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Netting : An Overview

Posted on January 23rd, 2008 by Sanjit Anand |Print This Post Print This Post |Email This Post Email This Post

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My last two post was on netting , lot of people asked me to provide some more insight view for netting, so this post is meant to walk through ,the concept to someone not very familiar with accounting in real world...so here to go..(adopted)

When trading partners agree to offset their positions or obligations, they are netting. By doing so, they reduce a large number of individual positions or obligations to a smaller number of positions or obligations, and it is on this netted position that the two trading partners settle their outstanding obligations. Besides reducing transaction costs and communication expenses, netting is important because it reduces credit and liquidity risks, and ultimately systemic risk. For a non accounting personal risk can be best understood as :the risk of a trading partner not fulfilling his obligations in full on due date or at any time thereafter is a risk that affects all aspects of business.

redarrow-1Definition of Netting

In this method of reducing credit, settlement and other risks of financial contracts by aggregating (combining) two or more obligations to achieve a reduced net obligation.

  • Netting rules a basic part of master agreements.
  • Netting rules define precisely the netting of positions or claims between counter parties.

redarrow-1Benefits of Netting

Netting potentially address four major risk in financial area, there are

  • Reduction of credit risk
  • Reduction of settlement risk
  • Reduction of liquidity risk
  • Reduction of systemic risk

redarrow-1Types of Netting

  • Payment Netting
  • Novation Netting
  • Close-Out Netting
  • Multilateral Netting

1Payment Netting

Also called “Settlement Netting” or Also called "Position or Accounting Netting".

On a payment date, each party will aggregate the amounts of a currency to be delivered by it, and only the difference in the aggregate amounts will be delivered by the party with the larger aggregate obligation.

PAYMENT

This can be best understood as:

  • Daily settlement or offsetting of several, due claims in the same currency
  • Reduction of transaction costs, settlement risk and liquidity risk.
  • No impact on credit risk.

Types of Payment Netting Agreements

  • Master Agreement with a Payment Netting Clause
  • Stand-Alone Payment Netting Agreement
  • Informal, “ad hoc” agreement

 

2Novation Netting

If the parties enter into a transaction which gives rise to an obligation for the same value date and in the same currency as an existing obligation, then the two obligations are cancelled and simultaneously replaced with a new obligation for the net amount.

  • Settlement of not yet due claims in the same currency and the same maturity.
  • Reduction of limit usage and credit risk.

Two Types of Novation Netting:

  • Matched Pair Novation Netting
  • “Comprehensive” Novation Netting

Matched Pair Novation Netting

Netting only occurs if the two transactions involve the same pair of currencies.

Example1: Matched Pair Novation Netting

Deal 1: Buy JPY / Sell USD
Deal 2: Buy USD / Sell EUR
Deal 3: Buy EUR / Sell JPY

No two deals involve the same currency pair, and therefore no netting under matched pair novation netting.

Example 2: Matched Pair Novation Netting

example2

Example 3: Comprehensive Novation Netting

EXmaple3

 

redarrow-1A Payment Netting vs Novation Netting

  • Payment Netting reduces settlement risk, but does achieve netting for balance sheet or regulatory capital purposes because the transactions remain in gross.
  • Contrast with Novation Netting, which achieves true netting through the cancellation of offsetting transactions and their replacement with a new, net transaction.

3Close-Out Netting

Effective upon a default:

  • Existing transactions are terminated
  • Termination values are calculated
  • Termination values are netted to arrive at a single net amount
  • Recourse to credit support, if any

That mean:

  • Settlement/offsetting of not yet due claims in different currencies in case of a default event or an early termination event of the contractual relationship.
  • All outstanding gross obligations or payments are replaced by a single obligation or payment

4Multilateral Netting

Bilateral Netting is between two parties.

Multilateral Netting involves netting among more than two parties, using a clearing-house or central exchange.

netting

 

When it come to party , it may be two party interacting with third party. Th two party may be your other entity in the same instance, which do business internally, what we called Intercompany.

Multilateral netting is a settlement mechanism used by companies to pay for goods and services purchased from affiliated companies. The netting process consolidates
intercompany transactions and calculates settlement requirements internally instead of using external payment systems. Netting is typically used by companies with a number of affiliates in different countries. By netting, these companies reduce bank fees, currency conversion costs, bank balances and improve operating efficiency.

Will take this in some more details in another post.

redarrow-1Requirement Mapping with Existing Oracle EBS Product

Still these two processes are not fully enabled in Oracle EBS suite. Though first type of netting somehow mapped as Contra Charging in post 11i10 releases where as in R12 this functionality can be mapped as part of AP/AR netting, a new feature of R12.

Here is summarize list of the different types of netting and there corresponding netting.

Netting as per EBS

Feel Free to comment or share any information.:)

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Posted in Basic Accounting, Finance | 9 Comments »Email This Post Email This Post | Print This Post Print This Post

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9 Responses
  1. Manish Says:

    I really appreciate your interesting posts about various topics in Oracle Financials. In your experience in the field, have you come across a client who generates a Cash Flow statement directly from Oracle Financials (FSG) when using multi-currency?

    We are implementing R12 GL (only GL) with 2 legal entities, one in US and another in Canada and will be consolidating in the US ledger. It seems you cannot generate a Balance sheet as per FASB and Cash Flow as per GAAP because of how Oracle uses currency rates.

    If you have any insights I would really appreciate it.

    Thanks,

    Manish

  2. Tim Says:

    Hey Sanjit
    AS the Apps developer that maintain ed contra charging in 10.7, 11 and 11i this is a great functional description of the netting. Good Stuff!
    Tim

  3. Sanjit Anand Says:

    Thanks Tim,

    for nice word.

    -sanjit

  4. Sanjit Anand Says:

    Thanks Manish, Frankly speaking I never get across such requirement for generating Cash Flow in system. In one of client they have used third party reporting tool and there accountant made cash flow statement.
    Not very sure , revalution transalation rate is not comply with FAS52 or not. One of my project I know controller has objection to relay on system.

    Just consulated with one of accountant at my client side who is also CPA , shared some more information,which is follows

    “Financial Accounting Standards Board pronouncement number 52 (FASB52) addresses presentation of foreign currency denominated financial consolidation or equity method of accounting. In general FASB 52 allows for two primary methods of translating foreign currency financials.

    These methods are known as
    1) Current Rate Method
    2) Remeasurement Method

    The Remeasurement Method uses a Monetary/Non-monetary approach.
    In this approach assets and liabilities are classified as either monetary or non-monetary. Non-monetary items have historical cost balances (e.g. Property Plant and Equipment, Prepaid Expenses, Inventories). Monetary items include cash and cash equivalents (e.g Cash, Accounts/Notes Receivable/Payable.

    where as non-monetary assets are measured in the primary currency at their historic cost (regardless of the transaction currency). However, both monetary and non-monetary assets and liabilities are translated using the current rate at the balance sheet date.

    Could you please share some more information , like did your system is MRC enabled or just have 2 different SOB. Your input would be suppotive in getting some more requirement.

    Thanks
    sanjit

  5. Shree Says:

    Hi Sanjit,

    great article on netting.. Really made it simple to understand.. I have a fixed assets question that i want to ask you.. really appreciate your help on this..

    ===========================
    Basically what they are trying to achieve is when they bring over a fixed asset from Company X (an acquired company) on to Company Y Oracle Fixed Assets they want to know what is best practice. Basically, he is using a step (up/down) approach which means the following:

    Company X shows an asset on their books as follow:

    Asset purchased 1/1/06 for $100,000, depreciated for 10 years at straight line depreciation. Company Y buys the asset for $60,000 and want to show the asset the following way in the Oracle Fixed Assets Corporate and tax book.

    Corporate
    Asset $60,000; depreciate for 10 years straight line method

    Tax book
    Asset $100,000; depreciate for 10 years straight line method.

    Finance will document any of the differences but per the tax department’s request they want Company Y to use the actual Company X cost and not the Y acquired cost. The question Finance has is is it possible to have two different asset value Corporate vs Tax? If so, how do you show the difference (ie manually change the tax book after you transfer from corporate….)

    The second question is what is best practice when creating a “step up/step down” situation in Oracle?
    ================================

  6. Arun Says:

    Hi Sanjit,

    Can you pls post about Blanket release through API against BPA?

    Arun

  7. Subhash Semalty Says:

    Dear Mr. Arun,

    this is subhash semalty MBA student i red this report this is very good.

    after reading this report i got an idea of what is called as netting which was very difficult to understand from a book or by a proff.

    Thankyou
    for subhash semalty

  8. Chandra Says:

    Sanjit.
    It’s a nice post, with simple and effective examples.

  9. kaja Says:

    its really understood…

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