Accounting for Factoring Receivables: How to Record Factoring Transactions
Small business owners have more forms of financing available to them than ever before, including invoice factoring, also sometimes known as factoring receivables. Whether you’re new to accounts receivable financing or not, knowing how you should be accounting for factoring receivables in your accounting software is often a pain point for small business owners. This post will give you a complete overview of accounting for factoring receivables, no matter your accounting software. While there are some specifics unique to each program, the general flow is more or less the same. Before we get into the nitty gritty, though, let’s go over a quick explanation of the various aspects of factoring receivables.
What Is Factoring Receivables (a.k.a., Account Receivable Factoring)?
Factoring receivables is a funding solution that allows small businesses to turn their unpaid invoices into cash on hand. Oftentimes, B2B companies have large customers who require payment terms of 30, 60, or even 90 days or more. Instead of waiting for weeks or months for your customers to pay their invoices, a factoring company gives you working capital for your invoice (minus a fee), giving you cash weeks or even months ahead of the original invoice terms. Your customer then pays the invoice to the factoring company according to the original net terms. This way, you have access to the cash flow you need to take on a big project to grow your business, make payroll, buy equipment and more, while your customer benefits from extended payment terms. If you want a more thorough explanation of factoring receivables, see our post, “What Is Invoice Factoring?”
How Factoring Receivables Works
Knowing how the invoice factoring process works is important background information to understand if you want to properly record invoice factoring transactions. Here are the basic steps:
- First, see if you qualify. (With FundThrough, the process takes just a couple of minutes and is completely free.)
- Next, submit your invoices. You can either do this manually, or connect to a supported invoicing software or accounting software if your factoring partner offers those options.
- Complete final steps. Once the invoice and your customer are deemed eligible and payment has been redirected, complete any final steps required for approval, after which funds are deposited to your account.
- Put your capital to work how you want. Use it to cover things such as payroll or operational expenses, or take on new projects.
- The factoring company then waits for outstanding receivables to be paid by your customer.
- Rinse and repeat anytime you need a quick boost of funding.
If you’re interested in learning more about accounting for factoring of receivables, our Complete Guide to Invoice Factoring answers 45+ questions you might have about the invoice factoring process.
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Advantages of Factoring Receivables
If you’re a small business that wants access to fast and flexible working capital to cover ongoing operational expenses or new expenses, factoring unpaid receivables for your business has many benefits. They include:
- Fast funding. Working with a bank or other lender to get access to funds can take weeks or even months, and involve a bunch of paperwork. Business accounts receivable factoring can put money in your account often in a matter of a few business days.
- Flexible working capital. Fund only the invoices you want, when you want. Best of all, there’s no long-term obligation once the invoice has been paid to the factoring company.
- Easy experience. Today’s modern factoring companies make the whole process as seamless as possible from start to finish, with online applications, integration with popular accounting software, and dedicated account management.
- Avoiding bank hassles and rejection. Unless you’ve been in business for a number of years and can prove your profitability, it can be very hard to get funding from a bank or other traditional lender. With accounts receivable factoring that’s not an issue. Because the factoring company is working with your customers, it’s their credit risk and business history that is most important.
- Growing your business. Allows you to fund a growth project or opportunity to help scale your business. You can even bid on larger projects when you have fast access to working capital.
- No debt. Invoice funding is not like traditional loans, so you aren’t adding any debt to your balance sheet with factoring in accounting.
- No dilution. Factoring does not require you to give up any ownership stake in your business, making it an ideal source of funding for those who want to remain in control of their business.
- Peace of mind. You no longer have to worry about uneven cash flow, and can better manage your day-to-day operations such as covering payroll or purchasing supplies. It can also help relieve any seasonal strain your business may typically experience, and lets you bolster your books by funding invoices at strategic times.
- Reduced admin load. Instead of spending your time tracking and chasing down payments, the factoring company takes care of that hassle for you. Accounts receivable factoring gives you back time to do what you do best – growing and running your business.
- Credit history is less important. Your personal credit rating or business credit history or credit score isn’t an issue when factoring receivables. Because factoring relies on your customer’s ability to pay the invoice, it’s their credit score and history that a factoring business is more concerned with.
- Another source of working capital for your business. You may have a credit card or line of credit, but accounts receivable factoring services complement them by providing additional funds on top of those existing financing options.
Disadvantages of Factoring Receivables
Some potential disadvantages to factoring receivables include:
- Concern about how a factoring firm will interact with your customers. We know how hard you’ve worked to build relationships with your customers, and you rightly want to ensure that any company you partner with will treat them with respect. Factoring has a bit of a bad reputation due to some companies aggressively pursuing customer payment and damaging relationships. Read more about how FundThrough works with your customers if you’re concerned about this.
- Hidden fees or not getting the full invoice total advanced up front. At FundThrough, we don’t charge hidden fees and we offer 100 percent advance rates.
- Long-term commitment (depending on factoring company). Some invoice factoring companies will make you sign a factoring agreement requiring you to do receivable financing for all invoices to a particular customer or a minimum monthly funding amount (instead of letting you choose which ones to factor, like we do here at FundThrough).
How to Set Up Accounting for Factoring Receivables
Factoring accounting for outstanding receivables can be tricky. We’ve broken down the process step by step for recording invoice factoring in your business accounting software. We’ve also included how recording factoring fees works. (If you use Quickbooks, see specific instructions for accounting for factoring in Quickbooks.)
Once you’ve received payment for the invoice from the business factoring company
1. Create an account for factored invoices
In your Chart of Account, create a liabilities account just for factored invoices. You’ll use this account for the advances from your factored invoices. You can call it something like, “loan payable – factor”.
2. Create an account for factoring fees
Follow the same steps as above to create an expense account for the factoring fees. You can call it something like, “factor fees”.
3. Create an invoice
Create an invoice just as you normally would.
4. Record a deposit
For the account, choose your liabilities account for factored invoices. Put the invoice number in the description section. In amount, put the full dollar amount of the invoice being factored.
5. Record the fee
Add a line in the same deposit. For the account, choose the expense account for factor fees. In the description amount, put the dollar amount of the invoice times the discount rate. (For example, if you had a $10,000 invoice factored with FundThrough, you’d record this as 10,000 X .0275 since our rate is 2.75 percent for a net 30 invoice.) For the amount, enter the fee amount as a negative number. At this point, make sure the net amount matches documentation from the factoring company. Save and close.
Once the customer payment has been received by the factoring company
6. Record the received payment
Go to Receive Payment. Put in the customer name for the outstanding invoice and the full invoice amount in the amount received. Under “Deposited to” choose “undeposited funds”. Save and close.
7. Apply payment to loan
Go to Bank Deposits. Select the deposit you just recorded. Under “Add funds to this deposit,” choose the liabilities account for factoring you created for the account section (such as “loan payable – factor”). In the amount section, record the full dollar amount of the invoice as a negative number. This will create a net zero deposit that records the loan as paid off. Save and close.
Step-by-Step Accounting for Factoring Receivables: Recourse and Non-Recourse
In addition to the steps above, how you document factoring receivables accounting will also depend on whether or not you’re factoring without recourse or with recourse. Each type of factoring process requires slightly different journal entries.
Briefly, factoring with recourse means if your customer fails to pay to the factoring company, you’re obligated to pay the invoice back. Since you’re guaranteeing recovery for the invoice, a recourse liability is determined and recorded. When accounts receivable are non-recourse factoring, the factoring company accepts any loss resulting from non-payment. Basically, you’re not obligated to pay the invoice back in the unlikely event that your customer doesn’t pay the invoice. Here’s how to record transactions based on the types of factoring.
How to Record Non-Recourse Factoring Transactions
Let’s look at an example to help understand how accounting for factoring receivables works.
The FastGrowth company factors $375,000 of accounts receivable with Ample Finance on a non-recourse factoring basis. Ample Finance does an assessment and determines a fee (also known as a discount rate) of 5 percent. It advances 90 percent of the invoice, retaining 10 percent of the invoice amount. When FastGrowth’s customer pays the invoice, Ample Finance will remit the 10 percent to FastGrowth, less their 5 percent discount rate.
Both FastGrowth company and Ample Finance will need to make journal entries in their accounting software for the above information, but we’re only going to focus on FastGrowth.
If you’re FastGrowth Company and accounting for factoring receivables without recourse, you’ll make the following journal entries on their balance sheet:
- Record the amount sold ($375,000) as a credit in accounts receivable.
- Record the cash received ($318,750) as a debit in the cash account.
- Record the paid factoring fee ($18,750) as a debit loss.
- Record the amount the factoring company retained ($37,500) in the debit-due account.
How to Record Invoice Factoring Transactions With Recourse
We’ll continue using the example above. If FastGrowth company estimates that the fair value of the recourse liability is $750, the journal entries to be recorded on their balance sheet are given below:
- Record a credit in accounts receivable for the sold invoice in the amount of $375,000.
- In the recourse liability column, record a credit after estimating the bad debts and any other possible losses ($750).
- Record the cash received ($318,750) as a debit in the cash account.
- Record the discount fee ($18,750) and the estimated bad debts ($750) as a debit loss.
- Record the amount the factoring company retained ($37,500) in the debit-due account.
What to Consider When Choosing a Factoring Company
There are a few main things to consider when choosing a factoring company for your business. They include:
Industry expertise. There’s no shortage of receivables factoring companies out there, but it makes sense to work with one that has experience in your industry. This means the company will already know and understand the unique characteristics of your business – you won’t have to waste time explaining the ins and outs to them.
Flexibility. Another thing to consider when looking at receivable finance companies is the amount of flexibility it offers to its clients. Some important questions that can help you determine how flexible a business factoring company is include: How long must I remain in the factoring relationship? Do you require a personal guarantee? Do I have to factor all my unpaid invoices? Is there a minimum (or maximum) amount I can factor?
Customer service. A good factoring company is one that’s available to its clients when they need them. Evaluate email and telephone response times during the sales process to get a feel for how a factoring company values its customer service.
Stability. Just as it’s important to find a factoring company that knows your business, it’s just as important to find one that’s well established and has a reliable track record in the factoring industry. At a minimum, look for a company that is affiliated with the International Factoring Association (IFA). IFA members must adhere to a strict code of ethics and business practices.
Cost. Finally, you’ll want to consider the cost of factoring when looking at factoring companies. Don’t forget that depending on the invoice factoring company, you could be looking at a high factoring fee, hidden fees, or not getting the full invoice total advanced up front. Be sure to ask about all potential fees up front so that you can more easily compare your options.
How Much Does Accounts Receivable Factoring Cost?
The main factor fee is called the discount rate. This is the amount of money that invoice factoring companies withhold from the invoice total as their payment for giving you a cash advance and waiting to get paid for you. You can expect to pay somewhere between 1 and 5 percent. Sometimes, however, factoring companies charge hidden fees on top of this depending on the factoring arrangement.
The invoice factoring fees you can expect vary between companies and the type of factoring transaction. In addition to the percentage a factor keeps, sometimes there are hidden fees to watch out for:
- ACH fee. This is the fee for the bank wiring funds to your account, passed on to you from the factoring firm.
- Application fee. A flat or percentage fee that’s highly variable.
- Invoice processing fee. A fee charged for getting your invoices processed in the back office.
- Closing fee. An additional amount the invoice financing company keeps from the invoice
- Monthly fee. If you sign a long-term contract requiring that you sell a certain portion of your invoices each month and you don’t meet the monthly minimums, you could end up paying this fee.
- Termination fee. Again, this applies if you signed a long-term contract and want to end it early.
It’s easy to see how hidden fees can make the cost of invoice factoring add up over a period of time, making it an important question to ask any factoring company you’re considering. Here’s where you can find more info about invoice factoring rates.
To give you our perspective, FundThrough’s factor fee is 2.75 percent per 30 days. We don’t charge any hidden fees. See our pricing page for more on what you can expect to pay for invoice funding.