Businesses need to assess their financial status periodically in light of changing economic or industry conditions. This includes examining their financial statements to ensure the statements continue to be adequate, accurate and complete. Occasionally, business owners or financial officers may determine that the financial statements need to be revised or corrected. When your borrowers provide you with corrected or restated financial statements, be vigilant and double-check the numbers. It may be that the restatements simply correct an honest mistake. Alternatively, there may be fraud involved.
When a mistake becomes intentional
When Tom took over his aunt’s marketing company, the lender quickly discovered that Tom’s accounting skills hadn’t kept pace with his marketing abilities. The company engaged in various types of related-party transactions, including seller financing and a leasing arrangement with the previous owner. Tom also seemed unsure when to capitalize or expense supplies and equipment.
After two years of sloppy, delayed financial reporting, Tom’s lender recommended hiring an accountant for financial reporting and tax expertise. Shortly thereafter, the lender received an unwelcome surprise: The company needed to reissue its financial statements for the past three years.
Ultimately, the restatements revealed that Tom had overstated profits by more than $3 million over the last three years. When confronted with the news, he confessed that he’d been intentionally padding profits, because he didn’t want to disappoint his aunt.
The lender called the company’s $4 million line of credit. Tom was forced to confess his mismanagement to his aunt, who eventually left retirement to turn around the business.
When complex rules invite misinterpretation
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 happen when a borrower converts from compiled financial statements to audited financial statements or decides to file for an initial public offering. They also may be needed when the borrower 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.
When errors become significant
Errors are a common cause of financial restatements. For example, borrowers sometimes make 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 among investing, financing and operating on the statement of cash flows. Other leading causes of restatements are equity transaction errors, such as improper accounting for business combinations and convertible securities, and valuation errors related to common stock issuances. Preferred stock errors and the complex rules related to acquisitions, investments, revenue recognition and tax accounting also can cause restatements.
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 high-risk 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.
Even the most well-managed business may slip up and make financial statement mistakes that need to be corrected. But some restatements are a warning flag — not just of potential fraud but of mismanagement or carelessness. When a borrower presents you with financial restatements, investigate the underlying cause to stay ahead of any potential problems.