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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 ratioCan someone tell me what they think ? In particular, please justify your answer for total assets and debt-to-equity.
Thank you
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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 understatedI 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?! -
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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.
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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.
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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 0B/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 +101So 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.
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