A letter of credit is a document given by a bank to its customer (usually a buyer) guaranteeing payment to a seller upon the presentation of documents. When a letter of credit is issued, the issuing bank requires the buyer to have cash in her account or credit available on a credit line to satisfy the payment amount on the letter of credit. Letters of credit are common in international transactions where seller and buyer do not know each other and a bank’s letter of credit provides some assurance to the buyer and seller that goods will be delivered and payment on the goods will be made. The letter of credit can be accounted for as an asset on the balance sheet.
Record the bank’s issue of the letter of credit. Debit a “Letter of Credit” account and credit “Cash” or “Line of Credit” account. This journal entry moves the payment amount from a cash or credit line account to the letter of credit account. This entry reserves the payment amount by decreasing cash (asset) or increasing the amount owed on a line of credit (liability). The balance of the “Letter of Credit” account is used specifically for payment of the amounts specified on the bank’s letter of credit.
Complete the order/transaction with the seller or other party involved. Once the terms of the order are complete and the seller can present the required documents stated on the letter of credit, the bank can issue payment to the seller. For example, in transactions involving international sales, when goods are delivered and the proof of delivery document is presented to the bank, payment is made to the seller.
Record the letter of credit’s payment to the seller. Debit the “Inventory” or other asset account for the value of the goods purchased, and credit the “Letter of Credit” account for the payment issued by the bank. This journal entry eliminates the cash or credit reserved for the letter of credit and records an asset for the inventory or other resources received from the transaction.
Do not confuse "letter of credit" with "line of credit"; a line of credit functions in the same way as a credit card.