The implementation of ASU 2016-15, Statement of Cash Flow Classification of Certain Cash Receipts and Cash Payments (Topic 230), has led to an increased focus on accounts receivable financing arrangements, with a variety of consequences, both real and paper-based, intended and unintended.
This article has three main objectives. First, it reviews and summarizes the options available to businesses wishing to use their trade receivables to obtain funds prior to customer payment, either through sale, transfer, or another arrangement. Each arrangement has different accounting consequences for the balance sheet (e.g., changes in liability balances), income statement (e.g., variability in fees among arrangements), and now the cash flow statement as well. Under ASU 2016-15, the total amount of recognized cash flow does not change, but the classification of those cash flows may change significantly. This might lead to undesirable effects on commonly used valuation metrics, such as free cash flow.
Second, it incorporates an explanation, discussion, and analysis of certain attributes of ASU 2016-15. This standard, depending upon its interpretation, has the potential to priori-tize form over substance. In the authors’ broader interpretation, most existing trade receivables factoring programs may be affected by this guidance, not just those securitized trade receivable programs it specifically identifies.
Last, it explains why some businesses with extant trade receivable arrangements may wish to restructure those arrangements to avoid undesirable effects, such as violation of debt covenants, reductions to free cash flow, or increased financing fees. For example, if an entity’s current arrangement requires some of its cash collections on trade receivables to be classified as investing under ASU 2016-15, it may wish to “move” those cash flows back to the operating section to restore free cash flow.
Example of Common Arrangements
There are several common arrangements a business can use to accelerate the collection of cash from a given pool of accounts receivable. To illustrate these options, consider the hypothetical Globex, Inc., which has $100 million of outstanding accounts receivable. For simplicity, complicating factors such as revolving transactions, interest costs, and credit losses are omitted; for the same reason, fees are assumed to be the same for all options. The mechanisms of each transaction are illustrated with journal entries and the effects on the balance sheet and, more importantly under ASU 2016-15, the cash flow statement.
In a traditional secured borrowing arrangement, the originator pledges a set of accounts receivable as collateral for an interest-bearing loan from an outside entity. For example, Globex chooses to acquire immediate funding by pledging $100 million of receivables as collateral for a $75 million bank loan. Globex continues to collect on the receivables and remits cash to the bank from the proceeds. The impacts on Globex’s balance sheet and cash flow statement are shown in Exhibit 1. Companies with secured borrowings carry a loan on the balance sheet, which may not be desirable. All cash collected on the receivables is classified as “operating,” while the cash provided by (and repaid to) the bank is classified as “financing.”
Factoring with recourse.
In a factoring arrangement, the originator of the accounts receivable sells the collection rights to a factor in exchange for cash. Factoring arrangements can be set with or without recourse, which is the right of the factor to demand payment from the originator for any non-collectible receivables. The inclusion of a recourse clause fundamentally alters the nature of a factoring arrangement. Because the factor has the right to return any uncollectible receivables after a predetermined period, the originator has not actually transferred the receivables per ASC 860, “Transfers and Servicing.” For accounting purposes, such an arrangement is instead treated as if it was a secured borrowing from the factor, contingent upon the receivables being collected. Exhibit 2 shows the consequences of Globex choosing instead to turn over $100 million of receivables to a factor in return for an initial cash payment of $75 million. Of the $25 million difference, $5 million is the factor’s fee and $20 million is reserved cash to be remitted to Globex if and when the factor collects on receivables in excess of the initial cash payment plus the factor’s fee.
Factoring with Recourse
Although this structure might be different from that of secured borrowing shown above, the accounting treatment is largely the same.
Factoring without recourse.
A strictly nonrecourse factoring arrangement is the most straightforward arrangement, although it is uncommon in practice. In this example, Globex opts to sell $100 million of receivables to a factor in exchange for cash. Globex retains no rights to the receivables and the transaction is considered a transfer under ASC 860. The factor pays Globex $95 million after assessing a $5 million fee upon transfer. Under this arrangement, shown in Exhibit 3, the $100 million cash payment from customers to a collection account is classified as operating cash flow for Globex. (Some entities may continue to perform their own collection servicing even after entering into a factoring arrangement. While the originator may save on servicing fees, the classification of cash flows will not change. Collections will be remitted to the factor.)
Factoring without Recourse (Uncommon Scenario)
Note that the above scenario with strictly no recourse (i.e., the factor has no means of recovery of defaulted receivables and pays the entire purchase price upon transfer, as illustrated in Exhibit 3) is rare in practice. Even if there is no specific recourse clause, the factor will often withhold some percentage of the total purchase price in a reserve account, to be remitted upon collection from the customer.
Consider a scenario under which Globex chooses to sell the same $100 million of receivables to a factor. The factor retains both a $5 million fee and a $20 million reserve (titled “due from factor” on the originator’s books), remitting $75 million to Globex upon receivables transfer (Exhibit 4, Transactions 1 & 2). Keep in mind that the journal entries and effects on the statements shown in Exhibit 4 have been generally used in practice prior to ASU 2016-15, and many companies with such a structure might use a more restrictive interpretation of the new standard and leave their accounting for such transactions unchanged. The authors contend, however, that a broader interpretation of this guidance calls for accounting for such a structure as equivalent to factoring with beneficial interest and post-transfer securitization, detailed below.
Factoring with beneficial interest and post-transfer securitization.
A recent trend in receivables-based funding is the use of a securitized sale, in which the originator sells its receivables to a purchaser, which then repackages and securitizes them to sell to outside investors. In this scenario, Globex could choose to transfer its trade receivables to an outside entity via a bankruptcy-remote special purpose entity (SPE; in this case, Globex Receivables Funding, LLC). This action is typically arranged as an ASC 860 transfer. The buyer is often structured as a conduit, taking these receivables (possibly along with receivables from other originators) and repackaging them as backing for commercial paper that is then sold to investors. Let us assume that Globex Receivables Funding sells $100 million of receivables to the conduit in exchange for $75 million in cash (referred to here as initial purchase price, IPP) and a beneficial interest of $20 million (often called deferred purchase price, DPP, receivables), after $5 million in fees. Investors buy commercial paper from the conduit and are repaid out of customer repayment, and the DPP is remitted to Globex Receivables Funding after collection. ASC Topic 230, “Statement of Cash Flows,” does not provide specific guidance on cash flow presentation for DPP receivable; as a result, prior to ASU 2016-15, the accounting treatments and cash flow statement presentations of DPP receivables had been diverse in practice. Some entities would treat the DPP receivable as an investment security and classify the resulting cash flows accordingly, with the initial cash payment as operating and later cash flows from DPP collection as investing; others would treat it as a trade receivable and classify all cash flows as operating.
ASU 2016-15 was issued to reduce this diversity in practice. Among the eight cash flow issues it addresses, the seventh—beneficial interest in securitization transactions—is salient to this discussion. As indicated above, DPP receivables is an example of beneficial interest.
Per ASU 2016-15, FASB requires that 1) “A transferor’s beneficial interest obtained in a securitization of financial assets should be disclosed as a noncash activity,” and 2) “The cash receipts from payments on a transfer-or’s beneficial interests in securitized trade receivables should be classified as cash inflows from investing activities.” The above provisions suggest that a transferor’s beneficial interest be treated as an investment security. Specifically, the initial recognition of beneficial interest disclosed as a noncash activity is supported by the notion that the transferor does not pay or receive cash to obtain it and significant noncash investing activities shall be disclosed. If a transferor’s beneficial interest were to be treated as operating, disclosure would not be mandatory, because noncash operating activities are not required to be disclosed.
The mandatory disclosure of noncash investing activities, and the absence of such a requirement for noncash operating activities, is in fact cited as a reason for FASB’s decision. Paragraph BC35 of ASU 2016-15 states: “The Task Force also noted that an investing activity classification is consistent with existing guidance in Topic 230 when considering its consensus to disclose the transferor’s beneficial interest obtained in a securitization of financial assets as a noncash activity. That is, Topic 230 requires disclosure of noncash investing activities but does not require disclosure of noncash operating activities.”
According to ASU 2016-15, FASB’s decision to treat DPP cash flows as investing rather than operating is based on two factors. First, additional credit risk exposure makes the beneficial interest more comparable to an investment than a trade receivable. In fact, one purpose of structuring a beneficial interest is to stratify credit risk, disproportionately allocating the risk of loss associated with the pool of receivables to the holders of the beneficial interest. One outcome of this disproportionate allocation is that the characteristics of the beneficial interest are arguably different (i.e., substantially higher-risk) from those of the larger pool of receivables from which they were sourced, justifying the treatment of that interest as investing, rather than operating. Second, since the trade receivables are exchanged in full for cash plus beneficial interest, and the transferor no longer retains ownership of the receivables, subsequent collection of beneficial interest is not the same as collection of trade receivables.
Nevertheless, FASB did acknowledge two drawbacks of classifying DPP cash flows as investing rather than operating. First, some financial statement users have typically viewed cash collections from beneficial interest as operating activities, and those users might have to adjust (i.e., reclassify) those collections to maintain comparability. Second, this classification creates an asymmetry between sales and the resulting operating cash flow. For example, assuming no credit loss, the $100 million trade receivables sold by Globex to the conduit, which resulted from $100 million in credit sales, will not result in $100 million in operating cash inflow for Globex, but rather $80 million in operating cash inflows and $20 million in investing cash inflows.
Although ASU 2016-15 will not change the total amount of the cash flows reported during a given period, it may significantly change the cash inflows from a specific activity, such as cash flows from operating activities. For example, Kraft-Heinz Company, an early adopter of this update, had to restate their 2016 operating cash flow in its 2017 Form 10-K, reducing it from $5.238 billion to $2.649 billion, a decrease of over 49%. This change may affect the calculation of several valuation measures, which merits attention from both preparers and users. The particular importance of operating cash flow and free cash flow in asset or business valuation is not new, and is very common in finance.
Exhibit 5 illustrates the accounting treatment and the effect on the balance sheet and cash flow statement under ASU 2016-15.
A comparison between Exhibits 4 and 5 shows that the economic substance of these two structures are the same for the originator. The “due from factor” reserve in a typical nonrecourse factoring program may be considered a beneficial interest held by the originator, similar in substance and function to the role of a DPP receivable in a securitized sale. Both “due from factor” and DPP receivable serve to concentrate the credit risk from the original receivable pool and allocate it to the holders of the interest. The key difference is whether the purchaser of the receivables securitizes them after transfer (the events below the dotted line in Exhibit 5). This treatment is made explicit in ASU 2016-15: “cash receipts from payments on a transferor’s beneficial interests in securitized trade receivables should be classified as cash inflows from investing activities” (emphasis added).
It is at this point that interpretations of the standard may differ. If ASU 2016-15 is read literally, referred to hereafter as the “narrow interpretation” of the standard, the actions of the purchaser of the receivables will affect the cash flow reporting of the transferor. The purchaser’s decision to securitize the receivables will automatically convert the treatment of the transferor’s DPP cash flows from operating to investing. If the purchaser opts not to securitize the receivables, then the transferor is free, in the absence of any FASB guidance to the contrary, to classify all resulting cash flows as operating.
In the authors’ view, the purchaser’s post-transfer behavior should not affect how the transferor of the trade receivables accounts for its transactions. If DPP, the beneficial interest under a securitized sale, is treated as investing cash flow, why not “due from factor,” the beneficial interest under a non-securitized factoring arrangement? The beneficial interest and the subsequent risk involved are the defining characteristics used in FASB’s reasoning, and these considerations apply equally well to non-securitized factoring arrangements. The authors call this perspective a “broad interpretation” of ASU 2016-15. Under this interpretation, the most common factoring scenario, wherein the factor withholds a certain percentage of the total purchase price in reserve and remits upon collection from the customer, would be accounted for in the same way as required by ASU 2016-15 for factoring with beneficial interest and post-transfer securitization. Such accounting is shown in Exhibit 6.
Factoring without Recourse (Broad Interpretation of ASU 2016-15)
Funding Arrangements’ Effects on Cash Flow Presentation
Differences in receivables-based cash flow presentation hinge on changes in only a few elements of a receivables funding arrangement. Exhibit 7 is a decision flowchart illustrating the key elements (circles) of a trade receivable funding program which cause different cash flow presentation outcomes (boxes).
Decision point 1: ASC 860 transfer.
If the arrangement doesn’t meet the criteria for a transfer under ASC 860, typically because there is substantial continuing involvement between the transferor and the receivables, then the transactions will be accounted for as a secured borrowing, and any subsequent collections from customers will be classified as operating cash flow.
Decision point 2: Beneficial interest.
Presuming an arrangement is a transfer under ASC 860, initial cash flows upon transfer are classified as operating cash flows. If the transfer-or retains beneficial interest in the receivables, any post-transfer cash flows collected from this beneficial interest are classified as investing cash flows. If there is no beneficial interest retained, then there are no future cash flows to be classified; the transaction is already complete.
By using a broad interpretation, Exhibit 7 ignores the issue of third-party securitization, an element specified in ASU 2016-15. Exhibit 8 is a decision flowchart using a narrow interpretation of ASU 2016-15. This flowchart shares the first two decision points from the prior flowchart: 1) does the arrangement count as a transfer under ASC 860? If so, 2) does the transferor retain a beneficial interest in the receivables? It has an additional decision point: If the transferor retains a beneficial interest, 3) does the recipient of the receivables securitize them? If so, the cash collection of DPP is classified as investing per ASU 2016-15; if not, then the arrangement is treated as a nonrecourse factoring arrangement, with all cash flows to the originator classified as operating. Compare this treatment to a similar outcome in Exhibit 7, in which DPP cash flow would be treated as investing. The comparison between Exhibits 7 and 8 illustrates how the securitization of receivables by a third party can substantially change the accounting treatment of the sale by the originator under ASU 2016-15.
Restructuring to Avoid Undesirable Consequences
Under ASU 2016-15, existing receivables funding arrangements may lead to undesirable accounting consequences. For example, because many discounted cash flow valuation models incorporate operating cash flow, any reclassification of a firm’s cash flows from operating to investing may result in a decreased valuation. Companies may find it worth the effort to avoid these consequences by restructuring their receivables arrangements. To illustrate, consider a company that currently uses a commercial paper securitization arrangement; its cash collection of DPP receivables will now be reclassified as investing cash flows under ASU 2016-15 (Exhibits 5 and 8). If this reclassification is not desirable, the receivables funding arrangement could be changed to a secured borrowing if the transfer of the receivables is reconfigured to fail the ASC 860 test.
These changes are not purely hypothetical; some public companies have already recognized and taken steps to avoid the consequences of ASU 2016-15. For example, in its March 31, 2018, Form 10-K, under Note 7, Sprint Corporation disclosed that it had amended one of its receivables facilities in February 2017 in order to regain control over the receivables transferred by obtaining the right to reacquire such receivables under certain circumstances. Prior to the amendment, receivables transfers qualified as sales under ASC 860. The new right-to-reacquire clause means that these transfers fail to qualify as sales and therefore are accounted for as a secured borrowing.
A Broad Interpretation Favors Substance over Form
As has been the case with many financial reporting phenomena, the complexity of accounting for receivables-based funding arrangements has increased with the rising diversity of the arrangements themselves. Rather than a binary choice between secured borrowing and factoring, businesses can now opt for any of a multitude of receivables factoring arrangements, with fee structures, beneficial interest, and post-transfer securitization creating a spectrum of options.
Unfortunately, new accounting rules may have had an unintended effect on cash flow classification, leading to managers making changes to their cash management practices. These changes may represent an unfortunate trade-off, with cosmetic improvements made at the cost of detrimental effects to real cash flow. The authors’ goal is to illustrate the effects of different arrangements on cash flow classification and presentation, and to highlight the areas where nearly identical economic activities may lead to substantially different accounting treatment.
The discussion featured here has omitted several complicating factors, including some related to the continuous nature of receivables funding arrangements. Most such arrangements presume a revolving set of accounts, rather than a static set. This rotation, and the speed with which accounts are paid off, will substantially complicate both third-party funding arrangements and the accounting for such arrangements. The choice of settlement periods, whether daily (as FASB has recently mandated) or over a longer period (e.g., monthly), will also affect assessment and the sheer administrative difficulty associated with managing and reporting such arrangements.
The authors also hope to encourage consideration by the broader accounting community of the effect of the language of ASU 2016-15. Strictly interpreted, the standard has the effect of segregating receivables originators based upon whether the transferees securitize the transferred receivables, and not based on any actions taken by the originator. The authors do not know, and cannot speculate, whether the broad or narrow interpretation of the ASU was intended. However, one can argue that the broad interpretation of the update would favor substance over form and should be the approach taken by preparers. The authors also direct financial statement users’ attention to the adverse impact of this update, as it may noticeably change companies’ operating cash flows, particularly under a broad interpretation.