Selling receivables lowers assets? Why?

I cannot understand question 16 from reading 27 in second CFAI book for level 2 exam.

The essence problem is in this part of the question:

“Compared to holding securitized finance receivables on the balance sheet, treating them as sold had the effect of reducing Software Services’ reported financial leverage by?”

And part of the answer says:

“Had the securitized receivables been held on the balance sheet, assets would have been $267,500 higher, or $3,878,100, and equity would have been unchanged.”

I thought that when I sell receivables to SPE i get cash for them. So receivables are going down and cash is going up. And assets are unchanged. Why in this question they are higher???

I think they are comparing the financial statement effects of including the SPE in the balance sheet vs. excluding it.

When a company has receivables and needs cash it has two options. It can either borrow straight from the markets against its receivables or sell it receivables to an SPE for cash.

In the first case, borrowing would increase cash and liabilities by the same amount, so total assets are higher but equity remains unchanged (because liabilities increased by the same amount).

In the second case, the company simply converts its receivables to cash with no changes in assets or equity. Instead the SPE borrows from the markets to buy the receivables from the parent company and manages the collection of debt to repay those from whom it borrowed.

If the parent company is expected to absorb the losses of the SPE despite it being a legally separate entity, then the second situation is not a true and fair representation of the underlying economic situation of the parent company and the SPE should be included on the balance sheet.

Including the SPE on the balance sheet means recognizing the receivables it purchased and the its debt to the markets - so assets and liabilities increase by the same amount. Total equity is unchanged but total assets are higher.

The point is that, while selling the receivables appears to result in relatively lower leverage ratios in an accounting sense, it is the same exact transaction in an economic sense.

I agree with all of the statements made by “Going for a CFA” however it still doesnt explain why the Assets were reduced when Software Services sold their account receivables to the SPE. If you sell account receivables you receive cash, which both reduces and increases assets. If you dont consolidate the transaction is as simple as that, A/R down; Cash up. If you do consolodate you would put the debt issued by the SPE on your books (a liab), along with the cash received from that debt, and the A/R you just sold. At the end of consolodation, your assets would be even higher as they now reflect cash from the issuance of debt, and the A/R you were trying to get off your books in the first place.

A perfect example of this can be seen in SS6 page 167 of the CFA curriculum. They clearly outline that total assets either stay the same under non consolidation or increase under consolidation.

Not sure what to make of this as the reading from SS6 and question 16 from reading 27 seem to be contradictory. Can someone please let me know if Im missing something with regards to the question?

I agree. Assets should not go down. I think the reading materials are fine but the quality of the questions is horrible. There are two mistakes in the morning mock exam. Very simple calculation; they even got it wrong (Q24), and Q17 they got the fact about the interest wrong.

It really shows that CFAI do not take good care of writting good questions. I know they pay good money to get the best writers for the cirriculum. It kind of makes one wonder what they do with all the extra money they get each year from all the fees.

when you sell your receivables for cash, the assets always reduce because you sell the receivables at a discount ( the person buying it needs to earn a rate of interest). This inturn reduces your equity and the debt remianing unchanged leads to higher leverage.

when you borrow against the receivables, debt increases with the asset and the levergae is higher in this case also. However in the first scenario, you are not taking on additional debt. The discount hit which you take reduces your net income for the yr with the subsequent yrs having greater net income and hence lower leverage.

In the second scenario, your Net income pattern will be greater the first yr but reduce in the subsequent yrs with the additional interest expense from the debt and hence the leverage is higher.

look at the big picture boss

Look at the question boss… you cant assume anything on these test when the answers are asking for hard numbers. In theory you are correct, assets should go down slightly becuase you probably wont get 100% of the receivable value, but again, the question asked for a straight calculation, no assumptions. The answer given said “Your Assets go down by the value of the Receivables sold,” there was no mention of Assets being increased by the cash received and the answer was then caculated as such… so I guess they just forgot about the increase in cash. I’ve looked this question over for awhile, along with the example in the CFA text whch directly contradicts it, and I’ve come to the concusion that the question is wrong. On the test faced with the same style question Im going to go with the readings, seems to make more sense.

I agree.