DAVID GUSTIN, Chief Strategy Officer, The Interface Financial Group
Whichever way you look at it and define it, supply chain finance has grown into a big number. And if you define it as using the balance sheet of a large company to offer early payment to some or all of its suppliers, it is has gained in popularity. Plus, it’s not only offered by large banks who can both originate and distribute large-scale programs for the likes of Unilever or Procter & Gamble, but also non-bank asset arrangers like Greensill, Seaport and others working together with source-to-pay platforms or directly with buyers to develop programs.
And always in the background we have heard this whispering of accounting treatment. And by now, most people who have dabbled in this space know the issue: Is it trade payable or is it debt? Fewer understand the implications.
If the supplier finance arrangement is treated as debt, the company will be subject to disclosing this on its borrowing arrangements. This action will have an impact on its ratios, especially if the program is very large, as was the case with Carillion and Abengoa, where it was not disclosed anywhere on financial statements. This could reduce the availability of other loan commitments from lenders.
Second, the consequences on the cash flow statement impact whether the cash flows are “operating” or “financing” cash flows. If trade debt, cash flows that extinguish this liability are presented as a financing cash flow.
The regulators have not provided clear guidance on this finance technique, and so it has been up to the accounting firms to make determinations case by case. The Big Four accounting firms have established criteria to make that determination. While the below list is not complete, the following questions tend to be very important in evaluating whether buyers have modified the substance of their liabilities:
- Is the buyer providing a higher level of comfort to the funder? The crux of the issue is if the buyer is confirming to the financial institution that it will pay at maturity of the invoice regardless of trade disputes or other rights of offset it may have against the supplier, then it is giving a higher commitment to pay to the financial institution than it owes to the supplier, and this may be construed as a bank financing and not a trade payable on its books.
- What type of agreements are in place between buyers, suppliers, lenders and their service and platform provider? In general, it is important not to have tri-party agreements with the buyer, seller and funder. It is very important to keep these programs with independent agreements.
- Does the buyer know who the funder is? Buyers generally must keep a hands-off approach as to who funds the program.
- Does the buyer have discretion over the lender?
- Does the buyer extend credit terms as a result of entering the finance program and pay their financier later than they could have paid their supplier under a normal commercial agreement?
In practice, the impact of a supplier finance arrangement on the presentation of a financial liability is likely to involve a high degree of judgment based on specific facts and circumstances.
Given the high stakes involved, there have been a few posts around this topic. In an Oct. 4 sponsored blog on Spend Matters, Taulia wrote, “As a rule of thumb, an early payment finance provider should not be put in a better position than the original trade debtors were.” Yet this is precisely what third-party supply chain finance programs do. By issuing an irrevocable payment undertaking (IPU) or guarantee to a funder, lenders are put in a better position.
In September, The Global Trade Review reported that the International Trade & Forfaiting Association (ITFA) will do research to release a set of guidelines to help those involved in supply chain finance assess their financing programs and “recognize instances where they are being misused — and when they should be reclassified as debt.”
Yet ITFA is not an accounting body, and thus likely lacks the necessary background to provide comprehensive guidelines around these issues — especially in the current grey area created from murky regulatory standards.
These kinds of statements concern me because misinformation is not good for the industry.
When we look at the cases of Abengoa and Carillion, we have to ask ourselves, are these one-offs and “extreme cases” as ITFA believes. Recall we have been living in the most benign credit cycle in all our collective pasts. And recent news about GE regarding accounting irregularities related to massive write downs in its power division to the tune of $22 billion is not comforting.
Without clear rules from regulators, we continue to live in this grey world. But clearly many supply chain finance programs are built on the back of an irrevocable payment undertaking to manage post confirmation dilution risk. While that is perfectly acceptable and is a way to broaden investor appeal, it provides a higher level of comfort to the funder than normal trade payables. That is clear.
This article was published first on Spend Matters.