In today’s competitive marketplace, banks must provide more value to their corporate customers and, in turn, their corporate clients, the buyers, need to better manage and take value from the ever-expanding financial supply chain. Suppliers see ever-increasing pressure on their working capital as payment cycles lengthen and margins fall. Unlocking the financial supply chain with payables financing is surely a win-win-win scenario for all players – so why has it been so slow to take off?
At the 2006 Treasurers’ Conference, a session chaired by Royal Bank of Scotland pinpointed one of the main issues keeping payables financing on the ground. Buyers are concerned that their participation in payables financing will bring with it an unpleasant and unwanted friend – the reclassification of trade payables to debt on the buyer’s balance sheet. This concern is probably heightened by some of the recent and rather provocative publicity around payables financing accounting, which has labelled it as ‘accounting shenanigans’ or even a ‘dirty process’.
With these headlines and a general accounting unease in the post-Enron world it is perhaps easy to see why treasurers are cautious of arrangements involving payables financing. Is this caution really warranted or are we allowing the accounting academics to overrule what our business sense is telling us? It is only by considering the basics first, and then moving on to what is really happening today with payables financing arrangements, that we are able to determine the outcome.
What is Payables Financing?
Ask a treasurer to explain what payables financing means to them in 2007 and they will probably explain the following scenario:
“A supplier takes early payment of a receivable from a financial intermediary (often a bank) at a finance rate dependent on the buyer‘s credit rating rather than the supplier‘s. The supplier gets instant access to cash and pays a lower finance rate based on the buyer‘s credit rating rather than its own. The buyer shares information to facilitate the process.“
The same question asked in the late 1990s would have been answered very differently:
“A buyer arranges a facility with a bank to pay suppliers on time. The supplier gets paid and therefore keeps supplying the buyer. The buyer uses the bank facility to manage cash flows in often very seasonal or capital intensive businesses.“
A quick ‘compare and contrast’ demonstrates that payables financing in the new millennium may not mean what you thought it did. It has now morphed into something quite distinct from supplier financing and invoice discounting.
Supplier financing
All corporates engage in supplier financing, whereby a buyer purchases goods from a supplier and pays them later under agreed credit terms. The supplier has financed the buyer with a credit line. For accounting purposes this is simple; the buyer maintains a trade payable on its balance sheet, the supplier has a receivable and there is no debt in sight.
Invoice discounting
If a supplier wants to unlock the funds they are owed because of supplier financing then they can approach a bank and ‘cash in’ their receivables documentation. The supplier ends up with debt on the balance sheet and retains a trade payable, even though legally the buyer now owes the bank the payment. Let us come back to this point later on. Accounting for such transactions is well established and the Generally Accepted Accounting Principles (GAAP) requirements focus predominantly, if not wholly, on ensuring that the supplier discloses debt.
Payables financing
Payables financing is rather like invoice discounting, but in reverse. The buyer contracts with a bank to settle its trade payables and the buyer either ends up with debt on its balance sheet or retains a trade payable. This mechanism for managing working capital became prevalent in the US where, for example, Delphi worked with GE Capital to fund their payables and disclosed the debt on their balance sheet. Accounting for such transactions quickly evolved through trial and error and, when a number of buyers didn’t disclose debt and the SEC got involved, it ended with GAAP requiring a buyer to disclose debt.
Payables financing appears to have started with a buyer intending to use a bank to pay suppliers, resulting in debt. Interesting then that the same term is still used but, according to treasurers, it now applies to the reverse situation: a new form of payables financing called ‘receivables purchasing’ – whereby the buyer has no intention of borrowing from a bank and the intent is all with the supplier. It therefore can be concluded that accounting for the ‘old’ payables financing is relatively simple and GAAP has been established. But, what we actually need to consider now is the accounting for receivables purchasing.
Receivables purchasing
The intention of a buyer engaging in the old payables financing arrangements is to actively engage with a bank to fund payment of suppliers, which, according to GAAP, introduces debt on to the buyer’s balance sheet.
In the case of receivables purchasing the intention of a buyer is passive. The supplier does most of the work and the buyer is left to confirm that payment will be made on a future date. The supplier engages with a bank and takes early payment of the amount due from the buyer. The buyer still settles the payable on the due date with the only difference being that the buyer now pays the bank rather than the supplier.
Remember that point in invoice discounting? Receivables purchasing sounds fairly similar other than the supplier is likely to sell their receivable to a bank and therefore shows no debt either.
So why would the buyer even consider entering debt on to its balance sheet? In my opinion, the buyer is probably better off stepping back and applying the ‘duck test’.
The ‘Duck Test’ for Debt
A phrase that is very applicable when establishing whether your proposed tranaction will result in debt or not is: ‘If it walks like a duck and quacks like a duck then it probably is a duck’. A senior member of the SEC thought the same way when asked to determine whether receivables purchasing should give rise to debt on a buyer’s balance sheet. His answer went right back to accounting basics – i.e. if it looked like debt, then it probably was debt and most accountants could determine the answer.
While this comment was a personal one and not one necessarily shared by the SEC, it did provide a valuable insight into how to apply accounting rules and, dare I say, apply substance over form. Applying the duck test is therefore probably as relevant as any other test in determining when debt will find its way on to a buyer’s balance sheet.
The duck test suggests that a buyer would have to intend to borrow money from a bank for any debt to be recorded on its balance sheet. It couldn’t just arrive there by accident. GAAP for invoice discounting supports this argument. If the buyer simply facilitates early payment to suppliers then no debts have appeared in the buyer’s books, as far as we can tell. Simply because parties refer to these transactions as payables financing (which they are not) does not convert a trade payable into a debt.
Credit Card Usage on the Up but No ‘Ducks’ in Sight
Thinking slightly wider, the use of credit cards in big corporates is commonplace. Employees purchase goods and services on credit and the corporate settles the balance monthly. The GAAP accounts do not report such transactions as debt. Outstanding balances are generally shown in the purchase ledger along with all the other trade payables.
Consider a corporate that uses credit cards to purchase goods that would otherwise be under supplier financing arrangements, i.e. on supplier credit. The supplier is receiving early payment of their invoices through a merchant card arrangement. The buyer settles their card bill monthly but no debt appears on the balance sheet.
Linking this to invoice discounting, perhaps GAAP for receivables purchasing has been established after all? However, suppose a corporate always paid cash for goods but then changes to make all of its purchases on credit card. Isn’t the buyer now borrowing money from the card provider to pay its suppliers on time? What if the buyer doesn’t settle the credit card balance on time? Shouldn’t the buyer now show debt?
Can the Buyer Go a Step Too Far?
The point around credit cards is that the buyer’s intent is really important in determining the accounting, even for existing methods of transacting. If the buyer simply replaced their normal supplier financing with payment by credit card with no change in the timing of the buyer’s payment, then the debts fade away slightly. But at the extreme there is a problem.
The reason that classic payables financing saw GAAP forcing debt onto the balance sheet was because the buyer was borrowing money. In a receivables purchasing arrangement, where the supplier does all the running, there is no reason why the buyer should show debt on the balance sheet. However, the buyer should constantly apply the duck test to the situation because it is possible that the form of transaction will change and the intent of the buyer could force debt onto the balance sheet.
The Bottom Line – Keep Testing for ‘Ducks’ but Trust Your Own Eyes
It seems clear that a buyer can engage in receivables purchasing without drawing debt on to its balance sheet. Existing GAAP appears to support that view. Buyers need to ask themselves more questions about what is really happening in practice and what they are intending to do, before immediately worrying about debt. Perhaps they should start by asking themselves why they do not show credit card liabilities as debt and supplier invoice discounting payables owed to banks as debt? The bottom line is that receivables purchasing arrangements are likely to increase significantly for many sound commercial reasons. The buyer is not seeking to borrow from a bank so debt should not be an issue, but remain vigilant.