Accounting: The Language of Business - Vol. 2 (Intermediate: Part 145)

• 2 Corinthians 8:21

  "Money should be handled in such a way that is defensible against any accusation"
• 
  

Short-Term Operating Assets: Cash and Receivables (Part J)

by

Charles Lamson

Factoring Accounts receivable

Factoring accounts receivable occurs when a company sells its accounts receivable to a third party, known as a factor, at a discount. In most factoring arrangements, customers are instructed to pay the factor directly. The factoring company discounts or reduces the amount remitted due to the risk of bad debts and the cost of collection.

Accounting for a factoring transaction depends on whether the arrangement qualifies as a sale and whether the sale includes conditions guaranteeing collection of the receivables.

Sales versus Secured Borrowing. When a company factors its receivables, it must first determine whether the transaction meets the requirements to record the transaction as a sale.

 Companies must meet all of the following conditions in order to record the transaction as a sale (The specific conditions are presented in paragraph 5 of FASB ASC 860-10-40—Transfers and Servicing - Overall - Derecognition.):

1. The receivables are isolated from the selling company. That is, the receivables must be out of the reach of the seller as well as its creditors—even in the case of bankruptcy.

2. The factor has the ability to pledge or exchange the receivables.

3. The selling company does not maintain effective control over the receivables (i.e., there is no continuing involvement by the selling company).

In general, these conditions, summarized in Exhibit 9.5, ensure that the seller does not retain any control of the receivables.

EXHIBIT 9.5 Sales versus Secured Borrowing

If the company determines that the factoring arrangement is a sale, it derecognizes the receivables (i.e, the company removes the receivables from the balance sheet). If the transaction does not qualify as a sale, the company treats it as a secured borrowing by using the same accounting as if the company had pledged or had assigned the receivables, which we discussed in Part 144.

If a transaction meets the conditions to be recorded as a sale, the accounting depends on whether the receivables are sold with or without a recourse provision guaranteeing that they will be collected in the factoring contract.

Factoring without Recourse. If the receivables are transferred without a guarantee of collection, the factor assumes the risk of uncollectible accounts and absorbs any credit losses. The customers now pay the buyer or factor. When the seller does not guarantee collectibility, the receivables are transferred without recourse. When factoring receivables without recourse, the seller company no longer retains any of the risks or rewards of the receivable.

When the sale of accounts receivable is made without recourse, the selling company removes the accounts receivable from its books and records the related gain or loss on the transaction as shown in Example 9.10. The gain or loss is the difference between the proceeds on the sale and the face amount of the receivables factored adjusted for any hold back. A hold back is an amount of cash that the buyer does not remit to the seller but instead retains as additional security. The seller recognizes the amount of the hold back as a type of receivable on its books. After the receivables are fully collected, the buyer returns the holdback amount to the seller.

Factoring with Recourse. When a seller transfers receivables with recourse, the seller guarantees that all or part of the receivables transferred will be collected. The selling company assumes the risk of uncollectibility and resulting credit losses. The seller separately recognizes any liability created by the guarantee by recording a recourse liability along with an additional estimated loss for possible losses due to the guarantee. The seller estimates the amount of the recourse liability as the amount that the buying company is not expected to collect. Example 9.11 provides an example of accounting for a factoring with recourse.

Factoring Accounts Receivable: International Financial Reporting Standards (IFRS). IFRS differs from U.S. GAAP by determining whether a factoring arrangement is a sale based on the transfer of contractual rights to the cash flows [IFRS Requirements for derecognition of financial assets are in Section 3.2 of IASB, International Financial Reporting Standards 9, “Financial Instruments” (London, UK: International Accounting Standards Board, 2014, Revised)]. When a company transfers the contractual rights to receive the cash flows from the receivables, it assesses whether it has also transferred all the risks and rewards of ownership. If it has, then the transfer is a sale. If the seller retains substantial risks and rewards of owning the receivable, he still may have a sale, but only if he meets three conditions. A company retaining the contractual rights to receive the cash flows must meet three conditions for the transfer to be considered a sale:

1. The company does not have to pay the factor unless it collects the receivables.

2. The company cannot use the receivables as collateral for other transactions.

3. The company has to pay the factor the cash it collects without a long delay.

Exhibit 9.6 provides a flowchart of the sale versus secured borrowing decision under IFRS. Observe that under U.S. GAAP, isolating the receivables and giving up effective control over the receivables are both required for a sale as Illustrated in Exhibit 9.5. However, under IFRS, receivables do not have to be isolated and companies do not have to give up effective control as long as they pay out any cash collected on a timely basis to the factor.

Although U.S. GAAP and IFRS use somewhat different criteria in determining whether the transfer is a sale, both standards often arrive at the same conclusion.

At December 31, 2016, Fiat Chrysler Automobiles N.V., a European car manufacturer and IFRS reporter, had transferred without records and derecognized €6,573 million of receivables. Fiat Chrysler indicates that even though some transactions may be legally viewed as a sale of receivables, it does not substantially transfer the risks and rewards associated with the receivables because of the significant loss guarantees and its continuing exposure. As such, these transactions do not meet the conditions required to record these transactions as sales. The carrying amount of Fiat Chrysler's transferred receivables not derecognized and the related liabilities total €410 million (Fiat Chrysler Automobiles N.V.'s 2016 financial statements).

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 460-463*

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