When anyone starts talking about accounting, most people cover their ears and run away. Many would prefer to have a root canal than to learn about financial controls. I’m a CPA, but also a musician and would personally prefer to write about drum sets than accounting. It is an undeniably dull topic, but proper accounting for any business is immensely important. So why learn accounting? Aside from the ability to know if your business is making money, learning accounting can protect your company from the growing threat of corporate theft.
For brokers and bankers
Most of the recommendations contained in this article are applicable to all mortgage lenders. Some of the content is specific to mortgage bankers. If you are a broker thinking about becoming a mortgage bank or looking at joining a mortgage bank then you need to understand all the issues addressed here. If you are an originator in a mortgage bank and you want to help your company stay in business, help your management understand the importance of proper accounting. For owners of mortgage banks, you may be surprised at what your accounting department is doing or not doing.
What do business owners need to know about financial management?
All too frequently, we see companies exposing themselves to the increased risk of corporate fraud due to a lack of structured control and transparency in their accounting systems. On a daily basis, we talk to mortgage banking executives across the county … many of whom are also the owner of the business. One interesting common comment we hear people say is their accounting system is running “just fine.” When a mortgage executive says accounting is “just fine,” it typically means they are able to get the information they think they need from their accounting systems, including their cash balance and the total volume closed within a month. Those two figures are important to know, but only represent a fraction of the essential information and do not represent fraud prevention.
We also note that most often the founder of a mortgage business or the mortgage executive who is happy with their accounting system is not a CPA. This is an important distinction because knowing if an accounting system is sufficient for a business is not a skill-set that is developed just by starting a business. In fact, assessing an accounting system is a very complex process that requires extensive experience and training in GAAP, (CPAs use these guidelines to record information), U.S. Department of Housing & Urban Development (HUD) requirements (this includes GAAP, net worth levels and borrower escrow), warehouse lender requirements, and Fannie Mae and Freddie Mac expectations.
So, when someone says accounting is fine, they are saying they feel good about it and think they are in good shape, but just like a doctor can listen to a heartbeat and know if the heart is okay … a CPA can tell if an accounting system is running okay. The patient may feel fine, but could have congested arteries and be on the path to a heart attack. The reality is, if we feel like we have a heart issue, we are going to get treatment from a heart specialist, a cardiologist, because not all doctors know the details about a heart. The same goes for CPAs. All CPAs know basic accounting, but not all CPAs understand the complexity of mortgage banking. Just like we’d see a cardiologist for our body, we’d see a mortgage expert CPA to tell us if the heartbeat of our business is okay.
Violation of trust
In our personal lives, we regularly trust the people around us. We trust the other drivers on the highway to stay in their lane and we trust airplane pilots to land safely at the correct airport. Even more, we trust those with whom we share a personal relationship to be honest and trustworthy. Can you image the unthinkable distress created by discovering that your child has been harmed by a trusted caregiver or that your best friend has been sleeping with your spouse? We all hear about the unthinkable, and hope we never face it, but sometimes, bad things happen to good people.
In our business world, we trust those around us without a second thought. We are confident that the accounting department will make the payroll deposit on time every time. We trust that the receptionist will let us know if we have a guest. But what happens when the fabric of our world is destroyed by a dishonest employee?
We initially think of employee dishonesty as someone taking your lunch out of the refrigerator, or even taking money out of your desk drawer. But what happens when our closest and most trusted employee, the person who makes sure there is money in the bank, takes advantage of us?
We all have accounting people who support our businesses, either as an employee or as a bookkeeper or auditor. These people perform essential functions like transferring money and making payroll; functions that we expect to be done correctly and timely without fail. We grow so comfortable with our accounting staff that we are confident they will continue to do what they have always done … move money and make payroll on time every time.
We all know there are substantial amounts of money rolling through a mortgage bank. The unthinkable of unthinkable events is when our trusted accountant who manages or money begins to move company money to their own account. At this point, most of you are thinking this is unbelievable. But it has happened. We’ve met with companies where the “always dependable” bookkeeper moved so much money out of the company that the company may not survive … thus the ultimate violation.
What if an accountant stole millions from your company by diverting money from loan purchases so they not only took lots of money, but they left you with millions of dollars in unpaid liability? All it takes is five loans to create losses in the millions. CPAs call corporate theft “DEFALCATION” defined as: “To misuse or embezzle funds by a person trusted with its charge.” Defalcation is similar to “DEFICATE” creating an interesting metaphor.
I cannot divulge any details, except to assure you that this is a true and recent story. The most disheartening issue of all is that it could have been prevented with just a few common controls mortgage CPAs expect to see in any company’s accounting system. As a side note, before there was an issue with this business, the owner was confident their accounting was fine; when, in fact, it was dangerously compromised. They didn’t know it was compromised because they lacked the knowledge and training necessary to monitor the system and trusted blindly without verification that things were, in fact, “just fine.”
All violations of trust are repulsive and end with the gut-wrenching feeling of pervasive violation. The closer the person is to you, if it’s a spouse or a longtime bookkeeper, the deeper the pain and the longer the violation is stained in your memory. No one ever thinks it will happen to them. There is a psychological event that we all fall victim to and this is denial. We engage this defense mechanism and bury our heads in the sand or state that: “This can’t happen to me nor has it happened to anyone I’ve ever known. This is just something that happens to other people.” And yet, the risk is real, but most business owners tell us their accounting is fine when the reality is they could be at risk and not know it.
here is an interesting quote from the Bible that states “Pride Comes Before a Fall.” Basically, if you are so confident in your actions and believe that you are right without exception or counsel, it is likely that you are next to fail. Just ask anyone who has failed. Another saying that speaks to the issue of control is “absolute power corrupts absolutely.” Said another way, someone with unlimited control will use that control to their personal advantage. There are many examples in history of this, from the Caesars through Hitler and on to Saddam Hussein. The lesson learned is without controls or oversight, dictators and those who control money in a business could use their powers to their own benefit.
Check the checkers: Trust but verify
So what are the reasonable precautions that are designed to keep honest people honest? The answer to this question is easy. Effective accounting systems require detailed and comprehensive data entry, accurate reporting, thorough breakdowns of where monies are at all times, and finally, absolute transparency. Transparency is not achieved without proper data capture, otherwise reporting can be inaccurate. As I stated previously, no one thinks it will happen to them.
Everyone trusts their accountant because generally accounting people are trustworthy. The entire CPA profession is based on providing trust and confidence in the work they perform. CPAs are the only profession in which the Securities & Exchange Commission (SEC) designated as qualified to express an opinion about the presentation of the financial statements of a company. To earn and preserve this trust, CPAs are specifically required to take regular ethics exams and undergo thorough training on how to implement procedures to prevent corporate theft. A very important distinction needs to be made between a non-certified accountant/bookkeeper and a Certified Public Accountant. Although CPAs often do similar work as a non-cert accountant, and a non-cert-accountant may have a degree in accounting, they do not have the same level of continuing education and testing as a CPA. A non-cert-accountant is not licensed and is not under regulatory oversight like a CPA. This distinction is important when identifying the path to protect from violations. Many non-certified accountants are excellent bookkeepers and are essential to the accurate record keeping of a company. Just make sure a mortgage CPA helped to set-up the accounting system and reviews the accounting reports on a monthly basis.
It is absolutely important to remember that an accounting department is populated by humans, and humans are capable of errors in action or judgment. It is also important for you to pay attention and ask questions about the numbers. If you don’t understand the answer, get someone else to help until the answer makes sense. Never accept the answer, “That’s just how it is,” or “That’s want the auditor said.” Dig deeper and understand the answer. Your first loss is your smallest loss when detecting corporate fraud. Defalcation usually begins in smaller amounts, and then increases in size if the scheme is undetected. Finding corporate theft early will reduce the loss and digging into accounting is the only way to find it.
Accounting systems prevent failure
Protecting your company from corporate theft begins with having a good accounting system, along with proper accounting procedures for the posting of loan funding and purchase transactions. No one wants to talk or think about the details of accounting, but this can be the difference between success and failure. Even the Small Business Administration (SBA) has statistics about this. The federal agency that helps small business says that 95 percent of all small businesses fail in the first three to five years because of poor planning and poor financial management.
Think about this, out of 1,000 people who started a new business, people who took all of their savings to start the business, people who were all 100 percent confident in their future success, 950 out of 1,000 of them have failed and lost everything. They lost everything because they didn’t have proper financial planning, which includes an accounting system with proper controls over money.
So, why didn’t they have good accounting systems? Maybe they didn’t know how to build one. Maybe they didn’t have access to a CPA. The unfortunate reality is almost all of them didn’t know what they needed to know. I heard a college professor comment, “It is better to ask a question and seem a fool than not ask a question and fail.” I think the same holds true when business owners think about their accounting.
From lemonade stand to used car accounting
When a lemonade stand buys sugar and lemons they create an asset of the business called raw materials inventory. When the owner of a car lot buys a car at an auction they can get 100 percent financing from a bank so there is no immediate cash spent. The car lot will record the borrowing from a bank as a liability and the car as an asset held for sale. The fundamental principal here is the moment you borrow money, you have a liability and the moment you close a loan you have an asset. Another important accounting event for a car lot is collecting money from a buyer for the purchase of a new DVD player to be purchased and installed by a specialty auto parts store. The money is a liability of the car lot until they give the money to the auto parts store. When a company receives money from a customer to be held for someone else the money is a fiduciary liability.
When we look at mortgage banking, we are surprised to see that many mortgage banks do not follow these basic accounting principals. When they close a loan (buy a car), they do not record the asset. When they borrow money from a warehouse lender (borrow from a bank), they do not record a liability. When they take money from a customer for taxes and insurance, they do not record the money as a liability for escrow impounds. By not implementing these basic accounting principals, the owners of mortgage banks are limiting the accuracy of their financial statement and creating a higher potential for corporate fraud.
Mortgage banking accounting is complicated … get help!
The complexity of a mortgage banking operation with warehouse lines and multiple investors can get confusing with many detailed accounting issues. Mortgage banks that hedge or retain servicing create a significantly more sophisticated accounting process. One the basic accounting processes to note is that when a loan is made, it creates an asset of the company and also creates a liability of the company to the warehouse bank. Any funds collected from the borrower at closing for impounds are a liability to the mortgage bank and are subject to the requirements for the segregation of fiduciary funds. When the loan is sold, the asset is removed from the balance sheet, along with the payoff of the warehouse liability and the profit for the specific loan is calculated. When you close a loan it is the same as if you purchased a loan, and as we just discussed when you buy an asset you should immediately record doing so in your books. These are irrefutable and fundamental accounting principals that combine with proper controls to protect a mortgage bank from corporate fraud.
Many mortgage banks do not focus on corporate fraud prevention and choose not to implement these fundamental accounting principals. When we ask why the owners do not implement comprehensive accounting protection, we usually hear one of three reasons:
1. The most common answer … the warehouse lender doesn’t make me do it. We work for many of the significant warehouse lenders, and I can state from firsthand experience that if this ever was the case, it is no longer the perspective. With the regulatory scrutiny the warehouse lending community is receiving, they are very aware of the importance of having properly prepared monthly financial statements from their mortgage bank borrowers. I predict that the warehouse lenders will soon require all mortgage bank borrowers to not only submit monthly financials, but to prove they have a dual entry accounting system with proper loan level posting.
2. The second answer we hear is: Our CPA told us this was okay. Recall the reference to the heart doctor above? Not every CPA understands mortgage banking. Please make sure your CPA is a mortgage expert. Unless a CPA is regularly and significantly associated with this business, it is possible they may not understand the intricacies of how a dual entry loan level posting procedure provides protection from corporate fraud in mortgage banking. As a small bonus, the more detailed and clean your accounting system is, the less expensive your annual audit will be.
3. The third answer we hear is: I own a $5 million a month mortgage bank and I do all the accounting myself; no one but me can get to the money. If this is the case, please be sure to have proper loan level posting in a dual entry accounting system to reduce the potential for errors. This way, when your company grows and you need to have someone else in accounting, you’ll already have a well-structured accounting system. All that aside, we usually see the owner of a company helping the sales team increase volume, looking for new branches, working on getting better pricing and planning the vision for the company. It will be challenging to get all of this done while wearing a green accounting eyeshade.
As an important side note, some companies use Excel as their accounting system. Excel is an amazing spreadsheet tool, but it is not an accounting system. The dual entry nature of an accounting system creates embedded controls and reconciliation points to keep the numbers on track. QuickBooks is a simple accounting system that uses dual entry accounting. The dual entry process is somewhat hidden by the nature of the posting process. Accounting for Mortgage Bankers and Great Plains are more sophisticated and more expensive accounting systems that can support an automated interface from a mortgage operations system. If you use Excel for your accounting, then you do not have an accounting system. We suggest that you switch to a system that deploys dual entry accounting; otherwise you are exposing yourself to a higher probability of corporate theft among other catastrophic oversights.
Metric management is an essential element of an accounting system. Metrics of mortgage banking include: profit per loan, cost per loan, profit per branch, margin per product, profit per originator and on and on. If you are not getting this information, then your accounting system is not giving you sufficient information to run your business.
Every business entity needs a system of checks and balances regardless of its size. We have worked with both large and small companies across the country. We find that virtually every company has an opportunity to improve their accounting processes in ways the owner had not seen. It is important to understand that no one is immune, regardless of experience or size. We’ve seen the ramifications of an inadequate accounting system have catastrophic consequences to a business.
The proper recording of each loan transaction, strong internal controls, and a thorough review of your monthly financial results is the best defense against corporate theft.
Mortgage banking controls
In an accounting system with proper controls, there are a number of procedures or rules to protect the business. Recall I’m a musician and generally don’t like rules, but in this case, it will protect your business from theft and failure. Here are just a few basic procedures to implement:
1. Two people must approve large transfers of money unless to a pre-approved title company or other pre-approved vendor.
2. When writing checks, if one person prepares the check, then another person signs the check and another person reconciles the bank statement. If you only have one person in accounting, then it is best to hire another company to perform the bank reconciliation. The bottom line is there should be at least two people involved in your accounting department to have minimal checks and balances.
3. For online banking, if one person enters the payment online, then someone else should approve the payment and another person reconcile the bank statement. If you only have one person in accounting then it is best to hire another company to perform the bank reconciliation. Again, you should have at least two people involved in your accounting department to have minimal checks and balances.
4. Never have the same person prepare the check, sign the check, and reconcile the bank statement. There are no circumstances that justify having one person with uncontrolled assess to the company's money. There must be oversight.
5. Record loan level financial detail for each loan in your accounting system to track all cash-related events created by or anticipated by the lock registration, closing statement and purchase confirmation. This will include tracking mortgage insurance premium (MIP) payments, impound funds and investor proceeds. Without loan level data capture, it is not possible to properly track branch profitability.
6. Have a monthly financial review with all owners and your chief financial officer. Ideally, your CFO is a CPA with 10-plus years of experience in mortgage banking. If you do not have a qualified CFO, it is possible to hire a contract CFO.
Concepts to minimize exposure to corporate theft
Corporate fraud is also called white collar crime because it doesn't take a gun to rob you if you give someone absolute control over money. As noted above, the saying “absolute power corrupts absolutely” means that someone with unchecked control is more likely to abuse the system to their benefit. Controls are designed to keep honest people honest and make it more difficult for purposed corporate theft to occur. In most cases, the incidents of corporate fraud occurred because of a breakdown in, or a failure to, implement a proper accounting system. The risk of corporate fraud can be minimized by implementing proper controls which include:
1. Strictly control who can approve wires and checks.
2. Implement a robust accounting process with a dual entry system and loan level recording. Do not use Excel as your accounting system; it does not have dual controls.
3. Make sure your accountant/bookkeeper records loan level entries including the creation of an asset when the loan is closed.
4. Have a qualified CFO review your books monthly. Your auditor is usually not able to be your CFO because “independence” rules prevent them from participating in the management of your company.
5. Calculate financial metrics each month to make sure the numbers make sense. Ask lots of questions.
6. Have a budget and compare your actual result to your budget. If there are any unexplained deviations in the numbers, don't stop asking questions until the answers make sense.
This may seem like a lot to implement, but remember the corporate fraud loss that I mentioned above was in the millions. With such a significant potential consequence, it seems reasonable to implement all of these steps together to minimize the risk of corporate fraud and create transparency in your accounting system.
There is a lot to digest in this article. The most significant to take away should be:
1. Check the checkers: Make sure someone is watching accounting.
2. Accounting systems matter: Have a strong set of controls over your accounting procedures all supported by a dual entry accounting system with loan level accounting.
3. Every company needs a qualified CPA/CFO to keep the numbers on track. If you don’t have a mortgage expert CFO, it is wise to engage these services.
4. At the very least, have a regular independent assessment of your accounting system. This review is not an audit, but an assessment of your corporate theft protection strategy.
It all connects for a reason
Think of an accounting system like the components of a new 100-in. plasma television. At the luxury TV store, they told you to get a back-up power supply and a power conditioner because your new $5,000 TV needs stable and consistent power to operate correctly. Failure to install either of these components could hurt your TV if there is a power surge or power failure.
If you go home and plug the TV into the wall it will turn-on and it will look like everything is okay. When there is an electrical surge and your TV gets fried, you’ll remember the importance of having proper power controls. Accounting controls are like the power components for the television. Everything can look okay, but when lightning hits bad things happen.
Corporate theft is a reality in business, the risk of which can be minimized with proper controls over the financial affairs of a mortgage lender.
Andrew Schell, CPA, CMB, is managing partner and president-CFO2Go for Mortgage Banking Solutions based in Austin, Texas. Over the past 30 years, he has been recognized as a results oriented leader who is often published discussing risk management, accounting, and capital markets issues.