Bank Overdraft Meaning, Features, Types, Advantages for UGC NET Notes

A bank overdraft signifies an excess withdrawal beyond the balance amounts in a bank account which an organization does. This is basically an advance drawn by the organization without money in its bank account, but up to an admissible limit. This is a short-term loan in the form of a liability in the company's account. A Bank Overdraft is a financial service offered by banks that allows account holders to withdraw more money than they actually have in their checking account, up to a specified limit. This facility acts as a short-term loan to address temporary cash shortages or unexpected expenses. Overdrafts are typically subject to interest charges, and they provide a flexible way to manage cash flow issues for both individuals and businesses.

Bank overdrafts are an essential part of accounting and finance, as well as the trial balance and balance sheet in general. This topic is asked in commerce-related exams such as the UGC-NET Commerce Examination.

 In this article, the readers will be able to know about the following:

• What is Bank Overdraft?
• Types of Bank Overdraft
• Practical Example: Journal Entry for Bank Overdraft
• Bank Overdraft Advantages
• Bank Overdraft in Trial Balance
• Bank Overdraft in Balance Sheet
• Bank Overdraft vs. Short-Term Loan

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Fig: what is bank overdraft in accounting

What is Bank Overdraft?

In the world of accounting, bank overdraft refers to a short-term liability when an account shows a negative balance. Basically, an overdraft can be understood as a facility provided by banks to account holders that allows them to withdraw from their checking or current account without having any money in it—that is, until the point where a pre-approved withdrawal limit is breached. This facility, however, is meant to serve as a short-term loan with which a person or company can finance temporary cash shortfalls or unanticipated expenses. 

When a customer overdrafts an account, the bank agrees to make up the balance amount, and the overdrawn amount has to be paid back with interest. Generally, terms such as the overdraft limit and the interest rate are determined based on the creditworthiness of the account holder and their financial history, together with the history of their relationship with the bank. Overdrafts often come with associated fees, such as a one-time overdraft fee per transaction and a daily interest charge on the borrowed amount.

Bank overdrafts, while quite functional, must be supported by strict responsibility, given the high cost and risk of accumulation of debt weight.

Bank overdraft is a type of financial facility in which banks allow an account holder not only to withdraw money from their account, but also to create a negative balance state within that account. Different kinds of bank overdrafts are available with respect to needs and purposes, types of which are as follows:

Authorized Overdraft

This overdraft gets prior approval from the bank; the accountholder then knows what the limit is and how much will be charged in terms of interest beforehand. Generally, it is a contractual transaction and mainly offers lower interest rates than an unauthorised overdraft. Fees relating to overdrafts are well known beforehand. The overdraft may be suitable for individuals and businesses looking to have a safety net for cash flow management.

Unauthorized (Unarranged) Overdraft

This occurs when an account holder withdraws more money than is available in their account without prior arrangement with the bank. Unauthorized overdrafts generally come with higher fees and interest rates due to the risk involved. These might also include penalties and additional charges. Typically not recommended due to the high cost, but it can occur if automatic payments exceed the available balance.

Secured Overdraft

A secured overdraft is backed by collateral, such as fixed deposits, property, or other tangible assets. Because the overdraft is secured by collateral, it usually comes with lower interest rates and higher credit limits compared to unsecured overdrafts. Commonly used by businesses and individuals with significant assets who need higher credit limits and lower interest costs.

Unsecured Overdraft

This type of overdraft does not require any collateral. It is granted based on the bank’s assessment of the account holder’s creditworthiness. Interest rates are generally higher compared to secured overdrafts, and the credit limits are lower. It is based on trust in the borrower’s ability to repay. Suitable for individuals and small businesses without substantial assets, but who have a good credit history.

Business Overdraft

A facility designed to address the working capital requirements of businesses. Business overdrafts come with higher limits that are matched to the financial requirements and revenues of a company and can be either secured or unsecured, depending on the economic health of the borrower and collateral offered. Used by companies to manage seasonal cash flow variations, unexpected expenditures, or investment in short-term opportunities.

Revolving Overdraft

The revolving overdraft enables account holders to borrow, repay, and reborrow up to a defined limit and over a specified period. There is, therefore, flexibility in terms of borrowing as the amount borrowed can be varied according to the needs of the account holder, with only the utilized amount being charged interest. Commonly used by both individuals and businesses that require flexible access to funds on an ongoing basis, a company overdraft is.

Comparison of Types of Bank Overdrafts 

There are different types of bank overdrafts tailored to different financial needs as well as levels of associated risk. The table below outlines the key differences between them for easier understanding:-

Practical Example: Journal Entry for Bank Overdraft

Journal Proper Entry for Bank Overdraft is an important aspect for commerce students and those appearing for UGC NET exams, since it strengthens concept clarity and prepares them for applied accounting questions. Bank overdraft borrowings are to be credited to the books of accounts when they are available. Here's what it looks like in the journal entries:

Journal Entry Overdraft Availed

In this case, the company avails a cash overdraft, which means an increase in cash (asset)-hence debit-, and as overdraft is a liability, it gets credited.

Journal Entry When Overdraft is Repaid:

In the case of an overdraft reimbursement or repayment, liability decreases; thus, overdraft accounts are debited. The bank paid out, so the bank account is credited.

Bank Overdraft Advantages

The bank overdraft advantage has been stated below. This will help me understand the topic better.

Flexibility

Overdrafts provide instant access to finance without the need for a separate approval process for a loan. This can be useful to meet unexpected expenses or to cover regular cash flow shortages.

Interest on Utilized Amount

Typically, interest is charged only on the amount overdrawn and only for the time it is used. This might prove cheaper than a loan, which charges interest on the entire amount lent, whether the funds are utilized or not.

No Repayment Schedule

In contrast to loans, overdrafts do not have any predetermined repayments. Businesses and individuals are free to repay an overdraft when cash flow permits, which provides added flexibility in financial management.

Boosts Creditworthiness

Proper management and timely repayment of overdrafts can improve the account holder’s credit rating. This can enhance the borrower’s ability to secure other types of financing in the future.

Quick Access to Funds

Once an overdraft facility is approved, funds can be accessed almost instantly when needed. This provides a reliable source of emergency funding.

Bank Overdraft in Trial Balance

In a trial balance, a bank overdraft is represented as a liability. This is because an overdraft indicates that the account holder owes money to the bank. Here’s how to properly account for a bank overdraft in a trial balance:

• Classified as a Liability: Since an overdraft represents funds that need to be repaid to the bank, it is recorded under the liabilities section of the trial balance. It is typically listed as a "Bank Overdraft" or "Bank Loan."
• Credit Balance: In the trial balance, the bank overdraft will have a credit balance. This is because it signifies an amount payable and not an asset.
• Accounts Payable: Depending on accounting policies and the layout of financial statements, a bank overdraft might sometimes be included with other current liabilities, such as accounts payable.

Bank Overdraft in Balance Sheet

The understanding of a bank overdraft plays a significant role in classifying it properly in the accounting records of financial statements. A bank overdraft is classified as a liability and would most likely appear under current liabilities in a company's balance sheet. This is due to the reason that overdraft is a transaction that is considered as a short-term loan made by the bank to the account holder to allow the owner to withdraw beyond the available balance. The amount borrowed thus has to be repaid within a short time, usually for next financial year, making it a current liability. Including bank overdraft into current liabilities helps accomplish reflection of what outstanding obligations a business has in the financial statements. Such classification is beneficial for the users of financial reports, for instance, investors, creditors, and management, because it helps them understand the company's short-term financial commitments and liquidity position. Recording overdrafts as current liabilities perfectly fits in with generally accepted accounting principles. It thus gives a proper picture of the health of the company's finances, and of the kinds of future cash flows it might need.

Bank Overdraft vs. Short-Term Loan

Bank overdrafts and short-term loans are both valuable tools for managing immediate financial needs, but they differ significantly in structure, cost, and flexibility. The table below highlights the key differences to help you understand which facility suits your needs better, especially useful for commerce students and UGC NET preparation.

Conclusion

In conclusion, a bank overdraft is a convenient financial tool for handling short-term liquidity needs and unexpected financial demands. While it offers the advantage of immediate access to additional funds, users need to be mindful of the associated costs, including interest and potential fees. Proper management and responsible use of an overdraft facility can help maintain financial stability and avoid long-term debt complications.

Bank overdraft is a critical topic in several competitive exams. It would help if you learned about other similar issues with the Testbook App.