Lender Due Diligence: Gauging the Quality of Accounts Receivable

Borrowers often pledge accounts receivable as loan collateral. But lenders shouldn’t necessarily take receivables at face value. Instead, lenders should conduct substantial due diligence to ensure that the book value of accounts receivable is accurate and up to date. If unattended, receivables may be plagued with unsettled accounts or, worse, fraud.

Why quality counts

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.

Where to start

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 often outsource these accounts to third-party collectors, borrowers may lack vital information on the status of them.

What to watch out for

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. This happens when a receivable 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.

Skimming. Here, 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.

How borrowers can boost quality

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. 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 receivable 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.

How accountants can help with lender due diligence

If lenders accept accounts receivable as collateral, they should expect to perform extra due diligence to help ensure that the amounts reported on the balance sheet are reliable. Financial statement audits and agreed-upon-procedures engagements that zero in on receivables can provide added assurance that borrowers — and their employees — are managing receivables efficiently and ethically.

Have questions about lender due diligence and gauging the quality of accounts receivable? Or, are you looking for more information on our commercial lender services, including SBA valuation? Contact Paul Atkinson at 404-874-6244 or fill out our form for more information.