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Receivables

Revsine/Collins/Johnson/Mittelstaedt: Chapter 8

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, All


Learning objectives
1. The methods used to estimate uncollectible accounts and the net realizable
value of accounts receivable.

2. How firms estimate and record sales returns and allowances.

3. How to spot whether or not reported receivables arose from real sales.

4. How and why interest is recorded on “non-interest bearing” notes.

5. How and why companies transfer or dispose of receivables to accelerate


cash collections, and how to tell whether the transaction is a sale or a
borrowing.

6. Why lenders “restructure” receivables when the borrower becomes


financially distressed, and how to account for the restructuring.

RCJM: Chapter 8 © 2009 8-2


Accounts receivable:
Assessing net realizable value
 GAAP requires that accounts receivable be shown on the
balance sheet at their net realizable value.

 Two things must be estimated to determine the net realizable


value of receivables:
1. Uncollectibles—the amount that will not be collected because
customers are unable to pay.
2. Returns and allowances—the amount that will not be collected
because customers return the merchandise or are allowed a
reduction in the amount owed.

Gross Estimated
NRV of Estimated
= amount - - returns &
receivables uncollectibles
owned allowances

RCJM: Chapter 8 © 2009 8-3


Accounts receivable:
Why estimating uncollectibles is
important
 Most companies establish credit policies by weighing the expected
cost of credit sales against the benefit of increased sales.
Customer collection and billing
costs plus potential bad debts
 This tradeoff illustrates that bad debts are often unavoidable.

 The matching principle requires that some estimate of uncollectible


accounts be offset against current period sales.

Today Some future dates


Time
$10,000 current $500 is
period sales uncollectible
$500 estimated
expense

RCJM: Chapter 8 © 2009 8-4


Accounts receivable:
Sales revenue approach
 Bristol Corporation estimates that bad debt losses arising from first quarter 2008 sales
are expected to be $30,000.

DR Bad debt expense $30,000


CR Allowance for uncollectibles $30,000
A contra-assets account
subtracted from gross
accounts receivable

 If Bristol’s gross accounts receivable and allowance for uncollectibles


before recording this bad debt entry were $1,500,000 and $15,000, then
after the entry the balance sheet would show:

RCJM: Chapter 8 © 2009 8-5


Accounts receivable:
Gross receivable approach

Management believes that Notice this


3% of existing gross second step
receivables will ultimately be
uncollectible

RCJM: Chapter 8 © 2009 8-6


Accounts receivable:
Writing off bad debts
 Some time later, Bristol determines that a $750 receivable from
Ralph Company cannot be collected.
DR Allowance for uncollectibles $750
CR Accounts receivable – Ralph Company $750

 Notice that no bad debt expense is recorded at this time because


the estimated expense was previously recorded (matching
principle).

 Only when the seller knows which specific receivable is


uncollectible can the individual account (Ralph Company) be
written off.

RCJM: Chapter 8 © 2009 8-7


Accounts receivable:
Estimating sales returns and allowances
 Bristol agrees to reduce by $8,000 the price of goods that arrived
damaged at Bath Company:
DR Sales returns and allowances $8,000
CR Accounts receivable –Bath Company $8,000

A contra-revenue account

 At the end of the reporting period, companies like Bristol also


estimate the expected amount of future returns and allowances
arising from receivables currently on the books:
DR Sales returns and allowances $$$
CR Allowance for sales returns and allowances $$$

RCJM: Chapter 8 © 2009 8-8


Accounts receivable:
Do existing receivables represent real
sales?

Reasons why receivables might


grow faster than sales:

• Change in credit policy. Sales

• Deteriorating credit worthiness Receivables


among existing customers.

• Firm has changed its financial


reporting policy – accelerated
revenue recognition. Time

RCJM: Chapter 8 © 2009 8-9


Accounts receivable:
Bausch & Lomb illustration

Receivables are growing


faster than sales

RCJM: Chapter 8 © 2009 8-10


Accounts receivable:
Bausch & Lomb’s changing DSO

DSO Receivables by Quarter


Days Sales Outstanding

RCJM: Chapter 8 © 2009 8-11


Accounts receivable:
Sunbeam Corporation illustration

18.7% sales growth


36.4% receivable growth

RCJM: Chapter 8 © 2009 8-12


Accounts receivable:
Clues available to the analyst
1. Receivable growth at Sunbeam greatly exceeded sales growth.

2. “Bill and hold” sales raise the possibility that some of this
disparity occurs because sales were booked too early—thus
generating receivables that won’t be collected quickly (if ever).

3. If Sunbeam had not sold about $59 million of receivables, the


receivable growth rate would have been much higher than
36.4%. This makes it even more likely that some “channel
stuffing” was occurring.

Overly aggressive
revenue recognition
on items “sold” to
dealers

RCJM: Chapter 8 © 2009 8-13


Imputed interest:
Non-interest bearing note
 Suppose Monson Corp. sells a machine to Davenport Products and
accepts a note for $50,000 due in three years. The note bears no
explicit interest.

 Suppose the cash selling price is $37,566…then the effective


borrowing rate must be 10%.

Interest
accumulates at
10% on the
unpaid balance

RCJM: Chapter 8 © 2009 8-14


Imputed interest:
Stated rate is below prevailing borrowing
rate
 Quinones Corp. sells a machine to Linda Manufacturing in exchange for a
$40,000, three-year, 2.5% note. At the time, the interest rate normally
charged to companies with Linda’s credit rating is 10%.
Stated rate Prevailing
rate
 What is the implied (cash) sales price of the machine?

RCJM: Chapter 8 © 2009 8-15


Imputed interest:
Calculating interest income for Quinones

RCJM: Chapter 8 © 2009 8-16


Accelerating cash collections:
Sale and collateralized borrowing
 There are two ways to accelerate cash collections:

 Companies might want to accelerate cash collection: (1) to avoid


processing and collection costs; (2) because of a cash flow imbalance
between supplier payments and receivable collections; or (3) to fund an
immediate cash need.

RCJM: Chapter 8 © 2009 8-17


Accelerating cash collections:
Discounted notes
 Suppose Abbott Manufacturing received a $9,000 six-month, 8% note
from Weaver, a customer. That same day, Abbott “discounted” the note
at Second State Bank:

 Abbott would make the following entry when the note is discounted:

DR Cash $8,789.40
DR Prepaid interest 201.60
CR Note receivable $9,000.00

RCJM: Chapter 8 © 2009 8-18


Accelerating cash collections:
Is it a sale or a borrowing?
 SFAS No. 140 provides
Sale of receivables:
guidance.
 Receivables removed Is control
from balance sheet surrendered?
 Gain or loss
recognized in income

Yes No

Borrowing against  Assets are beyond


receivables reach
 Buyer has right to
dispose
 Receivables stay on Sale Borrowing
 Seller has no obligation
balance sheet
to repurchase
 Loan shown as
balance sheet liability.
 No gain or loss  However, ambiguities abound.
recognized in income

RCJM: Chapter 8 © 2009 8-19


Accelerating cash collections:
A closer look at securitizations

 Bank forms a bundled portfolio of


7% home mortgage receivables
Receivables of “moderate” risk.
transferred
Bank in exchange Investor
for cash  A third-party investor is willing to
buy the portfolio at a price that
Mortgage yields a 6% return.
receivables

 Because the selling price at 6%


is higher than the carrying value
Customer
of the mortgages, the bank
records a gain.

 Both the bank and the investor


win in this transaction.

RCJM: Chapter 8 © 2009 8-20


Accelerating cash collections:
Special purpose entities
 Special purpose entities (SPEs) are
often part of the securitization.

 The SPE is a trust or corporation that


is legally distinct from the transferor
(e.g., bank).

 It protects investors who loaned


money.

 Under some circumstances, it also


allows the transferor to receive
favorable (off balance sheet)
treatment of the transaction.

RCJM: Chapter 8 © 2009 8-21


Accelerating cash collections:
SPEs and “off balance sheet” accounting

RCJM: Chapter 8 © 2009 8-22


Accelerating cash collections:
Doyle’s journal entries
 To remove the receivables transferred to the QSPE:

DR Cash $1,000,000
CR Mortgage receivable $1,000,000

Notice: No debt appears on Doyle’s books!

 If the transaction had been treated as a collateralized borrowing


(perhaps because the SPE was not a QSPE):
DR Cash $1,000,000
CR Loan Payable $1,000,000

RCJM: Chapter 8 © 2009 8-23


Accelerating cash collections:
Impact on Doyle’s balance sheet

As sale As borrowing

RCJM: Chapter 8 © 2009 8-24


Accelerating cash collections:
Impact on Doyle’s financial ratios

RCJM: Chapter 8 © 2009 8-25


Accelerating cash collections:
Cautions for financial statement readers
 When the transfer is with recourse, SFAS
No. 5 requires footnote disclosure of the
contingent liability.
Factoring
 But there is no similar unequivocal
disclosure requirement when receivables
are sold without recourse.
Assignment
 Even the cash flow statement may not
reveal that receivables were sold without
recourse.
Securitization
 When firms sell receivables, the balance
sheet will understate the true growth in
receivables during the period (because
some have been sold). That’s what
happened at Bausch & Lomb.

RCJM: Chapter 8 © 2009 8-26


Troubled debt restructuring
 When a customer is financially unable to make required interest
and principal payments, the lender can force the customer into
bankruptcy or restructure the loan receivable.

 The restructured loan can differ from the original loan in several
ways:
 Scheduled interest and principal payments may be reduced or
eliminated.
 The repayment schedule may be extended over a longer time period.
 The customer and lender can settle the loan for cash, other assets, or
equity interests.

 Restructured loans benefit both the customer and the lender.

RCJM: Chapter 8 © 2009 8-27


Troubled debt restructuring:
Disclosure illustration

1
2

 SFAS No. 15 says:

RCJM: Chapter 8 © 2009 8-28


Troubled debt restructuring:
Example
Assume that Harper Companies Purchased $75,000 of corn milling
equipment from Farmers State Cooperative on January 1, 2005. Harper
paid $25,000 cash and signed a five-year 10% installment note for the
remaining $50,000 of the purchase price. The note calls for annual
payments of $10,000 plus interest on December 31 of each year. Harper
made the first two installment payments on time but was unable to make
the third annual payment on December 31, 2007. After much negotiation,
Farmers State agreed to restructure the note receivable. At that time,
Harper owed $30,000 in unpaid principal plus $3,000 in accrued interest.
We will assume that the restructuring was agreed to on January 1, 2008,
and that both companies have already recorded interest up to that date.

RCJM: Chapter 8 © 2009 8-29


Troubled debt restructuring:
Settlement: the borrower
 Farmers state agrees to cancel the loan if Harper pays $5,000
cash and turns over the company car.

Does Harper benefit from the restructuring?

RCJM: Chapter 8 © 2009 8-30


Troubled debt restructuring:
Settlement: the lender
 Farmers state agrees to cancel the loan if Harper pays $5,000
cash and turns over the company car.

Does Farmers State benefit from the restructuring?

RCJM: Chapter 8 © 2009 8-31


Troubled debt restructuring:
Continuation with modification
 Farmers State agrees to postpone all principal and interest payments on
the note to maturity. Harper’s final payment would total $39,000.

Present value at
10% interest from
original note

RCJM: Chapter 8 © 2009 8-32


Troubled debt restructuring:
Continuation with modification
 Entries for the next two years:

RCJM: Chapter 8 © 2009 8-33


Troubled debt restructuring:
Another continuation with modification
 Farmers State waives all interest payments and defers all principal
payments so that Harper will only have to pay $30,000.

Present value at
10% interest

RCJM: Chapter 8 © 2009 8-34


Troubled debt restructuring:
Summary

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Troubled debt restructuring:
Evaluating the rules
 GAAP rules for troubled debt restructuring are subject to several
criticisms:

1. There is an obvious and uncomfortable lack of symmetry in the financial


reporting of the borrower and lender.

2. GAAP restructuring gains and losses sometimes differ from real economic
gains and losses.

3. GAAP’s use of the original loan’s effective interest rate can be questioned.

 The GAAP approach is a practical solution but it also fails to fully reflect
the economic reality.

RCJM: Chapter 8 © 2009 8-36


Summary
 GAAP requires that accounts receivable be shown at their net
realizable value (gross amount less estimated uncollectibles and
returns or allowances).

 Two methods are used to estimate uncollectibles: (1) the sales


revenue approach, and (2) the gross accounts receivables
approach. In either case, firms still must perform an “aging”.

 Analysts should scrutinize the allowance for uncollectibles


account balance over time.

 Receivable growth can exceed sales growth for several reasons,


including when aggressive revenue recognition practices are
being used.

RCJM: Chapter 8 © 2009 8-37


Summary continued
 It is sometimes necessary to “impute” the effective interest rate on
a note receivable.

 To accelerate cash collections, firms sometimes transfer or


dispose of their receivables. These transactions take the form of
factoring (a sale) or collateralized borrowing (a loan).

 SFAS No. 140 provides guidance for distinguishing between the


sale (control is surrendered) and borrowing (control is not
surrendered).

 Analysts should carefully examine receivable transfer


transactions.

RCJM: Chapter 8 © 2009 8-38


Summary concluded
 Lenders often restructure loans when the customer is unable to
make required payments.

 These troubled debt restructurings involve (a) settlement, or (b)


continuation with modification of debt terms.

 When terms are modified, the precise accounting treatment


depends on whether the sum of future cash flows from the
restructured note are above or below the original note’s carrying
value at the restructuring date.

 Remember, the interest rate used in accounting for troubled debt


restructurings may not reflect the real economic loss suffered by
the lender.

RCJM: Chapter 8 © 2009 8-39