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Charge offs are a simple accounting strategy that allows a company to remove what is obviously a bad debt from the company balance sheet. Essentially, a charge off can be utilized when a legitimate debt is obviously not going to be paid by the debtor. Removing the debt from the balance sheet and the Accounts Receivable of the company does not eliminate the obligation for the debt to be paid, but it does allow the company to cease using resources to attempt to manage the bad debt.
Charge offs provide several other advantages for the company. First, the approach eliminates the appearance of the line item on the income statement for the corporation. This means that the debt does not appear as net income on the financial records of the company, and as such are not subject to taxes. This benefit means the company will not incur further losses due to the failure of the creditor to honor and pay the outstanding indebtedness.
Second, charge offs make it possible for the accounting team to no longer have to deal with trying to manage the debt. Instead, persons within the organization that are dedicated to collecting outstanding debt will focus on attempting to eventually recover all or part of the bad debt. In some instances, the company may choose to outsource the collection effort. When this is the case, the company does not have to address the amount of the item until the debt is collected and the funds are forwarded by the collection agency to the corporation.
Many companies are aware that the chances for bad debt are always present. For this reason, it is not unusual for corporations to build an estimate of charge offs into the annual operating budget. This figure is often calculated using a combination of historical data, industry trends, and any information that the corporation may have about upcoming economic conditions that may adversely impact the ability of the client base to pay for services rendered. While most companies normally close out the fiscal year with the actual charge offs amounting to less than the projected amount, the strategy at least provides one more level of protection for the overall financial well being of the company.