I recently completed an audit where the lender was backed into an over advance through contras. (the over advance occurred before ECG was called in) The way that this occurred is pretty interesting. When I was involved with training audit staffs, we often cautioned against this very thing happening. This is one of the few times that I have actually seen it occur.
The company that was being audited had been operating at a loss for some time, so liquidity and availability were scarce. Borrowing availability was calculated daily and daily borrowings were dependent on that day’s sales and/or collections. Throughout the month the company reported roughly $100M (that is 100 thousand, not million in case you are not used to the notations used in commercial finance) in sales to a customer that was a known contra. They proceeded to borrow against those sales. The sales were offset with open payables through a journal entry. Because the AR was reduced by a journal entry and not through the issuance of a credit memo the lender was never notified of the reduction. Once the month end reports were received the lender soon realized that their collateral balance was substantially higher then the company’s month end AR balance and that the scarce availability that the lender thought the company had, was actually an over advance.
The interesting part is that the lender reserved for contras in the normal traditional way, that is comparing month end eligible AR and the month end AP and reserving for the lesser of the two. In this case, the month end eligible AR was somewhere around $8M, while the AP balance was about $90M. This resulted in a $8M reserve against eligible AR.
Under normal circumstances, or for a client with ample liquidity the $8M ineligible would be sufficient. Even if the contra offsets were not reported by the company, it would not be a large concern as the collateral would be reconciled at month end, new ineligible amounts would be calculated and any needed adjustment would be made at that time. It only became an issue because of the company’s current financial condition. A $8M ineligible is not sufficient when there is little or no availability and the intra month sales to the contra customer are $100M or more.
The other thing to keep in mind and to understand is that even if the contras were not offset through a journal entry, the sales activity to the contra still could have resulted in backing the lender into an over-advance. The only way the above would not result in an over-advance is if the credits to offset the contra were issued and assigned at the same time as the sales invoices.
For example lets assume that the above is still true, a company has $8M due from a contra account that they owe $90M to. In addition, lets assume that they have $0M availability. Now they make an assignment of $200M and borrow the full amount allowed by their advance rate of 80%, or $160M. Included in the $200M of sales was $72M of sales to the contra account. Per the loan agreement and the ineligibles calculated at the prior month end, the company is still within formula, availability has not improved, but it has not deteriorated either. The problem is that the month end contra calculation is no longer valid. The new contra balances (assuming no other contra activity) are now $90M of eligible AR and $90M of eligible AP. This would result in a $90M ineligible, not an $8M ineligible. At an 80% advance rate, the contra activity has resulted in a $58M over advance ($72M of additional contras times 80%).
There are several steps an auditor can take to protect the above from happening to their client or employer:
- Understand the contra relationship and the level of sales and offsets that normally occur within a month.
- Understand the timing of the offsets and how the offsets are reported to the lender.
- Do not become complacent and rely on “tried and true” methods that are inappropriate for a given situation. For example do not recommend a contra ineligible based on month end balances, when intra month sales to a contra customer routinely exceed those balances.
- When intra month sales to a contra customer are excessive, several contra ineligible recommendations can be made. The examiner will need to use his or her judgment; however, possibilities include:
- the maximum historical AR balance noted, regardless of the AP balance.
- the entire AR balance, and any subsequent sales regardless of the AP balance
- the average monthly sales volume that occurs to a contra customer
- the maximum monthly sales volume that occurs to a contra
The video below, deals with bartering. Bartering is the exchange of goods or services for another party’s goods or services (sounds like contras!)…… be on the look out for sales to Itex and IMS.