Question

Wood Incorporated sells $150,000 of accounts receivable to Engram Factors Inc. On a with-recourse basis. Engram assesses a finance charge of 2% and retains an amount equal to 6% of accounts receivable. Wood estimates a fair value of recourse obligation to be $7500. Prepare the journal entry for (a)Wood Incorporated (b) Engram

Do (1) journal entries, (2) adjusting entries, and (3) closing entries

Answer 1

Definition and explanation:

Factoring accounts receivable means selling receivables (both accounts receivable and notes receivable) to a financial institution at a discount. Factoring is a common practice among small companies. The institution to whom receivables are sold is known as factor.

Someone might think, why companies sell their receivables? The answer is simple – to meet their immediate cash needs. Rather than waiting for the due date, a company may quickly convert its receivables into cash by selling them to a factor for a fee which is usually a small percentage of the total value of the receivables being factored. As the due date approaches, factor meets receivables and collects full amount of cash. The difference between the cash collected from receivables and the cash paid to the seller company forms the profit of the factor.

In a factoring transaction, the receivables are evaluated regarding their recoverability and a fee is agreed upon between the factor and the seller. The factor then takes over the receivables along with all relevant records and pays the cash to the seller after deducting the agreed fee. In addition to this fee, the factor may also retain a small percentage of receivables for probable adjustment for discounts, returns and allowances. The amount deducted for such adjustments is usually refundable.

Accounts receivable are factored either without recourse or with recourse. These two conditions are breifly discussed below.

Factoring without recourse:

When accounts receivable are factored without recourse, the factor (purchasing institution) bears the loss resulting from bad debts. For example, if a receivable whose account has been factored becomes bankrupt and the amount due from him cannot be collected, the factor will have to bear the loss.

Factoring with recourse:

In a factoring with recourse transaction, the seller guarantees the collection of accounts receivable i.e., if a receivable fails to pay to the factor, the seller will pay. As the recovery is guaranteed by the seller, a recourse liability is determined and recorded by him. The loss on sale of receivable is also increased by the amount of recourse liability.

Considering the above theory lets solve the given problem :

A. Journal Entries in the Books of Wood Incorporated
Account Name	Desription	Debit	Credit
Cash	($150,000 - $9,000 - $ 3000)	138,000
Due from Engram Factors Inc.	6% of $150,000	9,000
Loss on Sale of receivables	(2% of $150,000)+ $7500	10,500
Accounts Receivables			150,000
Recourse Liability			7,500
		157,500	157,500
Ajustment entry for reversing Recourse Liability
Account Name	Desription	Debit	Credit
Recourse Liability		7,500
Loss on Sale of receivables			7,500
		7,500	7,500
Closing Entries for receipt of retention amount
Account Name	Desription	Debit	Credit
Cash		9,000
Due from Engram Factors Inc.			9,000
		9,000	9,000
Notes:
1. Due from Factor is calculated as a percentage of total accounts receivables.
2. Since the factoring is with recourse basis, the seller has to account for the expected liability of recourse obligation. Wood estimated the fair value of recourse obligation to be $7,500. So this $7,500 is added to the 2% finance charges to arrive at the total Loss on sale of receivables. As per the Accounting principles we have to account for the expected future losses
3. It is assumed that at the end of due date the Engram Factors Inc. is able to collect the full value of $150,000 from the parties
B. Journal Entries in the Books of Engram Factors Inc.
Account Name	Desription	Debit	Credit
Accounts Receivable		150,000
Due to Wood Incorporated	6% of $150,000		9,000
Cash	($150,000 - $9,000 - $ 3000)		138,000
Finance Revenue	2% of $150,000		3,000
		150,000	150,000
Closing Entries for receipt from accounts receivable
Account Name	Desription	Debit	Credit
Cash		150,000
Accounts Receivable			150,000
		150,000	150,000
Closing Entries for payment of retention amount
Account Name	Desription	Debit	Credit
Due to Wood Incorporated		9,000
Cash			9,000
		9,000	9,000