Letter of Credit
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Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
When a seller isn't confident a buyer will actually pay, a letter of credit removes that risk — by putting a bank on the hook instead of the buyer.
What is a letter of credit?
A letter of credit is a bank's guarantee that a company will pay what it owes. Say your company buys $1 million worth of goods, but the seller isn't confident you'll pay for them. The seller can require you to obtain a letter of credit: your bank issues a letter stating that if you don't pay the $1 million, the bank will pay it instead.
Why does a letter of credit matter to the seller?
It shifts the credit risk from the buyer to the bank. The seller no longer has to trust the buyer's ability or willingness to pay — they're getting paid either way, whether it's the buyer or the buyer's bank that writes the check.
A letter of credit substitutes the bank's creditworthiness for the buyer's. It's most useful when the seller doesn't know the buyer well enough to extend credit on trust alone — the bank's guarantee closes that gap.
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Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.