The importance of policy

Senior management needs to decide on a policy for profit remittance by each business
line. Too often this policy is not clearly communicated, even if it is made. It is
important that remuneration of traders is based on numbers which are aligned with
the interests of the shareholders. If the businesses do not have any requirement to
pay over their profits to head office at the end of each period then the net assets
method, which gave a result of ñ200, is the only correct approach. If the businesses
do have a requirement to pay over their exact profits (and receive their losses) at the
end of each month (or day or year) then the use of the closing exchange rate appears
appropriate. In fact, if properly implemented, the two methods would give much
closer answers because if the profits have to be paid over at the end of each period,
there would never have been an opening balance of GBP900. Indeed, if the policy is
that the profits are paid over in the currency in which they arise, then the two
methods will give exactly the same answer. Paying over the profit in the reporting
currency is a policy that may be easier for everybody to understand. If the amount
required is obtained by the business line selling exactly all its profit in the transaction
currency then the closing exchange-rate method gives exactly the same answer as
the net asset approach. If the business line does not make its FX position totally flat
at the end of each period, then there will be an exposure which does affect the
wealth of the organization, and the closing-rate method will miss this. Thus all the
transactions related to profit remittance should be reflected in the cash accounts in
the ledger system and the net assets method used.
Profit remittance policies are often less than clear because they are embedded in
systems calculations. This is particularly true of any policy which involves a daily
remittance. The logic will have been perfectly clear to the founding sponsor of the
system, but even if the programmers understood it and implemented in correctly,
later users may never have really understood the motivation behind the numbers
which the computer spews out. Such embedding is a good example of system logic
risk. Such risk is usually thought of in conjunction with complicated valuation
models, but we see here that it can also apply to accounting systems, which are
generally considered to be simple.
Policies which say that all FX risk is transferred to the FX desk are effectively
policies of daily remittance in transaction currency. It is important that whatever
policy is chosen is clearly understood by all trading personnel, otherwise avoidable
FX risks may be hedged out, or even unnecessarily introduced. Policies which do not
involve daily remittance need to specify the exact timing of remittances, and the
treatment of any FX gains or losses which arise between the end of the month/year
and the date of payment.