Tip of the month

Using the right Incoterm ® 2010 with Letter of Credit (L/C) transactions.

The introduction of the new Incoterms in 2011 (DAT/DAP) has thrown up some interesting issues for the likes of Export Training Services to advise on. In particular, can the new terms be used when the likely payment term is a Letter of Credit (L/C) transaction?

Many exporters/importers have started to use the two new terms. It appears that the lure of being seen to be keeping "up-to-date" has been quite powerful and perhaps one might think that the two new terms might well be suitable in all situations. Well perhaps not! Now, before I start to berate the new terms and wax lyrical about the more older and traditional ones, I do think it is imperative for all traders to review which ones they are using to ensure that they are up-to-date and "best practice" and reflect the correct level of risk and costs to the company in question. However, just replacing one old for one new without reviewing its suitability is daft and could lead to more problems down the line.

To understand the issue surrounding L/C transactions one has to understand the main difference between the "C" and the "D" family of terms. In addition, one has to appreciate the main principle of a L/C transaction which is that the paying bank likes to pay when the goods are seen to be "on the water" Or, for the airfreight traders amongst you, "in the air". So the main principle to focus on when reading this article is that the "shipment" date on an L/C is always the date the goods are "shipped" out of a country and not out of a factory. Traditionally this is one reason why EXW can be seen to be a poor term when using a L/C. In addition, most exporters would recognise that they can control the date of shipment but not the date of arrival (unless they were chartering a vessel/aircraft?) The place of delivery within the traditional EXW term is "the seller's loading bay" whilst most L/C's that I have seen over the years have all stated that the "shipping" date is the date the goods "leave the exporting country". This is normally evidenced by a "Shipped on Board Bill of Lading" or a "Certified that the goods have flown" Air Waybill. The International Chamber of Commerce (ICC) has also recommended that, going forward, EXW should be considered as a "national" term and not "international" which, perhaps, makes it even more unsuitable for an L/C transaction. Furthermore, the place of delivery under the "D" family of terms is deemed to be when the goods "land" or "arrive" in the importing country. Once again, contrary to the principle of a "shipped date".

So, here is a question for you to ponder:

What are the main two differences between these two terms:

CIP Singapore Airport Incoterm ® 2010 & DAT Singapore Airport Incoterm ® 2010?

Most observers will see that the shipping costs to Singapore would be paid by the seller on both terms, so no change there. Export Customs procedures both arranged by the seller too. The answer to the above lies not with costs or obligations, but with two other key issues, namely: risk and place of delivery.

An Incoterm like CIF Singapore Incoterm ® 2010 or FOB UK Port Incoterm ® 2010 assists both parties (seller and buyer) to confirm four key areas in a sales contract where there is a movement of goods involved. The four key areas are: Costs, Risks, Delivery and Obligations. Under the "C" family of terms the place of delivery and place where the risk passes from the seller to buyer is when the goods have been "shipped" or handed over to the carrier in the export country. The "D" family of terms are fundamentally different, under these terms the seller has to "deliver" the goods to the import country. Or as the ICC put it, "make the goods arrive" in the importing country.

Therefore, the inherent "delivery" date for a "C" term is a "shipping" date, whilst the date that the goods have been delivered on a "D" term would be when the goods have arrived. In some instances (sea freight mainly) this could be weeks/months after the goods have been "shipped". So, one wonders how a L/C expiry date could ever be 10-21 days after shipment date when a "D" term has been used?

In addition to the place of delivery, another key difference between the "C" and "D" terms is risk. Risk passes from the seller to the buyer when the goods are shipped or handed over to the first carrier under the "C" family of terms whereas the risk does not pass from seller to buyer until the goods have arrived in the importing country within the framework of the "D" terms.

As a L/C transaction will nearly always relate to the shipment of goods and not the delivery of goods, it would follow that the "C" terms are more suitable for these types of transactions.

For me, the letter "D" stands for "daft" when dealing with a L/C. So, sales guys should be encouraged to ensure that a sales contract is concluded with a "C" term, when a L/C is involved as a payment instrument, and not one of the "D" terms.

I think the two new Incoterms have there place. Perhaps they could be used within a trading area like the EU where L/C transactions are less common. However, the terms (and the skills) to be used when dealing with the more "international" markets are very different and the more traditional terms are certainly more suitable. In recent years many trading companies have looked to the EU for their sales and have treated these as their major markets. During that time, I feel that the UK has lost the skills needed to fully understand trade and how transactions like L/C's work. It occurs to me that the changes in Incoterms ® 2010 and the fact that the main additions were within the "D" family of terms highlights how the world has changed.

The growth markets, going forward are the BRICS (Brazil, Russia, India, China) these tend to lend themselves more to L/C type transactions, due to the currency and country risks. So, if British/EU exporters wish to trade efficiently with these types of markets, then understanding the subtle but vital differences between the terms used and what terms are most suitable is vital.

One last Incoterms thought for you to consider before I sign off. It involves an area that I will be reflecting on in our next series of "tips of the month", namely: Revenue Recognition ... When can you call a sale a sale? And in which period (month) should you count the revenue or stock? ... When the goods are shipped or delivered? Revenue recognition is a key factor when deciding which term is most suitable for the international trade transaction!