2018-09-02 Write-off vs. provisions

A non-performing debt can be usually written off using either the direct write off method or the provision method. For banks and NBFCs we use provision method as the direct write-off method tends to delay the recognition of the bad debt expense - and therefore is not allowing the management of financial institution to realize additional steps to control the risk.

It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible - usually 90 - 180 days without whole interest down-payment. Otherwise, an financial institution will carry an inordinately high loan accounts receivable balance that overstates the amount of outstanding eventually be converted into cash.

There are two ways to account for a bad debt:

Direct write off method - not used for financial institutions. The company can charge the amount of an loan to the bad debt expense account when it is certain that it will not be paid. The journal entry is a debit to the bad debt expense account and a credit to the loans receivable account. It may also be necessary to reverse any related sales tax that was charged on the original loan, which requires a debit to the sales taxes payable account.

Provision method - used for financial institutions. The company charge the amount of the loan to the allowance for doubtful accounts. The journal entry is a debit to the allowance for doubtful accounts and a credit to the accounts loan account. Again, it may be necessary to debit the sales taxes payable account if sales taxes were charged on the original loan.

In either case, when a specific loan is actually written off, this is done by creating a credit memo in the accounting software that specifically offsets the targeted loan.

Note:

Of the two methods presented for writing off a bad debt, the preferred approach is the provision method. The reason is based on the timing of expense recognition. If you wait several months to write off a bad debt, as is common with the direct write off method, the bad debt expense recognition is delayed past the month in which the original sale was recorded. Thus, there is a mismatch between the record of revenue and the related bad debt expense. The provision method eliminates this timing problem by requiring the establishment of a reserve when loans are initially recorded, so that some bad debt expense is recognized at once, even if there is no certainty about exactly which invoices will later become bad debts.