Receivables RCJ Chapter 8 (except )

Paul Zarowin2 key Issues 1.How receivables are used to raise cash 2.Recourse vs. non-recourse sales 3.Consequences of different methods on financial statements 4.Role of receivables in earnings management

Paul Zarowin3 Allowance Method 1. SalesDR A/R CR Credit sales revenue 2. CollectionsDR Cash CR A/R 3. Write-offsDR AUA (or ADA) CR A/R Adjusting entry: 4. Bad debts expenseDR Bad debt expense CR AUA (or ADA)

Paul Zarowin4 A/R Beginning Balance (+) Credit sales revenue(-) Write-offs (-) Collections Ending Balance Allowance of Uncollectable Accounts (AUA) Beginning Balance (-) Writeoffs (+) Bad debt exp. Ending Balance Allowance Method (contd) ex. C8-1, parts 1, 6, & 7

Paul Zarowin5 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 Zarowin6 Using A/R to Raise Cash: J.E. 1.Assignment: collateralized borrowing DR Cash DRFinance charge/Interest expense CRLiability 2.Factoring: sale of receivable DRCash DRLoss * CRA/R (*) can be gain (CR) if cash > A/R, but unlikely Note: different effects on assets vs. liabilities

Paul Zarowin7 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 Zarowin8 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 cant distinguish from ordinary collection. XNot allowed. Example: P8-18 SaleBorrowing Recourse12 Non-Recourse3X

Paul Zarowin9 Entries for Sale and Borrowing Why DR AUA for non-recourse sale only? SaleBorrowing DR Cash DR Loss DR AUA (for non-recourse sale) CR A/R DR Cash DR Interest expense CR Liability

Paul Zarowin10 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 Zarowin11 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 Zarowin12 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 AUA A/R reduces on B/S $90 cash received is CFO Firm A s J.E.Factor s J.E. DR Cash 90 AUA 5 Loss 5 CR A/R 100 DR A/R 95 CR Cash 90 AUA 5

Paul Zarowin13 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 AUA A/R reduces on B/S contingent liability disclosed for possible default of sold A/R $95 cash received is CFO Firm A s J.E.Factor s J.E. DR Cash 95 Loss 5 CR A/R 100 DR A/R 95 CR Cash 95

Paul Zarowin14 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. DR Cash 95 Interest exp. 5 CR N/P 100 DR N/R 100 CR Cash 95 N/P Discount 5 (and/or) factor fee (can show the N/R at 95 net)

Paul Zarowin15 Sale With Recourse: Is It a Sale? Issue: Effects of (non) recognition vs disclosure Is really collateralized borrowing; so assets and liabilities both understated. To correct: DRA/R DRInterest expense/finance charge CRLiability CRLoss If these are equal only effect is on B/S

Paul Zarowin16 Sale With Recourse: Is It a Sale? (contd) 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 ABAB

Paul Zarowin17 Aggressive Revenue Recognition Aggressive revenue recognition (trade loading, channel stuffing) will increase A/R grows faster than sales. Below is an illustrative example. Ex. C 3-6, Clear One Communications P. 8-21, Grosse Point Channel Stuffing

Paul Zarowin18 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.

Paul Zarowin19 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.

Paul Zarowin20 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 Zarowin21 Now consider this additional information: Two other pharmaceutical companies, Schering-Plough and Eli Lilly, also saw big receivables jumps in the first quarter of 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 Zarowin22 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 RCJs discussion on Bausch and Lomb pg , Table 8.1 pg. 349 and Sunbeam pg Key question: is factoring normal activity, or to camouflage? ex. C8-3