Have you ever wondered why banks announce that they’re writing off bad debt? After all, isn’t that it a loss for the bank that they are unable to recover the costs? Continue reading to understand what is a write off and why banks do it.
What is a write-off?
A bad debt is debt that cannot be recovered nor collected. Under the provision or allowance method of accounting, businesses credit the "Accounts Receivable" category on the balance sheet as per the amount of the uncollected debt. To balance the balance sheet, a debit entry for the same amount is entered into the "Allowance for Doubtful Accounts" column. This is called writing off bad debts.
Bad debts are expensed under the direct write-off method. The company debits the bad expense account on the income statement and credits the accounts receivable account on the balance sheet. There is no ‘Allowance for doubtful accounts’ part on the balance sheet under this form of accounting.
Why do banks write off bad debt?
Bad debts do not look good on a bank’s balance sheet. That is why banks use loan write-off to clean up their balance sheets. It is used in the cases of non-performing assets (NPA) or bad loans. The loan can be written off if a loan is not paid and is in default for more than three consecutive quarters.
The money that was parked by the bank for a loan write-off is set free for the provisioning of other loans. A certain percentage of loan amount is set aside by the banks for provisioning a loan. Minimum of 5% to maximum of 20% is the standard rate of provisioning for loans in Indian banks depending on the business sector and the repayment capacity of the borrower. 100% provisioning is required in accordance with the Basel-III norms in case of non-performing assets.
Earlier this year in a case of 12 large bankruptcy cases referred to the National Company Law Tribunal, the RBI asked banks to keep aside 50% provision against secured exposure and 100% for unsecured exposure.
What is the main reason why banks prefer to write-off bad loans instead of keeping it open in their account books?
A bank’s loan portfolio is its primary asset and source of future revenue. This is why by default, banks do not prefer to have their bad debts written-off. Yet unrecovered loans which are nothing but loans that could not be collected or are unreasonably difficult to collect can reflect negatively on a bank’s financial statements and can disrupt the resources from other productive activities.
Banks will write-off loans which are also sometimes known as charge-off. This is done only to get rid of loans from the balance sheets and reduce the overall tax liability.
Example of a Bank Writing-off Bad Debt
For example, imagine if a bank disbursed a loan amounting to Rs. 1 Lakh to a borrower. In this they are required to make a 10% of provision for it. Thus, the bank sets aside an amount of Rs. 10,000 by default. This amount is set aside, irrespective of whether the borrower defaults on payment or not.
However, in case the borrower is deemed to commit a bigger default of maybe Rs. 50,000, then the bank will set aside another Rs. 40,000 specifying it as an expense in the balance sheet mentioning the year of default. If it turns out more borrowers default than expected, the bank writes off the receivables and recovers the provisioned amount.
When the loan is written-off, the bank frees Rs.10,000 which was initially set aside for provisioning. This freed up money can be used for other business purposes by the bank.
Apart from this, writing-off bad loans also has additional benefits. The loan write-off does not take away the bank's right of recovery from the borrower through legal means. Any recovery made against the borrower is considered as a profit for the bank in that particular year of recovery after writing off bad loans. This may bring some colour to the bank’s balance sheet.
Banks are never too confident about recovering all the loans they provide. This is why generally accepted accounting principles require lending institutions to hold a reserve against expected future bad loans. This is otherwise known as the allowance for bad debts.
When a bank is not able to recover a loan then the debt becomes bad and is written off.
To clean up its balance sheet and to reduce its tax liability, banks often write off bad loans, the most similar form of bad debts for a bank. Necessarily banks are usually required to keep reserves for bad loans. Part of the debt is recovered and part is written off, usually as part of a settlement, when a bad debt is written off.