No matter what the intention, sometimes a company will not be able to collect on a debt. When this occurs, they will have to figure out how to deal with the debt from an accounting standpoint. Customers sometimes don’t pay their bills and can’t be found to pursue collections, items in inventory “disappear” for some reason or they malfunction or a customer makes a warranty claim against the company's product.
Perhaps you're in the business of lending money to people or companies, or you may be looking to borrow money or take out a credit card to handle your business affairs. Sometimes those bills that can’t be paid are charged off. What happens then?
To understand how the accounting is handled for each, it’s important to know the difference between a “charge-off” and a “write-off.”
A charge-off is a banking term that is used to describe an account that has become 180 days past due. Essentially, this occurs when a bank or credit card company has accepted that an account is unable to be collected and, for accounting reasons, will re-classify the debt as a charged-off account.
This kind of action usually results in the debt being transferred to a collection agency to be collected. It can negatively affect your credit score or ability to take on new credit.
A write-off is a term used to refer to an investment, such as a purchase of sellable goods, for which a return on the investment is now impossible or unlikely to occur. The item’s potential return is canceled and removed from the balance sheet of the business - “written off.”
In business accounting, an example of common write-offs in retail include spoiled and damaged goods. In commercial or industrial settings, a productive asset may be subject to write-off if it suffers failure or accidental damage that leaves the asset unusable for its intended purpose.
It is necessary to write off a bad debt when the related customer invoice is considered to be uncollectible. Otherwise, a business will carry an inordinately high accounts receivable balance that overstates the amount of outstanding customer invoices that will eventually be converted into cash.
The journal entries for a direct write-off are a debit to an expense account and a credit to an asset.
For example, if you determine that a customer will not make good on a credit purchase, the write-off is a debit to bad debt expense and a credit to accounts receivable. Similarly, when you discover damaged inventory, you write it off with a debit to cost of goods sold and a credit to inventory.
When you use the allowance method and encounter an actual loss, debit the allowance account and credit the asset account for the loss amount. This does not create an expense; rather, it transforms the loss amount from an estimate to an actuality.
For example, if you are a merchandiser and a customer defaults on a $1,000 purchase, debit the allowance for doubtful accounts and credit accounts receivable for $1,000. If your loss estimates consistently miss the mark, you can adjust the balances of allowance accounts as necessary.
In many cases, companies can plan ahead for expenses or obligations they expect to encounter in the future. Generally Accepted Accounting Principles, or GAAP, call for company accountants to use provision accounts – sometimes incorrectly labeled by International Financial Reporting Standards as “reserves”– to estimate write-offs in advance.
For accounting purposes, it’s important to know the difference between a provision and a reserve. In the financial industry, these are also known as provisions for loan losses vs. allowance for loan losses.
A reserve is an appropriation of profits for a specific purpose. The most common of these is a capital reserve, in which funds are set aside to purchase fixed assets such as equipment or materials at a later date. By setting aside a reserve, the company is able to segregate funds from the general operating usage of a company.
Some call it a rainy day fund, but that would be misleading. While reserve is another way of referring to the profit achieved by a company where a certain amount of it is put back into the business, this item is not an asset with a debit balance on the general ledger. A reserve, commonly referred to as “retained earnings,” always has a credit balance.
Some businesses will put aside part of their retained earnings in an account labeled “Reserve for Reinvestment,” to refer to amounts that will be used for capital purchases, or improvements. All reserve accounts are money that is put aside for a specific purpose and there is a big difference between a provision for loan losses vs. allowance for loan losses.
General reserves, as the name suggests, is money kept aside not for any particular purpose, but for the general financial strength of the company.
Specific reserves are set aside for a specific purpose and cannot be used for any other reason. Specific reserves are sometimes referred to as special reserves and can have specific names such as a “bad debt reserve,” an amount set aside in case a customer fails to pay an uncollectible account.
Capital reserves are funds created out of capital profits, or profits that arise from sources other than normal trading activities. Capital reserves are usually set aside for capital losses.
Any money allocated to a capital reserve fund is considered to be permanently invested and cannot be used to pay dividends to shareholders. The money is earmarked for specific purposes, such as long-term projects, mitigating capital losses or any other long-term contingencies.
A provision, on the other hand, is an amount of money set aside in a business’s accounts to cover a future liability or decrease in the value of an asset. It’s usually set aside for a liability cost that is certain in the future, the specific amount of which may be unknown.
In the banking industry, this is also referred to as a loan loss provision.
A provision should not be looked at as a form of saving, even though it is an amount that is put aside for a future cost or obligation. From an accounting standpoint, a provision results in a reduction in the company’s equity.
Some examples of provisions include guarantees, losses, deferred tax payments, restructuring liabilities, pensions and severance costs. Other common types of provisions include depreciation, repairs and renewals, bad debt and doubtful debts and warranty costs.
Under GAAP, there are certain criteria that must be met in order for an obligation to be treated as a provision. These include the following:
- The obligation must have been determined to be probable but not certain, and it must be estimated to have a probability of occurring of more than 50%.
- The obligation must be a result of events that will advance the balance sheet date, and could result in a legal or constructive obligation.
- It must be probable that the obligation will result in a financial drag on the company’s economic resources.
- The company must perform a reliable amount of regulatory measurement of the obligation. The measurement must be made by company management.
Journal entries for reserves and provisions are quite simple. To account for reserves on the balance sheet, the “retained earnings” account is debited, while the “reserve account” is credited for the same amount. When the activity which caused the reserve to be created – such as purchase of equipment – has been completed, the entry would be reversed, shifting the balance back to the retained earnings account.
As a loan loss reserve accounting example, if you are a bank that makes $10,000,000 in loans to various companies and individuals, some of those accounts inevitably will default, some will fall behind and some will have to be renegotiated.
Say your bank estimates that 1% of its loans, or $100,000, will likely never come back to it. This $100,000 loan loss reserve example is your estimate, and you’ll record it as such: a negative number on the asset portion of its balance sheet.
If and when your bank decides to write off all or a portion of a loan, it will remove the loan from its asset balance and also remove the amount of the write-off from the loan loss reserve. The amount deducted in this loan loss reserve example may also be tax deductible.
There is no actual need for a reserve since there are rarely any legal restrictions on the use of funds that have been “reserved.” Instead, management simply makes note of its future cash needs and budgets for them appropriately.
For this reason, a reserve may be referred to in the company’s financial statements without having been recorded within a separate account in the accounting system of journal entries for reserves and provisions
A provision is the amount of an expense or reduction in the value of an asset that an entity elects to recognize now in its accounting system of journal entries for reserves and provisions, before it has precise information about the exact amount of the expense or asset reduction.
In the general ledger, provisions are recorded as an appropriate expense in the income statement of the business and for establishing a corresponding liability as a provision account in the balance sheet statement.
For example, let’s say your company projects warranty costs. Generally, this is a good example of a provision, as a company can use historical data to estimate the number and average cost of each warranty claim they are likely to encounter.
Suppose your business estimates a warranty expense of $5,000 a year. A “warranty expense” account would be debited for $5,000, while a corresponding “provision for warranty costs” account would be credited for the same amount of money.
Using Provisions when Accounting for Write-Offs
A provision can also be used when accounting for write-offs, as discussed earlier. The seller can charge the amount of the invoice as a debit to a “doubtful accounts” provision account, while making a corresponding credit entry to the accounts receivable account.
The provision method of dealing with write-offs is preferred, generally, because of 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.
The provision method eliminates this timing problem by requiring the establishment of a reserve when sales 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.