Debit notes and SCF
I never would have thought, at the start of my emerging career as a trade banker, supply chain financier and potential "Master of the Universe" (per Tom Wolfe), that debit notes would be interesting, and that thirty years later I might be writing a blog about them.
But we here we are!
It is quite a long post, but this is a topic that merits a detailed treatment, even if the subject matter is rather dry and somewhat technical.
Myths and realities
This post sets out five myths about invoices and debit notes.
These myths can lead to various confusions, complications and inefficiencies when it comes to supply chain finance.
The post aims to set out clearly how things normally work in the real world of general ledgers and corporate ERPs. It also digs into the implications for SCF and for the design of platforms that help suppliers to access supply chain finance.
There are generally three strategies used to deal with debit notes in supply chain finance - and these are covered in the final section.
With the right design and approach, debit note recovery can be automated and fully-optimised - no more spreadsheets, no more manual-tracking and no need to get suppliers to deduct debit notes from future invoices.
PrimaTrade's platform was designed from the start to handle debit notes optimally for its corporate users. If you have an SCF program in place, perhaps check to see what you provide to the platform involved (debit notes and invoices, approved payables, approved invoices?). The relevance of this question is revealed in the last section.
What is a debit note?
A debit note acts as the evidence in the buyer's books for a reduction in its expenses.
So it is issued by the buyer's accounts payable team to a supplier when the buyer seeks to pay less than it has been invoiced.
For supplier financing transactions (including SCF), a debit note can be an unwelcome event. If an invoice has been financed and even purchased by a financier, the financier typically relies on the invoice being paid in full.
Myth #1: invoices can be "approved" or not approved
What if I told you that "invoices always get approved"?
A valid invoice is one that is properly addressed, is from a recognised counterparty (ie: a supplier), has the right taxes on it shown in the right way, and which adds up correctly.
Valid invoices always get approved and there is a good reason.
This is a fundamental part of the way financial controls work. A valid invoice has been received representing a claim for payment from a supplier and it will be posted in full to the general ledger.
If this didn't happen, we would get in a mess very quickly. Accounts payable teams cannot use their discretion and post valid invoices to the general ledger with whatever numbers on them they decide might be right.
Audits would be failed and financial controls would have broken down.
If the invoice from the supplier is for an amount that is too high (for whatever reason), a debit note is raised by the buyer so the supplier gets less money. The question is "what's the debit note?" not how much of the invoice should be approved.
Some accounts payable teams will, alternatively, ask the supplier to raise a credit note and the invoice remains pending and not posted until the credit note is received. Here, for ease of explanation, we assume the debit note route is the one that the accounts payable team uses.
Myth #2: Payables are the same as invoices
In the ordinary course of business, accounts payable teams in corporate clients approve payments and not invoices.
A few key points:
Valid invoices are posted to a supplier account in the general ledger at the full amount demanded by the supplier (see above). If debit notes are raised, they are also posted.
The amount due to the supplier is the balance on the supplier account in the general ledger - equal to invoices posted less debit notes posted.
When it comes to paying a supplier, it is the outstanding and due balance on the supplier account that is settled. The due balance is calculated by taking all the items posted to the supplier account that are due on or before the current date, summing them up and subtracting payments already made.
The result is a payable amount - a figure that will be settled to the supplier, usually via a payment run. That figure may be made up of many individual transactions (invoices, debit notes and credit notes). The key approval step is at the time of the payment run.
This makes supply chain finance and supplier financing tricky - since bankers and lawyers like to think in terms of transactions rather than balances.
Bankers purchase invoices not balances.
Debit notes do not conveniently fit into this model.
Whilst the corporate client may be settling a balance that is due to a supplier (invoices less debit notes),
bankers want the invoices that they have purchased to be paid in full to them.
This is also one of the two main reasons why many corporate clients operate an all-or-nothing model with suppliers when it comes to supplier financing.
Reason 1: if all the supplier invoices are financed by the same bank, there's no need to try and unpick a balance that has been settled and split it into individual invoices.
Reason 2: nothing to do with debit notes, so just mentioned here for completeness: most general ledgers cannot handle more than one account payee record per currency - so this one record gets changed from the supplier banking details to the financier banking details and then all the money due to the supplier simply goes to the financier. Again, this avoids the need to try and split the payment into the individual invoices involved.
These two reasons mean SCF programs can lose a lot of agility. There's no easy way to move suppliers between financiers, and no easy way to have dynamic management of funding, switching suppliers between financiers whenever needed (even daily) to optimise the use of limits and mix in own treasury funds as a funding source.
Myth #3: debit notes are somehow "outside" SCF
I made a statement earlier about "valid invoices always being approved".
The key question for the accounts payable team when they are deciding what the supplier might be owed is not how much of the invoice to approve.
The key question is: how big should the debit note be?
Yes, that's right. The full amount of a valid invoice is always posted to the ledger but if there is a reason to pay less than the full amount, then a debit note needs to be raised.
The questions being answered by the accounts payable team reviewing purchase orders, delivery paperwork and the invoice (ie: the 3-way match) are (a) whether a debit note should be raised and (b) how much it should be for?
For example, the invoice face value is 100, but there is a shortage on the delivery of value 5. So that means the invoice of 100 is posted to the ledger, and a debit note of 5 is created and posted - and 95 is the balance on the supplier account, which is what will be settled in due course.
As stated above, the general ledger is an account-based (ie: balance-based) system.
The supplier account is credited with the full amount of the invoices and debited with debit notes to reach the correct amount that should be paid to the supplier when a payment run is operated.
So what is the bank buying when it provides supplier financing?
The amount due under the invoice (without set off, counterclaim etc), or
the amount payable in respect of the invoice at the time of purchase, which could include amounts that are already planned to be netted from the invoice payment.
Is it an "approved payable" (an invoice that is net of specified debit notes) or is it an "approved invoice" (due at face value without deduction)?
This is a key documentary point and one which might not always be clear in the paperwork used to support supply chain finance. On the one hand, the bank wants to buy invoices free and clear of any debit notes. On the other hand, the corporate client may well want the ability to net pre-existing debit notes (at the time of financing) against those invoices.
Is the IPU for the same amount as the invoice? What exactly is the claim that the bank is buying and relying on here - the invoice or the payable amount (at IPU creation-time) in relation to each invoice? If the supplier financing is documented on the basis that the bank is buying the IPU (and not the invoice) - query the accounting treatment and whether the arrangement might then become financial indebtedness in the books of the corporate obligor?
Myth #4: debit notes specifically relate to invoices
Debit notes "sort of" relate to invoices - but this is an artificial construct and not one that is required in the ordinary course of business.
Companies typically want to collect claims (debit notes) against suppliers immediately. Why wait?
Invoices are posted with a due date (in the future) that reflects when the amount claimed by the supplier should be paid.
Debit notes are often posted with an immedate due date.
That means debit notes are usually collected by set off against the next amount due to be paid to the supplier - ie: as soon as possible. There's no waiting.
That would be the case even if the debit note might relate to a delivery where the invoice(s) for that delivery are not due to be paid for many days.
And debit notes may also arise that are wholly unconnected with individual deliveries - for example, where there are volume rebates or programme-wide discounts to be recovered.
As mentioned above, settlements clear the due portion of the balance outstanding on the supplier account.
The settlement is calculated by adding up all the transactions that are due and ignoring future-dated transactions. The debit note is always due immediately and is included as soon as possible in any payment that is made to the supplier. The invoice may be due in the future and has to wait.
The idea that this specific debit note goes with that specific invoice is typically a myth when it comes to the practical reality of payables and settlements.
Myth #5: we can ignore debit notes in SCF
Most platforms ignore debit notes. These are "someone else's problem".
That's why many accounts payable teams don't like supply chain finance and specifically prefer to limit the size and scope of programs to a handful of large suppliers.
And many SCF platforms ignore debit notes completely.
Corporate clients are expected to provide them with a nice and tidy file of "approved payables" which are guaranteed to be paid in full no matter what else may be going on.
This makes life easy for the platform and easy for the bankers and lawyers involved.
But this also makes life complicated for the corporate accounts payable team.
If clean "approved invoice" or "approved payable" files are to be provided to the SCF platform, this typically means that:
debit notes cannot be posted to the general ledger in the usual way
debit notes have to be tracked "off-system" with recovery of the debit notes handled away from the settlements and payments process.
This can mean that many clients end up failing to collect all the debit notes that they might claim, or end up having to track debit notes manually in excel and away from the general ledger. This all leads to extra work for everyone, compromising financial controls and adding costs and complexity.
Debit notes and SCF - are there solutions?
Yes - it requires a modern approach to the way that the supply chain finance platform is developed and operates.
There are three approaches:
Manual: Corporate accounts payable teams handle the debit notes away from the SCF program with manual tracking and recovery. SCF program is then simple as it is fed with an "approved invoice" file and all invoices are simply settled at their face value. Debit notes are tracked in a spreadsheet and suppliers are required by procurement teams to deduct them manually from future invoices.
Delay debit notes: The corporate accounts payable team runs two processes:
Debit notes are allocated to invoices before they are included in the file transmitted into the SCF platform; early payments to suppliers are then net of debit notes that were outstanding at that specific moment; and then
Those invoices that are in the SCF program are then ring-fenced from the further application of debit notes against them by the accounts payable team - so the SCF financier is not exposed to any netting and will be paid in full. This requires some careful management of posting processes and dates applied to debit notes in the ERP to ensure debit notes are not deducted from financed invoices. One way to do this is to post debit notes with future due dates to defer processing and delay their recovery, leading to earlier due invoices that are financed always being paid in full; this is a cost to the business though.
The PrimaTrade solution, which is for the platform to receive a file from the corporate general ledger that includes both the invoices and debit notes posted as usual - and then the recovery of the debit notes is optimised on the PrimaTrade platform.
PrimaTrade tracks debit notes and invoices. We automatically deduct unrecovered debit notes from early payments to recover them as fast as possible - so IPUs are generated net of debit notes and we manage settlements to ensure invoices, once IPUs are issued, are settled at least at the IPU amount.
PrimaTrade also has another trick up its sleeve in this area - which is the native ability for SCF financing to be offered at less than the invoice due amount (eg: early payments are set at 80% or 90% of the invoice face value upfront net of unrecovered debit notes at the time, leaving a balancing payment that can also be settled later net of any remaining or subsequent debit notes on the invoice due date). This buffer makes recovery of debit notes much more certain - and helps with the buyer's accounting treatment.
The ability of PrimaTrade to manage debit notes and to manage payments also means the platform is truly dynamic when it comes to financing. One supplier can simultaneously be funded by more than one financier - including mixing in own corporate treasury funds when this makes sense. Everyone in SCF claims to be multi-funder - but you can only be dynamically multi-funder if you have cracked debit notes.
Debit notes - who would have thought they could be so interesting?
There is much more to this topic. If you would like to talk to us - or see if any of our partner banks would be happy to provide you with a limit - do get in touch here: