To Reclassify Trade Payables or Not?
Early Pay Programs and their Accounting Treatment
David Gustin, Managing Editor, Trade Financing Matters, IFG Chief Strategy Officer
As more companies adopt early pay programs, including self funded and third party supply chain finance (“SCF”) programs, concerns are growing that third-party arrangements could trigger accounting problems. Trade Finance Matters examines the background and where we are today.
With the explosion of early payment solutions to assist a buyer’s supplier group (egs. dynamic discounting, reverse factoring, pcards) and the start of receivable auction markets, the issue of rebates and retiring payables early has become serious. The concern is that such an arrangement could prompt the Securities and Exchange Commission to require the company to reclassify its trade payables as short-term bank debt, potentially impacting loan covenants and leverage ratios.
For dynamic discounting programs, most of these programs are generally small and still self-funded by the corporate themselves. But, and here is the big issue, what happens when non banks become more significant and touch on more spend besides indirect?
Robert Comerford, a former professional accounting fellow in the SEC’s Office of the Chief Accountant (OCA), first addressed the issue of supply chain finance in speeches he did back in 2003 and 2004. Comerford posed several rhetorical questions about SCF arrangements, including whether the financial institution makes any sort of referral or rebate payments to the client, and whether it reduces the amount due from its client so that the payment is less than it otherwise would have paid to the vendor. This was a time when rebates (think of rebates as the buyer participating in the benefits of the financing by taking a portion of the spread) were rampant.
Two things have changed drastically in North America programs since that time.
- First, back in 2003 when Mr. Comerford made his comments, the bank had an agreement with the buyer that guaranteed them payment. Today, in most SCF programs, the banks purchase receivables from the supplier, check for liens against the receivables, file UCC statements (in the US), etc. In order to get paid the bank needs to rely on the validity of their receivable purchase, not on a guarantee from the buyer. That was not the case in 2003.
- Second, and this is most important, companies are aware of the rebate concerns with supply chain finance programs and most have taken the conservative route. The concern has long been that a funding provider is paying the buyer for access to their suppliers and the data from their internal systems and the buyer is participating in the benefits of the financing in some form of rebate (or cut of the spread). We believe that is because the rebate issue so critical back in Comerford’s days is no longer an issue.
In reaching out to various consultants and others, we have not found one instance of reclassification.
What we did find in speaking with a few large Fortune 1000 corporations is that they discontinued the practice of being offered data and access fees for every invoice sent to a funder (ie, the Buyer would get part of the spread).
This practice has been offered by a few select banks and vendors as recently as four years ago. Most corporations are now conservative enough with their accounting treatment and it appears to not be a standard offering. In addition, some companies mentioned that if their suppliers knew they were receiving a benefit on their margin, it would impact supplier negotiations.
Nomenclature around Self-funded and Third Party Programs
Supply chain finance is a confusing term and unfortunately many in the industry use the term to mean different things. Supply chain finance is part of a corporations Trade Credit, that is inter-firm trade credit between buyers and sellers. We tend to view supply chain finance as either self-funded using various early pay tools, or funded via third parties using platforms and financing techniques.
Self Funded Early Pay
Dynamic Discounting (DDM) means the supplier gets paid earlier than the due date on the invoice and money comes from the balance sheet of the buyer. That implies two things, the DPO metrics of the buyer will change as the Buyer extinguishes a payable earlier. And the buyer earns a discount in return. DDM is an online request for a change to a payment term.
The accounting issue with self-funded early pay is limited to one thing – what do you do in a VAT regime? Depending on the country, it can be calculated on the amount of the invoice and other times it can be calculated on the amount paid. This is not a SEC issue as there is no funding occurring.
Vendors operating in different tax jurisdictions, whether it be sales tax, VAT, or some VAT equivalent, should be able to adopt their platform whether you adjust net or gross price. For example, in the U.K., if an invoice is for £120 gross, £100 plus VAT and the buyer has a 2% rebate program, payment made to a supplier is £98 + VAT, so the supplier gets £117.60. The vendor can adjust the account system of the buyer the fact they paid less to the supplier and the fact VAT is less. The system can supply a debit note to supplier so they can reconcile new price for the goods and new VAT for the goods.
As to how companies record discounts, most corporations account for the discount the same way they account for traditional discounting, in most cases there is a discount account and that gets split back across cost centers where the original invoice (or buy decision) to credit the buying department. DDM should not be any different than what’s been done with decades with 2% net 10. Every company should have a policy on how they handle traditional discounts that has been vetted by their external auditor.
Funded by Third Party (Factor, Bank, Non Bank, Pcard)
What the market calls Supply Chain Finance – examples include Taulia’s TED program or PrimeRevenue’s multi-bank supply chain finance program, or Orbian’s capital market program, this is where the supplier is paid early but the money comes from someone other than the buyer. Now the issue becomes does the buyer keep it as trade payable or should they reclassify as debt.
The determination comes from the criteria that are applied. The Big Four accounting firms have established criteria (which is mostly consistent, but there would be some differentiation), to make that determination. There is not 100% consistency across the firms that make this determination.
This definition of third party funding can apply to a number of early pay techniques, including:
• Bank Approved Trade Payable programs (or Bank Supply Chain Finance)
• Pcards – pcards clashes with many of the criteria that Big 4 use with classification but all pcard is classified with Trade Payables.
Auditors and the Relationship with their Clients
I think it is important to note that when a corporation implements an early pay initiative, the two big areas that drive programs are Procurement and the Assistant Treasurer, and neither one of these deals with the external auditor. They may ask their internal auditor to get an opinion. Their internal auditor may ask the external auditor how to contemplate treating the proposed program.
What is most important is the criteria the lead auditing partner for Disney or Kraft uses to instruct his staff when reviewing Disney or Kraft’s receivables and payables. This is the most important checklist. And I am sure every company’s checklist for AP and AR is different.
Overall, the market for third party funding of payables is small, whether it be dynamic discounting programs, bank supply chain finance, or other techniques. For any one large corporate, confirmed payables are insignificant relative to their overall payables. For example, a typical Fortune 1000 running a program will have AP transactions into the many millions, with only a few thousand being part of a confirmed payables program.
Vendor Criteria to determine Trade Payable or Trade Debt
When it comes to the question of criteria for vendors using third party funding sources, the three questions to ask are:
1. What are these criteria?
2. How does any third party funded model perform against these criteria?
3. How do you minimize risk of reclassification to trade debt?
While this list is not complete, the following questions tend to be very important in evaluating programs:
• 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 agreement, ie, no tri-party agreement between 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 know the commercial borrowing terms?
• Does the Buyer have as part of the initiative the desire to extended payment terms?
If you answer yes to many of these questions, that is an indicator of trade debt.
Early Pay Vendors with Third Party Models Comments
One early payment vendor planning to offer third party finance commented, “We are building an automated factoring program, we make a deal between the supplier and lender. We can make better deal than factoring because we have way more information our platform controls payment, payment date, and amount, there is not double payment, no late payment, and no short pay. There is no agreement with Buyer. Buyer only has agreement with us.”
Buyer pays supplier account specified for supplier and the supplier in our platform has the ability to manage their “pay to” account. That’s a feature we have for all suppliers and their remit to addresses, etc. What we do we obtain the right from supplier on suppliers behalf to modify the pay to account to implement the factoring transaction. But for the Buyer just like normal factoring, you pay the supplier into the account specified by the supplier.
We do same thing but completely automated. The supplier agrees with us that we have the permission to implement on his behalf the factoring transaction and because we have access to the payment system of buyer we automatically put in collection account of supplier but we don’t override the supplier. We put it in only for this transaction and for this invoice. And that is extremely clean.
A supply chain finance vendor commented back in the early days, under early payment programs, when a supplier wanted early payment, the bank simply paid the supplier early on behalf of the buyer. The bank had an agreement with the buyer that guaranteed them payment. Today, in most SCF programs, the banks purchase receivables from the supplier. In order to get paid the bank needs to rely on the validity of their receivable purchase, not on a guarantee from the buyer. Also, regarding independent platform providers, those providers separate the buyer from the bank and don‚t utilize a contract between the buyer and the bank. So, while they certainly don‚t ensure maintaining a trade payables classification, they do eliminate some of the risk, such as the possibility of a tri-party agreement between the bank, buyer and supplier.
Shelly Luisi, senior associate chief accountant in the SEC’s Office of Chief Accountant (OCA), says that to her knowledge, the SEC hasn’t provided any additional public guidance on how to account for potentially problematic payables transactions since Comerford’s comments.
“The company may be sending the money to a different bank account, but if its relationship with the vendor stays the same, then the arrangement could very well be acceptable,” Luisi says.
She emphasizes that the OCA has yet to see two such arrangements that are the same and says each arrangement has to be examined individually to determine the proper accounting treatment. Luisi adds that OCA is occasionally asked to review a company’s accounting treatment for a supply-chain-finance program through its filings consultation process, which allows companies to submit the details of a transaction along with the proposed accounting to see if OCA has any objection to the proposal.
According to Luisi, she has not seen a consultation request that‚s included marketing fees since about the time of [Comerford’s] speech. In summary, I think it’s pretty clear that there is no clear guidance from the IFRS in regards to reclassification of trade payables to debt. This is something of paramount importance, as large companies will continue to be conservative. This issue continues to slow down acceptance of these programs and make the set up costs more expensive by enriching accounting firms.
Some of the large corporates I have dealt with are concerned with issues around credit notes (ie, dealing with returns with suppliers). Another big concern is providing some comfort to suppliers that this form of finance will not be pulled in three months (or some minimum period) thus risking reclassification.
It is time to get accounting guidance on these issues, as these Buyer led programs have proven to be a viable form of finance to suppliers.