Letter Of Credit

 

Definition of letter of Credit: “A letter of credit is a letter of guarantee from a bank for the payment to be received by seller on time as agreed from buyer.”

In other words, we may call it a letter of trust or guarantee for payment to the seller from the buyer.

It is used extensively in the financing of cross-border trades. It helps to inculcate trust between the buyer and seller who may not be known to each other. Therefore, to establish the reliability between buyer and seller, they introduce their bank as an underwriter that assumes the counterparty risk of the buyer who will pay to seller for goods. 

Types of LCs: The following are the LCs issued by banks.

a)    Irrevocable LC -: This type of LC can not be amended or cancelled without the agreement of all the concerned parties. This is an unconditional undertaking by the issuing bank to make the payment.

b)    Revocable LC -: It can be amended or cancelled at any moment by the issuing bank even without the consent of any other party until the documents are not taken.

c)     Transferrable LC -: It can be transferred completely or partly in favour of any party by advising the bank at the request of the issuing bank.

d)    Back-to-Back LC -: In this case, the beneficiary uses the same LC to get another LC in favour of the seller.

e)    Negotiation LC -: Negotiating LC can be freely negotiable to any bank chosen by the LC issuing bank.

f)      Red Clause LC -: This LC has a Red Clause through which an intermediary bank is allowed to make an advance payment to the beneficiary before shipment.

g)    Green Clause LC -: In this LC, pre shipment and post shipment advances are allowed to the exporter.

h)    Revolving LC -: Under this LC, a fixed amount can be renewed as soon as the earlier bills have been paid.

i)      Confirmed LC -: If advising bank provides the confirmation to the beneficiary then it is called confirmed LC and only irrevocable LC can be confirmed.

 

Prominently, four parties are involved in the payment of the Letter of Credit:

1)    Buyer/Importer: - Who makes the payment as per letter of credit’s terms and conditions.

 

2)    Seller/Exporter: - It gets the payment from the buyer’s bank as per the LC’s terms and conditions.

 

3)    Buyer’s Bank: - It may be called an opening bank or issuing bank and it is liable to pay.

 

4)    Seller’s Bank: - Who receives the payment from the buyer’s bank.

 

The letter of credit is governed by the rules of UCPDC (Uniforms Customs and Practice for documentary credits) and the International Chamber of Commerce, Paris. Letter of credit can be issued by banks, financial institutions, mutual funds and insurance companies.

The operations of LC could be easily understood with the help of the following steps:

1. 1.    Contract between buyer and seller for supply of goods.
2. 2.    Buyer approaches his bank to issue LC to the seller.
3. 3.    The seller consigns the goods to a carrier and takes a Bill of Lading from the carrier.
4. 4.    The seller gives a Bill of Lading along with documents to his bank for payment as proof of dispatch of goods.
5. 5.    The seller’s bank gives a Bill of lading along with documents to the buyer’s bank for payment.
6. 6.    The buyer’s bank provides the documents to the buyer.
7. 7.    The buyer provides the documents along with the Bill of Lading to the carrier and takes the delivery of the goods.

 

 MCQs

  

Q1. What type of error is called where one journal entry is debited to the wrong account head?

Ans. An error of principle

Q2. Provision for Bad Debts shown on which side of the trial balance?

 Ans. Credit side

Q3. Which of the following errors will affect the trial balance?

i)                Wrong balancing of an account

ii)              Wrong totalling of an account

iii)             Amount written in the wrong account but on the correct side

iv)             Omission of amount in an account.

Ans. (a) i        (b) ii & iii       (c) i, ii & iv    (d) i, ii, iii & iv

Q4. Which of the following accounts will generally show a credit balance?

i)                Loan a/c

ii)              Income a/c

iii)             Bank a/c

iv)             Capital a/c

Ans. (a) i, ii & iv       (b) iii (c) ii, iii & iv (d) i & iv

 

Q5. Case Study:

What would be the rectification entry if credit sales to Mr. Ram Rs. 5,000 was recorded as Rs. 50,000 in the sales book.

Ans.    i)        Ram a/c Dr. 45000 to sales a/c 45000

 ii)        Ram a/c Dr. 55,000 to sales a/c 55,000

iii)       Sales a/c Dr. to 45,000 to Ram a/c Cr.   45,000

iv) Sales a/c Dr. to 55,000 to Ram a/c Cr. 55,000

 

Q6. Is it possible to use the letter of credit for trade within the country?

Ans. Yes

Q7. In which type of letter of credit, pre and post-shipment advance is allowed to avail?

Ans. Green Clause LC

Q8. Which bank requests for confirmation of a letter of credit to the confirming bank?

i) Advising bank             ii) Negotiating bank           iii) Opening bank    iv) Reimbursing bank

Ans. iii

Q9. Which bank sends a letter of credit to the beneficiary?

a)    Issuing bank             ii) Negotiating bank           iii) Reimbursing bank            iv) Advising bank

Ans. iv

Q10. Case Study

M/s Porcupine Industries, a manufacturer of solar panels wants to import solar cells from U.S. based company named Apple Lighting Inc. in India for total cost of USD 10000. The Apple lighting Inc. who is banking with HSBC Bank, has issued an invoice stating that the sale transaction must be backed by a letter of credit. Therefore, M/s Porcupine Industries approached its bank SBI to open of letter of credit in foreign currency USD. The SBI’s correspondent bank in the U.S. is City Bank, New York.

i)                What is the name of the letter of credit issuing bank?

ii)              Who is the beneficiary of the letter of credit in this case?

iii)             Who is advising the bank in this case?

iv)             Who is the negotiating bank in this case?

v)              Who is confirming bank in this case?

 

Ans. i) SBI     ii) Apple Lighting Inc.         iii) City bank             iv) HSBC        v) City bank