I have to answer this case for class: Case 09-6 UpBeat, Inc. Tommy Toe, the cont
ID: 2574654 • Letter: I
Question
I have to answer this case for class:
Case 09-6 UpBeat, Inc.
Tommy Toe, the controller of UpBeat, Inc., a successful company in Greenville, South Carolina, was whistling. Sales in the last quarter substantially exceeded budgeted amounts, and the order backlog indicated that the next quarter would be even better. All of a sudden, Tommy frowned. When he reviewed the monthly reporting package and cash flow projections, he noticed that the debt-to-equity ratio had deteriorated. This poses a problem under UpBeat’s debt covenants. In addition, at present liquidity is tight and the company is having difficulty keeping current on taxes and on payments to suppliers and employees.
Tommy immediately called UpBeat’s local bank. The bank manager recommended that UpBeat sell off some of its accounts receivable to increase its liquidity and improve its debt covenant ratios. UpBeat agreed to sell the bank $50 million of accounts receivable at 90 percent of face value. The following provisions are included in the sale agreement:
Transfer Provision 1 — The bank has to obtain permission from UpBeat if it decides to sell/pledge the accounts receivable, which UpBeat would not unreasonably withhold.
Transfer Provision 2 — UpBeat has the option to repurchase the accounts receivable at a fixed price if it obtains sufficient liquidity from new investors or other sources.
Tommy knows that legal isolation is often an issue in sale accounting. As a result, he was not surprised when his auditor asked for a legal opinion. The legal letter Tommy obtained included a “would” opinion stating that the transferred assets would be beyond the reach of the powers of a bankruptcy trustee. Tommy’s auditor evaluated the legal letter and found it adequate to support legal isolation of the accounts receivable transferred.
Tommy has requested your assistance in determining whether the transfer provisions preclude sale accounting.
Required:
For each of the transfer provisions included in the agreement, determine whether the provision would preclude sales accounting.
If one or more of the provisions preclude sale accounting, but subsequently, after the transfer, UpBeat and the bank amend the agreement to eliminate the provision(s) in question, would sale accounting be appropriate after the initial transfer?
Explanation / Answer
Answer to Question no.1
Transfer Provision -1
Prima facie, it appears that the transferor Up Beat Inc, still exercise some form of indirect control over the receivable, by restricting the bank to sell or pledge the receivables without the permission of the transferor. Normally in a factoring arrangement of this sort, the transferor cannot exercise any right over the financial assets sold. By restraining the bank from selling/pledging on the bank's own accord, Up Beat Inc is exercising control over the transferred asset. Hence this right precludes Up Beat Inc, from accounting for the sale, notwithstanding the true sale opinion from the attorney.
Transfer Provision -2
Since Up Beat Inc, the transferor, has the option to repurchase the receivables at a fixed price, we can argue that the transferor has some kind of effective control over the receivables. It had been a pure sale agreement then there would be no provision in the agreement which entitles the transferor to enjoy some form of benefit which is more than trivial. Hence this provision as well precludes Up Beat Inc, from achieving the sale accounting.
Answer to Question No.2
If the provisions in the agreement are amended to make sure that the transferor does not exercise any control over the transferred financial assets or derive any benefit there from, then the transferor can go ahead and perform the sale accounting. The true sale opinion from the attorney which legally isolates the transferred asset from the transferor will then act as an enabler in achieving the process of sale accounting.