September 2008 The RMA Journal

A number of years ago, a bank had the opportunity to acquire the relationship of a prestigious local supplier of high-quality, custom materials, primarily targeted to the home-building trade. The prospect submitted financial statements that were company-prepared and backed by copies of income tax returns prepared by a local, well-regarded CPA firm. The internal statements and tax re-turns were virtually identical. Bank policy called for at least CPA-reviewed statements based on the amount of credit being requested.

Because of the bank’s eagerness to acquire this busi-ness from its competition and the bank’s confidence in the company’s management, which was “well known and highly regarded in the community,” and because the tax returns tracked so well with the internal statements, the bank waived the financial statement quality require-ment and replaced it with the condition that the borrower would continue to provide company-prepared statements along with copies of the tax returns.

The maximum amount that could be borrowed under the line was governed by a borrowing base composed of a percentage of accounts receivable less than 90 days beyond the original invoice date plus a percentage of inventory.

The bank had the capability to do a field audit, but again, based on the good tracking between the company’s internal financial statements and its CPA-prepared income tax returns, the company’s and its management’s reputation in the community, and the bank’s desire to close the deal

by Kyle Nye

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The Case of the

Accounts Receivable

A company’s good reputation and a bank’s eagerness to acquire it as a borrower lead to a breakdown in standard lending procedures, nearly resulting in disaster.

Spilled Milk

The RMA Journal September 2008 81

as quickly as possible, the bank’s management chose not to engage the field audit team prior to booking the credit.

Receivables and inventory turnover rates were about normal for this type of business at the inception of the relationship.

Modest Red Flags AppearFor the next few years, the bank was provided with monthly borrowing base certificates backed by copies of detailed accounts receivable agings, invoices, and invento-ry lists. The receivables agings always tied back to the total of accounts receivable on the balance sheet and indicated that only a very small dollar amount of the invoices was beyond the 90-day term specified in the borrowing base. However, spreadsheets produced over those years indicat-ed a gradual lengthening of the receivables turnover rate, from about 45 days at the inception of the relationship to something approaching 90 days four years later.

The increases were gradual and were commented upon in the annual analysis, but no special note was made of

the change because it had been quite gradual. As a result, the bank’s credit approvers, though aware of the increase in turnover days, did not question the analysis further.

The client also developed a series of “emergen-cies” when an “overline” was occasionally requested to cover seasonal needs that were in excess of the amount permitted by the borrowing base. These requests were granted without the bank asking too many questions, and the overlines were, in fact, paid back in accordance with their terms.

The Red Flags Start WavingFive years into the relationship, the analyst who had been assigned to the account for some time hap-pened to be on vacation when the time came for the annual analysis/renewal cycle. To ensure that the re-newal process moved ahead at the proper pace, the write-up was assigned to another analyst.

The new analyst noted, first, that the indicated accounts receivable turnover rate at the end of the last fiscal year was about 109 days, up from 90 days at the end of the previous year. Second, the analyst reviewed the latest borrowing base certificate and discovered that only about $9,000 out of over $2.4 million in accounts receivable was reported as more than 90 days past the original invoice date. These two facts were in apparent conflict with each other. For the average turnover rate to be 109 days, more than half the dollar amount of the receivables would need to be over 109 days past the original invoice date, not the apparent 0.4%, or less, of the total

($9,000 divided by $2.4 million) shown on the borrow-ing base certificate.

Puzzled, the analyst went back to the accounts receiv-able agings that accompanied the borrowing base certifi-cates for the previous four months and reviewed details of the individual invoices. He discovered that when an in-voice began to approach the 90-day mark, a new invoice number and date would be issued for the same purchase. This practice effectively moved the account from the 90-day column back to the current column.

This revelation was shocking because it meant that someone on the borrower’s staff was deliberately chang-ing the company’s accounting records to produce a re-sult that would allow a larger borrowing amount than would otherwise be the case. Was the borrower’s manage-ment aware of or responsible for this practice? Or was an employee changing the records without management’s knowledge or consent, perhaps to hide bad accounts re-ceivable or lax collection practices?

Reasons for the Problems The company’s owner was contacted immediately, and he acknowledged that he was behind the practice of is-suing a new invoice when an invoice was approaching the 90-day mark. He had a reasonable explanation that did not involve attempted fraud or a deliberate attempt to deceive anyone. The practice was related to another busi-ness practice that had started sometime in the past.

For many years, the borrower had allowed its customers to place special orders with no deposit against the future sale. Sometimes these customers did not actually pick up the special orders for six to nine months after contracting for them. Since the borrower had to pay its suppliers on a current basis, the borrower began to demand that its customers make a deposit to cover at least part of the cost of the special orders. The customers agreed, but in turn requested that an invoice be issued so that the customers’ accounts payable departments could issue a check for the prepayment. Thus, an invoice would be issued for the full amount of the special order long before the product was ever delivered to the customer. The borrower’s account-ing system tied the billing system to the general ledger in such a way that the issuance of an invoice resulted in the reporting of a sale and of a new account receivable being booked. Proper accounting would have required that the prepayment be treated as a liability against the future delivery of the product, and that no sale or account receivable be created until the product had actually been delivered to the borrower’s customer.

The problem was compounded when the borrower began to use its invoicing system to record future sales prospects, even when no prepayment was requested at

September 2008 The RMA Journal82

the time of the potential order.This practice began to cause cash flow difficulties for

the borrower. The borrower’s capacity to have funds ad-vanced under the line of credit was restricted by the bor-rowing base that counted as ineligible accounts invoices more than 90 days beyond the invoice date, and the bor-rower needed that additional borrowing capacity. Why? Because, as a result of booking sales for which no cost of sales would be recognized until the product was finally delivered, often many months later, it appeared that the borrower was enjoying a very large gross profit margin and making lots of money. As is common with small, closely held businesses, management attempted to shift as much of the income tax burden as possible to the owner rather than have it be paid by the business. The phantom profits created by the improper accounting for accounts receiv-able were paid out in bonuses to the company’s owner, creating a borrowing need that either would not have oth-erwise existed or would have been much smaller.

No Evident Character Flaws It is important to state here that the owner was not finan-cially sophisticated and did not fully understand the cash flow implications of how he was running his business. In other words, he was guilty of a lack of knowledge, but not of a basic character flaw.

A quickly arranged conference brought together the bank, the borrower, and the borrower’s accountant, who was surprised to learn of the accounting errors. Although the accountant had only prepared tax returns based on the borrower’s internal statements, the accountant was chagrined because the accounting firm had never ana-lyzed or questioned the numbers.

For his part, the company’s owner did not regard the issuance of new invoices with current dates as a problem because the company’s experience was that virtually all of these “pre-billings” eventually resulted in the delivery of the product to the customer and cash received by the business. He did not understand that the timing of these events was important. Because the owner was not finan-

cially sophisticated, he did not realize that generally accepted ac-counting principles do not permit the recogni-tion of income from a

sale until the product or service is actually delivered to the customer. The owner was not attempting to deliberately misstate his company’s operating results or balance sheet; he simply didn’t understand the applicable accounting rules and had never sought guidance from his accountant in these matters. In fact, his lack of financial sophistica-tion had caused the company and him, as its owner, to

incur substantially higher income taxes than otherwise would have been the case (due to the overstatement of profits), a situation he was anxious to avoid.

What the Audit RevealedThe bank, the company, and the accounting firm eventu-ally agreed that an unusual midyear full audit would be conducted to determine the company’s true financial posi-tion. The borrower’s management believed that what the owner called “pre-billings” amounted to about $1.1 mil-lion at that time. With the company’s positive net worth of some $1.6 million, a write-down of $1.1 million would have been substantive, but probably not fatal.

When the audit was complete, the actual amount of the “pre-billings” was determined to be close to $1.5 million, and there were other receivables accounting errors total-ing an additional overstatement of $200,000. The auditors also uncovered substantial problems in valuing inventory, resulting in another $1.5 million that needed to be writ-ten off. As with accounting for receivables, management’s lack of financial sophistication played no small part in the substantial overstatement of the inventory account.

The net results of these changes, including income tax effects, were as follows:1. The company’s net worth went from a positive $1.6 mil-

lion to a deficit of $2.3 million.2. The CPA’s opinion was qualified because the borrower’s

true financial position threatened the company’s “going concern” status.

3. The bank had a loan on its books of about $2.5 million supported by an actual borrowing base of a little less than $600,000, a gap of approximately $1.9 million.

A Partial Resolution The credit was immediately moved to the bank’s special-assets group for resolution. Fortunately, the owner had not “spent” his bonuses but had instead invested those funds in the stock market and in real estate. He was able to liquidate those investments to the tune of about $150,000 to put back into the business. Additional funds were obtained from a $124,000 income tax refund based on amended tax returns showing the correct amount of taxable profits accrued in previous years. Further, due to a rapidly expanding local economy, the company enjoyed excellent operating results during the 18 months follow-ing the discovery of the accounting anomalies and posted a very large, real profit during that period. The resulting cash flow reduced the bank’s line balance so that the gap between the line balance and the borrowing base was re-duced, although it was still large at over $1 million. The equity account was substantially improved by the profit, the tax refund, and the equity injection, although not to the point that net worth was positive.

He was guilty of a lack of knowledge, but not of a basic character flaw.

The RMA Journal September 2008

In the midst of all this, the borrower’s principal owner and manager was diagnosed with a fatal type of cancer. He became too ill to effectively manage the business, and one of his sons, who had grown up in the company, took over these responsibilities.

Final ResolutionThe bank continued to work with this client and attempt-ed to put together a financing package that would allow an even longer payout of the credit, given the improved collateral position and cash flow and the fact that life insurance proceeds would apparently be flowing to the company to further reduce the credit. Despite the bank’s efforts to maintain the relationship, the company ulti-mately made a decision to move to another bank. When this move occurred, the original bank was able to recover all principal as well as some interest that had not been col-lected while the credit was on nonaccrual status.

Thus, the only “milk” spilled by the bank in this en-counter was the additional cost for special legal advice, the extra time needed to monitor and supervise the cred-it, the lost opportunity cost while the credit was on non-accrual, and a considerable amount of worry and new gray hairs on the heads of the bank’s managers directly involved with the credit. The situation could have ended much less favorably.

Lessons Learned or Relearned1. Do remember that a business can often survive one

problem, but one problem is usually not the cause of a company’s difficulties. In the case described here, mul-tiple problems—some caused by the borrower, some by the borrower’s accountants, and some by the bank—came together to nearly destroy the business and to po-tentially cause the bank a large loss.

2. Don’t let pressures to increase business cause the bank’s lenders to avoid policies related to financial statement quality.

3. Don’t assume that CPA-prepared income tax returns—even if they track very well with the client’s internal statements and even if the returns are prepared by a CPA with a very favorable reputation—are confirmation that the borrower is using proper accounting techniques and producing reasonably accurate statements.

4. Don’t overlook the bank’s capability to do field audits as a way of confirming primary operating assets and li-abilities on a prospect’s balance sheet as part of initial due diligence. Had the bank made use of its field audi-tors’ expertise, the poor accounting procedures would likely have been uncovered before the relationship with the bank was even established.

5. Don’t let the reputation of the business or the owner’s standing in the community get in the way of a clear

understanding of the borrower’s business and financial position.

6. Don’t overlook obvious signs of changes in the borrow-er’s financial position—in this case, the gradual length-ening of the accounts receivable collection period and the emergency overline situations.

7. Do rotate duties among credit analysts, if possible. Cred-it analysts, just like lenders, can become complacent in their analytical work and thus miss or overlook important indicators of financial stress if they work with the same borrower’s state-ments year after year.

8. Do connect various items that apparently don’t make sense in the analytical process. It could be argued that the disparity between the receivables turnover rate and the lack of apparent delinquent accounts on the borrowing base certificates should have raised questions early in the relationship or perhaps even before the relationship was established.

9. Most important, do pay attention to the character of the borrower. Even though this client made substantive ac-counting errors, the errors were due to a lack of financial sophistication, not to a deliberate attempt to fraudulently obtain funds from the bank. When the errors were dis-covered, the owner did all in his power to restore funds to the business and operate it in such a way that the bank ultimately recovered all of what could have been a sub-stantial loss. Had the owner been lacking in character, the result could have been much different.

PostscriptThe events described in this article happened in the mid-to-late 1990s. As noted, the relationship was taken on by a competitor bank, and the company was able to contin-ue operating for several more years, at which point the business was acquired by a wealthy individual who paid a substantial premium over book value and was able to provide significant outside support through his personal guaranty. Ultimately, then, all worked out reasonably well. Both banks recovered their loan principal, the company’s owners received a significant amount of cash for the busi-ness over and above its book value, and the new owner acquired a viable company that should, if properly man-aged, provide a satisfactory return on his investment. v

••Kyle Nye is a former vice president and senior underwriter at Bank of America. Contact him by e-mail at nm.k2nye@gmail.com.

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Remember that a business can often survive one problem, but one problem is usually not the cause of a company’s difficulties.