Funding that masks “hidden debt” fuels accounting anxiety

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It’s a fundraising tool to free up money used by companies as diverse as paint makers Behr to Dr Pepper’s peddlers – and it’s in the sights of regulators.

Supply chain finance, a complex technique that allows companies to lengthen the time it takes to pay their suppliers, can free up money to hire more workers or invest in new technology. But it can also mask impending debt, in part because of obscure rules on how to account for such transactions, according to a growing number of investors, rating agencies and regulators.

That may soon change. As the Securities and Exchange Commission urges companies to reveal more details about these transactions, the U.S. accounting lawmaker plans to update its accounting requirements for supply chain finance.

No one wants to repeat the worst-case scenario, the 2018 collapse of UK construction company Carillion Plc, whose use of a form of financing called reverse factoring allowed it to label nearly half a billion of debt books as “other debts”.

“It’s not just that we’re in the dark. It’s actually misleading, ”said Kazim Razvi, director of financial reporting at the CFA Institute, of current accounting rules.

“Those we care about”

Supply chain finance comes in many forms, but it usually involves companies negotiating more time to pay suppliers by asking their banks, for a fee, to pay the supplier first. While normal payment terms with suppliers can range from 60 to 90 days, these special tripartite agreements can help businesses extend their repayment periods to 180, 210, or even 364 days.

Some multinational companies have used supply chain finance for years without raising any red flags. When Procter & Gamble Inc., during a call for results in April 2013, announced that it would soon start using supply chain finance, it called the mechanism a “win-win” solution for the company. company and its suppliers. Tupperware Brands Corp., in an Oct. 30 conference call with analysts, called the funding a “positive” way to help its cash flow.

But for companies with more fragile finances, abuse of the method can serve to delay the inevitable huge debt that must be repaid.

“These are the ones that concern us,” said David Gonzales, vice president and senior accounting analyst at Moody’s Investors Service. “What we have seen in the cyclical economy is that these facilities dry up when credit tightens.”

Example: Carillion. Fitch Ratings in July 2018 highlighted the company’s use of reverse factoring and cautioned investors against using other companies, calling it a “hidden debt breach.”

No clear rules

Carillion was not breaking any accounting rules because there were no financial reporting rules to break. There are no clear guidelines in US or international accounting rules that tell companies whether to treat transactions as trade payables or payables in their financial statements.

But as investors and regulators demand details, companies also want clarity, say the Big Four U.S. accounting firms.

Deloitte & Touche LLP, Ernst & Young LLP, PwC LLP, and KPMG LLP sent a rare joint letter to the Financial Accounting Standards Board in October, asking them to comment on how companies should classify transactions and what kind of details. ‘they should provide. . The FASB should consider the request in a public meeting, as it does for most agenda requests.

Across the Atlantic, however, the International Accounting Standards Board has not received any requests to tackle the accounting guidelines, an IASB spokesperson said.

Former IASB member Stephen Cooper, who now runs an investor website called Footnotes Analyst, said he believes existing international accounting standards requiring companies to disclose material material should, in theory, enter important details about reverse factoring.

“But the companies are resistant,” Cooper said.

Few details

The request made to the FASB by major US audit firms suggests how widely used the funding mechanism is, although the companies’ financial statements reveal few details about its use. In many cases, analysts do not know when companies are using the technique.

“We are not in a position to analyze it because we do not know that it exists in some cases,” Gonzales said.

Analysts should scan other parts of the financial statements looking for clues, such as a sudden increase in cash flow or fluctuations in receivables and payables from period to period. If they see a decrease in receivables or an increase in debt, they ask questions.

“Are you just seeing organic improvements in your working capital or is there some kind of funding arrangement?” Said Gonzales.

However, companies don’t have to provide a lot of detail, which can make their cash flow appear artificially healthy, CFA’s Razvi said.

He compared the arrangements to an individual negotiating with a cable company to pay his $ 100 bill every six months instead of every month. In theory, this frees up $ 100 per month in the customer’s checking account. But a $ 600 bill is looming by the middle of the year, Razvi said.

“If you’re not in the know, it looks like cash flow is improving and the metrics look good,” Razvi said. “Once you get adjusted to that, you see, ‘Oh my God, they increase their leverage and their risk. “”

SEC control

Transactions are also increasingly monitored by the SEC.

In 2019, the market regulator sent letters of comment to two companies, Michigan-based Keurig Dr. Pepper Inc. and Masco Corp., asking them for details on why their accounts payable periods had increased and whether they used supply chain finance to improve their cash flow. flows. Masco, the maker of Delta faucets, KraftMaid cabinets and Behr paint, has increased the length of its supplier payments from 47 days to 71 days, the market regulator noted. The agency asked the two companies why they labeled the money settled under supply chain finance as accounts payable instead of bank financing.

Masco in its second and third quarter financial statements wrote three paragraphs explaining its use of supply chain finance, disclosing exactly how much the company owed through these programs. Keurig Dr. Pepper, in his third quarter filing, also included more details on how the deals worked and how much money the company had tied to those bonds.

At an accounting conference in December, an SEC official said companies were increasingly using supplier financing programs, but did not disclose that they were using these arrangements to improve their liquidity. Lindsay McCord, deputy chief accountant of SEC Corporation Finance, who did not mention the names of the companies, said companies should use the Management Discussion and Analysis section of their financial statements to give investors insight into the changes in their financial situation, including the use of supplier financing programs. .

“Registrants don’t always disclose that they are using these deals as a strategy to increase their cash flow,” McCord said.

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