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Financing That Masks ‘Hidden Debt’ Stokes Accounting Anxiety

Jan. 6, 2020, 9:46 AM

It’s a financing tool to free up cash used by companies as diverse as the makers of Behr paint to the peddlers of Dr. Pepper—and it’s in regulators’ crosshairs.

Supply chain financing—a complex technique that lets companies extend the time it takes to pay their suppliers—can make money available for hiring more workers or investing in new technology. But it also can mask looming debt, in part because of murky rules on how to account for these transactions, say a growing chorus of investors, ratings agencies, and regulators.

That could soon change. As the Securities and Exchange Commission presses companies to reveal more details about these transactions, the U.S. accounting rulemaker is considering whether to update its requirements on accounting for supply chain financing.

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

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

‘The Ones We Worry About’

Supply chain financing comes in different forms, but it typically involves companies negotiating more time to pay suppliers by having their banks, for a fee, pay the supplier first. While normal payment terms with suppliers might be 60 to 90 days, these special three-party arrangements can help companies stretch out their payback periods to 180, 210, or even 364 days.

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

But for companies with more tenuous finances, overuse of the method can serve to delay the inevitable—hulking debt that has to be repaid.

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

Case in point: Carillion. Fitch Ratings in July 2018 highlighted the company’s use of reverse factoring and warned investors about other companies using it, calling it a “hidden debt loophole.”

No Clear Rules

Carillion wasn’t breaking any accounting rules, because there were no financial reporting rules to break. No clear guidelines in either U.S. or international accounting rules tell companies whether to treat the transactions as trade payables or debt in their financial statements.

But as investors and regulators press for details, companies want clarity, too, 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 it to weigh in on how companies should classify the transactions and what kind of details they should provide. FASB is expected to vet the request at a public meeting, as it does with most agenda requests.

Across the Atlantic, however, the International Accounting Standards Board has had no requests to tackle the accounting guidance, an IASB spokesperson said.

Former IASB member Stephen Cooper, who now runs an investor website called the Footnotes Analyst, said he believed existing international accounting standards requiring companies to disclose material items should, in theory, capture significant reverse factoring details.

“But companies are resistant,” Cooper said.

Scant Details

The request to FASB from the major U.S. audit firms suggests how broadly the financing mechanism is employed, although company financial statements reveal scant details about its use. In many cases, analysts don’t know when companies use the technique.

“We’re not able to analyze it because we don’t know it exists in some cases,” Gonzales said.

Analysts have to scour other parts of the financial statement for clues, like a sudden increase in cash flows or fluctuations in receivables and payables period over period. If they see a drop in receivables or an increase in payables, they ask questions.

“Are you just having organic improvements in your working capital or is there some kind of financing arrangement?” Gonzales said.

Companies don’t have to offer many details, however, and that can make their cash flows look 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 a month in the customer’s checking account. But a $600 bill looms by midyear, Razvi said.

“If you’re not aware of it, it looks like the cash flows are improving and the metrics look good,” Razvi said. “Once you adjust for that you see, ‘Oh boy, they’re increasing their leverage and risk.’”

SEC Scrutiny

The transactions are increasingly coming under the scrutiny of the SEC, too.

The market regulator in 2019 sent comment letters to two companies—Keurig Dr. Pepper Inc. and Michigan-based Masco Corp.—asking them for details about why their accounts payable periods had increased and whether they were using supply chain finance to help their cash flows. Masco, the maker of Delta faucets, KraftMaid cabinets, and Behr paint, had increased the length of its payments to suppliers from 47 days to 71 days, the market regulator noted. The agency asked both companies why they labeled the money settled under supply chain financing 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 financing, disclosing exactly how much the company owed through these programs. Keurig Dr. Pepper in its third-quarter filing also included more details about how the arrangements worked and how much money the company had tied to these obligations.

At an accounting conference in December, an SEC official said that companies were increasingly using supplier finance programs but not disclosing that they use these arrangements to improve their liquidity. SEC Corporation Finance Deputy Chief Accountant Lindsay McCord , who didn’t mention company names, said businesses needed to use the Management’s Discussion & Analysis section of their financial statements to give investors insight on changes in their financial condition, including the use of supplier finance programs.

“Registrants are not always disclosing they’re using these arrangements as a strategy to increase their liquidity,” McCord said.

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Kathy Larsen at klarsen@bloombergtax.com

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