In international trade, the term letter of credit is relatively common in use. What is a letter of credit? According to Investopedia, L/C is a letter from a bank guaranteeing that a seller will receive the buyer’s payment on time and for the correct amount. The Bank guarantees the payment of the importer to the exporter for the goods sent. L/C is issued at the request of the customer (importer) to make payment for the transaction documents sent by the exporter.
Types of Letter of Credit
Trade activities commonly use these several letters of credit examples. Not only international trade but sometimes domestic transactions also use L/C for security reasons.
Acceptance credit or time credit
Acceptance credit or time credit is a type of term note, which the buyer can make the payment for purchases within a certain period after they receive the goods. With this L/C, the bank lets the paying party pay in a certain period until the specified due date to pay for the product they receive.
Revocable credit and irrevocable credit
Revocable credit gives the right for the Bank that issues an L/C to cancel or make changes at any time without prior notification to the beneficiary. Even without notice, some reasons make the cancellation and changes happen, either from the seller or the buyer. In contrast to revocable credit, bank cannot cancel or change the content of the irrevocable credit unless both parties have an agreement to cancel it instead.
This credit document’s purpose is for direct payment as soon as the buyers receive the document from Bank. The order is, when the document is being checked, then it is declared to have passed and meets the requirements, then the paying party must immediately provide funds whose amount has been agreed upon by the buyer and seller.
is Not the letter of credit itself, the negotiations is use draft/note. Transferable credit is a document that can be diverted to a third party. This document should explicitly mention transferable credit to prevent misunderstandings.
When the buyer acts only as an intermediary or as a reseller, they use this letter of credit. Later the intermediary will distribute the goods to the actual buyer. Therefore, the recipient of the letter of credit must ask for bank assistance to open the letter of credit received from the real owner or abroad.
As the name implies, this letter of credit contains a particular clause from each opening party written in red ink. The clause states that the issuing bank gives authorization to the Bank responsible for payment to pay an advance to the recipient by the issuing Bank.
Revolving is a letter of credit that has unlimited time usage, which can use repeatedly without any remarkable changes to the L/C. A trustworthy bank usually makes these documents.
How Letter of Credit Works
The Bank that issued a letter of credit works as the third party that is not bound to any other party in a trade transaction. This L/C will protect both the seller and the buyer.
Not only buyers but sellers also get protection when using L/C. When the buyer cannot pay the seller, the Bank, as the issuer of the letter of credit, will pay the transaction to the seller. This is valid as long as the seller fulfills all the requirements in the L/C document.
L/C provides buyers protection in transactions. If the seller fails to deliver the goods or services they sell in a trade even though the buyer has paid, the letter of credit returns the buyer’s money. Therefore the seller will get penalty for failing to fulfill his obligations.
Using a letter of credit issued by the Bank as a third party in an international trade transaction will ensure that the transactions that occur are more secure and give such feelings to all parties involved. The Accounting System from Hashmicro will help you to simplify the data collection of your consumer payments. Monitor the company’s financial condition, reconcile all bank transactions, to manage and generate financial reports automatically in one integrated system.