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Module 13: Small and Medium Enterprises in ASEAN

Reading Text & Presentation

13.3 Methods of payment

It is important for all companies engaging in international trade to fully understand the standard methods of collecting money from foreign importers and distributors. Each payment method carries certain risks and costs, which often are the responsibility of the exporter. Initially, cash in advance or letters of credit are used and then moved to more flexible forms of payment, for example the use of an open account.
The standard methods of payment used in international trade are:

13.3.1 Cash in advance
13.3.2 Open account
13.3.3 Draft (Documentary collections)
13.3.4 Commercial letters of credit

Payment Risk

(Source: http://trade.gov/media/publications/pdf/trade_finance_guide2007ch1.pdf retrieved 10/5/2014)

13.3.1 Cash in advance

Cash in advance is used on low-value shipments, usually when the buyer has significant interest in obtaining products from the seller, access to the preferred method of currency, and is quite fiscally sound. Nevertheless, it is the least preferred method of payment for the buyer.

The seller must determine when to expect payment and back up this method of payment under this term if the buyer demands it, with a bank guarantee from the buyer’s bank. A bank guarantee means the buyer’s bank will pay should the buyer fail to pay. Foreign credit insurance on your receivables would also pay in the event of non-payment for either commercial or political losses.

13.3.2 Open account

In this method, the buyer receives delivery of the goods and services before making payment. It involves delivery of your goods or services to the buyer with an invoice requesting payment at a certain time after delivery. The time given to the buyer to pay is called a ‘credit term’.

In negotiating an export contract, the agreements concerning the amount, currency, timing and method of payment are made. The buyer receives an invoice identifying payment details after the shipment or provision of services. Control of the goods passes to buyer before the payment.

Under open account payment, the buyer will usually send it by:

Telegraphic (Wire) transfer

Payment by foreign check (Bank draft)

Payment by wire transfer is the fastest way for the seller to be paid, and the easiest to trace the movement of the funds between banks by using pin numbers. Moreover, the exporter can be paid in preferred currency. An exporter releases the shipment to the international freight forwarder or carrier once the transfer has been deposited into their account.

Fees will be charged to both the buyer’s and seller’s banks, which are usually split between them. In order to ensure accurate routing and processing of wire transfer, the seller should provide the buyer these following details:

Name and address of the receiving bank and branch
The receiving bank’s electronic identification codes, such as SWIFT, Telex and ABA numbers (SWIFT is the acronym given to the Society of Worldwide International Financial Telecommunications, an EDI technology, telex communications are still used in the international banking industry and ABA is the American Bankers Association Routing Number)
The seller’s name, address, bank account title and account number

Payment by check is convenient when the routing details for payment are unknown. However, the transit time can be slow and it cannot clear until the funds are obtained by the buyer’s bank. The value paid may change during the collection period due to currency fluctuations.

13.3.3 Draft (Documentary collections)

This payment method is often used in the exchange of merchandise for money. The goods are shipped to the foreign country, but the documents are sent to the buyer’s bank. Then, the buyer’s bank will release possession of the documents when the buyer makes payment arrangements or signs a promise to pay at a later date. Under this method, an exporter can be paid on a sight draft/time draft or be paid on a sight/time letter of credit to indicate what type of draft is to be shown together with the L/C and documents for payment.

Draft collection procedure
Goods are shipped to the foreign country, but they are not consigned to the buyer. Bills of lading are usually consigned to the order of the shipper or the buyer’s bank, (with their permission). They will release their possession once the buyer has made payment arrangements or signed a promise to pay at a later date.

The exporter (bank or their international freight forwarder) prepares a draft drawn on the buyer or their bank, and submits the draft together with the documents and instructions to the buyer’s bank. If drawn on the buyer, the buyer’s bank notifies the buyer to come in to the bank and either pay or accept the draft. Once completed, the documents are turned over and the buyer can make clearance arrangements. If a sight draft, the remitted amount would be wired to the seller’s bank, which credits the seller’s account after collecting their fee.

Collection flow chart

(Source: http://fea.files.cms-plus.com/ExportEssentials/9collectionflow.pdf retrieved 17/2/2014)

13.3.4 Commercial letter of credit

A letter of credit (L/C) is commonly used because of high risk of non-payment. It is an electronically generated contract between the buyer’s bank and the exporter. The buyer’s bank substitutes the credit of the buyer with their own, at a fee and with a set of instructions to secure payment. Under this term, the buyer’s bank enters into a letter of credit contract with the seller, stipulating them as the beneficiary. The buyer’s bank then (usually) contacts a bank and asks them to either advise the letter of credit to the seller or to add their confirmation. By adding their confirmation, the bank agrees to pay the beneficiary even if they are unable to collect from the issuing (buyers) bank. The most important aspect of a letter of credit is that the banks involved have no obligation to pay in the event of serious discrepancies on the documents supplied by the beneficiary (seller).

Example of letter of credit

(Source: http://fea.files.cms-plus.com/ExportEssentials/9draft%20Dennis.pdf retrieved 12/4/2014)

Procedure of the Letter of Credit
The following list describes the action for payment under an exporter letter of credit:

The pro forma invoice and the terms of sale and payment are agreed upon.
Instructions on opening the L/C are sent to the buyer.
The buyer establishes a line of credit with his bank.
The buyer’s bank issues a letter of credit to either the branch, correspondent or nominated bank.
The bank may or may not authorize confirmation, even if requested.
The advising bank forwards a letter of credit to the seller.
The seller carefully analyzes the L/C and coordinates shipment with a freight forwarder who assists with the pro forma invoice quotation.
The seller proceeds to ship if all terms are acceptable.
The freight forwarder arranges shipment and completes required documentation evidencing compliance with the terms and conditions of the credit.
Documents required by the L/C, demonstrating compliance, are sent to the advising or confirming bank that carefully checks against the terms and conditions.
If using a confirmed letter of credit, the draft is drawn on the confirming bank on either a sight or time basis; at sight payment is made within two business days, while a time draft is accepted by the confirming bank and payment is made within the terms of the draft.
If using an advised letter of credit, documents are sent to the issuing bank for secondary review, and the draft is drawn on either the issuing bank or applicant at sight or time basis.
The buyer is notified by the issuing bank of compliance.
The issuing bank then pays the confirming or advising bank, which has paid or will pay the beneficiary based on the terms and conditions of the draft.
Documents are released to the buyer or customs broker who makes arrangement for clearance.
The buyer takes title to goods to use or resell in their market.

(Source: Adapted from https://www.foodexport.org/GettingStarted/content.cfm?ItemNumber=1294 retrieved 13/6/14)

Differences between drafts and letters of credit

Draft	Letter of Credit
1. Obligation to pay
The obligation to pay is with the buyer.	The obligation is with the issuing/confirming bank.
2. Risk to seller
The seller has higher risk with payment by collection.	The seller has lower risk with payment by collection.
3. Documentation
Documentation is not checked for accuracy on collection.	Documentation is checked for accuracy on collection.
4. Role of the bank
The bank’s role is passive on collection.	Letter of credit is very active because the issuing or confirming bank has substituted its credit for the buyer.

Summary of payment methods

Method	Usual time of payment	Goods available to buyer	Risk to seller	Risk to buyer
Cash in advance	Before shipment	After payment	None	Complete. Relies on seller to ship exactly the goods expected, as quoted and ordered
Open account	As agreed, usually by invoice	Before payment	Relies completely on buyer to pay account as agreed	None
Draft	Remittance time from buyer's bank to seller's bank may still take one week to one month		Drafts, by design, should contain terms and conditions mutually agreed upon
Letter of Credit (L/C)			Commercial invoice must match the L/C exactly. Dates must be carefully headed. "Stale" documents are unacceptable for collection