Loan Receivable Accounting PDF

**Loan receivable** A loan receivable is a financial asset arising from a loan granted by a bank or other financial institution to a borrower or client. The term of the loan may be short-term but in most cases, the repayment periods cover several years. **Initial measurement of loan receivable**...

**Loan receivable** A loan receivable is a financial asset arising from a loan granted by a bank or other financial institution to a borrower or client. The term of the loan may be short-term but in most cases, the repayment periods cover several years. **Initial measurement of loan receivable** At initial recognition, an entity shall measure a loan receivable at **fair value** plus transaction costs that are directly attributable to the acquisition of the financial asset. The fair value of the loan receivable at initial recognition is normally the transaction price, meaning, the amount of the loan granted. Transaction costs that are directly attributed to the loan receivable include **direct origination costs.** *Direct origination costs should be included in the initial measurement of the loan receivable.* However, *indirect origination cost* should be treated as outright expense. **Meaning of amortized cost** The *amortized cost* is the amount at which the loan receivable is measured **initially:** a. *Minus* principal repayment b. *Plus or minus* cumulative amortization of any difference between the initial carrying amount c. Minus *reduction for impairment or uncollectibility* In other words, if the initial amount recognized is **lower** than the principal amount, the amortization of the difference is added to the carrying amount. If the initial amount recognized is **higher** than the principal amount, the amortization of the difference is deducted from the carrying amount. **Origination fees** Lending activities usually precede the actual disbursement of funds and generally include efforts to identify and attract potential borrowers and **to originate a loan.** The **fees charged by the bank against the borrower** for the creation of the loan are known as "origination fees". *Origination fees* include compensation for the following activities: a. Evaluating the borrower's financial condition b. Evaluating guarantees, collateral and other security c. Negotiating the terms of the loan d. Preparing and processing the documents related to the loan e. Closing and approving the loan transaction **Accounting for origination fees** The *origination fees received from borrower* are recognized as unearned income and amortized over the term of the loan. If the origination fees are **not chargeable** against the borrower, the fees are known as "direct origination cost". The direct origination costs are deferred and also amortized over the term of the loan. **Preferably,** the direct origination costs are offset directly against any unearned origination fees received. If the origination fees received exceed the direct origination costs, the difference is unearned interest income and the amortization will increase interest income. If the direct origination costs exceed the origination fees received, the difference is charged to "direct origination costs" and the amortization will decrease interest income. Accordingly, the origination fees received and the direct origination costs are *included in the measurement of the loan receivable.* **Impairment of loan** PFRS 9, paragraph 5.5.1, provides that an entity shall recognize a loss allowance for **expected credit losses** on financial asset measured at amortized cost. Paragraph 5.5.3 provides that an entity shall measure the loss allowance for a financial instrument at an amount equal to the **lifetime expected credit losses** if the credit risk on that financial instrument has increased significantly since initial recognition. **Credit losses** are the *present value* of all cash shortfalls. *Expected credit losses are an estimate of credit losses over the life of the financial instrument.* **Measurement of impairment** When measuring expected credit losses, an entity should consider: a. *The probability-weighted outcome* The estimate should reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs. b. *The time value of money* The expected credit losses should be discounted. c. *Reasonable and supportable information* that is available without undue cost or effort. PFRS 9 **does not** prescribe particular method of measuring expected credit losses. An entity may use various sources of data both internal or entity-specified and external in measuring expected credit losses. *The amount of impairment loss can be measured as the difference between the carrying amount and the present value of estimated future cash flows discounted at the original effective rate.* The carrying amount of the loan receivable shall be reduced either **directly** or through the use of an **allowance account.** **Meaning of credit risk** *Credit risk is the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation.* The risk contemplated is the risk contemplated is the risk that the issuer will fail to perform a particular obligation. The risk does not necessarily relate to the *credit worthiness* of the issuer. For example, if an entity issued a collateralized liability and noncollateralized liability that are otherwise identical, the credit risk, of the two liabilities will be different. The credit risk of the collateralized liability is surely less than the credit risk of the noncollateralized liability. The credit risk for a collateralized liability may be zero. **CHAPTER 8** **RECEIVABLE FINANCING** **Pledge, assignment and factoring** **Concept of receivable financing** *Receivable financing* is the financial flexibility or capability of an entity to raise money out of its receivables. During a general business decline, an entity may find itself in tight cash position because sales decrease and customers are not paying their accounts on time. But the entity's current accounts and notes payable must continue to be paid if its credit standing is not to suffer. The entity then would be in a financial distress as collections of receivable are delayed but cash payments for obligations must be maintained. Under these circumstances, if the situation becomes very critical, the entity may be forced to look for cash by financing its receivables. **Forms of receivable financing** The common forms of receivable financing are: a. Pledge of accounts receivable b. Assignments of accounts receivable c. Factoring of accounts receivable d. Discounting of notes receivable **Pledge of accounts receivable** When loans are obtained from the bank or any lending institutions, the accounts receivable may be pledged as collateral security for the payment of loan. Normally, the borrowing entity makes the collections of the pledged accounts but may be required to turn over the collections to the bank in satisfaction for the loan. No complex problems are involved in this form of financing except the accounting for the loan. The loan is recorded by debiting cash and discount on note payable if loan is discounted, and crediting note payable. The subsequent payment of the loan is recorded by debiting note payable and crediting cash. With respect to the pledged accounts, no entry would be necessary. It is sufficient that disclosure thereof is made in a note to financial statement. **Assignment of accounts receivable** Assignment receivable of accounts receivable means that a borrower called the *assignor* transfer rights in some accounts receivable to a lender called the *assignee* in consideration for a loan. Actually, assignment is a *more formal type* of pledging of accounts receivable. Assignment is secured borrowing evidence by *financing agreement* and a *promissory note* both of which the assignor signs. However, pledging is *general* because *all accounts receivable* serve as collateral security for loan. On the other band, assignment is *specific* because *specific accounts receivable* serve as collateral security for the loan. Assignment may be done either on a *non-notification* basis, customers are not informed that their accounts have been assigned. As a result, the customers continue to make payments to the assignor, who in turn remits the collections to the assignee. When accounts are assigned on a *notification* basis, customers are notified to make their payments directly to the assignee. The assignee usually lends only a certain percentage of the face value of the accounts assigned because the assigned accounts may not be fully realized by reason of such factors as sales discount, sales return and allowances and uncollectible accounts. The percentage maybe 70%, 80%, or 90% depending on the quality of the accounts. The assignee usually charges interest for the loam that it makes and requires a *service* or *financing charge* or commission for the assignment agreement. **Factoring** Factoring is a sale of accounts receivable on a *without recourse, notification basis.* In factoring arrangement, an entity sells accounts receivable to a bank or finance entity called a *factor.* Accordingly, a gain or loss is recognized for the difference between the proceeds received and the net carrying amount of the receivables factored. Factoring differs from an assignment in that an entity actually *transfers ownership* of the accounts receivable to the factor. Thus, the factor assumes responsibility for uncollectible factored accounts. In assignment, the assignor *retains* ownership of the accounts assigned. Because of the nature of the transaction, the customers whose accounts are factored are notified and required to pay directly to the factor, The factor has then the responsibility of keeping the receivable records and collecting the accounts. Factoring may take the form of the following: a. Casual factoring b. Factoring as a continuing agreement **Casual factoring** If an entity finds itself in a critical cash position, it may be forced to factor some or all of its accounts receivable at a substantial discount to a bank or a finance entity to obtain the much needed cash. **Factoring as a continuing agreement** Factoring may involve a continuing arrangement where a finance entity purchases all of the accounts receivable of a certain entity, In this setup, before merchandise is shipped to a customer, the selling entity requests the factor's credit approval. If it is approved, the account is sold immediately to the factor after shipments of the goods. The factor then assumes the credit function as well as the collection function. For compensation, typically the factor charge a commission or factoring fee of 5% to 20% for its services of credit approval, billing, collecting, and assuming uncollectible factored accounts. Moreover, the factor may withhold a predetermined amount as a protection against customer returns and allowances and other special adjustments. This amount withheld is known as the "factor's holdback" The factor's holdback is actually a receivable from the factor and classified as current asset. Final settlement of the factor's holdback is made after the factored receivables have been fully collected. **CHAPTER 9** **RECEIVABLE FINANCING** **Discounting of note receivable** **Concept of discounting** As a form of a receivable financing, discounting specifically pertains to **note receivable**. In a promissory note, the original parties are the *maker* and *payee,* The maker is the one liable and the payee is the one entitled to payment on the date of maturity. When a note is negotiable, the payee may obtain cash before maturity date by *discounting* the note at a bank or other financing company. To discount the note, the payee must *endorse* it. Thus, legally the payee becomes an *endorser* and the bank becomes an *endorsee,* **Endorsement** *Endorsement* is the transfer of right to a negotiable instrument by simply signing at the back of the instrument. Endorsement may be *with recourse* which means that the endorser shall pay the endorsee if the maker dishonors the note. In the legal parlance, this is the **secondary liability** of the endorser. In the accounting parlance, this is the **contingent liability** of the endorser. Endorsement may be *without recourse* which means that the endorser avoids future liability even if the maker refuses to pay the endorsee on the date of maturity. In the absence of any evidence to the contrary, endorsement is assumed to be *with recourse.* **Terms related to discounting of note** 1. *Net proceeds* refer to the discounted value of the note received by the endorser from the endorsee. Net proceeds = Maturity value minus Discount 2. *Maturity value* is the amount due on the note at the date of maturity. Principal plus interest equals the maturity value. 3. *Maturity date* is the date on which the note should be paid. 4. *Principal* is the amount appearing on the face of the note. It is also referred to as *face value.* 5. *Interest* is the amount of interest for the full term of the note. Interest is computed as Principal x rate x time. 6. *Interest rate* is the rate appearing on the face of the note. 7. *Time* is period within which interest shall accrue. For discounting purposes, it is the period from date of note to maturity date. In other words, the term "time" is the entire period or "full term" of the note. 8. *Discount* is the amount of interest deducted by the bank in advance. Discount is equal to *maturity value times discount rate times discount period.* 9. *Discount rate* is the rate used by the bank in computing the discount. The discount rate should not be confused with the interest rate. The discount rate and interest rate are different from each other. If no discount *rate* is given, the interest rate is safely assumed as the discount rate. 10. *Discount period* is the period from date of discounting to maturity date. Simply computed, discount period equals term of the note minus the expired portion up to the date of discounting. The discount period is the *unexpired term* of the note. **Conditional sale or secured borrowing** PFRS 9, paragraph 3.2.3, provides that an entity shall derecognize a financial asset when **either** one of the following criteria is met: a. **The contractual rights to the cash flows** of the financial asset have expired. b. **The financial asset has been transferred** and the transfer qualifies for derecognition based on the extent of transfer of risks and reward of ownership. The **first criterion** is usually easy to apply. The contractual rights to the cash flows may expire, for example, when a note receivable from a customer is fully collected. The application of the **second criterion** is often complex. It replies on the assessment of the extent of the transfer of risks and rewards of ownership. PFRS 9, paragraph 3.2.6, provides the following guidelines for derecognition based on transfer of risks and rewards: 1. If the entity has **transferred** substantially all risks and rewards, **the financial asset shall be derecognized.** 2. If the entity has **retained** substantially all risks and rewards, the financial asset **shall not** be derecognized. 3. If the entity has **neither** transferred nor retained substantially all risks and rewards, derecognition depends on **whether the entity has retained control** of the asset. a. If the entity **has lost control** of the asset, the financial asset is derecognized in it's entirely. b. If the entity **has retained control** over the asset, the financial asset is **not** derecognized. **Evaluation** Unquestionably, the contractual rights to the cash flows of the note receivable discounted with recourse have not yet expired. Thus, this **first criterion** does not apply. The discounting of note with recourse does not also fall squarely within a single guideline in the **second criterion** of "transfer of risks and rewards of ownership" The discounting transaction is a combination of the guidelines in the second criterion as follows: a. The entity has substantially **transferred** all "rewards". b. The entity has **retained** substantially all "risks". c. The entity has **lost control** of the note receivable **Conclusion** Much debate on this accounting issue can go on among academicians and theoreticians until a clear-cut interpretation of the standard is made by the Financial Reporting Standards Council Premises considered, it is believed that the discounting of note receivable with recourse is to be accounted for as a **conditional sale with recognition of a contingent liability.** The main justification is that upon discounting or endorsement of the note receivable, whether with or without recourse, **the transferor or endorser has lost control** over the note receivable. Accordingly, **the transferee has complete control** over the note receivable because the transferee has the practical ability to sell the asset to a third party without attaching any restrictions to the transfer. **CHAPTER 10** **INVENTORIES** **Definition** *Inventories are assets held for sale in the ordinary course of business, in the process of production for such sale or in, the form of materials or supplies to be consumed in the production process or in the rendering of services.* Inventories encompass **goods purchased and held for resale,** for example: a. Merchandise purchased by a retailer and held for resale b. Land and other property held for resale by a subdivision entity and real estate developer. Inventories also encompass **finished goods** produced, **goods in process** and **materials and supplies** awaiting use in the production process. **Classes of inventories** Inventories are broadly classified into two, namely *inventories of a trading concern and inventories of manufacturing* concern. A *trading concern* is one that buys and sells goods in the same form purchased. The term "merchandise inventory" is generally applied to goods held by a trading concern. A *manufacturing concern* is one that buys goods which are made available for sale. The inventories of a manufacturing concern are: a. Finished goods b. Goods in process c. Raw materials d. Factory or manufacturing supplies **Definitions** *Finished goods* are completed products which are ready for sale. Finished goods have been assigned their full share of manufacturing costs. *Goods in process* or work in process are partially completed products which require further process or work before they can be sold. *Raw materials* are goods that are to be used in production process. No work or process has been done on them as yet by the entity inventorying them. Broadly, raw materials cover all materials used in the manufacturing operations. However, frequently raw materials are restricted to materials that will be *physically incorporated* in the production of other goods and which can be traced directly to the end product of the production process. *Factory or manufacturing supplies* are similar to raw materials but their relationship to the end product is indirect. Factory or manufacturing supplies may be referred to as *indirect materials.* It is indirect because they are not physically incorporated in the products being manufactured. There are other manufacturing supplies like paint and nails which become part of the finished products. However, since the amounts involved are insignificant it is impractical to attempt to allocate their costs directly to the product. These supplies find their way into the product cost as part of the manufacturing overhead. **Goods includible in the inventory** As a rule, all goods to which the entity has *title* shall be included in the inventory, regardless of location. The phrase "passing of title" is a legal language which means "the point of time at which ownership changes." **Legal test** *Is the entity the owner of the goods to be inventoried?* *If the answer is in the affirmative, the goods shall be included in the inventory.* *If the answer is in the negative, the goods shall be excluded from the inventory.* Applying the legal test, the following items are includible in inventory: a. Goods owned and on hand b. Goods in transit and sold FOB destination c. Goods in transit and purchased FOB shipping point d. Goods out on consignment e. Goods in the hands of salesmen or agents f. Goods held by customers on approval or on trial **Exception on the legal test** Installment contracts may provide for retention of title by the seller until the selling price is fully collected. Following the legal test, the goods sold on installment basis are still the property of the seller and therefore normally includible in his inventory. However, in such a case, it is an accepted accounting procedure to record the installment sale as a regular sale involving deferred income on the part of the seller and as a regular purchase on the part of the buyer. Thus, the goods sold on installment are included in the inventory of the buyer and excluded from that of the seller, the legal test to the contrary notwithstanding. This is a clear example of economic substance prevailing over legal form. **Who is the owner of goods in transit?** This will depend on the terms, whether FOB destination FOB shipping point. *FOB* means free on board. Under FOB *destination,* ownership of goods purchased transferred only upon receipt of the goods by the buyer at the point of destination. Thus, under FOB destination, the goods in transit are still the property of the *seller*. Accordingly, the **seller** shall legally be responsible for freight charges and other expenses up to the point of destination. On the other hand, if the term is *FOB shipping point,* ownership is transferred upon shipment of the goods and therefore, the goods in transit is the property of the *buyer.* Accordingly, the **buyer** shall legally be responsible for freight charges and other expenses from the point of shipment to the point of destination. In practice, during an accounting period, the accountant *normally* records purchases when goods are received and sales when goods are shipped, regardless of the precise moment at which title passed. This procedure is expedient and no material misstatements occur in the financial statements because title usually passes in the same accounting period. However, the accountant should carefully analyze the invoice terms of goods that are in transit at the end of the accounting period to determine who has legal title. Accordingly, adjustments are in order if errors are committed in recording purchases and sales. **Accounting for inventories** Two systems are offered in accounting for inventories, namely *periodic system and perpetual system.* The *periodic system* calls for the physical counting of goods on hand at the end of the accounting period to determine quantities. The quantities are then multiplied by the corresponding unit costs to get the inventory value for balance sheet purposes. This approach gives *actual or physical* inventories. The periodic inventory procedure is generally used when the individual inventory items have *small peso investment,* such as groceries, hardware and auto parts. On the other hand, the *perpetual system* requires the maintenance of records called *stock cards* that usually offer a running summary of the inventory inflow and outflow. Inventory increases and decreases are reflected in the stock cards and the resulting balance represents the inventory. This approach *gives book or perpetual* inventories. The perpetual inventory procedure is commonly used where the inventory items treated *individually represent a relatively large peso investment* such as jewelry and cars. In an ideal perpetual system, the stock cards are kept to reflect and control **both units and costs.** Consequently, the entity would be able to know the inventory on hand at a particular moment in time. In recent year, the widespread use of computers has enabled practically all large trading and manufacturing entities to maintain a perpetual inventory system. With computers, the entities can conveniently and effectively store and retrieve large amount of inventory data. When the perpetual system is used, *a physical count of the units on hand should at least be made once a year* to confirm the balances appearing on the stock cards. **Trade discounts and cash discounts** *Trade discounts* are deductions from the list or catalog price in order to arrive at the *invoice price* which is the amount actually charged to the *buyer.* Thus, trade discounts are **not recorded.** The purpose of trade discounts is to encourage trading or increase sales. Trade discounts also suggest to the buyer the price at which the goods may be resold. *Cash discounts* are deductions from the *invoice price* when payment is made within the discount period. The purpose of cash discounts is to encourage prompt payment. Cash discounts **are recorded** as *purchase discount* by the buyer and *sales discount* by the seller. Purchase discount is deducted from purchases to arrive at net purchases and sales discount is deducted from sales to arrive at net sales revenue. **Methods of recording purchases** 1. *Gross method --* purchase and accounts payable are recorded at gross. 2. *Net method --* purchase and accounts payable are recorded at net. **Gross method vs. net method** The cost measured under the *net method* represents the cash equivalent price on the date of payment and therefore the *theoretically correct* historical cost. However, in practice, most entities record purchases at *gross invoice amount.* Technically, the gross method *violates* the matching principle because discounts are recorded only when taken or when cash is paid rather than when purchases that give rise to the discounts are made. Moreover, this procedure does not allocate discounts taken between goods sold and goods on hand. Despite its theoretical shortcomings, the gross method is supported on *practical grounds.* The gross method is more convenient than the net method from a bookkeeping standpoint. Moreover, if applied consistently over time, it usually produces no material errors in the financial statements. **Cost of inventories** The cost of inventories shall comprise: a. Cost of purchase b. Cost of conversion c. Other cost incurred in bringing the inventories to their present location and condition. **Cost of purchase** The *cost of purchase* of inventories comprises the purchase price, import duties and *irrecoverable* taxes, freight, handling and other costs directly attributable to the acquisition of finished goods, material and services. Trade discounts, rebates and other similar items are deducted in determining the cost of purchase. The cost of purchase shall **not** include *foreign exchange differences* which arise directly from the recent acquisition of inventories involving a foreign currency. Moreover, when inventories are purchased with deferred settlement terms, the difference between the purchase price for normal credit terms and the amount paid is recognized as **interest expense** over the period of financing. **Cost of conversion** The *cost of conversion* of inventories includes cost directly related to the units of production such as *direct labor.* It also includes a systematic allocation of *fixed and variable production overhead* that is incurred in converting materials into finished goods. *Fixed production overhead* is the indirect cost of production that remains relatively constant regardless of the volume of production. Examples are depreciation maintenance of factory building and equipment, and the cost of factory management and administration. *Variables production overhead* is the indirect cost of production that varies directly with the volume of production. Examples are indirect labor and indirect materials. **Allocation of fixed production overhead** The allocation of *fixed production overhead* to the cost of conversion is based on the **normal capacity** of the production facilities. Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances taking into account the loss of capacity resulting from planned maintenance. The amount fixed overhead allocated to each unit of production or idle plant. *Unallocated fixed overhead* is recognized as expense in the period in which it is incurred. **Allocation of variable production overhead** *Variable production overhead* is allocated to each unit of production on the basis of the **actual use** of the production facilities. A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or where there is a main product and a by-product, When the costs of conversion are not separately identifiable, they are allocated between the products on a rational and consistent basis, for example, on the basis of the relative sales value of each product. Most by-products by their nature are not material. By-products are measured at net realizable value and this value is deducted from the cost of the main product. **Other cost** *Other cost* is included in the cost of inventories only to the extent that it is incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include the cost of designing product for *specific customers* in the cost of inventories. However, the following costs are *excluded* from the cost of inventories and recognized as expenses in the period when incurred: a. *Abnormal* amounts of wasted materials, labor and other production costs. b. *Storage costs,* unless these costs are necessary in the production process prior to a further production stage. Thus, storage costs on *goods in process* are capitalized but storage costs on *finished goods* are expensed. c. *Administrative overheads* that do not contribute to bringing inventories to their present location and condition. d. Distribution or selling costs. **Cost of inventories of a service provider** The cost of inventories of a service provider consists primarily of the labor and other costs of personnel *directly engaged in providing the service,* including supervisory personnel and attributable overhead. Labor and other costs relating to *sales and general administrative personnel are not included* but recognized as expense in the period which they incurred.