factoring and assignment of receivables

The Difference Between Assignment of Receivables & Factoring of Receivables

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You can raise cash fast by assigning your business accounts receivables or factoring your receivables. Assigning and factoring accounts receivables are popular because they provide off-balance sheet financing. The transaction normally does not appear in your financial statements and your customers may never know their accounts were assigned or factored. However, the differences between assigning and factoring receivables can impact your future cash flows and profits.

How Receivables Assignment Works

Assigning your accounts receivables means that you use them as collateral for a secured loan. The financial institution, such as a bank or loan company, analyzes the accounts receivable aging report. For each invoice that qualifies, you will likely receive 70 to 90 percent of the outstanding balance in cash, according to All Business . Depending on the lender, you may have to assign all your receivables or specific receivables to secure the loan. Once you have repaid the loan, you can use the accounts as collateral for a new loan.

Assignment Strengths and Weaknesses

Using your receivables as collateral lets you retain ownership of the accounts as long as you make your payments on time, says Accounting Coach. Since the lender deals directly with you, your customers never know that you have borrowed against their outstanding accounts. However, lenders charge high fees and interest on an assignment of accounts receivable loan. A loan made with recourse means that you still are responsible for repaying the loan if your customer defaults on their payments. You will lose ownership of your accounts if you do not repay the loan per the agreement terms.

How Factoring Receivables Works

When you factor your accounts receivable, you sell them to a financial institution or a company that specializes in purchasing accounts receivables. The factor analyzes your accounts receivable aging report to see which accounts meet their purchase criteria. Some factors will not purchase receivables that are delinquent 45 days or longer. Factors pay anywhere from 65 percent to 90 percent of an invoice’s value. Once you factor an account, the factor takes ownership of the invoices.

Factoring Strengths and Weaknesses

Factoring your accounts receivables gives you instant cash and puts the burden of collecting payment from slow or non-paying customers on the factor. If you sell the accounts without recourse, the factor cannot look to you for payment should your former customers default on the payments. On the other hand, factoring your receivables could result in your losing customers if they assume you sold their accounts because of financial problems. In addition, factoring receivables is expensive. Factors charge high fees and may retain recourse rights while paying you a fraction of your receivables' full value.

• All Business: The Difference Between Factoring and Accounts Receivable Financing

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Assignment of Accounts Receivable: Meaning, Considerations

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

Investopedia / Jiaqi Zhou

What Is Assignment of Accounts Receivable?

Assignment of accounts receivable is a lending agreement whereby the borrower assigns accounts receivable to the lending institution. In exchange for this assignment of accounts receivable, the borrower receives a loan for a percentage, which could be as high as 100%, of the accounts receivable.

The borrower pays interest, a service charge on the loan, and the assigned receivables serve as collateral. If the borrower fails to repay the loan, the agreement allows the lender to collect the assigned receivables.

Key Takeaways

• Assignment of accounts receivable is a method of debt financing whereby the lender takes over the borrowing company's receivables.
• This form of alternative financing is often seen as less desirable, as it can be quite costly to the borrower, with APRs as high as 100% annualized.
• Usually, new and rapidly growing firms or those that cannot find traditional financing elsewhere will seek this method.
• Accounts receivable are considered to be liquid assets.
• If a borrower doesn't repay their loan, the assignment of accounts agreement protects the lender.

Understanding Assignment of Accounts Receivable

With an assignment of accounts receivable, the borrower retains ownership of the assigned receivables and therefore retains the risk that some accounts receivable will not be repaid. In this case, the lending institution may demand payment directly from the borrower. This arrangement is called an "assignment of accounts receivable with recourse." Assignment of accounts receivable should not be confused with pledging or with accounts receivable financing .

An assignment of accounts receivable has been typically more expensive than other forms of borrowing. Often, companies that use it are unable to obtain less costly options. Sometimes it is used by companies that are growing rapidly or otherwise have too little cash on hand to fund their operations.

New startups in Fintech, like C2FO, are addressing this segment of the supply chain finance by creating marketplaces for account receivables. Liduidx is another Fintech company providing solutions through digitization of this process and connecting funding providers.

Financiers may be willing to structure accounts receivable financing agreements in different ways with various potential provisions.​

Special Considerations

Accounts receivable (AR, or simply "receivables") refer to a firm's outstanding balances of invoices billed to customers that haven't been paid yet. Accounts receivables are reported on a company’s balance sheet as an asset, usually a current asset with invoice payments due within one year.

Accounts receivable are considered to be a relatively liquid asset . As such, these funds due are of potential value for lenders and financiers. Some companies may see their accounts receivable as a burden since they are expected to be paid but require collections and cannot be converted to cash immediately. As such, accounts receivable assignment may be attractive to certain firms.

The process of assignment of accounts receivable, along with other forms of financing, is often known as factoring, and the companies that focus on it may be called factoring companies. Factoring companies will usually focus substantially on the business of accounts receivable financing, but factoring, in general, a product of any financier.

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Factoring vs Assignment of Receivables: What is the Difference?

For businesses looking to improve their cash flow situation, understanding the tools available to them is vital. Two options frequently considered are factoring and assignment of receivables. Though they may seem similar at a glance, there are distinct differences between the two methods.

Factoring Explained

Factoring, also known as invoice factoring or accounts receivable factoring, is a financial transaction where a business sells its invoices to a third party (known as a factor) at a discount.

The factor pays you upfront and then collects the invoices from your clients in exchange for a small fee. This lifts the burden of collection off your shoulders and, even more importantly, saves you the trouble of having to wait 30 to 90 days to get paid.

To learn more, read our previous blogs, where we delve into specific aspects of receivables factoring:

• What Happens When a Company Factors Its Receivables
• Invoice Factoring vs Overdraft: What Is the Difference?
• Is Factoring a No-Doc Business Loan?

Assignment of Receivables

Assignment of receivables, on the other hand, refers to the use of receivables as collateral for a loan.

When a business goes this route, the assigned receivables act as security for the lending institution; if the business fails to repay the loan, the lender has the right to collect the outstanding receivables to recover the borrowed amount.

In an assignment of receivables, your company is responsible for pursuing any unpaid invoices, not the lender.

Factoring vs Assignment of Receivables: Key Differences

The primary difference between factoring and assignment of receivables is the type of financing provided.

Factoring is not a loan; it is the sale of an asset (invoices). There is no debt to repay, and the business’s balance sheet does not reflect a borrowing transaction. In the case of the assignment of receivables, the business takes on a liability in the form of a loan, with its receivables as collateral.

With factoring, the factor takes control of bill collection and assumes the credit risk for customer non-payment. In contrast, with the assignment of receivables, the business retains control of its customer relationships and the collection process, bearing all of the credit risk.

Wrapping It Up

While both factoring and assignment of receivables are effective ways to enhance business liquidity, they serve different needs and carry different implications. Understanding the nuances of each will allow businesses to make the best decision for their specific circumstances.

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Accounts Receivable Factoring: How It Works, How Much It Costs

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Accounts receivable factoring is a way of financing your business by selling unpaid invoices for cash advances. Though it can be expensive, this method can also make sense to bridge cash-flow gaps. And because receivables factoring isn’t technically a small-business loan , it can be a good option for business owners with uneven or short credit histories who may not qualify with a traditional lender.

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What is accounts receivable factoring?

Accounts receivable factoring, also known as factoring receivables or invoice factoring , is a type of small-business financing that involves selling your unpaid invoices for cash advances. A factoring company pays you a large percentage of the outstanding invoice amount, follows up with your customer for payment, then pays you the remainder of what you’re owed, minus fees.

How much does accounts receivable factoring cost?

Factoring companies usually charge variable rates. The longer your customers take to pay the invoice, the more you’ll owe.

For example, say a factoring company charges 2% of the value of an invoice per month. The invoice is for $50,000 of work.

If your customer pays within the first month, the factoring company will charge you 2% of the value, or $1,000. If it takes your customer three months to pay, the factoring company will charge 6% of the value, or $3,000.

Some factors charge weekly rates instead of monthly ones. For instance, if a factoring company charges 1% per week and your client takes four weeks to pay, you’ll owe 4%.

If you’ve agreed to recourse factoring , you’ll be on the hook if your customer doesn’t make payments. However, non-recourse factoring means that the factoring company accepts those potential losses. Non-recourse factoring generally comes with higher costs because the factoring company assumes more risk.

How does accounts receivable factoring work?

First, factoring companies typically pay most of the value of the invoice in advance. Advance amounts vary depending on the industry, but can be as much or more than 90%.

Next, your customer pays the factoring company the full value of the invoice.

Finally, the factoring company pays you whatever remains between the amount you were advanced and the full invoice amount minus fees.

For example, say you were advanced 90% of the value of your original invoice. You agreed to pay 2% per month and your customer took two months to pay, making your fees 4% of the value of the invoice. After your customer’s payment, the factoring company will pay you the remaining 6% of the value of the invoice.

Will I qualify for accounts receivable factoring?

To qualify for accounts receivable factoring services, business owners need to have established invoicing practices that give details about sales, prices and payment timelines. Invoices need to be for completed work, not work in progress. Customers also need to be other businesses or government agencies, not individual buyers.

» MORE: Best invoicing software for small businesses

Factoring companies may require businesses to have been in business for a certain amount of time and have a minimum amount of monthly or annual revenue.

The business owner’s credit score doesn’t determine creditworthiness when factoring receivables, however. Since lenders earn money by recouping payment from businesses’ customers, not businesses themselves, factoring companies focus on the creditworthiness of those customers instead. This can make factoring a good option for businesses facing credit challenges or startups with short credit histories.

How is factoring receivables different from accounts receivable financing?

Accounts receivable factoring is the sale of unpaid invoices, whereas accounts receivable financing, or invoice financing , uses unpaid invoices as collateral. Business owners receive financing based on the value of their accounts receivable. After invoices are paid, businesses pay lenders back, with fees.

Factoring is typically more expensive than financing since the factoring company takes responsibility for collecting on the invoice. In the case of non-recourse factoring, they also accept the losses if the invoice goes unpaid.

With accounts receivable financing, on the other hand, business owners retain all those responsibilities.

» MORE: Invoice factoring vs. invoice financing: What’s the difference?

How do I find an accounts receivable factoring company?

You will typically find accounts receivable factoring through specialized companies, like FundThrough or AltLINE . Factoring companies may also specialize in certain geographies or industries, like construction or trucking . Factoring costs can vary significantly, so reach out to multiple companies for a quote. After approval, many factoring companies can provide financing within a matter of days.

Once you develop a relationship with a factoring company, you can return to them again and again. However, the factoring company will evaluate each of your customers for creditworthiness before deciding whether to factor those invoices.

» MORE: Best accounts receivable software

Is accounts receivable financing a good idea?

Factoring receivables can be a great way to cover gaps in your business’s cash flow, especially if your personal credit history is preventing you from financing through traditional small-business lenders . However, it’s one of the most expensive types of financing, and your approval is also dependent on the credit history of your customers. There are alternatives to factoring receivables if you find it’s not right for you:

If you want to meet short-term cash flow needs . Business lines of credit and credit cards are both revolving, meaning you can draw up to your limit as many times as you need to, as long as you’re paying the balance down. Revolving funding can be a great way to cover cash-flow gaps without the high fees of factoring receivables.  

If you’re having trouble qualifying with a traditional lender. If you turned to factoring receivables because you couldn’t get approved for funding from your bank , you may consider trying an online lender instead. Online loans typically have less favorable terms than bank loans, but they still may be a better, cheaper long-term solution for your business than factoring. 

If you like how factoring receivables functions, but you want more control. Accounts receivable financing functions similarly to accounts receivable factoring, but instead of selling your invoices to a factoring company, they serve as collateral for a cash advance. While this leaves you with the responsibility of collecting payment from your customers, it also allows you to maintain a little more control. 

On a similar note...

What is Accounts Receivable Factoring?

How does accounts receivable factoring work, accounts receivable factoring vs. traditional operating line of credit, types of accounts receivable factoring, what types of businesses employ a/r factoring, more resources, accounts receivable factoring.

A form of short term financing available to business borrowers that sell on credit terms

Accounts receivable (A/R) factoring, often referred to as invoice discounting, is a type of short-term debt financing used by some business borrowers. The transaction takes place between a business (the borrower) and a lender (often a factoring company as opposed to a traditional commercial bank).

Factoring is only available as a funding source for companies that sell on credit terms, meaning that a borrower (the vendor) sells a good (or service), generating an invoice to its buyer for payment at a later date (terms may be 30, 45, or 60+ days). This expected future payment sits as an account receivable (a current asset ) on the vendor’s balance sheet.

A management team may choose to sell or assign this account receivable (or a specific invoice) to a factoring company at a discount to its face value in exchange for cash. The transaction permits the borrower to have cash today instead of waiting for the payment terms to be settled in the future.

Aside from the advantage of getting cash upfront, accounts receivable factoring is also commonly employed as a strategy to transfer payment risk to another party (in this case, the factoring company).

Key Takeaways

• Accounts receivable factoring is a source of debt financing available to businesses that sell on credit terms.
• The borrower assigns or sells its accounts receivable (or specific invoices) in exchange for cash today.
• A/R factoring is more expensive than a traditional bank line of credit but offers higher advance rates and greater flexibility around the uses of the loan proceeds.

A borrower’s management team assigns or sells the account receivable at a discount to its face value. The cash amount is expressed in percentage terms and is referred to as the “ advance rate .”

An advance rate can be thought of as a “loan-to-value” and it’s derived in a similar way to how a “borrowing base” or a “margin rate” might be calculated on an operating line of credit by a more traditional commercial lender.

A 90% advance rate on a $100,000 invoice would mean the factoring company wires the vendor $90,000 (90%) today, then remits the difference (less its interest charge) upon collection of the invoice from the vendor’s customer at the end of the invoice period.

Both A/R factoring and operating lines are considered forms of post-receivable financing, meaning an invoice has been generated (as opposed to Purchase Order Financing, which is pre-receivable). Assuming a commercial borrower qualifies for both, why might management choose one over the other?

There are advantages and disadvantages to both, best illustrated when measured against the following dimensions:

Interest rate

Rates can vary considerably based on a borrower’s risk, but in general, an operating line of credit will cost between 1% and 3.5% over the lender’s “Base Rate” (like bank prime), meaning an all-in annual interest rate of ~4% to ~9% depending on the jurisdiction and the rate environment. Factoring, on the other hand, will often cost 1.5%-3% per month (for an annualized rate of 20%-45%).

Duration of the exposure

While subject to annual reviews and margining requirements, a bank operating line is usually extended to revolve on an ongoing basis, as long as the lender can remain comfortable with the borrower’s risk profile. A/R factoring exposure generally only lasts as long as the vendor’s payment terms with its buyer (usually 30-90 days).

Loan-to-value (LTV)

A bank line of credit will generally advance up to 75% of good accounts receivable (meaning under some aging limit–usually 60 or 90 days). Many factoring companies will offer an advance rate of 75-90% of an invoice’s face value. This higher advance rate is considered attractive by many borrowers and might justify the higher cost.

Purpose of loan proceeds

A bank’s line of credit is used for “general working capital” support. This means it bridges a borrower’s working capital funding gap; it would usually be frowned upon (or even restricted) to use the proceeds to fund a dividend, for example.

Factoring, on the other hand, often has very few restrictions on the uses of loan proceeds. This flexibility is another reason many borrowers might be willing to pay a premium.

Broadly speaking, accounts receivable factoring can be categorized as follows:

1. Recourse vs. Non-Recourse Factoring

Recourse means that should a borrower’s customer not pay, the factoring company will retain “recourse” over the borrower (the vendor), meaning they can demand repayment. Non-recourse factoring means that the factoring company is out of pocket should the vendor’s buyer not settle its invoice.

2. Notification vs. Non-Notification

In a notification deal, the borrower’s buyer would be notified of the transaction, meaning that the company’s payable team would be contacted with new payment instructions by the factoring company. In a non -notification deal, the buyer is completely unaware of the vendor’s financing arrangement with the factoring company.

3. Regular vs. “Spot”

In a spot deal, the vendor and the factoring company are engaging in a single transaction. In what’s called a regular factoring arrangement, the factoring company will have an ongoing relationship with its borrower and they likely have an approved limit, which can be drawn, repaid, and redrawn again – based on newly issued invoices.

All else being equal, regular, recourse, and notification deals are less risky for a lender (or a factoring company); non-recourse, non-notification, and spot deals are more risky .

While accounts receivable factoring is most frequently used by smaller businesses, it can work with any type of company (as long as it sells on credit terms). However, it is very common in a smaller subset of specific industries, where:

• Collection times are long or unpredictable – like independent trucking and logistics companies.
• Collections and disbursements are uneven – like temporary staffing agencies, where employees are paid bi-weekly by the agency but its invoices may only be settled by the employer monthly (or longer).
• Invoice settlement is dependent upon a different party in the value chain settling its invoice – like with Construction sub-trades (plumbing, framing, HVAC, etc.); tradespeople complete work today but are only paid by the general contractor (GC) once the project owner or the real estate developer settles its invoice with the GC.

Thank you for reading CFI’s guide to Accounts Receivable Factoring. To keep advancing your career, the additional CFI resources below will be useful:

• Banking Products and Services Course
• Sales and Collection Cycle
• Allowance for Doubtful Accounts
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• Notes Receivables
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Factoring 101: The Ultimate Guide to Factoring

• February 2, 2024

Key Takeaways

• Factoring is a form of business financing that involves selling outstanding accounts receivable at a discount to a factor in exchange for same day cash
• Factoring primarily benefits companies experiencing rapid growth, managing slow-paying customers, or struggling to meet traditional lending requirements
• Factoring can give companies the liquidity and flexibility necessary to scale their businesses.

Introduction

Accounts receivable (A/R) factoring, invoice factoring, and factoring often refer to the same financial tool and fall under the larger category of accounts receivable financing. Freight factoring is a subset of factoring with nuances particular to the trucking industry. We will cover this subset of factoring in our guide to Freight Factoring.

In this guide, we aim to provide a comprehensive high-level view of factoring what it is, what it costs, and how companies can leverage it. Before diving in, it is important to understand certain factoring language.

• Factor: Refers to a company who offers the factoring services to businesses.
• Client: Refers to the businesses that use factoring
• Account Debtor: Refers to the customers of the client

Understanding these three players is crucial to effectively answering the three questions:

• What is factoring?
• What does factoring cost?
• How does factoring help?

What is Factoring?

Factoring is not a contemporary or unproven concept. Historians trace the precursors to factoring to ancient Mesopotamia, and find elementary forms of the modern practice in the American colonies. Today, although not as prevalent as traditional lending in the United States, factoring is still a respected form of commercial financing internationally.

To understand what accounts receivable factoring is, it’s important to know what it is not. True factoring is not a loan or a line of credit, it is an asset sale. This distinguishes between accounts receivable factoring and accounts receivable financing. Financing uses receivables as collateral for a loan/line of credit, whereas factoring involves the sale of receivables to a factor.

Authentic factoring is not debt, does not affect equity, and does not depend solely on the client’s credit. Rather, it depends primarily on the credit of the client’s customers.

Understanding Accounts Receivable

Accounts Receivable is an accounting term referring to services a business has performed (or products a business has delivered), for which the business has not yet received payment.

Consider a business that paints the stripes onto parking lots. Suppose they contract with Walmart and paint a supercenter parking lot, invoicing Walmart $10k with the agreed upon payment terms of Net 90. Until Walmart pays the invoice, the business considers it as accounts receivable on the asset side of the balance sheet.

Accounts Receivable + Factoring

Accounts receivable factoring involves selling of an asset (outstanding invoices or accounts receivable) at a discount to a factor so that a business can receive cash the day they invoice. Essentially, factoring speeds up the cash flow cycle by liquidating accounts receivable.

Advance Rates and Reserves

Often, factoring companies will initially advance 80-90% of the invoice’s value. The factor holds the remaining 10-20% as a reserve until the customer pays the invoice, at which point the factor will release the reserve to the client, minus the factoring fee. Sometimes the factor releases the reserve monthly or at the end of an agreed-upon period.

The Process

Provide the service.

As usual, the client provides a service or sells a product. Most factoring companies will not purchase invoices for incomplete work or undelivered product, because of the risks and complications down the line if the customer files complaints.

Invoice the Customer

Once the client completes the work or delivers the product, they invoice their customer as usual, and send a copy of the invoice to the factor. The client often sends invoices to the factor via email or uploads the batch through an online portal. Some factoring companies will generate invoices for the client, but that involves a deeper discussion.

The Factor Purchases the Receivables

The Factor receives and purchases the invoices, advancing cash to the client. Depending on the agreement, the factor will hold a percentage of the invoices in reserve until the customer pays.

Ongoing, the factor verifies the validity of invoice documentation. When necessary, the factor contacts the account debtor to ensure that the client has completed the work and delivered the invoice.

Customer Remits Payment

The account debtor remits payment to the factor, and the factor charges their fee. Depending on the type of factoring agreement, the factor may release the reserve at this time, or at the end of a designated period.

Common Forms of Factoring

Is factoring equivalent to outsourcing collections? Not necessarily. Two primary forms of factoring exist in the United States, commonly referred to as recourse and non-recourse factoring.

Recourse vs Non-Recourse Factoring

In recourse factoring, the factor reserves the right to return an invoice to the client should a customer fail to pay within the agreed upon terms. Just as a consumer may return a defective product for a refund, so a factor may return a faulty receivable for a refund in a recourse factoring agreement. Depending on the agreement, the factor may refund unpaid receivables from the client’s reserve, or from the next incoming sales batch. Generally, only when the reserve is insufficient to cover the chargeback will the factor ask their client to pay the difference. Often, business owners find recourse factoring appealing because of the lower fees, since they, as the client, are responsible for collecting on bad debt.

Non-Recourse

If recourse factoring is comparable to a consumer return and refund, non-recourse factoring is the opposite – all sales are final. Once the factor purchases the invoice, they take on the risk of nonpayment. There are no take backs, no returns, and no refunds. The client is therefore free to focus on growing their business rather than acting as a debt collector. The factor purchases the invoices and handles collections. Often, this type of factoring charges higher fees, since the factor takes on more risk by forfeiting the right to return bad debt and is responsible if the client’s customer doesn’t pay.

Spot Factoring

While most factoring relationships are ongoing and require the client to sell all of their receivables to the factor, a spot factoring relationship is different. When using spot factoring, a business owner may pick and choose which invoices to sell to a factor whenever the need arises. This allows for more flexibility for the client. However, spot factoring can be more expensive and have stricter invoice requirements.

What does Factoring Cost?

Factoring fees often range between 1-6% per invoice. While this is often more expensive than traditional bank lending, it is important to distinguish that comparing a factoring fee and an interest rate is like comparing apples and avocados. The two are structurally and functionally different. A more accurate comparison would be between a factoring fee and a credit card processing fee. In order to accept credit cards and speed up customer payments, a company must consider the credit card fees and the per-transaction rate charged by the credit card processor. This cost of accepting credit cards concept applies to factoring and if a business finds a good factor, the fees could be more cost effective than accepting credit cards.

That being said, 1-6% per invoice is a wide range, especially when dealing with large dollar amounts. Generally, a factor determines the client’s rate based on the following considerations:

Items Impacting your Factoring Rate

Your account debtors.

The greatest impact on your factoring rate is your customers or account debtors. Once you sell receivables to a factor, it is up to your customers to pay back the receivable to the factor. If a customer has a poor credit history, or poor payment history, the factor will be more reluctant to work with them. A factor doesn’t want bad debt. The poorer a customer’s credit, the more a factor will charge to mitigate the risk.

Your Volume

As with any industry, there are economies of scale. The greater the sales volume, the more receivables, the better the price you can negotiate. Considering two companies equal in every respect except size, a company operating with $10 million in sales will probably find a more competitive rate than a company doing $200 thousand.

Your Payment Terms

The payment terms you negotiate with your customers will also affect your factoring rate. If your payment terms are Net 120, as opposed to Net 60 or Net 30, then a factor will charge more. Longer payment terms increase the risk of nonpayment, and constrain the factor’s cash flow. Both considerations weigh into the factoring rate.

Your Industry

Some industries are riskier than others. Construction, for example, involves intricate contracts with stipulations and requirements that, should a project not go as planned, can make it a nearly impossible for a factor to receive payment. Some industries are complex and not all invoices are created equal. Factoring for staffing companies can sometimes require the client to submit timecards along with invoices. Overall, industry matters, and affects pricing.

Recourse vs Non-Recourse

As previously mentioned, in recourse factoring, the factor reserves the right to return bad debt should your customers default on payment. The ability to return bad debt means that the factor takes on less risk and thus can afford to offer more competitive rates. Non-recourse factoring means that all sales are final; the factor cannot often return bad debt. This can make things simpler for you, the client, since you won’t need to worry about collections, but it increases the risk for the factor, and so increases the factoring fee.

Factoring Fee Structures

Of course, the factoring company must make money somewhere, and the fee is charged in different ways, depending on how a factoring agreement is structured. The two primary fee structures are:

Fee on Sale

With this structure, the factor charges the free when the client sells the invoice (Fee on Sale). The benefit to Fee on Sale is the fixed fee structure. It is easy to calculate the overall costs of doing business with a factor.

Fee on Payment

With this structure, the factor charges the fee when the customer pays the invoice. Often the factor deducts the fee from the reserve, so that when the reserve is released at the end of the period, the fee is subtracted. For example, an agreement structured in this way with a 90% advance rate, a 10% reserve, and a 3% fixed fee would have a 7% reserve release. This fee structure is more flexible and variable. If customers pay early, the fee is lower, but if they pay late, the fees continue to accrue.

How does Factoring Help?

To understand the benefits of factoring, one must understand the benefits of cash flow, since, at its core, factoring speeds up the cash flow cycle. This allows companies to operate with more flexibility and liquidity. Although not a silver bullet to generate more revenue, business owners can leverage this tool to unlock their potential.

There are many other solutions to the problem of poor cash flow, such as equity investors or traditional bank loans. While each excels in serving a subset of the marketplace, neither fits every situation perfectly. Bank loans often require hard assets as collateral, and not every business has the luxury of owning large amounts of real estate, especially startups and service-based businesses. Alternatively, equity investors expect ownership, which is not always in the cards. Not every business fits these arrangements, and sometimes settling is akin to shoving a square peg into a round hole. Lending and equity investing work well for what they’re designed for, and a line of credit will often be less costly than factoring, but the question really rests upon the client’s unique situation and needs.

Who does Factoring Help?

Factoring, like lending and equity investors, is most beneficial in specific use cases. It is not a one size fits all solution that can transform any business. Some industries and business structures are better served by traditional forms of financing. Industries that commonly benefit from factoring include supply chain logistics companies, such as trucking, wholesaling and distribution. Manufacturing, business services, and temporary staffing companies are also common factoring clients. However, industry categories do not perfectly reflect the unique needs and circumstances of individual clients. Therefore, it can be more helpful to consider the unifying business profiles/circumstances where factoring best fits, such as:

• Slow-paying customers
• Rapid growth
• New opportunities
• Does not fit traditional lending requirements

Slow-Paying Customers

Servicing customers with slow payment terms can bottleneck cash flow, which can make it nearly impossible to continue growing, or even operating. If payroll deadlines roll around faster than customers pay invoices, or supplies need to be purchased before taking on a new job, things can go south fast. Some businesses can afford to wait 30, 60, 90 or even 120 days, but the cost of carrying receivables is never zero. Missed opportunities, and slow cash flow will inevitably inhibit the bottom line. Factoring is tailormade for these situations. Instead of waiting, a business can convert receivables to cash and pursue new opportunities.

High Growth

For companies experiencing rapid growth, cash flow is crucial. Rapid growth, without cash flow, is like driving a car focusing on the speedometer while running out of gas. Eventually, all that growth will come to a screeching halt, and the company will collapse under its own weight. A line of credit could help, but banks examine a company’s history to determine the line limit. For businesses growing at 15-20% per year, a credit line based on last year’s numbers doesn’t reflect this year’s needs. Although a line of credit may help, the line may not be large enough to sustain the desired growth.  If you max out your line of credit you no longer have cash flexibility, all business assets are usually pledged and you now have a fixed monthly payment to reduce the line balance.  A business will find themselves in the same situation, with an empty gas tank. Alternatively, a factor examines current receivables and payment history to determine facility limits, and may be able to increase that limit as needed. Essentially, lending looks in the rear-view mirror, factoring looks ahead through the windshield. This allows factors to be nimble in providing the working capital necessary to sustain high growth.

New Opportunities

Some clients stand on the verge of tremendous opportunity that could double, or even triple, the size of their business. Perhaps they landed a government contract, or a large project for a slow paying Fortune 500 company. However, they don’t have the working capital to take on that large customer. This mirrors the high growth profile and presents similar problems. A traditional bank loan could meet some of the need, but banks often require real estate collateral, or will examine previous years’ performance. Past performance, however, may not account for growth from large new contracts. Factoring, in this case, is best suited to meet the need.

Startups are in a precarious position for securing working capital. They may have passion and an idea, but for a bank, passion and ideas aren’t collateral. Additionally, two years of tax returns are often required for securing a line of credit, and even then, most banks, especially community banks, still require hard assets, such as real estate or equipment. It’s not that the bank doesn’t want to help, however, just that their lending requirements are sometimes are too strict for startups.

Equity investors are an option, but once again, without history, justifying a substantial valuation can be difficult. The business may not have enough equity, or the investors may ask for more than the owner will relinquish.

Depending on the startup’s structure and customer base, factoring can be an effective solution. The quality of a startup’s receivables is more important to a factor than the startup’s brief history.

Does not fit Traditional Lending Requirements

Lastly, some companies don’t qualify for the loan they need. We addressed a startup situation where hard assets are scarce. But what if the situation is more bleak? Suppose the business experienced a difficult financial situation two years ago, or an economic tectonic shift like Covid left them scrambling. Traditional financing may not be an option, but factoring might be.

Factoring looks at your customer’s credit first, and your credit second. Even if you had a rocky financial history, or just a poor year, you may still qualify for factoring. Factoring is the sale of an asset. If the asset is good, a company’s financial woes are less of a concern.

Selecting a Factor

Choosing a new financial partner is significant, and a business should properly weigh all factors (no pun intended). When looking for a lender, a credit card processor, or a factor, it is important to research and verify not only the institution’s credibility but also whether their product is truly the best fit for your business’ situation. Unfortunately, some financial service providers lock companies into contractual agreements for products that aren’t a fit.

Below are several considerations when selecting a factoring partner.

Fee Structure

Understanding the fee structure is critical when considering a factoring agreement. Some factors advertise high advance rates and low factoring fees, but will nickel and dime their clients to death with additional, sometimes hidden, charges, which may include setup fees, service fees, minimum volume fees, ACH fees, late fees, and lockbox fees, just to name a few. Worse, some factors legally lock businesses into long-term contracts with exorbitant exit fees in order to keep their clients onboard.

Considering other aspects, such as whether the agreement specifies fee-on-sale or fee-on-payment, is also important. If your customers pay quickly, fee-on-payment may be a better option, since the fee will have less time to accrue. Alternatively, fee-on-sale may be a better fit if your customers consistently pay in 120 days.

Finding an honest and upfront factor will make or break a factoring experience. If a factor is so afraid of losing your business that they will lock you into a contract, it may be worth looking elsewhere. As with anything, if it seems too good to be true, it probably is.

Accountability

Ensuring that a factor is reputable, respected, and abides by all applicable laws and regulations is essential. Legitimate reviews can be a helpful indicator, as well as the factor’s admission into groups such as the International Factoring Association (IFA), which is predicated on the factor’s ongoing ethical business practices.

A factor that is bank owned can also be a positive reputational indicator. Factoring is an ancient method of financing, but modern factoring is a relative newcomer in the United States, and thus the regulatory framework is less developed. Conversely, state and federal governments strictly regulate the banking industry, and require adherence to stringent guidelines in areas of accountability, data security, and operational consistency. As many banks have proven, governmental accountability does not preclude the need for personal responsibility. Rather, the intention is to encourage ethical business practice. Bank-owned factors must adhere to these standards and face scrutiny from internal auditors, external accounting firms, and state examiners.

Customer Service

Very little needs to be said about the importance of customer service. It can make or break any experience and is especially important in financial services industries. Trust, empathy, and professionalism are crucial. Unfortunately, the quality of customer service can be difficult to gauge prior to entering a factoring relationship. Reputable reviews and references are invaluable. Examining the sales process and the sales representative’s attitude can also be helpful indicators. Of course, a factor must charge fees and protect their assets, but any honest savvy business owner knows that treating the customer right is the best way to build a sustainable business. The same is true for factoring.

Recourse vs non-recourse factoring

We covered this topic earlier, but it is worth noting as a consideration when selecting a factor. Some factors offer both, while some specialize in only one variety of factoring. Which form a business selects affects not only the costs of factoring but also the time and costs involved in collections and accounting for chargebacks.

There’s always more to be said about factoring (as with any industry). Hopefully, this guide has helped to shed light on what factoring is, what it costs, and how it helps, as well as given you basic insight into the process and what to look for when choosing a factor. If you’re interested in learning more about how factoring can help you specifically, we welcome you to set up a call with us. We’d be happy to answer any of your questions!

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Module 6: Receivables and Revenue

Factoring accounts receivable, learning outcomes.

• Describe the process of factoring accounts receivable

Accounts receivable factoring, also known as factoring, is a financial transaction in which a company sells its accounts receivable to a financing company that specializes in buying receivables at a discount. Accounts receivable factoring is also known as invoice factoring or accounts receivable financing.

Companies choose factoring if they want to receive cash quickly rather than waiting for the duration of the credit terms. Factoring allows companies to immediately build up their cash flow and pay any outstanding obligations. Therefore, factoring helps companies free up capital that is tied up in accounts receivable and may also transfer the default risk associated with the receivables to the factor.

Factoring companies charge what is known as a “factoring fee.” The factoring fee is a percentage of the amount of receivables being factored. The rate charged by factoring companies depends on things like:

• The industry the company is in.
• The volume of receivables to be factored.
• The quality and creditworthiness of the company’s customers.
• Days outstanding in receivables (average days outstanding).

Additionally, the rate depends on whether it is recourse factoring or non-recourse factoring.

Here is a comparison between the two:

• In transfer with recourse, the factor can demand money back from the company that transferred receivables if it cannot collect from customers.
• In transfer without recourse, the factor takes on all the risk of uncollectible receivables. The company that transferred receivables has no liability for uncollectible receivables.

Factoring companies usually charge a lower rate for recourse factoring than it does for non-recourse factoring. When the factor is bearing all the risk of bad debts (in the case of non-recourse factoring), a higher rate is charged to compensate for the risk. With recourse factoring, the company selling its receivables still has some liability to the factoring company if some of the receivables prove uncollectible.

Just as in most business and investment transactions, the higher the risk, the higher the interest rate.

For example, take the following situation: On October 1, Larkin Co. transfers $250 thousand of receivables, without recourse, and pays an 8% fee. In addition, the factor keeps an allowance of $15,000 to cover bad accounts. The journal entry would be as follows:

Note: $20,000 factor fee is considered interest expense because the company obtained cash flow earlier than it would have if it waited for the receivables to be collected.

There will be some kind of deadline on the agreement. Let’s say it ends on Sept 30 of the next year, and actual bad debts came to $16,000. Without recourse means that the $15,000 the company gave to the factor is the limit of the bad debt liability. The final entry would look like this:

If this had been with recourse, and since the actual bad debts exceed the amount initially retained by the factor, Larkin, Co. would have to pay the factor an additional $1,000 and the journal entry would look like this:

It is important to note that the type of factoring influences the amount of fee charged and the amount of security held by the factor. The scenario in this example is only for the purpose of comparing the two types. The amount of security retained may be zero under factoring with recourse because the agreement guarantees the factor that any debts that may turn out to be irrecoverable will be reimbursed. As with any business contract, the parties negotiate the terms, and there are as many variations as there are transactions.

PRACTICE QUESTION

• Factoring Accounts Receivable. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Accounting Principles: A Business Perspective. Authored by : James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. Provided by : Endeavour International Corporation. Located at : http://The%20Global%20Text%20Project . License : CC BY: Attribution

• Receivables
• Notes Receivable
• Credit Terms
• Cash Discount on Sales
• Accounting for Bad Debts
• Bad Debts Direct Write-off Method
• Bad Debts Allowance Method
• Bad Debts as % of Sales
• Bad Debts as % of Receivables
• Recovery of Bad Debts
• Accounts Receivable Aging
• Assignment of Accounts Receivable
• Factoring of Accounts Receivable

Factoring of accounts receivable is the practice of transferring the ownership of accounts receivable to a company specialized in receivable collection, in exchange for immediate cash. In other words, the company that originally owns the receivables, sells them to another company called “factor” and receives immediate cash.

Factoring helps a business improve its cash flow by converting its receivables immediately into cash instead of waiting for the due dates of payments by customers. A drawback of factoring is that it is done at a discount, which means that the cash received on factoring of receivables is less than the value of the receivables transferred. This is because the factor expects a certain margin and it faces risks such as time value of money , and depending on the agreement, the risk of default by the debtors.

The parties to the factoring agreement assess the recoverability of the accounts receivable, decide whether or not the factoring agreement will be with recourse or without recourse, and then agree on a suitable discount factor to calculate the amount of fee to be charged by the factor i.e. the discount. After deducting such a fee from the value of the accounts receivable, the factor pays in cash to the originating company. The factor may also withhold an additional amount as a refundable security against any bad debts that may arise.

As a result of the above transaction, the factor gains ownership of the accounts receivable and has access to the detailed records of those receivables . The factor is specialized in receivable collection and it may actually be cost effective for businesses to factor their receivables because doing so will save costs such as wages paid to staff for following up with customers.

The factor collects cash from the debtors as the due dates approach. The procedure to be followed in a situation where a debt becomes irrecoverable, depends on whether or not the factoring agreement is with recourse.

Recourse vs non-recourse factoring

Under non-recourse factoring, the factor may set-off the sum retained as a security, if any, against any bad debts that may arise but the factor is not entitled to be reimbursed by the originating company if the total of bad debts exceed the amount of security. In other words, the additional loss on bad debts under non-recourse factoring is borne by the factor.

Under a factoring agreement with recourse, the company factoring its receivables agrees to pay bad debts in full to the factor. So if the security falls short of the total bad debts, the factor is entitled to be reimbursed for bad debts in full.

Non-recourse factoring is riskier than factoring with recourse for the factor, generally resulting in higher discount rates over factoring with recourse.

Factoring vs assignment of receivables

Factoring is different from a financing agreement involving assignment of receivables because the later uses receivables as a collateral security for a loan, but the actual ownership of the receivables and the right to collect them is not transferred as long as the loan and any related interest payments are paid in time.

The following example illustrates the journal entries to record transactions related to factoring with and without recourse:

On January 1, 20X5, Impatient Inc. factored its accounts receivable of $100,000 at a fee of 8%. Under the terms of the agreement, the company received $82,000 in cash and the rest of the amount was retained by the factor as a security for any bad debts that may arise. Any excess of this security sum over the total bad debts was agreed to be returned by the factor at the end of the accounting period i.e. December 31, 20X5.

On December 31, 20X5 the full amount of security sum was withheld by the factor because the actual bad debts totaled $11,000 exceeding the security sum.

Impatient Inc. had already provided allowance for doubtful debts in the factored accounts receivable and a bad debts expense was recognized in the income statement of year ended December 31, 20X4.

Required: Pass journal entries to record the above transactions for Impatient Inc. both under factoring with recourse and factoring without recourse.

January 1, 20X5: Here, the journal entry will be identical under both factoring with recourse and factoring without recourse.

December 31, 20X5: The journal entries will differ under the two types of factoring. Since the actual bad debts exceed the amount initially retained by the factor, Impatient Inc must pay the factor, an additional amount of $1,000 under factoring with recourse but there is no such remedy if the factoring is without recourse.

Under factoring with recourse:

Under factoring without recourse:

It is important to note that the type of factoring influences the amount of fee charged and the amount of security held by the factor and the scenario in this example is only for the purpose of comparing the two types. The amount of security retained may be zero under factoring with recourse because the agreement guarantees the factor that any debts that may turn out to be irrecoverable will be reimbursed.

by Irfanullah Jan, ACCA and last modified on Oct 29, 2020

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Run » finance, is factoring receivables right for your business.

Many small businesses struggle financially, but factoring receivables is one of the most popular ways to grow a business and generate cash flow.

Many small businesses struggle to finance new projects while they wait for their clients to pay previous invoices. Factoring receivables is one of the most popular ways to finance companies struggling with limited cash flow. This involves a larger company buying a business’s unpaid invoices for cash advances and helping it receive any outstanding payments it’s owed, for which the other company charges a fee. Here’s how to know whether factoring receivables is right for your business.

How factoring works

After you deliver a product or service to your client, you send them an invoice. The factoring company pays you immediately, using the invoice as collateral. Once the client pays the invoice, usually after 30 to 90 days, the transaction is closed.

Factoring can help your company grow rapidly and serve more clients. However, like any financing option, this method has its limitations and disadvantages.

[Read more: What Is Accounts Receivable? ]

Cost of factoring receivables

Factoring receivable rates vary , but ultimately, the longer your customer takes to pay the invoice, the more you’ll owe the factoring company.

For instance, a factoring company could charge you 1% of the value of the invoice per month. If your invoice is $10,000, and your customer pays after the first month, you would only owe the factoring company $100. If your customer takes 3 months to pay, you would have to pay the company $300.

There are also two kinds of factoring: recourse and nonrecourse. With recourse factoring, you will have to cover any money your client refuses to pay. With nonrecourse factoring (a more expensive option), the factoring company will accept those potential losses.

Receivable factoring vs. receivable financing

Receivable financing is a loan that uses unpaid invoices as collateral. Small business owners receive funds based on the values of their unpaid invoices, and after they’re paid, those owners then pay the lenders back, plus any fees.

Receivable factoring is more expensive than receivable financing, as the factoring company takes responsibility for collecting unpaid invoices and, in the case of nonrecourse factoring, will accept the losses for any invoices that remain unpaid.

Pros of factoring receivables

There are many good reasons to consider factoring as a way to improve your company's cash flow.

Your business gets immediate cash to provide payment terms

The number one reason to factor invoices is to quickly provide your company with cash to fund a new project for a client. Most payment terms require the client to pay in 30, 60, or 90 days, which can limit the number of clients you take on while you wait for invoices. With factoring, you have the cash in hand almost immediately to provide payment terms to clients and start on new projects.

Nearly any business can factor invoices

Factoring receivables is usually much simpler than applying for a business loan. The requirements are fairly straightforward and allow you to work with new clients quickly. You can consider factoring if 1) you operate a business that has commercial or government clients with good credit, and 2) your business is free of liens, other encumbrances, and legal problems.

You can increase the line as needed

Factoring invoices is an excellent option for companies that are pursuing an aggressive growth stage, as it can scale with your business. As long as your clients have good credit, you can increase the number of factors your business maintains.

It can be a long- or short-term solution

Most factoring companies will work with you to create a plan as brief as six months to help fund your business. If your business enters a period of rapid, unexpected growth or runs into some financial trouble, factoring invoices can strengthen your cash flow. Alternatively, you can work with a factoring company for several years to grow gradually yet consistently.

Your invoices are your collateral

Most traditional financing options require significant assets, such as real estate or business equipment, to use as collateral. Factoring only uses invoices as collateral, so you don’t have to surrender business-critical assets if your business starts to struggle.

Factoring provides you with cash fast, but it usually costs more than traditional financial solutions offered by lenders.

Any size business can use factoring

Most lenders will hesitate to offer a line of credit to businesses without a long credit history or aggressive profit margins. Factoring can be used by even the smallest of businesses to expand operations.

You’ll have lower credit risk

When your small business exchanges unpaid invoices for money, all credit risk is allocated to the factoring company, as they assume the risk of your customers not paying what they owe you. Any payment difficulties are also the responsibility of the factoring company, not the small business.

You have improved control over your business

Any money you receive in exchange for your business’s unpaid invoices will help your company become more flexible. If your progress on projects like physical expansion or investment expansion have slowed due to a lack of payments, the added funds will help you move forward without that financial burden.

[Read more: Accounts Payable vs. Accounts Receivable ]

Cons of factoring receivables

It doesn’t solve all of your financial issues.

Traditional loans and lines of credit can be used for any number of reasons, such as paying suppliers, purchasing a storefront, and stocking inventory, to help your business remain successful. Factoring, on the other hand, only solves the problem of limited cash flow due to slow-paying clients.

It costs more than traditional lines of credit

Factoring provides you with cash fast, but it usually costs more than traditional financial solutions offered by lenders. With factoring, the rate and the advantage are used in conjunction to determine your actual rate, which usually results in a 1–4% rate per 30 days. This can decrease your business’s financial flexibility. However, receiving capital upfront can help offset these service fees, making the transaction a worthy investment.

Finance companies may contact your customers

When you start a business relationship with a factoring company, they will contact your clients to inform them that they are managing your invoices. Additionally, the factoring company may also contact your clients if your payments are late, which can have a significant negative impact on your business reputation. Additionally, your company assumes any and all bad debt incurred while working with a factoring company.

Payment risk

Often, as mentioned previously, the finance company will take on the responsibility of customer credit dues. However, if enough customers don’t pay their invoices, your small business can be held accountable for the factoring company’s lost fees. This is not true in the case of a nonrecourse exchange, as the financing company assumes the nonpayment risk.

Client risk

While factoring receivables can lead to lasting mutually beneficial relationships between businesses and financial institutions if your customers or clients are known for not fulfilling their invoices, odds are that the financial institution will not continue working with you. Finding another trustworthy factoring company can also be difficult.

When deciding whether to use factor receivables, consider your clients’ creditworthiness and any associated fees. If you can ensure the financing company does not lose money in the exchange, your business and theirs will benefit from factoring your receivables and will lead to reliable transactions in the future.

Factoring invoices can help you solve cash flow problems quickly, but the cost, time, and energy may not be the best solution for your business. If you do decide to partner with a factoring company, look for one that has a positive reputation in your specific industry and has been in business for many years.

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Assignment of Accounts Receivable: Definition, Benefits, and Emerging Trends

Last updated 03/28/2024 by

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What is assignment of accounts receivable, how does assignment of accounts receivable work, what are some special considerations for assignment of accounts receivable, emerging trends in assignment of accounts receivable, fintech solutions.

• Access to immediate cash flow
• Allows businesses to leverage their accounts receivable
• May be available to companies with limited credit history or poor credit
• Provides an alternative financing option when traditional loans are not available
• Helps businesses manage cash flow fluctuations
• Higher cost compared to traditional financing options
• Interest rates and service charges can be substantial
• May indicate financial distress to stakeholders
• Loss of control over customer relationships and collections process
• Defaulting on the loan can result in loss of assets

Frequently asked questions

How does assignment of accounts receivable differ from factoring, can any business use assignment of accounts receivable, what happens if a customer defaults on payment, is assignment of accounts receivable a sign of financial distress, what are the eligibility criteria for assignment of accounts receivable, how does assignment of accounts receivable affect financial statements, are there any alternatives to assignment of accounts receivable, how can businesses mitigate the risks associated with assignment of accounts receivable, key takeaways.

• Assignment of accounts receivable allows businesses to access immediate cash flow by leveraging their outstanding invoices.
• While it provides an alternative financing option, it can be costly compared to traditional loans.
• Fintech companies are transforming the accounts receivable financing market with innovative digital solutions.
• Businesses should carefully evaluate the terms and implications of assigning their accounts receivable before entering into agreements with lenders.

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You might also like.

In the realm of trade credit security, factoring, forfaiting, and assignment of receivables share a common thread – they all revolve around the utilization of receivables as financial instruments. However, it is crucial to recognize that while they may seem similar due to their reliance on receivables, they differ fundamentally in their use and application. Let's explore how these financial strategies, though linked by receivables, serve distinct purposes in the world of trade credit security.

Factoring and Forfaiting:

Factoring involves the sale of a business's accounts receivable to a specialized financial entity, known as a factor, at a discounted rate. The factor takes on the responsibility of collecting customer payments, offering rapid access to cash flow and bolstering liquidity.

Principal Difference: Transfer of Ownership

The fundamental distinction lies in the transfer of ownership. In factoring, the trade creditor relinquishes ownership of the accounts receivable to the factor. This means the factor or forfaiter becomes the new legal owner of the receivables and directly manages the collection process. The trade creditor essentially converts future payments into immediate capital.

Assignment of Receivables:

Assignment of receivables, on the other hand, is a process where the rights and benefits of a receivable are transferred from one party (assignor) to another (assignee). It serves as a tool for credit risk management, allowing businesses to transfer the risk of non-payment or default to the assignee while stabilizing cash flow.

Principal Difference: Retention of Ownership

In contrast to factoring, in the assignment of receivables, ownership of the receivables remains with the assignor. The assignee, while assuming responsibility for collecting payments, does not become the new legal owner of the receivables. Instead, they act on behalf of the assignor to ensure payment collection.

In essence, while both factoring and assignment of receivables offer solutions for managing credit risk and enhancing cash flow, their fundamental difference lies in the ownership structure. Factoring involves the sale and transfer of ownership of accounts receivable to a factor, while assignment of receivables retains ownership with the assignor, with the assignee acting as a collector.

Businesses evaluating these trade credit security options should carefully consider their preferences, goals, and impact on customer relationships to determine which approach best aligns with their financial strategies.

#credit #creditmanagement #creditrisk #creditworthiness #creditengineering

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UAE clarifies factoring and assignments of receivables

The recently enacted Federal Decree-Law No. 16 of 2021 on Factoring and Transfer of Civil Accounts Receivable (the New Law) which enters into force on 8 December 2021, being the first federal regulation in the United Arab Emirates (the UAE) dealing specifically with factoring and the assignment of receivables, has ushered in some much-needed clarity as to how these arrangements should work in the UAE. Specifically, the New Law provides a new regulatory framework which sets out the basic legal requirements for assignments and transfers of receivables, validity and perfection requirements, as well as the rules for determining priority amongst competing claims over assigned receivables.

Historically, this had been viewed as something of a 'grey' area of the law – governed in a piecemeal way, with Federal Law No. 5 of 1985 (as amended, the Civil Code) governing the assignment of debt and Federal Law No. 4 of 2020 (the Moveable Assets Mortgage Law) governing assignments over receivables which are taken by way of security. This had created some uncertainty as to which regulation should apply in particular circumstances, as well as uncertainty regarding the relationship between the different laws. The fact that the New Law seeks to provide a unified framework in relation to this area is a very welcome development. There are, however, certain key aspects of the New Law which may require further clarification as market participants seek to rely upon this new framework.

Scope of the New Law

The New Law applies broadly to any assignment of receivables made as part of commercial or civil transactions. Notable exclusions from this new law are assignments in the context of:

• personal / family transactions;
• financial contracts regulated by clearing agreements;
• foreign exchange transactions;
• interbank payment systems, net-based clearing systems and settlement related to securities, assets or other financial instruments;
• repurchase of securities, assets or financial instruments deposited with a broker;
• the right to financial payments fixed in endorsable bonds;
• the right to payments deposited in credit accounts with banks; and
• the right to payments under securities, documentary credits and letters of guarantee.

What is an Assignment?

The New Law governs " Assignments ", which is defined to cover an arrangement where " contractual rights to settle a cash sum owed by the Debtor are transferred to the Assignee, and the Assignment constitutes the agreement to create a security right on the Debtor's debt, transfer it as a security, and sell it in a final sale ". One possible interpretation of this particular definition would be that the New Law only governs arrangements which not only assign a debt but which also create a security interest over that debt. However, many factoring arrangements and debt assignments simply involve a debt being assigned absolutely and do not necessarily involve a security right being created over that debt. The New Law also does not elaborate on the different types of factoring arrangements that can exist, such as the purchase or sale of receivables, discounting and reverse factoring.

Given that the New Law appears (on the face of it) to be intended to cover all factoring arrangements and assignments of debts, the prudent course of action for market participants would be to ensure that all of their factoring arrangements and assignments of debt comply with the New Law, regardless of whether those arrangements involve security being created.

Form of Assignment

When it comes to the form that an assignment of receivables should take, the New Law is not prescriptive, and simply provides that an assignment shall be considered effective provided that the receivables that are subject to the assignment are described in a general or specific manner in order to allow for their identification.

Importantly, the New Law goes on to clarify some of the key points around how to describe the receivables being assigned (in relation to which there previously was some uncertainty). Specifically, we highlight the following:

• It is acceptable for the purposes of the New Law to describe the assigned receivables generally, for example by simply saying that the assignment is of all receivables that are currently owed by a debtor, all receivables that will be owed by a debtor in the future, or a specific class or specific or general type of such receivables.
• The New Law therefore appears to confirm that, in an assignment agreement, it is not necessary to individually list out each particular contract under which a debt is assigned.
• The New Law confirms that if the subject of the relevant assignment is receivables which are owed by a debtor in the future, then that assignment may be effective without the need to enter into any new transaction to assign each future debt in due course.

Effectiveness and Priority

One key point which the New Law clarifies is in relation to the effectiveness of debt assignment agreements against third parties: with specific provisions of the Moveable Assets Mortgage Law being incorporated by reference in order to establish that such assignments, in order to be effective towards third parties, must be declared on the electronic register created under the Moveable Assets Mortgage Law (which is currently operated by the Emirates Integrated Registries Company (EIRC)). While, prior to the introduction of the New Law, it was common for market participants to register assignments of receivables with the EIRC, it was not previously clear whether this was strictly necessary with respect to absolute assignments of receivables under the Civil Code which did not create security interests.

Regarding any specific requirements which need to be met in order for an assignment of receivables to be effective against a debtor (which have traditionally been governed by the Civil Code and relevant cases), the New Law does not specifically repeal or replace the Civil Code in this respect, and so the prudent course would be for market participants to continue to satisfy the applicable conditions derived from the Civil Code. This essentially means that, in order for an assignment of receivables to be enforceable against a debtor, notice of the assignment is required to be provided to the relevant debtor and (depending on the exact circumstances) with it also being advisable for the assignment of receivables to be acknowledged by the relevant debtor. The New Law does however give an assignee the clear right to send a notification and payment instructions to the relevant debtor in relation to receivables that have been assigned to that assignee (even if that notification gives rise to a breach of the underlying contract as between the assignor and the debtor), and does also seem to indicate that the debtor must agree to the assignment particularly in the context where the underlying contract is being amended.

Similar to what we see with registration, when it comes to determining priority among competing claims over receivables, the New Law relies on the Moveable Assets Mortgage Law to allocate the priority (determined by the date and time of registration) of the rights of assignees over the accounts receivable, to determine the priority of the assignor's obligation and to determine the priority of the assignment towards non-contractual rights.

To conclude, the New Law has clarified certain key issues regarding the assignment of receivables, and in doing so has created a more unified framework. It is now clear that any receivables which are subject to an assignment (which may include future receivables) need only be described in the assignment in general terms, and it is also now clear that certain elements of the Moveable Assets Mortgage Law apply to assignments of receivables (such as the registration requirements and rules regarding priority). Question marks do, however, remain over how the New Law treats certain types of debt assignments and factoring arrangements (particularly ones that involve absolute assignments and not security rights), as well as the question of how a court would interpret the relevant provisions of the Civil Code in light of the New Law.

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New Federal Decree Law No. (16) of 2021 on Assignment of Receivables and Factoring

In Brief: This article discusses the recent enactment of Federal Decree Law No. (16) of 2021 on Assignment of Receivables and Factoring ( Assignment and Factoring Law ) and in particular it discusses:

• assignment under the Civil Code;
• assignment and factoring under the Assignment and Factoring Law; and
• priority and enforcement.

Assignment under the Civil Code

Historically, the law relating to assignment in the UAE has been governed by Federal Law No. 5 of 1985 on the Civil Transactions Law (the Civil Code ). The Civil Code deals with assignment in detail through Article 1106 to Article 1132.

Article 1106 of the Civil Code defines assignment to mean “an assignment of debt and claim from the liability of the assignor to the assignee”. An important note to make here is that the assignment provisions under the Civil Code only deal with assignment of ‘debt and claim’; that is, assignment of obligations rather than assignment of rights.

In an assignment of an obligation, A assigns to C its obligation to discharge a contractual claim or its obligation to pay B, whereas in an assignment of rights, A assigns to C its right to receive payment from B. One of the key provisions of assignment is that in order for it to be perfected or valid, notice has to be served to the counterparty and acknowledgment must be obtained. Article 1109 of the Civil Code states that “the validity of an assignment is conditioned upon the acceptance of the assignor, the assignee and the counterparty.” This means an assignment of an obligation (whether debt or claim) is not enforceable against the counterparty unless it agrees to it.

Assignment of rights has been governed by case law. The UAE Courts have been consistent in ruling that ‘consent’ or ‘acknowledgment’ in an assignment of rights from the ‘payor’ is not required and notice to the payor will suffice to perfect the assignment. The rationale for this is that in an assignment of rights no additional burden is imposed on the payor. For example, the Abu Dhabi Court of Cassation in Case No. 597 of 2012 stated that “an assignment of rights shall be established by mutual consent between the assignor and the assignee without the need to obtain the debtor’s consent. If the debtor has not been served with notice of assignment, the debtor can deal with its original creditor as the sole creditor.” The Court further stated that the counterparty will be bound by the assignment once it has become aware of the assignment.

Assignment and Factoring Law

The Assignment and Factoring Law was published on 9 September 2021, the first federal law in relation to assignment of right to payment and it came into force on 7 December 2021. As noted above, previously there was no UAE law on assignment of rights.

Assignment is defined in the Assignment and Factoring Law to mean “an agreement whereby the assignor assigns to the assignee its contractual rights for collecting a monetary amount owed by the Receivable's Debtor. The assignment involves an agreement to create a security interest over the receivable, to assign as a collateral and irrevocably sell the same.”

Article 2(2) of the Assignment and Factoring Law says that it applies to all commercial and civil transactions except for assignment of receivables that arise out of the following situations:

• a transaction carried for personal, family or household purposes;
• financial contracts regulated by netting agreements;
• foreign exchange transactions;
• systems and agreements of interbank payment, netting systems and adjustment relating to securities, assets or other financial instruments; and
• buyback of securities, assets or financial instruments deposited with a broker.

Article 2(3) of the Assignment and Factoring Law further says that it shall not apply to the following cases:

• the right to payments proven under endorsable instruments;
• the right to payments deposited into the credit accounts with banks; and
• the right to payments under securities, documentary credits and letters of guarantee.

Key provisions of the Assignment and Factoring Law

• The receivables must be generally or specifically described so that they can be identified (Article 4(4) of the Assignment and Factoring Law).
• Assignment of receivables can apply to future receivables (Article 4(5) of the Assignment and Factoring Law).
• Assignment will be effective regardless of any contractual agreement obliging the assignor not to assign its right to payment under the original agreement (Article 5(2) of the Assignment and Factoring Law).
• The counterparty will enjoy the same rights it has against the assignor under the original agreement and this includes right of set-off, however this can be contracted out (Articles 16 and 17 of the Assignment and Factoring Law).
• Once payment is made to the assignee the counterparty cannot claim it back from the assignee even if the assignor is in breach of the original contract (Article 19 of the Assignment and Factoring Law).
• Existing assignments can be registered in the Moveable Collateral Register within six months from 7 December 2021.

Enforceability of assignment and notice requirements

Article 4(2) of the Assignment and Factoring Law says that an assignment will be enforceable, once executed, between the assignor and the assignee even if notice has not been served on the counterparty (payor). This implies that if notice is not served on the counterparty, the assignment is still valid but in order for the assignment to be binding on the counterparty notice must be served, otherwise the counterparty will continue to pay the assignor.

As noted above, the Courts in the UAE have historically been consistent in ruling that an assignment of right does not requires consent of the counterparty and notice will suffice to perfect an assignment. The Assignment and Factoring Law maintains this position and does not require the counterparty to provide consent. However, the counterparty will only be bound by the assignment once notified and when payment instructions are received in accordance with Article 14 of the Assignment and Factoring Law.

Article 11(1) of the Assignment and Factoring Law provides that the assignor and the assignee may each serve notices and payment instructions to the counterparty and once notice is served, the counterparty is obliged to take payment instructions only from the assignee.

Priority and third-party rights

Articles 7 and 8 of the Assignment and Factoring Law provide that in relation to priority, the relevant provisions of the Federal Law No. (4) of 2020 on Securing Interest in Movable Property ( Movable Pledge Law ) will apply. Article 7(2) of the Assignment and Factoring Law particularly says that an assignment is not enforceable against third-parties (in other words, against competing creditors) unless it is registered in the Movable Collateral Register which is currently managed by Emirates Integrated Registries Company.

Under Article 10(1) of the Movable Pledge Law, a security right is effective against third-parties if:

• it is registered in the Movable Collateral Register;
• possession has been transferred to the pledgee; and
• the pledgee has taken control of the security assets.

The above priority in relation to assignment means that once an assignment of the right to receive payment is perfected by registration in the Movable Collateral Register, it will be binding against any subsequent assignment of the same right. This means a creditor under an assignment by way of security should immediately register the assignment in the Movable Collateral Register, in order to ensure priority over competing claims.

Factoring is defined in the Assignment and Factoring Law to mean a “transaction whereby the assignor assigns the current and/or future receivables to the assignee, or an agreement between the parties that the assignor shall retain the entries relating to and collect the receivable transferred and to afford protection to the assignee in case the Receivable's Debtor defaults on payment.”

A significant point to make is that the Assignment and Factoring Law provides that factoring can only be exercised by entities licensed by the UAE Central Bank. Although further guidance is anticipated from the UAE Central Bank in accordance with Article 25 of the Assignment and Factoring Law, no such guidance has been issued as at the date of the publication of this article. For any entities wishing to carry out factoring activities, it is important that they monitor any updates on this point and seek the relevant licence from the UAE Central Bank at the appropriate time.

Enforcement

The Assignment and Factoring Law does not provide a specific mechanism for enforcement should the counterparty refuse to pay the assignee upon receipt of payment instructions. However, Article 21 of the Assignment and Factoring Law says that the assignee can enforce its rights in accordance with provisions of the assignment or alternatively can take enforcement action under Chapters 7 and 8 of the Movable Pledge Law.

Chapter 7 of the Movable Pledge Law provides that the assignee can enjoy self-help (out of court enforcement) subject to notice being served on the counterparty and Chapter 8 of the Movable Pledge Law provides for an expedited court enforcement process. Under Chapter 8 of the of the Movable Pledge Law, the enforcement application is made to the Judge of Urgent Matters and the matter is considered by the Judge within a short timeline as set out in detail therein.

Filed under

• United Arab Emirates
• Company & Commercial
• Hadef & Partners

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