By Stephen Clyde, CPA, Manager at Blue & Co.
In today’s environment, many manufacturers and distributors are taking a fresh look at how they manage working capital. Longer customer collection times, increasing pressure on margins, and tighter lending conditions have pushed accounts receivable (AR) factoring back into consideration as a tool to help manage cash flow.
While factoring can provide an immediate boost in liquidity, it is not just a financing decision. It has meaningful accounting and financial reporting impacts. Understanding how these arrangements impact financial reporting under Accounting Standard Codification (“ASC”) 860, Transfers and Servicing, prior to entering into a factoring arrangement, can help you avoid unnecessary surprises on your balance sheet and with your banking relationships.
What is an AR Factoring Arrangement?
Put simply, AR factoring involves transferring receivables to a third-party (“Factor”) in exchange for cash. The amount of cash received upfront is typically 70 percent to 90 percent of the invoice amount. When the Factor collects on the invoice, the remaining amount, less a factoring fee, is remitted.
This can be attractive in instances where working capital is tied up in inventory and receivables with longer payment terms, such as the manufacturing industry.
Common Factoring Structures
Without recourse: The Factor assumes the risk of customer nonpayment.
With recourse: The company retains the risk of customer nonpayment.
While the difference between the factoring arrangement structures is important, it is not the sole factor in determining the proper accounting treatment. Under ASC 860, the accounting treatment depends on whether the transfer of receivables meets the criteria to qualify as a sale or a secured borrowing.
If the transfer qualifies for sale treatment, the receivable is removed from the balance sheet at the time of transfer, whereas under secured borrowing treatment, the receivable remains on the balance sheet. If you have sensitive covenants, it is important to be aware of this difference in accounting treatment.
How Do You Determine Whether a Receivable Transfer Is a Sale or a Secured Borrowing?
ASC 860 identifies three conditions that must be met in order for the transfer to qualify for treatment as a sale:
- The receivable must be legally isolated from the Company after transfer
- The factoring company must have the right to pledge or exchange the receivable
- The Company cannot retain control of the receivables after transfer. If the Company can be required to repurchase the receivables or provide guarantees, this indicates they still have control and risk related to the receivables.
As you can see, this is a bit more nuanced than the with-recourse vs. without-recourse distinction. The accounting treatment is driven by the substance of the transaction, not just the title of the agreement.
How Does The Accounting Treatment Impact My Financial Statements?
Sale treatment: As noted above, under sale treatment, the receivable is removed from the balance sheet at the time of transfer. Typically, a loss is associated with derecognition of the receivable due to factoring fees.
Secured borrowing treatment: The receivable remains on the Company’s books until the invoice is collected by the factoring company. When the cash is received upfront, a liability is recorded for the same amount. Financing costs (e.g., interest or fees) are recorded over time until the invoice is collected by the factoring company.
The receivable is extinguished when the invoice is collected, and the liability is reduced accordingly. Cash may or may not pass back through the Company.
Steps To Take Before Entering a Factoring Arrangement
- Engage accounting advisors to determine the accounting treatment under ASC 860
- Forecast the impact on financial statements, key financial ratios, and any covenants based on accounting treatment
- Understand how stakeholders will view the factoring arrangement
Planning Ahead for Financial Reporting Impacts
Accounts receivable factoring can be an effective working capital tool, but the accounting and financial reporting implications should be evaluated before an agreement is signed. If you are considering a factoring arrangement, contact your Blue & Co. advisor to discuss how ASC 860 may impact your financial statements, key performance metrics, and lender covenants.
