 Hello, and welcome to the session in which we would look at selling or factoring receivable. This topic is covered in intermediate accounting. This topic is very similar in idea to the pledging of receivable that we looked at in the prior session. And what's the idea? The idea is to raise cash quickly for the company. There are many reasons why we need to raise cash. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. My resources are a useful addition to your CPA review course. I help you understand the material better. I explain the theory behind the concept. Your risk to try me is one month of subscription. Your potential gain is passing the exam. If not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. This is a list of all my accounting courses, taxation, advanced accounting, managerial, governmental, intermediate, so on and so forth. My CPA supplemental courses are aligned to match that of your CPA review course. So it's easy to go back and forth between farhat and your CPA review course. If you haven't connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording. Share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So why do we need the cash? That's the question. Well, we need the cash for many reasons. Do I have to explain why? We need it for payroll, pay our suppliers, pay our bill, take advantage of certain opportunities. And as we mentioned earlier or in the prior session, we have two options. We can have a secured borrowing, use the receivable to pledge the receivable or we can sell the receivable. In this session, we would look at selling the receivable. We're going to look at selling the receivable without recourse and looking at the receivable, selling the receivable with recourse. So how does it work? Well, it's very important to understand the parties involved in this process. And there are three parties involved. And here's what we're going to assume. We're going to assume that a customer comes to a company and they place an order. Before the company accept this order, they're going to go to a factoring company. They're going to go to a bank, a factor or transferee. And the company, it's going to be the transferor and we're going to see what does that mean in a moment. They're going to go to the bank or to the factor and they're going to ask the factor whether they would be willing to finance this transaction. In other words, whether they were willing to give us the money to serve the customer and the customer will pay later. If they say yes, of the order, if they approve, what are we going to do? We're going to go ahead and ship the product to the customer. That's good. That's excellent. And the factor is going to give us the cash for the sale. Then the customer will pay the factor. So this is how we're going to play this out. So we're going to assume the customer will pay the factor directly. Another way to do it is to first sell to the customer, sell to the customer. So create the account receivable, then sell the account receivable to the factor. Selling the account receivable to the factor is easy. We're going to assume that the factor, that the customer pays the factor directly. So this is the assumption that we are going to make as we are processing journal entries. Now, for a transaction to be considered sale, for a transaction to be considered a factor, we have to meet three conditions and it's important to classify something whether it's a sale, it's a factor or pledge. Remember we can pledge the receivable or we can sell it. Here are the three conditions that needs to be met. One, the transferred asset, which is the account receivable, is isolated from the transferor. Simply put, this is the transferor, the company. The company isolated this asset so when they sell the receivable, the receivable is not listed with their assets. It's listed separately. Also, it's not only that, it's transferred to the factor. Two, the transferee, which is the factor. Once the account receivable is with the factor, with the bank, the bank can do anything with it. And what does that mean anything? They can pledge it with another bank, with another financial institution. They can sell it. They have the right to do anything with that receivable. You basically have no control over this. And there is no side agreement between the transferor, the company and the transferee, where the company will buy back the factor. There's no side agreement. Those, all those three conditions should be met. So the answer should be yes for all those three conditions. If the answer is no to any of them, then the transaction is considered a secured borrowing. Then what we have is a liability and we're going to record the expense, the expenditure to finance this transaction is interest expense. And this is what we looked at in the prior session. We looked at the transaction where we assume it's a secure transaction. So a secure transaction will fail any of these. In other words, if the company has a side agreement, then it's not really a sale. If the transferee cannot do whatever they want with the receivable, then we don't have a sale. If the transferor does not isolate the asset, the account receivable separately, then we don't have a sale. Now, what happened if the answer to these three questions is yes? Then we have another question to ask ourselves. Is the company have a continuing involvement in this transaction? It means the transferor. If the answer is no, then it's easy. We have a sale. And what happened as a result, we're going to reduce our receivable and record either again or a loss. Usually it's a loss. When you sell a receivable, when you sell a receivable, no one's going to pay you more than the face value. So if you have a receivable of a million dollars, the factor might pay you 960,000. In other words, they'll pay you $40,000 less. It means you have a loss. No one's going to pay you more than a million dollar because the maximum they can collect is a million dollar. If there is a continuing involvement by the company and continuing involvement means what? It means the company says if they don't pay you, if the customers don't pay you, we will guarantee a certain amount. Well, we will still record it as a sale, but now we're going to be recognizing, in addition to the asset that we're going to be receiving, we're going to be recognizing a liability. And obviously, we will have a loss. We will have a loss. Simply put, when we sell and we have no involvement, we call this without recourse. When we sell the receivable and we have a continuing involvement, we say we sold it with recourse. So let's look at a summary of what recourse without and with recourse. With recourse, remember the company, the seller of the receivable guarantees the payment to the purchaser. And they would say, look, if they don't pay you, we'll pay you. We have a potential liability. Sales without recourse, well, the factor, the bank assume all the risk of collection. Basically, we're out of the picture. Once they say this is an agreement without recourse, once they give us the money, we're no longer, we don't have to worry about collecting the money from the customer. The transfer is outright sale. It's 100% the sale. It's your asset. It's your risk. It's your reward. So the seller recorded a loss. As I told you, it's usually a loss because no one's going to pay you more than the face amount of your receivable. I mean, why would they do that? Why will they pay you more than a million dollars? The maximum they can collect a million dollars. The best way to illustrate this is to work an example. Adam Inc. factors half a million of account receivable with the First National Bank. So First National Bank is the factor or the transferee. Adam is the seller of the asset on without a recourse basis. So this is without recourse. First National Bank assesses a finance charge of 4%. So First National Bank says, look, I'm going to charge you 4% of the amount of the receivable. And if we take half a million times 4%, they're going to charge us $20,000 upfront. And they're going to retain an amount equal to 5% of the account receivable for probable adjustment. And they're going to say, if we're going to take half a million times 5%, that's going to be 25,000. Now this is called a retainer. What is a retainer? Why would they keep this retainer? They're not going to give you the money now. Why? Because you made the sale. Every time you make a sale, you debit account receivable, you credit sales. But remember at some point, customers might come back and say, look, we made the sale. We want a return. Therefore, you will debit returns and allowances and you credit account receivable. So what happened, the company says, look, we're going to assume or we're going to estimate that 25% of those sales, they're going to be returned. Therefore, we're not going to give you the money because the customers may return the item. So let's take a look at the journal entry. The first thing Adam company will do, if they factor half a million, they have to remove half a million of the receivable. They're going to have do from factor, do from national bank, which is an asset. They're going to have an asset receivable of 25,000. Why? Because the first national bank, it's going to withhold 25,000 for now. Why? Because customers might return the item. They may not return them. The first national bank collect all the money, they will give it to you. But we're not going to give it to you now. It's going to be receivable for you. So do from factor. We have a loss on the receivable. Remember they're charging us 4% fee. We have a loss. So a four transferring half a million of receivable. We're waiting for 25,000 and 25,000 is gone as a loss. What we're going to be receiving in cash today is 455,000. So this is the entry that Adam company will make, the seller of the receivable. First national bank, well, they're going to have an account receivable or a note depending on what the, depending on what the deal with the customer. If it's a note, it's a note, it's going to be an account of half a million. They expect to receive half a million. If they receive the full amount, they're going to give you 25,000 because they did not give it to you now because customers might return the product. So this is basically a buffer, a protection for first national bank because they know some customers will not pay because if they return the product, if they return the product, they're not going to pay first national and first national will not pay you. So we estimate that the amount will be 25,000. First national is going to book 20,000 of interest revenue upfront because that's their fee, that's their fee of 4%, 4% of their receivable is their revenue and they're going to give you cash 455,000. So this is a sale without recourse. Remember that 25,000, so do to customer, this is a liability for first national bank and this is an asset for Adam company. If they receive the full amount, if no customers return the product, Adam company will be receiving an additional 25,000. That's fine. Simply put, the profit for first national bank, if they collect all the money, well that's the assumption, even if they don't, we're assuming that the due to customers is not collected, which is we don't have to pay it, then their gain or their profit is 20 or the revenue is 20,000. So this is without recourse. Now let's assume Adam company sold the receivable with the recourse. With the recourse means what? Adam told first national bank, look, if you don't collect the money, we are responsible for giving you the difference. And now Adam company will have to estimate what is the value of that recourse, what's the value of that liability? And we're going to estimate that the value of the liability 7,000. Simply put, Adam thinks that we might have to cough up $7,000 in case the customers don't pay. So what are we looking at now? Now remember, the cash received 455,000. Why? Because we have half a million of a counter receivable, minus 25,000, minus 20,000 of the 4%. So the cash we're going to give, the cash we're going, we are going to receive is 455, 455. Then if everything is received, we're going to receive an additional 25, so it's going to be 480. Then we think we are not going to receive $7,000. Therefore, we will do a less. We're going to deduct $7,000. So the net proceeds, we think it's going to be 473,000. What are we assuming here? We are assuming we're receiving today 455,000 due from factor that 25,000 buffer, we're going to get it. But there's going to be an additional customers that will not pay their bill. And that's going to be $7,000, where we're going to have to pay it back to the factor. Therefore, the net proceeds is 473,000. This is how much we expect. Now, if this does not occur, we will be receiving 480. If this does not occur and everybody paid their bill, everybody paid their bill, it means the 455 plus the 25, we will get 480. If some customers don't pay and we're hoping it's going to be limited to 7,000, therefore, we're going to be receiving net proceeds of 473. Well, we are transferring an asset of half a million. We expect to receive 473. Therefore, our loss is 27,000. The loss, 20,000 of it is a fee of 4% times half a million. That's the 20,000. And the 7,000 we're estimating that customers will not pay up to 7,000. Therefore, we're going to have to pay back the first national bank, which is a loss for us. So the loss is 27,000. Now, whatever happened, we really don't know. So let's look at the journal entries under this recourse agreement. So the cash we will be receiving is 455. Do-from-factor, it's going to be 25,000 because we assume 25,000 is they're going to collect this, but now they don't want to give us the money now in case there is any sales returns and allowances. Loss on the receivable, we compute it to be 27. A counter receivable, we're going to remove it at half a million. And we have a recourse liability of 7,000. Hopefully, this liability never realized. Okay, if the first national bank collects the money, we don't have to worry about this liability. So what is the difference between this entry and the prior entry? Well, in the prior entry, we did not have a recourse liability. When we did not have a recourse liabilities, our losses were 20,000. It looks something like this. This is the entry without recourse. Under the entry without recourse, our loss is only 20,000 because that's it. They're going to charge us a fee and we're off the hook. Here, they're going to charge us a fee and we're still could be on the hook for 7,000. Up to 7,000, we think we're going to be on the hook for. Therefore, we have to estimate our total loss at 7,000, an additional 7,000. Remember, this is all estimate. If all customers pay, the maximum we would lose is the 20,000. But since we are on the hook, it's with the recourse and we think it's going to be 27,000. Now, if we estimate this to be 10,000, our loss will be 30,000. So we estimate it to be 7,000. Now, what's the journal entry for First National Bank? First National Bank does not really care. It has the same entry. First National Bank will have a receivable of half a million hoping to receive all of it. If they receive all of it, they're going to give them 25,000 in addition to the 455 and they have an interest revenue of 20. So that's it, their interest revenue. They don't have any more income. They don't have any more revenue. Why? Because that's the fee. If they could not collect, we will give them the money. We will give them the money, but they already gave us the money. They already gave us the 455 and they promised the 25. So if they don't collect anything, anything else, we will give them the money. So simply put, they have a receivable of 20,000. They charge us 20. They charge us 20. It means they're going to charge us $20 as a fee, 20,000 as a fee, and they are simply guaranteed 480,000. If we don't pay it, if they don't collect it, we will pay it. So they are guaranteed 20,000 of a profit. Now, again, the 25,000, if they don't collect it, they don't have to pay it to you because it's, again, if some customers return the product and we estimate 25 as a good number. So make sure you analyze these transactions, look at them, and make sure to understand the difference with recourse, without recourse. Not on the CPA exam. They don't go that much in depth, okay? But if you understand this, you should be good to go. Again, at the end of this recording, I'm going to remind you whether you are an accounting student or a CPA candidate to take a look at my material. I don't replace your CPA review course. Your CPA review course don't go in depth this much. The reason I go in depth, because once you understand this, well, you need it for your intermediate accounting course, but once you understand this for the CPA exam, they can throw anything at you and you'll be able to answer the questions. Now, on my website, I also have additional resources such as multiple choice that you can practice to see how this actually works. The CPA exam is a lifetime investment. Don't shortchange yourself. Throw everything on it. Good luck. Study hard and stay safe.