When applying for a bank loan, owners and managers of small businesses must decide what accounting basis to use for financial statement presentation and what level of CPA service to request. In addition, CPAs are often asked to advise clients about such matters. A critical consideration is how the banker will react to a particular basis of accounting or level of service. This article presents the results of a study of banker perceptions and decisions concerning tax basis versus GAAP, and review services versus audits. An understanding of these perceptions and decisions should be helpful to both small business owners seeking loans and their CPAs. Certain decisions can even cost small businesses additional interest!

Several CPAs observed that tax basis statements are less costly than GAAP statements. SAS 14, Special Reports, issued almost 15 years ago, officially recognized the tax basis as a comprehensive reporting basis other than GAAP (OCBOA). SAS 62, Special Reports, superseding SAS 14, continues to recognize the tax basis. Yet little knowledge exists about how loan officers react to tax basis statements.

Accountants can also offer a review to clients instead of an audit. SSARS 1, Compilation and Review of Financial Statements, indicates that reviews are appropriate for either GAAP or tax basis statements; but when should a CPA tell a client that an audit is unnecessary?

Overview of the Study

Loan officers consider financial statements and many other factors when deciding whether to approve a loan request. For secured loans, the most important determinant in the loan decision process is the value of collateral. When a small business applies for an unsecured loan, however, the financial reporting basis and the service provided become important questions, because the financial status of the business is especially pertinent to the loan approval decision.

To help answer these questions, loan officers attending the American Bankers Association (ABA) National Commercial Lending School were asked to evaluate loan requests accompanied by both GAAP and tax basis statements and subjected to both reviews and audits. Of 253 attending the school, 232 volunteered to take part.

Four financial statements for the same company and the same year were created:

1. A reviewed financial statement prepared on the basis of GAAP.

2. A reviewed financial statement prepared on an income tax basis.

3. An audited financial statement prepared on the basis of GAAP.

4. An audited financial statement prepared on an income tax basis.

Each participating lending officer received one of the four financial statements and then answered the following questions concerning a request for an unsecured line of credit:

1. Would you approve the loan?

2. What interest premium, above your bank's prime rate, would you charge for the loan?

3. What is the likelihood of default associated with this loan?

4. How useful is this financial statement to you in making decisions?

5. How confident are you that this financial statement properly reflects the financial status of this company?

6. How well do you understand this financial statement?

The participating lending officers averaged three years of commercial lending experience at banks throughout the country.

What Happens When a Small

Business Uses Tax Basis

Statements Rather than GAAP?

Most loan officers reported that they had never seen audited tax basis statements. It is not surprising, then, that loan officers equate the terms "audit" and "GAAP." Most loan officers have never seen the term "audit" when it did not involve "GAAP." One loan officer did point out, however, that his bank requires audited tax basis statements for all unsecured small business commercial loans. The loan officer indicated that his bank believed that the tax basis was far more conservative than GAAP, and, at the same time, his bank wanted the confidence associated with an audit. This practice has proven quite successful for the bank. Nevertheless, almost all of the participating loan officers felt extremely uncomfortable with tax basis statements if they had been audited.

Surprisingly, loan officers felt more comfortable with tax basis statements that had been reviewed, although they still preferred GAAP. Loan officers that used tax basis statements believed the company was more likely to default on a particular commercial loan than those that used GAAP basis statements. The tax basis statements were also viewed as less useful than GAAP basis statements, perhaps because loan officers believed that tax basis statements were not as complete as those prepared under GAAP.

When asked why tax basis statements were not complete, loan officers responded unanimously: tax basis statements do not usually contain a statement of cash flows or any similar statement. Often, when loan officers realize that tax basis statements do not include such a statement, they "change their minds" and require GAAP.

As noted earlier, almost every loan officer was extremely uncomfortable with audited tax basis statements. However, one group of loan officers was also particularly affected by reviewed tax basis statements. Loan officers in banks where most commercial loans are to large businesses had a very strong discain for reviewed tax basis statements. They were not confident in them, and they placed very strong default risk penalties on the company when reviewed tax basis statements were involved. These loan officers, however, did not charge higher interest rates for tax basis companies than they did for those using GAAP.

What Happens When a Small

Business Financial Statement is

Reviewed Rather than Audited?

Because the statements used were all for the same company and the same time period, loan officers might be expected to charge about the same interest rate, regardless of the financial statement used. Nevertheless, reviewed statements resulted in much higher interest charges than audited statements! The loan officers were asked what interest premium, above their bank's prime rate, they would charge for a particular loan: for audited statements, the average premium was 2.7%, but for reviewed statements, the average premium was 3.0%.

The study clearly states that loan officers place significantly higher confidence in audited statements than in reviewed statements. They associate a higher degree of default risk for loans when reviewed statements rather than audited statements are presented. This default risk perception resulted in higher interest rates.

Other Important Findings

Financial reporting basis and service choices can usually be made without fear of affecting loan approval. Loan officers were quick to explain that financial statements are only one of many inputs in the loan approval process. Many characteristics are examined before a loan is approved. Loan officers did indicate that the financial statement was the most important input in assessing the financial status of the company. But by itself, an assessment of financial status is usually not sufficient for loan officers to make loan approval decisions.

Based on the background of the loan officers, the effects of reporting basis and service level are in no way explained by the experience of the loan officer involved. An experienced loan officer is just as likely to prefer audited GAAP basis statements as an inexperienced loan officer.

A loan officer's accounting education is important. The accounting education of the loan officers in this study varied tremendously. A few of the loan officers had never taken an accounting course. A small portion of the loan officers had Master of Accountancy or MBA degrees with specializations in accounting. Most of the loan officers had either a year of accounting principles or a year of principles combined with one or two other financial accounting courses. Loan officers who had little, if any, accounting education perceived higher default risk with reviewed tax basis statements than did loan officers with more extensive accounting education. This may be understandable, because reviews and tax basis statements are rarely discussed in elementary accounting courses.

This finding does not mean that loan officers with a strong accounting education perceive reviewed tax basis statements more favorably. Loan officers with a strong accounting education are more confident with audited GAAP basis statements than are any other loan officers. Although the temptation is to believe that loan officers with a strong accounting education would best understand reviews and tax basis statements and be more likely to accept them, such loan officers are more likely to require audited GAAP basis statements. Perhaps this is because they best understand how audited GAAP basis statements differ from other statements. (See Table 1 for a summary of pertinent results.)

Douglas R. Carmichael, PhD, CPA Baruch College