Why Do Banks Write Off Bad Debt?

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.

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.