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The management of accounts receivable is essential in the cash flow of any company, since it is the amount that is expected to be received from customers for the products or services provided (net realizable value). Accounts receivable are classified as current or non-current assets. These transactions are recorded on the balance sheet. Current accounts receivable are cash and other assets that a business expects to receive from customers and use within one year or operating cycle, whichever is longer. Accounts receivable are charged as bad debt or prompt payment discount. Non-current assets are long-term, which means that the company holds them for more than one year. Apart from the well-known non-current assets, banks and other mortgage lenders have a mortgage receivable that is reported as a non-current asset.
Bad debts, also known as bad expenses, are considered a contra asset (subtracted from an asset on the balance sheet). The asset against increases with credit entries and decreases with debit entries and will have a credit balance. Bad debt is an expense account that represents receivables that a business is not expected to collect. The prompt payment discount is offered to a customer to encourage prompt payment. When a customer pays an invoice within a stipulated time which is normally 10 days, a prompt payment discount is given indicated as 2/10, which means that if the account is paid within 10 days, the customer gets a 2 percent discount. The other credit terms offered could be n30, which means the full amount: must be paid within 30 days. Prompt payment discounts are recorded in the income statement as a deduction from sales revenue.
Banks and other financial institutions that provide lending expertise or expect to make losses on the loans they make to customers. As the country witnessed during the credit crunch, banks issued mortgages to customers who, due to job loss or other events related to their circumstances at the time, were unable to pay their mortgages. As a result, mortgages were defaulted on causing a foreclosure crisis and banks repossessed homes and lost money. For better loss recovery, banks have secured accounting procedures to help bankers report accurate loan transactions at the end of each month or based on the bank’s mortgage cycle. Among those credit risk management systems, banks created a reserve account for credit losses and provisions for mortgage losses. Mortgage lenders also have a Mortgage Credit (non-current asset) account. By definition, a mortgage is a loan (a slow-interest-bearing sum of money) that a borrower uses to purchase property such as a house, land, or building, and there is an agreement that the borrower will repay the loan monthly and in installments. They are amortized over a specified number of years.
To record the mortgage transaction, the accountant debits the mortgage account receivable and credits the cash account. Crediting cash that reduces the account balance. If the borrower defaults on their mortgage, the accountant debits the bad debt expense and credit mortgage accounts receivable account. Mortgage receivables are reported as long-term assets on the balance sheet. Bad debt expense is reported in the income statement. Having an expense due to insolvency in the same year in which the mortgage is recognized is an application of the matching principle.
To safeguard losses from delinquent mortgage loans, banks created a loan loss reserve account which is a contra asset account (a deduction from an asset on the balance sheet) that represents the amount estimated to cover losses across the entire portfolio. of loans. The credit loss reserve account is reported on the balance sheet and represents the amount of outstanding loans that borrowers are not expected to repay (an allowance for credit losses estimated by mortgage lending institutions). This account is adjusted quarterly based on interest loss on current and past due (unearned and restricted) mortgage loans. The provision for loan losses is an expense that increases (or decreases) the allowance for loan losses. The insolvency expense is recorded in the Profit and Loss Account. It is designed to adjust the loan reserve so that the loan reserve reflects the risk of default on the loan portfolio. In my opinion, the loan loss reserve estimation methodology based on all loan accounts in the portfolio does not give a good measure of the losses that could be incurred. There is still the risk of exaggerating the loss or underestimating the loss. Therefore, there is still the potential for banks to operate at a loss, and that defeats the purpose of having the reserve and provision for credit losses. If the loans were categorized and then estimated accordingly, more credit losses would be eliminated.