The anatomy of a loan monitoring audit
Loan audits are a crucial part of managing ongoing risk for debt investors. When you raise debt facilities, investors require you to go through audits quarterly, semi-annually, or annually.
Most founders don’t know that after you raise a warehouse facility, debt investors conduct regular loan audits. Founders have generally only heard of financial audits. So loan audits may be surprising. These audits are focused on originated and serviced loans and are completed separately from annual audited financials.
Depending on the type of facility, scale, and size of the company, the frequency of audits ranges from quarterly to annually.
These audits are completed by a third party hired by the debt investors. These auditors specialize in auditing loan portfolios. Some investors conduct these audits with internal teams.
You could breeze through these audits if you set up the facility and ongoing operations correctly.
The frequency and cost of these audits are negotiated when closing the facilities. These audits can cost from $25k-$50k for a portfolio of $50M-$100M. If the investors are banks, the cost could be higher.
The company has to pay for the audit costs.
Sometimes, these audits could also include compliance verifications.
Regular loan audits are one of the ways for investors to manage investment risk. Future commitments and the ability to use the warehouse line depend on clearing these audits.
The audits are generally divided into 4 main areas: origination, repayments, cash application and reconciliation, and fraud prevention.
Auditors test these areas by selecting a random list of borrowers and requesting information for each of the selected borrowers. The random list of borrowers will be different for each type of test. And for each of these lists, auditors will request different pieces of information for verification.
Let’s look at each of these:
Origination
Loans were originated
Loans were originated to real borrowers
Funds were transferred to borrower accounts
Having the full view of originated loans, they can be confident that loans were originated to real borrowers with legally enforceable documents. These signed documents are their “assets”.
Repayments
Repayments were deducted legally
Repayments were deducted for the correct amounts
Loan Repayments are coming from borrower accounts
Repayments are applied to the principal and interest and to the correct loans
For verification of payments, you may need to submit signed payment authorization forms, ACH logs, the company’s bank account statements (where repayments for debt are deposited), etc.
This confirms that the loan balances are calculated correctly and payments applied reduce the principal correctly.
Cash Application and Reconciliation
Interest was accrued correctly
Repayments are deposited to the right bank accounts
Repayments can be reconciled
Interest accruals, payment applications to interest and principal, etc are verified using repayment schedules.
This confirms that the company is not skimming money and debt investors are paid the received cash.
Fraud Prevention
Fraud is mitigated and notifications are sent per fraud prevention policies
Loans are written off (once identified as fraudulent) per loan write off policies
Appropriate measures are put in place to mitigate loan fraud and once identified, fraudulent loans are written off and accounted in performance calculations.
What information do auditors require for auditing?
Below is a sample list of the few items auditors ask for during a loan audit process:
bank statements to show transfers to the borrower’s bank account
ACH batch statements with name, account, and routing number of the borrower
ACH batch amounts matched with the funds transfer amount in bank statements
timestamps, location, and date for digital signatures
signed promissory note with a unique loan ID including name, address, and other details of the borrower
signed ACH authorization forms (showing permission to deduct funds)
monthly statements sent to borrowers
payment schedules shared with borrowers at the time of origination
timestamped copies of emails sent to borrowers for payment confirmation
The loan audit workflow covers multiple teams including accounting, operations, compliance, and engineering. These teams work together to produce verifiable audit trails.
How to increase the speed of auditing?
A good way to increase the speed of auditing is to design workflows for the output right from the beginning. If engineers understand all the data that needs to connect to each other and shared with the auditors, they can design databases for faster retrieval. A few loan management systems have pre-built some of this reporting functionality but there is no standard reporting asked by auditors.
Every auditor develops their own process and requires the output in different ways, so it’s impossible to generate standardized reporting from the LMS. The best way is to put the right components (core items that are tested in an audit) in place so they can be combined in a way requested by auditors.
This reduces a week long process to just a couple of days. Maybe even one day.
We conducted at least 5 loan audits, cumulatively for hundreds of millions of dollars worth of loans using this method.
Hope this gives you a view into managing loan audits.