Loan write-off means that the bank has written off a debt. But this doesn’t mean that they have ceased the procedures to bring it back. Have you ever wondered why banks declare that bad debt is being written off? Isn’t it a loss for the bank that they can’t recoup the costs? Continue reading to learn what a write-off is, how banks write them off and why banks take them.
What Is a Write-Off?
Bad debt is debt that lenders cannot recover or collect from a debtor. Businesses use the provision or allowance method of accounting to credit the amount of debt they didn’t collect. They credit it to the “Accounts Receivable” category on the balance sheet. To balance the balance sheet, they make a debit entry for the same amount in the “Allowance for Doubtful Accounts” column. “Writing off bad debt” is the term for this.
The direct write-off method is used to expense bad debts. They credit the accounts receivable account on the balance sheet. And they debit the bad debt expense account on the income statement. There is no “Allowance for Doubtful Accounts” section on the balance sheet under this method of accounting.
How Banks Write off Bad Debt
Because their loan portfolios are their principal assets and source of future revenue. Therefore, banks aim to never have to write bad debt. Toxic loans are loans that cannot or are excessively difficult to collect, reflect badly on a bank’s financial accounts. Also, it can divert resources away from more productive activities.
They also know write-offs sometimes, as “charge-offs,” banks used to erase loans from their balance sheets. Besides that, they use it to decrease their overall tax burden.
Case study of a Bank Writing off Bad Debt
Banks never assume that they can collect all of their loans. Therefore, they require lending institutions to keep a reserve against unforeseen future bad loans. And this is under GAAP, which means accepted accounting principles. They also refer to it as the bad debt allowance.
For example, a company that provides GH₵100,000 in loans might set aside 5%, or GH₵5,000, for bad debts. They’ll deduct the GH₵5,000 as a cost as soon as they make the loans. This is because the bank does not wait for a default to occur. On the balance sheet, they show the remaining GH₵95,000 as net assets.
If more borrowers default than they expect, the bank writes off the receivables and absorbs the additional cost. If a GH₵8,000 loan defaults, the bank writes off the full amount and deducts an additional GH₵3,000 as an expenditure.
Why do banks write-off bad loans rather than keeping it open in their account books?
The loan portfolio of a bank is its most valuable asset and source of future revenue. Because of this, banks do not wish to have their bad debts written off by default. Unreceived loans, which are simply loans that could not be collected. Can have a negative impact on a bank’s financial results and divert resources away from other productive activities.
Banks will charge-off loans, which are also known as write-offs. This is solely to remove loans from balance sheets and lower overall tax liability.
Write off vs. Write Down
They remove the debts from the balance sheet as assets when they write it off. This is because the company does not expect to recover payment.
When a bad debt is written down, however, some of the value of the bad debt becomes an asset. Since the corporation hopes to recover it. They write the portion of the payment that the company does not expect to receive off.
Consider a bank that offers a consumer the option of paying off their debt through a settlement agreement. The bank may make a one time settlement offer of 50% to the consumer to satisfy their debt obligation. If they accept it, they move the paid component of the invoice from Accounts Receivable to Cash. And also write off the unpaid portion with the amount credited from Accounts Receivable. Then they debit it to Allowance for Doubtful Accounts or expense to the bad debts expense account.
The lender receives a tax reduction from the loan value when a non performing debt is written off. They give not only banks a tax break, but they also allow them to chase debts and earn money from them. Banks can also sell bad loans to third-party collection firms, which is a prevalent practice.
When a bank cannot recover a loan, they classify the debt as bad and is written off. Banks frequently write off bad loans, the most common form of bad debt for a bank. This is in bid to clean up its balance sheet and lower their tax liability. They require banks to maintain reserves for bad loans. When they write off a bad debt, they recover a portion of the money and write off the rest, usually as part of a settlement.