There are three parties directly involved: the factor who purchases the receivable, the one who sells the receivable, and the debtor who has a financial liability that requires him or her to make a payment to the owner of the invoice. The receivable, usually associated with an invoice for work performed or goods sold, is essentially a financial asset that gives the owner of the receivable the legal right to collect money from the debtor whose financial liability directly corresponds to the receivable asset. The seller sells the receivables at a discount to the third party, the specialized financial organization (aka the factor) to obtain cash. This process is sometimes used in manufacturing industries when the immediate need for raw material outstrips their available cash and ability to purchase "on account". Both invoice discounting and factoring are used by B2B companies to ensure they have the immediate cash flow necessary to meet their current and immediate obligations. Invoice factoring is not a relevant financing option for retail or B2C companies because they generally do not have business or commercial clients, a necessary condition for factoring.
The sale of the receivable transfers ownership of the receivable to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the receivable becomes the factor's asset, and the factor obtains the right to receive the payments made by the debtor for the invoice amount, and is free to pledge or exchange the receivable asset without unreasonable constraints or restrictions. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections; however, non-notification factoring, where the client (seller) collects the accounts sold to the factor, as agent of the factor, also occurs. The arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor. If the factoring transfers the receivable "without recourse", the factor (purchaser of the receivable) must bear the loss if the account debtor does not pay the invoice amount. If the factoring transfers the receivable "with recourse", the factor has the right to collect the unpaid invoice amount from the transferor (seller). However, any merchandise returns that may diminish the invoice amount that is collectible from the accounts receivable are typically the responsibility of the seller, and the factor will typically hold back paying the seller for a portion of the receivable being sold (the "factor's holdback receivable") in order to cover the merchandise returns associated with the factored receivables until the privilege to return the merchandise expires.
There are four principal parts to the factoring transaction, all of which are recorded separately by an accountant who is responsible for recording the factoring transaction:
- the "fee" paid to the factor,
- the Interest Expense paid to the factor for the advance of money,
- the "bad debt expense" associated with portion of the receivables that the seller expects will remain unpaid and uncollectable,
- the "factor's holdback receivable" amount to cover merchandise returns, and (e) any additional "loss" or "gain" the seller must attribute to the sale of the receivables. Sometimes the factor's charges paid by the seller (the factor's "client") covers a discount fee, additional credit risk the factor must assume, and other services provided. The factor's overall profit is the difference between the price it paid for the invoice and the money received from the debtor, less the amount lost due to non-payment.