Audited Financial Statements; Financial Statement Analysis

The Importance of the Audit:  A customer may fill in every space on the Credit Application form sent and provide financial statements as requested or required.  However, if the financial information presented is nothing but guesses or estimates, the information has little analytic value. This is why banks require an auditor's certificate on a borrower's financial statements wherever possible. 

Whether statements are audited or not is an important consideration for the credit analyst and decision maker.  Third party credit bureaus always make a point of stating whether or not a customer's financial statements reproduced in the credit report are audited or not.  When you receive financial statements from a customer, whether or not the statements are audited by a CPA firm and the extent of that audit as well as the audit findings should be the first things to consider.  To some extent, audits or lack of audited statements are a guide to the accuracy and the reliability of customer financial statements.

Not all third party auditors certifications are the same.  Therefore, you should carefully note the nature of the audit and the corresponding responsibility accepted by the accountant, both of which are expressed in the wording of Auditor's Opinion Letter sometimes referred to as the auditor's certification.  For example, the following certification statement establishes these financial statement as fully audited and therefore as reliable as any financial statement the creditor is likely to receive:

"We have examined the balance sheet of the X Company as of 20XX; and the related statements of income and surplus for the year then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly included such tests of the accounting records, and such other auditing procedures as we consider necessary in the circumstances.

In our opinion the accompanying balance sheet and statements of income and surplus present fairly the financial position of the X Company and the results of its operations for the year then ended, in conformily with generally accepted accounting principles applied on a basis consistent with that of the preceding year."

Standards for the wording and meaning of auditors' certifications have been established by the American Institute of Certified Public Accountants. The Institute has formulated these three requirements:

1. Whenever a CPA's name is associated with a financial statement, he/she must either give an opinion on the fairness of the statement, or indicate an inability to express an opinion and why. 
2. The report shall follow one of four well-organized forms, depending on the circumstances. 
3. The accountant may give: 
            - an unqualified opinion (has no reservations) 
            - a qualified opinion (regards the statement as generally fair but disagrees with certain points) 
            - a "disclaimer" (has not conducted a complete audit or spent enough time reviewing the statement) 

Beyond the certification of audit by a reputable independent accountant, veteran credit people often take three additional factors into consideration in judging the reliability of a statement:

1. Specialization by the Auditors:  Few accounting firms have adequate staff to provide specialists in all fields, and by the same token most trades and industries have groups of accountants who concentrate their practices in that field. Often, this specialization even extends to functional lines within an industry.  For example, in the textiles industry some accountants specialize in mill operations, others in wholesaling or jobbing, and still others in the various branches of the manufacturing of suits, dresses, shirts, etc.   As a result of their knowledge of specific product, processes, and market conditions, these accountants have become recognized as authorities in a particular line.  As a result, a supplier's credit department can place even more confidence in their audits than they do in those of less specialized CPA led accounting firms.

2. Frequency of Audit:  The terms "continuity of engagement" and "continuous audit" are frequently confused, but they are far from synonymous. Continuity of engagement means that a certain independent CPA is regularly employed to prepare annual and other statements, and that this same accountant has prepared these statements for several successive years. Continuous audit refers to an engagement in which the accountant makes periodic inspections of the books and records of a business between annual statement periods, although not necessarily auditing the statements on each occasion. Thus engaged, an accountant is able to follow the client's affairs more closely than if he or she made only a single visit each year.  As a result, the auditing work performed is apt to be more accurate.

3. Change of Auditor:  If a customer changes auditors,  and especially if it changes them repeatedly, this is a situation that needs investigation. The standard explanation you will likely receive is that the customer wants to lower its auditing costs, and this may indeed be the case. But whether it is or not, there can be important credit implications when customers change auditors frequently. If audit costs are lower, it may mean that the type of audit or the scope of the audit has changed.  

If the customer is not telling the truth, it may mean that there was a difference of opinion with the CPA regarding the treatment of certain items.  If this is the case, you may or many not hear about it from the terminated auditor.  Some terminated auditors still send announcements of their disengagement to creditors of a former client. The announcement will not give the reason for the disengagement and to find out what happened the creditor will need to make their own inquiries. Naturally you should also compare the certificate of the customer's new accountant with that of the former one for significant variations in scope.

Auditor Client-Credit Manager Relationships:  Accountants prepare balance sheets and supporting schedules for the use of their clients and not to meet the special needs of their clients' suppliers. They are not required to clarify items in their audits when suppliers raise questions.   Some auditors may be willing to answer certain questions, and most will not.  In this case, an outside auditor will be reluctant to discuss anything with a third party creditor and will almost certainly require their former client's permission and an indemnification against any damages before responding and revealing privaleged information.

We continue on with the nerve-wracking subject of financial statement reliability.   Now we can shift from what an auditor can do to help the creditor to what you can do to help yourself. We consider the techniques of financial statement manipulation and reclassification. 

Requesting Financial Information:  The older the financial statements you have, the less reliable they are as an indicator or predictor of credit risk. The goal of the credit department is to keep customers' financial statements current.  Requesting updated financials statements is a sensitive issue with some customers. Credit professionals do not want to be over-eager in their efforts to gather this type of information, but if a customer does not share financial information with a credit bureau then it may be necessary to ask the customer for financial information.

Some creditors give the debtor a lengthy explanation of their need for financial data. Other creditors simply assume the debtor does not need a detailed explanation about a request for current financial statements. Most requests of this type are deliberately brief. Generally, requests for financial data should be made to seem as "routine" routine as possible. Typical language includes the following:

"We periodically review the credit files on all of our active customers. I note that the financial statements we have on file for your company are more than two years old. Please send me your current financial statements including a Balance Sheet and Income Statement."

At some point, the credit department must draw a line beyond which open account credit terms will not be offered to certain privately held companies without updated financial statements since the financial statements of privately held companies are not published and readily avaialable online. Where that line is established depends on a number of variables. One of the most important of these variables is the creditor company's sensitivity [or lack of sensitivity] to credit risk. The credit manager has the difficult [and thankless] task of trying to figure out how much credit can safely be extended in the absence of current financial data. The better you are at striking a balance between demanding financial updates from customers and managing credit risk the more successful you will be as a credit manager.

Edited by Michael C. Dennis