When entering into new transactions between individuals and individual entrepreneurs, organizations and enterprises, the question often arises: "How to insure against dishonesty of counterparties and avoid the loss of money or goods?". This issue is especially relevant when payment is made in advance. At the same time, the risks increase if the contract is concluded for a significant amount with foreign partners. The solution is simple - to apply letters of credit for settlements. What is a letter of credit, not everyone knows. However, having studied all the intricacies of this type of calculation, customers feel more secure and confident in conducting major deals.
Letter of credit: what is it in simple language?
A letter of credit is a form of cashless payment, which is carried out under the control of two banking organizations. A bank that protects the interests of the buyer transfers money to the seller’s account of the product (service) only if the seller provides the necessary documents to the bank. A list of documents is compiled at the conclusion of the transaction and is prescribed in the contract.
The scheme of interaction between partners may be a little complicated, it all depends on the type of letter of credit. Despite this, the banking organization acts as an intermediary who, for a fee, ensures the execution of the transaction.
Benefits of a letter of credit for a buyer
Compensation under a letter of credit, in comparison with other forms of payment, has advantages for the buyer:
- money is transferred to the seller only after the delivery of the goods to the buyer - for this it is necessary to provide the bank with the entire necessary list of documents drawn up properly;
- if delivery is not made, the money is returned to the buyer at a predetermined time;
- the bank guarantees that the goods will be delivered in the agreed volume and assortment, as well as of appropriate quality, as the seller is obliged to provide bank employees with documents confirming the assortment, quality and quantity of the goods;
- the risk of negative tax consequences of the transaction is reduced - the bank guarantees the correctness of execution of documents accompanying the transaction, otherwise the bank will not transfer money to the seller’s account;
- settlements under a letter of credit can be provided by the bank on credit on terms favorable to the buyer - this allows not to withdraw a large amount of funds from the turnover to pay for the transaction.
Letter of credit scheme
What is a letter of credit, we found out. Now let's see how transactions with this form of payment go in practice.
Stage 1. The seller and the buyer sign a contract (contract of sale / purchase, delivery of goods, rendering of services), in the conditions of which the form of settlements on the letter of credit is prescribed, as well as the conditions for its disclosure.
2 stage. The buyer submits an application and a copy of the contract to the bank. Based on the documents provided, the banking organization opens a letter of credit. If necessary, the letter of credit can be confirmed by the seller’s bank, if these requirements are stipulated by the contract.
3 stage. Coverage of a letter of credit is formed either at the expense of the client-buyer, or on the basis of a loan provided to this person by the issuing bank.
4th stage. The seller delivers the goods, sends the properly executed documents to the bank. After the bank checks that all conditions are met, a letter of credit is opened and the seller receives payment.
5 stage. The buyer receives the goods and all accompanying documents.
This scheme is simple and transparent.The letter of credit for the supplier acts as a guarantee of payment, and for the buyer it reduces the risk of losing money, as in the case of prepayment to an unknown counterparty. At the same time, the bank accompanies the transaction, checking its purity.
Types of letters of credit
The decisions of the Central Bank of the Russian Federation stipulate the possibility of opening such types of letters of credit:
- A covered (deposited) bank letter of credit - what it is, in simple terms can be described as follows: the buyer opens an account with the bank and transfers money to it in the amount necessary to cover the letter of credit. The issuing bank transfers the amount to correspondent account financial institution where the seller’s account is open. This is the most common type of settlement for letters of credit.
- Uncovered (guaranteed) letter of credit - the issuing bank does not transfer funds to the executing bank, but provides the opportunity to write off funds from the account opened with it, within the amount specified in the contract. The procedure and terms for debiting funds from the account of the issuing bank occurs in accordance with the existing interbank agreement.
- Revocable - a documentary letter of credit, which can be revoked, amended or canceled by the bank on behalf of the payer without the consent of the supplier and even without prior notice.
- Irrevocable - a type of agreement that can only be canceled after the executing bank receives consent to change the conditions from the supplier of the goods. There is no partial acceptance of the terms irrevocable letter of credit.
- Confirmed - a form of interaction, which implies an additional guarantee of payment by the bank, which does not act as an issuer. A financial institution undertakes to pay for goods (services), even if the issuing bank refuses to make a payment. This form of interaction applies only to an irrevocable letter of credit. Confirmation requires an additional fee to the bank.
Additional varieties
Today, there are several types of letters of credit. They are varieties of those described above.
A documentary letter of credit with a red reservation is a contract according to which the executing bank receives the authority from the issuing bank to pay the advance payment to the supplier of the goods in the amount specified in the contract until the goods are fully delivered or the service is fully provided.
Revolving view - opens when the contract provides for several deliveries of approximately equal parts in value over a certain period of time. A letter of credit is opened for an amount equal to one delivery, with the condition that after each payment, the original amount will be restored to the account. In parallel with this, the contract amount will be cyclically reduced.
Transferable (transferable) letter of credit - makes payments not only in favor of the seller, but also in favor of third parties (suppliers). This type is used when the seller delivers through the supplier and is not the direct shipper. A third party, having shipped the goods to the specified address, provides the necessary documents to the executive bank, after which all previously agreed payments are made in his favor.
Which type of letter of credit to choose?
As a rule, participants must independently determine the form of the letter of credit and coordinate it with the bank. The main factors affecting the choice of a letter of credit are the terms of the transaction and the interests of the parties. To do this, you need to understand exactly what a letter of credit is and which of its forms are used in our country.
At the moment, Russian legislation regarding settlement of non-cash payments is somewhat behind our western neighbors, so you can focus on international rules for documentary letters of credit,developed by the International Chamber of Commerce.
It should be borne in mind that not every bank is ready to accept non-standard conditions of a letter of credit. This is due, to a greater extent, to the lack of qualified specialists in this field. Therefore, before including non-standard conditions in the main contract, you need to coordinate them with the banks of the recipient and payer of funds.
Settlement Participants
In order to choose this form of payment, it is not enough to know what a letter of credit is. You must also understand that, like any other form of cashless payment, it has its drawbacks.
In this transaction, not two parties are involved, as in ordinary settlements, but four. In addition to the seller and the buyer, the seller’s bank and the buyer’s bank participate in it, where a simple letter of credit is opened, an account is opened and all the main operations take place. This introduces certain difficulties in the transaction.
Design difficulties
Calculation of a letter of credit implies stringent requirements for documents and terms, as well as the complexity of the processing procedure. In addition to drafting the main contract between the buyer and seller, it is required to exchange documents between banks. Despite the fact that now this is done in electronic form, it takes time to check all the documents.
Expensive service
The cost of this type of payment is quite high. The Bank charges a fee for all operations carried out with letters of credit. In addition, from the moment of opening the letter of credit, the money in the buyer's account is frozen, which is a guarantee of the cover of the letter of credit.
Conclusion
Despite all its shortcomings, this form of payment is reliable and convenient for all participants in the transaction. Having understood all the intricacies of the process, the client will no longer be able to refuse this type of settlement.
