Would you extend trade credit to your customers?

As a proprietor of "Starbruce"

As a proprietor of the "Starbruce" construction company that sells houses, offices, and other buildings in Taipei, I offer multiple types of houses and buildings to individuals and business owners. Further, I also offer decorating services, to help my clients create a comfortable place with warm lighting and comforting interiors, and a beautiful cozy atmosphere. Starbruce’s vision is to be the leading construction company in all markets and to build a legacy of excellence.

Should I extend trade direct credit to your customers? 

The answer is sometimes yes, sometimes not. It's similar to a poker game. If we know the chance of uncollectible is pretty low, we will reduce the bids we put on them. With information technology, we can do the investigation much better. 

Why?

Yes, some people do deserve our trust. Credit sales can entice customers to make a purchase decision. However, trust must be earned. With a membership program, I can trust my customers who already earned my trust. I don't want to treat everyone with the same rules since there is always someone you can rely on and someone just can't. 

Why not?

Every devil was once an angel. As I said, in the real world, there is always someone we can trust, but someone just can't. Credit sales facilitate many business transactions, but it is also costly. Moreover, It's an opportunity cost, which means I must forego the alternative uses of the money while credit is extended. 

How will this decision affect my sales and profits?

Although credit sales are costly, it facilitates many business transactions. That's also why we do this, why we often take the risk. 

For instance, suppose my company builds a house for sale, and the price is $300,000, but my client only has $200,000 cash on hand. And my client can not get any more funds from banks because of the credit limit. In this case, I have to decide whether I should offer a $100,000 direct loan to the potential client or not. If I do, I have to forego the alternative uses of the money and take the risk of the uncollectible expenses. But it can be a good deal, the direct loan induce the client to make the purchasing decision, and it's worthwhile if the collections of the payments are smooth. While the house is delivered, the $300,000 is recognized as revenue. Therefore, I have $200,000 inflow of cash, and $100,000 notes receivable. 

If I don't offer any direct loan to the potential client, I will lose the deal, the $300,000 revenue, $200,000 inflow of cash, and the $100,000 notes receivable. However, I don't have to take the risk and feeling stressed about the receivable. Also, I can put the $100,000 on a treasury bond to gain my profits. 

How would I ensure that my firm is paid by its clients?

In the business field, I always thinking about how to get a win-win situation. I gain my profits and my clients get great deals. However, trust must be earned. The first step is to check the credit history of the client which is a normal procedure of doing business, to ensure they have the ability to repay the direct loan. The first step is the most important one I think because it reduces the risk substantially in the first place. 

To reduce the risk, I will request some collaterals, such as the house. The step is to increase their opportunity cost when they really have to decide to repay or not. Because of the collaterals, they have to make their choices among the opportunity cost. Would you like to risk your future on a payment you can afford? That's the third step, affordable. 

Everyone has their affordable life and products. My firm does not offer a direct loan to individuals or business owners who can not afford it in the first place. The future may be unpredictable, but the past has clear records. What you have done, what you have achieved, are the basic start point. For instance, if my client's life is struggling at around $1,000 per month, my firm does not offer a direct loan to the client if the loan has to be repaid $999 per month. 

How would you account for those who fail to pay?

As we learned from this chapter, there are "Direct Write-Off Method" and "Allowance Methods".  Under the direct write-off method, a bad debt is charged to expense as it apparently shows not to be paid. The allowance method, on the other hand, is an estimate of the future amount of bad debt that is charged to a reserve account as a sale is made. In short, the keywords are estimating the future or not.

Normally, it depends on what is material? It is material if its omission or misstatement could influence the economic decisions of my firm's taken on the basis of the financial statements. Materiality is relative to the size and particular circumstances of individual companies.

It depends on the size. If my firm is a big construction company that has net assets worth $10 billion, a default by a customer who owes only $1,000 to my firm is immaterial to the financial statements of my firm.

It also depends on the nature. As my firm is a construction company, selling houses is a major source of revenue for my company, then this information should be disclosed in the financial statements as it is by its nature material to understanding my firm's scope of operations in the future.

Reference 

Chapter 7: Accounts Receivable. (n.d.). Retrieved from https://www.principlesofaccounting.com/chapter-7/

Materiality Concept. (n.d.). Retrieved from https://accounting-simplified.com/financial-accounting/accounting-concepts-and-principles/accounting-materiality.html