Risk Management Archives

Are You Leaving Money on the Table? How a Contract Audit Can Help You Find Savings in a Turbulent Market Environment

You put a lot of time and energy into vetting vendors and drafting contracts. Even if things are going well with the vendor, whether you have worked with them for six months or six years, a contract audit can help ensure that contractual obligations are fulfilled and you reap the full benefits of the arrangement.

Your company can prepare for a contract audit by determining which questions to ask and what factors to consider to ensure beneficial relationships with third parties. You should not leave any money on the table if you are contractually entitled to it — especially amid market volatility.

Questions to ask

Prior to commissioning a contract audit, you should ask yourself a few questions related to the vendors and suppliers you work with. Questions will vary according to your line of business and the nature of your arrangement with the third party, but the following queries can serve as guidelines:

Has there been an increase in what vendors charge you?
Are there clauses in your contracts that cover price escalation? If so, has there been a significant change in the way costs are calculated?
Do you have most favored nation (MFN) clauses built into your contracts? If so, has your company verified the validity of those or similar clauses to make sure you get what was agreed to?
Is your company missing out on cost savings by not monitoring contracts?

Factors to consider

An audit can ascertain whether third parties are honoring all terms of the contract. A common area of for audit review is whether the third party is adhering to the terms of a contract’s MFN clause, which dictates that the company will benefit from priority pricing and terms.

Cost savings are always a key area of consideration when assessing partnerships, but a recessionary economic climate adds greater urgency to companies’ decisions to conduct a contract audit. A contract audit can show that you’re being overcharged under the agreed-upon terms and therefore could recover previous overpayments and avoid them going forward.

Example: Analyzing Pass-Through Costs

A college admissions consulting firm relies on a boutique communications firm to handle their marketing initiatives. Though the contract states pass-through costs encompass postage and delivery services, the consulting firm wonders if the communications vendor has chosen more expensive delivery options than stipulated under the contract. An audit conducted by a contract specialist shows where certain pass-through costs do not meet the terms of the contract, which facilitates recovery and future savings.

In a contract, particularly a long-term contract, every penny counts. That is especially relevant amid a high-inflation environment affecting labor, materials, and utilities costs, as well as rising interest rates and other market headwinds. Annual pricing adjustments should be reviewed carefully, and some contracts may also include volume-based or index-based pricing terms. An index can change on a daily basis, so even a penny on the index can make a significant difference.

Example: Analyzing Annual Adjustments

A chain of regional clothing retailers has a long-term sales contract with a garment manufacturer. The contract includes a clause that states items’ base selling price can be adjusted on an annual basis, according to changes in machinery, materials, and labor costs. A contract audit helps the clothing retailer determine where annual price adjustments do not fully align with fluctuations to costs in the data sets outlined in the contract and recoup some of the increased costs.

Inflation and the rising cost of doing business can also change the dynamic of partnerships. Third parties might begin requesting your company cover the rising costs of materials, labor, transportation, and other areas not explicitly stated in the contract. A contract audit can determine whether the price you are paying is consistent with market rates.

Example: Adherence to Contract Terms

A chain of Southern-style restaurants supplement revenue by selling mugs, t-shirts and home décor that celebrate country living. The merchandise supplier has recently begun charging the restaurant chain a higher rate to cover rising freight costs. Feeling the pinch, the chain hires a professional advisory firm to perform a contract audit. The audit reveals that the existing contract does not permit the supplier to charge the restaurant chain a higher rate for shipping costs, even if these costs have risen for the supplier. The merchandise supplier agrees to pay back the restaurant chain the difference for the higher freight charge.

The benefits of using an experienced advisor

Hiring an advisory firm to review a contract is not an adversarial act. Instead, working with experienced professionals helps ensure the arrangement benefits all parties, and it can strengthen the relationship further. Audits that uncover discrepancies between agreed-upon terms and operations are a critical first step toward recovering funds and refining operations for additional value, whether that means seeking a vendor that is a better fit or moving forward with the same vendor in a more equitable manner.

Audits that reveal operations are cost-effective and in alignment with contractual terms also provide value. They can tell you what to prioritize as you embark on new contracts with future vendors or enter contract renewals and renegotiations with existing partners.

There may even be instances when you decide to accept the terms of your suppliers and vendors, even if audit findings show the terms are not in the agreed-upon contract. While a contract audit can be a catalyst for contract revision, it does not have to be. The benefit of a contract audit is the insight and foresight to make the best decision for your business.

Realizing the full value of your relationships

Contracts between companies and third-party vendors can be complex. Particularly when faced with economic uncertainty, it is crucial for companies to prioritize and pursue partnerships that serve their interests and support cost savings.

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Bank Stress Tests – Two Approaches, Four Methods

Should you be stress testing your borrowers?

Most banks are familiar with the concept of stress testing: By evaluating the impact of adverse external events on a bank’s earnings, capital adequacy and other financial measures, stress testing can be a highly effective risk management tool. And while community banks generally aren’t required to conduct stress testing, banking regulators view it as a best practice.

For example, Office of the Comptroller of the Currency (OCC) guidance considers “some form of stress testing or sensitivity analysis of loan portfolios on at least an annual basis to be a key part of sound risk management for community banks.” Stress testing is often performed at the enterprise, or portfolio, level. However, testing at the individual loan level — beginning during the underwriting process — can be a powerful technique for revealing hidden risks.

Two approaches, four methods

Stress testing generally involves scenario analysis. This consists of applying historical or hypothetical scenarios to predict the financial impact of various events, such as a severe recession, loss of a major client or a localized economic downturn. Tools for performing such tests can range from simple spreadsheet programs to sophisticated computer models.

The OCC’s guidance doesn’t prescribe any particular methods of stress testing. It describes two basic approaches to stress testing: “bottom up” and “top down.” A bottom-up approach generally involves conducting stress tests at the individual loan level and aggregating the results. In contrast, a top-down approach applies estimated stress loss rates under various scenarios to pools of loans with similar risk characteristics.

The guidance outlines four methods to consider:

Transaction level stress testing. This estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower’s ability to service debt.
Portfolio level stress testing. This method helps identify current and emerging loan portfolio risks and vulnerabilities (and their potential impact on earnings and capital) by assessing the impact of changing economic conditions on borrower performance, identifying credit concentrations and gauging the resulting change in overall portfolio credit quality.
Enterprisewide stress testing. This considers various types of risk — such as credit risk within loan and security portfolios, counterparty credit risk, interest rate risk and liquidity risk — and their interrelated effects on the overall financial impact under a given economic scenario.
Reverse stress testing. This approach assumes a specific adverse outcome, such as credit losses severe enough to result in failure to meet regulatory capital ratios. It then works backward to deduce the types of events that could produce such an outcome.

The right approach and method for a particular bank depends on its portfolio risk and complexity, as well as its resources. Even a simple stress-testing approach can produce positive results. (See “Canada’s mortgage stress-testing law.”)

Stress testing and the underwriting process

A bottom-up approach at the transaction level may offer a significant advantage: In addition to assessing the potential impact of various scenarios on a bank’s earnings and capital, it can, according to the OCC, help the bank “gauge a borrower’s vulnerability to default and loss, foster early problem loan identification and strategic decision making, and strengthen strategic decisions about key loans.”

For example, when evaluating a loan application, consider gathering information on the various risks the borrower faces — including operational, financial, compliance, strategic and reputational risks. This information can be used to run stress tests that measure the potential impact of various risk-related scenarios on the borrower’s ability to pay. An added benefit of this process is that, by discussing identified risks and stress test results with borrowers, you can help them understand their risks and develop strategies for managing and mitigating them, such as tightening internal controls, developing business continuity / disaster recovery plans or purchasing insurance.

A powerful tool

Stress testing is an important part of a community bank’s risk management process. It can also be a powerful tool for evaluating loan applications and revealing hidden vulnerabilities that may jeopardize potential borrowers’ ability to pay down the road.

Sidebar: Canada’s mortgage stress-testing law

Canada takes an interesting approach to evaluating mortgage loans. Under a law that took effect in 2018, federally regulated banks are required to “stress test” all mortgage applicants. To pass the stress test, an applicant must qualify for a loan at the contractual interest rate plus 2% or at the Bank of Canada’s five-year benchmark rate (5.19% at press time), whichever is higher. So, for example, a borrower applying for a 3.75% mortgage would have to qualify for a mortgage at 5.75%. The rule doesn’t apply to borrowers who are renewing a mortgage with the same lender.

The idea behind the law is that requiring borrowers to qualify at a higher rate than they’re actually paying prevents them from overextending themselves. And since the law took effect, delinquency rates are down. But the law is also controversial because, among other things, it reduces purchasing power for many homebuyers and the benchmark rate is susceptible to manipulation by the largest banks. © 2020

Transaction level stress testing. This estimates potential losses at the loan level by assessing the impact of changing economic conditions on a borrower’s ability to service debt.

Enterprisewide stress testing. This considers various types of risk — such as credit risk within loan and security portfolios, counterparty credit risk, interest rate risk and liquidity risk — and their interrelated effects on the overall financial impact under a given economic scenario.

Reverse stress testing. This approach assumes a specific adverse outcome, such as credit losses severe enough to result in failure to meet regulatory capital ratios. It then works backward to deduce the types of events that could produce such an outcome.