# Accruals and Dilution

When performing exams, a recurring conversation that we have with borrowers (and sometimes lenders) is the idea that accruals for potential offsets such as co-op advertising and volume rebates should not be reserved for because the subsequent credits are captured in dilution.  This is not the case.

The example below illustrates why the accrual should always be reserved for.

For the purposes of this illustration, lets assume the following:

• The advance rate is based strictly on dilution, with no cushion
• AR at the beginning of the year was \$0, January, 2008 was the first month of operations
• The company has Sales of  \$1000/month
• 5% of sales are returned the following month
• All customers are eligible for a 5% of sales co-op advertising allowance which is accrued monthly and issued quarterly
• The Co-op advertising accrual account is never less than \$50M and never more than \$150M
• The collections are \$900M/month with \$50M being credited for returns and \$50M deducted by the customer for the co-Op advertising.  The \$50 Co-op advertising deduction is cleaned up with the issuance of the quarterly credit.
• The collections occur the month following the sale.

Based on the above the statistics for 12 months ending 12/31/2008 would look like this:

 Month BOM AR Sales Gr. Cash Credits Misc. Crs Jan-08 \$ – \$ 1,000 Feb-08 1,000 \$ 1,000 900 50 Mar-08 1,050 \$ 1,000 900 50 Apr-08 1,100 \$ 1,000 900 50 150 May-08 1,000 \$ 1,000 900 50 Jun-08 1,050 \$ 1,000 900 50 Jul-08 1,100 \$ 1,000 900 50 150 Aug-08 1,000 \$ 1,000 900 50 Sep-08 1,050 \$ 1,000 900 50 Oct-08 1,100 \$ 1,000 900 50 150 Nov-08 1,000 \$ 1,000 900 50 Dec-08 1,050 \$ 1,000 900 50 Jan-09 1,100 12 Mo. Total 12,000 \$550 \$450 Pct of Sales 4.58% 3.75% Total Dilution 8.33%

As you can see in the above A/R Statistics spread sheet, dilution in the above scenario is 8.33%, this would call for a 91.67% advance rate given the above assumptions.

A/R is \$1,100.  This includes \$50M of future returns, that will not be paid,  as well as \$150M for co-op advertising credits that have not yet been issued and will not be paid for by the customer.

The borrowing base below shows availability with and without the co-op advertising accrual reserve.

 Without With Co-op Co-op Accounts Receivable per the aging. \$ 1,100 \$ 1,100 Ineligibles Co-op Advertising 150 Total Ineligibles \$0 \$150 Eligible Accounts Receivable \$1,100 \$950 Advance Rate 91.7% 91.7% Available Accounts Receivable \$1,008 \$871

Without the reserve availability is \$1,008M, with the reserve the availability is \$871M.  Given what we know, or have assumed, the most we can expect to collect for this A/R in the event of a liquidation is \$1,100 less \$150M for the earned co-op advertising, less \$50M for future returns, which equals \$900M.

If this theoretical company were to liquidate, the lender is better secured with a borrowing base that reflects availability only \$29M under the true \$900M realizable value from the collateral,  rather than a borrowing base that shows availability \$108M more than the true realizable value.  Hence, the need to reserve for the co-op advertising as well as capturing it in the dilution.

Another way to look at it is; the borrowing base is a snap shot picture of the collateral at a given time.  It is meant to represent what the net realizable value is.  We start with the total collateral pool, eliminate what is considered questionable and then apply an advance rate to the remainder to determine how much a lender would be willing to lend a company.  The advance rate is determined based on the ongoing activity and performance of the collateral, its calculation is based on the collectability of eligible sales over time.  Given the above, accruals should be reserved for as there is a good chance that the corresponding receivables will not be collected at the point in time of the borrowing base and also included in dilution as the collection of eligible sales is affected by them.

However, if the client/prospect is able to segregate the accrual credits from regular credits, then the accrual credits should be considered non-dilutive (as the accrual balance is already reserved for the credit should have no impact to availability).  In the above scenario the realizable value of the AR collateral and the borrowing base would be basically equal if the items were treated this way (\$1,100M less \$50 of future returns = \$1050M; \$1,100 x 95.42% [accruals non dilutive so dilution is 4.58%] = \$1.049.62M).

That’s all for now….

Greg

For quality collateral examinations, please visit ECG Collateral Services, Inc.

The comic below has nothing to do with the above, other than it talks about sales, but its funny!