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.
Components of Offset Account
The following are the components of the offset account.
#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 debts which is actually 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 Depreciation, allowance for bad and doubtful debtors, Drawings are examples of offset account which relates to Fixed Assets, Sundry Debtors and Capital respectively. Provision for obsolete Inventory is also an example of an offset account that goes on to reduce the balance of Inventory on Hand.
#3 – Prudence
It is imperative that financial statements must show the true and fair view of the picture. So, it is always prudent to show the offset 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 entry is posted for the offset account and how it is shown in the books. Let us consider that ABC Ltd. recently bought a Machinery for $200,000 and it plans to depreciate the Machinery over a span of 5 years by using the Straight Line Method. 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 difficult 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 loan account and this net balance is used for interest calculation for the month or year as agreed by 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.
Benefits of Offset Account
The following are the benefits of an offset account.
- It helps in quick calculation of net book value.
- The annual reports are prepared 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.
Disadvantages of Offset Account
Some of the disadvantages are as follows:
- It is a time-consuming process.
- Many organizations find it difficult to implement.
- Need a robust accounting system, else operational difficulties may arise.
Points to Note
With increasing globalization and companies operating in many countries, it is imperative that the books of accounts are compatible with a global platform. They are also the result of globally accepted accounting principles 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 a true and fair view of financial statements.
This 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 –