Invoice factoring off-balance sheet method

With many alternative sources of finance like invoice factoring gaining popularity, businesses have various options to choose from for funding their businesses. While invoice factoring is a common financing option among businesses, one must know the procedures for accounting for it in their final accounts as an off-balance sheet item.

Meaning of invoice factoring

Invoice factoring is a source of finance where businesses realise their outstanding invoices by selling the invoices to a provider at a discount. The provider advances money against the outstanding amounts of the invoices. The provider may be:

• A third-party discounting entity to whom the business sells its invoices at a discount.
• The debtor agrees to the paid value of the invoices earlier for a discount.

Invoice discounting helps convert funds trapped in the form of debtors into cash quickly, allowing businesses to maintain a healthy cash flow. 

Popular international accounting treatment of invoice factoring

Since Invoice factoring does not create a debt for the business, it is treated as an off-balance sheet item in the financials. Off-balance sheet items are assets or liabilities that are not reported on the balance sheet. Examples of off-balance sheet items include contingent assets, contingent liabilities, guarantees, letters of credit, operating leases, etc. Hence, finances through invoice factoring are not recorded in the business’s balance sheet. 

This type of financing helps improve the overall outlook of the business by bringing in liquidity to the business without creating leverage and helps maintain a low debt-equity ratio. However, invoice factoring may become a liability for the business despite not being on the balance sheet. In cases where a third-party factor gives a secured advance against the invoice and the debtor defaults, these items turn into obligations.

Businesses disclose off-balance sheet items by following GAAP (Generally Accepted Accounting Principles). Hence, third-party invoice factoring finances appear under accompanying notes. The discounting and factoring costs are written off as borrowing costs against incomes. In the case of third-party secured factoring, the accounting also depends on the likelihood of the debtor to pay. If the debtor is highly unlikely to pay the invoice value, the business must consider the risk of non-payment and make necessary provisions. 

How to record invoice factoring in accounts in India

Indian Accounting Standard 37 deals with the disclosures related to off-balance sheet liabilities. As long as the chance of a liability occurring is remote to none, the business can report invoice factoring in the financials under the supporting notes. Adequate disclosures must be made about the type and amount of finance obtained from invoice factoring. Invoices discounted from the buyer are shown as advances from the buyer, and the discount is written off against income. 

Invoice factoring is an off-balance sheet financing method and is subject to similar limitations. One must not misuse such sources of finance since they can hide assets and liabilities. When one abides by regulations and principles of disclosures, invoice factoring can legally be a great source of finance.