Reverse factoring – Guidance on the applicable requirements under IFRS

Mon 17 May 2021

What’s the issue?

The IFRS Interpretations Committee (“IFRS IC”) has published a final agenda decision in relation to supply chain financing arrangements; specifically reverse factoring. The decision relates to the impact of reverse factoring arrangements on the presentation in the statement of financial position (balance sheet) and statement of cash flows, and disclosure within the notes to the financial statements. The decisions considered in particular:

• how an entity should present the liabilities to which reverse factoring arrangements relate (e.g. how trade payables should be presented when the corresponding invoices are part of a reverse factoring arrangement); and
• what disclosures about reverse factoring arrangements are required in an entity’s financial statements.

What’s the reason for the guidance?

The IFRS IC’s decision follows a request from Moody’s Investors Service, which noted that the use of such supply chain financing arrangements has become widespread and that there are divergences in practice in the classification and disclosure of related liabilities and liquidity risks.

The potential significance of the presentation and disclosure of reverse factoring arrangements became apparent following the liquidation of the British construction and facilities management group Carillion in 2018. At the time, some commenters described reverse factoring as a financing tool that had been used to disguise the group’s actual financial position.

Background – The prevalence of supply chain financing arrangements

During the analysis of supply chain financing arrangements, the IFRS IC’s staff identified the most frequently-used types of arrangement, and investigated whether they are a common approach to financing.

What are the most common types of supply chain financing arrangement?

The IFRS IC staff sent out requests for information on this topic to members of IFAS, securities regulators, and large audit firms. They received 13 responses: seven from national standard-setters, four from large audit firms and two from organisations representing a group of securities regulators.

Three types of arrangement were identified in the responses:

• reverse factoring, which is discussed further below;
• dynamic discounting, which is an arrangement between an entity purchasing goods and a supplier. The supplier offers a range of possible discounts, which vary depending on when the entity settles the amount payable to the supplier. The discount is often designed to be highest on the date on which the supplier would prefer to be paid, with lower discounts if the payment is made later than this date;
• supplier inventory financing, where an intermediary (usually a financial institution) purchases an item of inventory from the supplier and sells it to the entity. This may allow the entity to obtain longer credit terms for the purchase of inventory than it would obtain if it purchased its inventory directly from the supplier.

Based on the information received, the IFRS IC staff concluded that most respondents use the term “supply chain financing” to refer to reverse factoring; implying that dynamic discounting and supplier inventory financing are less commonly used.

Are supply chain financing arrangements widely used in practice?

The IFRS IC staff’s research, via the AlphaSense search engine, showed that a large number of entities present disclosures on supply chain financing arrangements in their financial statements and that most of these are referring specifically to reverse factoring arrangements. The staff also examined various publicly-available reports on reverse factoring – one report stated that around 50% of respondents already had a reverse factoring arrangement, a further 40% were considering it, and another estimated that payables being factored had risen by USD 327bn since 2014. These reports, which are linked from the IFRS IC staff’s paper on the IFRS IC’s tentative decision, are available here.

The IFRS IC staff therefore concluded that supply chain financing is widely used by companies and that reverse factoring is the most common type. They also noted that the request from Moody’s Investors Service identified several types of financing arrangements, but that the focus was on reverse factoring. Accordingly, the IFRS IC staff decided to concentrate on reverse factoring in their analysis and in their recommendation for the agenda decision.

Recap – What is a reverse factoring arrangement?

There are many different types of reverse factoring arrangements; this article discusses the most common type.  A reverse factoring arrangement involves the sale of trade receivables to a factor (i.e. a bank or other financial institution) by the debtor (“the customer” or “the buyer”).  This is therefore the opposite of a traditional factoring arrangement in which the supplier/creditor approaches the factor directly to sell its receivables. In addition to organising the sale to the factor, it is usually the customer which selects the suppliers to be involved in the reverse factoring arrangement.

Reverse factoring arrangements involve three parties (the customer, the supplier and the factor) signing multiple contracts, and at a minimum:

• the supplier enters into a contract with the factor for the sale of its customer’s receivables;
• the customer signs an agreement with the factor, under which it will set up a mechanism for approving invoices and committing to pay the invoices sold by its supplier(s) to the factor at the due date, or later.

Reverse factoring is therefore a form of framework agreement for financing, arranged by the ordering party with financial partners for its choice of supplier(s).

What is the reverse factoring cycle?

• The supplier sends the buyer an invoice.
• The buyer makes its invoices from suppliers firmly and irrevocably available on a technological exchange platform as soon as it approves their payment.
• The supplier may, at any time, ask the bank to pay the buyer’s invoices.
• The bank prepays the invoices assigned by the supplier.
• The buyer pays the bank on the due date shown in sales contracts with the suppliers enrolled in the Supplier Finance program.
• N.B. some reverse factoring arrangements allow the buyer to pay the bank later than the due date of the relevant invoices.

What guidance has been provided by the IFRS IC’s tentative agenda decision?

During the IFRS IC’s due process for dealing with requests for information, they analysed how existing IFRSs apply to reverse factoring arrangements, particularly with regard to presentation of liabilities within the statement of financial position and the statement of cash flows, and the disclosures within the notes.

Statement of financial position (balance sheet)

 The agenda decision discussed that two standards apply to reverse factoring:

• IFRS 9 Financial Instruments (“IFRS 9”) – should the liability be derecognised? and
• IAS 1 Presentation of Financial Statements (“IFRS 7”) – how should the liability be presented?

IFRS 9 – Should the liability be derecognised?

The agenda decision states that an entity should assess whether and when to derecognise a liability that forms part of a reverse factoring arrangement by applying the derecognition requirements in IFRS 9. Paragraph 3.3.1 of IFRS 9 stipulates that an entity shall remove a financial liability (or part of a financial liability) from its statement of financial position when it is extinguished; that is, when the obligation specified in the contract is discharged or cancelled or expires, or is substantially modified. When a trade payable is extinguished as a result of a reverse factoring arrangement, the entity should therefore derecognise the trade payable and recognised a financial liability to the financial institution.  

The agenda decision specifies that an entity that derecognises a trade payable and recognises a new financial liability to a financial institution should apply IAS 1 to determine how to present this new liability in its statement of financial position (see below).

IAS 1 – How should the liability be presented?

IAS 1 stipulates that trade and other payables must be presented separately. The IFRS IC stated that a financial liability should be presented under trade payables only when it:

• represents a liability to pay for goods or services (IAS 37.11a);
• is invoiced or contractually agreed with the supplier (IAS 37.11a); and
• is part of the working capital used in the entity’s normal operating cycle (IAS 1.70).

The IFRS IC also stated that “other payables” may only be presented with trade payables if they are similar in nature and function (e.g. they form part of the working capital used by the entity in its normal operating cycle). However, liabilities that form part of a reverse factoring arrangement must be presented separately if their size, nature or function make separate presentation necessary for a proper understanding of the financial statements. When assessing this, an entity must take account of the amounts, nature and due dates of these liabilities. Furthermore, the IFRS IC noted that an entity may also need to take other considerations into account in its analysis, such as:

• whether additional security is provided as part of the arrangement that would not be provided without that arrangement; and
• any substantial differences between the terms of liabilities that are part of the arrangement and the entity’s trade payables that are not part of the arrangement.

Statement of cash flows

The agenda decision states that an entity that has entered into a reverse factoring arrangement should determine whether cash flows relating to the arrangement should be classified as operating cash flows or financing cash flows.

The IFRS IC noted that the assessment of the nature of the instrument, carried out to determine how it should be presented in the balance sheet, is also relevant when determining the classification in the statement of cash flows (i.e. the classification in the cash flow statement should follow the classification in the statement of financial position). For example, if the entity considers the liability to be a trade payable or other payable forming part of the working capital used in the entity’s normal operating cycle, cash outflows to settle the liability shall be presented as cash flows arising from operating activities.  Conversely, if the entity considers that the liability is not a trade payable or other payable because it represents the entity’s borrowings, cash outflows to settle the liability shall be presented as cash flows arising from financing activities.

Drawing on paragraph 43 of IAS 7 Statement of Cash Flows (“IAS 7”), the agenda decision reminds preparers that investing and financing transactions that do not require the use of cash shall be excluded from the statement of cash flows. As a result, when an invoice is covered by a factoring arrangement:

• if a cash inflow and outflow result from this transaction, the entity presents these cash flows in its statement of cash flows;
• if no cash flows result from the transaction, the entity records the transaction elsewhere in the financial statements, in such a way as to provide all relevant information on this financing activity.

Furthermore, the IFRS IC noted that if cash flows are presented as arising from financing activities, additional disclosures must be presented in accordance with paragraph 44A of IAS 7.

Disclosures required

The agenda decision draws attention to the definition of liquidity risk in IFRS 7, being “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”.

The IFRS IC observed that reverse factoring arrangements often give rise to liquidity risk in that:

• they concentrate a portion of the entity’s liabilities with a single financial institution rather than a diverse group of suppliers. 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 counterparty; and
• some suppliers may have become used to, or come to depend on, earlier settlement 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 its liabilities, particularly if the entity were already in financial distress.

The agenda decision therefore reminds preparers of the disclosure requirements relating to liquidity risk in IFRS 7, in that an entity shall use its judgement to determine whether it needs to provide additional information about the impact of reverse factoring arrangements on its financial position, financial performance and cash flows.

It also noted that:

• the presentation of liabilities and cash flows relating to reverse factoring arrangements may require the use of judgement. Where relevant, an entity should disclose the judgements made by management on the issues that have the most significant effect on the amounts recognised in the financial statements (paragraph 122 of IAS 1); and
• reverse factoring arrangements may have a material impact on the financial statements. In this case, an entity should provide any additional information on reverse factoring arrangements that is useful to an understanding of its financial statements (paragraph 112 of IAS 1).

What is the IFRS IC’s decision?

The IFRS IC’s agenda decision states that IFRSs provide an adequate basis (as set out above) for an entity to determine how to present liabilities that form part of reverse factoring arrangements, the associated cash flows, and the disclosures required in the notes on, for example, liquidity risks arising from these arrangements. As a result, it was decided not to add these questions to the IFRS IC’s work plan.

However, following feedback received from stakeholders to the IFRS IC’s tentative agenda decision (as well as feedback received from Committee members, users of financial statements and other interested parties), the IASB are going to consider at a future Board meeting whether to undertake narrow-scope standard-setting in relation to supply chain arrangements. So watch this space.

Where can you obtain further information?

Further information about the IFRS IC’s agenda decision, including the basis for conclusions, can be found in Volume 4 of the Compilation of Agenda Decisions.