My questions relate to Practice Problems 16 and 17 of Reading 22. I don’t understand the effects of a sale of receivables on assets and liabilities.
@Practice Problem 16: Why does the sale of receivables decrease leverage ratio? Doesn’t the sale of receivables reduce acc. rec. by $267.5 mio and increase cash by the same amount? If that was the case, total assets would remain the same and thus the leverage ratio would also remain the same.
@Practice Problem 17: The solution states that the sale of receivables decreases assets and liabilities by the same amout. First, why do liabilities change when receivables are sold? Second (same as in Practice Problem 16), why do assets change when receivables are sold, i.e. does an increase in cash not offset the decrease in acc. rec.?
They are not account receivable, but SECURITIZED account receivable.
So it is a combination of Sale of assets (removal of asset) but no recognition of liability. (and no cash either available on hand).
problem 16 -> Leverage ratio = Total assets / Equity = 3610600/976500 = 3.70 before
The 3610600 reflects the figure after sale of the receivables - but since you have not yet realized the cash from the sale - but just pushed it into a SPE - the actual Total assets would have been 267.5 Mill Higher => or 3610600 + 267500 = 3878100
so Leverage = 3878100 / 976500 = 3.97
so leverage ratio decreased by 3.7/3.97 - 1 = -0.068 = 6.8% lower
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same applies to the next question - both assets and liabs would have been 267.5 Mill higher…
Question 17 seems to be testing/reinforcing that a True Sale to an SPE removes the asset from your balance sheet, as CPK 123 suggests.
But nep makes a good point. What about the Cash? If indeed Software Services sold $267M of receivbales to an unconsolidating SPE, what does that sale entry look like to get it off their books? You can’t have a one-sided entry to just remove the $267M in assets. it is a sale. The entry would look something like this:
DR Cash $267 + Margin
CR AR $267
CR Gain on Sale for Margin
The net impact on assets is simply the Gain on Sale, not $267M. If you say that Software Serives hasn’t receieved the Cash yet, then just swap Cash for “AR due from SPE” and you wind up in the same place. This looks like it may be an errata… But it is early. No cofffee yet, and plenty of Jack Daniels last night.
so Sale to SPE, cash in SPE. SPE on balance sheet, but the Account Receivable went off balance sheet… (and this disappearance from the balance sheet is what the analyst is trying to fix).
Not exactly, CP. The assets cannot just disappear from Software Services’s (SS) Balance Sheet. They are exchanged for something - cash. The SPE buys the assets, and issues the ABS. The SPE has a separate set of books that balances, just like Software Services’.
A question is: does the SPE consolidate into SS’s books?
If the SPE consolidates, then transactions between SS and the SPE eliminate, and the net transaction is an increase in cash (from the investors buying the ABS) and the ABS liability (entity owes investors). AR is still on the consolidted entity’s books. So the CFAI question doesn’t make any sense in tis scenario.
If the SPE doesn’t consoldiate (my assumption) on SS’s books you have a clean swap of AR for Cash. The AR Asset and the ABS liability are sitting over on the SPE’s books. No change to the leverage ratio for SS…Ooookay, I see now where the CFAI is getting their answer. If you return the AR to SS’s books, you must also return somethign else to keep the books in balance. I initially assumed it would be cash, since that was the sale transaction. But I bet they are saying it is the ABS liability (due to investors). Thus, there is an increase in assets but not equity. That’s how they must be getting their answer.
If that is the thinking, it has a separate, thoguh less fatal error. It assumed the value of the loans and ABS are the same. This is highly unlikley. An ABS from a software vendor would alomost certainly require overcollateralization. The $276 Sale probably resulted in an ABS of something less than $276. So equity would change when returning the AR to the books for the calculation. But that is getting nitpicky.
God bless anyone who made it this far. It isn’t a big part of my job, but I work with ABS accounting and this question really made me have to think (T accounts and consolidating worksheet drawn up at my desk).
@40yoCFAcandidate: First of all, thank you you for your time answering my question.
However, I still don’t fully understand the reasoning. I totally follow everything you say up to the point where you say that AR is returned to SS’s books. Why would the AR be returned to SS’s books? The idea of selling the AR to the SPE is that (if it is a True Sale transaction) it should stay with the SPE, i.e. get it off SS’s books. Why reverse everything and report an AR asset and an ABS liability on SS’s books?
Doesn’t the question ask: What would be the effect if the sale had never happened? So, why push the accounts over to the SPE and then pull them back on SS’s books?
@cpk123: Thank you as well for putting time into this. Why do you emphasize that it is not AR but securitized AR? Does that really make a difference regarding the sale of accounts receivables?
Neptune, if you interpret the question to be “What would the ratio be if the securitization never happened?” then the CFAI answer is wrong.
However, if the quesiton is “What woould the ratio be if the securitization happened and the full effect of the securitization was reflected on SS’s books?” then you get the CFAI answer.
After re-re-reading the question, I think the second interpretation is better.
Thank you both of you for trying to help out with this, in my opinion, very confusing question. I understand you, cpk123, when you say that assets and liablities would both increase by the same amount (in your example 100) if the SPE was consolidated. That definitely makes sense.
@40yoCFAcandidate: The way the question is phrased just confused, and still does confuse me after re-re-re…reading the question. I gues, I will just let it go and assume that what they meant was what you said “What woould the ratio be if the securitization happened and the full effect of the securitization was reflected on SS’s books?”