Bad debt or loan is a debt/loan that cannot be recovered or collected from the debtor. Businesses use the provision or allowance method of accounting, which credits the uncollected debt to the "Accounts Receivable" category on the balance sheet.
To balance the balance sheet, The banks or financial institutions make a debit entry for the same amount into the "Allowance for Doubtful Accounts" column. This is known as writing off bad loans.
Bad loans are expensed using the direct write-off method. The company credits the balance sheet for the accounts receivable and pays off the income statement for the bad loan expense account.
There is no section called the "Allowance for Doubtful Accounts" on the balance sheet in this accounting method.
In this article, we will learn more about write-off, why banks write off bad debts, how it helps banks, and more.
A write-off, in accounting terminology, means a reduction in the value of an asset when debiting a liability account.
The term is literally used by companies seeking accountability for unpaid loans, unpaid claims, or losses in the stored stock. From a different viewpoint, write-offs reduce the company's annual fiscal liability.
A loan write-off is used by banks as a tool to balance their books. It is used when there are bad loans/debts or non-performing assets (NPA). If a loan goes bad due to repayment defaults for at least three quarters in a row, the exposure (loan) can be written off.
A loan write-off frees up funds held by banks for the provisioning of any loan. A loan provision is a percentage of the loan amount set aside by the bank.
The standard rate of provisioning for loans in Indian banks ranges from 5 to 20%, depending on the business sector and the borrower's repayment capacity. In the case of NPA, 100% provisioning is required in accordance with Basel-III standards.
Scenarios for a Write-off
Unpaid bank loans, losses on stored inventory, and unpaid receivables are common business write-off scenarios. Let us look at each of them in detail:
When all other collection methods have been exhausted, banks and other financial institutions resort to the write-off method.
The loan loss reserves of a bank, a non-cash account that manages expectations for losses and unpaid loans, can provide detailed information about write-offs. While loan loss reserves anticipate unpaid loans, write-offs are the final action taken on them.
A company may have to write off some of its inventory for a variety of reasons, including theft, loss, spoilage, or obsolescence.
On a balance sheet, writing off inventory entails an expense debit for the value of unusable inventory and a credit to inventory.
When a company is convinced that a customer will not pay the bill, the company may be forced to write it off.
The debit to an unpaid receivables account may have to be recorded as a liability and the credit to accounts receivable as a credit on the balance sheet.
Let us assume a bank makes a loan of Rs. 1 crore to a borrower and is required to make a 10% provision for it. As a result, the bank puts another Rs 10 lakh aside without waiting for the borrower to default on repayment.
If the borrower defaults on a larger loan (let’s say Rs. 50 lakh) the bank can write off an additional Rs. 40 lakh as an expense on the balance sheet in the year of default.
However, as the loan is written off, the amount (Rs. 10 lakh) that was originally set aside for provisioning is released. That money can now be used by the bank for business processes.
The loan write-off does not remove the bank's legal right to recover the loan from the borrower. Any recovery made against bad loans after they have been written off is considered profit for the bank in the year of recovery. This is another advantage to writing off bad loans.
Banks prefer not to have to write off bad debt because their loan portfolios are their main assets and source of future revenue.
Toxic loans (i.e, loans that can’t be collected or are unreasonably difficult to collect), on the other hand, have a negative impact on a bank's financial statements and can divert resources away from more productive activities.
Therefore, the banks use write-offs to remove loans from their balance sheets as well as reduce their overall tax liability.
Banks never assume that they will be able to collect on all of the loans they make. This is why lending institutions are required by generally accepted accounting principles (GAAP) to hold a reserve against expected future bad loans.
This is also known as the bad debt allowance.
Let us look at an example.
A company that makes Rs. 1 lakh in loans may set aside 5%, (Rs. 5,000) for bad debts. Because the bank does not wait until an actual default occurs, this amount (Rs. 5,000) is taken as an expense as soon as the loans are made.
On the balance sheet, the remaining Rs. 95,000 is recorded as net assets.
If more borrowers default than expected, the bank writes off the receivables and absorbs the extra expense.
For example, if a bank has Rs. 8,000 in loan defaults, it writes off the entire amount and deducts an additional Rs. 3,000 as an expense.
When a debt is written off, it is removed from the balance sheet as an asset because the company does not expect to recover payment.
When a bad debt is written down, however, some of the bad debt value remains as an asset because the company expects to recover it. The portion that the company does not anticipate collecting is deducted.
Let us assume, for example, that a bank offers a customer the option to pay off their debt through a settlement agreement. The bank may make a one-time settlement offer of 50% to the customer in order to fulfill their debt obligation.
If accepted, the paid portion is transferred from “Accounts Receivable” to “Cash,” and the unpaid portion is written off, with the amount credited from “Accounts Receivable” and debited to “Allowance for Doubtful Accounts” or expensed to the bad debts expense account.
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