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Financial Reporting and Analysis 6e Receivables

CHAPTER 8

RECEIVABLES

CHAPTER OVERVIEW

Accounts receivables are generally reported in the balance sheet at their net realizable value

(the amount a business expects to collect). This means gross accounts receivable must be reduced

by the amount of estimated uncollectibles, returns, and/or adjustments. Companies estimate

uncollectible accounts using either the sales revenue approach or the gross accounts receivable

approach. Under either approach, firms must periodically assess the reasonableness of the

uncollectibles balance by performing an aging of accounts receivable.

Accounts receivable growth in excess of sales growth could indicate a change in

customer mix or credit terms and/or that aggressive revenue recognition practices are being

used. Significant increases in the allowance could indicate collection problems while

significant decreases in the allowance could be a sign of earnings management. For this

reason, careful analysis of period-to-period trends is necessary to determine whether

reported receivables arise from real sales.

In certain long-term credit sales transactions, interest is imputed based on the present value of

the note receivable. Receivables are also used as collateral for a loan. Firms may elect the fair

value option for accounts and notes receivable. Changes in fair value are recognized in net

income measurement.

Firms sometimes transfer or dispose of receivables before their due date in order to accelerate

cash collection. Sales of receivables—also called factoring—can be with or without recourse.

Receivables may also be used as collateral for a loan. In analyzing these transactions, it may not

be obvious whether the transaction to accelerate cash collection represents a sale or a borrowing;

however, authoritative accounting literature provides guidelines in Topic 860 Transfers and

Servicing of the FASB Accounting Standards Codification for distinguishing between sales

(when the transferor surrenders control over the receivables) and borrowings (where control is

not surrendered). Analysts must be alert to the possibility that fimissing” receivables distort the

true relationship between receivables’ and sales’ growth rates.

Banks and other corporations will swap debt to establish a balance of risk in their loan

portfolios. Subprime loans and securitizations were at the heart of the 2008 economic crisis.

Accounting and regulatory reforms are underway to address some of the problems identified during

the crisis.

Banks and other holders of receivables will frequently restructure the terms of the receivables

when a customer is unable to make required payments. These troubled debt restructurings may

represent settlements or continuations with modifications of debt terms. When terms are

modified, the precise accounting treatment depends on whether the sum of future cash flows

under the restructured note is more or less than the note’s carrying value at the restructuring date.

The interest rate used in troubled debt restructuring may not reflect the real economic loss

suffered by the lender.

Both the FASB and IASB have projects on financial instruments and future convergence may

be a possibility.

CHAPTER OUTLINE

I. ASSESSING THE NET REALIZABLE VALUE OF ACCOUNTS RECEIVABLE

A. Estimating the net realizable value of receivables:

1. The full amount of receivables may not be collectible either because customers:

Financial Reporting and Analysis 6e Receivables

a. Are unable to pay (referred to as uncollectibles), or

b. Return the merchandise for credit or are allowed a reduction in the amount

owed

(referred to as returns and adjustments).

2. These losses are an unavoidable consequence of the trade-off between increased

costs and additional profits from credit sales. The recognition of these write-offs

can be timed by management to meet short term earnings goals by postponing the

recognition until they have a period of restructuring where they ficlean the balance

sheet”.

B. Sales to customers who are ultimately unable to pay are treated as expenses of the period

in which the sales are made.

1. The entry under GAAP is: DR Bad debt expense

CR Allowance for uncollectibles

2. The allowance for uncollectibles (also known as allowance for doubtful accounts) is

a contra-asset account that is subtracted from gross accounts receivable and

reported as the net realizable value.

C. Companies can use two alternative methods of estimating

uncollectible accounts.

1. The sales revenue approach: Analyzes past customer payment

patters and takes a percent of current period sales to create a provision

for bad debt.

2. The gross accounts receivable approach: Management performs

an aging of accounts receivable.

a. An aging of receivables is simply a determination of how long each receivable

has been outstanding.

b. The allowan ce is adjus ted upward or downward to the est imated uncollectible

amount.

c. The longer a receivable is outstanding, the more likely that it

will be uncollectible.

Teaching Tip: Assume, for example, that a firm issues its financial statements 90 days

after the end of its fiscal year. By the time that the financial statements are issued, the

majority of the accounts receivable at year-end will have been collected. As a result, there

are no collectibility issues for these accounts. However, considerable judgment still goes

into evaluating the collectibility of the remaining accounts.

D. Writing off bad debts involves removing such bad accounts from

the books. A debit is made to allowance for uncollectibles and the

credit is to accounts receivable.

1. Only when the seller knows which specific receivable is

uncollectible can the individual account be written off.

E. Assessing the Adequacy of the Allowance for Uncollectible Account Balance:

1. Regardless of the approach used, management must periodically

assess the reasonableness of the allowance for uncollectibles balance.

2. An aging of accounts receivable aids in this process.

3. Because of the judgment that is required, the temptation to

Financial Reporting and Analysis 6e Receivables

fimanage” earnings by using bad debt accruals can be strong.

4. Management must continually adjust its allowance as its collection

experience change.

F. Estimating Sales Returns and Allowances:

1. It is inevitable that sometimes the wrong goods are shipped to customers or the

correct goods arrive damaged, prompting customers to return the goods or request

price adjustments.

2. These returns and adjustments reduce both the accounts receivable balance and

income.

3. Ignoring estimated future returns and adjustments has a trivial effect on income

when the amount of actual returns and adjustments does not vary greatly from year

to year.

E. Analytical Insight: Do Existing Receivables Represent Real Sales?

1. The growth rates in sales and accounts receivable will be roughly equal when sales

terms,

customer credit standing, and accounting methods do not change from period to

period.

2. Any disparity between the two growth rates represents a potential fired flag.”

Teaching Tip: Liven up the class discussion by pointing that revenue recognition

irregularities can be discovered by tracking the relationship between changes in sales and

changes in receivables. Use Sunbeam Corporation’s 1997 annual report and guide students

through a quick analysis.

3. A growth in receivable may be the result of an increase of sales or it could

indicate

aggressive revenue recognition that will not result in cash collections.

4. Many revenue recognition irregularities can be discovered by tracking the

relationship between changes in sales and changes in receivables.

5. Channel stuffing recognizes revenue on shipped products that exceed customer

needs and are likely to be returned.

II. IMPUTING INTEREST ON TRADE NOTES RECEIVABLE

A. Sellers may extend long-term credit to buyers, who then sign notes.

B. As in accounts receivable, a business must assess the collectability of its notes and

establish an appropriate allowance.

C. An attempt is made to separate the operating income (i.e., cash-equivalent selling price

minus cost of goods sold) from the financing income (i.e., interest income).

D. The transaction is recorded at the fair value of the item(s) given up, if known.

1. This should make sense as the first option since managers are likely to have a

better idea

about the value of the items that they routinely sell during the normal course of

business.

2. An imputed interest rate, that equates the value of the items given up to the

future cash

inflows from the note, is calculated. (Students will recognize this exercise as

calculating

the internal rate of return (IRR)).

E. If not, then the transaction is recorded at the present value of the note accepted in return

Financial Reporting and Analysis 6e Receivables

for the item(s).

1. If the stated rate is equal to the prevailing market rate for a note of that risk

level, then the sales price equals the face value of the note.

2. If the stated rate deviates from the prevailing market rate, or if there is no

stated interest rate, then the seller must calculate the present value of the

future cash inflows.

a. An estimated discount rate must be selected.

b. The rate selected directly affects the allocation of income between

operating and financing activities.

c. This allocation is important to assess the balance between the financing

and operating risk of a company.

III. THE FAIR VALUE OPTION

A. IFRS allow firms the option to voluntarily measure financial assets and liabilities at

fair market value under FASB ASC under Section 825-10-25. Generally a financial

institution would elect this option for receivable if it expects the fair value of the

receivable to move in the opposite direction of the fair value of another financial

instrument that also is carried at fair value.

Teaching Tip: An illustrative review of the examples provided in the text (Bristol

Corporation and Quinones Corporation) would help to clarify the fair value option treatment.

IV. ACCELERATING CASH COLLECTION: SALE OF RECEIVABLES AND

COLLATERALIZED BORROWINGS

A. There are two traditional ways to accelerate cash collections of accounts receivable:

1. Factoring, where the company sells its receivables outright in exchange for cash

and the receivables are removed from the company’s books.

a. Factoring can be without recourse, meaning that the factor cannot turn

to the company for payment in the event that some customer receivables

prove uncollectible.

i. The fee charged by the factor is charged to interest expense. Think of

this fee not only as a charge to cover the administrative cost of the

factor, but also as the difference between the present value and the net

realizable value of the receivables.

ii. All else being equal, the factor will charge a higher fee in a nonrecourse

arrangement than in a with-recourse arrangement, because of the higher

risk assumed.

b. Factoring can be with recourse, meaning that the company is willing to buy

back

any bad customer receivables from the buyer of the receivables.

c. A holdback account represents a cushion to absorb credit losses (in the case

of a sale

with recourse), or the costs of sales returns, discounts, or price adjustments

in both

with/without recourse transactions.

2. Assignment of receivables involves a loan that is collateralized by the

customer

receivables.

Financial Reporting and Analysis 6e Receivables

a. The accounts receivable is not removed from the company’s books.

b. A liability is credited to reflect the loan.

c. The fact that receivables have been pledged as collateral must be disclosed in

the notes to the financial statements, if material.

3. These alternatives are summarized in Figure 8.3 in the text.

B. Notes receivable can also be assigned or sold (with or without recourse).

1. Accelerating cash collections on notes in this way is called discounting.

2. The buyer advances cash to the company based on the discounted present value of

the notes.

C. Ambiguities Abound: Is It a Sale or Borrowing?

1. FASB provides guidance in the Accounting Standards Codification for

distinguishing between sales and collateralized borrowings.

a. If control is surrendered, then the transaction is treated as a sale, and any gain

or loss is recognized in earnings.

b. If control has not been surrendered, the transaction is accounted for as a

secured

borrowing.

2. If the transaction is really a borrowing, but is erroneously treated as a sale,

then both assets and liabilities are understated and ratios using these measures

are distorted.

3. If a transaction is really a sale, but is erroneously treated as a borrowing, then the

company’s net assets are misrepresented since a gain or loss on the transaction

should be recognized.

D. Securitization occurs when receivables are bundled together and sold or transferred to

another organization, which issues securities that are collateralized by the transferred

receivables (Refer to Figure 8.4 for greater clarity)

1. The transferor (i.e., the firm that is bundling the portfolio for sale) likely records a

gain on

the sale of the securitization.

a. The risk associated with the bundled portfolio in the aggregate is lower than

the risk

of the individual receivables.

b. The lower risk and discount rate results in a higher present value and sales

price, resulting in a gain to the transferor.

2. Banks and others that engage in securitizations do not transact directly with the

investors.

a. The transferor forms a special purpose entity (SPE) that is legally distinct from

the

transferor and is created solely for the purpose of the securitization

transaction.

i. The SPE protects the investors who bought the notes. Since the

receivables were sold to the SPE, they are beyond the reach of the

transferor’s creditors.

ii. The SPE allows the transferor to receive favorable financial reporting

treatment for the transaction. The receivables are removed from the

transferor’s financials, and since the SPE is not consolidated, the debt

never appears on the transferor’s balance sheet.

b. The transferor then sells the receivables to the SPE. Because the receivables

were sold

Financial Reporting and Analysis 6e Receivables

to the SPE, they are beyond the reach of the transferor and its creditors –

securing the

collateral underlying the notes from seizure in bankruptcy.

c. The SPE creates and issues debt securities (with the receivables as collateral)

that are

sold to investors.

d. The cash received from the investors by the SPE is then remitted to the

transferor.

e. The transferor may continue to service the assets for a fee that is paid by the

SPE.

E. Securitization and the 2008 Financial Crisis

1. Subprime lending increased substantially from 2004 to 2007. Subprime lenders

and borrowers, during this time, counted on increasing home prices.

2. Home prices fell instead and interest rates on adjustable rate mortgages increased

3. Default rates were much higher than anticipated and originators, guarantors, and

investors lost billions of dollars.

4. What went so wrong? Use Figure 8.4 to illustrate where many of the problems

occurred.

a. Originators had incentives to make and sell loans at will without concern for

underlying risk.

b. Originators and rating agencies underestimated the risk associated with their

guarantees.

c. As borrowers defaulted, complex legal issues prohibited SEs to modify loans.

d. As defaults occurred, originators and guarantors realized they had more loss

exposure than was evident from their financial statements.

F. Some Cautions for Financial Statement Readers:

1. Transfers of receivables with recourse require the disclosure of a contingent

liability, but no such disclosure is required when the receivables are sold without

recourse.

2. When firms sell receivables, the receivables number reported in the balance sheet

will understate the true growth in receivables over the period.

3. Special purpose entities (SPE) were a major issue in the Enron debacle.

4. The latest FASB guidance on securitization requires the sponsor to treat the

securitization as a collateralized borrowing instead of a sale if has both:

a. The power to direct the activities of the SPE that most significantly impact

the SPE’s economic performance, and

b. The obligation to absorb significant losses or the right to receive

significant benefits that potentially could be generated by the SPE

Teaching Tip: For currency, summarize the subprime lending issues that occurred from 2004

to 2009 relating to home prices. Emphasize what fiwent wrong” and possibly point to Figure

8.4 for clarity.

V. TROUBLED DEBT RESTRUCTURING

A. A lender may restructure the loan when a customer is unable to make the interest and

principal

payments required by an installment loan or other receivable.

Financial Reporting and Analysis 6e Receivables

1. Scheduled interest and principal payments may be reduced or eliminated.

2. The repayment schedule may be extended over a longer period of time.

3. The customer and lender can settle the loan for cash, other assets, or equity

interests.

B. For a restructuring to be troubled, the borrower must be unable to pay off the original

debt and

the lender must grant a concession to the borrower.

C. A concession means that in exchange for canceling the original loan, the lender must

new debt or assets with an economic value less than the book value of the original debt

plus

any accrued interest.

D. Troubled debt restructurings can be accomplished in two different ways as summarized

in Exhibit 8.11:

1. Through a settlement, where a transfer of cash or other assets to the lender cancels

the original loan.

a. Borrower:

i. The gain on debt restructuring is extraordinary,

ii. The gain (loss) on transfer of assets is ordinary.

b. The loss on debt restructuring to the lender is ordinary.

2. In a continuation with modification of debt terms, the original loan is canceled

and a new loan agreement is signed.

a. Borrower:

i. If the restructured loan cash flows are lower than the current book value

of the loan, the new loan payable is recorded at the total of the

restructured cash flows, the debt restructuring gain is extraordinary, and

future interest expense is zero since all payments are applied to note

principal.

ii. If the restructured loan cash flows are higher than the current book value

of the loan, the new loan payable is recorded at the book value of the

current loan, and future interest expense is based on a rate that equates

current book value and restructured cash flows.

b. Lender:

i. If the restructured loan cash flows are lower than the current book value

of the loan, the new loan receivable is recorded at the present value of

the new cash flows discounted at the original effective interest rate, the

debt restructuring loss is ordinary, and future interest income is based

on the original loan rate.

ii. If the restructured loan cash flows are higher than the current book value

of the loan, the new loan receivable is recorded at the present value of

the new cash flows discounted at the original effective interest rate, the

debt restructuring loss is ordinary, and future interest expense is based

on the original loan rate.

c. The borrower and lender may record different restructuring gains and losses

since the initial book value GAAP assigns to the payable is not the same as

that assigned to the receivable.

d. The financial gains and losses may not correspond to the economic gains and

losses.

E. Evaluating Troubled Debt Restructuring Rules – GAAP rules are subject to several

criticisms:

Financial Reporting and Analysis 6e Receivables

1. Lack of symmetry (use of differing measurement rules) in financial reporting of the borrower

and lender. As a result, the initial book value assigned to the payable is not the same as that

assigned to the receivable and hence the gain recognized by the borrower is different than the

restructuring loss recognized by the lender.

2. GAAP restructuring gains and losses do not always correspond to real economic gains and

losses.

3. GAAP’s use of the original loan’s effective interest rate to value the restructured receivable and

lender’s restructuring loss is questionable.

VI. GLOBAL VANTAGE POINT

A. Comparison of IFRS and GAAP Receivable Accounting.

1. Both are generally similar although the term fiamortized cost” is used to refer to

the gross amount of the receivable.

2. IFRS allows use of fair value option in cases where it eliminates an accounting

mismatch or because a group of assets are managed and evaluated using fair values.

U.S. GAAP allows fair value option for a broader set of transactions

3. IFRS requires fair values disclosures for short term trade receivables and loans in

addition to long term notes receivables.

4. IFRS for debt restructurings from the lender’s perspective are similar to U.S.

GAAP. No explicit international standards govern troubled restructuring from the

borrower’s perspective.

B. Expected FASB and IASB Actions

1. In February 2013, FASB issued a proposed Accounting Standards update on financial

instruments that would require short term receivables to be measured at amortized

cost (consistent with current U.S. GAAP) although long term receivables would

generally be accounted for using the fair value approach (with changes through other

comprehensive) if the receivables are not to be held until maturity.

2. Long term liabilities would likely stay at amortized cost unless conditions for

amortized cost are met. This fair value approach is consistent with the amortized cost

approach taken under IFRS.

3. U.S. accounting for long–term receivables may more toward fair value reporting.

4. Convergence between U.S. GAAP and IFRS depends on whether these boards

continue to work together to revise reporting standards for financial instruments.

Financial Reporting and Analysis 6e Receivables

CHAPTER QUIZ

1. Rosa Co. provides for uncollectible accounts based on an aging of accounts receivable.

The following data are available for 2015.

The aging indicates a potential loss of $74,000

Allowance for uncollectible accounts, January 1, 2015 34,000

Customer accounts written off as uncollectible during 2015 60,000

What is the amount of bad debts expense for the year ended December 31, 2015?

a. $34,000

b. $66,000

c. $100,000

d. $126,000

2. One criticism of financial statements is that they contain too many estimates. One such

estimate is

the allowance for uncollectible accounts. What information, of importance to investors and

creditors, does the allowance for uncollectible accounts provide?

a. The allowance provides investors and creditors with the amount of accounts that a firm

will be

unable to collect.

b. The allowance provides investors and creditors with an estimate of the amount of

accounts that

a firm will be unable to collect.

c. The resulting net realizable value is equal to the present value of the future cash

receipts.

d. The allowance is too discretionary to assist investors in estimating future cash flows.

3. Ritter Stores, Inc., had credit sales in February of $500,000. Experience has shown that

merchandise equaling 10% of sales will be returned within 90 days. Returned merchandise

readily resalable. In addition, merchandise equaling 15% of sales will be exchanged for

merchandise of equal or greater value. Assume that all of these amounts are material. What

will be

the increase in the net accounts receivable balance during February as a result of these

sales?

a. $375,000.

b. $382,500.

c. $450,000.

d. $500,000.

4. Although Petron Company has used 1% of net credit sales to estimate the allowance, that

percentage

should be reviewed each year. Which of the following would cause Petron to use a lower

rate even

though the 1% was appropriate in the past?

a. More rigorous collection efforts.

b. The sale of accounts receivable to a factor.

c. A looser credit policy.

d. A recession.

Financial Reporting and Analysis 6e Receivables

5. Losses from customer accounts (accounts receivables) that are estimated to become

uncollectible should be expensed in which of the following time periods?

a. In the period the related sale was made

b. When the actual determination is clearly made that the customer would never pay the

balance

c. Either (a) or (b) above, whichever is more clearly determinable

d. In the period when the company expects a profit

6. RMA reported the sale of accounts receivable in 2015 of $300 million. This amount was

uncollected at year end. Since RMA reports an allowance for doubtful accounts that includes

losses on the receivables sold, analysts make appropriate adjustments to their balance sheet

and statement of cash flows. What effect do the adjustments have on RMA’s accounts

receivable turnover ratio (i.e., sales / average receivables) and RMA’s current ratio (i.e.,

current assets / current liabilities) of 0.83?

a. The adjustments increase the accounts receivable turnover ratio and increase the

current ratio.

b. The adjustments decrease the accounts receivable turnover ratio and increase the

current ratio.

c. The adjustments increase the accounts receivable turnover ratio and decrease the

current ratio.

d. The adjustments decrease the accounts receivable turnover ratio and decrease the

current ratio.

7. Nittany Manufacturing sold $100,000 of accounts receivable (with a corresponding balance

of $2,000 in the allowance for uncollectibles) without recourse. While the factor was

responsible for all bad debts, Nittany was responsible for sales returns. The factor charged

12% per annum interest on the gross receivables for a period of one month (which is the

expected average time to maturity of the receivables) plus a factoring fee of 6%, both of

which were deducted by the factor from the value of receivables. A 5% holdback was

retained by the factor to cover expected sales returns. What loss on the sale of the

receivables did Nittany record?

a. $1,000.

b. $4,000.

c. $5,000.

d. $7,000.

8. Securitization occurs when receivables are bundled together and sold or transferred to another

organization, which issues securities that are collateralized by the transferred receivables.

The transferor (i.e., the firm that is bundling the portfolio for sale) likely records a gain on

the sale of the securitization when

a. The risk associated with the bundled portfolio in the aggregate is lower than the risk

of the individual receivables.

b. The lower risk and discount rate results in a lower present value and sales price, resulting

in a gain to the transferor.

c. The lower risk and discount rate results in a higher present value and sales price, resulting

in a loss to the transferor.

d. The risk associated with the bundled portfolio in the aggregate is higher than the risk

of the individual receivables.

9. Defiance Precision Products (DPP) has an increase in sales of 25% over the 2015

Financial Reporting and Analysis 6e Receivables

income statement. The company has a decrease in cash flow from operational sources

for the same time period. Which of the following statements describes a possible reason

for the discrepancy?

a. DPP has relaxed its credit policies resulting in increased sales but reduced collections.

a. Fictitious sales were recorded during the period

b. The company has additional revenue from non-operating sources.

c. Both A and B

10. What adjustment should an analyst make to the financial statements to reflect the

restructuring?

a. Debtor figains” should be added back to income in the period of the restructuring.

b. Debtor figains” should be added back to income over the remaining life of the

restructured obligation.

c. Restructured debt should be restated to fair market value using the reduced interest rate

agreed to in the restructuring.

d. Restructured debt should be restated to fair market value using a current market rate of

interest to discount the cash flows required by the restructured obligation.

QUIZ ANSWERS:

1. c. Beginning balance

Write-offs Bad debt expense

Ending Balance

Allowance

34,000

60,000

100,000

74,000

Financial Reporting and Analysis 6e Receivables

consent of McGraw-Hill Education.

(increased debt). In this case, with a current ratio less than 1, the adjustments increase the

current ratio.

7. c. Allowance for uncollectibles 2,000

Cash 88,000

Loss on sale 5,000

Receivable from factor 5,000

Accounts receivable 100,000

The loss consists of the following

components:

Interest expense 1,000

Factoring fee 6,000

Elimination of allowance (2,000)

Loss on sale of receivables 5,000

8. a. The risk associated with the bundled portfolio in the aggregate is lower than the risk

of the individual receivables and the lower risk and discount rate results in a higher

present value and sales price resulting in a gain to the transferor.

9. c. Both A and B could be the reason for the increase in sales without a corresponding

increase in cash collections. When sales increase but cash does not it is a fired flag” for

possible earnings management. Management may have a business reason for changing

their credit policy creating sales that will be collected in a future period.

10. d. For purposes of analysis, both impaired and restructured debt should be restated to fair

market value using a current market rate of interest to discount the cash flows required by

the (actual or expected) restructured obligation. However, debtor figains” should be viewed

warily since they result from an inability to repay. Any figains” will almost certainly be

offset by asset impairment. Since the figain” results from insufficient cash flows, it is also

likely that insufficient cash flows will also result in asset impairments under that rule’s

recoverability test).

RECOMMENDED EXHIBITS

Figure 8.3—Sale of Receivables and Collateralized Borrowings.

Figure 8.4—Structure of a Securitization.

Exhibit 8.11—Summary of Accounting Procedures for Troubled Debt Restructurings.