In its June 2, 2003,report to Congress,the House Commit-

tee on Financial Ser-vices estimated thatapproximately 42.5 bil-lion checks areprocessed every year.Checks that are notelectronically processedmust be physicallytransported betweenbanks for processingand payment. Thebanking system in theUnited States isdependent upon theground and air transport of checksbetween banks, at an estimatedcost of $250 million a year. Theterrorist attacks of September 11,2001, and the resulting responseshowed banking regulators howeasy it was for the banking sys-tem to be severely interrupted.For four days following Septem-ber 11, there was no air trafficallowed in the continental UnitedStates. As a result, millions ofchecks could not be transportedby air service, which caused theFederal Reserve Bank’s checkfloat to balloon to more than 100times its normal level.

Currently, checks do nothave to be transported when

there is either electronic paymentof checks within the same finan-cial institution or when there isan agreement between differentfinancial institutions to exchangechecks electronically. The majorproblem with this system is thenecessity for check-truncationagreements between financialinstitutions that wish to exchangecheck images.

THE CHECK 21 ACT

To eliminate the need for sep-arate agreements between eachand every financial institution thatwishes to exchange check images,the Federal Reserve Board advo-

cated that the CheckClearing for the 21stCentury Act (Check 21Act) be introduced inCongress. The Check21 Act reads as follows:

To facilitate checktruncation byauthorizing substi-tute checks to fos-ter innovation inthe check collec-tion system with-out mandatingreceipt of checksin the electronic

form, and to improvethe overall efficiency ofthe Nation’s paymentssystem, and for otherpurposes.

The Check 21 Act allows forthe creation of a substitutecheck, which includes an imageof the front and back of the orig-inal check. The Act provides thatthis substitute check is the legalequivalent of the original checkunder any provision of federal orstate law. Since this check imagehas legal equivalence, it must beaccepted by all parties, and nei-ther financial institutions nor thedisbursing party can require the

The terrorist attacks of 9/11 showed how easy itwas to severely disrupt our banking system. Thegrounding of air flights delayed the transportationof millions of checks—causing the FederalReserve Bank’s check float to balloon to morethan 100 times its normal level.To protect our banking system, Congress passed

the Check 21 Act. But what will be the impact onbusinesses, consumers, and financial institutions?What potential problems will companies face? Andwhat steps can you take to get ready for Check21? The authors take a close look at these issuesand provide some answers. © 2004 Wiley Periodicals, Inc.

David A. Burnie, David Hurtt, and Sheldon A. Langsam

Twenty-First-Century Check Clearing:Are You Ready?

featu

reartic

le

21© 2004 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20067

return of the original check. TheFederal Reserve Board andfinancial institutions lobbied forthe Check 21 Act because theyfelt that the use of electronicimaging would enable the pay-ments system to operate moreeffectively and efficiently. Withelectronic imaging, payeesshould have access to their fundsmore quickly and the float peri-od should be reduced. Yet byallowing the creation of substi-tute checks, the Check 21 Actallows financial institutions thatdo not have the desire or thetechnological equipment toprocess checks electronically tocontinue to process payments inthe same manner as theydo now.

Some consumergroups indicated that con-sumers should benefitfrom the implementationof the Check 21 Act. Forexample, currently, thebanking system is limited intheir ability to place ATMs inremote locations because checksdeposited at the ATMs must bepicked up and transported on adaily basis. The Check 21 Acteliminates the need for the trans-portation of original checks, thusallowing banks to place specialATMs that scan depositedchecks electronically in geo-graphically remote locations.Electronic imaging of checksalso allows financial institutionsto post paid checks on their Website so that customers can reviewtheir accounts on a near “real-time” basis. This should increaseconsumer convenience andenhance fraud prevention.

PURPOSES AND ANALYSIS OFTHE CHECK 21 ACT

The Check 21 Act specifi-cally states that the purposes ofthe Act are as follows:

1. To facilitate check trunca-tion by authorizing substitutechecks;

2. To foster innovation in thecheck collection systemwithout mandating receipt ofchecks in electronic form;and

3. To improve the overall effi-ciency of the nation’s pay-ments system.

The intent of the Check 21Act is to modernize the pay-ments system by making it easi-er for check images to be trans-ported electronically betweenfinancial institutions. To meetits objectives, the Act provides

for the creation of a new nego-tiable instrument referred to asa “substitute check,” which isconsidered the legal equivalentof the original check for all pur-poses. The efficiency arisesfrom the ability to move checkselectronically. For example, abank could accept a deposit atone location and create a checkimage. The image could then betransferred electronically by aclearinghouse to the payingbank. Note, however, that nobank is required to accept anelectronic image of a check butmust accept a substitute check.If the paying bank would notaccept an electronic image of acheck, efficiencies would stillaccrue in that the printing of asubstitute check could occur ata closer location. In this case,the length of time needed forcheck transportation would bereduced but not eliminated.

The bank creating a substi-tute check document must accu-rately represent all the informa-tion on the front and back of theoriginal check as of the time it istruncated. In addition, the substi-tute check must show all theendorsements of the banks thathandled the original check or theelectronic image and must clear-ly indicate on the substitutecheck “This is a legal copy ofyour check. You can use it thesame way you would use theoriginal check.”

The Check 21 Act providesthat any bank that transfers,presents, or returns a substitutecheck and receives payment

warrants to the depositor,or to any subsequent col-lecting bank, that the sub-stitute check is legallyequivalent to the originalcheck and no one willreceive payment on a checkthat has already been paid.The purpose of this section

of the Act is to assure con-sumers that they will not have topay a check more than once andto encourage banks in develop-ing systems of internal controlthat prevent duplicate payments.If a double payment occurs, thebank must indemnify, or makewhole, a consumer who suffers aloss due to the receipt of a sub-stitute check instead of the orig-inal check. The Check 21 Actalso provides for the right ofexpedited recredit of a cus-tomer’s account if the customerasserts that the electronic checkor substitute check was incor-rectly charged against his or heraccount.

One risk associated with theCheck 21 Act is that the firstbank that creates a truncated(imaged) check becomes liablefor these warranties and for pro-viding a good image. The risk isincreased by the unattainable

22 The Journal of Corporate Accounting & Finance

© 2004 Wiley Periodicals, Inc.

Some consumer groups indicated thatconsumers should benefit from theimplementation of the Check 21 Act.

standard that the image “accu-rately represents all the informa-tion on the front and back of theoriginal check as of the time theoriginal check was truncated.”This standard cannot beachieved, since the pressurepoints on the signature, informa-tion used when investigating for-gery, cannot be captured inimages. Definitions of selectedkey terms presented in theCheck 21 Act are provided inExhibit 1 for reference.

Let’s now look at the impactof Check 21 (see Exhibit 2 forpotential problems for your com-pany) and steps your company

can take to avoid problems(summarized in Exhibit 3).

IMPACT OF THE CHECK 21 ACTON BUSINESS ANDCONSUMERS

The Check 21 Act is a natu-ral extension of the Debt Reduc-tion Act of 1996 for the nation’sfinancial system. A provision ofthe Debt Reduction Act of 1996was that by July 26, 1996, thefederal government would payall new obligations electronicallyand by January 1, 1999, all fed-eral payments would be electron-ic. The savings at that time were

estimated to be greater than$500 million over five years,beginning with a savings ofmore than $.40 for every checkmoved from paper to an elec-tronic format. The use of elec-tronic checks has several advan-tages: reduction of costs,guaranteed deposits of funds,removal of theft of individualrecipients’ checks, and a reduc-tion of fraud and other risksassociated with paper checks.

Although the Check 21 Actdoes not create a check-free sys-tem, it will likely increase elec-tronic processing of checks.From a corporate treasury per-

November/December 2004 23

© 2004 Wiley Periodicals, Inc.

Definitions for Selected Terms Used in the Check 21 Act

Check–the term check (a) means a draft, payable on demand and drawn on or payable through or at an office of a bank,whether or not negotiable, that is handled for forward collection or return, including a substitute check and a traveler’s checkand (b) does not include a noncash item or an item payable in a medium other than U.S. dollars.

Consumer–the term consumer means an individual who (a) with respect to the check handled for forward collection, drawsthe check on a consumer account; or (b) with respect to a check handled for return, deposits the check into, or cashes thecheck against, a consumer account.

Indemnifying Bank–the term indemnifying bank means a bank that is providing an indemnity under Section 6 of the Check21 Act with respect to a substitute check.

Magnetic Ink Character Recognition Line (MICR line)–the term MICR line means the numbers, which may include thebank routing number, account number, check number, check amount, and other information, that are printed near the bottomof the check in magnetic ink in accordance with generally applicable industry standards.

Substitute Check–the term substitute check means a paper reproduction of the original check that (a) contains an image ofthe front and back of the original check; (b) bears an MICR line containing all the information appearing on the MICR line ofthe original check, except as provided under generally applicable industry standards for substitute checks to facilitate theprocessing of substitute checks; (c) conforms, in paper stock, dimension, and otherwise, with generally applicable industrystandards for substitute checks; and (d) is suitable for automated processing in the same manner as the original check. Alsocalled an image recognition document (IRD).

Truncate–the term truncate means to remove an original paper check from the check collection or return process and sendto a recipient, in lieu of such original paper check, a substitute check or, by agreement, information relating to the originalcheck (including data taken from the MICR line of the original check or an electronic image of the original check), whetherwith or without subsequent delivery of the original paper check.

Exhibit 1

spective, this change in checkprocessing will affect bothaccounts receivable and accountspayable. Collections of accountsreceivable will be more rapidand reliable. This effect, howev-er, may not be significant, sincethe bank float time is only asmall portion of the total timethat accounts receivables are out-standing. To take advantage ofthe bank collection efficiencies

resulting from the Check 21 Act,a company may want to select astheir lockbox bank a financialinstitution that uses the latesttechnology, such as check imageprocessing.

The Check 21 Act shouldmake the collection system morereliable and rapid, as there willbe no need to physically movechecks from banking center tocenter; transportation system

slowdowns or failures will nothinder the process. A breakdownin the electronic superstructurewill disrupt the collectionsthough; key back-up systems areabsolutely necessary. Businessesshould be aware that insufficientfund checks will be appearingmore quickly due to the decreasein the collection period. Howev-er, the shorter collection periodshould allow improvement of the

24 The Journal of Corporate Accounting & Finance

© 2004 Wiley Periodicals, Inc.

Potential Problems for Businesses Due to the Check 21 Act

• Fraudulent deposits of electronic images• Consumer reluctance to accept use of image replacement documents (IRDs) or substitute checks• Privacy concerns relating to making deposit account information widely available to businesses for electronic

payments• Fraudulent replication of substitute checks• Lack of guidelines in the Check 21 Act on how long a bank must keep the original checks• Increases in the number of insufficient fund checks businesses will receive

Exhibit 2

Steps Your Business Can Take To Get Ready for the Check 21 Act

• Develop a system that integrates Electronic Invoice Presentment and Payment (EIPP).• Implement fraud protection with check verification procedures for individual customer checks.• Use a Positive Pay system to match disbursements with checks presented to the bank.• Evaluate the ability of each financial institution your business uses to capture images, as costs may prohibit

smaller or regional institutions from early installation of necessary imaging equipment.• Educate customers as to any changes in business due to the Check 21 Act.• Establish and articulate a company policy on returned checks. Initially, there may be an increase in the number

of checks returned for nonsufficient funds (NSFs), as customers adjust to the reduction in the float period.• Evaluate the advantage of storage and retrieval of electronic check images versus the legal proof advantages of

storing original or substitute checks.• Reduce dependence on float, particularly the disbursement float. Make sure funds are available before issuing a

check.

Exhibit 3

funds availability schedule fromthe bank.

In regard to cash sales, busi-nesses must always be concernedabout fraudulent or bad checks.Businesses can use point-of-salereaders to read the magnetic inkcharacter recognition (MICR)data to cross-check with badcheck databases and identifypotential insufficient fundschecks before they are deposited.The implementation of theCheck 21 Act may also facilitatethe conversion of paper checksto electronic checks, with trun-cation of the paper check per-haps eventually occurring at themerchant.

With regard to checkwriting and accountspayable, companies shouldeliminate any reliance onfloat and make sure thatthey have sufficient fundsin the bank when they issuea check, since all disburse-ments, irrespective of dis-bursing location, will be quicklyaccessible electronically. Inci-dences of check fraud, particu-larly in the confusion of initialimplementation of the Check 21Act, will be elevated. The useful-ness of security features such aswatermarks or photocopy voidmarks will be reduced sinceimages of checks may be pre-sented. To counteract this higherrisk of fraud, businesses maywant to discuss with their bankthe implementation of controlleddisbursement systems that allowreview of check images by thecompany prior to their paymentby the bank.

The management of corpo-rate payables will be affected atleast as much as accounts receiv-ables by the Check 21 Act. Thedecrease in clearing time willmean corporate disbursementswill reduce bank balances soon-er. The potential float that the

cash management system incor-porates may decline. This alldepends on the shift in bothcomponents, collection float anddisbursement float. The use ofcorrespondent banks for remotedisbursement will not have asmuch benefit as in the past; dis-tance will not matter as much, asan electronic transaction can becompleted instantaneously andthe checks will clear muchfaster. The actual impact of thesetime reductions and efficiencieson the float period is difficult topredict. However, this improve-ment in efficiency should reducethe cost of services to business-es. Hopefully, this reduction in

bank service costs will be passedthrough to bank customers.

The larger benefits from theCheck 21 Act for businesses willcome from lower handling andtransaction costs and lower phys-ical storage costs. If checks aretruncated in the collection sys-tem and images are onlyreceived by the business, thenthis information can be deliveredvia an electronic file. Businesseswill have greater and more flexi-ble access to the archived imagesof checks and will no longerreceive bundles of paper, whichhave to be sorted by employeesand eventually stored. Auditingrecords may be much easier, asscanning a file of check imagesis much quicker than sortingthrough containers of cancelledpaper checks. Many businessesreceive electronic images ofchecks now, typically on CD-ROMs. While the Check 21 Act

allows truncation of checks, theconversion to electronic imagesis not required. A substitutecheck, which is created from animage file, must be accepted asa legal substitute under theCheck 21 Act. This will likelyresult in images saved going for-ward having the specific formatrequired to create substitutechecks. Courts have commonlyaccepted older check images asproof, but the new law does notguarantee that they will beaccepted as proof of payment.Companies should weigh thestorage and retrieval advantagesof check images versus the legalproof advantages of substitute

checks if they are consider-ing converting to imagingbank statements andchecks.

As the check imagingallowed under the Check21 Act becomes morecommonplace, businessesmay find customers more

willing to be moved to an Elec-tronic Invoice Presentment andPayment (EIPP) system. Underthis system, the customerreceives his or her bill electroni-cally, schedules payment withthe business, the business pre-sents the authorization for pay-ment to the financial institution,and final payment is made.

IMPACT OF CHECK 21 ACT ONFINANCIAL INSTITUTIONS

Financial institution imple-mentation decisions range fromvirtually ignoring the Check 21Act to fully embracing imagingin all aspects of check process-ing. At the minimal implementa-tion level, financial institutionscan maintain their existing sys-tems and just process substitutechecks as they previouslyprocessed the paper checks.However, even at this level of

November/December 2004 25

© 2004 Wiley Periodicals, Inc.

The management of corporatepayables will be affected at least asmuch as accounts receivables by theCheck 21 Act.

adoption, the financial institu-tion will still have to implementsteps to educate customersregarding the Check 21 Act andmodify check-handling process-es due to the larger size of thesubstitute checks. Other imple-mentation options would be tooutsource image processing or,for the larger banks, to developlarge imaging and printing busi-ness segments. Given the currentlow-interest rate environment, itmay be advantageous for firmsto be late adopters of imagingtechnology. Certainly, from thefinancial institution’s point ofview, the advantages of the floatreduction achievable from imag-ing are most meaningful for onlythe largest checks.

Many security featuresincorporated into checks willonly be useful until the check isconverted into an image. Onceconverted, the photocopy voidprotection and special watermarkfraud security features willbecome ineffective. Financialinstitutions must establish stronginternal controls for handlingchecks to prevent the introduc-tion of fraudulent checks. It like-ly will be easier for a criminal tocreate a counterfeit substitutecheck than it is to create a coun-terfeit paper check. Given theconfusion in implementation and

a mixed processing environment(both original and substitutechecks), financial institutionsshould be on the lookout forfraud schemes. Additionally, thismay be an excellent opportunityto move customers that havebeen receiving their checks backwith their statements to imagedchecks and statements.

The Act will likely have asignificant effect on banking ser-vice providers. Service providersare likely to consolidate overtime. The banking system hasthe biggest role in this change;this will require investment inequipment and software, whichwill take several months to yearsto implement. The cost savingswill not be achieved until a largeenough volume is sustained. Inthe meantime, banks not readyto truncate checks will still facethe inflow of image replacementdocuments (IRDs) and substitutechecks.

A NEW ERA?

We have discussed the factthat the Check Clearing for the21st Century Act was scheduledto take effect on October 28,2004. The intent of the Check 21Act is to promote innovation andefficiency in the U.S. paymentssystem by reducing legal restric-

tions to check truncation. TheCheck 21 Act facilitates checktruncation by creating a newnegotiable instrument referred toas a “substitute check.” The sub-stitute check will be the legalequivalent of the original checkand will include all visible infor-mation contained on the originalcheck. The use of substitutechecks will allow banks to trun-cate original checks in order toprocess check information elec-tronically, and to transport substi-tute checks to banks that want tocontinue to receive paper checks.It should be emphasized that theCheck 21 Act does not requirebanks to accept checks in theelectronic form nor does it requirebanks to create substitute checks.

There is little doubt that theimplementation of the Check 21Act will change the way inwhich checks are processed inthe United States. However,since the Check 21 Act does notrequire banks to create substitutechecks, the actual impact of theCheck 21 Act on businesses,consumers, and financial institu-tions remains unclear. Initially,there is always some resistanceto change; however, the FederalReserve Board is hoping thatonce businesses see the positiveimpact of the new legislation itwill become widely accepted.

26 The Journal of Corporate Accounting & Finance

© 2004 Wiley Periodicals, Inc.

David A. Burnie, PhD, CTP, CFA, is a professor in the Department of Finance and Commercial Law at West-ern Michigan University and associate dean of the Haworth College of Business. Prior publications havebeen in the Financial Review, Journal of International Finance, and Journal of Business Finance & Account-ing, among others. David Hurtt, PhD, CPA, CMA, is an associate professor in the Department of Accoun-tancy at Western Michigan University. He has published articles in the Accounting Review, the Journal ofAccounting and Economics, and the Journal of Corporate Accounting & Finance. Sheldon A. Langsam,PhD, CPA, is a professor in the Department of Accountancy at Western Michigan University. He has pub-lished several articles in the Journal of Corporate Accounting & Finance and in other journals.