Both FASB and the IASB recently issued exposure drafts related to supplier finance programs (SFP). The exposure drafts were issued in response to requests for greater transparency in financial reporting of supplier finance programs. They suggested that the financing nature of the SFPs is hidden in accounts payable (A/P), an operating activities account. Increased transparency is needed because of the potential impact on liquidity, working capital, and cash flows.
Supplier finance programs (SFP), also known as “structured payables,” supplier finance arrangements, payables finance, and reverse factoring (RF), appear to begin like any other typical purchase of goods or services on credit by a buyer, which subsequently pays within the agreed-upon time frame (e.g., 30 to 45 days). Whereas the buyer in a typical purchase directly pays the supplier, however, an SFP has an intermediary or finance provider (FP). In an SFP, the FP pays the supplier, and the buyer pays the FP. The use of SFPs, a supply chain finance tool, is accelerating, with current U.S. transactions estimated to be well above $300 billion. Extant accounting guidance for SFPs has come under intense scrutiny. The specific concern raised by the SEC, the Big Four, and Moody’s Investor Services is that current SFP accounting allows short-term debt to be hidden in accounts payable, with a corresponding distortion in the statement of cash flows. Major audit firms are concerned that the lack of U.S. GAAP guidance leads to limited disclosure of SFPs in practice, elevating litigation risk for auditors if hidden debt leads to the unforeseen collapse of companies with weaker-than-understood cash positions. This risk is especially high for buyers who have a concentration of their payments due to a small number of FPs, versus the typically larger number of suppliers.
FASB and the IASB responded to the call for greater transparency surrounding SFPs and issued exposure drafts that would require SFP disclosures. The program definitions and the required disclosures differ slightly between FASB and the IASB. Both exposure drafts (ED) will have ramifications for both the management of SFP users and their auditors. This article describes approaches to identify SFP programs and offers suggestions for identifying “key terms” for the required disclosures, as well as adjustments to audit programs to address the disclosures.
An SFP is a supply chain finance technique designed to maximize working capital by leveraging the buyer’s relationship with a third-party funding mechanism. By using an SFP, the buyer establishes an arrangement with an FP whereby the buyer’s suppliers gain attractive funding based on the buyer’s creditworthiness. Exhibit 1 depicts a basic SFP. Typically, the supplier is paid by the FP earlier than the payment terms, and at a discount, while the buyer receives an extended payment date (in some cases by more than 120 days). Typically, the FP funds the program and receives a fee. Third parties (e.g., Taulia, Oracle, C2FO) are well-known suppliers of supply chain finance and SFP services.
The use of SFPs is widely believed to be accelerating. A PricewaterhouseCoopers study (Supply Chain Finance Barometer 2018/2019, https://pwc.to/3kYrrdB) indicates that 49% of organizational leaders report using these types of programs, with another 37% considering their use. The use of supply chain financing techniques (e.g., SFP) to stretch the payment cycle has grown markedly during the coronavirus (COVID-19) pandemic, whereas other forms of short-term financing faltered. Julie Steinberg (“SEC Asks Boeing, Coke for Data on Financing Tool—WSJ,” Aug. 28, 2020, https://bit.ly/3M71PXS), reported that banks generated $12.7 billion in the first half of 2020 from supply-chain finance, up 3.6% from a year earlier, even as revenue fell 29% for commodities trade finance. Fitch Ratings (What Investors Want to Know: Supply Chain Finance, 2018, https://bit.ly/3FERUXc) suggests that RF activity may account for a $327 billion increase in payables financing over the 2014–2017 time frame, or about $1 billion per company. The Aite Group reports a similar estimate ($350 billion) of invoices currently associated with RF (Steinberg, 2020).
The expanding use of SFPs has necessitated a careful examination of accounting practices. Specifically, the Big Four (Letter to FASB, Oct 2, 2019, https://bit.ly/3wpLW9l) requested that FASB provide guidance on SFPs involving trade payables. In addition, the International Financial Reporting Standards (IFRS) Interpretations Committee (IC) also received requests to improve RF accounting standards (Moody’s Investors Service, letter to IFRS IC, AP3: Research summary, https://bit.ly/3wi7dR7, 2020). The requests express concern that a lack of clear regulatory guidance is resulting in RF purchase obligations being obscured (i.e., hidden) in “trade (accounts) payables.” It is argued that these payables should instead be included in short-term debt. The inclusion of RF amounts in trade payable excludes RF from key leverage and debt ratios and affects loan capacity, loan covenants, efficiency measures (e.g., cash flow from operating activities to sales) and potentially, market valuation (Nicola White, “Financing That Masks ‘Hidden Debt’ Stokes Accounting Anxiety,” Bloomberg Law, January 6, 2020, https://bit.ly/3N86RTU). Furthermore, a curtailment or cessation of RF availability may create a liquidity crisis that could lead to an immediate and material working capital outflow. The recent failure of Greensill, a popular provider of RF services, highlights the risks to buyers engaging in RF activity (Eshe Nelson, Jack Ewing, and Liz Alderman, “Greensill Capital: The Collapse of a Company Built on Debt,” The New York Times, March 28, 2021, https://nyti.ms/3yChUka). Absent adequate disclosure, investors cannot ascertain the sustainability of RF as a source of working capital. In addition, auditors are left to evaluate whether accounts/trade payables include amounts that should appear in short-term debt.
Accounting Challenges and Responses
The basic accounting challenge for SFP activity is both straightforward and complex, affecting both the balance sheet and statement of cash flows. It raises the following three questions: 1) Should the liability for goods and services purchased from a supplier in the ordinary course of business and initially paid by an FP in a SFP arrangement be shown as an “accounts payables” or “short-term debt?” 2) Should the transactions be classified in the statement of cash flows as operating activities (CFOA), financing activities (CFF), or noncash financing activities? 3) Which disclosures will enhance transparency and allow financial statement users to appropriately evaluate liquidity, cash flow, and working capital? As a complicating factor, an SFP can be initially structured or subsequently changed in a multitude of ways, altering the nature of the initial transaction and creating uncertainty about the appropriate accounting treatment. Such factors include, but are not limited to, changes in the nature, amount, or timing of the original terms, incentives to the buyer, or an increase in the product cost that could be interpreted as an interest element.
The perceived problems associated with SFP reporting and disclosure motivated comments from the SEC, FASB, IASB, and Big Four. In 2019 and 2020, the SEC sent comment letters to SEC filers about supply chain finance programs. Based on this, they detected these firms’ SFPs primarily based on the mention of third-party providers in the management discussion and analysis (MD&A), discussions about liquidity, unusually large increases in accounts payable, and a substantial increase in the days payable outstanding (DPO) metrics. The SEC requested a response to questions related to several entities’ SFPs, including: Boeing, Coca-Cola Company, Graphic Packaging Holding Company, Keurig Dr Pepper, Masco Corporation, and Procter & Gamble.
In late 2019, in an unusual move, signatories from each of the Big Four joined to draft an open letter to FASB in which they requested improved guidance (Big Four, “Agenda Request—Structured Trade Payables,” 2019). The Big Four proposed alternative solutions to the challenges of supply chain finance reporting and disclosure. As previously noted, the Big Four are concerned that weaknesses in U.S. GAAP have led to “limited disclosure of such programs in practice” that may elevate litigation risk for auditors. Without reporting and disclosure guidance, companies might hide this “financing-type” debt in accounts payable, potentially leading to unforeseen collapses by companies in weaker-than-understood cash positions. In part, an auditor’s inability to clearly identify SFP activity in a client can be at least partially attributed to the limited existing reporting and disclosure guidance.
Moody’s Investors Service expressed similar sentiments related to “hidden debt” and the subsequent effects related to SFP in a January 2020 letter to the IASB IFRS IC (Moody’s Investors Service, letter to IFRS IC, https://bit.ly/3wi7dR7, 2020). More specifically, Moody’s observed an increased use of SFPs without a corresponding increase in reporting and disclosure by companies; it also noted the lack of transparency, consistency, and comparability. Similar to the Big Four, Moody’s requested additional guidance regarding disclosures and classification.
FASB included “supply chain finance” multiple times on its meeting agendas throughout 2021. These meetings focused on staff research and scoping language for further investigation and comments from practice. The IASB had previously decided that current IASB, IFRS, and IAS contained relevant guidance and initially declined to provide further guidance. The issue was revisited, however, after the receipt of comments subsequent to that decision. Both FASB and the IASB issued exposures drafts at the end of 2021.
FASB and IASB Exposure Drafts
The IASB issued an ED, Supplier Finance Arrangements (SFA), which proposes amendments to the Statement of Cash Flows (IAS 7) and Financial Instruments: Disclosures (IFRS 7) in November 2021 (https://bit.ly/3yvzt5M). FASB followed in December 2021, with proposed Accounting Standards Update (ASU), Liabilities–Supplier Finance Programs (Topic 405-50): Disclosure of Supplier Finance Program Obligations. In general, the EDs contain descriptions of SFP characteristics and proposed disclosure requirements. Exhibit 2 lists the basic characteristics of SFP/SFAs, as defined by FASB and the IASB.
Supplier Finance Programs/Arrangements Defined
The two standards setters agree that supplier finance programs include three parties: 1) buyers, 2) suppliers, and 3) third-party finance providers (FP), or intermediaries. FASB and the IASB also agree that the program includes payment by the FP of the buyer’s obligations to the supplier. They both identify characteristics of these programs, with slight but significant variations.
The three characteristics specified in FASB’s ED that are listed in Exhibit 2 are further illustrated in Exhibit 3. Note the FASB requirement of “confirmed invoices”; the focus on confirmed invoices does not exist in the IASB ED. The IASB appears to focus on suppliers rather than invoices, confirmed or otherwise.
Another significant difference in the two proposals rests in the IASB requirement to disclose SFP as a non-cash financing activity. FASB is silent as to the cash flow treatment of SFPs. In effect, the IASB defines the FP payments on behalf of the buyer as a financing activity.
As the titles suggest, FASB’s proposal focus on the balance sheet account liabilities (Topic 405 Liabilities), whereas the IASB’s proposal focuses on the statement of cash flow (IAS 7) with disclosures about liabilities as well. FASB specifically states that the proposal does not include “recognition, measurement, or financial statement presentation” of the buyer.
Required Disclosures: Qualitative
Both EDs require qualitative and quantitative disclosures, as seen in Exhibit 4. Both EDs require the identification and disclosure of key terms about the programs (discussed further below). In addition, both EDs require disclosure of the specific balance sheet accounts that contain the SFP amounts.
SFP/SFA Required Disclosures
Management, as well as auditors, must identify SFP activity. Management will identify the SFPs and prepare the disclosures outlining the key terms of the program with a focus on the information required to increase transparency about elements that affect working capital, cash flows, and liquidity. In addition, management will prepare and present the required quantitative disclosures. Given the limited scope of SFP as proposed by FASB (i.e., require confirmed invoices), it will be imperative for auditors to identify SFPs as well.
Required Disclosures: Quantitative
FASB’s ED proposes reporting the SFP amounts included in each balance sheet item identified in the qualitative information (see Exhibit 4). In addition, the ED requires disclosure of a roll forward of the SFP obligations for each balance sheet presented. Exhibit 5 reproduces the presentation of the roll forward as it appears in the ED at proposed ASU 405-50-55-5. The roll forward is required for each balance sheet item that has SFP amounts within.
Disclosure of Roll Forward (FASB)
It is noteworthy that IFRS defines trade payables as “liabilities to pay for goods or services that have been received or supplied and have been invoiced or formally agreed with the supplier” (IAS 37). Despite the typical disclosure of changes in the trade payables account as an operating cash flow, the IASB clarifies the nature of the payments to FPs as a financing activity. The request for guidance related to SFPs’ placement on the statement of cash flows is not addressed in FASB’s ED.
Overall, both EDs require qualitative and quantitative information about the SFP that allows users to identify the effects of the SFPs on cash flows, liquidity, and working capital. The first critical variable in the disclosure reporting of SFPs is to identify the presence of such programs.
Identify the Presence of SFPs
Auditors will need to assess whether a company appropriately accounted for and met SFP disclosure requirements. The first step is to test for the existence of SFPs through the examination of SFP indicators that SFPs may exist. The first and most obvious method is client inquiry and the existence of information in the notes to the financial statements. Content in the financial statements (e.g., a third-party finance provider) may also indicate an SFP. In addition, SFP indicators might be found in the liquidity, capital resources, and financial position discussions found in the MD&A section of the SEC 10-K or notes to the financial statements for publicly traded companies.
Comparison of entity to industry norms.
Notwithstanding client responses, an auditor should compare a company’s supply chain activity to market norms. In the traditional model of buyer-supplier transactions, buyers order from suppliers based on agreed-upon credit terms. Suppliers then send the goods to the buyer and invoice them according to agreed-upon credit terms. Typical credit terms vary by industry, but normally hover between “2/10, net 30” and “net 45,” yielding a “days payable outstanding” (DPO) metric between 30 to 45 days. Thus, auditors can most easily identify unusual financing arrangements by comparing the client’s DPO with industry norms.
Exhibit 6 presents 2010 and 2020 DPO metrics for large companies known to engage in SFPs. It shows that the median DPO in 2020 for this RF-using group is 111.1 (83.3), a figure markedly higher than market norms of 55 days (Hackett Group, “Hackett Survey: Pandemic Drives Significant Changes in Working Capital Performance in 2020,” 2021, https://bit.ly/3MciGbJ) or more recent evidence from U.K. companies of 52 days for RF users and 38 days non-RF users (Elizabeth Chuk, Ben Lourie, and Il Sun Yoo, “The determinants and consequences of reverse factoring: Early evidence from the UK,” 2021, https://bit.ly/3FzuQsN).
DPO of DFP-Using Companies, 2010 & 2020
Exhibit 6 can inform auditors about a client’s working capital risk appetite. First, it is noteworthy that these large RF-using companies had relatively high average (median) DPO figures even in 2010 (66.8 and 53.6, respectively), though how this was accomplished can only be speculated upon. Second, all of the firms increased their DPO metric over the past 10 years, increasing by an average (median) of 44.3 (29.7) days. Unusually large or significant changes in DPO and payables balances can attract the attention of regulators. The SEC asked Coca-Cola in June 2020 to “consider disclosing and discussing changes in your accounts payable days outstanding to provide investors with a metric of how supply chain finance arrangements impact your working capital.”
Comparisons of supplier invoice terms to industry norms might also highlight SFP activity. Coca-Cola’s 2020 note disclosure asserted that the majority of their suppliers operate under “net 120” terms. Keurig Dr. Pepper (KDP), by contrast, opaquely disclosed: “Excluding our suppliers who require cash at date of purchase or sale, our current payment terms with our suppliers generally range from 10 to 360 days.” Not all RF activity can be conveniently found by invoice terms (or at least by comparing them between suppliers). P&G, in describing its supply chain financing (SCF) activities, stated that:
The terms of the Company’s payment obligation are not impacted by a supplier’s participation in the SCF. Our payment terms with our suppliers for similar materials within individual markets are consistent between suppliers that elect to participate in the SCF and those that do not participate. Accordingly, our average days outstanding are not significantly impacted by the portion of suppliers or related input costs that are included in the SCF.
(P&G, Form 10-K, 2020, p. 24.)
Examine invoice payments.
Examining invoice payments is yet another method to identify SFP activity. Specifically, if invoice payments to suppliers are directed to a financial intermediary (a common practice in SFP settings), auditors should request further information about buyer-supplier payment processes.
Evaluate accounts payable (A/P) characteristics.
Of course, large absolute or percentage changes in accounts (trade) payable balances may likewise flag SFP activity or at least attract the attention of regulators. Characteristics may suggest categorization of an A/P as an SFP if the substance of the transaction changes from a traditional A/P to, in effect, debt borrowing. Basic characteristics or changes might include the following:
- modifications to the terms of the original agreement with the supplier,
- changes of the rights of the FP toward the buyer (e.g., an FP right to require immediate payment by the buyer, collateral, or interest),
- the buyer incurs financing costs or agrees to cover any of the supplier’s costs of the arrangement,
- suppliers are required to participate in the program or the buyer has control over the relationship between the supplier and the FP, or
- the buyer receives kickbacks from the FP or otherwise profits from the SFP arrangement.
Key Terms and Conditions
Both FASB and the IASB require disclosure of the SFP terms; FASB requires “key terms” and IASB requires “terms and conditions.” FASB states that the key terms are better determined by management and leaves the specific terms disclosed to management’s discretion. The most relevant criteria by which to judge or determine which key terms of the program should be disclosed are those that better informs users’ analyses of the entity’s cash flows, working capital, and liquidity. By way of example, FASB’s ED includes potential key terms, but also states the example is not intended to imply the terms are required nor that the key terms in the example represent an exhaustive list. Exhibit 7 lists the key terms that appear in the ED example, proposed ASU 405-50-55-2 and 3.
The IASB, on the other hand, limits their example disclosures to just two: 1) extended payment terms and 2) guarantees provided.
SEC-Inferred Key Terms
Management might also garner sample key terms from the SEC’s Corporate Finance division’s relatively recent requests to SEC filers: Boeing, the Coca-Cola Company, Graphic Packaging Holding Co, KDP, Masco Corporation, and P&G. Each company received a request for additional information related to their SFPs. In the name of transparency, and with the intent to provide additional information to financial statement users for evaluating liquidity, these entities were asked to provide one or more of the key terms listed in Exhibit 7.
Select SEC Filers’ Disclosures
Coca-Cola and Masco both present comprehensive disclosures in their 2020 SEC 10-K filings. In general, both disclosures contain basic descriptions of their respective programs and include items such as the following:
- Supplier and buyer agree to the basic and customary trade terms and how the original terms (e.g., due date, amount) of the obligation to the supplier remain the same.
- Buyer is independent of the agreement between the financial institution and the supplier.
- Financial institution and supplier set the terms by which the supplier sells obligations to the financial institution, as adjusted to reflect credit-worthiness of buyer
- Supplier voluntarily (not mandated) participates in the RF arrangement.
- Buyer organization has no economic interest in the supplier’s decision to participate in an RF arrangement with the financial institution.
Insights can also be gleaned from other organizations presenting RF activity. The most salient disclosures to date address issues regarding the scope and potential risk of the arrangements. In particular, disclosures might include the percentage of suppliers that participate in the program or the discussion of any potential impact on liquidity in the event a program is terminated. The latter point is exemplified in the recent Boeing disclosure:
While access to supply chain financing has been reduced due to our [Boeing] current credit ratings and debt levels, we do not believe that these or future changes in the availability of supply chain financing will have a significant impact on our liquidity. Supply chain financing is not material to our overall liquidity. [emphasis added]
Similarly, Masco’s 2020 disclosure states the following:
A downgrade in our [Masco] credit rating or changes in the financial markets could limit the financial institutions’ willingness to commit funds to, and participate in, the program. We do not believe such risk would have a material impact on our working capital or cash flows, as substantially all of our payments are made outside of the program. [emphasis added]
Organizations and their auditors may consider including additional commentary for the benefit of stake-holders. In 2019, for example, P&G discussed projected trends and uncertainties associated with extended payment terms that might materially impact future liquidity as follows:
Although difficult to project due to market and other dynamics, we [P&G] anticipate incremental cash flow benefits from extended payment terms with suppliers could decline in fiscal 2020.
Adjusting the Audit Program
Given the increasing use of SFPs, the difficulty of identifying them on the face of the balance sheet, and the pending ED requiring additional disclosures, auditors should include SFPs in their audit program steps. The first steps are to inquire of the client about the use of SFPs and test for SFP indicators, as noted above. Possible questions for the audit program to identify the existence of SFPs appear in Exhibit 8.
Audit Program Questionnaire
Once the presence of SFPs has been established, reporting and disclosure issues move front and center. To this end, the audit program might also include the disclosure questions in Exhibit 8.
This discussion highlights the implications of FASB and the IASB’s exposure drafts related to supplier finance programs/arrangements. SFPs have been increasingly used to settle traditional trade payables account balances, leading to expressions of concern from investors, regulators, and auditors. Management and auditors should use practical methods to identify SFPs and possible key terms required to be disclosed under the EDs. Auditors should also consider adjusting their audit programs to address SFPs.