One of the perceived challenges with supply chain finance programmes is the need to structure them in a way that keeps the trade payables within working capital from an accounting perspective, and not moved elsewhere in the balance sheet, becoming reclassified as bank debt. Why does this matter? And what needs to be done to ensure that the accountants and auditors are happy?

In pure cash terms, of course, there is no difference between having a trade payable due in 45 days and having a bank debt due in 45 days. So it would seem that how an obligation is classified is a bit like worrying whether an IOU is in your left pocket or your right.

But there’s more to it than that. The Conceptual Framework – the set of principles that underlie international financial reporting standards (IFRS) – says that information about the payment requirements of existing obligations “helps users to predict how future cash flows will be distributed among those with a claim against the reporting entity”. Putting that IOU in the right part of the balance sheet, therefore, helps everyone understand why that lump of money is owed to anyone at all.

David Quillian, general counsel with Prime Revenue, says that in the ‘pocket’ analogy above, “The right pocket relates to your core business operations with regard to your trade payables whereas your left pocket is a financial debt owed to a financial institution.

“Things that relate to your core business operations and financial efficiencies in your core business operations are good. Debt that is owed to financial institutions is the type of debt that leads companies to bankruptcies so that’s bad.”

It’s a particularly important issue for public companies, under the scrutiny of financial analysts. How investors analyse the various financial ratios in the balance sheet and P&L does matter. Bas Rebel, senior director, corporate treasury solutions at PwC, says, “If you look at the quick ratio or interest cover ratios, for example, they are all impacted. The financial analyst will not make any adjustments for the fact that the company has disclosed that there is a vendor financing programme.”

More to the point, he says, inappropriate classification of obligations could mean that covenants in existing loan agreements are triggered because bank debt has breached set limits, for example.

Finance for the vendor or finance for the buyer?

So how can supply chain finance be put in place such that the accounting rules don’t trigger a reclassification of trade payables? The overarching requirement, experts say, is that a programme intended to provide finance for the vendor must not be implemented in a way that, instead, it effectively becomes finance for the buyer.

One of the most important determinants is whether there is any credit enhancement. That is to say, the bank or other financial institution providing the finance for the vendor must not, as a result, be put in a better position against the buyer than the vendor was. The arrangements must not, for example, allow for the bank to get any corporate guarantee or additional security from the buyer that the vendor didn’t have. Neither can there be a direct debit over the buyer. Such changes would give the bank greater certainty of being paid and of being paid on time than the vendor had.

“When those kinds of elements are part of the supplier finance agreement then most certainly the auditor would say that this is an arrangement that you would not agree to in an ordinary vendor relationship,” says Rebel. “They would see this as credit enhancement and so the vendor financing is not vendor financing but buyer financing – and that will trigger reclassification.

“Vendor financing is basically the same as endorsing a cheque. You’re basically saying, don’t pay me but pay the bank or the factor. The banker takes a credit risk on the buyer and he should be happy with that.”

Rebel adds that local legislation might give suppliers additional rights in the event that the buyer goes bankrupt, and the bank would be entitled to those rights as well.

But as Quillian puts it, “The financial institution truly needs to be stepping into the shoes of the supplier. It needs to obtain the exact same rights to receive payment that the supplier had.”

Where’s the interest?

Typically, of course, if buyer owes money to a supplier in 45 days, say, the buyer does not pay interest on that debt. If the supplier takes advantage of supplier finance of any kind, they will pay an interest charge for the benefit of receiving their cash early. So even if an auditor were to challenge a supply chain finance arrangement for some reason and urge reclassification of a trade payable as a debt, would the fact that the buyer still wouldn’t have to pay interest on that not be a material factor in arguing that the debt is still really a trade payable?

The problem, says Quillian, is that “a programme could be constructed in such a way that it’s not really clear who’s paying the finance cost.” If, for example, a supplier offers a 2% discount for payment on day 15 rather than day 45, a construct could be put in place whereby the buyer borrows money to pay the supplier early, then doesn’t actually repay the lender until some time after day 45. Why? Because in ordinary bank terms, a 2% interest charge would not accrue between day 15 and day 45. So if the buyer holds off repaying the bank until the interest charges equal the price discount, then there is no doubt that the arrangement has been finance for the buyer, not the supplier. Add in some legal obfuscation and the arrangement easily becomes very murky.

“It’s a combination of accounting rules and legal structure that can either get things done or lead to problems,” Quillian says.

Extending payment terms

The issue that really sparks concern, of course, is the inescapable fact that many businesses choose to optimise their working capital by extending their payment terms to their suppliers but then take some of the pain away by putting in place a supply chain finance programme. How can these two not entirely coincidental initiatives be put in place safely?

Rebel explains that there needs to be “some kind of generic rule: you should not change the terms and conditions just because you have implemented a financing programme.” What that means is, “You can’t make an exceptional case out of those vendors that apply to the SCF structure.”

If you offer supplier finance to ten vendors but only two of them enrol in the programme, you cannot extend the payment terms of those two but not of the other eight. “The auditor would say it’s clear that you’re making a distinction between those that are enrolled and those that are not,” he says. “It’s clear that you would be financing the buying organisation and they are using the terms extension just to get the credit.”

It isn’t necessary to offer supplier finance to all suppliers, nor is it necessary to adjust payment terms across the board. “But if you have certain categories of suppliers, irrespective of whether or not they participate in the vendor financing programme, one would need to extend the credit terms [for all of them],” Rebel says.

Quillian adds: “If there is a legitimate business reason for the company extending their payment terms – because they are moving to industry standard terms or have decided to standardise across commodity classes, but then recognise that that’s going to create pain for their supply base and they offer supply chain finance to help strengthen their supply base, then I don’t think there’s a problem.”

It can be a grey area, and particular care has to be taken with the rollout to ensure that there are no inappropriate thinly-veiled promises that, for example, payment terms will revert from 60 days to 30 days if for any reason the supplier finance programme is withdrawn in future.

The unanimous advice is to have supplier finance programmes carefully checked by the auditors before anything is signed. There is a good body of knowledge as to how these programmes should be implemented, today. But both Rebel and Quillian have heard of instances where buyer organisations have had robust discussion with their auditors, either before the programme was implemented or even after. Some supplier finance programmes in the auto industry were shut down about ten years ago because the payables wound up being reclassified as debt, Quillian recalls.

Rebel offers some final words of advice: “I always say there is a reason why it’s called vendor financing. If you want to have that classified as accounts payable, play by the rules.”

Bas Rebel will be on a panel at SCF Forum Europe in Amsterdam on 8th December that will be discussing the impact of accounting regulations on supply chain finance programmes.