## 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.

By using factoring, the business can release this cash by selling the invoices to a third party, normally called the factor.

The process of factoring receivables has five basic steps, which can be seen in the illustration to the left.

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

## Flow Chart of Factoring Receivables Process

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

1 | The business invoices the customer for products sold to them on account for 5,000 |

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2 | The business sells the invoice to the factor for a fee of 3% (150) of the invoice |

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3 | Factor gives the business an 85% (4,250) advance and holds 12% (600) in reserve |

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4 | The factor collects the invoice amount of 5,000 from the customer |

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5 | 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.

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.

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.

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.

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.

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.