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Essential Resources and Insights to Advance Success in Organized Trade
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Your Comprehensive Guide to Organized Trade and Barter
Glossary of Barter Terminology
- Barter Systems: Are also called Trade Exchanges, Mutual Credit, or Credit Clearing Exchanges. This does not indicate any fundamental operating difference. They all act as 3rd party record keepers to facilitate trade between member businesses (SME market). They all utilize a trade credit as a medium of exchange between participating members.
- Common Currency: A universal medium of exchange used by organizations that barter (such as trade exchanges, media companies and corporate trade companies) to transact a reciprocal trade.
- Trade Dollars: The medium of exchange used between trade exchange members in place of cash in a non- reciprocal trade transaction. The IRS values a trade dollar the same as a U.S. Dollar.
- Reciprocal Trade: A trade where two parties exchange products or services of equivalent values.
- Cost of Goods: The direct cost required to replace that which is sold.
- Fixed Expenses: Those expenses of a company that remain the same regardless of the sales volume. Some of these are: rent, fixed labor, equipment costs, general overhead such as heat A/C and electricity, etc.
- Incremental Sales: Sales generated outside of the seller’s normal market share.
- Wholesale Buying Power: The ability through trade to sell products or services to new customers at a price higher than the price paid for the product or service traded and therefore to receive in return a product or service of greater value than the cash dollar costs in the item originally traded.
- The Tax Equity and Fiscal Responsibility Act of 1982: Granted third party record keeper status to trade exchanges. Mandated that all trade exchanges file a report annually with the IRS that verifies the gross amount of barter sales made by their members and required trade exchanges to send 1099B reports to each member that made barter sales in the prior year.
- Corporate Barter Companies: Work with large (often multi-national) companies and manufacturers and are a principal in the transactions. They purchase inventory with their own “trade credits”, take possession of the inventory and resell it on their own time table.
- Trade: The cashless exchange or goods and services.
- Organized Barter: Networks that utilize a common medium of exchange.
- Non-Reciprocal Trade: An indirect exchange between two or more parties, usually accomplished through a third-party broker.
- Cost of Trade Dollars: The direct cash cost incurred to use one trade dollar, usually the company’s own wholesale cost of goods.
- Variable Expenses: Those expenses of a company that increase with the increases in production or sales, such as direct labor, shipping supplies, freight, additional product costs, etc.
- Trade Velocity: The speed at which trade dollars are turned. Trade velocity is measured by how many times the trade dollars are earned and spent in a client’s account within a certain period of time.
- Barter Leverage: The difference between the cash dollar amount invested in a product or service traded and the value received in the trade.
- Gross Profit Margin: Sales minus costs of goods sold. Companies with high gross profit margins generally are more receptive to trading large volumes, and companies with low gross profit margins generally hesitate to trade in large volumes because of their substantial cash dollar investment in their trade dollar.
- Deficit: Spending more trade dollars than you have earned, therefore having a negative trade balance. See IRTA’s Advisory Memo on Deficits.
The key feature of retail barter exchanges is the third party trading element. Barter exchanges act as third party record keepers and trade facilitators between their member companies. An internally issued trade credit is used to record the sales and purchases of the members. As the members accumulate trade credits from their sales they then can spend those credits with ANY other participating member of the barter exchange.
The internet provides a simple, low cost venue for entrepreneurs to start-up a barter exchange. In addition, competition in the third-party barter software market has significantly lowed the financial barriers for entry, which has resulted in a significant increase in new barter exchange start-ups.
However, pure internet based barter exchanges have not experienced a high degree of success due to their reliance on the internet to organically put the buyers and sellers together. The last fifteen years has shown that successful barter exchanges offer a professional customer service, (“trade brokers”), who pro-actively communicate with buyers and sellers to increase transaction volume. Any retail barter exchange that does not provide pro-active brokerage services to their clients will have a difficult time growing or even maintaining status quo.
The largest concentration of retail barter exchanges is in the U.S., but Australia and New Zealand have a strong barter exchange presence and the sector is growing across the globe. China and the OIC, (through the IDB & ITFC) are examining implementing multi-tiered barter systems which would include a retail barter component.
While the clear majority of barter exchanges are structured as privately owned C-Corp’s or LLC’s. However, a recent trend favors an ownership structure based on cooperative or member owned principles. In the U.S. the relatively new “B-Corp” (Benefit Corporation) is gaining popularity as a model since it encompasses community purpose goals by focusing on social, environmental and corporate sustainability thresholds and standards.
The number of corporate barter companies worldwide has declined in the last fifteen years due to “roll-up” acquisitions of smaller companies by the larger corporate barter and media companies.
Despite there being fewer corporate barter exchanges in operation, the volume that the remaining corporate barter exchanges does annually is impressive – approximately 30% of industry volume.
Corporate barter company’s clients are large companies (often times manufacturers) with obsolete or excess inventories, under-utilized plant capacity or real estate. Corporate barter companies use their own trade corporate trade credit to purchase these inventories and use their acquired media and other acquired goods and services as well.
Many of the largest retail barter exchanges include an in-house corporate barter division as part of their services.
The following chart explains the corporate barter process:
Countertrade is the nomenclature for all forms of non-cash based transactions that have a basic “linkage” characteristic between imports and exports between countries.
Countertrade vehicles are used to alleviate issues related to non-convertible currencies or fluctuating currency values, lack of hard currency, inflation, lack of commercial credit, blocked currencies and limited export markets.
Countertrade is typically initiated by national governments and private sector exporting primary product manufacturers (PM’S).
Countertrade transactions usually take the form of barter, Counter-Purchase, Compensation trade or Offset (although some would debate whether Offset is in fact a form of countertrade).
Countertrade historically has been a very effective business tool for completing large import-export transactions that otherwise would not have occurred, but for implementation of a countertrade based solution.
Cryptocurrencies are NOT barter trade credits.
Barter trade credits are NOT crypto currencies because they are not convertible to cash nor do they have a stored value, nor is cryptography involved with trade barter credits. IRTA has obtained numerous rulings verifying that cryptocurrencies have nothing to do with the organized trade exchange industry. The U.S. barter industry that was recognized by the IRS as a legal alternative form of commerce via the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982.
The IRS’s website at irs.gov is helpful in defining digital assets and delineating the differences between barter exchange trade dollars and digital assets:
“For federal tax purposes, digital assets are treated as property. General tax principles applicable to property transactions apply to transactions using digital assets. You may be required to report your digital asset activity on your tax return.
Definition of Digital Assets
Digital assets are broadly defined as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.
Digital assets include (but are not limited to):
- Convertible virtual currency and cryptocurrency
- Stablecoins
- Non-fungible tokens (NFTs)
The danger in the proliferation of cryptocurrencies presents a threat to the barter industry due to states reviewing their financial regulations in an attempt to regulate cryptocurrencies. The risk to the barter industry is that a given jurisdiction may unknowingly re-write their regulatory language so-tightly as to restrict or even eliminate heretofore legal barter activity in a given jurisdiction. Additionally, state regulatory definition may conflict with future federal regulations – which will add another layer of confusion for the public at large.
IRTA has successfully protected the barter industry with any previous regulatory re-write situations. And IRTA will continue to pro-actively protect the legal barter industry’s interests as it relates to new proposed cryptocurrency regulatory actions.
Please see IRTA’s Advisory Memos that cover in great detail the reasons why barter trade credits are NOT cryptocurrencies, under the ‘Library” tab, and “IRTA Advisory Memos” subtab.
I. Membership Agreements
Membership agreements provide the structure and framework for the terms and conditions of membership and an exchange’s trading rules and regulations. This is the foundational business agreement that a barter firm uses.
IRTA has developed a Model Membership Agreement contract template designed for retail trade exchanges to use with their members to establish the exchange’s operating rules and regulations.
The Model Membership Agreement covers the major components of the membership relationship in reasonable detail and was drafted to be easily readable and understood. Please note that every trade exchange operates a bit differently and state law and individual situations and factors will often dictate different terms and requirements.
This sample agreement template has been developed to easily permit an exchange working with its company legal counsel to tailor the sample contract form to meet its specific needs and circumstances.
II. Use of Electronic Form Membership Terms and Conditions
Internet posting of a trade exchange’s trading terms and conditions as well as any supplementary rules and regulations provides significant advantages of easier accessibility, use and updating to relying solely on paper membership documents.
Digital membership agreement terms and conditions can be implemented by:
1. Using a short form signed paper membership application which incorporates by reference the detailed trading rules and regulations found on the exchange’s website (e.g. “by my signature below, I certify that I have read and agree to the terms and conditions posted at http://www.tradeexchange.com/rules®ulations and agree that such terms and conditions are incorporated by reference into this application/agreement”).
2. Using an all electronic digital clickwrap agreement where the applicant evidences their affirmative assent to the trading rules and regulations by clicking on an “Agree” button after they have been offered the ability to read the detailed terms and conditions online.
Many retail trade exchanges use both digital and paper forms of membership terms and conditions before moving solely to electronic posting of their trading rules and regulations.
Application of the Quantity Theory of Money to Barter Exchange Management
The purpose of this paper is to present a concept that may assist trade exchanges to determine the proper amount of trade dollars in their system to finance a given volume of trade. It may also be useful for judging the effectiveness of trade broker operations, and improving the quality of clients by enhancing their propensity to trade.
QUANTITY THEORY OF MONEY
In monetary economics, the expression MV-PQ is a formula of major significance. The formula expresses “the quantity theory of money,” which has enjoyed widespread acceptance for 200 years and is still taught in economics courses today.
The formula states the truism that the volume of trade, PQ (price times quantity, measured in dollars per year or some other unit of time) is equal to the money supply (M) times its velocity of turnover (V). V is the number of times a unit of M must turn over during the year in order to finance the volume of trade, PQ.
In the formula:
M = money supply
V = velocity of turnover, i.e., the number of times M turns over during a year in order to finance a given volume of trade
P = average price of goods and services
Q = number of units (physical quantity) of goods and services sold
Applied to the national economy, PQ is another way of expressing GNP, the total volume of all final goods and services produced and sold during the year; M is what the Federal Reserve calls M1, the amount or currency in circulation plus demand, deposits of commercial banks; and V is the velocity of circulation of M1, a variable that is regularly measured by the Federal Reserve.
Applied to a barter economy:
M = number of trade dollars in circulation, i.e., the total amount of positive balances in clients accounts and any house accounts used regularly in trading
V = velocity of turnover of trade dollars, a figure that depends on the clients’ propensity to trade and how effective trade brokers are in stimulating trades
PQ = total volume of trade per time period, measured as total sales or total purchases on the exchange, not the sum of total sales and purchases.
For example, say the total volume of trade for a barter exchange was $6 million. The exchange measures its money supply, M, as the average amount of positive balances in the hands of its members and in the exchange’s house accounts used regularly in trading during the year, and finds this amount to be $2 million trade dollars. Then the formula tells us that the velocity of circulation (V) for this exchange is 3, i.e., each trade dollar turned over an average of 3 times during the year.
Suppose the same trade exchange sets $9 million as its trading goal for the following year, a 50 percent increase over the prior year. Knowing that its velocity of circulation is 3, and anticipating no significant change in velocity due to increase in the number or skill of trade brokers, or increase in the client’s propensity to trade, it knows that the number of trade dollars in circulation should increase to $3 million ($9 million divided by 3). Given a velocity of 3, the only way a trade volume of $9 million per year can be achieved is with a money supply equal to $3 million.
MONETARY EXPANSION AND TRADE GROWTH
The process by which trade volume grows in a barter system starts with the growing needs of the buyers. Clients who want to increase their purchases of things they need will seek ways of acquiring additional trade dollars. The demand for trade dollars to finance larger purchases results in clients’ seeking additional sales and/or additional credit.
As buyers seek to acquire more trade dollars to fulfill their needs, much of the increased demand for trade dollars will be satisfied by credit expansion, which puts additional trade dollars (M) into circulation. Prudent credit expansion in the barter economy is the vehicle by which buyers obtain additional trade dollars to make their demand effective. Trade volume will then rise as buyers increase their spending to satisfy their growing needs.
In sum, the money supply in a barter system increases through credit expansion in response to buyers’ growing demand for trade dollars to spend. More total spending causes trade volume to rise. As total trade grows, the money supply in the system rises to finance the increased trade volume. Increased money supply (M) is a consequence of growing trade volume and not the other way around.
The principal way of stimulating trade growth is by stimulating buyers’ needs. Buyers’ needs increase the demand for trade dollars and cause M to expand through expansion of credit.
To illustrate, the barter exchange in our example expects to increase its total trade volume by 50 percent, from $6 to $9 million, for the current year. Assume for purposes of discussion that each client desires to increase its total spending by 50 percent. Further that during the year Client A made $50,000 in trade sales (which are the purchases of others) and $50,000 in trade purchases (which are the sales of others) in the system. (A “one sided” analysis of client A’s trade volume is then $50,000 for the year, as opposed to $100,000 as is sometimes done that actually double-counts the transactions.)
Let us assume that Client A intends to raise its total purchases to $75,000. Where will it get the trade dollars to finance these purchases if M remains constant? First, it can increase its sales to other clients. But with a fixed supply of trade dollars, the other clients will have fewer trade dollars with which to increase their spending. The only thing that will allow total trade volume to grow, if M is fixed, is for A to spend its trade dollars faster, thus putting trade dollars back into the hands of other clients who are just as eager as A to raise their sales and spending. Faster spending means increased velocity of circulation.
The formula MV-PQ confirms this result, for it tells us that, if M remains constant, the only way that trade volume PQ will rise by 50 percent is if velocity (V) rises by 50 percent.
There is another way that total trade volume can rise: M can expand while V remains constant. If A wishes to make $75,000 in purchases, it can expand its sales to $75,000, or failing that, it can borrow the difference. If A succeeds in raising its sales to $75,000, others will be short the trade dollars required to expand their own purchases, and they will have to borrow. Such borrowing by A and other clients increases M, the supply of trade dollars in the system, by the full amount of the borrowing. Thus, the demand for trade dollars by clients to finance their growing purchases leads to expansion of M through the lending power of the members who comprise the exchange, and the larger M finances a larger volume of trade.
Note: Exchanges should create a credit line matrix that provides a prudent guideline for credit extension to their members, based on the history of sales, payment history, credit score of each member and other factors. Also, see IRTA’s March 28, 2012 Advisory Memo titled “Guidelines & Recommendations for Barter Exchange Deficits” attached hereto as Addendum “A” for more detail on the types of deficits that may arise and proper fiscal management of them.
If velocity of circulation (V) is essentially stable, since it depends on the number and quality of trade brokers and the client’s propensity to trade, normally M should expand if trade volume is to rise. Holding M constant could frustrate the desire of buyers as a group to increase their total spending, for whereas a few clients may be able to increase their spending through greater sales to others, all buyers collectively will be unable to do so, since they cannot obtain the trade dollars needed to increase their spending.
In theory, because the lending power of a barter system is based upon contract (clients grant administration of their lending power to the exchange and limit any borrowing by the exchange itself), the supply of credit to the exchange’s clients is capable of expanding to fully satisfy the demand at whatever interest rate is set. In practice, however, the supply of credit must be governed by the normal canons of creditworthiness, or else an excessive number of problem loans to the clients will endanger the health of the system. (If too many clients borrow from the exchange and then go bankrupt, they leave the system with a large unsecured deficit, ie., a “System Deficit.” The remaining clients hold positive balances with reduced opportunities for exchanging them, and trade may consequently fall or stop altogether.) This creates what is known as a “System Deficit.” The prudent administration of the lending power is one of the strictest duties of management.
Credit expansion in the barter system does not require that loans be increased to each and every client. It requires only that additional credit be extended to the most creditworthy clients. The spending of these clients will put trade dollars into the hands of other clients, thereby increasing the total supply of trade dollars (M) in circulation.
PUMP PRIMING AND DEFICIT SPENDING
There is another way of increasing M, the number of trade dollars in circulation, and that is by the exchange’s making a loan to itself, rather than to its clients.
CAUTION: Unlimited access to the credit window by the exchange is a source of potential abuse that can destroy a barter system.
In principle, just as many additional trade dollars are put in circulation if the exchange purchases a certain amount of Client A’s products instead of loaning A the same amount. Where does the exchange get the trade dollars to spend? One of its options is to create them by lending to itself. It is true that all trade exchanges have significant trade dollar earnings, but they also have significant trade dollar expenses; the result is that unless management exercises prudence and maintains strict budgetary controls, more trade dollars will be spent than are earned. That is, the exchange or its owners will have recourse to the credit window. This is known as an Exchange Deficit.”
When a client requires a loan, he must apply to the exchange for approval; hence, his access to credit is limited. When the exchange requires a loan it applies, as it were, to itself, hence its access to credit is restrained by no effective power other than stipulations of the client agreement, the laws governing fraud, IRTA’s Advisory Memo on Barter Exchange Deficits, or moral self-restraint itself.
IRTA recommends that provisions be inserted in each client/member contract obligating an exchange to keep its borrowing, (ie., its “Exchange Deficit”) within prudent limits. IRTA defines “prudent limits” as no more than 2.5 to 3.0 times the monthly annual averaged trade volume of the exchange, (calculated on one side only).
Example: XYZ Exchange averages 120,000 of trading volume per month for the year. XYZ’s maximum acceptable exchange deficit would be is 360,000, (120,000 x 3).
If managed properly, an exchange’s deficit spending can be exercised to benefit, rather than cause damage to, the barter system.
As with loans to clients, the exchange’s own borrowing and spending adds new trade dollars to the quantity in circulation. To prevent excessive supply of trade dollars, the exchange’s deficit spending must be rigorously controlled. As with other loans, the exchange’s borrowing must be repaid.
The theory of pump-priming holds that, in order to stimulate a growing volume of trade, M should be expanded through deficit spending by the exchange. The idea is that placing more trade dollars in the hands of the members will encourage them to spend and trade volume will grow. This sometimes works at first, but it quickly leads the unwary exchange manager down the path of excessive deficit spending and oversupply of money to the system. This eventually causes trade volume to decline, because once their need for liquid balances is satisfied, members will accept no further trade business until they can first spend the balances they have accumulated. When all members of the system hold excess balances no one will sell, and trade volume falls to zero.
It should also be noted that excessive deficit spending normally consists of uncollateralized borrowing by the exchange, so the trade dollars in the hands of members are doubly worthless: they have no transaction value, and the exchange has no assets with which to redeem them.
The pump-priming theory has been responsible for excessive deficit spending by some barter exchanges, resulting in large trade dollar balances held by clients. Instead of stimulating trade, this situation has resulted in rapidly declining trade and eventual trade gridlock, that is, existing clients unwilling to accept further trade dollar balances. This results in cessation of trade, collapse of the exchange, and total loss of the value of balances held by clients.
The proper way to stimulate trade is through advertising and marketing of products available on trade, and an effective cadre of trade brokers. Placing more trade dollars, M, in the hands of clients, must be done prudently in concert with fiscally sound credit extension policies. There must be opportunities for increased sales of the products and services members have, and opportunities for increased purchases of the products and services they need.
APPLICATION OF THE QUANTITY THEORY TO BARTER EXCHANGE MANAGEMENT
The quantity theory of money not only brings valuable insight to the ebb and flow of trade in the barter economy, but it also has valuable management uses. These applications may be described under two general headings: monetary management and velocity management.
Monetary management helps the barter exchange to answer the question: “What is the optimum supply of trade dollars I should have in the system to finance the trade volume I expect?” In order to answer this question, the exchange should study its trading records and make the best possible estimates, based on past experience, of the velocity of circulation, V. (The methods of estimating and Projecting V are discussed below.) Since expected trade volume PQ is known, and V is known, the optimum M can then be computed by the formula:
M = PQ / V
This M is the required average amount of trade dollars to be in circulation over a year’s time. In practice, it cannot be expected to remain constant over the entire year, or be subject to precise control. Volumes have been written about the Federal Reserve’s inability to precisely control M1, the money supply of the national economy.
To approximate the optimum M in the barter economy, the trade exchange should average the M for the beginning of the year with the M for the end of the year. Thus,
OptimumM = (BeginM + EndM) / 2
Since Moptimum and Mbegin are known, the target M for the end of the year can be computed. The exchange should use this target M for the year-end as a guide to control the supply of credit to clients during the year. Any increase or decrease in the supply of credit will change M by the same amount. That is,
Δ C = Δ M
where C is the total volume of outstanding loans to the exchange and its clients.
Most credit extension in a barter system occurs by allowing clients to “spend into the negative” (that is, their accounts will show negative balances) against a pre-established line of credit. This client deficit spending adds to the supply of trade dollars in circulation. A basic principle is that credit extension increases the supply of money, and loan repayments reduce the supply of money, in the barter economy.
Thus, by regulating the amount of credit (C) extended during any time period, the total number of trade dollars in circulation at the end of the time period, i.e., the target M, can be approximated.
Velocity management helps the trade exchange answer the question, “Are my trade broker operations efficiently moving the supply of trade dollars to finance a growing trade volume through spending down the high-balance accounts, bringing the deficit accounts back to surplus, and similar trade management policies?”
Sound velocity management is a precondition to sound management of the trade dollar money supply, as an accurate estimate of V is essential before the optimum M can be calculated. Even when historical V is accurately computed, what V will be in the year ahead in light of the projected number, training, skill, and experience of the trade broker staff, and in light of the trading propensities of the clients, should be projected as realistically as possible in management’s best judgment.
To compute the average velocity (V) for any time period, the trade volume (PQ) for the period should first be determined. The average number of trade dollars in circulation, M (positive balances in Clients’ accounts and house accounts used regularly in trading) should then be estimated, either at a single point during the period or as the average of the money supply for the beginning and the ending dates of the period, that is:
AverageM = (BeginM + EndM) / 2
The average velocity during the period should then be computed using the following formula:
V = PQ / M
It is desirable to make several estimates of V over different time periods to gain an idea of the variance of this factor. This will assist in arriving at the best possible estimate of V. The exchange’s estimate of its own particular velocity of circulation is one of the most important estimates it can arrive at, as the figure can be used as a guide to expanding the volume of trade by improving trade operations and increasing clients’ propensities to trade. It is also crucial for accurately estimating the optimum supply of trade dollars (M) for the exchange, which serves as a guide for the exchange’s credit policies.
Once an historical estimate of V is made, the caliber of trade operations and the average propensity to trade of the clients during that period should be considered. As previously mentioned, trade operations can be evaluated in terms of the number, training, and experience of trade brokers. Client propensities to trade can be evaluated by a simple scaling technique, by having trade brokers rate clients on their trading initiative on a scale of one to ten. The average trading propensity for all clients can then be computed. Some exchanges periodically purge their client lists, dropping from membership those that show low trading volume or low inclination to trade. Such exercises generally serve to raise the propensity to trade in the system.
The marginal propensity to trade is a measure of the clients’ tendency to spend trade dollars, rather than maintain trade dollar reserves and idle balances. Trade dollars have value principally as a medium of exchange; they have limited use as a store of value. Nevertheless, either from lack of opportunity to obtain what is needed, or from lack of initiative, idle balances are carried while time is spent waiting to consummate trades. This obviously reduces velocity of circulation and trade volume.
If average idle balances and waiting time can be measured, these factors can be taken into account in estimating the velocity of circulation. The marginal propensity to trade is defined as the fraction of each new trade dollar that is spent within some time period, say 3, 6, 9, or 12 months. The more time that elapses, the larger the fraction that will be spent. MPT’s can be estimated for individual clients and for the exchange as a whole. The average propensity to trade is the fraction of total trade dollars in one’s account that will be spent in a given time period. APT’s may also be computed for both individual clients and the exchange as a whole.
Management actions to raise the average and marginal propensity to trade of each client will increase V and stimulate greater trade volume and profits for the exchange. Other things being equal, clients with high MPT’s are good candidates for trade credit loans and for referral of new business. Clients with low MPT’s should be worked with, educated, and provided more trading opportunities to meet their needs and raise their propensity to trade.
A higher velocity also reduces loan exposure, as a smaller amount of lending is required to achieve the optimum money supply. A high velocity means less M is needed, and a low velocity means more M is needed. If more M is needed, loan exposure is greater, because more lending is required to create the larger M.
The average Velocity (V) should be adjusted judgmentally to take into account any significant changes in trade operations and/or trading propensities anticipated in the next time period. If no significant changes are anticipated, the historical figure for average velocity should be used.
Once V is estimated, the question for management is whether it is “right” for the exchange. The best way to determine this is to compare the figure with the V’s for other exchanges. If Trade Exchange A is financing $5 million annually in trade with M of $5 million, and Trade Exchange B is financing the same trade volume with an M of $1 million, A’s velocity is 1 and B’s is 5. A could well question why its velocity is so low, and its loan exposure is so high. If industry averages were available, analysis could further pinpoint why differences in velocity occur and what management actions are dictated.
In sum, the quantity theory of money helps exchanges to better understand and manage their trade operations. It generalizes into a single formula the myriad trading activity that goes on in an exchange, and identifies relationships that might otherwise be obscured. The variables have important management applications when measured on a systematic basis and compared to similar data for other exchanges or to industry-wide averages.
PUMP PRIMING AND DEFICIT SPENDING
There is another way of increasing M, the number of trade dollars in circulation, and that is by the exchange’s making a loan to itself, rather than to its clients.
CAUTION: Unlimited access to the credit window by the exchange is a source of potential abuse that can destroy a barter system.
In principle, just as many additional trade dollars are put in circulation if the exchange purchases a certain amount of Client A’s products instead of loaning A the same amount. Where does the exchange get the trade dollars to spend? One of its options is to create them by lending to itself. It is true that all trade exchanges have significant trade dollar earnings, but they also have significant trade dollar expenses; the result is that unless management exercises prudence and maintains strict budgetary controls, more trade dollars will be spent than are earned. That is, the exchange or its owners will have recourse to the credit window. This is known as an Exchange Deficit.”
When a client requires a loan, he must apply to the exchange for approval; hence, his access to credit is limited. When the exchange requires a loan it applies, as it were, to itself, hence its access to credit is restrained by no effective power other than stipulations of the client agreement, the laws governing fraud, IRTA’s Advisory Memo on Barter Exchange Deficits, or moral self-restraint itself.
IRTA recommends that provisions be inserted in each client/member contract obligating an exchange to keep its borrowing, (ie., its “Exchange Deficit”) within prudent limits. IRTA defines “prudent limits” as no more than 2.5 to 3.0 times the monthly annual averaged trade volume of the exchange, (calculated on one side only).
Example: XYZ Exchange averages 120,000 of trading volume per month for the year. XYZ’s maximum acceptable exchange deficit would be is 360,000, (120,000 x 3).
If managed properly, an exchange’s deficit spending can be exercised to benefit, rather than cause damage to, the barter system.
As with loans to clients, the exchange’s own borrowing and spending adds new trade dollars to the quantity in circulation. To prevent excessive supply of trade dollars, the exchange’s deficit spending must be rigorously controlled. As with other loans, the exchange’s borrowing must be repaid.
The theory of pump-priming holds that, in order to stimulate a growing volume of trade, M should be expanded through deficit spending by the exchange. The idea is that placing more trade dollars in the hands of the members will encourage them to spend and trade volume will grow. This sometimes works at first, but it quickly leads the unwary exchange manager down the path of excessive deficit spending and oversupply of money to the system. This eventually causes trade volume to decline, because once their need for liquid balances is satisfied, members will accept no further trade business until they can first spend the balances they have accumulated. When all members of the system hold excess balances no one will sell, and trade volume falls to zero.
It should also be noted that excessive deficit spending normally consists of uncollateralized borrowing by the exchange, so the trade dollars in the hands of members are doubly worthless: they have no transaction value, and the exchange has no assets with which to redeem them.
The pump-priming theory has been responsible for excessive deficit spending by some barter exchanges, resulting in large trade dollar balances held by clients. Instead of stimulating trade, this situation has resulted in rapidly declining trade and eventual trade gridlock, that is, existing clients unwilling to accept further trade dollar balances. This results in cessation of trade, collapse of the exchange, and total loss of the value of balances held by clients.
The proper way to stimulate trade is through advertising and marketing of products available on trade, and an effective cadre of trade brokers. Placing more trade dollars, M, in the hands of clients, must be done prudently in concert with fiscally sound credit extension policies. There must be opportunities for increased sales of the products and services members have, and opportunities for increased purchases of the products and services they need.
The Rationale, Benefits, and Public Policy Considerations of Commercial Barter Exchanges
WHAT WOULD YOU SAY IF YOU WERE CALLED UPON TO TESTIFY BEFORE YOUR NATIONAL LEGISLATURE ON THE ECONOMIC RATIONALE FOR BARTER AND WHETHER IT SHOULD BE ENCOURAGED AS A MATTER OF PUBLIC POLICY. IN THIS THINK-PIECE, IRTA’S FOUNDER PAUL SUPLIZIO TACKLES A QUESTION THAT THE BARTER INDUSTRY MOST ANSWER AS IT CONTINUES TO GROW INTERNATIONALLY.
To understand the role of commercial barter in the modern world, let us look at barter’s role at four distinct levels: the firm, the community, and the national and international economies.
WHY BARTER IS AN EXCELLENT ALTERNATIVE FORM OF COMMERCE
Business people barter because they are able to finance the purchases of things they need out of additional sales of their own product or service. When a merchant buys something using barter credits, he knows that the purchase will be paid for by his sales to other businesses in the marketplace.
In a cash situation, the cash spent by the merchant for the same purchase would have to come out of existing sales, not new sales. He has no assurance, when he makes a cash purchase, that this will result in additional sales of his own product. His prospects for making additional sales increase when he participates in the barter marketplace, because barterers will go out of their way to buy from other barterers. This is because they are paying with their own unused inventory or spare capacity.
The economic advantages of barter hinge on the fact that barter brings in new business and conserves cash. Barter sales are an increment over and above cash sales. They are a supplement to a firm’s cash business, usually amounting to not more than 20 percent of total business. All firms can take advantage of barter to bring in new business. Those firms with spare capacity or excess inventory have strong incentives to do so.
Financing purchases through additional sales of its own product or service is often the cheapest method of finance available to a business. This is because it is paying for its purchases with the profit margin on its extra sales or unused capacity.
Incremental barter sales yield trade dollars or trade credits which may be spent with the barter company or other members of the barter system. Trade dollars are units of account denominated in dollars representing the right to receive, or the obligation to pay, in goods or services available through the barter system. These accounting units are maintained by the barter exchange, which acts as a central clearinghouse. The cost of one trade dollar is the inventory, labor, or other cost of producing an additional dollar’s worth of barter sales. A firm buys with trade dollars which cost it less than the revenue it earns from extra sales. In textbook economics, so long as incremental revenue exceeds incremental cost, there will be an economic incentive to make the extra sale.
As an example, take an auto parts supplier who does a good deal of direct mail advertising. He joins a barter exchange and notes that several printers are members. Other things being equal, he has an incentive to buy his printing from the barter printers because (a) he won’t have to reduce his cash flow for this business expense, but instead, (b) he can finance this expense out of trade dollars earned from barter sales of his own products and services to other members of the barter system, at a price that exceeds his incremental cost.
Barter aids the businessman who has reached a certain level of cash sales and still has the capacity to expand output; or who has excess inventory or unproductive assets. Few and fortunate, indeed, are the business people who, having made an investment in plant and equipment, find themselves operating at full or over-full capacity. For most firms, spare capacity and obsolescent or unused inventory are a normal occurrence, with a powerful economic plus: they permit additional sales at relatively low incremental cost.
Examples are the printer, with large sunk costs in equipment, but relatively low cost of additional output; the hotel with rooms unfilled; the dentist with time to take more patients; the radio or television station with unsold advertising. These firms are foregoing income from their unused capacity. If shown how to stimulate additional sales through barter, they have a strong incentive to make those sales as long as they can cover their costs. The price at which they can sell on barter will either be the same as the normal cash price, or as a minimum, a price greater than the cash liquidation value of inventory. Firms with high cash Inventory costs will find barter even more advantageous if they are able to receive some cash in the transaction to apply to the cost of their inventory.
Income taxes take away part of the extra profit from barter sales. However, even at the highest bracket rate, a firm makes money after taxes on its additional sales. While reducing the extra profit, the income tax should not affect a firm’s decision to make sales to reap that profit. This applies whether the additional sales are cash sales or barter sales. Since passage of the Tax Equity and Fiscal Responsibility Act of 1982 in the U.S., barter exchanges are required to report the barter income of their clients to IRS on Form l099-B.
The economic advantages of barter can be seen by comparing a firm’s position before and after barter. We see that barter results in additional revenue, hence added profit; barter enables a firm to conserve cash, resulting in better liquidity and a saving equal to the going cost of money. Firms also gain from an intangible web of referrals, advertising and associations that generate both additional cash and barter business.
The barter company’s commission charges must be included in a firm’s cost calculation, but these charges are normally not a deterrent to barter. Indeed, the largest cost a firm can experience is the income foregone by not selling on barter. In many cases, firms might find it profitable to pay an even higher commission in order to have the opportunity to reap additional profits through barter sales.
BARTER INCREASES COMMERCE WITHOUT DISPLACING PRIOR CASH BUSINESS
Barter would benefit an economic community even if the barter system consisted of firms who had previously been each other’s cash customers. This is not to say that barter sales should replace cash sales at the same selling price—they should not. But the reality is that cash sales are limited by the cash incomes of firms in the community, resulting in some firms having excess capacity. These firms do more business with each other if they can barter because of their ability to (1) make additional sales out of excess capacity, earning “new” money in the form of trade credits, and (2) paying for what they buy with these additional trade credits whose cost to them is the incremental cost of their own product or service.
Establishing a barter exchange results over-all in new business for the community rather than displacement of pre-existing cash business. This conclusion stems from the existence of surplus inventory or excess capacity in the cash economy, and the ability of firms to make extra sales and earning “new” money in the form of trade credits. The new money supply adds to the cash money supply, and the extra liquidity finances a higher level of real trade.
BARTER AND THE NATIONAL AND INTERNATIONAL ECONOMY
By increasing demand for final goods and services in an economy, barter generates additional employment, production, and purchasing power. It results in a higher rate of capacity utilization, and enables firms to spread their overhead costs over more units of output, thereby reducing average costs and lessening inflationary pressures. Textbook economics tells us that when an economy is operating at full capacity, costs shoot up dramatically because of resource shortages and bottlenecks. But it is clear that there is a range between current capacity utilization (about 80 percent in the U.S.) and full capacity within which firms can expand output at constant or even declining cost. It is within this range that commercial barter transactions take place.
The reality is that a modern economy lacks a fully elastic currency, capable of expanding with the growth of production and providing the liquidity needed to clear product and service markets. Because monetary fluctuations have contributed to economic instability in the past, a nation’s money supply is not permitted to expand to meet the demand for money to finance an increase in gross domestic product. Instead, the money supply is controlled by monetary authorities who have their eyes fixed on particular economic objectives: curbing inflation, ensuring full employment, protecting the value of the currency in foreign exchange markets, and so on. Balancing between these sometimes conflicting objectives often leads in advanced economies to a policy of monetary restriction. This restrains the flow of spending in the cash economy, limiting demand for output, and creating excess capacity.
Barter and its modern counterpart, the creation of trade credit to finance greater demand for goods and services, helps alleviate monetary stringency, puts unutilized capacity to work, and speeds up the flow of goods and services to their most productive uses. It thus adds an important measure of flexibility to the trade and payments system and market adjustment mechanisms of the domestic and international economies at a period in history when global economic organization is undergoing a dramatic restructuring. Commercial barter should therefore, as a matter of public policy, be encouraged.
Legal Liability for Trade Dollars in a Barter Exchange
Trade dollars are defined by modern commercial barter exchanges as “a unit of account denoting the right to receive, or the obligation
to pay, in goods or services available within a barter system.” This “valuable right” is founded on the contract between a trade exchange and its clients whereby clients agree to accept trade dollars in payment for goods and services. In the U.S., written pronouncements of the highest accounting and tax authorities have likewise held that trade dollars are a “valuable right.” Therefore, trade dollars are assets to their owners.
If trade dollars are assets, they must be the liability of someone. Many people unfamiliar with the barter industry, including some traders, believe trade dollars are the liability of the barter exchange which manages the barter system. That this notion is erroneous can be readily demonstrated.
A barter system is a network of reciprocal trading partners. This network is established by written contract between the barter exchange and its members. This written agreement establishes, among other things, the terms and procedures whereby members make purchases and sales to and from each other. When sellers accept trade dollars in payment, they are extending credit to the other members of the network. The other members collectively have the obligation to fulfill the trade dollars of any member by selling goods and services to the member.
If businessperson A goes to businessperson B and purchases the product or service of B “on account”, B has extended credit to A. In commercial law this is known as “open book credit”. B simply records on his books a receivable due from A.
A commercial barter exchange is based on the same idea, except that, rather than B’s doing the bookkeeping, the barter exchange acts as a third-party record keeper for all parties who join the barter system. The barter exchange keeps the books which reflects the purchases and sales of the members. The advantage of this system is that it enables multilateral trade to take place, therefore overcoming the disadvantages of conventional two-party barter.
In a barter exchange, A purchases from B, paying with trade dollars. B has extended credit to the members collectively, because the barter is incomplete and B has not yet been paid in goods and services. B may spend his trade dollars with anyone, looking to members as a group to provide him with fulfillment goods and services.
In sum, members who hold trade dollars (have net positive balances) are collectively owed goods and services by those who have borrowed from the system (have net negative balances). The legal liability to fulfill trade dollars rests on the members collectively who owe the system. Trade dollars are not the liability of the exchange, but of all members (including, perhaps, the exchange) who have spent more trade dollars than they have earned, and have thus borrowed from the system.
As trade dollars circulate throughout the system, and the debtor or creditor status of the membership continually changes, no single debtor (including the barter exchange) can be singled out as the liable party for any particular trade dollars. All that can be said is that the debtor members collectively owe the creditor members collectively.
Thus, legal liability for the fulfillment of trade dollars lies with the network of members, specifically with those who are in deficit in their account and owe goods and services to others in the barter system. The soundness of the trade economy depends on the creditworthiness of the debtor members and their contractual obligation to repay. It is expected that they repay their borrowing by making sales of their product or service to other members, thereby earning trade dollars and liquidating their indebtedness. If they fail to repay, loan losses must be absorbed by the entire barter network. This is done by charging a loan loss reserve account, which is owned not by the barter exchange but by the members of the barter network collectively. Loan losses reduce the supply of goods and services available within the trade system, and must be controlled through prudent credit extension.
Trade dollars have value because of the willingness and obligation of the members of the barter network to accept them as a means of payment and hold trade dollar balances. Members consent to accept and hold trade dollars because of their confidence that they are exchangeable for goods and services. Trade dollars are “backed” by (1) the goods and services of members of the barter network who have a contractual obligation to accept them as payment up to the prescribed limit, and (2) the obligation of the members who owe trade dollars to repay their debt.
Over time, some members may increase their borrowing to finance larger purchases. In this way, the number of trade dollars in circulation expands to finance a larger volume of trade. The legal liability to fulfill the outstanding trade dollars rests, as always, with the debtor members of the system. The loan loss reserve established by the exchange, through deduction from each member’s account, ensures there are at all times sufficient trade dollars to pay the indebtedness of the doubtful accounts.
A barter exchange is not like a commercial bank, which makes commercial loans and is liable for all demand deposits. A barter exchange does not extend credit, the members who accept trade dollars do. A barter exchange, as one of the members of the barter system, is liable only for its own borrowing (if any) and not for all the trade dollars in the system. The amount of borrowing by a barter exchange is limited by the members through the contracts in use in the barter industry.
In sum, the legal liability of redemption in goods and services of trade dollars in a barter system lies with the debtor members collectively. A barter exchange may or may not be a debtor member, and is liable only to the extent of its own borrowing. A barter exchange does not extend credit, only the members of the network collectively do. The exchange has a managerial role in the extension of credit among members, verifying creditworthiness, collecting delinquencies, etc., but has no credit-extending power of its own.
Character, Use, and Valuation of Trade Dollars in the U.S.
CHARACTER AND USE OF TRADE DOLLARS
Trade dollars arise in the course of barter trade between buyers and sellers who are organized into a network of trading partners by means of written agreement with a company known as a barter exchange. Section 6045 of the Internal Revenue Code defines the term “barter exchange” as follows:
“The term ‘barter exchange’ means any person with members or clients that contract either with each other or with such person to trade or barter property or services either directly or through such person.”
A barter exchange/member contract that organizes the barter network and establishes the terms and conditions of trade is executed by each client with the barter exchange. Under the terms of a typical contract, the client agrees to make available a certain dollar amount of goods or services for barter trade with other clients and with the exchange. In so doing, they agree to accept a specified minimum amount of barter business by selling goods or services in return for payment received in the form of trade dollars.
As defined by the International Reciprocal Trade Association, a trade dollar is a unit of account that denotes the right to receive, or the obligation to pay, one U.S. dollar’s worth of goods or services available within a barter system. (The terms “barter network” and “barter system” are identical). The Treasury Department has recognized the existence o f trade dollars in Treasure Regulations T.D. 7873 (26 CFR part 1) issued March 11, 1983: “Property or services are exchanged through a barter exchange if payment for property or services is made by means of a credit on the books of the barter exchange or scrip issued by the barter exchange or if the barter exchange arranges a direct exchange of property or services among its members or clients or exchanges property or services with a member or client.” The fact that a credit on the books of the exchange is linked in the same sentence with a direct exchange of property or services indicates the essential equivalence of the two transaction in the eyes of this authority. Where credit is given on the books of the exchange, payment is to be made by delivery of goods or services in the future, rather than in the present as occurs in a direct exchange.
In the cash economy, when a sale is made and payment is deferred, there is an extension of credit from seller to buyer. In a barter network, when a sale is made and payment (in goods or services) is deferred, there is likewise an extension of credit by the seller. Under the exchange agreement, sellers accept trade dollars as payment and look to the other participants in the barter network collectively to fulfill their trade dollars.
At any point in time within a barter network, some participants will be net creditors, that is, holders of trade dollars. They have given up greater value than they have received in goods and services, and so they hold the balance as an asset or claim on goods or services available from the system. They are said to be in a positive or surplus position in their account. Other participants will be net debtors, that is, they will have spent more than their earnings and will owe trade dollars. They are said to be in a negative or deficit position.
Trade dollar assets are the liabilities of debtor members collectively, that is they are liabilities of those members who owe the system. It is axiomatic that barter assets and liabilities should always balance, that is, for every trade dollar outstanding there is a contractual obligation imposed on debtor members of the network to make available a U.S. dollar’s worth of fulfillment goods and services. When the system balances perfectly, it is known as
a “zero-based system.”
The Internal Revenue Service has analyzed barter exchanges to determine whether trade dollars received in payment constitute income. In Revenue Ruling 80-52, IRS promulgated the “valuable right” doctrine. Under this doctrine, trade dollars are a “valuable right” and receipt of trade dollars as payment constitutes receipt of income. Promulgation of the “valuable right” doctrine supports IRTA’s view that trade dollars constitute real claims upon valuable goods and services available from the members of the barter system. This capability is underpinned by the exchange agreement and by the debtor-creditor relationship established among the members, and between the exchange and its members, in the course of executing numerous barter transactions daily. Trade dollar assets are offset by an equal number of trade dollar liabilities, that is, an unqualified obligation of debtors within the exchange network to pay in goods and services an amount certain (valued in U.S. dollars) by a date certain.
Writing in Minnesota Law Review, Vol. 67:441, 1982, Professor Robert I. Keller states in “The Taxation of Barter Transactions”:
“Trade units, however, represent more than the mere promise of the individual member for whom the taxpayer
performed services or to whom he or she sold goods. Rather, each trade unit represents the promise of the entire exchange membership, as a group, to allow the recipient of the unit to use it to acquire the goods and services offered by the membership. Moreover, at least in the case of the established exchanges, these promises represented by trade units, are readily assignable or transferable to other members of the trade exchange.” (p.494)
Concerning the exchange’s own use of trade dollars, Professor Keller writes:
“It is in its capacity as broker that the Exchange receives commission from members. Any commissions the Exchange receives in trade units it can use in the same manner as any member to acquire goods and services within the system. The Exchange may use the goods and services it acquires from its members for its own business purposes or may transfer them to the individual shareholders, proprietors, or partners of the Exchange to be used by them for personal purposes. Frequently, however, Exchanges use their trade units to acquire merchandise which is maintained in the showrooms and warehouses of the Exchange for retrade to members. This results in the Exchange’s second role as a trader of goods.
To the extent the Exchange sells the acquired merchandise for the same number of trade units it paid for them, it simply acts as a clearing house for members’ goods. Nevertheless, the Exchange clearly benefits from this activity. Most importantly, by acquiring members’ goods for trade units, the Exchange keeps units circulating and thereby maintains an active barter economy. Also, to the extent the Exchange succeeds in re-trading the acquired goods to members, the Exchange earns additional commissions.”
As a participant in the barter system, the exchange earns trade dollars through commissions and profits on sale of goods and services to the other participants. Clearly, the trade dollars earned by the exchange represent a valuable claim on the goods and services of other members of the barter system. These members may be those seeking to earn trade dollars to repay their debt, or those seeking additional sales to increase their stock of trade dollars. In preparing the exchange’s financial statements, it would seem inappropriate, even irresponsible, to fail to account for the exchange’s trade dollar assets, liabilities, receipts, and expenditures.
VALUATION AND ACCOUNTING FOR TRADE DOLLARS
The U.S. Government, in Treasury Regulation T.D. 7873 cited above, addresses the question of trade dollar valuation as follows: “The amount received by a member or client in an exchange includes cash received, the fair market value of any property or services received, and the fair market value of any credits to the account of the member or client in a subsequent exchange of credits or scrip. For purposes of this section, the fair market value of a credit or scrip is the value assigned to such credit or scrip by the issuing barter exchange for the purpose of exchanges unless the Commissioner requires the use of a different value that the Commissioner determines more accurately reflects fair market value.”
In requiring trade exchanges to set the value of their trade dollar for all participants in the barter system, and to set that value at the amount (in dollars) used “for purpose of exchanges”, the U.S.Treasury was following an approach recommended by Professor Keller. Professor Keller called his method of valuation the “medium of exchange” approach and describes it as follows:
“The value of a trade unit should be determined by what it can buy within the exchange, and not the cash price for which it can be purchased or sold. By analogy, if a U.S. taxpayer receives foreign currency, usable within the foreign country to acquire goods and services, but not readily convertible into U.S. dollars, an informal market often develops, in which the taxpayer can sell the foreign currency to U.S. citizens wishing to invest or spend the currency in the foreign country. In such circumstances, it would be clearly improper to value the currency at the dollar amount realizable in the United States, since “the dollar amount realizable in the United States might be but a fraction of the dollar value of the property…which the foreign income would buy in the foreign country.” Since trade units are the equivalent of a foreign currency, they too should be valued by their “purchasing power” within the trade exchange, and not by what they would bring in a cash sale…
“The more appropriate approach, both as a matter of substantive law and from the viewpoint of administrative convenience, would be one that treats trade units, when used to acquire goods and services, as a medium of exchange. Under this approach, the goods and services acquired would be conclusively assumed to be equal in value to that of the trade units used to acquire them. Good deals and bad deals would simply be ignored. The taxpayer would, in effect, be treated as receiving the average value of the goods and services a trade unit could buy, which, absent exchange fluctuation, would be the same amount the taxpayer took into income on receipt of the unit. Assuming that there is indeed no change in the value of the trade unit itself from the time of acquisition to the time of disposition, this approach would result in no gain or loss to the taxpayer on the disposition of trade units, and produce tax deductions, if deductible business goods and services were acquired, equal to the value of
the units used.”
The basic accounting doctrine for barter exchanges is set forth in Accounting Principles Board Opinion Number 29, “Accounting for Non-Monetary Transactions.” This document was issued in 1972 by the predecessor to the current Financial Accounting Standards Board. It is an authoritative pronouncement of the accounting profession.
Bost and Yeakel (Management Accounting, December 1992) summarize the basic tenets of APB 29 as follows:
“APB Opinion No. 29, Accounting for Nonmonetary Transactions, defines nonmonetary assets and liabilities as those which are not fixed in terms of units of currency by contract or otherwise. With these transactions, questions may arise due to the subjectivity in valuation of an asset received or resulting liability, or the recognition of any gain or loss on the transaction. The Opinion states that the cost of a nonmonetary asset should be recorded at the fair value of the asset surrendered to obtain it. Any difference in fair value and book value given is recognized as a gain or loss. If fair value of the asset received is clearer than that of the asset given, the former should be used in valuation. Fair value should equal estimated realizable value for cash transactions involving same or similar assets, quoted market prices, independent appraisal, estimated fair value of merchandise or service received in exchange, or other available evidence. No gains should be recognized if fair value is not determinable within reasonable limits or if an exchange is not the culmination of an earnings process, such as exchanges of similar productive assets. Disclosures are required on the nature of the transaction, the basis of accounting, and any gains or losses
recognized.”
It should be stressed that “Fair value should equal estimated realizable value for cash transactions involving same or similar assets, quoted market prices, independent appraisal, estimated fair value of merchandise or services received in exchange, or other available evidence.”
In light of the foregoing authorities, the sole issue is the validity of the International Reciprocal Trade Association’s position, which expresses the view of the leading members of the commercial barter industry, that the value of a trade dollar in an operating commercial barter exchange (one that executes above 1,000 transactions per year) is, on average, equal to one U.S. Dollar. IRTA’s position asserts that one trade dollar equals one U.S. dollar not because the barter industry has arbitrarily assigned this value, set it for administrative convenience or simplicity, or established it for tax compliance purposes, but that the value of a trade dollar is in fact one U.S. dollar, on average over a broad range of transactions executed through a commercial barter exchange.
The key to this proposition is that, while trade dollars are indeed a unit of account and a medium of exchange within a barter system, the prices of goods and services bought and sold are denominated entirely in U.S. dollars. This means the trade dollar is a unit of account, but not a standard of value. A trade dollar has meaning in value terms only by reference to the U.S. dollar prices of the goods and services it can purchase. U.S. dollar prices are the same for the barter system as for the cash system under the terms of the contract between the exchange and its clients, and in actual practice for the vast bulk of trades. In algebraic terms, the larger the number of transactions considered, the more the value of the trade dollar will approach one U.S. dollar as a limit.
The trade dollar is a unit that has no intrinsic value, because prices set in trade dollars would be meaningless and, in fact, are non-existent. Prices are set only in U.S. dollars, and the number of trade dollars given or received is determined entirely by U.S. dollar prices and quantity. Put another way, a trade dollar is a financial unit of identical value to a cash dollar, except that a trade dollar is redeemable only by a dollar’s worth of goods and services and not by cash.
The crucial role of U.S. dollar prices as the standard of value in the barter economy means that, on average, across thousands of transactions, the value of trade dollars spent within the barter system is one U.S. dollar. While in particular cases there can be a variance between cash and trade dollar prices, in the vast majority of transactions these prices are the same.
To properly depict the financial results of barter transactions in financial statements, IRTA is persuaded that the trade dollar should be valued as a medium of exchange rather than looking at its value in discrete transactions. The latter approach would considerably magnify and complicate the accounting process, with little attendant benefit. It can be demonstrated empirically that the value of a trade dollar as a medium of exchange (the average value for a large number of transactions) is one U.S. dollar.
TRADE DOLLARS ARE A MEDIUM OF EXCHANGE
The medium of exchange for barter transactions is no more nor less in value than the U.S. dollar. But this is not to say that the two currencies are of equal utility for commerce. The supply of one is controlled by government, the other is privately-created and capable of expanding with trade. The value of one erodes steadily with inflation, but the trade dollar can realize constant-purchasing power by means of an annual price level adjustment applied to each deposit. The trade dollars required to pay for this adjustment can be obtained by transfer from debtors, or by a small levy on the gains from trade.
Trade dollars are a medium of exchange or currency within the barter system, not within the U.S. economy. They represent a claim on the ascertainable goods and services available from members’ in the barter system, who are obligated by contract to make a specified portion of their goods/services available for trade upon demand, and who willingly accept trade dollars and seek to acquire them to finance their purchases.
True, unlike lawful currency, trade dollars are not claims on the gross national product. But a trade dollar nonetheless represents a legal claim for a U.S. dollar’s worth of real goods and services. The fact that the claim is on a specific subset of firms in the economy, and not on the economy at large, has little relevance. All that matters is that the owners of trade dollars hold legally binding claims against others—not just a single firm but the entire group of firms who comprise the barter network. This lends solidity to the contractual promise to provide goods and services to the holders of trade dollars on demand.
Trade dollars are a form of privately-created medium of exchange, based upon contract. They are not lawful currency of the United States, but this does not mean that their financial consequences can be ignored in the preparation of financial statements. Under APB 29, as a general rule the financial consequences of a contract for non-monetary exchange can and should be valued. The IRS holds that only in rare and exceptional cases can a non-monetary transaction not be valued for tax purposes.
Under APB 29, in general an exchange of non-monetary assets is assumed to culminate an earnings process, so that gain, loss, and income should be currently recognized. Deferring recognition to a later period could significantly distort the financial picture, especially for a company that engages in a large number of transactions on a daily basis.
Proper Reporting of Assets and Liabilities of the Managing Exchange
Background
When the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) classified barter exchanges as third-party record keepers it required barter exchanges to adhere to the same IRS 1099B reporting requirements that banks and investment firms follow. However, the fundamental legal debtor/creditor relationship in a barter exchange differs from what exists in the commercial banking and investment firm sector. These differences have caused confusion in the barter industry regarding two specific areas:
- The proper reporting of assets and liabilities of the managing exchange vs. the exchange members.
- IRS 1099 Reporting Requirements Regarding Exchange Members’ Bad Debt Trade Accounts.
This Advisory Memo will review the history and legal precedent of these issues and provide guidance for handling both. IRTA’s guidance on these topics is further substantiated by a December 2nd, 2016 professional opinion from the accounting firm of Manning Silverman & Company, (attached as Addendum “A”).
In October of 1989 IRTA issued guidance regarding asset and liability recognition of the managing exchange vs. the exchange members – with the release of a model managing exchange “Balance Sheet” and a model “Statement of Condition” of exchange members, (attached as Addendum “B & C”).
NOTE: The managing exchange, (i.e., the barter exchange), is typically an incorporated entity, be it a C-Corp, Limited Partnership or Sub-Chapter S Corporation. The managing exchange balance sheet reflects the company’s assets and liabilities. In most cases the members of the exchange are not a separate corporate entity, rather, the members have signed a membership agreement with the managing exchange that articulates their rights and obligations, and grants the managing exchange various third-party record keeping responsibilities. Although the exchange members are not an incorporated entity per se, the exchange members collectively have their own assets and liabilities. Because the exchange members typically are not an incorporated entity, their financial report for their assets and liabilities, (which resembles a balance sheet), is called a “Statement of Condition,” (Addendum “C).
The Statement of Condition of the exchange member system, (Addendum “C”) clearly categorizes the members’ negative trade balances as assets and the members’ positive trade balances as liabilities. The exchange members’ positive and negative trade balances ARE NOT recorded as assets or liabilities on the managing exchange’s balance sheet, (Addendum “B”). Furthermore, trade loans between the members are only listed on the exchange members’ Statement of Condition, and ARE NOT listed on the managing exchange’s balance sheet.
The Exchange Enterprise v. Commissioner decision of 1987, (see Addendum “D”), further underscores the separation between the managing exchange’s books and the books of the exchange members themselves. Exchange Enterprises ruled that the managing could not take the bad debt write-offs of members’ accounts on the managing exchange’s tax return. The court ruled the managing exchange was not a guarantor of the members’ system and did not have any basis for the trade amount they attempted to write-off. The court went on to say, “The members’ trading accounts have no direct relationship to the Exchange’s books of accounts…the members’ accounts represent a separate system which reflect trade balances.”
The Exchange Enterprise decision recognized the lack of a “transactional relationship” between the managing exchange and the exchange members, and it noted the effect of closing negative trade balance accounts, when it said:
“Although Exchange was responsible for the overall management of the barter system, it was not a guarantor of the system. The act of closing out the debit and credit balances of members to Exchange’s books did not cause Exchange to have “paid or incurred” expenses in operating the barter exchange business. The lack of a transactional relationship between the members’ accounts and Exchange’s books of accounts renders meaningless the act of closing out the balances. Exchange, in its business capacity, is neither directly enriched by credit balances nor caused detriment by debit balance of other members’ trading accounts.”
IRTA’s 1989 model “Statement of Condition” of the exchange members’ system and the model managing exchange’s “Balance Sheet” were reviewed by Manning Silverman & Company on December 2, 2016 and were determined to be an accurate outline of the proper accounting for the assets and liabilities of both systems.
Managing Exchange’s Approaches to Defaulted Negative Trade Accounts of Exchange Members – Manning Silverman and Company Recommendations
Typically, when a managing exchange determines a member’s negative trade balance is in default, the managing exchange will close-out the account by entering a “purchase” from its “Bad-Debt Reserve” trade account and a “sale” from the defaulted member’s trade account, so as to effectively zero-out the account, (assuming the managing exchange has created and funded a bad-debt reserve account). The bad-debt reserve account entry on the exchange’s computer software will normally automatically generate a 1099B for the defaulted exchange member company, (unless the exchange specifically set the software to not generate a 1099B).
Other managing exchanges have handled the matter differently, by going through a debt forgiveness process whereby the defaulted negative trade balance member is issued a 1099C. Alternatively, other managing exchanges do not issue 1099’s in defaulted negative trade balance situations at all.
Manning Silverman & Company’s, (see attached Addendum “A”) guidance recommends managing exchanges should send 1099B’s in defaulted negative trade balance situations.
Manning Silverman & Company was also asked whether the managing exchange’s issuance of a 1099B for a defaulted negative trade balance create a nexus between the managing exchange and the exchange members, sufficient to create a debtor-creditor relationship.
Manning Silverman & Company’s opinion states that the managing exchange’s issuance of the 1099B for a defaulted members’ negative trade balance DOES NOT “establish a creditor-debtor relationship between the client/members’ and the solo (managing) exchange, IRC Sec. 6045 (a); Reg. Secs 1.6045(c), 1.6045(e).
Manning Silverman & Company’s conclusions are consistent with IRTA’s emphasis that a managing exchange’s third-party record keeping role and tax compliance responsibilities are paramount, and that the trade dollar lending is done collectively between the members. Therefore no debtor-creditor nexus is inferred or created between the managing exchange and the exchange members.
Background – 1099B Reporting of Bad Debt Accounts
The longstanding IRTA axiom that “the legal liability of redemption of goods and services of trade dollars in a (member) barter system lies with the debtor members collectively. A (managing) barter exchange does not extend credit, the client/members who accept trade dollars do,” (see Addendum “E” – IRTA’s Advisory Memo of March 3, 2014, titled “Legal Liability for Trade Dollars in a Barter Exchange”). This important axiom further supports IRTA’s position that the managing barter exchange “is not like a commercial bank, which makes loans and is liable for demand deposits,” and therefore managing exchanges are not subject to banking regulations.
Manning Silverman & Company’s December 2, 2016 opinion letter further supports IRTA’s axiom that trade dollar lending takes place collectively between the exchange members when it states:
“The legal liability of redemption of goods and services of trade dollars in a barter system lies with the debtor members collectively. The exchange has a managerial role in the extension of credit among members, verifying creditworthiness, collecting delinquencies, etc., but has no credit-extending power of its own.”
While TEFRA clearly recognized barter exchanges as third-party record-keepers and mandated exchanges provide IRS 1099B reporting for the barter sales of the exchange’s client/members, TEFRA did not address what a managing exchange’s reporting responsibilities are when the exchange members’ deficit trade accounts are deemed to be a bad debt.