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Structured payables: Should your trade payables be classified as debt?
Observations from the front lines
In an effort to more efficiently manage working capital, some companies may continue to extend the term of their trade payables. This is often done concurrently with the establishment of a program with a bank (or other financial institution) that serves two purposes: (1) to act as the company’s paying agent and pay the company’s vendors on its behalf on the date the payables are due; and (2) to provide liquidity to the company’s vendors seeking payment before the due date (i.e., factoring or discounting programs).
Vendors seeking to participate in factoring programs may sell their receivables from the company to the bank before the contractual due date. In exchange, the vendor will receive the stated invoice amount, less a discount. That discount represents interest income the bank will earn in exchange for holding the receivable until its contractual payment date.
The form of such programs, which are often referred to as “supply chain finance arrangements,” “structured payables,” or “paying agent arrangements” vary, with each designed to address the specific business objectives of the parties involved.
Whether the trade payables in these programs remain trade payables or should be reclassified as short-term bank debt is judgmental and not directly addressed in U.S. GAAP. The principles applied when analyzing such arrangements are based on financial instrument derecognition guidance and past SEC staff speeches.
Why it matters
The devil is in the details! Structured payables may contain provisions that appear innocuous, but could require a company to reclassify its underlying obligation from trade payables to short-term bank debt. This could have an adverse impact on the company’s debt covenants and leverage ratios. Additionally, it can impact the statement of cash flows, as payment of the obligation would be reflected as a financing outflow rather than an operating outflow.
How did the payable change?
As companies seek to implement these types of arrangements, and determine if reclassification of the payable as debt is required, they should carefully consider whether:
- The terms of the trade payable are typical supplier/vendor terms for the company and industry. Said differently, would the supplier offer the same terms to the company, absent participation in the structured payable program?
- The program modifies the payable so significantly that it should be considered a new arrangement.
Let’s look at each of these more closely.
1. Are the terms of the trade payable typical for the company and industry?
When evaluating trade payable terms, a company should consider whether it obtained additional rights that are atypical, relative to industry standard terms and the company’s other payables. Additionally, it should consider if it made commitments to the vendor that are not typical of a trade payable. Either could require the obligation to be classified as short-term bank debt.
Examples of such terms that may require reclassification to short-term bank debt include:
- Extended due date: The extension of payment terms beyond those that are typical for the company and industry.
- Varying terms: Extending payment terms only for vendors that participate in the program. This may suggest that the extension was due to the reliance on bank funding, which is not a characteristic of a typical trade payable.
- Interest: The presence of interest is not considered typical for a trade payable. When interest begins to accrue, reclassification may be required.
- Product cost increases: An increased cost of goods in return for the extended payment terms, could also be viewed as a form of interest which would be atypical for a normal payable and could result in short term debt, even though not from a bank.
2. Did the program modify the trade payable so significantly that it should be considered a new arrangement?
The inclusion of certain provisions could alter the economics of the payable so significantly that it may be presumed, from an accounting perspective, that the original obligation has been extinguished and a new obligation has been created. In such cases, it is important to carefully assess whether the modification resulted in a change to the nature of the trade payable that requires reclassification as short term bank debt.
Examples of provisions that may change the nature of the trade payable include, but are not limited to the following:
- Credit enhancement: The arrangement elevates the seniority of the trade payable, provides the bank with collateral or includes some other form of credit enhancement.
- Right of set-off: The arrangement provides the bank with the right to draw on the company’s existing bank accounts in the event of non-payment.
- Acceleration upon specified events of default: The arrangement states that upon specified events of default, such as a default on other trade payables, or on other bank or debt agreements, all trade payables in the program become immediately due.
- Legal extinguishment: The arrangement extinguishes the original payable and creates a new instrument. This question of legal fact should be evaluated based on the relevant jurisdiction.
- Interest: The arrangement requires that the company pay the bank interest. If interest is only due for unpaid payables after their due date, reclassification would generally not occur until that time.
- Joint and several liability: The arrangement substantively enhances the credit worthiness of the subsidiary’s trade payable through parent company joint and several liability.
- Profit sharing: The arrangement allows the company to participate in early pay discounts or discounts earned by the financial intermediary from purchasing the receivables prior to their due date without the company paying early.
- Line-of-credit: The arrangement counts toward utilization of a line-of-credit that the company has in place with the bank.
- Representations and warranties: The arrangement provides the bank with incremental rights that would not be in a normal trade payable or were not in the original trade payable.
Summary
Structured payable arrangements continue to grow in popularity, and companies should consider actively involving accounting and finance specialists before agreements are finalized to better understand the financial reporting implications.
For more insights on structured payables programs, please contact your PwC advisor.
Observations from the front lines provides PwC’s insight on current economic issues, our perspective regarding the financial reporting complexities, and what companies should be thinking about to effectively address those issues. For more information, visit www.pwc.com/us/cmaas.
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