How Businesses Should Account for Bad Debt
If you are either a newcomer to the banking industry or even just a casual customer, you probably have often wondered what financial institutions do about those loans that are considered “non-performing” or “toxic.” In other words, what does the bank do about a loan where the payments are not being made? When it is a car note or a house mortgage, the answer is simple: simply repossess the car or foreclose on the house. However, what about smaller loans for such things as furniture or computers? There are a number of strategies that financial organizations use for allowing for these non-performing loans. When it comes to these issues, consider some of the following principles:
Be Aware of Changes to Accounting Standards
The coming switch from ALLL to CECL may affect the way you calculate loss allowances. At present, the current designation allows for new loans to be evaluated at the amortized cost basis. However, under the current expected credit loss standard (CECL), all new loans can be evaluated under a fair value basis instead. What does this mean for those in the banking and lending industry? Simply put, it means that after December of 2019, they are expected to be more transparent regarding their expected loan losses.
Develop a Comprehensive Strategy for Non-Performing Loans
Lenders have to be as organized as possible when it comes to non-performing loans. This means they need to be able to segment the portfolio, identify recovery and exit strategies, develop a clear plan of policies and procedures and be continually measuring and evaluating all of these procedures.
Simply Write it Off
Sometimes the only thing a bank can do is to write off the bad debt. For example, even if they attempted to collect on the loan through traditional means, the borrower might not have any assets for them to seize or there might be laws preventing the bank from taking this step. Moreover, there is a certain amount of debt that the financial institution actually “expects” they will lose to bad debt anyway. Although it varies from location to location, most financial institutions expect that for every $100,000 in loans they dole out, about $5,000 of that will have to be considered “bad debt”, or money they will not get back.
There is no doubt that banks work hard to manage their money. That is why it is important for all of us to pay back our loans to the bank, simply because the more bad debt a bank has, the more difficult it is for them to operate. However, even if someone does default, the banks have experts working on ways to allow for this.
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