Regulating Risk

The corporate treasury's relationships with banks, auditors and the rest of the company are undergoing considerable change, while the treasury function itself, which has had no fixed design across the profession, is beginning to acquire one.

Richard Raeburn, chief executive of the UK's 3600-member Association of Corporate Treasurers (ACT), has been watching the transformation. 'There can be no doubt that there are a number of areas where compliance with new regulatory requirements or codes of practice is imposing significant extra burdens on companies,' he says, 'and many of these impact directly on the work of the corporate treasurer.'

In particular, ACT members report a significant extra workload with the implementation of International Accounting Standards (IAS). This, of course, is good news for the accounting profession, even though there have been reports of a shortage of available advisors in continental Europe, and consequent delays.

ENSHRINING BEST PRACTICE

Raeburn is phlegmatic about most of the changes: 'The interesting aspect for me is that IAS is actually giving further support to what we have always argued was best practice in terms of risk awareness, risk management and the disclosure of policies and practices in risk management,' he says. 'So, in many cases, what we are seeing is simply a greater formality around what should already have been in place with well-run companies.'

For Raeburn, the Combined Code revisions, the Smith recommendations on audit committees and the IAS are all about looking in more depth at risk, how it arises and how it is managed. 'If you are smart enough to be doing that anyway, because you think that managing risk is essential for creating value for your stakeholders, then you will have been doing this for some time,' he says. 'What is now needed is to ensure that you can comply with the framework of reporting and regulation.'

In the face of the evidence of the failures at the likes of Barings, Enron, WorldCom and Royal Dutch/Shell, concerned politicians have been pushing against an open regulatory door, even though the EU's corporate governance legislation was mooted before the 2001 Enron debacle that triggered SOX.

PROHIBITIVE US COSTS

The corporate world has protested at the cost of US compliance. Financial Executive International estimates that for a US company with an average $2.5bn turnover, the cost of fulfilling SOX Section 404, which enforces highly detailed annual filings on the adequacy and effectiveness of internal controls, to be around $3m. According to the Association of Chartered Certified Accountants (ACCA), large US-listed foreign companies have been paying significantly more.

It has been reported that British Airways and Diageo faced costs of $350m to meet the December Section 404 deadline for overseas businesses, and BP has said it is looking at a bill of $125m. A handful of European companies are setting about delisting in the US, even though they will still be required to comply with SOX and meet the expenses involved, for as long as they have a minimum of 300 US shareholders.

At its most extreme, the European view is that US regulation represents a prescriptive overreaction, which focuses too much on ticking boxes and not enough on qualitative judgements. The EU began work on its own corporate governance legislation in the mid-1990s, with a long consultation intended to evolve regulation slowly.

TRANSATLANTIC CONTRADICTIONS

Comparing the EU and US tacks, Raeburn says, 'Contradictions between the regulations is only a problem where they have clearly taken different approaches to a number of areas and that is where you have inefficiencies creeping in. The ACT very much supports the approach of the EU Commissioner, Charlie McCreevy, which is to strengthen the cooperation between the EU and US bodies. We see the same thing in the area of IAS, where the agenda is very much focused around IAS convergence with the FASB. The aim should be to take the best-in-breed from both approaches.'

According to one London analyst, 'None of this regulation is malevolent. The EU, for its part, is trying to create seamless and safe internal markets. Brussels has done a lot of consulting. However, in the short term, if you do a cost-benefit analysis, more often than not it only stacks up in the negative. The greatest immediate benefit will be not incurring the penalty cost of not completing the work by the due date.'

Raeburn believes that regulation should be as light a touch as possible. 'The ACT would always look to see what underlying need is being met by a particular area of financial regulation and what value is being added by seeing it go through,' he says. 'We usually find ourselves arguing against additional regulation, not for dogmatic reasons but because we are concerned about the burden and the value associated with regulation.'

OPERATING FINANCIAL REVIEWS

In November 2005, the UK Chancellor, Gordon Brown, announced he had scrapped the Treasury's planned Operating Financial Review (OFR) component of its Company Law Reform Bill, ostensibly as a result of a belated recognition that it constituted further red tape for business, which would cost some £33m a year. Consultations are due to finish in March 2006, which may see the OFR reinstated. The political repercussions of this 180° - and possibly 360° - turn aside, there has been widespread disquiet among business leaders at the original decision to abandon the OFR, which is described by one as 'merely a sop to be seen to be cutting back on regulation.'

Despite their inbuilt reservation about regulation, the ACT supported the proposed measure. 'We felt that the requirement for an OFR would be a significant enhancement of the standards of public reporting,' says Raeburn, 'A lot of the OFR would be about risk and thus central to the interests of people managing risk, which is largely a treasury function. In our view, the Chancellor went for the wrong target. We saw the OFR as a very sensible initiative.'

Raeburn takes the view that regardless of future legislation, companies should be undertaking OFRs on a voluntary basis. 'It certainly does require more analysis and more debate and discussion about policy and risk, but we feel that this is wholly in the interests of clarity and openness,' he says.

THE VALUE OF REGULATION

Indeed, Raeburn welcomes regulation if it improves the understanding of stakeholders as to how risk is being managed within the business. 'I would go further and say that ISA 32 and 39, and the fair market valuation principles that lie behind them, improve the quality of the risk management process and must therefore by definition be good for everyone in the business,' he explains. 'However, where we will always be very cautious and very wary is where we see regulation for regulation's sake.'

The ACT has been critical of the stringent hedging rules in IAS 39 - the standard on financial instruments which requires companies to state the market rather than the purchase price of their financial derivatives. The ACT has maintained that the measure is out of step with valid hedging techniques and leads to 'misleading' results.

Its technical officer, Martin O'Donovan, has pointed out that, 'there is a groundswell of opinion that some of the transactions that people do for very sensible reasons come out in an illogical way in the accounts.' IAS 39 was made retroactive to 1 January 2005 and the effect was highlighted in July 2005 when Reuters reported a

£123m unrealised first-half loss on its balance sheet, though its income statement showed a pre-tax profit of £147m.

IMPACT OF VOLATILITY

'If the way in which the hedging of a current exposure is reported is going to give rise to additional volatility in the profit and loss account, as a consequence of compliance with IAS, then some risk decisions will be taken differently because of the impact of that volatility on reporting,' comments Raeburn. 'Those decisions may be the right and proper thing to do, but may not produce the right accounting result. And it is very difficult to put on a hair shirt and be determined never to divert from the path of proper risk management, because of the accounting consequences. In reality people do have to give regard to the accounting.

If the accounting does not correspond to the cash, then the end result may not be the best one for the organisation. It may be the best one for the reporting of earnings, but it may not be the best one from a value creation standpoint.' Raeburn sees that companies have been reacting in different ways to the adoption of IAS 39 in risk management terms.

'Some have said we will continue to do what we have always done and we will live with the P&L account volatility that we know will arise,' he says. 'However there can be no doubt that some companies will be reporting significantly increased volatility as a consequence of sticking to what you could argue is best-practice risk management. Others will compromise, saying that they do not want that volatility, so they will tweak their risk management policies to reflect the accounting requirement, in order to reduce the volatility that will otherwise occur.'

KNOCK-ON FOR THE 'BIG FOUR'

Raeburn notes that there has been recent consolidation among treasury software vendors, which he ascribes to the new complexities in systems. 'In addition, the reality is that the adoption of IAS and the compliance requirements associated with the various new regulatory changes have created an enormous amount of demand for work provided by the "big four" firms,' he says. 'They have been extremely busy and profitable as a result.'

The welter of changes sweeping business has clear purpose but still unquantifiable outcomes. 'Treasurers are always dealing with uncertainty in various forms, as this is central to risk management, which is a large part of what a treasurer has to think about,' says Raeburn. 'Over the years, treasurers have been trying to refine the tools they use in order to reduce the chances of things going wrong.

Where things have gone wrong, it has been a failure of controls, which include good reporting systems as well as good practical controls that make it difficult for people to do the wrong things. The treasury profession over the last 25 to 30 years has been building its understanding of what is good practice and how to add value rather than become a Barings and allow value to be destroyed.

'With or without the impact of additional regulation and oversight, the management of a treasury has, over the last few years, become much smarter, much more integrated with the commercial side of the business, which is where it should always be. One would like to hope that there is now an even greater realisation of the value an effective treasury process can add to the business and that systems have been good at supporting that process. The treasury function is delivering more and doing it more efficiently.'