The Financial Statement Assurance Continuum

When a company sells a receivable on The Receivables Exchange, the Seller agrees to repurchase the receivable if the Account Debtor (the Seller’s customer) does not pay it.

The Seller’s commitment to repurchase is the Buyer’s initial line of defense against loss.

The strength of that defense is a function of the Seller’s ability to fulfill its commitment.

If the Seller’s customer doesn’t pay, how likely is it that the Seller will be able to pay as required?

The bulk of the information available to help answer that question will come from the Sellers themselves, principally in the form of financial statements. (Even if a Buyer obtains supplementary credit information from an independent provider, much of the information will have been sourced from the company itself.)

Two threshold questions always have to be asked: a) does it appear from the information provided that the Seller has the capacity to fulfill its commitment, and b) what level of confidence should we have in the information provided?

Each Buyer will look at financial statements somewhat differently but any analysis is only as good as the information available to analyze. So we’ll focus here on the question of confidence.

There are four generally-recognized types of financial statements produced by corporate entities: 1) audited, 2) reviewed, 3) compiled, and 4) internally-generated.

In the first three cases, an independent accountant or accounting firm has had some degree of involvement in the preparation of the statements. Statements that are internally-generated have no third-party whose name and reputation is associated with the data provided.

There are important procedural, technical and legal distinctions that have to be made to accurately distinguish among the first three types of statements. For our purposes, however, I think we can use a convenient “shorthand” distinction that appeared in a paper published in March 2008 by the Reliability Task Force of the American Institute of CPAs.

That paper presents an “Assurance Continuum” that positions each of the three types of financial statements on a line that proceeds from the highest level of assurance that the information is reliable to the lowest level of assurance.

In the language of that Task Force Report:

An audited financial statement has a “High Assurance” of reliability.
A reviewed financial statement has a “Limited Assurance” of reliability.
A compiled financial statement has “No Assurance” of reliability.

It follows, I think, that an internally prepared statement, which has had no independent accountant’s review, would also fall in the “no assurance” category.

Now, the fact that an accountant has not certified the accuracy of the data presented in a financial statement doesn’t mean the data is NOT accurate. And we’re all aware of cases in which apparently diligent audits have proven inaccurate.

We also have to acknowledge that the staff of The Receivables Exchange does spend time and effort vetting potential Sellers.

All that said, however: it is still only reasonable to acknowledge that there is a higher level of reliability in the financial statements of a company whose books have been audited by a third-party professional than there is in the books of a firm that internally generates its own statements.

The level of risk in a Buyer’s analysis does, without question, vary with the reliability of the financial data.

All else equal, the lower the level of assurance that the Seller's financial data is reliable, the higher the appropriate Buyer’s risk premium.

Liability: It's Not Personal.

Most firms that buy individual invoices routinely obtain a personal guarantee of the seller’s obligations from one or more individuals associated with the seller.

If the transaction goes bad, the personal guarantee can become critical in ultimately recovering the money advanced for the invoice purchased. One of the reasons is that, if litigation is required, the litigation process can take so long that other pledged security, such as other receivables and other financial assets, can be long gone by the time there is actually a judgment for the buyer to attempt to enforce.

The Receivables Exchange does not obtain personal guarantees from its Sellers. So the Buyers’ avenues of recourse in the event payments are not properly received are more limited.

Why would personal guarantees not be obtained by TRE and what are the implications?

I think there are a few pretty obvious answers to the first question.

1) TRE aims to become a very large-volume marketplace. As a practical matter, scaling up gross transaction volume requires two components: a) more Sellers, and b) larger average transaction sizes.

2) Larger average transaction size implies larger Sellers and the larger and more substantial the Seller the less likely its principals will be willing to provide personal guarantees.

3) In order for a personal guarantee to affect a Buyer’s assessment of risk, the substance of the guarantee would have to be known to the Buyer. Few individuals, especially owners or principals of more substantial Sellers, would be willing to have their personal financial information made broadly available to Buyers with whom they have no direct relationship and over whose use of the information they would have little effective control.

As to the implications, again, I think there are a few.

1) Analysis of the Seller’s financial condition and capacity becomes more critical. If a payment is not received for a purchased receivable, does the Seller have the ability to make good the Buyer’s loss?

2) Analysis of the validity of the receivable proposed for sale, which is always critical of course, becomes even more so.

3) Analysis of the Account Debtor’s capacity to pay and likelihood of paying the invoice likewise becomes more critical.

4) In short, when one source of security is removed, all of those that remain become more important.

I think it’s quite understandable that TRE does not obtain personal guarantees from its Sellers. But that doesn’t mean that there is no impact on risk assessment. And if there is an impact on risk assessment there should be an impact on pricing.

It does mean that analysis of the Seller’s financial condition, the validity of the invoices posted for sale and the ability and likelihood of the Account Debtors to pay those invoices, all take on heightened importance.

If analysis of the Sellers' financial condition becomes more important, reliability of the financial information provided (or otherwise available to Buyers) is key.

In our next post we’ll discuss the issue of the level of assurance that can be attributed to information in various types of Seller financial statements.

"Does this dress make me look fat?"

Wisdom from a good friend, older and wiser than I…

1. If you are asked: “Does this dress make me look fat?” and the questioner is your significant other, the appropriate answer is always “No!”. Honesty is neither virtuous (nor necessarily safe).

2. If that same person has a piece of parsley stuck in her teeth, on the other hand, you’ve just got to point it out.

I am a friend of The Receivables Exchange. I am a Buyer on TRE, so I am committed to it, and in my last several posts I’ve expressed very positive opinions on several major aspects of TRE structure, concept and operations.

But in my first post (scroll down or select the May 28 post from the sidebar) I did write:

“TRE is new and it is far from perfect. It will inevitably be required to make adjustments as experience teaches its operators and its users some valuable (and some potentially expensive) lessons. All beginnings are hard.”

So, in the next few posts I’m going to be discussing some aspects of TRE operations that I think are analogous to parsley in the teeth. You’re no less a friend for pointing it out; arguably you’re a better one; but it's less comfortable than delivering a compliment.

The issues to be discussed all bear on the assessment and pricing of risk.

More to follow.