Don’t Take Receivables at Face Value

Don’t take receivables at face value

Borrowers often use accounts receivable as collateral for their loans. But how can you ensure that your borrower’s receivables are truly collectible amounts? Lurking beneath the surface may be significant problems that, if not addressed, may lead to default. Do your research and get to know the warning signs that may indicate accounts receivable weaknesses — or even fraud. 

Evaluating quality

Accounts receivable represent the amount of money that customers owe a borrower for purchases. If a borrower pledges receivables as collateral to qualify for a loan or line of credit, lenders typically claim them to cover losses if the borrower defaults on repaying its debts.

Poorly maintained or fraudulent balances hobble the lender’s ability to recover losses, however. That’s why the quality of receivables is important.

When evaluating the quality of receivables for a new or existing borrower, begin by computing the days sales outstanding (DSO) ratio. This represents the average number of days the borrower takes to collect money after booking sales. It equals the average accounts receivable balance divided by annual revenues times 365 days.

Companies that are diligent about managing receivables may be rewarded with lower DSO ratios. Those with relatively high DSO ratios may have “stale” receivables on the books. In some cases, these accounts may be overdue by 31 to 90 days — or longer. If more than 20% of receivables are stale, it may indicate lax collection habits, a poor-quality customer base or other serious issues.

The percentage of delinquent accounts is another critical number. Because companies sometimes outsource these accounts to third-party collectors, borrowers may lack vital information on the status of them.

Looking for potential scams

Accounts receivable also may be a convenient place to hide fraud because of the high volume of transactions involved. Common receivables embezzlement scams include lapping or hiking, which happens when a receivables clerk assigns payments to incorrect accounts to conceal systematic embezzlement. For example, a fraudster might steal Company A’s payment and cover it up by subsequently applying Company B’s payment to Company A’s outstanding balance, Company C’s payment to Company B’s outstanding balance, and so on.

In a skimming operation, a fraudster sends the customer an inflated invoice and then “skims” the difference after applying the legitimate amount to the customer’s account. If a borrower segregates clerical duties related to invoicing and recording payments, this ploy requires collusion between two (or more) employees.

Lenders should also watch for owners who artificially boost receivables to enhance the company’s financial statements. For example, they might create phony invoices or customers to inflate collateral values.

Strengthening receivables

It’s important for all companies to establish clear, concrete procedures to strengthen the quality of their receivables. In some cases, borrowers may need to segregate duties to prevent employees from handling a wide range of tasks, such as cash collection, recordkeeping and marking accounts delinquent. Ideally, no individual should run all aspects of a customer account.

Other solutions include implementing a mandatory annual vacation policy and a regular job rotation schedule. Many receivables fraud schemes require constant monitoring. Fraud may be revealed when someone else covers a dishonest employee’s job duties.

Employees also may be deterred from receivables scams if the borrower engages in surprise internal or external audits. Audit procedures should include reconciliations between bank deposits and customer accounts. Any misapplied payments or delays in posting cash receipts may warrant further investigation, including obtaining written or telephone confirmations of outstanding receivables.

Engaging experts

Accounts receivable might be an excellent form of collateral — or not. It’s a good idea to engage a professional with accounting expertise to support your due diligence by performing financial statement audits and other procedures to verify the numbers. This extra layer of assurance will help ensure your loans are sound and secure.

For questions, please contact Paul Atkinson at 404-874-6244 or fill out the contact form below. 

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