Irrevocable Letter of Credit

A letter of credit is a mechanism a seller can use to reduce risk and facilitate payment for international trade.

A letter of credit works by substituting the credit of a bank for that of the buyer, it is basically a guarantee to the seller that the buyers bank will make payment. If the buyer does not pay, then the letter of credit places on obligation on the bank which issued it to pay the seller.

An irrevocable letter of credit, sometimes referred to as an irrevocable lc, is one which cannot be revoked or amended by the buyer or issuing bank without agreement from the seller.

For example, if a business (seller) is exporting goods, then it is sensible to obtain some form of payment guarantee before the goods are shipped, with an irrevocable letter of credit, providing the business presents the correct documents and complies with the terms and conditions, payment will be made.

Irrevocable Letter of Credit Procedure

  1. Buyer (applicant) and seller (beneficiary) agree contract with payment guaranteed by irrevocable letter of credit
  2. Buyers bank (issuing bank) issues an irrevocable letter of credit to seller
  3. Seller sends goods to carrier in exchange for shipping documents
  4. Seller sends shipping documents to sellers bank (advising bank)
  5. Sellers bank sends shipping documents to buyers bank
  6. Buyers bank sends payment to sellers bank who pays seller/li>
  7. Buyers bank sends shipping documents to buyer in return for payment/li>
  8. Buyers uses shipping documents to get goods from carrier

The irrevocable letter of credit has the advantage that the seller is guaranteed payment, and the buyer is guaranteed to receive their goods before payment is released. The disadvantage of an irrevocable letter of credit is that there are additional costs involved as the banks involved make charges to cover the cost of providing them.

Accounting for an Irrevocable Letter of Credit

When the buyer asks the issuing bank to open a letter of credit, the issuing bank is effectively guaranteeing payment and so will require security from the buyer, this security is given in the form of a letter of credit margin payment, which is an amount of cash set aside from the buyers main account with the bank. The amount of the letter of credit margin depends on the buyers relationship with the bank, and can range from 0% to 100% of the value of the irrevocable letter of credit.

Suppose for example, a buyer asks its bank to open a letter of credit for £40,000 to purchase inventory, the bank requests a letter of credit margin of £4,000 and charges commission fees of £350. The for this irrevocable letter of credit example is as follows:

Open the LC and pay the LC margin to the bank
Account Debit Credit
Letter of credit margin account 4,000
Cash 4,000
Total 4,000 4,000

The letter of credit margin account represents cash set aside by the bank and is an asset of the business included on the balance sheet.

Record the liability to the bank for the irrevocable letter of credit
Account Debit Credit
Goods in transit 40,000
Irrevocable letter of credit liability 40,000
Total 40,000 40,000
Pay the commission on the irrevocable letter of credit when realized
Account Debit Credit
Letter of credit commission fee expense 350
Cash 350
Total 350 350
Pay the bank to clear the irrevocable letter of credit liability
Account Debit Credit
Irrevocable letter of credit liability 40,000
Letter of credit margin account 4,000
Cash 36,000
Total 40,000 40,000

The cash payment is reduced by the letter of credit margin already held by the bank.

Record the receipt of the inventory
Account Debit Credit
Inventory 40,000
Goods in transit 40,000
Total 40,000 40,000
Irrevocable Letter of Credit November 6th, 2016Team

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