Managing receivables is fundamental to every firm’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 noncurrent assets. These transactions are recorded on the balance sheet. Current receivables are cash and other assets a company expects to receive from customers and use up to one year or as per operating cycle, whichever is longer. Accounts receivables are either collected as bad debt or cash discount. Noncurrent assets are long-term, meaning they are held by the company longer than a year. Apart from the well known noncurrent assets, banks and other mortgage lending institutions have a mortgage receivable account that is reported as a noncurrent asset.
Bad debts also known as an uncollectible expense is considered as a contra asset (subtracted from an asset in the balance sheet). Contra asset increases with credit entries and decreases with debit entries and will have a credit balance. Bad debt is an expense account that represents accounts receivables that are not expected to be collected by a company. Cash discount is offered to a customer to entice prompt payment. When a customer pays a bill within a stipulated time which normally is 10 days, a cash discount is offered noted 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: has to be paid within 30 days. Cash discounts are recorded in the income statement as a deduction from sales revenue.
Banks and other financial institutions that provide loans experience or expect to have losses from loans they lend to customers. As the country witnessed during the credit crunch, banks issued mortgages to customers who, due to loss of jobs or other facts surrounding their circumstances at that time could not repay their mortgages. As a result, mortgages were defaulted causing foreclosure crisis and banks repossessing houses and losing money. For better loss recovery, banks secured accounting procedures to assist bankers to 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 a loan loss reserve account and mortgage loss provisions. The mortgage lenders also have a Mortgage Receivable account (noncurrent asset). By definition, a mortgage is a loan (sum of money lent at interest) that a borrower uses to buy property such as a house, land or building and there is an agreement that the borrower will pay the loan on a monthly basis and loan installments are amortized for some stipulated years.
To record the mortgage transaction, the accountant debits mortgage receivable account and credit the cash account. By crediting cash that reduces the account balance. Should the borrower default on their mortgage, the accountant debits bad debt expense and credit mortgage receivables account. Mortgage receivables are reported as long-term assets on the balance sheet. The bad debt expense is reported in the income statement. Having a bad debt expense in the same year in which the mortgage is recognized is an application of matching principle.
To safeguard losses from defaulted mortgage loans, banks created a loan loss reserve account which is a contra asset account (a deduction from an asset in the balance sheet) that represents the amount estimated to cover losses in the entire loan portfolio. The loan loss reserve account is reported on the balance sheet and it represents the number of outstanding loans that are not expected to be paid back by the borrowers (an allowance for loan losses estimated by the mortgage lending financial institutions). This account is adjusted every quarter based on the interest loss in both performing and nonperforming (non-accrual and restricted) mortgage loans. The loan loss provision 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 based on all loan accounts in the portfolio in my opinion does not give a good measure of the losses that could be incurred. There is still a risk of overstating the loss or understating the loss. Therefore there is still a possibility that the banks may run at a loss, and that defeats the purpose of having the loan loss reserve and provision. If loans were categorized and then estimated accordingly, that would eliminate further loan losses.