Fundamentally, supply chain financing has two elements: receivables and payables. If implemented correctly, both suppliers and purchasers can benefit. With the cost of inventory increasing, and competitive pressures squeezing margins, supply chain financing offers an alternative to traditional forms of financing to help businesses manage precious cash. However, accounting for supply chain financing arrangements can bring a number of complexities to a company’s balance sheet.
How does it work?
Payables or supplier financing is similar to the better known receivables financing, or factoring. When factoring, a company that has a lot of working capital tied up in trade receivables will sell some portion of its trade receivables at a discount to a third party. By doing so, the company will receive cash earlier and the third party will collect the outstanding cash on the receivable. In a supplier financing arrangement, however, a company is trying to manage payables, not receivables. This is done by a financier taking on the trade payable balances of a company. Today, banks and other financiers have sophisticated platforms that allow a company to do this in real time for multiple suppliers via online portals.
For a business, the first question is why even consider this? Increasingly, customers are demanding extended terms of trade, with 60- or 90-day terms not uncommon. On top of this, there is often an extended purchase order approvals process in large organisations. This might lead to yet another month before any cheques are actually in the mail! Suppliers, however, have no similar inclination to extend charity when it comes time to pay their invoices, leaving businesses to use precious working capital to fund the gap.
Supplier financing works through a series of steps. Basically, a company nominates supplier invoices to be transferred to a financier. The financier provides funding enabling the supplier to be paid up front (taking advantage of any early payment discount). The company then pays the financier the amount due at original maturity or later as agreed.
Commercially, two benefits arise. First, cash flow and liquidity – a bank provides flexibility and extended settlement terms compared to suppliers. Businesses might need breathing space to manage seasonal fluctuations. Second, by using a financier’s superior credit rating, both the supplier and company can benefit from cheaper cost of funds. This financing is being increasingly made available through automated platforms, giving a company flexibility to select which invoices should be financed at any given point.
Is this a form of bank financing for the company?
The accounting follows the substance of the arrangement. In some situations, the supply chain finance arrangement is a form of bank financing and is disclosed as such. This would be the case if, in substance, the purchaser is deemed to be obtaining bank financing to pay its accounts payables earlier. The most obvious consequence to the financial statements would be the presentation of the financing as banking finance, such as a loan, as opposed to simply accounts payable. Various metrics, especially those involving working capital would be impacted in this case.
A further consideration is whether the transaction is deemed to be a replacement of the trade payable with bank financing. In such situations the arrangement could result in a gain or loss in profit if there are any differences in the measurement of the respective liabilities.
Alternatively, the supply chain financing arrangements can result in the supplier simply transferring the right to cash from the purchaser to the bank. In these situations, the supplier selling the invoice to the bank is almost identical to the supplier selling a bond of the purchaser to the bank. The change in who holds the claim against the purchaser does not affect the nature of the purchaser’s obligations to pay the cash at the previously agreed time. In these cases, it would then remain in trade payables.
The more familiar and traditional form of supply chain financing is trade receivables factoring. Historically, particularly for commercial accounts receivables portfolios, financiers have purchased pools of receivables and provided up front financing. Companies continue to service the receivables and deal with the customers. However, in consumer transactions, increasingly alternative financiers such as Afterpay and ZIP Pay have been taking a visible role, offering customers financing directly.
Is this a form of bank financing for the company?
If we then turn to the accounting for such factoring, the potential impact becomes significant. Factoring has the potential to cause receivables to be entirely derecognised, or be recognised as separate bank funding on a company’s balance sheet.
The treatment of factoring transactions under the financial instruments standard (AASB 9) is not straightforward, particularly for sales of receivables to a financier where the customer is not necessarily aware of the disposal. Listed below are some red flag indicators that might cause derecognition to fail:
- Classification of any factoring as an accounting sale of receivables or borrowing is fundamentally dependent on the extent of risk and reward transferred. Terms in any agreement providing for
- credit guarantees
- rights or guarantees of repurchase, or
- other continuing responsibility for collections and management of disputes
are all red flags that may, where substantive, cause sale accounting to fail.
- Synthetic sales, where legal ownership of the receivables is not transferred, are inherently more complex and it is usually more difficult to achieve accounting derecognition in such arrangements.
- Sales of receivables involving securitisation trusts where the company has an interest in the trust or shares in trust losses are another red flag indicator of potential complexity.
In contrast, the business model of consumer financiers (such as Afterpay) start with the customer choosing to fund purchases directly. No receivable typically exists in such situations as all credit risk and legal ownership of the customer promise to pay are taken on directly by the financier on day one. The company making the sale simply recognises cash received from the financier from a transaction. Typically, no further obligation exists requiring any funding liability to be recognised.
Financial reporting takeaways
When considering supply chain financing, the key takeaways from a financial reporting perspective are:
- Supplier financing arrangements are unlikely to give rise to derecognition of a liability on a company’s balance sheet. The only consideration is whether the obligation is classified as bank financing or within trade payables.
- Customer financing arrangements, however, can fundamentally alter a company’s balance sheet depending on whether an accounting sale is achieved. If risk and reward is sufficiently transferred, the receivables are derecognised. If not, an additional funding liability must be recognised. There is no bright line in the accounting literature and, as such, potential arrangements should be carefully evaluated in advance.
Manuel Kapsis, Alan Garner and John Ratna, PwC