What is an Offset Account?

Components

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#1 – Reduction in Value

Offset account, in most cases, goes on to reduce the balance of the account to which it is related. For example, 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.read more, 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, called drawings, it is an offset account for capital. So, for example, if the initial contribution from the owner was $50,000, and the withdrawal for the period is $5,000, it is interpreted that the 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.read more, allowance for bad and doubtful debts, and Drawings are examples that relate to Fixed Assets, Sundry Debtors, and Capital, respectively. Provision for obsolete Inventory is also an example that reduces 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.read more 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 create 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. read more is posted for the offset account and how it is shown in the books. First, let us consider that ABC Ltd. recently bought machinery for $200,000, and it plans to depreciate the machinery over five 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. read more. In this case, the depreciation each year for this machinery will be $200,000/5 = $40,000.

Accounting Entries

Example of Offset Account in Mortgage

This concept is used 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. For example, 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

  • 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.read more.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.read more for various parties; some of them might not be accounting versed; they help identify 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 related accounts’ reduction and net balances.

Disadvantages

  • 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.read more or impairment must be considered. 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 to how it should appear in the books of accounts.

Conclusion

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 PrinciplesGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more 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 –

  • Excel OFFSET FormulaShare Trading AccountManagement Audit ExamplesCarrying Amount Formula