Factoring of Accounts Receivable
Factoring of accounts receivable is the practice of transferring the ownership of accounts receivable to a company specialized in receivable collection, in exchange for immediate cash. In other words, the company that originally owns the receivables, sells them to another company called “factor” and receives immediate cash.
Factoring helps a business improve its cash flow by converting its receivables immediately into cash instead of waiting for the due dates of payments by customers. A drawback of factoring is that it is done at a discount, which means that the cash received on factoring of receivables is less than the value of the receivables transferred. This is because the factor expects a certain margin and it faces risks such as time value of money, and depending on the agreement, the risk of default by the debtors.
The parties to the factoring agreement assess the recoverability of the accounts receivable, decide whether or not the factoring agreement will be with recourse or without recourse, and then agree on a suitable discount factor to calculate the amount of fee to be charged by the factor i.e. the discount. After deducting such a fee from the value of the accounts receivable, the factor pays in cash to the originating company. The factor may also withhold an additional amount as a refundable security against any bad debts that may arise.
As a result of the above transaction, the factor gains ownership of the accounts receivable and has access to the detailed records of those receivables. The factor is specialized in receivable collection and it may actually be cost effective for businesses to factor their receivables because doing so will save costs such as wages paid to staff for following up with customers.
The factor collects cash from the debtors as the due dates approach. The procedure to be followed in a situation where a debt becomes irrecoverable, depends on whether or not the factoring agreement is with recourse.
Recourse vs non-recourse factoring
Under non-recourse factoring, the factor may set-off the sum retained as a security, if any, against any bad debts that may arise but the factor is not entitled to be reimbursed by the originating company if the total of bad debts exceed the amount of security. In other words, the additional loss on bad debts under non-recourse factoring is borne by the factor.
Under a factoring agreement with recourse, the company factoring its receivables agrees to pay bad debts in full to the factor. So if the security falls short of the total bad debts, the factor is entitled to be reimbursed for bad debts in full.
Non-recourse factoring is riskier than factoring with recourse for the factor, generally resulting in higher discount rates over factoring with recourse.
Factoring vs assignment of receivables
Factoring is different from a financing agreement involving assignment of receivables because the later uses receivables as a collateral security for a loan, but the actual ownership of the receivables and the right to collect them is not transferred as long as the loan and any related interest payments are paid in time.
The following example illustrates the journal entries to record transactions related to factoring with and without recourse:
On January 1, 20X5, Impatient Inc. factored its accounts receivable of $100,000 at a fee of 8%. Under the terms of the agreement, the company received $82,000 in cash and the rest of the amount was retained by the factor as a security for any bad debts that may arise. Any excess of this security sum over the total bad debts was agreed to be returned by the factor at the end of the accounting period i.e. December 31, 20X5.
On December 31, 20X5 the full amount of security sum was withheld by the factor because the actual bad debts totaled $11,000 exceeding the security sum.
Impatient Inc. had already provided allowance for doubtful debts in the factored accounts receivable and a bad debts expense was recognized in the income statement of year ended December 31, 20X4.
Required: Pass journal entries to record the above transactions for Impatient Inc. both under factoring with recourse and factoring without recourse.
January 1, 20X5: Here, the journal entry will be identical under both factoring with recourse and factoring without recourse.
|Factoring Expense [0.08×100,000]||8,000|
|Due from Factor||10,000|
December 31, 20X5: The journal entries will differ under the two types of factoring. Since the actual bad debts exceed the amount initially retained by the factor, Impatient Inc must pay the factor, an additional amount of $1,000 under factoring with recourse but there is no such remedy if the factoring is without recourse.
Under factoring with recourse:
|Provision for Bad Debts (expense)||11,000|
|Due from Factor||10,000|
Under factoring without recourse:
|Provision for Bad Debts (expense)||10,000|
|Due from Factor||10,000|
It is important to note that the type of factoring influences the amount of fee charged and the amount of security held by the factor and the scenario in this example is only for the purpose of comparing the two types. The amount of security retained may be zero under factoring with recourse because the agreement guarantees the factor that any debts that may turn out to be irrecoverable will be reimbursed.
by Irfanullah Jan, ACCA and last modified on