“We were duped by our client for $1 million.” This is a story I heard recently from a lender whose client had overstated their receivables and inventory, and then, unable to pay their bills, left the lender high and dry with outstanding credit extended, which cost that lender $1 million.
One of the most important issues for lenders is to know that their clients have sufficient collateral to cover potential outstanding borrowings. The most reliable way to provide this peace of mind is through a collateral field examination (field exam). A field exam can help a lender avoid being left in the lurch by their clients.
The story above is a prime example of why a field exam is an important tool for lenders to utilize in making credit decisions. A field exam can provide lenders with a greater comfort level as it relates to their clients’ collateral—specifically, accounts receivable and inventory. In a field exam, the examiners can perform procedures as they relate to verification of accounts receivable; analysis of sales dilution (i.e., how much of a company’s sales “stick”); items in accounts receivable that are ineligible to serve as collateral for the credit line; collectability; and an analysis and testing of the accounts receivable aging.
For inventory, a field exam can substantiate existence and test for obsolescence, cost and ineligible inventory items based on the terms of the credit agreement. A field exam can tell the lender about their client’s ratios, such as accounts receivable and inventory turnover, and other key financial ratios critical to the strength of a lender’s portfolio.
Some of the critical areas a field exam will assess are:
- Account verification
- Dilution analysis
- Analysis of credit collection procedures
- Inventory cost testing
- Test counts of quantities on hand
- Analysis of cash reconciliations and lockbox procedures
- Trend analysis in accounts receivable, inventory and accounts payable
- Verification that payroll and other trust fund taxes, and income tax filings, are current
- Insurance review to ensure the lender is the loss payee
- Analysis of the books and records, and the overall accounting system
- Analysis and independent calculation of borrowing bases
Equally important, if not more so, if the field examiners are certified public accountants, CPAs are uniquely trained to identify fraud risks and to gain a true understanding of how a company’s accounting systems and systems of internal controls are designed, as well as the effectiveness of the controls. While a field exam is not designed to detect fraud, and there is no assurance that fraud will be detected, a CPA comes to a field exam with a unique perspective and invaluable experience in understanding the risks of fraud.
This unique experience may, or may not, have caught the sleight of hand in the scenario described earlier, but having this type of scrutiny from an objective third party could have helped that lender make a more informed decision about whether or not to extend credit to that particular client.
So, if you have a recurring, renewable line of credit, are looking to make an informed lending decision, or are hoping to secure financing from a lender, a collateral field exam can provide the comfort that lenders seek in making their decisions.