CFA CFA Level 1 Securitization of receivables Q

Securitization of receivables Q

  • This topic has 11 replies, 6 voices, and was last updated Apr-17 by christine.
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    • lulu123
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      Q: Company uses trust to securitize its accounts receivable and gets a bit more than book value for them. If the trust isn’t consolidated with the co, what’s the effect of the following: Over/under stated or no effect:
      net income
      total assets
      total liabilities
      current ratio
      debt-to-equity ratio

      Can someone tell me what they think ? In particular, please justify your answer for total assets and debt-to-equity.

      Thank you

    • Zee Tan
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      @lulu123 can you post the full question? It’s hard to get a sense of what is needed from what you’ve given so far.

    • lulu123
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      that is exactly the full question lol @zee

      it asks to choose whether each of the items in the list will be overstated, understated, or won’t change due to the securitization of receivables

      basically, the answers are
      net income overstated
      total assets understated
      total liabilities understated
      current ratio overstated
      debt to equity ratio understated

      I don’t understand why total assets will be understated. I thought it would be over because it says they get a bit more cash than the book value of their receivables.
      I’m also not sure why debt-to-equity is understated.
      A = L + E –> E = A – L –> I thought assets went up so D/E has the E up = D/E will be understated, which was given as right answer –> goes against the provided answer of understated total assets?!

    • lulu123
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      PS: In my question, it’s “what’s the effect ON the following items”, not “of”

    • Sarah
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      I’m going to take a stab at this but my memory of level 1 material is pretty foggy. Securitization is sometimes used to do off-balance sheet financing. It is possible to “sell” the receivables to another entity (in this case a trust) but still retain the risks. There isn’t a 100% guarantee that all the receivables will be collected and the company may be responsible to indemnify the trust of any loss therefore the company has a liability that isn’t reflected on the balance sheet. This results in D/E ratio being understated.

    • Sophie Macon
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      @lulu123, is there any mention about sponsor’s recourse?

    • Reena
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      @lulu123, I’ll give it a go too.

      I think in this case, the keywords in the question is that “the SPV (trust) is not consolidated” with the company – I’m guessing here it is comparing it with the case where it should be consolidated.

      So in essence, the total assets and liabilities will be understated because the matching asset and liabilities of the SPV are not added to the company’s balance sheet (which does not change equity). Therefore D/E is also understated.

      Hope this makes sense.

    • lulu123
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      @sophie
      no this is all the information


      @reena
      @diya
      that makes sense for the D/E
      what about the total assets being understated though? didn’t they get cash?

      basically, some liability aspect is not shown
      but what part of the asset is not shown? did they take out AR and weren’t supposed to? or what…

    • Reena
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      @lulu123, total asset is understated because they didn’t consolidate the asset (and liabilities) of the SPV. For the SPV, the asset was the A/R, and liability is the debt to investors.

      So just to give a numerical example.

      B/S of Company (before securitisation):

      A/R 100
      Cash 0

      B/S of Company (after securitisation):

      A/R 0
      Cash +101 (say they receive $1 above book value)
      Debt to SPV +101
      Equity +1 (gain of $1)

      B/S of SPV (after securitisation):

      A/R +101
      Debt to Investors +101

      So if you imagine that the company does NOT consolidate the SPV’s assets and liabilities (when it should have), then the total assets and liabilities are understated, as it’s not a true and fair economic view of the company.

    • lulu123
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      @reena thank you!

    • Reena
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      No probs @lulu123! Glad I made sense 🙂

    • christine
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      Way to go @reena!

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