Author: Paul Muldoon
Beware of bloated assets, understated liabilities, and unrecorded items.
Many liabilities may be out of sight, but never out of a lender’s mind. For instance, a client’s balance sheet doesn’t list pending claims, contingent costs or underfunded accounts. A proactive lender will search for undisclosed risks in order to get a complete view of their borrowers’ financial health.
Beware of Bloated Assets
The search for risks and undisclosed liabilities begins with assets. For each asset, ask yourself what could cause the account to diminish. For instance:
- Inventory may include damaged goods.
- Accounts receivable may include bad debts.
- Some fixed assets may be broken or in desperate need of repairs and maintenance.
As you can imagine, such items compromise a client’s credit standing and affect its financial ratios just as much as unreported liabilities do.
Some problems may be uncovered simply by touring the business’s facilities or reviewing asset registers for slow-moving items. And benchmarking can help.
For instance, if a borrower’s receivables are growing faster than sales, it may be a sign of aging, uncollectible accounts. Or, if a client’s repairs and maintenance expense seems low when compared to historic levels or industry norms, it might signal neglected upkeep on assets, which can be a huge gamble over the long run.
Look for Understated Liabilities
Next take a look at the borrower’s liabilities on the balance sheet and ask if the amount reported for each item is complete and accurate. A business may try to understate its liabilities in order to appear stronger or to comply with its loan covenants.
For instance, borrowers may forget to accrue liabilities for vacation time or salaries. Some might even underreport payables by holding checks for weeks (or even months). This tactic preserves the checking account while giving a lender the impression that supplier invoices are actually being paid.
Other clients might hide bills in a drawer at year end in order to avoid recording the payable and the expense. This “scam” mismatches expenses and revenues, artificially enhances profits, and understates liabilities. Moreover, delayed payments can hurt the business’s credit score and even cause suppliers to restrict their credit terms.
Uncover unrecorded items
Make sure you investigate what isn’t showing up on the balance sheet. Examples include pending lawsuits, warranties, an IRS investigation or an underfunded pension. When available, look at the balance sheet footnotes. They may shed additional light on the extent and nature of these contingent liabilities.
These risks appear on the balance sheet only when they’re “more than likely” to be incurred and “reasonably estimable.” They are subjective standards. Some borrowers may claim that liabilities are too unpredictable or remote to warrant disclosure.
Lenders should also consider the goodwill (or badwill) that’s attributable to the company’s owners and top managers. For instance, certain “key” people may be so critical to the company’s success that their unexpected departures might expose the entity to financial hardship. On the other hand, people who are exceptionally tax averse, risk-seeking or unethical can put the company at risk for IRS inquiry, lawsuits, and insurance and warranty claims.
Work with a pro
If a business’s financial statements are audited, the auditor will automatically test for these hidden risks and liabilities. They also watch for any exaggerated asset balances. Keep in mind that compiled or reviewed statements aren’t subject to the same level of scrutiny.
For added assurance from any questionable borrowers, ask for an agreed-upon-procedures engagement that can target high-risk areas and anomalies. If a ratio analysis reveals unusual trends based on the client’s track record or industry benchmarks, you may want to meet with the borrower and its accountant in order to hunt for any hidden liabilities and risks.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.
For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.