Hold the pickles! On the virtue of sameness.

I spent a few years managing commodity futures investments.

The fundamental principle upon which the commodities business depends is sameness.

When you buy or sell a contract for the delivery of corn or coffee or oil or Swiss Francs, you know precisely what goods and services the contract requires: the quality, the quantity, the delivery date, the delivery location, the payment terms, etc. The only thing left to the operation of the market is price discovery.

In the classic fast-food differentiation war between Burger King and MacDonald’s, Burger King began the now famous “Hold the pickles” campaign in 1974.

BK promised that you could “have it your way”, customizing the product to your own particular tastes. While a brilliant marketing move, this also left BK open to a much higher incidence of customer complaints.

MacDonald’s promised to hand you a Big Mac, as standard (at that time) in its specifications as a futures contract on the wheat used in making its buns.

Burger King, on the other hand, promised to give you exactly what you asked for: “hold the pickles, hold the lettuce, no cheese, and extra mustard”; or, whatever.

MacDonald’s was the commodity provider; Burger King was the specialty supplier.

Here’s the point.

The odds of a complaint in a commodity transaction are significantly lower than the odds of a complaint in a specialty transaction. The Big Mac buyer can demand compensation if the burger is cold and dry. But the Whopper buyer who ordered it “his way” might have six other valid reasons for rejection of the product.

In our post of July 5 (An Inconvenient Essential—Part One) we pointed out that the TRE invoice verification process is limited in scope. TRE does NOT receive an assurance from the Account Debtor that the goods or services provided by the TRE Seller have met the specifications of the contract. All we know is that the invoice is in the Debtor’s Accounts Payable system. And that might only require that an invoice has been submitted by the vendor.

A Buyer considering the purchase of a TRE-posted receivable assumes some degree of risk that the obligation will be denied and payment refused (or that some negotiated compromise will be required). That risk should, of course, be reflected in the pricing of the transaction. The higher the risk that the goods or services might fail to meet contract requirements, the higher should be the appropriate return premium.

In pricing a transaction a Buyer has to ask: is the contract for a Big Mac or a Whopper?

In my traditional invoice-purchasing business I like to use the example of an excavation and demolition contractor who was an early client of mine. If my client had a contract to demolish a building I could go to the site and see that the building was demolished. If he had a contract to dig a foundation, I could go to see if there was a hole in the ground. It’s not perfect confirmation (maybe the hole in the ground is too deep) but there is some comfort in its simplicity.

When a client provides goods or services that are specialized, the question of risk becomes more complex and complexity requires compensation, especially in the absence of full verification.

When the product is “customized”, “specialized” or “turn-key”, I know that I’m not dealing with the guy who makes holes in the ground.

When the goods or services are based on “proprietary”, “innovative” or “patented” processes, I know I’m at the Burger King counter, not at MacDonald’s.

The more clearly I am dealing with a commodity, or a commodity-like service, the lower I can set my risk premium in bidding.

The more “customized” or “specialized” the product or service, the more I have to be compensated for the lack of assurance from the Debtor that he actually “got it his way”!

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.