What Is Factoring in Bookkeeping? A Simple Guide for Business Owners

Waiting for customers to pay their invoices can be frustrating, especially when your own business expenses aren't waiting around.

For businesses that offer customers 30, 60 or even 90-day payment terms, managing cash flow can sometimes be challenging. One financial arrangement you may have come across is invoice factoring.

But what exactly is factoring in bookkeeping, how does it work, and how should it be recorded in your accounts?

What is factoring in bookkeeping?

Factoring, also known as invoice factoring, is a financial arrangement where a business sells its unpaid customer invoices to a third-party finance provider, known as a factor.

Rather than waiting for customers to settle their invoices, the business receives an advance on the money owed, usually around 80% to 90% of the invoice's value.

When the customer pays, the factoring company releases the remaining balance, minus its fees.

Essentially, factoring allows businesses to access money tied up in outstanding invoices before their customers have paid.

How does invoice factoring work?

Let's say you run a construction company in Dartford and have completed £10,000 worth of work for a commercial customer.

You've sent your invoice, but your customer has 60 days to pay. Rather than waiting two months, you enter into an invoice factoring agreement.

Here's what happens:

1. You raise your invoice: You invoice your customer for £10,000.
2. The factoring company advances the money: The factoring provider purchases the eligible invoice and advances 85% of its value, meaning you receive £8,500 upfront.
3. Your customer pays: When the invoice becomes due, your customer pays the £10,000 directly to the factoring company.
4. You receive the remaining balance: The factoring company releases the remaining £1,500, minus its agreed fees. If those fees total £300, you receive a further £1,200.

In this example, your business receives £9,700 in total, with £300 going towards factoring fees.

The main difference is that you've received most of the money earlier, rather than waiting the full 60 days.

These figures are illustrative and exclude VAT considerations and any additional charges.

Who uses invoice factoring?

Invoice factoring is most commonly associated with businesses that invoice other businesses and offer extended payment terms.

Industries where factoring may be encountered include:

• Construction: Contractors and subcontractors waiting for commercial clients to pay.
• Recruitment: Agencies paying temporary workers before receiving payment from clients.
• Manufacturing: Businesses supplying products to customers on credit terms.
• Wholesale: Companies supplying goods to retailers with agreed payment periods.
• Professional services: Businesses invoicing commercial clients for completed projects.

Factoring is generally more relevant to businesses with business-to-business (B2B) invoices than those receiving immediate payments from consumers.

What are the advantages and disadvantages of factoring?

Like most financial arrangements, invoice factoring has benefits and drawbacks.

AdvantagesDisadvantagesEarlier access to money from unpaid invoicesFactoring fees reduce the amount receivedCan improve short-term cash flowCustomers may deal directly with the factoring providerMay include credit control servicesSome agreements involve minimum charges or contractual commitmentsFunding may increase alongside eligible salesBusinesses may remain liable for unpaid invoices

It's also important to understand the difference between recourse and non-recourse factoring. With recourse factoring, the business generally remains responsible if a customer doesn't pay. Non-recourse factoring may transfer certain specified non-payment risks to the provider, subject to the agreement's conditions and exclusions.

How is factoring recorded in bookkeeping?

Factoring needs to be recorded correctly to ensure your business accounts accurately reflect your income, expenses and outstanding balances.

Your bookkeeping will need to account for:

1. The original invoice: Recording the sale and the amount owed by your customer.
2. The advance payment: Recording the money received from the factoring company.
3. The factoring fees: Recording the provider's charges as an appropriate business expense.
4. The final settlement: Reconciling the remaining balance when the customer pays.

One important point is that money received through factoring isn't additional sales revenue. The original sale has already been recorded, so recording the advance as new income could artificially inflate your turnover.

The exact bookkeeping treatment depends on the factoring agreement. Some arrangements involve the sale of a receivable, while others are accounted for as secured financing.

Does factoring affect VAT?

Factoring can have VAT implications, particularly depending on how your business accounts for VAT.

Under standard VAT accounting, VAT is generally accounted for according to the usual tax point rules, regardless of whether the customer has paid.

Businesses using the VAT Cash Accounting Scheme need to be particularly careful, as selling or assigning an invoice can affect when VAT becomes payable.

The VAT treatment of factoring fees also varies depending on the services provided.

An accountant can help ensure factoring transactions and any associated VAT are recorded correctly.

Is invoice factoring the same as invoice discounting?

Although they're similar, there is an important difference.

Invoice factoring usually involves the finance provider managing customer payments and collecting outstanding invoices.

Invoice discounting typically allows the business to retain responsibility for collecting payments, meaning customers may not know that a finance provider is involved.

Both arrangements release funds against unpaid invoices, but they differ in how customer relationships and credit control are managed.

Is factoring a loan?

Not necessarily. Traditional factoring involves selling unpaid invoices to a finance provider, whereas a loan involves borrowing money that must be repaid.

However, some factoring agreements are treated as financing arrangements for accounting purposes, depending on their contractual terms and who retains the risks associated with the invoices.

How Blue Rocket Accounting can help

At Blue Rocket Accounting, we know that understanding your business finances is about more than simply keeping track of income and expenses.

Whether your business uses invoice factoring or other financial arrangements, accurate bookkeeping is essential for understanding your cash flow, profitability and overall financial position.

Our team supports businesses across Dartford, Kent and the surrounding areas with bookkeeping, management accounts and ongoing accounting support.

Need help making sense of your business accounts?

Call the Blue Rocket team on 01322 555 442 to find out how we can help.

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