The Cancellation of a Debt in Accounting

In accounting terminology, the cancellation of debt is perhaps quicker and more straightforward than what the legal process mandates. Accountants must follow specific standards to take financial obligations off corporate books, paying attention to such items as debt maturity and outstanding amount. Accounting rules dealing with debt cancellation include generally accepted accounting principles and international financial reporting standards.

A lender may cancel, or write off, a borrower’s debt if the borrower cannot repay the loan, either because of bankruptcy or owing to such adverse financial scenarios as near-insolvency and temporary distress. By writing off amounts loaned, the creditor records, or recognizes, a loss in corporate books. The concept of debt cancellation also applies in the business environment, especially in arrangements allowing customers to pay for goods at a later date. In that case, a supplier recognizes a charge financial commentators call “bad debt.”

Debt cancellation means less cash for the lender or supplier. A company that advanced funds to a business partner expects to receive payments in accordance with loan covenants. Failure to get such remittances might put the credit-issuing institution at risk, particularly if it is not a stalwart multinational company that can absorb losses. To prevent debt cancellation scenarios, the business may set adequate operational procedures aimed at delving into business partners’ finances and identifying those at risk of defaulting before granting them credit.

The accounting entries relating to debt cancellation depend on the company and the transaction. For a bank -- or another financial institution for which lending is a primary activity -- the cancellation entry is: debit the loan loss provision account and credit the loan receivable account. If the bank has already recorded loss reserves, as is common practice, the entry would be: debit the loan loss reserve account and credit the loan receivable account. Loan loss provision is an expense account, whereas loan loss reserve -- also known as allowance for loan losses -- is a contra account, meaning it reduces the loan receivable account, which is an asset. Debt cancellation postings are similar for a non-financial company. To record a customer’s account write-off, a corporate bookkeeper debits the bad debt expense account and credits the “allowance for doubtful items” account. This account is the banking equivalent for the loan loss reserve account.

Accounting debt cancellation entries affect specific financial statements. Loan loss provision and bad debt are integral to the statement of profit and loss (P&L), also known as an income statement or report on income. Loan loss reserve and allowance for doubtful accounts are components of the statement of financial position, also called a balance sheet.