When Businesses have borrowed money from a Bank or any other Financial Institute based on their Assets – usually AR and Inventory, they will be subject to a “collateral audit” as a condition of the loan. This is done by a CPA and is usually limited in scope, as their examination is primarily the businesses current assets. The Bank has lent money against your assets; they want to check the quality and accuracy of their collateral, which is constantly moving and changing.
When you borrow money, a firm should establish accepted accounting principles and be following them consistently – GAAP. What this means is, in the context of a collateral review is:
- Have genuine Sales – Do not raise tentative invoices that will subsequently be cancelled. Your invoices should have a contract or Purchase Order, a proof of delivery and acceptance.
- Have a regular sales cycle – a calendar month is normal. Do not invoice 2 or 3 days into the next month and pull these sales into the current month. Do not have a sales cycle where one month is 35 days and the next is 25 days.
- Do not “refresh you Invoices”. That is, as they get older than 90 days, do not re-date them to show a current date.
- Match collections to individual invoices.
- Keep a good record of adjustments, write-offs and Bad debts. You will be asked to explain.
- Do not write off a debt and then reintroduce it with a new date.
- Your delivery, invoicing and collections should show a good paper trail and relevant staff trained in what the Bank wants to see.
- Store and record Inventory in an easily verifiable manner.
- Value Inventory – Receipts and Issues in a consistent method and manner. Adopt FIFO, LIFO or average cost and do not change this method mid-year.
- Take a physical count and match it to your records.
In preparing for an audit; get a list of documents that the CPA will need to see, in advance. Usually, this will be the Financials – P&L and Balance Sheet, Aging reports – AR and AP, Inventory movement reports. Also, they will ask for samples of invoices, bank deposits, Inventory receipts and issues and Bad debt write-offs. The collateral audit should be handled in 3 stages:
- Assemble and send them the documentation in advance.
- When they visit- dedicate staff to work with them
- Answer all questions when they visit. At this stage, more documents and verification will be needed; do this as a priority.
I have done collateral audits that went from four days to one day and the frequency of the audit being reduced to twice a year compared to four times a year. All this saves money and improves the lenders’ confidence.