Various modes of Discharging of a Contract

Discharge of a contract means termination of the contractual relations between the parties to a contract. A contract is said to be discharged when the rights and obligations of the parties under the contract come to an end. Modes of discharge of contract 

Discharge by Performance 
A contract can be discharged by performance in any of the following ways: 

(a) By Actual Performance A contract is said to be discharged by actual per-formance when the parties to the contract perform their promises in accordance with the terms of the contract. 

(b) By Attempted Performance or Tender A contract is said to be discharged by attempted performance when the promisor has made an offer of performance to the promisee but it has not been accepted by the promisee. 

Discharge by Mutual Agreement 
Since a contract is created by mutual agreement, it can also be discharged by mutual agreement. A contract can be discharged by mutual agreement in any of the following ways: 

a) Novation [Section 62] Novation means the substitution of a new contract for the original contract. Such a new contract may be either between the same parties or between different parties. The consideration for the new contract is the discharge of the original contract. 

(b) Rescission [Section 62] Rescission means cancellation of the contract by any party or all the parties to a contract. 

(c) Alteration [Section 62] Alteration means a change in the terms of a contract with mutual consent of the parties. Alteration discharges the original contract and creates a new contract. However, parties to the new contract must not change. 

(d) Remission [Section 63] Remission means acceptance by the promisee of a’ lesser fulfillment of the promise made. According to Section 63, “Every promisee may dispense with or remit, wholly or in part, the performance of the promise made to him, or may extend the time for such performance, or may accept instead of it any satisfaction which he thinks fit.” 

(e) Waiver Waiver means intentional relinquishment of a right under the con-tract. Thus, it amounts to releasing a person of certain legal obligation under a contract. 

Discharge by Operation of Law 
A contract may be discharged by operation of law in the following cases: 

(a) By Death of the Promisor A contract involving the personal skill or ability of the promisor is discharged on the death of the promisor. 

(b) By Insolvency When a person is declared insolvent, he is discharged from his liability up to the date of his insolvency. 

(c) By Unauthorised Material Alteration If any party makes any material alteration in the terms of the contract without the approval of the other party, the contract comes to an end. 

(d) By the Identity of Promisor and Promisee When the promisor becomes the promisee, the other parties are discharged. 

Discharge by Impossibility of Performance 
The effects of impossibility of the performance of a contract may be discussed under the following two heads: 

(a) Effects of Initial Impossibility 

(b) Effects of Supervening Impossibility 

(c) Declaration of War The pending contracts at the time of declaration of war are either suspended or declared as void. 

(d) Change of Law The contract is discharged if the performance of the contract becomes impossible or unlawful due to change in law after the formation of the contract. 

Discharge by Lapse of Time 
A contract is discharged if it is not performed or enforced within a specified period, called period of limitation. The Limitation Act, 1963 has prescribed the different periods for different contracts, e.g. period of limitation for exercising right to recover a debt is 3 years, and to recover an immovable property is 12 years. The contractual parties cannot exercise their rights after the expiry of period of limitation. 

Discharge by Breach of Contract 
A contract is said to be discharged by breach of contract if any party to the contract refuses or fails to perform his part of the contract or by his act makes it impossible to perform his obligation under the contract. A breach of contract may occur in the following two ways: 

(a) Anticipatory Breach of Contract Anticipatory breach of contract occurs when party declares his intention of not performing the contract before the performance is due. 

(b) Actual Breach of Contract Actual breach of contract occurs in the following two ways: 

(i) On Due Date of Performance: If any party to a contract refuses or fails to perform his part of the contract at the time fixed for performance, it is called an actual breach of contract on due date of performance. 

During the Course of Performance: If any party has performed a part of the contract and then refuses or fails to perform the remaining part of the contract, it is called an actual breach of contract during the course of performance. 

ACCOUNTS RECEIVABLE AND ALLOWANCE FOR BAD DEBTS PART 3

Credit Risk

When a seller provides goods or services on credit, the resultant account receivable is normally considered to be an unsecured claim against the buyer's assets. This makes the seller (the supplier) an unsecured creditor, meaning it does not have a lien on any of the buyer's assets—not even on the goods that it just sold to the buyer.

Sometimes a supplier's customer gets into financial difficulty and is forced to liquidate its assets. In this situation the customer typically owes money to lending institutions as well as to its suppliers of goods and services. In such cases, it's the secured creditors (the banks and other lenders that have a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first from the sale of the assets. Often there is not enough money to pay what is owed to the secured lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what they are owed.

To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require instead that all of its goods be paid for with cash or a credit card. Such a company, however, may lose out on sales to competitors who offer to sell on credit.

To minimize losses, sellers typically perform a thorough credit check on any new customer before selling to them on credit. They obtain credit reports and check furnished references. Even when a credit check is favorable, however, a credit loss can still occur. For example, a first-rate customer may experience an unexpected financial hardship caused by one of itscustomers, something that could not have been known when the credit check was done. The point is this: any company that sells on credit to a large number of customers should assume that, sooner or later, it will probably experience some credit losses along the way.

Allowance Method for Reporting Credit Losses

Accounts receivable are reported as a current asset on a company's balance sheet. Since current assets by definition are expected to turn to cash within one year (or within the operating cycle, whichever is longer), a company's balance sheet could overstate its accounts receivable (and therefore its working capital and stockholders' equity) if any part of its accounts receivable is not collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will never be collected. This estimate is reported in a balance sheet contra asset account called Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance for Doubtful Accounts is known as the allowance method. (If a company does not use an allowance account, it is following the direct write-off method, which is discussed later.)

Allowance for Doubtful Accounts and Bad Debts Expense - June

As we stated above, the account Allowance for Doubtful Accounts is a contra asset account containing the estimated amount of the accounts receivable that will not be collected. For example, let's assume that Gem Merchandise Co.'s Accounts Receivable has a debit balance of $100,000 at June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a result, Gem reports a credit balance of $2,000 in Allowance for Doubtful Accounts. The accounting entry to adjust the balance in the allowance account will involve the income statement account Bad Debts Expense.

Since June was Gem's first month in business, its Allowance for Doubtful Accounts began June with a zero balance. At June 30, when it issues its first balance sheet and income statement, its Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the following adjusting journal entry:

With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts Receivable reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of $98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to as the net realizable value of the accounts receivable.

Under the allowance method, the Gem Merchandise Co. does not need to know specifically which customer will not pay, nor does it need to know the exact amount. This is acceptable because accountants believe it is better to report an approximate amount that is uncollectible rather than imply that every penny of the accounts receivable will be collected.

Gem's Bad Debts Expense will report credit losses of $2,000 on its June income statement. This expense is being reported even though none of the accounts receivables were due in June. (Recall the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching the bad debts expense as best it can to the accounting period in which the credit sales took place.

Allowance for Doubtful Accounts and Bad Debts Expense - July

Now let's assume that at July 31 the Gem Merchandise Co. has a debit balance in Accounts Receivable of $230,000. (The balance increased during July by the amount of its credit sales and it decreased by the amount it collected from customers.) The Allowance for Uncollectible Accounts still has the credit balance of $2,000 from the adjustment on June 30. This means Gem's general ledger accounts before the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a net realizable value of $228,000 ($230,000 minus $2,000).

Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately $10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts so that its ending balance is a credit of $10,000 (instead of the present credit balance of $2,000). This requires the following adjusting entry:

After this journal entry is recorded, Gem's July 31 balance sheet will report the net realizable value of its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the $10,000 credit balance in Allowance for Doubtful Accounts).

Here's a recap in T-account form:

As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know the precise amount of actual bad debts, nor will Gem know which customers are the ones that won't be paying their account balances. However, the matching principle is better met by Gem making these estimates and recording the credit loss as close as possible to the time the sales were made.

By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to the accounting principle of conservatism. In other words, if there is some doubt as to whether there are $10,000 of credit losses or no credit losses, Gem's accountant "breaks the tie" by choosing the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company knows with certainty that every penny of its accounts receivable will be collected, then the Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the accounts receivable will not be collected in full, the principle of conservatism requires that there be a credit balance in Allowance for Doubtful Accounts.

Difference Between Inflation and Deflation

In macroeconomics, we study about two burning issues of every country of the world, i.e. inflation and deflation. They are also most debated and a hot topic of group discussions. Inflation is a situation when the prices of goods and services get a boost, thus decreasing the buying power of money. If we talk about Deflation, it is opposite of inflation, whereby prices of goods and services falls and people can purchase more goods with the limited money.

Comparison Chart

BASIS FOR COMPARISON	INFLATION	DEFLATION
Meaning	When the value of money decreases in the international market, then this situation is termed as inflation.	Deflation is a situation, when the value of money increases in the international market.
Effects	Increase in the general price level	Decrease in the general price level
National income	Does not declines	Declines
Gold prices	Falls	Rises
Classification	Demand pull inflation, cost push inflation, stagflation and deflation.	Debt deflation, money supply side deflation, credit deflation.
Good for	Producers	Consumers
Consequences	Unequal distribution of income.	Rise in the level of unemployment
Which is evil?	A little bit of inflation is a symbol of economic growth of the country.	Deflation is not good for an economy.

Definition of Inflation

A situation arises due to variability in the demand and supply of money, which causes an increase in the price of goods and services over time, is known as Inflation. When the value of money falls in the world economy, resulting in the rise of gold prices, it is termed as Inflation. Due to the presence of inflation in a country’s economy, the purchasing power of money contracts because of the upward shift of the general price level. Therefore, the common man will have to spend more money to acquire a few items.

Many experts have the view that, inflation will not arise until the rise in the price level is < 5% for a long time. The following are the types of inflation:

• Demand-pull inflation
• Cost-push inflation
• Stagflation
• Deflation

In PAKISTAN, measurement of inflation is done with the help of Wholesale Price Index (WPI) and Consumer Price Index (CPI). Inflation can be caused due to rise in public expenditure, tax evasion on a large scale, deficit financing, uneven agricultural growth, black marketing, hoarding, etc.

Definition of Deflation

Deflation is a situation, occurring due to the fall in the supply of money and credit, in the economy. This is also known by the name negative inflation, because when the inflation rate is < 0%, deflation arises.

With the emergence deflation in the country’s economy, there is a downward movement in the general price level, i.e. the price of goods and services declines and therefore, increasing the buying power of money. Due to this, now people will be able to buy more items with very less investment. The following are the types of deflation:

• Money supply side deflation
• Credit deflation
• Debt deflation

The very reason for the occurrence of deflation is the fall in spending power at the micro and macro level as the price of the goods and services fall in the economy, so the customers wait for the further fall in their prices. In this way, the customers postpone their purchasing and consumption activity which hampers the whole economic cycle, due to which the investment remains idle. The outcome of deflation is the recession, fall in profits, depression and so on.

Key Differences Between Inflation and Deflation

The following are the major differences between inflation and deflation:

1. When the value of money decreases in the world market, it is inflation, while if the value of money rises, then it is deflation.
2. Inflation results in rising prices of goods and services, whereas prices of goods and services decrease in deflation.
3. Inflation is helpful for producers or manufacturers. On the other hand, customers are benefited in deflation.
4. There is a fall in national income in the situation of deflation, but this is not in the case of inflation.
5. In inflation, the distribution of income is not even amidst rich and poor. Conversely, Deflation becomes a cause for a rise in the level of unemployment.
6. A slight amount of inflation is good for the country’s economy. However, deflation creates hurdles in the path of economic growth of the country.

Conclusion

There are some measures adopted by the government of a country to control inflation like monetary measures, fiscal measures, controlling the investment, etc. There are several steps taken by the Central Bank to eradicate deflation from the economy. So, we can say that a lower rate of inflation is good, but a situation like deflation is hard to tackle because it may lead the country to depression and therefore deflation is dreadful.

Law of Equi-Marginal Utility:

(Equilibrium of the Consumer Through the Law of Equi-Marginal Utility):

Other Names of this Law:

Law of Substitution OR Law of Maximum Satisfaction OR Law of Indifference OR Proportion Rule OR Gossen's Second Law.

In the cardinal utility analysis, the principle of equal marginal utility occupies an important place.

Definition and Statement of Law of Equi-Marginal Utility:

The law of equi-marginal utility is simply an extension of law of diminishing marginal utility to two or more than two commodities. The law of equilibrium utility is known, by various names. It is named as the Law of Substitution, the Law of Maximum Satisfaction, the Law of Indifference, the Proportionate Rule and the Gossen’s Second Law.

In cardinal utility analysis, this law is stated by Lipsey in the following words:

“The household maximizing the utility will so allocate the expenditure between commodities that the utility of the last penny spent on each item is equal”.

As we know, every consumer has unlimited wants. However, the income this disposal at any time is limited. The consumer is, therefore, faced with a choice among many commodities that he can and would like to pay. He, therefore, consciously or unconsciously compress the satisfaction which he obtains from the purchase of the commodity and the price which he pays for it. If he thinks the utility of the commodity is greater or at-least equal to the loss of utility of money price, he buys that commodity.

As he buys more and more of that commodity, the utility of the successive units begins to diminish. He stops further purchase of the commodity at a point where the marginal utility of the commodity and its price are just equal. If he pushes the purchase further from his point of equilibrium, then the marginal utility of the commodity will be less than that of price and the household will be loser. A consumer will be in equilibrium with a single commodity symbolically:

MU^x = P^x

A prudent consumer in order to get the maximum satisfaction from his limited means compares not only the utility of a particular commodity and the price but also the utility of the other commodities which he can buy with his scarce resources. If he finds that a particular expenditure in one use is yielding less utility than that of other, he will tie to transfer a unit of expenditure from the commodity yielding less marginal utility. The consumer will reach his equilibrium position when it will not be possible for him to increase the total utility by uses. The position of equilibrium will be reached when the marginal utility of each good is in proportion to its price and the ratio of the prices of all goods is equal to the ratio of their marginal utilities.

The consumer will maximize total utility from his income when the utility from the last rupee spent on each good is the same.  Algebraically, this is:

 MU_a / P_a = MU_b / P_b = MU_c = P_c = MU_n = P_n

Here: (a), (b), (c)…. (n) are various goods consumed.

Assumptions of Law of Equi-Marginal Utility:

The main assumptions of the law of equi-marginal utility are as under.

(i) Independent utilities. The marginal utilities of different commodities are independent of each other and diminish with more and more purchases.

(ii) Constant marginal utility of money. The marginal utility of money remains constant to the consumer as he spends more and more of it on the purchase of goods.

(iii) Utility is cardinally measurable.

(iv) Every consumer is rational in the purchase of goods.

 

Example and Explanation of Law of Equi-Marginal Utility:

The doctrine of equi-marginal utility can be explained by taking an example. Suppose a person has $5 with him whom he wishes to spend on two commodities, tea and cigarettes. The marginal utility derived from both these commodities is as under:

Schedule:

Units of Money	MU of Tea	MU of Cigarettes
1	10	12
2	8	10
3	6	8
4	4	6
5	2	3
$5	Total Utility = 30	Total Utility = 30

A rational consumer would like to get maximum satisfaction from $5.00. He can spend money in three ways:

(i) $5 may be spent on tea only.

(ii) $5 may be utilized for the purchase of cigarettes only.

(iii) Some rupees may be spent on the purchase of tea and some on the purchase of cigarettes.

If the prudent consumer spends $5 on the purchase of tea, he gets 30 utility. If he spends $5 on the purchase of cigarettes, the total utility derived is 39 which are higher than tea. In order to make the best of the limited resources, he adjusts his expenditure.

(i) By spending $4 on tea and $1 on cigarettes, he gets 40 utility (10+8+6+4+12 = 40).

(ii) By spending $3 on tea and $2 on cigarettes, he derives 46 utility (10+8+6+12+10 = 46).

(iii) By spending $2 on tea and $3 on cigarettes, he gets 48 utility (10+8+12+10+8 = 48).

(iv) By spending $1 on tea and $4 on cigarettes, he gets 46 utility (10+12+10+8+6 = 46).

The sensible consumer will spend $2 on tea and $3 on cigarettes and will get maximum satisfaction. When he spends $2 on tea and $3 on cigarette, the marginal utilities derived from both these commodities is equal to 8. When the marginal utilities of the two commodities are equalizes, the total utility is then maximum, i.e., 48 as is clear from the schedule given above.

Curve/Diagram of Law of Equi-Marginal Utility:

The law of equi-marginal utility can be explained with the help of diagrams.

In the figure 2.3 MU is the marginal utility curve for tea and KL of cigarettes. When a consumer spends OP amount ($2) on tea and OC ($3) on cigarettes, the marginal utility derived from the consumption of both the items (Tea and Cigarettes) is equal to 8 units (EP = NC). The consumer gets the maximum utility when he spends $2 on tea and $3 on cigarettes and by no other alternation in the expenditure.

We now assume that the consumer spends $1 on tea (OC^/ amount) and $4 (OQ^/) on cigarettes. If CQ^/more amounts are spent cigarettes, the added utility is equal to the area CQ^/ N^/N. On the other hand, the expenditure on tea falls from OP amount ($2) to OC^/ amount ($1). There is a toss of utility equal to the area C^/PEE. The loss is utility (tea) is greater than that The loss in utility (tea) is maximum satisfaction except the combination of expenditure of $2 on tea and $3 on cigarettes.

This law is known as the Law of maximum Satisfaction because a consumer tries to get the maximum satisfaction from his limited resources by so planning his expenditure that the marginal utility of a rupee spent in one use is the same as the marginal utility of a rupee spent on another use.

 

It is known as the Law of Substitution because consumer continuous substituting one good for another till he gets the maximum satisfaction.

 

It is called the Law of Indifference because the maximum satisfaction has been achieved by equating the marginal utility in all the uses. The consumer than becomes indifferent to readjust his expenditure unless some change fakes place in his income or the prices of the commodities, etc.

 

Limitations/Exceptions of Law of Equi-Marginal Utility:

(i) Effect on fashions and customs: The law of equi-marginal utility may become inoperative if people forced by fashions and customs spend money on the purchase of those commodities which they clearly knows yield less utility but they cannot transfer the unit of money from the less advantageous uses to the more advantageous uses because they are forced by the customs of the country.

(ii) Ignorance or carelessness: Sometimes people due to their ignorance of price or carelessness to weigh the utility of the purchased commodity do not obtain the maximum advantage by equating the marginal utility in all the uses.

(iii) Indivisible units: If the unit of expenditure is not divisible, then again the law may become inoperative.

(iv) Freedom of choice: If there is no perfect freedom between various alternatives, the operation of law may be impeded.

 

Importance of Law of Equi-Marginal Utility:

The law of equi-marginal utility is of great practical importance. The application of the principle of substitution extends over almost every field of economic enquiry. Every consumer consciously trying to get the maximum satisfaction from his limited resources acts upon this principle of substitution. Same is the case with the producer. In the field of exchange and in theory of distribution too, this law plays a vital role. In short, despite its limitation, the law of maximum satisfaction is meaningful general statement of how consumers behave.

In addition to its application to consumption, it applies equally to the theory of production and theory of distribution. In the theory of production, it is applied on the substitution of various factors of production to the point where marginal return from all the factors are equal. The government can also use this analysis for evaluation of its different economic prices.

The equal marginal rule also guides an individual in the spending of his saving on different types of assets. The law of equal marginal utility also guides an individual in the allocation of his time between work and leisure. In short, despite limitations the law of substitution is applied to all problems of allocation of scarce resources.

ACCOUNTS RECEIVABLE AND ALLOWANCE FOR BAD DEBTS PART 2

Recording Sales of Goods on Credit

When a company sells goods on credit, it reports the transaction on both its income statement and its balance sheet. On the income statement, increases are reported in sales revenues, cost of goods sold, and (possibly) expenses. On the balance sheet, an increase is reported in accounts receivable, a decrease is reported in inventory, and a change is reported in stockholders' equity for the amount of the net income earned on the sale.

If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred at the seller's dock. If the sale is made with the terms FOB Destination, the ownership of the goods is transferred at the buyer's dock.

In principle, the seller should record the sales transaction when the ownership of the goods is transferred to the buyer. Practically speaking, however, accountants typically record the transaction at the time the sales invoice is prepared and the goods are shipped.

FOB Shipping Point

Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general ledger:

(While there may be additional expenses with this transaction—such as commission expense—we are not considering them in our example.)

FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller's dock. This means that the buyer is responsible for transporting the goods from Quality Product's shipping dock. Therefore, all shipping costs (as well as any damage that might be incurred during transit) are the responsibility of the buyer.

FOB Destination

FOB Destination means the ownership of the goods is transferred at the buyer's dock. This means the seller is responsible for transporting the goods to the customer's dock, and will factor in the cost of shipping when it sets its price for the goods.

Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's general ledger:

Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at the buyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with transporting the goods.

Now let's assume that Gem pays an independent shipping company $50 to transport the goods from its warehouse to the buyer's dock. Gem records the $50 as an operating expense orselling expense (in an account such as Delivery Expense, Freight-Out Expense, orTransportation-Out Expense). If the shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:

Credit Terms with Discounts

When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days after the sales invoice date.

To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem's net receivable from this customer will be $900.

Unfortunately, companies who sell on credit often find that they don't receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount, cash discount, or an early payment discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date.

Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period.

Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem's general ledger as follows:

If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will be the following entry on July 1:

Examples of Amounts Due Under Varying Credit Terms

The following chart shows the amounts a seller would receive under various credit terms for a merchandise sale of $1,000 and an authorized return of $100 of goods.

Credit Terms	Brief Description	Amount To Be Received
Net 10 days	The net amount is due within 10 days of the invoice date.	$900
Net 30 days	The net amount is due within 30 days of the invoice date.	$900
Net 60 days	The net amount is due within 60 days of the invoice date.	$900
2/10, n/30	If paid within 10 days of the invoice date, the buyer may deduct 2% from the net amount. ($900 minus $18)	$882
2/10, n/30	If paid in 30 days of the invoice date, the net amount is due.	$900
1/10, n/60	If paid within 10 days of the invoice date, the buyer may deduct 1% from the net amount. ($900 minus $9)	$891
1/10, n/60	If paid in 60 days of the invoice date, the net amount is due.	$900
Net EOM 10	The net amount is due within 10 days after the end of the month (EOM). In other words, payment for any sale made in June is due by July 10.	$900

Costs of Discounts

Some people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36% for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of these high percentage equivalents. Other sellers are discouraged to find that some customers take the discount and ignore the obligation to pay within the stated discount period.