Chapter 6 The use of documents in trade
This chapter examines the different terms
of payment used in trade and explains how
documents are used in each context. In
particular, it concentrates on how documents
can be used by both the buyer and the seller
to manage the risks associated with each
term of payment.
The four types of payment term
In any trade there is a risk to the seller or
exporter and the buyer or importer. The four
main types of payment term (discussed in
Chapter 3) represent different balances of
this risk between the two parties.
Open account trading
Under open account terms, the seller assumes
the majority of the risk in the transaction. The
goods or services are provided in advance,
with the buyer promising to pay within a pre-
agreed period. Once the goods have been
dispatched, the seller has very little control
over the contract, as the buyer will have control
of the goods. In the case of the provision of
a service, the provider has even less control,
as the buyer will already have consumed the
service before payment is made.
Documentary collection
Under the terms of a documentary collection,
the seller’s exposure is reduced, compared
with open account trading. The seller prepares
a set of documents which are forwarded to the
seller’s bank. The seller’s bank forwards these
documents to the buyer’s bank, together with
instructions for payment. The buyer’s bank
will exchange the documents for either a cash
payment or future payment by way of a bill
of exchange, drawn on the buyer. The buyer
exchanges the collection documents for the
shipped goods. The risk to the seller varies
according to whether payment is made in
cash or by acceptance of the bill of exchange.
In both cases, once the buyer has title to
the goods, the seller will either have cash
or a signed bill of exchange as evidence of
payment or a promise to pay.Documentary credit
Under the terms of a documentary credit
(or letter of credit, L/C), the balance of the
risk assumed shifts more towards the buyer
(the applicant), compared with both open
account terms and a documentary collection.
A documentary credit is a legal obligation of
the bank that has issued the credit to pay
funds to the seller (the beneficiary) upon
receipt of certain specified documents. As
long as the seller provides the bank with these
documents, the bank will pay the agreed
funds. However, the buyer does derive some
benefit from the use of a documentary credit,
as the seller will need to ensure the terms of
the credit are met in order to receive payment.Payment in advance
At the other end of the scale, the buyer
assumes the majority of the risk in the
transaction. The seller will only dispatch the
goods on receipt of settled funds from the
buyer. Once the buyer has submitted the
funds to the seller, the buyer is exposed to a
range of risks associated with the transaction,
from insolvency of the seller to failure to
deliver the goods or provide the service.Shipping terms
Incoterms
International Commercial Terms (Incoterms)
were developed by the International Chamber
of Commerce to help both parties to an
international transaction understand precisely