A financial institution perspective
The impact of the credit crunch has by now irrevocably changed the landscape of the economy. Companies have been forced to look at different and innovative ways of maintaining and improving on their operating cash flows.
The practice of debtors factoring has since established itself as a legitimate alternative source of funding. A previous article published in Accountancy SA demonstrated this by examining market perceptions surrounding the topic and found that there are a lot of positive attributes and that factoring could significantly improve cash flows of companies. By this stage, most companies would have felt the effects of the credit crunch on their cash flows, and turned to these sources of funding where overdraft and borrowings were insufficient to meet working capital demands.
In the accounting arena, debtors factoring has also remained an interesting example that cuts across IAS 18 Revenue and IAS 39 Financial Instruments: Recognition and Measurement. As the convergence projects of the IASB and FASB continue to align these standards, debtors factoring would no doubt continue to be used as an example to demonstrate some of the more intricate challenges to be resolved. This article will therefore analyse the current recognition and measurement of a debtors factoring transaction from the perspective of a factoring institution in an effort to inform and demonstrate the nature of the transaction. Armed with this background knowledge, we would be able to comment more constructively on the exposure drafts to come that use debtors factoring as an example. A quick search of published literature will show that there is sufficient guidance on dealing with the issue of factoring from the perspective of the seller, and this article will consequently not venture into this area.
Example of a standard debtors factoring transaction
A Finance House is approached by Company A and requested to factor one of their debtors. Company A is a manufacturing concern and requires upfront cash to start their next production run. One of their debtors has been given ninety day terms on the sale of their previous batch of product and therefore they are experiencing a cash flow constraint. Finance House examines the credit worthiness of Company A’s debtors and after satisfying themselves of their credit worthiness, decide to enter into the transaction. The terms of the transaction state, among other things, that they will fund 80% of the value of the debtors upfront, refund 15% of the payment received by the debtor back to Company A and take 5% as a fee. The debtor is to pay off its debt to Finance House and not Company A. Let’s say that the value of the debtor under consideration is R100 000.
This example is fairly straight forward and in order to get the basics right lets ignore complications such as outright and non-outright factoring, recourse agreements and guarantees. These elements remain relevant and will fall into place once the underlying transaction is correctly accounted for and disclosed in terms of IFRS. The first step is to identify the various elements of the transaction from the perspective of Finance House which need to be accounted for. At inception of the transaction, the following elements can be identified:
- Finance House has a financial asset which is a contractual right to receive cash from another entity (in this case the debtor of Company A)
- Finance House funded 80% of the amount (R80 000) upfront and is still liable to refund 15% (R15 000)
- Finance House will administer and recover the debt on behalf of Company A
- Finance House will hold back 5% of the debt (R5 000) as a fee
In substance the right to receive or transfer cash from or to another entity falls under the definition of a financial asset and liability. Therefore the transaction is a financial instrument as it gave rise to a financial asset of one entity and a financial liability of another. IAS 39 requires financial instruments to be recognised initially at fair value. In this example initially cash was exchanged between the parties and since cash is already stated at fair value, the various elements should initially be recorded at the cash value which was exchanged.
To put the example in perspective then the transaction would initially be recorded as follows: see table 1 below.
|Dr||Factoring debtor||B/S||100 000|
|Cr||Refund obligation||B/S||15 000|
|Cr||Unearned finance charges||B/S||5 000|
|Recognising the right to receive cash from the debtor, payout to Company A, refund obligation held as security and unearned finance charges in accordance with IAS 39|
In the example Company A provided it’s debtors with 90 day terms which implies that Finance House will only receive the cash from the debtor at the end of that time period.
Revenue on this transaction should now be recognised in terms of IAS 18 which provides for three categories of revenue recognition. The three categories available are: Sale of goods, Rendering of a service, and Interest on use by others of entity assets. Finance House has granted Company A the use of its cash for a three month period and therefore it falls within the interest category. IAS 18 requires revenue that falls within this category to be recognised on the effective interest method. The question of compounding depends on the transaction and the definition of the effective interest method allows for compounding to occur over a relevant period. In this example we assume that interest is to be compounded once on the three month mark.
There is no sale of goods and providing Company A with the use of its cash for three months similarly does not fall under rendering a service, as Finance House intends to recover the cash from the debtor. The potential charge for collecting the cash from the debtor though would fall under the category of rendering a service and should be accounted for accordingly.
The next step would be to unwind the Unearned Finance Charges over the three month period and recognise the interest as income. The interest (in substance the fee on the transaction) would be recognised with the following journal: see table 2 below.
|Month 1||Dr||Unearned finance charges||B/S||1 667|
|Cr||Interest received||I/S||1 667|
|Month 2||Dr||Unearned finance charges||B/S||1 667|
|Cr||Interest received||I/S||1 667|
|Month 3||Dr||Unearned finance charges||B/S||1 667|
|Cr||Interest received||I/S||1 667|
|Recognising effective interest over the period of the transaction in accordance with IAS 18|
At this point one might point out that part of the transaction was for Finance House to administer and collect the debt. Part of the fee therefore consists of a charge for this service and the question now is how much of the 5% fee should be allocated towards this service. It is a management decision to either take a portion of the R5 000 as a collection fee, or to charge a collection fee separately, similar to a normal bank charge.
At the end of the three month period the interest (or fee) of R5 000 would have been fully recognised. The debtor would settle his account and pay Finance House the full value outstanding. Out of this amount Finance House would refund the 15% withheld as security and the transaction would be complete. The completion of the transaction would be recorded as follows: see table 3.
|Cr||Factoring debtor||B/S||100 000|
|Dr||Refund obligation||B/S||15 000|
|Recognise the receipt of payment from the debtor and recognise the payout to Company A of the refund obligation|
Summary of the transaction
Before we move on let’s quickly summarise the transaction in broad terms. Finance House was approached by Company A and requested to provide short-term funding to them. As security for this funding Company A “factored their debtors’ book” to Finance House. The value of the debtors was R100 000 of which Finance House provided R80 000 funding upfront, withheld R15 000 as security in case any debtors defaulted and retained R5 000 as a fee. Because Company A had the use of Finance House’s asset (the cash) the transaction was recorded as a financial asset in terms of IAS 39 at its fair value, which was the same as the cash value. Revenue on the transaction falls within the third category of IAS 18 Revenue which is interest and was recognised over the three month period of the transaction according to the effective interest rate method.
The rigour with which we have now recorded this transaction will show once the business rationale of the transaction is evaluated. The work of management would be to decide if the transaction is profitable or not. In the example Finance House would have obtained funding from its bankers or would have had the cash on hand. Both scenarios would approximately result in the same answer, therefore let us assume Finance House obtained funding from a third party and the rate on the funding is 12% per annum. The effective interest rate on the transaction in the example comes to 25% which is calculated as follows:
(5 000 / 80 000) x 100 = 6.25%
6.25% / 3 months x 12 months = 25%
Therefore if Finance House pays 12% on their funding and effectively funds Company A at 25% there is a 13% profit margin and the transaction is profitable. Management would also consider taxation and any admin costs to establish a more accurate profit figure when doing the evaluation. During the life span of the transaction it is important to also periodically be able to match their level funding with the funds advanced to Company A and in this way manage their exposure to the client. If Finance House factors a number of debtors matching their level of funding with the funds advanced to customers it becomes more relevant.
Finally the tax on the transaction would be calculated in accordance with Section 24J of the Income Tax Act which also requires the income to be calculated on the effective interest method. This would result in no deferred tax over the period of the transaction and taxable income would equal accounting income throughout. As the transaction constitutes a supply of cash in exchange for a loan it falls under the definition of a financial service in terms of the VAT Act and therefore it is exempt from VAT.
Further accounting issues
The debtors factoring example is notable for providing an example of a multiple element revenue transaction. This is because there is the possibility of charging a fee for debt administration and collection in addition to the normal takings. The issue of identifying the multiple elements of a revenue transaction is currently being addressed in the IASB and FASB convergence project on Revenue Recognition. Furthermore the example also touches on derecognition of financial instruments. This element comes into play when the client for example Company A guarantees a portion of the debt. Because of their continued involvement in the transaction it is debatable to what extent they can derecognize their financial asset and whether or not they should be recognising a financial liability for the possibility of paying out on a default of any of their debtors. These issues constitute extensive further investigation and will not be covered comprehensively here. Suffice to say that the convergence project on Derecognition is also addressing this issue and hopefully a more comprehensive method of derecognition would be proposed.
Overall, the transaction that constitutes debtors factoring remains an interesting one from an accounting perspective. In addition, the value that factoring adds to the economy remains positive and with proper practices a very useful tool for companies to use in managing their cash flows. The above example hopefully demonstrated the application of IFRS to a contract where judgement calls need to be made on what exactly constitutes the substance of the transaction, from inception where the financial assets and liabilities are recorded, through to deeming the fee as interest and correctly recognising the income over the period of the transaction. Watch out for future exposure drafts on Derecognition and Revenue Recognition, where debtors factoring examples may well be used to illustrate some of the proposed concepts.
Ricky van der Walt CA(SA), is a Group Financial Manager at Merchant West (PTY) LTD