Credit Risk

Definition

Credit risk refers to the potential for financial loss due to a borrower's failure to meet their contractual obligations to repay a loan or debt. It is a critical consideration for lenders and businesses when extending credit or accounts receivable to customers.

5 Must Know Facts For Your Next Test

1. Credit risk is the primary reason companies record an allowance for doubtful accounts on the balance sheet.
2. The balance sheet approach to accounting for uncollectible accounts involves estimating the amount of accounts receivable that may not be collected.
3. The income statement approach to accounting for uncollectible accounts involves recording bad debt expense, which reduces net income.
4. Notes receivable generally carry a higher credit risk than accounts receivable due to the longer time frame and contractual nature of the agreement.
5. Effective credit risk management, including thorough customer screening and collection practices, is crucial for maintaining a healthy accounts receivable portfolio.

Review Questions

• Explain how credit risk relates to the balance sheet and income statement approaches for accounting for uncollectible accounts.
  • Credit risk is the primary reason companies record an allowance for doubtful accounts on the balance sheet. The balance sheet approach involves estimating the amount of accounts receivable that may not be collected due to credit risk. In contrast, the income statement approach records bad debt expense, which reduces net income and reflects the credit risk associated with uncollectible accounts. Both approaches aim to accurately represent the company's financial position and performance in light of the credit risk inherent in its accounts receivable.
• Describe how the credit risk associated with notes receivable differs from that of accounts receivable.
  • Notes receivable generally carry a higher credit risk than accounts receivable. This is because notes receivable involve a written promise to pay a specific amount on a specific date, often with interest, whereas accounts receivable are more informal extensions of credit. The longer time frame and contractual nature of notes receivable increase the likelihood of default, making them riskier from a credit perspective. Effective credit risk management, including thorough customer screening and collection practices, is crucial for maintaining a healthy balance of both accounts receivable and notes receivable.
• Evaluate the importance of credit risk management in the context of a company's accounts receivable and notes receivable.
  • Credit risk management is essential for maintaining a healthy accounts receivable and notes receivable portfolio. Effective credit risk management, including thorough customer screening and collection practices, helps a company minimize potential financial losses due to uncollectible debts. This, in turn, supports the company's overall financial performance and stability. By accurately estimating and accounting for credit risk through the balance sheet and income statement approaches, companies can make informed decisions about extending credit, pricing products and services, and managing their cash flow. Ultimately, proactive credit risk management is crucial for a company's long-term success and sustainability.

Related terms

Accounts Receivable: Money owed to a business by its customers for goods or services provided on credit.

Allowance for Doubtful Accounts: An estimated amount set aside to cover potential losses from uncollectible accounts receivable.

Notes Receivable: A written promise to pay a specific amount of money on a specific date, typically with interest.