ASC 460 Guarantees: Standby Letter of Credit Transaction Explained with Journal Entries

Posted In | ASC Education | Gridlex Academy

ASC 460 Guarantees, formerly known as FASB Interpretation No. 45, is a financial accounting standard that provides guidance on the accounting treatment for guarantees. In this article, we will delve into the concept of a standby letter of credit (SLOC), a popular guarantee instrument, and explain the accounting treatment for SLOC transactions, including journal entries.

 

What is a Standby Letter of Credit (SLOC)?

A standby letter of credit (SLOC) is a written guarantee issued by a bank, ensuring payment to a beneficiary if the applicant, typically a buyer or borrower, fails to fulfill the contractual obligations. SLOCs are commonly used in international trade transactions to reduce credit risk between parties, providing a safety net for the beneficiary.
 

Accounting for Standby Letters of Credit under ASC 460

The accounting treatment for SLOCs under ASC 460 requires recognition of the liability by the applicant (issuer) and the contingent asset by the beneficiary (receiver). The following steps describe the accounting treatment for SLOCs:
 

1. Issuance of SLOC: The applicant (issuer) applies for the SLOC with the issuing bank, agreeing to pay a fee for the service. The bank charges the applicant a fee for issuing the SLOC, which is typically recorded as a prepaid expense and amortized over the term of the SLOC.
 

Journal Entry (Applicant):

Debit: Prepaid SLOC Fees

Credit: Cash
 

2. Activation of SLOC: If the applicant fails to fulfill their contractual obligations, the beneficiary may draw on the SLOC. The issuing bank pays the beneficiary, and the applicant must reimburse the bank.
 

Journal Entry (Applicant):

Debit: SLOC Liability

Credit: Cash (amount paid by the bank)
 

3. Reimbursement of SLOC: After the beneficiary has drawn on the SLOC, the applicant is required to reimburse the issuing bank. This reimbursement amount is recorded as a liability for the applicant.
 

Journal Entry (Applicant):

Debit: Liability (e.g., Accounts Payable)

Credit: SLOC Liability
 

4. Settlement of SLOC: The applicant pays the issuing bank the reimbursement amount, settling the liability.
 

Journal Entry (Applicant):

Debit: SLOC Liability

Credit: Cash
 

5. Recording the Contingent Asset (Beneficiary): The beneficiary records the SLOC as a contingent asset. As a contingent asset, it is not recognized in the financial statements unless the realization of the asset becomes virtually certain.

 

Standby letters of credit serve as a valuable risk mitigation tool in international trade transactions. Understanding the accounting treatment for SLOCs under ASC 460 can help businesses accurately represent their financial position and ensure compliance with the applicable accounting standards. By following the steps and journal entries provided in this article, companies can navigate the complexities of SLOC transactions and maintain accurate financial records.