RECOGNITION AND MEASUREMENT OF NOTES

RECEIVABLE Notes receivables are initially recognized at the fair

value on the date that the note is legally executed
A note receivable is an unconditional written promise
(usually upon signing).
to pay a specific sum of money on demand or on a
defined future date and is supported by a formal
Subsequent valuation is measured at amortized
written promissory note. For this reason, notes
cost.
are negotiable instruments, the same as cheques and
bank drafts.
Transaction Costs
It is common for notes to incur transaction costs,
Notes receivable can arise due to loans, advances to
especially if the note receivable is acquired using a
employees, or from higher-risk customers who need
broker, who will charge a commission for their
to extend the payment period of an outstanding
services. For a company using either ASPE or IFRS,
account receivable. Notes can also be used for sales
the transaction costs associated with financial assets
of property, plants, and equipment or for exchanges
such as notes receivable that are carried at amortized
of long-term assets. Notes arising from loans usually
cost are to be capitalized which means that the costs
identify collateral security in the form of assets of the
are to be added to the asset’s fair value of the note at
borrower that the lender can seize if the note is not
acquisition and subsequently included with any
paid at the maturity date.
discount or premium and amortized over the term of
the note.
Notes may be referred to as interest-bearing or non-
interest-bearing:
Short-Term Notes Receivable
When notes receivable have terms of less than one
Interest-bearing notes have a stated rate of interest
year, accounting for short-term notes is relatively
that is payable in addition to the face value of the straightforward as discussed below.
note.
Calculating the Maturity Date
Notes with stated rates below the market rates or Knowing the correct maturity date will have an
zero- or non-interest-bearing notes may or may not impact on when to record the entry for the note and
have a stated rate of interest. This is usually done to how to calculate the correct interest amount
encourage sales. However, there is always an interest throughout the note’s life. For example, to calculate
component embedded in the note, and that amount the maturity date of a ninety-day note dated March
will be equal to the difference between the amount 14, 2020:
that was borrowed and the amount that will be repaid.

Notes may also be classified as short-term (current)

assets or long-term assets on the balance sheet:

Current assets: short-term notes that become due

within the next twelve months (or within the business’s
operating cycle if greater than twelve months);

Long-term assets: notes are notes with due dates

greater than one year.
Reca
ll the formula for simple interest:
Cash payments can be interest-only with the principal
portion payable at the end or a mix of interest and Interest = Principle × Rate × Time
principal throughout the term of the note.
For example, assume that on March 14, 2020, Ripple above. The interest amounts differ slightly between the
Stream Co. accepted a ninety-day, 8% note of $5,000 two calculations because the ninety-day note uses a
in exchange for extending the payment period of an 90⁄365 ratio (or 24.6575% for a total amount of
outstanding account receivable of the same value. $98.63) while the three-month note uses a 3⁄12 ratio (or
Ripple’s entry to record the acceptance of the note 25% for a total of $100.00).
that will replace the accounts.
Receivables, Interest, and the Time Value of Money
All financial assets are to be measured initially at their
fair value which is calculated as the present
value amount of future cash receipts. But what is
The entry for payment of the note ninety days at
present value? It is a discounted cash flow concept,
maturity on June 12 would be:
which is explained next.

It is common knowledge that money deposited in a

savings account will earn interest, or money
the example above, if financial statements are borrowed from a bank will accrue interest payable to
prepared during the time that the note receivable is the bank. The present value of a note receivable is
outstanding, interest will be accrued to the reporting therefore the amount that you would need to
date of the balance sheet. For example, if Ripple’s deposit today, at a given rate of interest, which will
year-end were April 30, the entry to accrue interest result in a specified future amount at maturity. The
from March 14 to April 30 would be: cash flow is discounted to a lesser sum that
eliminates the interest component. Hence the
term discounted cash flow.
The future amount can be a single payment at the
date of maturity or a series of payments over future
When the cash payment occurs at maturity on June 12, time periods or some combination of both. Put into
the entry would be:context for receivables, if a company must wait until
a future date to receive the payment for its receivable,
the receivable’s face value at maturity will not be an
exact measure of its fair value on the date the note is
legally executed because of the embedded interest
component.
The interest calculation will differ slightly had the note
For example, assume that a company makes a sale on
been stated in months instead of days. For example,
an account for $5,000 and receives a $5,000, six-
assume that on January 1, Ripple Stream accepted
month note receivable in exchange. The face value of
a three-month (instead of a ninety-day), 8%, note in
the note is therefore $5,000. If the market rate of
exchange for the outstanding accounts receivable. If
interest is 9%, or its value without the interest
Ripple’s year-end was March 31, the interest accrual
component, is $4,780.79 and not $5,000. The
would be:
$4,780.79 is the amount that if deposited today at an
interest rate of 9% would equal $5,000 at the end of
six months.  Using an equation, the note can be
expressed as:

Note the difference in the interest calculation between Where I/Y is interest of .75% each month (9% ÷ 12
the ninety-day and the three-month notes recorded months) for six months.
N is for interest compounded each month for six months. Assume that on
January 1,
FV is the payment at the end of six months’ time (future
value) of $5,000. Maxwell lends
some money in
exchange for a
$5,000, five-year
To summarize, the discounted amount of $4,780.79 is
note, payable as a
the fair value of the $5,000 note at the time of the sale,
lump sum at the
and the additional amount received after the sale of
end of five years.
$219.21 ($5,000.00 − $4,780.79) is interest income
The market rate of
earned over the term of the note (six months).
interest is 5%.
However, for any receivables due in less than one year,
Maxwell’s year-
this interest income component is usually insignificant.
end is December
For this reason, both IFRS and ASPE allow a net31. The first step is
realizable value (the net amount expected to be to identify the amount(s) and timing of all the cash
received in cash) to approximate the fair value for flows as illustrated below on the timeline. The
short-term notes receivables that mature within one amount of money that Maxwell would be willing to
year. So, in the example above, the $5,000 face value lend the borrower using the present value calculation
of the six-month note will be equivalent to the fair of the cash flows would be $3,917.63 as follows:
value and will be the amount reported, net of any
estimated collectability (i.e., net realizable value), on
the balance sheet until payment is received. However,
for notes with maturity dates greater than one-year, fair
values are to be determined at their discounted cash
flow or present value, which will be discussed next.
Long-Term Notes Receivable
The difference between a short-term note and a long-
term note is the length of time to maturity. As the
length of time to maturity of the note increases, the In this case, Maxwell will be willing to lend
interest component becomes increasingly more $3,917.63 today in exchange for a payment of $5,000
significant. As a result, any notes receivable that are at the end of five years at an interest rate of 5% per
greater than one year to maturity are classified as long- annum. The entry for the note receivable at the date
term notes and require the use of present values toof issuance would be:
estimate their fair value at the time of issuance. After
issuance, long-term notes receivable is measured
at amortized cost. Determining present values requires
an analysis of cash flows using interest rates and Now assume that on January 1, Maxwell lends an
timelines, as illustrated next. amount of money in exchange for a $5,000, five-year
note. The market rate of interest is 5%. The
repayment of the note is payments of $1,000 at the
end of each year for
Present Values and Time Lines the next five years
The following timelines will illustrate how present (present value of
value using discounted cash flows works. Below are an ordinary annuity).
three different scenarios: The amount of money
that Maxwell would
be willing to lend the
 borrower using the present value calculation of the the timing of the cash flows as discussed earlier.
cash flows would be$4, 329.48 as follows: In scenario 1, the principal is not reduced until
maturity and interest would accrue over the full
The entry for the note receivable would be: five years of the note. For scenario 2, the
principal is being reduced on an annual basis,
but the payment is not made until the end of
each year. For scenario 3, there is an immediate
Note that Maxwell is willing to lend more money
reduction of principal due to the first payment of
($4,329.48 compared to $3,917.63) to the borrower in
$1,000 upon issuance of the note. The remaining
this example. Another way of looking at it is that the
four payments are made at the beginning instead
interest component embedded in the note is less for this
of at the end of each year. This results in a
example. This makes sense because the principal
reduction in the principal amount owing upon
amount of the note is being reduced over its five-year
which the interest is calculated.
life because of the yearly payments of $1,000.
This is the same concept as a mortgage owing for a
Scenario 1 Scenario 2 Scenario 3 house, where it is commonly stated by financial
Single payment Five payments Five payments
at maturity of $1,000 at the of $1,000 at the advisors that a mortgage payment split and paid every
end of each beginning of half-month instead of a single payment once per month
month each month
will result in a significant reduction in interest costs
Face value of the over the term of the mortgage. The bottom line is: If
$5,000 $5,000 $5,000
note there is less principal amount owing at any time over
the life of a note, there will be less interest charged.
Less: present
3,918 4,329 4,546
value of the note
Present Values with Unknown Variables
Interest As is the case with any algebraic equation, if all
$1,082 $671 $454
component
variables except one are known, the final unknown
How would the amount of the loan and the entries variable can be determined. For present value
above differ if Maxwell received five equal payments calculations, if any four of the five variables in
of $1,000 at the beginning of each year (present value equation PV = (PMT, I/Y, N, FV) are known, the fifth
of an annuity due) instead of at the end of each year as “unknown” variable amount can be determined using a
shown in scenario 2 above? The amount of money that business calculator or an Excel net present value
Maxwell would be willing to lend using the present function. For example, if the interest rate (I/Y) is not
value calculation of the cash. flows would be known, it can be derived if all the other variables in the
$4,545.95 as follows: equation are known. This will be illustrated when non-
interest-bearing long-term notes receivable are
The entry for the note receivable would be: discussed later in this chapter.

Present Values when Stated Interest Rates are Different

Again, the interest component will be less because a than Effective (Market) Interest Rates. Differences
payment is paid immediately upon execution of the between the stated interest rate (or face rate) and the
note, which causes the principal amount to be effective (or market) rate at the time a note is issued
reduced sooner than a payment made at the end of can have accounting consequences as follows:
each year.
If the stated interest rate of the note (which is the
Below is a comparison of the three scenarios: interest rate that the note pays) is 10% at a time when
Note that the interest component decreases for the effective interest rate (also called the market rate,
each of the scenarios even though the total cash or yield) is 10% for notes with similar characteristics
repaid is $5,000 in each case. This is due to and risk, the note is initially recognized as:
 Below are some examples of journal entries involving
face value = fair value = present value of the note various stated rates compared to market rates.
This makes intuitive sense since the stated rate of
10% is equal to the market rate of 10%. 1. Notes Issued at Face Value
Assume that on January 1, Carpe Diem Ltd. lends
If the stated interest rate is 10% and the market rate is $10,000 to Fascination Co. in exchange for a $10,000,
11%, the stated rate is lower than the market rate and three-year note bearing interest at 10% payable
the note is trading at a discount. annually at the end of each year (ordinary annuity).
The market rate of interest for a note of similar risk is
If stated rate lower than market ⇒ Present also 10%. The note’s present value is calculated as:
value lower ⇒ Difference is a discount

If the stated interest rate is 10% and the market rate is

9%, the stated rate is higher than the market rate and
the note is trading at a premium.

If stated rate higher than market ⇒ Present

value higher ⇒ Difference is a premium
In this case, the note’s face value and present value
The premium or discount amount is to be amortized (fair value) are the same ($10,000) because the
over the term of the note. Below are the acceptable effective (market) and stated interest rates are the
methods to amortize discounts or premiums: same. Carpe Diem’s entry on the date of issuance is:

If a company follows IFRS, the effective interest

method of amortization is required (discussed in the
next section).
If Carpe Diem’s year-end was December 31, the
If a company follows ASPE, the amortization method interest income recognized each year would be:
is not specified, so either straight-line amortization or
the effective interest method is appropriate as an
accounting policy choice.

Long-Term Notes, Subsequent Measurement 2. Stated Rate Lower than Market Rate: A Discount
Under IFRS and ASPE, long-term notes receivable Assume that Anchor Ltd. makes a loan to Sizzle
that are held for their cash flows of principal and Corp. in exchange for a $10,000, three- year note
interest are subsequently accounted for at amortized bearing interest at 10% payable annually. The market
cost, which is calculated as: rate of interest for a note of similar risk is 12%.
Amount recognized when initially acquired (present Recall that the stated rate of 10% determines the
value) including any transaction costs such asamount of the cash received for interest; however, the
commissions or fees. Plus interest and minus any present value uses the effective (market) rate to
principal collections/receipts. Payments can also bediscount all cash flows to determine the amount to
blended with interest and principal. record as the note’s value at the time of issuance. The
note’s present value is calculated as:
Plus, amortization of discount or minus amortization of
premium. Minus write-downs for impairment, if
applicable
As
 note’s carrying value each year, thereby
shown above, the note’s market rate (12%) is higher increasing it's carrying amount until it reaches
than the stated rate (10%), so the note is issued at a its maturity value of $10,000.
discount.
Anchor’s entry to record the issuance of the note As a result, the carrying amount at the end of
receivable: each period is always equal to the present value
of the note’s remaining cash flows discounted at
the 12% market rate. This is consistent with the
accounting standards for the subsequent
measurement of long-term notes receivable
Even though the face value of the note is $10,000, the
amount of money lent to Sizzle would only be $9,520, at amortized cost.
which is net of the discount amount and is the difference
between the stated and market interest rates discussed If Anchor’s year-end was the same date as the
earlier. In return, Anchor will receive an annual cash note’s interest collected, at the end of year 1
payment of $1,000 for three years plus a lump sum using the schedule above, Anchor’s entry would
payment of $10,000 at the end of the third year, when the be:
note matures. The total cash payments received will be
$13,000 over the term of the note, and the interest
component of the note would be:

  Alternatively, if Anchor used ASPE the straight-line

As method of amortizing the discount is simple to apply.
The total discount of $480 is amortized over the
three-year term of the note in equal amounts. The
mentioned earlier, if Anchor used IFRS the $480 annual amortization of the discount is $160 ($480 ÷ 3
discount amount would be amortized using the years) for each of the three years as shown in the
effective interest method. If Anchor used ASPE, following entry:
there would be a choice between the effective
interest method and the straight-line method.

Below is a schedule that calculates the cash Comparing the three years’ entries for both the
received, interest income, discount amortization, effective interest and straight-line methods shows the
and the carrying amount (book value) of the note following pattern for the discount amortization of the
at the end of each year using the effective note receivable:
interest method:

The amortization of the discount using the effective

interest method results in increasing amounts of
interest income that will be recorded in the adjusting
The total discount of $480 amortized in the entry (decreasing amounts of interest income for
schedule is equal to the difference between the amortizing a premium) compared to the equal
face value of the note of $10,000 and the present amounts of interest income using the straight-line
value of the note principal and interest of method. The straight-line method is easier to apply
$9,250. The amortized discount is added to the but its shortcoming is that the interest rate (yield) for
the note is not held constant at the 12% market rate as Some companies will issue zero-interest-bearing
is the case when the effective interest method is used. notes as a sales incentive. The notes do not state an
This is because the amortization of the discount is in interest rate but the term “zero-interest” is inaccurate
equal amounts and does not take into consideration because financial instruments always include an
what the carrying interest component that is equal to the difference
amount of the note was at any given period of time. At between the cash lent and the higher amount of cash
the end of year 3, the notes receivable balance is repaid at maturity. Even though the interest rate is not
$10,000 for both methods, so the same entry isstated, the implied interest rate can be derived
recorded for the receipt of the cash. because the cash values lent and received are both
known. In most cases, the transaction between the
issuer and acquirer of the note is at arm’s length, so
the implicit interest rate would be a reasonable
3. Stated Rate More than Market Rate: A Premium
estimate of the market rate.
Had the note’s stated rate of 10% been greater than a
market rate of 9%, the present value would be greater
Assume that on January 1, Eclipse Corp. received a
than the face value of the note due to the premium. The
five-year, $10,000 zero-interest bearing note. The
same types of calculations and entries as shown in the
amount of cash lent to the issuer (which is equal to
previous illustration regarding a discount would be
the present value) is $7,835 (rounded). Eclipse’s
used. Note that the premium amortized each year
year-end is December 31. Looking at the cash flows
would decrease the carrying amount of the note at the
and the time line:
end of each year until it reaches its face value amount
of $10,000.

Anch
or’s entry on the note’s issuance date is for the present
value amount (fair value):
Notice that the sign for the $7,835 PV is preceded by
the ± symbol, meaning that the PV amount is to have
If the company’s year-end was the same date as the the opposite symbol to the $10,000 FV amount,
note’s interest collected, at the end of year 1 using the shown as a positive value.
schedule above, the entry would be: This is because the FV is the cash received at maturity
or cash inflow (positive value), while the PV is the
cash lent or a cash outflow (opposite or negative
value). Many business calculators require the use of a
± sign for one value and no sign (or a positive value)
The entry when paid at maturity would be: for the other to calculate imputed interest rates
correctly. Consult your calculator manual for further
instructions regarding zero-interest note calculations.

The implied interest rate is calculated to be 5% and the

4. Zero-Interest Bearing Notes note’s interest component (rounded) is $2,165 ($10,000
− $7,835), which is the difference between the cash
 lent and the higher amount of cash repaid at maturity. originally costing $120,000. The market rate for a
Below is the schedule for the interest and amortization note with similar characteristics and risks is 8%. The
calculations using the effective interest method. present value is calculated as follows:

PV = (0 PMT, 8 I/Y, 5 N, 200000 FV)

PV = $136,117

The entry upon issuance of the note and sale of the

land would be:

Remember – for zero-interest notes, you can re-arrange

the present value formula to calculate the interest rate However, if the market rate is not known, either of
if needed. following two approaches can be used to determine
The entry for the note receivable when issued would the fair value of the note:
be:
Determine the fair value of the property, goods, or
services given up. As was discussed for zero-interest
bearing notes where the interest rate was not known,
At Eclipse’s year-end of December 31, the interest the implicit interest rate can still be derived because the
income at the end of the first year using the effective cash amount lent, and the timing and amount of the
interest method would be: cash flows received from the issuer are both known. In
this case the amount lent is the fair value of the
property, goods, or services given up. Once the interest
is calculated, the effective interest method can be
At maturity when the cash interest is received, the applied.
entry would be:
For example, on June 1, Mayflower Consulting Ltd.
receives a $40,000, three-year note in exchange for
some land. The market rate cannot be accurately
determined due to credit risks regarding the issuer. The
If Eclipse used ASPE instead of IFRS, the entry using land cost and fair value is $31,750. The interest rate is
the straight-line method for amortizing the discount is calculated as follows:I/Y = (±31750 PV, 0 PMT, 3 N,
calculated as the total discount of $2,164.74, amortized 40000 FV)I/Y = 8%; the interest income component is
over the five-year term of the note resulting in equal $8,250 over three years ($40,000 − $31,750)The entry
amounts each year. Therefore, the annual amortization is upon issuance of the note would be:
$432.95 ($2,164.74 ÷ 5 years) each year is recorded as:

5. Determine an imputed interest rate. An imputed

Notes Receivable in Exchange for Property, interest rate is an estimated interest rate used for a note
Goods, or Services with comparable terms, conditions, and risks between
When property, goods, or services are exchanged for an independent borrower and lender. On June 1,
a note, and the market rate and the timing and Edmunds Co. receives a $30,000, three-year note in
amounts of cash received are all known, the present exchange for some swampland. The land has a historic
value of the note can be determined. For example, cost of $5,000 but neither the market rate nor the fair
assume that on May 1, Hudson Inc. receives a value of the land can be determined. In this case, a
$200,000, five-year note in exchange for land
 market rate must be imputed and used to determine the
note’s present value. The impairment amount is recorded as a debit to
bad debt expense and as a credit either to an
The rate will be estimated based on interest rates allowance for uncollectible notes account (a contra
currently in effect for companies with similar account to notes receivable) or directly as a
characteristics and credit risk as the company issuing reduction to the asset account.
the note. For IFRS companies, the “evaluation
hierarchy” identified in IFRS 13 Fair Value Derecognition and Sale of Receivables:
Measurement would be used to determine the fair Shortening the Credit-to-Cash Cycle
value of the land and the imputed interest rate. In this Derecognition is the removal of a previously
case, the imputed rate is determined to be 7%. The recognized receivable from the company’s balance
present value is calculated as follows: sheet. In the normal course of business, receivables
arise from credit sales and, once paid, are removed
(derecognized) from the books. However, this takes
PV = (7 I/Y, 3 N, 30000 FV)PV = $24,489) valuable time and resources to turn receivables into
The entry upon issuance of the note would be: cash. As someone once said, “turnover is vanity, profit
is sanity, but cash is king”[5]. 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
It’s important to note. Whether we are selling a good downturn in 2008, it has become the key to survival for
or service OR is a short-term accounts receivable many struggling businesses. As a result, companies are
becomes a long-term note receivable, the accounting always looking for ways to shorten the credit-to-cash
is very similar. cycle to maximize their cash resources. Two such ways
are secured borrowings and sales of receivables,
Loans to employees discussed next.
In cases where there are non-interest-bearing long-
term loans to company employees, the fair value is Secured Borrowings
determined by using the market rate for loans with Companies often use receivables as collateral for a
similar characteristics, and the present value is loan or a bank line of credit. The receivables are
calculated on that basis. The amount loaned to the pledged as security for the loan, but the control and
employee invariably will be higher than the present collection often remain with the company, so the
value using the market rate because the loan is receivables are left on the company’s books. The
intended as a reward or incentive. This difference company records the proceeds of the loan received
would be deemed as additional compensation and from the finance company as a liability with the loan
recorded as Compensation expense. interest and any other finance charges recorded as
Impairment of notes receivable expenses. If a company defaults on its loan, the finance
company can seize the secured receivables and directly
Just as was the case with accounts receivable, there is collect the cash from the receivables as payment
a possibility that the holder of the note receivable will against the defaulted loan. This will be illustrated in
not be able to collect some or all of the amounts the section on factoring, below.
owing. If this happens, the receivable is
considered impaired. When the investment in a note Sales of Receivables
receivable becomes impaired for any reason, the What is the accounting treatment if a company’s
receivable is re-measured at the present value of the receivables are transferred (sold) to a third party
currently expected cash flows at the loan’s original (factor)? Certain industry sectors, such as auto
effective interest rate. dealerships and almost all small- and medium-sized
businesses selling high-cost goods (e.g., gym Factoring- is when individual accounts receivable are
equipment retailers) make extensive use of third- sold or transferred to a recipient or factor, usually a
party financing arrangements with their customers to financial institution, in exchange for cash minus a fee
speed up the credit-to-cash cycle. Whether a called a discount. The seller does not usually have any
receivable is transferred to a factor (sale) or held as subsequent involvement with the receivable and the
security for a loan (borrowing) depends on the factor collects directly from the customer. (Companies
criteria set out in IFRS and ASPE which are selling fitness equipment exclusively use this method
discussed next. for all their credit sales to customers.)

Conditions for Treatment as a Sale The downside to this strategy is that factoring is
For accounting purposes, the receivables should be expensive. Factors typically charge a 2% to 3% fee
derecognized as a sale when they meet the following when they buy the right to collect payments from
criteria: customers.

IFRS – substantially all of the risks and rewards have A 2% discount for an invoice due in thirty days is the
been transferred to the factor. equivalent of a substantial 25% a year,
The evidence for this is that the contractual rights to
receive the cash flows have been transferred (or the and 3% is over 36% per year compared to the much
company continues to collect and forward all the cash lower interest rates charged by banks and finance
it collects without delay) to the factor. Also, the companies. Most companies are better off borrowing
company cannot sell or pledge any of these from their bank if it is possible to do so.
receivables to any third parties other than to the
factor. However, factors
will often advance
ASPE – control of the receivables has been funds when more
surrendered by the transferor. This is evidenced when traditional banks
the following three conditions are all met: will not. Even with
only a prospective
The transferred assets have been isolated from the order in hand from
transferor. a customer, a
business can turn
The factor has obtained the right to pledge or sell the to a factor to see if
transferred assets. it will assume or share the risk of receivable. Without the
The transferor does not maintain effective control of factoring arrangement, the business must take time to
the transferred assets through a repurchase agreement. secure and collect the receivable; the factory offers a
reduction in additional effort and aggravation that may
If the conditions for either IFRS or ASPE are not met, be worth the price of the fee paid to the factor.
the receivables remain in the accounts and the
transaction is treated as a secured borrowing (recorded There are risks associated with factoring receivables.
as a liability) with the receivables as security for the Companies that intend to sell their receivables to a
loan. The accounting treatment regarding the sale of factory need to check out the bank and customer
receivables using either standard is a complex topic; references of any factor. There have been cases where
the discussion in this section is intended as a basic a factor has gone out of business, still owing the
overview. company substantial amounts of money held back in
reserve from receivables already paid up.
Below are some different examples of sales of
receivables. 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:

The journal entry to record the sale of the receivables

(factoring):

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

Below is the balance sheet after the transaction:
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
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

If receivables are sold without recourse, the
purchaser assumes the risk of collection and is
responsible for any credit losses.  This type of
transfer is considered to be an outright sale of the
receivables.
For sales without recourse, all the risks and rewards value of $5,000. The entry for Ashton, including the
(IFRS), as well as the control (ASPE), have been estimated recourse obligation is:
transferred to the factor, and the selling 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
You will see that the recourse liability to Savoy results in
basis. All the risks, rewards, and control are transferred
an increase in the loss on sale of receivables by the
to the finance company, which charges an 8% fee and
recourse liability amount of $5,000. If there were no
withholds a further 4% of the accounts receivable for
uncollectible receivables, Ashton will eliminate the
estimated returns and allowances. The entry for Ashton
recourse liability amount and decrease the loss. Savoy’s
is:
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.

The accounting treatment will be the same for IFRS

and ASPE since both sets of conditions (risks and Securitization is a financing transaction that gives
rewards and control) have been met. If no returns and companies an alternative way to raise funds other
allowances are given to customers owing the than by issuing debt, such as a corporate bond or
receivables, Ashton will recoup the $8,000 from the note. The process is extremely complex, and the
factor. In turn, Savoy’s net income will be the $16,000 description below is a simplified version.
revenue reduced by any uncollectible receivables, since
it now has assumed the risks/rewards and control of The receivables are sold to a holding company called
these receivables. a Special Purpose Entity (SPE), which is sponsored
by a financial intermediary. This is similar to
Sales with Recourse factoring without re-course but is done on a much
If receivables are sold with recourse, the sellerlarger scale. This sale of receivables and their
guarantees payment to the purchaser of the receivables, removal from the accounting records by the company
if the customer fails to pay. holding the receivables is an example of off-balance
In this case, Ashton guarantees payment to Savoy for sheet accounting. In its most basic form, the
any uncollectible receivables (re-course obligation). securitization process involves two steps:
Under IFRS, the guarantee means that the risks and
rewards have not been transferred to the factor, and the Step 1: A company (the asset originator) with
accounting treatment would be as a secured borrowing receivables (e.g., auto loans, credit card debt),
as illustrated above in Cromwell—Note Payable. identifies the receivables (assets) it wants to sell and
Under ASPE, if all three conditions for treatment as a removes them from its balance sheet. The company
sale as described previously are met, the transaction divides these into bundles, called tranches, each
can be treated as a sale. containing a group of receivables with similar credit
risks. Some bundles will contain the lowest-risk
Continuing with the example for Ashton, assume that the receivables (senior tranches) while other bundles will
receivables are sold with re- course, the company uses have the highest-risk receivables (junior tranches).
ASPE, and that all three conditions have been met. In
addition to the 8% fee and 4% withholding allowance, The company sells this portfolio of receivable bundles
Savoy estimates that the recourse obligation has a fair to a special purpose entity (SPE) that was created by a
 financial intermediary specifically to purchase these Typically, investors with securities linked to the
types of portfolio assets. Once purchased, thelowest-risk bundles would have little expectation of
originating company (seller) derecognizes theportfolio losses. However, because investors often
receivables and the SPE accounts for the portfolio finance their investment purchase by borrowing, they
assets in its own accounting records. are very sensitive to changes in underlying
receivables assets’ quality. This sensitivity was the
In many cases, the company that originally sold the initial source of the problems experienced in the sub-
portfolio of receivables to the SPE continues to service prime mortgage market (derivatives) meltdown in
the receivables in the portfolio, collects payments from 2008.
the original borrowers and passes them on—less a
servicing fee—directly to the SPE. In other cases, the At that time, repayment issues surfaced in the riskiest
originating company is no longer involved and the SPE bundles due to the weakened underwriting standards,
engages a bank or financial intermediary to collect the and lack of confidence spread to investors holding
receivables as a collecting agent. even the lowest risk bundles, which caused panic
among investors and a flight into safer assets, resulting
Step 2: The SPE (issuing agent) finances the purchase in a fire sale of securitized debt of the SPEs.
of the receivables portfolio from the originating
company by issuing tradeable interest-bearing In the future, securitized products are likely to become
securities that are secured or backed by the receivables simpler. After years of posting virtually no capital
portfolio it now holds in its own accounting records as reserves against high-risk securitized debt, SPEs will
stated in Step 1—hence the name asset-backed soon be faced with regulatory changes that will require
securities (ABS). These interest-bearing ABS securities higher capital charges and more comprehensive
are sold to capital market investors who receive fixed evaluations. Reviving securitization transactions and
or floating rate payments from the SPE, funded by the restoring investor confidence might also require SPEs
cash flows generated by the portfolio collections. To to retain an interest in the performance of securitized
summarize, securitization represents an alternative and assets at each level of risk (Jobst, 2008).
diversified source of financing based on the transfer of
credit risk (and possibly also interest rate and currency Disclosures of Receivables
risk) from the originating company and ultimately to The standards for receivables reporting and disclosures
the capital market investors. have been in a constant state of change. IFRS 7 (IFRS,
2015) and IAS 1 (IAS, 2003) include significant
The Downside of Securitization disclosure requirements that provide information based
Securitization is inherently complex, yet it has grown on significance and the nature and extent of risks.
exponentially. The resulting highly competitive
securitization markets with multiple securitizes The Significance of Financial Instruments
(financial institutions and SPEs), increase the risk IFRS 7 and IAS 1 specify the separate reporting
that underwriting standards for the asset-backed categories based on significance such as the following:
securities could decline and cause sharp drops in the
bundled or trenched securities’ market values. This is Trade accounts, amounts owing from related
because both the investment return (principal and parties, prepayments, tax refunds, and other
interest repayment) and losses are allocated among significant amounts
the various bundles according to their level of risk.
The least risky bundles, for example, have first call Current amounts from non-current amounts
on the income generated by the underlying Any impaired balances and amount of any allowance
receivables assets, while the riskiest bundles have last for credit risk and a reconciliation of the changes in the
claim on that income, but receive the highest return. allowance account during the accounting period.
 Disclosure on the income statement of the amounts of Liquidity risk—the risk that an entity will have
interest income, impairment losses, and any reversals difficulties in paying its financial liabilities.
associated with impairment losses.
Market risk—the risk that the fair value or cash flows
Net losses on sales of receivables (IFRS, 2015, 7.20 of a receivable will fluctuate due to changes in market
a, iv). prices which are affected by interest rate risk, currency
For each receivables category above, the following risk, and other price risks. Disclosures include a
disclosures are required: sensitivity analysis for each type of market risk to
which the entity is exposed at the end of the reporting
The carrying amounts such as amortized cost/cost period, showing how profit or loss and equity would
and fair values (including methods used to estimate have been affected by changes in the relevant risk
fair value) with details of any amounts reclassified variable that were reasonably possible at that date
from one category to another or changes in fair (IFRS, 2015, 7.40 a).
values
In addition, information about company policies for
Carrying amount and terms and conditions regarding managing risk, including quantitative and qualitative
financial assets pledged as collateral or any financial data, is to be disclosed. ASPE disclosure requirements
assets held as collateral. An indication of the amounts are much the same as IFRS, though perhaps requiring
and, where practicable, the maturity dates of accounts slightly less information about risk exposures and fair
with a maturity of more than one year values than IFRS (CPA Canada, 2016, Part II, Section
3856.38–42).
For IFRS, extensive disclosures of major terms
regarding the securitization or transfers of $9,520 × 12% = $1,142 ↵
receivables, whether these have been derecognized in $10,253 × 9% = $923 ↵
their entirety or not. Some of these disclosures $7,845.26 × 5% = $391.76 ↵
include the characteristics of the securitization, the
fair value measurements and methods used, and cash Fair Value Measurement applies to IFRSes that
flows, as well as the nature of the servicing require or permit fair value measurements or
requirements and associated risks. disclosures and provides a single IFRS framework for
measuring fair value and requires disclosures about fair
The Nature and Extent of Risks Arising from value measurement.
Financial Instruments
Stakeholders, such as investors and creditors, want to The Standard defines fair value on the basis of an “exit
know about the various transactions that hold risks. price” notion and uses a “fair value hierarchy,” which
Basic types of risks and related disclosures are: results in a market-based, rather than entity-specific,
measurement.
Credit risk—the risk that one party to a financial
instrument will default on its debt obligation. IFRS 13 was originally issued in May 2011 and applies
Disclosures include an analysis of the age of financial to annual periods beginning on or after 1 January 2013
assets that are past due as at the end of the reporting and is beyond the scope of this course. For simplicity,
period but not impaired and an analysis of financial the fair value of the property, goods or services given
assets that are individually determined to be impaired up as explained in the chapter material assumes that
as at the end of the reporting period, including the IFRS 13 assumptions and hierarchy to determine fair
factors the entity considered in determining that they values have been appropriately considered. ↵
are impaired (IFRS, 2015, 7.37 a, b).
“Cash is king” is a catchphrase for “cash is most
important.” While a firm can generate a profit, if it
cannot be converted to cash fast enough to pay the
liabilities as they are due, then the company runs the
risk of failing. ↵