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7/29/2019 Debtors and Recivable Management
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INTRODUCTION
When a prospective customer asks for trade credit from a seller, he is
careful how to put his request, but if he had to be honest and speak his mind, he
would possibly actually ask the seller something like this:
Id like to borrow some money from your company. Id like the loan for at least
90 days, but I will probably take longer to repay you, if I repay you at all. There
is, in fact a chance that I will not actually repay you and, if I do, it will be after
you have spent a considerable amount of time, effort and money chasing me. I do
not intend to pay any interest on the amount borrowed and, incidentally, Im not
giving you any say in whether to give me the loan or not: Ive simply taken it.
Giving loans is not something that only banks do. Most businesses loan
money to their customers in the way stated above, such customers are known as
debtors, and this is the standard business practice. The only real difference
between bank loans and debtors is that banks get paid interest on the money they
have lent and the companies are not.
The following, again, is a debtor who is actually speaking his mind:
The one contribution that debt collectors do make is that every time they
telephone me, I have to think up an even more imaginative reason for further
delaying the payment: none of the directors are here to sign the cheque, I have run
out of cheques and the bank has run out of chequebooks, Malta post is becoming
more inefficient by the day, somebody has set fire to the post office box
Though this may seem a rather light-hearted approach, the problem is very
real, very costly, and has resulted in the failure of many organizations, particularly
in the last few years. It is often not the lack of profit flow that has caused these
failures, but the lack of cash flow caused by poor and slow payments bycustomers. So, with all this risk and hassle, why sell on credit at all? The reason is
to facilitate the sales process, and as an inducement or aid in the marketing of the
goods or services of the seller. Because all other sellers give credit, the company
would find it impossible to sell if it does not give credit.
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Objectives of Receivable Management
From creation of receivables the firm gets a few advantages & it has to bear
bad debts, administrative expenses, financing costs etc. In the management of
receivables financial manager should follow such policy through which cash
resources of the firm can be fully utilized. Management of receivables is a process
under which decisions to maximize returns on the investment blocked in them are
taken. Thus, the main objective of receivable management is to maximize the
returns on investment in receivables & to minimize risk of bad debts etc. Because
investment in receivables affects liquidity and profitability, it is, therefore,
significant to maintain proper level of receivables. In other words, the basic
objectives of receivables management are to maximize the profits. Efficient credit
management helps to increase the sales of the firm. Thus, following are the main
objectives of receivables management:-
(1) To optimize the amount of sales.
(2) To minimize cost of credit.
(3) To optimize investment in receivables.
Therefore, the main objective of receivable management is to establish a
balance between profitability and risk (cost). A business can afford to invest in its
receivables unless the marginal costs and marginal profits are the same. Althoughthe level of receivables is affected by various external factors like standards of
industry, economic conditions, seasonal factors, rate of competition etc,
management can control its receivables. Though credit policies, credit terms, credit
standards and collection procedures.
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Determinants of size of Receivables
Level of sales: The most important factor that determines the size of receivables isthe level of sales. Increased sales increase the size of receivables.
Credit policy: If the firm has a liberal credit policy, the receivables are likely to be
a more rigid policy which may restrict the size of receivables.
Terms of credit: The terms of credit include the period of credit and the rate of
cash discount. They affect the size of investment in receivables. The firms credit
terms should be comparable with those of the competitors. A longer credit period
may attract more customers and increase the sales and this size of receivables isalso likely to increase. A higher rate of cash discount may include the customers to
pay early and thus size of receivables may reduce.
Paying habits of the customers: The size of receivables also depends upon the
credit worthiness and paying habits of the customers. The nature of businessand
conventions prevailing in the trade also determine the blend of cash and credit sales
and thereby the size of receivables.
Operating efficiency: The strength and collection efforts i.e. the operating
efficiency of the firm also determine the level of its receivables.
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Different types of costs associated with receivables
management
Except for few monopolistic firms, most firms are required to sell goods on
credit because of trade customs. When competitors are allowing credit to customersand our firm does not extend credit, they may switch over to other firms. If the firm
offers credit, it can attract more customers and expand its sales.
Maximization of sales alone cannot be the objective of the firm. The
increased sales cannot be achieved without incurring additional costs. The firm
should evaluate its credit policy in terms of additional benefits and costs.
Additional sales should add to the operating profits of the firm.
The various costs associated with receivables management are as follows:
Costs of financing: Though credit sales increase the profits of the firm, they too
result in some costs. Till the receivables are converted into cash, the firm has to
arrange funds to meet its own obligation towards payment to its suppliers and
payment of other expenses. These funds are to be procured at some cost. These are
known as financing costs.
Administration costs: Extending credit facility to customers involves some costsof administration. First of all costs are incurred in obtaining information regarding
credit worthiness of customers. Later, costs are incurred in collecting money from
them. It also involves additional costs of administration for maintaining the
accounts of the customers.
Delinquency costs: If there is any delay on the part of the customer in making
payments, the firm may incur additional costs. It includes costs arising on account
of funds getting blocked up for an extended period and costs associated with steps
to be taken to recover the amounts including legal charges. These costs are calleddelinquency costs.
Cost of default: If the customers do not pay either full or any part of the amounts
due from them, it is a loss to the firm. This is what is called bad debts loss.
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Important Dimension of Receivables Management
One of the favourite sayings is that if you do not manage debtors, debtors
will manage you. Another is that, in spite of what accountants say, a sale is not
made until you get paid. It is not enough for a business to induce the customer
to choose its product or service over that of its competitor, but it must ensure
that it actually receives the cash and receives it in proper time. This objective
can only be achieved if we have in place a propercredit policy. The following
are the essential elements of a proper credit policy:
1. Setting the credit policy
Most organizations have no formal or even clear credit policy, and fewer
still have any sort of policy set out in writing. This often sets the stage for
problems for these organizations. In a properly set-up organization there is
usually a credit manager, it is often the Accountant whose function is to monitor
and chase trade debtors. However, the setting of the firms credit policy is done
by the top management because of the following reason.
The reason is that credit policy should not be viewed in isolation, but
must support the firms objectives. Only top management should decide what
these objectives should be. Once such objectives are determined, top
management, in consultation with the credit manager, will devise a credit
management policy that will complement and support corporate objectives. In
this way one eliminates from the start those conflicts that often arise between thesales and credit departments: the sales department wants to increase sales at all
costs, irrespective of the creditworthiness of the customer, while the credit
department does not want to run any risk of bad debts. This gives rise to
conflict. However, when the policy is clear, sales do not over-reach, while credit
policy is not so strict that it seeks to avoid total risk to the detriment of sales.
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The credit policy of a firm provides the framework to determine (a)
whether or not to extend credit to a customer, and (b) how much credit to
extend. The credit policy decision of firm has two broad dimensions:
I. Credit Standards and
II. Credit Analysis.
A firm has to establish and use standards in making credit decisions, develop
appropriate sources of credit information and methods of credit analysis.
I. Credit Standards
The term "credit standards" represents the basic criteria for the extension of
credit to customers. The quantitative basis of establishing credit standards is factors
such as credit ratings, credit references, average payments period and certainfinancial ratios. The overall standards can be divided into two categories:
i. Tight or restrictive.
ii. Liberal or non-restrictive.
That is to say, our aim is to show what happens to the trade-off when standards are
relaxed or, alternatively, tightened. The trade-off with reference to credit standards
covers
(a) The collection cost,
(b) The average collection period,
(c) Level of bad debt losses, and
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(d) Level of sales.
These factors should be considered while deciding whether to relax credit standards
or not. If standards are relaxed, it means more credit will be extended while if
standards are tightened, less credit will be extended. The implications of the fourfactors are elaborated below:
(a) Collection Costs
The implications of relaxed credit standards are
(i) More credit,
(ii) A large credit department to service accounts receivable and related matters,
(iii) Increase in collection costs.
The effect of tightening of credit standards will be exactly the opposite. These costs
are likely to be semi-variable. This is because up to a certain point the existing staff
will be able to carry on the increased workload, but beyond that, additional staff
would be required. These should be included in the variable cost per unit and need
not be separately identified.
(b) Investments in Receivables or the Average Collection Period
The investment in accounts receivable involves a capital cost, as funds have
to be arranged by the firm to finance them till customers make payments.
Moreover, the higher the average accounts receivable, the higher is the capital or
carrying cost. A change in the credit standards? Relaxation or tightening? Leads to
a change in the level of accounts receivable either through a change in sales, or
through a change in collections.
A relaxation in credit standards implies an increase in sales, which, in turn,
would lead to higher average accounts receivable. Further, relaxed standards would
mean that credit is extended liberally so that it is available to even less creditworthy
customers who will take a longer period to pay over dues. The extension of trade
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credit to slow-paying customers would result in a higher level of accounts
receivable.
In contrast, a tightening of credit standards would signify (a) a decrease in
sales and lower average accounts receivable, and (b) an extension of credit limitedto more creditworthy customers who can promptly pay their bills and thus, a lower
average level of accounts receivable.
Thus, a change in sales and change in collection period together with a
relaxation in standards would produce higher carrying costs, while changes in sales
and collection period results in lower costs when credit standards are tightened.
These basic reactions also occur when changes in credit terms or collection
procedures are made.
(c) Bad Debt Expenses
Another factor, which is expected to be affected by changes in the credit standards,
is bad debt expenses. They can be expected to increase with relaxation in credit
standards and decrease if credit standards become more restrictive.
(d)Sales Volume
Changing credit standards can also be expected to change the volume of sales. Asstandards are relaxed, sales are expected to increase. Conversely, a tightening is
expected to cause a decline in sales.
II. Credit Analysis
Besides establishing credit standards, a firm should develop procedures for
evaluating credit applicants. The second aspect of credit policies of a firm is credit
analysis and investigation. Two basic steps are involved in the credit investigation
process:
(a) Obtaining credit information, and
(b) Analysis of credit information.
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It is on the basis of credit analysis that the decisions to grant credit to a customer as
well as the quantum of credit would be taken.
The customer who applies for credit should be required to produce proof of
his ability to settle within an agreed period the amount he owes. This is the time tomake sure that the customer is creditworthy. Most debtors fully intend to pay their
debts, but many executives tend to be too optimistic about their financial condition
and future prospects, and thus find themselves short of funds.
The initial credit application, which should be done in writing, is intended to
provide the credit manager with certain information that can be readily verified.
Greater detail can be sought later, if necessary, in the form of financial statements.
The information included in the initial application should enable the seller,
however, to avoid considering doing business with those customers who have little
prospect of success or whose past performance indicates that they are unable to
meet their obligations when due. The seller should not deal with customers who ask
for credit but who refuse to supply the information requested.
Obtaining Credit Information
The first step in credit analysis is obtaining credit information on which to base the
evaluation of a customer. The sources of information are
(1) Internal
(2) External
Internal
Usually, firms require their customers to fill various forms and documents
giving details about financial operations. They are also required to furnish trade
references with which the firms can have contacts to judge the suitability of the
customer for credit. This type of information is obtained from internal sources of
credit information. Another internal source of credit information is derived from
the records of the firms contemplating an extension of credit. It is likely that a
particular customer may have enjoyed credit facility in the past. This type of
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information may not be adequate and may have to be supplemented by information
from other sources.
External
The availability of information from external sources to assess the
creditworthiness of customers depends upon the development of institutional
facilities and industry practices. Depending upon the availability, the external
sources such as financial statements, bank references, trade references, credit
bureau reports, and so on can be employed to collect information.
The decision whether the customer is eligible for credit terms generally
involves a detailed analysis of some of the attributes of the customers. Credit
analysis normally groups the attributes in order to assess the credit worthiness ofcustomers. One traditional way of organizing the information is by characterizing
the applicant along five dimensions namely, Capital, Character, Collateral,
Capacity and Conditions. These five dimensions are also popularly called five Cs
of credit analysis.
Capacity: It is the most critical factor that assesses your ability to repay the
loan. How you intend to repay the loan is the primary concern of lenders.
The lenders will take into account the factors like the timing of the
repayment, cash flow, and the likelihood of a successful repayment of the
loan.
Capital: This is another important criterion that most lenders look out for
while analyzing a loan application. Capital is the amount of money you have
personally invested in the business and is an indication of the available
financial resources you have to deal with the debt. Many a time's credit
analysts place more importance on it. Interested creditors, lending
institutions and investors expect you to contribute at least 25% from yourown assets before asking them to offer you any kind of funds.
Collateral: While perusing your loan application the lenders will also
consider the additional forms of security that you can provide in case you
default. Giving a collateral implies that you pledge an asset you own, such as
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your home, car or any valuable property, to the lender with the agreement
that in case of default, the lender has the absolute power and authority to take
hold of your property to make up the loss from the loan default.
Character: It is the impression you form on a lender or an investor. Thelender will form a subjective opinion on you after a series of talks to gauge
your willingness to repay the loan. Your financial history, educational
background and experience in business are some of the factors that are
considered by the lender.
Conditions: It describes the proposed motive of the borrower to apply for
the loan. Prospective lenders will consider the purpose of the loan: will the
loan be used for working capital, supplementary equipments or inventory?
The lending institution will also look at the external conditions that couldaffect your business.
Beyond the simple requirement of getting the signatures of those executives
who can bind the company normally the directors and managers, this question is
intended to find out something about the character of the owner and the senior
executives. The reputation of the companys Chief Executive Officer carries great
weight when it comes to such decisions.
Again, the owner of a business may have large personal resources and be
willing to pledge them to support his business. Such a factor would be carefully
considered by the credit manager, and weigh heavily in the customers favour. An
unwillingness to do so is also an important pointer, but in the opposite direction.
Whilst the materiality of the amount will dictate the degree of analysis
involved, the major sources of information available to companies in assessing
customers credit worthiness are:
Bank References: Banks can be sources of useful information
about customers, though nowadays laws dealing with privacy
have restricted the information which banks can supply. Banks
also tend to be reluctant to commit themselves formally to
recommending a customer lest they be held responsible if that
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customer should default. However, the credit manager may often
obtain useful information by talking to the customers bank
manager, especially if the client has given permission to do so. In
addition, the credit manager may ask his own banker for
indications he may have of the clients creditworthiness, asbankers hear a lot of things. Information can be passed on by the
banker in general terms without violating any confidentiality.
Professional Credit Rating Agencies: These agencies can also be consulted. Their
information is useful as an indicator of performance for an established business, but
they can usually report little or nothing about one just getting started
Trade References: A customer can also be asked to provide trade references from
suppliers he is already dealing with. Keep in mind, however, that no customer is
going to list a reference on a credit application if he has ever failed to pay that
supplier in time. The credit manager should therefore try to check with other
suppliers in the same line and find out if the applicant has ever done business with
them and what the results were. This cross checking is done regularly among
insurance companies when they have doubts about a customer.
Field Visit: Through visiting the premises and interviewing senior management,
staff should gain an impression of the efficiency and financial resources ofcustomers and the integrity of its management.
Financial Accounts: The most recent accounts of the customer can be obtained
either direct from the business, or from Companies House. While subject to certain
limitations past accounts can be useful in inspecting customers. Where the credit
risk appears high or where substantial levels of credit are required, the supplier may
ask to see evidence of the ability to pay on time. This demands access to internal
future budget data.
Past Experience: For existing customers, the supplier will have access to their past
payment record. However, credit managers should be aware that many failing
companies preserve solid payment records with key suppliers in order to maintain
supplies, but they only do so at the expense of other creditors. Indeed, many
companies go into liquidation with flawless payment records with key suppliers.
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General Sources of Information: Credit managers should scout trade journals,
business magazines and the columns of the business press to keep abreast of the
key factors influencing customers' businesses and their sector generally. Sales
staffs that have their ears to the ground can also prove an invaluable source of
information.
The general economic situation, and the industry conditions, will certainly
have a bearing on the credit decision, though most credit managers give more
importance to character and past performance. Some companies always manage to
survive bad economic conditions and succeed even when times are bad. However,
if credit has already been given and suddenly conditions get bad, then credit
managers should watch over their accounts more carefully, check the outstanding
balances especially the bigger ones more frequently, and revise the credit limits
more often.
Purpose
The purposeof all this checking before giving credit is to ensure as much as
possible the creditworthiness of the customer. Creditworthiness, however, is rarely
assessable in absolute terms, and it will be a matter of judging the risk in each case
and categorizing the customer accordingly. Some risk is inevitable when business
is done on credit, and this must be balanced against the expected returns from theadditional sales. Initially, a new customers credit limit should be set at a low level
and increased only if his payment record justifies it. Even in the case of old
customers, the credit limit and period should be periodically revived, and should be
raised only at request of the customer and if his credit performance has been good.
2. Credit Limits and Credit Periods
Credit Limits and Credit Periods should be established when the initial
request for credit is being considered. The credit period is an important aspect ofthe credit policy. It refers to the length of time over which the customers are
allowed to delay the payment. The credit period generally varies from 3 days to 60
days.
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In a computerized setting this is a simple matter. The customer is assigned an
account number and all payments and charges enter the computer system before an
invoice is issued. The credit limit is programmed into the computer for each
account, and any new sale which will lead to exceeding the limit is automatically
rejected. Rejections would then normally be brought to the attention of the creditmanager for a decision. He may approve a small excess and override the system,
but any large excess would call for an investigation and perhaps a demand on the
customer to prove that he can settle the amount soon.
In most cases the period of credit is set by the principle of the trade, and
very little flexibility is available to the individual business. It is usual to find credit
periods of 30, 60, or 90 days i.e. payment has to be made within that interval
following the date of the invoice.
It is useless demanding cash with orders if ones competitors are giving,
say, 30 days credit. Only a very marked price or quality advantage would make
this possible. On the other hand, there is usually little point in offering more credit
than your competitors. This would tie up more of your funds, and although it will
possibly attract more customers, there is a risk that many of these will be less
creditworthy, leading to higher bad debts.
However, if a firm is considering extending credit to attract more customers, it isfirst necessary to determine:
1. The expected additional sales volume;
2. The profitability of the extra sales;
3. The extra length of the average debt-collection period;
4. The return on the investment in additional debtors.
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3. Cash Discounts
Many firms offer a cash discount for the quick settlement of accounts.
Different discount rates may be offered for different periods. A typical invoice
might state: Terms 2.5% cash discount within 7 days, otherwise 30 days net.This means that the debtor is allowed up to 30 days to settle his bill at the stated
amount, but if he pays it within the first 7 days of this period he may deduct 2.5%
from the total. If the debtor takes up the discount offer, the effect would be to
reduce the average level of trade debtors; so one would expect that the amount of
cash discount would be related to the firms cost of capital.
E.g., 3% if payment made within 10 days; 2%discount if payment made within 20
days etc. Both the discount rate and the period within which it is available are
reflected in credit terms e.g, 3/10, 2/20. Net 30 means that 3%cash discount if the
payment made within 10 days; 2% discount if the payment made within 20 days;
otherwise full payment by the end of 30 days from the date of sale. When a firm
offers a cash discount, its intention is to accelerate the flow of cash into the firm to
improve its cash position. The length of cash discount affects the collection period.
In practice, however, the discount is usually more generous than this. This is
because early payment not only reduces capital requirements for the seller, but also
saves his administration costs in pursuing outstanding debtors, and also reduces therisk of bad debts. There may also be a hidden element of price reduction in the cash
discount. It is a concealed way of offering lower prices to a sector of the market
which might otherwise go to competitors.
4. Collection Procedures and Credit Control
A customer who has been paying regularly suddenly starts slowing down his
payments. This is always a danger signal, and so the credit manager must try and
discover immediately the reason for this, either perhaps by asking the salesman tocall on the customer, or by phoning the customer, or asking around for information.
The worst thing to do is to sit and wait for developments. In any case discovering,
hopefully, that there is nothing to really worry about will set your mind at rest.
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One danger signal that should not be ignored is the sudden unavailability of
any of the people that you usually contact. This often starts to happen after
collection efforts have been started but with no success. The firms managers and
directors, at a loss what to do and embarrassed by constant demands for payment,
are abroad, sick, or in a meeting.
When a debtor starts acting suspiciously, the best method of enforcing
payment is to stop any further supplies to him while you investigate. This will
show him that you really mean business, and in any case will ensure that your
problem does not grow any bigger. If the customer finally pays up, you should
still not relax and go back to the old arrangements before you are fully satisfied
that he has no long-term underlying problem. In fact it would be strongly advised
to start all over again the whole process of assessing his creditworthiness.
If companys efforts to collect do not give results, the company must decide
their next step. If the company believes that the customer is in deep trouble, then it
should not hesitate to take strong measures.
Collection letters are rapidly losing popularity among modern credit
managers. The telephone is a better way to get results. Some still use letters which
may begin as polite reminders and go on to threats of court action. Here again,
credibility plays an important role. A firm that sends out half a dozen pre-printedor computer-generated letters, each threatening something worse than the last,
loses credibility. If the company threatens to sue unless payment is effected within
a week, make sure that the action is taken if payment is not effected within the
week. Of course, this will probably mean the end of your relationship with the
customer, who will probably go to your competitor. By doing so, he will be doing
you a favour in helping to ruin him. The companies certainly do not need such
customers.
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FACTORING
Factoring involves raising funds against the security of a company's trade
debts; so that cash is received earlier than if the company waited for its credit
customers to pay. Three basic services are offered, frequently through subsidiaries
of major clearing banks:
Sales ledger accounting, involving invoicing and the collecting of debts;
Credit insurance, which guarantees against bad debts;
Provision of finance, whereby the factor immediately advances about 80% of
the value of debts being collected.
There are two types of factoring service:
Non-recourse factoring is where the factoring company purchases the debts
without recourse to the client. This means that if the clients debtors do not pay
what they owe, the factor will not ask for his money back from the client.
Recourse factoring, on the other hand, is where the business takes the bad debt
risk. With 80% of the value of debtors paid up front i.e. usually electronically into
the clients bank account, by the next working day, the remaining 20% is paid over
when either the debtors pay the factor i.e. in the case of recourse factoring, or,
when the debt becomes due i.e. non-recourse factoring. Factors usually charge fortheir services in two ways: administration fees and finance charges. Service fees
typically range from 0.53% of annual turnover. For the finance made available,
factors levy a separate charge, similar to that of a bank overdraft.
Advantages:
Provides faster and more predictable cash flows;
Finance provided is linked to sales, in contrast to overdraft limits, which tend
to be determined by historical balance sheets;
Growth can be financed through sales, rather than having to resort to externalfunds;
The business can pay its suppliers promptly (perhaps benefiting from
discounts) and because they have sufficient cash to pay for stocks, the firm
can maintain optimal stock levels;
management can concentrate on managing, rather than chasing debts;
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The cost of running a sales ledger department is saved and the company
benefits from the expertise and economies of scale of the factor in credit
control.
Disadvantages:
The interest charge usually costs more than other forms of short-term debt;
the administration fee can be quite high depending on the number of debtors,
the volume of business and the complexity of the accounts;
By paying the factor directly, customers will lose some contact with the
supplier. Moreover, where disputes over an invoice arise, having the factor in
the middle can lead to a confused three-way communication system, which
hinders the debt collection process;
Traditionally the involvement of a factor was perceived in a negative light
(indicating that a company was in financial difficulties), though attitudes arerapidly changing.