Payment Methods for International Transactions/Methods of Payment
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Unit 3.4-Payment Methods for International Transactions |
Introduction | Methods of Payment | Comparing Methods | Summary | Resources | Activities | Assessment |
Contents
Methods of Payment
Methods of payment include the following:
- open account
- documentary collections
- documents against acceptance
- documents against payment
- letter of credit
- confirmed letter of credit
- advised letter of credit
- cash in advance
Open Account
A seller ships the goods and all the necessary shipping and commercial documents directly to a buyer. This buyer agrees to pay the seller’s invoice at a future date ( net 15 days, net 30 days or with a discount offered--for example, 1% if paid within 20 days of invoice date).
Documentary Collections
A documentary collection is a payment mechanism in which a seller uses a bank as his/her "agent" in collecting payment from a buyer located overseas. After shipping the goods, the seller submits a draft (a demand for payment) and the relevant shipping documents to the bank. The draft will include instructions to release the documents to the buyer upon the buyer’s payment or acceptance of the draft. The seller’s bank sends the documents, draft, and collection instructions to a branch or correspondent bank in the buyer’s country. This bank carries out the seller’s collection instructions and, upon receipt of payment from the buyer, remits payment to the seller’s bank for the credit of the seller.
Documentary collection procedures are uncomplicated. After shipping the goods, the exporter submits to the bank:
- shipping documents, including the bill of lading conveying title to the goods, as well as other documents related to the shipment.
- a draft, also called a bill of exchange, demanding payment from a buyer. Depending on the agreed terms of sale, this may be a sight draft, demanding payment on presentation, or a time draft, demanding payment at some stated future time after presentation or after the bill of lading date.
- instructions to the bank as to how to handle the transaction. Note that a documentary collection requiring payment before the release of documents may sometimes be transacted without a sight draft. Under cash against documents (CAD) terms, the documents are released to a buyer against receipt of payment. CAD terms are generally used when the government of the importing country requires tax stamps affixed to drafts; by eliminating the draft, both buyer and seller avoid stamp taxes.
- release documents to a buyer upon payment of the sight draft, which is known as a documents against payment, or D/P collection; or release documents to a buyer upon acceptance of the time draft, a documents against acceptance, or D/A collection.
The seller’s bank, called the remitting bank, sends the documents, draft, and instructions to one of its branches or correspondent banks in the buyer’s country. This bank, called the collecting or presenting bank, contacts the buyer and informs him/her that the documents have arrived and can be obtained when he/she complies with the payment terms, which may be documents against payment or documents against acceptance.
Documents against Acceptance (DA)
A buyer is required to "accept" a seller’s time draft, thus acknowledging obligation to pay at the specific future date. The time of payment occurs at maturity of an accepted time draft, 30, 60 or 90 days after date of acceptance or date of bill of lading.
Documents against Payment (DP)
A buyer is required to pay a seller’s sight draft in order to obtain shipping documents. Payment is made on presentation of the sight draft by a bank to the buyer, usually one or two weeks after shipment. Under D/P terms, the seller, through a bank acting as an agent, is able to retain control of the goods until the buyer pays. Under certain circumstances, such as to meet legal requirements of the importing country or to obtain a government permit for foreign exchange, the buyer will require possession of the documents before payment. The seller should inquire as to the practice in specific countries. Air shipments are often made under documentary bill collections. The buyer, as direct consignee of the non-negotiable air waybill, will be able to take possession of the goods before meeting his/her payment obligations.
Letter of Credit
A commercial letter of credit is, essentially, an agreement in international trade whereby a bank assumes a conditional obligation on behalf of its customer, a buyer, to make payment to a seller. Payment is conditional upon a seller’s compliance with the terms and conditions specified in the letter of credit. These terms and conditions require the seller to present stipulated documents, which are usually those required for transport, commercial, and official purposes ( bill of landing, commercial invoice, insurance certificate, consular invoice). Once the seller has complied with the documentary requirements of the letter of credit, prompt payment is secured. In effect, a bank in the letter of credit transaction substitutes its credit standing for that of the buyer. Thus, the seller, who is the beneficiary of the letter of credit, has the undertaking of a bank to pay when the terms and conditions of the credit have been complied with. On the other side, the buyer is assured that payment will not be made unless the seller meets the conditions stipulated in the letter of credit.
The buyer’s bank substitutes its creditworthiness for that of its customer and agrees to honor a seller’s demand for payment if that seller complies with all the requirements specified in the letter of credit.
Confirmed Letter of Credit
In addition to the standard letter of credit, this instrument carries the undertaking of a second bank, usually in the seller’s country, to honor the seller’s demand for payment upon presentation of documents specified in the credit.
A second bank, usually in the seller’s country, gives its undertaking to the letter of credit issued by the buyer’s bank and promises to pay the seller upon that party’s compliance with the terms and conditions of the credit.
If the seller does not want to lessen risk, this seller may require that the letter of credit be confirmed by a bank in his/her country (or in some third country). A bank that confirms the letter of credit adds its commitment to pay to the original credit. Since the seller can look to the confirming bank for payment, he/she is protected against the financial risk of the issuing bank and the political risk of the importing country. To the extent that the credit standing of the confirming bank is undoubted, this is the most favorable type of letter of credit from the seller’s point of view.
Advised Letter of Credit
A letter of credit issued by the buyer’s bank (the issuing bank) may be advised to a seller by a bank, usually in his country--called the advising bank--without any undertaking on the part of that bank, except that it must use reasonable care to check the authenticity of the credit which it advised.
As the issuing bank undertakes to pay the seller, the advised letter of credit relieves the seller of the financial risk of the buyer. However, as beneficiary of the advised credit, the seller is subject to the financial risk of the issuing bank, which may not be willing or able to make payment when due. In addition, the seller is subject to political risk of the importing country: that is, the risk that sovereign action of the government may block the transfer of funds regardless of the issuing bank’s ability or willingness to pay the credit.
Cash in Advance
The seller requires receipt of payment from the buyer before shipping goods. Payment may be made by wire-fund transfer from the buyer’s bank to the seller’s bank, or by company check, credit card, or other agreed upon means.
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