How to Write-Off Bad Debts

All debts that can no longer be collected or recovered are treated as bad debts. Since banks do not assume that they can collect all their approved borrowings, the Generally Accepted Accounting Principles (GAAP) requires all lending institutions to hold a reserve to be used for future bad loans.

Under the write-off procedure, all bad debts are expensed. In the Balance Sheet, the accounts receivable account will be credited while the bad debt expense account is debited on the income statement. Banks usually prefer not to write off debts because their loan portfolios are their primary source of future revenues. Nonetheless, those borrowings that can no longer be collected or are very hard to collect will reflect poorly on the financial statements. Thus, banks often use write-offs to eliminate loans from their balance sheet and to decrease their tax liability.

A bank will write off debts once they assume that the debtors are unable to pay their loans. Banks or lending institutions can either try to collect the unpaid loans or turn them over to a third-party debt collector. Although writing off accounts does not directly affect the existence of the debt, it will however significantly impact the financial statements of a financial or lending institution.

How to Write-Off Bad Debts

What are the Debt Write-off Procedures

Bad debts can be written off in two ways. A bank or lending institution can either use the direct write-off method or the provision method. The difference between the two is that the former tends to delay recognition of bad debt expense while the latter eliminates the time problem by requiring the financial institution to hold a reserve once the loans are recorded initially; thus, a bad debt expense under the provision method is recognized at once despite no certainty as to when exactly do the loans become toxic debts.

To further explain the comparison between the direct write off method and the provision method, the proper accounting procedure between the two are simplified as follows:

  • Direct write-off method – Banks can charge the borrowed amount to the bad debt expense account when it is assured that the loan will not be paid. The journal entry should be to debit bad debt expense and credit accounts receivable.
  • Provision method – In this procedure, the bank can charge the amount to the allowance for doubtful accounts. The journal entry should be to debit the allowance for doubtful accounts and credit the accounts receivable.

How to Write-Off Bad Debts

Out of the two הליך מחיקת חובות, the most preferred technique is the provision method due to its timing of recognizing expenses. If direct write-off will be used, the bad debt expense recognition will be delayed since you’ll still need to wait for several months to write off bad debt that would result in a mismatch on revenues and related bad debt expense. Hence, the provision method removes the time problem as it requires banks or lending institutions to allocate reserves and to recognize bad debts right away even if there’s no certainty about when does the loan become a bad debt.

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