Irrevocable Letter of Credit

An irrevocable 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. Issuing bank issues an irrevocable letter of credit in favour of the seller and forwards it to the advising bank.
  3. Advising bank authenticates the letter of credit and forwards it to the seller.
  4. Seller sends goods to carrier in exchange for shipping documents.
  5. Seller sends shipping documents to advising bank.
  6. Advising bank examines shipping documents for compliance and forwards to issuing bank.
  7. Issuing bank sends payment to advising bank who pays seller.
  8. Issuing bank sends shipping documents to buyer in return for payment.
  9. Buyer uses shipping documents to get goods from carrier.

irrevocable letter of credit process

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 a 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 letter of credit.

Irrevocable LC Example

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 double entry bookkeeping 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
Letter of credit liability 40,000
Total 40,000 40,000
Pay the commission on the 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 letter of credit liability
Account Debit Credit
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
Last modified July 16th, 2019 by Michael Brown

About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.

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