Many people are familiar with the concept of debt factoring, in which the supplier of goods or services uses the trade debt owed by its customers (ie, the purchasers of those goods or services) as a means to obtain funds from a finance provider such as a bank. Yet people may be less aware of the concept, and implications, of reverse factoring.
Reverse factoring has been the subject of increasing focus by the regulator, the Financial Reporting Council (FRC), in recent years. Back in 2014 the regulator called for greater transparency around such arrangements and in 2018, they published their response to enquiries about the suitability of the accounting applied to reverse factoring by Carillion. In their 2018/19 review of corporate reporting, the FRC noted that it continues “to have concerns about the adequacy of disclosures provided to explain supplier financing arrangements, also known as reverse factoring”.
Supply chain financing was also on the agenda at the April 2020 meeting of the IFRS Interpretations Committee ahead of further discussions planned for June.
What is reverse factoring?
Traditional debt factoring arrangements can be structured in a variety of ways, with the accounting by the supplier being predominantly driven by the extent to which it has transferred its customer’s (ie, the purchaser’s) credit risk to the bank.
The purchaser, however, is not a party to the arrangement and so its contractual rights and obligations under the contract with the supplier are unaffected.<
Like debt factoring, reverse factoring is an umbrella term used to describe a spectrum of different arrangements. However, unlike traditional debt factoring arrangements, the purchaser is party in some way to the arrangements, typically being the initiator of the arrangement. As shown in the illustration opposite, the purchaser arranges for the bank to pay the supplier on its behalf and then later, pays the bank.
Motivations of the purchaser may be to:
- enable the purchaser to take advantage of any early settlement discount by arranging for the bank to pay the supplier on its behalf earlier than it is otherwise contractually required to;
- in effect, provide the purchaser with a further period of credit by arranging for the bank to pay the supplier in accordance with the original terms of the contract; or
- stabilise the purchaser’s supply chain by introducing their supplier to the bank, enabling the supplier to be paid in line with the credit terms originally granted to the purchaser.
Why is it an issue?
Reverse factoring has come to the attention of the regulator as the prevalence of this type of financing may significantly outweigh what is apparent from annual reports.
Companies that provide little or no disclosure of their payment practices are not being transparent with investors, and other users of the financial statements, about what may be a material component of the company’s working capital. This lack of transparency may also mean that other relevant questions are not appropriately considered, for example:
- whether the use of reverse factoring limits the company’s ability to raise further financing at market rates in the future; and
- whether it has an impact on other lines of credit the company holds with the bank
What are the implications for annual reports?
Unlike debt factoring, reverse factoring may have an accounting impact for the purchaser. It’s clear the purchaser has a liability, but what is less certain is whether the trade payable originally due to its supplier should be reclassified as a financing liability after being settled on its behalf by the bank.
The conclusion reached has a consequential impact on the cash flow statement and statement of profit or loss. The eventual cash payment made by the purchaser will either be presented as an operating or financing cash outflow, and any difference in the cash flows (if any) between the original and subsequent liabilities will be presented in profit or loss as either operating or financing expenses.
Notwithstanding the effect on the financial statements, the use of reverse factoring by a purchaser, as part of its relationship with its creditors, should have implications for the strategic report, liquidity risk disclosures, and the company’s section 172(1) statement.
Accounting requirements
Neither IFRS nor UK GAAP provides specific guidance on how a purchaser should account for reverse factoring arrangements. However, they both require a financial liability to be derecognised when, and only when, it is extinguished (ie, when the obligation specified in the contract is discharged, cancelled or expired). When a purchaser borrows from a bank (cash inflow) to pay a supplier (cash outflow) it usually requires little analysis to conclude that the liability to the supplier should be derecognised, and a new liability to the bank recognised. However, when the bank settles the supplier directly, and there’s no immediate cash inflow or outflow from the purchaser’s perspective, it may not be so obvious.
If, as a result of a reverse factoring arrangement, the purchaser is in exactly the same position as if it had borrowed from the bank to settle the debt owed to the supplier, it would be appropriate for the financial statements to reflect the liability as a financing transaction. In other situations, however, judgement may be needed to conclude if the purchaser’s original liability has been extinguished and replaced with a liability to the bank.
Where there has been a modification of a financial liability, both IFRS and UK GAAP require an assessment of whether the terms of the debt owed are substantially different. IFRS clarifies that this will be the case if the cash flows under the revised arrangement (including fees) are at least 10% different to the original contract. It is also generally accepted that qualitative changes to terms, such as security or guarantee enhancements provided by the purchaser, can also affect the assessment.
Where the purchaser’s liability to the supplier is not substantially different, the purchaser would continue to present the liability as a trade payable with the settlement being an operating cash flow. However, where the purchaser’s obligation is assessed as substantially different, the existing liability will be derecognised and a new liability recognised. Further factors will then need to be considered to determine whether that new liability continues to be a trade payable or is a financing liability. These factors might include whether:
- the purpose of the arrangement is predominantly to improve the purchaser’s or the supplier’s working capital position;
- any fees are payable as part of the arrangements and if so, by who and to whom; and
- the purchaser’s and supplier’s rights and obligations vis-à-vis discounts and refunds for the goods or services supplied has changed.
Summary
For companies considering entering into reverse factoring arrangements, it is important to understand the totality of the contractual arrangements in place between the supplier, the purchaser and the bank. Depending on those contractual arrangements, judgement may then be needed to determine how the purchaser should present the liabilities arising and subsequent cash flows on settlement of those liabilities.
Companies should also consider the need to disclose additional information. Both IFRS and UK GAAP require the judgements that management have made in the process of applying the company’s accounting policies and that have the most significant effect on the amounts recognised in the financial statements to be disclosed. We await the next steps of the IFRS Interpretations Committee with keen interest
About the author
Catriona Lawrie, Director, and James Nayler, Senior Manager, Mazars.
Views expressed are those of the authors
