Corporate Financial Reporting: Trade finance is getting attention from standard-setters

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“None of the financial reporting standards that are currently in effect ensure that financial reports are transparent with regard to trade finance programmes, and stakeholders have made it very clear that their expectations are not being met …”

Bruce Pounder is the Executive Director of GAAP Lab and a globally recognized expert on emerging issues in corporate financial reporting. In this interview, he explains why organizations that set financial reporting standards have begun to pay attention to trade finance programmes and why trade finance professionals should pay attention to what those standard-setters are doing.

Q: Let’s start with an overview … What’s the connection between corporate financial reporting and trade finance?

Pounder: The primary purpose of corporate financial reporting is to meet information needs of current and potential capital providers, such as equity investors and lenders. Many companies also have a legal obligation to provide financial reports periodically to governmental and/or non-governmental regulators.

The target audience for corporate financial reports routinely uses the reported information to make significant economic decisions. For example, a company’s current shareholders use the reports in deciding whether to sell or hold their shares in the company, while potential lenders use the reports in deciding whether to lend money to a company. Additionally, regulators use the reports to determine whether legal action against a reporting company is necessary in order to enforce compliance with pertinent laws and rules.

In every case, users expect a report to communicate the economic costs, benefits, and risks of the reporting company’s business. Because a company’s participation in trade finance programmes can significantly impact its costs, benefits, and risks, report users expect transparency from financial reports with regard to such programmes.

Q: Trade finance programmes have raised issues in corporate financial reporting. Why?

Pounder: Corporate financial reports have not been as transparent about trade finance programmes as report users expect. In most cases, financial reports issued by a company that participates in a trade finance programme do not disclose such participation, nor do the reports describe or explain the economic impacts of the programme on the company.

The reason for this lack of transparency is that financial reporting standards generally do not require a company to explicitly disclose its involvement in trade finance programmes, nor do standards specifically require a company to provide details about the economic impacts of such involvement.

As trade finance programmes have proliferated and as participation in such programmes has grown, the lack of prescriptive financial reporting standards and the resulting lack of transparency in financial reports have become more troubling to report users and other stakeholders. Recently, several influential stakeholders have publicly expressed concerns about these issues. Those concerns have, in turn, led organizations that set financial accounting and reporting standards to consider changing their standards with regard to trade finance programmes.

Q: Who specifically has expressed concerns—and what are those concerns?

Pounder: There are three distinct groups of stakeholders that have publicly expressed concerns about companies’ financial reporting with regard to trade finance programmes:

  • Credit-rating agencies (CRAs): These are organizations that rate the creditworthiness of individual companies. Such ratings characterize the risk of a company failing to make principal and interest payments to its creditors in full and on time. To develop their ratings, CRAs such as Moody’s Investors Service, S&P Global Ratings, and Fitch Ratings rely heavily on the financial reports issued by rated companies.
  • Regulators: Financial reporting by companies that participate in public capital markets is typically subject to governmental and/or non-governmental regulation. In the United States, for example, the primary regulator of corporate financial reporting is the Securities and Exchange Commission (SEC), an independent agency in the executive branch of the federal government.
  • Corporate auditors: Many companies, including nearly all of those that participate in public capital markets, engage independent firms to audit the companies’ financial reports. Those firms provide an objective opinion about the reliability of the information in the reports. The global market for audit services is dominated by the “Big Four” networks of audit firms: Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers.

CRAs and regulators have expressed concerns about the lack of transparency in corporate financial reports with regard to trade finance programmes. Additionally, CRAs and corporate auditors have expressed concerns about the lack of a single, prescribed approach to addressing trade finance programmes in corporate financial reports. Of particular concern to all of these stakeholders are reverse-factoring arrangements, primarily from the customer’s perspective.

Q: How would report users benefit from greater transparency about trade finance programmes in corporate financial reports?

Pounder: The key benefit is that more decision-useful information would be available to report users. In particular, users would be better able to judge whether the benefits of a company’s participation in a trade finance programme justify the programme’s costs and risks. Greater transparency would also enable report users to more-accurately foresee a company’s financial future.

For example, greater transparency might have enabled investors and creditors to avoid losses from the collapse of Carillion, whose questionable use of trade finance programmes resulted in excessive financial risk that was not apparent to users of the company’s financial reports. Alternatively, if it is clear to report users that a company’s participation in a trade finance programme results in benefits that outweigh the associated costs and risks, users would have greater confidence when investing in and/or lending to the company.

Q: Would there also be other benefits from having more-prescriptive financial reporting standards?

Pounder: Yes. Having more-prescriptive financial reporting standards with regard to trade finance programmes would improve the comparability of reported information. Currently, the very few companies that report the economic impacts of their involvement in trade finance programmes do so in different ways. The differences make it difficult for report users to compare the economic consequences of trade finance programmes across companies.

More-prescriptive standards would also result in each company’s reporting about trade finance programmes being more consistent over time. Consistency is important to report users because it helps them identify relevant trends and changes in trends.

Yet another benefit of more-prescriptive standards is that they would reduce uncertainty among reporting companies, auditors, and regulators about whether applicable standards are actually being followed. These stakeholders have been spending an increasing amount of time on resolving uncertainties around interpreting and applying existing standards to the expanding universe of trade finance programmes. This has increased compliance costs, which are ultimately borne by equity investors.

Q: How might financial reporting standards be changed to address these issues?

Pounder: With regard to trade finance programmes, there are four main areas of potential improvement in financial reporting standards. First, companies that participate in trade finance programmes could be required to disclose their participation. Such a disclosure would enable users of financial reports to distinguish companies that participate in trade finance programmes from companies that don’t. The distinction is important because it can help explain differences in financial performance and risk as users compare participating versus nonparticipating companies.

Second, companies could be required to provide qualitative disclosures about the economic impacts of their participation in trade finance programmes. Such disclosures would provide users of financial reports with additional information that is highly relevant to the economic decisions that those users routinely make.

Third, companies could be required to provide specific quantitative disclosures about costs, benefits, and risks arising from their participation in trade finance programmes. Such disclosures would, in turn, provide report users with still more detailed, decision-useful information. The disclosures would also better enable report users to identify significant trends over time and to make “apples to apples” comparisons of costs, benefits, and risks across companies.

Fourth, companies could be required to change how they present certain assets, liabilities, and cash flows in their financial reports so as to better reflect participation—or lack thereof—in trade finance programmes. For example, some CRAs and other users have called for companies to re-label trade payables as “debt” when the payables are subject to reverse-factoring arrangements. Although stakeholders do not agree on whether or when such re-labelling would be appropriate, it would almost certainly be more effective than supplemental disclosures at alerting report users to likely differences in costs, benefits, and risks between companies that participate in reverse factoring versus ones that don’t.

Q: Different countries have different financial reporting standards. Are the reporting issues with regard to trade finance programmes specific to certain countries?

Pounder: No, these are global issues. None of the financial reporting standards that are currently in effect ensure that financial reports are transparent with regard to trade finance programmes, and stakeholders have made it very clear that their expectations are not being met anywhere.

Throughout the world, corporate financial reporting is dominated by two specific collections of standards. One collection of standards is set by the US-based Financial Accounting Standards Board (FASB) and the other is set by the UK-based International Accounting Standards Board (IASB).

The FASB’s standards, known as Generally Accepted Accounting Principles (GAAP), are used extensively in the United States, whereas the IASB’s International Financial Reporting Standards (IFRS) are used extensively everywhere else. Unfortunately, neither US GAAP nor IFRS has kept up with innovations in trade finance products and services that have occurred in recent years. Furthermore, neither collection of standards differentiates among the profoundly different trade finance programmes that have come to exist.

Q: What are the organizations that set financial reporting standards doing to address stakeholders’ concerns?

Pounder: The IASB and FASB recently took their first steps toward responding to stakeholders’ concerns about trade finance programmes. Actions that the standard-setting Boards have taken to date include the following:

  • In April 2020, the IASB’s IFRS Interpretations Committee met to discuss, for the first time, “supply chain financing arrangements” in general and reverse-factoring arrangements in particular. At that time, the Committee decided to continue their discussions at a future meeting.
  • In October 2020, the FASB decided to undertake a project whose purpose is to “develop disclosure requirements that enhance transparency about the use of supplier finance [programmes] involving trade payables.” The focus of those requirements was understood to be reverse-factoring programmes.
  • In November 2020, the FASB’s Investor Advisory Committee met and discussed the Board’s project on supplier finance programmes. Committee members were generally supportive of the project.
  • Also in November 2020, the IASB and FASB met jointly to discuss supply chain financing arrangements. Nothing was resolved at the meeting, but the fact that the two Boards jointly discussed the issues raised by stakeholders reflected the global scope of those issues and the level of attention being given to them by standard-setters.
  • In December 2020, after continued discussion and deliberation, the IFRS Interpretations Committee formally decided to not undertake a standard-setting project on reverse-factoring arrangements—a decision that the IASB accepted without objection. The Committee’s reasoning was that existing IFRS standards adequately addressed when and how specific information about reverse-factoring arrangements should be presented and disclosed in financial reports. However, the IASB has signalled that in 2021 it will revisit the possibility of undertaking a standard-setting project on this matter.

Q: Why should trade finance professionals pay attention to what standard-setters are doing?

Pounder: Trade finance professionals who work for companies that prepare financial reports in accordance with US GAAP or IFRS should pay close attention to the future actions of the FASB and IASB for many reasons. For example, future reporting standards that improve report transparency would likely increase companies’ attractiveness to equity investors and creditors and thus decrease companies’ capital costs. But future standards could also carry negative consequences for participants in trade finance programmes:

  • Customers whose trade payables are subject to reverse-factoring arrangements could find themselves saddled with onerous new financial reporting requirements. They might also experience a higher cost of capital as a result of being perceived by capital providers as more financially risky.
  • Vendors would potentially lose the economic benefits and competitive advantages of trade finance programmes if programme adoption by customers is inhibited by future financial reporting standards. This could further stress vendors’ liquidity when it is already stressed by pandemic conditions.
  • Similarly, financial intermediaries that play a key role in trade finance programmes might see their growth stunted if programme adoption is inhibited by future standards.

Naturally, a lack of action by standard-setters would leave reporting companies with the current burdens of dealing with dissatisfied report users and the negative consequences of that dissatisfaction. Fortunately, companies and individuals have the opportunity to participate in the process by which US GAAP and IFRS are set, and thereby influence new standards and/or amendments to existing standards that emerge from that process.

Q: Please tell us about what you and GAAP Lab are doing to help in this situation.

Pounder: At this time, GAAP Lab is helping companies develop voluntary responses to the concerns that CRAs, corporate auditors, and regulators have expressed. This typically takes the form of including disclosures that are permitted, but not required, in corporate financial reports—disclosures that provide report users with more insight into the economic costs, benefits, and risks associated with reverse factoring and other trade finance programmes. And with an eye to the future, I have been advising clients on providing actionable input to the standard-setting Boards so that companies don’t end up being burdened by standards that are difficult to understand, interpret, and apply in practice.