Published: September 01, 2008
In today’s global economy, the stakes for treasurers trying to protect the value of their organizations from foreign currency volatility have never been higher. The world is getting flatter, as Thomas Friedman suggested, leading to increased globalization - but currency markets have only become choppier. With globalization leading to a projected rise in daily corporate FX volume to $1 trillion by 2010, currency volatility is expected to ride the same wave, rising from 10% in 2007 to 13.9% in 2010, according to the British Bankers Association. While market forces have converged to make foreign exchange exposure management more critical than ever, FAS and IAS compliance have added additional levels or scrutiny to the process, and an additional burden in terms of time and effort. As a recent wave of financial restatements in the US suggests, this scrutiny is unlikely to go away any time soon. In 2000, just over 100 US companies were forced to restate earnings; that number is projected to nearly triple, rising above 300 by 2010.
The world is getting flatter, as Thomas Friedman suggested, leading to increased globalization - but currency markets have only become choppier.
All these factors have converged to make managing foreign currency volatility a critical issue for companies today, according to Lawrence Lanza, Vice President and Treasurer for Kennametal. His company has experienced the impacts of those trends first hand.
“Historically, we would see relatively modest movement in our major currencies,” said Lanza. “But in the last year or two significantly greater monthly exchange rate volatility, combined with our geographic diversification strategy, has highlighted the importance of maintaining a robust FX exposure management program. Kennametal already devotes substantial resources to foreign exchange exposure management. The current environment only validates our commitment to understanding and effectively managing the potential risks inherent in foreign currency volatility.”
Over the past six months, Lanza and Assistant Treasurer Mark Olyarnik have been further refining their process of identifying the company’s exposure to foreign currency volatility. The process, as they both described it, is often a challenge.
“Extracting actionable information from our ERP system, and then identifying and hedging those exposures, is a time consuming and frustrating process, but a worthwhile effort consistent with our continuous improvement culture” Lanza says. “Sources of exposure, prevalent in any company with global operations, are numerous and internal data gathering and consolidation is cumbersome. The result is a complex problem with multiple layers that can consume significant manpower resources.”
Kennametal’s solution was to look for ways to automate and streamline the information gathering process. Lanza and Olyarnik sought an approach that would continue to meet the company’s high standards while at the same time improving the efficiency of the FX management program and reducing some of the complexity of the current process. Lanza and Olyarnik met with key members of Kennametal’s Finance team to evaluate several alternative approaches - with a goal of enhancing the predictability of the impact of FX fluctuations on the company’s P&L. The methodology that Kennametal employed began with a focus on intercompany balances, which then led to careful scrutiny of other potential sources of exposure, and ultimately to an analysis of the underlying transaction data and accounting processes that produced that information.
“We kept peeling back the layers of the onion because we were focused on better understanding how the underlying potential exposures could impact the income statement versus Treasury’s forecast,” said Lanza. [[[PAGE]]]
The challenges that Kennametal’s Treasury team tackled are not uncommon in most multinational companies today - but their attitude and approach is exceptional. Relying on their own experience and expertise, combined with a collaborative approach to engaging Finance and IT, Lanza and Olyarnik have been able to institute a process at Kennametal to translate accounting data into actionable information to quantify foreign exchange exposures and to more completely predict the impact to the company’s P&L from that exposure. Their processes are largely manual, requiring at least 25% of the Treasury team’s efforts on a monthly basis. For companies like Kennametal, with the benefit of a single instance of SAP to provide over 90% of the data they need to manage exposures, this approach has proven successful. Companies who rely on multiple ERP systems, multiple instances of the same system, or a disparate array of source business systems will likely uncover greater complexity and require more resources to achieve the same results.
Treasury needs to clearly articulate to Finance the business objective they have set out to achieve.
For those companies, the same basic approach embraced by Kennametal has been automated through software developed by companies like FiREapps, a foreign exchange exposure management Software as a Service provider. The FiREapps solution automates the process of aggregating data from one or more ERP and accounting systems, providing an analytical framework to facilitate the kind of ‘peeling of the onion’ that Kennametal underwent. Once a valid data set has been achieved, the system calculates a foreign exchange exposure and provides rules-based recommendations to arrive at the best ways to manage that exposure.
In either case, whether through manual methods or automated software tools, the process for effectively managing foreign exchange exposures depends on a foundation of reliable data and a certain degree of visibility to the underlying causes of exposure.
Any approach to an effective, value-driven foreign currency exposure management program depends upon four key factors:
All four of these factors are necessary to achieve even the most basic function of a foreign currency exposure management process: the ability to quantify foreign currency exposure in a way that is meaningful to the organization, including balance sheet, cash flow, translation, or economic exposure. At the highest level, any program designed to have an economic impact by reducing the income statement volatility associated with foreign currencies and enhancing shareholder value, will fail unless it is supported by these foundational elements.
Each of these factors represents a step in a process. That process begins by defining a business objective, which then determines the nature of the data you’re looking for and where it could potentially reside in the business systems of the company. Aggregating and validating that data is more than half the battle. Establishing a platform to process and analyze the data, make value-based risk mitigation decisions and measure business results, is the other half.
As Table 1 illustrates, there is a unique set of systems, transformation processes and potential pitfalls for each foreign currency exposure data source, depending upon your objective. Understanding where to look for the data, what context to apply and what issues to look for, will go a long way towards establishing what Treasury needs and how Finance, IT and other business system owners contribute to the problem of foreign currency exposure, as well as to the solution. [[[PAGE]]]
Regardless of the business systems and processes companies rely on to produce foreign currency exposure data, Treasury needs to clearly articulate to Finance the business objective they have set out to achieve. That’s critical, because foreign currency exposure data is a derived set of data, and the approach you take to define that data set depends on what you are setting out to accomplish.
Valid foreign currency exposure information is the cornerstone to the calcutlation of foreign currency exposure.
Whether you wish to protect the income statement above the line, below the line, or both, will greatly affect the systems and processes from which your data is derived. And in each case, the data you find there will most likely not be in the form you need it to be in. Furthermore, each system and the processes associated with recording the transaction in the systems will present data integrity issues that you’ll have to address.
Valid foreign currency exposure information is the cornerstone to the calculation of foreign currency exposure and ultimately to the effective management of the exposure within a company’s risk tolerance and policy. Foreign currency exposure information is derived by subjecting transaction currency data resident in the business systems of the enterprise to processes such as rule-based selection, calculations and transformations.
In the case of Kennametal, identifying the source system was simple enough since they rely on a single instance of SAP. “That’s a tremendous advantage,” said Olyarnik, “but there’s a significant challenge converting all of that ERP detailed transactional information into exposure sources that are actionable on the part of the Treasury organization. It is not enough to identify where the significant exposures are; any effective program must also enable a company to validate them, net them and then take action to cover or hedge those exposures.”
According to Olyarnik, software-based automation can significantly speed the derivation process, so that foreign currency exposure management can be performed daily, weekly, or as often as wanted as compared to the existing “just barely once a month” cycle that currently relies on manual processes.
After validating basic assumptions that treasury departments make each month about business activity level and exchange rates, the next step, when trying to identify sources of unanticipated FX gain/loss, is often accounting issues.
These types of issues are common to most organizations - what is uncommon is for someone to apply the level of scrutiny necessary to proactively uncover those problems.
Automation can potentially add speed of delivery, transparency and enhanced data quality to a best practices FX approach.
In general, sources of foreign currency exposure data integrity issues fall into two main categories: accounting and organizational issues, and system and configuration issues. The biggest accounting and organizational issues that impact accurate foreign currency exposure calculation are breakdowns in multicurrency accounting processes. The improper recording and relief of a transaction in its transaction currency, and improper, unilateral recording of intercompany transactions are two prevalent sources of error that can seriously distort a company’s foreign exchange exposure. Having valid transaction currency data is the first key component in producing valid exposure data.
An example of FX-related system configuration, administration and maintenance issues as it relates to the balance sheet, includes inconsistent revaluation of accounts across the enterprise by most major ERP systems. Accounts that should be revalued but are not, and accounts that are being revalued but shouldn’t be, are widespread in companies relying on today’s most popular ERP systems. In most cases, companies are unaware of the problem. [[[PAGE]]]
Understanding which accounts should be revalued is the second key component in producing valid exposure data. Acknowledging the potential for these issues, by mapping out your current processes should be the first step in determining where to look for potential errors. This will guide your organization in understanding what data should and should not be included in exposure data, and understanding which processes within your organization are putting that data at risk so you can provide more extensive oversight and/or training.
Kennametal’s focus on this process has paid off in terms of its ability to manage FX fluctuations, which translates into greater predictability of FX impact on the company’s results. What’s next for Kennametal’s Treasury team is to look for ways to invest less time and effort in the process.
According to AT Mark Olyarnik, “One of the opportunities we still have is finding ways to leverage our ERP system and potentially look at outside software systems to reduce the time, effort and manual nature of our current process. The time has been significantly reduced from where we were earlier in the process, but it is still a much greater consumption of time than we can afford.”
Automation can potentially add speed of delivery, transparency and enhanced data quality to a best practices FX approach like the one adopted by Kennametal, while providing a basis for compliance testing. Using a Software as a Service application like FiREapps, companies can reduce the man hours spent aggregating data from its SAP system, or from any number of business systems and automate the validation of that data as well as the calculation of their foreign exchange exposure. As a result, they could focus more of its Treasury team’s efforts on value-added analysis and risk management-based decision making.
Ultimately, the quest for better data not only supports better decisions to protect corporate value; the resulting efficiencies empower Treasury to take a more central role in identifying, quantifying and managing financial risks to the organization. In an era when enterprise risk management has been embraced by rating agencies and ascended to the agenda of most board rooms, this repositioning of Treasury as critical contributors to risk management couldn’t come at a better time.
Lanza agrees that for US multinational companies, the time for leadership with regard to FX is now - particularly considering the current economic climate.
“In a world where the dollar has been declining for years, organizations with significant U.S. exports have probably benefited from stronger foreign currencies. Despite this environment, unexpected earnings impacts from foreign exchange, positive or negative, are not welcome as we strive for earnings predictability.”
Olyarnik’s parting advice to Treasurers: don’t get discouraged.
“Getting started was the most difficult part. We began by looking at each entity in depth to understand the exposure categories and their interrelationships. As we gathered momentum in the process, we initially underestimated the degree of effort required. The reality is that identifying the various sources of exposure, converting them into actionable information, and evaluating the expected results is a major endeavor. It is probably one of the most challenging aspects of risk management that I’ve been involved in, but has also been one of the most worthwhile and satisfying.”
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