JAIIB IE and IFS Paper-1 Module-D Unit 9 : Factoring, Forfaiting and Trade Receivables Discounting System (2024)

JAIIB Paper 1 (IE and IFS) Module D Unit 9 : Factoring, Forfaiting and Trade Receivables Discounting System (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 1 (Indian Economy & Indian Financial System) includes an important topic called“Factoring, Forfaiting and Trade Receivables Discounting System ”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 1 (IE and IFS) Module D(FINANCIAL PRODUCTS AND SERVICES) Unit 9 : Factoring, Forfaiting and Trade Receivables Discounting System , Aspirants must go through this article to better understand the topic, Factoring, Forfaiting and Trade Receivables Discounting System and practice using our Online Mock Test Series to strengthen their knowledge of Factoring, Forfaiting and Trade Receivables Discounting System. Unit 9: Factoring, Forfaiting and Trade Receivables Discounting System

What Is Factoring?

Factoring is an arrangement for financing a company’s business against invoices raised on its buyers and in which, the factor is responsible for credit control, sales ledger administration, and collection activities. In full-service factoring, the factor bears the losses, if the buyer fails to pay.

The business of factoring in India is regulated by the Factoring Regulation Act, 2011, and Section 2(j) of the Factoring Regulation Act, 2011, defines factoring business as follows:

“Factoring business” means the business of acquisition of receivables of assignor by accepting assignment of such receivables or financing, whether by way of making loans or advances or otherwise, against the security interest over any receivables but does not include:

• Credit facilities provided by a bank in its ordinary course of business against security of receivables;
• Any activity as commission agent or otherwise for sale of agricultural produce or goods of any kind whatsoever or any activity relating to the production, storage, supply, distribution, acquisition or control of such produce or goods or provision of any services.

Types Of Factoring

Two types of factoring services,

Recourse factoring (with recourse):

• In this case of non-payment of invoices by buyers, the factor will recover the amount advanced from the client (seller).

Non-recourse factoring (without recourse).

• Factor provides both finance and credit protection.
• In case of non-payment of invoices by customers, the factor will bear the risk of bad debts and cannot recover the amount from the client/supplier.
• The factor operates by buying, from the seller’s company, their invoiced debts. These are purchased usually with credit protection by the factor, who will then be responsible for all credit control, collection and sales accounting work.
• The management of the seller company can, thus, concentrate on production and sales and need not concern itself, with unremunerative work, like control and sales accounting matters.

Factoring can also be classified as domestic or international, depending upon whether the sellers and buyers are in the same country (domestic) or in different countries (international). International factoring is also called cross-border factoring.

Domestic Factoring

• Under domestic factoring, receivables arising only out of domestic (inland) trade are considered for factoring.
• The supplier/borrower draws bills of exchange for goods supplied and the purchaser accepts them.
• Factor makes an upfront payment of about 80% of invoice value after deducting its discount charges, at normal interest rates for the period of bill of exchange to the supplier.
• The balance of payment (20% of the invoice value) is made, after collecting the payment from the purchaser.
• If the purchaser fails to pay the due amount on due dates, the supplier has to make good the payment.
• The borrower/supplier submits the bill of exchange along with the invoice and LR/ RR receipts, while requesting for factoring the transaction.
• Maximum credit period normally permitted under factoring is 150 days – inclusive of a maximum grace period of 60 days.
• Various Management Information System (MIS) reports such as Debtors Ageing Analysis, Weekly Statement of Accounts, Sales Analysis and Statement of Outstanding Invoices are provided to the seller by the factor.
• Sub-limit of each purchaser is fixed and sum of these sub-limits is the overall limit of the supplier.

International Factoring

In international factoring, there are usually two factors

Export factor

• looks at financing the exporter
• Sales administration (presenting invoices at the right time and collecting payments being the key tasks).

Import factor

• Interested in evaluating the buyer,
• collecting the money on time
• Ensuring that the buyer is protected against default.

International factoring encompasses all the four services,

• Pre-payments,
• Sales ledger administration.
• Credit protection
• Collections

The various steps involved in international factoring are listed here.

• The importer places the order for purchase of goods with the exporter.
• The exporter requests the export factor for limit approval on the importer.
• The export factor, in turn, forwards this request to an import factor in the Importer’s country.
• The import factor evaluates the importer and conveys its approval to the export factor, who in turn conveys commencement of the factoring arrangement to the exporter.
• The exporter delivers the goods to the importer.
• The exporter produces the documents to the export factor.
• The export factor disburses funds to the exporter up to the prepayment amount decided and at the same time forwards the documents to the import factor.
• The importer, on the due date of the invoice, pays the import factor, who in turn, remits this payment to the export factor.
• The export factor applies the received funds to the outstanding amount of the advance against the invoice.
• The exporter receives the balance payment. The above arrangement is also called the Two-factor system.
• In addition to the above, there are three other types of international factoring.

Single factor system –

• In this type of factoring, the import factor comes into focus only if the buyer defaults in making the payment.
• In such case, the export factor recovers the amount from the import factor, and it is then left to the import factor to recover the factored amount from the buyer.

• Factoring Agreement
• Delivery of goods
• Assignment of accounts receivable
• Funding to supplier by export factor
• Payment by buyer to export factor
• In case buyer does not pay in 90 days, import factor pays to export factor
• If point (6) materialises, import factor recovers amount from buyer

Direct Export Factoring System –

• In this system, there in only one factor, viz., the Export Factor.
• This factor manages all aspects of the factoring transaction

• Factoring Agreement
• Delivery of goods
• Assignment of accounts receivable
• Funding to supplier by export factor
• Payment by buyer to export factor

Direct Import Factoring System –

• In this type of factoring, there is only one factor, viz., the import factor and the sellers directly deal with the import factor for all aspects of the transaction.

• Factoring Agreement
• Delivery of goods
• Assignment of accounts receivable
• Funding to supplier by import factor
• Payment by buyer to import factor

Bills Discounting Vs Factoring

• Although, both bills discounting and factoring involve financing of receivables (often exports receivables), there are differences between them.

Fees Involved In Factoring

Finance Charge

• Finance charge is computed on the pre-payment outstanding in exporter’s account, at monthly intervals.

Service Fee

• Service charge is a nominal charge levied, at monthly intervals in order to cover the cost of services, viz., collection, sales ledger management and periodical MIS reports.
• It ranges from 0.1% to 0.3% on the total value of invoices factored/collected by the Banks.

Advantages Of Factoring

• Factoring replaces high-cost market credit and enables purchases on cash basis, for availing cash discounts.
• The customer gets instant finance against each invoice.
• Low margin (up to 20%), thereby improving cash flow.
• The customer gets large credit/grace period.
• Each invoice is followed up for payment by the factor, on the due date and thereafter.
• MIS reports and sales ledger administration is totally taken care of by the factor.
• Factoring accelerates receivables turnover and improves operating cycle, resulting in more production, larger sales, higher profits and increased ROI.

FORFAITING

What Is Forfaiting?

• Forfaiting can be defined as financing exports by discounting export receivables, evidenced by bills of exchange or promissory notes, carrying medium to long-term maturities, on fixed rate basis (known as discount) up to 100% of the invoice value.
• When an exporter transfers his right to receive payment in favour of the forfaiter, the transaction is called forfaiting.
• Thus, forfaiting is a method of discounting of international trade receivables on a ‘without recourse’ basis.
• Forfaiting is used for international trade transactions.
• In fact, it is the discounting of trade receivables such as drafts drawn under letters of credit, bills of exchange, promissory notes, or other freely negotiable instruments on a ‘no recourse’ basis
• Forfait’ is derived from the French word ‘forfeit’, which means surrendering of rights.
• All forfaiting transactions have a minimum transaction size, normally in the range of US$ 250,000.
• In terms of RBI guidelines, Exim Bank and AD Category – I Banks (on Non-recourse basis only) are permitted to handle forfaiting transactions.

Mechanism Of A Forfaiting Transaction

• Forfaiter gives commitment to forfeit to exporter
• Commercial contract made between exporter and importer
• Shipment of goods to importer
• Exporter submits shipping documents to importer’s bank thru his banker
• Importer’s bank obtains acceptance of importer an bill of exchange
• Importer’s bank co-accepts (avalises) the bill of exchange and sends to exporter thru his banker
• Exporter tenders avalised bill of exchange to forfaiter
• Forfaiter makes payment to exporter, less charges
• Forfaiter presents bill of exchange to importer’s bank on maturity
• Importer makes payment on maturity

Fees Involved In Forfaiting

Discount fees

• Discount is the interest cost payable by the exporter for the entire period of credit involved and is deducted by the forfaiter from the amount paid to the exporter, against the avalised (accepted) promissory notes or bills of exchange.
• The discount is normally linked to an international benchmark interest rate like LIBOR.

Commitment fees

• Commitment fees is payable to the forfaiting agency for its commitment to execute a specific forfaiting transaction at a firm discount rate, within a specified time.
• Ranges between 0.5% and 1.5% per annum of the unutilised amount to be forfaited and is charged for the period between the date the commitment is given by the forfaiter and the date the discounting takes

• Place or until the validity of the forfaiting contract, whichever is earlier.

Advantages Of Forfaiting

The following are the advantages of forfaiting to the exporters:

• 100% Financing: Forfaiting provides 100% financing – without recourse
• Improves cash flow of the exporter: By converting receivables into current cash inflow and it is beneficial to the exporter to improve his liquidity and his ability to improve further the fund-raising capability.
• Saves administration cost: By using forfaiting, the exporter will be freed from the management of the receivables.

Increases trade opportunity: With forfaiting, the exporter is able to grant credit to his buyer freely and thus, be more competitive in the market.

• Helps to realise price transfer: The exporter can also transfer the corresponding financing cost, which is known in advance, into the sale price.
• Enables the exporter to avoid various risks, i.e., forfaiting business enables the exporter to transfer various risks, resulting from deferred payment, such as interest-rate risk, currency risk, credit risk and political risk.

Differences Between Factoring and Forfaiting

TRADE RECEIVABLES DISCOUNTING SYSTEM (TReDS)

What is TReDS?

• TReDS is a scheme for setting up and operating the institutional mechanism, for facilitating financing of trade receivables of MSMEs from corporate and other buyers, including Government Departments and Public Sector Undertakings (PSUs), through multiple financiers.
• It is a form of factoring.
• MSMEs, despite their important role in contributing to the Indian economy, continue to face constraints in obtaining adequate finance.
• One big factor which affects the ability of MSMEs to convert trade receivables into liquid funds are their difficulty to realise the payments, in the absence of any well established system for doing so.
• RBI in the year 2014, introduced the concept of TReDS, a mechanism of trade receivables financing for MSMEs on a secure digital platform.
• It may be stated that the TReDS facilitates the discounting of both invoices as well as bills of exchange.
• Further, as the underlying entities are the same (MSMEs and corporate and other buyers, including Government Departments and PSUs), TReDS could deal with both receivables factoring as well as reverse factoring, so that, higher transaction volumes come into the system and facilitate better pricing.
• “Without recourse” to the MSMEs.

Participants Under TReDS

Direct Participants:

• MSME sellers,
• Corporate and other buyers, including the Government Departments and PSUs, and
• Financiers (both banks and NBFC factors)

• The TReDS will provide the platform to bring these participants together for facilitating uploading, accepting, discounting, trading and settlement of the invoices/bills of MSMEs.
• The bankers of sellers and buyers may be provided access to the system, where necessary, for obtaining information on the portfolio of discounted invoices/bills of respective clients.
• TReDS may tie up with necessary technology providers, system integrators and entities providing dematerialisation services for providing its services

Process Flow Under TReDS

PDF-JAIIB Paper 1 Module D Unit 9-Factoring, Forfaiting And Trade Receivables Discounting System (TReDS) (Ambitious Baba)

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