08.01 Trade Receivables

Question 1

What are trade accounts receivables?

Answer 1

Trade accounts receivable (AR) result from credit sales of goods or services in the ordinary course of business, covered in ASC 606, Revenue from Contracts with Customers. Notes receivable often relate to noncustomer transactions and are a contractual agreement between a creditor and a debtor to pay a specific amount at a future date. Receivables that are not related to normal operations, such as amounts due from officers, employees, or stockholders, are reported separately from trade AR (ASC 310).

Question 2

How are receivables valued on the balance sheet?

Answer 2

When a company sells goods or performs services on account, it will recognize revenue and record a corresponding trade AR. Receivables are valued on the balance sheet at net realizable value (NRV), the amount of cash that the entity expects to collect at due date or at maturity. There are several factors (e.g. trade discounts, cash discounts, reductions for returned goods) that cause the valuation of a receivable to be less than its face or nominal value.

Question 3

What is a trade discount?

Answer 3

A trade discount is a deduction that a seller offers to a buyer. Generally, trade discounts are offered to incentivize purchases.

Question 4

When does a sales contract include variable consideration?

Answer 4

A sales contract contains variable consideration when it includes provisions that have the potential to reduce the amount of consideration given. Variable consideration reduces the revenue recognized upon sale and is estimated according to the guidelines in ASC 606.

Question 5

What are examples of variable consideration?

Answer 5

Cash discounts for prompt payment; Reductions for returned goods; Reductions for defective or nonconforming goods.

Question 6

What impacts the net realizable value of AR?

Answer 6

Credit sales, collections, estimated credit losses, write-offs, and subsequent recoveries all impact the NRV of AR.

Question 7

What are credit losses?

Answer 7

Credit losses are the portion of trade receivables that the seller does not expect to collect due to the customers’ inability to pay. Credit losses are estimated considering the seller’s experience, industry standards, economic conditions, and other factors.

Question 8

What are the two methods for recording credit losses?

Answer 8

Direct write-off method and Allowance method.

Question 9

What is the direct write-off method for recording credit losses?

Answer 9

The direct write-off method is required for tax reporting. The credit loss expense is recognized when the account is deemed uncollectible. The allowance for credit losses account is not used. Receivables are reported at the gross amount.

Question 10

What is the allowance method for recording credit losses?

Answer 10

The allowance method is required for financial reporting. The credit loss expense is estimated at the end of each period and recorded. The allowance for credit losses account is used. Receivables are reported at their net carrying value (receivables less allowance).

Question 11

What method for credit losses is acceptable under GAAP?

Answer 11

Allowance method.

Question 12

Why is the direct write-off method not allowed under GAAP?

Answer 12

Not matching: credit loss (i.e. bad debt) expense is not recorded at the time of sale.
Not conservative: AR is carried at its face amount, which will overstate the AR balance on the balance sheet.

Question 13

What is the current expected credit loss (CECL) model?

Answer 13

Another name for the allowance method. Must be used for GAAP purposes. Under the CECL, credit losses are estimated each period and are reported with an expense on the income statement, along with an increase to allowance for credit losses, a contra account to AR.

Question 14

What does FASB require under the current expected credit loss (CECL) model?

Answer 14

Under the CECL model, the amount for the allowance account may be determined using various methods. FASB does not require the use of a specific method because economic and environmental conditions vary among companies. FASB does require companies to consider all relevant quantitative and qualitative factors that relate to the collectability of receivables. Thus, the method selected should be consistently applied and realistically reflect expected credit losses.

Question 15

What are examples of methods of estimating credit losses under the current expected credit loss (CECL) model?

Answer 15

Aging - based on account balances stratified by due date with different percentages applied to each stratum
Discounted cash flow - based on the present value of expected future cash flows
Loss rate - based on a percentage of total exposure
Roll rate - based on the time required for the conversion cycle
Probability of default - based on multiplying the likelihood that an instrument will be defaulted by the balance of that instrument.

Question 16

What does the current expected credit loss (CECL) model require for write offs?

Answer 16

The CECL model requires specific receivables to be written off in the period in which it is determined that they are uncollectible. Every reporting period, companies perform analyses to determine which specific accounts are uncollectible. They will then write off these accounts. Write-offs decrease AR as well as the allowance for credit losses.

Question 17

What happens when accounts previously written off are subsequently collected?

Answer 17

If accounts previously written off are subsequently collected, the company should first reinstate the previously written-off account. By reinstating the account, the company knows that the account was eventually paid instead of assuming that it was never paid. Then, the company will record the collection on the previously written-off account.

Question 18

What is an AR rollforward?

Answer 18

A rollforward is a high-level summary method to review periodic activity in related accounts. For trade AR, a rollforward starts with the beginning balance of AR and lists all activity that increased or decreased the account during the period, resulting in the ending balance. It includes credit sales, collections, write-offs/recoveries, and any additional adjustments needed to correctly present the AR balance in the FS.

Question 19

What does it mean to transfer receivables?

Answer 19

Business entities may use receivables as immediate sources of cash. Firms can use the receivables as collateral for a loan or sell the receivables to a third party rather than wait for cash to be collected from customers. Companies may transfer receivables to eliminate the need for a credit department, to receive cash so that they can meet current operating expenses more readily, etc.

Question 20

When is a transfer of receivables determined to be a sale?

Answer 20

If the following conditions are met, control has effectively passed and the transaction is accounted for as a sale:
1. The transferred assets have been isolated from the transferor, even in bankruptcy; 2. The transferee is free to pledge or exchange the assets; 3. The transferor does not maintain effective control over the transferred assets through either one of the following: a. an agreement that requires the transferor to repurchase the assets; b. an agreement that requires the transferor to return specific assets.

Question 21

When is a transfer of receivables determined to be a borrowing transaction?

Answer 21

If control has not passed, the asset is considered to have been used as collateral for a loan (borrowing transaction).

Question 22

What is the process called when a company sells its receivables to a bank for a fee?

Answer 22

This process is called factoring or discounting. Factoring is the sale of short-term AR. Discounting is the sale of long-term notes receivable. Factoring and discounting transactions can be accounted for as a sale or borrowing transaction.

Question 23

What does a sale with recourse mean?

Answer 23

In a sale with recourse, the company (seller) retains the risk of uncollectible accounts. The buyer has the right to demand payment for any defaulted receivable.

Question 24

What does a sale without recourse mean?

Answer 24

In a sale without recourse, the buyer assumes the risk for any uncollectible receivables.

Question 25

What does it mean when AR is assigned?

Answer 25

When AR is assigned, a company borrows cash from a third party and agrees to use the proceeds from the receivable to repay the third party. The borrower retains the receivables on its books and reclassifies them as AR assigned, a subcategory of total AR. As cash is received, it is remitted to the lender in payment of the loan. The lender has the right to seek payment from the receivables should the borrower default on the loan.

Question 26

What does it mean when AR is pledged?

Answer 26

Pledging of AR is less formal and more common in practice, than assignment. A company borrows cash and “pledges” (offers) the receivables to the lender as collateral to secure the loan. Receivables are not reclassified. Requires only footnote disclosure, and AR account is not adjusted.

Question 27

What is notes receivable?

Answer 27

Notes receivable are contractual agreements between a creditor and a debtor to pay a specific amount at a future date. NR do not occur in the ordinary course of business.