A Letter of Credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller (exporter) on behalf of a buyer (importer), provided that the seller meets specific terms and submits the required documents. It is primarily used for import transactions but can also be used for domestic (regular) purchases in certain cases.

For the Seller: Ensures they receive payment as long as they meet the conditions.

For the Buyer: Ensures goods are shipped as agreed before payment is made.

Step 1: When Goods are Received & LC Becomes Payable

The LC obligation becomes a liability once the seller ships the goods and presents documents to the bank.

Entry:

  • Debit: Inventory (or Purchases) → This records the cost of goods purchased.
  • Credit: Creditors (Accounts Payable) → This records the supplier's obligation to pay.

Example:

Entry in Buyer's Books (Importer):

  • Dr. Goods AED 2,500
  • Cr. Current Trade Payables AED 2,500


Step 2: Record Payment Using the LC Bank Account

Since the payment is made via an LC, a Dummy Bank account (representing the LC Bank Account) is created to track the LC-related transactions. The amount is transferred from Creditors to the LC Bank Account.

Entry:

  • Debit: Creditors → This reduces the liability, as the payment is initiated.
  • Credit: LC Bank Account → This represents the LC obligation in the books.

Example:

  • Dr Creditors AED 2,500
  • Cr Bank LC Account AED 2,500

Note: Since this is an import, the customs declaration and other import-related entries will remain unchanged. The only difference lies in the payment perspective.

Users can create a new GL account to separately track this balance and use the same GL for the dummy bank, renaming it as needed.

Step 3: Settling the LC Payment from the Actual Bank

Once the LC payment is due, the company transfers funds from its actual bank account to settle the LC Bank obligation.

Entry:

  • Debit: LC Bank Account → This removes the liability from the dummy LC Bank account.
  • Credit: Actual Bank Account → This reflects the payment made to the LC issuing bank.

Example:

Dr LC Bank Account AED 2,500
Cr Actual Bank AED 2,500

Create a Money transfer document, to transfer the balance between banks

This ensures that the LC process is properly recorded, from goods received to payment settlement. 


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