Electronic Check Conversion in the U.S.

Originally Published May-27-2007 

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An Update and An Overview

On March 16, 2007, a new standard for converting checks into electronic form for processing through the Automated Clearing House (ACH) system went into effect for U.S. businesses. Referred to as Back Office Conversion (BOC), this latest development represents one more step in the inexorable movement toward a paperless e-conomy.

History of Electronic Payments

The migration toward electronic payment began in the early 1970s with the introduction of direct deposit payroll and Social Security benefits via local private and government Automated Clearing House (ACH) networks. In 1978, these local ACH networks were linked into a nationwide system through the efforts of the Federal Reserve and NACHA (the National Automated Clearing House Association). Since the mid-1990s the volume of paper checks has been gradually declining in favor of electronic payments.

The development of electronic payments was driven by the desire of government, businesses and consumers to make payment processes more secure and efficient. The advent of digital technology provided the means to achieve these goals. And, as they say, the rest is history. According to NACHA, the ACH network volume has doubled in the last five years to nearly 14 billion ACH payments in 2005. Much of this growth was due to check conversion applications.

Check Conversion

Check conversion, sometimes called “electronic checks” or “e-checks”, is a process of converting paper checks into electronic debits. It was introduced in 1999 to utilize the same ACH network that had been used for direct deposit and direct payment transactions for more than 25 years.

As of March this year, there are three types of ACH check conversion applications:

1. POP – Point of Purchase, available in September 2000
2. ARC – Accounts Receivable Entries, introduced in March 2002
3. BOC – Back Office Conversion, in effect as of March 16, 2007

All three were developed:

• To reduce handling and transport required for paper check processing.
• To reduce the costs of processing payments.
• To accelerate payment processing time.
• To lessen the opportunity for loss and fraud.

All three check conversion systems apply to checks for less than $25,000. All three are governed by provisions of the Electronic Fund Transfer Act of 1978 (implemented by the Federal Reserve’s Regulation E). Some of the consumer protections include:

1. Payers must be notified, before issuing the check, that it will be converted into a one-time electronic debit.
2. Payers can “opt out” of the check conversion.
3. Payers have 60 days from the posting date to dispute the transaction. (Under check law, a bank or credit union has only until midnight of the business day following receipt of the check to return it through the system.)
4. Bank statements listing converted checks must provide transaction details that include the check number, date, amount and payee’s name. (With paper checks, the payee’s name is not provided on the bank statement, although customers usually do have the option of receiving copies of their canceled checks.)

The differences among the applications are primarily: (1) how the check is accepted by the business payee; and, (2) what is done with the paper check after conversion. Two of the applications – POP and BOC – primarily relate to merchant sales to consumers. ARC has application for both consumer and B2B organizations.

POP (Point of Purchase) Check Conversion

POP is used for checks written at the point of sale, which are converted to a one-time electronic debit “at the register”, then voided and immediately returned to the customer. POP’s popularity was not as widespread as was hoped due to: Cost of the technology - scanning equipment had to be available at every payment station; and Training Issues – each checkout clerk had to be able to properly explain the transaction to the customer.

BOC (Back Office Conversion)

As with POP, Back Office Conversion relates to checks written either at the point of sale or at a manned payment location. However, with BOC, the seller retains the checks and converts them in a centralized “back office” location. BOC can be considered an improvement over POP for a number of reasons: (1) Sellers only require equipment in their back office, not at every register; (2) Individual cashier’s do not require any special training, only the back-office personnel; and (3) the experience is more transparent to the customer, as no voided checks are returned to him at the point of sale.

ARC (Accounts Receivable Entries) Check Conversion

With ARC, checks are received by the biller through the mail, at a central location or drop box, and are converted into one-time electronic debits, which are batched and sent through the ACH network. The biller retains the check until the payment has been processed, at which time the check is destroyed.

Steps in the ARC Process

1. The biller mails a statement to its customer. As customers must be notified that their checks will be converted and offered the option to “opt out”, the billing statement itself is a good format for notification.
2. The payer pays the statement by check mailed either directly to a centralized billing location, or to a drop box.
3. The payment check is processed:
   1. The check MICR code is scanned.
   2. It is determined if the check is eligible for conversion. It must be written for less than $25,000 with no values in the auxiliary on-us line of the MICR. (“on-us” is a line of code sometimes utilized for routing information.)
   3. One or more batches of ARC entries are electronically transmitted to the bank that then routes them through the ACH network.

The biller must ensure that the paper checks are securely stored so that there is no opportunity for double submission: once as the electronic debit, and again as a paper check. Once the payment has been processed, the checks are destroyed.

Benefits of ARC

Any organization (business, not-for-profit, utility, etc) receiving volumes of check payments can take advantage of ARC. Benefits include:

• Reduced processing times
• Reduced errors caused by manual processing
• Streamlined A/R reporting
• Decreased costs

Interestingly, B2B companies are lagging behind B2C in utilization of e-checks. According to NACHA, in its March 5, 2007 “Check Conversion White Paper”: in 2004, 80% of business-to-business transactions were [still] completed by paper check.

Check Conversion and “Check 21”

Both check conversion and “Check 21” were developed for the same purposes: to increase the speed and efficiency of payment processing while decreasing the cost. Check conversion and the Check Clearing for the 21st Century Act (called Check 21), however, should not be confused, as the two are very different processes governed by entirely different rules and regulations.

With POP, ARC and BOC, the MIRC code on the paper check is read by a piece of equipment and the data is used to create an electronic debit transaction which is then batch-processed and passed through the ACH system. With Check 21, scanners take pictures of the front and back of the check, and this digital image is used to create a substitute check that has the same legal weight as the original paper check. The substitute check is processed through the check clearing system, which has an entirely different set of regulations.

Impact of Check Conversion

Overall, Check 21, check conversion, and ACH processing have a positive impact on buyers, sellers and the U.S. economy as a whole. NACHA’s “White Paper”: “the use of ACH in 2000 saved consumers, businesses, and the government approximately $8.4 billion.”

There is, though, one drawback of check conversion that affects what is probably a good portion of consumers and business purchasers. That is the loss of the “float”. While check conversion does not result in an immediate draw from the payer’s account, as does, for instance, use of a debit card, converted checks will clear by the day after they are written. So … the days of writing checks against future funds are rapidly waning. If you write a check, you’d better be sure the cash is already in your account.

The Future of Check Conversion

The conversion of paper checks into electronic format, whether by conversion or Check 21, is definitely a growing business trend in the United States. A Federal Reserve Payment Study confirmed that electronic payment transactions in the United States exceeded check payments for the first time in 2004. The international consultancy firm for financial institutions, Celent, has projected that paper check processing will nearly disappear in the US by the end of the decade.

According to NACHA president and CEO Elliott C. McEntee in a statement before the House Subcommittee On Financial Institutions and Consumer Credit on April 20, 2005:

In the long term, we expect that check conversion and other types of electronic check processing will be transitional, as consumers continue to write fewer and fewer checks and switch to various forms of electronic payments. This has already been happening for years at retail with credit and debit cards, and with various forms of electronic and online bill payment (which, incidentally, all have greater protections than checks). …

Check conversion is being rapidly adopted in the marketplace. Check conversion is an example of a true “win, win” innovation by providing consumers more protection, and providing businesses and financial institutions the ability to collect checks more efficiently.

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Information provided by ABC-Amega Inc., a global commercial collection and receivable management industry leader.