Accounting For Bad Debt Expense On Cash Flow Statement Mortgage Loan: Receivable

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Mortgage Loan: Receivable

Managing receivables is fundamental to every firm’s cash flow because of the amount expected to be received from customers for products or services provided (net realizable value). Receivables are classified as current or non-current assets. These transactions are recorded in the balance sheet. Current receivables are cash and other assets that a company expects to receive from customers and use within a year or operating cycle, whichever is longer. Accounts receivable are collected as either bad debts or cash discounts. Non-current assets are long-term, meaning they are held by the company for more than one year. In addition to the well-known non-current assets, banks and other mortgage lending institutions have mortgage accounts receivable that are recorded as non-current assets.

Bad debts, also known as uncollectible expenses, are considered contra assets (deducted from assets in the balance sheet). A contra asset increases with a credit entry and decreases with a debit entry and will have a credit balance. Bad debt is an expense account that represents accounts receivable that are not expected to be collected by the company. Cash discount is offered to attract the customer for prompt payment. When a customer pays the bill within a prescribed time which is usually 10 days, the cash discount is recorded as 2/10 which means that the customer gets 2 percent discount if the bill is paid within 10 days. Other credit terms offered may be n30 which means the full amount must be paid within: 30 days. A cash discount is recorded in the income statement as a deduction from sales revenue.

Banks and other financial institutions that make loans or expect to incur losses on loans they make to customers. As the country witnessed during the credit crunch, banks issued mortgages to customers who, due to job losses or other factors surrounding their circumstances at the time, were unable to repay their mortgages. As a result, mortgage defaults led to the foreclosure crisis and banks repossessing homes and losing money. For better loss recovery, banks secured accounting procedures to help bankers report accurate loan transactions at the end of each month or as per the bank’s mortgage cycle. Among those credit risk management systems, banks created loan loss reserve accounts and collateral loss provisions. Mortgage lenders also have a mortgage receivable account (a non-current asset). By definition, a mortgage is a loan (an amount paid on interest) that a borrower uses to purchase an asset such as a house, land or building, and an agreement that the borrower will repay the loan on a monthly basis and in installments. Some are amortized over a specified number of years.

To record the mortgage transaction, the accountant debits the mortgage receivable account and credits the cash account. Depositing cash reduces the account balance. If the borrower defaults on their mortgage, the accountant debits the bad debt expense and credits the mortgage receivable account. A mortgage receivable is recorded as a long-term asset on the balance sheet. Bad debt expense is recorded in the income statement. An application of the matching principle is to have a bad debt expense in the year in which the mortgage is recognized.

To protect against losses from defaulted mortgage loans, banks create a loan loss reserve account which is a contra asset account (deducted from assets in the balance sheet) that represents the estimated amount to cover losses on the entire loan portfolio. A loan loss reserve account is recorded on the balance sheet and represents the amount of outstanding loans not expected to be repaid by borrowers (an allowance for loan losses estimated by mortgage lending institutions). This account is adjusted every quarter on the basis of interest losses on performing and non-performing (non-accrual and restricted) mortgage loans. A provision for loan losses is an expense that increases (or decreases) the loan loss reserve. Loan loss expense is recorded in the income statement. It is designed to adjust the loan reserve so that the loan reserve reflects the risk of default in the loan portfolio. In my view, the method of estimating loan loss reserves based on all loan accounts in a portfolio does not provide a good measure of the potential losses. There is still a risk of overstating losses or understating losses. Banks are therefore likely to run into losses and thus defeat the purpose of loan loss provisioning and provisioning. If the loan is categorized and estimated accordingly, it will eliminate further loss of the loan.

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