How are Accounts Receivables Handled in a Business Sale?
Account receivables on a balance sheet represent credit sales that have not yet been fully settled. Most businesses usually extend credit to their customers for several reasons. Account receivables are assets. They can be converted to cash within a year. But receivables values decrease with time since the longer you are owed an amount, the less likely you are going to receive it.
So, what happens to accounts receivables in a business sale? It depends on the value of these balance sheet items. But in most cases, if the business is small, the seller remains with the cash account receivables, pays off debts to suppliers, and delivers a ‘free and clear’ business to the buyer who starts afresh. And if the business is large, the buyer will most likely acquire these cash receivables from the seller for use as working capital.
What are accounts receivables?
When a business sells goods or provides services to customers on credit, it is owed money. The amount owed is accounts receivable. Most businesses allow their customers time to settle their bills. Typical credit terms are either one, two, or three months.
On a balance sheet, the amount owed by customers is represented as an asset. Depending on how quickly it can be converted into cash, it’s either a current or long-term asset. Current assets can be converted to cash in less than a year; long-term assets take longer than that.
There is also the possibility that the amount will never be collected. Usually, businesses set up an allowance for bad debts.
Why businesses have accounts receivables?
Businesses extend credit to their customers for various reasons, but majorly it’s for growth purposes.
Selling on credit increases cashflow. Given two businesses, one offering goods/services on credit and the other asking for immediate payment, customers will opt for the one making credit sales. Everybody wants better payment terms. It increases loyalty and sales.
Credit sales attract both existing and new customers. Customers are willing to buy more, knowing they can pay later. Asking for immediate payment decreases a buyer’s morale.
With favorable credit terms, the seller can also negotiate better prices. If a customer doesn’t have enough cash, don’t just let him/her leave or sell the items at a loss. If you offer them a good credit term, they can give you what they have now and bring the rest later.
But credit sales are not always advantageous. The risk of cash account receivables includes:
High cash account receivables may go unpaid for a long, leading the business to write them off as bad debts. If a customer fails to pay their invoice or go bankrupt, it can be hard to recover the cash.
Credit sales also cause cash flow deficiencies. Selling on credit is only attractive in the short term, but it’s not pretty in the long-term. It may cause a business to run out of cash and start borrowing to finance operations.
Receivables are not always equal to their face values.
Tracking and collecting receivables is costly. It needs time and effort, plus the account may not be worth it; the longer it’s past due, the less likely you are to receive it.
For these reasons, the allocation of outstanding cash accounts receivables is a significant part of the negotiation process.
Buyer’s perspective
A smart buyer will look into the accounts’ status and decide if they are valuable to him or not. Receivables are discounted depending on how late they are, with those that have aged more discounted more.
Usually, the buyer sorts out which receivables are current and which ones are past due. They will then analyze those past due to know exactly how much they are late, the debtors’ payment history, and if these customers are worth keeping.
Depending on the information, the buyer can choose to acquire the account or leave them to the seller. That way, the buyer doesn’t need to start ‘chasing’ debtors for payment. It allows them to start afresh.
Seller’s perspective
Sellers will try to estimate how much effort it will take to collect some or all the receivables. This will determine whether they keep the accounts or package them as part of the sale.
In some cases, sellers want a clean break. They’ll want to part with all the receivables even if there’s nothing wrong with them. This happens when the seller is retiring or taking on a new challenge.
The purchase price of the entity is negotiated based on both party’s viewpoint.
Receivables can simply be allocated to the buyer or the seller. But in other cases, it is more complex than that; each can take their own share of receivables and treat them differently. It all depends on how large the deal is and the value of the receivables.
When the two parties decide to share the receivables, it’s known as a ‘slice and dice approach.’ Usually, the buyer acquires the most current receivables leaving the seller with the rest. This way, the buyer gets receivables, whose value is almost 100%. It also allows the seller to collect the receivable at a significantly higher amount than the buyer would have offered for them.
How are the gains from the sale of accounts receivables taxed?
The sale of accounts receivables attracts tax, too, just like the sale of other business assets. In fact, the tax usually figures heavily in the sale of a business. Gains from assets sales usually attract either ordinary income taxes or capital gains taxes.
Gains from the sale of receivables attract ordinary income tax rates. Additionally, the IRS requires that receivables be valued at fair market prices, just like other debt instruments.
Receivables are not eligible for installment sale. You cannot defer some of the tax due on receivables sales gain for later payment when you get paid by the buyer. Only capital assets can be subjected to the installment sale treatment.
The take-home?
There are many ways to deal with receivables. All options depend on each party’s motivation and the value of the receivables. Ultimately, how receivables are allocated impacts the business’ sale price.