Introduction to Revocable Letters of Credit
A revocable letter of credit is a financial instrument commonly used in international trade transactions to facilitate payments between buyers and sellers. It’s crucial for learners in accounting and finance to comprehend the concept of revocable letters of credit as they play a significant role in mitigating payment risks and ensuring smooth trade operations. This guide will explain the definition, usage, and examples of revocable letters of credit in simple terms.
Definition of Revocable Letter of Credit
- What is a Revocable Letter of Credit? A revocable letter of credit is a financial guarantee issued by a bank on behalf of a buyer (importer) to a seller (exporter), promising to make payment for goods or services upon presentation of specified documents. Unlike irrevocable letters of credit, which cannot be amended or revoked without the consent of all parties involved, revocable letters of credit can be modified or canceled by the issuing bank at any time without prior notice to the beneficiary.
- Flexibility for the Buyer: The key characteristic of a revocable letter of credit is its revocability, which provides flexibility for the buyer in terms of modifying or canceling the letter of credit based on changing circumstances or business needs. However, this flexibility may pose risks for the seller, as the letter of credit can be revoked even after the seller has shipped the goods or performed the services.
- Limited Assurance for the Seller: Since a revocable letter of credit can be canceled or modified by the issuing bank without notice to the seller, it provides limited assurance for the seller regarding the payment. The seller may not have the same level of confidence in the creditworthiness of the buyer or the commitment of the issuing bank compared to an irrevocable letter of credit, which offers greater security and protection.
Usage of Revocable Letters of Credit
- Trade Transactions: Revocable letters of credit are commonly used in international trade transactions, where buyers and sellers are located in different countries and may not have established a long-standing relationship or trust. By using a revocable letter of credit, the buyer can provide assurance to the seller that payment will be made upon presentation of the required documents, while retaining the flexibility to modify or cancel the letter of credit as needed.
- Short-Term Financing: In some cases, buyers may use revocable letters of credit as a form of short-term financing, allowing them to defer payment for goods or services until a later date. By issuing a revocable letter of credit, the buyer can obtain the necessary goods or services without immediately paying the seller, thereby preserving cash flow and liquidity for other purposes.
Example of Revocable Letter of Credit
Suppose Company A, a manufacturer based in the United States, wishes to purchase raw materials from Company B, a supplier located in China. Since Company A and Company B have not previously conducted business together and Company B is concerned about the creditworthiness of Company A, they agree to use a revocable letter of credit for the transaction.
- Issuance of the Letter of Credit: Company A applies for a revocable letter of credit from its bank, specifying the terms and conditions of the transaction, including the amount of the credit, documents required for payment, and expiration date of the letter of credit.
- Shipment of Goods: Upon receipt of the revocable letter of credit, Company B prepares and ships the raw materials to Company A as per the agreed-upon terms and conditions of the transaction.
- Presentation of Documents: Company B submits the required shipping documents, including the bill of lading, commercial invoice, and packing list, to its bank for payment under the revocable letter of credit.
- Payment Authorization: Before making payment to Company B, the issuing bank reviews the documents presented by Company B to ensure compliance with the terms of the letter of credit. If the documents are in order, the bank authorizes payment to Company B.
- Revocation of the Letter of Credit: However, after reviewing the documents, Company A decides to cancel the revocable letter of credit due to unforeseen circumstances or changes in its business requirements. The issuing bank revokes the letter of credit and notifies Company B of the cancellation.
In this example, Company B, the seller, faces the risk of non-payment due to the revocable nature of the letter of credit, as Company A, the buyer, can cancel the letter of credit even after the goods have been shipped and the documents presented.
Conclusion
In conclusion, a revocable letter of credit is a financial instrument used in international trade transactions to facilitate payments between buyers and sellers. While providing flexibility for the buyer, revocable letters of credit offer limited assurance for the seller and may pose risks in terms of payment security and reliability. Understanding the features, usage, and implications of revocable letters of credit is essential for learners in accounting and finance involved in international trade and finance operations.