Ted's Accounting Question
My friend, Ted (not his real name), is the ex-treasurer of a very large public company where he acquired extensive experience in solving accounting problems. He departed a few years ago to run a business that he and his brother had purchased. Business had been humming along nicely until the economy took a dive.
Ted recently came to me with a question about the accounting for a renegotiated payable to a long-time supplier, ABC Printing. While the negotiations were underway, Ted discovered that recent prices being charged by ABC were much higher than he could have obtained elsewhere. Eventually, the parties agreed to the following terms (more or less): (1) reduce the amount currently owed by 40%; (2) the remainder of the trade payable would be converted to a non-interest bearing note payable with equal monthly payments over the next three years; and (3) ABC would continue to be the exclusive printer for Ted's company for the next three years – at a 5% discount to prevailing market prices, so long as new billings were paid within 30 days of their invoice dates.
Solely for the sake of discussion, let's assume the following additional facts:
- The change to the terms of the payable would result in a $90,000 write-down, such that the remaining balance of the payable would represent the discounted present value – or equivalently, the fair value – of the 36 monthly payments over the next three years.
- The amortization schedule for the note payable results in changes to its balance that correspond to changes in its current value.
- The current value of the future purchases at discounted prices is $114,000.
Based on our collective knowledge (i.e., winging it without any formal research), Ted and I identified two potentially permissible accounting treatments:
Treatment #1 – Reduce the payable by $90,000; record a gain of $90,000; no recognition of the purchase commitment.
Treatment #2 – Reduce the payable by $90,000; record a deferred gain of $90,000; no recognition of the purchase commitment. In subsequent periods, amortize the deferred gain to income over the term of the purchase agreement.
Ted tells me that his former employer had engaged in similar deals, and it had accounted for them along the lines of Treatment #2 because it produced a smoother stream of earnings. That comes as no surprise, but it would seem to me that an auditor could find Treatment #2 to be inappropriate (even though it is more "conservative") because the deferred gain does not meet the conceptual definition of a liability, and there is no specific rule that permits it. So much for principles.
Moreover, whichever of these two treatments is elected, the parties will be able to manipulate the accounting results to their preferences by manipulating the monetary parameters of the agreement – i.e., the amount of the payable forgiveness and the amount of the discount on future purchases are interdependent. Consequently, should the executive compensation packages for either company have an earnings-based component, it's easy to see how the absence of neither rules nor principles creates perverse incentives for management that end up destroying value for shareholders. The only form of accounting that would prevent such value destruction would entail recognition of all of the assets and liabilities – including the purchase agreement – and measurement at their current values.
This is Also an Interesting Revenue Recognition Problem
I chose to blog about my conversation with Ted because the accounting issues for ABC Printing (the supplier) is even more interesting than the accounting for Ted's company. Mostly, it's a good example for thinking about how the exposure draft, Revenue Recognition (Topic 605): Revenue from Contracts with Customers, would fail to provide answers to many issues that are sure to arise if finalized in its present form.
Before considering the exposure draft, however, let's start with existing accounting standards; because ABC has an opportunity to manage its earnings in two respects. First, the writeoff of the receivable from Ted's company might not have an impact on current earnings if ABC can conclude that the allowance for bad debts is sufficient to absorb it without a charge to bad debt expense. Second, if ABC was concerned with maintaining its future profit margins, then they might be willing (and could "afford") to grant a larger forgiveness of their current receivable in order to minimize the amount of the discount on future sales in order to keep Ted's business.
None of this weirdness would be corrected by, or particularly affect the accounting under the exposure draft, without my adding one more twist to the problem: let's assume that a portion of the re-negotiated amount owed by Ted would be payable in a lump sum at the inception of the new arrangement. The exposure draft would require separate accounting for the forgiveness of the indebtedness (a financial instruments contract) and the contract to supply goods; yet, it is impossible to determine whether the lump sum payment is a partial settlement of the receivable or a prepayment for future goods. To the extent that it is seen as a prepayment, then the resulting "performance obligation" would be accounted for like a deferred gain.
It would seem that this is an issue that the FASB could resolve before finalizing the exposure draft, but my sense is that it is only one of many gaping holes in the standard. Again, the only principles-based way of accounting for this transaction would involve recognition of all assets and liabilities, and measurement at current values, as follows (for ABC):
Reduce the receivable by $90,000 and any cash received at the inception of the new arrangement; recognize a purchase agreement liability of $114,000 (to be netted against the receivable); record a gain/loss to balance the journal entry. In subsequent periods, recognize changes to the current values of the purchase agreement and receivable directly in earnings.
In addition to providing the most complete picture of the legal rights and obligations created, there would be need for highly stylized and vague accounting standards like the revenue recognition exposure draft, and no perverse incentives to manage earnings via exploitation of the gaps in GAAP.