Dataline A look at current financial reporting issues

Dataline A look at current financial reporting issues No. 2013-28 December 17, 2013 What s inside: Overview... 1 The main details... 1 Existing guidance... 2 Factors to consider... 3 Suppliers impacted... 3 Roles and responsibilities... 4 Payment Terms... 4 Handling of credits... 5 Legal characteristics... 5 Assessing the impact of a paying agent...6 Other factors... 7 Statement of Cash Flows implications... 7 Questions... 7 Supply chain finance Analyzing structured payable programs Overview Companies with significant purchasing power often approach their vendors with a request for extended payment terms. While some vendors accept the extended terms, others prefer not to wait to receive payment until the due date. Companies may introduce a structured vendor payable program whereby they arrange for the vendors to have the option to factor their receivables (i.e., the company s payables) to a bank. This results in the vendor monetizing its receivables, therefore lessening the burden of accepting the extension of payment terms. Such programs are becoming more prevalent as companies seek to improve their cash conversion cycles and enhance liquidity. When implementing a structured vendor payable program, companies should be mindful that changes to the terms of the trade payable could impact balance sheet classification. The introduction of specialized financing terms may change the economic substance of a company s liability, thus requiring reclassification of the trade payable to debt. Given the significance of most companies accounts payable balances, reclassification of trade payables as debt could significantly impact a company s leverage and covenant ratios. Reclassification of a company s trade payables as debt will also have statement of cash flow implications. At the time of reclassification, the affected trade payable balances should be reflected as an operating cash outflow and financing cash inflow. Payments made to the bank to settle the trade payable should be recorded as a financing cash outflow. The main details.1 Companies often negotiate modifications to the terms of their trade payables with existing vendors in the ordinary course of business. In many cases, the terms will be extended to allow for settlement of the payable at a later date. A company will often make arrangements that provide its vendors an opportunity to sell their receivables from the company (the company s payables) to a bank at the vendor s election. This program may National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 1

be offered by banks in conjunction with other standard cash management programs. If a vendor sells its receivable to the bank, the company becomes liable to the bank and is directed to pay the bank, as opposed to the vendor, upon the trade payable balance becoming due..2 In some cases, similar to factoring arrangements, the only change to the terms of the original trade payable is the party to which payment is due. In other cases, the terms of the payable may change upon the vendor s transfer of the receivable to the bank. The presence of specialized financing terms, some of which are described in more detail below, require careful evaluation and may change the economic substance of the liability from a trade payable to a debt financing. Existing guidance.3 No specific U.S. GAAP exists that addresses the accounting for structured vendor payable arrangements. In 2003 and 2004 1, the SEC staff discussed these types of arrangements in two separate speeches. The SEC staff noted that all relevant facts and circumstances should be thoroughly analyzed, but specifically addressed situations where settlement of the trade payable took place at a date later than that stated on the original invoice, and where the payable was settled at a different amount. In these situations, the SEC staff indicated that reclassification of the trade payable to debt upon its transfer to the bank would likely be appropriate based on the transaction being the economic equivalent of the company borrowing money from the bank and using it to repay the vendor..4 Vendors routinely factor their receivables from a company without affecting the company s balance sheet classification of the corresponding payable. In a traditional factoring arrangement with a bank, we would not expect the terms of the payable to change since the company (i.e., the obligor) is not involved in the negotiations between the vendor and the bank. If the terms of the payable change as a consequence of a factoring arrangement between a vendor and a bank, the transaction is not the same as a traditional factoring of receivables and additional analysis is required to determine whether the trade payable still has the economic characteristics of a traditional trade payable. If it does not, the payable should be reclassified as debt on the company s balance sheet. The analysis described above should focus on whether changes to the terms of a company s trade payables require reclassification to debt (i.e., are the terms substantively different from those typical of a normal trade payable). In order to apply this model, one should determine that the initial obligation is in fact a trade payable. That means the trade payable resulted from the purchase of goods or services by the company from its vendor on terms typical of similar purchases in the applicable jurisdiction and market. 1 SEC Staff Speeches: 2003 and 2004 AICPA National Conference on Current SEC and PCAOB Developments. Classification and disclosure of certain trade accounts payable transactions involving and intermediary. Comerford, Robert. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 2

Factors to consider when determining whether the substance of the payable has changed.5 Determining whether a trade payable should be reclassified as debt requires a thorough understanding of the terms of the arrangement. Specifically, it is important to understand whether any changes made to the terms of the trade payable arrangement indicate that the characteristic of the liability has changed, such that the liability is no longer a trade payable and has become more of a debt-like obligation. Although many factors should be considered when assessing a structured vendor payable program, the basic questions that companies should consider are (1) have the terms of the trade payables changed as a result of the factoring arrangement between the vendor and the bank, and (2) are any new terms consistent with the terms of normal trade payables. Inconsistencies between the new terms introduced by the structured vendor payable program and those of standard trade payables may indicate that the economic substance of the liability has changed, and that balance sheet reclassification of the trade payable amounts may be warranted. Understanding the population of suppliers impacted.6 In order to demonstrate that the obligation has retained the characteristics of a trade payable, a company will need to determine that the updated terms of the obligation are customary for its trade payable arrangements across a broad range of its suppliers. If the updated terms are only present with a small number of the company s suppliers, it may be difficult to say such terms represent customary trade payable terms. This consideration does not mean that every supplier's payment terms must be extended to demonstrate that the terms of the obligation represent a customary trade payable. In some cases, companies may extend terms and pilot the structured vendor payable program with only its largest suppliers. While it is not necessary for the company to offer the program to every supplier, we believe the supplier base needs to be broad enough to demonstrate that the obligation has retained the characteristics of a trade payable..7 In addition to a broad base of suppliers, participation in the bank s program to purchase the vendor s receivables should be voluntary. If vendors are required to participate in order to continue their relationship with the company, and thus cannot refuse to participate, one should consider whether this changes the nature of the trade payable since this restriction is generally not imposed on a vendor in a normal trade payable arrangement. Certain vendors may have sufficient bargaining power and thus refuse to accept a proposed extension of payment terms. We do not believe that the refusal of certain vendors to agree to an extension of payment terms is determinative in assessing whether obligations subject to the structured payables arrangement that now have updated terms still represent customary trade payables. However, it is important that a broad enough base of suppliers have accepted the updated terms. This would demonstrate that a sufficient amount of the company s trade payables contain such terms and that the payables being evaluated for classification purposes represent customary trade payable arrangements. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 3

.8 Companies should also evaluate the range of payment terms by jurisdiction. As part of that analysis, the percentage of trade payables with extended due dates that are factored to banks as part of the structured vendor payable program should be considered. If the factored trade payables are limited to those with extended payment terms, and all trade payables with extended payment terms are factored, this may be an indication that the terms are not customary relative to normal trade payables in those jurisdictions. In that case, balance sheet reclassification of the trade payables with extended terms to debt may be appropriate. Roles and responsibilities of each party.9 Each party's role in the negotiation process should be analyzed as it may indicate if the economics of, or legal rights associated with, the original trade payable have changed. Involvement of the company in the negotiations between the vendor and the bank may suggest that the company has been influential in the negotiations and that terms of the initial payable have been modified from the company s perspective..10 We would expect the company to have little to no involvement in the negotiation of the terms between its vendors and the bank. The bank and the vendor will negotiate directly, often without the company knowing the substance of the negotiations while they are occurring. In these situations, the nature of the trade payable remains unchanged from the company s perspective, notwithstanding the fact that the company now has an obligation to the bank instead of its initial vendor. This would lend credence to the argument that the economics of the trade payable have not changed irrespective of the negotiations and arrangements made between the vendor and the bank..11 The existence of a tri-party arrangement where the company, the vendor, and the bank are all signatories to the factoring arrangement may indicate that the company has been influential in negotiations between the vendor and the bank. As the company s level of influence in the negotiation process increases, the more challenging it becomes to assert that the company is not borrowing from the bank to pay its vendor. If facts and circumstances indicate that the company is borrowing from a bank to pay its vendor, reclassification of the factored trade payables to debt may be necessary. Consideration of the payment terms of the arrangement.12 Industry benchmarking studies may motivate companies to extend payment terms. For example, a company may perform an analysis to compare its key working capital ratios to comparable metrics reported by peer companies to determine whether it is managing its assets efficiently. One particular ratio of interest, days' payable outstanding, represents the average number of days between the company's accrual of a trade payable and the settlement date. This metric essentially tells how long, on average, a company takes to pay its suppliers. Extending a company's payment terms to better align its days' payable outstanding with its peer group does not in and of itself change the economic substance of the trade payable to a debt financing. However, the new agreed upon payment terms should generally be consistent with other peer companies in the company's industry. If the company s payment terms have extended beyond what is customary in its industry, it may suggest that the presence of the structured vendor payable arrangement has resulted in an obligation that is inconsistent with customary trade payable terms, and that the economic substance of the trade payable has changed..13 One key difference between a trade payable and a debt financing is that a trade payable does not contractually provide for accrued interest during the period it is National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 4

outstanding. While it is common for penalties to be imposed by vendors if the trade payable balance is not settled on the specified due date, we would not expect any interest to accrue prior to that point. The presence of interest is not customary in a trade payable arrangement and would suggest that the obligation is more akin to debt. Understanding how credits are handled.14 Credits (e.g., discounts, rebates, and returns) are typically negotiated between the company and the vendor, and, if there are disputes, the company has the ability to withhold payment. If an arrangement does not allow the company to retain its rights of negotiation with the vendor and ability to withhold payment, the economic substance (and legal form) of the arrangement may have changed. For example, if a company receives a defective product from the vendor but is obligated to pay the bank the full amount and must negotiate a credit on a future invoice, it may imply the company no longer retains its offset right for that specific payable. Understanding the company's past practice of handling credits is important when evaluating this factor. Some companies have a practice of posting credits to future invoices. If the company's process under the arrangement is consistent with its practice, we do not believe posting adjustments to future invoices indicates that the company has lost its right to negotiate with the vendor. In such situations, the substance of the trade payable has not changed from the company s perspective and reclassification of the trade payable balance as debt would not be warranted solely due to this factor..15 In a normal trade payable arrangement, a vendor s decision to factor its receivable from a company to a bank does not affect the company s cost of goods or services received from that vendor. If the company receives a discount or a fee from the bank that relates to its trade payables factored by its vendors, the company may have effectively secured financing at advantageous rates. For example, if the factored trade payable is $100 and the company is only required to pay the bank $99 on the trade payable due date, this may suggest the company has in effect secured a borrowing from the financial institution at a lower cost..16 Furthermore, if a company participates in any early pay discount that the bank negotiates with the vendor despite settling the payable on its due date, this may imply the terms of the trade payable have been modified. For example, a bank may receive a discounted amount from the company because payment is made within the discount period of 2/10, net 30. If the bank allows the company to pay the invoice beyond day 10 and share in the discount, it may indicate the terms (i.e., the discount payment period) of the payable were modified from the company s perspective. Had the company paid the vendor directly beyond day 10, it would not have been eligible to receive this discount. The ability to participate in pay discounts beyond the period stated on the invoice would not represent a customary trade payable characteristic and therefore may suggest that reclassification to debt would be appropriate. Determining whether the legal form of the trade payable has changed.17 Understanding whether the economic substance of the trade payable has changed is important. Another factor to consider is whether the legal characteristic of the liability has changed. If the legal characteristic is no longer that of a trade payable, the liability should be accounted for as a financing. Generally, in-house counsel or outside counsel can provide evidence as to whether the nature or characteristic of the trade payable has changed based upon the Uniform Commercial Code. National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 5

.18 Examples of rights introduced by a structured vendor payable program that may suggest the legal characteristic of the liability has changed include (but are not limited to): Interest on the factored trade payable balance; An immediate draw-down of existing or new lines of credit the company may have with the bank when the trade payable is factored; Altering the seniority of the trade payable in the company's capital structure; Requiring the company to post collateral to secure the collectability of the trade payable; and Incorporating cross-default provisions that would accelerate repayment of the trade payable if the company breaches covenants or defaults on other obligations..19 Multi-national corporations seeking to implement a structured vendor payable program generally implement the program globally, sometimes in phased approaches. In some instances, the bank may request that the parent company be jointly and severally liable for its subsidiary s obligation to settle its trade payables. Questions often arise as to whether the introduction of this term changes the economic substance of the arrangement such that the trade payable balances should be reclassified as debt. Joint and several liability clauses represent protective rights to the entity purchasing the receivable. While these types of clauses are not typically present in trade payable arrangements, the analysis of whether an obligation continues to possess the characteristics of a trade payable requires a consideration of all the facts and circumstances. If the insertion of a joint and several liability clause represents the only debt like characteristic of the obligation, it may not in and of itself result in a reclassification of the payable as debt. Assessing the impact of a paying agent.20 A structured payables program may be implemented as part of a broader accounts payable outsourcing initiative. This generally would entail a company signing up to use a paying agent's accounts payable platform, posting approved invoices to the platform, and directing the paying agent to draw from certain accounts (e.g., a checking account or line of credit) to settle the trade payable when due..21 In some cases a bank may act in the capacity of paying agent while simultaneously purchasing the company s payables from its vendors. Although these situations can create complexity, we would not expect the terms of one arrangement to impact the other. Regardless of whether a paying agent has been retained, the fundamental analysis should focus on whether the execution of these arrangements has changed the nature or characteristic of the company s trade payables. This requires a careful analysis of the terms of the trade payables before and after execution of the relevant agreements. If the terms have changed such that they are no longer consistent with the terms of a normal trade payable, reclassification of the affected trade payable balances as debt may be warranted. If the fees paid by the company for paying agent services vary National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 6

based on the level of activity between the company s vendors and the banks, one should consider whether the company is in effect receiving a more advantageous financing arrangement from the bank. Other factors.22 This Dataline sets forth an analytical framework to evaluate structured vendor payable programs. The factors described in the preceding paragraphs are not allinclusive. In addition to assessing whether the substance of the transaction indicates that the company is borrowing from the bank to settle its trade payable with its vendor, other factors to be considered when evaluating the accounting implications of a structured vendor payable program include whether: The bank has obtained any new rights; The company or the bank have discretion over which invoices are paid; and The bank has the ability to draw down on the company s other accounts without the company s permission if the designated payment account has insufficient funds. Statement of Cash Flow impacts.23 If the economic substance of a company s trade payables has changed as a consequence of implementing a structured vendor payable program, an in-substance refinancing will be deemed to have occurred. From a balance sheet classification perspective, the affected trade payable balances should be reclassified as debt. Furthermore, the SEC staff s position is that a company's statement of cash flows should reflect an operating cash outflow and financing cash inflow related to the affected trade payable balances, and a financing cash outflow upon payment to the bank and settlement of the obligation. Questions.24 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Accounting Services Group, Financial Instruments team in the National Professional Services Group (1-973- 236-7803). National Professional Services Group CFOdirect Network www.cfodirect.pwc.com Dataline 7

Authored by: Donald Doran Partner Phone: 1-973-236-5280 Email: donald.a.doran@us.pwc.com Chip Currie Partner Phone: 1-973-236-5531 Email: frederick.currie@us.pwc.com Christopher Rickli Senior Manager Phone: 1-973-236-5280 Email: christopher.rickli@us.pwc.com Lee Vanderpool Director Phone: 1-973-236-5129 Email: lee.vanderpool@us.pwc.com Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. They are for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwC s online resource for financial executives. 2013 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.