Here at Watchdog, we are firm believers in transparency, and we take a critical look at any accounting procedures which tend to make financial disclosures opaque. This guest blog on reverse factoring was contributed by Olga Usvyatsky, a former VP of Research at Audit Analytics. She has a distinguished library of blogs and op-eds on accounting, buy-side research, and data analysis. Ms. Usvyatsky is currently enrolled as a PhD in Accounting student at Boston College, where she earned her MS in Accounting degree.
One of the key factors in assessing a company’s business is understanding its sources of liquidity. After all, the most prevalent reason for a company to go out of business or declare a bankruptcy is running out of cash. Conversely, a not-yet-profitable company may stay afloat for an arbitrarily long period of time, and even consider an IPO, provided their investors are ready to foot the (pre-IPO) bill.
Liquidity comes in many shapes and sizes, ranging from cash received from sales to taking on debt. Supply chain financing is a one of form of liquidity management that has received some extra publicity lately from a prominent short seller, who claimed that NMC Health plc used an obscure reverse factoring agreement was to understate debt.
What is Reverse Factoring?
Let’s look at how the unusual accounting around reverse factoring (also known as supply chain financing) works.
In its simplest form, the company that has accounts payable to a supplier may want to extend the terms payable on their invoices. One way to achieve this is to ask the supplier to use a third-party financial institution to buy the company’s obligations, and then settle these obligations with the financial institution. When the cost of such transaction is low, it looks like a win-win situation for the company and the supplier.
One interesting example is Masco Corp (MAS). In response to the SEC comment letter, the company described how a supply chain finance program was used to increase accounts payable days to above 70. In the quarterly report for the nine months ended September 30, 2019 Masco stated that the “amounts settled through the program and paid to participating financial institutions were $181 million and $188 million for our continuing operations during the nine-month periods ended September 30, 2019 and 2018, respectively.” As of September 30, 2019, the company had $879 million of outstanding accounts payable.
Problematic Issues with Reverse Factoring
The use of supply chain financing appears to be on the rise. Yet, there is little regulatory guidance around the way supply chain financing transactions are accounted for or disclosed. This means that companies can report these transactions as either debt or liabilities. A company might not want to report the transaction as debt because of existing debt covenants that prevent the taking on of new debt. Additionally, some companies will choose to report the transactions as debt and others as liabilities, creating diversity in financial statements that make it difficult to compare peers.
The issue appears to be significant enough to prompt the Big Four to author an open letter to regulators requesting additional guidance. From the investors point of view, it is a noticeable event. The letter implies that the Big Four, which audit more than 90% of large accelerated filers, are facing challenges determining the appropriate accounting treatment of these reverse factoring transactions during the year-end auditing process.
The letter also expressed concerns that the transactions may not be even disclosed:
“…because there are no specific disclosure requirements in U.S. GAAP related to these types of programs, there has been limited disclosure of such programs provided in practice”
These concerns are shared by the rating agencies.
In response, the SEC is stepping up its scrutiny of supply-chain finance programs. In the past few months, the SEC issued comments to issuers requesting to clarify accounting treatment and provide more transparent disclosures (see, for example, comments to Keurig Dr Pepper (KDP) here and here).
To summarize, the main objective of the reverse factoring agreements is to improve working capital and liquidity. Yet, lack of transparent disclosure and limited information about such transactions, along with increased regulatory scrutiny, pose additional risks for the investors that need to be taken into consideration.
The Watchdog Blog Team
Note: Our team is made up of current and former Big Four CPAs, Public Company CFOs, Litigation Specialists, Lawyers, Accounting Educators, Ethicists, Regulators, Entrepreneurs, and yes, even a few overly opinionated Harvard MBAs. Our mission is to write blogs that promote transparency in corporate disclosures.
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