interest in concerns the different payment tools that importers and exporters use when selling goods. There is an added level of risk present when conducting transactions internationally. This risk is in the form of theft, fraud, non-payment, complications of multiple governing agencies, and the inability to meet time deadlines. There are many financial payment tools that are currently being used to combat the problem of international transaction risk. The most common payment types for an international transaction are a letter of credit, documentary draft for collection, open account, payment in advance, and barter. Most of these transactions involve not only the importer and the exporter, but the respective banks of the parties involved, freight forwarders, and government customs agencies as well.
The Role of an Importer
An importer is a company that is bringing in, or importing, goods to their domestic market for sale or distribution. Importers benefit from this practice because they can acquire products at a higher quality, or lower price, than would be available domestically.
The Role of an Exporter
An exporter is a company that is shipping, or exporting, goods outside their domestic market for sale or distribution. Exporters benefit from this practice by making a profit with the sale or transfer of goods to international markets, or by expanding into new, international markets to broaden their customer base.
The Role of a Forwarding Company
A freight forwarder is a company that ships goods, on a regular basis, to different locations around the world. An exporter will call a forwarder if that exporter wants to ship goods overseas without having to take on the responsibilities of logistics, customs, and paperwork by themselves.
A freight forwarder’s main concern is the efficient shipment of goods all over the world. Another objective of the forwarder is to make money. They make their profits by streamlining shipments, increasing efficiency, and spreading out costs by moving a constantly high volume of products on a regular, routine basis (Hickman, p.138).
Regardless of the forwarder’s desire to make a profit off of the exporter, an exporter ends up saving a lot of money by using a forwarder’s services (Hickman, p.139). The money that a forwarder might charge to ship a product is miniscule compared to what an exporter would pay if they tried to ship the products without using a forwarder (Hickman, p.139). Forwarders know the customs regulations of all of the world’s countries. Forwarders handle the massive amounts of paperwork that is involved in exporting a product to a different country. Forwarders have good working relationships with the shipping companies that provide actual overseas transportation. Forwarders have massive experience in all aspects of an import/export operation. The bottom line is that employing the services of a forwarding company is always a good idea for an exporter.
The Role of Governing Agencies
Customs agencies are powerful departments of a national government that regulate what comes in and goes out of that country (Weiss, p.171). Some of the tasks of a customs agency are:
? Check for the possibility of a contraband item entering or leaving the country.
? Collect duties, tariff fees, and enforce quota restrictions.
? Ensure the proper specification/labeling of imported products are to the standard of that country.
? To account for products entering or leaving the country. They do this to get statistical information concerning domestic product flow to and from other countries, computation of consumption rates, and to help in computation of the domestic country’s GDP.
Knowledge of the customs regulations of the importing and exporting country is absolutely critical in maintaining a successful import/export operation.
The Role of a Bank
The role of a bank concerning an import/export operation is structurally the same as a traditional, domestic banking relationship. Banks serve as a company’s main financial resource by providing tools to raise capital, a place to store capital, and most any dimension concerning a company’s money. Banks also provide an importing/exporting company with risk reduction tools such as a letter of credit, documentary drafts for collection, and verification of an international trading partner’s financial credit and well being.
Letter of Credit
A very common payment method for a cross border transaction between two companies is a letter of credit. A letter of credit reduces most of the risk and uncertainty that is usually involved when goods are purchased from, or sold to a foreign, and sometimes unfamiliar, client (Sowinski, p.82). The reduction of risk with using a letter of credit comes from intensive bank involvement with the entire transaction process.
Banks generally issue two distinctly different letters of credit; the first being a personal letter of credit, and the second is a commercial letter of credit. A personal letter of credit is issued to an individual who travels a lot, and wants to forward some money to a foreign bank for convenience, risk reduction, or exchange rate arbitrage. A commercial letter of credit is what a company would use to make a foreign transaction (Weiss, p.101). I am only interested in, with respect to this observation, a commercial letter of credit, and will imply the transaction as simply a letter of credit.
A letter of credit is a statement created by bank, and guarantees payment for shipped goods if the agreed conditions within the letter of credit are met (Luxton, p.93). Here is how a letter of credit works:
? Two companies decide to make an exchange of goods in the near future. A pro-forma agreement is made and the transaction process begins. Both companies need to have a good working relationship with their respective bank for this to work.
? The importer of the goods, after reviewing the pro-forma contract, issues an application to the importer’s bank for a letter of credit.
? The importer’s bank reviews the terms of the proposed letter of credit, makes sure that the importer has sufficient credit to make the transaction, and finalizes the proposal.
? The importer’s bank sends the letter of credit to the exporter’s bank. The exporter’s bank also reviews the terms of the letter of credit, checks the financial position of the exporter, and because the letter of credit is a legally binding document, the exporter/exporter’s bank must carefully scrutinize the letter of credit on a word-to-word basis.
? The exporter, upon approval of the conditions of the letter of credit, calls the freight forwarding company and has the goods picked up and readied for shipment. The freight forwarder ships the goods to the importer’s docking port for release to the importer once all of the conditions of the letter of credit are met.
? The exporter’s bank sends the shipping documents to the importer’s bank, which examines the documents for accuracy. After the examination takes place, the exporter’s bank will then take the money from the importer’s bank, subtract the fees for the letter of credit, and give the money to the exporter. At the exact same time the importer’s bank will debt the importers bank account.
? On that same day, the Exporters bank will send the letter of credit and shipping release information to the importer’s bank. The importer’s bank looks over the final documents and gives the paperwork needed to release the goods from the docking port to the importer. The goods are picked up, and the transaction is complete.
A letter of credit is used mainly by small to medium sized companies that are making transactions on an infrequent basis, or doing business with an unfamiliar client. A letter of credit, when compared to other international transactions, is a relatively complicated process. Most very large companies do not use this type of transaction because they trade very frequently, with large volumes of goods, to partner businesses or subsidiary companies without much risk of payment default.
Letters of credit are very flexible, and can take on many different forms, if needed, when negotiations between the importer and exporter require special instructions that would not be covered under the terms of a regular letter of credit. The importer can ask its bank to make any legal stipulation when applying for a letter of credit. If a letter of credit states that the exporter must personally load the goods on the ship while wearing nothing but a civil war flag and that the flag must be tied around his ankles, payment will not be made unless he presents documentary evidence of having done exactly that (Weiss, p.103).
Nearly all letters of credit are “irrevocable” letters of credit, which means that they cannot be changed or canceled without the consent of all the parties involved (Weiss, p.103). Once an irrevocable letter of credit is issued, an importer cannot back out of a deal unless the exporter, and both banks, agree to let the importer do so. A letter of credit is assumed irrevocable unless stated otherwise. Revocable letters of credit are very uncommon because, if the letter of credit is revocable, the assumed risk of the transaction would be as high as the other forms of payment.
A confirmed letter of credit is a stipulation that the banks involved identify each other and confirm that the funds are available for the transaction (World Trade Staff, p.48).
A confirmed letter of credit often occurs when an unfamiliar bank is involved in the transaction process.
A negotiation letter of credit is a stipulation that does not require the payment to the exporter, form the importer, to come from a specific bank (Hickman, p.172). A negotiation letter of credit is usually issued when commodity items are transacted, and may actually be financed by another source if the other source has a preferable cost of loaning the money.
A standby letter of credit is a stipulation that spells out the conditions of the transaction. The standby letter of credit is usually issued to set time limits on the delivery or payment of transacted goods (Hickman, p.172).
A revolving letter of credit is a stipulation that is used when there are multiple transactions taking place. If an exporter ships goods that may take several shipments to complete, a revolving letter of credit may be issued to avoid some of the redundancy with reapplying for a new letter of credit for each shipment. In addition, a revolving letter of credit may be used again if a repeat shipment for a product is desired (Hickman, p.173).
There are other, less used stipulations for a letter of credit, but the most common ones are mentioned above. The stipulations for a letter of credit are not limited to only one term. It is possible to have a commercial, irrevocable, confirmed, revolving letter of credit.
Letters of credit are tools that made possible, promoted, and governed by an international entity called the International Chamber of Commerce (Maulella, p.77). The International Chamber of Commerce has very close ties with all of the major international trade sanctioning entities of the world, such as the WTO and EU. Since 1933 the International Chamber of Commerce has published a set of guidelines called the Uniform Customs and Practice for Document Credit 500, and also publishes a generally guide to commerce called Incoterms that is updated every ten years (World Trade Staff, p.49). The International Chamber of Commerce sets these rules in an effort to promote small to mid-sized business participation in international trade through risk reduction legislation.
Documentary Draft for Collection
A documentary draft for collection is a less commonly used form of international transaction that is similar, but more risky, to a commercial letter of credit. Documentary draft for collection is a loose term that has several other descriptive names such as a documentary collection, sight draft, time draft, SD/DP, a bill of exchange, or a draft. A Documentary draft for collection is an unconditional order in writing, signed by the seller, and addressed to a foreign buyer to be paid when presented with the delivered goods (Weiss, p.96).
A documentary draft for collection is a simple and inexpensive way to make an international transaction. Here is how it works:
? Two companies decide to make an exchange of goods in the near future. A pro-forma agreement is made and the transaction process begins.
? The exporter fills out a documentary collection application at the exporter’s bank.
? The exporter sends the goods and the shipping documents to a freight forwarder. The freight forwarder sends the goods overseas.
? The exporter sends the completed collection documents to the exporter’s bank, and the exporter’s bank sends the collection documents to the importer’s bank
? The importer accepts the merchandise and gets the collection documents from the importer’s bank.
? The importer’s bank sends the money to the exporter’s bank, and the exporter collects the money.
There are different stipulations that can be attached to a documentary draft for collection. The two main categories of documentary drafts for collection are documentary drafts against payment, and documentary drafts against acceptance. A documentary draft against payment is when the exporter ships the goods and receives the proof that the title of the goods was transferred. The payment of the documentary draft will be made to the exporter upon the presentation of the proven documents (Hickman, p.96). A documentary draft against acceptance stipulates that the payment will not be made until the importer actually accepts the title of the goods (Hickman, p.96).
There are other, less used, stipulations for documentary drafts for collection such as sight drafts, arrival drafts, and time drafts. The purposes of these stipulations are to make payment under time constraints, or when certain conditions are met. A sight draft requires the importer to pay once the goods come in contact with a representative of the importer’s company or the importer’s company port (World Trade Staff, p.45). An arrival draft stipulates that payment will be made once the goods reach the final destination of the forwarder’s delivery (World Trade Staff, p.45). A time draft stipulates that payment will be made on a particular time setting (World Trade Staff, p.45).
These added stipulations are what make a documentary draft for collection unique. Without any stipulation used the document would basically resemble a simple bank check. Unlike a letter of credit, a documentary draft for collection does not require that cash for payment be on deposit when the transfer is initiated. A documentary draft for collection offers a stronger guarantee than a check, and is less time consuming, less intensive, and less expensive than a letter of credit.
The importer has comfort in knowing that the goods are already shipped, or have arrived, before the payment is made with a documentary draft for collection. The main disadvantage of a documentary draft for collection is that this method of payment by itself does not obligate the importer to accept and pay for the goods. This puts all of the risk of this type of transaction on the exporter (Weiss, p.97). The exporter runs the risk of shipping the goods, having the importer refuse acceptance of the shipment, and having to make a costly return shipment of the product back home to the exporter or simple abandonment of the goods altogether. Most of this risk is reduced if there is an underlying sales contract for the transfer of goods between the two companies (World Trade Staff, p.50). Because of the apparent disadvantages of a documentary draft for collection, this type of transaction usually only occurs when a large company, with a good reputation, purchases goods from a small, possibly less reputable company.
The predecessor to a documentary draft for collection, called a Bill of Exchange, has been in use for literally thousands of years as a result of differences in international currency, and as an alternative to bartering (Britannica.com Staff). During the early history of this type of transaction there were no laws, only reputation, to make the entire payment process work. England passed legislation in 1882, called the Bills of Exchange Act, followed by the United States in 1896 (Britannica.com Staff). International legislation for a documentary draft for collection was included in the Geneva Conventions of 1930 (Britannica.com Staff). The laws set forth in these conventions are still followed by most countries that participate in international trade
An open account is one of the most inexpensive, time saving, and simplest forms of payment for an international product exchange. As the name implies there is a previous agreement between the purchaser and seller of goods as to the terms of the transaction and behavior of the parties involved.
An open account works like this:
? The exporter sends the product overseas to the importer.
? The exporter sends a weekly/monthly/yearly bill to the importer.
? The importer pays the exporter.
? That is all!
An open account is a very risky form of international transaction for the exporter because of the idea that the importer, upon receiving the goods, will not pay the exporter. Small companies usually do not participate in open account transaction because they usually have infrequent suppliers/consumers, or simply can not accept the risk of a major account defaulting with non-payment.
Given mutual confidence between the buyer and the seller there is little need for a letter of credit or documentary draft for collection when making an international business transaction. For this reason, an open account is the most common form of payment for an international business transaction (Weiss, p.177). This is because the greatest majority of international trade is between affiliated companies, or between huge firms that know and trust each other without fooling with complex trade payment procedures (Weiss, p.177).
This type of account is basically an extension of the domestic type accounts that are common is the business world of today. With an open account an importer calls an exporter for an order, the order is shipped, and the importer bills the exporter in a monthly basis exactly like a normal, domestic account. The terms of an international account are usually similar (example: 1/20 net 40) and the importer usually pays all of the costs that are involved in getting the goods sent to the importer.
Payment in Advance
A payment in advance is the opposite of an open account. Advance payment shifts the risk of the transaction to the importer.
With an advance payment:
? An importer places an order with an exporter for the delivery of a product
? The importer sends the exporter a check in advance for the product.
? The exporter then ships the product to the importer at a specified time.
A bundle of samples, an international gift, or a small, one time purchase is usually the ideal candidate for a payment in advance transaction. The importer will look through a catalog, or on the Internet, purchase the item with cash/check/credit card, and rely on the exporter to send the goods as expected. This type of transaction does not occur very much in the business world, and usually only occurs in small, final consumer/international retailer transactions.
If a proper business relationship is going to be formed where a mutual trust between the importer and the exporter is expected, an open account, and not payment in advance, is usually created. Payment in advance does work, and if you are the exporter, it is the cheapest and most secure to get paid for an overseas transaction.
As a result of the historically recent decrease in the number of nations practicing communism, the world is becoming more capitalistic. Capitalism requires money, and the transfer of goods with money, to work effectively. Bartering, by definition, is the exchange of goods without the use of money. One would think, with the recent surge in international trade via capitalism, that barter exchanges are becoming less common. This is not true. Bartering today is common practice for businesses that wish to get rid of excess inventory, take advantage of emerging Internet technology, or to broaden their product reach past domestic markets.
Bartering by corporations has been practiced for the past century or so to get rid of, as mentioned before, excess inventory without having to liquidate the product. Companies do this because of manufacturing overruns, to rid themselves of discounted models, or to clear warehouse space for other goods (Emigh, p.56). More often than not the products in question are of top quality with no prior usage, and liquidation would be inefficient because the corporation will take a loss in profit. Here is how a modern barter works:
? A corporation decides that rather than liquidation, that they want to barter.
? The corporation contacts a barter company. The barter company sends a representative to evaluate the goods offered, or the goods are shipped to the barter company’s warehouse. An assessment of the value of the goods is made.
? The barter company issues an amount of trade credit that can be exchanged for any other goods in the barter company’s possession.
? The corporation decides to exchange the trade credits for a different desirable good that was bartered by another company minus a minimal fee from the barter company.
? The different goods are delivered to the corporation and the transaction is complete.
Bartering can be classified as an international transaction, because more often than not, the bartered items eventually end up in overseas markets. Companies are more likely, with a barter, to trade for products without losing as much profit margin than they would with a straight liquidation (Campbell, p.41). For example…Levi-Strauss manufactures a line of clothing that includes bell-bottom jeans, and drastically overproduces the jeans. There is no use for the jeans in the United States anymore, so liquidation would not be desired. Levi-Strauss can barter with a foreign company that might have a suitable market to sell the jeans in exchange for some raw manufacturing materials…such as denim. A barter exchange will occur, the value of the swap is advantageous to both parties, and there may be a relationship formed for future business. Bartering also has different, sometimes more advantageous tax implications than a straight liquidation (Meyer, p.48).
Bartering has recently come into the limelight though advances in information technology (Emigh, p.56). The Internet is a major contributor. The Internet has been a very important tool in the development, and upsurge of barter exchanges. Though B-2-B (business to business) organizations, a real-time, immense product database greatly facilitates the progression of a barter transfer (Meyer, p.47). Dot-com companies such as Ariba.com, Fastparts.com, Freemarkets.com, and Barterexchange.com all use “trade credits,” offer real-time solutions to overproduction through bartering, and have huge databases and company relationships that result in rapid product turnover. Despite the impending maturity, and shakeout of the Internet industry, this type of B-2-B practice is flourishing. Barter exchanges in the United States are growing at a rate of 8% annually, over half of the Fortune 500 companies use corporate barters (Campbell, p.41), and B-2-B barter transactions are expected to reach an equivalent of $1.3 trillion in value by the year 2003 (Meyer, p.49).
Insurance and Payment pitfalls
Regardless of how thorough and careful an importer or exporter may be, there will come a time when payment default or conflict will occur concerning an international transaction. In addition to selecting the proper type of international transaction a company may choose to further minimize risk of loss by carrying various forms of insurance. In addition, certain pitfalls may be avoided if a company educates themselves about potential problems that may occur when participating in a foreign transaction.
There are basically two types of insurance that a company needs to address when shipping products overseas. Companies need to know the benefits of accidental loss insurance and credit insurance.
Insurance can be acquired to cover a company’s loss due to theft, property damage, liability, and a host of other problems. Shipping materials overseas places unusual stresses on products due to extremes of transportation, shipping and handling. Things sometimes get broken. Shipyards, international ports, and warehouses are havens for criminal activity. Things are sometimes stolen. Insurance is designed to reduce the risk of all of these potential problems and should be a “no-brainer” for any company.
Most companies will not hesitate to insure against theft, property damage, liability, or a host of other unpredictable, high exposure events (Robertson, p.76). When it comes to their accounts receivable, exporters for some reason, bare the entire risk of non-payment themselves (Robertson, p.76). Credit insurance is a good idea for any company that runs the risk of non-payment or theft with an international transaction. This translates to basically anyone who does business as an importer or exporter with an unfamiliar client. There are many organizations that offer credit insurance. Credit insurance typically has low premiums and unusually high deductibles (Robertson, p.77). Of course, the deductible is usually lower than the loss that would be incurred if the company did not have an insurance policy for the goods in the first place.
There will always be a way to beat the system, and regardless of the rules set into place, there will always be a time that an entity will become a victim. Regardless of countering the threat with an insurance policy, the pitfalls of non-payment still hurt a company through lost time, damaged rapport, and lost efforts spent for replacement of lost goods. The best way for a company to come out ahead in the trade game is to simply learn the game. Banks, the Small Business Association, International Chamber of Commerce, and the EXIM Bank of America are all sources of information for the rules and regulations of international trade (World Trade Staff, p.51). The importance of proper documentation can not be stressed enough, and can be an important defense against payment default. Word of mouth information is also very important, and keeping in touch with a forwarder, counterpart company, or attending a trade show can bring forth insight on how to efficiently perform an international transaction.
Conflicts often occur using a letter of credit regarding discrepancies of a letter of credit must be carries out word-for word. Punctuation and grammar on the actual document is important as well. If somehow the name of a company is not spelled properly during the issuance of a letter of credit, that company can not acquire the profit from the transfer unless the conflict is resolved. The accurate documentation of a letter of credit can not be stressed enough (Mehta, p.13). This is where most of the payment problems occur on an otherwise riskless payment form.
Documentary drafts for collection offer more security than an open account of payment in advance. Most of the problems that arise from a documentary draft for collection are from a lack of importer credit and a fraudulent lack of importer payment. With a documentary draft for collection, the transaction may start without the bank’s approval of importer funding. This problem can usually be prevented by having an underlying sales contract to fall back on when reporting the loss to an international governing agency (Hickman, p.94).
Pitfalls experienced using an open account or payment in advance, as mentioned before, can be avoided if a mutually strong relationship is created between the importer and the exporter. Another problem that firms face when using open accounts or payments in advance is a form of strategic theft. An exporter commonly starts an account with a foreign importer. The importer pays promptly every month and frequently increases the amount of the requested product. Once huge payments are required for the large amounts of a product, the importer stops payments, “disappears,” and leaves the exporter with a huge loss (Weiss, p.96). Payments from such an activity are rarely recovered. The only defense of the exporter is to file complaints to the US commerce department, SBA, and hope that government threats to the importer will produce the funds.
Reasons That We Need All of These Payment Types
In the perfect situation, an importer would send a check to the exporter, and a week later the goods would arrive without risk of either party losing money, time, or rapport. Unfortunately companies are misunderstood, cheated, or ripped off at great expense to the importer or exporter. The reason all of these payment types exist is to balance risk between importers, exporters, and banks.
Open accounts and payments in advance are tools that do not require much bank involvement, or investigation of the parties involved. Because of this, open accounts and payments in advance are the riskiest form of payment type, and should not be transacted unless there s a mutual partnership between the importer and the exporter. Open accounts and payments in advance, however, are the least expensive form of international payment.
Letters of credit and documentary drafts for collection are tools that use banks as an intermediary to reduce risk for both the importer and the exporter. Stipulations can be made to further ensure that prompt, predictable, and reliable payment is made. Letters of credit and documentary drafts for collection have the potential to be virtually riskless forms of international transaction because of the bank’s role in the transaction process. Bank involvement, however, comes at a price. Also, letters of credit and documentary drafts for collection can be quite complicated and time consuming. These types of complicated payment types are not needed if there is a strong relationship between the importer and the exporter. Letters of credit and documentary drafts for collection are frequently used by small businesses that not tolerate the risk of a default payment.
Barters are unique in that there is virtually no risk involved between the importer and the exporter. The risk with a barter is carried by the barter company in the form of dead inventory. Barter companies, to eliminate dead inventory, usually have close relationships with liquidation firms, factor firms, and wholesale firms. Barter companies usually charge a fee for the services that they provide in order to minimize their risk. Barters are not always an option for a company because of a lack of demand of a particular item that an importer may possess or desire.
I have learned, as a result of this paper, that an international transaction is not as simple as running a credit card through a machine and signing the receipt. A letter of credit and a documentary draft for collection are actually quite complicated, and I really had a hard time understanding them until I plotted the transactions out on a flow chart. Payments in advance and open accounts are basically just extensions of their domestic counterparts. Barters were hard for me to include in my research because most of time the companies that use bartering are not really concerned if the products being bartered end up overseas. Most barters, however, do end up in a foreign market, and for this reason I believe that barters qualify as an international transaction. Also, the emerging trend of Internet B-2-B transactions have brought bartering into the limelight. I have spent entirely too much time on this term paper, am truly glad to be finished, and have learned immeasurably.
Britannica.com Staff. “Commercial Transaction.” http://www.britannica.com, Britannica.com Inc., 2000.
Campbell, Tricia. “Tapping New Methods Through Barter.” New York, NY: Sales and Marketing Management, October 1998, pg.41.
Emigh, Jacqueline. “Corporate Barter.” Framingham: Computer World, October 25, 1999, pg.56.
Hickman, Thomas K. and William M Hickman Jr. Global Purchasing: How to Buy Goods and Services in Foreign Markets. Homewood, IL: Richard D. Irwin Publishing Inc., 1992.
Luxton, Gary K. “Fifty Ways to Use a Letter of Credit.” Atlanta: TMA Journal, November/December 1998, pg. 92-96.
Maulella, Vincent M. “Payment Pitfalls for the Unwary.” Irvine, CA: World Trade, April 1999, pg.76-79.
Mehta, Ravi. “Export Letters of Credit.” Geneva: International Trade Forum, 1999, pg.12-15.
Meyer, Bob. “The Original Meaning of Trade Meets the Future in Barter.” Irvine, CA: World Trade, January 2000, pg.46-50.
Robertson, Aaron. “Covering Non-Payment Loss.” Irvine, CA: World Trade, October 1999, pg. 76-78.
Sowinski, Laura. “Letters of Credit.” Irvine, CA: World Trade, November 1999, pg. 80-84.
Weiss, Kenneth D. Building an Import/Export Business. New York, NY: John Wiley ; Sons Publishing, 1991.
World Trade Staff. “Getting Paid for What’s Transacted for.” Irvine, CA: World Trade, September 1999, pg. 42-52.