Is a Field Audit Program Adequate Fraud Protection?

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1 Is a Field Audit Program Adequate Fraud Protection? Caught in Fraud Published in the Jan./Feb issue of the ABF Journal by Juanita Schwartzkopf, Focus Management Group

2 Table of Contents An example of fraud: Ocean Fresh Seafood 3 How can a lender protect itself from dishonest borrowers? 3-4 How was this fraud uncovered? 4-5 How do the unique aspects of the seafood industry complicate asset-based lending? 5 Conclusion 6 Contact Information 7 2 Is a Field Audit Program Adequate Protection from Fraud? Focus Management Group

3 The losses lenders experience at the hands of dishonest borrowers can be a very large proportion of the total loans outstanding, and can monopolize a significant amount of lender time. The use of field exams and other financial reviews can help to identify problems at an early stage, therby allowing the lender time to protects its exposure. When new account relationships are established between a borrower and an asset-based lender, the asset-based lender typically implements a field audit program requiring quarterly examinations. The purpose of these field exams is to confirm the recovery value of the accounts receivable and the inventory. Lenders require field auditors to test accounts receivable balances against shipping documents, purchase orders, and future cash collections, and to test inventory counts and values against receipt documents and test counts. Lenders receive documentation from their field examiners comparing month-end borrowing base certificates provided by the customer with the valuation of assets determined by the field examiner. These examinations assist an asset-based lender in developing required reserves, establishing advance rates, and verifying accounting records for accounts receivable, inventory and the loan relationship. With the results from a field exam in hand, lenders can derive comfort when the recovery value of the accounts receivable and inventory is reasonable compared to loan outstandings. When dealing with honest borrowers, that is certainly a fair assumption. However, not all borrowers are honest, and lenders need to consider the use of other tools to augment field exams. An example of fraud: Ocean Fresh Seafood In the example of Ocean Fresh Seafood, the lender found itself confronted with an example of a dishonest borrower. This borrower was accused of, and eventually plead guilty to, falsifying customer invoices and inventory records to increase borrowings above that which would have legitimately been available based on actual accounts receivable and inventory asset values. As reported in The Sun Chronicle (Attelboro, MA newspaper) on March 16, 2008, when Ocean Fresh Seafood s assetbased lender conducted a field exam in September of 2007, bank representatives were able to verify only $85,000 of more than $8.2 million in available collateral listed by Ocean Fresh Seafood in its borrowing base certificates. The lender took over Ocean Fresh Seafood, and dealt with a costly court case. A situation like this is expensive for the lender in terms of both potential loan write offs and also the opportunity cost of lost time and energy by the lending staff. In the case of Ocean Fresh Seafood, the owner, Robert Coutu, plead guilty to conspiracy to commit bank fraud, bank fraud, and money laundering in September of 2010 three years after the fraud was initially uncovered. According to court records, the lender s loss in this case exceeded $7 million. How can a lender protect itself from dishonest borrowers? Lenders often request that financial advisory firms conduct a routine assessment of a business. This assessment serves to augment, rather than replace, a field exam. A financial advisory firm takes a different approach than a field auditor, in that an advisory firm s work requires the consultant to understand how the company makes its money, pays its bills, etc. The advisory firm needs to understand the business operations and not just check the accuracy of accounting reports. It is clear that the lender must understand how its borrower makes money and how it spends money. It is necessary to ask basic questions, and to not be intimated in the process. 3 Is a Field Audit Program Adequate Protection from Fraud? Focus Management Group

4 In a recent example, a lender had been receiving regular field exam reports from its field auditors, which showed no issue with the accounts receivable or inventory. The field auditors did perform standard tests of invoice registers, cash receipts, etc. However, during their first week onsite, the financial advisory firm discovered an overstatement in the borrowing base collateral values of approximately 60%. The impact of this discovery was that instead of having $30 million of collateral, the lender actually had only $12 million of collateral. How was this fraud uncovered? The financial advisory firm s consultant began asking simple questions, such as: What was the size of an average shipment? How much storage capability is onsite compared to the reported inventory volumes on site? How many delivery vehicles does the operation use? It rapidly became clear to the consultant that the borrower could not be running a $200 million annual sales business as reported. The company lacked sufficient quantities of delivery trucks, the average delivery size could not be large enough based on the number of trucks, and the on-hand inventory could not possibly be the quantity reported. As basic tests of reasonableness failed, additional questions surfaced: How could invoices be for even or rounded dollar amounts and not reflect gallons of product shipped? How could invoices for one truckload of product be for quantities three times the possible delivery size? In addition to the accounts receivable and inventory issues, the financial advisory firm s consultant found massive check kiting between several banks used by the borrower. The lender s field auditors did not cross check withdrawals and deposits, and they did not develop a daily cash sheet with an account balance roll forward. In this example, it is clear that the lender needs to understand how its borrower makes money and how it spends money. It is necessary to ask basic questions, and not be intimidated in the process. The company in this example sold petroleum products; however, the necessary questions to ask are the same across industries: What do you sell? How is the quantity measured? How is product delivered? Where is product stored? What does a specific volume of product look like? Where is the cash maintained? What are the check writing accounts? Show me your weekly cash budget OR give us the information we need to develop a weekly cash flow (including inventory, accounts receivable, cash balance, and loan balance roll forwards). In another example, a financial advisory firm spent approximately one week on site at a borrower whose lender had been receiving regular field audits, and uncovered a 25% overstatement of the accounts receivable balance. In this example, the company had told the lender s field auditors that a detail accounts receivable aging was not available, and certainly not available in a spreadsheet format. The financial advisory firm s consultants insisted on receiving a detailed aging and imported the text data into a spreadsheet. By using various sorting and testing techniques on the large amount of data, it became obvious the company was re-dating invoices. In this example of re-dating, the company did not even change the ship date. An indication of when a lender should move beyond the field exam would be if problems are uncovered during the field exam. Other indicators would be lack of cooperation with receipt of information requests, or lack of timely financial statement preparation. The lesson learned from this situation is that basic information, such as the detailed accounts receivable agings, should be demanded of a borrower by a lender. Excuses should not be tolerated. 4 Is a Field Audit Program Adequate Protection from Fraud? Focus Management Group

5 Frequently, dishonest borrowers bluster that information is not available or not necessary. The dishonest borrower may plead that the lender, the auditors, or the consultants cannot possibly understand the business. The dishonest borrower may threaten to move the relationship rather than provide information. Because honest borrowers often make those same comments, that alone is not indicative of fraud or dishonesty. However, when the level of excuses for lack of information, and push back on receipt of detailed records escalates, a clear warning flag is raised that problems may exist and action is required to be undertaken by the lender in order to get to the bottom of the issues. How do the unique aspects of the seafood industry complicate asset-based lending? Several unique business aspects of the seafood industry complicate the analysis of such enterprises. However, the basic questions, as discussed earlier, remain the same, with some specific slants related to this industry. In relation to inventory, the seafood industry exhibits the following unique characteristics: Fresh seafood has a very short shelf life. Frozen seafood can have a longer shelf life. A borrower needs to be able to provide an aging of its inventory by fresh sale date or expiry date. Fresh seafood can spoil before a lender can act to protect its collateral; therefore consideration should be given to making fresh seafood ineligible. Weight calculations can be increased by the addition of water (ice if frozen seafood). The borrower needs to track the amount of purchased inventory through preparation or packaging work, with volume losses at each stage. The quantity of sold product needs to be reviewed against the process reporting information. The quantity of inventory on hand must be reviewed against the process reporting information and the sale information. Inventory turnover should be fast. However, the speed of turnover is not an excuse for lack of reporting and tracking of inventory. A roll forward of inventory by species, showing how the incoming product is processed into outgoing products for sale, could uncover problems. The same product name (halibut, for example) can have widely varied values based on quality, cut, preparation, etc. Detailed inventory records incorporating this type of information must be available. Packaging materials may be included in inventory valuations and must be considered for ineligible calculations. Seafood has a market price, which fluctuates based on external factors. Lenders should consider a market value test when looking at internal inventory values. In relation to accounts receivable: Customer orders are often repeated, which increases the borrower s ability to hide rolling dates forward on invoices. Data, such as sales by product by month and by customer, should be provided and reviewed. Individual customers purchase different grades of seafood and different preparations (whole fish versus filets versus individual frozen portions). This can complicate the pricing comparisons and collateral valuations. Receivables should be scrutinized for sale of inventory prior to an ineligible date. Particular attention should be paid to related party transactions. These examples specific to the seafood industry should assist an asset-based lender in this space. More importantly, this adaptation of the basic questions outlined earlier in this article to a specific industry (seafood), provides an example of how to fine-tune such basic questions to address specific issues in a borrower s industry. 5 Is a Field Audit Program Adequate Protection from Fraud? Focus Management Group

6 Conclusion Field exams and consultant reviews cannot protect a lender from all dishonest borrowers. However, those reviews are critical to assist a lender in uncovering problems as quickly as possible. Field exams are a necessary and valuable tool one that lenders need to use. In addition to field exams, lenders should give consideration to employing additional financial and business reviews such as those provided by financial advisory firms. An indication of when a lender should move beyond the field exam would be if problems are uncovered during the field exam. Other indicators would be lack of cooperation with receipt of information requests, or lack of timely financial statement preparation. As a lender, when you hear push back related to the provision of information and availability of detailed information, you must not back down. Never accept excuses such as 1) it s just a timing difference, 2) you won t understand our business, or 3) we don t have time for a field exam or other reviews. The losses lenders experience at the hands of dishonest borrowers can be a very large proportion of the total loans outstanding, and can monopolize a significant amount of lender time. The use of field exams and other financial reviews can help to identify problems at an early stage, thereby allowing the lender time to take action to protect its exposure. About the Author Juanita Schwartzkopf is a Managing Director of Focus Management Group and has over 25 years of experience in commercial banking, financial management and operations and systems management. Juanita has an extensive background in credit risk assessment and loan portfolio appraisal, and has reviewed asset-based lending and commercial lending loan portfolios of various financial institutions. Throughout her career, she has worked with nearly all major financial institutions in the evaluation of credit risk surrounding various borrowers. In a recent role, Juanita served as the Senior Credit Officer and Senior Vice President at a regional lender. In that role, she was responsible for credit administration, including financial analysis, risk management, documentation review and manage ment, and loan file audits. Juanita is based in Focus Management Group s Tampa office can be reached at (813) or via at j.schwartzkopf@focusmg.com. 6 Is a Field Audit Program Adequate Protection from Fraud? Focus Management Group

7 Contact Focus Management Group is a leading business restructuring firm headquartered in Tampa, with offices in Atlanta, Chicago, Cleveland, Dallas, Los Angeles and Philadelphia. For more information regarding our field audit programs, contact our experienced Managing Director below: Corporate Offices 5001 W. Lemon Street Tampa, FL Tel: (800) Fax: (813) Key Contacts Juanita Schwartzkopf: j.schwartzkopf@focusmg.com