Accounts receivable pledging occurs when a business uses its accounts receivable asset as collateral on a loan, usually a line of credit. When accounts receivable are used as collateral on a loan, the lender typically limits the amount of the loan to either:
- 70% to 80% of the total amount of accounts receivable outstanding; or
- A percentage of the accounts receivable that declines based on the age of the receivables.
The latter alternative is safer from the perspective of the lender (and is therefore more commonly used), since it allows for more specific identification of those receivables least likely to be collected.
For example, a bank may not allow any accounts receivable to be used as collateral if they are more than 90 days old, 80% of all receivables between 30 and 90 days old, and 95% of all receivables that are 30 days old or less. The lender may also specifically exclude any receivables for which the company has granted unusually long payment terms. By being this conservative in calculating the maximum amount to be loaned, the lender protects itself from issuing debt that cannot be fully offset by collateral in the event of a payment default.
Under an accounts receivable pledging arrangement, the company subject to the arrangement completes a borrowing base certificate following the completion of each reporting period, and forwards the signed certificate to the lender. The lender may also require that a copy of the month-end accounts receivable aging report be forwarded along with the certificate, in case the lender wants to trace the amounts on the certificate back to the underlying accounts receivable detail. This request is most commonly made at the end of the year, not for each monthly certificate.
The borrowing base certificate itemizes the amount of accounts receivable outstanding at the end of the reporting period into the age brackets specified by the lender, calculates the maximum amount of borrowing allowable based on the amount of accounts receivable, and states the amount actually borrowed. The lender uses this certificate to monitor the amount of collateral available, and whether it needs to adjust the amount of debt available to the company. If the amount of debt outstanding exceeds the amount of accounts receivable stated in the borrowing base certificate, the borrower must pay this amount back to the lender.
Under a pledging agreement, the company retains title to and is responsible for collecting accounts receivable, not the lender. Even though the lender now has a legal interest in the receivables, it is not necessary to notify customers of this interest.