What Is a Write-Off?
Debt that cannot be recovered or collected from a debtor is bad debt. Under the provision or allowance method of accounting, businesses credit the "Accounts Receivable" category on the balance sheet by the amount of the uncollected debt. A debit entry for the same amount is entered into the "Allowance for Doubtful Accounts" column to balance the balance sheet. This process is called writing off bad debt.
Under the direct write-off method, bad debts are expensed. The company credits the accounts receivable account on the balance sheet and debits the bad debt expense account on the income statement. Under this form of accounting, there is no "Allowance for Doubtful Accounts" section on the balance sheet.
Key Takeaways
- When a business does not expect to recover a debt, the debt becomes bad and is written off.
- To assume a more attractive position and reduce its tax liability, banks often write off toxic loans, the most common form of bad debt for a bank.
- Under GAAP, banks are usually required to keep reserves for bad loans.
- When a bad debt is written down, part of the debt is recovered and part is written off, usually as part of a settlement.
How Banks Write off Bad Debt
Banks prefer to never have to write off bad debt since their loan portfolios are their primary assets and source of future revenue. However, toxic loans—loans that cannot be collected or are unreasonably difficult to collect—reflect very poorly on a bank's financial statements and can divert resources from more productive activity.
Banks use write-offs, which are sometimes called "charge-offs," to remove loans from their balance sheets and reduce their overall tax liability.
Example of a Bank Writing off Bad Debt
Banks never assume they will collect all of the loans they make. This is why generally accepted accounting principles(GAAP)require lending institutions to hold a reserve against expected future bad loans. This is otherwise known as the allowance for bad debts.
For example, a firm that makes $100,000 in loans might have an allowance for 5%, or $5,000, in bad debts. Once the loans are made, this $5,000 is immediately taken as an expense as the bank does not wait until an actual default occurs. The remaining $95,000 is recorded as net assets on the balance sheet.
If it turns out more borrowers default than expected, the bank writes off the receivables and takes the additional expense. So, if the bank has $8,000 worth of loans default, it writes off the entire amount and takes an additional $3,000 as an expense.
Write off vs. Write Down
When debts are written off, they are removed as assets from the balance sheet because the company does not expect to recover payment.
In contrast, when a bad debt is written down, some of the bad debt value remains as an asset because the company expects to recover it. The portion that the company does not expect to collect is written off.
For example, consider a bank offering a customer the opportunity to pay off their debt under a settlement agreement. The bank may offer the customer a one-time settlement offer of 50% to fulfill their debt obligation. If accepted, the 50% portion paid is moved from Accounts Receivable to Cash, while 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.
Bad loans and illiquid holdings might be sold to another financial institution called a bad bank. Selling these assets to the bad banks will generally cost shareholders and bondholders but protect depositors from a possible bank failure.
Special Considerations
When a nonperforming loan is written off, the lender receives a tax deduction from the loan value. Not only do banks get a deduction, but they are still allowed to pursue the debts and generate revenue from them. Another common option is for banks to sell off bad debts to third-party collection agencies.
FAQs
Charge-offs and write-downs create one-time hits to earnings — the loans written down or charged off effectively amount to expenses that offset revenue and curb net income — but these actions also remove the cost of servicing and trying to collect interest on a bad loan over time, allowing banks to focus on profitable ...
Why do banks write-off bad debts? ›
To assume a more attractive position and reduce its tax liability, banks often write off toxic loans, the most common form of bad debt for a bank. When a bad debt is written down, part of the debt is recovered and part is written off, usually as part of a settlement.
Why bad debts are written off? ›
Writing off bad debt ensures that a company's financial statements accurately reflect the true value of its accounts receivable. There are two primary methods for writing off bad debt: the direct write-off method and the allowance method.
What does it mean if a bank writes you off? ›
Getting a write-off on your debt is likely to have a negative impact on your ability to get credit in the future for up to six years. See our Credit reference agencies guide and credit reports for more information. If a creditor writes off a debt, it means that no further payments are due.
What are the rules for bad debt write-off? ›
Generally, to deduct a bad debt, you must have previously included the amount in your income or loaned out your cash. If you're a cash method taxpayer (most individuals are), you generally can't take a bad debt deduction for unpaid salaries, wages, rents, fees, interests, dividends, and similar items of taxable income.
What happens if my debt is written off? ›
A credit card debt write-off doesn't wipe out your liability for or obligation to pay that debt. It is simply a mechanism used by credit card companies to get bad debts off their books. As a result, debt collectors can still call or sue you to collect the debt even after it is written off.
What are the risks of a bad debt write-off? ›
Writing off a debt doesn't mean it can never be recovered. Partial or full payment can still be made if the debtor decides to make a settlement or issued by a bankruptcy trustee. It is usually possible to reclaim tax paid on bad debts (relief on VAT return).
What is the average bad debt write off? ›
The ratio measures the money a company loses on its overall sales due to customer(s) not paying their dues. The average bad debt to sales value in 2022 was 0.16%. The companies with the best ratio (best performers) reported a value of 0.02% or lower.
What is the reason for write off? ›
A write-off primarily refers to a business accounting expense reported to account for unreceived payments or losses on assets. Three common scenarios requiring a business write-off include unpaid bank loans, unpaid receivables, and losses on stored inventory.
What happens when an account is charged off as bad debt? ›
Highlights: A charge-off means a lender or creditor has written the account off as a loss, and the account is closed to future charges. It may be sold to a debt buyer or transferred to a collection agency. You are still legally obligated to pay the debt.
Understanding Prescribed Debt
Prescribed debt refers to debts that have expired and are no longer required to be paid by consumers. If you haven't acknowledged or paid a debt for more than 36 months, it's usually written off. However, different types of loans have different time limits for prescriptions.
How to pay a written off debt? ›
If the debt hasn't been sold to a collections agency, you can work with the original lender to make payment arrangements. Once it's paid off, the lender should change the status of the account to “paid charge-off” and update the balance to zero. Lenders usually see a paid charge-off as more favorable than unpaid debt.
How to solve bad debts written off? ›
This written-off bad debt is deducted from the accounts receivable balance. If the actual bad debt amount exceeds its provision, the excess is recorded as an expense in the income statement of the corresponding financial year. This brings down the net profits earned by the firm in that particular accounting year.
Can you reverse a bad debt write off? ›
Any action taken concerning a bad debt must be noted in the company's books. When the debt is written off, it must be accounted for as a loss. If it is recovered, the company must reverse the loss.
Does bad debt write off affect credit score? ›
The creditor reports the closed account and the charge-off to the credit bureaus. This can have a negative impact on your credit. The creditor may sell the balance to a collections agency, which can pursue you for the debt and list the balance as a new collections account tradeline on your credit report.
Why do banks sell off debt? ›
Banks may securitize debt for several reasons including risk management, balance sheet issues, greater leverage of capital, and in order to profit from origination fees.
What happens when a bank writes off a credit card debt? ›
What does credit card debt being written off mean? Having your credit card debt written off means that it no longer exists. Your credit card company, or anyone else, can't pursue you for the money anymore, and you'll no longer receive any communications asking you to pay it.
What does "bad debt write off" mean on a credit report? ›
If you've been delinquent on your credit card or loan payments for several months, you might have noticed a charge-off on your credit report. This occurs when the creditor has given up on collecting the money owed and has decided to categorize the debt as bad debt, meaning it is a loss for the company.
