RISKMANAGEMENT Field Exams as a Cost-Effective Approach to Risk Mitigation by Paul J. Schaefer he lengthy expansion in the U.S. economy has short- ened memories, leading to more generous credit Tstandards and greater chances for problem loans. The author’s field exam department performed 79 initial exams for mid- dle-market companies over the past three years. Serious risks were uncovered in a number of exams—risks that had not been caught by either the lender or the underwriter. This article, based on a review of the results of those exams, demonstrates the cost-effective nature of using field exams to mitigate risk. © 1999 by RMA. Schaefer is vice president and field examination manager for Bank One Asset-Based Finance Group South/West in Dallas. In addition to performing field exams for the bank's Asset-Based Finance Group, Bank One's field exam department performs due diligence, ongoing examinations, and trouble-shooting examinations for the commercial middle market, syndications, large corporate, and capital markets areas. 62 The Journal of Lending & Credit Risk ManagementNovember 1999 Field Exams ight years of an expanding and big audit firms to correctly Exam Results economy has resulted in provide information, don’t expect During the past three years, Ean overly competitive mar- the quality to improve with small- 79 initial exams were performed ketplace. Credit policies have er borrowers and smaller audit for middle-market companies. been rewritten beyond what once firms. The results of the exams were was considered essential for pru- Credit analysis is simple, if categorized into four groups with- dent lending. Profit margins have the lender has all the information. in prospect and existing cus- been trimmed thinner than was Therein lies the problem— tomers to indicate satisfactory or previously considered necessary obtaining the relevant informa- negative exam results. A capsula- to compensate for risk. Yet banks tion. One of the most underdevel- tion of the results is as follows: oped and underutilized tools for relentlessly compete to grow their Type Positive Negative Total portfolios, booking new loans middle-market credit analysis has Prospect 33 10 43 while exiting worn-out loans. been the field exam, long a main- Existing 23 13 36 stay of credit analysis in the asset- Often, the real difference Total 56 23 79 between new and worn-out loans based lending industry. In today’s is the lender's knowledge of the high-tech world, a personal com- The most important exam is the first, especially when performed borrower. As in the prior decade, puter and a laser jet printer are eventually a recession will come often all that is needed to provide on a prospect. Prospective and brutally shake out the weak a good-looking financial state- middle-market customers that rely heavily on borrowing bases lenders. ment. Behind the numbers, how- In early 1998, Waste ever, there sometimes lurks an are often approved subject to a Management reported a pretax unorthodox accounting system field exam. Initial exams on exist- ing middle-market customers can charge of $3.54 billion dollars. that provides an uncertain picture The company had “used improp- of what is happening. To make be prompted by changing finan- er, overly aggressive accounting informed decisions, a lender must cial trends, line increase requests, or changing markets. While 71% tactics in an effort to boost sag- know whether a customer or ging earnings.”1 The misstate- prospect has adequate accounting of the exams were rated satisfacto- ments were so pervasive that it systems and management tools to ry, some exams pointed out nega- tive issues that were either miti- required the company to restate manage its business. Sometimes earnings back to 1992. Waste aggressive interpretation of the gated or were considered insignif- Management overstated its hard information by management and icant when compared with the balance of the report. However, assets 38%, which overstated their auditors can mask hidden prob- equity by 315%. A more recent lems; therefore, the lender needs 23 of the exams (29%) were con- example in April 1999 is FirstPlus an independent evaluation of the sidered to have one or more seri- ous risks. The largest issues Financial, which admitted “that information underlying the finan- investors shouldn’t rely on finan- cial statements. Lending is usual- uncovered were: cial reports it has issued since ly very forgiving. Many things can Exam Issues ProspectsExisting 1994.”2The financial shenanigans be done wrong without conse- Collateral problems 7 10 at Waste Management and quence; however, the more mis- Aggressive accounting 3 4 FirstPlus were no aberrations. takes, the greater the likelihood of Other accounting issues 2 7 Cedant, McKesson, Sunbeam, a write-off. Field exams can help Over inventoried 0 2 Livent, Rite Aid, Donnkenny, and mitigate these risks significantly. Delinquent payroll taxes 1 1 Commercial Financial Services Combining field exams with an Computer problems 1 0 also had high profile accounting adept monitoring of the cus- Ten (23%) of the exams on irregularities reported during the tomer’s monthly reporting can prospective customers found sig- past two years. When you cannot provide an early warning system nificant issues to the extent that rely on NYSE-listed companies for spotting negative trends. nine of them were declined credit 63 Field Exams facilities. Of the 10 prospects with advance in the most optimistic statement to the general ledger to negative exams, six had approved circumstances. The problems with the detail. The importance of credit packages, three were given the asset quality included high audit trails cannot be overstated- term sheets, and one was given a dilution, weak customer base, and without them, financial state- commitment letter. Thirteen poor inventory quality. ments become meaningless. (31%) of the existing customers Aggressive accountingis the When a company lacks the disci- were found to have significant overly liberal interpretation of pline to account for their business problems. Twelve of the 13 cus- assets to enhance earnings or col- transactions, they usually lack the tomers were over-advanced, based lateral and is often synonymous capacity to comprehend where on the recommended borrowing with misrepresentation or fraud. they are profitable and where base structures, two of which In the case of Waste Manage- they are losing money. exceeded $5 million. The over- ment, the company extended Surprisingly, poor audit trails do advances were created by a com- depreciation schedules and not necessarily preclude a compa- bination of aggressive interpreta- increased residual values of fixed ny from obtaining a certified tion of the borrowing base defini- assets. Examples of aggressive audit. It is important to note that tions and weak collateral. accounting at the local level what is not important to an audit Collateral problemsexist include recording dubious assets firm may be critical to a lender. when the recommended borrow- as trade receivables and fixed Another prevalent accounting ing base structure is insufficient to assets. Other tactics, such as bill- issue is general ledger accounts repay the loan. This can happen and-hold merchandise, can pro- that are not reconciled to the sub- when the existing advance rates duce phantom sales to increase ledgers. It is not unusual to have are aggressive and/or when ineli- receivables and cash flow. aggressive accounting combined gibles are understated. Recom- Receivables also have been with poor accounting records. In mended advance rates are often recorded when contracts were the fog of poor accounting, a cus- misconstrued to represent an signed even though the contract tomer can hide inaccurate or dis- absolute liquidation value; howev- was to be performed over the next honest information. er, there are too many scenarios year. Not only was the collateral that could affect the liquidation overstated, the customer did not Significance of the Study value of the collateral. The differ- record deferred revenue or accrue Of the 43 prospect exams, 10 ence between forced liquidation associated expenses, creating an were found to have substantial and orderly liquidation can be sig- overstatement of income and risks that had not been detected nificant. Recommended advance equity. Another customer with until the field exam. Without the rates are represented as reason- negative collateral issues had capi- benefit of a field examination, it is able when compared with similar talized a $2.2 million bad debt by probable that most of the companies in the industry or simi- purchasing its customer and show- prospects would have been lar relationships within the bank. ing the loss as goodwill. Though booked. The likelihood that one Determination of asset quality can the effect to the tangible net or more would have resulted in a be made from a thorough exami- worth was equal, the method of write-off is high, because, if nation. If the borrowing base dealing with the uncollectable booked, borrowing base structures structure of a problem situation is receivables allowed the company would have been inadequate to reasonable, the bank should be to maintain net profits and cash find an alternative lender or there able either to move the customer flow of $2 million higher than was would have been collateral short- to an alternative lender or to liqui- actually attained. falls in a liquidation. The field date collateral with minimal time Accounting issuestypically exam information allowed the and cost. The problem with the are associated with poor audit bank to pass on high-risk lending collateral of the above seven trails. The accounting records opportunities and to resolve those prospects is that it would not have should allow an examiner to track risk factors that could be mitigat- repaid the required initial cash the information from the financial ed. 64 The Journal of Lending & Credit Risk ManagementNovember 1999 Field Exams For existing relationships, the exams furnished information that THEPOTENTIALSAVINGSINRELATIONTOCOST allowed the bank to better evalu- ISSIGNIFICANT ITHANAVERAGEREVOLVING ate the collateral values in the .