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Eight Red Flags that your Board Financial Package is Failing to Support Board Needs
Allan Tepper, CFO Consulting Partner LLC
One of the goals of boards is to oversee the financial performance of the company or companies to which they are associated. Informative, transparent financial statements are necessary for boards to discharge those duties. If your board financial package lacks one or more of the following, there would likely be a deficiency in the board’s oversight function.
– The financial package should contain the three basic financial statements – P&L, Balance Sheet and Cash Flow. The benefits of the P&Ls and balance sheets are fairly well known; however, the cash flow statement may not be as well known. The cash flow statement answers the question, “Where did our money go?”
– The package should contain accounts receivable and accounts payable agings.
– Critical notes to the financial statements should be included to explain complex accounting transactions.
– The P&L and balance sheet should be compared to budget.
– The package should contain reasons for variances from budget, and if it does, the explanations should be business reasons, not accounting reasons.
– The package should contain key business drivers.
Is Your Finance Department a Cost or Profit Center?
Allan Tepper, CFO Consulting Partner LLC
To begin, I will define cost and profit centers, using my definition developed after leading accounting and finance functions for over twenty-five years.
Cost centers need to be efficient and be doing critically important tasks. From a company perspective, cost centers need to keep their costs at the lowest possible level while functioning at a highly effective level.
Profit centers have all the same attributes as cost centers, but produce revenue, thereby adding profits to a company’s bottom line.
Well-run finance departments have profit center elements. Although finance departments, as a unit, are not true profit centers because they do not directly produce revenue, they have many positive bottom-line attributes. Finance functions aid other cost and profit centers to be more efficient and effective and incentivize them to work cross-functionally as a team.
There is an often used phrase called a “strategic CFO.” That person would primarily focus on making the whole company stronger. I believe it follows that a goal for all companies should be to make the finance department function more like a profit center than a cost counter.
Examples of how finance departments become strategic include:
– Perfect the closing process so the books are closed quickly and accurately after month end, and time is available for analysis.
– Make the budgeting and reporting process part of a company’s DNA.
– Work with the various company units that feed information to the accounting department in order to make the information accurate and at the proper level of detail.
– Provide analyses that allow for action-oriented decisions. An example would be an analysis of the profitability of various business units. Another could be customer profitability analysis.
– Have the capability – systems and people – to meet the normal demands of all stakeholders on a timely and accurate basis.
– Spearhead merger and acquisition projects.
In summary, well run accounting and finance functions have significant attributes that help improve the bottom line of the whole company. A discussion with a C-level financial management consulting firm should provide insights on how to transform an accounting function from a cost to a “profit center.”
Case Study: Financial Transformation
Engaged by a service provider (a boutique law firm) that had been in business for approximately 18 months. Firm was highly successful on the legal side but was immature on the operations/business process side. In 18 months, firm had had three Chief Operating Officers, all from “Big Law” and all who had not been successful. Position had been vacant for three months, placing great stress on the Managing Partner. Total staff the commencement of the engagement was approximately 50, with a ratio of 2 lawyers for each non-legal position.
WHAT WE DID
Our assignment was to perform a high-level assessment of all Firm operations: Finance, HR, IT; Billing and Payables and Administrative support; provide observations and make recommendations for improvement. Assessment also included evaluation of staff morale and related staffing issues. Expected duration of assignment; two weeks.
Assessment identified two issues requiring immediate attention; staff morale and need for full time Chief Operating Officer to relieve burden on Managing Partner. Remedial actions were taken within ten days and included the naming of our consultant as Interim Chief Operating Officer with undefined term of service.
Longer term recommendations included: steps to improve the Firm’s Information Security polices and IT infrastructure, execute a search for and implementation of new ERP system; actions to clarify and realign staff roles, hiring of a full time Finance Director; development of better reporting and creation of a capacity plan; establishment of a more formal HR function.
The firm was in the process of tripling the size of its primary offices as the engagement began. The subsequent six to eight weeks were devoted to managing the myriad of issues associated with that move while stabilizing and improving staff morale. In addition, significant planning was performed on the ERP and IT front while proposing a longer-term staff realignment plan.
Subsequent eight weeks were focused on ERP software selection, full scale IT and information security review, development of a new reporting dashboard for Partners; assessment of firm insurance coverage, development of a new 401K and profit-sharing plan and overseeing year end closing process including management of bonus recommendations.
Post year-end close focus has been on implementation of new ERP system, new 401K and profit sharing plan, complete rebuild of Firm’s IT infrastructure and creation of robust information security practices. In addition, an overall firm capacity plan and forecast was developed.
Since our arrival, there has been no staff turnover. Key initiatives have been conceived and executed. Managing Partner is primarily practicing law. Firm is well on the way to having an back office operation that is of the same superior quality as the Firm’s legal practice.
The CECL Approach, 3 of 3
For this newsletter CFO Consulting Partners has partnered with Ardmore Banking Advisors to review the potential material financial benefits of a well planned and executed implementation of the new current expected credit loss (“CECL”) accounting standard.
Most banks have an awareness of the need to prepare for the transition to CECL, and that many foundational activities need to be looked at now. Together CFO Consulting Partners (“CFO CP”) and Ardmore Banking Advisors (“Ardmore”) have constructed an approach to help banks address the “early must do’s” of CECL at a reasonable cost.
CFO CP leverages its extensive experience with banking industry finance, and Ardmore it’s deep expertise in credit and credit data to translate the CECL transition process into tasks and activities that create valuable efficiencies and bottom line impact for the Bank. Together we can cut through the noise and assess a bank’s CECL readiness and at the same time help create a CECL action plan that will drive real value for the bank.
We have discussed aspects of CECL implementations in prior newsletters, The New CECL Approach Part I, and Part II. Similarly, Ardmore’s webinar Step #1 Of the CECL Journey provides additional perspective.
CFO CP and Ardmore are each focused on complementary aspects of the CECL implementation process in the finance, accounting, and credit disciplines. Well executed CECL projects led by an interdisciplinary team of Credit, Finance, and other bank management, coordinated by experienced project managers and executed well, can produce tangible bottom line improvements, and better efficiency ratios.
Experienced CFO CP and Ardmore Project Managers can help the bank’s CECL team identify opportunities for process improvements. The resulting databases, internal control enhancements, and automation will produce faster decisions, easy access to controlled and trusted data, high functioning executive teams and, ultimately, improved efficiency ratios. If CECL implementation is managed well, a bank can leverage the implementation to break down silos, upgrade systems, improve processes, and reduce expenses.
CFOs can strategically manage the spending to required accomplish CECL goals AND drive efficiencies which will ultimately reduce the expense ratio. Opportunities exist in:
- Credit Administration: Ensure that all credit practices are properly aligned with your CECL implementation, upgrade automation, and improve underwriting processes.
- Finance: Re-engineer financial controls and loan accounting processes, optimize general ledgers, optimize risk adjusted capital levels, and Improve management information for the Board and Management.
- IT: Improve data governance, develop and data management tools, and retire inefficient loan and credit systems.
- Operations: Update credit processes (such as data entry and coding processes), and re-engineer controls and processes
- Lending: Efficient analysis of deal structures and lending to minimize life of loan losses and capital impacts
An assessment for CECL readiness can reveal a lot that can be useful to the institution beyond the needs of CECL compliance including:
- Assess the current state of the institution’s credit portfolio data and origination process, ALLL, Financial and
- Credit policies, practices and governance – all within the context of CECL;
- Review Current ALLL System & Processes;
- Review controls on data used in the current ALLL process;
- Identify data points required to support industry best practice portfolio data & regulatory compliance data for CECL;
- Review loan origination process, stakeholders, criteria and coding;
- Review data stored in the core for accuracy consistency and robustness;
- Review all identified credit data source systems for data/database integrity; and
- Review any existing data warehouse capabilities, and how portfolio data is organized, maintained, and retained.
CECL compliance practices and implementation plans should be in place in 2018. Auditors, regulators, boards of directors and investors will want to know bank’s plans for CECL, including the costs and the benefits beyond compliance.
Those institutions that leverage the potential benefits of the CECL implementation will have a competitive advantage over their competitors through increased efficiencies, automation and clarification of corporate risk management practices.
About the Authors
CFO Consulting Partners, Tom Van Lenten: Tom leads CFO Consulting Partners CECL consulting services to financial institutions. CFO CP’s CECL services include: CECL readiness assessment, analysis of the accounting and regulatory implications, project management, and assisting with updates of policies, procedures and internal controls which are impacted by CECL.
Ardmore Banking Advisors, Peter Cherpack: EVP, Partner. Peter is a nationally known thought leader in CECL implementation for community banks, and with other Ardmore consultants conducts CECL readiness assessments with a focus on credit and credit data readiness.
CFO Consulting Partners is the proud sponsor of an ACG Philadelphia event on March 15th.
A.M. Best Updates Its Rating Methodologies and Capital Model
Marc Liebowitz, CFO Consulting Partner LLC
A.M. Best (AMB) recently revised its rating methodologies, most of the changes relate to updated procedures and the underlying analytical components have generally remained in place. The below videos provide an overview of the methodology updates:
“A.M. Best’s Mosher: Methodology Update, Benchmarks Are Released”
“Market Issues, Methodology Updates Dominate A.M. Best’s NY Briefing”
As part of its revised rating methodology, AMB released its revised capital model, Best Capital Adequacy Ratio (BCAR). While the components and the equations to determine a group’s BCAR ratio have remained largely in place, the revised model applies updated technologies to better determine balance sheet risk. These technologies allow the model to quantify risk across various loss severity scenarios. Below are links that detail the updated processes:
“Understanding BCAR for U.S. Property/Casualty Insurers”
“Understanding BCAR for U.S. and Canadian Life/Health Insurers”
A.M. Best has termed its revised rating procedure the “building block approach.” The first step, or building block, is the capital assessment. Subsequent analytical steps either add or detract from the score assigned during the capital strength assessment. We discussed these steps in our previous articles on the ratings process. See our “Insurance Company Credit Rating Advisory Practice” Part 1 and Part 2
Balance sheet strength remains the foundation of the rating process, Best’s methodology will continue to review current capitalization and forecast future balance sheet strength. Operating performance, business profile and enterprise risk management are key elements which help to determine a groups prospective capital position. View A.M. Best’s Credit Rating Methodology
Benchmarks and peer group analysis remain an important factor in the determination of a group’s rating. Insurance companies which consistently outperform peer and/or industry benchmarks in terms of operating results and business profile are more likely to achieve higher rating categories. Peers are those that generally offer similar products, have approximate premium volume, operate in similar territories or otherwise compete in each other’s respective markets. Given the importance of benchmarks, companies should understand how they are developed and applied over the rating process.
AM Best expects the updates to the capital model and rating processes to support a more detailed rating analysis and lead to greater transparency relative to the assigned rating.
CFO Consulting Partners can guide companies through AMB’s revised rating processes and updated capital model. We can provide an understanding of the drivers of your current rating and develop strategies targeted at achieving your desired rating.
Implementations of the New Lease Standards Under the ASC 842
Mark Sloan, CPA, CFO Consulting Partners
On February 25, 2016, the FASB issued new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. The new standard will impact both lessees and lessors, with the most significant impact falling upon lessees. The standard is effective for years beginning after December 15, 2018 for public firms and December 15, 2019 for nonpublic firms.
This is one of the most comprehensive changes to accounting principles in many years, almost 250 pages long, and it will require major effort of firms to understand and implement its impact.
Due to the complexity of this pronouncement, this update will focus on the impact the new standard will have on lessees; a future update will focus on the impact on lessors.
In summary, the significant effect of this standard on lessees is as follows:
- Transactions which had been previously reflected as rent expense on the income statement will now require a right-of-use asset and a related lease liability being reflected on the balance sheet;
- Service arrangements for the use of assets over a period of years need to be evaluated and, if certain criteria is met, there needs to be a segregation of elements that are considered either lease components or non-lease components;
- Lease liabilities must be continually evaluated for the occurrence of significant events and revised accordingly, and;
- Criteria under previous guidance for determining a lease to be either an operating lease or a financing lease has been changed for the following:
- eliminating specific guidance regarding thresholds for determining economic life and fair value of leased assets;
- replacing such guidance with transaction specific judgement, and;
- adding a criteria that the leased asset has no alternative use to the lessor at the end of the lease term.
As a result of the new standard, it is expected that balance sheets will increase with over $1.5 trillion of additional assets and liabilities.
As a starting point, contracts for services must be reviewed, and both the lease and non-lease components must be identified and segregated. In its simplest terms, the standard states that if a contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration, without significant control or substitution rights by the lessor, then a lease exists.
This will be among the most challenging aspect of the new standard. There must also be an analysis to determine whether there are multiple lease components which need to be accounted for separately and whether there are multiple non-lease components which should be accounted for under other appropriate GAAP. Also, there needs to be an ongoing evaluation of contracts to determine when an event occurs that may change the recognition or measurement of the lease, and that the entity distinguish whether there is a modification of an existing lease or the recognition of a new lease arrangement requiring separate accounting.
In addition to arrangements which clearly demonstrate a lessee/lessor relationship (such as the lease of office space), other arrangements must be carefully evaluated to determine if a lease exists. Such arrangements may include:
- Advertising agreements
- Service agreements
- Transportation agreements
- Construction agreements
- Related party arrangements
It is important to identify lease and non-lease component of a service arrangement. The arrangement must be carefully evaluated for any asset that could be construed to be a lease in nature. One example is a data storage arrangement with a service provider. If the service contract includes the installation of a server on the location of the lessee, the lessor has no substantive substitution rights and the lessee derives most of the benefit of the asset over the lease term, then the server represents a lease component. An allocation of the rent payments need to be made between the server (the lease component) and the data storage (the non-lease component). The lease component must then be evaluated for either an operating lease or a finance lease and treated accordingly. The major difference between the two types will be that the income statement effect of the operating lease will be through rent expense while the income statement effect of the financing lease will be through interest expense and amortization expense.
Similar to previous guidance, leases meeting certain criteria will be considered a finance lease and there will need to be a right-of-use asset with a corresponding lease liability reflected on the balance sheet. The two amounts will be initially set up as the present value of the lease payments discounted at an appropriate interest rate (e.g., the lessee’s incremental borrowing rate).
A lease meeting any of the five following criteria will need to be classified as a finance lease:
- Ownership of the leased asset transfers at the end of the lease term;
- A bargain purchase option (i.e., one that is reasonably certain to be exercised) for the leased asset exists;
- The lease term, which does not commence near the end of the economic life of the leased asset, is primarily the remaining economic life of the leased asset;
- The sum of the present value of the lease payments and the residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset, and;
- The leased asset has no alternative use to the lessor at the end of the lease term because of its specialized nature.
What is important to bear in mind is the new pronouncement removes the 75% (for criteria #3) and 90% (for criteria #4) that former GAAP had provided as guidance and, instead, the lessee will need to take positions as to determining the remaining economic life or substantially all of the fair value of the leased asset. Also new is criteria #5 which needs to be taken into account in the determination of the character of the lease. The right-of-use asset will be amortized on a straight line basis (or any more systemic approach) over the term of the lease and the lease liability will be extinguished using the effective interest method. The income statement will reflect amortization expense for the reduction of the right-of -use asset and interest expense for the interest component of the lease payments.
If a lease arrangement is identified and considered not meeting the above criteria for a finance lease, then such operating lease will reflect, on the balance sheet, a right-of-use asset and a corresponding liability recorded at the present value of the rent payments, using an appropriate interest rate such as the lessee’s incremental borrowing rate. Both the amortization of right-of-use asset and the accreted interest on the lease liability will be reflected in rent expense on the income statement.
If an entity has both finance leases and operating leases, then the right-of-use asset and the lease liabilities must be presented separately for each type of lease.
If there are elements in the lease arrangement for step-up in rent payments, initial direct costs, payments of residual values, etc., such elements must be taken into account in calculating the right-of -use asset and corresponding liability.
Leases with terms of 12 months or less will be exempt from the standard as it relates to reflecting a balance sheet impact. Such leases will continue to be accounted for as under previous guidance, i.e., off balance sheet and footnote disclosure only.
As part of the transition process for the standard, there are practical expedients that an entity may elect, as a package and applied consistently, to all of its leases which commenced prior to the effective date of the standard:
- An entity need not reassess whether any expired or existing contracts are or contain leases;
- An entity need not reassess the lease classification (i.e., operating versus finance lease) made under previous GAAP for any expired or existing leases, and;
- An entity need not reassess initial direct costs for any existing leases.
If an entity foregoes these practical expedients, then it must apply the standard to all previous periods presented for which there are leases or contracts which contain lease and non-lease components.
On January 5, 2018, the FASB issued an Exposure Draft revising some of the provisions of ASC 842. The Board is requesting comments to this Exposure Draft no later than February 5, 2018.
The two issues on which the Board is seeking comments are as follows:
- Comparative reporting for initial adoption, and;
- Separating and allocating lease and non-lease components in a contract.
As it relates to comparative reporting for initial adoption, the Board has proposed recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As it relates to separating and allocating lease and non-lease components in a contract, this proposed amendment would be applicable to lessors only. The amendment would provide lessors with a practical expedient that is currently available to lessees, which is to not separate non-lease components from related lease components for identified classes of underlying assets. This practical expedient would be available only upon meeting certain requirements, i.e., (i) the timing and pattern of revenue recognition for the non-lease component(s) and related lease components are the same, and (ii), the combined single lease component would be classified as an operating lease.
A subsequent newsletter will provide an update to the standard once the comment period has expired and the Board has finalized any revisions to ASC 842 regarding the aforementioned issues.
As can be seen from this brief summary, the new pronouncement on lease accounting will have a deep and profound effect on most entities. While the implementation date is still some time off, it would be prudent to begin to assess the effect this pronouncement will have on your financial statements. We here at CFO Consulting Partners have an extensive understanding of the new standard and stand ready to assist in evaluating and implementing this standard.