Definition and Explanation
Pledging accounts receivable is essentially the same as using any asset as collateral for a loan. Cash is obtained from a lender by promising to repay. If the loan is not repaid, the collateral will be converted to cash, and the cash will be used to retire the debt.
The receivables can be either an identified set of notes and accounts or a general group in which new ones can be added and old ones retired. The collection of a pledged receivable has no impact on the loan balance.
The pledging agreement usually calls for the substitution of another receivable for the one collected.
As an example, suppose that Sample Company borrows $80,000 on 31 December 20×1, and agrees to pay back $81,600 on 1 April 20×1. Further, it pledges $100,000 of trade receivables for the loan. The company would make three journal entries as follows:
The last two entries can be combined, but they are shown separately here to facilitate a comparison of pledging with the other approaches.
The only financial statement disclosures provided for pledged receivables are notes or parenthetical comments. A similar notation is provided for the notes payable.
As an alternative to pledging, the company may decide to assign its receivables to a lending institution. Under this arrangement, the original holder essentially transfers title to the third party but agrees to collect the receivables and pay the cash to the factor.
Suppose that Sample Company obtains $80,000 cash on 31 December 20×1 by assigning $100,000 of its trade receivables.
The company agrees to place the collections in a special restricted checking account from which it will repay the original $80 000 plus a $2,400 finance charge on April 1, 20×2.
These journal entries would be made as follows:
To record partial collection of the assigned accounts:
To accrue the finance charge:
To reclassify the uncollected accounts and unrestricted cash:
The disclosures that would be provided on various balance sheet dates are shown in the following example, under the simplifying assumption that no other activity took place.
Notice that the payable to the factor is contra to the assigned accounts. Any restricted cash balance is, in turn, contra to the payable account.
Most arrangements of this type call for more frequent payments than the example shows. The net result of the assignment is that Sample Company obtained $80,000 by giving up $82,400 of receivables.