Customer Submitted Case Studies

Case Study: Functional Overview on Letter of Credit

Author: Deepak Seeruwani, Consultant Contributors: Naveen Rangineni, Consultant Skill Level Rating for this Case Study: Intermediate

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Case Study Abstract

This case study will provide a practical guide to letters of credit and as there is no functionality as of now to use Letter of Credit as a means of payment which is increasingly being used, a workaround in Oracle Payables to handle payments through Letters of Credit. Within its limitations it is hoped that:

x x

This paper will serve as a basic tool in understanding letters of credit and The solution given in this case study is specific to Letter of Credit transactions of our Middle East client and might not applicable globally to all types of Letter of Credit transactions because the practice adopted in other regions of world might differ from what is followed in Middle East.

Case History
Documentary credits, commercial letters of credit or just letters of credit, play an integral part in facilitating international trade while providing a secure and reliable means of payment. One of our clients in Middle East is using letters of credit extensively as a means of payment to their Suppliers. To map payments using Letters of credit in Oracle Payables module we suggested the given solution without any customization.

Analysis Letter of Credit defined

In simple terms, a letter of credit is a bank undertaking of payment separate from the sales or other contracts on which it is based. It is a way of reducing the payment risks associated with the movement of goods. Expressed more fully, it is a written undertaking by an issuing bank to the beneficiary to make payment within a specified time, against the presentation of documents which comply strictly with the terms of the credit. Therefore, the risk to the seller of nonpayment by the buyer is transferred to the issuing bank (and the confirming bank if the letter of credit is confirmed) as long as the exporter presents the documents in strict compliance with the credit. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods. Other than cash in advance, a letter of credit is the most secure method of payment in international trade, with the payment undertaking of the bank, as long as the terms of the credit are met. The letter of credit also provides security for the importer who can ensure all contractual documentary requirements are met by making them conditions of the letter of credit.

Why Letter of Credit is used?

When the seller has doubts about the credit worthiness of the buyer and wishes to ensure prompt payment, the seller can insist that the sales contract provides for payment by irrevocable letter of credit. Furthermore, if the bank issuing the letter of credit (issuing bank) is unknown to the seller or if the seller is shipping to a foreign country and is uncertain of the issuing banks ability to honour its obligation, the seller can, with the approval of the issuing bank, request its own bank or a bank of international repute to assume the risk of the issuing bank by confirming the letter of credit.

Benefits of Letter of Credit

To the Exporter/Seller
x x Letters of credit open doors to international trade by providing a secure mechanism for payment upon fulfillment of contractual obligations. A bank is substituted for the buyer as the source of payment for goods or services exported.

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x x

x x

The issuing bank undertakes to make payment, provided all the terms and conditions stipulated in the letter of credit are complied with. Financing opportunities, such as pre shipment finance secured by a letter of credit and/or discounting of accepted drafts drawn under letters of credit, are available in many countries. Bank expertise is made available to help complete trade transactions successfully. Payment for the goods shipped can be remitted to your own bank or a bank of your choice.

To the Importer/Buyer x Payment will only be made to the seller when the terms and conditions of the letter of credit are complied with. x The importer can control the shipping dates for the goods being purchased. x Cash resources are not tied up

Steps in Letter of Credit Transaction

1. Sales Contract
The sales contract is the formal agreement between the buyer and seller specifying the terms of sale that both parties have agreed upon. The contract should include: a description of the goods; the amount; the unit price; the terms of delivery; the time allowed for shipment and presentation of documents; the currency; and the method of payment.

2.

Application & Agreement

The banks letter of credit application and agreement forms, when executed, constitute a payment and reimbursement contract between the issuing bank and its customer. It is also the customers instruction to the issuing bank. The agreement constitutes an undertaking by the customer to reimburse the issuing bank for drawings paid in accordance with the terms of the letter of credit, and normally takes the form of an authorization to debit the customers account.

3.

Issuance of the Letter of Credit

The issuing bank prepares the letter of credit as specified in the application and forwards it to the advising bank, (a branch or correspondent of the issuing bank). The issuing bank instructs the advising bank as to whether or not to add its confirmation, as per their customers instructions.

4.

Advising

The advising bank forwards the letter of credit to the beneficiary (seller) stating that no commitment is conveyed on its part. However, if the advising bank has been asked to confirm the letter of credit and agrees to do so, it will incorporate a clause undertaking to honour the

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beneficiarys drafts, provided the documents evidence that all terms and conditions of the letter of credit have been complied with.

5.

Shipment of Goods

Upon receiving the letter of credit, the beneficiary should examine it carefully and be satisfied that all the terms and conditions can be complied with. If this is not possible, the beneficiary should request the applicant to arrange an amendment to the letter of credit. Once completely satisfied, the beneficiary will then be in a position to assemble and ship the goods.

6.

Presentation of Documents by Beneficiary

The beneficiary prepares an invoice in the number of copies required, with the description of goods shown exactly as stipulated in the letter of credit. The beneficiary obtains the bill of lading and/or other transport documents from the carrier and prepares and/or obtains all other documents required by the letter of credit. These are attached to the draft, drawn on the bank indicated and at the term stipulated in the letter of credit, and are presented to the advising/confirming/negotiating bank.

7.

Sending Documents to the Issuing Bank

The advising/confirming/negotiating bank checks the documents presented by the seller against the letter of credit. If the documents meet the requirements of the letter of credit, that bank will send them to the issuing bank, claiming reimbursement and paying the seller.

8.

Delivering Documents to the Applicant

The issuing bank will also check the documents for compliance and then deliver them to the applicant either against payment or as an undertaking to pay on maturity of the drawing under the letter of credit

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Results, Conclusion and Learnings

We concluded that we could provide a solution that could be adopted in Oracle Applications to record Letter of Credit transactions. The functional process we used is shown below.

In case of Sight letter of credit:

Sight letter of credit can permit the beneficiary to be paid immediately upon presentation of specified documents.

1.

Raise a Purchase Order

Raise a Purchase Order in Oracle Purchasing stating the description of goods, quantity, unit price, and terms of delivery. Purchase order would be issued after beneficiary examined that all the terms and conditions of letter of credit are/can be complied with. Letter of Credit number and/or other details can be tracked on Purchase Order with the help of DFF.

2.

Record a Prepayment Invoice against Vendor

In case of confirmed sight letter of credit the confirming bank is obliged to honour the drawing without recourse to the beneficiary. Beneficiary (Seller) should present following documents to Advising / Confirming Bank: x Invoice with description of goods shown exactly in LC x Bill of lading and/or other transport documents x Draft (Bill of exchange) x Other documents as required by letter of credit The advising/confirming/negotiating bank will claim reimbursement from the issuing bank and issuing bank in turn from buyer by debiting his account. On receipt of the debit advice from Bank enter a Prepayment Invoice in Oracle Payables against Vendor:

In cases where seller bears the risk (Trade term is DAF/DES/DDU/ DDP)
Dr Advance to Supplier Cr Liability

Debit Credit

In cases where title of goods Debit are deemed to be transferred to Buyer (Trade term is EXW/ FOB/CFR/CIF)
Dr Goods in Transit XXXX Cr Liability

Credit

XXXX XXXX

XXXX

3.

For Payment of the above Prepayment Invoice

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Record a dummy payment against the above Prepayment Invoice. For making this dummy payment, a Dummy LC Bank or Dummy LC Bank Account (under a Bank through which Letter of Credit has been processed) can be created. Account Dr Liability Cr LC Payment Clearing Account Debit XXXX Credit XXXX

4. Simultaneously, raise an Invoice against Bank to record the liability towards payment made by Bank to Vendor.
Account Dr LC Payment Clearing Account Cr Bank Liability Debit XXXX Credit XXXX

5.

Payment to Bank
Account Dr Bank Liability Account Cr Bank / Bank Clearing Account Debit XXXX Credit XXXX

6.

Receipt of Goods

On receipt of goods record a receipt transaction in Inventory Account Dr Material Account Cr AP Accrual Account Debit XXXX Credit XXXX

7.

On receipt of Invoice from Vendor

Enter an Invoice in Oracle Payables & match it with Purchase order: Account Dr AP Accrual Account Cr Liability Account Debit XXXX Credit XXXX

8.

Apply the prepayment against above Invoice

Account Dr Liability Account Cr Advance to Supplier / Goods in transit Debit XXXX Credit XXXX

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In case of Usance letter of credit:

Term/Usance Letters of credit can permit the beneficiary to be paid at a future date as established in the sales contract.

1.

Raise a Purchase Order

Raise a Purchase Order in Oracle Purchasing stating the description of goods, quantity, unit price, and terms of delivery. Purchase order would be issued after beneficiary examined that all the terms and conditions of letter of credit are/can be complied with. Letter of Credit number and/or other details can be tracked on Purchase Order with the help of DFF.

2.

Receipt of Goods

On receipt of goods record a receipt transaction in Inventory Account Dr Material Account Cr AP Accrual Account Debit XXXX Credit XXXX

3.

On receipt of Invoice from Vendor

Enter an Invoice in Oracle Payables & match it with Purchase order: Account Dr AP Accrual Account Cr Liability Account Debit XXXX Credit XXXX

4.

For Payment

Record a dummy payment against the above Invoice. For making this dummy payment, a Dummy LC Bank or Dummy LC Bank Account (under a Bank through which Letter of Credit has been processed) can be created.

Account Dr Liability Cr LC Payment Clearing Account

Debit XXXX

Credit XXXX

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5. Simultaneously, raise an Invoice against Bank to record the liability towards payment made by bank to Vendor with the Payment term attached (Say Due in 30 days)
Account Dr LC Payment Clearing Account Cr Bank Liability Debit XXXX Credit XXXX

6.

Payment to Bank

Pay the above Invoice as and when installments are due Account Dr Bank Liability Account Cr Bank / Bank Clearing Account Debit XXXX Credit XXXX

References
Glossary of commonly used terms
Issuing bank: The bank which issues the letter of credit on the instructions of the importer
(usually, but not necessarily, the importer's own bank).

Beneficiary: The party in whose favour the letter of credit is issued. Advising bank: The bank, usually but not necessarily in the beneficiary's country, through which
advice of the letter of credit is sent by the issuing bank.

Confirming bank: A bank usually in the country of the beneficiary which, at the request of the
issuing bank, joins that bank in undertaking to honour drawings made by the beneficiary, provided the terms and conditions of the letter of credit have been complied with.

Negotiating bank: The bank specifically nominated in the letter of credit to purchase the bill of
exchange (draft) drawn by the beneficiary on a drawee other than the negotiating bank. (If a letter of credit is freely negotiable, any bank willing to do so can be the negotiating bank).

EXW Ex works: "Ex Works" is the minimum/lowest obligation of a seller. The seller agrees to make the goods available to the buyer at the seller's premises (named place). The seller under EXW is not even responsible for bearing the cost of loading the goods onto the vehicle provided by the buyer, unless otherwise agreed in advance. The buyer bears the full cost and risks involved in bringing the goods from the EXW location to the ultimate destination. FOB Free on board: Goods shipped under FOB terms are placed on board the ship by the seller
at the specific port of shipment named in the sales agreement/purchase order/contract. All costs and risks from the point where the cargo "crosses the ship's rail" (i.e. is lifted from the quay/pier onto the vessel) passes to the buyer.

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CFR Cost & freight: Under CFR, the title and risks change at the ship's rail, just as in FOB terms,
but the cost allocation is different. For goods shipped under CFR, the seller pays all costs to deliver the goods up to the named port of destination (while under FOB, above, the buyer is responsible for those costs).

CIF Cost, insurance & freight: In its simplest form, CIF is CFR + Insurance. The seller must procure transport insurance against the risk of loss or damage to the goods (to the extent that is mutually agreed upon in the sales agreement). Seller contracts with insurance carrier or agent and pays the premium but issues insurance in a form/format that allows the buyer to later make claim directly to the insurance carrier or said carrier's agent. (Since Title/Risk has changed hands at FOB point, the seller is no longer entitled to make claim, unless specifically on behalf of the buyer, who, in fact, owns the goods.) DAF Delivered at frontier: DAF means that the seller is obliged to move the goods to the
named place at the frontier (border crossing). This is primarily a rail/truck term. The seller bears all costs/risks up to this point, but is not responsible for customs clearance, duty, or taxes

DES Delivered ex ship: Using DES requires the seller to make the goods available to the buyer "on board the ship at the place named in the sales contract". Unlike CFR and CIF terms, the seller has agreed to bear not just cost, but also Risk and Title up to the arrival of the vessel at the named port. Costs for unloading the goods and any duties, taxes, etc are for the Buyer. DDU Delivered duty unpaid: DDU terms require that the seller delivers the goods to the
buyer, UNCLEARED FOR IMPORT, at the point or place named in the sales agreement. The seller bears all costs and risks up to this point/place.

DDP Delivered duty paid: Just as EXW represented the seller's minimum obligation in an
international transaction, DDP would represent the seller's MAXI MUM obligation. Under DDP, the seller agrees to all costs and risks, including customs clearance fees and payment of import duties, up to the named place/point.

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