Disclosing supplier finance arrangements

Supplier finance arrangements can distort operating cash flow and mis-state leverage. What may, in part, be a source of debt finance for a purchaser is often wholly presented as trade payables in their balance sheet and not identified as a financing liability. Changes in this liability are included in operating cash flow, which may be artificially enhanced where the financing component increases. Even if a supplier finance arrangement is classified as debt, operating cash flow is still distorted, particularly due to the resulting ‘non-cash’ operating outflow.

Existing IFRS disclosure requirements are not sufficient for investors to identify how operating cash flow and debt finance have been affected by supplier finance arrangements. A recent Exposure Draft issued by the International Accounting Standards Board (IASB) aims to rectify this.

Trade payable or bank borrowings?

Where payments by a purchaser to a supplier do not involve any external finance arrangement, the trade payable and trade receivable are equal. The purpose of supplier finance is to break this link, with the intermediary bank paying the supplier before the bank is, in turn, paid by the purchaser. 

There may be different objectives for a supplier finance arrangement, which influences the accounting treatment:

• Finance for the purchaser: if the arrangement increases payable days for the purchaser, while the supplier still receives payment on the normal due date, it is only the purchaser that benefits from additional finance. The same effect is achieved if the purchaser arranges for the supplier to grant longer payment terms, but in return the supplier is provided with a facility whereby payment can be obtained on the original due date.
• Finance for the supplier: the purchaser may enter the arrangement simply to improve cash flow for its suppliers. The purchaser pays on the normal due date, but earlier payment by the bank to the supplier provides the supplier with an alternative, and potentially cheaper, source of finance.
• Finance for both: if the purchaser pays later than it would have done without the arrangement and the supplier receives payment earlier, both receive a financing benefit.

The classification of the liability under IFRS depends on whether the liability is regarded by the purchaser as ‘similar in nature and function to trade payables’ and consequently whether the ‘liabilities are part of the working capital used in the entity’s normal operating cycle’. This depends on the extent to which the terms of the arrangement differ from other trade payables. 

If the purpose of the arrangement is to provide finance for the purchaser by significantly extending the payment date, it is likely to be classified as a financing liability. Otherwise, it will be part of trade payables. 

The proposed new IFRS disclosures

The IASB’s Exposure Draft outlines proposed disclosures by a purchaser who engages in supplier finance arrangements. Some of these are reminders of existing requirements, such as the effects on liquidity risks and the non-cash changes in financing. Others are new, including information about payment dates. 

The table below summarises the proposed new IFRS disclosures.

These proposals will not change what appears in the balance sheet or change reported operating cash flow. However, the disclosures should enable better understanding of how supplier finance arrangements affect – and distort – metrics and may well change what investors should use in their analysis.

Using the proposed disclosures to adjust cash flow and leverage

To adjust reported cash flow and leverage, it is first necessary to identify the total amount of bank finance provided under the arrangement. This is the amount that has been paid by the bank to the supplier, but which has not yet been paid by the purchaser to the bank. This figure is one of the new disclosures proposed by the IASB.

The total finance amount can be split between that attributable to the supplier and purchaser. For the supplier, it is the extent to which they are paid earlier than they would have been without the arrangement. For the purchaser, it is the delay in their payment. These can be estimated using the new disclosures by comparing the average payment date under the arrangement with what it would have been had the arrangement not existed. 
The total liability of a purchaser under a supplier finance arrangement can then be split between this amount of debt finance and an amount that represents the underlying trade payables that would have been present had the arrangement not been used. 

If the finance provided under the arrangement is wholly attributed to suppliers, no adjustments to operating cash flow or leverage are necessary. In this case, the arrangement simply involves the purchaser facilitating bank finance for its suppliers.

But if the finance is partly or wholly attributable to the purchaser, investors will need to identify the effect and adjust both leverage and operating cash flow. The nature of that adjustment depends on the classification of the liability in the purchaser’s balance sheet.

Liability classified as trade payables

If a component of trade payables is in effect debt finance, cash flow will be affected by changes in that financing amount and leverage will be understated. Investors should reclassify this part of trade payables as debt financing and remove the change in this financing from operating cash flow. 

Liability classified as borrowings

If the liability is classified as borrowings, the payments made by the purchaser to the bank would be presented as a financing cash outflow. The reduction in trade payables and increase in borrowings that occurs when the arrangement is entered into is generally not an actual cash flow. As a result, there is no operating outflow reported in respect of purchases and therefore operating cash flow is likely to be grossly overstated. 

However, the non-cash movement in financing should be disclosed. This non-cash flow is, in effect, an offsetting operating cash outflow and financing cash inflow. To correct operating cash flow, it is necessary to deduct the non-cash increase in borrowings (the effective operating outflow) from the reported cash flow amount. In addition, the change in the liability component that represents trade payables should be included as part of operating cash flow.

Too much complexity?

The proposals in the Exposure Draft will certainly help investors who are willing to make the effort to delve into the data and make the appropriate adjustments. But are they unnecessarily complex? Disclosure of the adjustments themselves, together with pro-forma adjusted operating cash flow and borrowings, would be much more useful for investors and no less informative.

A longer version of this article was previously published in Steve’s investor-focused blog The Footnotes Analyst (footnotesanalyst.com).