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

Paul Zarowin 14

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

Paul Zarowin 17

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

Paul Zarowin 18

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

Paul Zarowin 21

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