Accounts-receivable secured lending: looking over your shoulder

RMA Journal, The,  July-August, 2004  by Mark Zoeller

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On several occasions I have seen that loan officers fail to notice that the loan balances were fixed for an extended time. A/R loan balances should fluctuate with need. In one notable instance, the borrower diverted funds from the bank's lockbox, and, for several months, the loan officer failed to see that there had been no payment applied to the loan balance.

Collateral Audits

In some banks, collateral audits are a "sometime" thing. A bank may view the risk of an A/R line the same as a seasonal line. The risks, though, are considerably different. Other banks accept audits that do not address potentially critical information. And some banks do little or nothing with the audits when they get them.

Audits can tell the loan officer where risk is or might be developing. They can reduce surprises. One bank, for example, recently conducted its first collateral audit after advancing the money. It had waived its usual pre-loan survey because of competitive pressure. The post-advance audit, unfortunately, showed that neither the accounts receivable nor the accounts payable agings reconciled to the general ledger. Moreover, the auditor stated that upcoming year-end adjustments would reduce A/R. This created the potential for the bank to become overloaned soon after putting the line on the books.

More than anything else, though, a good audit can ferret out information indicating that a fraud is occurring or could occur. Audits cannot absolutely prevent fraud, but they may reduce the occurrences or the impact of fraud.

Among the more important items a good collateral audit should include are whether:

* The borrower is paving not only income taxes, but payroll sales, and property taxes as well.

* The accounting staff has had recent turnover.

* The books and records are up-to-date, closed monthly, and do not need large monthly adjustments.

* There are unusual, large cash transactions.

* The borrower is repaying debt subordinated to the bank.

* A/R and A/P turn rates are increasing or decreasing.

* The borrower has diverted checks away from the bank's lockbox.

* The borrower has kited payments from one A/R debtor to the past-due invoices of another debtor.

* The dilution rate is increasing or decreasing.

* The borrower is including pre-billed invoices in the borrowing base (showing an invoice as eligible collateral when the goods have not been shipped or the services performed).

* The borrower is putting credit memos on the aging and is matching credit memos to invoices.

* The borrower is shipping according to terms of the purchase orders.

* The borrower has the documentation to show that the existing invoices are legitimate A/R (that they are not consignment or bill-and-hold, for example).

* A sampling of A/R debtors verifies that the A/R are real.

* The borrowing-base numbers are accurate and include accurate concentration and cross-aging recognition.

* Any vendor has placed the borrower on accelerated terms or COD.

* The borrower's inventory is properly costed and correctly accounted for, is where it is supposed to be, and matches its list of current products.