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.
1
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.
2
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.
3
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.)
4
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 - when
 Valuation – how
 Disposition –
collected/sell/write-offs

5
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.
6
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 of
receivables
=
Gross
amount
owned
-
Estimated
uncollectibles
-
Estimated
returns &
allowances
7
Uncollectible Accounts
Describe the accounting treatment of
anticipated uncollectible accounts
receivable.
8
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 dates
Time
$10,000 current
period sales
$500 is
uncollectible
$500 estimated
expense
9
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.
10
Direct Write-off Method
If uncollectible accounts are immaterial, bad debts
are simply recorded as they occur (without the
use of an allowance account).
GENERAL JOURNAL
Date
Description
Bad Debts Expense
Accounts Receivable
Post
Ref.
Page 18
Debit
#####
Credit
#####
11
Allowance Method
Allowance Method: Most businesses record an
estimate of the bad debt expense by an adjusting
entry at the end of the accounting period.
Normally classified as
a selling expense and
closed at year-end.
Contra asset account to
Accounts Receivable.
GENERAL JOURNAL
Date
Description
Dec. 31 Bad Debt Expense
Allowance for Uncollectible
Page 78
Post.
Ref.
Debit
Credit
####
####
Accounts
12
Allowance for Uncollectible Accounts
Accounts Receivable
Less: Allowance for Uncollectible Accounts
Less: Returns and allowances
Net Realizable Value
Net realizable value is the amount of the
accounts receivable that the business
expects to collect.
13
Uncollectible Accounts
Allowance Method:
Describe the two approaches
to estimating bad debts
14
Two Approaches to Estimate Bad Debts
Allowance Method:

Sales Revenues Approach (Percentage of Sales
Method):
Current Period Credit Sales
× Bad Debt %
= Estimated Bad Debts Expense

Gross Receivables Approach
 Composite Rate (Percentage of Receivables):
Year-end Accounts Receivable
× Bad Debt %
 Aging of Receivables
15
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.
Bad debts expense is
computed as follows:
Current Period Sales
× Bad Debt %
= Estimated Bad Debts Expense
16
Sales Revenues Approach
In 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?
$
×
=
$
400,000
0.60%
2,400
MusicLand computes
estimated Bad Debts
Expense of $2,400.
GENERAL JOURNAL
Date
Dec.
Description
31 Bad Debts Expense
Allowance for
Uncollectible Accounts
Post
Ref.
Page 95
Debit
2,400
Credit
2,400
17
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
18
Gross Receivables Approach
1. Composite Rate method:
Desired balance in allowance for
uncollectible accounts = year-end accounts
receivable balance x bad debt expense %
19
Gross Receivables Approach :
Composite Rate
On 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?
Desired balance in Allowance
for Uncollectible Accounts
$
×
= $
50,000
5.00%
2,500
GENERAL JOURNAL
Date
Dec.
Description
31 Bad Debts Expense
Allowance for
Uncollectible Accounts
Post
Ref.
Page 95
Debit
2,300
Credit
2,300
20
Now, let’s
look at the
accounts
receivable
aging
approach!
21
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 ”.
22
Aging Schedule of Accounts Receivable
:
Is the allowance for uncollectibles adequate?
31-90 days 91-180
Current
old
days old
Amount
$1,450,000 $125,000 $15,000
Estimated % of bad debt losses
2.50%
6%
20%
Allowance for uncollectibles
$36,250
$7,500
$3,000
Over 180
days old
Total
$10,000 $1,600,000
40%
$4,000
$50,750
• The Allowance for uncollectible accounts has a balance of $39,000
prior 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.
DR Bad debts expense
$11,750
CR Allowance for uncollectibles
$11,750
23
Accounts receivable disposition:
Writing off bad debts

Some time later, Bristol determines that a
$750 receivable from Ralph Company cannot
be collected.
Allowance for uncollectibles
$750
Accounts receivable – Ralph Company

$750
Note that no bad debt expense is recorded at this time
because the estimated expense was previously
recorded (matching principle).
So what happens if someone pays after a write-off
of the accounts receivable?
24
Collection of Previously
Written-Off Accounts
When a customer makes a payment after
an account has been written off, two
journal entries are required.
GENERAL JOURNAL
Date
Description

Accounts Receivable

Cash
Page 69
Post.
Ref.
Debit
####
Allowance for Uncollectible Accounts
Accounts Receivable
Credit
####
####
####
25
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?
26
Sales Returns and Allowances
Describe the accounting treatment for
merchandise returns
27
Sales Returns and Allowances
Sales Returns
Sales Allowances
Merchandise
returned by a
customer to a
supplier.
A reduction in
the cost of
defective
merchandise.
28
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.
29
29
Sales Returns & Allowances (FASB 48)
C.The amount of sales R&A is
significant and six conditions are
met:

Allowance method.
30
30
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.
31
31
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
10,000
Sales
12/31/2006 Sales R&A
(Adj. entry)
Allow. for sale R& A
(estimate 10% returns)
Sales returns occurred
1/10/2007 Allowance for sales R&A
A/R
Inventory
Cost of Goods Sold
10,000
1,000
1,000
900
900
XXX
XXX
32
Learning Objective
Do existing receivables represent real sales?
33
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.
Sales
Receivables
Time
34
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.
35
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
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.
38
Accounts receivable:
Sunbeam Corporation illustration
18.7% sales growth
36.4% receivable growth
1
2
8-39
Accounts receivable:
Clues available to the analyst
1.
2.
Receivable growth at Sunbeam greatly
exceeded sales growth (a disparity in
growth rates of sales and receivables).
“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).
40
Accounts receivable:
Clues available to the analyst
3.
4.
Had Sunbeam not sold about $59
million of receivables, the receivable
growth rate would have been much
higher than 36.4% in 1997.
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
.
41
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
42
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.
Cash and Receivables
43
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
8-44
Journal Entries for Monson’s Case
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
375,660
Discount on N/R
Year 2: Cash

375,660
413,226
N/R
At the saleDiscount
of theonequipment:
Year 3: Cash
413,226
454,514
Note Receivable
Discount on N/R 5,000,000
454,514
45
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%.
Stated rate

What is the implied (cash) sales price of the machine?
Prevailing
rate
8-46
Imputed interest:
Calculating interest income for Quinones
8-47
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
Discount on N/R
100,000
225,397
Interest Revenue
325,397
Year 2:
Cash
Discount on N/R
100,000
247,936
Interest Revenue
347,936
Year 1:
Cash
Discount on N/R
100,000
272,701
Interest Revenue
372,701
48
Additional Examples on
Example A

Long-Term N/R
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
49
Long-Term N/R
Example A (contd.)
1/1/x1
Notes Receivable
Sales Revenue
Discounts on N/R

100,000
96,620
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
50
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
51
Long-Term N/R
Example A (contd.)
12/31/x2 (recording int. received on 12/31/x2):
Cash
Discount on N/R
Int. Revenue
10,000
1,785.7
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
52
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
53
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
Discount on N/R
Revenue from Services
72,000
a. (18,000  4) - 55,844.10
= 16,155.9
Cash and Receivables
16,155.9a
73,844.10
54
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
55
Long-Term N/R
Example B (contd.)
12/31/x3
Cash
N/R
Discount on N/R
Interest Revenue
18,000
18,000
4,838.56
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
56
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%
Cash and Receivables
= 30,825.51  11% = 3,390.81
57
Long-Term N/R
Example B (contd.)
12/31/x5
Cash
N/R
Discount on N/R
Interest Revenue
18,000
18,000
1,783.68
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
Cash and Receivables
58
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
8-59
Financing With Receivables
60
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.
61
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
DR Prepaid interest
CR Note receivable
$8,789.40
201.60
9,000
62
Accelerating cash collections/Financing with
accounts receivables: Sale and collateralized
borrowing

There are two ways to accelerate cash collections:
63
Financing With Receivables

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.
64
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:
DR Cash
$76,800
DR Prepaid interest
3,200
CR Loan Payable – Leslie Financing
Note: $80,000 of accounts receivable were pledged for this loan.

$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
$80,000
$80,000
$3,200
$3,200
65
Financing With Receivables: Sale of
Accounts Receivable


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.
66
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.
67
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.
68
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
DR Interest expense (loss)
CR Accounts receivable
76,000
4,000
80,000
69
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.


70
Sale of Accounts Receivable with Recourse
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.
71
Sale of Accounts Receivable with
Recourse (contd.)
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 as
a sale, it will be treated as a
secured borrowing.
72
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 noncollections. The entry to record the sale of
receivables with recourse is:
DR Cash
$71,800
DR loss
3,200
DR Due from Leslie Financing 5,000
CR Accounts receivable
80,000
73
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
74
Accelerating cash collections:
Is it a sale or a borrowing?

Sale of receivables:
The FASB has provided guidelines in
the Accounting Standards Codification
 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
Sale

No
 Assets are beyond
reach
 Buyer has right to
dispose
 Seller has no obligation
to repurchase
Borrowing
However, ambiguities abound.
8-75
Securitizations
76
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
77
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., mortgagebacked securities), consumer debts (i.e.,
assets-backed securities), and corporate
bonds (i.e., collateralized debt obligations).

78
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.

79
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.
80
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.
81
Procedures of Securitization (contd.)

The SPE is served as a “pass through”.

The transferor can continue to service the
loan for a fee.
82
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.
83
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.
84
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..
85
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.
86
Benefits of SPE
1.
To protect the investors of assetbacked 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.
87
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.
88
Benefits of SPE (contd.)
3.
4.
With SPE, the reduction in credit risk
decreases the cost of capital of the
transferor’s.
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.
89
90
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).
8-91
A Closer look at Securitizations:
Notice: No debt appears on Doyle’s books!
8-92
Accelerating cash collections:
Impact on Doyle’s financial ratios
 Securitization removes
the mortgage assets from
the B/S and does not put a loan payable on the
B/S.
30% Increase
27% reduction
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.
93
Securitization and the 2008 Financial Crisis (souce:
RCJM textbook)

1.
Subprime lending increased substantially from
2004 to 2007 due to:
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.
3.
The originators and rating agencies
underestimated the risks associated with their
guarantees and securitizers shopped for high
ratings.
.
94
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.
95
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.
96
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.
97
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).
8-98
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.
8-99
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.
8-100