Factoring Receivables

What is Factoring?

Factoring is the selling of accounts receivables to a third party to raise cash.

When a business sells products and services to a customer on account, the goods are delivered and the sales invoice is created, but the customer does not have to pay until the invoice due date. In the meantime, the business has its cash tied up in the customer account receivables until the customer pays.

Rather than wait for your customers to pay you and deal with the problems of collection, you can factor accounts receivable.

To factor the accounts receivable means that you sell your invoices to a factoring company. The factoring company is then responsible for collecting the accounts receivable in return for which it charges you a commission, normally based on the value of the invoices factored. Factoring accounts receivable allows you to obtain cash advances from the factoring company which frees up cash from working capital.

The process of factoring invoices includes the following steps.

  1. Sell goods to customers on credit terms and generate invoices.
  2. Submit invoices to the factoring company.
  3. Factoring company advances your business cash based on a percentage of invoice value.
  4. The business pays interest on the percentage advanced.
  5. The factoring company manages the collection of accounts receivables.
  6. Factoring company collects the accounts receivable from the customer.
  7. Factoring company pays your business the balance of the invoice after deducting a commission fee based on a percentage of the invoice value.

Flow Chart of Factoring Receivables Process

To explain the process of factoring receivables, we have set out the seven steps involved in the flow chart diagram below using typical example values based on accounts receivables invoices of 5,000.

factoring receivables

The factoring receivables process diagram is available for download in PDF format by following the link below.

Factoring Receivables Process
1 The business invoices the customer for products sold to them on account for 5,000
2 The business sells the invoice to the factor for a fee of 3% (150) of the invoice
3 Factor gives the business an 85% (4,250) advance and holds 12% (600) in reserve
4 Business pays interest on the advance of 4,250
5 Factoring company manages the collection of accounts receivable
6 The factor collects the invoice amount of 5,000 from the customer
7 The factor releases the reserve amount of 600 to the business

By factoring, the business has immediately released cash of 85% of the invoiced amount (4,250) back into the business, and will receive the reserve amount of 600 on the due date when the customer pays the factor. Having collected 5,000 from the customer and paid over 4,250 + 600 = 4,850 to the business, the factor is left with 150, which represents their fee for factoring the invoice.

Factoring Receivables Without and With Recourse

Factoring can be without recourse factoring or with recourse factoring. Without recourse factoring means that the business does not have to refund the factor if the customer does not pay and the factor bears the loss.

With recourse factoring means that the business has to refund the factor if the accounts receivable cannot be collected from the customer and the business bears the loss.

As without recourse factoring passes the liability for the uncollectible accounts on to the factor, the fees tend to be higher than those paid on with recourse factoring.

Factoring Accounts Receivable Journal Entries

Without Recourse Journal Entries

Using the numbers above as an example of factoring receivables accounting. When the customer is invoiced, the invoice (5,000) is posted to the accounts receivable ledger.

Accounts receivable
Account Debit Credit
Accounts receivable 5,000
Revenue 5,000
Total 5,000 5,000

When the invoice is factored, it is cleared from the accounts receivable ledger as the money is no longer due to the business from the customer. The cash advance (5,000 x 85% = 4,250) and the loss on factoring (5,000 x 3% = 150) are recorded, and the reserve (5,000 x 12% = 600) held by the factor is posted to the due from the factor account.

Invoiced factored without recourse
Account Debit Credit
Cash 4,250
Due from factor account 600
Loss on factoring 150
Accounts receivable 5,000
Total 5,000 5,000

After the customer has paid the factor, the reserve amount is received from the factor.

Reserve amount received from the factor
Account Debit Credit
Cash 600
Due from factor account 600
Total 600 600

The net effect of factoring the receivables of 5,000 without recourse is that the business has received cash of 4,850 and paid a fee to the factor of 150.

With Recourse Journal Entries

When the invoices are factored with recourse, the business will bear the loss if the customer does not pay the factor. The business will need estimate this loss and recognize this contingent liability (called a recourse liability) when it factors the invoices.

Suppose for example, the business estimates, based on past experience, that 500 of the invoices are doubtful, the recourse liability will be established at 500 and the loss on factoring is now 5,000 x 3% + 500 = 650.

Invoiced factored with recourse
Account Debit Credit
Cash 4,250
Due from factor account 600
Loss on factoring 650
Recourse Liability 500
Accounts receivable 5,000
Total 5,500 5,500

If the doubtful invoices are not paid by the customer, the business needs to buy them back from the factor and the factor will reduce the amount of the reserve paid over by the 500.

Reserve amount received less the recourse liability
Account Debit Credit
Cash 100
Recourse liability 500
Due from factor account 600
Total 600 600

The net effect of factoring receivables of 5,000 with recourse is that the business has received cash of 4,250 + 100 = 4,350, paid fees to the factor of 150, and has written of accounts receivable amounting to 500.

Last modified July 16th, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.

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