For over two years, the SEC staff and advisory committees, credit rating agencies, investors, the Big Four accounting firms and other interested parties have been making noise about a popular financing technique called “supply chain financing.” 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. Currently, there are no explicit GAAP disclosure requirements to provide transparency about a company’s use of supply chain financing. That may be why Bloomberg has referred to supply chain financing as “hidden debt.” Late last month, the FASB announced that it had issued a proposed Accounting Standards Update intended to help investors and others “better consider the effect of supplier finance programs on a buyer’s working capital, liquidity, and cash flows.” The proposed ASU would require the buyer in a supply chain financing program to “disclose sufficient information about the program to allow an investor to understand the program’s nature, activity during the period, changes from period to period, and potential magnitude.” The comment period will be open until March 21, 2022.
Supply chain financing (sometimes referred to as “supplier finance programs” or “reverse factoring”) typically involves a company arranging for a bank or other financial intermediary to pay the company’s suppliers on its behalf. According to Bloomberg, companies “like supply chain financing because it lets them spread out their bills and free up cash for other purposes. Suppliers like the programs, too, because the third-party financing provider guarantees payment, often much earlier than they would receive from a customer. The arrangements allow suppliers to submit bills to a financial intermediary, which pays the invoice at a slightly lower price than the full value of the bill. The financial institution then collects the full amount of the invoice from the company at a later date, profiting on the difference.”
As discussed in this Bloomberg article, companies that are “well capitalized” and run their programs effectively receive “high marks” on their use of these programs: “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 supplier finance programs, 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 been prodding companies to increase transparency regarding supply chain financing arrangements. In 2019, 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 supplier finance programs “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 and comment process to ask a number of companies for more disclosure. For example, the SEC staff has 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 supplier finance programs.
In October 2019, 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 particular, the four firms observed that, although some practices have developed, “there is no specific guidance in U.S. GAAP that addresses the classification of these programs as trade payables or debt….”
At a meeting of the SEC’s Investor Advisory Committee in May 2020, 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, supplier finance programs 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 2020, 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 finance 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.)
The FASB’s proposed ASU is intended enhance the transparency of supplier finance programs by requiring the buyer to “disclose sufficient information about the program to allow an investor to understand the program’s nature, activity during the period, changes from period to period, and potential magnitude.”
As described by the FASB, in a typical supplier finance program, the buyer “(1) enters into an agreement with a finance provider or an intermediary to establish the program, (2) purchases goods and services from suppliers with a promise to pay at a later date, and (3) notifies the finance provider or intermediary of the supplier invoices that it has confirmed as valid. Suppliers may then request early payment from the finance provider or intermediary for those confirmed invoices.” The FASB also later notes that typically the “early payment transactions between the supplier and the finance provider or intermediary are subject to an agreement between those parties that the buyer understood would be established but is neither involved in negotiating nor is legally a party to.” The FASB decided that, while not determinative, “a buyer’s commitment to pay certain invoices to a third-party intermediary would be an indicator that a supplier finance program may have been established.”
The FASB indicates that investors and analysts wanted more transparency about supplier finance programs so that they could “better understand the potential risk of the longer payment terms with suppliers and sources of working capital.” The proposal would require disclosure of qualitative and quantitative information about the program in the notes to financial statements that would be “sufficient to allow a user to understand the nature, activity during the period, changes from period to period, and potential magnitude of the program.” Qualitatively, the buyer would need to disclose the key terms of the program and a description of where that amount is presented in the balance sheet. Quantitatively, the buyer would be required to disclose the amount of the obligation that the buyer has confirmed as valid and remains outstanding and unpaid by the buyer as of the end of the period, along with changes during the period. More specifically, the disclosures would include a “rollforward” of those obligations showing the amount of obligations outstanding at the beginning of the reporting period, the amount added to the program during the reporting period, the amount settled during the reporting period and the amount of those obligations outstanding at the end of the reporting period. To improve the comparability of financial information, the FASB determined that, in the initial application, the proposed amendments should be applied retrospectively to each period for which a balance sheet is presented. If a company has multiple programs, it would be permitted to aggregate disclosures, so long as the aggregation doesn’t obscure useful information about programs with substantially different characteristics. The FASB believes that these disclosures collectively should “provide investors and analysts with information that is relevant to their analyses of working capital, liquidity, and cash flows.”
The FASB decided, with three dissents, not to require information about the rollforward and the outstanding confirmed amount at interim periods. However, the proposed ASU asks whether, in addition to annual periods, a company should “be required to disclose the outstanding confirmed amount and the rollforward of those obligations at each interim reporting period,” or only for interim reporting periods when there has been a significant event or transaction related to the programs that has a material effect on the company. In addition, the FASB said that, because it did not find a pervasive diversity in practice, it “considered but decided not to address the cash flow statement presentation of changes in obligations covered by supplier finance programs.”