Numb and number: bankers and accountants

RMA Journal, The, Sept, 2002 by Dev Strischek

This article evaluates the current climate of financial statement quality and offers some suggestions on how to manage the related risk.

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 the accounting profession to substantiate their observations while bankers and other creditors rely on the auditors to validate their borrowers' financial statements.

Our industry has long relied on the accounting profession for accurate, consistent, and material information on which to evaluate repayment ability. Sound, prompt credit decisions require reliable, timely financial statements. 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 bankers to reassess their traditional reliance on accountants' accounting.

Under these circumstances, what can we do to manage this informational and reputational risk? Is there a cost-benefit trade-off on financial statement quality? Are there other informational options to supplement or supplant financial statements?

What Do You Really Need?

Bankers have operated under some basic assumptions in their use of financial statements. 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 parry to 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 generalizations 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

Nevertheless, 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 use an outside preparer and not turn them off with the negative-sounding "unaudited financial statement." The profession hoped that clients would upgrade to full audits after their introduction to the cheaper compilation and review.

In fact, perusal of RMA's Annual Statement Studies shows a steady decline in full audits as a percentage of the statements received by banks. (1) The ongoing controversy over fraudulent accounting continues to occupy the business press, and although these revelations typically expose publicly held companies, the consequence of the adverse publicity is to diminish the reputation of the entire profession 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 and less inclined to take on the legal risk of full audits.

Less Quality, More Risk?

Less quality might be tolerable if users promptly received the financial information. However, the IRS has raised the sales limit for the use of cash basis accounting to $10 million for certain types of companies effective for tax years ending on or after December 31, 2001, and the change has made it feasible for another 500,000 companies to forgo 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-the fastest-growing sector of the American economy-is an obvious beneficiary of the IRS action. (2) 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 (GAAP).

As more companies adopt cash-basis accounting, the trend away from full audits to the unaudited compilation and review is likely to accelerate. 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 unaudited numbers. The traditional busy season in bank credit analysis is likely to slide out of the second quarter well into the second half of the year. Even now, 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.