What is Netting?

FinLync | May 23, 2022

For corporate treasurers, it’s important to minimize unnecessary costs, mitigate risk and manage cash more effectively. Fortunately, there is much that companies can do to achieve their goals – and netting is one technique that treasuries can use to achieve their liquidity goals and keep costs under control. However, the meaning of netting is not always clear, as it can be applied to a number of different practices as well as to intercompany payments. So what is the definition of netting in finance, how does it work and what are the benefits for companies using this technique?

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Netting meaning

What does netted mean in accounting terms? Broadly speaking, netting is a way that organizations can reduce risk by aggregating different obligations or exposures. This approach can be applied to a number of different situations, including financing and investing and foreign exchange as well as intercompany payments.

Where intercompany payments are concerned, netting – also known as intercompany netting – is a technique that companies can use to offset different positions or transactions, thereby saving transaction costs. This can be useful when different entities within the group are in the practice of sending intercompany invoices to each other, particularly when this results in multiple payments in different currencies.

By using an intercompany netting program, companies can consolidate or combine their subsidiaries’ payables against their receivables. As a result, they can reduce the number of payments that need to be made, which reduces transaction costs and FX requirements.

There are a number of reasons why companies may choose to adopt a netting system. By using this technique, companies can:

  • Reduce the number and size of transactions that have to be paid each month, thereby reducing transaction costs and saving time
  • Minimize the number of cross-border payments that need to be made
  • Improve FX hedging by achieving an overview of the group’s currency needs and lets organizations leverage scale for bulk FX and better rates
  • Simplify the invoicing process

Types of netting

Not all netting programs are alike. For one thing, there are two main netting techniques available: bilateral netting and multilateral netting.

Bilateral netting is carried out between two subsidiaries. For example, Subsidiary A might owe Subsidiary B $8,000, while Subsidiary B owes Subsidiary A $5,000. Instead of each subsidiary making a payment to the other, the two amounts are offset, resulting in a net obligation of $3,000. This reduces the number of transactions that need to be made from two to one, and reduces the total value of all transactions from $13,000 to $3,000 – resulting in cost savings.

Multilateral netting works on the same principle, but with three or more parties included in the netting arrangement. A netting center collates the various subsidiaries’ invoices and calculates the net payment that each party needs to make or expect to receive from a central counterparty.

A netting program may involve physical transfers of cash between the netting participants. Alternatively, if netting is used in conjunction with an in-house banking structure, the process may involve creating intercompany cash movements that will impact the relevant in-house bank balances and thereby eliminate the need for intercompany cash flows.

Another difference between netting programs is that some are settled on the basis of intercompany payables, whereas others are driven by intercompany receivables.

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Establishing a netting center

Not every company will have a netting program in place – so what do you need to think about when implementing netting?

A netting initiative will be led by the group’s parent company or a series of regional centers, which will define which subsidiaries should be involved in the netting program. Once the program has been set up, the functional currency will need to be identified for each netting participant. It’s also important to consider the nature of the invoices that will be included in the netting process, the countries and currencies involved and any technology and integration needs that will have to be addressed – for example, the company might choose to adopt a dedicated netting system, or might use the netting functionality of an existing treasury management system.

For each participating subsidiary, the following questions will need to be addressed:

  • What is the default currency?
  • Will cash movements be physical or notional?
  • To which netting center do they belong?


Netting cycle and netting rules

The netting center will need to define how the netting process will be carried out. This includes defining when the netting cycle begins and ends, as well as setting out everything that needs to happen in between. Decisions will need to be made about specific points such as the date when invoices are due, settlement dates and proposed netting amounts, as well as how any disputes or discrepancies are to be handled.

While different models are available, the netting cycle usually lasts for one month. During a typical netting cycle, subsidiaries send their invoices to the netting center. Any disputes will need to be managed and resolved. The invoices are then reconciled, following which the netting center informs each subsidiary of the amount they will either receive or need to pay.

Settlement will then take place, either through physical payments or via intercompany booking. The netting center will receive payments from the subsidiaries that owe money, and send payments to the participants that are owed money. All of the payments are carried out on the same day. After that, the next netting cycle will begin.


Benefits of netting

Netting can be used for a number of different reasons. For example, companies can use netting to:

  • Reduce the number of transactions that need to be made, resulting in lower fees.
  • Improve visibility and control over cash.
  • Reduce administrative workload.
  • Improve cash management and manage foreign exchange risk more effectively on a centralized basis.
  • Reduce the need for FX hedging.
  • Simplify what does netted mean in accounting
  • High efficiency reconciliation of invoices between subsidiaries.

 

Of course, netting is just one of a number of techniques that treasury teams can use to improve their cash management, minimize costs and keep risk under control. With a sophisticated treasury solution that’s based on direct bank API connectivity, you can harness the possibilities of real-time treasury to reduce manual labor, track payments, improve decision-making and speed up reconciliation.

 

Hackett Group report