 Hello and welcome to the session. This is Professor Farhad. In this session, we would look at the recognition of receivable, a topic that's covered on the CPA exam as well as the ACCA exam. Please connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have over 1500 plus accounting, auditing and tax lectures. Please like the lectures if you liked them. Click on the like button. It helped me tremendously. Share them, put them in playlists. Let the world know about them. Share benefiting from my lectures. I mean, other people might benefit as well. So please share the wealth. This is my Instagram account. Please follow me on Instagram as I'm trying to increase my following. And this is my Facebook account. I also have a website on my website. If you choose to donate to support the channel, you can do so. Also on my website, I do have offers for my followers right now. 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And the first thing I want you to think about is a company called Lehman Brothers when you think about the recognition of an asset of a financial asset. Why? Because when we deregognize, deregognize is when we remove something, an asset from the balance sheet. We are deregognized at it. Well, we have to know that we sell it or is it used to borrow money. And to be more specific, let's talk about a receivable. Remember, a receivable is a financial asset, is some sort of a financial asset. Okay, it's a security. It's a financial security. So the question is, if we are going to get rid of it, if we're going to sell it to a third party, the question is that we really sell it? Or are we borrowing money against that receivable? So when an entity sells a receivable to a third party, there's a question as to whether the sale is truly a sale or simply a borrowing arrangement secured by the account receivable. If we consider the transaction a sale, so let's assume we're going to go down the sale method. If it's a sale and we're going to see what are the rules to determine whether it's a sale or not. Here's what's going to happen. We're going to deregognize the receivable. Simply put, deregognizing means we're going to be removing the receivable from the books. And by extension, we're removing the credit risk. Think about the prior session when we looked at impairment. You have to guess, you have to estimate your impairment on the receivable. Guess what? If you don't have the receivable, you have less assets to worry about impairment. So that's a huge advantage when you sell the receivable, if it's sold. If it's not sale, if it's not considered a sale, the receivable are not deregognized. It means you don't remove them and the transaction is considered borrowing. Now when you borrow money, when if it's a borrowing, your risk will go up. Your risk will go up tremendously. Why? Because now your liability ratios go up. Your debt to equity ratio go up. Also, if it's considered a sale, your risk will go down because you have less credit risk. And if you have less credit risk, also, it's not only you have less credit risk. Your income went up. Your income went up. And as a result, your profitability ratios went up. So you always want to go. If you want to go, go with option one. You want to consider it a sale. There are rules you have to follow. And this is what Lehman did not do. This is what Lehman Brothers did not do. So let me tell you what Lehman did. Lehman dealt with something called repo 105. So I'm not going to explain why it's called repo 105, but I will maybe I will mention it briefly. Why it's called repo 105. So basically here's how it works. The transaction start. Lehman transfer security to another party. Let's assume this is a bank for borrowing for a borrowing for a borrowing transfer. So here we go. Lehman will transfer securities, account receivables, stocks, bonds, whatever bonds, let's call them bonds. They will transfer bonds that investments that are mortgage backed and they transfer worth $102 or 102 million or whatever. They will transfer 102 to this bank and the bank will pay them only 100. Well, would the bank do so? Of course they will do so. If those securities are worth 102 and you can only give you 100, I have a profit of $2 or $2 million. But the bank would say all the counterpart, you would say, sure, I will give you the money. Now the question becomes is this, was this really a sale that Lehman sold the securities for $100 or are they borrowing? What Lehman did? Lehman did this was a sale. Lehman booked, what Lehman did? Lehman booked cash 100 credit sales. Sales was debit cash credit sales 100 and they remove the whatever the cost of the sale was. So they consider it as a sale. So they consider this as a sale. But what happened is later on Lehman, which is this, they did not disclose this, Lehman returned the borrowed money plus interest. So Lehman said, like a month later, Lehman said, I'm going to buy back that security from you. I'm going to pay you 100 plus interest and you're going to give me back that investment that I gave you the 102. So basically what I did, I did not really sold my securities. I basically gave them to you, you gave me money, then I gave you back the money plus interest that you gave me and you gave me back my securities. The securities were basically collateral. But what Lehman did, booked the securities as a sale, not as a borrowing. And this is why we have to know, is it a sale or is it a borrowing? Obviously Lehman went out of business. It was the largest bankruptcy when that happens. Basically, they were cooking the books. That's basically what happened. And why were they doing so? Because the risk, they had so much bad receivables. Their impairment became so, so large if they really wanted to recognize the impairment losses. So what they did, they said, we don't have those receivables. If you don't have them, you don't have to worry about the credit risk. So that's what they were trying to do, not to book that impairment losses because they were bad debt investments. They were not able to collect the money from them. The financial asset may be deregognized when significant risk and reward associated with the ownership have been transferred to another entity. So Lehman did not transfer the risk to the other entity or the risk and reward. Risk and reward means the other entity now is responsible for their asset. If the value of it went down, they take the risk of the value of it went up. They have to absorb the risk. That's not what really happened. The bank is going to give the asset back to Lehman. Lehman assumed, booked it as if it was a sale. Now, why is it called repo 105? Because the security has to be worth 105% of the asset that they're given up. So Lehman basically gave them an asset that's worth 105, not 102 to be more specific for the repo transaction to work. So they gave them $105 worth of assets and they get $100, but it was not really a sale. They were going to buy it back from them. Now, in some cases, and here's what happened. The seller retained significant risk, for example, by guaranteeing the collectability of the receivable through the right of recourse and the recognition is not appropriate. So what happened is in Lehman's situation, they did not really transfer the risk. They basically, they still have the risk and if they transfer any receivable, they are still responsible for collecting the money for the receivable. So if the money is not collected, it's their loss. Okay. So instead, the cash received under those circumstances where we are responsible for the risk is treated as a loan. And to be more specific, let's look at the rules. What happened is what you will do is you'll have what's called the pass through arrangement. What is a pass through arrangement? It exists when one entity retained the right to collect the cash from the receivable as it's obligated to transfer those cash to a third party. So here's what happened. I have a receivable. This is the bank. I have a receivable. But what I do is I transfer the receivable to another financial institution. So I transfer my receivable. So my receivable now is sitting here. That financial institution gave me the money. Then I'm still collecting the receivable from the customers. So the customers, what they do is they send me the money. So the customer send me the money. I'm Bank A. So the customer still send the money to Bank A. But what happened is Bank A automatically transferred the money to the financial institution. So as a customer, you borrowed the money from the bank. You don't care about the financial institution. When you make your payment, you'll make your payment to the bank. Now the bank immediately doesn't have to be immediately in that second, but they will have to transfer the money without using the money to the financial institution. This is called the pass through arrangement. In this type of arrangement, the recognition is appropriate if the following condition exists. So here we go. So if you transfer the risk and the reward, the recognition exists. Or if you have a pass through arrangement, the entity has no obligation to pay cash to the buyer of the receivable unless it collects equivalent amount from the receivable. So simply put, if it's a pass through and you want to consider it, you made the sale. Your only obligation is to receive the money from the buyer. The entity has no obligation to pay cash to the buyer unless it collects the money. So as long as it collects the money, it transfer it. If it doesn't collect any money, it doesn't have to pay the financial institution anything, okay? Because the risk now is for the financial institution. The entity is prohibited by the terms of the transfer contract from selling or pledging the receivable. So basically at this point, the account receivable, we cannot sell it to another party. We cannot pledge it. So it's not really ours. And the entity has an obligation to remit the cash. It collects the eventual recipient without material delay. So it doesn't have to be immediate but cannot be a material delay. And they cannot, they are not entitled to reinvest that cash. In other words, they cannot earn interest on it with a small exception. An exception exists for investments in cash equivalent during the short settlement period from the collection date to the remittance date. So basically when they receive the money, it may take them three days to transfer it during those three days. If they put that money in a money market fund, that's okay. As long as it's not material. So this is if you have a pass through arrangement. Technically what you do is you have a sale. You have a sale, okay? Because you're not responsible for paying more than what you are receiving. And you don't have to make the financial institution home, okay? Let's take a look at an example. Edward had a receivable for $1,000, a face value of $1,000. Edward transferred the receivable to Main Street for 900 without recourse. Without recourse means they're not responsible for anything. Once they transfer it, the bank is responsible for collecting the money from the customers if the customer does not pay. So we're not responsible for anything except if we receive the money, we might have to transfer it. That's about it. The discount rate reflect the fact that the bank has assumed the risk. So the bank, well, they discounted almost 10%. The discount rate is that the bank is assuming the risk. Technically, it's starting to look like it's a sale. Edward will continue to collect the receivable, deposit them the receivable in a non-interest-varying account with the cash flow remitted to the bank at the end of the month. So what happened is Edward would still receive the money from the customer. They'll put the money in a bank account and that money is exclusive for the bank and they will transfer the money to the bank by the end of the month. Edward is not allowed to sell or pledge the receivable to anyone else and is under no obligation to repurchase the receivable. And this is what we meant by recourse. Without recourse means they have no obligation to take the receivable back. So this is a pass-through arrangement. And Edward's appear to meet the three criteria required for the recognition. What are those three criteria? We're under no obligation to pay more than what we collect, where we cannot resell or pledge that receivable. It means that the risk transferred to the other entity. It has agreed to remit the money in a timely manner. There's no interest earned on the short-term bank deposit. So there's no question whether Edward passes interest to the main bank. So we're not even invested in that money. So what entry do we make? We're going to debit cash because the bank gave us $900 cash. We're going to credit some sort of an expense and we're going to credit the debit, I'm sorry, debit expense and credit the receivable. So the receivable is gone. This is a technically a sale. We debited cash, credited the receivable. We're done. Okay. We do recognize the receivable. This is where we recognize the receivable. Okay. Now, just want to let you know under USGAP, the entry is a little bit different. If you really want to look at it a little bit more detailed example, go to my chapter seven intermediate accounting. And I have a detailed examples of how to do this under USGAP. And the entry is a little bit more not complicated, a little bit more involved. Okay. Then this is just simplification. Now assume that change the example. Edwards collect the receivable, deposit the collection and its interest bearing account at the end of the month. Edwards remit to Main Street bank only the amount collected on the receivable. Interest earned on the short term deposit is retained by Edwards. So we're keeping the interest. So basically during that month, we assume that money is ours. Now, because we are retaining the interest, the third, the third party pass through criteria has not been met. Okay. Now, in those situation, Edward would not be allowed to recognize the receivable. Instead, it's now considered a borrowing. So we debit cash, debit and expense and credit and notes payable, which in turn increased our risk because now we have more debt. Also, the receivables that are on the books. Now we have to worry about impairment losses that we talked about in the prior session. So obviously the company will prefer to treat something legally as a receivable, not as a not. I'm sorry. They will prefer to treat it as a sale, not as a borrowing arrangement. Borrowing arrangement are bad in a sense that they increase your credit risk and all your ratios will deteriorate, especially your profitability ratios as well as your liability. Like debt to asset, current liabilities and any similar interest bearing, interest earned, interest coverage, all these ratios will deteriorate. If you have any questions about this topic, please email me. If you happen to visit my website for additional lectures, please consider donating. If you are studying for the CPA or the ACCA exam, study hard. It's worth it. Good luck.