Why do some banks declare they are writing off bad debt? Isn’t it an expense for the bank since they’re unable to recover the costs? Read on to learn more about a write-off and why banks use it.
What is a write-off?
A bad loan is not able to be repaid or is it able to be collected. According to the provision or allocation method, companies can credit the “Accounts Receivable” category on the balance sheet according to the amount of not accumulated debt. To ensure the balance sheet is balanced, there is a debit entry of the amount added in the “Allowance for Doubtful Accounts” column. This is referred to as the writing off of bad debts.
Debts not paid off are accounted for in the direct write-off process. Companies debit the account for bad expenses from the balance sheet and credit the accounts receivables account in the balance sheet. The balance sheet does not have an ‘Allowance for questionable accounts’ section per this accounting method.
Why the banks have to write off bad loans?
In the eyes of a bank, bad debts don’t look well on the bank’s balance sheet. This is the reason banks employ the process of writing off loans to clear their balance accounts. It is often used in situations of non-performing assets (NPA) and bad loans. The loan may be canceled if the loan unless paid or is in default for more than three consecutive months.
The funds parked by the bank in anticipation of the purpose of writing off a loan are now set up for provisioning other loans. Banks put aside a specific percentage of the money borrowed to provide the loan. A minimum of 5% and a up to 20% can be the typical rate of provisioning loans at Indian banks based on the industry sector and the ability to repay the lender. Provisioning must be 100% according to the Basel-III standards in the instances of assets that are not performing.
In a case involving 12 major bankruptcy cases referred to National Company Law Tribunal, the RBI demanded that banks set an extra 50% of their reserves for secured exposure and 100% for disclosure that is not guaranteed.
What is the most crucial motive behind banks’ decision to write off bad loans instead of allowing them to be open in their accounts books?
A bank’s portfolio of loans is the primary asset of the bank and a source of future income. This is the reason why, by default, banks don’t want to write off their bad debts. However, unrecovered loans that are nothing more than loans that are not easily collected or are unreasonable to collect may affect a bank’s financial statements and could disrupt the financial resources of other productive actions.
The banks will write off loans that are sometimes referred to as charge-offs. This is only done to eliminate loan balances and to reduce the tax burden.
Example of a Bank Writing-off Bad Debt
As an example, suppose the bank granted an amount of 1 lakh rupees. 1 Lakh to the person who requested it. The borrower is obliged to make a 10% provision for the loan. Therefore, the bank set aside a sum of Rs. 10,000 in default. This sum is set aside, regardless of whether the borrower is in default on payment or not.
If, however, the borrower is found to have committed a more significant default, such as a total of Rs. 50,000, the bank reserves an additional amount of Rs. 40,000. It will then declare it as an expense on the balance sheet that mentions the year in which it was a default. If the default is that more borrowers fail to pay than anticipated, the bank is required to write off the receivables and then recover the amount that was provisioned.
After the loan has been written off, the bank releases Rs.10,000, put initially aside to provide provisioning. The unrestricted funds can be used for other reasons by the bank.
Additionally, writing off bad loans has other advantages. The writing of loans doesn’t eliminate the bank’s right to regain the loan from the borrower by legal methods. Any money recovered against the borrower is considered an income for the bank during the year it is recovering after rewriting bad loans. This can add some color to the balance sheet of the bank.
Banks can never be to always confident to repay all their loans. This is why generally accepted accounting standards oblige lending institutions to keep reserves against the possibility of bad loans. This is also referred to as an allowance to cover bad loans.
If a bank isn’t capable of recouping the loan, then the debt is wrong, and it is erased.
Banks often eliminate bad loans to clear their balance sheet and lessen their tax burden. They are the most comparable form of bad debt to banks. Typically, banks are required to have reserves to cover bad loans. A portion of the debt is paid back, and the other is written off, typically in the settlement process, after the loan is written off.