Bad Debts associated with extension of credit to customers represented which category of cost?

Correct option is D

Bad debts arise when customers fail to repay the credit extended to them, resulting in financial losses for the company. This is classified as a Default Cost, which refers to the losses incurred due to non-payment of credit.

1. Definition of Default Costs:

   • Default costs are the irrecoverable losses a company faces when customers fail to pay their debts.

   • These costs include bad debts, legal expenses for recovery, and provisions for doubtful debts.

2. Why Bad Debts Fall Under Default Costs?

   • Bad debts are an unavoidable risk for businesses offering credit.

   • When a customer defaults on payment, the amount owed becomes a bad debt, leading to financial loss.

   • Companies account for these losses under default costs in financial statements.

3. Example:

   • A company extends credit of ₹1,00,000 to a customer. If the customer fails to pay ₹50,000, this amount is classified as a bad debt and recorded under default costs in the company’s accounts.

Information Booster:

Default costs arise when customers or borrowers fail to repay their dues, leading to financial losses for businesses. These costs are categorized as bad debts and directly impact a company's profitability. High default costs can strain cash flow and increase financial risk, making it crucial for businesses to manage credit efficiently. Companies minimize default risks by conducting thorough credit screenings, offering early payment incentives, and engaging collection agencies if needed. Provisions for doubtful debts are often maintained to offset potential losses. Industries such as banking, retail, and telecommunications frequently deal with default costs due to unpaid loans, credit card dues, and overdue bills. In financial statements, default costs are recorded as bad debt expenses or adjusted through provisions. For instance, if a company sells goods on credit and a portion remains unpaid, it is classified as a default cost and written off. Effective credit management strategies help reduce default costs, ensuring business sustainability.

Additional Knowledge:

(a) Collection Costs are expenses incurred while trying to recover overdue payments, such as legal fees, collection agency charges, and administrative costs, but they are not actual losses like bad debts.

(b) Capital Costs refer to the cost of acquiring funds for business activities, including interest on loans or cost of equity, and have no relation to credit losses or bad debts.

(c) Delinquency Costs arise due to delays in payments (late payment charges, follow-up costs) but do not represent permanent losses; unlike default costs, payments may still be received eventually.