September 6, 2018 Fitch Suggests Supply Chain Finance Reclassification

In the wake of Carillion's collapse, Fitch Ratings suggests construction firms to eliminate supply chain accounting loophole.

Fitch Ratings has recently been reporting about supply chain finance programs, and that reporting comes in the wake of the UK construction firm Carillion collapsing. What Fitch is suggesting is that the payments for these programs should be classified as debt. Currently, by the use of a “loophole” in the accounting process, these payments are being factored another way and they are not showing as debt. Because of this, Fitch suggests companies may have the opportunity to be less than transparent with their finances, and that this can lead to companies that aren’t as solvent as they would appear — which may in part have caused the bankruptcy and collapse of Carillion.

On financial statements, Carillion classified supply chain finance programs as ‘other payables,’ vs. debt. This classification was accomplished through reverse factoring and the extension of payment terms, both of which proved to be very dangerous for the UK construction company. It ultimately led to the largest corporate construction bankruptcy in UK history, according to Fitch. But not everyone is in agreement with the decisions of reclassification to debt And not every company in the construction industry believes that supply chain finance programs or the way these programs are reported is a problem that needs solved.

How Dangerous Are ‘Accounting Loopholes’?

The idea that there are loopholes or other legal ways of accounting for the same types of assets and liabilities is certainly not new. However, one of the pervasive problems with having several ways of handling the same issue can lead to confusion and misunderstanding or the misstatement of financial facts. Problems arise about what constitutes a loophole or accounting method as professionals often see things differently. Add to that fact that debt can often be used and seen in different ways whether an individual, corporation or private company.

Loopholes or differing methods accounting classifications are often read differently by professionals, depending on the amounts, reasons and timings of the amounts in question. Add to this, the interpretation of accounting rules as regulations can vary from person to person or company to company. These differing accounting methods or loopholes, however, often become a slippery slope as many times they can be used for fraudulent activity. They can also lead to a lack of transparency in financial dealings. According to Fitch, this is what occurred with Carillion.

The Safety of Standard Supply Chain Practices

The standard practices that are used for supply chain finance are commonly seen in UK construction companies. Not all construction companies use the identical accounting rules however. In some companies there is a higher level of transparency. As a result, these companies understand that the payments they must make on their supply chain are, essentially, debt. These payments may not be traditional forms of debt, but they are still very much financial obligations that the company must meet. Receiving a payment extension does not negate the fact that these payments have to be made, or that there are supply chain concerns that come about should payment problems arise.

Is Reverse Factoring Becoming More Common?

Reverse factoring is becoming a more common issue with UK construction companies today. While it may seem harmless, it can have the potential impact on the vulnerability of a company to possibly default on its obligations. If a company does indeed default, it may end in bankruptcy which harms creditors, employees, and vendors. The use of reverse factoring may be a factor for ratings agencies to adjust their credit metrics so the obligations of the company are correctly reflected. Rating adjustments for individual companies can change depending on the amount of debt on the balance sheet and whether or not reverse factoring is counted as debt or not.

Supply Chain Financing is Not Bank Debt

Is supply chain financing truly debt? The argument from the construction industry is that debt should involve bank debt, and supply chain financing is not that same type of debt. By using reverse factoring and not showing the supply chain financing as debt, construction companies keep supply chain financing separate from bank debt on the balance sheet. The different classifications of supply chain financing from company to company can be confusing and, at times, misleading. While construction companies would usually prefer not to show the financing as debt, the rating companies usually classify them (or consider them to be) debt. That is where the discrepancies com into play, because there are issues regarding classification of supply chain financing that aren’t necessarily easy to solve. The construction companies have a point, but so does Fitch.

Rating Agencies Are Concerned About Disclosure

The largest issue for Fitch and other rating agencies is the lack of disclosure that UK construction companies are providing by not accounting for reverse factoring financing as debt. With these disclosure concerns by Fitch, investors and others may be unpleasantly surprised by the actual levels of obligation held by some construction companies. However, current accounting methods (or loopholes) available today continue to make different classifications possible. Unless there is a change to accounting methods to standardize classification, there is little that can be done by the rating agencies.

By finding a way to classify supply chain financing as debt, and yet keep it separate from bank debt, both sides may find the common ground they need. Rating agencies will feel comfortable with the way UK construction companies are operating, and these companies will feel that they are being transparent with others when they show their bank debt and their supply chain debt.

Kris Lindahl is a Minnesota native and owner of Kris Lindahl Real Estate.

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