- Supply chain finance (also known as reverse factoring) can be a useful tool that allows suppliers and customers to improve their working capital management.
- However, for customers using supply chain finance to delay the time taken to pay invoices, current accounting rules and disclosures are not fit for purpose.
- We believe that some customers extend the contractual payment terms with suppliers at the same time as encouraging them to engage in supply chain finance. This allows them to arbitrage the accounting rules and claim that payments are made at the original invoice date and that the liabilities are therefore trade payables rather than debt.
- We typically view payments made by customers to financial intermediaries after 90 days as a form of borrowing and will seek to make adjustments to debt and operating cash flows unless amounts are clearly trivial.
- We strongly disagree with the IASB's current position on disclosures in supply chain finance and consider that this area requires urgent improvement.
Supply chain finance is not a new tool. The concept--essentially a switch of the creditor relationship--dates back as far as several thousand years, where it was reportedly used in Mesopotamia. While the terminology used to describe it (such as "reverse factoring") can often be confusing, at its heart is a simple idea--a bank or other intermediary steps into the middle of a contractual arrangement and pays the supplier of the goods or services more quickly than would otherwise be the case, taking a margin for itself. Meanwhile, the customer often pays the bank more slowly than it would normally have paid the supplier directly. Thus, the supplier gets paid more quickly, the customer can pay more slowly, the bank takes a margin for its efforts, and in theory everyone benefits from the transaction. Or do they?
Greensill Highlighted The Hidden Risks
The recent, high-profile collapse of supply chain financier Greensill Capital has highlighted some of the risks that we have long associated with the use of this type of financing. In the Greensill case, we note some additional elements not typically seen with plain vanilla supply chain financing. These include the securitization of the underlying receivables into Credit Suisse funds, the concentration of financing to a collection of high-risk companies, as well as certain examples of financing provided on the basis of future, hypothecated receivables rather than real invoices.
Accordingly, the Greensill failure should not necessarily cast aspersions on the entire supply chain finance industry, much of which operates in a controlled manner with manageable risks. Nonetheless, there is one pervasive feature of supply chain finance, which we have long been concerned about and which may have helped to fuel its spectacular growth in recent years. This is the fact that insufficient accounting rules allow companies to extend payment terms to flatter both their net debt and operating cash flow figures.
Supply Chain Finance Arrangements
S&P Global Ratings may treat the implicit financing that companies obtain from supply chain finance arrangements as a debt-like obligation, both for the customers and suppliers who receive a working capital benefit. Supply chain finance poses risks--for customers, it is the extension of payment terms beyond what is normal; and for suppliers, it is the accelerated monetization of trade receivables in lieu of borrowing. In both instances, the working capital benefit will unwind if the supply chain finance arrangement ceases to be available, which may happen under conditions of credit stress.
Greater Disclosure Is A Must
S&P Global Ratings strongly disagrees with the International Accounting Standards Board's (IASB's) current position on disclosures in supply chain finance. The IASB sees the principles and requirements in IFRS Standards as sufficient for companies to determine the appropriate accounting, presentation, and disclosure for liabilities and cash flows that are part of reverse factoring arrangements. In our view, the status quo fails to give appropriate accounting and disclosures in this area and requires urgent improvement.
The IASB--specifically the IFRS Interpretations Committee which published an agenda decision on reverse factoring in December 2020--believes that IAS 1 provides sufficient guidance for companies to decide whether supply chain financing liabilities are trade payables or debt. We believe this is at the heart of the financial reporting problem. Under IAS 1, trade payables are part of the working capital used in the entity's normal operating cycle, so companies should consider whether the liabilities associated with reverse factoring programs have changed in nature so as to no longer be part of the normal cycle. Any significant delay in settling payment, for example a change from paying the supplier directly after 90 days to paying the bank after 180 days, would imply that the liability, or at least a portion of it, is no longer a trade payable and should be classified as debt.
The difficulty with this is that there is a great deal of judgment inherent in what represents a company's "normal operating cycle" and so we only see a small number of companies actually treat any of their supply chain finance liabilities as debt. Moreover, we believe that some companies may be renegotiating contracts with suppliers to deliberately arbitrage the accounting rules. Companies can do this by extending payment terms with suppliers at the same time as encouraging them to enter into reverse factoring agreements. A customer might persuade a supplier to change the contractual payment terms from 90 to 180 days. Of course from the supplier's perspective, they will be paid on day 1 by the intermediary regardless. This change in contractual terms then allows the customer to claim that they are still settling their invoices--now paid to the intermediary--within a "normal operating cycle", albeit a new normal that they have created on the back of supply chain finance. The liabilities can therefore remain as trade payables, even though the customer now settles its invoices significantly more slowly than it used to.
We note that in 2019 the "Big Four" accountancy firms submitted an agenda request letter to the U.S. accounting watchdog FASB, which made a similar point, albeit in more oblique terms.
Extract From A Letter From The "Big Four" To The FASB
In recent years, we have seen an evolution of these types of programs (i.e., trade payable terms). For example, there has been an increase in the average number of days payables outstanding for goods or services for some companies that use these arrangements. Whereas typical payment terms with suppliers historically might have been 60 to 90 days, some entities today seek to negotiate payment terms with suppliers of up to 180, 210, or even 364 days. Suppliers are more likely to accept extended payment terms when the purchaser has arranged a structured payable program that permits the suppliers to monetize their trade receivables before its due date.
Source: Agenda request letter to the Financial Accounting Standards Board (Oct. 2, 2019).
As a result of this letter, as well as growing pressure from regulators such as the Securities and Exchange Commission (SEC), the FASB has agreed to investigate whether disclosure standards may be necessary for supply chain finance programs. We also understand that the IASB may take another look at their December 2020 conclusion, with the potential for improved disclosures to be mandated for companies who report under IFRS.
How We Consider Supply Chain Finance In Our Rating Analysis
For several years, S&P Global Ratings has highlighted the risks relating to the ability of supply chain finance to flatter net debt, operating cash flows, and associated debt payback ratios of companies that we examine as part of our corporate credit analysis. Accordingly, we have sought to make an adjustment to treat amounts owed to financial intermediaries as debt where the company defers payment beyond the term that is customary for its supply chain.
The challenge with this case-by-case approach is the inherent judgement in what exactly constitutes the "customary" term for a supply chain, especially as such terms may have been growing over the years precisely because of the increased use of supply chain finance, as noted above. To break the deadlock of never-ending debates about what constitutes customary terms, we now typically take 90 days as a "rule of thumb" and a reasonable cut-off point, that is, we typically view payments made more slowly than this as a form of financing.
Using a simplified example for illustration, if a company has £500 million of liabilities owed to a financial intermediary at year-end and the liability was paid (or will be paid) after 180 days, then we would typically view £250 million as a normal trade payable and the other £250 million as a debt-like liability that we include in our S&P-adjusted debt figure. On the cash flow side, if that debt-like liability increased from £200 million in 2019 to £250 million in 2020, we would view the additional £50 million draw down of debt as a financing cashflow and make an adjustment to reduce operating cash flow accordingly.
In many real-world cases, we can quickly determine that any potential adjustment to debt would be a clearly trivial amount, for example less than 1% of adjusted debt. But for companies where the adjustment is more significant, we seek the information we need to make adjustments in the manner outlined above, even if not disclosed in a company's financial statements.
How Exactly Could The IASB And FASB Improve Financial Reporting In This Area?
S&P Global Ratings has recommended to the IASB potential ways to improve the financial reporting of supply chain finance. We believe that the existing accounting and disclosures for suppliers, who engage in supply chain financing to accelerate the monetization of receivables, is today usually adequately provided by existing disclosure requirements under IFRS 9 and IAS 7. What is missing is a robust financial reporting framework for the customers who use supply chain finance to pay invoices more slowly.
We don't believe that it will be necessary or practical to make changes that would treat the liabilities owed by customers to financial intermediaries (or a portion of them) as debt, or the corresponding drawdown as a financing--rather than an operating--cash flow. We believe the most crucial improvement would be to mandate some simple disclosures that companies must provide wherever they engage in supply chain finance. This would enable investors, analysts, and other users of financial statements to form their own view about the risks in these arrangements and make the analytical adjustments they deem appropriate.
For customers who engage in supply chain finance and who may be using it to pay their invoices more slowly, obtaining financing in the process, the following disclosures at the very minimum would be useful:
- Prominent disclosure that supply chain financing is being used;
- A brief description of the nature and contractual terms of such arrangements;
- The value of liabilities owed to the financial intermediary at the year end; and
- The actual (or intended) time taken to pay those outstanding invoices at year end.
In addition, if possible, the below information would be valuable to users of financial statements:
- The value of invoices passing through the programs during the year;
- The average time to pay the financial intermediary during the year; and
- The average time taken to settle regular invoices, outside the program, during the year.
- Corporate Methodology: Ratios & Adjustments, April 1, 2019
- Guidance: Corporate Methodology: Ratios & Adjustments, April 1, 2019
- Reverse Factoring: Why It Matters, March 10, 2020
- Reward With Risk: U.S. Consumer Goods Companies Use "Reverse Factoring" To Free Up Funds, Oct. 23, 2019
- Carillion's Demise: What's At Stake?, March 24, 2018
This report does not constitute a rating action.
|Primary Credit Analyst:||Sam C Holland, FCA, London + 44 20 7176 3779;|
|Secondary Contacts:||Shripad J Joshi, CPA, CA, New York + 1 (212) 438 4069;|
|Gregg Lemos-Stein, CFA, New York + 212438 1809;|
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