Suppliers see ever‐increasing pressure on their working capital as payment cycles lengthen and
margins fall. Unlocking the financial supply chain with a form of financing is surely a win‐win‐win
scenario for all players.
Apparently one of the main issues keeping supply chain financing (financing arrangements involving
accounts payables) on the ground as far as large business is concerned, is that these large buyers are
concerned that their participation in payables financing will bring with it an unpleasant and
unwanted friend ‐ the reclassification of trade payables to debt on the buyer's balance sheet.
Is this caution really warranted?
It is only by considering the basics first, and then moving on to what is really happening today with
financing arrangements involving accounts payables, that one is able to give an opinion of the
outcome.
What is Payables Financing?
"A supplier takes early payment of a receivable from a financial intermediary (often a bank) at a
finance rate dependent on the buyer's credit rating rather than the supplier's. The advantage to the
supplier is that it gets instant access to cash and pays a finance rate based on the buyer's credit
rating rather than it’s own. The buyer shares information to facilitate the process." Payables
financing is rather like invoice discounting, but in reverse. The buyer contracts with a bank to settle
it’s trade payables and the buyer either ends up with debt on its balance sheet or retains a trade
payable.
Supplier financing
Most corporates engage in supplier financing, whereby a buyer purchases goods from a supplier and
pays them later under agreed credit terms (can range from 14 days to as much as 120 days). The
supplier has financed the buyer with a credit limit/line. For accounting purposes this is simple; the
buyer maintains a trade payable on its balance sheet, while the supplier has a trade receivable on its
balance sheet. There is no debt in sight on the buyers balance sheet.
Invoice discounting
If a supplier wants to unlock the funds they are owed because of supplier financing then they can
approach a bank and equitably assigns their receivables documentation in exchange for cash. The
supplier ends up with debt on the balance sheet and retains a trade payable, even though legally the
buyer now owes the bank the payment. Accounting for such transactions is well established and the
Generally Accepted Accounting Principles (GAAP) requirements focus predominantly, if not wholly,
on ensuring that the supplier discloses debt.
Receivables purchasing
In the case of receivables purchasing, the intention of a buyer is passive. The supplier does most of
the work and the buyer is left to confirm that payment will be made on a future date. The supplier
engages with a financial institution by legally assigning its receivables and takes early payment of the
amount due from the buyer. The buyer still settles the payable on the due date with the only
difference being that the buyer now pays the financial institution rather than the supplier.
Remember that point in invoice discounting? Receivables purchasing sounds fairly similar other
than the supplier is likely to sell their receivable to a bank and therefore shows no debt either.
So why would the buyer even consider entering debt on to its balance sheet? The buyer is probably
better off stepping back and applying the 'dog test'.
The 'dog Test' for Debt
A phrase that is very applicable when establishing whether a proposed transaction will result in debt
or not is:
'If it walks like a duck and barks like a dog then it probably is a dog'.
Accounting basics ‐ i.e. if it looked like debt, then it probably was debt and most accountants could
determine the answer.
Applying the dog test is therefore probably as relevant as any other test in determining when debt
will find its way on to a buyer's balance sheet.
The dog test suggests that a buyer would have to intend to borrow money from a bank for any debt
to be recorded on its balance sheet. It couldn't just arrive there by accident.
If the buyer simply facilitates early payment to suppliers then no debts should appear in the buyer's
books.
Business Credit Card Usage
Thinking slightly wider, the use of credit cards in big corporates is commonplace. Employees purchase goods and services on credit and the corporate settles the balance monthly. The
GAAP accounts do not report such transactions as debt. Outstanding balances are generally shown in
the purchase ledger along with all the other trade payables.
Consider a corporate that uses credit cards to purchase goods that would otherwise be under
supplier financing arrangements, i.e. on supplier credit. The supplier is receiving early payment of
their invoices through a merchant card arrangement. The buyer settles their card bill (loan) monthly
but no debt appears on the balance sheet.
Suppose a corporate always paid cash for goods but then changes to make all of its purchases on
credit card. Isn't the buyer now borrowing money from the card provider to pay its suppliers on
time? What if the buyer doesn't settle the credit card balance on time? Shouldn't the buyer now
show debt? Can the Buyer Go a Step Too Far? The point around credit cards is that the buyer's intent
is really important in determining the accounting, even for existing methods of transacting. If the
buyer simply replaced their normal supplier financing with payment by credit card, then the debts
fade away slightly. But at the extreme there is a problem.
However, the buyer should constantly apply the dog test to the situation because it is possible that
the form of transaction will change and the intent of the buyer could force debt onto the balance
sheet. Buyers should start by asking themselves why they do not show credit card liabilities as debt.
The Octet concept is where both the buyer and the seller arranges a facility with
financial institutions in order for the supplier to be paid on a cash settlement
basis but still allowing the buyer the normal supplier financing (accounts
payable financing) terms of between 30 days to 90 days.
It incorporates all the principle of the credit card. In fact it is the modern version
of a business‐to‐business credit card.
In addition there is a general requirement in accounting standards to put
substance before their legal form. The substance of the Octet transaction is that
the trade creditor is replaced by Octet.
Assume Octet took over all the buyers trade creditors, then the buyer will not
show any trade creditors even though it purchased goods and has an obligation
to pay albeit to Octet. Now applying the basis of substance over form. The
substance of Octet's finance would be no different to that of a trade creditor with similar characteristics:
- It could very well be unsecured
- It is payable by the buyer within a short time frame or else interest is charged
- If the buyer defaults Octet will lose out like any other trade creditor
- It is a current liability that funds working capital
- Like trade creditors Octet is only recognised as a liability once the transaction is completed and the buyer has ownership of the goods
Therefore our opinion is that the Octet facility should not be treated as a debt
on the buyer’s balance sheet. It should continue to be incorporated with
accounts payable.