Receivables Revsine/Collins/Johnson/Mittelstaedt: Chapter 8 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Receivables

Revsine/Collins/Johnson/Mittelstaedt: Chapter 8

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning objectives

1. How to account for accounts receivable using net realizable value.

2. How to analyze accounts receivable under net realizable value accounting.

3. How to spot whether or not reported receivables arose from real sales.

4. How and why interest is recorded on “non-interest bearing” notes.

5. How to account for accounts receivable and notes receivable using the fair value option.

6. How companies use receivables to accelerate cash inflows and how this affects financial statement ratios.

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Learning objectives (cont.)

7. Why receivables are securitized and how this affects financial statement ratios

8. Why receivables are restructured when a customer experiences financial difficulty and how to account for the troubled-debt restructuring.

9. The key differences between current GAAP and IFRS requirements for receivable accounting and possible changes.

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Accounts receivable:Assessing net realizable value

Accounts receivable are generally reflected in the balance sheet at their net realizable value.

Two things must be estimated to determine the net realizable value of receivables:1. Uncollectibles—the amount that will not be collected because

customers are unable to pay.2. Returns and allowances—the amount that will not be collected

because customers return the merchandise or are allowed a reduction in the amount owed.

NRV ofreceivables

Gross amount owned

Estimated uncollectibles

Estimated returns &

allowances= - -

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Accounts receivable:Why estimating uncollectibles is important

Most companies establish credit policies by weighing the expected cost of credit sales against the benefit of increased sales.

This tradeoff illustrates that bad debts are often unavoidable.

The matching principle requires that some estimate of uncollectible accounts be offset against current period sales.

Customer collection and billing costs plus potential bad debts

Today Some future datesTime

$10,000 current period sales

$500 is uncollectible

$500 estimated expense

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Accounts receivable:Sales revenue approach

Bristol Corporation estimates that bad debt losses arising from first quarter 2011 sales are expected to be $30,000.

DR Bad debt expense $30,000

CR Allowance for uncollectibles $30,000

A contra-asset account subtracted from gross accounts receivable

If Bristol’s gross accounts receivable and allowance for uncollectibles before recording this bad debt entry were $1,500,000 and $15,000, then after the entry the balance sheet would show:

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Accounts receivable:Sales Revenue approach

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Accounts receivable:Gross receivable approach

Management believes that 3% of existing gross receivables will ultimately be uncollectible

Notice this second step

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Accounts receivable:Do existing receivables represent real sales?

Reasons why receivables might grow faster than sales:

• Change in credit policy.

• Deteriorating credit worthiness among existing customers.

• Firm has changed its financial reporting policy – accelerated revenue recognition.

Receivables

Sales

Time

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The Fair Value OptionBristol Corporation

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

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

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

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Accelerating cash collections:Sale and collateralized borrowing

There are two ways to accelerate cash collections:

Companies might want to accelerate cash collection: (1) to avoid processing and collection costs; (2) because of a cash flow imbalance between supplier payments and receivable collections; or (3) to fund an immediate cash need.

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Accelerating cash collections:Is it a sale or a borrowing?

The FASB has provided guidelines in the Accounting Standards Codification

However, ambiguities abound.

Sale of receivables:

Is controlsurrendered?

Receivables removed from balance sheet

Gain or loss recognized in income

Borrowing againstreceivables

Receivables stay on balance sheet

Loan shown as balance sheet liability.

No gain or loss recognized in income

Sale Borrowing

Assets are beyond reach

Buyer has right to dispose

Seller has no obligation to repurchase

Yes No

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in exchange for cash

Accelerating cash collections:A closer look at securitizations

Bank forms a bundled portfolio of 7% home mortgage receivables of “moderate” risk.

A third-party investor is willing to buy the portfolio at a price that yields a 6% return.

Because the selling price at 6% is higher than the carrying value of the mortgages, the bank records a gain.

Both the bank and the investor win in this transaction.

Bank Investor

Customer

Receivables transferred

Mortgage receivables

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Troubled debt restructuring

When a customer is financially unable to make required interest and principal payments, the lender can force the customer into bankruptcy or restructure the loan receivable.

The restructured loan can differ from the original loan in several ways:

Scheduled interest and principal payments may be reduced or eliminated.

The repayment schedule may be extended over a longer time period. The customer and lender can settle the loan for cash, other assets, or

equity interests.

Restructured loans benefit both the customer and the lender.

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Troubled debt restructuring:Summary

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Global Vantage PointComparison of IFRS and GAAP Receivable Accounting

IFRS is similar to the accounting under U.S. GAAP – called amortised cost which refers to the gross amount of the receivable and an allowance for doubtful accounts is created.

IFRS allows a more limited version of the fair value option IFRS – firms may elect the fair value option only in cases where it

eliminates an accounting mismatch or because a group of assets are managed and evaluated using fair values.

GAAP

Allows the fair value option for a broader

set of transactions

IFRS

Requires fair value disclosures for short-

term trade receivables and loans in addition to

long term notes receivable

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Summary

GAAP requires that accounts receivable be shown at their net realizable value.

Two methods are used to estimate uncollectibles: (1) the sales revenue approach, and (2) the gross accounts receivables approach. In either case, firms still must perform an “aging”.

Analysts should scrutinize the allowance for uncollectibles account balance over time.

Receivable growth can exceed sales growth for several reasons, including when aggressive revenue recognition practices are being used.

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Summary continued

It is sometimes necessary to “impute” the effective interest rate on a note receivable.

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).

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).

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Summary concluded 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.

Lenders often restructure loans when the customer is unable to make required payments. These troubled debt restructurings involve (a) settlement, or (b) continuation with modification of debt terms.

When terms are modified, the precise accounting treatment depends on whether the sum of future cash flows from the restructured note are above or below the original note’s carrying value at the restructuring date. Remember, the interest rate used in accounting for troubled debt restructurings may not reflect the real economic loss suffered by the lender.

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

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