eNews July 22, 2021

How does your company determine bad debt reserve? ○ Sliding scale based off of open receivables. ○ Sliding scale based off of past-due receivables. ○ Special reserve due to potential insolvencies. ○ Percentage based on historical bad debt to sales ○ Special reserve for customers in bankruptcies. ○ Special reserve for potential preference actions. ○ General reserve for sales allowances and bad debt. ○ Determine it on a case-by-case basis.

In the News

	I. Inflation, Labor Shortages, and Supply Chain Disruptions, Oh My!
	II. Looking for the Red Flags in Financial Statements

	III. How to Strengthen Work Relationships as Colleagues Return to the Office
	IV. What to Look for When Reviewing Construction Contracts

The global economy came roaring back this spring at a stronger rate than some economists predicted, but now the dust is settling. Inflation, supply chain disruptions and labor shortages are counteracting some of those initial economic strides.

“I think we should have expected there to be frictions in getting the economy reopened after this unprecedented shock,” Karen Dynan, a Harvard economist and a former official at the Federal Reserve and Treasury, told the New York Times. “We’ve seen serious frictions, and it’s totally reasonable to expect those frictions to continue.”

Furniture, chemical, machinery and electrical manufacturers are having a hard time filling orders because of the sudden demand surge and material shortages, according to a recent survey of manufacturers from the Institute for Supply Management.

Several factors are contributing to inflation and supply-demand imbalance, which makes the situation difficult to resolve. “The quick ramp-up of COVID-19 vaccines unleashed a surge in demand for meals at restaurants, ball parks and other venues that caught food producers and suppliers off guard,” according a Reuters article.

Part of the problem is that cargo ships, trains and trucks are taking longer to deliver goods and are having difficulties keeping up with the demand spike. But labor shortages may have an even greater impact on supply shortages.

The labor shortage is holding back economic growth from reaching its full potential, with more than 90% of chambers of commerce leaders reporting a lack of available workers, a recent U.S. Chamber report states.

The manufacturing and wholesale and retail trade industries are having some of the hardest times attracting enough workers, the report states. With a lack of factory workers and truck drivers, it’s no surprise businesses are struggling to produce and deliver product.

Companies are now left to deal with the consequences of supply shortages. Restaurants are slow to restock their shelves, forcing some dishes to be taken off the menu. And in the construction industry, some projects have been paused due to a lack of materials like lumber and sand.

“We are building cities and towns at an unprecedented pace," Shobha Bhatia, a professor of civil and environment engineering at Syracuse University, told the BBC. "But many of us also don't realize that sand is used for things like smartphone and TV screens, solar panels and other electric items."

And there’s no real sign of the supply chain picking up pace any time soon. Federal Reserve officials expect the supply chain woes to last well into 2022.

The supply-demand imbalance is driving another problem, inflation. As businesses face higher prices for materials, that increase gets passed down the chain. Higher prices for supplies mean companies are likely to eat up more of their commercial credit lines.

“Hanging over it all is great uncertainty over whether the Delta variant of the coronavirus will create a new wave of disruptions to commerce—both domestically and overseas in places with less vaccine availability,” the New York Times article says.

The rise in Delta variant cases also has caused uncertainty and the global financial market is paying the price.

Financial statements are supposed to provide a picture of the past performance and current situation of a potential business partner’s financial situation. However, you are not always able to receive them, and if you do, it doesn’t mean the information is reliable.

When doing business, creditors must be wary of potential red flags that can pop up while reviewing these extensive reports. Johnson Controls Inc.’s Craig Simpkins, CCE, CICP, director of finance transformation, outlined a variety of factors that credit professionals should take note of when reviewing a company’s financial statements, during the NACM and FCIB webinar, Financial Statements and Red Flags in Credit Risk Management.

Although Simpkins’ focus was on international financial statements, the red flags he identified would apply to any set of financials, he said. Examples of red flags from a financial standpoint include:

• Sudden or gradual increases in gross profit margin compared with the company’s prior performance. What’s driving that increase? That change should be noted in the financial statements, Simpkins said. For example, maybe there was a big initiative that cut general and administrative expenses within an organization.
• Cash flows that are negative for the first three quarters followed by a positive cash flow for the fourth quarter. “That’s a pretty miraculous recovery,” which should be questioned, he said. Simpkins cited the Enron scandal that resulted from company leadership implementing fake holdings and off-the-books accounting methods as an example.
• Significant sales to questionable business partners.
• Sudden above-average profit for specific quarters.
• Large last-minute transactions that result in significant revenue boosts for quarterly or annual reports.
• Financial results that seem too good to be true or significantly better than competitors.
• Consistently close or exact matches between reported and planned results. For instance, if the company’s results are exactly on budget or the managers always achieve 100% of their bonus opportunities.
• Frequent or significant changes in estimates for no apparent reason, such as increasing or decreasing reported earnings.

In addition to financial trends, Simpkins advised credit professionals to make note of certain operating strategies such as:

• Executives or board members that have direct dependence on the company’s performance.
• A lack of board oversight of senior management.
• Complex or confusing business arrangements that serve little practical purpose.
• Frequent changes in auditors over accounting or auditing disagreements.
• Overly optimistic communication with company higher ups to convince investors of future growth.
• Hesitancy or a lack of specifics from management or auditors when questioned about financial statement findings.
• Frequent differences in viewpoints between company management and their auditors.
• Often ships the last week or day.

“There are many indicators other than financial results that indicate a company may be facing difficult times,” Simpkins cautioned. For this reason, he recommends also considering other credit risks such as poor prior credit history and how a company is addressing it, negative commercial credit reports and cash flow problems.

On average, a person will spend one-third of their life at work, according to a study by a former Gettysburg College student. That is partly why forming strong and healthy bonds with coworkers matter so much.

But with most people working remotely, the pandemic made it difficult to maintain existing relationships, and even more challenging to create new ones. Jeanne Brett, professor emeritus of management and organizations at Northwestern University’s Kellogg School of Management, shared some tips to rebuild those connections, and maybe make them even better, as colleagues slowly return to the office.

The fundamental advice about getting along with coworkers does not change, she said. “We need to be very, very sensitive to people’s needs and understand that people’s behaviors are a function of those needs.”

However, sensitivity and understanding are more important now than ever as a way to reconnect with coworkers. “This year, with so much distance, has potentially fundamentally affected the assumption we make about whether other people are trustworthy,” Brett said.

The pandemic may have strained team relationships and disrupted collaboration, according to a King's Fund article. “COVID-19 has changed the balance of power in many teams … with some people left feeling frustrated, undermined, voiceless and sidelined,” the article says.

Teams that have people from all over the world may have found remote work especially difficult because video conferences can exacerbate already existing communication and cultural barriers.

“Misunderstanding can lead to high emotion that gets in the way of the team doing its work. People’s relationships get involved,” Brett said in a Kellogg Insight podcast. “People won’t work together, and you lose business.”

Different regions have had different pandemic responses, which can also create tension between colleagues, she added. For example, some teammates in one area may already be returning work, while others are still in lockdown, which can contribute to confusion.

“All these different cultural ways of going about teamwork generates conflict,” Brett said. “When you go global, we have very strong differences in the pandemic regulations and it’s going to continue to fluctuate.”

With all of these challenges created by the pandemic, Brett said its crucial to understand that the work environment will likely be quite different when your team returns in person. Try to be flexible and stay open-minded to everyone’s concerns. “It’s a challenge to think everyone is going to go back to the office, and it’s going to be the same,” she added.

Managers can facilitate improved colleague relationships by regularly asking staff to write down their frustrations. Have workers think about the conflict from a neutral perspective and consider what’s best for you, what’s best for your coworkers and what’s best for the organization, when trying to create a solution.

Keeping this broad perspective makes the issue seem less personal and in turn helps overcome the situation.

Also, staying sensitive to how the pandemic affected your coworkers is one the key ways to strengthen relationships, Brett said. Allow your colleagues to feel comfortable openly discussing their emotions, while readjusting to being back in-person.

Most importantly, don’t be afraid to discuss some of your own challenges. This is a way to connect with others who may share the same frustrations.

Language in contracts sets the tone and foundation for transactions so it’s important to make sure it’s clear and accurate.

Reviewing construction contracts can be a daunting task because of the various parties involved in a project. But suppliers must take the time to ensure these contracts support their ability to get paid in a timely manner.

In one of his blog posts, Construction Contract Drafting Considerations, construction attorney, John Caravella, of The Law Office of John Caravella, P.C., identified five essential terms that should be carefully considered in a construction contract: identification of parties and their responsibilities, scope of work, payment terms, scheduling and delays, and unanticipated conditions.

Sam Smith, regional finance manager of Crescent Electric Supply Company (East Dubuque, IL), provided some additional insight from the perspective of a credit professional.

“The failure to identify essential terms in the construction contract will lead to project confusion, extended completion time and expenses, as well as raise the likelihood of a future legal dispute,” Caravella wrote in his post.

Identification of parties and their responsibilities

Given the number of participants typically involved in a construction project, make sure all of the parties and their responsibilities are clearly identified, the post states.

Language within a supplier’s contract or purchase order sometimes references another contract that is incorporated into the supplier’s documents, Smith said.

For example, a supplier may be linked to a separate contract with the general contractor if there is language presented in the suppliers’ contract that reads, “This purchase order incorporates by reference all terms of the subcontractor’s contract with the general contractor,” Smith said. Therefore, if a supplier signs the purchase order without striking this language or requesting to review the general contract, they are unknowingly agreeing to separate clauses.

A contract incorporated within another contract is one of “the largest landmine to avoid,” Smith said. So extra care should be taken to review that language as well.

Chris Ring, of NACM Secured Transaction Services (STS), agreed. Suppliers that are incorporated by reference can be vulnerable to various terms and conditions such as payments within the general contract, Ring added. “This means suppliers may be subject to a pay-if-paid or pay-when-paid clause in a general contract if the purchase order or contract they agreed to incorporates the terms and conditions of the general contract by reference.”

Scope of Work

A contract also should clearly identify the roles and responsibilities of each party throughout the project to avoid confusion, Caravella pointed out.

Construction contracts might include who’s responsible for warranties and under what conditions, Smith said. For example, contractors often specify that any defects found within the first year following a project’s completion will be addressed under the warranty. However, a general contractor or owner may request an extended warranty from the subcontractor. If the supplier is tied into the general contract, it also may be subject to language regarding extended warranties.

Language to keep an eye for include “all warranties in the general conditions are incorporate herein” or “seller warrants …,” Smith said. This language can limit any say suppliers may have during extended warranty negotiations, leaving them subject to any terms that are agreed upon between the subcontractor and the general contractor.

Payment Terms

Payment terms should be clearly defined before your work on the project starts, Caravella warned.

One of the larger issues found within contractual terms is pay-if-paid versus pay-when-paid language, Ring said. “Obviously, pay if paid is always a term that [suppliers] should try to negotiate out of a contract. From a financial standpoint, pay-if-paid language may negate lien rights and make it a longer and harder road to get paid. From a legal standpoint, the loss of lien rights makes it legally impossible to impose a legal remedy on the property owner.”

Scheduling and Delays

Contract language could “assign financial liability for any delays caused by a party’s failure to perform in their agreed time frame,” Caravella said.

Many construction projects experience delays at some point, Smith said. So, construction contracts often address scheduling and delays to plan in advance of potential setbacks.

Liquidated damages is a term that can refer to both damaged goods and late deliveries, he added.

Suppliers also may come across contractual clauses where they could be liable to pay in the instance where a delivery does not show up on time such as “if materials are not delivered by X date, damages of $X a day will be incurred,” Smith said. In this case, suppliers should ensure they are only being held responsible for their liabilities stated in the contract and the agreed upon prices are reasonable.

Unanticipated Conditions

There is no way to predict what might happen during the construction of a project. “It is important to clearly state which party is responsible if unanticipated conditions should arise,” Caravella said.

To address the uncertainty of any possible incidents, construction contracts will often include “indemnification clauses.” These clauses can protect a party from financial loss related to the performance, or lack of, from another party during project development. It can also shift these potential costs from one party to another, Smith said.

Suppliers should look for language such as “hold harmless, indemnify or defend” as parties associated with this language can be dismissed from any loss related to certain liabilities, he advised.

Pay attention to your own liabilities and ensure your potential loss exposure is at a comfortable level, he said.