What is Allowance For Credit Losses
Allowance for credit losses is an estimate of the debt that a company is unlikely to recover. The allowance for credit losses is taken from the perspective of the selling company that extends credit to its buyers.
BREAKING DOWN Allowance For Credit Losses
Most businesses conduct transactions with each other on credit, meaning that a business does not have to pay cash at the time it purchases merchandise from another entity. The credit results in an accounts receivable on the balance sheet of the selling company. Accounts receivable is recorded as a current asset and is the amount that is due for providing a service or selling goods to a company. However, not all payments from invoices or accounts receivable are expected to be collected. To factor in this occurrence, companies create an allowance for credit losses entry.
Since current assets by definition are expected to turn to cash within one year, a company's balance sheet could overstate its accounts receivable and, therefore, its working capital and shareholders' equity if any part of its accounts receivable is not collectible. The allowance for credit losses is an accounting technique that allows companies to take these anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables it expects will be delinquent.
A company can use statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. Companies regularly make changes to the allowance for credit losses entry to correlate with the current statistical modeling allowances. When accounting for allowance for credit losses, a company does not need to know specifically which customer will not pay, nor does it need to know the exact amount. An approximate amount that is uncollectible can be used. Companies may have a bad debt reserve to offset these credit losses.
Since a certain amount of credit losses can be anticipated, these expected losses are included in a balance sheet contra asset account. The line item can be called allowance for credit losses, allowance for uncollectible accounts, allowance for doubtful accounts or provision for doubtful accounts. Any increase to allowance for credit losses is also recorded in the income statement account bad debts expense.
For example, a company has $40,000 worth of accounts receivable on September 30. It estimates 10% of its accounts receivable will be uncollected and proceeds to create a credit entry of 10% x $40,000 = $4,000 in allowance for credit losses. In order to adjust this balance, a debit entry will be made in the bad debts expense for $4,000. Even though the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for credit losses is $4,000, the net amount reported on the balance sheet will be $36,000.
This same process is used by banks to report uncollectible payments from borrowers who default on their loan payments.