Question

Accounting for Off-Balance-Sheet Financing.

On June 24, Year 4, a major airline entered into a revolving accounts receivable facility (Facility) providing for the sale of $489 million of a defined pool of accounts receivable (Receivables) through a wholly owned subsidiary to a trust in exchange for a senior certificate in the principal amount of $300 million (Senior Certificate) and a subordinate certificate in the principal amount of $189 million (Subordinate Certificate). The subsidiary retained the Subordinate Certificate, and the company received $300 million in cash from the sale of the Senior Certificate to a third party. The principal amount of the Subordinate Certificate fluctuates daily depending on the volume of Receivables sold and is payable to the subsidiary only to the extent that the collections received on the Receivables exceed amounts due on the Senior Certificate. The full amount of the allowance for doubtful accounts related to the Receivables sold has been retained, as the company has substantially the same credit risk as if the Receivables had not been sold. Under the terms of the Facility, the company is obligated to pay fees that approximate the purchaser’s cost of issuing a like amount of commercial paper plus certain administrative costs.

REQUIRED
The airline’s management requests your advice on the appropriate accounting for this transaction. How would you respond?

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Answer 1

The analyst should consider separately the receivables for which the airline received the $300 million Senior Certificate and the receivables for which its wholly-owned subsidiary received the $189 million Subordinate Certificate.

First, consider the receivables underlying the Senior Certificate. The airline states that it has retained the full amount of the allowance for doubtful accounts related to these receivables because it “has substantially the same credit risk as if the receivables had not been sold.” Although there is no explicit statement that the purchaser of the Senior Certificate has recourse against the airline if uncollectible accounts exceed pre-set amounts, it appears that the airline has not transferred any credit risk. Placement of the additional $189 million of receivables in the trust provides a cushion for debt service on the Senior Certificate. The airline's payment of fees to the purchaser of the Senior Certificate that compensate the purchaser for varying costs of issuing a like amount of commercial paper, in addition to certain administrative costs, suggests that the airline bears the risk of changes in interest and administrative costs. Thus, control of the economic benefits and risks appears to reside with the airline. The airline should account for the arrangement as a loan and record a liability on its books.

The receivables related to the Subordinate Certificate clearly give rise to a receivable for the airline. The airline has merely transferred the receivables to a wholly-owned subsidiary. No cash inflow has occurred. The airline continues to bear the risks related to these receivables. The subsidiary receives cash from the trust only to the extent that cash collections from the receivables exceed amounts necessary to service the Senior Certificate. The purchaser of the Senior Certificate probably required the airline to place the extra $189 million of receivables in the trust to ensure that debt service costs on its Senior Certificate were paid.