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The word “set-off” gives us the idea that it is something related to writing off or reduction in the value. In simple accounting terms, when a debtor can decrease the amount of one’s debt by the amount owed by the creditor to the debtor it is known as setting off. The creditor’s claim on the debtor is reduced by the amount of the debtor’s claim on the creditor. It is important to note that the claims are unrelated or separate transactions.
Working of a set-off
A set-off in terms of accounting is of the following types and applies accordingly:
1. Contractual set-off – Many a time based on a contract or business relations a debtor agrees on excluding the right to set off. In this case, although the creditor owes some amount to the debtor it is considered nil, and the debtor is obliged to pay the entire amount of debt.
2. Banking set-off – The bank gets the right to set off a credit balance against another debit balance when a person has more than one accounts.
3. Insolvency set-off – There are compulsory statutory rights of set-off under the Insolvency rules 2016 for an insolvent debtor of the company against its creditor.
4. Legal set-off – Under legal proceedings, mutually exclusive unsettled debts between the two parties, arising from transactions not related to each other can be set off.
Mr. A purchased goods from XYZ Ltd. amounting to 40,000. However, XYZ Ltd. owes an amount of 10,000 to Mr. A as per past transactions. The working of the amount owed by Mr. A (debtor) to XYZ Ltd. (creditor) as per their agreement is as follows:
Original amount owed by Mr. A = 40,000
Amount owed by XYZ Ltd. to Mr. A as per past transactions = 10,000
Set-off hereby allows Mr. A to pay only 30,000 (40,000 – 10,000) to XYZ Ltd. as a settlement of the claim.
The main benefit of set-off is that ensures payment security and hassle-free settlement of disputes at both the ends.
Hope this helps.