Play it Again, Sam

by: Smith and Howard

July 31, 2014

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Everyone deserves a second chance or “mulligan,” as they say in golf. But lenders become understandably uneasy when borrowers reissue their financial statements. They wonder, “Why couldn’t they get it right the first time?” or “What are they trying to hide?” For most borrowers, financial restatements result from an honest mistake or misinterpretation of accounting standards, rather than from incompetency or fraud. But that’s not always true, as this hypothetical example points out.

Cheaters never win 

When Sam bought Dimples & Drivers Golf Club from his retiring father, his lender quickly discovered that Sam’s “handicap” wasn’t his short game — it was his accounting skills. The club engaged in various types of related-party transactions, including seller financing and a leasing arrangement with the previous owner. Sam also seemed unsure how to report prepaid dues and golf lessons — or when to capitalize or expense supplies and equipment.

After two years of sloppy, delayed financial reporting, Sam’s lender recommended hiring an accountant for financial reporting and tax expertise. Shortly thereafter, the lender received an unwelcome surprise: Dimples & Drivers needed to reissue its financial statements for the past three years.

Ultimately, the restatements revealed that Dimples & Drivers had overstated profits by more than $2 million over the last three years. When confronted with the news, Sam confessed that he’d been intentionally padding profits, because he didn’t want to disappoint his father.

The lender called the club’s $3 million line of credit, just before the start of the summer busy season. So Sam was forced to confess his mismanagement to his father, who eventually left retirement to turn around the business.

Complex standards can lead to restatements 

Not all restatements result from misleading or unethical management. Often owners and managers just aren’t on top of today’s increasingly complex accounting rules — and honest mistakes or misinterpretations cause a restatement. Restatements typically occur when the company’s financial statements are subjected to a higher level of scrutiny. For example, restatements may occur when a borrower:

  • Converts from compiled financial statements to audited financial statements,
  • Decides to file for an initial public offering, or
  • Brings in additional internal (or external) accounting expertise, such as a new controller or audit firm.

The restatement process can be time consuming and costly. Regular communication with interested parties — including lenders and shareholders — can help overcome the negative stigma associated with restatements. Management also needs to reassure employees, customers and suppliers that the company is in sound financial shape to ensure their continued support.

Error-prone accounts add risk

Recognition errors are one of the most common causes of financial restatements, according to a report from proxy research firm Glass, Lewis & Co. Borrowers typically make these mistakes when accounting for leases or reporting compensation expense from backdated stock options.

Income statement and balance sheet misclassifications also cause a large number of restatements. For instance, a borrower may need to shift cash flows between investing, financing and operating on the statement of cash flows.

Equity transaction errors, such as improper accounting for business combinations and convertible securities, can also be problematic. Other leading causes of restatements are valuation errors related to common stock issuances and preferred stock errors and the complex rules related to acquisitions, investments, revenue recognition and tax accounting.

You can minimize your dependence on bad numbers by requiring independent audits for private borrowers. You also may request cost-effective internal control testing procedures for prospective and highrisk borrowers, such as those that engage in hedge accounting, issue stock options, use special purpose or variable interest entities, or consolidate financial statements with related parties.

Get it right the first time

Many restatements result from unintentional errors — but some occasionally signal intentional attempts to mislead lenders and other stakeholders who rely on financial statements. It’s your job to evaluate restatements carefully to unearth the underlying cause. In some cases, you’ll need to cut ties with weak or unethical borrowers. But, if you decide to stick beside a borrower throughout the restatement process, you can engender trust and long-term customer loyalty.

It is especially critical that lenders have confidence in the accounting firm working with their borrowers. Smith and Howard, a top Atlanta CPA firm, has an impeccable reputation in the financial community, coupled with a history of peer review reports that have provided “unqualified” opinions and a track record of PCAOB compliance. Call us at 404-874-6244 for more information on how we work with businesses and lenders.

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