Accounts receivable management is central to every company’s cash flow as it is 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 in one year or in the operating cycle, whichever is longer. Receivables are collected as a bad debt or cash discount. Non-current assets are long-term, which means that the company holds them for more than a year. Apart from the known non-current assets, banks and other mortgage lending institutions have a mortgage receivable account that is reported as a non-current asset.
Bad debts, also known as uncollectible expenses, are considered as a counterpart asset (subtracted from an asset on the balance sheet). The contra principal 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 are not expected to be collected by the company. A cash discount is offered to the customer to entice immediate payment. When a customer pays an invoice within the stipulated time which is usually 10 days, a cash discount is given as 2/10 which means if the account is paid within 10 days, the customer gets a 2 percent discount. Other credit terms offered can be n30 which means full amount: must be paid within 30 days. Cash discounts are recorded on the income statement as a deduction from sales revenue.
Banks and other financial institutions that make loans have experienced or expect to incur losses from the loans they lend to customers. As the country witnessed during the credit crunch, banks issued mortgages to customers who were unable to pay their mortgages due to job losses or other facts surrounding their circumstances at the time. As a result, the mortgages defaulted causing a foreclosure crisis and the banks repossessed their homes and lost money. To improve loss recovery, banks have secured accounting procedures to help bankers report accurate loan transactions at the end of each month or according to the bank’s mortgage cycle. Among those credit risk management systems, banks have established a Loan Loss Reserve Account and Mortgage Loss Provisions. Mortgage lenders also have a mortgage debit (non-current asset) account. By definition, a mortgage is a loan (a sum of money lent with interest) that is used by the borrower to purchase real estate such as a house, land or building and there is an agreement that the borrower will pay back the loan on a monthly basis and the loan installments are amortized for some stipulated years.
To record the mortgage transaction, the accountant debits the mortgage debit account and credits the cash account. By depositing cash you reduce the account balance. If a borrower defaults on their mortgage, the accountant debits the bad debt expense and calculates the mortgage debt. Mortgage receivables are recorded as long-term assets on the balance sheet. Bad debt expense is recorded in the income statement. Having bad debt expense in the same year that the mortgage is recognized is an application of the matching principle.
To protect losses from non-performing mortgages, banks have 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 in the entire loan portfolio. The loan loss reserve account is recorded in the balance sheet and represents the amount of outstanding loans that are not expected to be repaid by borrowers (provision for loan losses estimated by financial institutions for mortgage lending). This calculation is adjusted each quarter based on the interest loss on performing and non-performing (non-accrual and restricted) mortgage loans. A loan loss allowance is an expense that increases (or decreases) the loan loss reserve. The 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. The methodology of estimating the loan loss reserve on the basis of all loan accounts in the portfolio in my opinion does not give a good measure of the losses that can be incurred. There is still the risk of exaggerating the loss or underestimating the loss. Therefore, there is still the possibility that the banks may incur a loss and this defeats the purpose of having a reserve and provision for loan losses. If loans are rated and then graded accordingly, it will eliminate more loan losses.