Debtor and creditor
Debtors and creditors are fundamental concepts in finance and business transactions. A debtor is an individual or entity that owes money to another party, while a creditor is the one that extends credit or lends money. These relationships are essential for the functioning of commerce, as most business deals involve goods or services provided on credit, establishing both roles in a transaction. The historical roots of these terms can be traced back to accounting practices from the 1500s, particularly with the development of double-entry bookkeeping, which helps maintain financial balance in transactions.
On a company's balance sheet, debtors are classified as current assets, as they represent amounts expected to be converted to cash within a year, whereas creditors are current liabilities, indicating debts that must be settled within a short period. The management of these relationships is crucial for ensuring efficient cash flow and working capital. There are various types of creditors, including secured and unsecured creditors, each with different claims to repayment. The dynamics between debtors and creditors also include implications for credit policies, payment terms, and interest on delayed payments. Understanding these roles is vital for anyone involved in financial management or business operations.
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Subject Terms
Debtor and creditor
The word debtor is derived from the Latin word debere, which means "to owe." The term creditor comes from the Anglo-French creditour, and from the Latin word that means lender.
Generally, debtors are people or enterprises that owe debt to an individual, company, bank, or government agency, including individuals filing for bankruptcy. Whenever an entity sells its goods or provides services on credit to a person, then the entity giving the credit is considered a creditor, and the recipient of the goods or services is known as a debtor.
Most business transactions involve both debtors and creditors. They are two sides of the same coin. Sometimes, a debtor can also become a creditor. Anyone conducting transactions where money changes hands should understand how these two entities are identified.
Understanding the concepts of debtor and creditor is extremely important in business. They are relevant for an effective working capital management of a company.
Brief History
The use of debtors and creditors in some form of company accountancy can be traced back to Venetian merchants in Italy in the 1500s, and was codified by Luca Pacioli in 1494. Pacioli, a Franciscan monk in Milan, is considered the father of accounting and is credited with introducing the system of double-entry bookkeeping, wherein the Latin words credere ("to entrust") and debere ("to owe") and describe the two sides of a closed accounting transaction.
In fact, the first recorded history of the description of double-entry bookkeeping was done by Benedikt Kotruljević in 1458 in his work, Book on the Art of Trade. This was a great intellectual breakthrough enabling merchants, investors, and entrepreneurs to keep track of every cent they spent or received. It became the backbone of modern accounting.
Whether it was Kotruljević’s or Pacioli’s innovation, in the system of double-entry bookkeeping, debits and credits occur simultaneously in every financial transaction. In the accounting equation, Assets = Liabilities + Equity (A = L + E). If an asset account increases, a debit occurs, then either another asset account must decrease, creating a credit, or a liability or equity account must increase (a credit).
On a company balance sheet, the concept of debtor and creditor ensures that the equation remains in balance after every transaction.
The terms debtor and creditor were introduced at a time when negative numbers were still not accepted in mathematics, and the concepts were revolutionary at the time. Since then, when used in accounting, the words take on a different meaning than when used to indicate the purchase or sale of goods without immediately paying or obtaining finance from a banking institution.
Double-entry bookkeeping has been the model method employed by accountants throughout the ages in most parts of the world. The system was introduced in China at the turn of the twentieth century and was designated as the standard bookkeeping method in 1992 after years of political and socioeconomic upheaval.
Overview
In terms of a company balance sheet, debtors are considered current assets of a company, as within one year, they can be converted into cash. They are listed under the heading trade receivables on the asset side of the balance sheet.
Creditors are the company's current liabilities, whose debt must be paid within one year. They are called current liabilities because they provide credit for a limited time and must be paid within a short period of time. Creditors allow a credit period, after which the company has to discharge its obligation. If the company fails to pay within the agreed-upon time, then interest is charged for delayed payment.
It is the financial responsibility of the debtor to pay the creditor on time. After the debtor pays back the whole amount to his creditor, the debt will not show on the balance sheet.
Prior to allowing goods to be purchased on credit, a company checks the person’s credibility, financial status, and capacity to pay. Company management determines the credit policy with regard to the credit time period permitted to debtors as well as any discount awarded to them for making early payments. Debtors that fail to pay the amount due on time are charged a late payment, and they must pay interest as well as any monetary penalty that is added on.
Debtors and creditors are the stakeholders of the company. To ensure an efficient flow of working capital, most companies maintain a time lag between the receipt from debtors and payment to creditors.
There are several types of creditors in a company. Secured creditors provide debt after pledging the asset for security; therefore, they are paid first. Creditors whose debt is not backed by any kind of security are known as unsecured creditors. A preferential creditor is one that has priority over unsecured creditors for repayment of debt. They are usually tax authorities or employees.
A debtor’s control account documents the total amount owed by all the individual debtors. The balance of this account must be equal to the total of the debtors’ list, which represents the amounts owed by the individual debtors as recorded in the individual balances in the various subsidiary ledger accounts for each debtor. This subsidiary ledger is known as the debtors’ ledger.
Debt Securities. A debt security refers to money borrowed—usually from a government agency—with a fixed monetary amount, a maturity date(s), and usually a specific rate of interest. Debt securities include corporate bonds, government bonds, corporate bonds, municipal bonds, certificates of deposit (CDs), preferred stock and collateralized securities such as collateralized mortgage obligations (CMOs), Government National Mortgage Association (GNMA or Ginnie Mae) bonds, zero-coupon securities, and collateralized debt obligation (CDOs).
The interest rate on a debt security is largely determined by the ability of the borrower to repay the interest for the use of the money on an ongoing basis and the principal amount on a specified future date. Higher risks of payment default almost always lead to higher interest rates to borrow capital. Some debt securities are discounted in the original purchase price.
Trade Creditors/Trade Debtors. In the commercial arena, there are trade creditors who are suppliers that are owed payment for raw materials or a product's component parts by the manufacturer. More creditor days mean that cash remains in the company for longer. In business accounting applications, trade creditors and the amounts owed are listed in the company's balance sheet as liabilities.
Trade debtors represent cash amounts due to be paid by customers who have purchased goods or services from a company. Fewer debtor days means that cash is being received faster from customers.
Under the Fair Debt Collection Practices Act (FDCPA), debtors who owe consumer debt cannot be jailed for their debts. Only individuals who consistently fail to pay child support can be imprisoned. However, creditors can attempt to garnish wages or repossess certain possessions of individuals who owe specific types and amounts of debt.
Bibliography
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