What is Offset Account?
Offset account is an account which is directly or indirectly related to another account and it reduces the balance of the related account to give us a net balance which is used for calculation, valuation, interpretation, and application in financial statements as the requirement may arise in the course of business and statutory requirements.
#1 – Reduction in Value
Offset account, in most cases, goes on to reduce the balance of account it is related to. Let’s say we expect 3% of our total receivable of $100,000 has gone bad, so we show $3,000 ($100,000*3%) as provision for doubtful debtsProvision For Doubtful DebtsA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year., which is a reduction from debtors value and here provision for doubtful debts is offset account for debtors. Also, in a sole proprietorship business, when the owner withdraws the funds for personal use, which is called drawings is an offset account for capital. If the initial contribution from the owner was $50,000, and withdrawal for the period is $5,000, it is interpreted that net capital balance is $45,000 ($50000 – $5000).
#2 – Types
Accumulated DepreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet., allowance for bad and doubtful debtors, Drawings are such examples that relate to Fixed Assets, Sundry Debtors, and Capital, respectively. Provision for obsolete Inventory is also an example that goes on to reduce the balance of Inventory on Hand.
#3 – Prudence
Financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. must show an accurate and fair view of the picture. So, it is always prudent to show this account separately, and at any point, it gives us the netbook value explaining what the actual cost was and how much of that has been depreciated. It also helps in creating reserves, and later any change in the expected number can be adjusted through allowances and reserves.
#4 – Accounting
Let us understand how the accounting entryAccounting EntryAccounting Entry is a summary of all the business transactions in the accounting books, including the debit & credit entry. It has 3 major types, i.e., Transaction Entry, Adjusting Entry, & Closing Entry. is posted for the offset account and how it is shown in the books. Let us consider that ABC Ltd. recently bought machinery for $200,000, and it plans to depreciate the machinery over 5 years by using the Straight Line MethodStraight Line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. . In this case, the depreciation each year for this machinery will be $200,000/5 = $40,000.
By the end of the first-year machinery, balance will be $200,000, and accumulated depreciation will show $40,000. By the end of 2nd-year, the machinery balance will still be $200,000, and accumulated depreciation will show $80,000. The netbook value of the machinery by the end of the first year will be $160,000 ($200,000-$40,000) and $120,000 ($200,000-$80,000) by the end of the second year. This method helps a third person in identifying what the book value was at the time of purchase and what is the remaining value of an asset. If we just show $120,000 as an asset in the third year, it will be challenging to understand whether $120,000 is all new purchases or the remaining value of an asset. This account helps all the stakeholders in understanding the financial numbers accurately.
Example of Offset Account in Mortgage
This concept is used majorly in the banking sector for interest calculation on the loan amount. The net loan amount is calculated by deducting the balance in a savings account from the loan account, and this net balance is used for interest calculation for the month or year as agreed by the bank and customer. Let’s say Mr. Ricky has taken $400,000 as a mortgage loan from Bank of America in Washington DC, and he recently received $100,000 from sale proceeds of property in Georgia. He has kept $100,000 in the bank account linked to his loan account with bank of America. As the net balance of the loan is $300,000 ($400,000 – $100,000), the bank will charge the interest only on $300,000 for that period. In this case, a $100,000 balance is a savings account that offsets the loan balance and reduces the interest liability of Mr. Ricky.
- It helps in quick calculation of net book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company..
- The annual reports are preparedAnnual Reports Are PreparedAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements. for various parties; some of them might not be accounting versed; they help them in identifying the reduction in total value.
- It helps in audit facilitation and annual filings.
- It is a globally accepted policy to maintain offset accounts to show the reduction and net balances of related accounts.
- It is a time-consuming process.
- Many organizations find it challenging to implement.
- Need a robust accounting system; else, operational difficulties may arise.
Points to Note
Nowadays, with the development of a computerized accounting system, it is easy and quick to prepare and maintain the offset accounts as the system does all the calculations. However, an accountant or person in charge must ensure that any change in the value of the assets due to revaluationAssets Due To RevaluationAssets revaluation is an adjustment made in the carrying value of the fixed asset, either upwards or downwards, depending upon the fair market value of the fixed asset. Its purpose includes selling the asset to another business unit, merger and acquisition. or impairment must be taken into consideration. Accordingly, the value of such an account will change. Also, with IFRS (International Financial Reporting Standards) asking to report the offset account in a particular way, the accountants must be updated with recent changes as to how it should appear in the books of accounts.
With increasing globalization and companies operating in many countries, the books of accounts must be compatible with a global platform. They are also the result of globally accepted accounting principlesGlobally Accepted Accounting PrinciplesGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors. for accurate reporting of financial numbers as we have seen in the above discussion how reporting offset accounts helps in a better understanding of financial statements of any organization. So, an organization looking for a robust accounting process must include offsetting accounts reporting to present an accurate and fair view of financial statements.
This article has been a guide to what is Offset account, and it’s meaning. Here we discuss an example and components of offset account along with accounting entry, benefits, and disadvantages. You can learn more about accounting from the following articles –