At the Supply Chain Finance Forum in Amsterdam last December, the panel on the accounting treatment of reverse factoring (RF) programmes prompted lively discussion between the accounting experts on stage and the supply chain professionals from the banking and corporate worlds in the audience. The challenge of ensuring that RF programmes don’t result in trade payables being reclassified as bank debt remains one of the most contentious issues we face.
Perhaps the single biggest point to come out of that discussion was the argument that there isn’t enough guidance from the accountancy profession which is sometimes divided as to how exactly the trade debtors in specific programmes should be accounted for. This leaves corporates and finance providers scratching their heads as they try to implement SCF programmes and innovate new structures.
It’s timely, then, that the Supply Chain Finance community is about to publish a short research paper that identifies the three most important factors relevant to the decision as to whether to reclassify trade payables that qualify for a supply chain finance programme:
- Whether payment terms are in line with those in the rest of the business: How much of the supplier base is included in the payment terms extension is an important factor in evaluating whether the characteristics of trade payables has been changed. Likewise, offering an SCF programme to a restricted number of suppliers could be a signal that the affected trade payables should be treated as debt. Taking these together, it emerges that the most important factor is that the payment terms for suppliers in the SCF programme do not deviate from the normal payment terms across the business.
- Whether anything such as fee or interest payments or guarantees are given by the buyer to the bank or suppliers. If the buyer makes any kind of interest payment on trade payables that have not yet fallen due, that would signal that reclassification could be called for. Similarly, in the ordinary course of business, quality shortcomings or delivery of damaged goods usually give the buyer rights against the supplier. If because of an SCF programme, however, the buyer is still required to pay the bank in full despite receiving damaged goods, say, and instead must negotiate a credit note for future purchases from the supplier, then the SCF arrangement could well require reclassification of trade debtors. Moreover, buyers don’t usually experience a direct benefit if suppliers take part in an offered SCF programme. But if they were, for example, to receive favourable finance rates or some kind of fee from the bank related to the volume of debts factored by suppliers, then that could be a flag that the trade payables should be reclassified.
- The existence of separate agreements or tri-party agreements: If the buyer has been involved in negotiations between suppliers and the bank – or there is a tri-party contract – then it becomes more difficult to argue that the buyer doesn’t have a financing arrangement with the bank. Such arrangements could well require that the trade payables be reclassified.
More specific guidance from the global accounting boards that set the financial reporting standards would go a long way to providing greater certainty as to the circumstances in which these factors would apply. But that’s not to say that bankers or corporates should expect a checklist with which one can go tick, tick, tick and be sure that any proposed SCF scheme would survive a reclassification discussion. That would be as unlikely as having a checklist that would guarantee eligibility for a bank loan!
Does the accounting actually matter?
But the larger question is, even with more clarity as to how debtors should be treated in the balance sheet, does it really matter? My belief is that corporates will increasingly focus on the EBIT benefits of supply chain finance rather than the balance sheet or working capital benefits.
In the shorter term, at least, that will result in a greater rate of take-up of dynamic discounting (DD) rather than reverse factoring. The P&L benefit that corporates currently enjoy from DD improves EBIT, while the financial yield generated by the working capital benefit only benefits the P&L below the EBIT line
In time, however, we should see innovative finance facilities become available that enable corporates to take advantage of DD without deploying their existing cash resources. These new hybrid models will effectively arbitrage between DD and RF. This will especially be the case in an environment where the focus of the financial community – analysts, bond holders, shareholders and credit ratings agencies – is on disclosure, transparency, and cash flow rather than balance sheet classification of debts.
Admittedly, for now we have to contend with legacy bank and bond covenants that don’t provide for the possibility that trade debtors might wind up in a different part of the balance sheet. But that need not be the case for covenants written in future. And in any event, many businesses could easily take reclassification in their stride today without encroaching on their covenant limits. So they can afford to be more agnostic about the accounting treatment of debtors.
In other words, today’s raging debate about how to ensure that RF programmes don’t result in the reclassification of trade debtors is one that generates more heat than light. It will ultimately be rendered pointless as supply chain finance grows, innovates and matures.