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Estimates vs. actuals: Was your 2018 budget reasonable?

As the year winds down, business owners can be thankful for the gift of perspective (among other things, we hope). Assuming you created a budget for the calendar year, you should now be able to accurately assess that budget by comparing its estimates to actual results. Your objective is to determine whether your budget was reasonable, and, if not, how to adjust it to be more accurate for 2019.


Identify notable changes

Your estimates, like those of many companies, probably start with historical financial statements. From there, you may simply apply an expected growth rate to annual revenues and let it flow through the remaining income statement and balance sheet items. For some businesses, this simplified approach works well. But future performance can’t always be expected to mirror historical results. For example, suppose you renegotiated a contract with a major supplier during the year. The new contract may have affected direct costs and profit margins. So, what was reasonable at the beginning of the year may be less now and require adjustments when you draft your 2019 budget.

Often, a business can’t maintain its current growth rate indefinitely without investing in additional assets or incurring further fixed costs. As you compare your 2018 estimates to actuals, and look at 2019, consider whether your company is planning to: build a new plant, buy a major piece of equipment, hire more workers, or rent additional space. There are external and internal factors, such as regulatory changes, product obsolescence, and in-process research and development; also may require specialized adjustments to your 2019 budget to keep it reasonable.


Find the best way to track

The most analytical way to gauge reasonableness is to generate year-end financials and then compare the results to what was previously budgeted. Are you on track to meet those estimates? If not, identify the causes and factor them into a revised budget for next year. If you discover that your actuals are significantly different from your estimates — and if this takes you by surprise — you should consider producing interim financials next year.

Some businesses feel overwhelmed trying to prepare a complete set of financials every month. So, you might opt for short-term cash reports, which highlight the sources and uses of cash during the period. These cash forecasts can serve as an early warning system for “budget killers,” such as unexpected increases in direct costs or delinquent accounts. Alternatively, many companies create 12-month rolling budgets — which typically mirror historical financial statements — and update them monthly to reflect the latest market conditions.


Do it all

The budgeting process is rarely easy, but it’s incredibly important. And that process doesn’t end when you create the budget; checking it regularly and performing a year-end assessment are key. We can help you not only generate a workable budget, but also identify the best ways to monitor your financials throughout the year. © 2018

Financial Institutions and Banking

Bank Wire

FinCEN creates exception to Beneficial Ownership Rule

As part of its efforts to combat money laundering and other fraudulent activity, the Financial Crimes Enforcement Network (FinCEN) issued its Beneficial Ownership Rule, effective for new accounts opened on or after May 11, 2018. The rule requires banks, as part of their customer identification programs, to verify the identity of the beneficial owners of certain legal entities. Beneficial owners include individuals who, directly or indirectly, own 25% or more of an entity, as well as any individual who has “significant responsibility to control, manage or direct the legal entity.”

In a September 7, 2018, ruling, FinCEN created an exception to the beneficial ownership rule for legal entities that open new accounts on or after the effective date as a result of:

  • Rolling over a certificate of deposit,
  • Renewing, modifying or extending a loan, commercial line of credit or credit card account that doesn’t require underwriting review and approval, or
  • Renewing a safe deposit box rental.

The exception applies only to rollovers, renewals, modifications or extensions of the above product types that take place on or after May 11, 2018. It doesn’t apply to the initial opening of such accounts.

Banks considering use of alternative credit data

Some lenders are considering the use of alternative data to expand access to credit for people with thin credit histories or negative items on their credit reports. By developing innovative techniques for analyzing a borrower’s ability to repay, lenders can expand their pools of potential borrowers beyond those identified by traditional techniques.

Alternative data refers to information that may be used to evaluate creditworthiness but is not traditionally part of a credit report. Examples include rent payments, mobile phone payments, cable TV payments, and bank account information. This may also include education, occupation and even social media activities.

It may take some time before alternative data techniques catch on among community banks. In 2017, the Consumer Financial Protection Bureau (CFPB) released a “Request for Information” seeking information about alternative data and the modeling techniques used to analyze them. You can find the document, which discusses the benefits and risks associated with alternative data, at

Supervisory guidance isn’t the law

In a recent joint statement, the federal banking agencies clarified that supervisory guidance “does not have the force and effect of law.” Among other things, the agencies intend to limit the use of numerical thresholds or other “bright lines” in describing expectations, and examiners won’t criticize banks for “violations” of supervisory guidance.

© 2018

Financial Institutions and Banking

Keeping due diligence on the front burner

Every banker knows the importance of due diligence in determining whether to make a loan. But it’s easy to backslide and rely on just a few superficial financial markers that may, or may not, indicate creditworthiness. Here’s a reminder of some due diligence steps to take to help you dig deeper and ensure your bank’s loan portfolio is more secure.

Assessing risk from many angles

Start the due diligence process as an auditor would. That is, before you open a borrower’s financial statements, consider documenting the risks in the borrower’s industry, applicable economic conditions, sources of collateral and the borrower’s business operations.

This risk assessment identifies what’s most relevant and where your greatest exposure lies, what trends you expect in this year’s financials, and which bank products the customer might need. Risk assessments save time because you’re targeting due diligence on what matters most.

Evaluating reliability

Now tackle the financial statements, keeping in mind your risk assessment. First evaluate the reliability of the financial information. If it’s prepared by an in-house bookkeeper or accountant, consider his or her skill level and whether the statements conform to Generally Accepted Accounting Principles. If statements are CPA-prepared, consider the level of assurance: compilation, review or audit.

Comprehensive statements include a balance sheet, income statement, statement of cash flows and footnote disclosures. Make sure the balance sheet “balances” — that is, assets equal liabilities plus equity. You’d be surprised how often internally prepared financial statements are out of balance.

Statements that compare two (or more) years of financial performance are ideal. If they’re not comparative, pull out last year’s statements. Then, note any major swings in assets, liabilities or capital. Better yet, enter the data into a spreadsheet and highlight changes greater than 10% and $10,000 (a common materiality rule of thumb accountants use for private firms). You should also highlight changes that failed to meet the trends you identified in your risk assessment. For example, you expected something to change more than 10% but it did not.

Now ask yourself whether these changes make sense based on your preliminary risk assessment. Brainstorm possible explanations before asking the borrower. This allows you to apply professional skepticism when you hear borrowers’ explanations.

Keeping score

Use your risk assessment to create a scorecard for each borrower. It often helps to discuss your risk assessment with co-workers and to specialize in an industry niche.

One ratio that belongs on every scorecard is profit margin (net income / sales). Every lender wants to know whether borrowers are making money. But a profitability analysis shouldn’t stop at the top and bottom of the income statement. It’s useful to look at individual line items, such as returns, rent, payroll, owners’ compensation, travel and entertainment, interest and depreciation expense. This data can provide reams of information on your client’s financial health.

Other useful metrics include current ratio (current assets / current liabilities), which measures short-term liquidity or whether a company’s current assets (including cash, receivables and inventory) are sufficient to cover its current obligations (accrued expenses, payables, current debt maturities). High liquidity provides breathing room in volatile markets.

In addition, total asset turnover (sales / total assets) is an efficiency metric that tells how many dollars in sales a borrower generates from each dollar invested in assets. Again, more in-depth analysis — for example, receivables aging or inventory turnover — is necessary to better understand potential weaknesses and risks.

Finally, calculating the interest coverage ratio (earnings before interest and taxes / interest expense) provides a snapshot of a company’s ability to pay interest charges. The higher a borrower’s interest coverage ratio is, the better positioned it is to weather financial storms.

When applying these metrics, compare a company to itself over time and benchmark it against competitors, if possible. If customers’ explanations don’t make sense, consider recommending that they hire a CPA to perform an agreed-upon-procedures engagement, targeting specific high-risk areas.

Keeping aware of risk and reward

A healthy loan portfolio carries with it a certain amount of uncertainty. But, to minimize the potential for problems down the line, that uncertainty needs to be quantified, documented and analyzed. Taking these due diligence steps can help make your loans rewarding, rather than risky.

© 2018

Financial Institutions and Banking

Do you need a bank holding company?

Do you need a bank holding company?

For years, the vast majority of U.S. banks have used a bank holding company (BHC) structure. Recently, however, several prominent regional banks have elected to shed their BHCs by merging them into their subsidiary banks. This development has many community banks wondering whether the BHC model has become obsolete.

Pros and cons

The answer to this question: It depends (big surprise). Some banks may find that eliminating the BHC structure simplifies financial reporting, streamlines regulatory oversight and reduces administrative expenses. Others — particularly those that qualify as “small bank holding companies” — may find that the benefits of the BHC structure outweigh its costs.

It’s important to keep in mind that recent legislation expanded the definition of small BHC to include those with consolidated total assets of $3 billion or less (up from $1 billion). (See “Advantages of small BHC status.”) Here are some of the possible reasons for eliminating a holding company, along with a review of the continued benefits of the BHC structure.

Reasons for discarding your BHC

Potential advantages of eliminating a BHC include the following:

Reduced regulatory oversight. Banks without a holding company are no longer supervised by the Federal Reserve (the Fed) — except for Fed member banks. This can reduce compliance costs. The Fed strives to rely on an organization’s primary regulator and scales its supervisory approach depending on that organization’s complexity, risk and condition. So the cost savings from reduced regulatory oversight will likely be insubstantial for smaller organizations.

Lower administrative costs. Eliminating the BHC simplifies financial reporting and reduces costs associated with maintaining separate legal entities. These costs include additional taxes, fees, and accounting expenses; dual boards; and duplicative policies and procedures.

No need to deal with the SEC. Some BHCs must report to the SEC, but banks are generally exempt from the SEC’s registration and reporting requirements. However, it’s important to note that, in the absence of a BHC, some securities-related reporting requirements will shift to the bank’s primary regulator.

Benefits of BHC structure

Although the Dodd-Frank Act eliminated some earlier advantages of BHCs, most notably the inclusion of trust-preferred securities in Tier 1 capital, the BHC model continues to provide significant benefits for many banks, including:

Liquidity. BHCs have greater flexibility to repurchase stock. The ability of banks to create a market for their own stock is limited by state and federal law, and reducing capital usually requires prior approval.

M&A flexibility. BHCs (particularly small BHCs) have significant flexibility in structuring and financing M&A transactions. Plus, they can maintain acquired banks as separate institutions, allowing them to be integrated more deliberately with other subsidiary banks.

Increased permissible activities. BHCs may engage in specific business and investment activities that are off limits to banks. For example, a BHC may invest in up to 5% of any entity’s voting securities without prior regulatory approval.

Purchasing problem assets. BHCs can purchase problem assets from their subsidiary banks, helping them improve their capital ratios and otherwise strengthen their financial performance.

Dividend flexibility. BHCs have more flexibility than banks in paying dividends.

Leveraging debt. Small BHCs have the ability to use debt to raise capital for their subsidiary banks. (See “Advantages of small BHC status.”)

Long-term needs

If you’re considering eliminating your BHC, be sure to carefully weigh the potential cost-savings and other benefits compared with the benefits of maintaining the BHC structure. This is especially necessary if your organization has total consolidated assets of $3 billion or less. Also consider the costs and administrative burdens of merging your BHC into its subsidiary bank, including shareholder and regulatory approval, modification of contracts and policies, and advisory fees.

Even if you conclude the pros of eliminating the BHC outweigh the cons, evaluate your bank’s long-term needs. If there’s a possibility that a BHC structure will become advantageous down the road, it may be wise to retain it. Creating a new BHC when a need arises in the future may be difficult — if not impossible — and costly.


Sidebar: Advantages of small BHC status

Banks whose holding companies qualify as small bank holding companies (small BHCs) under the Fed’s small bank holding company policy statement enjoy significant advantages, especially when it comes to raising capital. And last year’s Economic Growth, Regulatory Relief and Consumer Protection Act expanded these advantages to a greater number of banks by raising the threshold for small BHC status from $1 billion to $3 billion in total consolidated assets.

Small BHCs can incur greater amounts of debt than other BHCs. Plus, they’re permitted to measure capital adequacy at the bank level only, without considering the BHC’s consolidated capital. This allows the BHC to borrow money — using virtually any type of debt instrument — and “downstream” the proceeds to a subsidiary bank in the form of capital.

Greater access to debt also gives small BHCs greater flexibility in structuring and financing M&A transactions.

© 2018

Dyersburg, TN Helpful Articles Henderson, KY Henderson, TN Jackson, TN Martin, TN Memphis, TN Milan, TN Murray, KY Nashville, TN Owensboro, KY Paris, TN Trenton, TN Tupelo, MS Union City, TN

Tax-Saving Moves

It’s not too late for businesses to implement some 2018 tax-saving moves. One is making the most of the new deduction for qualified business income.

For tax years starting after 2017, taxpayers other than corporations may be entitled to a Sec. 199A deduction of up to 20% of their qualified business income. For 2018, if taxable income exceeds $315,000 for a married couple filing jointly, or $157,500 for all other taxpayers, the deduction may be limited based on whether the taxpayer is engaged in a service-type trade or business. Contact us for more info.