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- 12/2021
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December 2021 Comments
In this issue:
Federal Tax Returns and the Credit Write-Up
In 2021, we conducted 262 online sessions arrayed between a) multi-week Credit College Courses - Accounting Essentials, Cash Flow Statements and Cash Flow Proxies, Credit Basics, Commercial Business Underwriting, Commercial Real Estate Underwriting, and Using Federal Tax Returns for Ratio and Cash Flow Analysis - and b) single topic webinars that addressed more than 30 credit assessment issues two or more times throughout the year.
On reflection, the analytical issue that appeared most pressing in 2021 was the proper use of federal tax return documents as the source of financial information for assessing borrower risk. Consequently, it seems appropriate to consider this issue in some detail as we end 2021 and prepare for 2022.
Federal tax returns are used by many lenders as the source document for borrower analysis for two primary reasons.
Based on information in the federal tax returns, lenders conduct an analytical assessment of the borrower that flows into the analytical sections of the credit write-up. The format and content of credit write-ups vary greatly from one lender to the next, but they all seem to have the same basic analytical objectives in assessing the risk of repayment for a commercial loan transaction, which are to:
To successfully pursue these objectives, a lender needs to conduct both an historical assessment and a projected assessment. The past offers insights into the future. Future events determine the borrowing causes, suggest the cash sources of debt service, point to relevant risks for each cash source of repayment, and raise the issue of identifying mitigants for these anticipated risks.
Problems and Limitations
It seems fair to say that it is much easier to conduct an historical assessment than a projected assessment since the relevant data for doing so are established facts. Yet the use of tax returns as the relevant data faces immediate problems.
First, federal tax returns are prepared according to IRS regulations and guidelines, which, in turn, reflect Congressional legislation. IRS tax preparation regulations and guidelines invariably differ from guidance provided by Generally Accepted Accounting Principles (GAAP), which establishes the guidelines for preparing accrual financial statements. As a result, taxable revenue and tax-deductible expenses rarely, if ever, match accrual revenue and accrual expenses.
Second, every tax professional or accountant preparing federal tax returns has a single overriding objective, which is to drive down taxable income to the lowest possible point for the client. As a result, federal tax returns present the operations of the borrower in the worst possible light.
There are other problems that emerge as a lender sifts through the financial information in the federal tax returns. It is difficult to clearly identify the historic borrowing cause or causes since no cash flow statement - or Schedule - exists in a set of federal tax returns. A lender can review Schedule L in the returns, which is the borrower's accrual balance sheet in a fixed format with fixed account titles, to identify significant increases in assets that may require funding or significant decreases in liabilities that may also require funding. But the process is very inexact.
The same difficulties exist with respect to identifying the cash sources of repayment. It is possible to compute traditional "cash flow" from available federal tax return information, but taxable net income and tax-deductible depreciation may differ significantly from their GAAP counterparts in an accrual income statement - especially if the tax accountant attempts to drive taxable net income as close to zero as possible. But absent a statement of cash flow in a set of federal tax returns, traditional "cash flow," however computed, is virtually no help in identifying the cash sources of repayment.
A Path Around the Problems
The common work-around is to plug the federal tax return information into a spreading system and use the resulting output for analysis, which means accepting an "unexplained difference" in the reconciliation of net worth on the balance sheet. The "unexplained difference" signals that taxable net income is either more or less than accrual net income, which means that taxable revenue or tax-deductible expenses, or both, differ from accrual revenue and accrual expenses. The message is that performance ratios based on taxable revenue or tax-deductible expenses will differ from performance ratios based on accrual revenue or accrual expenses. Further, the "unexplained difference" states, in effect, that the cash flow statement generated by the spreading system will not match a cash flow statement based on accrual financial statement information.
In fact, the set of performance ratios and a cash flow statement produced by spreading software and based on input from federal tax returns tends to be more negative than those metrics based on accrual financial information simply because of the universal objective of driving down taxable revenue to the lowest amount possible in preparing federal and statement tax returns.
Another Approach
There is an alternative to this work-around, which is simply to ask the client for its company-prepared accrual financial statements and use them. Line 1 on Schedule M-1 in the federal tax returns reports the accrual net income for the borrower. Schedule M-1 reconciles accrual income at Line 1 with the borrower's taxable income. This reconciliation process implies that the tax professional or tax accountant preparing the federal tax returns has closely reviewed the company's accrual financial statements and made any necessary adjustments to assure a proper reconciliation. In other words, a professional has indeed "touched" the company-prepared statements to assure proper revenue and expense reporting very much as he or she would in preparing reviewed statements.
Even if the lender is reluctant to give up federal tax returns as the relevant data for borrower analysis, company-prepared financial statements offer rather invaluable support to the assessment process. They always include a FASB 95 Statement of Cash Flows as a standard report in every accrual financial statement package regardless of the accounting software, such as QuickBooks, used by the borrower. This report identifies the historical borrowing causes and the cash source or sources of repayment precisely. In addition, the lender can enter the accrual financial information into its spreading system and compare the resulting performance ratios with those generated from federal tax return information by the same spreading system. It can then explore reasons for the differences and decide which set of output it wishes to use for its historical analysis.
The Projected Assessment
With respect to a projected assessment to identify borrowing causes and cash sources of repayment, focus on the likely values of the performance ratios for the Business Drivers, which are as follows:
These eight Business Drivers, which will not apply to all companies, determine both the accrual and cash position of the borrower. It takes considerable knowledge working with company management to shape useful projection values for these performance ratios. But the results can indeed be worth it and lead to considerable confidence in identifying risks to each projected cash repayment source as well as exploring practical mitigants to those risks.
Happy New Year and Best Wishes for a Prosperous 2022!
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A New Administrator Tool
During 2021, we added a new enrollment feature to our learning platform that allows member Administrators to assign learning paths - a series of courses - to a participant without immediate course activation. That means member connections are not used until each course or courses are activated by the participant, done by clicking a button next to the course when he/she is ready to enroll.
Once assigned, the new feature allows an Administrator to view participant progression through courses assigned.
Once logged into your Administrator account, follow these steps to use the new feature:
If you wish, as an Administrator, you can assign a learning path to your own account, and then view what a user will see, a list of courses with an "Awaiting Activation" button next to each.
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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.