Audit of Administrative Controls over the Foreign Debt Portfolio and Foreign Currency Asset Reserves

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1 Audit of Administrative Controls over the Foreign Debt Portfolio and Foreign Currency Asset Reserves Internal Audit and Evaluation May 2006

2 Table of Contents Page SUMMARY INTRODUCTION AUTHORITY FOR THE PROJECT ENVIRONMENT AND BACKGROUND AUDIT OBJECTIVES AUDIT SCOPE AUDIT METHODOLOGIES AND WORK PERFORMED AUDIT OBSERVATIONS AND RECOMMENDATIONS GOVERNANCE Legislative Governance Management Framework Governance HUMAN RESOURCE MANAGEMENT MANAGEMENT INFORMATION COMPLIANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) AND TREASURY BOARD SECRETARIAT (TBS) DIRECTIVES Foreign Liabilities Foreign Asset Reserves PUBLIC REPORTING WEBSITE REPORTING CONCLUSION APPENDIX A APPENDIX B

3 Summary The Canadian public debt is composed of three distinct groups of financial instruments; Domestic Debt (Canadian currency denominated), Foreign Debt (foreign currency denominated), and Retail Debt (the various Canada Savings Bond issues). In November 2003, a risk assessment of the administrative controls over the public debt financial instruments was completed and presented to the Internal Audit and Evaluation Committee. The risk assessment recommended that the domestic debt portion of the public debt be audited in , the foreign debt be audited in and the retail debt be audited in the following year. This recommendation was endorsed at the November 2003 meeting of the Internal Audit and Evaluation Committee of the Department of Finance. As foreign denominated debt is issued in order to support the funding of the foreign currency reserves, a decision was taken to audit the administrative controls over foreign assets jointly with the administrative controls over foreign liabilities. The management of the foreign currency assets and liabilities is a complex mechanism that involves both the Department of Finance and the Bank of Canada. Foreign assets are maintained to provide a source of funds needed to help promote orderly conditions for the Canadian dollar in the foreign exchange market and to provide foreign currency liquidity for the Government of Canada. Foreign currency liabilities are issued to fund foreign currency assets: The foreign assets are entirely financed by foreign liabilities. As of March 31, 2004, foreign currency assets were valued at $41.2 billion while foreign currency liabilities were at $45.1 billion including foreign currency swaps at $24.6 billion. Total outstanding government unmatured debt at that date was approximately $440 billion. Although the Department of Finance has sole responsibility and accountability of the management and reporting for both the foreign assets and liabilities, the Bank of Canada has been delegated administration and day-to-day management of the foreign currency assets. The foreign assets and liabilities have distinctive and unconnected processes, although they are managed together as a whole to ensure minimal risk exposure to the Government of Canada. Not only has the Bank of Canada been delegated administration and day-to-day management of the foreign currency assets, through the Exchange Fund Account (EFA), it also acts as the fiscal agent for the foreign assets as stated in the Bank of Canada Act. However, as stated above, ultimate responsibility and accountability lies within the Department of Finance. This arrangement is reflected in the yearly management responsibility statement of the EFA financial statements that are signed by the Senior Deputy Governor and the Chief Accountant of the Bank of Canada and the Deputy Minister of the Department of Finance. The annual EFA financial statement, representing the total foreign currency assets reporting, is prepared by the Bank, audited by the Office of the Auditor General and presented in Volume 1, Section 8 (Foreign Exchange Accounts) of the Public Accounts of Canada. 3

4 The responsibility and accountability for the authorization and management of the foreign liabilities lies within the Reserves and Risk Management Unit of the Financial Markets Division. The Bank of Canada also acts as the fiscal agent for the foreign liabilities: On transaction approval from the Financial Markets Division of the Department of Finance, the Bank arranges the issue and settlement of the foreign debt. Recordkeeping of debt transactions, to support the preparation of the Public Accounts of Canada Volume 1, Section 6 (Interest Bearing Debt), is performed by the Department of Finance in the Public Debt Unit of the Financial Operations and Accounting Services Division (FOAS) in the Finance and Administration Division (FAD). The following diagram illustrates the responsibility and communication matrix of the foreign asset reserves and foreign debt portfolio. Responsibility and communication of the Foreign Debt Portfolio and Foreign Asset Reserves Overall accountability and responsibility of the Exchange Fund Account (EFA) Dept of Finance Financial Markets Limited Communication Dept of Finance Public Debt Unit Foreign Liabilities Accounting Joint management of the EFA $ Provides periodic information on Liability transactions and Asset reporting Responsible for the purchase, sale and accounting of Foreign Assets through the EFA Bank of Canada Fiscal agent responsible for the issuances, interest payment and repayments of Foreign Liabilities Advises on and oversees Foreign Asset and Liability policies and strategies for funds and risk management The audit examination conducted found that key portions of the liability transactions were accounted for correctly. On the program side of foreign debt and assets, a comprehensive management framework has been developed and is being adhered to. A number of opportunities were identified, however, to strengthen procedures and reduce the residual risk currently associated with the foreign debt and asset administration programs. Recommendations The report details 9 specific recommendations to enhance the overall management control framework of the foreign currency asset reserves and debt portfolios. A Management Action 4

5 Plan is provided in Appendix B. However, three main recommendations are at the basis of the overall realignment. The Department of Finance should consider the following: Reassessment of the level of its reliance on the Bank of Canada for the processing, recording and reporting of activity and performance of the foreign assets and the foreign assets-liabilities matching program. Consideration should be given to establish substantiation processes for the foreign currency asset reserves; Enhance performance reporting that will communicate evidence-based performance information and support decision-making, accountability, due diligence and transparency. The reporting should integrate all benefits and costs of the asset-liability matching program in order to adequately evaluate performance; and, Strengthen financial analysis resources with experienced professional accountants that will provide the Financial Markets Division with appropriate, relevant information for decision-making and accurate performance reporting. The report also notes a number of specific recommendations for strengthening effective and efficient processes and procedures and to ensure compliance with Government of Canada policies. 5

6 1.0 Introduction 1.1 Authority for the project The Internal Audit and Evaluation Committee approved this project as part of the Risk-Based Audit Plan. 1.2 Environment and Background In the past decade, the world of foreign exchange markets has evolved tremendously due, in part, to increased globalization of markets and information technology. Foreign exchange reserve management is a process that ensures that adequate official public sector foreign assets are readily available to and controlled by the authorities for meeting a defined range of objectives 1. In Canada, the foreign exchange reserves are held in support of a range of objectives including liquidity of the Canadian currency and to provide a source of funds to ensure orderly conditions of the Canadian dollar. The Exchange Fund Account (EFA) is the repository of Canada s official international reserves composed of securities, bank deposits, gold and special drawing rights (SDR). The audit focuses only on the securities held in the EFA. In 1996, the Government of Canada began increasing foreign reserves to take into account the amplified flows in foreign exchange markets and brought the reserves more in line with comparable countries. Since that time, Canada s foreign reserves, and corresponding liabilities, have more than doubled. The last time the Bank of Canada undertook any official foreign exchange market intervention was in September Prior to this, Canada's policy was to intervene systematically in the foreign exchange market to resist, in an automatic fashion, significant upward or downward pressure on the Canadian dollar. The current policy is to intervene in foreign exchange markets on a discretionary basis and only in the most exceptional of circumstances. The EFA is governed by the provisions set out in the Currency Act and is not subject to the Financial Administration Act. Although the Government approves the general policies related to its management, the Department of Finance and the Bank of Canada share the management of the EFA. The Bank of Canada acts as the fiscal agent for the Minister of Finance. The Bank is also responsible for maintaining appropriate evidence supporting the amounts and disclosures in the financial statements. The financial statements, however, reflect the joint Department of Finance / Bank of Canada management responsibility 2. 1 International Monetary Fund document : Guidelines for Foreign Exchange Reserve Management 2 Foreign Exchange Account, Section 8, Public Accounts of Canada 6

7 With the purpose of funding the EFA, Canada has adopted an asset-liability management strategy whereby specific foreign assets and their funding liabilities are matched (as closely as possible) in currency and duration, so as to limit the Government s risk exposures. The audit was to originally only cover liabilities. However because of the asset-liability management framework, the audit includes the assets portion as well. The foreign asset portfolio is composed of short, medium and long-term securities and a small amount of deposits. As at December 31, 2003, US-dollar holdings make up approximately half of the portfolio. Euro and Yen holdings are heavily weighted towards the longer-term investments. The foreign debt portfolio is composed of several different financial instruments: Global Bonds Syndicated, marketable debt instrument (usually denominated in US dollars) with a fixed interest rate. Limited term to maturity (10.5 years). As at March 31, 2004, there were 6 in circulation totaling $12.8B. Canada Notes Promissory notes (usually denominated in US dollars) and available in book-entry form. Can be issued for terms of nine months or longer, and at a fixed or floating rate. Issued for foreign exchange reserve funding purposes only. As at March 31, 2004, there were 2 in circulation totaling $1.3B. Euro-Medium Term Notes Medium-term notes issued outside the US and Canada denominated in a range of currencies and structured to meet investor demands. Limited term to maturity (10.5 years). Issued for foreign exchange reserve funding purposes only. As at March 31, 2004, there were 7 in circulation totaling $3.0B. Canada Bills Promissory notes denominated in US dollars and issued only in book-entry form. Mature not more than 270 days from their date of issue, and are discount obligations with a minimum order size of US$1,000,000 and a minimum denomination of US$1,000. Issued for foreign exchange reserve funding purposes only. As at March 31, 2004, there were 197 in circulation totaling $3.4B. Swaps (derivative) Contractual agreements between two parties to exchange a series of cash flows. For crosscurrency interest rate swaps, principal amounts and fixed and floating rate interest payments are exchanged in different currencies. At the end of each period, the parties to the swap contract settle up based on agreement. Limited term to maturity (10.5 years). As at March 31, 2004, there were 230 swaps outstanding totaling $24.6B. 7

8 The increased government focus on accounting and financial reporting exercises constant pressure on financial operations to properly communicate accurate and sufficient information in the Public Accounts of Canada. Appropriate presentation of the information is critical to support accountability, due diligence and transparency of the Department of Finance. 1.3 Audit Objectives The objectives of the audit were to: Assess the extent to which administrative controls surrounding the foreign debt and foreign asset currency reserve portfolios are in compliance with relevant legislation, Treasury Board Secretariat polices and Generally Accepted Accounting Principles (GAAP); Assess the extent to which management control mechanisms are in place and operating effectively; and Document, for current and future use, the key activities, accountabilities and control points in foreign debt and foreign asset administration. 1.4 Audit Scope The audit focused on the efficiency, effectiveness and completeness of the administrative controls in place over the financial recording and reporting of the transactions and balances that comprise the Foreign Debt portfolio. As issuances of foreign debt liabilities are supported by purchases of foreign assets, the audit examined administrative controls in the Department of Finance over both foreign liabilities and foreign assets. The audit team worked primarily with personnel in the Financial Operations and Accounting Services Division and the Financial Markets Division and would like to thank both areas for the time and support they provided to the audit. 1.5 Audit Methodologies and Work Performed The audit methodology incorporated the knowledge and the sources of information identified during the Public Debt Risk Assessment and the Audit of Administrative Controls over the Domestic Debt and are in compliance with Internal Audit methodology used in the federal government. The audit methodology consisted of: Identifying and reviewing authoritative directives for foreign debt recording and reporting; Reviewing a sample of foreign debt and asset transactions and the supporting documentation maintained in the Department of Finance; 8

9 Interviewing representatives of various entities involved in the management, recording and reporting of the domestic debt and reviewing documentation and reports produced and / or utilized in their areas. (List of interviewees presented in Appendix A) Foreign debt and assets activities and controls were assessed with regards to: The compliance of foreign debt accounting practices with Generally Accepted Accounting Practices (GAAP) and Treasury Board Directives. The role of the Bank of Canada and co-ordination of the Bank of Canada s activities with Department of Finance. The process for authorizing transactions and its compliance with relevant legislation. Recordkeeping related to the role of the Bank of Canada as transfer agent and the role of other institutions, including, JP Morgan Chase Bank of New York, Royal Bank of Canada in London, Deutsche Bank AG, Bank of New York and Citibank, who act as agents for the Government for the foreign currency denominated debt. The information and reports required and provided to facilitate the management of the foreign debt and asset portfolios. Public Accounts of Canada reporting (with significant reliance on the reports of the Office of the Auditor General), particularly with regard to the OAG audited financial statement of the Exchange Fund Account. The authorization and confirmation of foreign liability and asset information reported on the Department of Finance website. 9

10 2.0 Audit Observations and Recommendations 2.1 Governance Legislative Governance Audit Criteria In a well-managed government activity, there is a clear trail from the enabling legislations to the management processes and reports. Audit Observations Direction and authority for foreign assets and liabilities activities derives from three enabling federal acts; Financial Administration Act defines oversight for Public Debt, Currency Act establishes the Exchange Fund Act and defines its role and accountabilities, and Bank of Canada Act establishes the Bank of Canada and defines its role and responsibilities as fiscal agent to the Government. These acts lay the management framework for foreign assets and liabilities. Specific required strategic authorities and reports are identified. For example: The Financial Administration Act (FAA) requires two oversight Governors in Council (GIC); one which authorizes the amount that can be borrowed in a fiscal year, and a second which authorizes the Minister of Finance to enter into contracts and agreements, including options, swaps and forwards. The Currency Act requires that the Minister of Finance report to Parliament on the Exchange Fund Account (accompanied by an OAG audit report), each calendar year. The Bank of Canada Act requires that at the end of each financial year, the Bank must send the Minister its audited financial statements for the year. Copies of the two GICs referenced in the FAA were obtained and reviewed; GIC P.C noting the approved annual amount that may be borrowed and designating key authorities to senior staff in the Department of Finance, and GIC P.C which sets the dollar limit for swap activity. All strategic authorities and reports, and legislated delegations are consistent with corresponding legislative acts. Recommendation None. 10

11 2.1.2 Management Governance Framework Audit Criteria Management policies and frameworks exist to structure and direct performance. Audit Observations In order to expand on the legislative outline provided, the Department of Finance and the Bank of Canada have developed and implemented two key documents of management framework. The first document is the Memorandum of Understanding on Treasury Risk Management between the Bank of Canada and the Department of Finance (the MOU). This document, which has been signed by both parties, outlines the focus of treasury risk management, the policy and principal document that will be adhered to, the roles and responsibilities of the Department of Finance and the Bank and the period the agreement will remain in place. The second document is the management framework document that is referenced in the above noted MOU. This document is the Treasury Management Governance Framework (the Framework). The Framework defines the objectives, the operational practices, the roles and responsibilities, coordination and control, and performance management for managing the government s assets and liabilities. The MOU and the Framework envision management as being supported by a number of specifically defined joint committees. The following key joint committees are outlined: Fund Management Committee (FMC) Oversees all activities covering wholesale debt, cash management, reserves and risk control; Advises the Minister through the Deputy Minister on policy and strategy for funds and risk management; Meets semi-annually and on an ad-hoc basis. Members Finance: Associate Deputy Minister and Assistant Deputy Minister Bank of Canada: Deputy Governor 11

12 Funds Management Coordinating Committee (FMCC) Discusses key issues, develops policy advice and provides on-going coordination of work on wholesale debt, reserves and cash management; Proposes the agenda for the FMC meetings and ensures the reports on performance outcomes are provided to the FMC; Typically meets once a month. Members Finance: Director Financial Markets Division, Chief Debt Management Policy and Chief Reserves and Risk Management Bank of Canada: Chief Financial Markets, Directors and Team leaders/senior Officer Debt Management and Settlement Systems, Foreign Reserves Management, Market Analysis and Operations, Financial Risk Office Risk Committee (RC) Provides advice to the FMC and the Reserves and Risk Management Section on the risk implications of recommendations from the Foreign Reserves Management Working Group; Responsible for maintaining and updating the Risk Management Framework; Typically meets twice a year. Members Finance: General Director, Financial Sector Policy Branch and one other senior level officer (external to FSP); Bank of Canada: Advisor, Risk (Financial Markets) and one other senior level officer. The Director of Financial Markets Division (FMD) and the Chief of Reserves and Risk Management for the Department of Finance confirmed that the above-mentioned committees are in place. Further, a FMC meeting report and a FMCC meeting agenda were reviewed. Currently, the majority of members on the three key management committees from the Department of Finance are the same who have responsibility for managing the assets and liabilities. Only one committee member, a member of the Risk Committee, does not hold a job responsibility for managing the Public Debt. Consideration has been given to bring further independent perspective to the committees by expanding membership to other outside subject matter experts. To date, this concept has not been pursued largely because much of the material reviewed by the committees is very sensitive. The MOU states that the Bank of Canada is to maintain a Financial Risk Office (FRO) that functions independently from the funds management operations at the Bank of Canada. The FRO prepares the key monthly management report which the Department of Finance relies on for tracking foreign asset and liability matching and performance to the FMD. This reporting relationship provides Department of Finance with assurance concerning the Bank s independence: Rather than reporting to the financial management and operations area of the Bank of Canada, the FRO reports to the Adviser, Strategic Planning and Risk Management, who reports directly to the Governor of the Bank of Canada. 12

13 The Bank of Canada is the only transactional and information custodian of the Exchange Fund Account (EFA). The authority is not a legislated mechanism but rather delegated by the Department of Finance through the MOU. To ensure value of the management committees, regular, informed and structured reviews of performance information should occur. An opportunity exists to include a senior member of the Financial Operations and Accounting Services (FOAS) to these committees to increase the ability to obtain and provide financial information to the decision-making processes. The participation of the FOAS at the FMCC would greatly benefit the overall financial information and appropriate cost analysis needed for sound decision-making and due diligence. This participation would also strengthen stewardship of the committee and would significantly benefit the Public Debt Unit with a direct source of information to upcoming transactions and workload expectations. Recommendation 1. It is recommended that the Assistant Deputy Minister, Financial Sector Policy Branch add a senior, technically proficient, member of Financial Operations and Accounting Services management (senior manager or above) to the Financial Management Coordinating Committee. Management Action 1. A senior member of Financial Operations and Accounting Services (FOAS) was included as part of future Funds Management Coordinating Committee (FMCC) meetings in order to enhance the understanding and information flow. 13

14 2.2 Human Resource Management Audit Criteria Staff members should be equipped with the necessary skills and expertise to permit them to perform their jobs well and to permit them to understand the basic processes and risks associated with their component of the workflow. Audit Observations Interviews with management in the Financial Markets Division (FMD) revealed that the staff in the unit with responsibilities for foreign debt and assets are professional economists where most are Chartered Financial Analysts. In addition, individual annual development plans are prepared and staff members are encouraged to participate in professional associations and seminars. For example, the Chief of Reserves and Risk Management is a member of the Canadian Foreign Exchange Committee. Furthermore, in audit interviews and discussions, it was noted that the staff members were able to readily respond to questions and explain processes and supporting documentation. The majority of staff within the Financial Operations and Accounting Services (FOAS) are more administrative in nature as, historically, the transactions only required a focus on entering transactions in accordance with previously established templates. It has not been necessary for staff to understand the program risks or process controls involved with the transactions they recorded. When probed, some of the staff members had difficulty explaining why transactions were recorded as they were. Corporate knowledge, within FOAS and Financial Markets Division (FMD), rests with key individuals. This knowledge may be lost unless steps are taken to mitigate this risk. In addition, the lack of formal policies and procedures may lead to tasks being carried out incorrectly or by an unauthorized individual. Regularly updating departmental policies and procedures also give management the opportunity to revisit the workflows and reevaluate their effectiveness and efficiency. Under the direction of the Office of the Comptroller General, the Government of Canada has been moving to strengthen its financial management capacity. Expected results include ( ) effective and fully qualified financial management professionals ( ) who provide value added service to their deputy heads, and are supported by certification standards, fully developed corelearning curricula, specialized programs for recruitment and retention. 3 The recent change in environment, along with increased government focus on full accrual accounting and monthly financial reporting, elevates the need to strengthen financial positions to ensure appropriate expertise is available and offered to effectively support the needs of the Department of Finance Priorities of the Office of the Comptroller General 14

15 Interviews revealed that the FOAS management also prepares annual employee development plans. Without appropriate succession planning in place, there is a potential risk of problems with continuity, corporate knowledge and integrity of information. Three of the most experienced and knowledgeable staff members have recently moved to other positions within the Department of Finance: because they have all moved within the same Division, this allowed for extensive over-lapping of work assignment and knowledge transfer. A strengthened and updated succession plan would ensure that unplanned staff rotation creates minimal impact on the Division s operations. Recommendations 2. It is recommended that the Assistant Deputy Minister, Corporate Services Branch consider staffing to include experienced professional accountants to ensure appropriate level of credibility of the services offered, better challenge functions and meaningful interactions with departmental policy areas. 3. It is recommended that the Assistant Deputy Minister, Corporate Services Branch consider formalizing succession planning and training opportunities. Management Actions 2. As per the recent reorganisation on June 1, 2005, the Public Debt Section now reports directly to the Executive Director, Finance and Administration. The Section now has a full-time manager whose position must have a professional accounting accreditation. The Public Debt Section has also added more FI (Financial Management classification) group positions (e.g. 1 FI-1, 1 FI-2 and 1 FI-4). This allows for opportunities for succession and progression within the Section. 3. Agreed. This has been addressed as explained in the previous response. A training plan is required for each staff member within the Finance and Administration Directorate. A joint training event has been held for all staff within the Public Debt Section with Financial Sector Policy Branch (FSPB) and the Office of the Comptroller General (OCG) on Financial Instruments. 15

16 2.3 Management Information Managing of operations is based on timely and valuable information. Relevant information should be appropriately tracked and reported to management for decision-making. Valuable information measures and analyses performance corresponds with planned results and objectives. Audit Criteria The Treasury Management Governance Framework identifies the following funds management objectives for foreign reserves management: Maintain foreign currency liquidity including funds needed to promote orderly conditions for the Canadian dollar in foreign exchange markets. o Maintain appropriate level of reserves while minimizing the cost of carrying reserves. o Minimize interest rate and currency risk in funding reserve assets. o Maintain diversified funding sources and a prudent liability structure. Consequently, one would expect to find management reports in place that speak to the above noted objectives. Audit Observations For decision-making information, all reports are produced entirely at the Bank of Canada with information on both foreign currency assets and liabilities kept in their records. There is no reconciliation with independent sources within the Department of Finance to ensure appropriate level of confidence of the information used for decision-making. As detailed in section 2.4 and 2.5, the Department of Finance does not maintain detailed records of the foreign currency assets that would permit any reconciliation to be performed but there is extensive information available on the foreign currency liabilities. Each month, the Bank of Canada prepares a report entitled The Exchange Fund Account Monthly Performance and Risk Report. This is a new report that combines two previous reports, performance and risk, into one. This report provides detailed information on the levels of the foreign reserves, and foreign currency assets and liabilities balances and aggregate performance information such as Cost of Carry (difference between interest received and paid) and Total Return by Currency information. Additionally this report includes two types of forward-looking analysis techniques: stress test scenario analysis and sensitivity stress testing. These tests are performed in order to assess the risk and vulnerability of the reserve portfolio and to regularly ascertain potential effects of economic and financial variables. 16

17 There are two areas of performance reporting which were not evident; full dollar costing of financial instruments and cost of carry information on the various types of instruments over time. The current Cost of Carry report covers interest earned and interest paid. The report does not include legal costs, contract and other fees paid to third parties and differences in administration costs between the various types of instruments. Similarly, there was no report analyzing returns by types of instrument beyond a one-year period. Certain legal costs, contract and other fees are being paid directly by the Department of Finance and the Bank of Canada and are not used in evaluating results. For example, foreign liability fees are accounted for differently depending on the invoice recipient. The audit discovered that the fees received by FOAS (Public Debt Unit) were accounted for in the Fund Center 413 whereas fees received and paid by Financial Markets Division were paid through Fund Center 409. Because fees are being presented in two different Fund Centers, the actual performance results of the management of foreign assets and liabilities may not be complete or accurate. When determining which types of financial instruments to use, the absence of full costs by types of financial instrument and the absence of multi-year returns, limits the benefits of performance evaluation used for decision-making. Recommendation 4. It is recommended that the Assistant Deputy Minister, Financial Sector Policy Branch institute a policy to ensure that, to the extent possible, all investment costs are to be attributed to the financial instruments that gave rise to them. Management Action 4. Investment costs not included in the measure of carry are negligible relative to interest expenses and are not necessarily attributable to specific programs (e.g. legal fees). However, Financial Sector Policy Branch (FSPB) will introduce these costs on an aggregate basis in the future. These other costs will now be coded to the same fund centre which will allow for easier and more accurate reporting. 17

18 2.4 Compliance with Generally Accepted Accounting Principles (GAAP) and Treasury Board Secretariat (TBS) Directives Foreign Liabilities The Foreign Currency Liabilities are incurred solely to finance the Foreign Reserve Assets in the Exchange Fund Account (EFA). The liabilities are reported through the Public Accounts of Canada, Volume 1, Section 6 Interest-bearing Debt. The cross-currency swaps do not appear in the Public Accounts of Canada. Audit Criteria The Treasury Board Accounting Standards state that Departments will follow Generally Accepted Accounting Principles (GAAP) as defined in the Canadian Institute of Chartered Accountants Public Sector Account Handbook and the Financial Administration Act (FAA). The Standards also state that to ensure appropriate level of consistency throughout Government, departments will establish accounting policies specific to their needs. Formal processes and procedures are important in all organizations to ensure compliance with government policies and regulations, knowledge sharing and that information is available for consultation. In accordance with GAAP, FAA and TBS, accounting practices should support the following attributes of information: Existence Accuracy Authorization Timeliness Completeness Presentation and Disclosure Audit Observations Policies and Procedures The Public Debt Unit of the Financial Operations and Accounting Services in Corporate Services Branch (CSB) is responsible for accounting of the foreign exchange liabilities. Only one accounting policy, Gain or Loss on Foreign Exchange Transactions, was available for review during the course of the audit. For every type of financial instrument, there are system descriptions that outline the general definition and processes used. These descriptions are updated yearly and submitted to the Office of the Auditor General for review and audit of the debt transactions as part of the Public Accounts audit. However, these documents were not readily available for consultation and some key staff members were not aware of their existence. 18

19 With the help of outside consultants, Financial Operations and Accounting Services (FOAS) are developing process maps of all Public Debt procedures. These descriptions and procedures are important tools for transmitting information on the Public Debt Unit s environment and responsibilities. Financial Instruments (Bonds, Bills and Notes), Derivatives (Swaps) and related fees Appropriate and adequate audit trails existed for all transactions tested. The file review demonstrated that sufficient evidence was available to support the legitimacy of the liabilities. The audit has revealed a high level of accuracy of transactions. Errors that occurred were detected and corrected internally in a timely manner. Monthly interest accruals are calculated independently for each financial instrument and reversed when the interest payment is made. The exchange rate used for most transactions is the latest available rate on the transaction date. For Canada Bill transactions, some discrepancies were found when applying the appropriate rate at maturity the rate being used is the issuance rate. Although materiality may be low, there should be effective compliance to internal accounting policy and TB Policies. Authority for transactions lies within the FMD and therefore, FMD should provide section 34 authorization for all payments relating to the Foreign Assets transfers to the EFA and for all disbursements relating to the Foreign Liabilities. Authorization for payments should be confirmed by FMD in accordance with the TBS Account Verification Policy which states: All payments and settlements must be verified and certified pursuant to section 34 of the FAA. Furthermore, the ( ) Financial officers with payment authority pursuant to FAA section 33, must provide assurance of adequacy of the section 34 account verification and be in a position to state that the process is in place and is being properly and conscientiously followed. FMD authorizes the Bank of Canada, its fiscal agent, to execute broad orders on various transactions. The specific payment transactions are executed by the FOAS (Public Debt Unit) in the Department of Finance. The audit has revealed that the following disbursements were not appropriately authorized by the FMD prior to payment: All transfers from the Consolidated Revenue Fund Euro Medium Term Notes, Canada Bonds and Canada Notes Commissions and discounts Interest Payments Maturities Canada Bills Issuances Fees Maturities Swaps Interest Payments Maturities 19

20 Lack of appropriate FAA section 34 authorization is a direct violation to the FAA and a section 33 compliance deficiency. The absence of appropriate authorization exposes the Department of Finance to unnecessary risks and non-compliance to policies and legislation. Solicitor-client privilege applies here. Timeliness of transactions ensures an appropriate level of accuracy in information. All transactions were entered in timely fashion. Public Debt Unit supports completeness of information through the monthly reconciliations and reviews of all liability instruments. The audit included analysis and comparison with available information on the outstanding debt in the Bank of Canada and the Department of Finance, Public Debt Unit records. Presentation and disclosure for the sections of the audited 2003/2004 Public Accounts statements relevant to the foreign debt were reviewed. Information on all financial instruments (liabilities) is available both at the Bank of Canada and the Department of Finance Public Debt Unit. Details of foreign liabilities are published yearly by the Bank of Canada in the Summary of Government of Canada Direct Securities and Loans booklet. Consolidated information on unmatured debt is published in Section 6 of the Public Accounts of Canada. Prior to 2003/2004 Public Accounts of Canada, the Interest-Bearing Debt Section offered valuable information on unmatured debt, supported by information on maturities that was widely used in several Divisions within the Department of Finance. By having extended information on liability maturity available in the Public Accounts of Canada, official records existed that was widely used and referenced from year to year. The 2003/2004 PAC information on unmatured debt has been consolidated. Interviews with several different divisions within the Department of Finance could not conclude on the reason for this consolidation of information but there was concern as to the lack of available information internally on the data available on unmatured debt. Recommendations 5. It is recommended that the Assistant Deputy Minister, Corporate Services Branch ensure that: i. Consideration is given to expanding / communicating the internal accounting policies and procedures to ensure an appropriate level of guidance for all transactions unique to the Department of Finance. ii. Interest rate accruals are refined so that the accumulated accruals are as close as possible to the actual settlements. iii. All foreign currency transactions are translated into Canadian dollar equivalents using rates of exchange in effect at the transaction date. iv. All authorization procedures are reviewed for compliance with policies and legislation specifically regarding disbursement transactions and ensure clarification of roles, responsibilities and accountability at the transactional level for the foreign currency liability portfolio and of the transfer of funds to the EFA. 20

21 v. Official records on debt maturity should be available and communicated within the Department of Finance stakeholders, which will ensure appropriate level of confidence and permanence of information. 6. It is recommended that the Assistant Deputy Minister, Financial Sector Policy Branch ensure that the master Bill Agreement with JP Morgan is formally revisited to incorporate any new financial markets development and legal safeguards. Management Actions 5. i) The Public Debt Section has made significant progress in reviewing and documenting accounting treatments and activities. A significant portion of the key processes have been mapped and documented. Staff has been engaged in this process, which has elevated the knowledge base of the team. A review of our accounting practices in preparation for audited financial statements has also been completed. ii) Reconciliation is done on the difference between what is paid and what was accrued for. The difference is re-balanced semi-annually for each payment date, and at year-end an entry is done to adjust the difference in the currency. The monthly difference is not material but will continue to be monitored. iii) The revaluation of foreign assets and liabilities is done at year-end only. Therefore, all gains/losses on revaluation of liabilities and assets offset one another. For example, when a Canada Bill is issued at the rate of , an asset (cash) is also received at the same rate. At maturity, the Canada Bill is redeemed at the original rate. Same situation when cash is used to redeem a Canada bill. If the rate at the time of transaction is used, then the same rate would be applied for the cash and there would be no gain or loss. This will be re-valuated based on the training on Financial Instruments that will take place in June iv) Agreed. Since the audit, authorization procedures have been revised for interest payments and maturities related to swaps, Canada Bills fees, foreign debt interest and commissions. It is part of the mandate of the Bank of Canada, as the government s fiscal agent, to process transactions of Canada Bills. Assurance of the balance is obtained through a monthly reconciliation process with the Bank of Canada and JP Morgan. A review of the design and procedures for the Canada Bills program, is planned for

22 v) The Public Accounts of Canada is produced for a general audience with general needs. The Treasury Board Secretariat (TBS) decided that the public debt information reported in the Public Accounts was more detailed than required. Therefore, the Public Accounts no longer contains the same level of detail on the public debt as was contained in older versions of the publication. Although no longer reported in the Public Accounts, the same detail is available on demand from the Public Debt Section. Fiscal Policy Division is now provided with information that is more detailed than what was previously publicly reported and it is available in a more timely manner on a monthly and annual basis. 6. Solicitor-client privilege applies here. 22

23 2.4.2 Foreign Asset Reserves The Foreign Asset Reserves is an actively managed portfolio of liquid foreign currency maintained to provide the funds needed to help promote orderly conditions for the Canadian dollar in foreign currency markets and to provide foreign currency liquidity for the Government of Canada. These assets are managed and reported through the Exchange Fund Account (EFA). Audit Criteria Effective control systems are important to ensure reliance can be given to the information provided. Appropriate control systems generally will include adequate segregation of duties, risk management monitoring, management oversight and other policies and procedures designed to ensure that the entity s control objectives are met. Those control objectives include; authorized execution, complete and accurate information, prevention or detection of errors, ongoing monitoring and appropriate valuation. Audit Observations The Exchange Fund Account (EFA) operates under provision in Part II of the Currency Act. Section 22. (1) of the Act states: The Financial Administration Act does not apply to the Exchange Fund Account or operations or transactions in connection with the Account. Furthermore, in accordance with Section 22(2), the Auditor General ( ) shall make an annual audit of the Exchange Fund Account ( ). The Bank of Canada not only acts as the Government s fiscal agent as it pertains to the foreign exchange transactions, it also maintains the only accounting records of the assets in the Exchange Fund Account (EFA). During the course of this audit, only the Department of Finance s activities related to assets were reviewed. No review was conducted of the asset related activities performed by the Bank of Canada. Reliance was placed on the EFA Financial Statements audited by the OAG. The OAG audit is an audit of financial statement balances at a point in time. It does not address the appropriateness of internal or management controls. Assets in the EFA represented $41.2B as at March 31, Although management responsibility and accountability lie within the Department of Finance, the audit revealed they perform minimal record keeping oversight and receive incomplete performance reporting on expenditures related to the fund. Transaction tracking performed relative to the EFA at the Department of Finance is limited to tabulation of advances and repayment made through the account to support the assets presented in the EFA. 23

24 There are daily transfers to and from the EFA account to ensure the Canadian cash component of the account does not surpass one million dollars. Monthly reconciliations of EFA Advances and Repayments are performed at the Department of Finance (Public Debt Unit) to the Advances balances in the monthly. These are only partial reconciliations of the EFA because the exchange rate used for valuation is different from the Bank of Canada to the Department of Finance. Only on December 31 and March 31 are full reconciliations performed to ensure the amount presented on the EFA Balance Sheet as Advances from the EFA corresponds with amount indicated in the asset account of the Department of Finance Foreign Exchange Account. The Bank of Canada monthly report on EFA entitled FX Summary Trial Balance Exchange Fund Account report is sent to the Department of Finance Public Debt Unit and the Fiscal Policy Division. Although this report includes balances of all accounts, there is no indication that complete EFA reconciliation is exercised within the Department of Finance for other than the Advance and Repayment accounts. The Department of Finance does not monitor or reconcile any part of the other transactions within the Exchange Fund Account. This exposes the Department of Finance to risks of communicating inaccurate information, of undetected errors and of inappropriate or unauthorized use of the EFA. The yearly report entitled Report on the Management of Canada s Official International Reserves reviews operations of the EFA for each calendar year. Although this report is produced by the Department of Finance, the Bank of Canada provides information such as the financial statements and the facts, figures and information needed to populate charts, graphs and tables. Historically, the relationship between the Bank of Canada and the Department of Finance has been one of unconditional trust. The Department of Finance and the Bank of Canada are two separate and distinctive entities that gravitate within different legal and regulatory environments. The absence of independent confirmation of asset management and performance reporting controls may expose the Department of Finance to risks of undetected operational or reporting misstatements. Furthermore, expenditures related to the fund are not subject to the rigorousness of the FAA authorization processes. The absence of independent confirmation of appropriate controls also exposes the Department of Finance to unnecessary risks of incomplete costs relative to management of the foreign reserve portfolios and this approach may not withstand the test of public scrutiny. Recommendation The recommendation for this section is closely linked to recommendations stated subsequently. For enhanced clarity, the recommendation was moved to Section

25 2.5 Public Reporting Audit Criteria Appropriate procedures should be in place to ensure that public reporting activities are performed in a timely, accurate and complete manner. The reporting should be balanced, transparent and easy to understand. Audit Observations The Auditor General audits the Public Accounts of Canada. In order to assess whether there were significant problems related to the Public Accounts reporting, a meeting was held with representative of the Office of the Auditor General (OAG). In addition, the Public Accounts audit report for and the Auditor General Management Letters to the Department of Finance on the Public Account of Canada audits for the years 2002/2003 and 2003/2004 were reviewed. The Department of Finance responded to the debt related points in Management Letters with an undertaking to either correct the reported problem or to complete a detailed analysis to identify the best course of action to address the issue. It should be noted that two recommendations in the 2002/2003 Management Letter are repeated in the 2003/2004 Management Letter: These recommendations were relating to the Monitoring of Public Debt Charges and the Verification of 3 rd Party Information. Information on foreign debt for monthly and annual Public Accounts originates from Public Debt Unit, under FOAS, at the Department of Finance whereas the Bank of Canada provides information on foreign assets. Other areas involved in monthly or yearly reporting include: 1. The Bank of Canada maintains the only records and prepares monthly and annual reports on all foreign asset transactions executed for the Exchange Fund Account (EFA). The Exchange Fund Account financial statements are reported yearly to parliament as part of the Report of the Management of Canada s Official International Reserves as legislated in the Currency Act. The Auditor General, on behalf of the Department of Finance, audits the EFA financial statements. Both Bank of Canada and Department of Finance sign the Management Responsibility Statement of the financial statements. 2. The Central and Public Accounts Reporting Directorate (CPARD) in PWGSC prepares monthly-accrued financial statements (both balance sheets and income statements) for the government. They are also responsible for preparing year-end reports to be imported to the yearly Public Accounts of Canada. Relative to foreign debt, only reasonableness checking is done of values reported. 3. The Fiscal Policy Division in the Department of Finance is responsible for preparing the monthly Fiscal Monitor that reports on highlights and details of the Government of Canada s fiscal performance. The Fiscal Monitor is uploaded to the Department of 25