Credit Instruments

The credit instrument is the basic evidence of indebtedness. Most trade credit is offered on open account. This means that the only formal instrument of credit is the invoice, which is sent with the shipment of goods and which the customer signs as

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evidence that the goods have been received. Afterwards, the firm and its customers record the exchange on their books of account.

At times, the firm may require that the customer sign a promissory note. This is a basic IOU and might be used when the order is large, when there is no cash discount involved, or when the firm anticipates a problem in collections. Promissory notes are not common, but they can eliminate possible controversies later about the existence of debt.

One problem with promissory notes is that they are signed after delivery of the goods. One way to obtain a credit commitment from a customer before the goods are delivered is to arrange a commercial draft. Typically, the firm draws up a commercial draft calling for the customer to pay a specific amount by a specified date. The draft is then sent to the customer's bank with the shipping invoices.

If immediate payment is required on the draft, it is called a sight draft. If immediate payment is not required, then the draft is a time draft. When the draft is presented and the buyer "accepts" it, meaning that the buyer promises to pay it in the future, then it is called a trade acceptance and is sent back to the selling firm. The seller can then keep the acceptance or sell it to someone else. If a bank accepts the draft, meaning that the bank is guaranteeing payment, then the draft becomes a banker's acceptance. This arrangement is common in international trade, and banker's acceptances are actively traded in the money market.

A firm can also use a conditional sales contract as a credit instrument. With such an arrangement, the firm retains legal ownership of the goods until the customer has completed payment. Conditional sales contracts usually are paid in instalments and have an interest cost built into them.

Ross et al.: Fundamentals VII. Short-Term Financial 21. Credit and Inventory of Corporate Finance, Sixth Planning and Management Management

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