BACKGROUND
Banks may
offer services to buyers of goods or services in order to facilitate payment of
their trade payables arising from purchases from suppliers. In a reverse
factoring arrangement, a bank agrees to pay amounts an entity owes to its
suppliers and the entity agrees to pay the bank at a date later than when the
suppliers are paid. Reverse factoring arrangements can vary significantly in
both form and substance. When the original liability to a supplier has been
extinguished or there is a change in terms, the following issues arise:
(a) Whether the resulting new liability to the
bank should be presented as bank borrowing or ‘trade payables.’ A point to note
is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. Needless to say that
presentation as bank borrowing may have a significant impact on the gearing
ratios and debt covenants.
(b)
Additionally, the entity is also required to consider various disclosure
requirements. Consequently, this issue is very important.
Whether the
resulting new liability to the bank should be presented as bank borrowing or
‘trade payables’?
REQUIREMENTS OF Ind AS
STANDARDS
Before we
embark on answering these questions, let us consider the various requirements
under Ind AS standards:
1. Paragraph
54 of Ind AS 1 – Presentation of Financial Statements: ‘The
balance sheet shall include line items that present the following amounts:
(a)………….. (k) trade and other payables; (l) provisions; (m) financial
liabilities excluding amounts shown under (k) and (l)……….’
2. Paragraph
57 of Ind AS 1: ‘This Standard does not prescribe the order or format in which
an entity presents items. Paragraph 54 simply lists items that are sufficiently
different in nature or function to warrant separate presentation in the balance
sheet. In addition:
(a) line
items are included when the size, nature or function of an item or aggregation
of similar items is such that separate presentation is relevant to an
understanding of the entity’s financial position; and (b)…’
3. Paragraph
70 of Ind AS 1 explains that ‘some current liabilities, such as trade payables…
are part of the working capital used in the entity’s normal operating cycle’.
4. Paragraph
29 of Ind AS 1 states that ‘…An entity shall present separately items of a
dissimilar nature or function unless they are immaterial …’
5. Paragraph
11(a) of Ind AS 37 – Provisions, Contingent Liabilities and
Contingent Assets states that ‘trade payables are liabilities to pay for
goods or services that have been received or supplied and have been invoiced or
formally agreed with the supplier’.
6. Paragraph
3.3.1 of Ind AS 109 – Financial Instruments states: ‘An entity
shall remove a financial liability (or part of a financial liability) from its
balance sheet when, and only when, it is extinguished – i.e., when the
obligation specified in the contract is discharged or cancelled or expires.’
ANALYSIS
Based on the
various requirements of Ind AS standards presented above, an entity presents a
financial liability as a trade payable only when it:
(i)
represents a liability to pay for goods or services;
(ii) is
invoiced or formally agreed with the supplier; and
(iii) is
part of the working capital used in the entity’s normal operating cycle.
Other
payables are included within trade payables only when those other payables have
a similar nature and function to trade payables; for example, when other
payables are part of the working capital used in the entity’s normal operating
cycle.
A point to
note is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. In assessing whether to
present reverse factoring arrangements as trade payables (whether included with
other payables or not) or bank borrowing, requires further analysis. An entity
will have to assess whether to derecognise a trade payable to a supplier and
recognise a new financial liability to a bank as bank borrowings. Such an
assessment is made in accordance with Ind AS 109 – Financial Instruments.
Under Ind AS
109 if the arrangement results in derecognition of the original liability (e.g.
if the purchaser is legally released from its original obligation to the
supplier), an entity in such a case will have to pay the bank rather than the
supplier. Consequently, in such a case, presentation as a bank borrowing may be
more appropriate. Derecognition can also occur and presentation as bank
borrowing will also be appropriate if the purchaser is not legally released
from the original obligation but the terms of the obligation are amended in a
way that is considered a substantial modification. For example, the payment of
trade payable may not entail transfer of any collateral. However, if collateral
is provided in a supplier financing arrangement, this would mean that the
original agreement to pay to the creditor has been substantially modified. In
such cases, too, presentation of the reverse factoring as a bank borrowing
rather than trade payable may be more appropriate. Even if the original
liability is not derecognised, other factors may indicate that the substance
and nature of the arrangements indicate that the liability should no longer be
presented as a trade payable and a bank borrowing presentation may be more
appropriate.
Analysis of
supply-chain finance is a complex and judgemental exercise. Obtaining an
understanding of the following factors would help in making the decision on the
presentation:
• What are
the roles, responsibilities and relationships of each party (i.e. the entity,
the bank and the supplier) involved in the reverse factoring?
• What are
the discounts or other incentives received by the entity that would not have
otherwise been received without the bank’s involvement?
• Whether
there is any extension of the date by the bank by which payment is due from the
entity beyond the invoice’s original due date?
• Is the
supplier’s participation in the reverse factoring arrangement optional?
• Do the
terms of the reverse factoring arrangement preclude the company from
negotiating returns of damaged goods to the supplier?
• Is the
buyer released from its original obligation to the supplier?
• Is the
buyer obligated to maintain cash balances or are there credit facilities with
the bank outside of the reverse factoring arrangement that the bank can draw
upon in the event of non-collection of the invoice from the buyer?
• Does the
buyer have a separate credit line for these arrangements?
• Whether
additional security is provided as part of the arrangement that would not be
provided without the arrangement?
• Whether
the terms of liabilities that are part of the arrangement are substantially
different from the terms of the entity’s trade payables that are not part of
the arrangement?
Some reverse
factoring arrangements require that a buyer will pay the invoice regardless of
any disputes that might arise over the goods (for example, the goods are found
to be damaged or defective). In the event of a dispute, a buyer who agrees to
such a condition would use other means, such as adjustments on future purchases
from the supplier, to recover the losses. These provisions provide greater
certainty of payment to the bank and may reflect that the arrangement in
substance is a financing to the buyer. However, for a buyer who buys regularly
from a supplier to routinely apply credits for returns against payments on
future invoices, this condition might not be viewed as a significant change to
existing practice. Additionally, this provision may not constitute a
significant change to the terms of the original trade payable if failure by the
buyer to pay on the invoice due date does not entitle the bank to any recourse
or remuneration beyond what is stipulated in the terms of the invoice.
In some
reverse factoring arrangements, the buyer may be required to maintain
collateral or other credit facilities with the bank. These requirements may
indicate a financing arrangement in substance, particularly if a buyer’s
failure to maintain an appropriate cash balance would trigger
cross-collateralisation events on the buyer’s other debt instruments held by
the bank. For the liability to be considered a trade payable, the bank
generally can collect the amount owed by the buyer only through its rights as
owner of the receivable it purchased from the supplier. Some examples are
provided below which help in understanding the above requirements.
Example 1 –
Financing of advances to suppliers made by the buyer
A buyer
makes an advance payment to a supplier for goods to be delivered to the buyer
six months later. For this purpose, the buyer obtains a credit from the bank
based on its own credit rating and credit facility. The supplier is not
involved in the buyer obtaining the credit facility from the bankers. Here, as
far as the buyer is concerned, the buyer obtains credit from a bank and makes
an advance payment to the supplier. The buyer may directly make the advance to
the supplier, or the bank may do so on behalf of the buyer. In this example, it
is not appropriate for the buyer to present the borrowing from the bank and the
advance to the supplier on a net basis. It is also not appropriate for the
buyer to present the borrowing from the bank as trade payable, because no goods
have been received at the date of borrowing.
Example 2:
Bank negotiates with supplier directly on buyer’s behalf
A supplier
approaches a bank for discounting an invoice representing supply of goods to a
buyer. The bank agrees to pay the supplier before the legal due date to obtain
an early payment discount. However, the buyer is not legally relieved from the
obligation under its trade payable. The way the mechanism works is that the
supplier agrees to receive the amount from the buyer net of the early payment
discount at the contractual due date and to pay the bank this same amount only
if it receives the payment from the buyer. If the supplier fails to pay the
bank, the buyer agrees to pay the bank. The bank charges a fee to the buyer,
which is lower than the early payment discount. This effectively results in the
bank and the supplier sharing the benefit of the early payment discount. In
this example, since the buyer is not legally relieved of his obligation to pay
the supplier (or to the bank on behalf of the supplier), the buyer continues to
recognise the trade payable to the supplier. Furthermore, the buyer does not
provide any collateral to the bank, nor is the arrangement substantially
different from the terms of the entity’s trade payable. The buyer will
recognise the liability as trade payable. Additionally, the buyer also
recognises a guarantee obligation, initially measured at fair value, for its
promise to pay the bank if the bank does not receive a payment from the
supplier.
Example 3:
Receivables purchase agreement
In a reverse
factoring arrangement, a bank acquires the rights under the trade receivable
from the supplier. However, the buyer is not legally released from the payable.
The buyer may be involved to some extent in such an arrangement. For example,
the buyer agrees that he is no longer eligible to offset the payable against
credit notes received from the supplier, or the buyer may be restricted from
making direct payments to the supplier. In this fact pattern, the buyer would
need to consider whether the change to the terms of the trade payable is
significant or not.
If there is
a substantial change, the transfer is accounted for as an extinguishment –
which means, the previous liability should be derecognised and replaced with a
new liability to the bank. The impact of any additional restrictions imposed by
the reverse factoring agreement on the buyer’s rights will need to be properly
evaluated. One possibility is that because the buyer selects each payable at
its sole discretion, it will only select those payables where the effect of any
such restriction is not significant. On the other hand, it may be the case that
the buyer, bank and supplier have agreed initially on a minimum amount of
payables / receivables being refinanced by the bank. In such a case, the buyer
has no further discretion to avoid the change in his rights, even when the
change is significant.
Example 4:
Trade structure / supply chain finance / reverse factoring
• Steel
Limited (SL) purchases raw material and other supplies from various suppliers.
• SL has
negotiated 180 days’ extended credit term with all suppliers, which fact will
be stated in the invoice.
• To address
the working capital issues of suppliers, SL’s bankers have agreed to buy bills
endorsed by SL.
• The
suppliers decide whether they need to transfer bills to SL’s bankers as well as
timing and other terms of transfer. The suppliers can also get their bill
discounted from other bankers. However, it may not be cost effective.
• If a
supplier decides to get bill discounted from SL’s banker, the banker will
consider SL’s credit risk to decide the amount payable on transfer.
• Transfer
does not release SL from its liability toward the supplier. Rather, SL
continues to be liable to pay the amount to the supplier.
• If SL
defaults in payment of dues, the banker can use the court process against SL
for payment but only through the involvement of the supplier.
• SL does
not receive any additional benefit except extended credit period as originally
agreed with the supplier.
• SL does
not have a separate credit line with the bank for these arrangements, nor
provides any collateral.
Response
From the
facts it is clear that:
• SL is not released from its obligation towards the supplier.
• Nor is
there a change in the terms of payable.
• Nor has SL
received any discounts or rebates that would not have otherwise been received.
• There is no
extension of the payment date beyond the invoice’s original due date.
• The
supplier’s participation in the reverse factoring arrangement is completely
optional.
• SL does
not have a separate credit line with the bank for these arrangements, nor does
it provide any collateral.
• These
factors indicate that SL should continue to classify its liability as trade
payable.
Example 5:
Trade structure / supply chain finance / reverse factoring
• SL
purchases raw material and other supplies from various suppliers.
• SL has
negotiated 180 days’ extended credit term with all suppliers.
• Within one
month of purchase, SL can select suppliers who need to get their bill
discounted from SL’s bank. The selected suppliers will transfer their bills to
the bank for immediate cash.
• Assume
that the bill amount is Rs. 100; the bank will deduct Rs. 10 as discounting
charge and pay the remaining amount (Rs. 90) to the supplier.
• Through an
agreement signed between SL and the bank, SL:
• Commits itself to pay to the bank the specified
invoice on its due date.
• Pays a service fee for ‘services’ to the
bank.
• Pays finance cost to the bank (as per a
credit line with the bank).
• In
summary, SL will pay to the bank:
• Nominal amount of the invoice (Rs. 100).
• Less discount for immediate payment
included in the payment conditions between the buyer and SL (Rs.
10).
• Plus, the service and finance
commission payable to the Bank (Rs. 5).
Response
• The
supplier appears to have relinquished its obligation to pay to the bank. It
appears that SL has now the obligation for payment to the bank.
• The
substance of the transaction is that SL is paying in advance to the supplier
for getting the benefit of cash discount.
• For this
purpose, it is drawing a credit line from the bank and paying the related
interest expense.
• The
supplier’s participation in the arrangement is decided by SL.
• These
facts indicate that the supplier payable should be reclassified from trade
payable to a bank borrowing.
What are the
various disclosure requirements applicable in a reverse factoring arrangement?
REQUIREMENTS OF Ind AS
STANDARDS
1. Paragraph
6 of Ind AS 7 – Statement of Cash Flows defines: (a) operating activities as
the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities; and (b) financing activities as
activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity.
2. Paragraph 43 of Ind AS 7 states: ‘Investing and financing transactions
that do not require the use of cash or cash equivalents shall be excluded from
a statement of cash flows. Such transactions shall be disclosed elsewhere in
the financial statements in a way that provides all the relevant information
about those investing and financing activities.’
3. Paragraph
44 of Ind AS 7 states: ‘Many investing and financing activities do not have a
direct impact on current cash flows although they do affect the capital and
asset structure of an entity. The exclusion of non-cash transactions from the
statement of cash flows is consistent with the objective of a statement of cash
flows as these items do not involve cash flows in the current period.’
4. Paragraph
44A of Ind AS 7 states: ‘An entity shall provide disclosures that enable users
of financial statements to evaluate changes in liabilities arising from
financing activities, including both changes arising from cash flows and
non-cash changes.’
5. Paragraph 122 of Ind AS 1 – Presentation of Financial Statements states: ‘An entity shall disclose,
along with its significant accounting policies or other notes, the judgements,
apart from those involving estimations, that management has made in the process
of applying the entity’s accounting policies and that have the most significant
effect on the amounts recognised in the financial statements.’
6. Paragraph
112 of Ind AS 1 states: ‘The notes shall: …. (c) provide information that is
not presented elsewhere in the financial statements, but is relevant to an
understanding of any of them.’
ANALYSIS
The analysis
below is consistent with the IFRIC tentative agenda decision in June, 2020, ‘Supply
Chain Financing Arrangements – Reverse Factoring – Agenda Paper 2.’
Cash flow
statement
An entity
that has entered into a reverse factoring arrangement determines whether to
classify cash flows under the arrangement as cash flows from operating
activities or cash flows from financing activities. If the entity considers the
related liability to be a trade or other payable that is part of the working
capital used in the entity’s principal revenue-producing activities, then the
entity presents cash outflows to settle the liability as arising from operating
activities in its statement of cash flows. In contrast, if the entity considers
the related liability as borrowings of the entity, then the entity presents
cash outflows to settle the liability as arising from financing activities in
its statement of cash flows.
Investing
and financing transactions that do not require the use of cash or cash
equivalents are excluded from an entity’s statement of cash flows (paragraph 43
of Ind AS 7). Consequently, if cash inflow and cash outflow occur for an entity
when an invoice is factored as part of a reverse factoring arrangement, then
the entity presents those cash flows in its statement of cash flows. If no cash
flows are involved in a financing transaction of an entity, then the entity
discloses the transaction elsewhere in the financial statements in a way that
provides all the relevant information about the financing activity (paragraph
43 of Ind AS 7).
NOTES TO FINANCIAL
STATEMENTS
Paragraph 44A of Ind AS 7 requires an entity to provide ‘disclosures that
enable users of financial statements to evaluate changes in liabilities arising
from financing activities, including both changes arising from cash flows and
non-cash changes’. Such a disclosure is required for liabilities that are part
of a reverse factoring arrangement if the cash flows for those liabilities
were, or future cash flows will be, classified as cash flows from financing
activities.
Ind AS 107 –
Financial Instruments: Disclosures defines liquidity risk as ‘the risk
that an entity will encounter difficulty in meeting obligations associated with
financial liabilities that are settled by delivering cash or another financial
asset’. Reverse factoring arrangements often give rise to liquidity risk
because:
(a) the
entity has concentrated a portion of its liabilities with one financial
institution rather than a diverse
group of suppliers. The entity may also obtain other sources of funding from
the financial institution providing the reverse factoring arrangement. If the
entity were to encounter any difficulty in meeting its obligations, such a
concentration would increase the risk that the entity may have to pay a
significant amount, at one time, to one counter party.
(b) some
suppliers may have become accustomed to, or reliant on, earlier payment of
their trade receivables under the reverse factoring arrangement. If the
financial institution were to withdraw the reverse factoring arrangement, those
suppliers could demand shorter credit terms. Shorter credit terms could affect
the entity’s ability to settle liabilities, particularly if the entity were
already in financial distress.
Paragraphs 33-35 of Ind AS 107 require an entity to disclose how exposures
to risk arising from
financial instruments including liquidity risk arise, the entity’s objectives,
policies and processes for managing the risk, summary quantitative data about
the entity’s exposure to liquidity risk at the end of the reporting period
(including further information if this data is unrepresentative of the entity’s
exposure to liquidity risk during the period), and concentrations of risk.
Paragraphs 39 and B11F of Ind AS 107 specify further requirements and factors
an entity might consider in providing liquidity risk disclosures.
An entity
applies judgement in determining whether to provide additional disclosures in
the notes about the effect of reverse factoring arrangements on its financial
position, financial performance and cash flows. An entity needs to consider the
following:
(i)
assessing how to present liabilities and cash flows related to reverse
factoring arrangements may involve judgement. An entity discloses judgements
that management has made in this respect if they are among the judgements made
that have the most significant effect on the amounts recognised in the
financial statements (paragraph 122 of Ind AS 1).
(ii) reverse
factoring arrangements may have a material effect on an entity’s financial
statements. An entity provides information about reverse factoring arrangements
in its financial statements to the extent that such information is relevant to
an understanding of any of those financial statements (paragraph 112 of Ind AS
1).
