I was recently asked the following question by one of my students on whats app and I thought I would share my it and my answer more widely!
If the company is factoring trade receivables then my understanding is that I am legally selling my trade receivables for an amount of cash less than the nominal. Say my debtors are $100,000 I might only get $90,000 from the factor – the bank. So I debit cash $90,000 – but what next?
Tom replies
There are two answers! And it all depends on the substance (truth) of the factoring arrangement.
First it is necessary to understand who has the risks & rewards of this asset. With receivables the primary risk is default (bad debt).
1st answer
It could be that the trading company has really and truly sold the rights to receive the cash and so has actually passed away the risks and rewards of ownership. In other words it no longer carries the risk of bad debt.
In these circumstances it will then derecognise the asset – in other words the receivables disappear and there is an expense of $10,000 recognised.
Dr Cash $90,000 – hello cash
Cr Asset $100,000 – goodbye asset
Dr Expense $10,000 – hello expense
This is appropriate where the factoring arrangement is without recourse for bad debts. So if the receivable goes bankrupt then it is the factor (bank) who suffers and not the trading company.
OR 2nd answer
The substance of the transaction could be that the $90,000 received is really an interesting bearing loan.
This would be the case if the factor (bank) has a right of recourse so if the receivable does not pay up the trading company would have to refund the monies received (plus interest). In this case the trading company may have legally sold the asset but it still has the risks and rewards associated with the asset – so the receivable remains recognised as asset.
Here the economic reality – the truth as to why $90,000 has been received is that it is a loan. It is an obligation that is secured against the asset. This is factoring with recourse.
Dr Cash $90,000 – hello cash
Cr loan $90,000 – hello liability
Comment
The first answer although results in a small immediate hit to PL – is often favoured by creative accountants wanting to engage in off balance sheet finance to minimise gearing and to keep with debt covenants.