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Reverse factoring was cited as a significant issue in the collapse of Carillion Group plc, the largest publicly traded forced liquidation in U.K. history. The procedure helped to hide large debts on the company’s balance sheet in the years leading up to its collapse. Yet the accounting requirements for public companies to disclose reverse factoring are non-existent.

Reverse factoring occurs when a company sells — or “factors” — its accounts receivable, but the recipient of the products and services instigates the deal instead of the supplier.

As a way to manage cash, companies will extend the length of time they take to pay their suppliers by using an intermediary. The arrangement allows suppliers to be paid faster but at a discounted rate.

The company pays the intermediary the full amount previously owed to the supplier on the date it would have normally paid that supplier (or later, which can be a serious cause of concern for investors); the intermediary, which has already paid the supplier at the lower rate, keeps the difference as a fee.

The supplier benefits from better financing terms than it could get on its own through traditional receivables factoring. The intermediaries like the ability to aggregate many smaller accounts, and to grow faster as a result.

The company benefits from easier cash flow management, which, in some cases, leads to dubious financial reporting. If a company is stretching the time it takes to pay suppliers — and paying for that privilege — there’s a good argument to be made that the company is simply borrowing funds from the intermediary and paying interest on the effective loan.

Enter Carillion Group and the controversy over how reverse factoring was presented in its financial statements. Instead of appearing as debt, and as financing cash flows, the factoring was treated like regular trade payables and operating cash flows. This had the effect of lowering outstanding long-term debt and improving financial leverage ratios.

Reverse factoring is also called supply chain financing, which should hint that it’s more debt-like in nature than a part of normal operations. Carillion’s ex-CFO once described reverse factoring as creating a partnership atmosphere with suppliers, whereby once they received “instant access to cash” they wanted to stay with the program “over a sustained period of time.”

Fitch Ratings estimated that the hidden borrowings through reverse factoring had grown to more than 200% of Carillion’s reported net debt by the time the company folded. In short, companies aided by eager suppliers can easily get hooked on a growing addiction that remains hidden from most investors.

What, no rules?

Reverse factoring is a fast-growing area of finance that is attracting intermediaries (including specialists outside of traditional lenders). Its slippery-slope nature is concerning because it’s been the starting point of many past accounting problems, made worse by deficient disclosure rules.

In addition to lawmakers in the U.K., Australian regulators have sounded the alarm over the lax financial reporting requirements for reverse factoring. Earlier this year, CIMIC, an Australian engineering and construction conglomerate, saw its shares plunge as much as 40% after it came under scrutiny for its increased use of reverse factoring.

In Canada, disclosures from public companies involving reverse factoring are scant. Gildan Activewear mentions its use, and includes the amounts in accounts payable and cash from operations, as opposed to treating the amounts as debt and financing cash flows. Dorel Industries follows the same financial statement presentation as Gildan, but does not disclose the amounts involved. It’s not possible to say whether either company should consider the borrowings as debt because not enough information is provided.

While warning bells have sounded since Carillion, investors can’t expect the accounting rules to be tightened anytime soon. The normal process to reform accounting standards can be measured in geological time.

Investors are faced with multiple problems. Some companies are not disclosing the use of reverse factoring. Others are not accounting for it in a way that reflects its debt-like nature. It’s easy for companies to get hooked on reverse factoring and start piling on debt while masking its existence in the financial statements.

Ideally, the debt figure should be adjusted higher if payable days are materially longer than industry practice. Unfortunately, using quantitative investment analysis based on factors or ratios can easily miss pitfalls like reverse factoring because these approaches routinely ignore important aspects of the financial statements. For instance, ratios based on long-term debt or cash from operations are incomplete because other liabilities, and other cash outflows, can be hidden outside these amounts.

The best course is for advisors to be attuned to large or changing amounts in other payable accounts on the balance sheet — those that are left out of typical portfolio screening techniques for financial leverage.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.