Business & Finance Case Study: IFRS Adoption in the U.S. Assignment
Serenity3203
Chapter9-Receivables.pptxReceivables
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 9
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Learning Objectives 1 After studying this chapter, you will understand:
How to account for accounts receivable using net realizable value.
How to analyze accounts receivable under net realizable value accounting.
How to evaluate whether or not reported receivables arose from real sales and how to spot danger signals.
How to impute and record interest when notes receivable have either no explicit interest or an unrealistically low interest rate.
How to account for accounts and notes receivable using the fair value option.
How companies use receivables to accelerate cash inflows and how the accounting treatment affects financial statement ratios.
Why receivables are securitized and how the accounting treatment affects financial statement ratios.
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Learning Objectives 2 After studying this chapter, you will understand:
Why receivables are restructured when a customer experiences financial difficulty and how to account for the troubled-debt restructuring.
The key differences between current G A A P and I F R S requirements for receivable accounting.
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Assessing the Net Realizable Value of Accounts Receivable
Accounts receivable are generally reflected in the balance sheet at net realizable value.
Two things must be estimated to determine the net realizable value of receivables:
Credit losses—the amount that will not be collected because customers are unable to pay.
Returns and allowances—the amount that will not be collected because customers return the merchandise for credit or are allowed a reduction in the amount owed.
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Accounting for Credit Losses 1
Most companies establish credit policies by weighing the expected cost of credit sales against the benefit of increased sales.
Expected cost:
Customer collection and billing costs plus potential bad debts.
This tradeoff illustrates that bad debts are often unavoidable.
Accrual accounting requires that some estimate of uncollectible accounts be offset against current period sales.
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Treatment of Bad Debt Losses
Traditionally, firms referred to losses from uncollectible accounts as bad debt expense and treated them as operating expenses.
However, the final F A S B revenue recognition standard, effective for fiscal years beginning after December 15, 2017, requires that bad debt losses be treated as expenses and include them with other impairment losses.
The impairment losses must be disclosed separately if material.
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Recording and Reporting the Allowance for Credit Losses
Bristol Corporation estimates that bad debt losses arising from first quarter sales are expected to be $30,000.
| D R Credit loss expense | $30,000 | |
| C R Allowance for credit losses | $30,000 |
A contra-asset account subtracted from gross accounts receivable.
If Bristol’s gross accounts receivable and allowance for credit losses before recording this entry were $1,500,000 and $15,000, respectively, then after the entry the balance sheet would show:
| Accounts receivable (gross) | $1,500,000 |
| Less: Allowance for credit losses | (45,000) |
| Accounts receivable (net) | $1,455,000 |
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Approaches to Estimating Uncollectible Accounts: Sales Revenue Approach
Bristol Corporation prepares quarterly financial statements and must estimate the bad debt provision at the end of each quarter. Analyzing past customer payment patterns, Bristol determined that bad debt losses average about 1% of sales. First quarter sales total $3,000,000.
Sales Revenue Approach
Estimate the current period bad debt provision as a percentage of current period sales. For Bristol Corporation, the estimate is:
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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach
Gross Receivables Approach
Estimate the required allowance account balance as a percentage of gross receivables and then adjust the allowance upward or downward to this figure. For Bristol Corporation, the required allowance account balance is:
Access the text alternative for slide images.
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Writing Off Credit Losses
When a specific account receivable is known to be definitely uncollectible, the amount must be removed from the books.
Assume that Bristol later determines that a $750 receivable from Ralph Company cannot be collected.
| D R Allowance for credit losses | $750 | |
| C R Accounts receivable – Ralph Company | $750 |
Notice that the entry has no effect on income.
The specific account receivable (Ralph Company) is eliminated from the books and the allowance contra-account is reduced, but no credit loss expense is recorded.
This is consistent with the accrual accounting philosophy of recording estimated uncollectibles when the sales is made rather than at a later date when the nonpayment is identified.
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 1
No matter which method is used to estimate bad debts, management must periodically assess the reasonableness of the allowance for uncollectibles balance.
The F A S B approach uses a current expected credit loss (C E C L) model.
F A S B A S C Topic 326 does not require a specific method, but provides an aging of accounts receivable example.
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 2
Exhibit 9.1 Bristol Corporation: Allowance for Credit Losses Based on Aging of Receivables
On December 31, 20X1, Bristol Corporation’s gross accounts receivable are $1,600,000, and the balance of the Allowance for uncollectibles is $39,000. Bristol’s normal sales terms require payment within 30 days after the sale is made and the goods are received by the buyer. Bristol determines that the receivables have the following age distribution:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | Total | |
| Amount | $1,450,000 | $125,000 | $15,000 | $10,000 | $1,600,000 |
Once the receivables have been grouped by age category, a separate estimate of credit losses by category is developed. Based on past experience, Bristol determines the following estimate of expected credit losses by category:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | ||
| Historical % of credit losses | 2.3% | 5.5% | 18.4% | 36.8% |
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 3
Exhibit 9.1
Numerous government forecasts predict that economic growth will slow in 20X2. In addition, unemployment rates have increased. Consequently, Bristol estimates that the 20X2 credit loss rates will be approximately 8% higher. Consequently, it uses the following loss percentages to estimate its allowance at December 31, 20X1.
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | ||
| Forecasted % of credit losses | 2.5% | 6.0% | 20.0% | 40.0% |
The required balance in the Allowance for credit losses account would then be as follows:
| Current | 31 to 90 days old | 91 to 180 days old | Over 180 days old | Total | |
| Amount | $1,450,000 | $125,000 | $15,000 | $10,000 | $1,600,000 |
| Estimated % of credit losses | 2.5% | 6% | 20% | 40% | |
| = Allowance for credit losses | $ 36,250 | $ 7,500 | $ 3,000 | $ 4,000 | $ 50,750 |
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Assessing the Adequacy of the Allowance for Credit Losses Account Balance 4
Exhibit 9.1
Because the balance of the Allowance for credit losses is only $39,000 on December 31, 20X1, the account must be increased by $11,750. This is the difference between the $50,750 required balance (as computed) and the existing $39,000 balance. To bring the balance up to the $50,750 figure indicated by the aging, Bristol makes the following adjusting entry:
| D R Credit loss expense | $11,750 | |
| C R Allowance for credit losses | $11,750 |
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Analysis of Uncollectible Accounts Receivable 1
Exhibit 9.2 Mattel, Inc.: Analysis of Accounts Receivable Credit Losses
| ($ in millions) | Dec. 31, 2018 | Dec. 31, 2017 | Dec. 31, 2016 |
| A. Select Reported Amounts | |||
| Revenues | $ 4,510.9 | $ 4,882.0 | $ 5,456.7 |
| Pre-tax income | (419.3) | (505.0) | 409.7 |
| Ending gross accounts receivables | 992.1 | 1,154.0 | 1,136.6 |
| B. Change in Allowance for doubtful accounts | |||
| Balance at beginning of year | $ 25.4 | $ 21.4 | $ 24.4 |
| Provision for doubtful accounts | 40.9 | 17.6 | 9.2 |
| Write-offs | (44.3) | (13.6) | (12.2) |
| Balance at end of year | $ 22.0 | $ 25.4 | $ 21.4 |
| C. Analysis | |||
| Provision for doubtful accounts as a % of sales | 0.91% | 0.36% | 0.17% |
| Provision for doubtful accounts as a % of ending gross receivables | 4.12% | 1.53% | 0.81% |
| Provision for doubtful accounts as a % of ending allowance | 185.91% | 69.29% | 42.99% |
| Allowance as a % of ending gross receivables | 2.22% | 2.20% | 1.88% |
Source: Mattel, Inc. Form 10-Ks.
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Analysis of Uncollectible Accounts Receivable 2
Sales declined over the three-year period.
The provision for doubtful accounts increased substantially over the three year period.
The percentage of, gross receivables, and ending allowance increased substantially over the period as Mattel’s collection experience worsened.
Firms must continually adjust their allowance account as collection experience changes.
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Estimating Sales Returns and Allowances
When goods are returned or a price allowance granted, the customer’s account receivable must be reduced and an income statement charge made.
Assume that Bristol agrees to reduce by $8,000 the price of goods that arrived damaged at Bath Company:
Companies must estimate the expected amount of future returns and allowances arising from receivables currently on the books at the end of each reporting period. If significant, an adjusting entry must be recorded.
| D R Sales returns and allowances | $$$ | |
| C R Allowance for sales returns and allowances | $$$ |
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Analytical Insight: Do Existing Receivables Represent Real Sales?
Generally, the growth rates in sales and in accounts receivable should be roughly equal.
Receivables might grow faster than sales for the following reasons:
Deliberate change in (that is, loosening of) sales terms to attract new customers.
Deteriorating credit worthiness among existing customers.
Firm has changed its financial reporting procedures, which determine when sales are recognized (that is, accelerated revenue recognition.)
Large increases in accounts receivable relative to sales frequently represent a danger signal.
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Notes Receivable 1
When a note bears an interest rate that approximates prevailing borrowing and lending rates, the accounting is straightforward.
Michele Corporation sells a machine to Texas Products Company for $5 million. Michele accepts a three-year, $5 million interest-bearing note signed with 10% interest per annum to be paid in quarterly installments each year.
| D R Note receivable—Texas Products Company | $5,000,000 | |
| C R Sales revenue | $5,000,000 |
Interest income accrues each quarter.
| D R Accrued interest receivable | $125,000 | |
| C R Interest income | $125,000 |
To accrue three months’ interest = [$5,000,000 × 0.10]/4.
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Notes Receivable 2
Upon receipt of the cash payment, the accrued interest receivable is reduced.
| D R Cash | $125,000 | |
| C R Accrued interest receivable | $125,000 |
To record receipt of the interest payment.
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Accounting for Credit Losses 2
Firms use the Current Expected Credit Loss (C E C L) model to assess the collectability of notes receivable and an appropriate allowance.
Methods may include a discounted cash flow method, a loss-rate method, or a probability-of-default method.
Significant credit quality information must be disclosed by type of receivable including:
Credit quality indicator.
Amortized cost for prior five years and in total.
How expected loss estimates are determined.
Changes in risk factors, policies, or methodologies.
Amount of significant sale of receivables.
Roll-forward of the allowance for credit losses.
Aging analysis of amortized cost by receivable type for past due receivables.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 1
A complication arises for a note that does not state an interest rate.
Monson Corporation sells equipment it manufactured to Davenport Products in exchange for a $5 million non-interest-bearing note due in three years. The note bears no explicit interest. It says only that the entire $5 million is to be paid at the end of three years. Monson’s published cash selling price for the equipment is $3,756,600.
The difference between the $5 million note and the $3,756,600 cash price is the imputed interest.
The implied interest rate equates the present value of the $5 million payment to the cash price of $3,756,600.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 2
Although the $5 million note itself does not contain any mention of interest, Monson will earn a return of 10% per year for financing Davenport’s long-term credit purchase.
Exhibit 9.3 Monson Corporation Effective Interest Table
| (a) Interest Income—10% of Column (d) Balance for Prior Year | (b) Cash Interest Received | (c) Increase in Present Value of Note: (a) Minus (b) | (d) End-of-Year Present Value of Note | |
| 1/1/20X1 | — | — | — | $ 3,756,600 |
| 12/31/20X1 | $ 375,660 | $ 0 | $ 375,660 | 4,132,260 |
| 12/31/20X2 | 413,226 | 0 | 413,226 | 4,545,486 |
| 12/31/20X3 | 454,514* | 0 | 454,514 | 5,000,000 |
| Total | $1,243,400 |
* Rounded.
Interest accumulates at 10% on the unpaid balance.
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Imputing Interest on Notes Receivable: Interest Rate not Stated 3
Monson Corporation records the sale and note receivable as:
| D R Note receivable—Davenport | $3,756,600 | |
| C R Sales revenue | $3,756,600 |
Over the next three years, the note receivable is increased and interest income recognized.
At the end of Year 1, the entry is:
| D R Note receivable—Davenport | $375,660 | |
| C R Interest income | $375,660 |
At the end of Year 3, Monson receives a $5 million payment, which consists of the cash sales price ($3,756,600) plus interest ($1,243,400 = $375,660 + $413,226 + $454,514).
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Imputing Interest on Notes Receivable: Interest Rate not Stated 4
| D R Cash | $5,000,000 | |
| C R Note receivable—Davenport.. | $5,000,000 |
This process of allocating the proceeds of the note between sales revenue and interest income is called imputed interest.
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Imputing Interest: Stated Rate Is Less than Prevailing Rate 1
Another complication arises when the stated interest rate is lower than prevailing rates for loans of similar risk.
Quinones Corp. sells a machine to Linda Manufacturing in exchange for a $4 million, three-year, 2.5% (Stated rate) note. At the time, the interest rate normally charged to companies with Linda’s credit rating is 10% (Prevailing rate).
The implied (cash) selling price of the machine is $3,253,966, as computed on the following slide’s exhibit.
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Imputing Interest: Stated Rate Is Less than Prevailing Rate 2
Exhibit 9.4 Quinones Corporation: Computation of Implied Sales Price for a Note with a Below-Market Interest Rate
Calculation of Present Value at 10% Effective Interest Rate
Present value of $4,000,000 principal repayment on 12/31/20X3 at 10%:
| $4,000,000 | × | 0.75132 | = | $3,005,280 |
Present value of three interest payments of $1,000,000 (that is, $4,000,000 × 0.025), each at 10%:
| 12/31/20X1 | $ 100,000 | × | 0.90909 | = | 90,909 |
| 12/31/20X2 | $ 100,000 | × | 0.82645 | = | 82,645 |
| 12/31/20X3 | $ 100,000 | × | 0.75132 | = | 75,132 |
| Implied sales price of machine | $3,253,966 |
Note: All present value factors are from the book’s Appendix A, Table 1, 10% column.
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Imputing Interest: Stated Rate is Less than Prevailing Rate 3
Exhibit 9.5 Quinones Corporation: Computation of Interest on Note Receivable
| *Rounded | (a) Interest Income 10% of Column (d) Balance for Prior Year | (b) Cash Interest Received | (c) Increase in Present Value of Note (a) Minus (b) | (d) End-of-Year Present Value of Note |
| Inception | - | - | - | $3,253,966 |
| Year 1 | $ 325,397 | $100,000 | $225,397 | 3,479,363 |
| Year 2 | 347,936 | 100,000 | 247,936 | 3,727,299 |
| Year 3 | 372,701* | 100,000 | 272,701 | 4,000,000 |
| Total | $1,046,034 |
Notice that the present value of the note, and thus its carrying value increases each year.
Entry for Year 1 (similar entries are made in Years 2 and 3):
| D R Note receivable—Linda Mfg. | $225,397 | |
| D R Cash | 100,000 | |
| C R Interest income | $325,397 |
Entry when the note is paid at maturity:
| D R Cash | $4,000,000 | |
| C R Note receivable—Linda Mfg. | $4,000,000 |
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The Fair Value Option
Although most firms record accounts and notes receivable at net realizable value, they have the option to record them at fair value.
Bristol Corporation reports a net realizable value of $1,455,000 (gross receivables of $1,500,000 – allowance for uncollectibles of $45,000).
There is an active market for these types of receivables; the price is 95% of face value, or $1,425,000.
To adjust the receivable’s carrying value to fair value, the difference between the fair value and the face amount of the receivable is recorded as an unrealized loss as follows:
| D R Unrealized loss on receivables | $75,000 | |
| C R Fair value adjustment—Accounts receivable | $75,000 |
An asset valuation account that is adjusted upward or downward as the fair value changes.
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The Fair Value Option: Calculating Interest Income for Quinones 1
Quinones will continue to compute interest income using the original 10% rate. However, the balance sheet will reflect the fair value based on the 9% rate (shown in column e below).
Exhibit 9.6 Quinones Corporation: Note Receivable Recorded at Fair Value
| (a) Interest income | (b) Cash interest received | (c) Increase in present value of note | (d) Present value at 10% | (e) End of year fair value of note at 9% | (f) Fair value adjustment –Note receivable: (e) Minus (d) | (g) Unrealized gain (loss) on note receivable: (f) Minus prior (f) | |
| Inception | $3,253,966 | ||||||
| 20X1 | $ 325,397 | $100,000 | $225,397 | 3,479,363 | $3,542,631* | $63,268† | $ 63,268 |
| 20X2 | 347,936 | 100,000 | 247,936 | 3,727,299 | 3,761,468 | 34,169 | (29,099) |
| 20X3 | 372,701 | 100,000 | 272,701 | 4,000,000 | 4,000,000 | – | (34,169) |
| Total | $1,046,034 | $ – |
The fair value option changes the pattern of income recognition but not the total amount recognized.
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The Fair Value Option: Calculating Interest Income for Quinones 2
* Present value at market rate of 9%:
| $4,000,000 × 0.84168 (pv 2, 9%) | = | $3,366,720 |
| 100,000 × 1.75911 (pvoa 2, 9%) | = | 175,911 |
| = | $3,542,631 |
† Fair value of $3,542,631 minus $3,479,363 carrying value using 10%.
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The Fair Value Option: Calculating Interest Income for Quinones 3
At the end of Year 2, the fair value (column e) represents the present value of the interest payment and principal to be received in one year.
At the end of Year 3, the fair value equals the principal amount because no interest payments are remaining.
To reflect the Year 2 and Year 3 changes in the fair value, Quinones debits Unrealized gain (loss) on note receivable (column g) and credits Fair value adjustment—note receivable (column f).
The Year 2 and Year 3 losses offset the initial gain recognized in Year 1.
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Accelerating Cash Collections: Sale of Receivables and Collateralized Borrowings
Companies might want to accelerate cash collection for the following reasons:
Competitive conditions require credit sales but the company is unwilling to bear the cost of processing and collecting receivables.
There may be an imbalance between the credit terms of the company’s suppliers and the time required to collect customer receivables.
The company may have an immediate need for cash but be short of it.
There are two ways to accelerate cash collections:
Sale of receivables (factoring)
Collateralized borrowings
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Ambiguities Abound: Is It a Sale or a Borrowing?
Sometimes, it is not obvious whether the receivables have been sold or are instead being used as collateral for a loan. The ambiguity arises when certain obligations, duties, or rights regarding the transferred receivables are retained by the firm undertaking the transfer (the transferor).
Sale of Receivables:
Receivables removed from balance sheet.
Gain or loss recognized in earnings.
Collateralized Borrowing:
Receivables stay on balance sheet.
Loan shown as balance sheet liability.
No gain or loss recognized in earnings.
The F A S B has provided guidelines in the Accounting Standards Codification:
Assets are isolated and beyond reach of transferor’s creditors.
Transferee has right to pledge or exchange the assets.
Transferor has no obligation to repurchase or redeem assets in future.
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A Closer Look at Securitizations
Customers with “low” to “moderately high” risk take out 7% home mortgages with bank.
Bank forms a bundled portfolio of the 7% home mortgages; risk in the aggregate is “moderate.”
Investors are willing to buy the portfolio at a price that yields a 6% return.
A bank may reduce risk further by paying a guarantor to bear some of the default risk.
Because the selling price of the bundled portfolio is higher than the carrying value of the mortgages, the bank records a gain on the sale of receivables.
Both the investors and the bank benefit from the transaction.
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Securitization Entities
Figure 9.3 Structure of a Securitization
The transferor (for example, the bank) forms a securitization entity (S E) that is legally distinct from the transferor.
The transferor sells the receivables to the S E; receivables are beyond the reach of the transferor and its creditors.
The S E creates and issues debt securities.
The S E sells the securities to investors.
The S E remits the cash that it receives from the investors to the transferor.
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Financial Statement Effects of Securitizations 1
On December 31, 20X1, Doyle securitized $1,000,000 of mortgages using a securitization entity (S E). The cash received from the S E was exactly $1,000,000, so it recognized no gain or loss on the transaction. If the transaction meets the criteria for sale accounting, it will make the following entry:
| D R Cash | $1,000,000 | |
| C R Mortgages receivable | $1,000,000 |
The effects of this entry on Doyle’s balance sheet are as follows:
| Balances Prior to Securitization | Change in Balances If Transaction Is Treated as a Sale | Balances after Securitization | |
| Assets | |||
| Mortgages receivable | $ 2,200,000 | $ (1,000,000) | $ 1,200,000 |
| All other assets | 800,000 | 1,000,000 | 1,800,000 |
| Total assets | $ 3,000,000 | $ 3,000,000 | |
| Liabilities and equity | |||
| Liabilities | $ 2,700,000 | $ 2,700,000 | |
| Equity | 300,000 | 300,000 | |
| Total liabilities and equity | $ 3,000,000 | $ 3,000,000 |
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Financial Statement Effects of Securitizations 2
If the transaction does not meet the criteria for sale accounting, Doyle would treat the transaction as a collateralized borrowing and make the following entry:
| D R Cash | $1,000,000 | |
| C R Loan Payable | $1,000,000 |
The effects of this entry on Doyle’s balance sheet are as follows:
| Balances Prior to Securitization | Change in Balances If Transaction Is Treated as a Sale | Balances after Securitization | |
| Assets | |||
| Mortgages receivable | $ 2,200,000 | $ 1,200,000 | |
| All other assets | 800,000 | $1,000,000 | 1,800,000 |
| Total assets | $ 3,000,000 | $ 4,000,000 | |
| Liabilities and equity | |||
| Liabilities | $ 2,700,000 | $1,000,000 | $ 3,700,000 |
| Equity | 300,000 | 300,000 | |
| Total liabilities and equity | $ 3,000,000 | $ 4,000,000 |
Doyle’s net income for the year ended December 31, 20X1, is $40,000.
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Financial Statement Effects of Securitizations 3
Assuming that the net income of Doyle National Bank is $40,000 for the year, its return-on-assets ratio and debt-to-equity ratio would be computed as follows:
The left column reflects the ratio under sales treatment.
The right column shows the ratio balances that would have been reflected if the transaction had been treated as a borrowing with the mortgages serving as collateral.
Treating the transaction as a sale improves the return-on-assets ratio from 1% to 1.3%—a 30% increase.
Similarly, the sale treatment improves (reduces) the debt-to-equity ratio from 12.33 to 9—a 27% reduction.
If a gain had been recognized on the securitization, both ratios would have been improved even further.
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Troubled Debt Restructuring
When a customer is financially unable to make required interest and principal payments, rather than force the customer into bankruptcy, lenders frequently agree to restructure the loan receivable.
The restructured loan can differ from the original loan in several ways:
Scheduled interest and principal payments may be reduced or eliminated.
The repayment schedule may be extended over a longer time period.
The debtor and lender can settle the loan for cash, other assets, or equity interests.
Restructured loans benefit both the customer and the lender.
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Definition of Troubled Debt Restructuring
A restructuring of debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.
In other words, for the 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.
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Criteria for Troubled Debt Restructuring
F A S B A S C 310-40-15-13 states that a creditor (lender) has granted a concession when it no longer expects to collect everything owed, including interest.
The creditor would consider collateral in determining the amount expected to be collected.
When assessing whether the debtor (borrower) is experiencing financial difficulties, the creditor should consider all of the following indicators:
The debtor is currently in default on any of its debt or default is probable.
The debtor is in the process of declaring bankruptcy.
The debtor is unlikely to remain a going concern.
The debtor has securities that are being delisted from an exchange.
The creditor forecasts that the debtor’s cash flows are insufficient to pay interest and principal on its debt.
Without the current modification, the debtor cannot obtain funds at nontroubled rates.
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Accomplishing a Troubled Debt Restructuring
Troubled debt restructurings can be accomplished in two different ways:
Settlement, which cancels the original loan by a transfer of cash, other assets, or equity interests (borrower’s stock) to the lender.
Continuation with modification of debt term by canceling the original loan and signing a new loan agreement.
Some troubled debt restructurings contain elements of both settlement and modification.
The accounting issues related to troubled debt restructuring encompass both the measurement of the new (modified) loan and the recognition of any gain or loss.
Example
Harper Companies purchased $75,000 of corn milling equipment from Farmers State Cooperative on January 1, 20X1. Harper paid $25,000 cash and signed a five-year, 10% installment note for the remaining $50,000 of the purchase price. The note calls for annual payments of $10,000 plus interest on December 31 of each year. Harper made the first two installment payments on time but was unable to make the third annual payment on December 31, 20X3. After much negotiation, Farmers State agreed to restructure the note receivable. At that time, Harper owed $30,000 in unpaid principal plus $3,000 in accrued interest. The restructuring was agreed to on January 1, 20X4, and both companies have recorded interest up to that date.
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Settlement: Entries Recorded by the Borrower 1
Suppose Farmers State agrees to cancel the loan if Harper pays $5,000 cash and turns over the company car. The car has a current fair value of $18,000 and is carried on Harper’s books at $16,000.
Harper Companies (Borrower)
| D R Automobile | $ 2,000 | |
| C R Gain on disposal of asset | $ 2,000 |
To increase the net carrying amount of the automobile ($16,000) to its fair value ($18,000).
| D R Note payable | $30,000 | |
| D R Interest payable | 3,000 | |
| D R Accumulated depreciation | 5,000 | |
| C R Cash | $5,000 | |
| C R Automobile | 23,000 | |
| C R Gain on debt restructuring | 10,000 |
To record the settlement.
Access the text alternative for slide images.
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Settlement: Entries Recorded by the Borrower 2
Does Harper benefit from the restructuring?
Yes ~ The combined economic value of the cash ($5,000) and automobile ($18,000) is $23,000—or $10,000 less than the $33,000 Harper owes Farmers State.
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Settlement: Entries Recorded by the Lender
Recall that Farmers State agrees to cancel the loan if Harper pays $5,000 cash and turns over the company car.
Farmers State Cooperative (Lender)
| D R Cash | $ 5,000 | |
| D R Automobile | 18,000 | |
| D R Loss on receivable restructuring | 10,000 | |
| C R Note receivable | $30,000 | |
| C R Interest receivable | 3,000 |
To record the settlement.
Included in income from continuing operations (not extraordinary)
Does Farmers State benefit from the restructuring?
Most likely ~ Lenders often receive more through restructuring than they would from foreclosure or bankruptcy.
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Continuation with Modification of Debt Terms
Instead of reaching a negotiated settlement of the note receivable, Harper and Farmers State could have resolved the troubled debt by modifying the terms of the original loan.
The possibilities are endless.
For accounting purposes, what matters is whether the undiscounted sum of future cash flows under the restructured note is:
More than the note’s carrying value (including accrued interest) at the restructuring date.
Less than the note’s carrying value (including accrued interest) at the restructuring date.
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Summary of Accounting Procedures for Troubled Debt Restructurings
Exhibit 9.10 Summary of Accounting Procedures for Troubled Debt Restructurings
Restructured Loan Cash Flows Are
| Settlement Gain or Loss | Lower Than Current Carrying Value of Loan* | Higher Than Current Carrying Value of Loan* | |
| Borrower | |||
| New loan payable | N A† | Total of restructured cash flows | Current book value |
| Gain on debt restructuring | Yes | Yes | None |
| Gain (loss) on transfer of assets | Yes | N A | N A |
| Future interest expense | N A | None, all payments applied to principal | Based on rate that equates current carrying value and restructured cash flows |
| Lender | |||
| New loan receivable | N A | Present value of new cash flows at original effective interest rate | Present value of new cash flows at original effective interest rate |
| Loss on debt restructuring | Yes | Yes | Yes |
| Future interest income | N A | Based on original loan rate | Based on original loan rate |
* Includes unpaid accrued interest.
† N A means “not applicable.”
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Global Vantage Point: Credit Losses 1
The general accounting for accounts and notes receivable under I F R S is similar to the accounting under U.S. G A A P.
The accounting is called amortized cost, which refers to the gross amount of the receivable.
An allowance is still established for credit losses and returns.
Both I F R S and U.S. G A A P use a current expected credit loss model (C E C L) but the approaches are different.
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Global Vantage Point: Credit Losses 2
The I A S B modified I F R S 9 effective for fiscal years beginning after January 1, 2018.
The I A S B approach computes loss expected values by multiplying probabilities by potential cash shortfalls and summing the products.
The approach recognizes expected credit losses, but measures the losses according to how credit quality for a financial instrument has changed.
For receivables with only small declines in credit risk, the loss is based on expected cash shortfalls associated with a possible default within the 12 months after the balance sheet date.
For receivables that have had significant declines in credit quality, the loss is based on expected losses over the life of the loan.
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Global Vantage Point: Credit Losses 3
The F A S B provided its credit loss guidance in A S U 2016-13.
Public companies do not have to comply with guidance until they issue financial statements for fiscal years beginning after December 15, 2019.
The F A S B approach uses a current expected credit loss (C E C L) model. It is similar to the approach used under I F R S 9; however, the F A S B:
Has one model that computes expected losses over the life of the receivable for all financial assets measured at amortized cost.
Guidance differs for investments carried at amortized cost and those classified as available-for-sale securities.
Allows firms to use judgment in determining relevant information and estimation methods.
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Global Vantage Point: Fair Value Option, Sale of Receivables, and Debt Restructurings 1
Fair Value Option:
G A A P
Allows the fair value option for a broader set of transactions.
I F R S
Firms may elect the fair value option only in cases where it:
Eliminates an accounting mismatch or,
Because a group of assets are managed and evaluated using fair values.
Requires firms to disclose the fair value of short-term trade receivables and loans in addition to long-term notes receivables.
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Global Vantage Point: Fair Value Option, Sale of Receivables, and Debt Restructurings 2
Guidance regarding sales of receivables is similar to the post-2009 U.S. accounting guidance. Under prior guidance, Q S P Es were off-balance-sheet. Under both I F R S and U.S. guidance, most of these entities will not stay on the balance sheet.
I F R S for debt restructurings from the lender’s perspective are similar to U.S. G A A P. I F R S does not have explicit guidance from the borrowers perspective. The F A S B provides explicit guidance related to credit losses for troubled debt restructurings, but I F R S 9 does not address this specifically.
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Summary 1
G A A P requires that accounts receivable be shown at their net realizable value.
Companies use one of two methods to estimate credit losses: (1) the sales revenue approach or (2) the gross accounts receivables approach. In either case, firms must periodically assess the reasonableness of the uncollectibles balance using a method consistent with the Current Expected Credit Loss (C E C L) model, which utilizes both historical collection experience and expectations about the future.
Analysts should scrutinize the allowance for uncollectibles balance over time. Significant increases in the allowance could indicate collection problems, while significant decreases in the allowance could be a sign of earnings management.
Receivables growth can exceed sales growth for several reasons, including a change in customer mix or credit terms. But a disparity in the growth rate of receivables and sales could also indicate that aggressive revenue recognition practices are being used.
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Summary 2
In certain long-term credit sales transactions, interest must be imputed by determining the note receivable’s present value.
Firms may elect the fair value option for accounts and notes receivable. Changes in fair value are recognized in net income.
Firms sometimes transfer or dispose of receivables before their due date to accelerate cash collection. Sales of receivables—also called factoring—can be with or without recourse.
Receivables are also used as collateral for a loan.
In analyzing receivables transactions, it is sometimes not obvious whether the transaction to accelerate cash collection represents a sale or a borrowing; however, authoritative accounting literature provides guidelines in Topic 860 Transfers and Servicing of the F A S B Accounting Standards Codification for distinguishing between sales (when the transferor surrenders control over the receivables) and borrowings (when control is not surrendered). Sales of receivables change ratios such as receivables turnover as well as potentially masking the underlying real growth in receivables.
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Summary 3
Subprime loans and securitizations were at the heart of the 2008 economic crisis. Accounting and regulatory reforms are under way to address some of the problems identified during the crisis.
Banks and other holders of receivables frequently restructure the terms of the receivable when a customer is unable to make required payments because of financial difficulties.
These troubled debt restructurings can take one of two forms: (1) settlement or (2) continuation with modification of debt terms.
When terms are modified, the precise accounting treatment depends on whether the sum of future cash flows under the restructured note is more or less than the note’s carrying value at the restructuring date. The interest rate used in troubled debt restructurings may not reflect the real economic loss suffered by the lender.
Both the F A S B and I A S B have finalized most of their rules on financial instrument reporting. There are significant differences in the requirements related to estimating credit losses.
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Accessibility Content: Text Alternatives for Images
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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach – Text Alternative 1
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The 0.03 is circled with the callout reading Management believes that 3% of existing gross receivables will ultimately be uncollectible. And the credited $30,000 has a callout that reads Notice this second step.
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Approaches to Estimating Uncollectible Accounts: Gross Receivables Approach – Text Alternative 2
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"Backing into” the $30,000 with the use of a T-account is shown as follows. All three entries are on the right side of the T account. First is a current balance of $15,000, followed by a required adjustment of 30,000, which computes to a new balance of $45,000.
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Analytical Insight: Do Existing Receivables Represent Real Sales? – Text Alternative
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Assume that before introducing more lenient credit terms, Hmong Company had annual sales of $12 million and customers, on average, paid within 30 days. Outstanding accounts receivable, therefore, represent one month's sales, or $1 million. Under the new credit program, customer receivables would represent four months' sales, or $4 million; this represents a 300% increase in receivables even if total sales remain unchanged.
The line graph shows two lines: Sales, steadily increasing, and then Receivables, also steadily increasing as Sales but then increasing more rapidly at midway point indicating faster growth
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Accelerating Cash Collections: Sale of Receivables and Collateralized Borrowings – Text Alternative
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Sales of receivables (factoring) is comprised of three parties: Company, Credit customer of company, and Bank or other financial institution. 1. Company makes sale to customer on credit.
Interaction: Company to Credit customer
2. Company sells customer receivable to factor for cash.
Interaction: Company to Bank
3. Customer payment sent to factor.
Interaction Credit customer to Bank
4. If sold “with recourse,” company buys back uncollectible accounts.
Interaction: Bank to Company
The process of collateralized borrowings is comprised of three parties: Company, Credit customer of company, and Bank or other financial institution.
1. Company makes sale to customer on credit.
Interaction: Company to Credit customer
2. Company borrows cash from lender using receivables as security. Interaction: Bank to Company
3. Customer payment sent to company. Interaction Credit customer to Company
4. Company’s loan payment sent to lender. Interaction: Company to Bank
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A Closer Look at Securitizations – Text Alternative
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Bank has an arrow leading to Investors which reads Receivables transferred in exchange for cash. Customers has an arrow pointing up to Bank that reads Home mortgage receivables.
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Securitization Entities – Text Alternative
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The diagram contains five entities:
Securitization entity (S E) is formed to facilitate the securitization.
Transferor (the firm undertaking the securitization).
Investors.
Guarantor.
Credit-rating agency.
The steps in a securitization proceed as follows:
Mortgage receivables are transferred to the S E (Interaction: from transferor to S E).
SE obtains default guarantees from a third party (Interactions: SE pays fees to Guarantor; Guarantor provides guarantee to S E).
SE obtains a rating for new securities (Interactions: S E pays fees to Credit-rating agency; Credit-rating agency provides rating to S E).
Mortgage receivables are collateral for newly created debt securities sold to investors (Interaction: S E sells to investors).
Cash from sale of debt securities is received by the SE (Interaction: from Investor to S E).
Proceeds from the sale of debt securities is remitted to the transferor (Interaction: from SE to transferor).
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