Bank Overdraft

A bank overdraft is a line of credit in which a bank honors checks presented to it even if no balance is available in the customer's bank account.

When the bank has a right to offset the overdraft balance with another bank account of the business, the overdraft is netted off against other bank accounts maintained with the same bank and the net bank balance is shown as the balance of cash at bank. However, when the bank has no such right to offset, the overdraft is reported as a liability. It is reported separately from other liabilities if it is material.

Bank overdraft and the statement of cash flows

Under US GAAP, any changes in bank overdrafts are reported as a cash flow from financing activities. Under IFRS, bank overdraft is treated as part of cash and cash equivalents if it forms an integral part of a company’s liquidity management. If this is the case, any change in bank overdraft balances is not reported as a cash inflow or outflow rather the overdraft balance is netted off from cash and cash equivalents and a reconciliation is shown in the notes to the financial statements.

Example

Earth Inc. has four bank accounts: Account A and B which are maintained at Mars Bank. Account A has a balance of $20 million and Account B has an overdraft of $2 million. Account C and Account D are maintained at Venus Bank. Account C has a balance of $50 million and Account D has a balance of -$10 million.

On Mars, banks are entitled to set off any negative bank balances with positive balances while Venetian banks have no such luxury. Earth applies US GAAP and Account B and Account D have no balance at the start of the year.

Comment on balance sheet and statement of cash flows presentation of the overdraft.

Solution

In its balance sheet, Earth Inc. shall report cash and cash equivalents of $70 million ($20 million in Account A plus $50 million in Account C). It shall show a corresponding bank overdraft liability of $10 million, the sum of overdrafts in Account B and Account D.

In its statement of cash flows, Earth Inc. shall report a cash inflow from 'changes in overdrafts' of $10 million under cash flows from financing activities.

Bank overdraft vs book overdraft

When a company's bank account has a negative balance it is said to be running a bank overdraft (also referred to as an overdraft). However, when the balance as per cash book is negative while the balance as per bank book is positive, it is referred to as book overdraft. Book overdraft arises when the checks written exceed the general ledger bank balance available thereby resulting in negative bank balance in books but since those checks are not yet presented so the bank balance is not negative and there is no 'actual bank overdraft'.

by Obaidullah Jan, ACA, CFA and last modified on

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