Many operating companies borrow on a revolving line limited by a borrowing base, a formula applied to receivables and inventory. The company certifies the base to the lender, often weekly or monthly. When the certificate is wrong, the company can be over-advanced, in default, or in a misreported debt classification. A CPA firm preparing or auditing the financials for a company with an asset-based line should understand the certificate and trace it to the ledger.
How the base is built
The OCC's Comptroller's Handbook booklet on asset-based lending (ABL) describes the mechanics. The lender advances a percentage of eligible collateral, and the borrower certifies the amounts in a borrowing base certificate. Banks that lend to retailers may require daily or weekly certificates, with supplemental sales, purchase and markdown data. The booklet also describes field audits, which test the validity and value of the collateral shown on the financial statements and borrowing base certificates by examining original invoices and supporting documents, and which are often conducted quarterly.
Receivables
- Advance rates. Common advance rates range from 70 percent to 85 percent of eligible receivables, and some banks go up to 90 percent for eligible business-to-business receivables. Effective rates are often lower after subtracting historical dilution and minimum reserves.
- Past-due ineligibles. An account is normally ineligible when past due by three times the terms, for example 90 days on 30-day terms and 21 days on seven-day terms.
- Cross-aging. Many agreements designate all of a customer's accounts as ineligible when some percentage of its receivables become ineligible.
- Other ineligibles. The booklet lists receivables that exceed concentration limits, affiliate receivables, re-aged receivables, government receivables subject to the Assignment of Claims Act, foreign receivables, and contra-accounts where the borrower both sells to and buys from the customer. To be eligible at all, a receivable must arise in the ordinary course of business and be subject to a perfected first-priority security interest in favor of the bank.
- Concentrations. A bank normally treats receivables as concentrated when a single account is 10 percent or more of the portfolio, and limits concentrated accounts to no more than 10 percent to 20 percent of the receivables borrowing base, or reduces the advance on them.
- Dilution. Returns and allowances, disputes, bad debts and other credits reduce the receivable balance. Dilution is usually expected to be 5 percent or less of receivables, and lenders watch trends.
Inventory
A bank typically advances up to 65 percent of the book value of eligible inventory or 80 percent of net orderly liquidation value (NOLV). Lenders favor liquidation value rather than market value and build in margin for price risk and marketing and administrative costs. Work-in-process has limited liquidation value and is frequently excluded. Consigned goods are ineligible because another party owns them, and inventory excluded for age or obsolescence is ineligible. Most agreements also let the lender set reserves against the base for liquidation costs, dilution and obsolescence.
Worked certificate
A company's month-end ledger shows $2,000,000 of receivables and $900,000 of eligible inventory at cost. The loan agreement sets an 85 percent advance on eligible receivables and 50 percent of eligible inventory cost. Ineligibles identified in the aging:
- Past due more than 90 days: $300,000.
- Cross-aged accounts: $80,000.
- Contra-accounts: $40,000.
- Affiliate receivables: $120,000.
Calculation:
- Eligible receivables: $2,000,000 minus $300,000 minus $80,000 minus $40,000 minus $120,000, or $1,460,000.
- Receivable availability: $1,460,000 times 85 percent, or $1,241,000.
- Inventory availability: $900,000 times 50 percent, or $450,000.
- Borrowing base: $1,241,000 plus $450,000, or $1,691,000.
- Loan balance: $1,750,000.
- Over-advance: $1,750,000 minus $1,691,000, or $59,000.
The OCC booklet defines an over-advance as a loan advance that increases the balance beyond the amount supported by the borrowing base. How the company cures or obtains a waiver of the over-advance should be documented, and the result feeds the debt classification and covenant analysis in loan covenant compliance testing.
The over-advance is $59,000 divided by $1,691,000, or 3.5 percent of the base. The OCC booklet says most banks do not allow an over-advance above 10 to 15 percent of the borrowing base, and that an unapproved over-advance may indicate inaccurate reporting by the borrower.
Second example: a concentration limit
Take the same ledger, and assume one customer's $400,000 account is otherwise eligible. The agreement limits any one customer to 20 percent of eligible receivables.
- Cap: 20 percent times $1,460,000, or $292,000.
- Excess over the cap: $400,000 minus $292,000, or $108,000, which is ineligible.
- Eligible receivables: $1,460,000 minus $108,000, or $1,352,000.
- Receivable availability: $1,352,000 times 85 percent, or $1,149,200.
- Borrowing base: $1,149,200 plus $450,000, or $1,599,200.
- Over-advance: $1,750,000 minus $1,599,200, or $150,800, which is 9.4 percent of the base.
A certificate that skips the concentration test understates the over-advance by $91,800 ($150,800 minus $59,000).
Testing dilution
With $2,000,000 of receivables, dilution at the 5 percent level the booklet describes as the usual upper expectation is $100,000. If credit memos, returns and allowances in the period total $130,000, dilution is 6.5 percent ($130,000 divided by $2,000,000). The auditor looks at the trend by month and at whether the reserves in the agreement reflect it.
Inventory: book value or NOLV
The booklet gives two measures: up to 65 percent of the book value of eligible inventory, or 80 percent of NOLV. With $900,000 of eligible inventory at cost and an appraisal setting NOLV at 70 percent of cost ($630,000), the measures are $585,000 (65 percent of $900,000) and $504,000 (80 percent of $630,000). The loan agreement sets which applies, and a lender using the lower figure advances $504,000. A certificate that applies the cost percentage to an inventory whose appraisal has since fallen overstates availability.
Common errors on certificates
- Leaving consigned goods, obsolete stock or work-in-process in eligible inventory.
- Omitting the cross-aging step for customers with some accounts past the cutoff.
- Treating a contra-account as eligible, when the customer can set off what it owes against what it is owed.
- Using the prior month's NOLV appraisal after a material change in the inventory mix.
What the CPA tests
- Agree the receivable total on the certificate to the general ledger and aging, and recompute the aging buckets from invoice dates.
- Recompute each ineligible category and confirm that the company's definitions match the agreement, not its own summary.
- Test dilution: compare credit memos and returns after period end to the receivable base.
- Agree inventory on the certificate to the perpetual records and the physical count, and check the cost basis against the NOLV appraisal.
- Check that sales and collections between certificates tie to cash receipts. See accounts receivable aging and allowance.
- Compare the lender's field exam findings to management's certificates.
- Test concentrations against the cap, and compare any reserves the lender has set to the certificate.
- Obtain the lender correspondence on any over-advance or waiver and evaluate the subsequent-events and disclosure effects.
Sources
- Office of the Comptroller of the Currency, Comptroller's Handbook, Asset-Based Lending: https://www.occ.treas.gov/publications-and-resources/publications/comptrollers-handbook/files/asset-based-lending/pub-ch-asset-based-lending.pdf
- Office of the Comptroller of the Currency, Bulletin 2014-11, Asset-Based Lending booklet: https://www.occ.gov/news-issuances/bulletins/2014/bulletin-2014-11.html
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Part of CORAA University · Specialized engagements: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error