Financial institutions have developed a wide variety of ways for companies to use their receivables to obtain immediate cash. Companies can find this attractive because it shortens their operating cycles by providing cash immediately rather than having to wait until credit customers pay the amounts due. Also, many companies avoid the difficulties of servicing (billing and collecting) receivables by having financial institutions take on that role. Of course, financial institutions require compensation for providing these services, usually interest and/or a finance charge.
The various approaches used to finance with receivables differ with respect to which rights and risks are retained by the transferor (the company who was the original holder of the receivables) and which are passed on to the transferee (the new holder, the financial institution). Despite this diversity, any of these approaches can be described as either:
A secured borrowing. Under this approach, the transferor (borrower) simply acts like it borrowed money from the transferee (lender), with the receivables remaining in the transferor's balance sheet and serving as collateral for the loan. On the other side of the transaction, the transferee recognizes a note receivable.
A sale of receivables. Under this approach, the transferor (seller) “derecognizes” (removes) the receivables from its balance sheet, acting like it sold them to the transferee (buyer). On the other side of the transaction, the transferee recognizes the receivables that it obtained and measures them at their fair value.
Let's discuss each of these approaches in more detail as they apply to accounts receivable and notes receivable. Then we'll discuss the circumstances under which GAAP requires each approach.
As indicated in the previous section, companies sometimes use receivables as collateral for loans. You already may be familiar with the concept of assigning using receivables as collateral for loans; nonpayment of a debt will require the proceeds from collecting the assigned receivables to go directly toward repayment of the debt. or pledging trade receivables in general rather than specific receivables are pledged as collateral; the responsibility for collection of the receivables remains solely with the company. receivables as collateral if you or someone you know has a mortgage on a home. The bank or other financial institution holding the mortgage will require that, if the homeowner defaults on the mortgage payments, the home be sold and the proceeds used to pay off the mortgage debt. Similarly, in the case of an assignment of receivables, nonpayment of a debt will require the proceeds from collecting the assigned receivables to go directly toward repayment of the debt.
In these arrangements, the lender typically lends an amount of money that is less than the amount of receivables assigned by the borrower. The difference provides some protection for the lender to allow for possible uncollectible accounts. Also, the lender (sometimes called an assignee) usually charges the borrower (sometimes called an assignor) an up-front finance charge in addition to stated interest on the loan. The receivables might be collected either by the lender or the borrower, depending on the details of the arrangement. Illustration 7-5 provides an example.
Assignment of Accounts Receivable
On December 1, 2011, the Santa Teresa Glass Company borrowed $500,000 from Finance Bank and signed a promissory note. Interest at 12% is payable monthly. The company assigned $620,000 of its receivables as collateral for the loan. Finance Bank charges a finance fee equal to 1.5% of the accounts receivable assigned.
Santa Teresa Glass records the borrowing as follows:
Santa Teresa will continue to collect the receivables, and will record any discounts, sales returns, and bad debt write-offs, but will remit the cash to Finance Bank, usually on a monthly basis. When $400,000 of the receivables assigned are collected in December, Santa Teresa Glass records the following entries:
*In theory, this fee should be allocated over the entire period of the loan rather than recorded as an expense in the initial period. However, amounts usually are small and the loan period usually is short. For expediency, then, we expense the entire fee immediately.
In Santa Teresa's December 31, 2011, balance sheet, the company would report the receivables and note payable together as follows:
Netting a liability against a related asset, also called offsetting, usually is not allowed by GAAP. However, in this case, we deduct the note payable from the accounts receivable assigned because, by contractual agreement, the note will be paid with cash collected from the receivables. In Santa Teresa's financial statements, the arrangement also is described in a disclosure note.
A variation of assigning specific receivables occurs when trade receivables in general rather than specific receivables are pledged as collateral. The responsibility for collection of the receivables remains solely with the company. This variation is referred to as a pledging trade receivables in general rather than specific receivables are pledged as collateral; the responsibility for collection of the receivables remains solely with the company. of accounts receivable. No special accounting treatment is needed and the arrangement is simply described in a disclosure note. For example, Graphic 7-7 shows a portion of the long-term debt disclosure note included in the July 31, 2009, quarter-end financial statements of Virco Mfg. Corporation, a manufacturer of office furniture.
Disclosure of Receivables Used as Collateral—Virco Mfg. Corporation
Real World Financials
Note 5: Debt (in part)
The Revolving Credit facility is secured by certain of the Company's and its subsidiaries' accounts receivable, inventories, equipment and real property.
Sale of Receivables
Accounts and notes receivable, like any other assets, can be sold at a gain or a loss. The basic accounting treatment for the sale of receivables is similar to accounting for the sale of other assets. The seller (transferor) (a) removes from the accounts the receivables (and any allowance for bad debts associated with them), (b) recognizes at fair value any assets acquired or liabilities assumed by the seller in the transaction, and (c) records the difference as a gain or loss.
The sale of accounts receivable became an increasingly popular method of financing over the past couple of decades. Traditionally a technique used by companies in a few industries or with poor credit ratings, the sale of receivables is now a common occurrence for many different types of companies. For example, Harley-Davidson, Toyota, Whirlpool, and Raytheon all sell receivables. The two most common types of selling arrangements are factoring and securitization. We'll now discuss each type.
| ||Two popular arrangements used for the sale of receivables are factoring and securitization.|
A factor financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for this service. is a financial institution that buys receivables for cash, handles the billing and collection of the receivables, and charges a fee for this service. Actually, credit cards like VISA and Mastercard are forms of factoring arrangements. The seller relinquishes all rights to the future cash receipts in exchange for cash from the buyer (the factor).
As an example, Graphic 7-8 shows an excerpt from a recent advertisement of Bankers Mutual Capital Corporation, a financial institution that offers factoring as one of its services.
Advertisement of Factoring Service—Bankers Mutual Capital Corporation
Accounts Receivable Factoring
Accounts receivable factoring is the selling of your invoices (accounts receivable) for cash versus waiting 30–60 days to be paid by your customer. Factoring will get you the working capital you need now and improve your cash flow. Bankers will advance 65%–80% against the invoice you generate and pay you the balance less our fee (typically 3%–6%) when the invoice is paid.
Notice that the factor, Bankers Mutual, advances only between 65%–80% of the factored receivables. The remaining balance is retained as security until all of the receivables are collected and then remitted to the transferor, net of the factor's fee. The fee charged by this factor ranges from 3%–6%. The range depends on, among other things, the quality of the receivables and the length of time before payment is required.
Another popular arrangement used to sell receivables has been securitization the company creates a special purpose entity (SPE), usually a trust or a subsidiary; the SPE buys a pool of trade receivables, credit card receivables, or loans from the company and then sells related securities.. In a typical accounts receivable securitization, the company creates a “special purpose entity” (SPE), usually a trust or a subsidiary. The SPE buys a pool of trade receivables, credit card receivables, or loans from the company, and then sells related securities, typically debt such as bonds or commercial paper, that are backed (collateralized) by the receivables. Securitizing receivables using an SPE can provide significant economic advantages, allowing companies to reach a large pool of investors and to obtain more favorable financing terms.18
As an example of a securitization, Graphic 7-9 shows a portion of the disclosure note included in the 2009 annual report of Flextronics International Limited, a worldwide leader in design, manufacturing and logistics services, describing the securitization of its trade accounts receivables.
Description of Securitization Program—Flextronics International Limited
Real World Financials
Note 6: TRADE RECEIVABLES SECURITIZATION (in part)
The Company continuously sells a designated pool of trade receivables to a third-party qualified special purpose entity… . The securitization agreement allows the operating subsidiaries participating in the securitization program to receive a cash payment for sold receivables, less a deferred purchase price receivable. The Company continues to service, administer and collect the receivables on behalf of the special purpose entity and receives a servicing fee of 1.00% of serviced receivables per annum.
Dropping the Q. What if a company had to consolidate its securitization SPE? In that case, it would eliminate any transactions between the SPE and the company, such that, after consolidation, it no longer would appear as if the company had sold its receivables to an outside entity. Instead, the company would appear to have kept its receivables and engaged in a secured borrowing with whoever loaned money to the SPE. Until recently, companies that securitized their receivables could avoid some consolidation rules by setting up a particular type of SPE, called a “qualifying SPE” (“QSPE”), which operated solely to facilitate securitization transactions. The company would sell its receivables to its QSPE, often recognizing a gain on the sale, and the QSPE (not the company) would hold the receivables and related debt in the QSPE's balance sheet. Effective in 2010, the FASB eliminated the QSPE concept, leaving these SPEs vulnerable to consolidation requirements.19 The FASB also tightened consolidation requirements with respect to these sorts of entities.20 As a consequence, securitizations are much less likely to qualify for sales treatment after 2009 than they were previously.
The specifics of sale accounting vary depending on the particular arrangement between the seller and buyer (transferee).21 One key feature is whether the receivables are transferred without recourse or with recourse.
SALE WITHOUT RECOURSE. If a factoring arrangement is made without recourse the buyer assumes the risk of bad debts., the buyer can't ask the seller for more money if customers don't pay the receivables. Therefore, the buyer assumes the risk of bad debts. Illustration 7-6 on the next page provides an example of receivables factored without recourse.
| ||The buyer assumes the risk of uncollectibility when accounts receivable are sold without recourse.|
Note that, in Illustration 7-6, the fair value ($50,000) of the last 10% of the receivables to be collected is less than 10% of the total book value of the receivables (10% × $600,000 = $60,000). That is typical, because the last receivables to be collected are likely to be reduced by sales returns and allowances, and therefore have a lower fair value.
SALE WITH RECOURSE. When a company sells accounts receivable with recourse the seller retains the risk of uncollectibility., the seller retains all of the risk of bad debts. In effect, the seller guarantees that the buyer will be paid even if some receivables prove to be uncollectible. In Illustration 7-6, even if the receivables were sold with recourse, Santa Teresa Glass still could account for the transfer as a sale so long as the conditions for sale treatment are met. The only difference would be the additional requirement that Santa Teresa record the estimated fair value of its recourse obligation as a liability. The recourse obligation is the estimated amount that Santa Teresa will have to pay Factor Bank as a reimbursement for uncollectible receivables. Illustration 7-7 on the next page, under Illustration 7-6, provides an example of receivables factored with recourse.
| ||The seller retains the risk of uncollectibility when accounts receivable are sold with recourse.|
Accounts Receivable Factored without Recourse
In December 2011, the Santa Teresa Glass Company factored accounts receivable that had a book value of $600,000 to Factor Bank. The transfer was made without recourse. Under this arrangement, Santa Teresa transfers the $600,000 of receivables to Factor, and Factor immediately remits to Santa Teresa cash equal to 90% of the factored amount (90% × $600,000 = $540,000). Factor retains the remaining 10% to cover its factoring fee (equal to 4% of the total factored amount; 4% × $600,000 = $24,000) and to provide a cushion against potential sales returns and allowances. After Factor has collected cash equal to the amount advanced to Santa Teresa plus their factoring fee, Factor remits the excess to Santa Teresa. Therefore, under this arrangement Factor provides Santa Teresa with cash up front and a “beneficial interest” in the transferred receivables equal to the fair value of the last 10% of the receivables to be collected (which management estimates to equal $50,000), less the 4% factoring fee.22
Santa Teresa Glass records the transfer as follows:
Accounts Receivable Factored with Recourse
Assume the same facts as in Illustration 7-6, except that Santa Teresa sold the receivables to Factor with recourse and estimates the fair value of the recourse obligation to be $5,000. Santa Teresa records the transfer as follows:
Notice that the estimated recourse liability increases the loss on sale. If the factor collects all of the receivables, Santa Teresa eliminates the recourse liability and increases income (reduces the loss).
Gain-on-Sale Accounting. When applying the sales approach to accounting for a transfer of receivables, what if a transferor estimates a relatively high fair value associated with its beneficial interest? The higher valuation will result in a higher debit associated with that “beneficial interest” (in Illustrations 7-6 and 7-7, the “receivable from factor”). The offsetting credit produces a lower loss or higher gain. In the years leading up to the financial crisis of 2008/2009, high valuations of beneficial interests on securitized receivables were so prevalent that the sales approach was known on Wall Street as “gain-on-sale” accounting, because a gain usually was recognized in the transaction. This accounting approach likely contributed to the financial crisis by encouraging mortgage lenders to make loans (and record gains upon securitization of those loans) that were of low quality. As discussed elsewhere in this chapter, recent changes in GAAP make it harder to qualify for the sales approach, and therefore are likely to decrease the prevalence of “gain-on-sale” accounting.
Transfers of Notes Receivable
We handle transfers of notes receivable in the same manner as transfers of accounts receivable. A note receivable can be used to obtain immediate cash from a financial institution either by pledging the note as collateral for a loan or by selling the note. Notes also can be securitized.
| ||The transfer of a note receivable to a financial institution is called discounting.|
The transfer of a note to a financial institution is referred to as discounting the transfer of a note receivable to a financial institution.. The financial institution accepts the note and gives the seller cash equal to the maturity value of the note reduced by a discount. The discount is computed by applying a discount rate to the maturity value and represents the financing fee the financial institution charges for the transaction. Illustration 7-8 provides an example of the calculation of the proceeds received by the transferor.
Discounting a Note Receivable
STEP 1: Accrue interest earned on the note receivable prior to its being discounted.
STEP 2: Add interest to maturity to calculate maturity value.
STEP 3: Deduct discount to calculate cash proceeds.
On December 31, 2011, the Stridewell Wholesale Shoe Company sold land in exchange for a nine-month, 10% note. The note requires the payment of $200,000 plus interest on September 30, 2012. The company's fiscal year-end is December 31. The 10% rate properly reflects the time value of money for this type of note. On March 31, 2012, Stridewell discounted the note at the Bank of the East. The bank's discount rate is 12%. Because the note had been outstanding for three months before it's discounted at the bank, Stridewell first records the interest that has accrued prior to being discounted:
Next, the value of the note if held to maturity is calculated. Then the discount for the time remaining to maturity is deducted to determine the cash proceeds from discounting the note:
Similar to accounts receivable, Stridewell potentially could account for the transfer as a sale or a secured borrowing. For example, Illustration 7-9 shows the appropriate journal entries to account for the transfer as a sale.
Discounted Note Treated as a Sale
Deciding Whether to Account for a Transfer as a Sale or a Secured Borrowing
Transferors usually prefer to use the sale approach rather than the secured borrowing approach to account for the transfer of a receivable, because the sale approach makes the transferor seem less leveraged, more liquid, and perhaps more profitable than does the secured borrowing approach. Graphic 7-10 explains why by describing particular effects on key accounting metrics.
So, when is a company allowed to account for the transfer of receivables as a sale? The most critical element is the extent to which the company (the transferor) surrenders control over the assets transferred. For some arrangements, surrender of control is clear (e.g., when a receivable is sold without recourse and without any other rights, continuing servicing, or other involvement by the transferor). However, for other arrangements this distinction is not obvious. Indeed, some companies appear to structure transactions in ways that qualify for sale treatment but retain enough involvement to have control. This led the FASB to provide guidelines designed to constrain inappropriate use of the sale approach. Specifically, the transferor (defined to include the company, its consolidated affiliates, and people acting on behalf of the company) is determined to have surrendered control over the receivables if and only if all of the following conditions are met:23
Why Do Transferors of Receivables Generally Want to Account for the Transfer as a Sale?
The transferred assets have been isolated from the transferor—beyond the reach of the transferor and its creditors.
Each transferee has the right to pledge or exchange the assets it received.
The transferor does not maintain effective control over the transferred assets. Effective control would exist, for example, if the transfer is structured such that the assets are likely to end up returned to the transferor.
| ||If the transferor is deemed to have surrendered control over the transferred receivables, the arrangement is accounted for as a sale; otherwise as a secured borrowing.|
If all of these conditions are met, the transferor accounts for the transfer as a sale. If any of the above conditions are not met, the transferor treats the transaction as a secured borrowing.
Graphic 7-11 provides a disclosure note from United Components Inc. (UCI) in which UCI accounts for the factoring of its trade accounts receivable as a sale, indicating that the conditions for sale treatment have been met.
Disclosure of Factoring Arrangement—United Components Inc.
Real World Financials
Note C: Sales of Receivables
UCI has agreements to sell undivided interests in certain of its receivables with factoring companies, which in turn have the right to sell an undivided interest to a financial institution or other third party… . UCI retained no rights or interest, and has no obligations, with respect to the sold receivables. UCI does not service the receivables after the sales. The sales of receivables were accounted for as a sale… . The sold receivables were removed from the balance sheet at the time of the sales.
Graphic 7-12 summarizes the decision process that is used to determine whether a transfer of a receivable is accounted for as a secured borrowing or a sale.
The amount of disclosures relevant to asset transfers increased dramatically in response to the 2008/2009 financial crisis. In particular, much disclosure is required when the transferor has continuing involvement in the transferred assets but accounts for the transfer as a sale. Why? Those are the circumstances under which it's most likely that the transferor may still bear significant risk associated with the arrangement, so those are the arrangements that financial statement users may want to instead view as a secured borrowing. As a result, transferors must provide qualitative and quantitative information about the transfer at a level that allows financial statement users to fully understand (a) the transfer, (b) any continuing involvement with the transferred assets, and (c) any ongoing risks to the transferor.
Accounting for the Financing of Receivables
The company also has to provide information about the quality of the transferred assets. For example, for transferred receivables, the company needs to disclose the amount of receivables that are past due and any credit losses occurring during the period. Among the other information the company must disclose are:
How fair values were estimated when recording the transaction.
Any cash flows occurring between the transferor and the transferee.
How any continuing involvement in the transferred assets will be accounted for on an ongoing basis.25
Participating Interests. What if, rather than transferring all of a particular receivable, a company transfers only part of it? For example, what if a company transfers the right to receive future interest payments on a note, but retains the right to receive the loan principal? Recent changes in U.S. GAAP require that a partial transfer be treated as a secured borrowing unless the amount transferred qualifies as a “participating interest” as well as meeting the “surrender of control” requirements described above. Participating interests are defined as sharing proportionally in the cash flows of the receivable and having equal and substantial rights with respect to the receivable. Many common financing arrangements do not qualify as participating interests, so this change in GAAP makes it harder for partial transfers to qualify for the sale approach. However, GAAP also emphasizes that the particular legal form of a transfer determines its accounting,24 so anticipate the financial services industry working creatively to structure transfers in a manner that achieves the accounting that its customers desire.
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Transfers of Receivables.IAS No. 3926 and FASB ASC 86027 cover financing with receivables under IFRS and U.S. GAAP, respectively. The international and U.S. guidance often lead to similar accounting treatments. Both seek to determine whether an arrangement should be treated as a secured borrowing or a sale, and, having concluded which approach is appropriate, both account for the approaches in a similar fashion. Also, the recent change in U.S. GAAP that eliminated the concept of QSPEs is a step toward convergence with IFRS, and is likely to reduce the proportion of U.S. securitizations that qualify for sale accounting.
Where IFRS and U.S. GAAP most differ is in the conceptual basis for their choice of accounting approaches and in the decision process they require to determine which approach to use. As you have seen in this chapter, U.S. GAAP focuses on whether control of assets has shifted from the transferor to the transferee. In contrast, IFRS requires a more complex decision process. The company has to have transferred the rights to receive the cash flows from the receivable, and then considers whether the company has transferred “substantially all of the risks and rewards of ownership,” as well as whether the company has transferred control. Under IFRS:
If the company transfers substantially all of the risks and rewards of ownership, the transfer is treated as a sale.
If the company retains substantially all of the risks and rewards of ownership, the transfer is treated as a secured borrowing.
If neither conditions 1 or 2 hold, the company accounts for the transaction as a sale if it has transferred control, and as a secured borrowing if it has retained control.
Whether risks and rewards have been transferred is evaluated by comparing how variability in the amounts and timing of the cash flows of the transferred asset affect the company before and after the transfer.
This is a broad overview of the IFRS guidance. Application of the detailed rules is complex, and depending on the specifics of an arrangement, a company could have different accounting under IFRS and U.S. GAAP.
As indicated previously in this chapter, the FASB recently modified accounting for transfers of receivables. However, the Board also indicated that those changes were a short-term solution and that it intended to work with the IASB to produce a standard that comprehensively addressed derecognition of assets and liabilities (which would include determining when transfers of receivables can be accounted for as sales). At the time this book was written, the IASB had issued an exposure draft of a proposed standard, and the IASB and FASB intended to consider the comments the IASB receives before going forward.28 The IASB's proposed standard focuses on transfers of control rather than transfers of risks and rewards of ownership, and in that sense moves IFRS closer to the approach used currently in U.S. GAAP, but many differences between current IFRS and U.S. GAAP remain to be resolved before full convergence is achieved in this area.
The FASB and IASB both have projects under way relevant to transfers of receivables.
FINANCING WITH RECEIVABLES
The Hollywood Lumber Company obtains financing from the Midwest Finance Company by factoring (or discounting) its receivables. During June 2011, the company factored $1,000,000 of accounts receivable to Midwest. The transfer was made without recourse. The factor, Midwest Finance, remits 80% of the factored receivables and retains 20%. When the receivables are collected by Midwest, the retained amount, less a 3% fee (3% of the total factored amount), will be remitted to Hollywood Lumber. Hollywood estimates that the fair value of the amount retained by Midwest is $180,000.
In addition, on June 30, 2011, Hollywood discounted a note receivable without recourse. The note, which originated on March 31, 2011, requires the payment of $150,000 plus interest at 8% on March 31, 2012. Midwest's discount rate is 10%. The company's fiscal year-end is December 31.
Prepare journal entries for Hollywood Lumber for the factoring of accounts receivable and the note receivable discounted on June 30. Assume that the required criteria are met and the transfers are accounted for as sales.
Add interest to maturity to calculate maturity value.
Deduct discount to calculate cash proceeds.
|DECISION MAKERS' PERSPECTIVE|
RECEIVABLES MANAGEMENT A company's investment in receivables is influenced by several variables, including the level of sales, the nature of the product or service sold, and credit and collection policies. These variables are, of course, related. For example, a change in credit policies could affect sales. In fact, more liberal credit policies—allowing customers a longer time to pay or offering cash discounts for early payment—often are initiated with the specific objective of increasing sales volume.
| || (K)|
Management's choice of credit and collection policies often involves trade-offs. For example, offering cash discounts may increase sales volume, accelerate customer payment, and reduce bad debts. These benefits are not without cost. The cash discounts reduce the amount of cash collected from customers who take advantage of the discounts. Extending payment terms also may increase sales volume. However, this creates an increase in the required investment in receivables and may increase bad debts.
The ability to use receivables as a method of financing also offers management alternatives. Assigning, factoring, and discounting receivables are alternative methods of financing operations that must be evaluated relative to other financing methods such as lines of credit or other types of short-term borrowing.
Management must evaluate the costs and benefits of any change in credit and collection policies.
Investors, creditors, and financial analysts can gain important insights by monitoring a company's investment in receivables. Chapter 5 introduced the receivables turnover ratio and the related average collection period, ratios designed to monitor receivables. Recall that these ratios are calculated as follows:
The turnover ratio shows the number of times during a period that the average accounts receivable balance is collected, and the average collection period is an approximation of the number of days the average accounts receivable balance is outstanding.
As a company's sales grow, receivables also will increase. If the percentage increase in receivables is greater than the percentage increase in sales, the receivables turnover ratio will decline (the average collection period will increase). This could indicate customer dissatisfaction with the product or that the company has extended too generous payment terms in order to attract new customers, which, in turn, could increase sales returns and bad debts.
These ratios also can be used to compare the relative effectiveness of companies in managing the investment in receivables. Of course, it would be meaningless to compare the receivables turnover ratio of a computer products company such as IBM with that of, say, a food products company like Hershey. A company selling high-priced, low-volume products like mainframe computers generally will grant customers longer payment terms than a company selling lower priced, higher volume food products. Graphic 7-13 lists the 2009 receivables turnover ratio for some well-known companies. The differences are as expected, given the nature of the companies' products and operations. In particular, companies designing expensive products for medical and business applications turn over their receivables less frequently than do consumer-goods manufacturers and wholesalers.
GRAPHIC 7-13 (K)
Receivables Turnover Ratios
To illustrate receivables analysis in more detail, let's compute the 2009 receivables turnover ratio and the average collection period for two companies in the software industry, Symantec Corp. and CA, Inc. (formerly Computer Associates, Inc.).
Balance sheet and income statement information—Symantec Corp. and CA, Inc.
Receivables turnover and average collection period—Symantec Corp. and CA, Inc. (K)
On average, Symantec collects its receivables 30 days sooner than does CA, and 11 days faster than the industry average. A major portion of Symantec's sales of products like Norton antivirus software are made directly to consumers online who pay immediately with credit cards, significantly accelerating payment. CA, on the other hand, sells primarily to businesses, who take longer to pay.
Academic research has shown receivables information to be useful in financial statement analysis. Professors Lev and Thiagarajan empirically demonstrated the importance of a set of 12 fundamental variables in valuing companies' common stock. The set of variables included accounts receivable (change in accounts receivable minus change in sales) and allowance for uncollectible accounts (change in accounts receivable minus change in the allowance). Motivation for the receivables variable was that disproportionate increases in accounts receivable (relative to sales increases) can indicate difficulties in selling products, reflected in more lenient credit policies. The allowance variable was expected to indicate inadequate bad debt provisions. Both were found to be significant indicators of stock returns during high inflation years.29
EARNINGS QUALITY. Recall our discussion in Chapter 4 concerning earnings quality. We learned that managers have the ability, to a limited degree, to manipulate reported income and that many observers believe this practice diminishes earnings quality because it can mask “permanent” earnings. Former SEC Chairman Arthur Levitt listed discretionary accruals, which he called “Miscellaneous Cookie Jar Reserves,” as one of the most popular methods companies use to manipulate income.
Dell Inc. provides an example of a company that engaged in this sort of behavior. Dell had to restate four years of financial statements (from 2003 to 2007) after it discovered that executives had been using a variety of accounting techniques to achieve quarterly earnings targets. For example, revenue associated with software licenses and product warranties was being recognized too quickly, and extra warranty reserves were maintained that could be adjusted to compensate for earnings shortfalls.
Sometimes financial statement users can examine accounts receivable, the allowance for bad debts, and other accounts to detect low earnings quality. For example, in April 1998, PaineWebber Inc. downgraded its stock recommendation for Sunbeam, Inc., after noticing unusually high accounts receivable and unexpected increases in sales of certain products. Also, Sunbeam's allowance for uncollectible accounts had shown large increases in prior periods. It eventually came to light that Sunbeam had been manipulating its income by using a “bill and hold” strategy with retail buyers. This involved selling products at large discounts to retailers before they normally would buy and then holding the products in third-party warehouses, with delivery at a later date.
| ||ARTHUR LEVITT, JR.|
A third illusion played by some companies is using unrealistic assumptions to estimate … such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookie jars during good times and reach into them when needed in the bad times.30
Bad debt expense is one of a variety of discretionary accruals that provide management with the opportunity to manipulate income.
Often times, though, financial statement users must rely on the company's internal control system to prevent fraud and preserve earnings quality, because the effects of poor accounting quality can be difficult for outsiders to detect. Dell's accounting problems were identified by an internal investigation that followed an SEC inquiry on another matter. Dell acknowledged that poor internal controls contributed to its problems. Dell's income manipulation was never extreme enough to be detected by outsiders, but strong internal controls could have prevented it from occurring at all.
Another area for accounting-quality concern is the sale method used to account for transfers of receivables. Recent research suggests that some companies manage earnings by distorting the fair value estimates that are made as part of recording securitizations.31
Also, some firms classify cash flows associated with selling their accounts receivable in the operating section of the statement of cash flows, such that changes in the extent to which accounts receivable are sold can be used to manipulate cash flow from operations. In fact, evidence suggests that sophisticated investors and bond-rating agencies undo sales accounting to treat transfers of receivables as secured borrowings before assessing the riskiness of a company's debt.32
As noted earlier in this chapter, recent changes in GAAP have made it more difficult for transfers to qualify for sales accounting, but Wall Street is very good at identifying clever ways to structure transactions around accounting standards, so it is important to be vigilant regarding the accounting for these transactions. (0.0K)
|FINANCIAL REPORTING CASE SOLUTION|
|Explain the allowance method of accounting for bad debts. (p. 347) The allowance method estimates future bad debts in order to (1) match bad debt expense with related revenues and (2) report accounts receivable in the balance sheet at net realizable value. In an adjusting entry, we record bad debt expense and reduce accounts receivable indirectly by crediting a contra account to accounts receivable for an estimate of the amount that eventually will prove uncollectible.
What approaches might Cisco have used to arrive at the $275 million bad debt provision? (p. 348) There are two ways commonly used to arrive at an estimate of future bad debts: the income statement approach and the balance sheet approach. Using the income statement approach, we estimate bad debt expense as a percentage of each period's net credit sales. The balance sheet approach determines bad debt expense by estimating the net realizable value of accounts receivable. In other words, the allowance for uncollectible accounts is determined and bad debt expense is an indirect outcome of adjusting the allowance account to the desired balance.
| |Are there any alternatives to the allowance method?
) An alternative to the allowance method is the direct write-off method. Using this method, adjusting entries are not recorded and any bad debt that does arise simply is written off as bad debt expense. Of course, if the sale that generated this receivable occurred in a previous reporting period, this violates the matching principle. Operating expenses would have been understated and assets overstated that period. This is why the direct write-off method is not permitted by GAAP except in limited circumstances. (0.0K)
18Because the SPE is a separate legal entity, it typically is viewed as “bankruptcy remote,” meaning that the transferor's creditors can't access the receivables if the transferor goes bankrupt. This increases the safety of the SPE's assets and typically allows it to obtain more favorable financing terms than could the transferor.
19FASB ASC 860: Transfers and Servicing (previously “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” Statement of Financial Accounting Standards No. 166 (Norwalk, Conn.: FASB, 2009)).
20FASB ASC 810: Consolidation (previously “Amendments to FASB Interpretation No. 46R,” Statement of Financial Accounting Standards No. 167 (Norwalk, Conn.: FASB, 2009)).
21FASB ASC 860: Transfers and Servicing (previously “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” Statement of Financial Accounting Standards No. 166 (Norwalk, Conn.: FASB, 2009)).
22Consistent with Graphic 7-8, Illustration 7-6 depicts an arrangement in which the factor's fee is paid out of the 10% of receivables retained by the factor. Alternatively, a factoring arrangement could be structured to have the factor's fee withheld from the cash advanced to the company at the start of the arrangement. In that case, in Illustration 7-6 the journal entry recorded by Santa Teresa would be:
23FASB ASC 860–10–40: Transfers and Servicing—Overall—Derecognition (previously “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” Statement of Financial Accounting Standards No. 140 (Norwalk, Conn.: FASB, 2000), as amended by SFAS No. 166).
24FASB ASC 860–10–40: Transfers and Servicing—Overall—Derecognition (previously “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” Statement of Financial Accounting Standards No. 166 (Norwalk, Conn.: FASB, 2009), par. 26C).
25FASB ASC 860–10–40: Transfers and Servicing—Overall—Derecognition (previously “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” Statement of Financial Accounting Standards No. 166 (Norwalk, Conn.: FASB, 2009), par. 17).
26“Financial Instruments: Recognition and Measurement,” International Accounting Standard No. 39 (IASCF), as amended effective January 1, 2009.
27FASB ASC 860: Transfers and Servicing (previously “Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140,” Statement of Financial Accounting Standards No. 166 (Norwalk, Conn.: FASB, 2009)).
28Exposure Draft:Derecognition, Proposed Amendments to IAS 39 and IFRS 7 (IASCF), April 2009.
29B. Lev and S. R. Thiagarajan, “Fundamental Information Analysis,” Journal of Accounting Research 31, No. 2 (Autumn 1993). The main conclusion of the study was that fundamental variables, not just earnings, are useful in firm valuation, particularly when examined in the context of macroeconomic conditions such as inflation.
30Arthur Levitt, Jr., “The Numbers Game,” The CPA Journal, December 1998, p. 16.
31P. M. Dechow, L. A. Myers, and C. Shakespeare, “Fair Value Accounting and Gains from Asset Securitizations: A Convenient Earnings Management Tool with Compensation Side-Benefits,” Working paper, February 11, 2009.
32Other recent research provides evidence that investors treat securitizations as loans rather than asset sales, suggesting that they are unconvinced that a sale has truly taken place. For example, see W. R. Landsman, K. Peasnell, and C. Shakespeare, “Are Asset Securitizations Sales or Loans?” The Accounting Review 83, no. 5 (2008), pp. 1251–72.