Accounting: The Language of Business - Vol. 2 (Intermediate: Part 146)

• Whoever loves money never has enough (Ecclesiastes 5:10) ...

 Short-Term Operating Assets: Cash and Receivables (Part k)

by

Charles Lamson

Securitizations

The term securitization refers to a financing technique that involves taking many separate, and often times diverse, financial assets and combining them into a single pool or bundle. Investors then purchase interest in the pool of assets rather than buying an individual asset or group of assets.

Securitization allows a company to engage in a collateral borrowing arrangement with a large number of lenders by issuing debt obligations or equity shares rather than attempting to sell each asset. Securitization also allows a company to obtain financing at a lower cost of borrowing. The pooling of many individual assets diversifies the default risk from each individual asset, thereby enhancing an investor's ability to predict the investment's future cash flows, lowering risk, and thereby lowering the required rate of return.

These benefits are possible because a company can select high quality assets to collateralize the notes or equity shares. For example, a major telecommunications company can bundle the cell phone accounts of subscribers with the highest credit rating to use as collateral for a series of notes payable. The investors purchasing the notes can rely on the collection of the cell phone receivables to pay interest and cover the note principal at maturity. Rather than attempting to sell the receivables to a single factor [Factoring accounts receivable, also known as invoice factoring, is a financial practice where a company sells its unpaid invoices to a third-party financial institution, called a factor, for cash. The factor then collects payment from the customer, and the company receives immediate funding without waiting for payment or taking on more debt (highradius.com).], the company has effectively sold the receivables to multiple investors, lowering the cost and the concentration of risk. A company can also bundle diverse types of receivables into the securitization transaction. For example, the credit affiliate of an automobile manufacturer can bundle auto loans and lease receivables as security for a note payable.

Securitization can also have drawbacks. Potential investors do not always have detailed knowledge on the original borrowers or their risk of default. Therefore, a company may have to offer the securities at a lower price. Even when a company can securitize its receivables, there is still the risk of non-collection. For example, securitization of mortgage receivables from borrowers with poor credit histories and higher risks of default led to the subprime mortgage crisis of 2007-2010.

Exhibit 9.7 summarizes ways in which a company can use accounts receivable to provide financing. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., P. 463*

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