to one year (not just to the current year end). Bank-relationship management Facilities provided by bank with usage history and any issues, including concentration risk and attitude to renewals Quarterly, with a longer-term annual review. Credit risk Credit exposure against limits, significant issues or downgrades etc. Monthly, with a longer-term annual review and special report following any major event that affects a banking relationship. FX (and commodity) risk Reports addressing transaction, translation and economic exposure. Monthly, with an annual review focusing on longer-term economic exposure. Funding and debt-portfolio management Funding review and outlook, debt-maturity profiles and possible proposals for refinancing/new funding/equity raising. Monthly, but more frequently in run up to the issue of new debt/equity, and with a major annual review. Covenant compliance Performance against covenants (if any) on historical and forecast basis. Monthly, but weekly or daily or more often at times of stress. Interest rate risk Interest rate risk report. Monthly, with an annual review. Investments Reports on security, liquidity and return. Monthly, with an annual review. Treasury operations Reports to the treasurer on controls Daily. **Dashboard reporting** is another tool for reporting the organization's financial risks. This is a report which summarizes in one page the organization's key risks/positions, with a brief commentary on any deviations. This is a particularly valuable tool for reporting to senior management. In the treasury domain, items on the dashboard may include: **GOVERNANCE** Effective oversight of treasury activities involves a clear definition of the organization's strategic and financial objectives and its risk management guidelines. Formal documentation and regular reviews of policies, procedures and performance ensure compliance with Board intentions. **Treasury objectives** Has the Board's financial risk appetite been quantified and clearly communicated to treasury? Do the CFO, Audit Committee and Board of Directors understand the treasury function's strategies? It is not always easy to quantify the Board's risk appetite. The potential impact on the financial statements, such as the Board's maximum acceptable fluctuation in earnings, is one possible measure. To assist the Board in understanding its risk appetite, management accountants should model the impact of various scenarios (such as interest rate and foreign exchange rate movements) on earnings, cash flows and key balance-sheet ratios. They should also engage with treasury to consider options for mitigating the risks to key financial targets posed by factors like exchange and interest rate variability and to model the impact of mitigating options or derivative products. Products like derivatives might have impacts on the presentation of the organization's profit and loss and balance sheet under accounting and reporting regulations like IFRS and GAAP. They might even affect the company's valuation. Gaining clarity on such matters prior to discussing them with boards and audit committees could improve the quality of discussion and avoid surprises down the line. **Treasury policy** Key questions to consider: All well-managed treasury activities are backed by written treasury policies that have processes in place for managing regular updates. Treasury policy is a mechanism by which the Board and management can delegate financial decisions about the business in a controlled manner. It should give those responsible for treasury activities written guidelines on their areas of responsibility, how they should go about these responsibilities, what their boundaries are and how their performance will be measured. These guidelines can be developed in formal procedures. **The treasury policy document should explain:** The organization's financial risk management objectives, which should reflect its goals, risk appetite and sources of risk for the specific business and the economic environment in which it operates The risk management framework to be adopted by the organization (identify, assess, evaluate, respond, report) For each financial risk, what is the risk and why is it being managed, all in the context of the organization's risk appetite Risk measures to set target outcomes and to model the likelihood of their occurring. This may include sensitivity analysis with indicative probabilities attached Procedures for the day-to-day management of financial risks, including: -- The delegation of responsibility for managing them -- How treasury will relate to business operations where financial risks are identified and/or being managed -- Financial risk targets and limits based on an acceptable level of risk, adapted as the organization evolves -- Performance-reporting/feedback mechanisms. Boards have ultimate responsibility for risk management and for approving risk policies. In larger organizations, risk management tasks may be delegated -- but not abandoned -- to a subcommittee of the Board, often called the Risk Management Committee (RMC). Those responsible for the treasury function should recommend financial risk management (and potentially other) policies to the RMC and ensure that the approved policies are followed.