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Payday lender Cash Store Financial Services has a pretty simple business model – make loans and collect as many as possible. It's short-term lending to clients who don't always have a great credit profile, so losses are to be expected and the company charges a lot up front to cover those.
The problem is, Cash Store hasn't done a very good job of explaining to investors what its experience has been on losses, and that's catching up to the company. Thursday, a credit rating agency downgraded the lender and one of the reasons was the ineffective controls over the way it measures and accounts for loan losses.
As an investor, the key to valuing any lending business is understanding what kind of losses the loan provider is taking at any given time. So when a lender discloses that it has not been up to snuff in terms of how it determines and communicates loan losses to investors, that's something to pay attention to. What's more, one of the usual backstops for the process, an auditing firm, is absent in the case of Cash Store. Because Cash Store qualifies for an exemption for smaller companies under U.S. accounting rules, its auditors don't have to sign off on its internal controls for financial reporting (ICFR).
Here is what Cash Store had to say about this in its financial statements, and what it is doing about it, when it filed its financial statements in late December:
"During the year ending September 30, 2012 the Company determined that the following material weaknesses existed in ICFR:
1) Management did not maintain effective processes and controls specific to accounting for the January 31, 2012 acquisition of the portfolio of consumer loans. Management did not effectively research, develop, communicate and implement an accounting policy with respect to this non‐recurring transaction. In addition, management did not implement sufficient preventative and detective controls governing the determination of the key valuation assumptions associated with the assets acquired and allocation of the purchase price.
2) Management did not maintain effective processes and controls specific to the determination of the provision for loan losses. Senior finance personnel did not effectively communicate with operations to obtain a sufficient understanding in making the determination of the provision for loan losses. This material weakness resulted in material errors in the unaudited interim financial statements. Further, there is a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected on a timely basis.
The accounts that could reasonably be affected by these material weaknesses are provision for loan losses, premium paid to acquire the loans, intangible assets and consumer loans receivable, net.
In response to the material weakness specific to the January 31, 2012 acquisition of the loan portfolio and related intangible assets identified above, as part of the preparation of the 2012 annual financial statements management established a project team, led by a senior member of the finance team, to coordinate with accounting and valuations specialists in the final measurement of this transaction. Because this is a non‐recurring transaction, the Company considers this material weakness to be remediated as of September 30, 2012. In response to the material weakness specific to the provision for loan losses identified above, as part of the preparation of the 2012 annual financial statements the Company formally adopted an accounting policy and established a credit committee, comprised of senior financial and operational executives, to meet on a regular basis to monitor loan loss rates and approve provisioning levels. Management also hired additional senior finance personnel in the fourth fiscal quarter of 2012 to assist in the monitoring of the provision for loan losses. There have been significant improvements made to ICFR in relation to the provision for loan losses. However, management needs sufficient time to assess the effectiveness of the change and to implement further improvements before they can conclude that a material weakness does not exist."
"Auditor Attestation Report on Internal Control over Financial Reporting The Company's independent auditor, KPMG LLP, has not issued an audit report as at September 30, 2012, on the effectiveness of ICFR due to an exemption for Emerging Growth Companies provided by The US Jumpstart our Business Startups Act, which was signed into law on April 5, 2012."