Factoring of Accounts Receivable
The financial accounting term factoring refers to the process whereby a company sells its accounts receivable to another company. When accounts receivable is sold to a factor, the purchasing company assumes responsibility for collection of the money owed.
In the normal course of business, customers are constantly making purchases on credit and remitting payments. Factoring receivables to another party allows companies to reduce the sales to cash revenue cycle time. In addition to factoring, disposition of accounts receivable can also take place through what is known as pledging, or assignment.
The factoring process involves an agreement with a factor, which is a company that purchases receivables for a fee, and then collects the money owed directly from customers. Once sold, the receivables are removed from the seller's books. Generally, there are two approaches to factoring:
- Transfer with Recourse: when sold with recourse, the seller promises to buy back any receivables that are not collected by the purchaser; essentially guaranteeing payment.
- Transfer without Recourse: when sold without recourse, the purchaser assumes the risk of non-payment.
Companies selling receivables will create what's called a holdback account. This is used to absorb the credit losses that might occur under a sale with recourse agreement or the cost of sales discounts and returns under an agreement without recourse.
Company A would like to transfer $100,000 of receivables to First Factors Collection Group. Company A agrees to sell its receivables at a 5% discount, and will establish an account at 2% for sales discounts and returns customers may request when First Factors attempts to collect money owed.
The journal entries for Company A would be the same regardless if the agreement were with recourse or without. The holdback account (Due from Factor), would merely serve a different purpose under each arrangement: