An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM process framework can protect and create value for organizations and their owners.
Smart Business spoke with John T. Alfonsi, managing director at Cendrowski Corporate Advisors LLC, about how ERM precesses can mitigate risk and increase a company’s value.
Effective ERM processes can help businesses increase value by affecting the estimates for these quantities.
Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections. Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment.
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. A project with relatively high risk will require a relatively high yield to compensate an investor for bearing these risks.
The ERM process has little impact on systematic risks unless the business’s performance is heavily tied to market performance. Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates.
Company-specific risks encompass all other risks, including size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health.
Smart Business spoke with Breuer about the benefits of ESOPs and how they’re implemented.
This is an attractive option to companies that may need capital to acquire the stock. Implementing an ESOP also allows a company to receive significant tax and financial benefits. Among the numerous benefits, the dividends paid on stock held by the ESOP are fully tax-deductible, the principal can be repaid with tax- deductible funds, and the owner can choose what portion of his or her stock to sell.
The transaction costs associated with ESOPs are also comparable to traditional buy-outs.
Under certain circumstances, selling shareholders can defer the entire gain recognized from the sale of shares for federal income tax purposes.
Smart Business spoke with James Martin, managing director at Cendrowski Corporate Advisors LLC, about the finer points of a CRP.
Setting up a CRP is an extension of the risk management process. It involves deep planning around what tools will be needed for specific threat types and proactively ensuring they will be available. When a risk actually occurs there will be no time for planning and coordination, so it needs to be done upfront. Consider who should be involved, both from a company perspective and any outside experts who would be required. Identify the information that’s essential to evaluate the extent of the threat and analyze an appropriate course of information. Also, consider procedures to ensure that data and information are adequately preserved and available for the CRP.
Expert witnesses are frequently used in the courtroom by attorneys. While many qualified experts exist, the “right” expert can greatly assist counsel and the litigation with his or her testimony.
An expert witness can offer testimony about a scientific, technical or professional issue in a court case. Finding the right expert is often a difficult task, but attorneys generally look for several attributes when selecting expert witnesses.
Smart Business spoke with John T. Alfonsi, managing director, Cendrowski Corporate Advisors LLC, about the qualities attorneys look for in an expert witness.
What are the key attributes an expert witness should possess?
Attorneys generally seek an expert witness who possesses at least four attributes: Relevant professional experience; a history of testimony in which that person has represented both plaintiffs and defendants; active involvement in his or her field of expertise; credentials.
Why are professional experience and testimony history both key qualities?
Opposing counsel may try to discredit an expert witness by demonstrating a lack of relevant business and/or courtroom experience. Though a potential expert may have years of experience, this does not necessarily mean he or she has a high level of expertise in the specific area of the case, or that his or her experience demonstrates the unbiased nature that an expert must possess.
For example, some experts have only provided their services on behalf of either the defendant or plaintiff. Such a track record might be used by opposing counsel to infer a bias on the part of the expert, even if the bias does not exist.
Why is active involvement an essential quality of an expert witness?
Active involvement often manifests itself in an expert’s writing and speech; both are key elements of his or her testimony. Experts who contribute to their field generally pride themselves on having a thorough understanding of the subject matter. They may be most up to date on recent rulings and opinions regarding relevant analytical techniques, and will generally ensure their testimony complies with these items.
Active involvement may also manifest in the expert’s ability to convey findings to nontechnicians. Experts primarily work with individuals who readily understand the technical terms and analytical methods of the field. This peer group may be quite different from a judge or jury pool.
Involved experts will recognize this difference and have a profound understanding of their area of expertise so they can better articulate their findings.
Do attorneys generally look for specific credentials in selecting an expert witness?
Attorneys generally engage experts who hold credentials in their field, requiring the expert to pass rigorous tests, participate in continuing education programs and/or possess significant related experience. Multiple credentials adhering to such criteria might exist in some fields.
For instance, business valuation credentials fitting the previously mentioned criteria include: Accredited in Business Valuation (ABV), Certified Valuation Analyst (CVA), Certified Business Appraiser (CBA) and Accredited Senior Appraiser (ASA). No one credential is generally better than the other, but credentials generally emphasize the expert’s commitment to his or her profession and understanding of the technical issues.
Is analytical ability the most important attribute of an expert?
It is a key attribute, but sometimes not the most important. Though an expert may have strong analytical abilities, it is important that he or she be able to articulate his or her findings in a clear and concise manner, both on the stand and in written testimony.
To specifically address this issue, some experts purposefully make liberal use of visual tools, including graphs and flowcharts, and include detailed explanations to ensure findings are well articulated and written at a level that nonbusiness professionals can fully comprehend. These experts might also assume a reader has little- understanding of the technical aspects of the case, or of the analytical methods employed.
This strategy helps ensure a reader or listener will not be confused by necessary technical jargon or methods that might otherwise be nonintuitive to a layperson. ●
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Executives often wonder why they need to have machinery and equipment appraised, but these appraisals are important components of business today.
“Typically, appraisals are performed because of buy/sell agreements, mergers and acquisitions, business valuations, partnership dissolutions, insurance, bankruptcy, property taxes, financing and Small Business Administration lending. Other reasons would be divorce, estate planning or other estate issues, retirement planning, cost-segregation analysis and litigation support,” says Theresa Shimansky, a manager at Cendrowski Corporate Advisors LLC.
Smart Business spoke with Shimansky about how machinery and equipment appraisals are typically handled.
What is the useful life of an appraisal?
Generally, an appraisal is good for three years, but it depends on the current market, economy and industry. An appraisal’s useful life also depends on the availability of the type of equipment being appraised. The value can drastically change with economic factors such as supply and demand.
Is a machinery and equipment appraisal beneficial when buying or selling a business?
Absolutely. Buyers want to know the breakdown between real and personal property. This is a cost segregation analysis or study. Appraisals are completed for many reasons, but most importantly for tax reasons — breaking the assets into different categories for depreciation purposes.
What information and documentation will an appraiser require?
The appraiser will need to know the manufacturer, model, serial number and age of the equipment. This information typically can be found on a plate attached to the equipment. Mostly, it will be visible; however, sometimes locating this plate can be tricky. For example, restaurant equipment will occasionally have a kick plate covering the information plate. Machines may have the plate attached inside a compartment or near the motor, while others may not have one at all. When a machine does not have a plate, it is helpful if the owner has the original manual or sales invoice that should list most of the information.
The appraiser also needs to know about the condition, special features and upgrades. Important questions to keep in mind are:
- Does it work well?
- Has it had any major repairs or is it in need of any?
- Is it maintained according to manufacturer specifications? The appraiser may request to see maintenance logs or ask about special attachments or upgrades.
- Is its software up to date?
An appraiser will evaluate and photograph each piece of equipment. When this is not possible, appraisers will note in the report which equipment could not be visually inspected and explain they are relying on the representations of similar machines’ condition and other pertinent information.
What is a ‘qualified appraisal’?
A ‘qualified appraisal’ is clearly defined in Internal Revenue Service (IRS) Publication 561, where the appraisal:
- Is made, signed and dated by a ‘qualified appraiser’ in accordance with appraisal standards.
- Does not involve a prohibited appraisal fee.
- Includes, but is not limited to, a description of property, condition, date of value, terms of the engagement agreement, qualifications of the appraiser, method used to determine value and basis for value.
Generally, an appraisal is considered qualified if it follows the Uniform Standards of Professional Appraisal Practice, developed by the Appraisal Standards Board of the Appraisal Foundation.
What should you look for in an appraiser?
When searching for an appraiser, only use a ‘qualified appraiser.’ This is an individual, as defined by the IRS, who has earned an appraisal designation from a recognized professional organization for demonstrating competency in valuating property. Also, qualified appraisers regularly prepare appraisals for which they are compensated, and demonstrate verifiable education and experience in valuating the type of property being appraised.
Theresa Shimansky is a manager at Cendrowski Corporate Advisors LLC. Reach her at (866) 717-1607 or email@example.com.
Website: For additional information, please visit our website at www.cca-advisors.com.
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One of the primary functions of management is to understand what is actually going on in an organization, as opposed to what is supposed to be happening. However, for monitoring to be truly effective, there must first be good communication, a culture that promotes ethical behavior and a solid understanding of the particular organization’s risk factors.
“Organizational monitoring is not just about protecting a company from fraud,” says James P. Martin, CMA, CIA, CFE, managing director at Cendrowski Corporate Advisors LLC. “Monitoring systems can help ensure quality, that customer needs are being met and that the company is doing everything else that is necessary to achieve its goals.”
Smart Business spoke with Martin about how management can understand what is truly going on within the business.
What are the steps to an effective organizational monitoring plan?
First, the company must clearly define its goals. What is it trying to accomplish and how will it accomplish those goals? Second, what risks does it face? What can get in the way of the company accomplishing those goals? Third, what type of early warning system does the company need? How will it know if and when a risk has occurred or if someone has not performed as expected?
What impacts are electronic monitoring systems having?
Electronic monitoring systems have been around awhile but are drawing increased attention now with more severe penalties and potential outcomes for violations under Sarbanes-Oxley. Electronic monitoring systems are similar to a car’s dashboard. When trigger points, predefined events or hurdles are detected, ‘warning lights’ appear on the manager’s desktop.
While electronic monitoring is useful, it cannot — and should not — replace human involvement. The most important thing managers can do is be involved with operations on a day-to-day basis by walking around and talking with employees, holding regular meetings, receiving regular reports and phone calls, etc.
How are trigger points identified?
An organizational assessment of risk will help management identify areas that have more robust monitoring needs. Examples might include finance, everything related to potential issues arising with cash, or vendor management, such as notification every time a vendor’s address changes. Triggers also can monitor quality metrics, supply chain issues, personnel issues, etc. The system should be proactive so that management can address issues before they get out of control, preventing a crisis management situation.
It’s important to note that a monitoring system is more holistic than the definition of trigger points. The single biggest factor is people — what they will do in a given situation. The overall culture needs good communication systems and a clear understanding of management expectations.
Monitoring techniques need to continuously adapt to consider potential changes in behavior. There are a lot of examples of companies that had defined monitoring procedures, but creative people were able to identify and exploit areas that were not considered in those procedures.
How do private equity firms monitor the activities of the companies they invest in?
Private equity firms have to monitor the operations of the portfolio companies, not to the extent of detail that internal management does, but they do need to define risk. These companies have expectations, and if they identify certain events on the horizon, they can be prepared to take certain actions. Like the companies they monitor, private equity firms also must define their own particular trigger points.
Any tips for improving a system?
Make sure you’re monitoring the right areas. There may be areas you’ve historically monitored that have now changed, which is where the internal audit function comes in. The board’s audit committee must understand what is critical for the upcoming year. In examining the ‘audit universe’ — the model that defines every auditable event within the organization — areas of risk are identified, and then prioritized for audit. It's management’s responsibility to determine how many resources to invest in each given area of risk.
James P. Martin, CMA, CIA, CFE is managing director at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org.
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Cost segregation studies are an effective component of any cash management strategy for a business that owns buildings or other depreciable real property for business use. The strategy involves the deferral of income tax liabilities to later years through the identification of property having a shorter cost recovery period for federal income taxes, which even the IRS acknowledges as an appropriate deferral method.
Smart Business spoke with Walter McGrail, senior manager at Cendrowski Corporate Advisors LLC about using cost segregation.
Why are cost segregation studies effective?
The benefit is the ‘present value savings’ attributable to the deferral of federal and state income taxes. The actual savings is the reduction in current tax payments now, with resulting increases in taxes payable in subsequent periods, i.e., the ‘time value of money’ attributable to tax deferral. As with any treasury cash management program, a property owner’s cost of capital is typically the appropriate discount rate to measure the ‘present value savings’ of deferring cash charges for income taxes.
How does it work?
First, cost segregation studies identify categories of costs that have a shorter cost recovery period for income tax purposes. Buildings typically have a depreciable life of either 27 or 39 years, while the depreciable lives of furniture and fixtures ranges from five to seven years. Though the total amount of cost recovered is the same regardless of the recovery period, the shorter it is, the sooner the resulting tax savings occurs.
Second, shorter life property generally qualifies for accelerated depreciation methods. Buildings are depreciated under the straight line method, which results in the same depreciation expense during each year the building is owned. Shorter recovery life property identified in a cost segregation study may be depreciated under accelerated cost recovery methods. For example, depreciating property with a five year life using accelerated depreciation on the same five year property results in more than 70 percent of the cost being depreciated during the first three-year period. There are also new Treasury regulations that permit immediate deduction of qualified repair costs. The professional conducting the cost segregation study will be able to apply the new expensing regulations, as well. The tax savings occurs for both federal and state income taxes. Current federal corporate income tax rates are 35 percent and states’ are typically are around 5 percent.
How is a cost segregation study conducted?
Studies must be properly conducted to withstand IRS scrutiny, which requires not only professionals trained in the proper classification of assets for federal depreciation purposes but also personnel with engineering and construction experience to properly classify the components of a structure. Key to a successful audit defense are documentation of findings and expert personnel.
What businesses might benefit from this?
Cost segregation studies can be conducted on new construction, rehabs, recently purchased properties, or even properties held for a period of years. For newly constructed property, and to some extent rehabilitated properties, shorter life depreciable property may qualify for bonus depreciation. Bonus depreciation rules permit a first year depreciation deduction equal to 50 percent of the cost of identified qualifying property. Bonus depreciation and more favorable capital expenditure expensing elections will expire after 2012.
What is the time frame to conduct a study?
In order to make a claim for the 2012 calendar year, the study must be conducted before the extended due date of the 2012 returns, typically Sept. 15, 2013. Sufficient time should also be permitted to coordinate the findings of the study with the business’s preparation of its 2012 income tax returns. For properties owned prior to 2012, the IRS has provided a relatively straightforward means to claim the resulting difference in depreciation expense before and after the study is conducted.
Walter McGrail is a senior manager at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com
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While the results of the presidential election have been determined, the tax landscape is less than settled. Absent any legislative changes, taxpayers are looking at significant modifications in federal taxation beginning in 2013.
“Taxpayers need to be aware of the changes and know how they will impact them. Year-end tax planning becomes critical,” says John T. Alfonsi, managing director at Cendrowski Corporate Advisors.
Smart Business spoke with Alfonsi about what business owners and individuals should know about the anticipated changes.
What are some of the changes individuals will be experiencing in 2013?
Plenty of changes will occur by virtue of the expiration of the Bush-era tax cuts primarily enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs Growth Tax Relief Reconciliation Act of 2003. For starters, tax rates will revert back to the former brackets, with the top marginal rate rising from 35 percent to 39.6 percent. Capital gain rates will also change. Currently, long-term capital gains are taxed at a maximum rate of 15 percent. Beginning in 2013, that maximum rate goes up to 20 percent.
What about dividend income?
Dividend income is currently taxed at the same rate as long-term capital gains, or a maximum of 15 percent. All dividend income will be taxed at ordinary income rates beginning in 2013. Accordingly, individuals in the top tax bracket will see their dividend income go from being taxed at 15 percent to 39.6 percent.
Are tax rates the only thing affected?
No, deductions are impacted, as well. For example, overall itemized deductions are currently not subject to any limitations. Beginning in 2013, we revert back to prior law, where higher-income taxpayers must reduce their total itemized deductions by 3 percent of the amount in excess of a threshold amount of adjusted gross income; total itemized deductions cannot be reduced by more than 80 percent, however. Personal exemptions are another deduction that will be impacted. Currently, there are no restrictions on the amount of personal exemptions a taxpayer can deduct in arriving at taxable income. After 2012, however, personal exemptions will be limited for higher income taxpayers — the amount is reduced by 2.5 percent for each $2,500 by which the taxpayer’s adjusted gross income exceeds applicable thresholds.
Are there any new taxes individuals should be aware of?
Absolutely. There are two specific taxes higher income individuals need to consider. First, the employee portion of the hospital insurance payroll tax will increase by 0.9 percent — from 1.45 percent to 2.35 percent — on wages over $250,000 for married individuals and $200,000 for unmarried individuals. The employer portion will remain at 1.45 percent. The other new tax is the Medicare contribution tax on unearned income of higher-income individuals. This tax was enacted as part of the Patient Protection and Affordable Care Act, better known as ‘Obama Care.’ The tax is 3.8 percent on the lesser of an individual’s net investment income or the amount of adjusted gross income in excess of certain thresholds — $250,000 for married individuals and $200,000 for unmarried individuals. For purposes of this tax, investment income includes interest, dividends, and income and net gains from passive activities and ‘trader’ activities, such as hedge funds.
To illustrate the impact of these changes, let’s assume a married individual has an adjusted gross income of $700,000, which is made up of wages and salary of $500,000, dividend income of $100,000 and $100,000 long-term capital gain, both from investment partnerships. Further, assume the taxpayer has gross itemized deductions of $50,000 and four personal exemptions. Taxable income will increase by approximately $35,000 solely because of the limitation on itemized deductions and personal exemptions. The total federal income tax liability will increase from approximately $151,500 to $206,000 as a result of the higher tax brackets, dividend income being taxed at ordinary income rates and the new Medicare contribution tax on the dividend and long term capital gains income. This is a 36 percent increase in the federal income tax liability without any change in gross income. This also ignores the impact of the additional $2,250 hospital insurance payroll tax on the wages.
What can taxpayers do to minimize the potential tax increase?
Tax planning becomes important. Conventional wisdom suggests you should defer income and accelerate deductions. But in a period of increasing tax rates, there are no steadfast rules; each situation needs to be looked at individually. For example, with the higher tax rates in 2013, you may want to defer any charitable contributions from 2012 to 2013 as you get a potentially bigger benefit at the higher rate. But the taxpayer needs to consider the limitation on itemized deductions that will apply in 2013, but not in 2012. This ignores, of course, the impact of the alternative minimum tax, which presents its own set of issues, concerns and tax planning. Accelerating capital gains into 2012 may be a planning opportunity to take advantage of the 15 percent rate and avoid the Medicare contribution tax on such income.
Do you have any other tax planning tips?
Taxpayers looking to make significant gifts as part of their estate plan should consider taking advantage of the $5 million lifetime gift exclusion, which expires at the end of 2012. Beginning in 2013, the lifetime gift tax exclusion decreases to $1 million. Further, estate and gift tax rates are scheduled to increase from a maximum of 35 percent to 55 percent. Of course, all of this becomes moot if new legislation is enacted to avoid the ‘fiscal cliff’ we are facing.
John T. Alfonsi is managing director at Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or firstname.lastname@example.org.
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A significant part of the risk management process for any business enterprise is the proper classification of its work force for federal employment tax purposes as either employees or independent contractors.
“The risks from misclassification are a potentially significant underpayment of employer Social Security, Medicare and unemployment taxes, as well as the interest and penalty from failure to pay such employer taxes and for failure to withhold income taxes,” says Walter McGrail, senior manager, Cendrowski Corporate Advisors LLC.
Employers, he says, are responsible for withholding taxes for employees, but they are not responsible for such taxes on independent contractors.
Smart Business spoke with McGrail about the Voluntary Classification Settlement Program (VCSP) and how it can be used to a business’s advantage.
What are the factors for determining work force classification?
For more than 20 years, the IRS has adopted the so-called ‘common-law’ test for classification of workers as employees or independent contractors. The common-law test for classification is used to determine whether business managers have the right to direct the ‘means and details’ of the services being performed. Under the ‘means and details’ standard, it doesn’t matter whether the business managers actually direct the means and details, only whether they have the right to do so. The IRS has published a list of the ‘20 factors’ used to make the common-law determination of classification. Generally, such factors fall into one of three categories: behavioral control, financial control and the relationship of the parties.
What is the IRS Voluntary Classification Settlement Program?
Work force classification has long been a source of acrimony between the IRS and taxpayers. For prospective employers, classification of its work force using independent contractor status has some obvious advantages: lower employment tax costs, less burdensome reporting (1099s vs. W-2s) and non-inclusion in employee benefit programs. While the IRS has a real economic incentive to audit potential employers for taxes, interest and penalties related to prior years can be very costly for the IRS to conduct.
In an effort to coax voluntary compliance from taxpayers, the IRS has rolled out what amounts to a relatively inexpensive amnesty program, the VCSP. In exchange for taxpayers’ agreement to voluntarily treat their work force as employees for federal employment tax purposes going forward, the IRS will limit the exposure of qualifying employers to employment taxes on previous periods to a one-time surcharge equal to approximately 1 percent of the most previous year’s wages. The surcharge can be a bargain compared to the actual cost of tax, interest and penalty for all years open to IRS inspection, as well as the cost of defending an IRS audit.
How do employers qualify for the program?
In the event that a taxpayer’s risk management analysis demonstrates that the VCSP is a cost-effective means of managing its employment tax risk, the employer must meet the following qualifications: the taxpayer must enter into a closing agreement and pay the entire surcharge at closing; the taxpayer must have treated its work force as independent contractors for the previous three years; the taxpayer must have filed U.S. Form 1099 reporting the payments to such work force as non-employee compensation; and the taxpayer or its business must not be currently under audit.
What additional risk assessment might be required before taking advantage of the VCSP?
For any employer that has assessed its exposure to employment taxes, and related interest and penalties for misclassifying its work force in a prior year, there are other risks to assess. First, and as suggested, the VCSP requires full funding of the amount due at closing. To the extent that a taxpayer is in financial difficulty, they should assess whether it makes sense to even apply for the VCSP.
Secondly, taxpayers opting under the VCSP must agree to keep the statute of limitations for audits open for six years after the first year a taxpayer participates in the program. Normally, a taxpayer’s statue of limitations period for assessment of employment taxes closes after three years.
Third, the VCSP in its current form does not necessarily shelter the work force from assessment by the IRS from penalty or interest with regard to personal tax returns. While it is unclear that the IRS would pursue any claims against such employees, the IRS would have authority to do so if it chose to. The possible cost to employees should at least be considered.
Finally, each state provides for its own employment and withholding tax requirements. As it currently stands, the VCSP does not preclude a state or local taxing authority from relying on participation in the VCSP as an admission by the employer of responsibility for such state and local employment taxes for any open year.
For each of these reasons, any employer that has weighed the cost and benefit of complying with IRS guidelines for registering its work force for employment taxes must evaluate all of the risks associated with participating in the VCSP. Contact a CPA to assist you with the difficult task of properly executing the risk management process for employment taxes.
Walter McGrail is senior manager of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com.
Understanding when, where and how much credit risk is being incurred throughout an enterprise is important knowledge to possess to not only survive, but thrive, and that applies to both businesses and financial institutions.
Smart Business spoke with Scott B. McCallum, senior manager at Cendrowski Corporate Advisors, about how to create a basic credit risk assessment framework for banks, the elements of which businesses may wish to consider adopting and adapting for their own purposes.
What is credit risk?
Credit risk is the financial exposure one party has to a counterparty’s failure to meet its financial obligation. For a typical business, the most prevalent form of credit risk is, of course, the accounts receivable owed by clients or customers. Another credit counterparty is a company’s bank, whether to access deposit balances, fund draws on a revolving credit facility or receive contractual cash flows associated with an interest rate swap or foreign currency contract. Another form is prepaid expenses, such as insurance premiums, in which the business becomes an unsecured creditor of the provider of the service to the extent of unearned revenue. Credit risk arises to a seller of a business to the extent that a buyer finances a portion of the purchase price with notes payable to the seller.
How does credit risk arise at banks?
The primary risk that causes a bank to fail is credit risk. Looking at credit risk on an enterprisewide basis, banks hold most of their assets in the form of loans and investment securities. The most prevalent form of credit risk is in the loan portfolio, in which the bank lends money to a variety of borrowers with the intention of getting repaid in full.
Depending on the underlying investment securities in the portfolio, there is often credit risk embedded in securities other than those backed by the full faith and credit of the U.S. government.
Was JP Morgan Chase’s recently announced $2.3 billion loss related to credit risk?
Yes, according to an editorial in the May 14, 2012, edition of The Wall Street Journal, ‘J.P. Morgan recently suffered an unexpected loss of more than $2 billion on trades related to the creditworthiness of various corporations.’ The editorial also stated, ‘The bank had tried to protect itself from the potential of deteriorating financial markets by essentially making a bet that would pay off if corporate default risks increased.’
What is a risk assessment?
A risk assessment is an analytical exercise conducted to identify the risks associated with a particular business activity. A risk inventory is developed in the context of the defined business activity or process. Once the risks are identified, they are measured and ranked in priority based on an understanding of the magnitude and frequency of occurrence. Then, key risk indicators (KRIs) are developed to facilitate ongoing measurement of actual performance versus the KRIs. Risk reporting enables management and the board to provide effective monitoring and oversight.
What does a credit risk assessment process look like at a bank?
Banks are often organized to conduct business activities in silos, which can result in some risk gaps. A credit risk assessment helps to neutralize silos. Here is a basic credit risk assessment framework.
- Identify major subcategories of credit risk (e.g., residential mortgages and home equity lines and loans; consumer loans; commercial and industrial, and owner-occupied commercial real estate loans; agriculture and farm loans; construction and development loans; and investment securities).
- Engage key team members involved in making/underwriting the loans to identify credit risks for each subcategory.
- Prioritize risks based on evaluation of financial impact from the magnitude of each occurrence and frequency of occurrence.
- Develop KRIs for each credit risk subcategory.
- Determine credit risk tolerances, limits and controls.
- Develop reporting for effective monitoring by management and the board.
What are credit concentrations?
Managing credit concentrations is about maintaining prudent diversification in the composition of a bank’s assets. Banks have stepped up monitoring and management of credit concentrations such as limits on dollar exposures to any single borrower, or limits on the aggregate percentage of the portfolio consisting of certain loan types. Bank regulators also have been strong advocates of managing credit concentrations, as many that failed had high concentrations of those loan types.
What can businesses learn from banks to apply in their own credit risk assessments?
Know your counterparty. For the customer base to which you extend terms, establish credit limits per account debtor, obtain credit reports, background checks or similar reports that provide timely information and monitor for deterioration. Manage concentrations of business with your top 10 accounts. Identify local market or industry-specific key risk indicators that provide early warnings of elevated risks. Look for credit risk enterprise-wide, on and off the balance sheet. Understand the financial impact of the potential loss, based on magnitude and frequency of occurrence.
Finally, don’t compound a problem. Don’t sell more to deadbeats. Stay disciplined and diligent in actively managing customer limits and monitoring account debtors for deterioration. If you are concerned, take some risk out of the sale by requiring wire transfer remittances or cash-in-advance. And know your counterparty and sleep better at night.
Scott B. McCallum is senior manager at Cendrowski Corporate Advisors. Reach him at firstname.lastname@example.org.
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