A Quality Opportunity?

In our post of June 23 we wrote about the differences among the principal types of financial statements that privately-owned companies produce.

The companies that sell receivables on The Receivables Exchange are privately-owned firms that usually do not have audited financial statements. Many, in fact, don’t provide even “reviewed” or “compiled” statements; the financial statements available to a TRE Buyer are most often those of the management only, without independent review.

In our June post we quoted a report of the American Institute of Certified Public Accountants that a “compiled” financial statement carries with it “no assurance” of reliability from the accounting firm that has prepared the statement. Clearly a report that is prepared and presented by management alone can be considered no more credible than one complied by an independent CPA.

It’s not that management-prepared statements are necessarily less accurate than those prepared by independent accountants but I think it’s fair to say that the odds of material error or misstatement are far greater in a management-prepared financial statement than in one audited by an independent accountant.

If TRE is to become a major force in the receivables-finance industry, as we certainly hope it will, it will have to attract thousands of Sellers and it will have to attract sufficient Buyer capital to meet the needs of those Sellers. It will ultimately need to provide Buyers with more and better tools to make decisions regarding the quality of Sellers and the risks involved in buying the receivables of those Sellers.

Just as we suggested that eventually TRE would do well to go back to the model of having an independent invoice-verification agent, it also would do well to actively promote the establishment of an independent Seller-quality rating system.

It is unrealistic to expect that each Buyer will be able to maintain appropriate due-diligence information on thousands of TRE Sellers. It is also unrealistic to expect that TRE growth targets will be met unless Buyers have some source of risk analysis independent of TRE itself.

Many of the Buyers that TRE will certainly want to attract will be capital sources with some (at least internal) quality-rating requirements on funding. Recent experience in the markets for "new" financial products also suggests that those with oversight responsibility for the investments of potential Buyers will find it prudent to have third-party quality opinions.

At some point, attracting capital is inevitably going to require greater perceived objectivity and independence in analysis of Seller risk.

My guess is that TRE understands this. My hope is that they are working on it.

There are several possible models for establishing rating mechanisms. There are qualified entities already in the business of analyzing the financial condition of private companies. If a convincing case can be made for the ultimate success of TRE, and I think one can, there should be someone interested in providing a rating system of some sort for its Sellers.

There are just as many potential difficulties and inconveniences for TRE in dealing with an independent quality-rating system as there are with an independent invoice-verification system. Dealing with those inconveniences and solving those problems is part of the price of success.

It’s one of those examples of the paradox of control: the more control, in this case over the analysis of risk, that TRE is ultimately willing to give up, the more likely it is to actually accomplish its objective.

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.