In the real world everyone refers to working with a third party financing party (known as Factor) to improve your cash flows as accounts receivable factoring. However it turns out that there are different ways to use your customer’s invoices to smooth out your cash flows. This article will discuss the difference between factoring and discounting.
When a company factors its account receivables, it is selling them to a third party (although this type of transaction is often referred to as accounts receivables financing, it is actually a sale, not a financing loan). All of the risks and rewards for the receivable are transferred to this third party, commonly known as a Factor. In other words it is now up to the Factor to collect from the customer. If the customers do not pay, then the Factor loses out. Note that failure to pay is usually a bad thing for both the Factor and the company selling the invoices because the Factor will no longer want to work with the selling company. Also note that who ultimately bares the burden of collection is a matter of contract.
So basically factoring is a sales transaction that involves three parties: the debtor (customer), the company, and the Factor. The Factor will usually give the company a certain percentage of the face value of the receivable up front (anywhere from 60-90 percent). The Factor will remit the remaining 10-40 percent when it collects. The Factor then charges the company a fee for doing all of this (usually around 1-4 percent per invoice per month).
Discounting is slightly different from factoring, though as was mentioned previously most people use the two terms interchangeably. With discounting there is no sales transaction, but a loan. So the company is not passing the risks and rewards of the invoice to the third party. The receivables are simply used as collateral against a loan. This means that if the customer doesn’t pay, the company still has to pay back on the loan. It also means that if the company doesn’t fulfill its loan agreements, then the bank or the loaning party can confiscate the receivables pledged.
In short invoice factoring refers to the selling of your invoices whereas invoice discounting refers to using them as collateral for loan purposes. As far as what is actually happening there isn’t a lot of difference. This lack of difference has given accounting service standard setters and auditors headaches as they’ve tried to determine whether factoring should be treated as a sale or a loan.
As far as trying to determine which one you should use for your company is concerned. It really depends on the industry and third parties you are working with. If the fees and overall economic costs of factoring and discounting are the exact same for your company, then you should probably go with factoring because in that case you are shifting the risk of your customers not paying to a third party.
In reality it doesn’t make a lot of sense to try and shift the risk of not collecting to the factor. If you burn them on this once, chances are they are not going to work with you in the future. Most people who factor have a long-term working relationship with their Factors. In addition, the factoring companies know what they are doing and will find a way through contracts to avoid you burning them.
That sums up our discussion on factoring (selling) invoices and discounting (using them as collateral) accs. Hope you learned something. For more information please check Medical Receivables Factoring Solutions and 40 Year Mortgage.