How can financial statements be more useful to lenders?

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The Commercial Finance Association (CFA) has become more active in the Financial Accounting Standards Board (FASB) "Users Council" through its Cooperation With Accountants Committee (the Committee),

chaired by Neville Grusd, executive vice president, Merchant Factors Corp. and Merchant Financial Corporation. One purpose of this Committee is to enhance the quality of disclosures made in financial statement presentations through consideration of what is important to those who use financial statements, such as secured lenders and credit grantors, who rely upon accurate financial statements.

The Committee considered some of these issues during a recent meeting and asked Mark A. Alimena, CPA, CFE, of Marden Harrison & Kreuter, CPAs, to make a presentation from the point of view of a practicing CPA who also specializes in field examinations and forensic accounting. The following conversation between Neville Grusd and Mark Alimena reviews the substance of that meeting and its implications for lenders and CPAs.

NG: Do you think that the current climate of pressure on accountants to improve accounting disclosures, auditing techniques and independence standards will be of benefit to lenders?

MA: Yes, lenders dealing with publicly held companies will be the first to see significant changes benefitting them, but lenders from all sectors should expect benefits from auditors' expanded considerations of the potential for fraud in conducting financial statement audits. In the future, I believe audits will become less commodity-oriented. Expansion of accounting disclosure requirements (GAAP) will make all financial statements (i.e., compiled, reviewed and audited) more useful for credit evaluation. Independence standards will become more rigorous, but the more subtle influence of rising audit fees will have a positive effect by providing CPAs the economic motivation to perform their valuable functions, as expected, without being financially trapped into selling other services to their audit clients to survive.

NG: Has your firm changed any of its policies regarding acceptance of clients, auditing techniques and accounting disclosures in the last two years?

MA: Yes, we have expanded the level of inquiries made in client acceptance. To be certain, new business opportunities are good for the firm, but the process otherwise remains largely unchanged. Our auditing techniques (GAAS) are regularly evolving with new standards as they are issued. For example, our firm's auditing approach will be updated for new fraud standards effective for financial statement audits this year. Accounting disclosures and GAAP also change constantly. We keep up with these developments through continuing education, current work tools and a culture that strives to meet the intent of financial accounting and disclosure, as we understand and interpret that intent to be.

NG: There are new GAAP disclosure rules for trade accounts receivable, which you refer to in a January/February 2003 article in The Secured Lender. Please summarize the main points and tell me if you think they will be of benefit to lenders.

MA: Lenders will benefit from expanded trade-receivable credit-risk disclosures that were not required before in financial statements of "nonfinancial institution" borrowers. Collectively, GAAP is making accounting and disclosure of trade accounts receivable, regardless of industry, the same as what would be applied to financial institution loans and other forms of credit. Borrowers with trade accounts receivable are now viewed as credit grantors and must bear the burden of informing readers about credit risks in their financial statements.

Assuming materiality of amounts involved, concentration risks from large customer balances, industries, geographical locations, or other group concentrations like "contras" and "extended-term customers," should be disclosed more than before. If arrangements for settlement of accounts receivable are to be made "in kind" (e.g., barter, inventory exchange, contra offset, etc.) and not in cash, that should be disclosed. The definition of what is considered the age (e.g., accounts over 40 days old) of a delinquent, past-due receivable and the related considerations of collectability, loss reserves, collateral and other risk-mitigating factors, will be presented in a combination of tabular and written form. Of course, this assumes borrowers will faithfully comply with GAAP.

NG: We lenders are pushing to improve GAAP disclosures which will make financial statements more useful in making credit decisions. What items do you think we should focus on in order to achieve this?

MA: In the CFA Committee meeting, we discussed the following disclosure items that the group agreed would make financial statements more informative:

* Presentation or disclosure of gross and net sales, and the components of the difference; only net sales is currently required;

* Disclose separate revenue streams when gross profits by stream are materially different; it is rare to see GAAP "Segment Reporting" outside the publicly held company sector;

* Present details of cost of sales, including fixed and variable components;

* Disclose material inventory write-downs or negative valuation adjustments, as currently required under GAAP;

* Present components of or disclose major items in S, G & A expenses, especially officers' compensation;

* For factored receivables, disclose "receivables sold less advances received" and "client risk receivables," in addition to the existing disclosure requirements.

NG: Specifically, can you tell us what the benefits of these disclosures will be to lenders?

MA: The list of recommended disclosures reflects items of information typically asked for by secured lenders in the course of their relationships with their borrowers. If GAAP requirements included them, financial statements would be more responsive to matters secured lenders find important to their decision-making process. Whether or not these recommendations make their way into GAAP over time, secured lenders may consider asking borrowers for "supplementary schedules" of this information prepared specifically for them.

The benefit of this approach is that the supplemental information can be obtained now, without waiting for standards to develop. Some in the accounting and borrowing communities have objected to these recommendations on the grounds that they are beyond GAAP and may divulge confidential information to the wrong parties. The supplemental information can be kept confidential simply by removing it if the financial statements will be sent to other parties who have not asked for it.

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NG: I think that this is a very practical point. In my discussions with other users on the FASB Council, it is clear that not all users need the same information. For example, borrowers do not think it is necessary for trade creditors who get financials to see all the details which'the company's lender requires. While we will continue our efforts with the FASB, the CFA should develop the "supplementary schedules" to which you refer to cover items not already disclosed in the financials. Now, on to another subject: In addition to your firm providing customary accounting and auditing services, you also specialize as a field examiner for the lending community and are also a fraud examiner and forensic accountant. Are there any recent case studies which you could share with us which could be of interest to lenders?

MA: There are too many cases to share the specifics, but I will offer the following observations. Diligence is preventive in nature. Asset recovery is forensic in nature. One must decide where to place one's resources to best reduce the risk of loss, while allowing business to succeed. Place your risk-management money where the highest risks are, and remain vigilant in monitoring the relationship. Be disciplined in the credit culture you choose by not allowing its vitality to be sapped through misguided or inexperienced actions on the part of individuals. The "team" approach is best.

With respect to trade receivables, I have seen fraud schemes from the crude to the sophisticated. Regardless, fraud often involves the commission of willful acts, accompanied by fraudulent financial reporting to keep outsiders in the dark. Look for inconsistencies between verbal and written communications and presentations. Do not hesitate to make inquiries when these become apparent. The manner, quality and timeliness of the borrower's response to your regular inquiries provide windows through which the borrower's integrity can be viewed. If you don't like what you see, don't ignore the problem, hoping it will go away. It rarely goes away and often becomes worse with time. Time is an ally of the troubled borrower and an enemy of the lender in trouble.

MA: Neville, there are some questions which we CPAs would pose to you, starting with what lenders expect from CPA audited financial statements?

NG: Audited statements should represent accurate disclosure of the financial condition of reporting entities that are fully in compliance with GAAP, audited in accordance with GAAS and using auditing techniques capable of discovering the presence of material errors in the financial statements. We expect the auditors to have the courage of their convictions and qualify their reports where necessary.

MA: Do secured lenders rely on CPA-audited or -reviewed financial statements?

NG: Different lenders have different standards for whether reviews or audits are required. Some lenders will accept compiled financial statements or even tax returns in certain circumstances. Secured lending has different levels of monitoring depending on the product, the risk and market forces influencing the lender. The more that lending relies on collateral, the less reliance there may be on the financial statements. However, many factors still require financial statements from a quality CPA firm before a transaction can go forward. At the other end of the spectrum, cash-flow lenders probably rely more on audited financial statements, since their monitoring efforts are less than those of secured lenders.

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The truth is that lenders are not qualified to conduct financial statement audits and lender's field examinations are not substitutes for CPA audits and reviews. Lenders must rely on an independent party, like the CPA, to know that at one point in the borrower's year, all the economic aspects of a borrower's business activities were addressed. Field examinations are limited in scope and duration, as they focus mostly on operational and collateral aspects of borrowers' businesses, for short periods at a time.

Ideally there should be a relationship between the lender and the accountant and, of course, within the confines of his/her professional relationship with the client, there should be open lines of communication with the lender.

MA: How will the new trade accounts receivable disclosures affect lending practices?

NG: With more information made available in the financial statements, lending decisions on the front end (new business) will be easier to make. Sometimes a quick "no" to a credit request is as valuable to a borrower as a long drawn-out "yes" that has surprises waiting at the end, which were only discovered after a field exam has been conducted.

MA: Some are concerned that the AICPA may soon lose its place in the professional standards setting process, and that the FASB may not be responsive to direction from the FASB Users Council. How can lenders protect themselves if their disclosure requirements are not served by professional standards?

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NG: Generally, by asking the borrowers for the required information, in the form of supplementary schedules as discussed above. However, if a sufficient amount of other lenders do not request these supplementary schedules, it may be difficult for lenders to obtain them. This is an example of how competition sometimes inhibits the flow of beneficial information to lenders. This is similar to lenders who accept compiled financial statements for lending purposes, creating market pressure that erodes the quality of what is considered acceptable.

MA: Will the new CPA standards affect management of lending risk and the manner in which field examinations are performed?

NG: If borrowers and their CPAs faithfully adopt the new standards, lenders will be able to read about credit-risk issues in the financial statements they receive during the due-diligence process. If some of the additional disclosures desired by the CFA are adopted, then even more meaningful information would be available to speed up the credit-risk evaluation.

CPAs may realize, more than ever, that disclosure about loan terms and covenants is vital to the interests of lenders. For example, I recently became aware that CPAs are not required to read loan documents when performing reviews and that this information is usually obtained by inquiry from the management, who may overlook some vital details. Loan-covenant violations may be present and not disclosed, potentially affecting the going-concern assumption if the lender decides to call the loan. I believe matters such as these should not be overlooked by CPAs if their borrower clients are dependent on lending relationships.

The types of field-examination procedures used by lenders likely will not change from their current focus on the borrower's operations and collateral. However, planning the extent and focus of procedures will be more effective, benefiting from additional information available in the financial statements.

MA: Is it fair to sue CPAs when loan losses occur?

NG: "If there were material errors present in the audited or reviewed financial statements relied on and the CPA did not detect their presence due to willful or gross negligence, then it is fair to seek recovery from the CPA. Though reviews are not audits, CPAs are vulnerable if they have knowledge of material errors and allow themselves to be associated with materially flawed statements. It would be wrong to sue the CPA when a business failure occurs and no material errors are present in the financial statements. Like lenders, we understand that CPAs cannot control the actions of their clients.

In my view, the responsibility for material errors rests equally with management (including owners in closely held companies) and the CPAs, both of whom are the most knowledgeable parties concerning how the economic events of a borrowing entity are recorded, presented and disclosed. CPAs are an important source of referrals for lenders and should know that their reputation and association with a borrower is very meaningful to the lender's credit decision."

MA: Where do we go from here?

NG: Let's keep the dialogue going. As you know, we are currently inquiring about FASB "Fin 46" and how this may or may not affect secured lenders when borrowers are thinly capitalized. The more that lenders and accountants keep in communication about what each needs and expects from the other, the more all parties, including clients, will benefit.

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WE KEEP UP WITH THESE DEVELOPMENTS THROUGH CONTINUING EDUCATION, CURRENT WORK TOOLS AND A CULTURE THAT STRIVES TO MEET THE INTENT OF FINANCIAL ACCOUNTING AND DISCLOSURE, AS WE UNDERSTAND AND INTERPRET THAT INTENT TO BE.

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IF BORROWERS AND THEIR CPAS FAITHFULLY ADOPT THE NEW STANDARDS, LENDERS WILL BE ABLE TO READ ABOUT CREDIT-RISK ISSUES IN THE FINANCIAL STATEMENTS THEY RECEIVE DURING THE DUE-DILIGENCE PROCESS.

AUTHOR_AFFILIATION

by Mark A. Alimena in discussion with Neville Grusd

AUTHOR_AFFILIATION

Mark A. Alimena, CPA, CFE, is a shareholder in the accounting firm of Marden, Harrison & Kreuter, CPAs, P.C., White Plains, NY. He is a Governing Board member of the CFA Education Foundation and a member of CFA's Cooperation with Accountants Committee.

AUTHOR_AFFILIATION

Neville Grusd, CPA, is executive vice president of Merchant Financial Corporation and Merchant Factors Corp., New York, NY. He is a member of the CFA Executive Committee and chair of the Committee for Cooperation with Accountants.