For over a year, the SEC, credit rating agencies, investors, the Big Four accounting firms and other interested parties have been sounding the alarm about a popular financing technique called “supply chain financing”—not that there’s anything wrong with it, inherently at least. It can be a perfectly useful financing tool in the right hands—companies with healthy balance sheets. But it can also disguise shaky credit situations and allow companies to go deeper into debt, often unbeknownst to investors and analysts, with sometimes disastrous ends. This week, the FASB voted to add to its agenda a project to address the lack of transparency associated with the use of supplier finance programs.
As discussed in this Bloomberg article, supply chain financing (sometimes referred to as “reverse factoring” or “supplier finance programs”) “involves companies negotiating more time to pay suppliers by having a third party, like a bank, pay the supplier first. Normal payment terms with suppliers might be 60 to 90 days, but these special three-party arrangements can help companies stretch out their payback periods to 180 or 210 days, or even as long as a year.” Companies that are “well capitalized” and run their programs effectively receive “high marks”: “The suppliers get paid, the banks get fees, and the companies have more time to pay their bills. Companies get a bonus: Extended payment terms mean better looking cash flows.” But where companies’ financial situations are more precarious, overuse of the technique could be problematic, especially if not fully disclosed. According to one commentator, “[w]here it begins to raise eyebrows, is where companies that have been engaged in this are reporting a large improvement in cash flows that may not be sustainable….And they aren’t highlighting to their investors why.” One instance in 2018 saw the collapse of a company that used reverse factoring, which “allowed it to label almost half a billion pounds of debt as ‘other payables.’” As described by a member of the FASB, these programs allow payment terms to be extended and can distort cash flow trends, potentially leading to a sudden deterioration of credit quality, in which event, the banks pull the program and there is a “liquidity event.”
As noted above, the SEC has begun to prod companies to increase transparency regarding supply chain financing arrangements. In December, the Corp Fin Deputy Chief Accountant, in remarks to the AICPA, reported by Bloomberg, observed that there had been an increase in the number of companies using supply chain financing “to increase their liquidity but no corresponding increase in communication with investors about how the transactions work.” That, however, needed to change: “‘If they are material to your current period or are reasonably likely to materially impact liquidity in the future, these are things we’d expect a registrant to disclose.’” As reported, she urged businesses to “convey whether the increase in operating cash flows is sustainable, trends related to the payment terms, and whether they need to extend or enter into more supplier finance programs.” And the SEC has used the review process to provide comments to a number of companies asking for more disclosure. For example, the SEC staff have asked companies about increases in the length of their accounts payable periods and why the amounts were classified as accounts payable instead of bank financing. Staff comments have also asked companies to disclose the terms of their supply chain financing arrangements.
At a meeting of the SEC’s Investor Advisory Committee in May, the committee submitted recommendations to the SEC to closely monitor the practice of supply chain financing. To the committee, this technique looked more like a debt arrangement that should be reflected on balance sheets and in the statement of cash flows, but, under current accounting guidance, the accounting is left to the discretion of companies. According to the committee, reverse factoring may disguise a company’s financial position, impact key performance ratios and increase financial risks, especially in light of COVID-19-related disruptions in supply chain relationships and financing. But, the committee argued, current disclosure is inadequate. The committee recommended that the SEC closely monitor accounting developments related to this issue, review MD&A disclosures and make inquiry where disclosure is absent, and consider adoption of a line-item disclosure requirement. (See this PubCo post.)
In June, the staff of Corp Fin issued Disclosure Guidance: Topic No. 9A, which supplements CF Topic No. 9 with additional views of the staff regarding disclosures related to operations, liquidity and capital resources that companies should consider as a consequence of business and market disruptions resulting from COVID-19. The staff noted that many companies have been compelled to engage in new financing activities, including supplier finance programs, some of which may involve novel terms and structures. The staff advised companies to “provide robust and transparent disclosures about how they are dealing with short- and long-term liquidity and funding risks in the current economic environment, particularly to the extent efforts present new risks or uncertainties to their businesses.” To help companies evaluate their disclosure obligations, the staff suggested that companies consider the following questions regarding supply chain financing:
“Are you relying on supplier finance programs, otherwise referred to as supply chain financing, structured trade payables, reverse factoring, or vendor financing, to manage your cash flow? Have these arrangements had a material impact on your balance sheet, statement of cash flows, or short- and long-term liquidity and if so, how? What are the material terms of the arrangements? Did you or any of your subsidiaries provide guarantees related to these programs? Do you face a material risk if a party to the arrangement terminates it? What amounts payable at the end of the period relate to these arrangements, and what portion of these amounts has an intermediary already settled for you?”
The staff notes here that supplier financing or reverse factoring programs can vary widely and often involve financial institutions as intermediaries. For these types of programs, companies will need to determine the appropriate balance sheet and cash flow classifications of obligations under the programs, which also may impact how the programs are discussed in MD&A. (See this PubCo post.)
In October last year, with the prevalence of these programs increasing, the Big Four submitted a letter to the FASB requesting guidance “regarding (1) the financial statement disclosures that should be provided by entities that have entered into supplier finance programs involving their trade payables and (2) the presentation of cash flows related to such programs under Accounting Standards Codification (ASC) Topic 230, Statement of Cash Flows.”
In light of the Big Four request, as well as the results of outreach to both users and auditors, the FASB decided on Wednesday, with two dissents, to add to its agenda a project to address the lack of transparency regarding supply chain financing. To one Board member, the problem was clearly pervasive: she cited a survey in 2019 showed that 49% of responding companies had these programs in place and 37% were considering adding them. However, a large investment bank and a large credit rating agency reported that they saw disclosure from only about 5% of these entities—and that disclosure was inadequate. In addition, in outreach, users had indicated that they wanted to see some quantification and specific terms to the extent available. (Apparently, because the programs are sometimes negotiated or set up by intermediaries, the company may not have all the information.) One dissenting board member did not see a viable solution to the issue because of the unclear scope of these types of “program,” which vary considerably and, depending on the structure, may not always be of concern. He also thought that the SEC was beginning to address the issue and that the FASB should simply monitor developments for now. In addition, to the extent that companies would be required to quantify or otherwise disclose information of which they were “aware,” in this dissenter’s view, that would pose problems from an audit and an internal control standpoint, i.e., what type of control could be established regarding “awareness”? Although the Big Four also requested that the FASB address the current diversity in practice of the presentation of these programs in the statement of cash flows, the FASB decided not to include that as part of the current project.
Of course, no need to wait for the FASB to act. With the SEC commenting on disclosure of supply chain financing—or the lack thereof—and now the FASB called into action to address the topic, companies that engage in this type of financing may want to take the opportunity to revisit the adequacy of their own disclosures.