Field exams are not what they used to be in today’s collateral lending environment. Most bank field exam managers and reviewers have set a different focus due to the advent of the computer and field exam work paper templates.
When I first started in asset-based lending in 1972, the focus was the collateral that supported the outstanding loan. Today it is about the work papers and how many you can add to the existing 50 to 75 worksheets/papers that most banks have as part of its template. During the 80s and 90s, the main focus was the report with a reasonable amount of work papers that supported the write-up.
I have been running a field examination firm for more than 25 years. Over the years my examiners have dealt with numerous field exam managers and reviewers. I have noticed most banks have built-up bureaucracy in the field exam process. There are schedulers, reviewers, exit interview examiners and field exam managers. The review of the completed exam can take two weeks or more because the process is about the work papers not the written report. The bank’s focus is on the work papers and whether all the boxes are checked.
Three Types of Borrowers
Do not get me wrong — work papers are important in the exam process. However, you do not need 50 or 75 to achieve an adequate report. Before I lay out the most important and critical work papers, it is necessary to understand the types of borrowers you can encounter. There are three types: the honest borrower, the honest to a fault borrower and the professional crook.
Most borrowers fit into the first two categories. However, some borrowers resort to unethical practices when they encounter difficulties obtaining more money under the asset-based lending advance rates on A/R and inventory. The most common examples of these practices are pre-billing receivables before shipment or before the service has been completed, refreshing the A/R aging by credits and rebills to current receivables rather than over 90-day bills that may be uncollectible, and creating inventory increases that do not exist. A borrower resorts to using these tricks to create more availability to borrow. Those in the professional crooks category are difficult to catch on a field exam because they are good at defrauding banks. Usually there is collusion among various parties outside and within the company. The parties can be phony vendors, phony customers as well as dishonest truckers and warehouse personnel.
The Seven Critical Work Papers
There are seven critical work papers in the field exam process.
1. The Collateral Status of the Account
This is the most important work paper. It shows the examiner the availability on the collateral based on the A/R and inventory advance rates versus the outstanding loan. The amount and extent of the sample testing is determined by the amount of availability or lack of any. If there is substantial availability, the sample testing is less. However, if there is nominal availability, no availability or there is an over-formula based on the advance rates, the sample testing is increased substantially. Sample size is important and it is important to “use common sense.” I heard this saying in the 80s from one of the premier asset-based lenders, Congress Financial, which is no longer around. Similarly, using common sense seems to no longer apply in today’s field exam world.
2. The Shipping or Proof of Service Test
This work paper shows invoices that are billed, pre-billed or never shipped, or that the service was never performed based on the backup that is reviewed. A satisfactory result would show all merchandise shipped on the billing date or before. A satisfactory proof of service test shows that the work has been performed. If the results show the merchandise never shipped or the service was not performed, I call the work paper the s*** test.
3. Cash Application Test
In cash application testing, examiners review A/R customer payments to make sure the actual billed customer is paying. If the company is using its own checks to pay an outstanding invoice, it could mean that the original payment was copped by the borrower and used for needs other than business.
4. A/R Statistics
A/R statistics track the performance of the receivables (usually over a one to two-year periods) to determine turnovers and dilution. Dilution is the amount that is not paid because of discounts, returns or other deductions. The work paper should support the advance rate on the A/R. Over the last 10 years, I have seen banks require turnovers and dilution in increments of three, six, nine and 12 months on a calendar and to date basis. This is simply overkill and adds nothing in determining the A/R advance rate. Simply put, all you need is the 12-month analysis and year-to-date comparison to the similar prior period. More analysis is only necessary when field exams are performed on highly seasonal businesses.
5. Test Counts on the Inventory
6. Cost Test on the Inventory
7. Type and Nature of the Inventory
These all relate to the inventory testing.
The examiner’s test count on the merchandise in the warehouse to the perpetual records only tells the quantity and accuracy not the value.
The cost test tells if the value listed on the perpetual records is fairly accurate. Most perpetual inventory systems use an average weighted value, with freight, customs and duty charges imputed into the system. Examiners review the actual vendor bills showing the landed cost without the freight, duty and customs charges. Examiners should use “common sense” and obtain information from the borrower and financial statements to impute the additional charges to determine if it is reasonable. Slow moving analysis may be difficult to assess if there is no aging of the inventory by purchase date in the perpetual system. Most companies may not have an aging of inventory. However, borrowers normally know the percentage of the slow-moving products, although slow-moving does not mean obsolete. A tour of the warehouse during the test counts should give an examiner a better perspective on the quality of the merchandise. Conservative advance rates on the inventory at 10% to 35% take into consideration the lack of any slow-moving reports. Higher inventory advances of 50% to 65% can be determined by the type and nature of the products. Again, using common sense is invaluable.
Although I have highlighted the seven most important work papers, there are several others related to accounts receivable credit memos, financial statements, taxes, bank account analysis and insurance requirements. Today bank lenders have added numerous work papers when simply reviewing and scanning the documents involved in these areas would suffice.
In conclusion, I have seen field exams over the last 10 years focus on work papers alone, with more being added all the time. The real focus should be on collateral and the status of the account. The field exam process should be 30% preparation, 50% completing the work papers and 20% reporting.
Over the last 10 years, I have heard very few comments from field exam managers and reviewers about the status of the account and the performance of collateral. Banks emphasize the work papers and what was not filled in or correctly entered. Some of the reviewers and field exam managers do not read the report first, but only go to the work papers before reading the report. I repeat an earlier saying: use common sense. The banks have lost focus on what a field exam is all about, but I am hopeful that will change.