A bank overdraft is a short-term credit facility that allows borrowers to withdraw funds with zero account balances.
It is a flexible credit facility that helps borrowers in cash flow management. Borrowers only incur interest payments for the negative balance when utilizing the facility.
Let us discuss what is an overdraft, its accounting treatment, and the financial statement representation.
What is an Overdraft?
A bank overdraft or simply overdraft is a credit facility offered by banks. These are debt instruments and should be recorded as short-term liabilities on the financial statements of an entity.
Unlike other credit facilities, an overdraft works only when required by the borrower. A bank would allow credit when the available balance reaches zero.
Overdrafts facilitate customers to successfully make payments to their clients or withdraw funds even if their account balances drop to zero.
Like other credit facilities, banks will allow a certain limit up to which the credit facility can be extended. The bank would charge interest on the overdraft amount only.
Since a borrower only incurs interest charges on the amount used as a loan, it offers a flexible credit facility to save interest costs.
A borrower can utilize the normal bank balance without paying any interest. When the balance falls below zero, the borrower can now utilize the overdraft credit facility.
An immediate cash deposit or funds transfer can reduce the outstanding liability and hence the interest costs.
An overdraft facility is a flexible credit facility that allows customers to withdraw funds or make payments without worrying about low balances.
A formal overdraft facility works as a short-term credit program. The bank sets a maximum limit for the borrower to withdraw funds.
Sometimes, a bank will provide further overdraft protection to its customers.
Overdraft protection allows clearance of payments such as checks when the credit facility has been fully consumed.
In such cases, the bank would usually withdraw funds from the customer’s other bank account or would notify the customer to arrange the funds immediately.
Overdraft protection can also be offered for normal bank accounts. Banks would proceed with checks or payments for certain customers out of courtesy.
The overdraft protection comes with additional fees and arrangement charges on top of the interest costs.
In this sense, an overdraft credit facility in itself is overdraft protection. That is, it avoids any overdrafts for the customers.
Bank Overdraft Vs Book Overdraft
As discussed, a bank overdraft is a loan facility that should be recorded as a short-term liability by an entity.
An entity can separately record all of its overdraft facilities or combine them to record the full liability balance in its financial statements.
A book overdraft is not a credit facility. It occurs when an entity issues more checks than it has an account balance for a certain bank account.
A bank does not offer additional credit facilities or overdraft protection. Therefore, it cannot be recorded as a liability or loan in the financial statements of an entity.
An entity would immediately reduce the cash balance when issuing checks. However, in certain cases, the cash balance would be insufficient against issued checks.
Therefore, a book overdraft represents a phenomenon where an entity faces a shortage of cash. Contrarily, a bank overdraft is a credit facility obtained from a bank.
Overdraft Vs Negative Balance
Both terms refer to a situation when the account balance falls below zero. When an entity withdraws more funds than is available, it will incur a negative balance.
However, a negative balance can only occur when a bank facilitates an overdraft. Without an overdraft, a negative balance transaction will be blocked.
Suppose an entity ABC has an overdraft facility of $ 0.5 million. It has deposited funds of $ 300,000 as well.
ABC company has issued checks to its suppliers worth $ 500,000. It can clear the first few checks up to $ 300,000 from its available funds.
Beyond that, when the next checks are presented, the bank will utilize the overdraft facility. The bank account balance will reflect a negative balance of – $200,000 at the completion of all payments.
Therefore, a negative balance or overdraft represent the two sides of the same coin.
Types of Bank Overdraft
Banks can arrange overdrafts in different ways. In many cases, the bank would not enter into a formal arrangement with the customer.
In other cases, a formally arranged facility is offered to the customers.
Authorized overdrafts are formal arrangements between the bank and an entity. The bank would allow overdraft protection up to a certain limit.
The customer would pay interest charges on the utilized credit facility only. This arrangement also comes with overdraft charges and protection fees.
It is a non-formal overdraft facility where a customer withdraws more funds than is available in the account.
Although without a formal overdraft facility account balance cannot fall below zero, banks allow such payments out of courtesy for specific customers.
Accounting for Overdraft – Journal Entry
An entity should not record a journal entry at the arrangement date of an overdraft as it will show no liability.
Once an entity utilizes the overdraft, it should record the impact in its accounting records. However, since the facility changes during the credit term several times, a wise approach is to record the ending overdraft balance at the end of an accounting period.
The journal entry to record an overdraft facility will be:
|Overdraft Liability||$ XXXX|
The second entry can be recorded for the interest expense:
|Interest Expense||$ XXXX|
|Overdraft Interest Payable||$ XXXX|
When the entity deposits funds to reduce the overdraft liability or settles the liability, it can record the reversal journal entry as:
|Overdraft Liability||$ XXXX|
|Overdraft Interest Payable||$ XXXX|
If the overdraft facility has a small negative balance, it can be pooled or netted against other account balances as well.
Balance Sheet Representation of Overdraft
The overdraft facility is a short-term liability. Banks allow such facilities for up to one year on a rolling basis or auto-renewal arrangements usually.
An entity can create a separate line item of the bank overdraft under the current liability line. If the outstanding balance of the overdraft facilities is significant, the entity should use this format.
If an entity utilizes a small overdraft facility linked with the main bank account, it can add the outstanding negative balance to the accounts payable as well.
However, an explanatory note should be added to reflect the overdraft balance in the payables properly.
Cashflow Statement Representation of Overdraft
If an entity records the overdraft balance in the accounts payable, it should reflect the same cash flow under the operating activities of the cash flow statement.
However, if the entity utilizes a significant overdraft facility, it should record the cash flow changes separately in other cash or financing cash activities.
An entity should also provide disclosures to offsetting the positive cash and cash equivalent balance and the negative overdraft balance.
Alternatively, an entity should include reconciliation cash flow lines together for the positive cash flow from the balance sheet and the negative cash flow from the overdraft.
Key Features of Bank Overdraft
An overdraft facility is different for every borrower.
Here are a few key features that define an overdraft facility.
- Banks allow different overdraft limits to different borrowers
- Borrowers do not need to make minimum or fixed payments in equal installments
- Overdraft interest is only payable for the negative balance withdrawn
- A borrower can reuse the overdraft facility several times during the contract term
- Overdraft facilities can be combined for different accounts
- A borrower can link several accounts to reduce the interest expense
Advantages of Overdraft
Overdrafts are flexible loan facilities for borrowers.
Here are a few key advantages of using an overdraft for borrowers.
- Flexible credit facility that can be utilized several times without reapprovals.
- Interest expenses are payable only for withdrawn funds from the negative balance.
- Helps an entity maintain cash flow and meet payment requirements.
- Avoids any check returns and bounced payments.
- Usually, banks do not require collateral against overdraft facilities.
- It is an easy and time-saving credit facility for borrowers.
Disadvantages of Overdraft
Despite several benefits, overdrafts come with certain disadvantages as well.
- Interest rates for overdrafts are high.
- Banks allow this facility at their discretion to certain account holders only.
- Variable interest rates can further increase at any time during the overdraft term.
- A borrower may not obtain the full credit limit as applied since the banks evaluate the credit profile of the borrower strictly.
- It is only a short-term credit facility and is often offered with small approved limits.