Bank Overdraft – A Concept-First Explanation
Think of a bank overdraft like a credit limit on steroids. You know how a credit card lets you spend money you don't have, up to a limit? An overdraft works the same way, but on your current account (the account businesses use for daily transactions). Your bank says, "If your balance goes to zero, we'll still honour your cheques and payments, up to an agreed limit." That negative balance is the overdraft.
The Precise Meaning
A bank overdraft is a short-term borrowing facility where a bank allows a customer to withdraw more money than is actually in their account. The customer pays interest only on the amount overdrawn, and only for the period it remains overdrawn. It is not a fixed loan — it fluctuates daily as cheques are deposited and payments are made.
An overdraft is a liability for the business. It represents money owed to the bank. In the balance sheet, it appears under Current Liabilities (or sometimes under "Short-Term Borrowings").
Why It Matters
Businesses face timing mismatches. You may have to pay suppliers today, but your customers will pay you next week. An overdraft bridges that gap. It is cheaper and more flexible than a formal loan because you pay interest only when you use it. But it is also dangerous — interest rates are high, and banks can demand repayment at short notice.
Accounting Treatment
When you take an overdraft, the bank credits your account (they give you money). In your books, you record this as:
- Debit the Bank Account (because the bank balance increases — yes, even though it's negative from the bank's perspective, from your books it's an asset that has gone up)
- Credit the Bank Overdraft Account (a liability account)
In practice, many businesses use a single Bank Account in their ledger. When the balance is positive, it's an asset. When it becomes negative, it's an overdraft (a liability). But for exam purposes, you often maintain a separate Bank Overdraft Account.
The journal entry when you overdraw:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|---|
| Bank A/c Dr. | | 10,000 | |
| To Bank Overdraft A/c | | | 10,000 |
| (Being amount overdrawn from bank) | | | |
But this entry is rarely passed as a single transaction. Instead, the overdraft arises from multiple transactions. The Bank Overdraft Account is credited when the overdraft increases and debited when it decreases.
Interest on Overdraft
Interest is calculated on the daily balance (the amount overdrawn each day). The formula:
Interest = Overdrawn Amount × Rate of Interest per annum × (Number of days / 365)
For example, if you overdraw ₹50,000 for 15 days at 12% p.a.:
Interest = 50,000 × 12/100 × 15/365 = ₹246.58 (approx.)
The entry for interest:
| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |
|------|-------------|------|-----------|------------| …