Lecture 09 Accounts Receivable

Question 1

How do we match default costs present for transactions on credit to revenues?

Answer 1

Businesses take on the risk of the customer’s defaulting at the time a credit sale is made.
By the matching principle, the seller should therefore recognize the associated cost at the time of sale.
This cost of customers’ potential failure to pay is called bad debt expense and is recognized via the journal entry

DR bad debt expense xxx
CR allowance for doubtful accounts xxx

The allowance for doubtful accounts is a contra-asset account attached to the receivables account.

Question 2

What is the net realizeable value in the context of transactions on credit?

Answer 2

The total amount of receivables less the allowance for doubtful accounts is the amount the firm expects to collect ultimately and is called the net realizable value.

On the balance sheet, accounts receivable are always shown at their net realizable value.

On the income statement, the bad debt expense reduces the amount of revenue.

Question 3

What happens in the context of bad debt expense when actual default happens?

Answer 3

The bad debt expense is recognized for potential defaults. What happens when a customer actually defaults afterwards?

We have already taken an expense and created a ‘reserve’ (the allowance for doubtful accounts), so an actual default can simply be handled by

DR allowance for doubtful accounts xxx
CR accounts receivable xxx

This entry is called a write-off.

Question 4

What are the two standard approaches to calculating bad debt expense and the allowance for doubtful accounts?

Answer 4

Under the income statement approach, we calculate the expected amount of loss from customer defaults for all the credit sales made during the year (usually a percentage of sales).
This amount gets recorded as bad debt expense.

Under the balance sheet approach, we calculate how big the allowance needs to be, given the amount of receivables currently outstanding.
The bad debt expense is a plug number to adjust the current allowance balance to this target value.

Question 5

What is the balance sheet approach to computing the allowance for doubtful accounts?

Answer 5

The balance sheet approach to computing the allowance for doubtful accounts can be implemented by

• a customer-by-customer analysis. Doubtful accounts are identified individually based on known facts and circumstances about the customer and on the reviewing manager’s judgment.
• an aging of receivables. The allowance is a percentage of each account receivable. The percentage varies depending on the age of the receivable (i.e., the number of days it has been outstanding past its due date).

Question 6

What are the types of financing with accounts receivable?

Answer 6

At times, firms may wish to accelerate the conversion of receivables into cash.

• Secured borrowing. The firm can use its receivables as collateral to take a loan.
• Factorization. The firm can transfer its receivables to a third party in exchange for cash. The third party then carries out the collection.
• Securitization. The firm can issue securities to investors, who will receive payments based on the collections from the receivables.

Question 7

What is the practice of factoring in the context of financing with accounts receivable?

Answer 7

In case of a factoring, the firm transfer its receivables to a third party (called the factor), who undertakes the collection.

If the factoring is with recourse, the factor has the right to return any uncollectable receivables to the seller and demand repayment, i.e., the seller retains the collection risk. Factoring with recourse is therefore akin to a collateralized loan.

If the factoring is without recourse, the factor takes on all of the collection risk and hence the factoring is tantamount to a sale. Accordingly, factors demand higher fees for factoring without recourse

Question 8

What is the practice of securitization in the context of financing with accounts receivable?

Answer 8

In case of a securitization, the firm sells securities (e.g., bonds or commercial paper) backed (collateralized) by a pool of its receivables. This can take various forms, depending on the type of receivable.

In principle, the receivables underlying the securities issued remain on the balance sheet of the issuing firm. Securitization therefore increases the issuing firm’s debt-to-equity ratio.

To avoid this, a firm can use a special-purpose entity (SPE) that purchases the receivables from the firm and issues the securities in its stead.

If the SPE is not consolidated with the firm, the liability associated with the issued securities stays off the firm’s balance sheet. (This is one form of ‘off-balance sheet financing.’)

Question 9

What are the specifics of an SPE set up for securitization of accounts receivable?

Answer 9

The SPE is typically set up by a third party (the sponsor) that is independent from the firm. Under certain conditions, neither firm nor sponsor need to consolidate the SPE.

• The sponsor of the SPE charges the firm (the transferor) fees for creating and operating the SPE.
• The transferor can continue to service the loan for a fee.
• If the debtors default on the receivables, the transferor may be forced to take back receivables (or the sponsor takes the loss).
• The SPE may not be able to operate on its own because of its mismatched capital structure (long-term assets against short-term borrowings).