Supply chain finance: accounting and five tests
SCF programs are under fire. Is it short term debt or trade credit?
Here are five tests to apply in order to account correctly for supply chain finance. CFOs and corporate treasurers have to get this right.
Supply chain finance is a system that many corporate treasurers / CFOs implement in order to support their suppliers and to increase the efficiency of their payables functions.
Our five tests to apply in order to account correctly for supply chain finance should be considered when determining what accounting treatment is appropriate for supply chain finance.
It should be noted that accounting for supply chain finance remains under review – and that these five tests are not formalised in any accounting standard.
FASB has published updated rules in September 2022 (see here) but has also left open the opportunity to consider further tightening in the future.
CFOs and corporate treasurers wanting to be prepared for what may be to come should find this checklist useful.
How does supply chain finance work?
Whilst there are variations, the basic principle of supply chain finance is:
Suppliers agree to provide extended credit terms to the buyer, their customer. For example, all invoices are issued with a payment term of 120 days post-shipment.
The buyer, working with one or more funders, arranges an option for suppliers to obtain an advance in exchange for a small discount.
This delivers trade credit to the buyer, whilst ensuring that suppliers can access funding early from a third-party funder at a reasonable cost.
The accounting question
Our five tests to apply in order to account correctly for supply chain finance are crucial.
For most buyers, it is very important that the funding provided via supply chain finance is accounted for as trade credit and not shown in their books as short-term debt. The key question for the accounting treatment is to understand who is borrowing the money?
If the buyer is borrowing the money, then the accounting treatment should be short term debt;
If the supplier is borrowing the money, and then using the borrowed funds in order to provide trade credit to the buyer, the accounting treatment should be trade credit.
Here are five simple questions that corporate treasurers and CFOs might ask of their supply chain finance program to help establish the right accounting treatment:
1. Who is paying the costs?
The supplier should pay all the costs involved in receiving payment in advance of the invoice due date. Buyers should not be subsidising the early payment service.
Point to check: the charge that the supplier accepts should equal or exceed all the costs that are involved in the provision of the service.
2. Who is the funder’s client?
The supplier should be the client of the funder and not the buyer. The funder must be lending money to the supplier or purchasing the supplier’s invoice. It is the supplier who is providing trade credit via extended payment terms to the buyer not the funder.
Point to check: The funder must be on-boarding and completing full and appropriate compliance and KYC checks on the supplier as the party receiving credit from the funder. If the funder does not consider the suppliers to be “borrowing clients”, this indicates that short-term debt might be the appropriate accounting treatment.
Comments: Greensill programs were often very weak on some important areas. As has been widely reported, Greensill never considered the supplier to be their client – only the buyer. This allowed them to offer very inclusive programs with high levels of supplier eligibility – but it meant that they were saying one thing to the regulator (our client is the buyer, no need to KYC suppliers) and another thing to the accountants (our client is the supplier, the suppliers are borrowing the money).
Clearly, if the supplier is providing trade credit, the supplier must be the person who borrows the money from the funder that is the client for the service … and the rest of the point follows pretty logically.
3. Who decides whether to take early payment?
The supplier should have complete freedom to decide whether to take the advance payment from the funder.
Point to check - 1: There should be no pressure put on suppliers to take the advance payment option. It should be a free choice for the supplier.
Point to check - 2: Invoice terms for suppliers that take an advance should be no different to invoice terms for suppliers who do not. For example, all suppliers should be on 120 days post-shipment payment terms and all suppliers should be offered the early payment option, subject to availability of funds.
4. Is the buyer commercially disadvantaged?
The buyer should not accept more commercial risk by facilitating the payment of the advance to the supplier. For example, he should still be able to reduce payments on invoices in line with his standard terms of business in respect of credit notes or adjustments that might be expected arise in respect of the supply.
Point to check: can the buyer reduce the amount that he pays on the invoice due date to take credit notes into account, at least up to an expected level of credit notes plus an additional safety margin?
Comments: This is a simple point: if the buyer is surrendering rights he naturally has in his terms and conditions, he is paying something for the early payment service and the nature of the buyer’s obligation may have changed - for example, changed from being a trade credit into a short-term debt.
A good example is the right to deduct credit notes from the invoice payment. This is a standard feature of terms and conditions in commercial trade – and with a longer invoice term, there is a greater chance that credit notes may arise. In many older SCF programs, the initial advance to the supplier is 100% of the invoice and the buyer surrenders his right to deduct amounts arising subsequently from the invoice payment that he will make later.
A robust supply chain finance system should either:
Advance less than 100% of the invoice as an early payment, in order to provide a budget for both expected and unexpected credit notes, so that credit notes arising in the ordinary course of business can continue to be deducted by the buyer; or
Advance 100% but on the basis that the funder accepts the risk of credit notes arising between the advance date and the invoice payment date.
5. Whom does the buyer pay?
The buyer should pay the person who is owed the money that is due under the invoice. This means, in practice, he should be paying the legal owner of the invoice. If the buyer is paying the funder but the funder is not the owner of the invoice, it can be argued that the buyer is repaying the funding that has been provided – which suggests it is a short-term debt.
Point to check: who owns the invoice, and is this also the person that the buyer is paying? More advanced supply chain finance programs ensure the invoice is transferred to the funder as part of the arrangements; the advance payment made to the supplier is the purchase price paid to acquire the invoice.
Are the five tests reasonable?
One way to consider the five tests is to compare supply chain finance to a typical invoice discounting or factoring arrangement that a supplier arranges for himself. It should be pretty clear that, if a supplier decides to factor his invoice, this should not trigger a change in accounting recognition for the buyer.
A typical invoice factoring program for a supplier meets the above tests. To be safe, a supply chain finance program should aim to meet similar standards.
And supply chain finance programs can be organised, if supported by the right technology, to meet the five tests. This is especially true for cross-border supply chains, where more sophisticated platforms are generally required to support payments to suppliers at shipment rather than after delivery.
Does PrimaTrade's supply chain trade finance platform meet all five tests?
Yes, although it does depend upon the precise implemenation model used. A standard approach, as recommended by us, would meet the five tests with a minimum of cost and effort during implementation - perhaps even avoiding a major IT project.
See here for more information about supply chain trade finance works and our digital trade finance platform.
So what should corporates do right now?
There is increasing pressure on corporates and their auditors to look at how supply chain finance programs work, and to check whether they should be booked as trade credit or short-term debt in the books of the buyer. Rules are likely to change. It would be a good idea to use the five tests above and to consider how well your supply chain finance program measures up – as it may be too late to make changes if new rules arrive.
This article originally appeared on CTMFile here. It has been amended since its original publication.