Receivables

1. Receivables Revsine/Collins/Johnson: Chapter 8

2. Learning objectives • The methods used to estimate uncollectible accounts and the net realizable value of accounts receivable. • How firms estimate and record sales returns and allowances. • How to spot whether or not reported receivables arose from real sales. • How and why interest is recorded on “non-interest bearing” notes. • 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. • Why lenders “restructure” receivables when the borrower becomes financially distressed, and how to account for the restructuring.

3. 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: • Uncollectibles—the amount that will not be collected because customers are unable to pay. • Returns and allowances—the amount that will not be collected because customers return the merchandise or are allowed a reduction in the amount owed. NRV of receivables Gross amount owned Estimated uncollectibles Estimated returns & allowances - - =

4. 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. • 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. Customer collection and billing costs plus potential bad debts Some future dates Today Time $10,000 current period sales $500 is uncollectible $500 estimated expense

5. 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: Accounts receivable:Accounting for estimated uncollectibles • Bristol Corporation estimates that bad debt losses arising from first quarter 2005 sales are expected to be $30,000. DRBad debt expense $30,000 CR Allowance for uncollectibles $30,000 A contra-assets account subtracted from gross accounts receivable

6. Accounts receivable:Sales approach for estimating uncollectibles Management’s estimate is that 1% of current period sales will ultimately be uncollectible

7. Accounts receivable:Gross receivable approach Notice this second step Management believes that 3% of existing gross receivables will ultimately be uncollectible

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

9. Accounts receivable:Is the allowance for uncollectibles adequate? 1 2 3 4 5

10. Accounts receivable:Understanding receivable disclosures

11. A contra-revenue account Accounts receivable:Estimating sales returns and allowances • Bristol agrees to reduce by $8,000 the price of goods that arrived damaged at Bath Company: • 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: DRSales returns and allowances $8,000 CR Accounts receivable –Bath Company $8,000 DRSales returns and allowances $$$ CR Allowance for sales returns and allowances $$$

12. Sales Receivables Time Accounts receivable:Do existing receivables represent real sales? • Reasons why receivables might grow faster than sales: • Change in credit policy. • Deteriorating credit worthiness among existing customers. • Firm has changed its financial reporting policy – accelerated revenue recognition.

13. Accounts receivable:Bausch & Lomb illustration Receivables are growing faster than sales

14. Accounts receivable:Bausch & Lomb’s changing DSO DSO Receivables by Quarter Days Sales Outstanding

15. Accounts receivable:Sunbeam Corporation illustration 18.7% sales growth 36.4% receivable growth 1 2

16. Accounts receivable:Clues available to the analyst • Receivable growth at Sunbeam greatly exceeded sales growth. • “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). • 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

17. Michele’s entries each quarter for interest: DRAccrual interest receivable $1,250 CR Interest income $1,250 (To accrue three months’ interest=[$50,000 x .10]/4) DR Cash $1,250 CR Accrual interest receivable$1,250 (To record the receipt of interest payment) Imputed interest:Accounting for interest bearing notes • Suppose Michele Corp. sells a $50,000 (cash price) machine to Texas Products and accepts a three-year note with interest of 10% per year. Interest is to be paid quarterly. • Michele’s entry at the time of sale: DRNote receivable –Texas Product Company $50,000 CR Sales revenue $50,000

18. 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

19. Over the next three years, the note receivable is increased and interest income is recognized. Here is the entry for year 1: DRNote receivable –Davenport $3,756.60 CR Interest income $3,756.60 • When the customer makes the required $50,000 payment, Monson records: DRCash $50,000.00 CR Note receivable –Davenport $50,000.00 Imputed interest:Accounting for non-interest bearing notes • Because the cash selling price is $37,566, Monson’s entry at the time of sale is: DRNote receivable –Davenport $37,566.00 CR Sales revenue $37,566.00

20. 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%. • What is the implied (cash) sales price of the machine? Prevailing rate Stated rate

21. Imputed interest:Calculating interest income for Quinones

22. Imputed interest:Note receivable carrying value Note principal at maturity Implied cash sales price

23. Interest income and the cash interest payment for Year 1: DRNote receivable –Linda Mfg. $2,253.97 DR Cash 1,000.00 CR Interest income $3,253.97 • When the final payment of note principal is received in Year 3: DR Cash $40,000.00 CR Note receivable –Linda Mfg. $40,000.00 Imputed interest:Quinones’ journal entries • At the time of sale: DRNote receivable –Linda Mfg. $32,539.66 CR Sales revenue $32,539.66

24. 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.

25. Suppose Leslie also withholds 4% (or $5,000) to cover possible noncollections. The entry to record the sale of receivables with recourse is: DRCash $71,800 DR Interest expense 3,200 DR Due from Leslie Financing 5,000 CR Accounts receivable $80,000 • If all but $3,750 of receivables are collected by Leslie, Hervey’s final entry is: DRCash $1,250 DR Allowance for uncollectibles 3,750 CR Due from Leslie Financing $5,000 Accelerating cash collections:Sale of receivable (factoring) • Hervey Corp. sells $80,000 of its customer receivables to Leslie Financing (the factor) for $76,000. The entry to record the no recourse sale on Hervey’s books is: DR Cash $76,000 DR Interest expense 4,000 CR Accounts receivable $80,000

26. Accelerating cash collections:Borrowing using receivables as collateral • Suppose instead Hervey uses the $80,000 of customer receivables as collateral for a loan. The entry to record the collateralized loan on Hervey’s books is: • Once the loan is due (in one year), Hervey would make these entries: DRCash $76,800 DR Prepaid interest 3,200 CR Note receivable $80,000 DRLoan Payable –Leslie Financing $80,000 CR Cash $80,000 DR Interest expense $3,200 CR Prepaid interest $3,200

27. 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: DRCash $8,789.40 DR Prepaid interest 201.60 CR Note receivable $9,000.00

28. Accelerating cash collections:Is it a sale or a borrowing? • SFAS No. 140 provides guidance. • However, ambiguities abound. Sale of receivables: • Receivables removed from balance sheet • Gain or loss recognized in income Is control surrendered? Yes No Borrowing against receivables • Assets are beyond reach • Buyer has right to dispose • Seller has no obligation to repurchase Sale Borrowing • Receivables stay on balance sheet • Loan shown as balance sheet liability. • No gain or loss recognized in income

29. Accelerating cash collections:A closer look at securitizations • Bank forms a bundled portfolio of 7% home mortgage receivables of “moderate” risk. • A third-party investor is willing to buy the portfolio at a price that yields a 6% return. • Because the selling price at 6% is higher than the carrying value of the mortgages, the bank records a gain. • Both the bank and the investor win in this transaction. Receivables transferred Bank Investor in exchange for cash Mortgage receivables Customer

30. 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.

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

32. If the transaction had been treated as a collateralized borrowing (perhaps because the SPE was not a QSPE): DRCash $1,000,000 CR Loan Payable $1,000,000 Accelerating cash collections:Doyle’s journal entries • To remove the receivables transferred to the QSPE: DRCash $1,000,000 CR Mortgage receivable $1,000,000 Notice: No debt appears on Doyle’s books!

33. Accelerating cash collections:Impact on Doyle’s balance sheet As borrowing As sale

34. Accelerating cash collections:Impact on Doyle’s financial ratios

35. Accelerating cash collections:Cautions for financial statement readers • When the transfer is with recourse, SFAS No. 5 requires footnote disclosure of the contingent liability. • But there is no similar unequivocal disclosure requirement when receivables are sold without recourse. • Even the cash flow statement may not reveal that receivables were sold without recourse. • 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. Factoring Assignment Securitization

36. 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.

37. Troubled debt restructuring:Disclosure illustration • SFAS No. 15 says: 1 2 3

38. Troubled debt restructuring:Example

39. 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?

40. 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?

41. 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

42. Troubled debt restructuring:Continuation with modification • Entries for the next two years:

43. Troubled debt restructuring:Continuation with modification • Entries at maturity:

44. 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

45. Troubled debt restructuring:Another continuation with modification • Entries for the next two years:

46. Troubled debt restructuring:Summary

47. Troubled debt restructuring:Evaluating the rules • GAAP rules for troubled debt restructuring are subject to several criticisms: • There is an obvious and uncomfortable lack of symmetry in the financial reporting of the borrower and lender. • GAAP restructuring gains and losses sometimes differ from real economic gains and losses. • 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.

48. Summary • GAAP requires that accounts receivable be shown at their netrealizable 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.

49. 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.

50. 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.