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Cost of Compliance

Method · January 2021

DOI: 10.13140/RG.2.2.14375.98720

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 Cost of Compliance
Michael W. Hoche∗
[email protected]

January 10, 2021

Abstract

This paper defines expenses incurred to adhere to regulations also known as cost of compliance. We provide
an analysis of these cost and an economic model for informed decision making when investing or divesting
compliance engagement.
Keywords: Compliance Management, Compliance Management Systems, Economics

Contents v Opportunity costs . . . . . . . . . 3

vi Macro-economic costs . . . . . . 4
I Introduction 1
V Economic Evaluation 4
i Definition . . . . . . . . . . . . . 1
i Example . . . . . . . . . . . . . . 4
ii Understanding Variation . . . . . 2
ii.1 Regulation . . . . . . . . . 2 ii Sources . . . . . . . . . . . . . . . 4
ii.2 Restitution . . . . . . . . . 2 iii Simple Interest . . . . . . . . . . 4
ii.3 Implementation . . . . . . 2 iv Compound Interest . . . . . . . . 4
ii.4 Automatisation . . . . . . 2 v Effective Interest . . . . . . . . . . 5
ii.5 Competencies . . . . . . . 2 vi Cash Flow Model . . . . . . . . . 5
vii Anuities . . . . . . . . . . . . . . 6
II Compliance or non-compliance 2
viii Time Value . . . . . . . . . . . . . 7
III Cost Factors 2
VI Continuous Improvement 8
IV Cost Taxonomy 3
i Administrative . . . . . . . . . . 3
i.1 Substantive costs . . . . . 3
I. Introduction
i.2 Implementation costs . . 3
i.3 Direct labor costs . . . . . 3 i. Definition
i.4 Environment costs . . . . 3 Compliance cost refers to all the expenses in-
i.5 Restoring costs . . . . . . 3 curred to adhere to applicable regulations.
i.6 External service costs . . 3 Compliance costs include salaries of people
ii Enforcement . . . . . . . . . . . . 3 working in compliance, time and money spent
ii.1 Transition cost . . . . . . . 3 on reporting, new systems required to meet re-
ii.2 Renewals . . . . . . . . . . 3 tention, and so on. Compliance costs increase
ii.3 Role assignment cost . . . 3 as the regulation standards in an industry in-
ii.4 Community management 3 crease and as a company expands. Generally,
iii Financial costs . . . . . . . . . . . 3 compliance costs are rising for businesses as
iv Indirect costs . . . . . . . . . . . . 3 more stringent measures are being put in place
∗ This work is licensed under a Creative Commons to prevent fraud, loss of data privacy, pollution,
Attribution-NonCommercial 4.0 International License. or infringement.

1
ii. Understanding Variation increase in their total compliance budget and
growing compliance departments. The cost
There are many factors that impact on the cost
of senior compliance officers is expected to
of compliance. Notably are these:
increase as well, as there is a high demand and
a high level of skill and knowledge is needed
ii.1 Regulation for the role.
Compliance costs increase as the relevant reg-
ulations’ and commitments’ complexity in-
II. Compliance or non-compliance
creases. Compliance costs can be incurred as a
result of domestic, national, and international Compliance is not for free. As regulations
regulations, and they increase in number of keep coming, alongside companies focus more
jurisdictions and application domains. on transparency and ethics, money and time
spend on compliance grow. There is not only
ii.2 Restitution one option how to handle those problems. You
may decide not to follow the standards of leg-
Compliance costs are often mixed up with reg-
islative.
ulatory risk and conduct costs. Regulatory
risk is the risk that all companies face due to Following of ordinances has expenditures.
potential changes in the rules going forward Failing to grant with the standards mostly en-
and conduct costs are the fees and payments a sue with penalties. Increasingly, corporations
company makes for breaking the current regu- come to the ending that compliance is every-
lations. Compliance costs are simply the ongo- one’s responsibility. They cannot afford to un-
ing price for following the rules as they are. derestimate the effect any defect or imperfec-
tion in governance might have on commercial
performance.
ii.3 Implementation
Comparing compliance and non-compliance
Compliance with shifting regulatory regimes costs, breaches of the rules mostly lead to nega-
is a complicated task. Differing regulation sys- tive reactions and loss of reputation, fines or in
tems and law as well as expanding jurisdictions some cases prohibiting performing a business
increases complexity and cost to ensure com- activity. On the contrary, perfect governance
pliance to applicable legislation. put in advance companies compared to their
competitors. In spite of the fact costs to meet
ii.4 Automatisation the requirements are likely to be noticeable, in-
direct costs of not complying can be far higher.
Enterprise information systems help to lower Despite the increases in cost for compliance,
the headcount needed to dedicate to compli- studies show that it is more costly not to meet
ance. The trends that created these systems, compliance standards, in average at least 2.7
have also helped to spot non-compliance. So times.
even as spending on compliance costs has in-
creased, conduct costs have as well. Often
nations go through phases of increased reg- III. Cost Factors
ulation followed by deregulation. The general
rule is that once a regulation is in focus, it gets Compliance costs are simply onward for fol-
tweaked rather than erased. lowing rules as they arise. Compliance cost
mostly includes
ii.5 Competencies
• Cost of assembling and issue declarations
Most companies expect increased interaction and records
with regulatory personnel and they expect an • Cost of restoring compliance

2
 • Cost of creating and maintenance of the i.5 Restoring costs
compliance management system needed to
These are cost related to resolve compliance
collect facts
issues.
• Cost of monitoring compliance systems
and to construct them
• Cost of governance and issuing reports i.6 External service costs

Compliance impact on operating models. We These are cost related to professional assis-
can distinguish two operating models tance.

• OODA: Adaptive operation, reacting to ii. Enforcement

changes as they happen without intense
planning, and ii.1 Transition cost
• PCDA: Imperative operations, that are de-
These are cost related to introduction of sys-
rived from patterns identified in transfor-
tems innovation and release of improvements.
mations.

The first one is suitable for applications or reg- ii.2 Renewals

ulation domains with a high velocity, variety,
These are cost related to licensing and mem-
volume, or veracity whereas the second one is
bership fees.
more suitable for more stationary domains.

ii.3 Role assignment cost

IV. Cost Taxonomy
These are cost related to the role assignment,
Compliance costs can be grouped into the fol- advice, and governance.
lowing standard categories
ii.4 Community management
i. Administrative These are cost related to the role alignment and
direction.
i.1 Substantive costs

These are costs related to the the creation of iii. Financial costs
compliance records and databases.
These are all cost related to price of capital
spent (investment) on being in accordance with
i.2 Implementation costs
compliance requirements
These are cost related to training actors, acquir-
ing of competency to understand and manage iv. Indirect costs
obligations, and developing compliance strate-
gies. These are cost that are not directly accountable;
e.g. the establishment of compliance officers.
i.3 Direct labor costs
v. Opportunity costs
These are cost related to salaries.
These are cost that when an option is chosen
from alternatives, incurred by not enjoying the
i.4 Environment costs
benefit associated with the best choice, e.g.
These are cost related to office equipment.and staff dedicated to compliance instead of cre-
to information systems and machinery. ating revenue.

3
vi. Macro-economic costs lender. Wherever capital is obtained, there is
a cost associated with the use of the funds. If
They are related cost to be paid by a legal entity
they are obtained from a lender, the cost of
on the basis of debt owed by the prevailing
capital is the interest rate at which the funds
regulation, e.g., tax, fines, exemptions or offset.
are loaned to the investor.
The interest rate reflects the current state of
V. Economic Evaluation the economy, the administrative costs, and, per-
haps, the risk associated with the particular
When we desires to invest an amount of capital loan as viewed by the lender. If the investor
in a long-term endeavour like compliance, the chooses to use his own funds for the required
effect of time on the value of that capital needs capital, then the cost is called the opportunity
to be considered. The effect as illustrated by cost of capital. The opportunity cost reflects
examples. the income that could be generated from other
opportunities the investor might have for his
i. Example funds. This opportunity cost is often referred
to as the minimum acceptable rate of return.
Consider a sum of 1000 Euro that you have
accumulated. If the 1000 Euro were stored for
some future need, one year later, you would iii. Simple Interest
still have 1000 Euro. However, if the 1000 Euro Call the amount of interest earned by an invest-
were placed in an insured savings account earn- ment simple interest
ing say 0.03 interest per year, amount would
have grown to 1030 Euro. I = Pin
Obviously, the length of time and the dif-
where,
ferent investment opportunities (represented
by different interest rates) lead to varying • I is the total interest,
amounts of money that the 1000 Euro can be • P is the amount of principal,
yield at some future date. • i is the interest rate per interest period,
The second example deals with the purchas- • n is the number of interest periods.
ing power as a function of time. Suppose you
have the choice of purchasing 1000 items now Example A agrees to loan B 1000 Euro for a
at a price of 1.00 Euro per item or waiting until time period of 3 years. B agrees to pay A the
a future date to make the purchase. 1000 Euro at the end of the 3 years, plus an
If, over the course of one year, the price in- amount of interest determined by applying a
creased to 1.03 Euro per item, the 1000 Euro simple interest rate of 0.10 per year. The total
will only be able to purchase 970 items. Thus, interest charge will be
the value, in terms of purchasing power, has I = 1000Euro ∗ 0.10 ∗ 3 = 300Euro
decreased with time.
The longer the life of the endeavour, the At the end of 3 years, B will pay a total of 1300
more important will be the considerations of Euro to A which would represent the 1000 Euro
the time value of money. Other factors that may initially borrowed plus 300 Euro interest for the
affect the outcome of investment are inflation, use of A’s money.
taxes, and risk.
iv. Compound Interest
ii. Sources
Simple interest concepts are used infrequently,
There are, in general, two sources of capital but they do provide the basis for compounded
needed to make an investment. Capital can interest rate that are utilised. Compounded
be obtained either from own funds or from a interest is computed by applying the interest

4
rate to the remaining unpaid principal plus any Therefore, the effective rate is
accumulated interest — as if the interest earns
interest. ie = (1000(1.05)2 − 1000)/1000 = 0.1025
Referring back to the example presented
above, the total interest that B will pay A over per year.
3 years would be calculated by In general, the effective interest rate can be
found by
• Year 1: I = 1000Euro * 0.1 = 100 Euro, i
i e = (1 + ) m − 1
resulting in a balance of 1100Euro m
• Year 2: I = 1100Euro * 0.1 = 110 Euro, where,
resulting in a balance of 1210Euro
• Year 3: I = 1210Euro * 0.1 = 121 Euro, • m is the number of interest periods per
resulting in a balance of 1331Euro year
• i is the yearly nominal interest rate,
At the end of 3 years, B will pay a total of 1331 • ie is the yearly effective interest rate.
Euro to A which is 31 Euro higher than for
the simple interest case. This difference results In the limiting case of continuous compound-
from compounding the interest. Note that die ing, the effective rate is given by
difference between the two interests will be-
come larger as the interest rate and number of ic = lim ie = ei − 1
m→∞
interest periods increase.
Differences can become insignificant when
considering the many uncertainties associated
v. Effective Interest with analysing most economic investments.
The length of the interest period varies. Com-
mon interest rate periods are annually, semi- vi. Cash Flow Model
annually, quarterly, monthly, daily, and in the
The construction of a cash flow diagram visu-
limiting case, continuously. The amount of
alises the analysis of an investment opportu-
interest that is earned or charged to a princi-
nity. The cash flow diagram is a way of ac-
pal will increase as the compounding period
counting for all incomes and outflows at their
becomes smaller.
appropriate position in time. That is, the cash
Example Consider a loan that is quoted at
flow for any particular period is the income re-
0.10 nominal with semi-annual compounding
ceived during that period minus the expenses
(and, thus, semi-annual payments). The 0.10
incurred during that same period.
annual interest compounded semi-annually
Consider it as a check book. Deposits and
means that every one-half year, 0.05 interest is
checks are written at specific points in time.
earned or charged to the principal. This leads
These transactions could be consolidated on a
to the concept of effective yearly interest rate.
monthly basis to show the net cash flow in or
The effective yearly interest rate can be found
out of the check book each month. With a cash
by computing the value that the principal has
flow diagram, the economic analysis becomes
grown to at the end of year one, F, subtracting
easy.
the original principal, and then dividing by the
A horizontal line is drawn which represents
principal
the length of time (life) of the investment op-
F = 1000Euro + portunity. The interest periods are then marked
off and labeled above the line.
1000Euro ∗ 0.05 +
At the extreme left of the time line is time
(1000Euro + 1000Euro ∗ 0.05) ∗ 0.05 zero (present). Time zero represents the time
= 1000Euro ∗ 1.052 when the first cash flow is made. All cash flows

5
are then placed beneath the line, correspond- as
ing to the position in time (or interest periods) P = F (1 + I ) − n
in which they occurred. Negative cash flows
(expenses exceeding revenues) are given a mi- vii. Anuities
nus sign. In the time line illustrated below,
C1 , C2 , C3 . . ., represent the cash flows occur- Compliance management systems constitute
ring at the end of interest period 1, 2, 3, . . . (if not improved) uniform series. To know the
Assume that all investments for a particu- amount of a uniform series payment A, which
lar year are made at die beginning of the year, would be equivalent to a present sum P, or a
while all revenues and operating expenses oc- future sum F let
cur at the end of die year. This will lead to a
• P occur one interest period before the first
conservative evaluation.
value of A
0 1 2 3 • A occurs at the end of each interest period
• F occurs at the same time as the last A (at
C0 C1 C2 C3 time n)

The value of a future sum F of a series of

Before equations can be developed that re- uniform payments, each of value A, can be
late the time value of money, it is necessary to found by summing the future worth of each
define a set of notations. Let individual payment
• P be the present sum of money. The
F = A (1 + i ) n −1 + · · · + A (1 + i ) + A
present (time zero) is defined as any point
from which the analyst wishes to measure Multiplying each side by (1 + i ) yields
time.
• F is the future sum of money. The future F (1 + i ) = A (1 + i ) n + · · · + A (1 + i )
is defined as any point n that is greater
than time zero. Subtracting of both equations collapses the
• A is the annuity. This is a uniform set of summation to
equal payments that occur at the end of
F (1 + i ) − F = A (1 + i ) n − A
each interest period from 1 to n.
• G is the uniform gradient. This is a series yielding
of payments that uniformly increase or
decrease over the lifetime. (1 + i ) n − 1 i
F=A or A = F
• i is the compound interest rate per period. i (1 + i ) n − 1
• n is the total number of compounding pe-
riods in the cash flow diagram. and by substitution

This following formula allows the calcula- (1 + i ) n − 1 i (1 + i ) n

P=A or A = P
tion of the equivalent future amount F, of a i (1 + i ) n (1 + i ) n − 1
present single payment, P. Suppose P is placed
Cash flow is the sum of money recorded as
in a bank account that earns i interest per pe-
receipts or disbursements in a project’s finan-
riod. Then it will grow to a future amount F, at
cial records. A cash flow diagram presents the
the end of n interest periods
flow of cash as arrows on a time line scaled
F = P (1 + I ) n to the magnitude of the cash flow, where ex-
penses are down arrows and receipts are up
If the future amount F, is known and it is arrows. In the following we assume that ex-
desired to calculate the equivalent present penses occurring during the year are assumed
amount P, then the equation can be arranged to occur at the end of the year.

6
 Uniform gradient amount that repeats at the mathematical terms, this instantaneous cash
end of each year, starting at the end of the flow is modelled as a Dirac delta function
second year and stopping at the end of year n.
Evaluation is based on comparison of alter- δu (t) := δ(t − u)
natives of investments. Compliance is an in-
vestment with infinite life that has repeating The Green’s function for the value at time t of
expenses every year. Comparing alternatives a 1Euro cash flow at time u is
by calculating the capitalised costs, i.e., the  Z u 
amount of money needed to pay the start-up b(t; u) := H (u − t) · exp − r (v) dv
cost and to yield enough interest to pay the t

annual cost without touching the principal.

where H is the Heaviside step function., u is a
parameter, i.e., fixed in any instance, the time
viii. Time Value when the cash flow will occur, while t is a
variable. In other words, future cash flows
While time value of money can be understood
are exponentially discounted by the sum of
without using the framework of differential
the future discount rates for future, r (v) for
equations, the added sophistication sheds ad-
discount rates, while past cash flows are worth
ditional light on time value.
0.
The fundamental change that the differential 
1 t<u
equation perspective brings is that, rather than H (u − t) =
0 t>u
computing a number like the present value,
one computes a function, i.e., the present value because they have already occurred. Note that
at any point in future. This function may then the value at the moment of a cash flow is not
be analysed how does its value change over well-defined. There is a discontinuity at that
time or compared with other functions. point, and one can use a convention (assume
Formally, the statement that value decreases cash flows have already occurred, or not al-
over time is given by the linear differential ready occurred), or simply not define the value
operator at that point.
L := −∂t + r (t) In case the discount rate is constant, r (v) ≡ r
this simplifies to
This states that values decreases over time ∂t
at the discount rate r (t). Applied to a function
it yields ∆b(t; u) = H (u − t) · e−(u−t)r
 −(u−t)r
e t<u
=
L f = −∂t f (t) + r (t) f (t) 0 t>u

For an instrument whose payment stream is where (u − t) is time remaining until cash flow.
described by f (t), the value V (t) satisfies Thus for a stream of cash flows f (u) ending by
time T, the value at time t, V (t; T ) is given by
LV = f combining the values of these individual cash
flows:
This encodes the fact that when any cash flow
occurs, the value of the instrument changes by Z T
the value of the cash flow. V (t; T ) = f (u)b(t; u) du
t
In terms of time value of money, the Green’s
function is the value of a bond paying 1Euro at This formalises time value of money to fu-
a single point in time u. The value of any other ture values of cash flows with varying discount
stream of cash flows can then be obtained by rates, and is the basis of many formulas in fi-
taking combinations of this basic cash flow. In nancial mathematics.

7
 VI. Continuous Improvement [4] "Cost of compliance 2018 report". le-
gal.thomsonreuters.com. Retrieved April
A framework for compliance encompasses mul- 2020.
tiple components that drive prevention, detec-
tion and response. [5] Jump up to: a b "The cost of compliance"
To advance in their compliance journey, there (PDF). home.kpmg.com. Retrieved April
are several options to move toward greater 2020.
agility and proactive compliance management [6] "OECD Regulatory Compliance Cost As-
while enhancing their compliance effectiveness, sessment Guidance" (PDF). normenkon-
efficiency, and sustainability. This alternative trollrat.bund.de. Retrieved April 2020.
imply different investments with an opportu-
nity to benefits to meet compliance standards [7] "Banks Trimming Compliance Staff as $321
(in average at least 2.7 times). Billion in Fines Abate". bloomberg.com. Re-
Viewing compliance as an investment, as op- trieved April 2020.
posed to as simply a cost, helps measure its
[8] "The cost of compliance". international-
return during ongoing compliance improve-
banker.com. Retrieved April 2020.
ments, while simultaneously propelling the
organization toward greater effectiveness, sus- [9] "Cost of compliance Survey 2019".
tainability, agility and efficiencies in its compli- blogs.thomsonreuters.com. Retrieved June
ance efforts. 2020.
While an investment in technology, cultural
change, or strategic evaluations of the program [10] "Will compliance or non-compliance cost
is a real cost, it can result in significant ef- you more?". simplifie.com. Retrieved July
fectiveness and efficiencies including process 2020.
improvement, control enhancements, and im-
[11] Carr, Peter; Flesaker, Bjorn (2006), Robust
proved customer experiences, which can be
Replication of Default Contingent Claims,
hard to quantify, but impactful nevertheless.
Bloomberg LP.
In applying the above economic analysis, a
compliance approach, cost - benefits r (t) can [12] Crosson, S.V., and Needles, B.E.(2008).
used to analyse realised increased value. Managerial Accounting. Boston: Houghton
Mifflin Company.
Conclusion
We have presented how compliance as a con-
tinuous endeavour. We have also explained a
set of econometric methods to evaluated invest-
ment in compliance.

References
[1] "Compliance cost". investopedia.com. Re-
trieved April 2020.

[2] "What does compliance cost means?". defi-

nitions.net. Retrieved April 2020.

[3] "Compliance cost". accountingtools.com.

Retrieved April 2020.

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