UK Accounting Glossary
A form of liability that represents money borrowed from banks or other institutions, or any money owed to another party. Simply put, debt is when you owe someone money. For most people, this means the balances they owe on credit cards, personal loans, mortgages, and overdrafts.
Consumer debt is running at an all time high, with easy access to credit causing many people to run up potentially dangerous levels of unsecured borrowing, while record house prices mean that the average mortgage size is getting larger and larger.
Since the credit crunch of 2008, more and more people are finding their debts are becoming unsupportable as the ability to take out new credit to pay for old dries up, and cash-strapped banks hike the interest rates on credit cards and so on.
Debt is that which is owed. A person who owes debt is called a debtor. A person to whom it’s owed is called a creditor. Debt is used to borrow purchasing power from the future.
In business, debt is an obligation of one party to pay another, usually as repayment for money borrowed. The entity that owes the debt is the debtor. The entity that must be repaid to satisfy the debt is typically called the creditor or in specific cases, a debt holder. A debtor unable to satisfy debt obligations is insolvent. Debt is characterized by the type of debt instruments, such as a loan or a bond. In accounting, debt obligations are grouped by time until obligation maturity. A current debt, or current liability, is due in under a year, and long-term debt, or long-term liability, is payable in a year or more. Secured debt has collateral pledged as security against default, and unsecured debt does not. A business debt that the business owner is not personally liable for is called nonrecourse debt. Senior debt is legally entitled to satisfaction ahead of other debt; the latter is called subordinated debt. The amount paid above the principal borrowed is called the interest on the debt.
Important concepts related to debt:
People or organisations often enter into agreements to borrow something. Both parties must agree on some standard of deferred payment, most usually a sum of money denominated as units of a currency, but sometimes alike good. For instance, one may borrow shares, in which case, one may pay for them later with the shares, plus a premium for the borrowing privilege, or the sum of money required to buy them in the market at that time.
There are numerous types of debt obligations. They include loans, bonds, mortgages, promissory notes, and debentures. It is very common to borrow large sums for major purchases, such as a mortgage, and pay it back with an agreed premium interest rate over time, or all at once at a later date. The amount of money outstanding is usually called a debt. The debt will increase through time if it is not repaid faster than it grows. In some systems of economics, this effect is termed usury, in others, the term “usury” refers only to an excessive rate of interest, in excess of a reasonable profit for the risk accepted.
Large organisations can break their debt into many small units of debt, known as bonds. Each bond entitles the holder to the remaining repayments on that unit of debt. Bonds can be traded during the repayment period, and so ownership of the debt is seen as a form of investment.
Because bonds are traded on the bond market, they have a fluctuating price. This implies that the overall debt represented by the total number of any particular type of bond also has a fluctuating price.
As noted above, debt is normally denominated in a particular monetary currency, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to inflation or deflation, so it can happen even though the borrower and the lender are using the same currency. Thus it is important to agree on standards of deferred payment in advance so that a degree of fluctuation will also be agreed as acceptable. It is, for instance, common to agree to “US dollar-denominated” debt.
The form of debt involved in banking gives rise to a large proportion of the money in most industrialised nations (see money and credit money for a discussion of this). There is, therefore, a complex relationship between inflation, deflation, the money supply, and debt. The store of value represented by the entire economy of the industrialized nation itself, and the state’s ability to levy a tax on it, acts to the foreign holder of debt as a guarantee of repayment, since industrial goods are in high demand in many places worldwide.
Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and are used in some countries. For example, the US government issues two types of inflation-indexed bond – TIPS and I-bonds. These are one of the safest forms of investment available since the only major source of risk – that of inflation – is eliminated. A number of other governments issue similar bonds, and some did so for many years before the US government.
In countries with consistently high inflation, ordinary borrowings at banks may be inflation-indexed also.
Debt ratings, risk and cancellation
Lendings to stable financial entities such as large companies or governments are often termed “risk-free” or “low risk” and made at a so-called “risk-free interest rate”. This is because the debt and interest are highly unlikely to default. A textbook example of such risk-free interest is a government bond of US government – it yields you the minimum return available in economics, but you get the security of the knowledge that the US has never defaulted on its debt instruments. A risk-free rate is commonly used in setting floating interest rates, the floating interest rate is usually calculated as risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor.
However, if the value of a currency has changed in the meantime, the purchasing power of the money repaid may vary considerably from that which was expected at the commencement of the loan. So from a practical investment point of view, there is still considerable risk attached to “risk-free” or “low risk” lendings, even though in terms of the amount of a currency that will be returned there may not be.
The Bank for International Settlements is an entity that sets rules to define what loans qualify as “risk-free” or not. It is a very powerful institution, formed by the Bretton Woods agreements, which has had a pivotal position in central banking since 1947 when it opened.
The debt of countries, as well as private corporations, are rated by rating agencies, s.a. Moody’s, A. M. Best and Standard and Poors. These agencies assess the ability of the debtor to honour his obligations and accordingly give him a credit rating. Moody’s, for example, uses the letters Aaa Aa A Baa Ba B Caa Ca C, where ratings Aa-Caa are qualified by numbers 1-3. Munich Re, for example, currently is rated Aa3 (as of 2004). S&P; and other rating agencies have slightly different systems using capital letters and +/- qualifiers.
A change in ratings can strongly affect a company since its cost of refinancing depends on its creditworthiness. Bonds below Baa/BBB (Moody’s/S&P;) are considered junk- or high-risk bonds. Their high risk of default is compensated by higher interest payments. Bad Debt is a loan that can not (partially or fully) be repaid by the debtor. The debtor is said to default on his debt. These types of debt are frequently repackaged and sold below face value.
Short of bankruptcy, very often debts are wholly or partially forgiven. Traditions in some cultures demand that this be done on a regular (often annual) basis, in order to prevent systemic inequities between groups in society, or anyone becoming a specialist in holding debt and coercing repayment.
International Third World debt has reached the scale that many economists and Christians are convinced that debt cancellation is the only way to restore global equity in relations with the developing nations.
Debt allows people and organisations to do things that they otherwise wouldn’t be able or allowed to. Commonly people in industrialised nations use it to purchase houses, cars and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage the investment made in their private equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the higher more debt per equity, the riskier.
The properties of debt have been blamed for exacerbating economic problems. For example, during the onset of the Great Depression, there was deflation, which effectively made debt throughout society grow. This resulted in a contraction of consumption since the borrowers were on average people who had to consume less due to the increased proportion of their earnings going towards repayments while the lenders were on average people who would invest their extra purchasing power. The reduction in consumption reduced business activity and caused further unemployment. Also in a direct sense, more bankruptcies occurred due to increased effective debt than otherwise might have been the case.
It is possible for some organisations to enter into alternative types of borrowing and repayment arrangements which will not result in bankruptcy. For example, companies can sometimes convert debt that they owe into equity in themselves. In this case, the lender hopes to regain something equivalent to the debt and interest in the form of dividends and capital gains of the borrower. The “repayments” are therefore proportional to what the borrower earns and so can not in themselves cause bankruptcy. Once a debt is converted in this way, it is no longer known as debt.
There are many arguments against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. Economics criticism focuses on debt fostering inequality. Religious critics contend the ethical issues connected with debt, especially the element of luck, while Feminism concentrates on the perceived coercive nature of debt contracts. Environmental critics point out the disparity between material use of resources from economic growth and the limited resources of natural production. Examples would be the low ecological yield of natural resources and the limited usable energy from the sun.
Comparing a company’s accounts receivable and accounts payable statements is often a quick way of determining their level of debt.
Some forms of debt are beneficial; for example, when a company invests in upgraded machinery to streamline their production process, the increase in future revenue can be greater than the initial outlay of funds.
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This glossary post was last updated: 7th February 2020.