Don’t Get Left High & Dry
“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. Then, unable to pay their bills, the client left their lender high and dry with outstanding credit extended, which ultimately cost the lender $1 million.
Before extending credit, it’s absolutely vital for lenders to know that the client has sufficient collateral to cover potential outstanding borrowings. And the most reliable way to get this information (not to mention peace of mind) is by conducting a collateral field examination (field exam). Requiring a field exam to take place can help you prevent being left in the lurch by a client.
Don’t Make A Credit Decision Without A Field Exam
The story presented above is a prime example of why a field exam is an important tool for lenders to utilize when 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, 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.
With regard to 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.
What Field Examiners Will Look At During A Field Exam
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, is to ensure that your 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.
To Lend Or Not To Lend?
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. Contact me at 440.266.0936 or firstname.lastname@example.org to learn more about field exams.
By Jim Suttie, CPA (Mentor office)