For some years, in parallel with the worldwide spread of reverse factoring agreements as the main financial instrument for the supply chain, there has been some debates on the methods of accounting representation of these agreements.
It is a very technical debate which can at times appear paradoxical if viewed through the eyes of a layman.
The scope of this note is to try to elucidate the terms of this debate, whose provisional conclusion came on last December 14th when the IFRS Committee has ruled that no new rules are needed on the matter, as those provided by the international accounting standards are fully adequate to address this specific issue.
We will also try to explain the limits and risk of reverse factoring structures for the debtors who use them, and we will explain how these limits can be overcome through alternative solutions, such as the one proposed by Polaris.
What is a reverse factoring agreement .
While a factoring agreement operates between a creditor and a financial institution and has as its object the receivables claimed by the creditor towards a third-party debtor, a reverse factoring agreement acts between the financial institution and the debtor and provides:
- the possibility that the financial entity becomes the assignee of receivables from the debtor;
- the possibility that, due to the assignment, the payment terms are modified (usually extended);
- for the debtor’s commitment to pay the new debtor;
- for the eventual debtor’s commitment to not raise against the new creditor all or part of the objections that he could raise against the original creditor.
The actual scope of the agreement may include only a part of the potential component mentioned above and, as we will see later, those actually critical for the representation of the transaction in the debtor's financial statements are essentially those under b) and d).
What involves the problem of accounting representation of the reverse factoring agreement.
Outside a reverse factoring context, the transfer of credits from one subject to another has no impact on the accounting representation of the debt by the debtor. The latter is indeed unrelated to the operation and continues to record its own debt in accordance with its original nature: commercial debt, if it arises from a commercial transaction; financial debt, if it arises from a financial transaction.
In a reverse factoring context, however, the debtor is indirectly involved in the transaction between the original creditor and the financial entity, specially due to the fact that it benefits from an extension of the payment terms and / or assumes specific commitments towards the new creditor. This potential rearrangement of the ex-ante situation opens up a theme referring to the potential reclassification of the original commercial debt into financial debt.
It might seem a question of little or no importance: whether the debt is of a commercial or financial nature it is still a debt.
In fact, the topic is subtly technical and has significant consequences on the representation and interpretation of financial statement. The models of balance sheets analysis use different metrics depending on the type of business of the company under examination. The main watershed (not the only one) is the one between financial and non-financial activities (commercial, industrial, ...).
Is it important? Yes, I will try to explain it with two anecdotes.
At the end of the 1980s I was working in a financial institution ad my colleagues told me that they accidentally noticed that the commercial information provided by one of the main operators in the sector about the company defined it as not trustworthy. They protested and it came out that the financial statements had been reclassified as a consequence of the use of a scheme applied to industrial companies rather than financials, thus generating an incongruous judgment. The key difference is that financial activity is structurally leveraged on debt (which is systematically a multiple of the assets), while for industrial and commercial activities the (financial) debt is structurally lower. The opinion was expressed based on an irrelevant analysis scheme and was therefore misleading for the reader and harmful to the company.
The second anecdote illustrates the opposite situation.
In the last stages of Parmalat's history - before its default -, the company presented itself to analysts with inconsistent volumes of assets and liabilities compared to the volumes of industrial revenues (it was the result of the creation of debt aimed at diverting funds and concealing accounting losses). The analysts had solved the problem by defining Parmalat as a financial holding with some industrial interests and by applying the model of analysis of a financial company. A purely formal explanation that favoured the increase in debt, which then cost investors hundreds of millions.
The logic of the models of analysis is to place the data of the single individual within homogeneous clusters in order to highlight (and then explain) the deviations from the average. Likewise, the use of homogeneous accounting principles is the tool used to ensure the comparability of information for the purposes of analysis by investors. Within this framework, the reclassification of operational items into financial items and vice-versa has an impact on the understanding and interpretation of the data.
The impacts of reverse factoring agreements on the accounting representation in the debtor's financial statements.
The question is substantial and depends on the actual content of the agreement.
An agreement that only provides for above mentioned points a) and c) does not change the substantial position of the debtor nor gives him any ancillary benefit with respect to the ex-ante situation.
If instead the agreement also includes the possibility of extending the payment terms, this results to the debtor in a longer passive cycle (if the debt is not reclassified as financial), giving the image of a more prosperous liquidity situation. The risk, however, is that this result was obtained through the use of the same financial credit lines that would have been used to pay, at maturity, the original creditor and which are therefore no longer available to the debtor, so that the representation as a commercial debt hides a purely cosmetic effect and can mislead the third observer.
Even the presence in the reverse factoring agreement of contents such as the one indicated under point d) can have the substantial effect of changing the nature of the debt.
The commercial debt is in fact a debt conditional upon the correct execution of the service by the supplier, where the financial debt is - as a rule - an incontestable debt. This potential effect of the reverse factoring agreement is, however, less relevant than the previous one since, under normal conditions, the services are actually performed and the related debts are therefore perfectly due in a way that is completely similar to the financial debt. Therefore, the commitment to not raise objections has less impact for the position of the debtor and can even be considered irrelevant if the debtor is able to verify the execution of the service before the assignment to the financial entity (once again, it is, in this case, a normal situation).
Benefits and risks (substantial) of the reverse factoring agreements for the debtor.
Looking beyond the purely cosmetic effects, there are two classes of substantive reasons for which a debtor may be interested in setting up a reverse factoring agreement:
- mitigate a fundamental imbalance in its operating cycle, as for example when the active cycle (sales / invoicing / collection) is structurally longer than the passive cycle (order / invoicing / payment);
- financially support their suppliers (or part of them), allowing them to benefit from the possibility of anticipating payment, by selling their receivables.
The two purposes are not alternatives to each other and, looking at the overall balance of the production process of which the debtor is the culmination, both may be necessary to ensure the overall financial sustainability and the process of the supply chain.
As a result, the substantial benefits for the debtor can be traced back to the improvement of its operating cycle and the strengthening of its logistics and production processes because of the support provided to suppliers.
These benefits are not separated from risks, even significant ones. Let's see the three main ones here.
- Whenever the reverse factoring credit line made available by the financial entity is a simple transformation of pre-existing cash lines, the improvement of the operating cycle is only virtual.
- The reverse factoring agreement determines a concentration of the debt on the financial entity when such concentration was previously splatted between suppliers: even if only temporary, this circumstance increases debtor's vulnerability, especially in times of financial difficulty. The issue of concentration must in any case be concretely assessed, bearing in mind how effective it is: if the reverse factoring agreement is applied, for example, to ten suppliers of raw materials, it is likely that the increase in vulnerability resulting from the nominal concentration of the debt is irrelevant compared to the pre-existing vulnerability towards the (normally few) suppliers of raw materials.
- A final risk is the sustainability of the reverse factoring agreement itself over time. The rearticulation of the financial cycles of suppliers and debtor induced by the reverse factoring agreement determines a stable situation, whose alteration due to the effects of a potential disengagement of the financial entity can have immediate and important impacts, both on the debtor and on the suppliers involved in the reverse factoring agreement.
Is it possible to maintain the benefits of reverse factoring agreements, mitigating their risks?
As previously seen, the major risk linked to reverse factoring agreements is the potential dependence resulting from the concentration of debt on the financial entity.
Reducing this risk component means splitting the debt across multiple financial partners, pursuing a mobile balance between the efficiency determined by a single structural partnership and the lower dependence resulting from the presence of a greater number of partners.
In operational reality, however, the management of several reverse factoring agreement can be rather demanding. In addition to the balance between dependence and efficiency, the debtor must also manage the competitive pressures between financial partners, the requirements of suppliers and the optimization of the use of the available creditworthiness, usually distributed viscously to individual suppliers.
The other theme - the mixture of credit lines for cash and reverse factoring lines at the same financial entity in such a way that the improvement in the debtor's net financial position can be a purely cosmetic effect - suggests the opportunity to diversify, as far as possible, the financial partners used for reverse factoring programs from those used for current operativity.
In any case, the multiplication of reverse factoring agreements does not exclude the need to individually assess their impact in order to represents its effects in the debtor’s financial reporting, in accordance with the international accounting standards, as mentioned by the IFRS Committee.
Polaris: a balanced and innovative solution compared to traditional reverse factoring operations.
Polaris is a digital platform for the management of debtors' supply chain finance programs. A natively multifunder and neutral solution for what concerns the relations between the members of the platform itself (Buyers, suppliers and financial partners).
Polaris provides a unitary contractual framework for the transactions of trade receivables due from suppliers to the debtor, without the need to formalize any reverse factoring agreements between the debtor and the financial partners.
The individual transactions of sale of receivables are carried out in atomic form within the contractual architecture of the platform and supply and demand are in principle free to encounter without having to establish ongoing sales relationships. Furthermore, any extension of the payment terms is the result of a prior negotiation between debtor and supplier and is therefore only "inherited" by the financial partner.
Within the Polaris operating scheme, the problems posed by reverse factoring agreements lose substance, since:
- the element constituted by the bilateral reverse factoring agreement between the debtor and the financial partner is missing, replaced by a structure common to all the subjects who adhere to the platform and which uniformly governs the obligations of all members and transactions that may occur between them;
- the plurality of financial partners involved in the purchase of the Buyer's commercial debt is ensured, although in a purely factual basis, such circumstance may prove insufficient to significantly reduce the concentration’s issue;
- the possible disengagement of a financial partner - even the main one - has the sole effect of reducing the liquidity available for suppliers on the platform, though without directly and immediately affecting only some of them. The relative effect is therefore diluted on the mass of participating suppliers and over time, avoiding unmanageable shocks;
- the potential extension of payment terms is the result of bilateral Buyer / supplier agreements, so that the negotiation of the credit does not modify its configuration in any way.
Furthermore, it is hardly the case to underline that the n:n relation logic between suppliers and financial partners and the atomic management of transactions causes the distribution of the creditworthiness made available by financial partners is completely flexible, with a remarkable optimization effect compared to the rigid distribution, which is typical of reverse factoring agreements.
FS