Accounts receivable factoring, also known as factoring, is a financial transaction in which a company sells its accounts receivable to a financing company that specializes in buying receivables at a discount. Accounts receivable factoring is also known as invoice factoring or accounts receivable financing.

The buyer (called the “factor”) collects payment on the receivables from the company’s customers.

Companies choose factoring if they want to receive cash quickly rather than waiting for the duration of the credit terms. Factoring allows companies to immediately build up their cash flow and pay any outstanding obligations. Therefore, factoring helps companies free up capital that is tied up in accounts receivable and may also transfer the default risk associated with the receivables to the factor.

Factoring companies charge what is known as a “factoring fee.” The factoring fee is a percentage of the amount of receivables being factored. The rate charged by factoring companies depends on things like:

• The industry the company is in.
• The volume of receivables to be factored.
• The quality and creditworthiness of the company’s customers.
• Days outstanding in receivables (average days outstanding).

Additionally, the rate depends on whether it is recourse factoring or non-recourse factoring.

Here is a comparison between the two:

• In transfer with recourse, the factor can demand money back from the company that transferred receivables if it cannot collect from customers.
• In transfer without recourse, the factor takes on all the risk of uncollectible receivables. The company that transferred receivables has no liability for uncollectible receivables.

Factoring companies usually charge a lower rate for recourse factoring than it does for non-recourse factoring. When the factor is bearing all the risk of bad debts (in the case of non-recourse factoring), a higher rate is charged to compensate for the risk. With recourse factoring, the company selling its receivables still has some liability to the factoring company if some of the receivables prove uncollectible.

Just as in most business and investment transactions, the higher the risk, the higher the interest rate.

For example, take the following situation: On October 1, Larkin Co. transfers $250 thousand of receivables, without recourse, and pays an 8% fee. In addition, the factor keeps an allowance of $15,000 to cover bad accounts. The journal entry would be as follows:

Note: $20,000 factor fee is considered interest expense because the company obtained cash flow earlier than it would have if it waited for the receivables to be collected.

There will be some kind of deadline on the agreement. Let’s say it ends on Sept 30 of the next year, and actual bad debts came to $16,000. Without recourse means that the $15,000 the company gave to the factor is the limit of the bad debt liability. The final entry would look like this:

If this had been with recourse, and since the actual bad debts exceed the amount initially retained by the factor, Larkin, Co. would have to pay the factor an additional $1,000 and the journal entry would look like this:

It is important to note that the type of factoring influences the amount of fee charged and the amount of security held by the factor. The scenario in this example is only for the purpose of comparing the two types. The amount of security retained may be zero under factoring with recourse because the agreement guarantees the factor that any debts that may turn out to be irrecoverable will be reimbursed. As with any business contract, the parties negotiate the terms, and there are as many variations as there are transactions.