[Anonymous]

Hello everyone – I’ve attempted to resolve this MCQ several times and I get it wrong everytime. When I read the explanation I cant seem to understand a portion of it. Maybe you could help. The question is as follows:

A comoany enters into an agreement with a firm who will factor the companys account receivable. The factor agrees to buy the companys receivables, which average $100k per month and have an average collection period of 30 days. The factor will advance up to 80% of the FV of the receivables at an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18k in collection expenses over the year. Fees and interest are not deducted in advance. Assuming 360 day year, what is the annual cost of financing?

A. 10%

B. 14%

C. 16%

D. 17.5%

Correct answer says its D because the total amount paid to the factor would be ($100k x 80%) x 10% + ($100k x 12) x 2% = $32k. The net cost is equal to $14k ($32k – $18k cost savings). Therefore, annual interest cost is $14k / $80k = 17.5%.

The part that Im missing is why, if its asking for the annual cost, we have to multiply $100k x 80% instead of ($100k x 12) x 80%???

Your help would be greatly appreciated!

[spatel15]

Got it, I was confused too. Factoring companies just “advance” you some of the receivables; i.e. they'll take the burden of waiting for a fee(interest plus commission), but once ALL the receivables for the agreement(which I think is re-agreed every 30 days?).

Factor companies just hold a reserve balance for the 20% discount, but its still gonna come to you, just not until receivables are collected. Thus not expensed.

[UM1868]

The 10% fee is on money loaned to you. Think of it as what it is, an advance. They are loaning you 80k pretty much. The 2% is on all receivables, or 100k, because they are buying all the receivables at 80k, but processing 100k of receivables.

Bec-76 (7/14)
Aud-81 (8/14)
Reg-82 (7/15)
Far- 82 (10/15)

Moral of the story, don't do your CPA while working in Big 4 Public Accounting.

[Anonymous]

It is really unfortunate that Gleim doesn't have factoring equations or questions. Thank you so much for this

[Anonymous]

I had a problem with this question too I guess because I don't understand what advance means in context of factoring. So “Fees and interest are not deducted in advance” doesn't really mean anything to me

[spatel15]

I'm not totally confident about this, but I'm pretty sure it's just due to potential uncollectibles. Because the bank just intends to take on the liquidity(time) burden and not the risk of bad debt, so it holds a bit(20%) until the collectibles are received. In this question, nothing mentions bad debt and it mentions 30 days' receivable, so after every 30 days(i.e. the collectibles have been received) that 20% reserve is returned.

The part Im not totally sure on is if recourse is in play. I'm pretty sure factoring usually doesn't involve recourse, but I'd have to look back at FAR

Edit: And the charges at end part, that doesn't make too much sense to me either, because I feel like those charges should accrue, but again, they don't mention that the 10% is compounding monthly or anything so it makes sense for the interest part to be what it is. Not sure why the 10% isn't applied to the 2% charge though. Guess it's part of the ordinary business cycle so it doesn't earn interest/doesn't need to be discounted? Idk…im just spewing stuff out now loll.

[Anonymous]

@ spatel and UM1868 thank you both for replying but I still have the same doubt.

– I understand about the discount and and the difference betwwen 10% and 2%. Now, why in the equation to resolve the problem they consider the 12mos to calculate the 2% fee but they only use 1mo to compute the 10% annual rate? How could you assume that the agrreement could be re-agreed every 30days?

@ anjanja, were you able to completely understand the answer given?

By the way, this is a Wiley Excel MCQ for those who are wondering.

[UM1868]

@Coquipr, it has to deal with the 30 day collection pretty much. Due to averaging, at any given time, they would have 100k in A/R due to the collection period of 30 days.

Bec-76 (7/14)
Aud-81 (8/14)
Reg-82 (7/15)
Far- 82 (10/15)

Moral of the story, don't do your CPA while working in Big 4 Public Accounting.

[Anonymous]

Coquipr41,

I can't say I completely understand this, but as to your question about re-agreeing every 30 days, it doesn't say the agreement is for 1 month only, it just says that the average collection period of 30 days, so I assume the agreement is for 1 year? The 80% advance thing isn't clear, do they advance every month or 80% of annual AR? No idea

[spatel15]

Whenever A/R comes in I believe. so…

Month1Day 0:Company A gets 100K receivables.

Month1Day 0: Co. factors receivables to the bank; receives 80K cash; bank now owns A/R and collects directly.

Month1Day 30: Customer pays bank 100K; bank returns that 20K “safety” to Company A. Company A owes 10%/12 on $80K, but interest stops accruing because nothing is owed.

Month1Day 31: No interest being accrued. No balance, except the interest accrued. (interest receivable won't accrue interest though)

Month2Day0: Repeat.

Month2Day31: Back at the same point no customer owes money, bank isn't looking to collect; just add another 10%/12 on 80K for that month's advance.

In that way, interest is only being paid/earned for 80k of advances a month. Yes, I added a day31, just go with it lol. I wanted to give a gap day to emphasize that no interest was accrued for that day.

.

.

.

EDIT:I hope this doesnt confuse you because it's really not formal at all but maybe think of this way:

2% is on the VOLUME of inflows?

10% interest is on the NET average balance over the year?

=/ really taking a leap with this one. i hope no one chews me out lol.

[Anonymous]

so what is it, like a credit line that's being paid out at the end of every month (AR collected)? If the average collection period was 60 days and advance was 160, it wouldn't make a difference, would it?

I don't think the bank actually returns the extra $20000 though

[Anonymous]

Thank you Spatel and UM18, I think I get the average portion now. However,this problem is not clear cut.

[Author]

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