Receivables
Revsine/Collins/Johnson: Chapter 8
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.
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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.
NRV of
receivables
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=
Gross
amount
owned
-
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Estimated
uncollectibles
-
Estimated
returns &
allowances
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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
period sales
$500 is
uncollectible
$500 estimated
expense
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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.
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:
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Accounts receivable:
Sales approach for estimating uncollectibles
Management’s estimate is
that 1% of current period
sales will ultimately be
uncollectible
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Accounts receivable:
Gross receivable approach
Notice this
second step
Management believes that
3% of existing gross
receivables will ultimately be
uncollectible
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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
CR Accounts receivable – Ralph Company
$750
$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.
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Accounts receivable:
Is the allowance for uncollectibles adequate?
1
2
3
4
5
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Accounts receivable:
Understanding receivable disclosures
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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
$$$
CR Allowance for sales returns and allowances
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$$$
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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.
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Sales
Receivables
Time
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Accounts receivable:
Bausch & Lomb illustration
Receivables are growing
faster than sales
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Accounts receivable:
Bausch & Lomb’s changing DSO
DSO Receivables by Quarter
Days Sales Outstanding
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Accounts receivable:
Sunbeam Corporation illustration
18.7% sales growth
36.4% receivable growth
1
2
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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
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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:
DR Note receivable –Texas Product Company
$50,000
CR Sales revenue
$50,000
 Michele’s entries each quarter for interest:
DR Accrual interest receivable
$1,250
CR Interest income
(To accrue three months’ interest=[$50,000 x .10]/4)
DR Cash
CR Accrual interest receivable
(To record the receipt of interest payment)
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$1,250
$1,250
$1,250
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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
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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:
DR Note receivable –Davenport
$37,566.00
CR Sales revenue
$37,566.00
 Over the next three years, the note receivable is increased and
interest income is recognized. Here is the entry for year 1:
DR Note receivable –Davenport
$3,756.60
CR Interest income
$3,756.60
 When the customer makes the required $50,000 payment,
Monson records:
DR Cash
$50,000.00
CR Note receivable –Davenport
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$50,000.00
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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
 What is the implied (cash) sales price of the machine?
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Prevailing
rate
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Imputed interest:
Calculating interest income for Quinones
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Imputed interest:
Note receivable carrying value
Note principal
at maturity
Implied cash
sales price
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Imputed interest:
Quinones’ journal entries
 At the time of sale:
DR Note receivable –Linda Mfg.
$32,539.66
CR Sales revenue
$32,539.66
 Interest income and the cash interest payment for Year 1:
DR Note 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.
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$40,000.00
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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.
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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
DR Interest expense
CR Accounts receivable
$76,000
4,000
$80,000
 Suppose Leslie also withholds 4% (or $5,000) to cover possible
noncollections. The entry to record the sale of receivables with recourse
is:
DR Cash
DR Interest expense
DR Due from Leslie Financing
CR Accounts receivable
$71,800
3,200
5,000
$80,000
 If all but $3,750 of receivables are collected by Leslie, Hervey’s final entry
is:
DR Cash
DR Allowance for uncollectibles
CR Due from Leslie Financing
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$1,250
3,750
$5,000
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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:
DR Cash
DR Prepaid interest
CR Note receivable
$76,800
3,200
$80,000
 Once the loan is due (in one year), Hervey would make these
entries:
DR Loan Payable –Leslie Financing
CR Cash
DR Interest expense
CR Prepaid interest
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$80,000
$80,000
$3,200
$3,200
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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
DR Prepaid interest
CR Note receivable
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$8,789.40
201.60
$9,000.00
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Accelerating cash collections:
Is it a sale or a borrowing?
 SFAS No. 140 provides
guidance.
Sale of receivables:
 Receivables removed
from balance sheet
 Gain or loss
recognized in income
Is control
surrendered?
Yes
Borrowing against
receivables
 Receivables stay on
balance sheet
 Loan shown as
balance sheet liability.
 No gain or loss
recognized in income
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Sale
No
 Assets are beyond
reach
 Buyer has right to
dispose
 Seller has no obligation
to repurchase
Borrowing
 However, ambiguities abound.
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Accelerating cash collections:
A closer look at securitizations
Bank
Receivables
transferred
in exchange
for cash
 Bank forms a bundled portfolio of
7% home mortgage receivables
of “moderate” risk.
Investor
 A third-party investor is willing to
buy the portfolio at a price that
yields a 6% return.
Mortgage
receivables
 Because the selling price at 6%
is higher than the carrying value
of the mortgages, the bank
records a gain.
Customer
 Both the bank and the investor
win in this transaction.
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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.
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Accelerating cash collections:
SPEs and “off balance sheet” accounting
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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
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$1,000,000
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Accelerating cash collections:
Impact on Doyle’s balance sheet
As sale
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As borrowing
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Accelerating cash collections:
Impact on Doyle’s financial ratios
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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.
Even the cash flow statement may not
reveal that receivables were sold without
recourse.
Assignment
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.
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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.
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Troubled debt restructuring:
Disclosure illustration
1
2
3

SFAS No. 15 says:
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Troubled debt restructuring:
Example
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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?
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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?
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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
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Troubled debt restructuring:
Continuation with modification
 Entries for the next two years:
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Troubled debt restructuring:
Continuation with modification
 Entries at maturity:
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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
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Troubled debt restructuring:
Another continuation with modification
 Entries for the next two years:
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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.
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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.
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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.
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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.
 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.
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