Factoring Accounts Receivable

Factoring accounts receivable is the sale of a company's unpaid customer invoices to a specialist finance company, known as a factor, in exchange for immediate cash. The factor pays less than the full face value of the invoices, keeping the difference as its fee, and then collects the money from the customers when it falls due. Factoring turns accounts receivable that might take 30, 60 or 90 days to collect into cash within a day or two.

Factoring is widely used by small and fast-growing businesses, exporters, staffing agencies, apparel makers and transport firms, all of which tend to have long payment cycles and tight working capital. It differs from a bank loan because the factor relies mainly on the creditworthiness of the seller's customers rather than the seller itself.

A typical deal runs in three steps. The seller ships goods and issues invoices to customers as usual. It then submits those invoices to the factor, which advances a large part of their value up front, commonly 70 to 90 percent. When the customers pay, the factor releases the remaining balance to the seller, less its fees. Fees are usually expressed as a percentage of the invoice value for each 30 days the invoice is outstanding.

The most important term is who bears the risk if a customer does not pay. In factoring with recourse, the seller must buy back or replace any invoice the customer fails to pay. In factoring without recourse, the factor absorbs the credit loss, so it charges more and is more selective. In notification factoring customers are told to pay the factor directly; in non-notification arrangements they may not know their invoice has been sold.

A manufacturer sells $100,000 of receivables to a factor without recourse. The factor charges a 3 percent fee and holds back a 10 percent reserve for returns and disputes, releasing it once customers pay.

• The fee is 3 percent of $100,000, which is $3,000, recorded as a loss on sale of receivables or a factoring expense.
• The reserve is 10 percent of $100,000, which is $10,000, recorded as a receivable from the factor.
• Cash received now is $100,000 less $3,000 less $10,000, which equals $87,000.

The entry debits cash for $87,000, the receivable from the factor for $10,000 and the factoring loss for $3,000, and credits accounts receivable for $100,000. Any related allowance for doubtful accounts on those invoices is also removed, since the seller no longer bears the credit risk.

Under US GAAP (ASC 860), a transfer of receivables is recorded as a sale only if the seller gives up control. In broad terms, the receivables must be legally isolated from the seller, beyond the reach of its creditors even in bankruptcy; the factor must be free to pledge or resell them; and the seller must not keep effective control, for example through an obligation to repurchase. This is often called true sale analysis. If the tests are not met, as can happen with full-recourse deals, the receivables stay on the balance sheet and the cash received is recorded as a loan, similar to assigned accounts receivable pledged as collateral. IFRS 9 reaches a comparable answer through a risks-and-rewards and control assessment.

The main benefits are speed, predictability of cash flow, and outsourcing of collections and credit checks. Funding grows automatically as sales grow. The drawbacks are cost, which is usually higher than a bank line of credit, the loss of some control over customer relationships, and the possibility that customers read factoring as a sign of financial weakness. Related structures include invoice discounting, in which the seller keeps collecting from customers, and reverse factoring, in which a large buyer arranges early payment for its suppliers through its own bank.