RMA Portland Metro Chapter

Collateral Exam Compared to CPA Audit

Borrowers sometimes say, “I get an audit 1 of our financial statements from our CPA each year. Why do the Collateral Examiners need to come out to our offices and do the same thing?”.

Companies borrowing on their trade receivables and inventories under a line of credit with their Lender are subjected to the scrutiny of both – and usually at the same time of year! Their loan officer must prepare a big analysis to renew the line of credit for another year. This process happens in the 3-4 months following the Borrower’s fiscal year end. The loan officer must synthesize an array of information to get the renewal approved: financial statements spread, compared and analyzed; industry analysis updated (tariffs anyone?); projections of the coming year’s business plans; and a review of the collateral performance – among other things.

What is the difference between the collateral examination and the CPA’s audit? At heart, it is a difference of scope and purpose.  The scope of the collateral exam is focused on the “operating cycle”:

 

The CPA Audit, on the other hand, has responsibility for the financial statements as a whole – not just current assets and certain liabilities. So, where the Collateral Exam takes a few days, the CPA audit may take weeks and costs significantly more. Collateral Examination firms or individuals (CEs) are not practicing as accountants, although CEs are trained to some degree in accounting and a few may have the CPA designation hanging on their wall.

Approvers of loans at financial institutions recognize that collateral is, at best, the secondary source of payment for the loan (possibly tertiary or even lower), if a business fails to cash-flow its way out of debt. The Lender needs to know, “What amount of cash could be realized out of the collateral?” This question is always in an unfavorable context – liquidation of the business, however remote that may seem today. This is where the CPA Audit and the Collateral Examination diverge: the CPA assumes a “going concern”. 2 The CE cannot do that.

The liquidation analysis is a squishy sort of work: The CE uses asset-based lending 3 underwriting rules of thumb, questions around the nature of the asset, and a sprinkling of judgment. Receivables at a construction subcontractor differ greatly from a distributor’s. Inventories at a manufacturing concern are way different compared to the wholesale distributor or retailer. The conversion of assets to cash to pay down the loan…how would that actually be done? What strategies – and costs – will be associated with keeping the lights on and rent paid in an extended liquidation? The CE, in a few day’s work, deals with these concepts in the abstract and based on the bitter historical experience of Lenders who have been faced with the reality of wringing cash out of the remaining assets of a failed business.

For a business needing to leverage its receivables and inventory, their Lender needs to know a) the financial statements are reliable, and b) what the pledged collateral will probably yield if it were necessary to rely on it. The loan must be limited by the calculated collateral value discounted for the uncertainties that exist in every business and industry.

Both the CPA and the Examiner are key partners with the Lender and Borrower in greasing the wheels of commerce.

 

About Rich Denman:

Rich founded Cascade Credit Services in 1995, providing due diligence for Pacific Northwest lenders. Seven years later he co-founded Cascade Financial Management, a complimentary financial consulting practice. Prior to founding CCS, Rich spent over twenty years at US Bank, principally in the Portland, OR headquarters. From 1984 to 1994, Rich managed US Bank’s Accounts Receivable Department, overseeing the ABL portfolio monitoring function. Responsible for commitments in excess of $1B, Rich also helped to structure the bank’s first trade receivables securitization. Rich holds a BA in Economics from Oregon State University and is a graduate of Pacific Coast Banking School at the University of Washington. Rich does Bikram (hot) Yoga in his off-hours and also climbs mountains. He enjoys hiking and cycling around the Northwest as well.

 

 

But I Planned to Pay It Back!

We have likely all heard the stories, maybe even from our own customers! A long‑term trusted employee (we’ll call him Vic) betrayed that trust. Some time ago, maybe years, Vic ‘borrowed’ $500. He has the best intentions to pay it back from his next paycheck. But, of course, on the next payday, Vic actually needs to ‘borrow’ more. Since Vic is the Company’s Controller and the owner trusts him like family, he is an authorized check signer, has control of the general ledger and reconciles the bank accounts. Now 3 years after his first ‘loan’ Vic owes his employer over $350,000! What started out as a ‘need’ quickly became a ‘lifestyle’. Eventually, Vic’s exploits are exposed but not before he spent all the money. Vic has few assets to use for restitution and the Company’s crime insurance policy is only for the $50,000 that was included in the standard owner’s policy.

The Company’s owner is shocked and embarrassed by the discovery of Vic’s actions. She is also not very happy with her bank and professional advisors for missing the red flags of theft. So are there some recommendations we can make to help business owners avoid being defrauded by trusted employees? Here are our top 10, none of which are hard or expensive to do:

#1 – GAP Analysis – Encourage the owner to gather her bank and professional advisors to discuss the inherent fraud risks of her Company. For example, the risks of a retail business are quite different than an architecture firm. After identifying the inherent risks, the owner can better evaluate the controls in place and identify the gaps.

#2 – Hotline – The owner may want to consider implementing an anonymous hotline. Co‑workers are often the first ones to notice a colleague’s change in lifestyle or stresses in their life. Providing a safe and anonymous way to express their concerns is a powerful deterrent. Hotlines can dramatically reduce the length of time embezzlement continues (and thereby reduce the loss).

#3 – Positive Pay – Offered in some form by most banks, Positive Pay is not only a strong control to help prevent external theft, it can be effectively used to help deter employee embezzlement too. Treasury management professionals can recommend solutions to help protect against check fraud and ACH electronic transaction fraud as well as options for transaction blocks, dual controls, online user permissions and alerts to help strengthen the Company’s bank account protection strategies.

#4 – 2nd Bank Statement – What if the owner received her own copy of the monthly bank statement directly from the bank? Knowing the boss is looking at the bank statement can be a powerful deterrent.

#5 – Segregate Duties – Vic was an authorized check signer, recorded the checks and reconciled the bank account. If he had been prevented from performing any one of these tasks his embezzlement would have been stopped.

#6 – Payroll – Embezzlements through payroll are common and can continue for a long time. Let’s face it, even though they should, many business owners do not review the payroll register. But even an occasional ‘surprise’ review might reveal phantom employees, inflated pay rates, overtime and bonuses.

#7 – Call Back Verifications – We know it can be a hassle but what a great deterrent to fraud a call back can be. Having the owner accept a short call from the bank to verify an outgoing wire or ACH can be the best phone call she has ever received.

#8 – Crime Insurance – Companies often carry an owners’ package as a best practice or bank loan requirement but how often do they bind a higher limit for the crime risk.  While not a substitute for strong controls, insurance can make all the difference if fraud occurs. Investigating fraud can be expensive (fees for attorneys’ fees and forensic accountants, for example). In addition, seldom are there assets available for restitution.

#9 – Vacations – Ask the owner if their Controller takes an annual vacation. Does someone perform his duties in his absence, especially reconciling the bank statement? Check out this story to learn how an employee’s $52 million embezzlement was uncovered while she was on vacation.

#10 – Background Checks – The Association of Certified Fraud Examiners reports that the vast majority of fraudsters are first time offenders but companies should still insist on a thorough background check (don’t assume the search firm has done one for you). Background checks are fast, easy, inexpensive and can save the company a bundle down the road.

So there you have it, ten simple ideas to discuss with your customers. Consider introducing one or two ideas at a time to your business owner customer. The Company’s Controller should welcome this discussion and offer additional ideas.

If you think the conversation will be difficult, compare it to a conversation after a fraud is discovered. Invite your treasury management colleague to join you in meeting the customer. Need more information, invite a treasury management specialist and a certified fraud examiner (CFE) out for a cup of coffee. You can find a CFE at the OACFE.

 

About David Porter:

 

Responsiveness, creativity, and client focus: these aspirations have guided Dave Porter over the course of his career. After 15 years in public accounting with a Big 4 firm, Dave started and led two successful consulting firms over the next 14 years before coming aboard. “Running your own business is an eye opener. The experience has shaped the way I serve clients today. There’s no better way to learn about a company’s issues than by sitting down with the owners, especially when you’re a business owner yourself.”

Dave also helps companies develop stronger internal controls to help prevent and mitigate risks associated with occupational fraud and assist the victims of fraud recover. “Business owners are focused on running their companies, and may not stop to consider that a trusted employee might be stealing from them.” This need led Dave to launch Geffen Mesher’s Forensic Accounting group. Under his leadership, the group has quickly become a well-rounded and sought after forensic team.

When he’s not sitting down with business owners, Dave likes to hit the open road on his motorcycle, packing everything from hiking boots to his nine-iron. “The typical ways people like to relax in the Northwest.”

 

About Lorrie Nelson:

 

The Commerce Bank of Oregon

Lorrie Nelson comes to The Commerce Bank with over 30 years of banking experience, starting at US Bank in southern Oregon. Providing outstanding customer service has always been Lorrie’s focus, which led her to Sterling Bank as the first Corporate Banking Representative in Portland, later moving into Treasury Management as a sales consultant. She joined Umpqua Bank through the merger in 2014.

“I’m excited for the opportunity to be part of the Commerce Bank of Oregon team, helping to build and maintain great relationships with so many valued business clients. As a division of Zions Bancorporation, N.A., we offer the best of both worlds – the personalized care of a small bank backed by the strength and services of a large bank. Clients want someone who knows them and is responsive to their needs, and that is what we offer here at The Commerce Bank of Oregon”.

As Senior Treasury Management Sales Officer, Lorrie works with businesses to offer services that provide greater efficiencies and security tools for each company’s cash management processes. Lorrie holds the Certified Treasury Professional (CTP designation and is a member of the Association for Financial Professionals of Oregon and Southwest Washington.

A native Oregonian, Lorrie loves the beautiful and diverse nature found in the Pacific Northwest. She enjoys reading, taking trips to the beach with her husband, and having fun times with their grandchildren.

The Commerce Bank of Oregon, a division of Zions Bancorporation, N.A. Member FDIC

AUDITS, REVIEWS AND COMPS – OH MY!  

You’ve worked hard to land that new customer.  They want a new line of credit and you want to give it to them.  Of course, you will need financial statements for underwriting but which ones?

Audits are the ‘gold standard’ but they are the most expensive for your customer.  Maybe you should ask for a review or maybe a compilation this year.  But what are you giving up by not requiring an audit or settling for a compilation instead of a review?  Let’s look at the differences.  After comparing them we’ll take a look at how the costs compare.

Audits –the highest level of assurance that a CPA expresses.  The CPA performs procedures in order to provide a high but not absolute level of assurance about whether the financial statements are ‘free from material misstatement’.  In an audit, the CPA obtains an understanding of the internal controls and assesses the risk to fraud.  The CPA will also confirm accounts receivable, observe the physical inventory count and perform other procedures.  A CPA cannot perform an audit if they are not independent of the client.  The CPA will issue a formal report that expresses an opinion on whether the financial statements have been presented fairly, in all material respects, and in accordance with the chosen reporting framework (usually GAAP but sometimes cash, tax or other bases).  The CPA will also issue a report of any significant or material weaknesses in the customer’s system of internal controls that are identified during the audit.

If audited financial statements are asking for too much relative to the credit risk maybe a review will work.

Reviews – consist of analytical procedures and inquiries regarding the customer’s financial information.  A review does not include observing physical inventories, confirming accounts receivable or gaining an understanding of the company’s internal controls or fraud risk.  Nor does it include a separate letter of material weaknesses.  A review does not entail gathering any evidence from outside of the company to corroborate the customer’s financial data.  The CPA will gather industry information to help him understand the industry that the company operates in.  The CPA will issue a formal report that includes a ‘conclusion’ as to whether any material modifications he becomes aware of during the review for the financials to be fairly presented.  The CPA’s review report includes ‘negative assurance’ (that is nothing came to his attention) as compared to the auditor’s ‘positive assurance’.  As with audits, the CPA must be independent of the company when performing a review.

Reviews are definitely less work for the CPA and less intrusive on the customer, but a review can still require a lot of time preparing analyses and answering questions.  Reviewed financial statements may be too much of a time burden and cost on your new customer.  Maybe ‘compiled’ financial statements will get the ball rolling with your new client.

Compilations – the CPA offers no assurances or conclusions regarding the customer’s financial statements.  However, the involvement of the CPA can often start the conversation with the company regarding the quality of their financial reporting.  For example, the company may be using accelerated depreciation on their internally prepared financial statements because that is what their tax preparer provided.  Accelerating depreciation can reduce profits and equity which does not help with the underwriter’s credit evaluation.  A CPA may become aware of these potential errors in conversation with the customer and by reading the financial statements.  Unlike audits and reviews, the CPA does not have to independent of the company when performing a compilation, but he does have to disclose his lack of independence.  Unlike with audits and reviews, compiled financials do not need to be accompanied by footnotes (a valuable source of information).

What if these service levels still don’t work for you and your customer?  Consider a combination of services from the CPA.  For example, compiled financial statements with footnotes may be a good starting point but you want some comfort around the customer’s inventory.  The CPA can perform ‘agreed-upon procedures’ (AUP) for inventory that is tailored to meet your needs (e.g.; observe the counts, test the costing, test for obsolescence).  The cost and intrusion on your customer from this combination may be less than a review and provide you with the needed information.

Cost comparison – As a rule of thumb each increase in service level doubles the cost.  For example, a compilation might cost $6,000 without footnotes and $10,000 with.  A review of those same financial statements could cost $20,000 and an audit closer to $40,000.  Costs will vary depending on the complexity of the company’s financial statements and the customer’s sophistication, the number of adjusting entries, etc.

Need more information?  Take a CPA to lunch or refer to this publication from the American Institute of CPAs. https://www.aicpa.org/interestareas/privatecompaniespracticesection/qualityservicesdelivery/keepingup/what-is-the-difference-between-compilation-review-audit.html

 

About David Porter:

Responsiveness, creativity, and client focus: these aspirations have guided Dave Porter over the course of his career. After 15 years in public accounting with a Big 4 firm, Dave started and led two successful consulting firms over the next 14 years before coming aboard. “Running your own business is an eye opener. The experience has shaped the way I serve clients today. There’s no better way to learn about a company’s issues than by sitting down with the owners, especially when you’re a business owner yourself.”

Dave also helps companies develop stronger internal controls to help prevent and mitigate risks associated with occupational fraud and assist the victims of fraud recover. “Business owners are focused on running their companies, and may not stop to consider that a trusted employee might be stealing from them.” This need led Dave to launch Geffen Mesher’s Forensic Accounting group. Under his leadership, the group has quickly become a well-rounded and sought after forensic team.

When he’s not sitting down with business owners, Dave likes to hit the open road on his motorcycle, packing everything from hiking boots to his nine-iron. “The typical ways people like to relax in the Northwest.”