Question

During the audit of ABC Company for the year ended December 31, 2017, you uncover the following two transactions affecting the company's receivables:

            1)        On October 1, 2017, Acme Realty Co. gave ABC a 3-year, 1%, $20,000 note to purchase a tract of land from ABC. ABC had bought the land as an investment several years ago for $12,000. Interest payments on the note are due on September 30 of each year.

            2)        On December 28, 2017, ABC factored, on a with recourse basis, $40,000 of Accounts Receivable with Molina Finance Company. Molina charged a 3% finance charge and withheld an additional 4% to cover any possible adjustments.

ABC Company made the following entries to record these transactions:

            1)        Notes Receivable 20,000

                                    Land                                                 12,000

                                    Gain on Sale                                    8,000

            2)        Cash                                      37,200

                        Loss on Factoring               1,200

                        Due from the Factor          1,600

                                    Accounts Receivable                   40,000

You decide to question ABC's controller about these transactions. The controller justifies these entries by stating the following regarding each of the two situations:

            1)        The note contains a provision for interest and, therefore, no special accounting is needed for the note.

            2)        Molina Finance Company will collect the receivables. Therefore, ABC no longer owns the receivables and, as a result, the transaction must be a sale.

ABC's controller has held this position for many years and his reasoning for the accounting choices that have been made in each of these situations appears to be sound, or does it? What would you require as the proper accounting for these two transactions? Be sure to cite appropriate justification from the Accounting Standards Codification.

Answer 1

Sol. Being an auditor, I would advise the below treatments per Accounting Standards Codification.

Suggestions for these two given transactions:

Given Transaction 1:

1. On October 1, 2017, Acme Realty Co. gave ABC a 3-year, 1%, $20,000 note to purchase a tract of land from ABC. ABC had bought the land as an investment several years ago for $12,000. Interest payments on the note are due on September 30 of each year.

Journal justified by ABC’s Controller

Notes Receivable	$20000
Land		$12000
Gain on Sale		$8000

Ans. In my suggestion and as per Accounting Standards Codification, the company should also recognize the interest receivables on an accrual basis as income for three months i.e, for the period of October 1, 2017, to December 31, 2017. The interest receivable amount would be

20000 *1%*3/12 = $ 50. Therefore, an additional journal needs to be posted in the book along with the above journal:

Interest Income Receivable	$ 50
Interest Income		$50

2. On December 28, 2017, ABC factored, on a with recourse basis, $40,000 of Accounts Receivable with Molina Finance Company. Molina charged a 3% finance charge and withheld an additional 4% to cover any possible adjustments.

Journal justified by ABC’s controller

Cash	$37200
Loss on Factoring	$1200
Due from the Factor	$1600
Accounts Receivable		$40000

Ans. In this case, the company ABC has factored its receivables of $40,000 on a with recourse basis. When the invoices are factored with recourse, the business will bear the loss if the customer does not pay the factor. The business will need to estimate this loss and recognize this contingent liability (called a recourse liability) when it factors the invoices. However, in the above case, the company ABC’s controller has not made any provision/estimation for such contingent liability. If there are any uncollected receivables, the company ABC needs to bear that loss.

Let’s assume that 2% of the receivables are doubtful, based on the past experience i.e, $40000 * 2% = $800. The following journal will be posted in this case:

  

Cash	$37200
Loss on Factoring ($1200 + $800)	$2000
Due from the Factor	$1600
Recourse Liability		$800
Accounts Receivable		$40000

If the doubtful invoices are not paid by the customer, the business needs to buy them back from the factor and the factor will reduce the amount of the reserve paid over by the $800.

The following journal will be posted in that case:

Cash	$800
Recourse Liability	$800
Due from the Factor		$1600