Letter of Credit (Documentary Credit)

Letter of Credit Documentary Credit International Trade Irrevocable Revocable Confirmed Export Import
A letter of credit, or documentary credit, is a fundamental financial tool in international trade, providing a promise of payment from a bank to a seller on behalf of a buyer under specified conditions.
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Definition

A Letter of Credit (LC), also known as a Documentary Credit, is a document issued by a bank to another bank, generally in a different country, that guarantees payment to a seller on behalf of a buyer. The issuing bank backs this promise, ensuring payment will be made once the agreed conditions and documentary requirements are satisfied. Letters of credit serve as a reliable means of payment in international import and export transactions.

Types of Letters of Credit

  1. Irrevocable Letter of Credit: Cannot be canceled or altered without the consent of all parties, including the beneficiary.
  2. Revocable Letter of Credit: Can be amended or canceled at any time without prior notice to the beneficiary.
  3. Confirmed Letter of Credit: Includes a guarantee from a secondary bank (usually in the beneficiary’s country), ensuring payment even if the issuing bank defaults.
  4. Unconfirmed Letter of Credit: Does not have a secondary bank guaranteeing the payment.
  5. Circular Letter of Credit: An instruction from a bank for its correspondent banks to pay the stated sum to the beneficiary upon identification presentation. This has largely been replaced by traveler’s cheques.

Examples

  1. Exporter and Importer Trade: An exporter in the United States sells goods to a buyer in Japan. The buyer’s bank in Japan issues a letter of credit that promises the exporter will be paid upon presentation of specified documents (like shipping receipts).

  2. Manufacturer and Supplier: A manufacturer in Germany supplies parts to an automobile company in Brazil. To secure payment, the Brazilian automobile company’s bank issues a letter of credit to the German manufacturer’s bank.

Frequently Asked Questions

1. What is the main advantage of using a letter of credit in international trade?

  • It offers a guarantee of payment to the seller and reduces the risk of non-payment due to buyer insolvency or deliberate default.

2. Can a letter of credit be extended beyond its expiry date?

  • Yes, but extensions require the consent of all involved parties, including the issuing bank, the negotiating bank, and the beneficiary.

3. What’s the primary difference between confirmed and unconfirmed letters of credit?

  • A confirmed letter of credit includes a guarantee from a secondary bank, ensuring the beneficiary gets paid even if the primary issuing bank fails. An unconfirmed letter lacks this additional security.

4. Why is an irrevocable letter of credit preferred over a revocable one?

  • Because it cannot be changed or canceled without all parties’ consent, providing, especially to the seller, a higher security level regarding payment.

5. How are shipping documents related to letters of credit?

  • The presentation of specific shipping documents (detailed in the letter of credit) by the beneficiary triggers the payment promise of the credit.
  • Beneficiary: The party (usually the seller/exporter) in favor of whom the letter of credit is issued.
  • Issuing Bank: The bank that issues the letter of credit on behalf of the importer/buyer.
  • Negotiating Bank: Typically the beneficiary’s local bank that facilitates payment upon receiving and verifying the required documents.
  • Expiry Date: The final date by which the terms of the letter of credit must be fulfilled.

Online References

  1. Investopedia - Letter of Credit
  2. International Chamber of Commerce - Documentary Credit
  3. U.S. Small Business Administration Article on Letters of Credit

Suggested Books for Further Study

  1. “The Law of Letters of Credit” by James G. Barnes
  2. “International Trade Finance: A Practical Guide” by Trader Hojn
  3. “UCP 600: An Analytical Commentary” by John F. Dolan

Accounting Basics: “Letter of Credit” Fundamentals Quiz

### What is generally the main advantage of using a letter of credit in international trade? - [ ] Simplifying shipping logistics - [x] Guaranteeing payment to the seller - [ ] Reducing customs duties - [ ] Avoiding currency exchange > **Explanation:** The primary advantage is that a letter of credit guarantees payment to the seller and reduces the risk of non-payment. ### An irrevocable letter of credit ________. - [x] Cannot be canceled or altered without consent - [ ] Can be changed at any time without notice - [ ] Is the same as a revocable letter of credit - [ ] Guarantees quick shipment > **Explanation:** An irrevocable letter of credit cannot be canceled or amended without all parties’ consent, ensuring higher security for the involved parties. ### What does a confirmed letter of credit provide? - [x] An additional payment guarantee from a secondary bank - [ ] A quicker negotiation process - [ ] A waiver of documentary requirements - [ ] A preset exchange rate > **Explanation:** It offers an additional guarantee from another bank, typically in the beneficiary's country, ensuring payment even if the issuing bank fails. ### In which scenario can a revocable letter of credit be changed or canceled? - [ ] Only when the issuing bank fails - [ ] Only before the documents are presented - [x] At any time without prior notice to the beneficiary - [ ] Only with the beneficiary’s consent > **Explanation:** A revocable letter of credit can be amended or canceled at any time without prior notice to the beneficiary, offering less security compared to irrevocable credit. ### Circular letters of credit have been largely replaced by ________. - [ ] Bank drafts - [ ] Credit cards - [x] Traveler's cheques - [ ] Electronic fund transfers > **Explanation:** Circular letters of credit are mainly replaced by traveler's cheques. ### Which type of letter of credit provides the highest assurance of payment? - [x] Confirmed irrevocable letter of credit - [ ] Circular letter of credit - [ ] Unconfirmed letter of credit - [ ] Revocable letter of credit > **Explanation:** A confirmed irrevocable letter of credit offers the highest assurance, providing multiple layers of payment guarantee. ### What is required for payment under a letter of credit? - [ ] Just an ID check - [ ] Issuing bank approval only - [x] Presentation of specified documents - [ ] An independent corporate bond > **Explanation:** Payment is made upon presenting specified documents outlined in the letter of credit, which proves the terms have been met. ### What happens to a letter of credit after its expiry date? - [ ] It remains valid indefinitely - [ ] It converts into cash automatically - [ ] It’s reversible - [x] It can only be amended or negotiated with consent from all parties > **Explanation:** After its expiry date, it can only be negotiated or amended with the agreement of all involved parties. ### Why is a letter of credit termed 'documentary'? - [x] Because it requires presentation of specific documents for payment - [ ] It involves documentation of company policies - [ ] It must be documented in governmental records - [ ] It involves documentation of stock levels > **Explanation:** It's termed 'documentary' as the payment process depends on presenting specific, required documents that confirm contract fulfillment. ### What’s the role of the negotiating bank in a letter of credit transaction? - [ ] To issue the letter of credit - [ ] To approve the buyer's credentials - [ ] To provide logistics services - [x] To facilitate payment to the beneficiary upon verifying documents > **Explanation:** The negotiating bank is responsible for facilitating payment to the beneficiary once it verifies that all documentary conditions specified in the letter of credit are met.

Thank you for exploring the detailed accounting term “Letter of Credit” and testing your understanding through our structured quiz. Keep enhancing your financial acumen!

Tuesday, August 6, 2024
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