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.
The critical requirement of the creditor-debtor relationship in business is a debt agreement (or contract) stating 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 its responsibilities.
Explaining Creditor and Debtor in Context
Sections below further describe the creditor-debtor relationship in context with related terms including the following, focusing on three themes:
- First, legal rights and responsibilities of both parties in a debtor-creditor relationship.
- Second, reasons that almost all businesses take on debt, simultaneously playing the role of debtor to their creditors, and creditor to their own customers.
- Third, remedies available to creditors when debtors do not pay.
- Who are creditors and debtors?
- Why do businesses borrow and otherwise take on debt?
- Creditors and debtors have a legal relationship.
- What happens if the debtor does not pay?
Anyone can understand why an unprofitable, struggling company might create debt (borrow) to survive while trying to rebuild the business. However, people not in "business" sometimes ask why a profitable, well-funded firm 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 business operations today. Companies that sell goods and services are creditors and debtors at the same time. They are creditors to customers who purchase goods but before they actually pay for the 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 normal practice in modern finance. Boards of Directors sometimes expect their financial officers to borrow funds to purchase assets that produce returns for their owners that exceed the cost of borrowing.
Informal creditor-debtor relationships of many kinds develop between businesses, just as they extend 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 in business, 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 for payment 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 an unambiguous and detailed description of the following:
Timespan For the Relationship
A loan contract will state the timespan 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 a statement with their purchase with the issuer's commitment to interest payments and the bond's maturity date.
The contract will describe legal changes, if any, that can be made to the time frame or payment terms during the life of the relationship.
- Such a change 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 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 secure 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. If 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, solutions available to both parties should one or the other party fail to meet the terms of the agreement. In reality, however, these statements deal almost exclusively with remedies available to the creditor should the debtor fail to meet payment terms.
Usually, when customers fail to pay on time or otherwise fail to meet payment agreements, the creditor bank or merchant still tries for a period 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 noncash Expense account. The Bad debt expense lowers profits, of course, but it does not decrease reported Revenues from sales. These revenues have been earned and legitimately claimed, even if the customer fails to follow through with cash payment.
Writing off 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 remaining 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 debtor has a secured loan (or asset-based loan) when the debtor does not pay, the creditor may take ownership of the collateral assets.
When the collateral is property, such as an automobile, the creditor is said to repossess the collateral. And, when real estate properties serve as collateral, the creditor "forecloses" 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 debt.
Non Payment is Not a Criminal Offense.
Non-payment of a legal debt is a civil offense, not a criminal offense, almost everywhere. Most people know that legal jurisdictions everywhere abolished debtors prisons and jail terms for non-payment practically 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 obtaining the loan 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 kind of order follows, for instance, when a parent fails to pay court-ordered child support. The critical 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 overestimate the value of their asset base.