FC 102/INF/18

Finance Committee

Table of Contents

Introduction and Background

Regular Budget Performance Reporting

Internal Management Reporting - Allotments
Alternative Option – Use of Dual Currency Accounting

Proposed approach to split assessment – Official Accounts

Management of financial risks

Introduction and Background

1. The Finance Committee at its 100th Session and the Council at its 123rd Session in its response to the Committee’s report noted that “there was general agreement that the approved programme of work and budget should be protected to the maximum extent possible from the effects of fluctuating exchange rates” and that a decision needed to be taken at the next FAO Conference in November 2003 in the context of the PWB 2004-2005. The results of the Secretariat’s examination of the impact of split assessment strategy on the budget process and the changes necessary in the Basic Texts and Conference resolutions, are contained in FC 102/18.

2. The Committee also agreed that the Secretariat should proceed with preparatory work in this regard with a view to reporting to the Committee at its 102^nd Session in May 2003 on its initial examination of the issues of accounting treatment, internal and external reporting requirements, required accounting system changes and risk management strategy and policies. This information paper reports on the Secretariat’s analysis of these issues and how the necessary structures, systems and controls will be put into place to support the introduction of split assessments. It also highlights where there are likely to be administrative gaps and notes that the first biennium of split assessments involve transitional measures.

Regular Budget Performance Reporting

3. Notwithstanding the adoption of a split assessment strategy, the functional currency of the Organization would remain the US dollar. Therefore, the Euro portion of assessments and expenditures in Euros would continue to be converted into US dollars for accounting purposes. Budget holders would continue to receive allotments and budgetary performance reports in US dollars only. An internal management reporting system would be designed so as to ensure that a manager’s responsibility for budget control and management would not be affected by gains or losses on exchange over which the budget holder has no control.

4. For accounting purposes all transactions would continue to be reported in the Organization’s official accounts at the UN official rate of exchange in effect at the date the transaction is created. For budgetary performance reporting, transactions in Euros would be recorded at the budget rate established for the biennium. Various options are being explored for reporting purposes, each having associated accounting implications and therefore it is suggested that the 2004-05 biennium be treated as a transitional biennium. The effect on Statement IV will depend on the Special Reserve Account (SRA) arrangements adopted and the procedure for recording transactions. A possible presentation of Statement IV is appended as Annex 1.

Internal Management Reporting - Allotments

5. As discussed above, it is essential that the Organization provide the managers responsible for budgetary performance with a report that is not affected by exchange rate gains or losses over which they have no control. The allotment system is the primary tool used by FAO management to control and monitor expenditure during the biennium. Under the split assessment system allotments would continue to be issued only in US dollars based upon the budget approved by the Conference at the budget rate of exchange. Expenditures reported against the allotments would continue to be reflected only in dollars with transactions in Euros converted at the budgetary rate of exchange as described above. Transactions in all currencies other than Euros and US dollars would continue to be reported in the budgetary performance reports at the UN official rate of exchange.

6. An alternative approach would be to adjust the amount of the allotments issued periodically to reflect the impact of fluctuations between the € = $ UN official rate of exchange and the budgetary rate. This approach is not as accurate as identification of the variance on actual transactions, since the real mix may vary from that assumed in the budget. In addition, budget holders are accustomed to receiving annual allotments that usually remain unchanged. This helps to ensure that managers take full responsibility for their allotments and are able to plan realistically and transparently for their annual expenditures. Creating confusion over the funds at their disposal could make it difficult for budget holders to take control performance against their budgets. This is a serious complaint in IAEA, which has adopted such a system. The system would require a substantial central budgetary control staff to constantly monitor results along with a significant manual effort to adjust the allotments every month for every line item of every working allotment (probably at programme entity level for the technical units).

Alternative Option – Use of Dual Currency Accounting

7. The above proposal for budgetary presentation and control using a split assessment system continues the current single functional currency approach. An alternative system, not currently in use within the UN system, would be to adopt a dual currency system. Under this approach separate accounts would be maintained for the operations conducted in each currency. Income and expenditures and related assets and liabilities in Euros would be recorded in the Euro accounts, and income, expenditures, assets and liabilities in US dollars and other currencies would be recorded in the US dollar accounts.

8. Dual currency functionality is currently available within the core financial system but the complexity of preparing and administering two budgets is not considered feasible and is not recommended. In such a system, a budget would have to be presented in each currency, and programme activities and projects allocated between the two. One of the major disadvantages of the dual currency approach is that it assumes that programme activities and projects can be budgeted by currency. Furthermore, budget holders and central management would subsequently be required to manage the programme and project activities in two currencies. Although the system has the capacity to provide consolidated reports at the institutional level using one or both of the currencies, UNIDO which operated such a system, found two budgets cumbersome to administer and abandoned the approach at the end of 2001.

Proposed approach to split assessment
– Official Accounts

9. As at present, the functional currency of the Organization would remain the US dollar notwithstanding the introduction of the split assessment system. This follows the recommendations contained in the KPMG consultant report presented to the Committee at its 100th Session in September 2002 [FC 100/4]. No changes would, therefore, be necessary in the presentation of the financial statements or in the official accounts maintained by the Organization, except possibly Statement IV. All transactions in currencies other than US dollars would be entered into the accounts in US dollars at the UN official rate of exchange in effect on the date the transaction is recorded, as provided in the UN Accounting Standards, and following the principles of International Public Sector Accounting Standards.

10. As noted above, the exception would be the budgetary performance Statement IV, which would reflect Euro income and expenditure transactions converted to US dollars at the budget rate of exchange. Since, in the official accounts Euro income and expenditure transactions would be recorded at the UN official rate of exchange and for budgetary performance purposes at the budget rate, it would be necessary to maintain an auxiliary set of accounts.

11. A Working Group has been established to identify the precise requirements for internal and external reporting and to identify the costs of meeting these requirements.

Management of financial risks

12. The introduction of the split assessment strategy is designed to protect the PWB by:

1. Ensuring that fluctuation in the relative value of the major currencies in which the Organization receives income and incurs expenditures (Euro and US dollar) has the minimum possible impact on the funds available to finance the programme of work.
2. Reducing the risk of absolute realised gains and losses between the Euro and the US dollar by matching income from assessments and expenditure in terms of currency of exposure, thereby minimising the net transfer required to the Special Reserve Account.

13. The main risk resulting from the implementation of the split assessment strategy would be inaccurate estimates of requirements in the two currencies. The estimates for expenditures are based on historical data. Based on these estimates, the split proportions for the upcoming biennium will be fixed as percentages for each currency. FAO will have no possibility to change instructions to member countries during the biennium.

14. For a budget of US$ 750 million, an inaccurate estimate – too high or too low - of 2 % in Euro expenditures would result in a variance of US$ 15 million between income received and expenditures incurred in Euros. If the rate moves, as observed over the last 2 years, from 0.85 to 1.08, and this movement is utilised as an estimate of the maximum variance between budgetary and market rates, the maximum risk on a position of US$ 15 million would have been US$ 3 450 000 in exchange gains or losses for transfer to the Special Reserve Account, a relatively minor amount compared to recent experience under the current US dollar assessment. The impact could be further reduced through the use, after careful verification of data, of corrective foreign exchange spot or forward contracts during the biennium.

15. A secondary risk would be the result of uneven flows of receipts and expenditure by currency. The current irregularity of receipt of assessment in US dollars will most likely continue. Contributions will not be received at the very same time and delays from large contributors will still create shortages in two instead of one currency. Actual shortages would be covered by reserves which are primarily held in US dollars. As an alternative, a commonly used instrument to cover temporary shortages in one currency could be a foreign exchange swap. A foreign exchange swap combines a spot sale with a forward purchase at the same time (or vice-versa), based on the interest rate differentials with the actual spot rate being of relatively little consequence. The impact on the foreign exchange position/risk is limited to the interest amounts exchanged thus minimising the impact on the Special Reserve Account.

16. The remaining risk relates to the maintenance of the Organizations reserves (cash, deposits and investments). Assuming income and expenditure estimates for the two currencies are correct and all incoming funds are matched, no additional reserves will be created. However, since 100% accuracy is unlikely, the amount of funds held in the two currencies will vary. Converting US dollar reserves into Euro reserves would create a foreign exchange position and therefore a foreign exchange risk due to revaluation. To minimise this risk the recommended currency of general reserves would continue to be the US dollar since it would remain the Organization’s functional currency of accounts.

17. However, following recommendations from the Advisory Committee on Investments and the External Audit, an asset and liability study including an assessment of the currency composition of the investments will be undertaken within the coming months. The goal of the study will be to best match the reserves to liabilities represented in non-US dollar amounts. For example, the liabilities from the Separation Payments Scheme are basically in Euros though the actuarial valuations are performed each biennium and calculated and expressed in US dollars. By having liabilities identified in Euro matched by investments in Euro, the currency risk will be fully eliminated, even if the base currency for balance sheet reporting is the US dollar. Both the assets and the liabilities will be or will have to be recognised and translated at the same rate.

18. Introduction of the split assessment system will have no impact on the potential exchange risk in currencies other than the US dollar or Euro, with the exception of the Euro linked currencies. Since expenditure incurred in all other currencies represents an estimated 17% of total PWB expenditure for the biennium, the exchange risks involved are significant. The Organization will continue to manage such risks by minimising the balances held in currencies other than the two currencies of assessment.

Annex I

POSSIBLE FORMAT FOR
STATUS OF REGULAR PROGRAMME APPROPRIATIONS

For the biennium ended 31 December 2xxx
(US$ '000)

______________________________
¹ Set at € 1 = US$1.10 and approved by the Finance Committee at their xxx session in document FC xxx/yy using a methodology approved by the xx Conference.

² For information and reconciliation purposes only.