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### CHAPTER 8

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $39,000($30,000 principal + $9,000 accrued interest as of Jan 1st ,2001).

FINANCIAL REPORTING & ANALYSIS

BY

REVSINE – COLLINS – JOHNSON

2nd Edition

RECEIVABLES

Slides Authored by

Brian Leventhal

University of Illinois at Chicago

I. Assessing the Net Realizable Value of Accounts Receivable

A. Estimating the net realizable value of receivables:

1. The full amount of receivablesmay not be collectible either because customers:

a. Are unable to pay (referred to as uncollectibles), or

b. Return the merchandise for credit or are allowed a reduction in the amount owed (referred to as returns and adjustments).

I. Assessing the Net Realizable Value of Accounts Receivable

A. Estimating the net realizable value of receivables:

2. These losses are an unavoidable consequence of the trade-off between increased costs and additional profits from credit sales.

I. Assessing the Net Realizable Value of Accounts Receivable

- Sales to customers who are ultimatelyunable to pay are treated as:

- Expensesof the period in which the sales are made to follow the matching principle.
- Most likely this will be an ESTIMATE!

1. The entry under GAAP is: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

Allowance

For

Uncollectibles

Actual Uncollectibles

When Known

Estimate of Uncollectibles

In the Period of Sale

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

Allowance

For

Uncollectibles

Beg. Balance XX

Actual Customer

Written Off

Bad Debts Expense (Estimate) XX

Ending Balance XX

For

Uncollectibles

Bad Debt

Expense

I. Assessing the Net Realizable Value of Accounts Receivable

1. The entry under GAAP is: DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

The allowance for uncollectibles is a contra-asset account that is subtracted from gross accounts receivable.

Beg. Bal.

$15,000

$30,000

$30,000

Goes

On

I/S

End. Bal.

$45,000

For

Uncollectibles

Accounts

Receivable Gross

I. Assessing the Net Realizable Value of Accounts Receivable

Balance Sheet Presentation

Accounts

Receivable

Net

=

Less

$1,500,000

=

$45,000

$1,455,000

OR

Accounts Receivable (gross) $1,500,000

Less: Allowance for uncollectibles (45,000)

Accounts Receivable (net) $1,455,000

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Allowance

For

Uncollectibles

Estimate of Uncollectibles

In the Period of Sale

Method #1 – The Sales Revenue Approach

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #1 – The Sales Revenue Approach

Allowance

For

Uncollectibles

- A specific loss percentage is multiplied by sales revenue to estimate bad debt expense.
- The loss percentage is based on past experience of the firm.

Est. of Uncoll.

In the

Period

of Sale

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #1 – The Sales Revenue Approach

Bad Debts Exp = Net Credit Sales * Loss %

=

$3,000,000 * .01

$30,000

This method directly provides the adjusting entry amount.

DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

For

Uncollectibles

Bad Debt

Expense

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #1 – The Sales Revenue Approach

DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

Beg. Bal.

$15,000

$30,000

$30,000

For

Uncollectibles

Est. of Uncoll.

In the

Period

of Sale

How do we get this $$?

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #2 – The gross receivables approach:

- A specific loss percentage is multiplied by gross receivables to estimate the required allowance account balance.
- The adjusting entry is the amount necessary to get the unadjusted allowance balance to the required amount.
- The loss percentage is based on past experience.

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #2 – The gross receivables approach:

Required

Allowance = Gross Receivables * Loss %

Balance

+/- Bal. In Allowance

Bad Debts Expense

This method does notdirectly provide the adjusting entry amount.

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #2 – The gross receivables approach:

Required

Allowance = Gross Receivables * Loss %

Balance

+/- Bal. In Allowance

Bad Debts Expense

$1,500,000

$45,000

.03

- $15,000

Bad Debts Expense

$30,000

The Adjusting entry is:

DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

For

Uncollectibles

Bad Debt

Expense

I. Assessing the Net Realizable Value of Accounts Receivable

C. Estimatinguncollectible receivables:

Method #2 – The gross receivables approach:

DR Bad debt expense $30,000 CR Allowance for uncollectibles $30,000

Beg. Bal.

$15,000

$30,000

$30,000

For

Uncollectibles

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

What happens when we know this $$?

Actual Customer

Written Off

Actual information is updated when known!

DR Allowance for uncollectibles $750 CR Accounts Receivable-Ralph Co. $750

For

Uncollectibles

I. Assessing the Net Realizable Value of Accounts Receivable

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

DR Allow. for uncoll. $750 CR A/R-Ralph Co. $750

Actual customer write-off

It makes sense because bad debtsexpense is an estimate and already recorded.

This is updating your estimate in theAllowance Account!

Actual Customer

Written Off

Bad Debts Exp.

(Estimate)

Assets = Liabilities + Owner’s Equity

Allow. For Uncoll Accts. ($750)

A/R- Ralph Co. 750

Why does this make sense?

Why is Bad Debts Exp. not affected?

Overall effect $0

For

Uncollectibles

Actual Customer

Written Off

Bad Debts Exp.

(Estimate)

I. Assessing the Net Realizable Value of Accounts Receivable

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

- The loss % is based on historical averages.
- Changes in credit terms, the credit policy, or economic changes may require use of a different %.
- Actual write-offs that differ from expected levels in any year may not require a changeinestimate.

For

Uncollectibles

Actual Customer

Written Off

Bad Debts Exp.

(Estimate)

I. Assessing the Net Realizable Value of Accounts Receivable

I. Assessing the Net Realizable Value of Accounts Receivable

How the Allowance Account Works

A change in estimate is required only when there is fundamental change in underlying market conditions.

I. Assessing the Net Realizable Value of Accounts Receivable

D. Assessing the adequacy of the allow. for uncoll. accounts balance:

1. Management performs an aging of A/R.

a. An aging of receivables is a determination of how long each receivable has been outstanding.

b. The longer a receivable is outstanding, the more likely that it will be uncollectible.

I. Assessing the Net Realizable Value of Accounts Receivable

D. Assessing the adequacy of the allow. for uncoll. account balance:

2. Because of the judgment that is required, the temptation to “manage” earnings by using bad debt accruals can be strong.

I. Assessing the Net Realizable Value of Accounts Receivable

E. Estimatingsales returns & adjust.:

- Sometimes the wrong goods are shipped to customers orthe correct goods arrive damaged
- prompting customers to return the goods or request price adjustments.

I. Assessing the Net Realizable Value of Accounts Receivable

E. Estimatingsales returns & adjust.:

2. These returns & adjustmentsreduce both the accounts receivablebalance and income.

Contra Revenue Account

DR Sales Returns & Allowances $8,000 CR A/R-Bath Co. $8.000

3. Ignoringestimated future returns & adjustments has a trivial effect on income when the amount of actual returns & adjustmentsdoes not vary greatly from year to year.

I. Assessing the Net Realizable Value of Accounts Receivable

F. Do existing receivables represent real sales?

- The growth ratesinsales and accounts receivable will be roughly equal when:
- sales terms,customer credit standing, and accounting methods
- do not change from period to period.

2. Any disparity between the two growth rates represents a potential “red flag.”

A. Sellers may extend long-term credit to buyers, who then sign notes payable.

- An attempt is made to separate the operating income ( gross profit from sale) from:
- the financing income (interest income).

C. The transaction is recorded at the fair value of the item(s) given up, if known.

1. This is the first option since managers have a better idea about the value of the items they routinely sell.

- An imputed interest rate, that equates the value of the items given up to the future cash inflows from the note, is calculated. This is calculating the IRR.

D. If not recorded at fair value of items given up, then the transaction is recorded at the present value of the note accepted in return for the item(s).

- If the stated rate is equal to the prevailing market rate for a note of that risk level,
- then the sales priceequals the face value of the note.

Stated Rate = Prevailing Rate

NO NEED TO IMPUTE INTEREST

Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year.

Assume that 10% approximates prevailing borrowing rates for like companies.

DR Notes Receivable-Texas Products $50,000

CR Sales Revenues $50,000

Stated Rate = Prevailing Rate

NO NEED TO IMPUTE INTEREST

Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year.

Assume that 10% approximates prevailing borrowing rates for like companies.

Interest Incomeaccrues each quarter:

DR Accrued Interest Receivable $1,250

CR Interest Income $1,250

3 months interest = [$50,000 x .10] /4 = $1,250

Stated Rate = Prevailing Rate

NO NEED TO IMPUTE INTEREST

Example: Michelle Corp. sells a machine to Texas Products Co. accepting a $50,000 three-year note with interest of 10% per annum to be paid in quarterly installments each year.

Assume that 10% approximates prevailing borrowing rates for like companies.

When cash payment is received, the accrued interest receivable would be reduced:

DR Cash $1,250

CR Accrued Interest Receivable $1,250

D. If not recorded at fair value of items given up, then the transaction is recorded at the present value of the note accepted in return for the item(s).

- If the stated ratedeviates from the prevailing market rate, or
- if there is no stated interest rate,
- then the seller must calculate the present value of the future cash inflows.

a. An estimated discount rate must be selected.

b. The rate selecteddirectly affects the allocation of income between operating and financingactivities.

NEED TO IMPUTE INTEREST

II. Imputed Interest

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paidoff at end of three years.

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

The Present Value factor for 3 years at 10% is .75132

PV of note = Future Value x Present Value interest factor

(Sale Price)

=

x

$37,566

$50,000

.75132

NEED TO IMPUTE INTEREST

II. Imputed Interest

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

The Present Value factor for 3 years at 10% is .75132

DR Notes Receivable-Davenport Products $37,566

CR Sales Revenues $37,566

NEED TO IMPUTE INTEREST

II. Imputed Interest

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

Over the next 3 years, interest incomerecognized is:

Let’s see

How to split this up over the 3 yrs.

Notes Receivable-Davenport Products $50,000

Less: Sales Revenues $37,566

Total Interest on N/R all 3 years $12,434

NEED TO IMPUTE INTEREST

II. Imputed Interest

Example: Monson Corp. sells a machine to Davenport Products Co. accepting a $50,000 three-year note with no interest to be paid at end of three years.

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

Year 1- N/R is increased and interest incomerecognized.

Interest Income = CV of N/R x Prevailing Rate

=

$3,756.60

$37,566

.10

x

NEED TO IMPUTE INTEREST

II. Imputed Interest

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

The Present Value factor for 3 years at 10% is .75132

DR Notes Receivable-Davenport Products $3,756.60

CR Interest Income $3,756.60

NEED TO IMPUTE INTEREST

II. Imputed Interest

Notes

Receivable

Interest

Income

Beg yr.1

$37,566.00

Year 1

$3,756.60

$3,756.60

$41,322.60

End yr.1

NEED TO IMPUTE INTEREST

II. Imputed Interest

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

Year 2- N/R is increased and interest incomerecognized.

Interest Income = CV of N/R x Prevailing Rate

=

$4,132.26

$41,322.60

.10

x

NEED TO IMPUTE INTEREST

II. Imputed Interest

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

The Present Value factor for 3 years at 10% is .75132

DR Notes Receivable-Davenport Products $4,132.26

CR Interest Income $4,132.26

NEED TO IMPUTE INTEREST

Beg yr.1

$37,566.00

$3,756.60

$41,322.60

End yr.1

II. Imputed Interest

Notes

Receivable

Interest

Income

Year 1

$3,756.60

Year 2

$4,132.26

$4,132.26

End yr. 2

$45,454.86

NEED TO IMPUTE INTEREST

II. Imputed Interest

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

Year 3- N/R is increased and interest incomerecognized.

Interest Income = CV of N/R x Prevailing Rate

=

$4,545.14 r

$45,454.86

.10

x

NEED TO IMPUTE INTEREST

II. Imputed Interest

Monson’s cash selling price for equipment is $37,566.

Assume that 10% approximates prevailing borrowing rates for like companies.

The Present Value factor for 3 years at 10% is .75132

DR Notes Receivable-Davenport Products $4,545.14

CR Interest Income $4,545.14

NEED TO IMPUTE INTEREST

II. Imputed Interest

Notes

Receivable

Interest

Income

$37,566.00

Beg yr.1

Year 1

$3,756.60

$3,756.60

$41,322.60

Year 2

End yr.1

$4,132.26

$4,132.26

Year 3

$4,545.14

$45,454.86

Total 3 years

$12,434.00

End yr. 2

$4,545.14

End yr. 3

$50,000.00

NEED TO IMPUTE INTEREST

II. Imputed Interest

Notes

Receivable

Interest

Income

$50,000.00

End yr. 3

$50,000.00

Year 1

$3,756.60

0

Year 2

$4,132.26

Year 3

DR Cash $50,000

CR N/R $50,000

To record payment of N/R

$4,545.14

Total 3 years

$12,434.00

Accelerating Cash Collections: Transfers and Dispositions of Receivables

A. There are two traditional ways to acceleratecash collections of accounts receivable:

- Factoring, where the company sells its receivablesoutright in exchange for cash and
- The receivables are removed from the company’s books.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Factoring, where the company sells its receivablesoutright in exchange for cash and the receivables removed from books.

- Factoring can be without recourse,
- The factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Factoring can be without recourse, the factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible.

- The fee charged by the factor is charged to interest expense.
- This fee is not only as a charge to cover the administrative cost of the factor,
- but also as the difference between the present value and the NRV of the receivables.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Factoring can be without recourse, the factor (buyer)cannot turn to the company for payment if customer receivables prove uncollectible.

ii. The factor will charge a higher fee in a nonrecourse arrangement than a with recourse arrangement, because of the higher riskassumed.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Factoring, where the company sells its receivablesoutright in exchange for cash and the receivables are removed from the company’s books.

- Factoring can be with recourse,
- The company is willing to buy back any bad customer receivables from the buyer of the A/R.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Factoring, where the company sells its receivablesoutright in exchange for cash and the receivables are removed from the company’s books.

- A holdback account represents a cushion to absorb credit losses (in the case of a sale with recourse),
- or the costs of sales returns, discounts, or price adjustments in both with/without recourse transactions.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

A. There are two traditional ways to acceleratecash collections of A/R:

2. Assignment of receivables involves a loan that is collateralized by the customer receivables.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

2. Assignment of receivables involves a loan that is collateralized by the customer receivables.

a. The A/R is not removed from the company’s books.

b. A liability is credited to reflect the loan.

c. The fact that receivables have been pledged as collateralmust be disclosed in the notes to the F/S, if material.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

B. Notes receivable can also be assigned or sold (with or withoutrecourse).

1. Accelerating cash collections on N/R is called discounting.

2. The buyeradvances cash to the company based on the discounted present value of the N/R.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Sale of A/R (FACTORING Without Recourse)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor).

Leslie charges a 5% fee (5% x $80,000 = $4,000) for the service and pays Hervey $76,000.

The entry to record the nonrecourse sale of the A/R on Hervey’s books is?

DR Cash $76,000

DR Interest Expense 4,000

CR Accounts Receivable $80,000

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Sale of A/R (FACTORING Without Recourse & Holdback)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor). The holdback is $3,000.

Leslie charges a 5% fee (5% x $80,000 = $4,000) for the service and pays Hervey $73,000. ($80,000 – $4,000-$3000)

The bank refuses to bear the costs of sales returns , discounts or price adjustments. So a hold back is required.

The entry to record the nonrecourse sale w/holdback of the A/R on Hervey’s books is?

DR Cash $73,000

DR Interest Expense 4,000

DR Due from Leslie (A/R) 3,000

CR Accounts Receivable $80,000

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Any returns, discounts or adj. Reduce the amount paid to Hervey by Leslie.

$1,800 of these items occurred.

Example: Sale of A/R (FACTORING Without Recourse & Holdback)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor). The holdback is $3,000.

Leslie charges a 5% fee (5% x $80,000 = $4,000) for the service and pays Hervey $73,000. ($80,000 – $4,000-$3000)

The entry to record the nonrecourse sale w/holdback of the A/R when collection period is over on Hervey’s books is?

DR Cash ($3,000 - $1,800) $1,200

DR Sales returns, adj. & discounts 1,800

CR Due from Leslie (A/R) 3,000

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Sale of A/R (FACTORING With Recourse & Holdback)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor). Leslie’sholdback is $5,000 to cover possible non-collections.

Leslie charges a 4 % fee (4 % x $80,000 = $3,200) for the service and pays Hervey $71,800. ($80,000 -$3,200-$5,000)

The entry to record the recourse sale & holdback of the A/R on Hervey’s books is?

DR Cash $71,800

DR Interest Expense 3,200

DR Due from Leslie (A/R) 5,000

CR Accounts Receivable $80,000

All but $3,750 of the sold A/R are collected.

- Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Sale of A/R (FACTORING With Recourse & Holdback)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor). Leslie’sholdback is $5,000 to cover possible non-collections.

Leslie charges a 4 % fee (4 % x $80,000 = $3,200) for the service and pays Hervey $71,800. ($80,000 -$3,200-$5,000)

The entry to record the recourse sale w/holdback of the A/R when collection period is over on Hervey’s books is?

DR Cash ($5,000 - $3,750) $1,250

DR Allowance for Uncollectibles 4,000

CR Due from Leslie (A/R) 5,000

WHY??

All but $3,750 of the sold A/R are collected.

- Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Sale of A/R (FACTORING With Recourse)

Hervey Corp. sells $80,000 of its A/R to Leslie Financing (factor). Leslie’sholdback is $5,000 to cover possible non-collections.

Leslie charges a 4 % fee (4 % x $80,000 = $3,200) for the service and pays Hervey $71,800. ($80,000 -$3,200-$5,000)

- The $3,750 debit to the AFUA is appropriate if normal allowances had been accrued on A/R that were sold.
- If no Allowance was maintained, then the debit of $3,750 would be made to “Loss on Sale of Receivables” on the I/S.

The entry to record the recourse sale w/holdback of the A/R when collection period is over on Hervey’s books is?

DR Cash ($5,000 - $3,750) $1,250

DR Allowance for Uncollectibles 4,000

CR Due from Leslie (A/R) 5,000

WHY??

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Borrowing Using A/R as Collateral

Hervey Corp. pledged $80,000 of its A/R to Leslie Financing for a $80,000 Loan.

Leslie charges a 4% for the loan.

Proceeds from loan are $76,800 ( $80,000 - $3,200)

The entry to record the loan on Hervey’s books is?

DR Cash $76,800

DR Prepaid Interest 3,200

CR Loan Payable-Leslie Financing $80,000

Accelerating Cash Collections: Transfers and Dispositions of Receivables

Example: Borrowing Using A/R as Collateral

Hervey Corp. pledged $80,000 of its A/R to Leslie Financing for a $80,000 Loan.

Leslie charges a 4% for the loan.

Proceeds from loan are $76,800 ( $80,000 - $3,200)

The entry to record the payment of the loan on Hervey’s books is?

DR Loan Payable-Leslie Financing $80,000

CR Cash $80,000

DR Interest Expense $3,200

CR Prepaid Interest $3,200

Accelerating Cash Collections: Transfers and Dispositions of Receivables

C. Ambiguities abound: Is it a sale or borrowing?

1. SFAS No. 125 provides guidance for distinguishing between sales and collateralized borrowings.

a. If control is surrendered, then the transaction is treated as a sale.

b. If control has not been surrendered, the transaction is accounted for as a secured borrowing.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

C. Ambiguities abound: Is it a sale or borrowing?

- If the transaction is really a borrowing, but is erroneously treated as a sale, then
- both assets and liabilities are understated and ratios using these measures are distorted.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

C. Ambiguities abound: Is it a sale or borrowing?

- If a transaction is really a sale, but is erroneously treated as a borrowing, then
- the company’s net assets are misrepresented since a gain or loss on the transaction should be recognized.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Securitization occurs when receivables are bundled together and sold or transferred to another organization, which
- Issues securities that are collateralized by the transferred receivables.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Securitizationoccurs when A/R are bundled together and sold to another organization, which issues securities that are collateralized by the transferred A/R.

1. The transferor (i.e., the firm that is bundling the portfolio for sale) likelyrecords a gain on the sale of the securitization.

a. The risk associated with the bundled portfolio in the aggregate is lower than the risk of the individual receivables.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

- Securitizationoccurs when A/R are bundled together and sold to another organization, which issues securities that are collateralized by the transferred A/R.

1. The transferor (i.e., the firm that is bundling the portfolio for sale) likelyrecords a gain on the sale of the securitization.

b. The lower risk and discount rate results in a higher present value and sales price, resulting in a gain to the transferor.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

2. Banks and others that engage in securitizationsdo not transact directly with the investors.

a. The transferor forms a special purpose entity (SPE) that is legally distinct from the transferor and is created solely for the purpose of the securitization transaction.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

a. The transferor forms a special purpose entity (SPE) that is legally distinct from the transferor and is created solely for the purpose of the securitization transaction.

i. The SPEprotects the investors who bought the notes. Since the receivables were sold to the SPE, they are beyond the reach of the transferor’s creditors.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

a. The transferor forms a special purpose entity (SPE) that is legally distinct from the transferor and is created solely for the purpose of the securitization transaction.

- The SPEallows the transferor to receive favorable financial reporting treatment for the transaction.
- The receivables are removed from the transferor’s financials, and since the SPE is not consolidated, the debtnever appears on the transferor’s balance sheet.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

2. Banks and others that engage in securitizationsdo not transact directly with the investors.

- b. The transferor then sells the receivables to the SPE.
- c. The SPEcreates and issues debt securities (with the receivables as collateral) that are sold to investors.
- d. The cash received from the investors by the SPE is then remitted to the transferor.
- e. The transferor may continue to service the assets for a fee that is paid by the SPE.

Accelerating Cash Collections: Transfers and Dispositions of Receivables

E. Some cautions for readers:

- Transfers of receivableswith recourserequiredisclosure of a contingent liability,
- But no such disclosure is required when the receivables are sold without recourse.

2. When firms sell receivables, the receivables number reported in the balance sheet will understate the true growth in receivables over the period.

IV. Troubled Debt Restructuring

- A lender may restructure the loan when:
- a customer is unable to make the interest and principal payments required by an installment loan or other receivable.

IV. Troubled Debt Restructuring

- A lender may restructure the loan when a customer is unable to make the interest and principal payments required by an installment loan or other receivable.

1. Scheduledinterest and principal payments may be reduced or eliminated.

2. The repayment schedule may be extended over a longer period of time.

3. The customer and lender can settle the loan for cash, other assets, or equity interests.

IV. Troubled Debt Restructuring

- B. For a restructuring to be troubled :
- the borrowermust beunable to pay off the original debt and
- the lendermust grant a concession to the borrower.

IV. Troubled Debt Restructuring

- A concession means that in exchange for canceling the original loan :
- the lendermustaccept new debt or assets with an economic value
- less than the book value of the original debtplus any accrued interest.

IV. Troubled Debt Restructuring

D. Troubled debt restructurings can be accomplished in two different ways:

1. Through a settlement, where a transfer of cash or other assets to the lendercancels the original loan.

a. Borrower:

i. The gain on debt restructuring is extraordinary.

ii. The gain (loss) on transfer of assets is ordinary.

IV. Troubled Debt Restructuring

D. Troubled debt restructurings can be accomplished in two different ways:

1. Through a settlement, where a transfer of cash or other assets to the lendercancels the original loan.

b. The loss on debt restructuring to the lender is ordinary.

IV. Troubled Debt Restructuring

D. Troubled debt restructurings can be accomplished in two different ways:

- In a continuation with modification of debt terms,
- the original loan is canceled and
- a new loan agreement is signed.

IV. Troubled Debt Restructuring

- In a continuation with modification of debt terms,the original loan is canceled and a new loan agreement is signed.

a. Borrower:

- If the restructured loan cash flows are lower than the current book value of the loan :
- the new loan payable is recorded at the total of the restructured cash flows,
- the debt restructuring gain is extraordinary, and
- future interest expense is zero since all payments are applied to note principal.

IV. Troubled Debt Restructuring

- In a continuation with modification of debt terms,the original loan is canceled and a new loan agreement is signed.

a. Borrower:

- If the restructured loan cash flows are higher than the current book value of the loan :
- the new loan payable is recorded at the book value of the current loan, and
- future interest expense is based on a rate that equates current book value and restructured cash flows.

IV. Troubled Debt Restructuring

- In a continuation with modification of debt terms,the original loan is canceled and a new loan agreement is signed.

b. Lender:

- If the restructured loan cash flows are lowerthan the current book value of the loan :
- the new loan receivable is recorded at the present value of the new cash flowsdiscounted at the original effective interest rate,
- the debt restructuring loss is ordinary, and future interest income is based on the original loan rate.

IV. Troubled Debt Restructuring

b. Lender:

- If the restructured loan cash flows are higherthan the current book value of the loan :
- the new loan receivable is recorded at the present value of the new cash flowsdiscounted at the original effective interest rate,
- the debt restructuring loss is ordinary, and future interest expense is based on the original loan rate.

IV. Troubled Debt Restructuring

- The borrower and lender may recorddifferent restructuring gains and losses since:
- the initial book value GAAPassigned to the payable is not the same as that assigned to the receivable.
- d. The financial gains and lossesmay not correspond to the economic gains and losses.

IV. Troubled Debt Restructuring

Example – Troubled Debt Restructuring

Harper Co. purchased $75,000 of equipment from Farmers State on 1/01/98.

Harperpaid $25,000 cash and signed a 5 year 10% installment note for $50,000.

The note calls for annual payments of $10,000 plus interest on Dec 31st of each year.

Harper made the first two installments on time but was unable to make the third annual payment on Dec 31st, 2000.

At that time, Harper owed $30,000 in unpaid principalplus$3000 in accrued interest.

The restructuring was on Jan 1st , 2001 and that both companies have already recordedinterest up to that date.

IV. Troubled Debt Restructuring

Example - Settlement

Suppose Farmers Stateagrees to cancel the loan if Harperpays $5,000 cash and turns over the company car.

The car was purchased for $21,000 cash, has a Current FMV of $18,000 and has a BV at $16,000($21,000 - $5,000 A/D)

Notice the combined economic value of the Cash ($5,000) & Auto ($18,000) is $23,000.

Or $10,000 less than the $33,000Harper owes Farmers State.

What are the January 1, 2001 entries to record the settlement?

IV. Troubled Debt Restructuring

Example – Settlement- Harper (Borrower)

The car was purchased for $21,000 cash, has a Current FMV of $18,000 and has a BV at $16,000($21,000 - $5,000 A/D)

What are the January 1, 2001 entries to record the settlement?

A. Increaseassets given up to their FMV.

DR Automobile $2,000

CR Gain on Disposal of Asset $2,000

$18,000

IV. Troubled Debt Restructuring

Example – Settlement- Harper (Borrower)

Suppose Farmers Stateagrees to cancel the loan if Harperpays $5,000 cash and turns over the company car.

The car has a Current FMV of $18,000 and has a BV at $16,000($21,000 - $5,000 A/D)

Notice the combined economic value of the Cash & Auto is $23,000. Or $10,000 less than the $33,000 ($30,000 N/P & $3,000 Acc. Interest) owed.

B. Record the Settlement:

First record the

Assets given up

Then record the debt

being settled

Then record the gain

on the restructuring

DR Note Payable $30,000

DR Interest Payable $3,000

DR Accumulated Depreciation $5,000

CR Extraordinary gain on debt restr. $10,000

CR Automobile $23,000

CR Cash $5,000

IV. Troubled Debt Restructuring

Example – Settlement- Farmers (Lender)

Suppose Farmers Stateagrees to cancel the loan if Harperpays $5,000 cash and turns over the company car.

The car has a Current FMV of $18,000 and has a BV at $16,000($21,000 - $5,000 A/D)

Notice the combined economic value of the Cash & Auto is $23,000. Or $10,000 less than the $33,000 ($30,000 N/P & $3,000 Acc. Interest) owed.

B. Record the Settlement:

Then record the N/R &

Int. Rec. being settled.

Then record the loss

on the restructuring.

First record the

Assets received.

DR Cash $5,000

DR Automobile $18,000

DR Loss on N/R Restruc. $10,000

CR Note Receivable $30,000

CR Interest Receivable $3,000

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $39,000($30,000 principal + $9,000 accrued interest as of Jan 1st ,2001).

The book value of the N/R$30,000plus the accrued interest is $3,000 soTotal BV of N/R =$33,000

What are the January 1, 2001 entries to record the restructure?

Before this can be recorded, the Future Cash Flow of the restructured N/R must be compared to the BV of the old N/R.

In theory, since the future cash flows are greater than the BV of the N/R there is not a gain but the interest rate being paid is adjustedlower if you are the borrower.

The new interest rate must be calculated to charge future interest expense by using thetime value of money.

PV note = FV new note x PVIF 2, %?

$33,000 = $39,000 x PVIF 2, %?

$33,000 = . 84615 PVIF 2,%? = 8.7% $39,000

This is the % used to accruefuture interest expense.

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $39,000($30,000 principal + $9,000 accrued interest as of Jan 1st ,2001).

The book value of the N/R$30,000plus the accrued interest is $3,000 soTotal BV of N/R =$33,000

What are the January 1, 2001 entries to record the restructure?

Future Cash Flow BV of the old N/R.

Restruct. N/R

>

$39,000

$33,000

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $39,000($30,000 principal + $9,000 accrued interest as of Jan 1st ,2001).

The book value of the N/R$30,000plus the accrued interest is $3,000 soTotal BV of N/R =$33,000

What are the January 1, 2001 entries to record the restructure on the borrower? ( Old CV < Future Cash Flows)

Old CV of N/P

is transferred

to newN/P

DR Note Payable $30,000

DR Interest Payable $3,000

CR Restructured Note Payable $33,000

IV. Troubled Debt Restructuring

Since there is a modification, the lenderdoes incur a loss. The lender is in the business of loaning money so the new N/R is calculated using the original interest rategoing forward and the loss is recorded.

The new N/R must be calculated in order to charge future interest expense & record the loss by using thetime value of money.

PV restructurednote = FV new note x PVIF 2, 10%

= $39,000 x .82645

= $32,232

Loss = $33,000 (CV of old N/R) - $32,232 (PV new N/R) = $ 768

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

The book value of the N/R$30,000plus the accrued interest is $3,000 soTotal BV of N/R =$33,000

What are the January 1, 2001 entries to record the restructure on the lender?( Old CV < Future Cash Flows)

DR Restructured N/R $32,232

DR Loss on N/R Restruc. $768

CR Note Receivable $30,000

CR Interest Receivable $3,000

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the borrower(Harper)? (8.7% new rate)

( Old CV < Future Cash Flows)

A. To record interest on Dec 31st, 2001:

Restructured N/P

$33,000

($33,000 x 8.7% = $2,871)

2,871

$35,871

DR Interest Expense $2,871

CR Restructured N/P $2,871

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the borrower(Harper)? (8.7% new rate)

( Old CV < Future Cash Flows)

A. To record interest on Dec 31st, 2002:

Restructured N/P

$35,871

($35,871 x 8.7% = $3,121)

3,121

$39,000

DR Interest Expense $3,121

CR Restructured N/P $3,121

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the borrower(Harper)? (8.7% new rate)

( Old CV < Future Cash Flows)

Restructured N/P

$39,000

$39,000

A. Payoff of N/P on Dec 31st, 2002:

0

DR Restructured N/P $39,000

CR Cash $39,000

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the Lender (Farmers)? (10% rate)

( Old CV < Future Cash Flows)

A. To record interest on Dec 31st, 2001:

Restructured N/R

$32,232

($32,232x 10% = $3,223)

3,223

$35,455

DR Restructured N/R $ 3,223

CR Interest Income $ 3,223

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the Lender (Farmers)? (10% rate)

( Old CV < Future Cash Flows)

A. To record interest on Dec 31st, 2002:

Restructured N/R

$ 35,455

($ 35,455x 10% = $3,546)

3,546

$39,000

DR Restructured N/R $ 3,546

CR Interest Income $ 3,546

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers State agrees to postponeall principal and interest payments on the N/R to maturity.

Harper'sfinalpayment on Dec 31st, 2002 total $39,000.

What are the entries to record the restructured note for the next 2 years of the Lender (Farmers)? (10% rate)

( Old CV < Future Cash Flows)

Restructured N/R

$39,000

- To record payoff of N/R
- on Dec 31st, 2001:

$39,000

0

DR Cash $ 39,000

CR Restructured N/R $ 39,000

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers Statewaivesall interest payments and defersall principal payments until Dec31st, 2002.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $30,000.

The BV ofN/Rplus the accrued interest = $33,000

TheFuture Cash Flow = $30,000

What are the January 1, 2001 entries to record the restructure?

The Future Cash Flow restructured N/R< BV old N/R.

Future Cash Flow BV of the old N/R.

Restruct. N/R

<

$30,000

$33,000

IV. Troubled Debt Restructuring

The borrower (Harper) will recognize an extraordinary gain on restructuring, Gain =$33,000 CV of N/R-$30,000 FCF new N/R= $3,000

and since FCF< BV ,no interest is due, all subsequent payments will reduce principal.

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers Statewaivesall interest payments and defersall principal payments until Dec31st, 2002.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $30,000.

What are the January 1, 2001 entries to record the restructure?

DR Note Payable $30,000

DR Interest Payable $3,000

CR Restructured N/P $30,000

CR Extraordinary Gain on Debt Restruc. $3,000

Future Cash Flow BV of the old N/R.

Restruct. N/R

<

$30,000

$33,000

Since there is a modification, the lenderdoes incur a loss. The lender is in the business of loaning money so the new N/R is calculated using the original interest rategoing forward and the loss is recorded.

The new N/R must be calculated in order to charge future interest expense & record the loss by using thetime value of money.

PV restructurednote = FV new note x PVIF 2, 10%

= $30,000 x .82645

= $24,794

Loss = $33,000 (CV of old N/R) - $24,794 (PV new N/R) = $ 8,206

IV. Troubled Debt Restructuring

Example – Continuation w/ Modification of Debt Terms

Suppose Farmers Statewaivesall interest payments and defersall principal payments until Dec31st, 2002.

Harper'sfinal (and only) payment on Dec 31st, 2002 would total $30,000.

What are the January 1, 2001 entries to record the restructure on the Lender (Farmer)?

DR Restructured N/R $24,794

DR Loss on N/R Restruc. $8,206

CR Note Receivable $30,000

CR Interest Receivable $3,000

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