The Hunt for Hidden Liabilities and Risks
Some liabilities may be out of sight, but they should never be out of a lender’s mind. For example, a borrower’s balance sheet won’t list contingent costs, pending claims or underfunded accounts. Proactive lenders search for undisclosed risks to get a complete assessment of their borrowers’ financial health. Here are some items you might unearth.
The search for undisclosed liabilities and risks starts with assets. For each asset, ask what could cause the account to diminish. For example:
• Accounts receivable may include bad debts.
• Inventory may include damaged goods.
• Some fixed assets may be broken or in desperate need of repairs and maintenance.
These items compromise a borrower’s credit standing and affect its financial ratios just as much as unreported liabilities do.
Some of these problems may be uncovered by touring the company’s facilities or reviewing asset registers for slow-moving items. Benchmarking can also help.
For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts. Or if repairs and maintenance expense seems low compared to historic levels or industry norms, it could signal neglected upkeep on assets, which can be a costly gamble over the long run.
Next look at liabilities on the balance sheet and ask if the amount reported for each item seems accurate and complete. A company may try to understate its liabilities to appear stronger or to comply with its loan covenants.
For example, borrowers may forget to accrue liabilities for salary or vacation time. Some might underreport payables by holding checks for weeks (or months). This ploy preserves the checking account while giving lenders the impression that supplier invoices are being paid.
Other borrowers might hide bills in a drawer at year end to avoid recording the payable and the expense. This scam mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can also hurt the company’s credit score and cause suppliers to restrict their credit terms.
Finally, investigate what isn’t showing on the balance sheet. Examples include warranties, pending lawsuits, an IRS investigation or an underfunded pension. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities.
Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred. These are subjective standards. Some borrowers may claim liabilities are too unpredictable or remote to warrant disclosure.
Lenders also might consider the goodwill (or badwill) attributable to the company’s owners and top managers. Certain “key” people may be so instrumental to the business’s success that their unexpected departures could potentially expose the entity to financial hardship. Conversely, people who are risk-seeking, exceptionally tax averse or unethical put the company at risk for lawsuits, IRS inquiry, and insurance and warranty claims.
If a company’s financial statements are audited, the auditor will automatically test for these hidden liabilities and risks. Auditors also watch for exaggerated asset balances. Compiled or reviewed statements, however, aren’t subject to the same level of scrutiny.
For added assurance from questionable borrowers, request an agreed-upon-procedures engagement that targets high-risk areas and anomalies. If your ratio analyses reveal unusual trends based on the company’s track record or industry benchmarks, it may be time to meet with the borrower and its accountant to hunt for hidden liabilities and risks.