receivables rcj chapter 8 (except 405-412). paul zarowin2 key issues 1.how receivables are used to...
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Receivables
RCJ Chapter 8 (except 405-412)
Paul Zarowin 2
key Issues
1. How receivables are used to raise cash2. Recourse vs. non-recourse sales3. Consequences of different methods on financial
statements4. Role of receivables in earnings management
Paul Zarowin 3
Allowance Method
1. Sales DR A/R CR Credit sales revenue
2. Collections DR Cash CR A/R
3. Write-off’s DR AUA (or ADA) CR A/R
Adjusting entry:4. Bad debts expense
DR Bad debt expense CR AUA (or ADA)
Paul Zarowin 4
A/RBeginning Balance
(+) Credit sales revenue
(-) Write-offs (-) Collections
Ending Balance
Allowance of Uncollectable Accounts (AUA)
Beginning Balance
(-) Writeoffs(+) Bad debt exp.
Ending Balance
Allowance Method (cont’d)
ex. C8-1, parts 1, 6, & 7
Paul Zarowin 5
Using A/R to Raise Cash Sometimes companies have need to accelerate cash collections:
A. Immediate cash needs
B. Credit sales: the company is unwilling/unable to bear the cost of processing and collections of credit
C. Imbalance in the cash cycle: days for payable (to suppliers) is shorter than days for receivables (from customers)
D. Loan covenants may preclude the company from borrowings
In such instances companies can use their A/R to raise cash: Assignment: Collateralized borrowing (A/R used as collateral) Factoring: Sale of Receivables
Paul Zarowin 6
Using A/R to Raise Cash: J.E.
1. Assignment: collateralized borrowingDR Cash
DR Finance charge/Interest expenseCR Liability
2. Factoring: sale of receivable
DR Cash
DR Loss*
CR A/R(*) can be gain (CR) if cash > A/R, but unlikely
Note: different effects on assets vs. liabilities
Paul Zarowin 7
Recourse vs. Non-Recourse Is transaction a sale or a borrowing?
Who bears risk of loss? How does this affect price of A/R?
Recourse: seller/borrower must buy back defaulted A/R from buyer/ lender.
Non-Recourse:
buyer/lender must keep defaulted A/R.
The conditions are specified in RCJ, page 400
Paul Zarowin 8
3 Possible Cases
1. Recognize a loss and a contingent liability (disclose in footnote, not on B/S) for the possibility of defaulted receivables.
2. Recognize interest expense or finance charge and a recognized (on B/S) liability.
3. Recognize a loss, but no required disclosure (of A/R sale), so can’t distinguish from ordinary collection.
X Not allowed.
Example: P8-18
Sale Borrowing
Recourse 1 2
Non-Recourse
3 X
Paul Zarowin 9
Entries for Sale and Borrowing
Why DR AUA for non-recourse sale only?
Sale BorrowingDR CashDR LossDR AUA (for non-recourse sale) CR A/R
DR Cash DR Interest expense
CR Liability
Paul Zarowin 10
Effect of Cash Receipt on SCF
#1 is really collateralized borrowing; cash is recorded as CFO, but should be CFF
#2 is actual borrowing, so cash is CFF
#3 is acceleration of collection, so cash is CFO (like collection)
#1 overstates CFO, understates CFF, understates current liabilities and A/R (no effect on O/E)
Paul Zarowin 11
What is a Holdback? When the sale or assignment of A/R is with recourse,
the factor or borrower usually delays payment of a portion of the amount due – this is called a Holdback.
The factor/borrower uses this held-back amount to cover contingencies, such as sales returns.
The holdback appears as a current asset ‘due from factor’ on the seller’s balance sheet.
If the contingencies do not materialize, the seller gets the money back.
Paul Zarowin 12
Example: Sale (with/without recourse) vs. Borrowing
Firm A transfers to a factor $100 of A/R having ADA of $5. The transfer can be treated as sale or a borrowing.
Case 1 - Sale without recourse: the transfer is without recourse, and firm A receives $90. Since there is no recourse, it must be a sale.
Note: since sale is without recourse, Firm A DR’s AUAA/R reduces on B/S$90 cash received is CFO
Firm A’s J.E. Factor’s J.E.
DRCash 90AUA 5Loss 5
CR
A/R 100
DRA/R 95
CRCash 90AUA 5
Paul Zarowin 13
Example (cont’d)
Case 2 - Sale with recourse: the transfer is with recourse, and firm A receives $95 (note that the amount received is higher than in case 1, since A still bears the default risk). Assume that the conditions exist for this transfer to be as a sale.
Note: since sale is with recourse, Firm A does not DR AUAA/R reduces on B/Scontingent liability disclosed for possible default of sold A/R$95 cash received is CFO
Firm A’s J.E. Factor’s J.E.
DRCash 95Loss 5
CR
A/R 100
DRA/R 95
CRCash 95
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Example (cont’d)
Case 3 - Assignment with recourse: the transfer is with recourse, and firm A receives $95. Assume that the conditions exist for this transfer to be as a borrowing.
Note: total assets and total liabilities higher than in cases 1 or 2$95 cash received is CFF
ex. P8-14 (Atherton Manufacturing)
Firm A’s J.E. Factor’s J.E.
DRCash 95
Interest exp. 5
CR
N/P 100
DRN/R 100
CRCash 95
N/P Discount 5
(and/or) factor fee
(can show the N/R at 95 net)
Paul Zarowin 15
Sale With Recourse: Is It a Sale?
Issue: Effects of (non) recognition vs disclosureIs really collateralized borrowing; so assets and liabilities
both understated.
To correct:DR A/R
DR Interest expense/finance charge
CR Liability
CR Loss
If these are equal only
effect is on B/S
Paul Zarowin 16
Sale With Recourse: Is It a Sale? (cont’d)
What is effect on ratios? Profitability
ROA (=NI/TA): overstated ROE (=NI/OE): no effect (why? See slide #9)
Liquidity Current Ratio (=CA/CL) If CR>1, it is overstated If CR<1, it is understated
of recording a sale instead of a borrowing
AB
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Aggressive Revenue Recognition Aggressive revenue recognition (trade
loading, channel stuffing) will increase
A/R grows faster than sales.
Below is an illustrative example.
ratio Sales
A/R
Ex. C 3-6, Clear One CommunicationsP. 8-21, Grosse Point Channel Stuffing
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Case 1: Normal Sales (all on credit) grow at 10% per year. Collections equal 50% of current year’s sales (receivables)
plus 40% of last year’s sales (receivables). Any receivables uncollected by the end of the year after sale,
must be written off. Thus, 10% of receivables are written off.Year 1 Year 2 Year 3 Year 4
A/R @ BOY 0 500 550+400=950 440+605=1045
Sales 1000 1100 1210 1331
Collections 500 550+400=950 440+605=1045 484+665=1149
Write-offs - 100 110 121
A/R @ EOY 500 550 605 666
A/R growth% - 10% 10% 10%
A/R÷Sales 50% 50% 50% 50%
A/R @ EOY = A/R @ BOY + sales - collections - writeoffs
Paul Zarowin 19
Case 2: Aggressive
(trade loading, channel stuffing) Sales (all on credit) grow at 20% per year, due to aggressive
revenue recognition, but collections are based on “real” sales (see Case 1); i.e., only “real” sales result in collections.
Any receivables uncollected by the end of the year after sale, must be written off.
Year 1 Year 2 Year 3 Year 4
A/R @ BOY 0 500 650 835
Sales 1000 1200 1440 1728
Collections 500 400+550=950 440+605=1045 484+665=1149
Write-offs - 100 210 351
A/R @ EOY 500 650 835 1063
A/R growth% - 30% 28% 27%
A/R÷Sales 50% 55% 58% 62%
A/R @ EOY = A/R @ BOY + sales - collections - writeoffs
Paul Zarowin 20
Pfizer’s revenue grew by 11% (from 7,584 to 8,418), while receivables grew by 21% (5,337 to 6,453).
Relevant information:Bristol-Myers, another big pharmaceutical firm, warned earlier this year of a large sales and profit shortfall because it sold too much to wholesalers last year (channel stuffing).
What do you think the increase in Pfizer’s receivables indicates?
1. Channel stuffing
2. Legitimate change in the business environment
Pfizer’s 2002 Q1 Report
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Now consider this additional information: Two other pharmaceutical companies,
Schering-Plough and Eli Lilly, also saw big receivables jumps in the first quarter of 2002.
What do you think about Pfizer’s receivables increase now?
1. Channel stuffing
2. Legitimate change in the business environment
Pfizer’s 2002 Q1 Report (cont’d)
Paul Zarowin 22
Factoring to Camouflage Increase in Receivables
1. Inflate revenues by aggressive revenue recognition.2. Growth in A/R ÷ sales is a red flag. 3. Factorings (sale of the good A/R) hides this signal.4. Detection problem: lack of required disclosures for
sales without recourse.
# See RCJ’s discussion on Bausch and Lomb pg. 348-352, Table 8.1 pg. 349 and Sunbeam pg. 361-362
Key question: is factoring “normal” activity, or to camouflage?
ex. C8-3
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