Irrevocable Letter of Credit (ILOC) Definition
In accounting, an irrevocable letter of credit is a financial document from a banking firm that guarantees the buyer’s payment obligation to the seller. It is referred to as irrevocable because it cannot be canceled or altered. What this means is that no one has the right to cancel or make changes to the details in the letter. It can only happen with the approval of all the concerned parties. The parties, in this case, include the seller, buyer, and the issuing bank.
A Little More on What are Irrevocable Letters of Credit (ILOC)
An Irrevocable letter of credit is much more common in the international trade space because of the risks involved. International traders use ILOC to secure payments. The document enables traders to do business transactions with confidence because it gives the seller payment assurance. Apart from offering credit risk protection to the seller, the document consists also of other transaction details such as:
- Price of the goods
- Terms of payment
- Delivery time
- Where to deliver the goods
Generally, ILOC is the means through which buyers and sellers facilitate their business transactions, of course, with their respective bank’s assistance. It is the buyer who initiates this process by requesting an ILOC from his or her bank. The document is then given to the bank of the seller.
Remember that the most crucial section of ILOC is where the bank of the buyer gives assurance to make payments should the buyer default. So, what happens is that in case the buyer fails to pay for the goods or services, his bank will come in to settle the pending payments. The transaction takes place between the banks where the buyer’s bank makes the payments to the seller’s bank account.
How Irrevocable Letter of Credit Works
An irrevocable letter becomes important when someone somewhere fails to commit to the obligation they agreed to. A good example of this is as follows:
- When an exporter ships goods and the buyer does not pay in time
- When a contractor is awarded a contract to ensure the implementation of a project and does not complete it
- When a buyer makes payment for goods to be delivered and the seller fails to deliver
The document also applies when you want to do business with someone outside your country you have never met in person. Or when you are dealing with a new vendor or customer. It means that you have not dealt with this person or firm before.
So, to some extent, you have your doubts as to whether or not the business transactions will pull through successfully. At this point, you may want an ILOC that will give you assurance of either payment or delivery of goods.
The main point is that without some guarantee, doing business with such kinds of risks may lead to traders incurring losses in the process. However, with ILOC in place, they can confidently sign contracts and do transactions with the assurance that they won’t lose their money in the process. In a nutshell, ILOC reduces such risks for both the seller and the buyers.
What purpose does an Irrevocable Letter of Credit Serve?
An irrevocable letter of credit serves two major reasons:
It helps traders in the international market to transact their business more confidently. The reason is that overseas transactions involve more risk compared to domestic. Also, in international trade, there are different legal requirements, political landscapes, and business cultures that my force the seller (beneficiary) to want to cover his payment. To ensure this, the seller will demand an ILOC from the buyer to guarantee his payments.
Secondly, the ILOC serves as a guarantee where, according to the seller, the creditworthiness of the buyer does not meet the minimum criteria that qualifies him for trade credit. Buyers also do not want to receive their goods late. They also want to ensure that they receive the exact quality and quantity they ordered. So, they may also request a letter of credit with all these details so that they are safe in case there is a problem with the shipment.
Which Parties are Involved in Irrevocable Letters of Credit?
An Irrevocable letter of credit consists of three parties; the applicant, issuing bank, and beneficiary. The beneficiary here is the seller, the buyer is the applicant. A seller may want a buyer to get a letter of credit from his or her bank for guaranteeing the amount of money involved in the transaction.
Besides the three parties, there is also what we call advising banks. Its responsibility is to review and verify the ILOC issued by the buyer’s bank to the seller. The seller may request it to review and confirm if the terms in the letter are okay and that the document is valid. Note that the bank moves from the advising bank to confirming the bank after reviewing and confirming the document.
Types of Irrevocable Letter of Credit
There are two types of ILOC and they are as follows:
Standby Irrevocable Letter of Credit
As the name implies, a standby ILOC is a document on standby in case there is a payment default by the company’s customer. Companies use this letter of credit when dealing with new customers so that they can establish a smooth payment pattern. Also, when customers happen not to meet the line of line minimum criteria, a company can use this document to meet the costs.
Documentary Irrevocable Letter of Credit
A documentary irrevocable letter of credit is a document that traders commonly use when making international transactions. However, this transaction can only take care of one transaction. Some of the details in the document include:
- Product departure as well as arrival dates
- Terms of payment
- Product description
- Amount involved (Price of the goods)
The Bottom Line
Generally, the irrevocable letter of credit is a very crucial document, especially to those in international trade. So, it is advisable not to draft the letter yourself. You are also advised not to copy someone else’s letter.
Remember, any slightest mistake in the letter may cause misinterpretation, which may later result in an expensive and long legal battle. Things may get ugly if the lawsuit involves a firm or a person overseas, where the law is different from the one in your country. In this case, the likelihood of you losing the case becomes high leading to a magnitude of loss from your end.
So, you may want to get a professional who understands how the letter is crafted to help you with this. Yes, you will incur additional costs, but it will go a long way to save you from unforeseen risks.