6.3.3: Derecognition and Sale of Receivables- Shortening the Credit-to-Cash Cycle

Derecognition is the removal of a previously recognized receivable from the company's balance sheet. In the normal course of business, receivables arise from credit sales and, once paid, are removed (derecognized) from the books. However, this takes valuable time and resources to turn receivables into cash. As someone once said, "turnover is vanity, profit is sanity, but cash is king"2. Simply put, a business can report all the profits possible, but profits do not mean cash resources. Sound cash flow management has always been important but, since the economic downturn in 2008, it has become the key to survival for many struggling businesses. As a result, companies are always looking for ways to shorten the credit-to-cash cycle to maximize their cash resources. Two such ways are secured borrowings and sales of receivables, discussed next.

Secured Borrowings

Companies often use receivables as collateral for a loan or a bank line of credit. The receivables are pledged as security for the loan, but the control and collection often remain with the company, so the receivables are left on the company's books. The company records the proceeds of the loan received from the finance company as a liability with the loan interest and any other finance charges recorded as expenses. If a company defaults on its loan, the finance company can seize the secured receivables and directly collect the cash from the receivables as payment against the defaulted loan. This will be illustrated in the section on factoring, below.

Sales of Receivables

What is the accounting treatment if a company's receivables are transferred (sold) to a third party (factor)? Certain industry sectors, such as auto dealerships and almost all small- and medium-sized businesses selling high-cost goods (e.g., gym equipment retailers) make extensive use of third-party financing arrangements with their customers to speed up the credit-to-cash cycle. Whether a receivable is transferred to a factor (sale) or held as security for a loan (borrowing) depends on the criteria set out in IFRS and ASPE which are discussed next.

Conditions for Treatment as a Sale

For accounting purposes, the receivables should be derecognized as a sale when they meet the following criteria:

IFRS—substantially all of the risks and rewards have been transferred to the factor. The evidence for this is that the contractual rights to receive the cash flows have been transferred (or the company continues to collect and forward all the cash it collects without delay) to the factor. As well, the company cannot sell or pledge any of these receivables to any third parties other than to the factor.

ASPE—control of the receivables has been surrendered by the transferor. This is evidenced when the following three conditions are all met:

1. The transferred assets have been isolated from the transferor.

2. The factor has obtained the right to pledge or to sell the transferred assets.

3. The transferor does not maintain effective control of the transferred assets through a repurchase agreement.

If the conditions for either IFRS or ASPE are not met, the receivables remain in the accounts and the transaction is treated as a secured borrowing (recorded as a liability) with the receivables as security for the loan. The accounting treatment regarding the sale of receivables using either standard is a complex topic; the discussion in this section is intended as a basic overview.

Below are some different examples of sales of receivables; such as factoring and securitization.

Factoring

Factoring is when individual accounts receivable are sold or transferred to a recipient or factor, usually a financial institution, in exchange for cash minus a fee called a discount. The seller does not usually have any subsequent involvement with the receivable and the factor collects directly from the customer. (Companies selling fitness equipment exclusively use this method for all their credit sales to customers.)

The downside to this strategy is that factoring is expensive. Factors typically charge a 2% to 3% fee when they buy the right to collect payments from customers. A 2% discount for an invoice due in thirty days is the equivalent of a substantial 25% a year, and 3% is over 36% per year compared to the much lower interest rates charged by banks and finance companies. Most companies are better off borrowing from their bank, if it is possible to do so.

However, factors will often advance funds when more traditional banks will not. Even with only a prospective order in hand from a customer, a business can turn to a factor to see if it will assume or share the risk of the receivable. Without the factoring arrangement, the business must take time to secure and collect the receivable; the factor offers a reduction in additional effort and aggravation that may be worth the price of the fee paid to the factor.

There are risks associated with factoring receivables. Companies that intend to sell their receivables to a factor need to check out the bank and customer references of any factor. There have been cases where a factor has gone out of business, still owing the company substantial amounts of money held back in reserve from receivables already paid up.

Factoring versus Borrowing: A Comparison

The difference between factoring and borrowing can be significant for a company that wants to sell some or all of its receivables. Consider the following example:

Assume that on June 1, Cromwell Co. has $100,000 accounts receivable it wants to sell to a factor that charges 10% as a financing fee. Below is the transaction recorded as a sale of receivables compared to a secured note payable arrangement, starting with some opening balances:

Cromwell Co. Balance Sheet – Opening Balances

Cash		$	10,000
Accounts receivable			150,000
Property, plant, and equipment			200,000
Total assets		$	360,000
Accounts payable		$	70,000
Note payable			0
Equity			290,000
Total liabilities and equity		$	360,000
Debt-to-total assets ratio			19%

Below is the balance sheet after the transaction:

Cromwell Co. Balance Sheet – Sale of Receivables

Cash		$	100,000
Accounts receivable			50,000
Property, plant, and equipment			200,000
Total assets		$	350,000
Accounts payable		$	70,000
Note payable			0
Equity			280,000
Total liabilities and equity		$	350,000
Debt-to-total assets ratio			20%

 

Cromwell Co. Balance Sheet – Note Payable

Cash		$	100,000
Accounts receivable			150,000
Property, plant, and equipment			200,000
Total assets		$	450,000
Accounts payable		$	70,000
Note payable			90,000
Equity			290,000
Total liabilities and equity		$	450,000
Debt-to-total assets ratio			36%

Note that the entry for a sale is straightforward with the receivables of $100,000 derecognized from the accounts and a decrease in retained earnings due to the loss reported in net income. However, for a secured borrowing, a note payable of $90,000 is added to the accounts as a liability, and the accounts receivable of $100,000 remains in the accounts as security for the note payable. Referring to the journal entry above, in both cases cash flow increased by $90,000, but for the secured borrowing, there is added debt of $90,000, affecting Cromwell's debt ratio and negatively impacting any restrictive covenants Cromwell might have with other creditors. After the transaction, the debt-to-total assets ratio for Cromwell is 20% if the accounts receivable transaction meets the criteria for a sale. The debt ratio worsens to 36% if the transaction does not meet the criteria for a sale and is treated as a secured borrowing. This impact could motivate managers to choose a sale for their receivables to shorten the credit-to-cash cycle, rather than the borrowing alternative.

Sales without Recourse

For sales without recourse, all the risks and rewards (IFRS) as well as the control (ASPE) have been transferred to the factor, and the company no longer has any involvement.

For example, assume that on August 1, Ashton Industries Ltd. factors $200,000 of accounts receivable with Savoy Trust Co., the factor, on a without-recourse basis. All the risks, rewards, and control are transferred to the finance company, which charges an 8% fee and withholds a further 4% of the accounts receivables for estimated returns and allowances. The entry for Ashton is:

The accounting treatment will be the same for IFRS and ASPE since both sets of conditions (risks and rewards and control) have been met. If no returns and allowances are given to customers owing the receivables, Ashton will recoup the $8,000 from the factor. In turn, Savoy's net income will be the $16,000 revenue reduced by any uncollectible receivables, since it now has assumed the risks/rewards and control of these receivables.

Sales with Recourse

In this case, Ashton guarantees payment to Savoy for any uncollectible receivables (recourse obligation). Under IFRS, the guarantee means that the risks and rewards have not been transferred to the factor, and the accounting treatment would be as a secured borrowing as illustrated above in Cromwell—Note Payable. Under ASPE, if all three conditions for treatment as a sale as described previously are met, the transaction can be treated as a sale.

Continuing with the example for Ashton, assume that the receivables are sold with recourse, the company uses ASPE, and that all three conditions have been met. In addition to the 8% fee and 4% withholding allowance, Savoy estimates that the recourse obligation has a fair value of $5,000. The entry for Ashton, including the estimated recourse obligation is:

You will see that the recourse liability to Savoy results in an increase in the loss on sale of receivables by the recourse liability amount of $5,000. If there were no uncollectible receivables, Ashton will eliminate the recourse liability amount and decrease the loss. Savoy's net income will be the finance fee of $16,000 with no reductions in revenue due to uncollectible accounts, since these are being guaranteed and assumed by Ashton.

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Securitization

Securitization is a financing transaction that gives companies an alternative way to raise funds other than by issuing debt, such as a corporate bond or note. The process is extremely complex and the description below is a simplified version.

The receivables are sold to a holding company called a Special Purpose Entity (SPE), which is sponsored by a financial intermediary. This is similar to factoring without recourse, but is done on a much larger scale. This sale of receivables and their removal from the accounting records by the company holding the receivables is an example of off-balance sheet accounting. In its most basic form, the securitization process involves two steps:

Step 1: A company (the asset originator) with receivables (e.g., auto loans, credit card debt), identifies the receivables (assets) it wants to sell and remove from its balance sheet. The company divides these into bundles, called tranches, each containing a group of receivables with similar credit risks. Some bundles will contain the lowest risk receivables (senior tranches) while other bundles will have the highest risk receivables (junior tranches).

The company sells this portfolio of receivable bundles to a special purpose entity (SPE) that was created by a financial intermediary specifically to purchase these types of portfolio assets. Once purchased, the originating company (seller) derecognizes the receivables and the SPE accounts for the portfolio assets in its own accounting records. In many cases, the company that originally sold the portfolio of receivables to the SPE continues to service the receivables in the portfolio, collects payments from the original borrowers and passes them on—less a servicing fee—directly to the SPE. In other cases, the originating company is no longer involved and the SPE engages a bank or financial intermediary to collect the receivables as a collecting agent.

Step 2: The SPE (issuing agent) finances the purchase of the receivables portfolio from the originating company by issuing tradeable interest-bearing securities that are secured or backed by the receivables portfolio it now holds in its own accounting records as stated in Step 1—hence the name asset-backed securities (ABS). These interest-bearing ABS securities are sold to capital market investors who receive fixed or floating rate payments from the SPE, funded by the cash flows generated by the portfolio collections. To summarize, securitization represents an alternative and diversified source of financing based on the transfer of credit risk (and possibly also interest rate and currency risk) from the originating company and ultimately to the capital market investors.

The Downside of Securitization

Securitization is inherently complex, yet it has grown exponentially. The resulting highly competitive securitization markets with multiple securitizers (financial institutions and SPEs), increase the risk that underwriting standards for the asset-backed securities could decline and cause sharp drops in the bundled or tranched securities' market values. This is because both the investment return (principal and interest repayment) and losses are allocated among the various bundles according to their level of risk. The least risky bundles, for example, have first call on the income generated by the underlying receivables assets, while the riskiest bundles have last claim on that income, but receive the highest return.

Typically, investors with securities linked to the lowest-risk bundles would have little expectation of portfolio losses. However, because investors often finance their investment purchase by borrowing, they are very sensitive to changes in underlying receivables assets' quality. This sensitivity was the initial source of the problems experienced in the sub-prime mortgage market (derivatives) meltdown in 2008. At that time, repayment issues surfaced in the riskiest bundles due to the weakened underwriting standards, and lack of confidence spread to investors holding even the lowest risk bundles, which caused panic among investors and a flight into safer assets, resulting in a fire sale of securitized debt of the SPEs.

In the future, securitized products are likely to become simpler. After years of posting virtually no capital reserves against high-risk securitized debt, SPEs will soon be faced with regulatory changes that will require higher capital charges and more comprehensive valuations. Reviving securitization transactions and restoring investor confidence might also require SPEs to retain an interest in the performance of securitized assets at each level of risk (Jobst, 2008).