## What is factoring

Factoring is a contract where a company transfers or sells its accounts receivable balance (the debtors balance) to a factor, usually a specialized factoring provider.

The topic is of particular importance when it comes to the accounting treatment of the transaction and whether the company should keep reporting the accounting receivables or whether they should be removed from the balance sheet. Accounting standards (Both IFRS and GAAP) distinguish two different cases, factoring with recourse and factoring without recourse.

## Advantages of Factoring

- A short term quick solution that can bring cash and help the company meet its short term obligations.
- The fees are usually based on the credit worthiness of the company’s accounts receivable (the company’s clients) and not on the credit worthiness of the company itself.
- The transaction is not secured with any of the company’s assets.
- The company does not increase its debt putting at risk any bank covenants.

## Disadvantages of Factoring

- Is it only a short term solution that should be used when the company faces liquidity problems.
- The fees including any interest payment can be substantial.
- It can be perceived by creditors and investors as a signal of debt and liquidity problems.

There are two different factoring transactions, a factoring with recourse and factoring without recourse.

## Factoring without recourse

Factoring without recourse or the non recourse factoring is the transaction where the rights and the obligations (including the risk of the receivables turning out to be a bad debt) are transferred to the factor.

The difference between the value of the receivables and the amount received is an expense and should be reported on the income statement. The non recourse factoring has increased fees that reflect the transfer of the risk to the factor.

## Factoring with recourse

Factoring with recourse has lower fees since the company does not sell the accounts receivable and the risk of the debtors balance turning out to be not receivable remains with the company and is not transferred to the factor.

## Difference between a loan and factoring

There are several differences between a loan that a company can take from a bank and a factoring transaction. First of all, the factor will assess the credit worthiness and the recoverability of the accounts receivable. However, for a loan, the bank sets an interest rate that reflects the creditworthiness of the company based on several factors which include the total assets, the debt to equity ratio, the profitability etc.

In addition, when a company takes a loan, the bank will provide the funding providing that a fixed or a floating charge is set as a collateral. The charge (either floating or fixed) is of course enforced only if the loan is considered as non recoverable. However, under a factoring transaction the asset is sold and not secured.

## Factoring without recourse example

Company A factors $1,000,000 of its accounts receivable to Factors Inc. without recourse. The factor applies 5% interest fee and retains 20% of the receivables which will be paid when the all of the receivables are collected.

Company A will therefore receive in total $1,000,000* (1-0.05)=$950,000. The company will record $50,000 as an expense on its income statement. The amount that will be received immediately is 75% * 1,000,000=$750,000.

The remaining $200,000 will be recorded as a receivable which will be collected when the factor collects the receivables that have been factored.

### Factoring without recourse journal entries

The journal entries are therefore as follows:

Debit Factor Loss $50,000

Debit Factor Receivable $200,000

Debit Cash $750,000

Credit Accounts Receivable $1,000,000

## Factoring with recourse example

We will use the same example as above but $20,000 is the estimated recourse obligation which has been forecast based on the recoverability of the similar debtors balances.

### Factoring without recourse journal entries

The entries are therefore as follows:

Debit Factor Loss $70,000

Debit Factor Receivable $200,000

Debit Cash $750,000

Credit Accounts Receivable $1,000,000

Credit Recourse Obligation $20,000