ABL lenders place much of their focus on the valuation of the loan collateral, typically accounts receivable and inventory, when performing due diligence credit analysis. This collateral forms the basis for the borrowing base, and the conversion of such collateral is part of the lender’s exit strategy. Obviously converting the collateral to cash is the primary exit strategy; however, savvy lenders are also always concerned with repayment/paydown of the line of credit. Lenders therefore underwrite to EBITDA and spend significant time understanding the financial statements and management pro forma financials.

Large capital market non-ABL lenders devote considerable time and resources to independently evaluating EBITDA, above and beyond what is simply contained in historic audited financial statements, at a cost much higher than most ABL transactions will support. And as is often the case many ABL borrowers do not have audited financial statements and are reluctant to obtain them due to the cost and time strain necessary.

Lenders hire field examiners to go out in the field to validate collateral and collateral reporting, but while these field exams typically do a good job of AR and inventory collateral valuation, the standard ABL industry field exam scope and examiner does little to verify the accuracy of reported financial statements. So, what can your field examiners do ensure that the financial statements are accurate?

For many of our lenders, we have found that our “Earnings Validation Report” is a reliable and cost effective way of validating revenue and earnings, providing EBITDA analysis, delivering many of the insights of a Quality of Earnings Report, at a fraction of the cost. This analysis is performed with the goal of validating revenue and expenses, and hence validating EBITDA. The following steps are taken on each of our Earnings Validation Reports:

     1.  The examiner should have an in-depth conversation with the borrower’s accounting staff regarding the recognition and timing of revenue. How are customers obtained, how do they place orders, how the orders are fulfilled, when and how is revenue recognized? Does the company have deferred revenue? Is so, describe how revenue is recognized, when it is earned and how deferred revenue is tracked? The goal here is to make sure that all revenue recognized is truly earned.

     2.  The Revenue Validation is performed by reconciling revenue per the income statement to cash deposited into the bank statements, after adjusting for certain items such as changes in AR, deferred revenue, bad debt and other “non-revenue” deposits (such as intercompany transfers, insurance reimbursement, loan proceed or equity infusions).

     3.  The Expense Validation is performed by reconciling expenses per the income statement to cash disbursements out of the bank statements, after adjusting for certain items such as changes in AP & accruals, loan repayments, the employee portion of payroll taxes, cash fixed assets, depreciation, bad debt and other non-expense payments.

     4.  A sample test should be performed from invoices posted to the sales journal. Whereas the invoice/ship test is selected from the AR aging, this test is selected from the sales journal. The Examiner should obtain and vouch the following information:

     5.  A reconciliation should be performed between the revenue recorded on the income statement and the revenue per the examiner completed rollforward. Any variances should be explained.

     6.  The examiner should perform an in-depth analysis of the levels and reasonableness of bad debt and allowance for doubtful accounts. Also, if the borrower has inventory, the examiner should inquire as to how the cost of goods sold is determined. In both bad debts and cost of goods sold, there are some judgments that the borrowers are required to make and that can affect earnings.

     7.  Review and analysis of the financial statements and discussion with the Company regarding the possibility of any unrecorded transactions or material adjustments.

The above steps are not the totality of the Earnings Validation Examination, however, hits the high points.

On a recent exam, our firm discovered a material $1.6 million (19%) overstatement of revenue during performance of an Earnings Validation Examination of a Borrower, something that the lender was unaware of even though financial statements had been provided to the loan officer by the borrower.

The borrower had acquired Company A and was in the process of acquiring Company B. The proceeds of the financing were to be used to finance the two acquisitions.

Watermark used our standard scope for the Earnings Validation of the borrower. For Company A, in conjunction with the analysis of deferred revenue, an in-depth analysis of contracts was performed. An overstatement of revenue was discovered, as the deferred revenue schedule did not agree to the contract detail. For Company B, the analysis indicated that the Company did not have the level of cash receipts that supported the revenue reported on the Income Statement as identified by the Revenue Validation.

Ultimately, the lender declined the credit and may have saved themselves from a future loan loss or at the very least, saved themselves from a couple headaches and forbearance agreements. Likewise, the borrower realized that their analysis of Target Company B was faulty and did not consummate that particular acquisition and has used Watermark’s report to trigger the claw-back provisions in the M&A agreement with Company A. Even though the borrower was not our customer, it has subsequently engaged Watermark to perform Earnings Validations examination on their future acquisitions.