CHAPTER 5 CURRENT ASSETS AND LIABILITIES
5. FINANCING AND SALES OF RECEIVABLES
Another accounting issue related to receivables arises from the practice of converting receivables into cash prior to collection either by borrowing using the receivables as security for the loan or by selling the receivables. If the receivables are assigned or pledged as collateral for a loan, the loan is recorded as a liability and accounted for in the normal manner. Generally, the assignor of the receivables
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retains the responsibility for collecting the receivables. The assigned receivables remain as current assets, although they may be transferred to an account called “Assigned Accounts Receivable” to facilitate segregation of the assigned accounts from accounts that have not been assigned. Thus, assume that a business borrows $95,000 by assigning accounts receivable in the amount of $100,000. An interest bearing note is executed. This transaction would be recorded as follows:
Cash $ 95,000
Notes Payable $ 95,000
Assigned Accounts Receivable $100,000
Accounts Receivable $100,000
Interest expense on the note payable would be recorded periodically. When the note is repaid and the assignment of the receivables is terminated, the remaining assigned accounts would be transferred back to the general accounts receivable.
When receivables or other financial assets are pledged as security for a loan as discussed above, the existence of the security interest in the receivables needs to be disclosed in the financial statements. ASC 860-30-25-5. How that disclosure is made depends on the rights that the secured party has with respect to the collateral. If the creditor (secured party) has the right either by contract or custom to sell or repledge the receivables, the receivables
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that have been pledged as collateral must be reclassified and reported in the balance sheet separately from other receivables that have not be pledged. If the receivables have been pledged to a secured party that does not have the right to sell or repledge the collateral, the receivables do not need to be reclassified on the balance sheet but the existence of the pledge must be disclosed in the notes to the financial statements.
Alternatively, receivables may be the subject of a sale or other financing arrangement that is intended to be “off balance sheet,” which means that instead of recording the proceeds of the “sale” as a loan, the business would “derecognize” the receivables, that is, remove the receivables from the balance sheet and report no liability. If the party selling the receivables has no continuing involvement with or liability related to the transferred assets, the sale arrangement would be recorded as a sale. The more difficult accounting issues arise when there is some continuing involvement of the transferor of the receivables with those receivables. Sales of receivables, even with some continuing involvement (for example, the buyer having some recourse back to the seller) may still qualify as sales thus removing the receivables from the balance sheet (although some liability may have to be recorded in connection with the recourse rights of the buyer of the receivables).
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ASC 860-10 governs the accounting for sales of receivables and other transfers of financial assets. In this discussion, a sale of receivables will be used to illustrate the accounting issues that arise in these types of transfers. After reviewing the requirements to treat the transfer as a sale, the accounting for a transfer of receivables treated as a sale will be illustrated.
For a transfer of receivables to be treated as a sale (“derecognizing” an asset), the transferor must have “surrendered control” over the receivables. The transfer must be to a transferee that would not be treated as a consolidated affiliate of the transferor. ASC 860-10-40-4(a). (See Chapter 9 for a discussion of consolidation.) Consideration must be
given to the nature of any continuing involvement of the transferor in the transferred assets including a review of all the arrangements and agreements entered into in connection with the transfer such as servicing arrangements, recourse or guarantee arrangements, agreements to purchase or redeem transferred assets, options, derivative financial instruments, financial support arrangements, and continuing beneficial interests retained by the transferor.
To be recognized as a sale, the transfer must be of an entire financial asset or group of financial assets or be a transfer of a “participating interest” in an entire financial asset. A participating interest in an
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entire financial asset has all of the following characteristics:
(i) It represents a proportionate interest in an entire financial asset;
(ii) All cash flows from the entire financial asset are shared based on proportionate ownership (servicing cash flows can be excluded from consideration as long as they are not subordinated and are not significantly in excess of the amount that would compensate a substitute service provider in the market place); and
(iii) All participating interest holders including the transferor must have the same priority status with no one being subordinated, the priority must not change as a result of bankruptcy of the transferor, the transferee, or the debtor, and the participating interest holders must not have recourse to the transferor (other than with regard to standard representations and warranties in connection with a sale of the assets).
Three additional tests must be satisfied for the transfer of the financial assets to be treated as a sale for accounting purposes. One test, called isolation analysis, requires that the transferred financial assets must be beyond the reach of the transferor and its creditors or creditors of consolidated affiliates
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of the transferor including in a bankruptcy or receivership. In analyzing this isolation requirement, so-called bankruptcy remote vehicles will not be treated as consolidated affiliates, but these bankruptcy remote vehicles are still subject to separate review for consolidation purposes (see Chapter 9).
The second test relates to an ability to pledge the transferred assets after the transfer.
Each transferee must have the right to pledge or exchange the transferred assets with no conditions that both limit the transferee’s rights to pledge or exchange the assets and provide more than a trivial benefit to the transferor. If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is restricted from pledging or exchanging the assets, the ability to pledge requirement will still be satisfied as long as the third party holders of the beneficial
interests in the transferee vehicle are allowed to pledge or exchange their beneficial interests in accordance with this requirement (effectively an ability to indirectly pledge or exchange the transferred assets).
The third requirement relates to a lack of control following a transfer. The transferor and its consolidated affiliates can’t effectively control the transferred financial assets or third party beneficial interests related to the transferred assets. Examples of effective control would include agreements that both entitle and obligate the transferor to redeem
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financial assets prior to their maturity, an agreement that gives the transferor both the unilateral ability to cause the holder to return specific financial assets with a non-trivial benefit attributable to that unilateral ability (excluding clean-up calls), and put or repurchase agreements that permit the transferee to require the transferor to repurchase the transferred financial assets at a favorable price that is so favorable to the transferee that it is probable that the transferee will exercise the right.
The transferor may incur various liabilities as part of the transfer. Similarly, the transferor may obtain certain assets including beneficial interests in the transferred assets. Such liabilities or assets must be measured and recorded at their fair values at the time of the transfer. ASC 860-20-25. When there is a transfer of receivables that qualifies as a sale and the transferor undertakes an obligation to service those assets, the transferor must recognize and initially measure a servicing asset or servicing liability at fair value A “servicing asset” or “servicing liability” exists where the estimated future revenues from contractual service fees, late charges, and other related revenues from the servicing obligation are either more than (a servicing asset) or less than (a servicing liability) an amount that adequately compensates the servicer for performing the servicing.
To illustrate the accounting for a sale of receivables that qualifies for sale treatment, assume that
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Benjamin’s Bridle Shop sells its receivables and that the transfer of the receivables meets the requirements for sale treatment. The receivables sold have a book value of
$5,000 to Benjamin’s Bridle Shop and the transferee pays $4,800. In addition, Benjamin’s Bridle Shop enters into a servicing contract to service the receivables transferred in exchange for a fee. The fair value of the servicing rights is $200. Finally, assume that Benjamin’s Bridle Shop retains a recourse obligation to repurchase any delinquent receivables and that the obligation under that recourse arrangement is determined to have a fair value of $100.
The total proceeds of the sale would be the cash proceeds of the sale ($4,800) plus the value of the servicing asset ($200) less the obligation retained ($100) for a net proceeds
of $4,900. The current book value of the receivables is $5,000 so the sale of the receivables results in a loss of $100.
The entry to record the sale of the receivables would be:
Cash $4,800
Servicing Asset $ 200
Loss on Sale $ 100
Receivables $5,000
Recourse Liability $ 100
With regard to the servicing asset recognized on the sale, Benjamin’s Bridle Shop may elect either (a)
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to amortize to expense the amount assigned to the servicing contract in proportion to and over the expected period of estimated servicing income to be recognized (subject to testing for an impairment or increased obligation) or (b) apply a fair value measurement method recognizing changes in the fair value of the contract each reporting period as they occur.
If the transfer of financial assets or participating interests in financial assets does not meet the requirements for sale treatment as discussed above, the transaction would be recorded as a secured borrowing. The transferor would recognize a liability for the proceeds of the purported sale and would retain the transferred assets on its books with no change in their carrying amount. ASC 860-30-25. There would be no recognition of any servicing asset or liability even if the transferor undertakes an obligation to service the transferred assets.