Problem:
Franklyn Furniture (FF) is a midsized owner operated business that was started 25 years ago by Fred Franklyn. The retail furniture business is cyclical, with business dropping off in times of economic downturn, as is the case currently. In order to encourage sales, the store offers its own credit cards to good customers. FF has run into a bit of a cash crunch and is planning to go to the bank to obtain an increase in its line of credit in order to replenish and expand the furniture stock. At present, the line of credit is capped at (ie. Limited to) 70% of the credit card receivables and inventory. The receivables and inventory have been pledged as security for the loan.
Fred Franklyn has identified two possible sources of cash shortage outstanding credit card receivables and a build-up in old inventory. He has come up with two strategies to deal with the problem:
1. Credit card receivables:
For the existing receivables, Franklyn has found the company Factors, Inc. (FI), which will buy the receivables for 93% of their face value. The two companies are currently negotiating the terms of the deal. So far, FF has agreed to transfer legal title to the receivables to FI, and FF WILL MAINTAIN AND COLLECT THE RECEIVABLES. The one term that is still being discussed is whether FI will have any recourse to FF if the amounts become uncollectible.
2. Excess inventory:
A new sales promotion has been advertised in the newspaper for the past two months. Under the terms of the promotion, customers do not pay anything up front and will be able to take the furniture home and begin payments the following year. Response to the advertisement has been very good and a significant amount of inventory has been moved to date, leaving room for new inventory once the bank financing comes through.
Instructions:
Assume the role of Fred Franklyn's bookkeeper and advise him about the impact of the strategies on the company's financial reporting.