What is the meaning of set off in accounting?

Meaning

Set-off means discharging reciprocal monetary obligations by counterbalancing debt or claim. The set-off is carried out by debiting one account against a credit on another. The word “set-off” gives us the idea that it is related to writing off or reducing 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.

To set off a debit on one account against a credit on another, you deduct the debit from the credit. The balance you receive is the difference between the two amounts, either payable or receivable.

Key Features of set-off : (with the exception of contractual set-off)

  • both claims must be for the non-payment of money
  • there must be mutuality of debts

 

Types of Set-off

In commercial transactions, contractual set-off, banking set-off, and insolvency set-off are important. A set-off in terms of accounting is of the following types and applies accordingly:

1. Contractual set-off – Many times, a debtor agrees on excluding the right to set off based on a contract or business relations. 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 account, i.e. combining two or more accounts held by the same entity.

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 (also known as independent set-off or statutory set-off) – Under legal proceedings, mutually exclusive unsettled debts between the two parties, arising from transactions unrelated to each other can be set off.

5. Equitable set-off (also known as transaction set-off) – It is an independent provision where the set-off is given at the discretion of the court. Here, the amount of set-off is according to the decision of the court.

 

Example

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 unrelated transactions. The working of the amount owed by Mr. A (the debtor) to XYZ Ltd. (the creditor) as per their agreement is as follows:

 

Solution:

Mr. A originally owes a sum of 40,000 to XYZ Ltd. Also, XYZ Ltd. owes a sum of 10,000 to Mr. A on the basis of prior transactions. So, Mr. A is allowed to set off by paying only a sum of 30,000 (40,000 – 10,000) to XYZ Ltd. as a settlement of the claim.

Here, XYZ Ltd. A/c is debited with 10,000 which represents the amount set off. The ledger account of XYZ Ltd. in the books of Mr. A is provided below.

set-off example

The main benefit of set-off is that ensures payment security and hassle-free settlement of disputes at both ends.