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 it can also be used for domestic (regular) purchases in certain cases.
It is commonly used in international trade to reduce risks for both parties:
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:
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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:If the invoice amount is AED 10,000
Entry in Buyer's Books (Importer):
- Dr. Inventory/PurchasesGoods AED 102,000500
- Cr Creditors AED10,000. Current Trade Payables AED 2,500
Step 2: Record Payment Using the LC Bank Account
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- 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 AED10 AED 2,000500
- Cr Bank LC Account AED10,000 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:
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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: Creditors LC Bank Account → This reduces removes the liability , as the payment is initiatedfrom the dummy LC Bank account.
- Credit: LC Actual Bank Account → This represents reflects the payment made to the LC obligation in the booksissuing bank.
Example:
Dr
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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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