Q: I am a small business credit analyst and, at my institution, we only require tax returns for underwriting. It seems as if borrowers want to supply as little financial information as possible. We seem to be fine with it as they would most likely go elsewhere to get financing that required less financial information if we asked for additional accrual statements. In your experience is this a standard practice amongst banks or is this specific to my institution, and what do you think the impact on our portfolio this would have?
A: As a general comment, many lenders require only the accrual financial statements and do not use federal income tax returns (nor ask for them) as the basic document to assess a borrower’s credit worthiness. They frequently ask for a personal guarantee accompanied by a personal financial statement drawn up by the lender and signed by the guarantor, along with one or more years of the guarantor’s personal income tax returns.
If your institution requires federal income tax returns, it would be very difficult to ask your borrower for additional information in the form of accrual financial statements as you point out. But if your institution is prepared to use accrual financial statements in place of federal tax returns, then it would be appropriate to ask the borrower about his willingness to provided them. Many borrowers provide federal tax returns with some hesitation since they can be voluminous and, on occasion, require the help of an accountant for assembling them properly for transmission to the lender, an added expense for the borrower.
To recall, federal tax returns are not intended to be used to analyze commercial businesses for several reasons. They do not represent an impartial look at a company’s financial statements based upon Generally Accepted Accounting Principles (GAAP). Federal tax returns do contain an accrual balance sheet based upon GAAP. However, the quasi income statement on the first page of the return is prepared according to the United States Tax Code. This means that the balance sheet and the income statement are not compatible with each other, i.e., they do not reconcile to the change in net worth on the balance sheet.
As a result, financial statement ratio and cash flow analysis cannot be done correctly with a balance sheet and income statement that are not compatible. It is therefore necessary to either get the accrual financial statements or convert the tax-based income statement to one that is based on GAAP.
In addition, federal tax returns are somewhat incomplete in that they do not include any income that is not taxable (U.S. bond income, for example) nor do they include any expenses that are not tax deductible (one-half of meals and entertainment expenses, etc.).
And finally, the accountant needs the accrual GAAP-based financial statements to complete the federal tax return. Evidence that a GAAP income statement does exist can be found on Line 1 of Schedule M-1 which reports GAAP-based accrual income or loss.
Course overview: Business Income Tax Returns and Ratio Analysis