CHAPTER 8 RECEIVABLES

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CHAPTER 8RECEIVABLES
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Roadmap

• Accounts Receivable
• How to estimate the net realizable value
• Estimate uncollectibles
• Estimate sales return and adjustments
• Notes Receivable
• Imputed interest
• How to accelerate cash payments
• Troubled debt restructuring

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I. Assessing the Net Realizable Value of Accounts
Receivable

• A. Estimating the net realizable value of
  receivables
• 1. The full amount of receivables may not be
  collectible either because customersa. Are
  unable to pay (referred to as uncollectibles),
  orb. Returns the merchandise for credit or are
  allowed a reduction in the amount owed (referred
  to as returns and adjustments).

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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.

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I. Assessing the Net Realizable Value of Accounts
Receivable

• C. Estimating uncollectible receivables
• 1. The sales revenue approacha. A specific loss
  percentage is multiplied by sales revenue to
  estimate bad debt expense.b. The loss percentage
  is based on past experience of the firm.

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I. Assessing the Net Realizable Value of Accounts
Receivable

• C. Estimating uncollectible receivables
• 2. The gross receivables methoda. A specific
  loss percentage is multiplied by gross
  receivables to estimate the required allowance
  account balance.b. The adjusting entry is the
  amount necessary to get the unadjusted allowance
  balance to the required amount.c. The loss
  percentage is based on past experience.

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I. Assessing the Net Realizable Value of Accounts
Receivable

• D. Assessing the adequacy of the allowance for
  uncollectible account balance1. Management
  performs an aging of accounts receivable.a. An
  aging of receivables is simply 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.

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I. Assessing the Net Realizable Value of Accounts
Receivable

• E. Estimating sales returns and adjustments
• 1. It is inevitable that sometimes the wrong
  goods are shipped to customers or the correct
  goods arrive damaged, prompting customers to
  return the goods or request price
  adjustments.2. These returns and adjustments
  reduce both the accounts receivable balance and
  income.

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I. Assessing the Net Realizable Value of Accounts
Receivable

• F. Do existing receivables represent real
  sales?1. The growth rates in sales 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.

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II. Imputed Interest

• For long-term credit sales transactions utilizing
  notes receivable
• 1. Sales revenue is recorded at the known cash
  price or the implied cash price of the item sold.
  The implied price is determined by computing the
  note receivables present value using the
  prevailing borrowing rate.
• 2. Interest income is recorded each period over
  the notes term to maturity using the prevailing
  borrowing rate (i,e. effective market rate of
  interest)

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Three cases

• Case 1
• When the stated interest rate on the note is the
  same as the prevailing borrowing rate, life is
  easy.
• Dr. Interest Receivable (Face value of the Note
  Interest rate
• Cr. Interest income
• Dr. Cash
• Cr. Int. Receivable

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Three cases

• Case 2
• When the notes receivable only specifies the
  total amount payable at maturity (future value)
• You value notes receivable at its present value
  using the prevailing borrowing rate
• Dr. Notes receivable (Notes receivablePrevailing
  borrowing rate)
• Cr. Interest income

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Three cases

• Case 3
• When the stated interest rate on the note is
  different from the prevailing borrowing rate
• You determine the value of the N/R by discounting
  the interest income and the principal payment
  using the market int. rate
• Dr. N/R (Plug in number)
• Dr. Cash (Principal Stated interest rate)
• Cr. Interest Income (N/R Market int. rate)

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III. Accelerating Cash Collections Transfers and
Dispositions of Receivables

• A. There are two ways to accelerate cash
  collections of accounts receivable
   1. Factoring, where the company sells its
  receivables outright in exchange for cash and the
  receivables are removed from the companys
  books.
• 2. Assignment, where the company uses receivables
  as collateral to get cash from the bank.

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Figure 7.3 Transfers and Disposition of
Receivables
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III. Accelerating Cash Collections Transfers and
Dispositions of Receivables

• 1. Factoring, where the company sells its
  receivables outright in exchange for cash and the
  receivables are removed from the companys books.
• ii. All else being equal, the factor will charge
  a higher fee in a nonrecourse arrangement than in
  a with recourse arrangement, because of the
  higher risk assumed.b. Factoring can be with
  recourse, meaning that the company is willing to
  buy back any bad customer receivables from the
  buyer of the receivables.
• c. 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.

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III. Accelerating Cash Collections Transfers and
Dispositions of Receivables

A. There are two ways to
accelerate cash collections of accounts
receivable

• 2. Assignment of receivables involves a loan that
  is collateralized by the customer receivables.
• a. The accounts receivable is not removed from
  the companys books.b. A liability is credited
  to reflect the loan.c. The fact that receivables
  have been pledged as collateral must be disclosed
  in the notes to the financial statements, if
  material.

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III. Accelerating Cash Collections Transfers and
Dispositions of Receivables

• B. Notes receivable can also be assigned or sold
  (with or without recourse). 1. Accelerating
  cash collections on notes in this way is called
  discounting.2. The buyer advances cash to the
  company based on the discounted present value of
  the notes.

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III. 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.

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IV. Troubled Debt Restructuring

• A. 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. Scheduled interest
  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.

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IV. Troubled Debt Restructuring

• Definition
• a. For a restructuring to be troubled, the
  borrower must be unable to pay off the original
  debt and the lender must grant a concession to
  the borrower.
• b. A concession means that in exchange for
  canceling the original loan, the bank must accept
  new debt or assets with an economic value less
  than the book value of the original debt plus any
  accrued interest.

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IV. Troubled Debt Restructuring

• D. Troubled debt restructurings can be
  accomplished in two fundamentally different
  ways1. Through a settlement, where the original
  loan is canceled by a transfer of cash or other
  assets to the lender.a. Borroweri. The gain on
  debt restructuring is extraordinary.ii. The gain
  (loss) on transfer of assets is ordinary.b. The
  loss on debt restructuring to the lender is
  ordinary

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IV. Troubled Debt Restructuring
D. Troubled debt
restructurings can be accomplished in two
fundamentally different ways

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

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IV. Troubled Debt Restructuring
D. Troubled debt
restructurings can be accomplished in two
fundamentally different ways

• ii. 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.

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IV. Troubled Debt Restructuring
D. Troubled debt
restructurings can be accomplished in two
fundamentally different ways

• 2. In a continuation with modification of debt
  terms, the original loan is canceled and a new
  loan agreement is signed.
• b. Lenderi. No matter whether the
  restructuring loan cash flows are lower than the
  current book value of the loan, the new loan
  receivable is recorded at the present value of
  the new cash flows discounted at the original
  effective interest rate, the debt restructuring
  loss is ordinary, and future interest expense is
  based on the original loan rate.