Background

A letter of credit, often known as a “credit letter,” is an assurance from a bank that a buyer will pay a seller on time and in full. The bank will be obligated to pay the full or remaining balance of the transaction if the buyer is unable to make a payment on it. It might be provided as a service.

The usage of letters of credit has developed into a crucial component of international trade due to the nature of such dealings, which includes elements like distance, different regulations in each country, and difficulty in getting to know each partner personally.

(Investopedia as a source)

This blog describes the SAP Treasury & Risk Management procedure and the SAP Letter of Credit (Buy and Sell) process. SAP offers a basic letter of credit solution called “Trade Finance.” Starting with SAP 6.0 EHP8, SAP Trade Finance is accessible. The scenario presented in this blog is a commercial letter of credit that is directly paid by banks.

Use Case

Lee, the purchasing manager, is in charge of making the purchase orders for the raw materials used in the production of copper-insulated wires. Lee occasionally had to issue a buy order in order to obtain the raw material copper from a far-off source. Since copper is a commodity, it is traded on exchanges for commodities including the COMEX, Shangai Futures Exchange, and LME (London Metal Exchange). Lee must make sure that the price and amount of the transaction are fixed because market rates are what determine copper prices. Since the vendor is from another nation, Lee and the business partner agree to a Letter of Credit in order to eliminate the risk of vendor payment and the legal requirements of the vendor nation.

Lee spoke with his counterpart in finance (Rohan). Lee needs Rohan to clarify the IFRS requirement.

  • Letter of Credit Disclosure as a Contingent Liability (IFRS 4-Financial guarantee contracts and credit insurance)

Business need

In accordance with a business need, Lee issues a purchase order in exchange for an LC payment and contacts Rohan to discuss and complete the Letter of Credit with CITIBANK. Payment in accordance with the purchase order will be made upon the delivery of the goods to the port of Munich.

Payment will be granted once the bill of lading and invoice have been received (LC payment). The issuing/obligatory bank will receive payment and forward it to the recipient bank. Vendor is paid by the recipient bank. CITIBANK debits the following bank statement (payment against LC to the receiving bank). Once the LC payment has been debited from the bank statement, the vendor should be credited.

Details of the letter of credit must be submitted to the bank, and a SWIFT message must be used to confirm it.

Fig: 1 International Chamber of Commerce is the source.

According to IFRS accounting requirements, the LC accounting procedure should compile.

  1. Letter of Credit Disclosure as a Contingent Liability (IFRS 4-Financial guarantee contracts and credit insurance)

Utilizing SAP

Fig: 2

Process for Letters of Credit in SAP Trade Finance

Fig: 3

Agreement with Issuing Bank for LC Issue

Fig: 4

Fig: 5

Checking the counterparty’s credit limit (CITIBANK)

Fig: 6

LC presentation to the issuing bank

Fig: 7 (Standard SAP Workflow can be utilised for paying the contract) (Standard SAP Workflow can be used for settling the contract)

There is generated Contingent Liability.

TR-TM Clearing A/c Dr. 194200

Contingent Liability, Cr 159100

Fig: 8

LC presentation to the issuing bank

Fig:9

LC presentation

Fig:10

Bank LC Presentation (Payment obligation)

Fig: 11

Fig:12

Bank LC Presentation (Acceptant Payment)

Fig:13

Bank LC Presentation (Acceptant Payment)

Fig. 14 (JP Morgan is used as the advising/recipient bank in this blog and CITIBANK is the issuing bank)

Upon LC payments’ due date

Note that all dates are shown merely for illustration.

Fig:15 (Counterparty CITIBANK is associated with client 5000010099) (Counterparty CITIBANK is linked with customer 5000010099)

Vendor payment received on time

Fig:16 (Vendor payment accounting based on the bank statement obtained on next day of payment processing to Recipient bank) (Vendor payment accounting based on the bank statement received on next day of payment processing to Recipient bank)

Word of Credit (Sales Process)

Fig:17

LC presentation to the bank

Fig:18

Giving a letter of credit to the advising bank

Fig:19

alerting the issuing bank

The business partner master data can be used to build a PDF document and send it automatically to that partner’s email address.

Fig:20 (Sample utilised for this blog, Prior initiation to bank for getting into an LC contract) (Sample used for this blog, Prior initiation to bank for entering into a LC contract)

System of LC Accounting in the Treasury

Fig:21

Bank LC Presentation (Acceptant Payment)

Fig:22

Upon LC payments’ due date

Fig:23 (Counterparty CITIBANK associated with client 5000010099. LC Sales is against ABC Forwarder) (Counterparty CITIBANK linked with customer 5000010099. LC Sales is against ABC Forwarder)

Fig:24 (Payment credited to Customer based on the bank statement, LC payment received by issuing bank) (Payment credited to Customer based on the bank statement, LC payment received by issuing bank)

Additional Details

  • SWIFT, Open Text, and Block Chain integration for counterparty communication
  • The following can result in correspondence (MT700* per ISO standards) being triggered.
  1. LC Agreement
  2. Settlement
  3. Presentation
  4. Acceptance of presentation
  • Payment with SWIFT
  • Accounting entries are fully automated (bank statements/Treasury module).
  • Accounting for LC Fees may be integrated.
  • The SAP Limit Management feature can be expanded to include counterparty limits.

Disclaimer:

Depending on the needs of the client, accounting entries may alter. All of the accounting transactions shown in the blog are illustrative only and follow the LC standard operating procedure.

Conclusion

Complete solutions for the Buy & Sell Letter of Credit processes are covered by SAP Trade Finance. The entire procedure is automated using the usual SAP workflow process. To reduce the danger of manipulation using the workflow, contracts are automatically matched using the SWIFT MT format for communication with the banks.