How to Account for Factoring of Accounts Receivable?

Introduction

The accounts receivable balance of business represents all its credit sales to customers for which it hasn’t received cash. Usually, businesses will have credit policies that will influence their account receivable balances. Different factors influence these policies. For example, it may depend on the credit terms of the industry or competitors of the business. Similarly, it may also depend on the demand for the products of the business. Other factors may include working capital policies, financing costs and costs of credit control.

While making credit sales can be highly beneficial for businesses as it allows them to increase their sales significantly, it may also come with some problems. First of all, when businesses allow their customers with better credit sales terms, it may create cash flow problems for the business. The main reason for this is that while receivables do result in future cash flows to the business, they still take some time. Furthermore, another problem that comes with higher receivables is that of bad debts. Bad debts are defaults on payments from customers.

What is Factoring?

Businesses may try to speed up the recovery process of receivables To tackle problems associated with receivables. To do this, they can factor their receivables. Factoring receivables consists of outsourcing the credit-control of a business to a third-party specialist. In factoring, the debts which a business sells to a factor, usually at a lower price than the receivables are worth.

There are three types of services that factors offer to businesses. The first type of service that factoring businesses offer is debt collection and administration services. It includes two main types, Recourse factoring and Non-recourse factoring. Furthermore, these businesses can offer financing services and credit insurance services.

There are certain advantages and disadvantages of factoring that businesses must face.

Advantages of Factoring Accounts Receivable

The main advantage of factoring is that it can help businesses looking for cash or going through cash flow problems. Therefore, it can provide some quick cash flows to a business. For example, if a business is in dire need of cash flows and does not expect any payments from receivables soon, it can easily sell its receivables and receive cash for it. This can be a life-saver for businesses that are going through cash flow problems.

Secondly, while it does come with some costs, factoring can also help a business save costs. By outsourcing its credit control to a factor, the business can easily save up on administration costs. Similarly, the business can also save management time. Management can focus on more important value-adding tasks rather than focus on the recoverability of receivable balances.

Finally, factoring can be very advantageous for small businesses and fast-growing businesses. This is because these businesses may not have a competent credit control department to look over their receivables. Similarly, as discussed above, these businesses may also want to focus on other tasks that can give them a competitive edge and let the factor deal with their receivables. For fast-growing business, in particular, factoring may be a better option than a credit control department that cannot keep up with volume growth.

Disadvantages of Factoring Accounts Receivable

One of the main disadvantages of factoring is that it is costly. This is mainly because a business selling its receivables will get lower compensation from the factor as compared to the value of the receivables it is selling. Similarly, the cost of factoring is also higher for businesses as compared to running a dedicated internal credit control department that runs efficiently.

Another disadvantage of factoring for businesses is that it comes with a negative reputation. As mentioned above, businesses can sell their receivables to factors for an easy way to receive cash. However, some stakeholders may perceive selling receivables to factors as cash flow problems within the business.

One of the long-term disadvantages of factoring is that it can result in loss of customers. When a business sells its receivables to factors, the factors use different methods to recover receivables from the debtors, who are customers of the business. Some of these methods may be considered harsh or intrusive by customers. Therefore, customers may not be willing to deal with factors. Some customers may even stop buying from the business for this reason.

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What is Recourse Factoring of Accounts Receivable?

Recourse factoring or with recourse factoring is when a business factors its receivables to a factor but is ultimately held responsible for any non-payment. Recourse factoring is the most common type of factoring that businesses use. It is mainly used to speed up the recovery process of receivables as it does not provide a guarantee against bad debts.

In recourse factoring, a business will agree with the factor, which requires the business to buy back any unpaid receivables from the factor. Therefore, in this type of factoring, the risks of bad debt or default will always exist for the business. The business selling the receivables will always remain liable for the receivables as long as the factor does not receive cash for it for any reason. In case a receivable is not recovered, the business either has to pay the factor for the amount of the receivable or pay them with new receivables or invoices.

Advantages of Recourse Factoring

Since recourse factoring is a type of factoring, it also incorporates all the advantages of factoring and some other specific advantages as compared to non-recourse factoring. First of all, recourse factoring is cheaper as compared to non-recourse factoring. This is mainly because for the factor, the risks are lower in this type of factoring.

Due to its lower costs, recourse factoring also allows businesses to receive the most cash for their receivables. In comparison, due to the higher costs of non-recourse factoring, the cash a business receives is slightly lower. The higher cash received can be highly valuable for some businesses, especially ones going through cash flow problems.

The approval process for recourse factoring is also less strict as compared to non-recourse factoring. This is mainly because, in this type of factoring, the factor has minimal or no risk at all. Therefore, factors are always willing to accept recourse accounts receivable factoring applications.

Finally, most non-recourse factoring options require businesses to sell all of their receivables to the factor. With recourse factoring, businesses get the option to sell only selected receivables to them. This can help the business only outsource recoverability of late-paying invoices and still hold to invoices that they expect to be received soon.

Disadvantages of Recourse Factoring

Recourse factoring has all the disadvantages of factoring and some other disadvantages specific to it. The main disadvantage of recourse factoring is that it is riskier for the business. As mentioned above, the ultimate responsibility for recoverability falls on the business rather than the factor. Therefore, businesses cannot use recourse factoring as protection against bad debts.

Recourse factoring may also cause a business to lose its assets. This is because if the factor cannot recover a receivable balance, the business will have to cover the invoice for the factor. While factoring accounts receivable may be better for startups and fast-growing businesses, it may also force them to sell their assets in case of failure to recover invoices.

What is Non-Recourse Factoring?

Non-recourse factoring or without recourse factoring is the opposite of recourse factoring, as the name suggests. In non-recourse factoring, the business selling its invoices is not held responsible for defaults or bad debts. This type of factoring is uncommon, as very few factors will agree to undertake the risks associated with bad debts. Non-recourse factoring can be used to both speed up the recovery of receivables, and protect against bad debts.

Non-recourse factoring will also limit the reason of bad debt that is acceptable to the factor. Therefore, the factor only agrees to absorb the bad debts that are caused due to a certain condition. Mostly, the condition is limited to the liquidation of a customer or debtor. This excludes bad debts caused due to genuine disputes with customers.

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With non-recourse factoring, there are still some risks involved when the business sells its receivables. The risks are, however, lower than with recourse factoring as the business does not have to accept responsibility for every type of bad debt.

Advantages of Non-Recourse Factoring

The most obvious advantage of non-recourse factoring is that it protects a business against certain types of defaults or bad debts. Businesses are covered in a without recourse factoring meaning that they aren’t responsible if a customer goes bankrupt or goes into liquidation. This can be very helpful for businesses in tough economic conditions.

While non-recourse factoring might be slightly more difficult to obtain, it is still easy for businesses to obtain it. Compared to other types of finance such as a line of credit or bank loans, non-recourse factoring is much easier to apply for and obtain. As long as the invoices of business are from creditworthy customers, there are no restrictions in getting non-recourse factoring.

Disadvantages of Non-Recourse Factoring

While non-recourse factoring may be easy to get as compared to other types of loans, very few factoring businesses offer it. This is mainly due to the reason that non-recourse factoring is riskier for them as compared to recourse factoring or other types of factoring services. Therefore, businesses may have a hard time finding a factor that offers non-recourse factoring.

Similarly, as mentioned above, recourse factoring allows businesses to sell selected invoices to the factor. Non-recourse factoring takes a more aggressive approach instead. Non-recourse factoring mostly requires businesses to sell all their receivables to the factor. Similarly, factors also check the creditworthiness of each customer.

Finally, non-recourse factoring is also more expensive as compared to recourse factoring. This is because accounts receivable factoring in this type can be more expensive to the factor. Therefore, they charge higher to cover their risks.

Non Recourse vs Recourse Factoring – Key differences

In both recourse and non-recourse factoring, there are typically several key differences. First of all, in recourse factoring the risks related to bad debts of balances falls on the business. In non-recourse factoring, the risk is borne by the factor, although its scope may be limited to liquidation or bankruptcy. This also means that in recourse factoring, the risks for the factor are lower as compared to non-recourse factoring.

Conversely, the risks for business are the higher in recourse factoring due to the responsibility for bad debts of receivables falling on the business. In non-recourse factoring, the risks, although still high, are slightly lower for the business as compared to recourse factoring.

Another difference is the cost of each type of factoring. Recourse factoring is cheaper for business as compared to non-recourse factoring. As mentioned above, this is mainly due to the risks being lower for the former type of factoring. This makes recourse factoring more affordable for businesses as compared to without recourse factoring.

How to Account for Accounts Receivable Factoring?

The accounting for factoring arrangements of accounts receivable is different for both the business selling its receivables and the factor. Similarly, the accounting treatment will differ according to whether the accounts receivable factoring type is recourse or without recourse. In order to understand clearly about the accounting treatment for both recourse and non-recourse accounts receivable factoring, let’s go through the examples below:

Accounting for Factoring with Non-Recourse

Example:

ABC Co sells US$100,000 of its accounts receivable to the factoring company. The contractual rights have been transferred to the factoring company to receive the cash flow. The factoring company provide the cash advance of 96% of total accounts receivable to ABC Co at the date of factoring agreement. ABC Co will still administer the collection of accounts receivable and upon receiving the collection, the company will make payment to factoring company.

Any uncollected accounts receivable, ABC Co has not any obligations to repay to the factoring company. Below are the relevant information regarding the factoring:

  • Book value of accounts receivable: US$100,000
  • Fair value of accounts receivable: US$99,000
  • The fee for factoring service: US$3,000
  • Service fee for the factoring: US$2,000
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One month later, the accounts receivable have been collected totally US$95,000.

Below are the accounting treatment for the non-recourse factoring for both seller and factoring company perspectives:

From Seller Perspective

From the seller’s perspective, the accounting treatment is done under IFRS 9 Financial Instruments. The business factoring accounts receivable will determine whether significant risks or rewards of ownership are transferred to the factor. With non-recourse factoring, the risks are transferred. Therefore, the accounting treatment for non-recourse factoring will be:

  • On the transfer date:
 DebitCredit
Cash96,000 
Loss on Factoring1,000 
Prepaid Factoring Fee3,000 
Accounts Receivable 100,000
(To derecognize the accounts receivable transferred to factoring company)  
  • On the collection date:
 DebitCredit
Cash95,000 
Amount Due to/From Factor 93,000
Servicing Revenue 2,000
Prepaid Factoring Fee 3,000
Factoring Expense3,000 
Amount Due to/From Factor93,000 
Cash 93,000
(To record the collection of accounts receivable as well as service earned and payment made to factoring company)  

From Factoring Company Perspective

The factoring company must also pass accounting entries in its books. However, for the factoring company, the accounting treatment will be the same for both options. This means that the factoring company will use the same accounting treatment for buying accounts receivable regardless of whether it is recourse or non-recourse factoring. The accounting entry is as follows:

  • On the transfer date:
 DebitCredit
Receivable from Seller99,000 
Deferred Factoring Revenue 3,000
Cash 96,000
(To record the purchase of accounts receivable from ABC Co)  
  • On the collection date:
 DebitCredit
Cash93,000 
Servicing Expense2,000 
Credit Loss4,000 
Deferred Revenue3,000 
Factoring Revenue 3,000
Receivable from Seller 99,000
(To record the collection of accounts receivable with net of credit loss as well as the service fee)  

As apparent from the above accounting treatments, in non-recourse factoring, the account receivables are written off as the risks and rewards are transferred. In recourse factoring, a liability is created instead, as the risks and rewards of ownership remain with the business. With recourse factoring, there might be a subsequent accounting treatment as well. If a customer pays the factor, then the liability and receivable balance are written off.

Accounting for Factoring with Recourse

Example:

ABC Co sells US$100,000 of its accounts receivable to the factoring company. The contractual rights have been transferred to the factoring company to receive the cash flow. ABC Co will guarantee the credit risk of accounts receivable at full amount. The factoring company provide the cash advance of 60% of total accounts receivable to ABC Co at the date of factoring agreement with the additional consideration to be paid upon successful collection of accounts receivable. The factoring company will charge interest at 10% until the full repayment of the advance. ABC Co will continue to service the accounts receivable.

Below are the relevant information regarding the factoring:

  • Book value of accounts receivable: US$100,000
  • Fair value of accounts receivable: US$99,000
  • Upfront payment: US$60,000
  • Interest: 10%

One month later, the accounts receivable have been collected totally US$95,000.

Below are the accounting treatment for the recourse factoring for both seller and factoring company perspectives:

From Seller Perspective

With recourse factoring, the risks are not transferred to the factoring company. Therefore, the accounting treatment for recourse factoring will be:

  • On the transfer date:
 DebitCredit
Cash60,000 
Loan from Factor 60,000
(To record cash advance from factor)  
  • One month later:
 DebitCredit
Interest Expense (60,000*10%/12)500 
Loan from Factor 500
(To accrue to interest expense on the advance from factoring company)  
  • On the collection date:
 DebitCredit
Cash95,000 
Credit Loss5,000 
Accounts Receivable 100,000
Loan from Factor60,500 
Cash 60,500
(To record collection of accounts receivable with net of credit loss and settlement of loan from factor.)  

From Factoring Company Perspective

The factoring company must also pass accounting entries in its books. However, for the factoring company, the accounting treatment will be the same for both options. This means that the factoring company will use the same accounting treatment for buying accounts receivable regardless of whether it is recourse or non-recourse factoring. The accounting entry is as follows:

  • On the transfer date:
 DebitCredit
Receivable from Seller60,000 
Cash 60,000
(To record cash advance to ABC Co)  
  • One month later:
 DebitCredit
Receivable from Seller (60,000*10%/12)500 
Interest Revenue 500
(To accrue to interest revenue on the advance to ABC Co)  
  • On the collection date:
 DebitCredit
Cash60,500 
Receivable from Seller 60,500
(To record settlement of loan to Seller)  

Conclusion

Businesses can sell their receivables to obtain cash earlier using factoring. There are many advantages of factoring, although it may come with some disadvantages. There are two types of debt collection services that factoring companies offer, recourse and non-recourse factoring. In recourse factoring, the business factoring accounts receivable is responsible for the recoverability of the receivables. In non-recourse factoring, the factor is responsible for recoverability of the receivables. However, in non-recourse factoring, the factor only absorbs bad debts from customers that have been liquidated or have gone. Each factoring method has its advantages and disadvantages.

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