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- 10/2021
Guidance
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Wed. Jul 23rd - Series Kickoff Analytical Decision Tree and the Credit Write-Up | ||
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Tue. Sep 23rd - Series Kickoff Financial Statements and Business Organizations | ||
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October 2021 Comments
In this issue:
Contractor Financial Statements - Facts versus Estimated Facts
Under generally accepted accounting principles, contractor financial statements may be prepared according to a) the completed contract method (CCM) of accounting or b) the percentage of completion method (PCM) of accounting. Presumably, roughly 90% of all contractors use the PCM in preparing their accrual financial statements. If so, the odds are high that lenders will generally receive contractor financial statements prepared according to the PCM.
The fundamental difference between the two methods is quite simple: The CCM presents operating results based on actual facts, i.e., the profit or loss for a reporting period based on finished contracts delivered to clients. The PCM, however, presents operating results based on a combination of facts and estimates, i.e., the profit or loss for a reporting period based on a combination of finished contracts delivered to clients and estimates of the profit and loss - to date - of uncompleted contracts in progress at the end of the reporting period.
Further, the greater the relative share of earned revenue from uncompleted contracts and the associated cost for earned revenue from these uncompleted contracts in the PCM financial statements, the greater the end result reflects management estimates and not factual data.
To see this, let's review information for Southwest Contractors, Inc., a road construction contractor in Tempe, Arizona organized as a Subchapter S corporation. The company prepares its accrual financial statements in accordance with the PCM.
The gross margin for the company (including non-cash charges) based on both information in the accrual income statement and the work in progress report was 4.07% in 2018. Its gross margin based on contracts completed in 2018 was 2.17% while its gross margin based on management estimates of revenue and cost for uncompleted contracts in 2018 was 5.92%.
In this instance, roughly half the reported gross margin was based on management estimates, and this estimated gross margin was more than twice the factual gross margin on completed contracts and their associated cost.
Given 2018 performance based on completed contracts, it is highly suspicious that Southwest Contractors, Inc. will, in fact, enjoy a gross margin of 5.92% when all uncompleted contracts at the end of 2018 are finished and accepted by the client.
Bottom line? Tread carefully in assessing those contractor financial statements prepared according to the PCM, especially if the relative importance to reported operating results are significantly dependent on work in progress. The work in progress, or contract status, report should provide all the necessary information to determine financial statement dependence on estimates. If this report fails to do so and the contractor prepares and files its business income tax returns using the CCM - which it may do if average contract revenue earned is $25 million or less - the estimated dollar amount of earned revenue on uncompleted contracts and the estimated dollar amount of cost on earned revenue from uncompleted contracts are reported on Schedule M-1.
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The Possible Limits to Present Worker Leverage
In a recent New York Times article, David Leonhardt contends that the U.S. does not have a labor shortage. Rather, it has a shortage of workers willing to take jobs under present working conditions.
To support his contention, he cites the following reasons:
In a word, a great many workers are fed up with low paying, dead-end jobs, devoid of benefits and lacking any assurance of job security. With some cash in the bank, there is no better time to seek jobs with better pay, benefits, and a brighter future - particularly when a great many employers are in critical need of workers to meet increasing demand.
Leonhardt is skeptical the shortage will continue much longer. The shortage itself has resulted in numerous instances of higher pay, health benefits, and better working hours in some segments of the economy. But the federal stimulus checks have run their course and unemployment benefits have diminished. $1,000 of cash in the bank can stretch only so far, especially in an economy subject to steadily rising prices.
Apart from the COVID impact, the shortage of workers willing to work depends on their collective ability to outlast employers reluctant or unable to offer more attractive working conditions. Leonhardt concludes that, at the end of the day, employers have the greater leverage. The absent workers, as a result, will have little choice but to return to a business-as-usual jobs market and to do so in the fairly near future.
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The Conventional Wisdom May Have Missed the Mark
As The Economist notes in a recent report, the conventional wisdom in the world of economics states that expectations drive and determine inflation. Inflation is triggered by one of the two following events or by both emerging simultaneously:
One set of expectations reinforces the other. For example, if companies today anticipate an increase in materials cost because of supply chain bottlenecks and delivery delays, they tend to raise the price of their final products or services. Workers, on the consuming end of these price increases, demand greater wage and salary compensation, which compels companies to further increase prices of products and services. And the cost and price spiral continues, triggered initially by expectations.
If this cause-and-effect relation is valid, the key to controlling inflation is to control expectations about inflation. In the past three decades this task has fallen to central banks, such as the Federal Reserve. Since inflation has been quite modest over the past thirty years - excluding brief spikes during the Great Recession - it appears that central banks have curtailed inflation expectations quite effectively and, therefore, have curtailed actual inflation.
Very recently, however, a researcher at the Federal Reserve - Jeremy Rudd - published a study that contends this established explanation is all wrong. Expectations about inflation do not trigger inflation. Rather, expectations about inflation are based on observable facts and experience by companies and wage earners.
In effect, if central banks wish to control inflation, they need to focus first and foremost on the actual events driving inflation and not on the expectations resulting from these events.
Applied to today's environment, central bank focus should be on unraveling supply chain problems and controlling the steep increases in various raw materials and supply cost, if they have the ability and resources to do so. Any success they have in doing so will translate to stable or lower prices which, in turn, will result in a moderation of company and wage earner expectations about inflation. In other words, observable facts determine expectations about inflation, not central bank pronouncements.
Needless to say, Mr. Rudd's contention has set off a firestorm of controversy about the proper role of central banks and federal governments in controlling inflation.
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Another Look at Flat Reporting Structures
As The Economist notes in a recent commentary, the popular preference for flat reporting structures, triggered and sustained in part by the impact of COVID-19, eliminates middle management, which, in the opinion of The Economist, can be highly detrimental to a company's performance.There are two arguments in favor of a flat reporting structure in which the employee / boss reporting relationship is unimpeded by one or more layers of middle management:
Further, flat reporting structures give individual employees more responsibility for their own performance as well as contribute to a company's ability to respond more quickly to client needs and competitive initiatives unimpeded by established bureaucratic procedures.
Experience with flat reporting structures has not necessarily supported the anticipated benefits, according to The Economist. In every flat organization an informal leader emerges among a group of employees and, in effect, serves as a middle manager. Whether the emerging middle manager is right for the job is an open question. He or she may warrant the position on the basis of competence and managerial skills, or the informal leader may have emerged based on a dominant personality devoid of the necessary skills to effectively manage employees.
As The Economist observes, the stakes are high in getting the proper managers in place, regardless of whether they are formally recognized in the reporting structure. A company may pride itself on its flat reporting structure and use that structure as a recruiting tool. But such a company must also acknowledge that informal middle managers will emerge in any group and take steps to assure that such informal middle managers possess and display the talents and skills necessary to advance the fortunes of the company.
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Distant Cousins
On November 18th, Shockproof! Training conducts Debt Capacity and Cash Flow.
The webinar's target audience are analysts and lenders interested in reviewing the fundamental considerations that shape the concept of debt capacity, in examining methodologies for computing estimates of debt capacity, and in identifying the differences between debt capacity and cash flow.
The webinar complements and extends the body of analysis addressed in the Credit College Course on Cash Flow Statements and Cash Flow Proxies. It addresses and explores:
If you would like more information about any of our other 26 single-topic Webinars or about our six Credit College Courses, please call us at 1-866-237-7228 or send us an email at inquiry@shockproof.com.
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To access a 12 minute company overview, please click here.
To access a postcard PDF of our upcoming live sessions, please click here.
Please note, too, that Shockproof! Training recently incorporated a learning path function into its website that suggests single topic webinars and Credit College Courses that might be applicable for selected positions within financial institutions. The positions in question range from newly appointed credit analysts in commercial business and commercial real estate lending to experienced loan review officers, specialty lenders, and board members.