Paying by letter of credit: how does the bank protect both sides, and how is it accounted for on account 5510?
The buyer says «goods first», the seller says «money first». A letter of credit settles this dispute through the bank: the money is placed in a separate account in advance, and the seller receives it only after presenting the documents. The mechanism, a partly used letter of credit and all the journal entries under NAS No. 21, on the example of a tile sale.
The «Chorsu qurilish mollari» shop ordered 180 million soum worth of tiles from the «Afrosiyob keramika» factory in Samarkand. They had not worked together before. The factory director: "Pay in advance, then we ship." The shop owner, Jasur: "What if I transfer the money and the goods never arrive?" Both have good reason to worry. At times like this, banks offer a letter of credit.
All names and amounts are hypothetical and compiled by the author. For simplicity, amounts are shown without VAT.
How does a letter of credit work?
A letter of credit is the bank's obligation: on the buyer's instruction the bank pays the seller, but only if the documents agreed in the terms of the letter of credit are presented on time and correctly. The exact types, terms and deadlines are set by bank rules and the parties' contract. This article looks at the case where the buyer transfers the money into the letter of credit in advance.
The process step by step:
| Step | Who does what |
|---|---|
| 1 | The shop and the factory agree in the contract on payment by letter of credit, the amount, the deadline and the list of documents to be presented |
| 2 | The shop applies to its bank and transfers the money from its settlement account to a separate letter of credit account |
| 3 | The bank notifies the factory's bank that the letter of credit has been opened. Seeing that the money is "reserved", the factory ships the goods |
| 4 | The factory presents the documents confirming shipment to the bank |
| 5 | The bank checks the documents against the terms of the letter of credit. If they match, it pays; if they do not, it does not pay |
| 6 | If money remains in the letter of credit when it expires, it is returned to the buyer |
The bank usually does not check the goods themselves or their quality; it checks the documents. That is why it matters to state clearly in the contract which document confirms what.
What is each side protected from?
| Risk | Without a letter of credit | With a letter of credit |
|---|---|---|
| The buyer pays in advance and does not receive the goods | The money is with the seller; a claim is needed to get it back | Until the documents are presented, the bank does not release the money to the seller |
| The seller ships the goods and is not paid | The debt has to be collected | The money is reserved in the letter of credit before shipment |
| The buyer spends the money on something else | It can happen | The money in the letter of credit is held separately and is not used outside the terms of the letter of credit |
A letter of credit has a cost too: the bank may charge a fee, and the buyer's money is "frozen" until payment. So it makes sense to use it mainly with a new partner or for a large amount.
How is it recorded in the buyer's accounts?
Money in a letter of credit is recorded on account 5510 "Letters of credit". It is still the shop's money, just kept in a separate "pocket". Under paragraph 231 of NAS No. 21, 5510 is debited when money is transferred into the letter of credit, written off to 6010 when it is used, and 5510 is credited when unused money comes back.
Sequence of events: the factory shipped 172 million soum worth of tiles and presented the documents; an 8 million soum portion (tiles in one colour) was not shipped because it was out of stock. After the letter of credit expired, the remainder came back.
| No. | Transaction | Debit | Credit | Amount | NAS No. 21 |
|---|---|---|---|---|---|
| 1 | Money transferred from the settlement account to the letter of credit | 5510 | 5110 | 180 000 000 | Paragraph 234, line 1 |
| 2 | Tiles received into the warehouse | 2910 | 6010 | 172 000 000 | Paragraph 154, line 2 |
| 3 | The bank paid the factory from the letter of credit (based on the bank statement) | 6010 | 5510 | 172 000 000 | Paragraph 234, line 7 |
| 4 | Unused remainder returned to the settlement account | 5110 | 5510 | 8 000 000 | Paragraph 234, line 6(a); paragraph 226, line 6 |
Check: on 5510 the debit is 180 000 000 and the credit is 172 000 000 + 8 000 000 = 180 000 000, balance zero. On 6010 the credit is 172 000 000 and the debit 172 000 000, so the debt is closed.
If the shop opens the letter of credit not from its own money but from a short-term bank loan, entry 1 becomes Dr 5510 – Cr 6810 (paragraph 234, line 4).
For the bank's fee for the letter of credit, the pattern "payments for banking and audit services" in paragraph 412, line 12 of NAS No. 21 applies: Dr 9430 – Cr 6990.
And in the seller's accounts?
For the factory a letter of credit looks like an ordinary payment: the money arrives in its settlement account.
| Transaction | Debit | Credit | Amount | NAS No. 21 |
|---|---|---|---|---|
| Buyer's debt (sale) recorded | 4010 | 9010 | 172 000 000 | Paragraph 174, line 1 (9010–9030) |
| Money from the letter of credit received in the settlement account | 5110 | 4010 | 172 000 000 | Paragraph 226, line 3 |
The entry writing off the cost of the products sold does not depend on the letter of credit and is not shown here.
Practical tips
- Analytical records. Open a separate analytical account under 5510 for each letter of credit (paragraph 231). If several letters of credit are open at once, the balances will not get mixed up.
- Month-end check. Compare the 5510 balance with the letter of credit balance in the bank statement. If there is a difference, an amount used or returned has not been recorded.
- Watch the deadline. Money left in an expired letter of credit may have come back automatically while entry 4 remains unrecorded.
- List of documents. State clearly in the contract the documents the seller must present: the bank checks against exactly this list.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
"Arnasoy kimyo" LLC deposited 10 mln soum from its settlement account into a chequebook. The bank paid 6.2 mln soum on the cheques; another cheque for 1.5 mln soum was issued to a supplier but has not yet been presented to the bank for payment (hypothetical amounts). Under paragraph 232 of NAS No. 21, what is the balance of account 5520 "Checkbooks"?
A company borrowed money for 8 months from another organisation that is not a bank. In which account is this borrowing recorded?
The accounting ledger of "Sho'rchi texno" LLC shows a balance of 18 600 000 soum in account 5110. When reconciled with the bank statement, two entries not yet recorded in the ledger were found: a customer payment of 1 200 000 soum was received and a bank service fee of 90 000 soum was charged (hypothetical amounts). After both entries are recorded in the ledger, what is the balance of 5110 under paragraph 225 of NAS No. 21?
The bank lent "Tomdi tikuv" LLC 60 000 000 soum for 45 days. Under the contract the annual rate is 18% and a year is taken as 360 days for interest calculation (hypothetical terms). What is the amount of interest accrued on the loan?
Money had been deposited in a checkbook from a short-term loan. The bank returned the amount of unused checks to repay the short-term loan. What journal entry is made?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 21 "Chart of Accounts for Accounting of Business Entities and Instructions for Its Application", paragraph 231 · 5510 records cash held in letters of credit; transfers are recorded on the debit of 5510 and the credit of 5110, 5210, 5220; use is charged to the debit of 6010 on the basis of bank statements; unused funds returned are recorded on the credit of 5510; analytical records are kept for each letter of credit
- NAS No. 21 "Chart of Accounts for Accounting of Business Entities and Instructions for Its Application": paragraph 234 (lines 1, 4, 6(a) and 7) · 5510 / 5110–5220; 5510 / 6810; 5110–5220 / 5510; 6010 / 5510
- NAS No. 21 "Chart of Accounts for Accounting of Business Entities and Instructions for Its Application": paragraph 226 (lines 3 and 6); paragraph 154 (line 2); paragraph 174 (line 1); paragraph 412 (line 12) · 5110 / 4010; 5110 / 5510, 5520; 2910–2990 / 6010, 7010; 4010 / 9010–9030; payments for banking and audit services 9430 / 6990
- Fundamentals of banking (general concepts) · the letter of credit mechanism: buyer's bank, seller's bank, payment against documents; the exact types, terms and validity are set by bank rules and the parties' contract
- Example, company names, amounts and calculations · compiled by the author, hypothetical; VAT is not shown for simplicity