Magazine article The Journal of Lending & Credit Risk Management

Helping Financial Institutions Apply New Rules on Special Reports

Magazine article The Journal of Lending & Credit Risk Management

Helping Financial Institutions Apply New Rules on Special Reports

Article excerpt

Financial institutions often request CPA services to help support their loan documentation. However, some lenders would like to receive CPA assurance regarding certain potential problems without obtaining a full audit, for example, in ascertaining the value of certain inventories or the collectibility of certain accounts or loans receivables.

In response to these needs, the American Institute of Certified Public Accountants' (AICPA) Auditing Standards Board issued recently two authoritative standards, commonly known as Agreed-Upon Procedures (AUP).(1) Loan officers, credit managers, and others involved in the loan process may benefit from these new standards by requesting the right type and amount of CPA services without necessarily incurring the time and expense of a complete financial statement audit. Clients can be asked to provide financial statement information based on one of the new standards.

Applications of the New Standards

AUPs can prove to be more efficient than other types of CPA services by:

* Allowing CPAs to focus on specific problem areas (for example, account for "missing" fixed assets) without the costs of a (full) traditional audit. If sufficient problems persist, lenders can later ask their CPAs to expand the AUPs to audits.

* Allowing CPAs to tailor their work to satisfy specific needs with the desired level of detail and depth to augment the credibility of financial reports and assess the risk of certain construction, lease, and loan contracts.

Other examples of such services include:

* A lender can assess a mortgage applicant's liquidity position by analyzing the "quality" of working capital and the current, quick, debt-to-equity, and times-interest-earned ratios.

* A lender can learn the budgeted full cost of constructing a housing project to meet certain customer specifications.

* A dealer can ask for a schedule of lease payments using different interest rates and assuming different inflation rates.

* A mortgage applicant can show the lender its "collectible" accounts receivable balances.

* A lender can verify the quantity and quality of a customer's plant and equipment assets, as well as the assets' current market value, before granting a loan.

* A financial institution can confirm the cost estimates of converting a traditional building into a "smart" building equipped with fiber-optic systems and the ability to bring telecommunications to various departments.

* A borrower can find out if a lender's calculated interest and principal payments after allowing for specific allowances for a risk premium are accurate.

* A bank can ask its developer-client to perform a sensitivity analysis of the amounts of revenue that can be earned using different estimates of the percentage of completion of a bridge built on an interstate highway.

While users of such services expect certain CPA assurances regarding the validity of the procedures performed, these users are responsible to ascertain which procedures the CPAs should perform. Thus, the engagement letter should detail these procedures and define in advance precisely key operating terms as budgeted full cost, collectible, market value, and accurate, by using such criteria as adherence to specific portions of stated contracts, the type of cost allocation followed in the specific client industry, amounts due for less than 60 days from active customers, and amounts listed in current catalogs and appraisal reports.

Overview of the New Standards

Financial institutions can request many financial and nonfinancial sets of AUPs, as shown in Figure 1. A Statement on Auditing Standards (SAS) No. 75 engagement requires CPAs to perform some - but not all audit procedures to specified elements, accounts, or items found in the financial statements. For example, CPAs can attest to the validity of information (for example, accounts receivable balances), notes to the financial statements (for example, discounted notes receivable with recourse), or other information derived from the financial statements (for example, if the clients meet working capital ratios specified in loan covenants). …

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