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Receivables

Receivables. RCJ Chapter 8 (except 405-412). key Issues. How receivables are used to raise cash Recourse vs. non-recourse sales Consequences of different methods on financial statements Role of receivables in earnings management . Allowance Method. Allowance Method (cont’d).

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Receivables

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  1. Receivables RCJ Chapter 8 (except 405-412)

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

  3. Allowance Method Paul Zarowin

  4. 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: • Immediate cash needs • Credit sales: the company is unwilling/unable to bear the cost of processing and collections of credit • Imbalance in the cash cycle: days for payable (to suppliers) is shorter than days for receivables (from customers) • 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. • Assignment: collateralized borrowing DR Cash DR Finance charge/Interest expense CR Liability • 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? The conditions are specified in RCJ, page 400 Paul Zarowin

  8. 3 Possible Cases • Recognize a loss and a contingent liability (disclose in footnote, not on B/S) for the possibility of defaulted receivables. • Recognize interest expense or finance charge and a recognized (on B/S) liability. • Recognize a loss, but no required disclosure (of A/R sale), so can’t distinguish from ordinary collection. • Not allowed. Example: P8-18 Paul Zarowin

  9. Entries for Sale and Borrowing • Why DR AUA for non-recourse sale only? 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 AUA A/R reduces on B/S $90 cash received is CFO 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 AUA A/R reduces on B/S contingent liability disclosed for possible default of sold A/R $95 cash received is CFO 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) Paul Zarowin

  15. 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: If these are equal only effect is on B/S Paul Zarowin

  16. Sale With Recourse: Is It a Sale? (cont’d) of recording a sale instead of a borrowing • 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 A B 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. Ex. C 3-6, Clear One Communications P. 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. 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. Paul Zarowin

  20. Pfizer’s 2002 Q1 Report • 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? • Channel stuffing • Legitimate change in the business environment Paul Zarowin

  21. Pfizer’s 2002 Q1 Report (cont’d) • 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? • Channel stuffing • Legitimate change in the business environment Paul Zarowin

  22. Factoring to Camouflage Increase in Receivables • Inflate revenues by aggressive revenue recognition. • Growth in A/R ÷ sales is a red flag. • Factorings (sale of the good A/R) hides this signal. • 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 Paul Zarowin

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