Netting in Finance: An Immersive Guide to Global Reconciliation
Mastering intercompany netting
Multi-national corporations and companies who garner high transaction volumes are familiar with some of the pitfalls that arise when attempting to keep data organized. Approval processes, currency exchange, and poor transaction offsetting procedures are woes that accounting and treasury departments may experience on a daily basis. From an accounting point-of-view, having a centralized dashboard to input invoices and monitor payments is essential. From a treasury point-of-view, having a platform that can assess risk and effectively forecast liquidity is equally essential.
Whether the company deals exclusively with internal suppliers, third-party companies, or a combination of the two, a centralized solution is a feasible option. Integrating a centralized netting system can be a two-pronged solution for both departments to function on a highly-efficient level. Keep reading for an in-depth breakdown of the practicality of netting, the associated benefits and participants, and how BELLIN’s intuitive solution is your answer.
Netting or “Intercompany Netting” is the process of reconciling and netting intercompany invoices between two parties, resulting in a final payment and netted cash flow. In regard to financial markets, the purpose is essentially to minimize transactions and distinguish remuneration in multiparty agreements.
BELLIN was founded by treasury experts who are familiar with the woes involved with international corporations. As an international company ourselves, netting is a function we use on a regular basis. We remain diligent on understanding the core functions of treasury, and how to create the right products to maximize efficiency. Firstly, it is imperative to understand the fundamental forms of netting.
Bilateral Netting is the process of consolidating invoices between two parties into a single agreement. Rather than each individual invoice leading to strenuous volumes of transactions, companies can consolidate invoices and agree upon one net payment stream. It minimizes risk while adding increased security by ensuring both payables and receivables are paid. It is also effective in the event of a bankruptcy between independent companies because it ensures the defaulting company will not cherry-pick only profitable invoices.
Multilateral Netting is the process of consolidating invoices between multiple parties using a clearing-house or central exchange (netting center). Rather than having several transactions, invoices or assets are consolidated into one net payment stream. It is especially productive when utilized for international transactions in which conversion rates can be hefty. With cloud-based technology making centralized platforms the preferred option, multilateral netting is the answer for multi-national companies to operate at an efficient level.
Further Reading: What is Multilateral Netting?
To begin with, a corporation needs to determine which type of system suits company needs, and then they must establish who the participating entities will be – whether they are internal or affiliated external companies.
Intercompany reconciliation and netting
An intercompany reconciliation and netting solution entails one parent company with multiple subsidiaries being a part of a centralized netting solution. The implementation of a cycle entails the participation of a few stakeholders. Generally, treasury, accounting, human resources, and the IT department will be involved.
The planning and oversight of the netting system will be a task for the accounting and treasury department to determine approval processes, invoice procedures, and execute ongoing functions. The technical implementation is handled by the IT department. Finally, the human resources department enforces consequences based on the predefined protocol.
It is possible to integrate a netting system that includes non-group companies. While a third-party system can be efficient, it presents a few guidelines. Some of those guidelines include ensuring the participating companies have both sufficient cash flow and that the cash flow is relevant. The non-group company can benefit from the system if they buy and sell goods from any number of entities within the group. Essentially, that non-group company can net payments between multiple companies within the group – thus capitalizing on the mentioned benefits.
The general process of a netting system is constant across most forms. The cycle goes as follows:
Data is sent to the center
- The first step of the cycle involves participants sending copies of desired documentation, invoices and payment requests to the netting center. Subsequently, the data is stored and consolidated on an end-of-cycle basis or ongoing when data is received.
The data is reconciled
- Based on pre-defined parameters, the system can match, reject or investigate invoices. The tm5 netting module includes an automated reconciliation process for all invoices between your subsidiaries. Next, the system automatically matches invoices and highlights discrepancies between companies. The netting center will generate a new statement for each subsidiary.
Information from the center
- Once data is reconciled and invoices are consolidated, the netting center will send each subsidiary a final balance. The final balance or invoice can be in whichever currency is cost-efficient or convenient. The tm5 module can be accessed to view updated balances at any time.
Close of cycle
- Finally, the netting center will distribute payments to subsidiaries with positive balances. Subsidiaries with negative balances will have to make one netted payment to the netting center.
Foreign exchange and liquidity risk minimization
On the foreign exchange (FX) side, subsidiaries see a massive benefit in regard to their sales activities. Companies often purchase products internally at the group level and flip the products in their local market. This opens the door for Foreign Exchange (FX) risk as they will be invoiced in the originating currency. Consequently, individual subsidiaries may not have a team that is prepared to mitigate such risk effectively.
To address this, there are two choices a company can make: either bite the bullet on the invoicing currency exchange or implement netting. It will not only keep existing invoicing procedures intact but avoid the loss of money involved with inflated currency exchange rates when using external exchanges. In addition, the FX risk can be transferred from the subsidiaries to the parent company, which is typically in a better position to manage affiliated FX risk. It is not uncommon that the netting center manages the entire FX risk of the group from the start. More about FX Risk below.
By streamlining payment processes and avoiding external banks, companies also experience a reduction in cash-in-transit and liquidity risk. Keeping payments internal and prompt leads to less banking fees and quicker access to funds through receivables collection.
Another benefit appears in intercompany invoicing and the increased visibility over cash flows. Subsidiaries that make regular bulk payments require consistent monitoring by treasurers in the event there are financing issues. When bulk payments backload and are concentrated in a short amount of time, cash flow can be stretched thin among many of the subsidiaries. A netting system will provide daily reports and monitoring tools that provide efficient payment flows throughout the group. The system thrives in reducing treasury workload in regard to intercompany financing, improves cash visibility and automated invoicing.
Summary of benefits
- Decrease the total number of intercompany transactions and limit cashflow settlement to defined currencies per company
- Drastically reduce the workload within the process of intercompany reconciliation
- Integrate your intercompany payments and settlements with ERPs and accounting systems
- Alleviate uncertainty in intercompany receivables
- Get a report of all intercompany invoices that have been outstanding for a long time
- Manage disagreements in connection with outstanding intercompany invoices directly in the system
- Centralize funding and FX risk to where it can be handled best: central treasury
- Gain a view of your entire intercompany trade flows, and their evolution over time
Further Reading: The Core Benefits of Netting For Corporates
There are specific situations that call for netting. Here are a few instances:
Let’s say two companies engage in a swap agreement for a specific security. After the swap agreement goes through, Company A is owed $200,000 from Company B while Company B is owed $120,000 from Company A. Rather than each company paying their respective balances, a proper netting system will offset the balances and Company B will perform one transaction of $80,000 to Company A. Both balances become settled with transactions with limited transactions and both companies are happy.
Foreign Exchange or “FX” Risk is essentially the risk that changes in exchange rates can potentially affect a company’s profitability or the value of assets and liabilities. The various forms of FX risk include transactional risk, accounting risk or economic risk. Implementing a netting system that focuses on FX risk and exposure aims to avoid external stressors by reducing transaction volume and consequently, reducing fees associated with exchange rates.
Let’s take the case of a German entity that has an $8M USD balance that they wish to convert to euros. Rather than using an external bank, the entity can go through the system who will credit them with euros according to the global conversion rate.
In the event of a bankruptcy, all other companies who do business with the defaulting company are able to offset their balances with each other. The resulting balance remaining represents the total amount owed to or by the defaulting company.
Third-party invoices can also be a situation that can benefit from such a system. For example, An eCommerce company with multiple internal entities purchases and sells products to a supplier. Rather than potentially-thousands of invoices exchanged between both companies and all the entities, a single invoice that offsets all invoices can be constructed using a netting solution fit for third-party reconciliation. The entities are charged using final statements, foreign currency exchanges are centralized, and each company receives one invoice.
The act of replacing an existing contract and the obligations involved with a new agreement and a single payment stream. As a result, a new legally-binding contract with new parameters for obligations is created, consolidating payments of the original contracts. When the new contract is concluded through Novation, the obligations on the original contracts are legally dismissed. Novation typically occurs when one of the parties involved is having issues with existing contractual parameters.
Typically occurs after a default – existing transactions are closed out and the consolidated values are calculated into a single amount. This form is especially productive to reduce pre-settlement credit risk.
BELLIN’s tm5 is a comprehensive and integrated treasury platform that consolidates typical treasury tasks into one convenient interface. The netting module (IC) contains interactive components that include reconciliation, dispute management, and reporting.
The fundamental purpose of an effective treasury management system is to maximize the precision and speed of treasury activities. Consequently, treasurers can allocate more time focusing on forecasting and optimization.
Payables vs. receivables-driven netting
Companies must submit their payables to the netting center, which will then be reconciled.
Disadvantages – Subsidiary that is obligated to pay is less inclined to submitting their invoices on time and disputes are a constant occurrence.
Companies must submit their receivables to the netting center, which will then be reconciled.
Disadvantages – Decision to collect invoices lies with the issuing party who may not be interested in the accuracy or the ability of the payee to be able to pay it. Re-invoicing is a constant and grueling occurrence.
Both situations represent conflicting incentives to input data to the netting center. This leads to an inefficiency in the very first step of the cycle.
The golden-mean: agreement-driven
BELLIN’s tm5 boasts a netting module that reconciles payables and manages disputes with an ‘agreement-driven approach’. It finds the golden mean between both payable- and receivable-driven netting.
The ‘agreement-driven approach’ is essentially a self-clearing methodology to settling intercompany trade. The TMS provides an automated invoice matching process with a unique dispute workflow for intercompany disagreements. Disputes between subsidiaries are visible within the netting center and can be resolved by predefined stipulations. In the event the dispute is not resolved, it will be escalated. With this approach, all entities are involved in the process, disputes are minimized, and transparency is elevated.
The tm5 components
Intercompany Netting, Dispute Management, and Balances
tm5 contains a module that we call Intercompany Settlement or IC. Within the IC module, there are various components including ICNetting and ICDispute.
Intercompany Netting (ICNetting)
The ICNetting component contains an intercompany reconciliation function that we call ICRecon, as well as tools for entering items, generating statements, and viewing calendars.
ICrecon allows users to enter receivables and payables, upload confirmations, and view reconciliation status. Then, the platform will reconcile invoices and a transaction to or received from the netting center is generated through the netting process in ICnetting and a netting statement is issued.
Our highly effective dispute management component is called ICDispute. With it, companies harness the Agreement-driven approach to manage disputes. The dispute management function implements automated escalation when disputes arise and participants can utilize the embedded chat to dictate why they have not made said payment.
For companies that exist in countries that do not allow netting, the module provides a virtual netting function. Although subsidiaries cannot execute payments, It allows for the reconciliation of balances for viewing. It ensures that invoices and receipts are matched wherever a subsidiary is based. Any disputes are processed through the agreement workflow, resulting in reliable cash flows.
Real life application
Imagine a multi-national company with over 50 internal entities in 50 different countries. Let’s call this imaginary company Multasito which has different entities that buy and sell goods internally on a daily basis. On average, they have 100 separate transactions per day scattered across all of its entities. Traditionally, 100 transactions in different currencies, time zones, and management structures will involve a large sum in external bank transaction fees, foreign currency fees, and potentially a litany of disputes. With tm5, Multasito can establish a centralized and cloud-based platform to act as the group-wide gatekeeper.
Using the agreement-driven approach, subsidiaries upload invoices, tm5 reconciles receivables and payables, and they pre-emptively define dispute protocol. Firstly and proactively, the dispute protocol utilizes an escalation system that works as natural dispute deterrents because of the company-wide transparency it provides. Employees are less likely to stall on payments or become a hitch in the system with such transparency. Consequently, the system integrates an automated dispute management system that will elevate disputes to management in the event the dispute could not be resolved automatically.
Multasito subsidiaries and headquarters have full transparency, live reporting, streamlined payment management, and have avoided FX and bank fees.