Letters of Credit

Q: Due to some potential new business opportunities off-shore through India, Russia, etc., we are exploring "Letters of Credit" as a means to make payment to suppliers. I am looking for any information possible that describes how an AP "Letter of Credit" process works and any best practice suggestions for how to manage that type of process? Should the AP, Treasury, or Procurement business areas of an organgization be the owner of this type of process? Any suggestions?

A: Here are a few things to consider with using Letters of Credit ("LC") including the types of LCs available, how the process works, and internal duties:

What is an LC?
A letter of credit is a document issued by a financial institution (bank) that basically acts as a guarantee for payment to the beneficiary of the LC. In this case Hallmark issues a letter of credit to its international vendor in an amount you expect to purchase. Your bank or lending institution would set up an LC with Hallmark as applicant (company who wants to send money) and your vendor as a beneficiary (company who wants to receive the money). The issuance and performance of an LC is generally subject to publications of the International Chamber of Commerce (ICC) and Uniform Commercial Code (UCC). The LC can state the conditions that govern its enforcement.

Example Transaction
Hallmark decides to do business with International Acme and wants to buy $1 million in paper products. International Acme agrees to sell Hallmark $1 million in paper products and give you 60 days to pay on the condition that they are provided a 90 day LC for the full amount. So the following can occur to secure the LC.
  • Hallmark goes to its lending institution (Big Bank) to request a $1 million LC with International Acme as beneficiary
  • Big Bank issues the LC based on a standard underwriting process much like a loan, or Hallmark funds it with a direct deposit of funds of $1 million plus fees
  • Big Bank sends a copy of the LC to International Acme's bank, who in turn notifies International Acme that payment is ready and they can ship the product to Hallmark
  • On presentation of specific documents outlined in the terms of the LC such as delivery of the product to Hallmark, etc... then Big Bank would send International Acme's bank the $1 million to settle the account
Types of LCs: Stand By LC or Revolving LC
If the LC that is required from your vendor is not tied to a specific transaction but rather they are asking for a guarantee of payment in case you default, then they are probably asking for a Stand By or Revolving LC. In this case you pay the vendor per their terms from an invoice you receive directly from them. If you default, then they have the means to get paid through the LC.

Revocable LC
As the name states it is an LC that your bank can revoke without agreement of the beneficiary.

Irrevocable LC
This LC cannot be cancelled or amended without all parties agreeing.

Internal Duties
Generally if a company has a Treasury Department, then Treasury will delegate the set up and securing of an LC from their bank. The Accounts Payable Department can facilitate the collection of all the appropriate documents in order to allow the payment to proceed. If there is a stand by letter of credit, then the Accounts Payable Department will function per its normal processes in processing and paying vendor invoices. Who performs what duties will largely depend on your management's philosophy on internal controls, available staff resources, and your internal control environment. Since an LC is a guarantee of payment to a vendor, you should treat it with due care and make sure there are appropriate management sign-offs based on the dollar limits you place on personnel for purchasing. Some companies require each LC issued to by signed by two executive level managers. Below are some of the groups who can be involved in the LC process.
  • Treasury Department – secure an LC
  • Accounts Payable – responsible for processing vendor invoices per company policy
  • Receiving – responsible for receiving documentation that supports receipt of the product and forwarding to AP
  • Purchasing – issues the purchase order to initiate the transaction and forwards a copy to AP for matching to invoice
  • CFO/CEO/Treasurer or similar level manager – approve issuing an LC
  • Company's bank – issues the actual LC
References
Below are some articles with good information about LCs. We trust this gives you information to discuss with your management team in understanding an LC process, the types of LCs and who may be involved within your company in facilitating this type of transaction.

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