Bankers and Accountants: Numb and Number

Introduction: Figuring Out What’s Going On

              When the British historian Thomas Carlyle observed a century ago that you may prove anything by figures, little did he realize that so many people in today’s financial world would try to prove him right. Stock market analysts and chief financial officers count on accountants to substantiate their points of view, and bankers and other creditors rely on auditors to validate their borrowers’ financial statements. 

              Our industry has relied for a long time on the accounting profession for accurate, consistent, and material information on which to evaluate repayment ability. Sound, prompt credit decisions require the prompt delivery of reliable, timely financial statements. cHowever, daily revelations of deceptive accounting practices, catastrophic failures of some of the nation’s largest corporations, and probing questions about the accounting profession’s role in these practices and failures require us bankers to reassess our traditional reliance on accountants and their accounting. As the Who complained in their 1965 I Can't Explain, "Dizzy in the head and I'm feeling bad, The things you've said have got me real mad." Indeed, the complexity of generally accepted accounting principles (GAAP) and the number crunching by accountants sometimes do numb bankers and other users of financials.

              Under these circumstances, what can we bankers do to manage this informational risk? Is there a cost-benefit trade-off on financial statement quality? Are there other informational options to supplement or supplant financial statements? Let's try to evaluate the current climate of financial statement quality and offer some suggestions on how to manage the related risk.

What Do You Really Need?

              First, take a fresh look at your financial statement requirements. Bankers have operated under some basic tenets of financial statement quality. First, the greater the risk, the more reliable the information should be. Therefore, the better the quality of the financial statements, the more reliable we bankers expect them to be. We generally prefer financials prepared by an objective third party rather than those done by the borrower. Further, the more involved the external preparer, the better, so we view audited statements as superior to unaudited numbers. These general rules date back to a time when few companies had accounting software, management information systems, and chief financial officers. Today’s standard financial reporting packages generate financial statements with the speed, accuracy, and detail that render many company-prepared financials today on a par with the unaudited product of outside accounting firms a generation ago. 

              Opinions and No Opinions. The Game of Thrones' sinister Tywin Lannister once responded to concerns about his actions, "A lion does not concern himself with the opinion of sheep." Wooly remarks aside, the CPA’s unqualified opinion remains the zenith of financial statement quality. Much rarer and much less desirable are qualified and adverse opinions. In off-color contrast to these darker shades of audited financials is the unaudited statement. If the term “unaudited” looks odd to you, it’s because you entered banking after 1979 when the accounting profession retired the unaudited financial statement and replaced it with two new unaudited products, the compilation and the review. The original intent of the name change was to entice clients to go to outside preparers and not turn them off with the negative-sounding unaudited financial statement. Once they were introduced to the cheaper compilation and review, the profession hoped that clients eventually would upgrade to full audits.

              Meanwhile, the ongoing controversy over fraudulent accounting continues to fascinate the business press, and although these revelations typically expose publicly held companies, the adverse publicity tends to tarnish accounting's reputation and reduce users’ trust in the quality of the full audit.  Gresham’s Law that bad money drives out good provides an apt analogy for the downmarket impact of the bad news. More and more users are wondering just how much value is added by requiring audited financials. The value-added math has become more problematic as accountants find themselves more vulnerable to high-profile lawsuits. 

              Less Quality, More Risk? The comedian Steven Wright once advised, "If at first you don't succeed, then destroy all the evidence." A little less evidence of a borrower's success might be tolerable if users promptly received useful financial information. However, on top of its automatic 6-month extension option, the IRS also raised the sales limit for the use of cash basis accounting to $10,000,000 for certain types of companies effective for tax years ending on or after December 31, 2001, and the change made it feasible for another 500,000 companies to forego accrual accounting in favor of cash basis accounting. The change does not yet apply to companies in industries that rely heavily on inventory for income such as retailers, wholesalers, manufacturers, mining, farming, and publishing. On the other hand, the services sector is an obvious beneficiary of the IRS action, and services is the fastest growing sector of the American economy, anyway.  If an outside accountant prepares the company’s tax returns, the accountant can get double duty out of them by labeling them a compilation or review and noting that the financials do not reflect generally accepted accounting principles.

              As more companies adopt cash basis accounting, the trend away from full audits to the unaudited compilation and review is likely to continue. Since tax returns are typically some variant on cash or tax basis accounting for which there is really no standard per se, not only will full audit quality continue its decline, but the specter of automatic extensions to October portends even slower delivery of less reliable numbers. The traditional busy season in bank credit analysis is likely to slip out of the second quarter well into the second half of the year. Even now, many bankers observe that the distance between a borrower’s fiscal year end and its annual review or renewal has lengthened to six months or more. Timely credit analysis is fossilizing into epochal financial archeology.

              So pull out your financial statement policy and ask yourself whether you are asking for the right level of financial validity relative to the credit risk. Must every borrower provide you audited financial statements? One common approach is to gauge financial statement quality requirements to the level of total creditexposure:

              Level of credit exposure              financial statement requirements

              <$1,000,000                                company prepared

              $1MM <$5MM                          unaudited (compilation or review)

              >$3,000,000                               unqualified audit

Some variations on the scheme above is to treat unaudited financials as audited if the loan’s collateral is being audited by the bank regularly, Other banks grant a little more exposure to reviews than to compilations. Yet another layer of tolerance can be injected by policy exception administration. Banks may establish a financial statement policy exception that permits up to some percentage of loans to be made with inferior quality financial statements if some effort is made to mitigate the policy exception with additional protection such as more frequent company-prepared financial statements, bank physical audits of collateral, more guarantors, etc.

Who Do You Really Trust?

              Bob Hope once observed, "I'm from Los Angeles--I don't trust any air I can't see." You might breathe more easily if you think of the accounting firm as a potential subcontractor to whom you are considering the outsourcing of the validation task for financial statements. As part of your due diligence, you might want to employ a checklist of questions such as these:

1- Familiarity with the industry-does the accounting firm have experience with the borrower’s line of business? Construction, real estate, colleges and universities have unique accounting rules and their own specialized accounting principles, bulletins, and guides. These specialized industries require extra education and training reinforced with the experience of accounting for them, not the other way around. 

2- Other clients in the industry—the more clients in the borrower’s line of business, the deeper and wider the accountant’s industry experience.

3- Mix of audits to non-audits—the more audited financials the accountant has done, the better they are likely to be. Moreover, auditing is a skill and talent that not all accountants possess equally, just as not all attorneys are gifted trial lawyers.

4- Years in practice—years of experience generally correlates positively with experience and success.  Bad lawyers usually don't accumulate long track records.

5- Credentials—the accountant should have the appropriate accreditation and licenses to practice accounting in your legal jurisdiction. Not every bookkeeper is a CPA.

6- Quality of clients—the accounting firm with bankrupt clients is likely to share some of the attributes of its fallen customers. More ominously, the accountant may have contributed to their clients’ failures.

7- Accounting criss-cross directory—some banks maintain an accountant cross-file in which accounting firms and bank customers are listed alphabetically and cross-filed against one another so that bankers can see who and what kind of bank clients a given accounting firm serves. Problem borrowers seem to gravitate to problem professionals.

As you peruse these points, you may want to think about the attention your credit analysis function pays to the quality of the accountant as well as the quality of the accounting. Russian premier Nikita Khruschev once boasted that in nuclear warfare, quantity has a quality all its own, but number mess may be no less devastating than nuclear mass. Poor accountants have the potential for dropping a quantity of poor quality financial bombs on unwary bankers. 

What Do You Really Need to Know?

              Will Rogers once admitted, "Everybody is ignorant, only on different subjects." On the subject of accounting, we users need to remember that as we give up audits and accept more unaudited financials, we assume a greater intellectual burden for the risk. Therefore, some strategies to consider for developing and maintaining these intellectual resources include:

1- Supplementing financial analysis with behavioral indicators such commercial and personal credit reports. The borrower may have a 2.0 current ratio because the receivables are uncollectible, the inventory is unsaleable, and the payable are unrecorded. It the commercial credit reports shows past-due trade debt, the personal credit bureau reports indicate delinquencies, judgments, and liens, the depository accounts are frequently overdrawn, and interest payments are often late, the lender doesn’t need financial statements to know the borrower is in trouble.

2- Improving your own bankers' accounting and finance deficiencies with remedial training in accounting, auditing, and finance

3- Recruiting more individuals with degrees or previous work experience in accounting, auditing, and finance. This option offers a way to reduce remedial training in these subjects by simply hiring individuals with the education, training, and skills.

4- Maintaining proficiencies in accounting, auditing, or finance by requiring some minimum number of hours of certified, professional education

5- Conducting training in tax return analysis to accommodate the rising tide of tax-based financials

6- Rotating lenders and credit approvers through asset-based lending (ABL) and floor plan auditing units

7- Revising policies to encourage more ABL and audit supported lending by allowing more exposure and higher LTV’s to borrowers where collateral is physically checked by the bank, funds are advanced under borrowing base certificates, monthly company financials and audited statements are required, quarterly covenant compliance certificates are mandatory, etc.

8- Upgrading loans where the collateral is monitored and audited

Einstein has postulated that matter cannot be created or destroyed, and risk is also indestructible. It can’t be eliminated, but it can be transferred. As we accept more of the audit risk inherent in unaudited and company-prepared financials, we must be willing to mitigate that risk by assuming competent execution of the audit function.

Closing and Summary: Adding It Up

              Marvin Gaye had more on his mind than debits and credits when he recorded What's Going On back in 1971, but his line "There's too many of you crying" still seems apt to us financial statement users as we bemoan their increasing inscrutability. The Financial Accounting Standards Board now has a Private Company Council working hard to simplify GAAP for private firms, and given an estimated 26 million private companies, relief is on the way for the thousands of bankers puzzling over their borrowers' books. After all, financial statements play a vital role in our credit decision-making, and we need to maintain a flow of accurate, timely credit nformation. However, despite the wealth of information that detailed, audited financial statements can yield, management lecturer Robert Townsend has observed that there is sometimes an inverse relationship between the sophistication of tools and the usefulness of the results. 

         Therefore, we need to be realistic in our qualitative expectations for financial statements and the professionals who prepare them. In recognition of the overall improvement in borrower-prepared financial reporting, at some lower level of exposure, we can probably accept company-prepared financials and manage the risk on an exception basis. However, as we accept these unaudited financial statements, we must understand that we are assuming more of the audit risk and so should acquire, maintain and improve our own intellectual resources in accounting, finance, and audit training.  As John Wayne advised, "Life is tough, but it's tougher if you're stupid."  We bankers need to saddle up, toughen up, and drive those debits and credits to market.