Query No. 41

Subject:          

Accounting treatment of factored debts.1

A. Facts of the Case

1. A  company,  which  is  a  subsidiary  of  a  government  undertaking, manufactures  bearings  for  use  in  automobiles,  tractors  and  other engineering industries.

2. The company’s bank has provided working capital facility and term loan facility to the company for purchase of plant and machinery. In view of  the  fact  that  the  funding  provided  by  the  bank was  not  adequate  to fulfill the working capital requirements, the company has entered into a factoring arrangement.

3. Under the factoring arrangement, the company has entered into an agreement  for  factoring  of  debts  and  also  for  a  prepayment  agreement with the factoring agency, (hereinafter referred to as ‘the Factor’). The querist  has  also  submitted  copies  of  the  factoring  arrangement  and prepayment agreement, etc., with the query. The querist has highlighted the following clauses given under the head ‘definitions’ in the factoring agreement:

“(iii) ‘Assignment’ means an absolute Assignment and transfer of a Debt  in  writing  made  by  the  client  (i.e.,  the  company),  and where the context so requires, includes instrument evidencing or creating such Assignment.”

“(vii) ‘Debt’ means the amount owing or accruing due to the Client

(i.e.,  the  company)  from  a  Customer  (of  the  company) consequent upon the sale or supply of goods or services by the Client to the Customer, under a Contract.

(viii) ‘Drawing Power’ means that portion of Debts purchased upto which  the  Factor  has  agreed  to  allow  prepayment  within  a specified limit, as per the terms and conditions of the sanction letter.

(ix)   ‘Facility’ means any one of the following factoring facilities:

       (a)        Purchase of debts with recourse/without recourse;

       (b)        Sales Ledger Administration;

       (c)        Debts collection; and

       (d)        Prepayment against the purchase of Debts, and the expression “Facilities” means more than one of such facilities.”  

4. The  querist  has  stated  that  the  process  of  factoring  involves  the issue of Power of Attorney in favour of the Factor and getting the same acknowledged from the specific customer who, in turn, issues a letter of awareness  to  the  Factor  stating  therein  his  consent  to  pay  the  amount payable against specific invoices to the Factor. All the invoices raised on such customers bear the following matter:  

“The amount payable under this invoice has been purchased by the Factor, besides M/s. XYZ, Hyderabad (the Company) to whom you are hereby authorised and requested to make payment at Hyderabad and whose receipt shall alone be good discharge. The authority and request is irrevocable without the consent in writing of the Factor. If this invoice is not found to be correct the Factor is to be notified immediately.”

5. During the year 2000-2001, the company had factored invoices of customers with the Factor with effect from November 2000. In view of the clause that debts are irrevocably assigned, the company has reduced the debtors while presenting balance sheet with a note under the relevant schedule indicating that sundry debtors do not include the value of the factored invoices. As the prepayment facility granted to the company is with recourse, the amount received from the Factor under the prepayment agreement has been shown as a contingent liability. The difference between the total value of factored invoices (reduced from the debtors) and the amount received under prepayment agreement has been shown under the head ‘Advances’ as amount receivable from the factor.

6. During the course of audit under section 619(4) of the Companies Act,  1956,  the  Principal  Director,  Commercial  Audit,  Hyderabad, representing the Comptroller and Auditor General of India (C&AG), has made the following provisional comment on the subject:  

“Provisional Comment No. 5: Sundry Debtors, (Sch. 5.2)-Rs. 1497.24 lakh. 

This  is  understated  by  Rs.  112.50  lakh  due  to  not  retaining  the balance amount receivable against the factored debts of Rs. 403.31 lakh purchased by the Factor, under Sundry Debtors. This has resulted in overstatement of loans and advances by Rs. 112.50 lakh.”

7. The company has given the following reply to the said comment:  

“The  fact  of  exclusion  of  debtors  amounting  to  Rs.  403.31  lakh irrevocably assigned to the Factor and purchased by them is stated in Schedule No. 5.2 under Sundry Debtors. 

The balance amount receivable from them arising out of contractual obligation is in the nature of a claim and cannot be treated as debtor as the total debt is purchased by the Factor and the assignment by the company is irrevocable. Hence treatment.”

8. During  the  course  of  the  discussions  on  the  observations  of  the Principal Director  Commercial Audit, the  company has agreed  to refer the  matter  on  accounting treatment  of  the  factored  debts  to  the  Expert Advisory Committee of the Institute for its opinion.

B. Query

9. The querist has sought the opinion of the Expert Advisory Committee on the accounting treatment that should be followed by the company for the factored debts.

C. Points considered by the Committee

10. The Committee notes that the term prepayment as used in the facts of  the  case  is  that  amount  of  the  purchase  price  of  the  factored  debts which becomes due to the company in respect of debts purchased by the Factor pursuant to the factoring agreement prior to the receipt of payment from the concerned debtors.

11. The  Committee  is  of  the  view  that  the  accounting  treatment  of factored debts depends upon the fact whether significant risks and rewards incidental  to  ownership  of  factored  debts  have  been  transferred  to  the Factor or not. In case significant risks and rewards incidental to ownership of the factored debts have not been transferred to the Factor, the debts should continue to be recognised in the books of the company and the prepayment received should be accounted for as a borrowing secured by the  relevant  debts.  On  the  other  hand,  if  significant  risks  and  rewards incidental to ownership of the factored debts have been transferred to the Factor, the factored debts should be derecognised from the books of the company.  In  such  a  case,  the  difference  between  the  value  of  factored debts and the prepayment received should be shown as amount recoverable from the Factor.

12. The  Committee  is  of  the  view  that  significant  risks  and  rewards incidental to ownership of the factored debts would get transferred to the factor, if and only if the company has transferred to the Factor:  

-  all significant rights or other access to benefits relating to the said debts; and

-  all significant exposure to the risks inherent in those benefits.

13. The  Committee  is  of  the  view  that  significant  rewards/benefits relating to the ownership of the debts are the future cash flows arising from  the  payments  by  debtors.  Similarly,  significant  risks  relating  to ownership of debts are slow payment risk and the credit risk (i.e., the risk of bad debts).

14. The  Committee  notes  the  following  clauses  from  the  factoring agreement supplied by the querist:  

“Clause 4(F) If the total amount due from any customer comprises both purchased debts and other debts (the unsold debts) any payment received  from  such  customer  shall  as  between  the  parties  to  this agreement be deemed to have been paid by the customer first in or towards satisfaction of the sums then due by the customer in respect of  the  purchased  debts  and  secondly in  or  towards  satisfaction  of any sums then due from the customer in respect of the unsold debts.”

“Clause 5(B) On the last working day of each calendar month, the Factor shall calculate the Discount charge for the month, based on day to day debit balances in Client’s Prepayment Account at the rate set  out  in  the  schedule,  and  recover  the  same  from  Client’s Prepayment Account, under advice to the client.”

“Clause  8(a)  The  client  shall  pay  to  the  Factor  forthwith,  on demand,  the  amount  of  a  debt,  if  the  customer  fails  to  make  the payment within  the maturity date or  the grace period that  may be permitted by the Factor or if the customer claims to reject the goods/ or fails or declines or disputes his liability to pay that debt or any part thereof and gives as a reason therefor any alleged breach by the client of the contract or if such debt shall for any other reason not be or becomes due and owing or shall be alleged by the customer not to be due and owing.”

“Clause 8(f)  The client shall indemnify and keep indemnified the Factor  against  any  and  all  claims  or  counterclaims  of  whatsoever nature  by a  customer  in  respect of  a  purchased  debt and  all  costs and expenses suffered or incurred by the Factor in connection with any such claim and the client shall pay to the Factor, without any deduction  whatsoever,  the  amount  of  any  losses,  damages,  costs, charges and expenses so suffered or incurred by the Factor.”

“Clause 9(D)  If on account of insolvency, liquidation, moratorium, or other disability attaching to or in respect of the debt assigned to the Factor or due to protracted default on the part of the customer, the Factor is not in a position to realise or recover the whole or any part of such debt the client shall, at the option of the Factor, forthwith repurchase such debt, and for this purpose, the purchase price shall be a sum equal to the purchase price previously paid, or agreed to be paid by the Factor, in terms of clause 3-C less any sum previously received by the Factor on account of the relevant debt.”

“Clause 22   Costs and Expenses

All costs and expenses (including legal costs incurred by the Factor between counsel and client on a full indemnity basis) in preparation, administration,  and  management  of  this  agreement  and  for  the purpose  of  transfer  and  assignment  including  reassignment  of  the debts and costs of recovery and realisation thereof shall be borne by and be to the account of the client, and the client shall, merely upon the  receipt  of  a  request  for  reimbursement  from  the  Factor,  shall reimburse the same. In the event of any failure by the client to do so the  Factor  shall  be  entitled  to  debit  the  personal  account  of  the client in its books of account with the amount so incurred together with  interest  at  the  rate  of  2%  above  the  rate  specified  in  the Schedule.”

15. The  Committee  notes  from  the  above  that  slow  payment  risk  is borne by the company for the reason that the Factor continues to charge interest/discount  on  all  prepayments.  Also,  the  company  continues  to bear the credit risk since it is required to make the payment to the Factor if the customer fails to make the payment within the maturity date or the grace  period  that  may be  permitted  by the  Factor.  Even  in  the  case  of insolvency, liquidation, etc., in respect of the debt assigned to the Factor, the risk of loss remains with the company. The Committee is, therefore, of the view that all significant risks related to ownership of debts remain with the company. Accordingly, the factored debts should continue to be recognised in the books of the company at full amount and prepayment received from the factor should be shown as a borrowing secured by the relevant debts.

D. Opinion

16. On the basis of the above, the Committee is of the opinion that the company should continue to recognise the factored debts at full amount and prepayment received, if any, from the Factor should be shown as a borrowing secured by the relevant debts.

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1 Opinion finalised by the Committee on 18.12.2001.