FREE ESSAY ON PAYMENT METHODS FOR AN INTERNATIONAL TRANSACTION

PAYMENT METHODS FOR AN INTERNATIONAL TRANSACTION

One of the subjects of international business that I have a particular 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
Open Account
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.
Barter
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. 
Closing Statements
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.
Bibliography
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