How to spot accounting gimmickry: Write-offs of receivables
Author: Y. Woo
Receivables are defined as the amount owed to the company by other business entity whether it’s individual or corporate. Some receivables coming from credit sales never get collected that’s why they are such a painful thing for any entrepreneur to deal with. Also, receivables can be used to borrow as collateral, thus creating further ambiguities for any potential investor and any financial statement reader in determining whether the receivable is indeed a sale or a loan.
You might ask why companies engage in selling their receivables; this is because some companies prefer not to wait for customers to pay because they are under pressure to produce a profit so that they can use it for their daily operations. That is why they might opt to sell their receivables to a bank or a financing company.
The thing that complicates this is that sometimes companies mistakenly treat a sale as borrowing and vice versa.
Usually the condition wherein the transaction of the receivable ownership used are clear as to what it is, whether it was an actual sale or used as a collateral for a loan. Thus, the FASB has created a standard basis on how to determine its classification. They defined a real sale as transferring the control over the receivables to the new owner. However if this condition is not met, then the transaction is considered as a collateralized borrowing.
A good example of this is the banks usual practice of transferring a group of mortgages they consider to be receivables to other business organization but retains the right to service the mortgages, like collecting the mortgage payments.
As an investor there are two serious implications this thing has in store for you. This is one of the signs how to spot accounting gimmickry.
First, if the transaction is actually a borrowing but for some reason treated as sale, then both asset and liabilities are understated. Even finance analysts would have a distorted picture of the company’s financial situation since ratios like debt to equity and ROA are also seriously warped by the understatements. If the unscrupulous executive plans to hide a loss, they can just mislabel the receivable as sale and not as actual debt.
Lastly, if the deal was actually a sale and was erroneously treated as borrowing then you wouldn’t see a gain or loss effect in the balance sheet in effect seriously misrepresenting the company’s net assets. That’s why when you see a receivable as a write-off, this should give you an early warning sign.
