A company sold its receivables but retains the risk associated with bad debts. When reviewing this company, a financial analst would adjust the company’s debt to equity ratio and its accoutns receivable turnover ratio: Debt to equity…Receivables turnover Upward…Upward Downward…Upward Upward…Downward Downward…Downward
so pretend the A/R wasn’t sold because the company retains risk, so selling A/R is nothing more than collaterized borrowing. debt to equity is adjusted upward (because there should be more debt) and receivables turnover is adjusted downward.
In economic substance, the company incurred a collateralized loan (with A/R serving as the collateral). Accounts receivable and short-term debt should both be increased by the amount of the sale. The result is that the debt to equity ratio increases (since debt increased, and equity did not) and receivables turnover decreases (since receivables increased, but sales did not).
I think Accounting standards would just reduce AR and increase Cash. But the analyst would reverse that by increasing Assets and Liabilities. So debt is higher, a/r is higher, equity unchanged, sales unchanged, therefore D/E increases, A/R T/O decrease.
I would guess C. Debt/Equity: You have been paid for the AR that would be in Bad Debt Expense, thus you don’t write down AR. However, the economic reality of the situation is that you may not be paid and should write down AR. I think that Equity is overstated —> Debt/Equity is understated. Rec. Turnover ----> Sales/Avg. Rec. ----> Rec. are understated seeing as they have been removed from the Balance Sheet but you retain risk—> Rec. Turnover is overstated. C. I would adjust Debt/Equity upwards and adjust Rec. Turnover downwards.
answer is C