by Gregory S. Dowell

September 7, 2017

Having a firm grasp on financial performance is a fundamental of every good business, and effective accounting systems don’t just happen, they come with planning. Owners who are using their professionals wisely and strategically will have consulted a CPA firm during the early planning stages of the business. Working together, the owner and CPA will have determined what the best accounting processes are for the business, as well as the appropriate basis of accounting to be used. A CPA can help the business owner determine who should do what from an accounting and bookkeeping perspective, as well as who should be in charge of oversight. It is in those early stages that a business owner will want to determine if the accounting function should be largely outsourced to an accounting firm, or if the accounting firm should provide oversight of the internal accounting/bookkeeping department. Remember as well that it is also important to re-consider and re-assess the accounting processes as the business grows.

Virtually every business will also develop a banking relationship early in its timeline. A growing business will also attract additional attention from its bank for many reasons – including new services to sell and new products to deploy. A growing business will cause a bank to become more interested in the business’ financial statements. As lending and risk exposures grow, the bank will look more closely at the business’ accounting processes and look for more frequent reporting from the business. In the end, the bank will look for more comfort in the type of financial statements that are being prepared. By the way, the term “banks” is used in this article, but virtually all lenders will follow this pattern.

In the early stages of a business’ life, assuming that there has been a minimal amount of lending involved, a bank may be perfectly fine with accepting annual financial statements that are internally prepared by the client. If it is a competitive banking environment, banks may accept internally prepared financials for a surprisingly long time. At some point, however, a bank has to mitigate the risk of financial misstatement or fraud. As soon as lending hits that sensitive threshold of unacceptable risk, the bank will ask deeper and more probing questions about financial performance and may ask for more frequent reporting than just on an annual basis. Almost inevitably, as the business grows and the financial statements become more critical to the bank, the bank will require financial statements that are prepared by a certified public accountant. Hopefully, when that time arrives, the business owner has already created a relationship with a CPA firm, and the CPA firm can provide some coaching during this process.

Depending again on the size of the lending engagement, a bank may be content to receive statements that are “prepared” or “compiled” by a CPA firm. “Prepared” and “compiled” are two distinct level of service provided by CPAs. Prepared statements are relatively new to the market and come with no cover report from a CPA firm and are the lowest level of formal financial statement that a CPA firm can prepare; prepared financials are effectively equivalent to statements that would be generated internally by a controller or CFO. Because of their newness, most bankers are not aware of prepared statements; more importantly, most bank legal departments that draft loan documents are not familiar with prepared statements. A bank is much more likely to ask for compiled financial statements, and these come in two flavors: with footnotes and without footnotes. If a bank is looking for a higher level of comfort as the loan exposure grows, they will typically ask for “reviewed” financial statements or “audited” financial statements.

A business owner should be aware that when the bank requires a different level of financial statement, they still have some ability to negotiate. A bank may be willing, for instance, to postpone the requirement for another year, or possibly two, particularly if the business has a good track record with the bank and has provided reliable financial statements and other information on a timely basis throughout the relationship. The level of financial statement can often be negotiated as well. Again, if the market is very competitive for loans, banks will often be willing to change their terms in order to keep a valued relationship. In addition to having a strong track record as a good borrower and a good customer with the bank in general, a business owner is also wise to cultivate a relationship with the banker. A good banker can absolutely be an advocate for the business owner and can apply reasonable pressure to the loan committee to make concessions, when appropriate.

A business owner should know these basic levels of financial statements that can be prepared and should lobby to provide the least costly, when appropriate. In terms of complexity and cost, from lowest to highest, here is how they rank:

1. Prepared (least complex, least costly)
2. Compiled without footnotes
3. Complied with footnotes
4. Reviewed
5. Audited (most complex, most costly)

In addition, there is another little-asked question that we have often used to save our clients tens of thousands of dollars over the life of a loan. When a bank asks for reviewed or audited statements, most bankers will assume that they (the legal department of the bank) require financials that follow generally accepted accounting principles (“GAAP”). In fact, most loan documents so not specify the type of accounting basis that needs to be used, but will simply note “reviewed” or “audited”. This is a big issue, because the most complicated financials to prepare are GAAP-based statements. Many businesses that are privately-owned will keep their books and records (as well as their tax returns) on some other basis of accounting, typically income-tax-accrual based or income-tax-cash based. If formal financial statement can be audited on a basis other than GAAP, the typical business will save several thousand dollars annually.

The discussion of accounting basis is often beyond the comfort zone of the business owner (as well as the banker). We often step in at this point and work with the banker to educate on the various possibilities and to advocate for the business owner. This has, in some cases, resulted in our firm having conferences with the bank’s legal departments as well.

There are four takeaways from this article for the business owner. First, develop a relationship with your CPA so that you have a trusted advisor at your side. You want the CPA to give you input from the outset, so that you thoughtfully structure the accounting function. You want the CPA at your side before you negotiate with the bank. Second, develop a relationship with a banker; you want that banker to know your business and be willing to go to bat for you at a critical time in the future. Third, in conjunction with your CPA, advocate to provide the least complex and least costly type of financial statements to your bank. This may require some educating and negotiating with the bank. Fourth, confer with your CPA and check the loan documents and then lobby to prepare the financial statements using a basis of accounting that will be less costly for the business.