In business, the terms creditor and debtor refer to the parties involved with borrowed funds such as bank loans, credit extended, notes payable, or bond sales. A creditor is a party who lends money or extends credit to another party, the debtor.
Creditors and debtors may be individuals or they may be legal entities such as public or private corporations, registered companies of another kind, a chartered or registered organization, or a government. All of these can legally borrow and lend funds.
The important characteristic of the creditor-debtor relationship in business is that debt agreements (or contracts) state explicitly the legally binding rights, responsibilities, and obligations of both parties. Business debt agreements typically enumerate also the legal remedies available should either party fail to meet responsibilities.
Explaining Creditor and Debtor in Context
Sections below further explain the creditor-debtor relationship in context with related terms including the following:
- What are creditor and debtor?
- Why do businesses borrow and otherwise take on debt?
- Creditors and debtors have a legal relationship.
- What happens if the debtor does not pay?
It is readily understandable to all why an unprofitable, struggling company might create debt (borrow) in order to survive while trying to rebuild the business. However, people outside of business sometimes ask why a profitable, well funded business would borrow or otherwise take on debt. Many are no doubt thinking of Shakespeare's best known quote on borrowing and lending. In Hamlet, the character Polonius advises his son:
Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
The wisdom of Polonius notwithstanding, borrowing and lending sit, irremovably, at the heart of modern business. Companies that sell goods and services typically are creditors and debtors at the same time. They are creditors to customers who have purchased but not yet paid for products (the company's accounts receivable) while at the same time they can be debtors to their bondholders and banks.
Business borrowing, moreover, is a well-respected practice in modern finance. Financial officers, in fact, are sometimes expected to borrow funds to purchase assets, which produce returns for their owners that exceed the cost of borrowing.
Informal creditor-debtor relationships of many kinds develop between businesses, just as they develop between individuals. Companies can and do sometimes reach out to other companies with courtesies, gratitude, obligations, respect, and assistance of many kinds.
The defining characteristic of the formal creditor-debtor relationships discussed in this article, however, is the existence of a legally binding agreement (or contract).
- Banks that make loans to individuals or business become their creditors in a formal legally-binding relationship.
- Merchants who sell goods and services on credit, or with an invoice payable at some future date, become legal creditors to their customers.
- Companies can loan funds to customers or other firms in the form of notes payable. A note payable represents a legally-binding creditor-debtor relationship.
- Any purchase by one party from another represents a legally-binding creditor-debtor relationship when both parties sign a legal contract for the sale.
In business, these agreements almost always include clear, unambiguous, and detailed description of the following:
Time Period For the Relationship
A loan contract will state the time period over which the specific creditor-debtor relationship should exist.
- With bank loans, for instance, this includes a payment schedule with specific calendar dates.
- Credit card plans specify payment timing requirements.
- Bond investors receive with their purchase a statement of the issuer's commitment to interest payments and the bond's maturity date.
The contract will describe allowable changes, if any, that can be made to the time frame or payment terms during the life of the relationship.
- This might include, for instance, a clause allowing the debtor to make an early payoff.
- Allowable changes may include the creditor's right to recall (revoke or take back) the loan before the end of its planned life.
Debtor and Creditor Rights and Responsibilities
The contract will state certain rights and responsibilities of both debtor and creditor, clearly, unambiguously, and in complete detail. Both parties affirm agreement to these terms with hand written signatures on paper, and these may or may not may not require signed witness by a responsible third party, such as a Notary Public. Some contracts instead call for affirmation or agreement by electronic signature.
- In the case of a secured loan, the creditor ultimately has some claim to the loan collateral or other of the debtor's assets, if the debtor fails to repay the loan as agreed.
- Companies or individuals who buy bonds, for example, are lending money to the issuing organization and become its creditors. In the event that a bond-issuing company shuts down and liquidates, the company must pay the claims of bond holding creditors before it pays preferred share stock owners. In liquidation, owners of common stock shares have the lowest payment priority. As a result, common stock shareholders are paid only if liquidation funds remain after paying higher priority creditors.
In principle, debt contracts state, explicitly, remedies available to both parties should one or the other party fail to meet terms of the contract. In reality, however, these statements deal almost exclusively with remedies available to the creditor should the debtor fail to meet payment terms.
Normally, when customers fail to pay on time or otherwise fail to meet payment agreements, the creditor bank or merchant still tries for a period of time to persuade the customer to pay. Creditors specify in advance the number of days they can let these attempts continue, for example, 30, 60 or 120 days. If the customer does pay during that time, the creditor may or may not add a "late charge."
If, however, the customer still does not pay during that time, the creditor may choose to write off the amount due as a bad debt. The write-off is an accounting practice that that does the following:
- A write-off reduces the creditor's Balance sheet Accounts Receivable. Accounts receivable is an Assets account.
- The same write-off also appears on the creditor's Income statement as an expense. Bad debt expense is a non-cash Expense account. The Bad debt expense lowers profits, of course, but it does not lower reported Revenues from sales. These revenues have been earned and legitimately claimed, even if the customer follows through with cash payment.
Writing off a debt by the creditor is an accounting practice, but it does not remove the debtor's obligation to pay. The creditor may still attempt to collect payment by engaging a collection agency, or pursuing other legal means.
The Creditor's Last Resorts
When the unpaid debt is sufficiently large, creditors may try a more costly recovery attempt.
- The creditor may sue the debtor with a lawsuit that will, if successful, bring a court order for the debtor to pay. Note that the debtor is already legally bound to pay the debt, but a court order adds to the creditor's ability to enforce payment.
- In cases where the debt was acquired through a secured loan (or asset-based loan), where the debtor does not pay, the creditor may take ownership of the collateral assets.
When the collateral involved is property, such as an automobile, the creditor is said to repossess the collateral. And, when real estate properties serve as collateral, the creditor is said to foreclose the loan.
In both cases (repossession and foreclosure), the actions are possible because the lender—not the borrower—legally owns the collateral until the debtor fully pays off the loan. The purchaser takes possession of the auto title, or real estate title deed, only after paying off the loan.
Non Payment is Not a criminal Offense. However ...
Non payment of a legal debt is a civil offense, not a criminal offense, almost everywhere. Most people know that debtors prisons and jail terms for non payment were abolished, almost everywhere, many years ago.
While non payment is not, itself, a criminal offense, the manner in which buyers or borrowers acquire debt can be a different matter. Criminal prosecution and imprisonment are a real possibility if acquiring the debt involves a criminal offense of some kind.
- Creditors can, in some cases, prosecute a debtor who willfully abstains from making a court-ordered payment. This occurs, for instance, when a parent fail to pay court-ordered child support. The key issues in such cases are the debtor's will and the debtor's actual ability to pay.
- A debtor can be criminally liable for debt acquired through fraud. Fraud is involved when debtors obtain loans by knowingly overstating their ability to repay. or overstate the value of their own asset base.