Bank overdrafts is a popular feature of bank facilities that allow you to spend more than you have in your account. This is known as an “overdraft facility” and can be helpful if you need to make an urgent purchase that isn’t covered by your current balance.
However, overdrafts come with fees and interest charges which can add up quickly. If you’re planning on using one, it’s essential to understand how they work and the best way to avoid getting caught out by them.
A bank overdraft allows customers to spend more than their current balance allows. If your card or cash machine is declined, but there’s enough money in your account to cover the transaction, then it will go through as an authorized overdraft. This authorized loan is what most people refer to when talking about overdrafts.
Overdrafts aren’t always necessary — if you want to spend money from an account that has insufficient funds, then you can ask for a transfer from another account (known as an “internal transfer”) or apply for a new credit card with a higher limit (known as a “line of credit”).
When signing the overdraft agreement with the bank, no journal entry is necessary. This is the case because a bank overdraft agreement is regarded as an off-balance sheet item. It is only added to the balance sheet once the company uses it.
The company here makes the journal entry by debiting the cash account and crediting the overdraft loan account when it starts using the bank overdraft (e.g., taking money from the overdraft loan).
After utilizing the bank overdraft, the corporation must account for the interest expenditure and interest payable at the period-end adjustment entry.
|Interest Payable – Overdraft||$|
When the corporation pays its overdraft to the bank, including interest, it can make the following journal entry:
|Interest Payable – Overdraft||$|
This journal entry separates the overdraft loan and the interest payable that the company had recorded in the previous period.
For instance, on June 1, 2020, Susha Ventures executed a contract with the bank for a $30,000 overdraft. The overdraft loan is for six months (from June 1 to December 1, 2020), with a 12-percent-per-year interest rate on the amount borrowed.
At the end of the overdraft loan period, Susha Ventures must repay any amount of overdraft borrowed, plus interest.
On July 1, 2020, Susha Ventures withdrew $20,000 from its bank overdraft to use for business purposes. Since then, it hasn’t used any further overdrafts, and the unused balance isn’t subject to interest or fees.
Show the bank overdraft journal entry:
1. When the company initiates an overdraft agreement with the bank on June 1, 2020.
2. When the corporation spent $20,000 of its bank overdraft amount on July 1, 2020.
3. when the corporation enters the adjustment entry for July 31.
4. at the end of the overdraft loan period, on December 1, 2020, when the corporation repays the borrowed amount plus interest.
June 1, 2020.
No journal entry is necessary for the bank overdraft on the date the company agrees with the bank.
This is because, even though the bank acknowledges that the firm can withdraw money at any moment throughout the loan period, it is still an off-balance sheet item if the company has not yet withdrawn money from the bank overdraft loan.
July 1, 2020.
When the corporation uses $20,000 from the overdraft, it must write the following journal entry for the bank overdraft:
July 31, 2020.
At the July 31 adjustment entry, the corporation must account for $200 (20,000 x 12 percent /12) of accumulated interest on the utilized balance of the bank overdraft as follows:
|Interest Payable – Overdraft||$200|
December 1, 2020.
When the company pays back the bank both the used balance of the overdraft and the interest after the overdraft loan period, it can make the following journal entry:
|Interest Payable – Overdraft||$1,000|
The $1,000 of interest payable – overdraft comes from the accrued interest for five months after the corporation has spent the $20,000 on July 1, 2020.
Because the due date is December 1, 2020, it is safe to presume that the corporation has made the adjusting entry for the $200 interest at the end of each month for the previous five months.
It’s worth noting that the bank typically charges a minimal cost if the company doesn’t utilize the overdraft throughout the loan time. This ensures that the bank does not lose money if the company does not use the overdraft after signing the contract.
There are many advantages of bank overdrafts.
- First and foremost, it is a convenient way to get money when you need it. If you have an account with a bank, you can overdraw your account by writing a cheque or using an ATM card. If the amount of your cheque or withdrawal is greater than the balance in your account, the bank will pay it automatically but will charge you an overdraft fee.
- Another advantage of bank overdraft is that it allows you to write cheques even if there are no funds in your account. This will be useful if you need to make a purchase and don’t have time to transfer money into your cheque account. However, it may have negative consequences as well. If too many cheques go through and overdraw your account, this could result in bounced cheques and high fees from other institutions such as merchants where those cheques were written and from your bank for each overdrawn cheques.
- The most vital advantage of bank overdrafts is convenience. They allow people who don’t want to carry cash around with them all the time to write cheques when necessary without worrying about whether there’s enough money in their accounts at that moment.