Field Exam: What a Collateral Audit Tests

An asset-based lender advances money against numbers it did not prepare. Every week or month the borrower reports its receivables and stock, and the lender lends a share of them. The arrangement works only if the reported numbers are true, and a lender cannot tell from a spreadsheet whether an invoice was raised before the goods left, whether credits are being held back until after the certificate date, or whether the stock in the system is still on the shelf.

The field exam is the check. It is usually run before the facility is signed, to set the eligibility rules and advance rates in the first place, and then periodically for the life of the loan. The right to run it, and the obligation to pay for it, are commonly written into the facility agreement. No statute in New Zealand, Australia or the UK requires it; it exists because the contract does.

Scope varies with the facility and the collateral, but most exams cover the same ground. The examiners reconcile the debtor ledger and the stock records to the general ledger and the management accounts, so that the base is drawn from the same numbers the business runs on. They test a sample of invoices against customer orders, delivery or dispatch records and the cash later received, looking for invoices raised early, duplicated or not collected. They measure dilution, the share of invoiced sales that is reduced by credit notes, rebates, returns and write-offs rather than paid, because that share is what the advance rate must leave room for.

They read the ageing for overdue balances and cross-ageing, the concentration of the ledger in a few customers, and any customer who is also a supplier and could set off what it owes. They trace a run of receipts from the bank statement into the ledger to see that collections go where the agreement says. On stock, they test counts, costing, ageing and obsolescence, and check that nothing reported as owned is held on consignment or subject to a supplier's retention of title. The valuation of stock on a forced sale is usually a separate appraisal, by a different specialist.

A supplier of animal-health products to farms and veterinary clinics, constructed for this page like every figure in it, has an asset-based facility advancing 85% of eligible receivables and 50% of eligible stock. Its last certificate, in US$m, showed eligible receivables of 9.60 and eligible stock of 5.00, a base of 10.66 against drawings of 9.20. The annual field exam finds four things.

March credit notes of US$0.40m were raised in April, after the certificate. In a sample of forty invoices, three totalling US$0.25m were raised before the goods were dispatched. Dilution over twelve months was 4.8%, against the 2.0% the advance rate was set to absorb. And US$0.60m of stock counted as eligible was past or near its expiry date.

Nothing happened to the business between the two columns. What changed is that the lender now reads it from source records rather than from the certificate. Availability falls by three-quarters, and the reserve and eligibility changes stay in place until a later exam shows them unnecessary. The levels here belong to the example: the reserve is one way of handling excess dilution, and a lender could as well lower the advance rate.

The pre-billed invoices matter more than their size. Three in forty is a sample rate, and the lender will want to know whether it is a habit at month end. The exam's next date moves forward, and the lender may add debtor verification on large invoices between exams.

The auditor gives an opinion on whether the financial statements as a whole are fairly presented, once a year, applying a materiality level set for the whole business. The field examiner has a narrower question and a finer one: are these receivables and this stock, on this date, what the certificate says, and will they turn into cash for the lender? A misstatement too small to matter to the auditor can be large against availability. An exam is also not an assurance engagement under auditing standards; it is a report to the lender, on the lender's terms.

Nor is it the borrowing base certificate itself. The certificate is produced by the borrower and signed by an officer, often every week. The exam is produced by the lender's side, a few times a year, and its job is to tell the lender how far to trust the certificates in between.

DEFINED IN ONE PARAGRAPH → · THE BORROWING BASE CERTIFICATE → · ELIGIBLE RECEIVABLES →

The first exam decides the facility before it exists. A borrower that arrives expecting a base of a certain size learns from the exam which customers are excluded, how much dilution its ledger carries and what its stock is really worth, and the term sheet is rewritten around that. Once the facility is running, exams are typically more frequent when availability is thin or results are weak, and agreements often let the lender call extra exams at the borrower's cost after a default.

Findings are graded by what they say about the people as well as the numbers. A reconciliation that does not quite tie is a systems issue. Credits held back past the certificate date, invoices raised before dispatch, or receipts that do not reach the controlled account are a reporting issue, and a lender reads them as a question about every certificate the borrower has signed.

ASSET-BASED LENDING → · INVOICE FINANCE →