Supply Chain Finance: Gray Area Abounds on Early Pay Programs, Accounting

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 gray 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 writedowns in its power division to the tune of $22 billion is not comforting.

Without clear rules from regulators, we continue to live in this gray 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.

David Gustin, a Spend Matters contributor and former editor of Trade Financing Matters, is chief strategy officer for The Interface Financial Group.

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Voices (5)

  1. Ian Harvey-Samuel:

    David/Tony,

    Isnt the easiest way to distinguish “debt” from a “trade payable” is that there can only ever be one trade payable?

    SCF most often gives rise to the risk that the buyer must pay the bank and the original supplier.

    This is because every SCF that I have ever seen requires the buyer to pay the bank even if the bank does not legally own the trade payable. They pass that risk back to the buyer via the buyer agreeing to pay them even if they did not legally acquire the receivable from the supplier.

    This is why virtually all SCF should be debt for accounting purposes.

    This explains why banks dont do any material legal work on SCF to determine if they have bought the trade payable. in contrast in receiveables purchase programmes the banks are obsessed with true sale risk. Their totally different approach to true sale risk in SCF sort of gives the game away – ie they dont think they are bearing that risk – and if they are not bearing it then the only other person who takes that risk is the buyer.

  2. Tat Yeen Yap:

    A supplier finance arrangement put in place with a buyer is quite simply an arrangement that brings in a third party lender to finance the suppliers for the credit that they extend to the buyer. Unless the financing is on a with-recourse basis to the suppliers, it is reasonable for a lender to only finance trade payables which the buyer has undertaken (irrevocably) to pay at maturity. Take away the ability to enter into arrangements between buyer and lender, payables financing will cease and activity will shift to the receivables financing side with less comfort for lenders, lower financing advance ratios, potentially costlier financing, and much more administrative burden for the buyer to keep track of which lender its debt has been assigned to by its suppliers..

    Ideally, supplier financing arrangements ought to be disclosed in financial statements, and the nature of debt would not be viewed with a jaundiced eye – the debt arises as a trade payable, and the financing arrangement ought to be treated as a transfer of debt with notice, an arrangement which ought to preclude future set-offs against the assigned debt (subject to legal advice).

    1. David Gustin:

      Hi Tat.

      Appreciate your comments.

      Supply chain finance is certainly needed as a product. SCF exists because large companies crush their suppliers with extended payment terms that are way beyond what is necessary. Payment terms were designed to ensure service or good was delivered and met contractual arrangements, not to increase working capital for the bigger company. This gave rise to banks to inject liquidity in the balance sheet.
      Second, programs are predominately for Investment Grade corporates and only their top suppliers, as the KYC costs for banks are prohibitive to onboard non customers.

      Third, there is another way to do SCF without a buyer issuing a guarantee or an IPU, which is a higher commitment to pay. Period!

      There is a new business model in place that enables supply chain finance without IPUs or asking buyers credit line. It is gaining traction and one of the reasons is accounting treatment due to high profile cases like Abengoa and Carillion.

  3. Anthony Brown:

    One way to get around the issuance of an “irrevocable payment undertaking” or similar to “provide a level of comfort to the funder” that augments the position of the funder as creditor relative to the supplier is to use bills of exchange. These negotiable trade payment instruments have been around for centuries and are covered by a well established global body of law and precedent.

    Once drawn by suppliers and “accepted” by buyers, they can be endorsed without recourse to the funder without the latter having any exposure to dilution or supply contract disputes. This reliable and well-tested technique has been the backbone of forfaiting for ages.

    To avoid the paperwork entailed in signing individual bills of exchange, their use can be built into the operating platform of the funder under which the funder (via power of attorney) can create and execute the instruments as needed.

    Since bills of exchange can originate between the seller and buyer, it would be surprising if regulators would deem their use to enhance the creditor status of the funder.

    1. David Gustin:

      Bill of Exchange is not as simple as you make it appear Tony. Use of B/E is not because of accounting treatment. Every time buyer has to sign B/E, its not a one-off, like IPU. It governs specific transactions. I dont know how PrimeRevenue has done with their Electronic drafts program, but I dont think it has widespread use like the IPU.

      Btw, for those that dont have a good grasp on Bills of Exchange, suggest this post http://spendmatters.com/tfmatters/paper-bills-of-exchange-inhibit-finance/

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