Accounting Entries for a Letter of Credit

Businesses require economic resources in order to start up, maintain and operate their revenue-producing activities. In order to acquire these economic resources, these businesses must either receive them as investments from their owners or incur economic obligations to other independent entities. Assets are economic resources, liabilities are economic obligations and the owner's investment is more often called owner's equity. Letters of credits are documents that provide irrevocable payments and are accounted for as being a contingent liability by the issuer.

Recognition is the concept of recognizing a transaction's existence by recording its values on the accounts. For example, recognizing a sale means to record it as being an increase to revenue and an increase to either cash or receivables depending on the method of payment. In most cases, transactions should be recognized once they are complete and if their payment or collection is reasonably assured.

The purpose of accounting is to provide the users of financial statements with accurate, faithful and timely information that they can use to make sound financial decisions. Sometimes, the figures disclosed on the statements will not constitute the totality of the business's knowledge of its imminent financial circumstances. For example, a business might know that one of its operations is a dud, but its recorded figures do not reflect this knowledge because it hasn't been disseminated yet. In these cases, the businesses are obligated to disclose all pertinent information in footnotes to their statements.

The issuer of the letter of credit is the financial institution that issues the letter of credit. Said financial institution records the letter of credit as being a contingent liability, meaning that it makes no entry for the document until it has been exercised. Instead, the financial institution must disclose in a footnote that it has such documents outstanding. Once exercised, the entry for them is an increase to expenses and either a decrease to the issuer's cash account or the occurrence of a payable on its part depending on its payment method.

Letters of credit has no impact on how other parties involved in the transaction account for the transaction. The buyer records an increase to whatever asset is being bought and a corresponding increase to whatever liability is appropriate for the asset in question. In comparison, the seller records an increase to its receivables, an increase in its revenues, a decrease in its inventory and an increase to its expenses in particular cost of goods sold.