Accounts receivable factoring:
The process in which a business entity sells its receivables to a financial institute (called a factor) is known as factoring or accounts receivable factoring. A factor is a financial institute or bank that buys receivables from business entities and then collects the payments directly from the customers.
Let’s illustrate this process with the example of accounts receivable factoring. Assume that, company A sells its receivables of $100,000 to the factoring institute. The service charges assessed by the factoring institute are 2% of receivables. So, the accounting entry in the book of company A would be as follows.
When Company A sells its receivables frequently, it records the service charges as a selling cost. On other hand, if a business entity infrequently sells receivables, it may report this amount in the “Other expenses and losses” section of the income statement.
Importance of factoring
One benefit of factoring is that the company selling its receivables receives immediate cash for operating and other purposes. Furthermore, depending on the terms of the factoring agreement, a portion of the risk of uncollectible accounts may also be transferred to the factor. Factoring is helpful for business entities in order to release their capital that is stuck with accounts receivables.
Service charges of factoring institutes
Factoring arrangements vary widely. Typically, the factor charges a commission to the business entity that is selling the receivables. Factoring fee ranges from 1–3% of the number of receivables purchased. Some factoring institutes offer a flat fee structure in which a one-time fee is charged in advance. However, the rate charged by factoring companies is determined based on:
- The volume of receivables to be factored
- Days outstanding in receivables
- The credibility of the debtor
- The industry that the business entity is in
- Whether it is recourse factoring or non-recourse factoring
Recourse factoring and non-recourse factoring
Accounts receivable factoring is of two types: With recourse and without recourse.
Transfer with recourse
In case of transfer with recourse, a factoring company can demand money back from the business entity (who sold receivable) if it is unable to collect the whole or partial account of receivable from customers.
Factoring institutes typically charge a lower rate for resource factoring than they do for non-recourse factoring.
Transfer without recourse
In this case, the whole risk of uncollectible debt is transferred to the factoring institute. So, the business entity that sold the receivable is free from any liability.