In one sentenceA written undertaking the bank issues at the business's request to pay the beneficiary a set amount if the business does not meet its obligation during the letter's term.
Simply put
It is often required in tenders and contracts: a bid bond with the offer, a performance bond after the award, and an advance payment guarantee when part of the contract value is received before work starts.
The bank may hold part of the amount as a cash margin. The held margin is not an expense but restricted cash shown separately, and the letter's value itself is disclosed as a contingent liability.
Worked example
A contracting business requested a performance letter of guarantee of 500,000 SAR for a project, and the bank holds a cash margin (we assume 10% for illustration only).
Letter of guarantee value500,000
Assumed margin rate10%
Dr Letter of guarantee margins50,000
Cr Bank50,000
Cash held = 500,000 × 10%50,000 SAR
Don't confuse it with
Letter of creditA letter of guarantee is paid only if you fail to meet your obligation, while a letter of credit is a normal way of paying the supplier when the documents are presented.