What is letter of credit? What are the differrent types of LOC?

Definition of Letter of credit:-

A written document issued by the bank on request of its customer, promising to pay specified sum in a specified currency by a buyer's (or importer's) bank i.e. issuing bank to the seller's (beneficiary or exporter's) bank i.e. accepting bank or negotiating bank or paying bank for providing of goods and services. The banks collect a fee for issuing a Letter of credit. The "Letter of credit" is also termed as "Credit letter" or "Documentary credit" which contains the below supporting documents:-

(a) Commercial invoice (Proof of value of goods and services),
(b) Bill of Entry / Bill of lading (Proof of shipment),
(c) Waybill either by air or by sea,
(d) Certificate of Origin,
(e) Packing list,
(f) Insurance certificate,
(g) Inspection certificate as proof of quality,
(h) Draft or Bill of exchange which Is negotiable instrument to be given to the bank in order to get paid.

Parties involved in Letter of credit:-

(a) Buyer or Importer or applicant,
(b) Issuing Bank,
(c) Seller or Exporter or Beneficiary
(d) Confirming bank or Seller's bank or Negotiating bank or Advising bank.

Accounting procedure:-

(a) Buyer and seller agree the contract with payment guaranteed by ‘Letter of credit (LC)' ,
(b) Buyer's bank issues Letter of credit LC to seller or beneficiary,
(c) Seller sends goods to carrier in exchange of shipping documents,
(d) Seller sends shipping documents to seller's bank,
(e) Seller's bank sends the shipping documents to buyer's bank,
(f) Buyer's bank sends payment to seller's bank,
(g) Buyer's bank sends shipping documents to buyer in return for payment,
(h) Buyer uses shipping documents to get goods from carrier,
(i) Buyer will make payment to Buyer's bank.

Types of Letter of credit:-

1. Commercial LC :-

The seller of goods may face difficulty to judge credibility because the seller don't know about foreign buyer. Hence, for the security of money purpose, seller can accept for providing the goods to buyer by using Letter of credit. This type of LC is known as Commercial or Standard LC.

2. Standby LC :-

An LC that gives guarantee by the issuing bank for the payment in case payment not done by the buyer of goods is known as Stand by LC. It is similar to Bank guarantee which does not enable transaction, but guarantees the payment.

3. Confirmed LC :-

The seller (or exporter) of goods may acquire the guarantee for payment from a confirming bank (or second bank, or seller's bank) to avoid the risk of non-payment from the issue bank (or first bank, or buyer's bank). This type of LC is called as Confirmed LC.

4. Transferable LC:-

The beneficiary (seller) having the right to further transfer of payment which is entire or a part of payment to another beneficiary in case of intermediary between the actual supplier/seller of goods and the buyer. For example, the intermediate beneficiary sends only documents whereas actual supplier sends goods to the buyer.

5. Revocable LC:-

An issue bank having the facility to adjust the terms and conditions of LC or cancel the LC completely without giving prior notice to the beneficiary. This kind of LC is called as Revocable LC. The reasons for revoke the LC are Declined market conditions, Political tension, Insufficient funds, etc. If applicant of LC gives personal guarantee or mortgage to obtain LC, it is called as secured Revocable LC. If the issue bank issues LC solely by looking at applicant's history and credit score, etc. is known as un-secured revocable LC.

6. Revolving LC :-

An LC which allows to issue for covering multiple transactions in place of issuing separate LC for each transaction is known as Revolving LC.

7. Red clause LC :-

An LC which allows an advance payment to the beneficiary (or seller / exporter) on written confirmation, before the goods are shipped or services performed to the buyer, for the purpose of working capital to purchase raw material, processing, and packaging of goods, etc. is called as red clause LC.

8. Green clause LC :-

An LC which allows a payment is granted to the beneficiary (or seller / exporter) on written undertaking receipts and additional advances for pre-shipment warehousing at port of origin, and insurance expenses apart from covered in red clause, etc. only after the purchased goods are stored in bonded warehouses, is known as Green clause LC.

9. Deferred payment LC :-

The Letter of credit which allows the payment after a certain period of goods are shipped to the buyer. The buyer's bank may review the documents early, but the payment to the beneficiary (or exporter/seller) will be made after the agreed time passes is termed as Deferred payment LC.

Advantages of LC :-

(a) Works as a credit certificate to buyer,
(b) Risk free credit to seller,
(c) Customized contract between buyer and seller,
(d) Global business expansion as safe,
(e) Guaranteed payment in disputable transactions,
(f) Pre-shipment fund available to exporter of goods,
(g) Timely payment leads to better cash flow planning for seller of the goods and services.
(h) Less production risk, if the buyer cancels or changes the order

Disadvantages of LC :-

(a) Bank fee is an additional cost to the buyer,
(b) Time consuming process (or formalities),
(c) Possibility of fraud risk.
(d) Default risk by issuing bank,

Difference between Letter of credit and Bank guarantee:-

Letter of credit:-

(a) It is a financial document for enable payments to seller on behalf of the buyer against the stated documents provided by seller.
(b) Less risk for buyer (or merchant), and more risk for the buyer's bank,
(c) Buyer's bank need not to wait till payment made by buyer to seller,
(d) Buyer's bank can make Payment only when condition specified is fulfilled,
(e ) It is suitable for import and export business.

Bank guarantee:-

(a) The guarantee given by the bank to the beneficiary on behalf of the applicant when the applicant fails to make payment to the beneficiary.
(b) Less risk for the applicant's bank, and more risk for the buyer (or merchant),
(c) Guarantee becomes active only when applicant will not make payment to the beneficiary,
(d) Buyer's bank can make Payment only when applicant fails to make payment to the beneficiary,
(e) It is suitable for government contracts.

Example of Letter of credit transaction :-

‘Tata motors' company wants to buy 1000 tyres from ‘MRF' limited, which costs of Rs50,00,000 but Tata motors having bank balance of Rs20,00,000 at present. Tata motors ask MRF for credit period of 60 days to pay balance payment, but MRF is in doubt whether Tata motors will be able to pay the balance payment or not. At the same time MRF is not ready to leave the customer. Thus, MRF limited asks Tata motors to produce Letter of credit to receive the material. Therefore, Tata motors consults SBI to make the total payment of Rs50,00,000 to MRF through LC, SBI accepts the letter of credit on payment of LC commission @ 25%. Then, Tata motors make payment of Rs12,50,000 as 25% LC commission to SBI, and SBI make the required payment of Rs50,00,000 to MRF. Then, MRF limited sent 1000 tyres to Tata motors. Finally, Tata motors received the tyres, and balance payment of Rs37,50,000 will be made to SBI within the said due date by SBI.

Accounting treatment in the books of accounts of buyer for purchasing of goods through Letter of Credit :-