Chapter 3 The Role of Accounting Systems in the Ordinary Course

• Jurisdiction: United States

Chapter 3 The Role of Accounting Systems in the Ordinary Course

As detailed in Chapters 1 and 2, the evaluation of whether a transfer was made in the ordinary course (subjectively or objectively) is based on several factors. Of the five factors typically considered by courts in assessing if payments between the parties were ordinary (the subjective test), four can be directly impacted by information maintained by accounting, finance or credit departments:⁷⁰

(1) whether the subject transfers were in an amount more than usually paid;
(2) whether the payments were tendered in a different manner as compared to past practices;
(3) whether the debtor or creditor engaged in unusual collection or payment activity; and
(4) whether the creditor took advantage of the debtor's deteriorating financial condition.⁷¹

Ultimately, an actual payment is the result of the actions of people and is often the result of those people following certain routine or common practices, guidelines or internal corporate policies. As such, it is helpful when evaluating historical transfers to understand how the relevant information is gathered and maintained in business accounting records and systems, as well as how corporate credit management departments operate. This can be relevant not only for gathering the appropriate information, but also for evaluating whether the payments were "ordinary" with respect to timing as well as business process.

Due to the delay between the bankruptcy filing and the initiation of a preference action, often the books and records of either the creditor or the debtor may not be available or may not have been adequately maintained subsequent to the transfers. Further, a number of the key accounts payable or accounts receivable personnel that had the most intimate knowledge of the relationship between the creditor and debtor may no longer be employed by the company. If the company utilizes a unique or customized accounting platform that is managed by one or several key people, gathering data from this system may be challenging in their absence. These factors may limit the ability to obtain certain data and the completeness of the books and records available from either the debtor or the creditor.

Recognizing the challenges and limitations that these factors pose in certain cases, the first step in analyzing whether payments were preferential (under both the subjective and objective tests) is often simply to determine the extent of information available from the debtor and creditor. Such data may include information from each of the companies' books and records regarding characteristics for the payments in question as well as for other non-preference period transfers. As described below, as companies increasingly utilize electronic systems with certain automated characteristics, the "books and records" often are not physical paper ledgers and invoices but rather electronic records of invoices, wire transfers, accounts payable and accounts receivable. The timing and execution of the processes impacting the formation of these books and records can be an important consideration in understanding the historical relationship between the parties and the timing of transfers.

General Statistics

Below is a sampling of survey responses provided by Analyze-This-Business.com, a global financial analysis and benchmarking business that provides reports and statistics for a wide array of business topics. The distribution of responses to the questions detailed below exemplifies the variability in the approaches businesses take to basic credit management functions.

• Before a client is provided with an "open account," is there any discussion with them regarding payment terms and expectations? Percentage that indicated "Yes":⁷²

° 2008: 43%
° 2009: 41%
° 2010: 47%
° 2011: 47%

• Does the company or business offer clients a "Prompt Payment Discount"? Percentage that indicated "Yes":⁷³

° 2008: 46%
° 2009: 50%
° 2010: 49%
° 2011: 44%

• Is there an established, defined process for communicating with customers and clients as their outstanding invoices age, for example, at 30, 60, 90 days and beyond? Percentage that indicated "Yes":⁷⁴

° 2008: 77%
° 2009: 81%
° 2010: 82%
° 2011: 74%

It is interesting to note that this data often varies across industries, geographies and company size. For example, a greater number of large companies answered "Yes" to the first question than did small companies (63% for large companies as compared to 44% for small companies in 2011). This underscores the importance of assessing information that is comparable and most relevant to the circumstances in any matter, recognizing the limitations of the data that may be available. It is important to inquire about processes and procedures as well as actual payment information, if possible.

The varied responses illustrated above also provide an indication of the challenge in precisely defining "ordinary." The data above indicates that 20-25% of businesses may not have a defined process for communicating with customers regarding outstanding receivables and that more than 50% of companies may not discuss payment expectations with new customers. In this chapter and the chapters that follow, we will further discuss the forms of information that may be helpful in overcoming these challenges.

Processes and Documents

Typically, before a single payment is ever made on an invoice, a sale must first occur. A sale will typically be the result of a customer seeking to obtain a good or service and a provider offering that good or service. In the modern world, many payments are not made immediately to the seller. That is, the seller agrees to receive payment at a later date. As customers enter into contracts for the ongoing supply of product or services, it becomes reasonable for the parties to have a relationship in which all amounts are not paid immediately. This is commonly referred to as the "extension of credit."

A company will often dedicate personnel within its accounting or finance departments to monitor those relationships in which a customer has been extended credit. The terms of the credit relationship may differ from one customer to another depending on the negotiations between the parties. Once the credit relationship has been established (formally or informally), personnel on either side of the transaction (seller and buyer) will typically monitor the relationship (invoicing and payment — accounts receivable and accounts payable). As a business grows, the number of personnel dedicated to monitoring credit relationships will increase. In large companies, a credit department is established, and if warranted, individual personnel will be dedicated to single customer relationships for purposes of monitoring payment and resolving concerns, disputes or other issues.

Following is an example detailing several of the roles and responsibilities of accounting or credit management professionals.

Day 1 Purchase Order	?	Day 3 Invoicing	?	Day 3 - 5 Invoice Processing
Purchase Order sent from Customer to Supplier Indicating Quantity, Price, and Key Terms		Seller Prepares Goods for Sale and Issues Invoice to Customer		Invoice is Documented by Buyer and Seller and Processed by Both Parties
Days 5 -10 Invoice Adjustments	?	Days 10-35* Invoice Outstanding	?	Day 35 * Payment
Credits, Debits, Returns and Other Adjustments Documented and Approved as Necessary		Invoice Remains Open for a Period of Time Prior to Payment		Payment Made by Buyer, Subject to the Parties' Payment and Credit Terms

*Note: This is a hypothetical example assuming 30-day payment terms.

Purchase Order Creation (Buyer)

A purchase order will be generated by a customer that notifies a seller of its intent to purchase certain goods and services. A purchase order can take several forms. In certain instances, a purchase order will not identify a specific quantity of parts, but will simply indicate that the buyer is planning to purchase at the stated price as its needs arise. In other instances, a purchase order will offer specific volumes, delivery dates and prices. In addition to quantity and price, a purchase order will also often indicate other terms that the buyer proposes regarding such items as credit terms, nonconform-ing goods, returns, duration and termination. In understanding the credit relationship between buyer and seller, it can also be important to consider the other terms and conditions in the purchase order and whether the seller accepted those terms.

Invoice Creation and Transmission (Seller)

When the seller provides the requested goods or services, it may also provide an invoice indicating date of delivery, date of the invoice, a description of the goods or services provided, a unit price, payment terms, shipping terms and the total invoice amount. This will typically be created by the accounting system utilized by the seller, which will simultaneously create an accounts receivable entry. The invoice is then transmitted to the buyer, who is thereby informed of the seller's expectations regarding payment timing, amount and other terms. With the increasing use of electronic accounting systems, email and data exchanges, often paper invoices will not be generated, printed and mailed to the buyer. Rather, an email notification or electronic data system entry will be made to notify the buyer of these terms. Similarly, while businesses of a certain size or sophistication may still maintain traditional accounts payable and accounts receivable vendor files in which purchase orders, invoices and payments are all matched, this is increasingly done only through electronic system updates.

Invoice Processing (Buyer)

After an invoice is transmitted to the buyer, the seller continues to monitor the invoice until payment. The buyer typically records the receipt of the invoice, a process that can require several steps. For example, in a manufacturing...