To: Mr. Lammer
From: Ellie Kramer
Date: November 28, 2012
RE: Transfer of Receivables
Thank you for your inquiry on the various options to transfer a portion of your
receivables to an outside party. There are a few different options for you including secured
borrowings and different methods of outright selling of you receivables. I will go into detail
about each method to hopefully make you comfortable with each method.
Many companies choose to use secured borrowing. When using secured borrowing you
pledge your accounts receivable as collateral for a loan. This loan would be recognized as a
financing arrangement- a liability account. There are also types of secured borrowing that require
certain assets to be assigned as collateral for a loan. For example if you buy a car the bank keeps
the title to the car until it is fully paid off; that way if you default on the payments for a certain
period of time the bank can then sell the car to pay off the rest of the loan. Typically, the amount
a bank or a financial institution lends to your company is less than the amount of the receivable
your company assigns, due to the risk of possible uncollectible accounts. You are not required to
associate certain accounts receivable with the loan but rather your accounts receivables as a
whole. Dealing with secured borrowing does not require any special accounting principles but
rather a disclosure note on the financial statements. Also, other than the stated interest on the
loan, the lenders often require an upfront finance charges to provide some sort of insurance to the
bank. Therefore, the amount of cash that your company receives would be less than the amount
of the loan in fact. Once you collect the cash from the receivables, you would use that to settle
the financing arrangement and pay for the interest of the loan. As a result, accounts receivable
and financing arrangement would go down accordingly. On another note, the consequence for
secured borrowing is that in case the debt is not paid off by your company, the collection of
assigned receivable would go directly toward the payment of the debt. If your company assigns
an asset as collateral for the loan, the asset would be sold to pay for the debt.
Another alternative is factoring where a company sells its accounts receivables to a
financial institution. Major credit card companies are examples of factoring. Companies such as
Discover or VISA handle collection and billing and charge a fee for this service and this is a
form of factoring. Factoring will create more capital to help your cash flow because you are
getting the cash immediately in exchange for accounts receivable rather than waiting a couple of
months for the customer to pay you. In exchange for the cash from the factors, your company
would have to give up the future cash receipts of receivables. The requirement for factoring is
that receivables quality and length of time before payment must be reasonable and clearly stated.
In reality, it is natural that not every account receivable will be collected, as well as every
receivable will be collected in full. Consequently, there is a significant factor your company must
consider when receivables are transferred: risk of uncollectibility. If the buyer assumes this risk,
accounts receivable are sold without recourse. In other words, the buyer of these receivables
cannot ask for more money from the seller if receivables are not paid by customers. On the other
hand, if the seller holds the risk of un-collectability, accounts receivable are sold with recourse
and buyer will be paid whether receivables are collectible or not. Either way, companies that are
involved in sales of receivables must establish two new accounts for their transactions:
receivable from factor and loss on sale of receivables. Receivable from factor is the difference
between the fair value of last part of receivables (e.g. 10%) to be collected and the factoring fee.
Loss on sale of receivable will be calculated lastly in order to balance the journal entries. Also, if
receivables are sold with recourse, the seller has to estimate a liability called recourse obligation
as the approximate amount that the seller will have to pay the financial institution as
reimbursement for uncollectible receivables. If the financial institution collects all of receivables,
the seller would eradicate recourse liability and reduce the loss.
Understanding that the concept is lengthy and possibly confusing, we would try to clarify
the idea with an example. Suppose Lammer Inc. has sold a net amount of receivables of $10,000
(without recourse) to Ellie Bank. Ellie Bank will immediately pay Lammer Inc. 80% of the
factored amount, which is $8,000. The factoring fee is 5% of the factored amount, which is $500.
Management estimates that last 15% of receivable to be collected worth $1,000. Notice that the
fair value ($1,000) of the last 15% of receivables is less than 15% of receivables’ book value
($1,500). This is understandable since last receivables are more likely to be cut down due to
allowances and sale returns. Back to our example, we would recognize $500 ($1,000-$500) as
receivables from factor. The rest ($1,500) of the journal entry is loss on sale of receivables. As a
whole, the journal entry would look like this:
Cash
$8,000
Loss on sale of receivables
Receivable from factor
Accounts receivable
$1,500
$500
$10,000
Now, suppose the factor’s fee is withheld from the cash advanced to the company at
beginning of the arrangement. Then, the amount of cash would go down by $500, which is the
factor fee; in addition, receivable from factor would go up by the same amount.
If the receivables are sold with recourse, and the recourse obligation is estimated to be
$1,000, that would simply increase loss on sale of receivables by $1,000 and keep everything
else the same. The journal entry now would look like:
Cash
$8,000
Loss on sale of receivables
Receivable from factor
$2,500
$500
Recourse liability
$1,000
Accounts receivable
$10,000
Another method for sales of receivables is securitization. In this case, your company
would establish a trust or a subsidiary named “special purpose entity” (SPE) in order to
securitize accounts receivable. After the SPE buys a pool of receivables, it would use them as
collateral before selling related securities (etc. debt) such as bonds or commercial paper. It also
allows your company to receive a cash payment for sold receivable. On behalf of SPE, your
company continues to provide services and collect receivables. An advantage of securitization is
that your company can reach a hefty pool of investors and attain promising financing terms.
Consequence for securitization may be that when SPE is consolidated, any transactions between
your company and the SPE are eradicated. The company would look like they have kept its
receivables and participated in secured borrowing with financial institutions that loaned money
to the SPE. I hope this answered some of your questions regarding your concern about transfer of
receivables. If you have any further questions we would be more than willing to help.
Best regards,
Ellie Kramer