A product financing arrangement is a transaction in which an entity sells and agrees to repurchase inventory with the repurchase price equal to the original sales price plus the carrying and financing costs. The purpose of this transaction is to allow the seller (sponsor) to arrange financing of its original purchase of the inventory.
As such, this is an alternative to other common methods of financing, such as secured working capital loans, where the ownership does not change but the lender places a lien on the inventory, which may be seized for nonpayment of the debt.
For better understanding here is how a product financing transactions flows:
1. In the initial transaction the sponsor “sells” inventoriable items to the financing entity in return for the remittance of the sales price and at the same time agrees to repurchase the inventory at a specified price (usually the sales price plus carrying and financing costs) over a specified period of time.
2. The financing entity procures the funds remitted to the sponsor by borrowing from a bank (or other financial institution) using the newly purchased inventory as collateral.
3. The financing entity actually remits the funds to the sponsor and the sponsor presumably uses these funds to pay off the debt incurred as a result of the original purchase of the inventoriable debt.
4. The sponsor then repurchases the inventory for the specified price plus costs from the financing entity at a later time when the funds are available.
In a variant of this transaction, an entity can acquire goods from a manufacturer or dealer, with the contractual understanding that they will be resold to another entity at the same price plus handling, storage, and financing costs.
The purpose of either variation of product financing arrangement is to enable the sponsor to acquire or control inventory without incurring additional reportable debt. Transactions of this type are addressed fleetingly under IAS 18, which does note that a separate agreement to repurchase may negate the effect of a sale transaction. In effect, the substance of this type of transaction is that of a borrowing.
Under the pertinent US standard (FAS 49, Accounting for Product Financing Arrangements), such transactions are, in substance, no different from those where a sponsor obtains third-party financing to purchase its inventory.
As a result, the FASB ruled that when an entity sells inventory with a related arrangement to repurchase it, proper accounting is to record a liability when the funds are received for the initial transfer of the inventory in the amount of the selling price. The sponsor is then to accrue carrying and financing costs in accordance with its normal accounting policies. These accruals are eliminated and the liability satisfied when the sponsor repurchases the inventory. The inventory is not to be taken off the statement of financial position of the sponsor and a sale is not to be recorded. Thus, although legal title has passed to the financing entity, for purposes of measuring and valuing inventory, the inventory is considered to be owned by the sponsor.
Although the other variation on this financing arrangement with a nominee entity acquiring the goods for the ultimate purchaser is not addressed in FAS 49, logic suggests that an analogous accounting treatment be prescribed.
Product Financing Arrangement Case Example
The Lie Dharma Company has borrowed the maximum amount it has available under its short-term line of credit. Lie Dharma obtains additional financing by selling $280,000 of its product inventory to a third-party financing entity. The third party obtains a bank loan at 6% interest to pay for its purchase of the product inventory, while charging Lie Dharma 8% interest and $1,500 per month to store the product inventory at a public storage facility.
As Lie Dharma obtains product orders, it purchases inventory back from the third party, which in turn authorizes the public warehouse to drop ship the orders directly to Lie Dharma’ customers at a cost of $35 per order.
Since this is a product financing arrangement, Lie Dharma cannot remove the product inventory from its accounting records or record revenue for sale of its inventory to the third party.
Instead, the following entry records the initial financing arrangement:
[Debit]. Cash = 280,000
[Credit]. Short-term debt = 280,000
After one month, Lie Dharma records accrued interest of $1,867 ($280,000 × 8% interest × 1/12 year) on the loan, as well as the monthly storage fee of $1,500, as shown in the following entry:
[Debit]. Interest expense = 1,867
[Debit]. Storage expense = 1,500
[Credit]. Accrued interest = 1,867
[Credit]. Accounts payable = 1,500
On the first day of the succeeding month, Lie Dharma receives a prepaid customer order for $3,800. The margin on the order is 40%, and therefore the related inventory cost is $2,280, Lie Dharma pays the third party $2,280 to buy back the required inventory as well as $35 to the public storage facility to ship the order to the customer, and records the following entries:
[Debit]. Short-term debt = 2,280
[Credit]. Cash = 2,280
(To repurchase inventory from the third-party financing entity)
[Debit]. Cash = 3,800
[Credit]. Sales = 3,800
(To record the sale to the customer)
[Debit]. Cost of goods sold = 2,280
[Credit]. Inventory = 2,280
(To record the cost of the sale to the customer)
[Debit]. Freight out = 35
[Credit]. Accounts payable = 35
(To record the cost of fulfilling the order)
With the above case example, I hope reader get a clear understanding about Product Financing Arrangement. Read also: