Documentary Credit

What is Documentary Credit?

Documentary credit, also referred to as a letter of credit (L/C), is a financial instrument issued by a bank or a financial institution facilitating international trade. It assures the seller that they will receive payment for the goods or services they provide, provided that they comply with the conditions outlined in the credit, such as shipping documents, bill of lading, invoices, and certificates of origin.

Examples of Documentary Credit

Example 1: A U.S. company purchases goods from a manufacturer in Germany. To mitigate risk, the German manufacturer requests a documentary credit. The U.S. company’s bank issues a letter of credit ensuring that payment will be made upon receipt of specific documents confirming shipment.
Example 2: A Chinese exporter wants to be assured of payment before shipping electronics to a buyer in Brazil. The buyer establishes a letter of credit with their bank, which assures the Chinese exporter that payment will be made upon presenting documents that meet the specified conditions.

Frequently Asked Questions (FAQs)

Q1: What is the purpose of a documentary credit?
A1: The primary purpose is to mitigate risks associated with international trade by providing assurance of payment to the seller and assurance of receiving goods to the buyer, contingent on compliance with all stipulated conditions.

Q2: Who issues a documentary credit?
A2: A documentary credit is typically issued by a bank or a financial institution on behalf of the buyer.

Q3: What documents are usually required under a letter of credit?
A3: Documents generally include a bill of lading, commercial invoice, packing list, certificate of origin, and other relevant shipping documents.

Q4: Is a letter of credit irrevocable?
A4: Most letters of credit issued today are irrevocable, meaning they cannot be altered or canceled without agreement from all parties involved.

Q5: How does a letter of credit reduce risk for the seller?
A5: It provides the seller with a guarantee of payment from a reputable financial institution, provided that they deliver the required documents specified in the credit.

Bill of Lading: A legal document issued by a carrier to a shipper detailing the type, quantity, and destination of the goods being transported.
Certificate of Origin: A document declaring the country of origin of goods in a particular export shipment.
Irrevocable Letter of Credit: A type of letter of credit that cannot be changed or canceled without the consent of all parties.
Confirmed Letter of Credit: A letter of credit where a second bank, usually in the seller’s country, guarantees payment.
Standby Letter of Credit: A financial instrument that provides a secondary payment mechanism for not fulfilling terms of a primary agreement.

Online References

Suggested Books for Further Studies

UCP 600: Uniform Customs and Practice for Documentary Credits by International Chamber of Commerce (ICC)
The Law and Practice of Documentary Letters of Credit by Peter Ellinger and Dora Neo
Trade Finance: A Complete Guide by Stefano Nunziata
International Trade Finance: A Practical Guide by Kwai Wing Luk

Accounting Basics: “Documentary Credit” Fundamentals Quiz

### What is another name for a documentary credit? - [x] Letter of credit - [ ] Credit memo - [ ] Credit line - [ ] Bank draft > **Explanation:** Documentary credit is commonly known as a letter of credit (L/C), which is mainly used in international trade for assuring payments. ### What is the primary benefit of using a documentary credit for sellers? - [ ] Immediate revenue increase - [x] Assurance of payment - [ ] Reduction in logistical costs - [ ] Export tax benefits > **Explanation:** The primary benefit for sellers using a documentary credit is the assurance of payment, provided they comply with the stipulated terms. ### Who usually issues a documentary credit? - [ ] Government agencies - [ ] Multinational corporations - [ ] Individual buyers - [x] Banks or financial institutions > **Explanation:** A documentary credit is typically issued by banks or financial institutions on behalf of the buyer. ### Which document is typically not required under a letter of credit? - [ ] Bill of lading - [ ] Commercial invoice - [ ] Packing list - [x] Employee details > **Explanation:** Employee details are not relevant for a letter of credit; however, a bill of lading, commercial invoice, and packing list typically are required. ### What does an irrevocable letter of credit signify? - [ ] It can be changed anytime. - [x] It can't be altered without consensus. - [ ] It's valid indefinitely. - [ ] It lacks documentation requirements. > **Explanation:** An irrevocable letter of credit cannot be changed or canceled without the agreement of all parties involved. ### What is a bill of lading used for? - [x] To confirm shipment details. - [ ] To issue credit against future purchases. - [ ] To document employee transfers. - [ ] To list office supplies. > **Explanation:** A bill of lading is a document issued by the carrier to confirm shipment details including type, quantity, and destination of the goods. ### How does a confirmed letter of credit differ from a regular one? - [x] It involves a second bank guaranteeing payment. - [ ] It has no expiry. - [ ] It is only used domestically. - [ ] It guarantees immediate payment. > **Explanation:** A confirmed letter of credit involves a second bank, usually in the seller's country, that guarantees payment thereby providing an extra layer of security. ### Why would a buyer prefer using a letter of credit? - [ ] To avoid legal obligations. - [x] To assure the seller of payment. - [ ] To evade taxes. - [ ] For reducing transaction costs. > **Explanation:** Buyers use letters of credit to assure the seller of payment upon meeting the terms, thereby facilitating smoother international trade transactions. ### What do we call a letter of credit that serves as a backup payment mechanism? - [x] Standby letter of credit - [ ] Repeating letter of credit - [ ] Conditional letter of credit - [ ] Unconfirmed letter of credit > **Explanation:** A standby letter of credit serves as a secondary payment mechanism, ensuring payment if the primary obligation is not met. ### What is a certificate of origin? - [ ] A document issued by customs authorities. - [x] A document declaring the origin country of goods. - [ ] A receipt for payment. - [ ] An insurance policy for goods. > **Explanation:** A certificate of origin is a document that declares the country of origin of the goods being shipped.

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