Professor Paul Zarowin - NYU Stern School of Business
Financial Reporting and Analysis - B10.2302/C10.0021 - Class Notes
Accounts and Notes Receivable
 review of allowance method
 assignment - collateralized borrowing
 factoring - sale of receivable or borrowing
 recourse vs non-recourse for bad debts
 3 possible cases
 required disclosures
 managing earnings
 B/S effects
 SCF effects
 ratio effects
 journal entries
Accounts and Notes Receivable
The allowance method for calculating bad debts expense (expense on I/S) and the associated
allowance for uncollectible accounts (contra-asset on B/S), based on a percentage of sales (I/S
method) or a percentage of gross A/R (B/S method, often based on an analysis of the aging of
A/R), is shown on pages 329-333
There are 2 primary methods of disposing of A/R (other than by cash receipt or write-off). These
are called Assignment and Factoring. These are methods by which a company can accelerate
cash collection on receivables, rather than waiting until the receivables are paid off.
Assignment is borrowing and using the A/R as collateral for a loan. There are 2 types of
assignment, general and specific. General assignment means any A/R you have can be used as
collateral. The journal entry is basic: just record the loan (DR to cash and CR to N/P) and
disclose the assignment in the financial statement footnotes.
Specific assignment means that specific A/R are pledged as collateral. The journal entries for
specific assignment are shown on page 344. These journal entries boil down to the following:
(1) N/P issuance and interest payment -
DR
Cash
finance charge
CR
N/P
finance charge (RCJ call this prepaid interest) is generally a percentage of the N/P or of the
assigned A/R
and
DR
CR
interest expense
N/P
Cash
(2) cash receipt -
DR
Cash
CR
A/R
Thus, the general form of the sale or borrowing entry, with or without recourse, is:
DR
CR
Cash
Loss (for a sale)
or interest expense (borrowing)
AUA (for a non recourse sale)
Liability (borrowing) or A/R (sale)
Factoring is usually a sale of A/R, but it can be a borrowing against A/R (like assignment). The
key issue is whether the factoring is with or without recourse. With recourse means the buyer
(lender) can get paid by the seller (borrower) if the A/R defaults. In effect, the seller (borrower)
bears the burden of the default. Without recourse means the opposite - the buyer (lender) bears
the burden. As you would expect, factorings that are sales are generally without recourse, and
factorings that are borrowings are generally with recourse. But, sales can be with recourse.
Borrowings cannot be without recourse. The relation between sale vs borrowing and recourse vs
no recourse can be summarized as follows:
sale
borrowing
with recourse
1
2
without recourse
3
4
The most natural combinations are 2 and 3; 1 can happen, but 4 cannot. The accounting
implications of each case are:
1. Recognize a loss and a contingent liability (only in footnote, not on B/S, for the possibility of
defaulted receivables).
2. Recognize interest expense or finance charge and an actual (on B/S) liability
3. Recognize a loss, but no required disclosure.
4. Not allowed.
The conditions that allow a factoring with recourse (you do not have to memorize them for this
class) to be a sale are on the bottom of page 345. The journal entries are as follows (the sale
entry is the same, with or without recourse, except for the DR to AUA):
Sale
DR
Cash
AUA (for a non recourse sale)
Loss on sale of A/R
CR
A/R
note: (1) the CR to A/R wipes it off the books, as per a sale; (2) cash received < gross A/R (i.e., a
loss on sale).
(RCJ call the loss Ainterest expense@; either way is ok)
Borrowing
DR
Cash
finance charge or discount
CR
Liability
Note that the CR is to a liabilty, so the A/R is still on the borrower=s books. Note also that this is
essentially the same borrowing entry as #2 for the assignment, as shown above.
Note the Due From Leslie Financing (the Factor) account. It is like an account receivable held
out to cover contingencies, such as sales returns, discounts, write-off=s etc.
The key issue is whether a factoring is really a sale or a borrowing, and the guidelines do not
always provide the correct answer. Note that treating a factoring as a sale reduces (current and
total) assets and does not increase liabilities. Thus, relative to a borrowing, a factoring-sale
results in both lower assets and lower liabilities (but no effect on owners= equity), and this
affects ratio calculations for rates of return, liquidity, and leverage. Specifically, sale- factorings
(relative to borrowings) produce higher ROA, but no differential effect on ROE. Effects on
leverage depend on whether TA or O/E is in the denominator. The decrease in A/R from the sale
reduces the numerator of liquidity ratios, but if the borrowing is for a current liability, this
reduces liquidity also.
Factoring can also be a means to camoflague increases in questionable receivables (those with
poor credit, that are more likely to default). Companies can inflate revenues by booking
questionable credit sales. The growth in outstanding (unpaid) A/R would normally be a Ared
flag@ for this procedure, but factorings (of the good A/R) as sales of A/R can hide this signal.
Unfortunately, the lack of required disclosures for sales without recourse makes it extremely
difficult to tell if a firm is managing its receivables by using without recourse sales. [If the sale is
with recourse, the firm must disclose the contingent liability]. See RCJ=s discussion on 348-352
and 361-362.
Notes Receivable
The basic journal entries for N/R=s are: (1) the initial loan:
DR
CR
N/R-face value
Cash - PV
Discount - plug
and (2) the periodic entries:
DR
CR
Cash (maybe)
Discount
Interest Revenue
Interest revenue = r% x Net BV of the N/R (Net BV = face value - unamortized discount),
regardless of the cash coupon rate (or whether there are any cash coupons at all), where r% is the
effective or market rate of interest implicit in the note (RCJ call this Aimputed@ interest). The
accompanying three examples show N/R=s with (1) zero coupons (i.e., no periodic cash receipt),
(2) coupons at less than r%, and (3) coupons at the effective rate of interest, r%.
Troubled Debt Restructurings (chapter 8, pages 362-368)
When a firm cannot meet the interest and/or principal payments on its debt, it may restructure the
debt. This can involve settling the debt immediately for less than its book value, or continuing
with modified terms, such as a reduction in future interest and/or principal payments. By
definition, the borrower will pay less than originally contracted for; thus, the borrower will
always have a gain on restructuring. Analogously, since the lender will receive less, the lender
will always have a loss. The key issues are when should the gain/loss be recognized, and for how
much. There are 3 types of restructurings: (1) settlement, (2) impairment, and (3) restructuring.
Settlement - When troubled debt is settled, the lender gives the borrower another asset (perhaps
cash) in exchange for extinguishing the debt. The value of the asset, by definition, is less than the
value of the debt (otherwise the borrower could sell the asset and pay off the debt in full). The
difference is the borrower=s gain and the lender=s loss (which are equal). Both parties recognize
the loss/gain at the time of settlement. Note that the borrower can recognize a gain or loss on
disposition of the asset, which is the difference between its book value versus its market value.
Assume that a note is settled in exchange for PPE. The journal entries are:
lender
DR
CR
Asset (FMV)
Loss on debt retirement(plug)
N/R (NBV)
borrower
DR
N/P (NBV)
CR
Asset (NBV)
Gain on debt retirement
Loss
Or Gain on asset transfer
Note that the lender=s loss equals the borrower=s gain on debt retirement.
Impairment - In impairment, the debt contract lives on, but with a lower future cash payment
than originally contracted for. Impairment is a specific type of restructuring when there is no
recontracting, but the lender knows that the loan has been impaired (i.e., the original contracted
cash flows will not be paid back in full). Due to accounting conservatism, the lender recognizes a
loss immediately upon impairment, whereas the borrower defers recognition of the gain until the
(lower) final payment is made.
The lender calculates the loss as the difference between (1) the BV of the note at the time of
impairment versus (2) the new lower expected final payment discounted at the note=s effective
rate of interest (r%). By definition, the BV equals the original final payment discounted at the
note=s effective rate of interest. Thus, the loss is the decrease in the payment discounted at the
effective interest rate (i.e., the lender writes down the note to the new, lower BV). From this
point on, the lender calculates periodic interest revenue in the usual way: r% x BV of the note,
using the note=s new, written down, BV.
For the borrower, the gain is the difference between the original versus the new final payments,
and is recognized when the final payment is made. The example below shows the journal entries
for both parties.
Restructuring - Restructuring is similar to impairment, but where there is a specific
recontracting. In this way, there is immediate, objective evidence of the decline in debt value.
The lender calculates the loss in the same way as for an impairment: the BV of the loan (which
equals the original payments discounted at r%) versus the new, lower payments discounted at
r%, and he writes down the loan to this new value immediately. Also like impairment, the lender
continues to calculate interest revenue = r% x new BV.
Unlike an impairment, however, the borrower might recognize a gain at the time of impairment.
The borrower compares the new, lower undiscounted cash flows to the NBV of the loan (which
equals the discounted original cash flows). [Note: by not discounting, the calculated value will be
higher than with discounting; however, the cash flows are lower. These 2 forces work in opposite
directions, and the new undiscounted value can be higher or lower than the original value.]
If the new undiscounted amount is lower, a gain is recognized immediately. The gain is the
difference between the 2 values. If a gain is recognized, the loan is written down to the
undiscounted value of the cash flows (DR to the liability and CR to the gain). Effectively, since
there is no discounting, the implicit interest rate is zero; thus, all future cash payments are
repayments of principal, and the borrower recognizes no more interest expense.
If the new undiscounted amount is not lower, no gain is recognized. The borrower calculates the
implicit interest rate (the internal rate of return) that equates the future cash flows with the
(unchanged) BV of the loan. Since the cash flows are lower, this new interest rate must be lower
than the original effective interest rate of the loan. The borrower then uses this new interest rate
to calculate future interest expense = new r% x BV of the loan. Since the new r% is lower, future
interest expense is lower (than previously), and net income is higher. In this way, the gain is
deferred over the remaining life of the loan, rather than recognized up front, consistent with
accounting conservatism. The example below shows the journal entries for both parties.
Note the following central principles of both impairments and restructurings: (1) the lender uses
the original interest rate, both to calculate the loan loss and to compute interest revenue for the
rest of the note=s life, and (2) consistent with accounting conservatism, the lender always
recognizes a loss immediately, whereas the borrower usually delays recognition of the gain - the
only exception for the borrower is when his payments are reduced so much, that even when not
discounted, they are of lower value than the original discounted payments.
The difference between impairment vs restructuring can be subtle. In general, a restructuring
requires a formal recontracting, whereas an impairment does not. To compare the two types of
events, consider the following examples.
Example 1: Impaired/Restructured Loan, with restructuring borrower gain up front
Assume a r=10%, 5 year, zero coupon note, with a $1,000 principal. Assume that with 2 years
remaining, the borrower and the lender agree that the final principal repayment will be $700
instead of the original $1,000. At this point the NBV of the original (unimpaired) loan is
$1,000/(1.10)2 = $826 (rounded to the nearest $). It is a N/R (N/P) for the lender (borrower). The
PV of the impaired note is $700/(1.10)2 = 578. For the borrower under restructuring, the key
point here is that the original NBV 826 is greater than the undiscounted new cash flows, 700.
Under both impairment and restructuring, the lender writes down the N/R to $578 at this time, by
taking a loss of 826-578=248:
DR
Loss 248
CR
N/R 248
He then goes forward with the N/R at the new NBV of $578. His final 2 period=s je=s are:
DR
CR
per 4: N/R 58
Interest revenue 58
Note: 58=10% x 578; new NBVof N/R
=578+58=636
per 5:
N/R 64
Interest revenue 64
Note: 64=10% x 636; new NBVof N/R
=636+64=700
final:
Cash 700
N/R 700
Under impairment, the borrower ignores the change in NBV and continues to account for the
$1,000 N/P, such that the gain is recognized at the end:
DR
CR
per 4: Interest expense 83
N/P 83
Note: 83=10% x 826; new NBVof N/P
=826+83=909
per 5:
Interest expense 91
N/P 91
Note: 91=10% x 909; new NBVof N/P
=909+91=1000
final: N/P 1000
Cash 700
Gain 300
Under restructuring when the NBV of the original loan > undiscounted cash flows of the new
loan, the borrower recognizes a gain immediately for the difference, thereby wriring the loan
down to its undiscounted value. Since the effective interest rate is zero, there is no future interest
expense, and all future cash flows are repayments of the loan:
DR
CR
N/P 126
Gain 126
Note: 126=826(original discounted NBV)-700(new
undiscounted NBV)
[note: per 4 and per 5: no je=s, since no cash payments in this example]
DR
CR
final: N/P 700
Cash 700
Note that under impairment, the net 2 year effect on the borrower=s I/S is:
83 DR (per 4) + 91 DR (per 5) + 300CR (final) = 126 CR. Under restructuring, the effect on the
borrower=s I/S is 126 CR (per 3). Thus, the net effect on the borrower=s I/S is the same, only the
timing differs.
Example 2: Impaired/Restructured Loan, with no restructuring borrower gain up front
Assume an r=10%, 5 year, zero coupon note, with a $1,000 principal. Assume that with 2 years
remaining, the borrower and the lender agree that the final principal repayment will be $900
instead of the original $1,000. At this point the NBV of the original (unimpaired) loan is
$1,000/(1.10)2 = $826 (rounded to the nearest $). It is a N/R (N/P) for the lender (borrower). The
PV of the impaired note is $900/(1.10)2 = 744. For the borrower under restructuring, the key
point here is that the original NBV 826 is less than the undiscounted new cash flows, 900.
Under both impairment and restructuring, the lender writes down the N/R to $744 at this time, by
taking a loss of 826-744=82
DR
CR
Loss 82
N/R 82
He then goes forward with the N/R at the new NBV of $744. His final 2 period=s je=s are:
DR
CR
per 4: N/R 74
Interest revenue 74
Note: 74=10% x 744; new NBVof N/R
=744+74=818
per 5:
N/R 82
Interest revenue 82
Note: 82=10% x 818; new NBVof N/R
=818+82=900
final:
Cash 900
N/R 900
Under impairment, the borrower ignores the change in NBV and continues to account for the
$1,000 N/P, such that the gain is recognized at the end:
DR
CR
per 4: Interest expense 83
N/P 83
Note: 83=10% x 826; new NBVof N/P
=826+83=909
per 5:
Interest expense 91
N/P 91
Note: 91=10% x 909; new NBVof N/P
=909+91=1000
final:
N/P 1000
Cash 900
Gain 100
Note that only the borrower=s final je differs from the previous example, because in both cases
the borrower ignores the Again@ until the end.
Under restructuring, the NBV of the original loan < undiscounted cash flows of the new loan, so
the borrower does not recognize a gain immediately, but computes the implicit IRR that equates
the original NBV with the new final cash flows:$900/(1+r)2 = $826, for r= 4.38%. The borrower
then uses this IRR% to compute his interest expense going forward, deferring his gain until the
end. Note that since the cash payment has been reduced, the new IRR% must be lower than the
original effective r% on the loan. Thus, using the new IRR% results in lower interest expense.
per 4:
DR
Interest expense 36
CR
N/P 36
per 5:
DR
Interest expense 38
CR
N/P 38
final:
DR
N/P900
Note: 36=826x4.38%; new NBV=826+36=862
Note: 38=862x4.38%; new NBV=862+38=900
CR
Cash 900
Note that under impairment, the net 2 year effect on the borrower=s I/S is:
83 DR (per 4) + 91 DR (per 5) + 100 CR (final) = 74 DR. Under restructuring, the effect on the
borrower=s I/S is 36 DR (per 4) + 38 DR (per 5) = 74 DR. Thus, the net effect on the
borrower=s I/S is the same, only the timing differs.