Factoring is a contract where a company transfers or sells its accounts receivable balance (the debtors balance) to a factor, usually a specialised factoring provider. This factoring can be with or without recourse to the factor.
The topic is of particular importance in the accounting treatment of the transaction and whether the company should keep reporting the accounting receivables or whether the company should remove them from the balance sheet. Accounting standards (IFRS and GAAP) distinguish two 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 or other lending agreements.
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, factoring with recourse and factoring without recourse.
Factoring Without Recourse
Factoring without recourse or 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 we disclose it 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. The risk of the debtor’s balance turning out to be not receivable remains with the company, rather than transferring 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, the factor will assess the creditworthiness and the recoverability of the accounts receivable. However, for a loan, the bank sets an interest rate that reflects the company’s creditworthiness 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 floating charge collateral is in place. Only if the loan becomes non-recoverable does the bank enforce the charge. However, under a factoring transaction, the asset is sold and not secured.
Without Recourse Example
Company A factors $1,000,000 of its accounts receivable to Factors Inc. without recourse. The factor applies a 5% interest fee and retains 20% of the receivables, which will be paid when all 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 company A will receive 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 in.
|31 March||Factor Loss||50,000|||
With Recourse Example
We will use the same example as above, but $20,000 is the estimated recourse obligation forecast based on the recoverability of the similar debtors’ balances.
|31 March||Factor Loss||70,000|||