Almost all of us have faced a situation when the bills are due and the incomes have not come around yet. Bank overdraft is ideal in such situations, It is one of the most common sources of short-term financing, especially for small and medium enterprises (SMEs) with fluctuating financial requirements.
It works as a backup for unexpected costs which helps individuals to ease pressures on their pockets and businesses on working capital. By definition, a bank overdraft is a type of financial instrument provided by the bank to its trustworthy customers in the form of an extended credit facility, once the actual bank balance of the customers goes zero.
In simpler words, a bank overdraft gives the user a facility to cover the shortage of short-term cash through an unsecured form of credit. Bear in mind, that bank overdrafts are provided at a cost.
The cost generally includes maintenance charges, interest rates, professional fees, and unauthorized borrowing fees depending on the size of the facility borrowed. This credit facility can be availed either for a rolling time with no specific end date or a fixed period of time to pay back all the money borrowed.
It is also interesting to note, that there can be joint borrowers of a single bank overdraft. However, both participants are then equally responsible for paying back. Also, unlike other types of loans, there is no penalty for the prepayment of overdrafts but in case the borrower fails to repay or defaults, the bank will charge an interest rate significantly high.
Usually, the banks offer two types of bank overdrafts i.e. authorized and unauthorized. Under authorized bank overdraft, all the arrangements are made in advance between the bank and the user. They agree on the borrowing limit, service fee (15%-20%), and mode of payment which may vary from bank to bank.
In addition, the service fee can be charged daily, weekly, or per month. On the other hand, unlike authorized bank overdrafts, no pre-agreement is made in the case of unauthorized bank overdrafts.
The account holder spends more than a specific limit. Hence, It is an expensive form of overdraft and banks charge a significant interest rate on it. Also, unauthorized bank overdrafts are termed unarranged or unplanned overdrafts.
Let’s consider a simple example to further clarify our concept. Assume Joanne went to a cosmetic shop, purchased cosmetics amounting to $1500, and wrote a Cheque. The shopkeeper deposited it but the banker told him that Mary’s account only had $1000 which meant she was short of $500.
Consequently, Mary’s Cheque can bounce. But in these situations, bank overdrafts came in handy. The bank will pay $500 and will charge Mary with interest later on as per the agreement.
Though bank overdrafts are advantageous to small businesses and individuals as well in their hour of need it has some serious disadvantages as well. It is not a good option for long-term financing, the interest rate is not fixed and sometimes it becomes significantly high.
The limit of avail loan depends on the financial position of the business or the creditworthiness of an individual and this facility is only offered to the bank account holders, particularly current accounts.
However, the need for bank overdrafts can be avoided in the first place. The bank accounts must be maintained regularly to determine the spending ability, communicate often with the bank, and seek banks that are overdraft friendly to avoid high-interest expenses.
JOURNAL ENTRY FOR BANK OVERDRAFT
When an individual or a business signs an agreement for an overdraft with the bank, there is no need to record any journal entry. It is considered an off-balance sheet item and goes only on the balance sheet when it begins to be utilized.
However, a bank overdraft is treated as a current liability and recorded on the balance sheet. But why? Because a bank overdraft is treated as excess money withdrawn from an account instead of the amount deposited. Hence, results in a negative balance.
- On the date of using bank overdraft: When an individual or a company actually starts using money from the bank, the bookkeeper should make the journal entry in the books of accounts by debiting the cash account and crediting the overdraft loan account against it as shown below.
|Bank overdraft loan||$XX|
- Adjusting Entry: In order to account for the interest expense, the company has to record a journal entry by debiting the interest expense account and crediting the interest payable account.
- On the date of payment to the bank: This journal entry is made when the principal amount of bank overdraft with interest is actually paid to the bank by debiting interest payable and bank overdraft accounts and crediting cash account against them.
|XX/XX/XXXX||Bank overdraft loan||$XX|
Example #1: On June 1, 2021, LMN Limited signed an agreement for a bank overdraft with a bank amounting to $20,000. The loan period is for 6 months from June 1 to December 1 2021 with an interest rate of 12% per annum. Assume LMN Limited used $10,000 of its loan amount only and nothing has been charged for the unused balance. Pass the journal entries accordingly.
- On July 1, 2021: The company has used $10,000 for its overdraft loan account, hence the journal entry will be debit cash (as the increase in the asset is debit) and credit bank overdraft loan account (as the increase in liability is credit).
|Bank overdraft loan||$10,000|
- Adjusting entry: At the end of the month, the company has to pass a journal entry to record interest paid on the borrowed account. As the interest rate per annum is 12% hence, per month will be 12%/12 = 1%. So, LMN will record $100 ($10,000 8 1%) each month as an interest expense.
- On the date of payment to the bank: The entry for the payment will be made on 1 December 2021 as:
|01/12/2021||Bank overdraft loan||$10,000|
IMPACT OF BANK OVERDRAFT ON FINANCIAL STATEMENTS
The cash account shows a credit balance in the bank in case of a negative balance. This negative balance does not mean a negative asset but a short-term liability as a bank overdraft is considered a short-term loan.
In addition, the cash account will appear on the balance sheet under the short-term asset section. While overdraft on a cashflow statement like all other types of loans (as cash inflows from financing activities).
On the other hand, when the repayment of a bank overdraft Is made it will decrease the short-term liability account and appear as a cash outflow on the statement of cash flows.
Talking about the fees and interest charged by the bank, they are recorded as an expense on the profit and loss statement and ultimately reduce shareholder’s equity under the retained earning section on the balance sheet and net income on the statement of profit and loss.