LEARNING MODULE #2

FUNDAMENTALS OF CREDIT AND COLLECTION

CHAPTER II: CREDIT INSTRUMENTS

The Nature of Credit Instruments
A credit instrument becomes the evidence that there exists a credit transaction. Therefore,
it starts after credit of the borrower has been accepted by the creditor. Generally, credit
instrument are in written form. The reduction of the oral contract into a written agreement is one
of the developments of modern-day credit usage. However, the contract may also be an oral
agreement evidencing the existence of a credit transaction. Nevertheless, a written agreement
seems more advantageous.

What is Credit Instrument? – it is a written agreement or contract evidencing the existence of

debt which gives a legal claim to the creditor against the debtor.

CHARACTERISTIC OF CREDIT INSTRUMENT

1. The presence of risk involved which is due to the fact that payment is postponed to a
future date.
2. The stress on the debtor-creditor relationship.

IMPORTANCE AND ADVANTAGES

1. The parties can stipulate the details of the transaction clearly and definitely. Hence,
the obligation of the debtor is set in unmistakable terms and the rights of the creditor
are likewise spelled out. The rate of interest charged is also cited in the contract.
2. In cases of court litigation, the creditor is armed with incontestable proof and is thus
given a legal leg to stand on.

CLASSIFICATION OF CREDIT INSTRUMENT

A. As to Acceptability – the instruments may be of either unlimited or limited
acceptance. Those instruments which pass from hand to hand without questions as to
their source and which possess the characteristics of money are considered unlimited
 acceptability. (example. government credit money as well as private bank notes) all
other instruments are of limited acceptability and their acceptance will depend on the
credit standing of the issuer or maker.

B. As to Form – the credit instrument may either be orders to pay or promise to pay. An
order to pay is generally defined as the order of one person to a second person to pay
a third person a certain sum of money. An order to pay therefore has three parties,
namely, the drawer who gives the order, the drawee who is ordered to pay, and the
payee who receives the payment. On the other hand, a promise to pay contains the
promise of a person to pay another a certain sum of money on demand or at future
determinable time. In a promise to pay, there are only two parties: the person
promising to pay, known as the maker, and the one who receive payment, known as
the payee.

C. As to Function – as to function or field of usage, the credit instrument may be

classified as credit money - emphasizes its use as a medium of exchange,
commercial credit instrument - comprises the instruments used to facilitate the use
of credit in short term commercial pursuits,
or investment credit instrument - those used for long term credit.

D. As to Negotiable Character – credit instruments may either be negotiable or non-

negotiable. To be negotiable, they must contain the following essentials of
negotiability:
1. The instrument must be in writing
2. There must be an unconditional promise (in the case of promise to pay) or
unconditional order (in the case of an order to pay).
3. There must be a determinable future time of payment.
4. There must be indicated a definite sum of money.
5. The instrument must be signed by the drawer (in the case of order to pay) or
the maker (in the case of a promise to pay)
 6. The instrument must be made payable to order or to bearer.

DIFFERENT INSTRUMENTS DEFINED

Credit Money – is that kind of money which is issued by a government to represent the
standard money or is in itself the standard money. It may or may not be convertible to specie
reserves. If the commodity standard is adopted in the country, credit money is usually
convertible. Otherwise, the credit money is inconvertible and is sometimes termed fiat money.

Commercial Credit Instruments – are subdivided into promise to pay and order to pay.

The promise to pay will be considered first. These consist of the following
a. Open Book Account – one of the most common form of credit instrument which in
effect gives the implied verbal promise of the debtor when he buys consumable goods
on credit. In most cases, however, the listing is not as formal as in bookkeeping
terms, but it is simply listed in a notebook kept by the owner of the store.

ADVANTAGES OF OPEN BOOK ACCOUNTS

1. It is convenient. The only thing a debtor has to do is to go to the store and
make a request for the goods and give his oral promise to pay later. On the
part of the creditor, he will just list the items bought on credit. After
settlement made, the list is simply crossed out or marked PAID and the
transaction is completed.
2. To the debtor this is an advantage as he gives no written evidence for his debt.
Thus it will also stimulate sales on the part of the creditor.
3. It is simple. As already stated, the transaction is completed without
documentation. Hence it is simply handled, on the part of debtor and creditor.
 4. It may lead to prompt payments. In mercantile credit were retailers are easily
accommodated through this type, they may take advantage of cash discounts
offered by creditor for early settlements.

DISADVANTAGES OF OPEN BOOK ACCOUNTS

1. It may lead to dispute and misunderstanding. Since it can be of whose word is
better rather than a tangible proof of existence of debt.
2. Payment is dependent on the debtor’s voluntary action. Even if the terms are
agreed upon as to time of payment, the debtor usually takes his own sweet
time before he settles his account.
3. Since there is no written agreement, the essentials of negotiability are lacking
in this type of credit instrument.

b. Promissory Note – is an unconditional written promise of the maker to pay to the

bearer or order a certain sum of money on demand or at a future determinable time.
 ADVANTAGES OF PROMISSORY NOTE
1. There is a tangible proof of the existence of the debt.
2. There is a fixed time for payment, which, if the debtor ignores it, will lead to
more interest or court action.
3. Prompt payment, therefore, can be expected rather than at the whim of the
debtor.
4. It commands a higher value as an asset especially for seeking financial
assistance.
5. It gives no opportunity to dispute the quality or quantity of goods purchased
upon credit.

DISADVANTAGES OF PROMISSORY NOTE

1. Inflexibility and inconvenience on the part of the debtor

c. Collateral Promissory Note – this type of note is similar to the ordinary note.
However, it called a collateral note because the collateral is described on its face or
on a separate document. The collateral usually has a value over and above the loan
granted. Such may be in the form of stocks and bonds, or those pledges under chattel
mortgages.
CHARACTERISTICS OF COLLATERAL PROMISSORY NOTE
1. It contains the borrower’s unconditional promise to pay the amount of the loan
to the order of the lender at maturity.
2. The description of the collateral pledged is either written on its face or
attached to it in a separate document.
3. It contains a provision that the holder of the note has a lien to the extent of the
borrower’s liability on all securities and funds of the latter which are under the
control of the holder of the note.
4. It may also provide that upon default of payment or maintenance of the
margin requirement, the note and all other liabilities will become due and
payable without demand or notice, thus giving the holder the right to dispose
of the collateral deposited.
 5. The holder is also given the right to transfer the note and pledge collateral
without notice to the borrower.
6. It may sometimes include a provision which would require the borrower to
submit additional collateral in case the value of that already held by the
creditor declines.

d. Commercial letter of credit – is a written promise on the part of the bank to honor
drafts drawn against it or for its account, by a specified beneficiary or his order, under
the specifications contained in the letter of credit. The letter of credit usually contains,
among other details the following:
1. The maximum amount covered by it
2. The length of time it will be in force, which usually takes into account the
period of shipment and the drawing of drafts.
3. The documents that must be attached as well as the disposal of these so that
payment may be made.
4. The quantity and quality of the merchandise to be shipped.
5. The instructions on how the drafts are to be drawn.

Letter of credit may be classified as follows:

1. According to the method of transmission, we have the circular and the
specially advised.
a. Circular. A letter of credit is termed circular when the opening bank
issues a letter addressed generally to persons or companies indicating
its intention to honor the drafts of the beneficiary under the terms
specified therein.

b. Specially advised. On the other hand, when the opening bank notifies
the beneficiary directly or through a notifying bank, the letter of credit
is known as specially advised.
2. According to the duration of the substitution of credit, it may either be a
revocable or an irrevocable letter of credit.
a. Revocable. The bank reserve the right to withdraw or modify the credit
substituted for the buyer by such phrases as “good until cancelled” or
“good until …[a certain period of time],”

b. Irrevocable. When the bank waives its right to cancel the credit or
revoke the same prior to the date specified. It has a binding effect since
it cannot be revoked as long as the exporter fulfills his part of the
conditions specified in the letter of credit.

3. According to obligations assumed by the bank, a bank confirms the credit or

does not do so. Hence we have the confirmed and the unconfirmed letter of
credit.
a. Confirmed. When the notifying or advising bank upon instructions of
the opening bank, assumes the obligation to perform the undertaking
stipulated in the letter of credit.

b. Unconfirmed. When the advising bank does not assume any other
obligation except that of notifying the beneficiary.