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This is the third of a series of three short newsletters on how to stay ahead of finance process issues and prevent these challenges from becoming more significant problems. Each newsletter has addressed a different aspect of these challenges: Producing Data, Garbage In, Garbage Out, and The Audit: Don’t Get Scared, Get Organized (today’s topic).
As noted in the first two newsletters, a strong finance team is critical to the success of any company. One of the roles of the finance team is to prepare for and manage the external audit of the company’s financial statements. Several of the points covered in the previous newsletter, regarding controls over spreadsheets and data management, will also be helpful in preparing for the audit, but we recommend some specific steps below.
Challenge – The External Audit Takes an Inordinate Amount of Time to Complete
Many companies have experienced this, and it is human nature to blame the auditors, but there is usually more going on here. Here are some of the symptoms:
- Documentation requested by the auditors is difficult to locate or does not agree with the accounting records. Documents that do not support recorded amounts are considered errors by the auditors, so they need to expand their testing and the expanded testing often finds more errors.
- The audit takes much longer than planned, so accounting firm staff are reallocated to other commitments and replaced by staff new to the audit.
- Once problems start Auditors are no longer committed to deliverable dates and are reluctant to commit to new dates, audit cost overruns become obvious and a sore point in the relationship with the auditors.
- Audit fatigue sets in on both sides and it becomes very difficult to manage the process.
Action Plan, Step One – Prepare Well in Advance for the Audit
- Review issues experienced in the prior audit and take steps to correct them before the audit begins. If certain transactions, or a class of transactions, have been challenging to audit in the past, or are new to the company, consider performing an ‘internal audit’ of those transactions so the issues with their documentation can be addressed before the audit begins.
- Request a detailed timeline from the external auditors that includes key deliverables to and from them. Last year’s listing of schedules ‘Prepared by Client’ is a good place to start.
- If the audit includes multiple locations, make sure the reporting from the auditors at the other locations to the auditors in the center is included. The auditors at the center, particularly at the staff level, may not see this as ‘their problem.’
Action Plan, Step Two – Proactively Manage the Audit
- Insist on frequent (and brief) meetings between key audit firm and company personnel to assess progress. These meetings should be more often than once a week during the “heat” of the audit, daily 15 minute ‘stand-up’ meetings are a good idea during this period.
- The objective of these meetings is to timely find and address issues (e.g., exactly who is to give what to whom).
- On a weekly basis these meetings should seek to reaffirm that all parties remain committed to the ultimate deliverable of a signed audit opinion on the required date. Auditors may be reluctant to raise a concern about timing of completion in these meetings, as it can be a difficult conversation, but it is important to identify any potential problem early so it can be addressed.
A Company can achieve an effective and efficient audit by starting to plan well in advance of when the audit work is to be done and proactively managing the process from start to finish.
Announcement of Final Rule
On September 11, 2020, the Securities and Exchange Commission announced that it has adopted rules to update and expand the statistical disclosures that bank and savings and loan registrants provide to investors, in light of changes in this sector over the past 30 years. The rules also eliminate certain disclosure items that are duplicative of other Commission rules and requirements of U.S. GAAP or IFRS. The rules replace Industry Guide 3, Statistical Disclosure by Bank Holding Companies (Guide 3), with updated disclosure requirements in a new Subpart 1400 of Regulation S-K (Subpart 1400). SEC Chairman Jay Clayton said “Guide 3 has not been substantively updated for more than 30 years. The changes we are adopting today are designed to elicit better disclosures for investors and add efficiencies to the compliance efforts of registrants.” (https://www.sec.gov/news/press-release/2020-205)
Modernization of Statistical Disclosures for Bank and Savings and Loan Registrants
The rules update the disclosures that investors receive and eliminate overlap with Commission rules, U.S. GAAP or IFRS. The updated statistical disclosure requirements are codified as a new Subpart 1400 of Regulation S-K and Industry Guide 3, Statistical Disclosure by Bank Holding Companies is rescinded.
The Commission’s rules require disclosure about the following:
- Distribution of assets, liabilities and stockholders’ equity, the related interest income and expense, and interest rates and interest differential (Average Balance, Interest and Yield/Rate Analysis and Rate/Volume Analysis)
- Weighted average yield of investments in debt securities by maturity
- Maturity analysis of the loan portfolio including the amounts that have predetermined interest rates and floating or adjustable interest rates
- Certain credit ratios and the discussion of the factors which explain material changes in the ratios, or their related components during the periods presented
- The allowance for credit losses by loan category
- Bank deposits including average amounts and rate paid and amounts that are uninsured
A detailed discussion of the changes to each of the disclosure requirements follows in Appendix A.
The new rules apply to bank and savings and loan registrants. Guide 3, by its terms, applied to bank holding companies but was widely adopted by savings and loan holding companies and other registrants with material lending and deposit gathering activities.
The rules apply to domestic registrants, including Regulation A issuers, and to foreign registrants. The disclosure requirements are linked to categories or classes of financial instruments disclosed in the registrant’s U.S. GAAP or IFRS financial statements, aligning the reporting period statistical disclosure requirements with those required to be presented in the financial statements, and explicitly exempting IFRS registrants from certain of the disclosure requirements that are not applicable under IFRS.
Impact of Changes
Significant new disclosures include weighted average yield of debt investment securities by maturity, maturity analysis of loan portfolios, expanded credit ratios and factors explaining changes in those ratios and uninsured time deposits including a breakdown by maturity. Certain ratios required in Guide 3 (return on assets, return on equity, dividend payout, and equity to assets) are eliminated from Subpart 1400 but are likely to continue. These ratios are not unique to bank and savings and loan registrants, and the Commission’s guidance on MD&A already requires registrants to identify and discuss key performance measures when they are used to manage the business and would be material to investors.
Location of Disclosure Requirements and XBRL
Consistent with existing Guide 3, the disclosures of new Subpart 1400 are not required to be presented in the notes to the financial statements. Therefore, if disclosures are provided outside the financial statements, for instance in the MD&A sections, the disclosures would not be required to be audited, nor would they be subject to the Commission’s requirement to file financial statements in a machine-readable format using XBRL.
The rules will be effective 30 days after publication in the Federal Register and will apply to fiscal years ending on or after December 15, 2021. Voluntary compliance with the new rules will be accepted in advance of the mandatory compliance date however the new rules must be adopted in their entirety. Guide 3 will be rescinded effective January 1, 2023.
Notice to Readers
This publication has been carefully prepared, but it necessarily contains information in summary form and is therefore intended for general guidance only; it is not intended to be a substitute for detailed research or the exercise of professional judgment. The information presented in this publication should not be construed as legal, tax, accounting, or any other professional advice or service. CFO Consulting Partners LLC can accept no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. You should consult with professional advisors familiar with your factual situation for advice concerning specific audit, tax or other matters before making any decisions.
Appendix A: SEC Modernizes Disclosure for Banking Registrants
– Outline of Requirements of Subpart 1400 of Regulation S-K
Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rate and Interest Differential (Average Balance, Interest and Yield/Rate Analysis and Rate/Volume Analysis)
Item 1402 of Regulation S-K:
- Codifies all of the average balance sheet, interest and yield/rate analysis and rate/volume analysis disclosure items currently in Item I of Guide 3
- Requires segregation of domestic and foreign activities, if applicable
- The categories enumerated in Item 1402(a) must be included, if material
- Additionally, registrants are required to separate (1) federal funds sold from securities purchased with agreements to resell and (2) federal funds purchased from securities sold under agreements to repurchase and to disaggregate commercial paper, if material.
Item 1403 of Regulation S-K:
- Codifies the requirement to disclose weighted average yield for each range of maturities by category of debt securities required to be disclosed in the registrant’s U.S. GAAP or IFRS financial statements
- Applies to debt securities that are not carried at fair value through earnings.
- Eliminates requirement for certain disclosure items in Item II of Guide 3 as these items substantially overlap with U.S. GAAP and IFRS disclosure requirements:
- book value information
- the maturity analysis of book value information
- the disclosures related to investments exceeding 10% of stockholders’ equity
Item 1404 of Regulation S-K:
- Item 1404(a):
- Codifies the requirement to disclose the maturity by loan category disclosure currently called for by Item III.B of Guide 3, with the loan categories based on the categories required by U.S. GAAP or IFRS in the financial statements
- Requires additional maturity categories to provide investors with sufficient information on the potential interest rate risk associated with the loans in the portfolio
- Codifies the existing Guide 3 instruction stating the determination of maturities should be based on contractual terms
- Also codifies the language, as proposed, regarding the “rollover policy” for these disclosures
- To the extent non-contractual rollovers or extensions are included for purposes of measuring the allowance for credit losses under U.S. GAAP or IFRS, such non-contractual rollovers or extensions should be included for purposes of the maturities classification and the policy should be briefly disclosed
- Item 1404(b):
- Codifies the disclosure items in Item III.B of Guide 3 regarding the total amount of loans due after one year that have (a) predetermined interest rates or (b) floating or adjustable interest rates
- Specifies that this disclosure should also be disaggregated by the loan categories disclosed in the registrant’s U.S. GAAP or IFRS financial statements to promote consistency of loan portfolio disclosures throughout a registrant’s filing, and elicit trend information about interest income and potential interest rate risk
- The final rules require additional maturity categories (1) after five years through 15 years, and (2) after 15 years
- The additional maturity categories
- o will elicit more decision-relevant information for investors by capturing the maturity periods of commonly offered residential mortgage loan products, such as 15-year and 30-year residential mortgages
- o residential mortgage loans would no longer be classified in a single maturity category
- o the loans would move through the maturity categories until they are paid off or sold, such that over time, even 30-year residential mortgage loans would migrate into different maturity categories
- Eliminates the loan category disclosure items in Item III.A of Guide 3, the loan portfolio risk element disclosure items in Item III.C, or the other interest bearing asset disclosure items in Item III.D
Allowance for Credit Losses
Item 1405 of Regulation S-X:
- Disclosure of the ratio of net charge-offs during the period to average loans outstanding based on the loan categories required to be disclosed in the registrant’s U.S. GAAP or IFRS financial statements, instead of on a consolidated basis as called for by Guide 3
- Requires disclosure of the following new credit ratios on a consolidated basis, along with each of the components used in their calculation:
- (1) Allowance for Credit Losses to Total Loans
- (2) Nonaccrual Loans to Total Loans
- (3) Allowance for Credit Losses to Nonaccrual Loans.
- (4) Discussion of the factors that drove material changes in the ratios, or related components, during the periods presented
- IFRS registrants are not required to disclose the ratio of nonaccrual loans to total loans or the allowance for credit losses to nonaccrual loans, as there is no concept of nonaccrual loans in IFRS
- Requires registrants to provide the tabular allocation of the allowance disclosure called for by Item IV.B of Guide 3, except that the allocation would be based on the loan categories presented in the U.S. GAAP financial statements, instead of the loan categories specified in Item IV.B of Guide 3
Item 1406 of Regulation S-X:
- Codifies the majority of the disclosure items in Item V of Guide 3, with some revisions
- Defines uninsured deposits for bank and savings and loan registrants that are U.S. federally insured depository institutions as the portion of deposit accounts in U.S. offices that exceed the FDIC insurance limit or similar state deposit insurance regimes and amounts in any other uninsured investment or deposit accounts that are classified as deposits and not subject to any federal or state deposit insurance regimes
- Requires foreign bank and savings and loan registrants to disclose the definition of uninsured deposits appropriate for their country of domicile
- The rules require disclosure of:
- (1) U.S. time deposits in excess of the FDIC insurance limit
- (2) time deposits that are otherwise uninsured by time remaining until maturity of: (A) three months or less; (B) over three through six 57 months; (C) over six through 12 months; and (D) over 12 months
Certain Existing Guide 3 Disclosures That Are Not Codified in Subpart 1400 of Regulation S-K
- A. Return on Equity and Assets – Item VI of Guide 3 calls for disclosure of four specific ratios for each reported period, including return on assets, return on equity, a dividend payout ratio, and an equity to assets ratio. The requirement to disclose these ratios is not included in Subpart 1400 as these ratios are not unique to bank and savings and loan registrants, and the Commission’s guidance on MD&A already requires registrants to identify and discuss key performance measures when they are used to manage the business and would be material to investors.
- B. Short Term Borrowings The new rules do not codify the short-term borrowing disclosure items in Item VII of Guide 3 in their current form. Instead, Item 1402 of Regulation S-K codifies the average balance and related average rate paid for each major category of interest-bearing liability disclosures currently called for by Item I.B.1 and I.B.3 of Guide 3, and requires disaggregation of the major categories of interest-bearing liabilities to include those referenced in Item VII of Guide 3 and Article 9 of Regulation S-X. Other existing disclosure items in Item VII are not included as they are substantially covered by existing Commission rules and the financial statement requirements.
This is the second of a series of three short newsletters on how to stay ahead of finance process issues and prevent these challenges from becoming more significant problems. Each newsletter addresses a different aspect of these challenges: Producing Data, Consuming or Using Data (today’s topic), and Preparing for and Managing the Audit.
As noted in Part 1 of 3, Producing Data, a strong finance team is critical to the success of any company. In Part 1 we covered challenges and action plans around the process for producing timely reporting of business results and indicators. There are similar potential pitfalls when it comes to using or consuming the data to make business decisions.
Challenge — Lack of Clarity on Required General Ledger Account Details
Accurate data in the general ledger, and in supporting systems populated by staff outside the finance team, is critical. Bookkeeping and data entry errors make it difficult to rely on the information in the systems without laborious data cleansing exercises and adjustments. Also, if inclusion of a few digits in the account code when booking entries makes the difference in how information is processed, they must be used consistently. If not, this can lead to unmatched debits and credits, inflation of the balance sheet and eventual write-offs that could have been avoided.
Action Plan — Document the Process and Train the Team
- Ensure that requirements for posting entries are well understood by the accounting, finance, and operations teams
- Train the staff that processes entries to supporting systems to eliminate errors. Perhaps a visual aid with exactly how to book various entries may help
- Enable automated error checking, and reconciliation capabilities to the extent possible
- Have the accounting team review a sampling of entries monthly before the close as an opportunity to reinforce training and to randomly test for errors as part of a quality control process
Challenge — Over-Reliance on Spreadsheet Links for Reports and Analysis
An integrated system, whether finance and accounting or multi-function, is often beyond the resources of many organizations, both in terms of the cost and the time to convert from old process to new. As a result, finance, risk, and other staff often rely on spreadsheets which can proliferate and become very complex. With a strong foundation of process management and internal controls these tools can still support the needs of many organizations and make an eventual systems conversion far easier when the time comes.
Action Plan – Implement Data Management to Bring New Resilience to the Process
- Produce an inventory of recurring reports and analysis – this is also a great opportunity to eliminate redundant or unused reporting
- Review the data elements comprising the reports, including the source and definition, and to the extent that sources for similar elements vary, identify and agree on the source and definition – in effect, a data source inventory
- Ensure that numbers are consistent across various reports by always using the data source inventory so, if and when spreadsheet links break, the data source inventory takes away the guesswork
Challenge — Financial Reporting Doesn’t Address Needs of Decision Makers
Financial reports should drive discussion through presentation of trend analysis, period and budget comparisons, and relevant metrics. If there are no questions or discussion when the CFO presents the financials, perhaps the information presented is no longer relevant.
Action Plan — Design Financial Reporting to Drive Performance
- Focus reporting on performance by identifying the key indicators that are most critical to driving success
- Include trend graphs to drive clarity on over / under performance and generate discussion on decisions and actions required to get back on track
- Ensure that variance explanations versus prior year, budget and prior month are clear – this is important from a control perspective as well as for the analysis of business performance
“Post-COVID, bankers can no longer point to adoption curves for color television, personal computers, and other innovations to make excuses for low digital and paperless adoption in their client base. Online self-servicing is taking care of itself, fueled by COVID-19 and its resulting long call wait times.”
Cash forecasting, always important, becomes even more highly critical during times of economic disruption. Here are some key points to consider for an effective process:
1. Use a segmented approach to avoid over forecasting cash inflows. Consider customer segment, size, and seasonality – tax time could drive slower payment behavior for all types of clients.
2. Experiment with data that helps differentiate slower payers, e.g. credit ratings, industry, etc., to inform the forecast and contribute to faster collections.
3. Test solutions that help manage the lag between payments and collections; For example, tying accounts receivable team compensation to timely invoice issuance, offering discounts to slower paying customers for prompt payments, and perhaps requiring a partial upfront deposit from customers who regularly pay late.
4. Organize the forecasting approach and outputs in a consistent manner so that the accuracy of prior forecasts can be assessed. and so that it’s clear where to adjust management’s estimates.
5. For cash outflows, communication across the management team can make or break this process. Especially in a start-up where monthly spend patterns based on history are not available, there is no steady state to rely on. Management team members should regularly discuss and consolidate their outlooks for daily cash receipts and disbursements.
6. Start with prior bank statement activity to come up with typical monthly recurring items.
7. Map key bank statement items to actual expense so that the expense patterns in business plans and budgets can provide context for the cash forecast.
8. Identify cash items already expensed and therefore not in management’s outlook, as well as future capital outlays.
If CFO Consulting Partners can help your organization with additional support and skill sets of experienced accounting and finance professionals, please do not hesitate to contact us.
We hope your families, employees, and colleagues remain safe and healthy during these unprecedented times.
- Prepare for talent disruption by considering interim executive resources, and by evaluating how functions are operating virtually. Parts of the accounting and finance function may be operating effectively in remote locations, while others may require intervention.
- Bolster liquidity by understanding and managing your short-term credit, cash, and performance needs. A strategic focus when combined with well-thought through tactical plans to drive operational and cash flow improvements, including a 13-week cash forecast, should provide sound direction.
- Increase communication with your critical stakeholders, including employees, customers, suppliers, auditors, regulators, and the SEC. It is said that one should err on the side of over communicating. In times of crisis, we suggest that this is truer than not.
- Review and manage all risks in the organization to ensure that a less obvious risk doesn’t catch the organization off guard and hinder recovery or growth plans.
- Conduct a cost reduction review of all areas of the company. This may be a time to take cost reduction actions that may have been postponed during good economic times.
- Review your financial reporting to make sure it continues to serve the needs of the company during times of distress. It is said and I paraphrase, if one can’t measure the results of an action, then we don’t know if the action produced the expected result. There may also be specific reporting issues that come to the fore, such as asset impairments and going concern analyses.
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Challenge — Difficulty Getting the Books Closed
Action Plan — Fill Resource Gaps and Re-introduce Closing Discipline
- Plan for an adequate level of resources as a better alternative to late reporting and reporting errors, by either hiring additional staff or enlisting operations and other resources to contribute as a regular part of the closing process
- If temporary resources are used, integrate those resources into the full-time team and make sure regular communication is taking place among the extended team members
- Make sure roles and responsibilities are well defined, in writing, including review responsibilities
- Develop a closing calendar with input from all affected team members; the focus should be on what is achievable, and expectations on timing of deliverables should be set realistically
- Communicate the timing and nature of deliverables to senior management
Challenge — Integrating Information from Outside the Financial Process
Action Plan — Regularly Reconcile Estimates with Actuals and Improve Critical Processes
- Reconcile estimates to actuals regularly (at least quarterly), to avoid a year-end crunch that will delay year-end reporting and raise concerns from auditors or investors and directors
- Get representatives of the operations and finance teams together to for a process improvement project. This can be a high-level gap analysis – an honest assessment of the current process vs. desired process and agreement on how to fix the issues. The detailed approaches of the Six Sigma, LEAN, or Continuous Process Improvement (CPI) methodologies are also useful.
Challenge — Little Staff Development, Communication, Documentation, and Training
Action Plan — Formalize Annual Finance Team Development and Back-up Plans
- The Chief Financial Officer (CFO) should create a succinct written plan for the closing process. The document should address role descriptions, critical processes performed, and the back-up person for each critical process.
- Review the plan with the finance team and senior management to ensure that critical processes are not overly concentrated with one person, especially the CFO, revise as needed and ensure that plans are made to close any skills gaps.