COVID 19 continues to create challenges with determining income for borrowers with more complex pay types such as self employment. The most common questions for a self employed borrower is “How do I meet agency guidelines for unaudited profit and loss statements”.
The what, why, and how
First we need to understand what a profit and loss is used to determine. The best way I can explain its use is to think of it as a draft for an upcoming tax return. Most businesses create a P&L every month to track the financial health of the business. Each month they update the P&L showing gross sales, cost of goods, general business expenses, and other business expenses to generate net profit. At the end of the year that information is used to generate the next years tax return. So this means it has similar information to the tax returns underwriters use to evaluate self employed income.
Second issue is why does the investor now require the profit and loss to be reviewed? Prior to March 2020 the agencies took a general stance that in most cases if the business was doing well in the prior tax years and the borrowers credit and assets appeared normal that everything was good. Meaning their business was stable, which means the borrowers pay was normal. As we all know now… 2020 threw a major monkey wrench in that theory. A business could have been growing revenue in February 2020 and two months later, thru no fault of their own, would lose almost all revenue and have to take drastic measures to survive.
The challenge that FNMA and FHLMC had to overcome was how to measure income without the ability to see filed tax returns during this time period. Enter in the profit and loss statements as the primary solution!
Now we get to answer the question and title of this blog How do we meet agency guidelines when reviewing the profit and loss forms.
NOTE the list below is set up as a summary to help you form a thought process or procedure NOT an end all be all method.. I am sure we can add or take away some information!
Step One: Confirm if the P&L is audited or unaudited
Is the P&L audited and signed by a CPA? If YES you can accept the income as is, you can move to step three!
Step Two: Unaudited P/L’s means YOU Audit the P/L
This is the least desirable part, if your borrower did not pay for a CPA to audit the profit and loss, and most will not, YOU get the joy of being that auditor. Follow these steps to meet your new job requirements as “Chief P/L auditor”
- Review the P/L and determine the average monthly gross sales
- Review the P/L and determine the average monthly gross expenses
- Agency rules REQUIRE you review a minimum of three month business bank statement(s). Look at the statement and determine the AVERAGE income per month (Deposits) for the account. Next determine the AVERAGE expenses (withdrawals) per month out of each account.
- Compare the average income between the P/L and bank statement to see if it is comparable (i.e. within 10%) and do the same thing for the expenses.
- IF they do compare, move onto step three. If they are NOT comparable, I recommend getting all bank statements for 2021 and repeating steps 3 & 4 to see if that makes them comparable. If not, this profit and loss is unusable and I would recommend asking for an audited profit and loss
Important note on deposits into the business account
When comparing the total deposits for each of the three months of provided bank statements to the average monthly revenue on the P&L it is important to identify which deposits can be counted as actual business revenue and which deposits would be deemed as “unallowable deposits” Some examples of unallowable deposits are as follows: transfers from other accounts owned by the borrower such as a personal checking/savings account, IRS deposits, PPP loan proceeds and any other deposits that do not appear to be a result of normal business operations. If any of these unallowable deposits are needed to validate the P&L additional documentation may be required to verify that the deposit is in fact revenue for the business
Step Three: Does the profit and loss support the tax returns
The key here is step one and two you have vetted out the profit loss to a reliable document. You are now going to use the profit and loss MUCH like a tax return. NOTE I mention 10% as a threshold, this is a very conservative number. The key to the declining number is have a company standard for what the declining threshold is, avoid having each employee “make up” their own level.
- Determine the monthly income following the same procedure as you would a tax return. net profit + any self employed wages + any allowable add backs divided by number of months the P/L covers.
- Does the average monthly income compare at or above the average for the tax returns? If YES use the lower number of the one or two year average for the filed tax returns.
- Note YOU CAN NOT use the profit and loss to get a higher income than filed tax returns.
- Example: YTD PL $5,000 per month versus and the Year 1 Tax Return $4,000 per month and the Year 2 Tax Returns $3,500 per month. The final answer will be $3,500 per month to qualify.
- Does the average monthly income compare lower than the average for tax returns averages?
- If it is lower, but is at 10% or less decline, you have to use the P/L average monthly income.
- If the P/L is greater than a 10% decline compared to the one or two year average, then the income is not useable without further documentation and review by the underwriter.
My goal here is to give you a logical method to determine income for your self employed borrowers AND keeping compliant with the FNMA and FHLMC Lender Letters for current COVID guidelines. Everything above is a best practice I have learned over decades of underwriting complex loans that did allow P/Ls (mainly Jumbos and FHA) to show stability of income.
If you’re interested in tools to help with determining any borrower’s income, check out our IncomeXpert software at www.getblueprint.io. Easy to use for both sales and operations professionals. If you are interested in getting more training on this and dozens of other underwriting topics (Income / Assets / Credit / Collateral), check out the Underwriting Field Guide training program at www.uwfieldguide.com. This training is meant for loan officers, loan processors, underwriters, and auditors alike!