SEC Reignites Supply Chain Finance Debate

Reports in Bloomberg Tax this week said SEC Corporation Finance Deputy Chief Accountant Lindsay McCord spoke Tuesday (Dec. 10) during the American Institute of CPA’s (AICPA) annual conference, held in Washington D.C.

According to McCord, the SEC recognizes a rise in supply chain finance use as more businesses turn to the trade finance tool to strengthen cash flows. However, at the same time, McCord said corporates have not adequately elevated transparency with their investors, causing a lack of visibility into businesses’ supply chain financing arrangements as well as a lack of understanding among investors over how those arrangements work.

The result could lead to masked debts, McCord warned.

Now, the SEC is urging businesses to disclose their supply chain financing arrangements in their Management’s Discussion and Analysis section of financial statements, reports said.

The SEC’s remarks follow requests by the Big Four U.S. auditing firms — EY, Deloitte, KPMG and PwC — for guidance from the Financial Accounting Standards Board in October with regard to how supply chain finance should be classified on financials, similarly pointing to an increased use of reverse factoring arrangements.

“Trade payables classification tends to be treated more favorably than borrowings (i.e., financings) in the calculation of financial ratios and for purposes of determining compliance with financial covenants,” the Big Four firms said in the letter, per the report. “Accordingly, we believe greater transparency and consistency in disclosures in the financial statements of entities that utilize structured trade payable arrangements … is warranted.”

Rising Criticism

The SEC’s position on supply chain financing disclosure follows a notice issued in September by Moody’s Investors Service, which warned corporates and their investors of the possibility that supply chain financing could limit investors’ visibility into company financials.

Supply chain financing, also known as reverse factoring, is rarely disclosed on financial statements, said Moody’s. Even when it is disclosed, investors may not fully understand the risks associated with it.

“Users of financial statements may not be aware of a customer’s usage of reverse factoring, despite the potentially material consequences,” said Moody’s Associate Managing Director William Coley. “The customer itself may not fully understand the added risk that accompanies the use of this financing technique.”

Previous criticism has come from Fitch Ratings, which similarly issued a report last year raising concerns over what it described as a “loophole” that allows corporates to use supply chain finance without classifying it as debt. Rather, the tool is classified as “other payables” on financial statements.

The controversy over how to classify supply chain finance, and its impact on investors’ understanding of corporate financials, has surged in recent years as high-profile corporate collapses were found linked to a high reliance on reverse factoring.

The collapse of contracting giant Carillion in the U.K., for example, raised concerns over the company’s use of supply chain finance, which, critics argue, may have impeded financial service providers’ ability to adequately assess the company’s financial troubles.

Earlier reports in the Financial Times also called supply chain into question, as well as the use of supply chain finance by GFG Alliance, the business empire of Sanjeev Gupta, whose financing strategy has been largely spearheaded by Greensill Capital. According to the FT, reverse financing is a “signature technique” for Greensill and could “disguise a troubled company’s mounting borrowings.”

“It’s just borrowing,” said Chris Higson, London Business School accounting professor, in an interview with the FT about corporates’ use of supply chain financing. “It matters because the more you borrow and the more you sell receivables, then the weaker the balance sheet. And if there’s a downturn in your market and you face a setback, you’re more likely to fail.”

Immediate Backlash

Despite some analysts’ warnings over supply chain financing, as well as some calls to reclassify the tool as debt, trade finance proponents and corporates have remained firm in their support of the financing tool.

Following Fitch Ratings’ 2018 report, the International Trade and Forfaiting Association (ITFA) issued a statement in defense of reverse factoring.

“There has been an increase in days payable because it is very widespread,” ITFA Chairman Sean Edwards said, according to Global Trade Review reports last year. “But does that mean it should be treated as bank debt? I don’t think so.”

He added that in the case of Carillion, supply chain finance “dwarfed their other lines of finance.”

A Global Controversy

The U.S. and U.K. aren’t the only markets in which use of supply chain finance is being called into question.

Earlier this year, Australia Small Business and Family Enterprise Ombudsman (ASBFEO) Kate Carnell announced an inquiry into supply chain finance and its impact on small to medium-sized businesses (SMBs).

“Supply chain finance is a legitimate and effective tool to free up cash flow for small and family businesses,” Carnell said in a statement in October, adding there are concerns, however, that large corporates are relying on supply chain finance to stretch out their Days Payable Outstanding (DPO) to small suppliers.

Reports at the time noted the ASBFEO plans to review large corporates’ use of supply chain finance and whether firms are “manipulating” the tool, with a focus on “whether supply chain finance is being used by big business as a means to stretch out formal payment terms and as a strategy to manipulate the reporting of working capital and cash reserves.”