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forecasts are systematically under- or over-budget, what are the implications
for performance reported in the current period?




Challenge Three: Products or Services Sold
but Residual Rights Retained by Seller
The third area where challenges arise in revenue recognition is where the seller retains
some ongoing rights in the product or service sold. For example, a ¬rm sells its receiv-
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ables to a bank, but the bank has recourse against the seller if the creditor fails to pay off
the receivable. Has the receivable been sold or has the ¬rm simply borrowed against its
receivables? Alternatively, if a ¬rm signs a long-term agreement to lease equipment from
the manufacturer but the manufacturer retains the residual rights to the equipment, has
the equipment been sold or has it been rented?
To determine which of the above approaches best re¬‚ects the economics of the trans-
action, analysts need to understand the risks that are borne by the parties involved and
how those risks are managed. Accounting standards frequently attempt to regulate the
reporting of these types of transactions. However, the transactions frequently arrange for
risks to be shared by both parties involved, making accounting complex. Receivable
sales and long-term leasing contracts are discussed further to illustrate the reporting
challenges for these types of transactions.

EXAMPLE: RECEIVABLE SALE WITH RECOURSE. Many companies sell receiv-
ables to banks, ¬nancial institutions, or public investors as a way to accelerate the col-
lection of cash. Two forms of sale are typically used: factoring and securitization. Under
factoring, a ¬nance company or bank purchases the rights to the cash ¬‚ows under the
receivable. Under securitization, a portfolio of receivables (such as credit card, auto
loan, or mortgage receivables) is packaged into securities that represent claims on the
interest and principal payments under the receivables. These securities are then sold to
multiple buyers.
Securitization as a form of ¬nancing has become increasingly popular. For example,
on February 17, 1999, the Financial Times reported that many Japanese ¬nance houses
have been launching “asset-backed securities, which allow consumer ¬nance compa-
nies, among others, to remove assets from their balance sheets. These assets, typically
equipment leases, car purchase loans and other types of consumer receivables, are trans-
ferred to a ˜special purpose vehicle,™ which stands legally at arm™s-length from its orig-
inator. The special purpose vehicle launches a bond, often rated AAA because it is
backed by the collateral of the asset™s cash ¬‚ow (such as repayments on car loans).”
How should these types of transactions be recorded? One approach is to view the re-
ceivables as having been sold at a gain or loss, depending on any difference between the
interest rate on the receivable and the rate charged by the bank. Under this treatment, the
seller creates a reserve to re¬‚ect any default and prepayment risks borne by the seller.
Alternatively, the contract can be viewed as a bank loan where the receivables are a form
of collateral.
Which of these two approaches best captures the economics of the transaction? Have
the receivables really been sold, or should we consider the transaction as a bank loan us-
ing the receivables as collateral? To answer this question, we have to understand the po-
tential risks faced by the seller. These include default and prepayment risks. Default risk
arises if the receivables subsequently default and the bank is forced to recover from the
seller. Prepayment risk arises if the receivables are ¬xed rate notes and interest rates sub-
sequently fall. Receivables are then likely to be re¬nanced through alternative ¬nancing
sources at lower interest rates. As a result, the seller of the receivables will no longer
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receive any spread difference between the interest rate on the note and the rate charged
by the bank. Accounting rules in the U.S. (SFAS 77) argue that receivables sold with re-
course can only be accounted for as a sale if (a) the seller gives up control of the eco-
nomic bene¬ts associated with the receivable, (b) the seller can make a reliable estimate
of any obligations due to the default and prepayment risks, and (c) the buyer of the re-
ceivables cannot require the seller to repurchase the receivables. Otherwise, the transac-
tion should be treated as a loan.

EXAMPLE: SALES-TYPE LEASE AGREEMENTS. IBM sells mainframe computers
to its customers under two different contractual arrangements. First, the customer can
purchase the computer using either its own funds or ¬nancing through a third party. Sec-
ond, the customer can sign a long-term lease agreement with IBM for use of the com-
puter for much of its useful life. At the end of the lease term, IBM retains the residual
value of the asset.
The ¬rst of these options (outright sale) is straightforward. However, it is more com-
plex to determine how to record the other contractual arrangement. A long-term lease
contract is very similar in form to an outright sale. IBM sells the use of the computer to
the lessee for much of its useful life. However, instead of requiring the customer to raise
external ¬nancing for the purchase, IBM agrees to provide ¬nancing. At the end of the
lease term, IBM retains some residual claim to the computer. Should this transaction be
viewed as a rental agreement or as a sale? Under a rental agreement, the lessor continues
to own the asset and rents it to the lessee for the lease term.
Financial reporting for leases attempts to re¬‚ect these different types of lease arrange-
ments. The critical accounting question is whether the lease terms are equivalent to the
sale of the asset or to a rental agreement. In substance, a lease can be thought of as the
equivalent of a sale if the lessee bears most of the risks normally associated with own-
ership. Thus, if the IBM customer contracts to use the computer for the bulk of its life, it
bears much of the loss in value from obsolescence. The lease is then equivalent to a sale.
Alternatively, if IBM bears most of these risks, the contract is more like a rental
agreement.
Accounting rules in the U.S. are intended to re¬‚ect these differences in the nature of
lease contracts. Under SFAS 13, a lease transaction is viewed as equivalent to a sale if
any of the following conditions hold: (1) ownership of the asset is transferred to the les-
see at the end of the lease term; (2) the lessee has the option to purchase the asset for a
bargain price at the end of the lease term; (3) the lease term is 75 percent or more of the
asset™s expected useful life; or (4) the present value of the lease payments is 90 percent
or more of the fair value of the asset.
Lease contracts that satisfy the criteria for an effective sale for accounting purposes
are recorded as sales-type leases. For IBM, revenues from the sale would be recognized
at the present value of the lease payments. This would also be shown as a receivable”
Investment in Sales-Type Leases”on IBM™s balance sheet. The expected residual value
of the computer at the end of the lease term would be removed from inventory and in-
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cluded in the asset Investment in Sales-Type Leases. Finally, the balance of the book
value of the computer would be removed from inventory and recorded as the cost of
goods sold. The markup on the computer “sale” would then be re¬‚ected in the gross
pro¬t. In subsequent periods, the lease payments received by the lessor are separated
into interest income and principal repayments of the note receivable.
Lease contracts that do not qualify as an effective sale for accounting purposes are
termed operating leases. The lessor then reports rental income throughout the lease term
and continues to depreciate the cost of the asset.


Key Analysis Questions
Accounting can become complex when a seller retains a residual value in a prod-
uct or service. Managers are then required to determine whether the asset has been
sold and, if so, how to value the residual owned by the seller. For ¬nancial ana-
lysts, the following questions are likely to arise:
• What are the residual risks borne by the seller? What factors affect these
risks? Does the seller have control over these risks?
• What processes does the seller have in place to manage its residual risks?
How effective are these processes?
• What have been the historical outcomes of risks borne by the seller relative
to forecasts? If these risks have been poorly managed, where on the financial
statements are they reflected? Have historical forecasts of the seller™s residual
risks systematically over- or understated subsequent realizations?
• What has been the seller™s experience in managing its residual risks relative
to other firms in its industry? If its historical experience has been different
from its industry peers, does it follow a different strategy, or target different
customers?
• If the firm does not have a strong track record in managing and forecasting
residual risks, is it appropriate to view the transaction as a sale? Accounting
rules typically require that a transaction either be recorded as a sale or that
revenue be deferred. As a result, among the transactions that meet the re-
quirements for current revenue recognition, some are closer to satisfying the
minimum requirements than others. Where on this continuum do the transac-
tions being analyzed lie?




Challenge Four: Credit-Worthiness of Customer
Many ¬rms provide credit to their customers. In most instances, customers are expected
to pay for the product or service within thirty days of billing. However, for some busi-
nesses, sellers provide long-term ¬nancing.
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Transactions where there are signi¬cant credit risks for the seller raise a number of
questions for ¬nancial statement users. Does the seller have a system in place to evaluate
and manage credit risks of customers? Has the ¬rm done a good job of managing credit
risk in the past? Is past success in managing credit risk likely to be a good indicator of
the future?
Credit risk can be particularly dif¬cult to analyze if (a) customers have experienced
a change in circumstances, (b) sales growth has led to a change in the mix of a ¬rm™s
customers, or (c) the seller has an innovative strategy that makes it dif¬cult to use his-
torical data to assess credit risk. The following two transactions illustrate these points
and the challenges of assessing collectibility.

EXAMPLE: REAL ESTATE TRANSACTIONS. Real estate companies frequently
provide long-term ¬nancing for their customers. A customer may put down 5 percent of
the full purchase price of a property and arrange a mortgage with the seller to cover the
remaining 95 percent. If the buyer is unable to pay off the loan, the seller can reclaim
possession of the property, resell it, and use the proceeds to cover the remaining balance
on the mortgage. This transaction raises several questions about collectibility. First, is
the initial 5 percent payment refundable? If so, the buyer can potentially renege on the
contract with no penalty. Second, is the owner™s equity in the property suf¬cient to pro-
vide some assurance to the seller that the buyer is likely to be committed to meeting the
payments, particularly if the property value subsequently declines? For example, if the
property in the above transaction declines in value by 20 percent, a buyer with only a
5 percent equity stake has a strong incentive to return the property to the seller. The
buyer then loses the equity investment, but avoids further losses that would arise from
continuing to make mortgage payments.
Accounting standards attempt to capture the above risks. Under SFAS 66, retail land
sales can be recognized as revenue only if all of the following conditions are met:
1. The buyer signs a legally binding contract for the land purchase and pays a non-
refundable down payment of 10 percent or more of the sales price.
2. The seller™s collection experience on similar sales indicates that at least 90 percent
of the receivables will be collected in full. A down payment of 20 percent or more
is an acceptable substitute for this test.
3. The seller™s receivable for the property is not subject to subordination of new
loans.
4. The seller is not obliged to construct amenities or other facilities or to make other
improvements to the property.
If a real estate contract satis¬es the above requirements for recognizing a property
sale, the seller can recognize the full price of the land as revenue. Otherwise, accounting
rules require that revenue be recognized on a cash basis.

EXAMPLE: SUBPRIME LENDING. The subprime lending industry is a relatively re-
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cent phenomenon. Subprime lenders provide consumer credit to individuals who have
incomplete or poor credit records and who are unable to obtain ¬nancing from tradition-
al bank ¬nancing. Subprime lenders thus provide consumer credit through credit cards,
automobile ¬nancing, and home equity loans. Yields on these loans and service fees tend
to be high.
Of course, there are signi¬cant risks associated with these loans, notably a higher de-
fault rate than traditional lending. To manage these risks, subprime lenders attempt to
stratify the additional default risk inherent in the loans and to price them accordingly.


Key Analysis Questions
Credit risks require management to estimate the effect of default risks, raising the
following questions for ¬nancial analysts:
• What is the seller™s business strategy and how does that strategy affect its
ability to manage credit risks? For example, does the firm use low-cost fi-
nancing as a form of marketing for its product? Alternatively, does it offer
low prices on its product and make money on financing? What are the risks
of these different strategies?
• Do the accounting rules governing whether a transaction is a sale factor in all
of the risks faced by the seller? Are there risks that are not considered in ac-
counting rules? If so, how serious are these risks? How do firms manage
these risks?
• Does the seller have a credit process in place to help manage default risk?
This process will access customers™ credit histories, job security, assets, and
other liabilities. From this information, the seller can adequately assess the
risks and price the loan accordingly.
• Is the estimated provision for doubtful debts consistent with historical data and
with industry norms? If the provision appears to be lower than these norms,
what factors explain the differences? For example, has the firm changed its
strategy, or does it follow a different strategy from other firms in the industry,
making these norms less reliable benchmarks? Is it growing rapidly and selling
to different types of customers than historically? If so, are these new customers
likely to be more or less risky than the current portfolio mix?




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