Accounting for Letter of Credit
Letter of Credit is the bank guarantee that ensures the seller will receive payment from the buyer on the exact date.
In the modern business day, it is normal for the business to allow the buyer to purchase on credit. And it is even normal for the sell from business to business transaction. Each company will look for the opportunity to save on the cash flow. So most of the suppliers will the customer to purchase on credit in a certain period of time.
In internal trade, the purchase on credit will be complicated. Some companies even get scammed due to the trade across the border. The seller is not feeling comfortable delivering the goods to a random customer across the country. The buyer may receive the goods and never make payment.
The buyer will not feel comfortable making payment before receiving the goods as well. They may end up getting scammed by the seller who will never deliver the goods after receiving payment.
This is the reason that letter of credit becomes a solution for both buyer and seller. The bank will provide a guarantee to the seller the payment will receive after the goods are delivered. The bank collects payment from the buyer and only transfers it to the seller after the buyer receives and is satisfied with the goods. The goods must be the same as to purchase agreement. In the end, the buyer will receive the goods as promised and the seller receive full payment while the bank charge fees base on a certain percentage.
Letter of credit allows businesses to make trade more easily and reduce the risk of being scammed by another party.
Journal Entry for Letter of Credit (Buyer)
When the buyer requests the bank to open a letter of credit, the bank will require to make some payment in advance, it is called the margin account. It is the partial balance of the total LC amount and the percentage depends on the bank policy.
The company has to make the journal entry of debiting margin accounts and credit cash at the bank.
| Account | Debit | Credit |
|---|---|---|
| Margin Account (LC) | 000 | |
| Cash at Bank | 000 |
The margin account is the current asset which records on balance sheet. It will be reversed when the company makes full payment to the bank.
After the LC application is approved by the bank, the company has to pay the full LC amount to the bank to process further.
The journal entry is debiting goods in transit and credit cash at bank, Margin Account (LC).
| Account | Debit | Credit |
|---|---|---|
| Goods in Transit | 000 | |
| Cash at Bank | 000 | |
| Margin Account (LC) | 000 |
When the goods are delivered to the warehouse, the company has to record inventory and reverse the goods in transit. The journal entry is debiting inventory and credit goods in transit.
| Account | Debit | Credit |
|---|---|---|
| Inventory | 000 | |
| Goods in Transit | 000 |
In addition, the bank will charge LC fees based on the amount and bank policy. Company has to record it as an expense on the income statement.
The journal entry is debiting LC commission fee expense and credit cash at bank.
| Account | Debit | Credit |
|---|---|---|
| LC Commission Fees Expense | 000 | |
| Cash at Bank | 000 |
Example
Company ABC needs to purchase inventory of $ 100,000 from the supplier oversea which needs to process through letter of credit. ABC has requested the bank and the bank require to pay a margin account of $ 10,000 on the requested date.
One week later, the LC application got approved and ABC pay the full amount on the same day.
One month later, the inventory arrive at the company warehouse without any quality issues. The bank charge LC fee of $ 2,000. Please prepare an accounting record of LC process.
When the company pays the margin account, they have to record LC margin account and credit cash paid.
| Account | Debit | Credit |
|---|---|---|
| Margin Account (LC) | 10,000 | |
| Cash at Bank | 10,000 |
One week later, ABC pay the full LC amount. The journal entry is debiting goods in transit $ 100,000 and credit cash $ 90,000, Margin account $ 10,000.
| Account | Debit | Credit |
|---|---|---|
| Goods in Transit | 100,000 | |
| Cash at Bank | 90,000 | |
| Margin Account (LC) | 10,000 |
When the goods arrive, company has to record goods receives and reveres goods in transit. The journal entry is debiting inventory $ 100,000 and credit Goods in Transit $ 100,000.
| Account | Debit | Credit |
|---|---|---|
| Inventory | 100,000 | |
| Goods in Transit | 100,000 |
The LC fees charge must be recorded as an expense on the income statement. The journal entry is debiting LC Fees Charge $ 2,000 and credit cash at bank $ 2,000.
| Account | Debit | Credit |
|---|---|---|
| LC Commission Fees Expense | 2,000 | |
| Cash at Bank | 2,000 |