Account receivables are a very important asset for any business. Account receivables represent the proceeds of revenues that are still unpaid.
When a business entity makes sales, all sales are not cash-based. However, a considerable percentage of the sales are made on a credit basis. The customers are supposed to make payments in the future.
Customers agree on different terms with the businesses. These terms can vary according to the amount outstanding, frequency of orders, and other factors that a business & buyers might agree on. However, in general, the account receivables are current assets that are paid within 12 months or one financial year.
However, the company might need funds during the period to pay for the expenses or any other business needs. There are several options for business entities to finance their needs, including the line of credit, bank loans, etc. However, there is another option that businesses might go for.
Yes, it’s the factoring of account receivables.
In this article, we are going to talk about factoring in account receivables. We will also discuss why do businesses opt for this option and how the journal entries for factoring are recorded in the accounting books of any entity.
So let’s get into it.
What is Factoring of Receivables?
Factoring of account receivables can be defined as,
“When a company decides to sell its account receivables to authorized third parties to meet their immediate cash needs, the practice is called factoring of account receivables.”
We can also define factoring as
Any company discounts account receivables when it sells the receivables at a lower price than the face value. The third-party buyers will charge a fee for taking the risk that is equal to the difference between the face value and selling price.
A business keeps the invoices against the account receivables. These receivables- are transacted against cash to meet the needs of any business. Businesses usually go after this method to avoid tying up cash in the form of account receivables.
Contingent liability can be explained as a material liability that might occur in the future. However, when a company factors its receivables, it gives rise to a contingent liability for the business entity.
Therefore, the companies record contingent liability in their notes to financial statements. If certain account receivables become bad debts, the contingent liability is recognized as a loss.
Why Does a Business Entity Factor Its Receivables?
It’s a common question why does a business entity factor in its receivables instead of other options?
The most obvious reason to go after factoring in receivables is to get immediate access to cash. Cash needs can arise to pay salaries, and suppliers, purchase inventory, or acquire more clients. However, the other reasons why the company goes for the option of factoring can be qualitative.
These reasons include improving cash flow from slow-paying clients’ inability to qualify for bank loans or lines of credit.
Sometimes, the turnaround situations when financial statements do not look good to get financing also make it inevitable for any entity to go after alternative options.
To sum it up, most of the reasons why companies go after selling their receivables relate to bad credit, bankruptcies, or unsatisfactory financials to get a loan.
Types Of Factoring
Factoring can be of two types: factoring with resources and factoring without resources.
Factoring With Resources
Transfering receivables with resources mean that the companies agree to get cash against the account receivables, but the risk is not transferred to the third party.
If one or more debtors of the factoring entity default, the factoring agent will claim the amount from the business entity.
The discounting of receivables with resources is recorded as short-term debt in accounting books. When the entity recovers the cash from debtors, the short-term debt is written off.
However, in the case of bad debts, the recognition of bad debts is made in accounting books by crediting the holdback amount.
Factoring Without Resources
The business entities might choose to sell their receivables without resources. The risk and responsibility are transferred to the factoring company, and the selling company doesn’t owe anything for the bad debts or uncollected receivables. It implies that no liability remains at the company’s end.
The selling company doesn’t make any additional entry other than the one to debit the cash and credit the account receivables. However, the interest expense is higher in the case of discounting without resources.
It’s important to understand the method of recording journal entries for discounting receivables. We will discuss journal entries in both scenarios of discounting with resources and discounting without resources.
We will discuss both cases when the discounting is done and what if a certain amount of receivables remain uncollectible.
Case 1. Selling Receivables
The first case is selling receivables to a factoring company.
Let’s assume that a company, Al-Khair, has decided to factor the account receivables with a factoring company ABC. The amount of account receivables is USD 4,000,000.
- Let’s discuss the scenario of factoring with resources.
In this case, an amount of reserve is kept with the factoring agent. They have decided to factor in receivables at 6%. The amount of reserve is USD 500,000. Besides, the short-term debt is credited in the journal entry. There is no effect on receivables when the receivables are discounted. The journal entry for discounting with resources will be as follows:
|Due to Factor(Hold Back||500,000|
- The second case will be when the company decides to factor without resources.
All the terms described in the example description will remain the same when the company is factoring in the receivables without resources. However, there will be no reserve held back by the factoring company.
The amount can be as much as double what the company will pay in case of factoring in resources. Besides, the interest rate is also higher when the company goes after discounting without resources. The interest rate will be 12% instead of 6%.
How the accounts are debited and credited in the books also varies when the company is discounting the account receivables without resources. The following journal entry will be made in the accounting books in this scenario:
Case 2. When Your Customer Doesn’t Pay Back
The second case is when the account receivables become due, and a certain amount of collectibles become bad debt. The journal entries and accounting treatment for factoring with resources will be different from factoring without resources. So let’s have a look at the journal entries in either case.
- Account receivables became due, and it was found that USD 100,000 out of the total account receivables remained uncollectible. Therefore, the amount is bad debt for the transferring entity. The company has received USD 3,900,000 as proceeds from the receivables.
The first entry to be made by transferring company is to record the bad debts. It will be as follows:
|Allowance for bad debts||100,000|
|Due to Factor(Holdback)||500,000|
The next entry will be passed into accounting books to write off the remaining debt against the interest expense. The journal entry will be as follows:
- No liability remains at the company’s end when they discount their receivables by transferring invoices(without resources). Therefore, no entry or recognition has to be made in their accounting books if certain debts remain uncollectible. All the responsibility and risk remain with the factoring agent. Therefore, no journal entry is passed in accounting books.
Factoring or discounting of account receivables is common for new and small businesses with a high collection rate but less access to credit facilities.
It’s important to understand how the phenomenon works and how it is recorded in the financial records of any business entity.
We will conclude with a note that factoring/discounting of receivables is different from the assignment of receivables. Receivables are assigned by signing an agreement with a third-party financing company to assign the account receivables as collateral security against the loan.
However, the factoring is about selling the receivables to the factoring company. Therefore, the difference between the two methods should be understood for accounting treatment in each case.