Mortgage loan: Collection

Mortgage loan: Collection

Accounts receivable management is fundamental to any 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 non-current assets. These transactions are recorded in the balance sheet. Current accounts receivable are cash and other assets that the company expects to receive from customers and use within one year or the operating cycle, whichever is longer. Receivables are collected either as bad debt or as a cash discount. Non-current assets are long-term, meaning they are held by the company for more than one year. In addition to the well-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 a contra asset (subtracted from an asset on the balance sheet). The 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 receivable that are not expected to be collected by a company. A cash discount is offered to the customer to attract prompt payment. When a customer pays a bill within a specified time, which is usually 10 days, a cash discount is offered, marked as 2/10, meaning that if the bill is paid within 10 days, the customer receives a 2 percent discount. Other credit terms offered may be n30, meaning that the 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 experience or expect to experience losses on loans they make to customers. As the country witnessed during the credit crisis, banks issued mortgages to customers who, due to job loss or other facts related to their circumstances at the time, were unable to pay their mortgages. As a result, mortgages defaulted, causing a foreclosure crisis and banks repossessing properties and losing money. For better loss recovery, banks have provided accounting procedures to help bankers report accurate credit transactions at the end of each month or as per the bank’s mortgage cycle. Among these credit risk management systems, banks have established a loan loss reserve account and mortgage loss provisions. Mortgage lenders also have a mortgage receivables (non-current asset) account. By definition, a mortgage is a loan (an amount of money lent against interest) that the borrower uses to purchase a 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 the loan installments are amortized over a set number of years.

To record the mortgage transaction, the accountant debits the mortgage receivable account and credits the cash account. By crediting cash that reduces the account balance. If the borrower defaults on their mortgage, the accountant debits the Bad Debt Expense and Mortgage Receivables account. Mortgage receivables are reported as fixed assets on the balance sheet. Bad debt expense is reported on the income statement. Having a bad debt expense in the same year the mortgage is recognized is an application of the matching principle.

To protect against losses on delinquent mortgage loans, 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 calculated to cover losses on the entire loan portfolio. The loan loss allowance account is reported on the balance sheet and represents the amount of outstanding loans that are not expected to be repaid by borrowers (a provision for loan losses calculated by mortgage lending financial institutions). This account is adjusted quarterly based on the loss of interest on both serviced and non-serviced (non-accrual and limited) mortgage loans. A loan loss allowance is an expense that increases (or decreases) the loan loss allowance. Loan loss expense is recorded in the income statement. It is designed to adjust the credit reserve so that the credit reserve reflects the default risk of the loan portfolio. In my opinion, the methodology of estimating the loan loss allowance based on all the loan accounts in the portfolio does not give a good measure of the losses that can be incurred. There is still a risk of overestimating or underestimating the loss. Therefore, there is still the possibility of banks operating at a loss and this defeats the purpose of the provision and loan loss provisions. If loans were categorized and then priced accordingly, this would eliminate additional loan losses.

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