1

Chapter 8: Receivables 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 evaluate whether or not receivables arose from real sales.

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Learning Objectives (contd.)

4. How to impute and record interest when notes receivable have either no implicit interest or unrealistic low interest rate.

5. How companies use receivables to accelerate cash inflows and how the accounting treatment affect the financial ratios.

6. Securitization and off-balance sheet financing.

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Receivables Current receivables--Collected within one

operating cycle or one year, whichever is longer. Trade receivables: amount owed by

customers for goods sold and services rendered as part of normal business operations, including Accounts receivable: receivables

arise from credit sales or performing services to customers on account.

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Receivables Trade Receivables (contd.):

Notes receivable: receivables arise when the seller extends long-term credit to the buyer, who then signs a note.

Nontrade Receivables: all others (i.e., interest receivable, advances to employees, deposits to cover potential damages, etc.)

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Accounts Receivable Accounts receivable are recorded at

face amount to be collected. Management must periodically assess

the allowance for uncollectibles. Management has to concern with:

Recognition - whenValuation – how Disposition –

collected/sell/write-offs

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Accounts Receivable : Recognition and Valuation

Recognition: Consistent with revenue recognition criteria.

Valuation: Follow conservatism GAAP requires that accounts receivable be

reported on the balance sheet at their net realizable value (NRV).

NRV is to estimate value of Accounts Receivables to be ultimately collected by the firm.

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Accounts receivable:Assessing NRV of Receivables Two amounts must be estimated to

determine the NRV 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.

NRV ofreceivables

Gross amount owned

Estimated uncollectibles

Estimated returns &

allowances= - -

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Uncollectible Accounts

Describe the accounting treatment of anticipated uncollectible accounts

receivable.

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Accounts Receivable:Why estimating uncollectibles is important? Most companies establish credit policies by

weighing the following: Expected cost (e.g. Customer collection and

billing costs plus potential bad debts) of credit sale. Benefit of increased sales.

The bad debts are often unavoidable. The matching principle requires that the estimate of uncollectible accounts be offset against current period sales--- Allowance Method

Today Some future datesTime

$10,000 current period sales

$500 is uncollectible

$500 estimated expense

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Uncollectible Accounts Receivable Bad debts: the uncollectible accounts

receivable. Methods to report receivables at the

NRV: Direct Write-off Allowance method: Bad debt expense

is recorded in the same accounting period in which the sales related to the uncollectible accounts were recorded.

This method is in compliance with the matching principle.

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If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the

use of an allowance account).

If uncollectible accounts are immaterial, bad debts are simply recorded as they occur (without the

use of an allowance account).

Direct Write-off Method

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Allowance Method

GENERAL JOURNAL Page 78

Date DescriptionPost. Ref. Debit Credit

Dec. 31 Bad Debt Expense ####

Allowance for Uncollectible ####

Accounts

Normally classified asa selling expense and

closed at year-end.Contra asset account toAccounts Receivable.

Allowance Method: Most businesses record an estimate of the bad debt expense by an adjusting

entry at the end of the accounting period.

Allowance Method: Most businesses record an estimate of the bad debt expense by an adjusting

entry at the end of the accounting period.

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Allowance for Uncollectible Accounts

Net realizable value is the amount of the accounts receivable that the business

expects to collect.

Accounts Receivable

Less: Allowance for Uncollectible Accounts

Less: Returns and allowances

Net Realizable Value

Accounts Receivable

Less: Allowance for Uncollectible Accounts

Less: Returns and allowances

Net Realizable Value

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Uncollectible Accounts

Allowance Method:

Describe the two approaches to estimating bad debts

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Two Approaches to Estimate Bad DebtsAllowance Method: Sales Revenues Approach (Percentage of Sales

Method):

Gross Receivables Approach Composite Rate (Percentage of Receivables):

Aging of Receivables

Allowance Method: Sales Revenues Approach (Percentage of Sales

Method):

Gross Receivables Approach Composite Rate (Percentage of Receivables):

Aging of Receivables

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Sales Revenues Approach

Focuses on past credit sales to make estimate of bad debt expense.

Emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales.

Focuses on past credit sales to make estimate of bad debt expense.

Emphasizes the matching principle by estimating the bad debt expense associated with the current period’s credit sales.

Bad debts expense iscomputed as follows:

Bad debts expense iscomputed as follows:

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MusicLand computes estimated Bad Debts Expense of $2,400.

Sales Revenues ApproachIn 2006, MusicLand has credit sales of $400,000 and estimates that 0.6% of credit sales are uncollectible.

What is Bad Debts Expense for 2006?

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Gross Receivables Approach Focuses on the collectability of accounts

receivable to make the estimate of uncollectible accounts.

Involves the direct computation of the desired balance in the allowance for uncollectible accounts.

Two Estimation methods: 1. Composite Rate 2. Aging Receivable

Focuses on the collectability of accounts receivable to make the estimate of uncollectible accounts.

Involves the direct computation of the desired balance in the allowance for uncollectible accounts.

Two Estimation methods: 1. Composite Rate 2. Aging Receivable

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Gross Receivables Approach 1. Composite Rate method: Desired balance in allowance for uncollectible accounts = year-end accounts receivable balance x bad debt expense %

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Desired balance in Allowancefor Uncollectible Accounts

Gross Receivables Approach : Composite RateOn Dec. 31, 2006, MusicLand has $50,000 in Accounts Receivable and a $200 credit balance in Allowance for Uncollectible Accounts. Past experience suggests that 5% of receivables are uncollectible. What is MusicLand’s Bad Debts Expense for 2006?

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Now, let’s look at the accounts receivable

aging approach!

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Gross receivable approach: Estimated the uncollectibles by using Aging Schedule of Accounts Receivable An aging of receivables is simply a

determination of how long each receivable has been on the books.

Receivables that are long past due often because customers are experiencing financial difficulties and may ultimately become uncollectible.

The aging schedule generates the desire ending balance of “ Allowances for doubtful accounts ”.

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Aging Schedule of Accounts Receivable :Is the allowance for uncollectibles adequate?

Current31-90 days

old91-180

days oldOver 180 days old Total

Amount $1,450,000 $125,000 $15,000 $10,000 $1,600,000Estimated % of bad debt losses 2.50% 6% 20% 40%Allowance for uncollectibles $36,250 $7,500 $3,000 $4,000 $50,750

DR Bad debts expense $11,750

CR Allowance for uncollectibles $11,750

• The Allowance for uncollectible accounts has a balance of $39,000prior to the adjustments.• The allowance account needs to increase by $11,750.This is the difference between the desired balance ,$50,750, and the existing balance $39,000.

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Accounts receivable disposition:Writing off bad debts Some time later, Bristol determines that a

$750 receivable from Ralph Company cannot be collected.

Note that no bad debt expense is recorded at this time because the estimated expense was previously recorded (matching principle).

Allowance for uncollectibles $750

Accounts receivable – Ralph Company $750

So what happens if someone pays after a write-off of the accounts receivable?

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GENERAL JOURNAL Page 69

Date DescriptionPost. Ref. Debit Credit

Accounts Receivable ####

Allowance for Uncollectible Accounts ####

Cash ####

Accounts Receivable ####

Collection of PreviouslyWritten-Off Accounts

When a customer makes a payment after an account has been written off, two

journal entries are required.

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Accounts receivable:Understanding receivable disclosures

Scotts was taking a more conservative view of receivable collections in 2001.What impact did this conservative view have on the 2001 pre-tax earnings?

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Sales Returns and Allowances

Describe the accounting treatment for merchandise returns

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Sales Returns

Merchandise returned by a customer to a

supplier.

Sales Allowances

A reduction in the cost of defective

merchandise.

Sales Returns and Allowances

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Sales Returns & Allowances (FASB 48)

A. The amount of sales R&A is not significant

Direct method

B. The amount of sales R&A is significant and six conditions are not met:

Postpone the revenue recognition until all six conditions are met or the return period expired.

3030

Sales Returns & Allowances (FASB 48)

C.The amount of sales R&A is significant and six conditions are met:

Allowance method.

3131

Six Conditions (SFAS No. 48)1. Sales price is determinable or fixed;2. Buyers have paid or have the obligation to pay

the sales price;3. The buyer’s obligation would not be changed

due to theft or damage of the product after purchase;

4. Sellers are not responsible for the performance of the product;

5. Buyers and sellers are two separate economic entities;

6. The amount of returns can be estimated.

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The Amount of Sales Returns & Allowances Is Significant and Six Conditions Are Met

Sales can be recognized in the period in which the sales are made.

Also, at the end of the same period, the amount of sales returns would be estimated and recognized.

10/5/2006 A/R 10,000Sales10,000

12/31/2006 Sales R&A 1,000(Adj. entry) Allow. for sale R& A 1,000

(estimate 10% returns)

1/10/2007 Allowance for sales R&A 900A/R 900

Inventory XXX Cost of Goods Sold XXX

Sales returns occurred

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Learning Objective

Do existing receivables represent real sales?

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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.

Receivables

Sales

Time

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Do existing receivables represent real sales? (contd.)

Large increases in receivables relative to sales represent a danger signal.

Revenue recognition irregularities are often connected to the disparity of the growth rates of receivables and sales.

Sales of receivables can conceal the real increase of receivables.

Accounts receivable:Bausch & Lomb illustration

Receivables are growing faster than sales

8-36

Accounts receivable:Bausch & Lomb’s changing DSO

DSO Receivables by Quarter

Days Sales Outstanding

8-37

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Notes to the Case of Bausch & Lomb In the 4th quarter of 1993, the company shifted

responsibility for the sale and distribution of a portion of the US contact lens business to optical distributors.

Thus, revenue was recognize upon the shipment of lenses to these distributors rather than waiting until lenses were sold to final consumers.

The top-down pressure to achieve sales and profit goals caused the company to loose its credit policy (i.e., extend the payment period) and pressured the distributors to take unwanted goods. This practice lasted from Q4 of 1992 to early 1994.

Accounts receivable:Sunbeam Corporation illustration

18.7% sales growth

36.4% receivable growth

2

1

8-39

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Accounts receivable:Clues available to the analyst1. Receivable growth at Sunbeam greatly

exceeded sales growth (a disparity in growth rates of sales and receivables).

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).

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Accounts receivable:Clues available to the analyst3. Had Sunbeam not sold about $59 million

of receivables, the receivable growth rate would have been much higher than 36.4% in 1997.

4. This makes it even more likely that some “channel stuffing” was occurring.

* Channel stuffing ( Trade loading): a business practice where a company inflates its sales by forcing more products through a distribution channel than the channel is capable of selling .

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Learning Objective

Derive and record the impute interests of notes receivable when the notes receivable

either carry no interest or lower interest than the market rate

Cash and Receivables 43

Notes Receivable Short–term notes receivable: Reported at

the net realizable value (i.e., the face minus the allowance for uncolletibles)

Long-term notes receivable: Initial Recording Net present value.

End of Period: Net present value.

Companies can also choose the fair value option for the reporting of the long-term notes receivable.

Imputed interest: Non-interest bearing note Suppose Monson Corp. sells a machine to Davenport Products

and accepts a note for $5 million due in three years. The note bears no explicit interest.

Suppose the cash selling price is $3,756,600…then the effective borrowing rate must be 10%.

Interest accumulates at 10% on the unpaid balance

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Journal Entries for Monson’s Case

At the sale of the equipment:

Note Receivable 5,000,000

At Sale:

Note Receivable 4,000,000

Sales Revenue Discount on N/R

3,756,600 1,243,400

At the end of each year:

Year 1: Cash Discount on N/R

375,660 375,660

Year 2: Cash Discount on N/R

413,226 413,226

Year 3: Cash Discount on N/R

454,514 454,514

Imputed interest: Stated rate is below prevailing borrowing rate

Quinones Corp. sells a machine to Linda Manufacturing in exchange for a $4 million, 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?

Stated rate Prevailing rate

8-46

Imputed interest:Calculating interest income for Quinones

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Journal Entries for Quinones Corp (see Exhibit 8.7)

At Sale:

Note Receivable

4,000,000

Sale Revenue Discount on N/R

3,253,966 746,034

At the end of each Year:Year 1:

Cash 100,000 Discount on N/R 225,397

Interest Revenue

325,397

Year 2:

Cash 100,000 Discount on N/R 247,936

Interest Revenue

347,936

Year 1:

Cash 100,000 Discount on N/R 272,701

Interest Revenue

372,701

Cash and Receivables 49

Additional Examples on

Long-Term N/R

Example A Receiving a 2-year note on sales of goods on

1/1/x1. The face amount of this note is $100,000 and the annual interest of the note is 10%. The interests are paid annually and the market interest rate (i.e., the imputed interest)is 12%. Present value of the note:

$100,000 0.79719 + 10,000 1.69005

=96,620

Cash and Receivables 50

Long-Term N/R

Example A (contd.)1/1/x1

Notes Receivable 100,000

Sales Revenue 96,620

Discounts on N/R 3,380

Effective Interest of 20x1

= PV of note on 1/1/x1 12%

= ($100,000 - 3,380) 12%

= 11,594.4

Cash and Receivables 51

Long-Term N/R

Example A (contd.)12/31/x1 (recording receiving of $10,000 interest)Cash 10,000 Discount on N/R 1,594.4

Interest Revenue 11,594.4

P.V. of the note on 1/1/x2 = 100,000 - (3,380 - 1594.4) = 98,214.4

Effective Interest of 20x2 = PV on 1/1/x2 12% = 98,214.4 12% = 11,785.7

Cash and Receivables 52

Long-Term N/R

Example A (contd.)12/31/x2 (recording int. received on 12/31/x2):Cash 10,000 Discount on N/R 1,785.7

Int. Revenue 11,785.7

12/31/x1 (recording face amount of N/R received on maturity date):

Cash 100,000 N/R 100,000

Discount on N/R has been amortized to zero after two years of amortization using the effective interest method.

Cash and Receivables 53

Long-Term N/R

Example B (see E8-5 and E8-7)

On 12/31/x1 La Tourette Inc. rendered services to Husky Corp. at an agreed price of $73,844.10, accepting $18,000 down and agreeing to accept the balance in four equal installments of $18,000 receivable each 12/31. An assumed interest rate of 11% is imputed. Record the journal entries for La Tourette for the sale and for the receipts and interest on the following dates:

1. 12/31/20x1 2. 12/31/20x2

3. 12/31/20x3 4. 12/31/20x4

5. 12/31/20x5

Cash and Receivables 54

Long-Term N/R

Example B (contd.) PV of $18,000 annuity @11%, four payments = 18,000 3.10245 = 55,844.10

Thus, the revenue from the services = 18,000 + 55,844.10 = 73,844.10

12/31/x1

Cash 18,000

Notes Receivable 72,000Discount on N/R 16,155.9a

Revenue from Services 73,844.10

a. (18,000 4) - 55,844.10 = 16,155.9

Cash and Receivables 55

Long-Term N/R

Example B (contd.)12/31/x2 (recording install. Payment of $18,000 and the amortization of discount on N/R):

Cash 18,000

N/R 18,000

Discount on N/R 6,142.85

Interest Revenue 6,142.85a

a. Interest Revenue of 20x2 = pv of note on 1/1/x2 (or 12/31/x1) 11% = 55,844.1 11% = 6,142.85

Cash and Receivables 56

Long-Term N/R

Example B (contd.)12/31/x3

Cash 18,000 N/R 18,000

Discount on N/R 4,838.56Interest Revenue 4,838.56a

a. Interest Revenue of 20x3 = PV of the note on 1/1/x3 11% = (55,844.1 - 18,000 + 6,142.85) 11% = 43,986.95 11% = 4,838.56

Cash and Receivables 57

Long-Term N/R

Example B (contd.)12/31/x4 (recording install. Payment of 18,000 and the amortization of discount on N/R):

Cash 18,000

N/R 18,000

Discount on N/R 3,390.81

Interest Revenue 3,390.81a

a. Interest Revenue of 20x4= PV of the note on 1/1/x4 11% = (43,986.95 - 18,000 + 4,836.56) 11% = 30,825.51 11% = 3,390.81

Cash and Receivables 58

Long-Term N/R

Example B (contd.)12/31/x5

Cash 18,000

N/R 18,000

Discount on N/R 1,783.68

Interest Revenue 1,783.68a

a. Interest Revenue of 20x5 = pv of note on 1/1/x5 11% = (30,825.51 - 18,000 + 3,390.81) 11% = 16,216.31 11% = 1,783.68

The Fair Value Option: Bristol Corporation (Also see Exhibit 8.8 for an example of the fair value option applies to a long-term note receivable )

Recall that Bristol Corporation reports a net realizable value of $1,455,000 (gross receivables of $1,500,000 minus allowance for uncollectibles of $45,000).

Assume that there is an active market for these types of receivables and that the price is 95% of face value, or $1,425,000. To adjust the receivable’s carrying value to fair value, the difference between the fair value and the face amount of the receivable is recognized as an unrealized loss on the income statement as follows:

An asset valuation account that is adjusted upward or downward as fair values change

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Financing With Receivables

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Accelerating cash collections/ Financing With Receivables Companies might want to accelerate cash

collection of receivables for these reasons:

(1) to avoid processing and collection costs;

(2) because of a cash flow imbalance; between supplier payments and receivable collections;

(3) to provide product financing in order to be competitive.

(4) to fund an immediate cash need.

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Accelerating cash collections on Notes receivable in this way is called discounting: 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 $8,789.40DR Prepaid interest 201.60 CR Note receivable 9,000

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Accelerating cash collections/Financing with accounts receivables: Sale and collateralized borrowing There are two ways to accelerate cash collections:

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Secured Borrowing (i.e., assigning or Pledging of accounts receivable): The owner of the receivable borrows cash from banks by writing a promissory note using the receivable as collateral.

Companies will pledge of assign receivables for borrowing when other ways of borrowing are not possible or too expensive.

Financing With Receivables

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Accelerating cash collections: Secured borrowing using receivables as collateral (i,.e.,Pledge) 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:

DR Cash $76,800 DR Prepaid interest 3,200 CR Loan Payable – Leslie Financing $80,000Note: $80,000 of accounts receivable were pledged for this loan.

DR Loan Payable –Leslie Financing $80,000 CR Cash $80,000 DR Interest expense $3,200 CR Prepaid interest $3,200

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Factor (Sell) of accounts receivables: accounts receivable holders sell receivables to finance companies or banks for cash. The banks charge a fee (i.e., service charge) and collect the receivables directly from customers.

Factor of receivables may be without recourse (no footnote disclosures required) or with recourse.

Financing With Receivables: Sale of Accounts Receivable

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Sale of Accounts Receivable :Without recourse

Without recourse (always treated as a sale): An ordinary sale of receivables to the

factor. Factor assumes all risk of uncollectibility. Control of receivable passes to the factor. Receivables are removed from the books,

cash is received and a financing expense or loss is recognized.

Without recourse (always treated as a sale): An ordinary sale of receivables to the

factor. Factor assumes all risk of uncollectibility. Control of receivable passes to the factor. Receivables are removed from the books,

cash is received and a financing expense or loss is recognized.

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Accelerating cash collections: Sale of receivable (factoring) without recourse Sale of Accounts receivable without

recourse – the buyer is responsible for the bad debts. In this case we are selling an asset

(treated as a sale). Any difference between what we are

giving up and what we are getting is a gain or loss.

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Accelerating cash collections:Sale of receivable (factoring) without recourse Hervey Corp. sells $80,000 of its customer

receivables to Leslie Financing (the factor) for $76,000. The entry to record the without recourse sale on Hervey’s books is:

DR Cash 76,000DR Interest expense (loss) 4,000 CR Accounts receivable 80,000

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Ambiguities Abound : Is it a sale or a borrowing when factoring accounts receivable with recourse?

When sale of Accounts receivable with recourse, the seller is responsible for the bad debts (i.e., the transferor (seller) retains the risk of uncollectibility).

In this case: Is the firm selling an asset or borrowing?

Answer: If it meets the SFAS No.140 criteria, it

can be treated as sales of assets.

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Treat as a sale if all of these conditions are met (SFAS 140):

Receivables are isolated from transferor. Transferee has right to pledge or exchange

receivables. Transferor does not have effective control over

the receivables. Transferor cannot repurchase

receivable before maturity. Transferor cannot require return

of specific receivables.

Treat as a sale if all of these conditions are met (SFAS 140):

Receivables are isolated from transferor. Transferee has right to pledge or exchange

receivables. Transferor does not have effective control over

the receivables. Transferor cannot repurchase

receivable before maturity. Transferor cannot require return

of specific receivables.

Sale of Accounts Receivable with Recourse

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With recourse Must meet the three conditions of determining

surrender of control to be recognized as a sale. If the transaction fails to meet the three

conditions necessary to be classified asa sale, it will be treated as asecured borrowing.

With recourse Must meet the three conditions of determining

surrender of control to be recognized as a sale. If the transaction fails to meet the three

conditions necessary to be classified asa sale, it will be treated as asecured borrowing.

Sale of Accounts Receivable with Recourse (contd.)

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Accelerating cash collections:Sale of receivable (factoring) with recourse Hervey Corp. sells $80,000 of its customer receivables to Leslie Financing

(the factor) for $71,800. Leslie’s fee is reduced to 4% with a recourse transaction. Suppose Leslie also withholds 5,000 to cover possible non-collections. The entry to record the sale of receivables with recourse is:

DR Cash $71,800DR loss 3,200DR Due from Leslie Financing 5,000 CR Accounts receivable 80,000

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Accelerating cash collections:Sale of receivable (factoring) with recourse If only $3,750 of receivables are uncollectible by Leslie,

Hervey’s final entry is:

DR Cash 1,250

DR Allowance for uncollectibles 3,750

CR Due from Leslie Financing 5,000

Accelerating cash collections:Is it a sale or a borrowing? The FASB has provided guidelines in

the Accounting Standards Codification

However, ambiguities abound.

Sale of receivables:

Is controlsurrendered?

Receivables removed from balance sheet

Gain or loss recognized in income

Borrowing againstreceivables

Receivables stay on balance sheet

Loan shown as balance sheet liability.

No gain or loss recognized in income

Sale Borrowing

Assets are beyond reach

Buyer has right to dispose

Seller has no obligation to repurchase

Yes No

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Securitizations

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Reasons to Finance with Accounts Receivable

Securitizations are popular for two reasons:

1. Investors have a strong appetite for acquiring collateralized securities.

2.Firms with large amounts of receivables have incentives to engage in securitizations. e incentives to engage in securitizations

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Securitization

A sale of securities (i.e., bonds or commercial paper) backed (collateralized ) by a pool of receivables or loans.

These receivables or loans can be mortgage receivables (i.e., mortgage-backed securities), consumer debts (i.e., assets-backed securities), and corporate bonds (i.e., collateralized debt obligations).

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Securitization (contd.)

When a company uses its receivables (i.e., auto loan receivables) as collaterals to issue bonds (i.e., asset-backed securities), the receivables will remain on its balance sheet and its liability will be increased from the increase of the bonds payable.

As a result, this transaction will have an adverse effect on its return on assets and debt/equity ratios.

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Securitization and Off Balance Sheet Financing A special purpose entity (SPE) is created by a

third party which is independent of the company (referred to as the transferor) with receivables.

The SPE serves the purpose of buying receivables from the transferor and issuing securities (i.e., commercial papers) collateralized on the receivables transferred from the transferor.

The SPE is legally distinct from the transferor and can be in the form of a trust, partnership or corporation.

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Procedures of Securitization

The transferor will first transfer its receivables to the SPE.

The SPE issues securities using these receivables as collaterals.

The cash received by the SPE from issuing securities will go back to the transferor to pay off the receivables transferred.

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Procedures of Securitization (contd.)

The SPE is served as a “pass through”. The transferor can continue to service the

loan for a fee.

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Qualifying SPE If the SPE is a qualified SPE (i.e., with at

least 10% of capital invested by the third party who created the SPE), the transferor does not have to consolidate the balance sheet of the SPE.

As a result, both the receivables and the liabilities from issuing securities will appear only on the balance sheet of the SPE, not the transferor.

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Pre-Codification SFAS 166 and SFAS 167 The concept of qualifying SPE is

eliminated by pre-codification SFAS No.166 issued in June 2009, and became effective as of the beginning of the first annual reporting period beginning after Nov. 2009 (i.e., January 2010).

SFAS 167 redefine variable interest entity and the assessment method in determining the primary beneficiary.

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SFAS 166 and SFAS 167 (Contd.) Thus, more SPEs are subject to

consolidation by the sponsors or the transferors under these new rules.

Fannie Mae reported an increase of its assets from $869.1 billion to $3,246.2 billion, and its liabilities increased from $884.4 billion to $3,258.2 billion (source: RCJM textbook, p448) after the adoption of the new accounting rules at the beginning of 2010..

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Additional Notes on Securitization

In order to market the asset-backed bonds, It is common that the SPE is rated by bond rating agencies and the bonds issued by the SPE is guaranteed by an independent third party.

When the balance sheet of the SPE is not consolidated with the balance sheet of the sponsor, the transferor benefits from obtaining financing without reporting the liabilities (i.e., bonds payable).

The transferor, therefore, has an off-balance sheet financing.

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Benefits of SPE

1. To protect the investors of asset-backed securities issued by a SPE:

Even the transferor were to declare bankruptcy, the collaterals underlying the asset-backed securities are safe from seizure by the creditors of the transferor.

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Benefits of SPE (contd.)

2. The transferor can receive favorable financial reporting for the transaction.

Without the SPE, the transferor would issue the debt securities directly to investors.

This would constitute a collateralized borrowing, and therefore, receivables and liabilities would both be reported on the balance sheet of the transferor.

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Benefits of SPE (contd.)

3. With SPE, the reduction in credit risk decreases the cost of capital of the transferor’s.

4. When SPE receives a better bond rating (i.e., AAA) from a bond rating agency than its sponsor (i.e., BBB), the securities issued by the SPE will have a lower effective interest rate than the securities issued by the transferor.

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A Closer look at Securitizations Prior to November 15, 2009, most structures were designed to

meet the definition of a qualifying special purpose entity (QSPE).

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A Closer look at Securitizations:

Notice: No debt appears on Doyle’s books!

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Accelerating cash collections:Impact on Doyle’s financial ratios

Effect on Accounts receivable turnover :• The measure for the average duration of an account receivable. • A/R turnover= Credit sales/ Account receivable.• The ratio will show there is an improvement, but it cannot be sustained indefinitely.

30% Increase

27% reduction

Securitization removesthe mortgage assets from the B/S and does not put a loan payable on the B/S.

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Securitization and the 2008 Financial Crisis (souce: RCJM textbook)

Subprime lending increased substantially from 2004 to 2007 due to:

1. Originators had incentives to make as many loans as possible since they can sell the loans (either to other financial institution such as Fannie Mae or SPE). Therefore, they do not care about the credit risk associated with the lending. Many of the mortgage applications contained frauds (Fitch Ratings).

2. The originators and rating agencies underestimated the risks associated with their guarantees and securitizers shopped for high ratings.

3. .

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Securitization and the 2008 Financial Crisis (souce: RCJM textbook)

3. When the borrower began to default, some of the complex legal issues and structures related to the securitization prevented the SPE to modify loans for borrowers.

4. As the defaults began, it was clear that the originators and guarantors had more loss exposure than was disclosed in their financial statements.

5. The investors over-relied on the ratings for investment decisions.

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Accelerating cash collections:Cautions for financial statement readers

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.

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.

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Summary GAAP requires that accounts receivable be

shown at their net realizable value . Two methods are used to estimate

uncollectibles: (1) the percentage of sales approach, and (2) the percentage of account receivable approach.

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.

Summary continued It is sometimes necessary to “impute” the

effective interest rate on a note receivable. Firms may elect the fair value option for

accounts and notes payable. Changes in fair value are recognized in net income.

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).

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Summary continued ASC Topic 860 Transfers and Servicing of the

FASB Accounting Standards Codification provides guidance for distinguishing between the sale (control is surrendered) and borrowing (control is not surrendered).

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.

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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.

Both the FASB and the IASB have projects on financial instruments and derecognition.

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