Table of Contents
This article was written to explain the basics of accounting behind charge-off. It should in no way be used as accounting or legal advice.
Introduction
When collections efforts are unsuccessful, lenders may deem a portion of a loan to be uncollectible. When this happens, lenders need to properly record and account for the the loss on these loans. This article is an overview of charge-off accounting. It provides an introduction to accounting, and information about how to account for a charged-off loan (sometimes called a write down or a write off).
LoanPro's loan management system (LMS) makes charge-offs easy to apply and record. If you're a lender who needs to charge off loans, but you want to learn more about how the charge-offs affect accounting, you're in the right place. If you are not familiar with charge-offs, read Intro to Charge-Offs first. This article will cover a basic introduction to accounting, how to account for charge-offs, and a brief overview of capital gains and losses.
How Charge-Off Accounting Works
A charge off takes place when a lender deems a loan or a portion of a loan to be uncollectible. Most lenders have a policy that dictates when a loan should be charged off. This usually happens when a borrower does not make payments for a set number of days (for example, a lot of lenders charge off after 120+ days with no payment). But how can businesses account for these charge-offs? Of course lenders want to make all of their money back plus interest, but they understand that some borrowers will not pay them back. To account for this, businesses often set up a bad debts expense account. This account helps businesses anticipate losses. Lenders account for a certain percentage of charge-offs and it acts as a business expense each month.
To understand what happens on the accounting side when a charge-off takes place, you need to understand some basics about accounting. There is a basic accounting equation that accounting will balance in order to help detect accounting errors. You may be familiar with the term "double-entry accounting", which specifically refers to the two entries required to balance the accounting equation. The basic accounting equation is:
$$assets = liabilities + \text{owner's equity}$$
This equation works like any other equation in algebra. Anything that happens on one side of the equation happens on the other. Note that in accounting sometimes both entries will occur on the same side of the equation. When a transaction occurs, there will be one debit entry and one credit entry to keep things balanced.
When a loan is charged off, the credit is applied to the loan note asset account (the loan note), lowering the value of the asset. The debit is applied to the bad debts expense account, raising the balance of that account. Bad debts expense is a common account, but your company may call it something different.
Charge-offs can also be called a "Charge-off" or a "write-down." When a borrower does not pay back a loan, the lender can charge off the entire amount or a partial amount (they "write down" the loan so its value, often called book value, is a smaller amount). Losing value on an asset that is not being depreciated results in a loss. Operating losses and capital losses usually offset ordinary income and capital gains. Capital losses usually have limits in the amount of income they can offset. Lenders should consult with accounting professionals to determine how to categorize losses.
While tax breaks are great, remember that even if the charge-off is accounted for and offset, the offset will be less than or equal to the amount lost on the loan. Therefore, uncollectible loans and charge-offs should always be avoided.
Capital Gains and Losses
A capital gain is when you make money off an asset that you own. Say you bought a house in 2018 for $500,000 but now, in 2022, the house is worth $800,000. You made a capital gain of $300,000. A capital loss is when you lose money on an asset you own. For example if you bought a car in 2018 for $20,000, but by 2021 it was only worth $15,000 you suffered a capital loss of $5,000. When a company charges off a loan it is usually considered a capital loss.
Common Questions
Does LoanPro LMS tell me when to charge off an account? While LoanPro doesn't make the decision on when you should charge off a loan, we do have default processes that deal with charge-offs that can be configured in your account.
Does LoanPro do charge-off accounting for me? No, LoanPro is not a general ledger. LoanPro applies and records charge-offs but the accounting for charge-offs is taken care of by the customer.
Terminology
| Term | Definition |
| Assets | An asset is something that has value. Also referred to as liquid assets. |
| Liability | All of the debts a company has. |
| Equity | This is all of the money the company actually has. |
| Debit | Adds to accounts with a normal debit balance (usually asset accounts). Subtracts from account with a normal credit balance (usually liability accounts). |
| Credit | Subtracts from accounts with a normal debit balance (usually asset accounts). Adds to accounts with a normal credit balance (usually liability). |
What’s Next?
With an understanding of charge-off accounting, now you are able to learn how to use charge-offs in LoanPro LMS.
Default Policy Charge-Off Process: How LoanPro handles the charge-off process.
Charge-Off History Report: How to see all charge-off transaction in your account.
Charge-off – Collectable vs. Uncollectable: What to do with charged off loans.
Net Charge-Off Overview: Track amounts that you have deemed uncollectable.
Written by Andy Morrise
Updated on May 30th, 2024