A closer look at centralizing exposure and settling intercompany invoices.

Introduction

One of my previous publication outlined insights in Asia’s treasury focus and priorities. As it is nearly impossible to realize proper treasury management when group companies settle their obligations at random, or worse, not at all, I indicated to spend some time on the technique that can be used to address this “Netting of payables and receivables, or just “Netting” for short.

Summary

When taking a look at how Netting can support the Business, we may unfortunately come to the conclusion that a good understanding of the (clients’) Business, is exactly what some representatives of service providers lack when promotion their tools. Lot of effort is traditionally spent on generically marketing products as a commodity, with the emphasis on product capabilities. But hardly any time is put into trying to understand clients’ internal processes and procedures, not to mention trying to comprehend how this factors into the clients’ bottom-line. Hence, the sales proposition is usually not tailored to specific needs, and consequently not tailored to fit the clients’ organization. This leads to a gap between what is generally offered and what is actually needed. Oddly enough sometimes clients respond to this gap by trying to implement change in their own organization in order to adapt to the shortcomings of services provided.

This article deals with the first steps in product evaluation. Which elements should be considered before we can even begin product selection?

 The importance of understanding context before jumping to solutions

Human beings are trained to be proficient at offering solutions. Not just only in our personal life but also in a professional setting. Just consider your elevator pitches, presentations, lead generation, sales trainings etc. We are taught at an early age not to think in terms of problems and obstacles, but to think in solutions and possibilities.

What we can be convinced of, is the strong belief that we have the right solution. It will therefore  come as no surprise that jumping to solutions also happens to be the predominant behavior. However, before we switch to this (problem solving) mode, it is paramount that we understand the general context. This obviously also applies when studying if and how implementing new systems and procedures adds value. Failure to understand the challenges may lead us disregard change altogether, and favor the current over the new (favor the known over the unknown). Or worse, if it is generally accepted that change is necessary, failure to understand the real challenges may probably lead to adopting ineffective solutions irrespective how sophisticated those solutions are.

The same paradigm applies to service providers. Some can reach a fervent pitch with their marketing and sales in seeking to tell companies they have the solution. But how much of that solution is really based upon a real understanding of the context (the challenges) the audience actually faces? How much is merely based on pushing the capabilities of the service provider?  Does “one size fits all”?

On the receiving side it’s not always better. Often the selection of the most complex treasury or cash management systems is based on “everybody is using it, so, so do we”. General consensus of accepting a product or service because others (peers or competitors) seem to have done so. And what if it after all doesn’t seem to work as expected? Well, then we try to make our organization (our context, our reality) fit the solution. Simply reverse reengineer internal systems and procedures to align with the (wrong) choices we made.

The Right Perspective – Bottom up

When it comes to the context and challenges I discussed, having the right perspective is very important. Context is not something that merely happens or is made up. In order to get the right perspective it is recommendable to have a bottom up approach. For Netting the designated point of departure for this approach, as all companies have this one thing in common, is the purchase order or invoice. But from that point onwards, there is no standardized method, as the context differs from one company to the next. So what I’ll do is discuss some of the items one could consider in order to come to a structured rationale before selecting a specific Netting solution (or combination of solutions).

Understand the challenges

With context we need to try to comprehend the processes and procedures currently in place. We need to try to map (understand) who (which departments) are involved irrespective of the transaction (sell or purchase) and irrespective of the underlying value (goods, services, interest, royalties etc.). What is the relevance of each individual step of the process.

A simple example; an MNC affiliate purchased goods from an overseas affiliated company. Consequently it receives an – intercompany – invoice in a foreign currency. The accounting department will need to administrate this by updating the general ledger and reconciling the eventual payment. Tax will want to ensure that the selected routing is the most tax efficient, whilst Treasury is tasked with ensuring sufficient funds remain available in the right currency at the right moment in time, with minimal or no exposure. Risk and compliance will want to safeguard the company from potential counterparty and country risk, but are also involved in the processes surrounding topics like for example currency risk and operational risk. So how does this factor into a Netting system even before we can look at solutions.

Recording and reconciliation – Who processes the invoice?

As soon as a purchase-order is accepted and shipment of items ordered took place, an invoice is generated. Invoices are recorded in Accounts Payable and Accounts Receivable systems. This happens on either centralized or decentralized level. But probably on both. So attention needs to be paid to how invoice data is interfaced with the Netting system. Unlike certain activities that need to be taken care of centralized – like for example foreign exchange – both the input and output of invoice data needs to be available on multiple levels (globally centralized, regionally and locally) at the same time. For those that run the save release/version of a single AP and AR globally, this is easy to achieve. But most do not have this luxury.

Payment – How do we settle an invoice?

After the actual delivery of items sold is matched with the  purchase-order, the invoice can be released for payment. When payment of intercompany invoices is not settled by means of a physical settlement (bank transfer), most likely intercompany balances, as recorded in the general ledger, are debited and credited. Obviously this avoids the in- and outflow of cash, hence making life more easy for some departments, but not necessarily for all. Creating – or mutations in – intercompany balances eventually lead to intercompany loans (rule of thumb, in 90 days). Intercompany loans go hand in hand with an intercompany loan administration, which consequently triggers transfer pricing (arm’s length), as well as possible thin cap rules and withholding tax depending on which affiliated company the intercompany balances are recorded against (for example residency and legal form).

As it is probably not the intention to keep on adding to the intercompany balances, eventually a physical settlement is required. For some counties we would like to avoid intercompany balances all together. Besides the ones not permitted due to foreign exchange regulations, in some cases immediate physical settlement is preferred for various reasons (for example country risk). For example in the case of a country like Russia, from which outstanding amounts need to be collected asap.

Netting systems that allow more tailoring provide hybrid solutions combining both physical settlement as well as settlement by mutations in intercompany loan balances. Ideally this is  supported by the option to run an intercompany loan administration that, if needed, even calculates, (re-)allocates and reports intercompany interest automatically.

Settlement – What do we settle?

Regardless how we settle, we also need to understand what we settle before we can continue. Do invoices get paid one on one (gross)? Or are they clustered in batches with similar due date? Perhaps affiliated companies net amongst themselves (bilateral Netting) using a system or spreadsheet. Maybe a more sophisticated process nets with one single counterparty – a shared service center for example – using an ERP system, whereby per region a different tool is used. Conceivably a multi-lateral Netting system achieves offset that leads to one single payment or receipt in local currency, combined with both insight in as well as offset of foreign exchange exposure on a central level.

In some cases foreign exchange regulations prohibit Netting of payables and receivables. Conclusion; net payables and net receivables separately, but don’t comingle payables and receivables. In other countries, like for example China, both Netting of payables and Netting of receivables is prohibited (unless special permission is applied for and granted). Conclusion; settle gross. Or more exotic flavors like for example for India. Net receivables may be received in local currency, but for net payables local currency is prohibited. Conclusion; settle net, but ensure that the tool employed allows for sufficient flexibility.

What all alternatives have in common, is that firstly; exposures need to be clearly identified so they can be managed. Secondly; for settlement ultimately a bank is required. So we also need to understand how payments are interfaced (manual, host-to-host, SWIFT-net, etc.). Thirdly, flexibility is key.

And whilst we are on the topic of settlements, to think Netting is synonym for Payment Factory is a misconception. Sure, there are overlaps, but inherent there serve two entirely different purposes.

Exposures – Who “owns” the invoice, and why?

Invoices payable or receivable that dominate in a foreign currency lead to a foreign exchange exposure. The way and how sophisticated this is recorded and processed differs per MNC’s treasury policy.

If exposures are strictly maintained at the lowest level (local subsidiary), inefficiencies might occur as independently local banks are contacted to manage/hedge the exposure. Possible foreign exchange offset within the group will be completely disregarded.

If re-invoicing centers are employed, they will likely limit the firm’s risk to transaction exposure. Here all intra-firm transactions are centralized and foreign currency related receivables and liabilities are netted. The means of hedging the entire multinational firm’s foreign currency exposures are also determined by the re-invoicing center. However re-invoicing changes the ownership of the invoice, sometimes complicating matters financially (for example tax, as revenues may shift) but also administratively (reconciliation).

Besides efficiently settling intercompany invoices, a multilateral global Netting tool can obviously also be used to aggregate, offset and centralize foreign exchange exposures. This can even be used for re-invoicing centers. Next, according to hedging policies, those exposures can be mitigated.

The Netting concept outlines

Netting is nowadays perceived as a commodity, it’s not the Rolls Royce anymore as it was in the past. It’s a family car at best. However the devil is in the details. Both the ability of tailoring the Netting process as well as operational excellence are of the utmost importance. Tailoring is required in order to cater to the specific needs of the different affiliated companies and various departments, maybe working with different systems. It will be quite hard, if not impossible, to push towards a “one size fits all” framework. Furthermore, usage of a Netting system should not be limited to intercompany flows. What about vendor payments, and settlement towards FX-banks.

As nowadays even a 11 year old whiz-kid can write the code for comprehensive Netting software, focus on operational excellence becomes paramount. After the software takes care of all the required calculation and generates the payments that wash through the various foreign currency netting accounts, it boils down to flawless execution in a global multi-bank environment as well as timely problem follow-up. In some cases the importance of this is played down, so that the reconciliation efforts and the chasing of delinquents can be left up to the client. This is clearly the most time consuming, costly and labor intensive part of the process. Definitely worth something considering.

So not having to have to open and operate any netting accounts yourselfers in the first place, and therefore outsourcing the administrative role to the service provider all together, may lead to substantial additional – intangible – savings. Unfortunately these savings usually only become apparent after the fact.

If and when the Netting system achieves foreign exchange FX offset, this obviously reduces revenue for banks and hence generates savings for clients. But don’t stop here. Ensure that the residue foreign exchange, the part that could not be offset, can be dealt with a panel of (relationship-) banks. Alternatively, based on preliminary reporting, utilize the Netting system to also determine and settle internal and external hedges. It is a misconception that Netting cancels out already executed hedging. Netting of course primarily focuses on the payment flows, which irrespectively if they are hedged, still need to occur. However integrating hedging flows in the Netting can achieve further savings, but that may be the subject of a next post.

In conclusion

Netting is sometimes perceived as just a mathematical tool. Maybe it is, if the functionality remains limited to software that only calculates and generates payments, or an ERP system that processes mutations in intercompany balances. But it can be so much more. It can be a powerful tool to centralize Foreign Exposure whilst maintaining the freedom to deal with relationship banks. It should be able to offer various different alternatives, supporting foreign exchange regulations. It should be able to bridge the centralized and decentralized, and hence lead to better reporting and savings. But most importantly you should expect your service provider to take the time and effort to get to know your business, and how the netting system can contribute to improving your bottom-line. Besides that, service providers should be able to leverage their client base to share experience, innovations, provide insights and update on current developments on a wide range of topics, relevant to the service provided. Service providers should show Thought Leadership and try to earn the role of Trusted Advisor.

 

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