NOVEMBER/DECEMBER 2004
“Does it pass
the sniff test?”
Asset-based lenders ask this question when
presented with a prospective borrower, aware that
it is not always easy to sniff out trouble that may
lie hidden beneath the surface of a company’s
financial statements. Indeed, it takes experience
and judgment to assess that information and to
sense whether the business activities behind them
bear further scrutiny.
This makes comprehensive due diligence an
essential element of the lender’s enterprise,
perhaps even the surest antidote to disaster. But
due diligence doesn’t mean simply accepting the
reports provided by the borrower and its auditor as
sufficient without extensive double checking.
Although lenders look to inventory and
accounts receivable as security for their loans,
they commonly rely on the borrower’s auditing
firm to confirm the existence of these assets and
assess their value, without engaging in extensive
due diligence on their own. Why shouldn’t they?
The auditors say they have applied generally
accepted auditing standards in conducting their
audit – standards requiring the auditors to obtain
reasonable assurance that the financials are free
of material misstatement, whether caused by error
or fraud.
Fraud artists know that lenders rely on
audited financials. They also know that this limits
the effectiveness of lenders’ due diligence. And they take
full advantage of this situation.
We have investigated recent scams with ultimate
losses ranging between $10 and $150 million involving
public and private companies. All were accompanied by
audited financial statements. The perpetrators created and
reported fictitious inventories and accounts receivable. The
inventories turned out to be valueless, or they existed only
as computerized bookkeeping entries superimposed on real
activities. The accounts receivable were conditional or
contingent sales or transactions recorded by members of
management to bolster collateral reports or cash flows. The
scams were so sophisticated that they fooled lenders into
thinking that the enterprises in question were far bigger and
healthier than they actually were.
And no wonder. The lenders in question relied on the
outside auditors, and the outside auditors relied on management. Do you see a pattern developing here?
For any deal to pass the sniff test, lenders should
understand the audit process in detail. They owe it to
by Jeffrey E. Brandlin
themselves to know whether, and to what extent, the
company’s auditors applied specific auditing procedures.
Did the auditors support their report with competent
evidential matter obtained from third parties? Or did they
rely almost solely on management representations, company
records, and so on? This is a common theme in many
frauds, to the great regret of the lenders involved.
In a study, “Top 10 Audit Deficiencies,” published in
the AICPA’s Journal of Accountancy in September 2002,
the authors, Mark S. Beasley, Joseph Carcello and Dana R.
Hermanson, discovered that among SEC enforcement
actions against auditors in the period 1987 to 1997:
“The most common problem, in 80 percent of the
cases, was the auditor’s failure to gather sufficient audit
evidence. Many of the cases involved inadequate
evidence in areas such as asset valuation, asset ownership and management representations. In almost half of
the enforcement actions, the SEC alleged the auditors
failed to apply GAAP pronouncements or applied them
incorrectly.”
Copyrighted material. For website posting only. Reproduction or bulk printing prohibited.
The cases involved public companies, and the lesson
is clear: Lenders should not assume that audited financials
will give them a true picture of their borrower’s financial
position, results of operations and cash flows. They should
be doubly skeptical of audits done on privately held
companies without SEC oversight.
The lender’s first line of defense is to put the auditing
firm on notice that it is relying on the information in the
audit in deciding whether to advance credit to the borrower.
This can be accomplished by asking the auditing firm to
sign a letter acknowledging its awareness that the lender is
relying on its work to decide whether to extend credit. Or
the lender can send copies of the borrower’s financial
statements to the auditor asking whether they are the
statements the auditor certified and requesting the auditor
to advise if this is not the case. Either way, the goal is to put
the auditor on notice that, should a borrower fall into
trouble, the lender does not intend to absorb the loss on its
own.
Note, however, that this strategy merely provides the
lender with an umbrella in case of a downpour. The better
idea is not to go out into the rain in the first place.
Lenders should focus their due diligence on filling in
the gaps exposed by the question, “What procedures did
the auditing firm follow in verifying the numbers on the
financial statements that represent inventory and receivables?” Assume, for example, that a borrower has $100
million in inventory and that the auditor verified the
existence of half by physical inspection and, finding
nothing out of line with the numbers offered by management, inferred that the remaining, uninspected half would
comport with management’s numbers.
Such procedures may or may not set alarm bells
ringing, depending on a lender’s appetite for risk and its
confidence in the honesty of the borrower. If the lender
finds that the auditors really know the composition of the
borrower’s inventory and not just the overall
performance characteristics, it’s a good sign.
To that end, lenders should determine what
observation procedures the auditors
followed and how much of inventory they
covered. Most readers of financial statements assume that outside auditors participate in inventory observations covering
inventory in its entirety. This is a dangerous
assumption. In one case, the certifying
accountants participated in none of the
borrower’s inventory procedures, choosing
instead to rely on the work of “other auditors.” In another case, the auditors participated in checking only half of the inventory.
In yet another case involving a perishable
foods distributor, the auditor’s work papers listed items
purchased one or two years prior to the audit. As a lender,
would you want to know this before or after you funded a
loan to such a borrower?
Lenders must also know whether the auditors have
done adequate detailed testing of inventory values,
salability, obsolescence, and the like. Do the auditors know
which SKUs sell fast and which sell slowly? Is their audit
evidence generated internally or externally?
The same evaluation is necessary when considering
accounts receivable. Did the auditors confirm accounts
receivable? If not, why not? Did they confirm transactions
or balances? If transactions, did they present all transactions comprising the balance for confirmation, or at least
significant transactions comprising a significant part of the
balance? Or did they subject only a small percentage of
transactions to confirmation? What were the results of the
confirmation circularization? Are those results reliable? Are
they adequate? Do they confirm payment terms? How did
the auditors satisfy themselves that sales were not conditional or contingent?
Irrespective of the scope and results of the confirmation testing, it is not a good sign if the auditors did not
inspect the actual remittance advices representing subsequent cash receipts. The testing of subsequent cash
receipts should not be perfunctory; coverage should be
substantial. Absent adequate and appropriate testing, how
can the auditors satisfy you that the balances are properly
valued and that the balances are collectible? These are
simple questions, but because the answers may affect the
decision whether to extend credit, they demand good oldfashioned pick-and-shovel audit work.
See “A Lender’s Checklist"
Shallow auditing can also hide sloppy accounting
with a similar impact on the borrower’s position even when
there is no intent to defraud. In another case, the borrower
exchanged overhauled industrial equipment for its customers’ expended equipment. The borrower reconditioned the
expended equipment, charging its customers the cost to
overhaul the items plus a service fee. In essence, the
borrower was trading items in and out of its inventory,
There was no apparent fraudulent intent here, just sloppy
accounting procedures and an auditor who didn’t dig into
them. Taken together, this enabled the borrower to show its
lenders a value for inventory that didn’t come close to
reality.
Unfortunately, failures like these happen, making it all
the more necessary for lenders to understand the audit
process. Lenders must also evaluate the adequacy of their
own standard due-diligence procedures in light of the
shortfalls of the audit process, embellishing and tailoring
those procedures to fit the particular credit facility under
consideration.
Skepticism is the lender’s most valuable virtue, and it
should extend beyond what a borrower says about its
prospects to what the borrower’s accounting firm does or
does not say about the borrower’s financial position,
results of operations and cash flows. There is no substitute
for good due diligence, and sometimes the most reliable due
diligence is what lenders do on their own. ▲
typically taking in an item from a customer for reconditioning and sending the customer the identical part, already
reconditioned, from inventory. The borrower properly
recognized the cost to overhaul the equipment and capitalized these costs in inventory, but it failed to relieve inventory for reconditioned equipment sent to the customer.
Jeffrey E. Brandlin, CPA, is president of
Brandlin & Associates, Los Angeles, CA. He
may be reached at jeff@brandlin.com, or
310-789-1777.
Investigative Accounting & Consulting
1801 Century Park East, Suite 1040
Los Angeles, California 90067
(310)789-1777
www.brandlin.com
Reprinted from The Secured Lender, November/December, 2004 by The Reprint Dept., 800-259-0470; Part #9567-1204
S
ome of the items on the following checklist require more work than others. Some, in addition, may seem so
elementary as to invite the lender to take them for granted. In fact, the items on this list are crucial, and the lender
who ignores them invites trouble sooner or later.
Background checks of:
➤ Company principals
➤ Related parties operating companies doing
business with borrower
➤ Principals of important suppliers and/or customers
Finance Department
➤ CFO/controller
Education
Technical skills
Independence from undue pressure from
company principals
Reputation among past lenders
Promptness and openness in supplying
company data to lender
➤ Back Office Procedures
Strength and adequacy of internal controls
Segregation of duties
Integrity and safety of accounting records,
including password/firewall protections
Procedures for backup of accounting records
Access to such data
➤ Cash
Procedures for establishing new bank accounts
Control over and location of domestic and
foreign bank accounts
Control over wire transfers
Confirmation of bank statements
Confirmation of interim balances
Adequacy of monitoring procedures for
unusual activity in cash accounts at lenders
institution
➤ Accounts Payable
Concentration
Turnover
Aging
Credit terms
➤ Accounts Receivable
Borrowing base audit
Concentration of risk
Aging trends with emphasis on turnover
Stated credit terms
Favored-customer credit terms
Credit memo accounting recognition
procedures
Unapplied cash transactions and accounting
procedures
Policy for determining reserve for bad debts
Historical AR write-offs
Monthly adjustments to aging report
➤ Inventory
Borrowing base audit
Existence and location of product
Aging
Control of inventory
Policy for determining obsolete or slowmoving product
Frequency of product transfers among
company locations and effect on
inventory aging report when this
happens
Consistency of allocations in inventory
valuation for:
Material
Direct labor
Manufacturing overhead
IT Department
➤ Education and technical skills of director
➤ Independence from undue pressure from company
principals
➤ Degree of control over company hardware and
software