Bad debt is debt that cannot be recovered or collected from a debtor. Businesses use the provision or allowance method of accounting to credit the amount of uncollected debt to the “Accounts Receivable” category on the balance sheet.
To balance the balance sheet, a debit entry for the same amount is made in the “Allowance for Doubtful Accounts” column. This is referred to as “writing off bad debt.”
Bad debts are expensed using the direct write-off technique. On the balance sheet, the corporation credits accounts receivable, and on the income statement, it debits bad debt expense.
There is no “Allowance for Doubtful Accounts” section on the balance sheet under this method of accounting.
How Do Banks Get Rid of Bad Debt?
Because their loan portfolios are their principal assets and source of future revenue, banks aim to never have to write down bad debt. Toxic loans, on the other hand, reflect adversely on a bank’s financial accounts and can divert resources away from more productive activities.
Write-offs, also known as “charge-offs,” are used by banks to erase loans from their balance sheets and decrease their overall tax burden.
A Bank Writing Off Bad Debt as an Example
Banks never assume that they will be able to collect on all of their loans. This is why lending institutions are required to keep a reserve against projected future bad loans under generally accepted accounting principles (GAAP).
This is also referred to as the bad debt allowance.
For example, a company that provides $100,000 in loans might set aside 5%, or $5,000, for bad debts. The $5,000 is deducted as an expense as soon as the loans are granted because the bank does not wait for a default to occur.
On the balance sheet, the remaining $95,000 is shown as net assets.
If more borrowers default than anticipated, the bank writes off the receivables and absorbs the additional cost. If a $8,000 loan defaults, the bank writes off the full amount and deducts an additional $3,000 as an expenditure.
Write off vs. Write Down
Because the corporation does not intend to recoup payment, debts are written off and removed as assets from the balance sheet.
When a bad debt is written down, however, some of the value of the bad debt is retained as an asset since the corporation hopes to recover it. The percentage of the bill that the corporation does not anticipate collecting is written 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 accepted, the paid portion is transferred from Accounts Receivable to Cash, while the unpaid portion is written off, with the amount credited to Accounts Receivable and debited to Allowance for Doubtful Accounts or expensed to the bad debts expense account.
The lender receives a tax reduction from the loan value when a nonperforming debt is written off. Banks are not only given a discount, but they are also authorized to pursue debts and profit from them. The sale of bad debts to third-party collection firms is another prevalent option for banks.
When a bank is unable to collect on a loan, the debt is classified as bad and is written off.
Banks frequently write off bad loans, the most common form of bad debt for a bank, to clean up its balance sheet and lower their tax liability. Banks are typically required to maintain reserves for problematic loans.
When a bad debt is written off, part of the amount is recovered and portion is written off, usually as part of a settlement.