Definition
A preferential creditor is a creditor who has priority over others for the payment of debts in the case of bankruptcy or corporate winding-up. This higher ranking increases their chances of being repaid in full. Preferential creditors commonly include the trustees of occupational pension schemes and employees with outstanding remuneration. The legal status of the Crown, which once stood as a preferential creditor (HM Revenue and Customs), was abolished in 2003.
Examples
- Occupational Pension Schemes: Trustees managing employee pension funds are considered preferential creditors. In the event of a company’s liquidation, they have a higher chance of recovering money to fund employees’ pensions.
- Employee Remuneration: Employees owed wages or salaries at the time of a company’s bankruptcy or winding-up become preferential creditors. They are subsequently repaid before ordinary creditors.
- Customer Deposits: Some jurisdictions prioritize customers with pre-paid deposits for undelivered services or products as preferential creditors.
Frequently Asked Questions (FAQs)
What distinguishes a preferential creditor from an ordinary creditor?
Preferential creditors, as indicated by their name, have preferential rights to be paid before ordinary creditors in the event of bankruptcy or company winding-up. Their status arises due to specific legislative provisions that prioritize their claims.
What types of debts are usually classified as preferential?
Typically, debts related to employee wages, accrued holiday pay, and contributions to occupational pensions are classified as preferential. Additionally, certain taxes owed to governmental authorities used to be preferential but are not in the UK since 2003.
Has the status of preferential creditors changed over time?
Yes, modifications in legislation, like the UK abolishing the Crown’s status as a preferential creditor in 2003, alter the landscape of who is considered a preferential creditor.
Are there any limitations to the preferential status of these creditors?
The scope and extent of preferential status can be limited. For example, the maximum amount owed to employees or for pensions that is treated preferentially may be capped by legislation.
How does the prioritization process work?
In the asset distribution process during bankruptcy or liquidation, debts owed to secured creditors are settled first, followed by preferential creditors, and finally, any remaining assets are distributed to ordinary creditors.
Secured Liabilities
Claims against a debtor backed by specific assets providing collateral, ensuring that secured creditors are repaid before preferential creditors in business winding-up.
Bankruptcy
A legal procedure involving a person or business that cannot repay outstanding debts, leading to asset distribution among creditors.
Liquidation
The process of winding up a company, selling off its assets, and distributing the proceeds to creditors to dissolve its legal existence.
Online Resources
- Insolvency Service
- United States Courts – Bankruptcy Basics
- ACCA - The Role of the Preferential Creditor
Suggested Books for Further Studies
- Principles of Corporate Insolvency Law by Roy Goode
- Bankruptcy and Insolvency Accounting by Grant W. Newton
- Corporate Insolvency Law: Perspectives and Principles by Vanessa Finch
- The Law of Insolvency by Ian F. Fletcher
Accounting Basics: “Preferential Creditor” Fundamentals Quiz
### What is a preferential creditor?
- [ ] A creditor who is last in line for repayment.
- [ ] A creditor given special status due to political reasons.
- [x] A creditor whose debt is prioritized over other creditors.
- [ ] A creditor only during profitable business periods.
> **Explanation:** A preferential creditor has the legal right to be paid before other creditors in the event of a bankruptcy or company liquidation.
### Which of the following typically class as preferential creditors?
- [x] Employees owed wages.
- [ ] Local suppliers of office supplies.
- [ ] Shareholders expecting dividends.
- [ ] Freelance consultants unpaid for recent projects.
> **Explanation:** Employees owed wages are usually classified as preferential creditors, affording them higher priority in repayment.
### In terms of priority, who gets paid first during company winding-up?
- [ ] Ordinary creditors
- [ ] Customers with complaints.
- [x] Secured creditors
- [ ] Freelancers
> **Explanation:** Secured creditors are paid before preferential creditors, with their claims backed by specific assets as collateral.
### Have there been changes in the status of preferential creditors in recent years?
- [x] Yes, the status has changed. The UK abolished the Crown's preferential creditor status in 2003.
- [ ] No, the status of preferential creditors has remained constant.
- [ ] Some changes, but only affecting non-governmental creditors.
- [ ] Changes only affecting regular employees.
> **Explanation:** The status of certain preferential creditors has indeed changed, such as the UK abolishing the Crown's preferential creditor status in 2003.
### Which one is NOT considered a typical preferential creditor?
- [ ] Trustees of occupational pensions
- [ ] Employees with outstanding wages
- [ ] Government for certain unpaid taxes before 2003 (in the UK)
- [x] Corporate shareholders
> **Explanation:** Corporate shareholders are generally not classified as preferential creditors and usually have claims settled after secured and preferential creditors had been paid.
### What is the role of a trustee in occupational pension schemes in terms of preferential status?
- [ ] To manage company's profits distribution.
- [ ] To ensure shareholders' benefits first.
- [x] To protect employees' pension by ranking as preferential creditors.
- [ ] To regulate cash flows within the company.
> **Explanation:** Trustees of occupational pension schemes act as preferential creditors to protect the funds needed for employees' pensions in the event of a liquidation.
### Why were HM Revenue and Customs (Crown) removed from being preferential creditors in the UK?
- [ ] Due to enhancing ordinary creditors' chance of payment.
- [x] Legislative changes in 2003.
- [ ] Governmental financial policy shifts.
- [ ] Constitutional amendments regarding creditors' hierarchy.
> **Explanation:** Legislative changes in 2003 removed the Crown's typical preferential creditor status in the UK.
### What sets aside preferential creditors from secured creditors?
- [ ] The preference for asset annexation.
- [ ] Geographical payment priorities.
- [x] Preferential creditors deal with non-specific claims.
- [ ] Secured creditors receive standardized bonuses.
> **Explanation:** Preferential creditors generally have non-specific claims, unlike secured creditors whose claims are backed by specific collateral assets.
### Are customer deposits typically considered under preferential creditor status?
- [ ] Yes, universally.
- [x] Not in all jurisdictions.
- [ ] Only within private corporations.
- [ ] Deposits never count as claims.
> **Explanation:** Customer deposits can be considered under preferential creditor status in some jurisdictions, providing higher odds of recovery for prepaid services/products.
### Preferential creditors are typically paid:
- [ ] After ordinary creditors.
- [ ] Simultaneously with secured creditors.
- [x] Before ordinary creditors.
- [ ] Only if liquidation is profitable.
> **Explanation:** Preferential creditors are prioritized to be paid before ordinary creditors during bankruptcy or company winding-up.
Thank you for exploring the intricacies of preferential creditors with us and tackling our informative quiz. Continue to broaden your financial and accounting acumen!
