Account For Factoring

If you run a small or mid-sized business and extend credit to your customer, then you are obliged to wait for payment until the stipulated credit period is over. Factoring your receivables can bring immediate cash to augment your working capital without increasing your debt burden. This option is especially helpful if your customers demand long credit periods. To factor means to sell accounts receivables to another company, called a "factor." The factor will advance you a major portion of the receivable amount, retain the rest until the account is paid, and then charge you the mutually agreed fee, generally from three to 10 percent. Factoring can be performed with or without recourse, meaning either the buyer assumes full responsibility in the event of nonpayment, or the seller takes some responsibility. Both the process of factoring receivables and reflecting the transactions in the account books may seem to be very complex. By following these steps, you can easily account for factoring.

Steps

Factoring on a Non-Recourse Basis

  1. Negotiate an agreement with the factoring company. You will want to know what percentage of the receivables they will advance to you in cash, and you will want to know what their service fee is. On a non-recourse basis, the factoring company must take full responsibility if the accounts aren't paid, so they will charge a relatively high fee.
    • The percentage the factoring company will give you depends on the quality of the receivables (Home Depot vs. Joe Blow) and historical data on how long it has taken to collect payments.[1]
    • Major factoring companies include 1st PMF Bancorp (who will also provide international factoring services), American Receivable, and BlueVine.
  2. Sell and record the receivables. After selling your accounts receivable to a factoring company, you will need to record the transaction in the appropriate journal entry. For example, imagine you sell $10,000 worth of receivables to a factoring company that offers you an 80 percent cash advance and charges a 10 percent fee. (Note that these calculations will work equally well in other currencies.)
    • To record the journal entry, debit Cash for $8000, debit an account called Due from Factor for $1000, and debit Loss on Sale for $1000. Credit Accounts Receivable for $10,000.[2]
    • Due from Factor is an asset account, and is used to indicate the amount that the factor will pay you upon collecting the accounts in full. The factor's service fee is recorded as a loss in the Loss on Sale account.
  3. Record a journal entry when the accounts are collected. When the factoring company is paid, they will pay you the retainer. In the previous example, the journal entry would involve debiting Cash for $1000 and crediting Due from Factor for $1000.[2]
  4. Record a journal entry if a customer defaults. If the customer does not pay the amounts owed, you will not receive the retainer back from the factoring company and will have to record a loss. Using the previous example, imagine the accounts are not collected. To record the journal entry, debit Loss on Sale for $1000, and credit Due from Factor for $1000.[2]

Factoring on a Recourse Basis

  1. Negotiate an agreement with the factoring company. Just like factoring without recourse, you want to know how much of a cash advance you will receive, and you want to know what fee you will be charged. When factoring with recourse, your company is liable if the accounts can't be collected. Because of this, you have to record a liability upon sale of the receivables called a "recourse liability."
  2. Sell the receivables, and record the appropriate journal entry. For example, imagine you sell $10,000 worth of receivables to a factoring company that offers you an 80 percent cash advance and charges a 2 percent fee. Based on historical data regarding your receivables collections, you estimate that the recourse obligation is worth $500. This means you expect that about $500 of these accounts will not be collected, and you will have to record the associated loss.
    • To record the journal entry, debit Cash for $8000, debit Due from Factor for $1800, and debit Loss on Sale for $700. Credit Recourse Liability for $500, and credit Accounts Receivable for $10,000.[2]
    • The Loss on Sale account now includes both the factor's fee and the expected loss due to doubtful accounts. In keeping with the conservatism principle of accounting, the loss is recognized even before it is incurred. A gain will be recorded later if the accounts are actually collected.
  3. Record the journal entry when the accounts are collected. When the factoring company is paid, they will pay you the retainer. In the example above, assume all the accounts are collected. To record the journal entry, debit Cash for $1800, debit Recourse Liability for $500, credit Gain on Sale for $500, and credit Due from Factor for $1800.[2]
  4. Record a journal entry in case of customer default. If some of the accounts are not paid, you must buy those accounts back from the factor. In the previous example, assume that $9500 of the accounts was collected and $500 defaulted. To record the journal entry, debit Cash for $1300, debit Recourse Liability for $500, and credit Due from Factor for $1800.[2]

Weighing the Pros and Cons of Factoring

  1. Consider the positive aspects of factoring. If you are having cash flow issues, your customers take a long time to pay, or you need to spend a large amount of money on raw materials before you even start a job, factoring may work well for you. The small fee you pay is the trade-off for getting cash immediately in exchange for your receivables.[3]
  2. Consider the negative aspects of factoring. Over time you may be losing a lot of money that you are paying as fees to the factoring company. It might be more profitable to get a line of credit from a bank to help with cash flow, secured with your receivables. However factoring might be the best solution if you have bad credit, an unproven business venture, or nothing to offer as collateral.[1]
  3. Investigate the online marketplace for factoring. Companies such as The Receivables Exchange let you post your receivables on their private website, and then factoring companies bid on them. You might get better financing rates as a result.[1]

Tips

  • Although factoring operates on similar principles in different countries, the exact journal entries will differ based on each country's reporting standards. The examples above are consistent with U.S. Generally Accepted Accounting Principles (GAAP). However, you must find out and follow the standards applicable to you.
  • Your customers may have reservations about making payment to a third party. Take them into confidence, preferably at the time of accepting their order and reveal that you intend to engage a factor to collect payment. However, you may be able to negotiate this with the factor so customers continue to make payments to you.[1]
  • Be sure to notify your customers when their accounts have been factored as they will be paying their invoices to the factoring company, not to you, unless you have negotiated this term away with the factor.[1]
  • Get feedback from your customers on the style, conduct and behavior of the factor.

Things You'll Need

  • Accounting software

Related Articles

Sources and Citations

  1. ↑ 1.0 1.1 1.2 1.3 1.4 http://www.bloomberg.com/bw/stories/2008-10-03/the-pros-and-cons-of-factoringbusinessweek-business-news-stock-market-and-financial-advice
  2. ↑ 2.0 2.1 2.2 2.3 2.4 2.5 http://accountingexplained.com/financial/receivables/factoring-of-accounts-receivable
  3. ↑ https://www.gov.uk/business-finance-explained/invoice-financing
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