What is Allowance For Credit Losses?

What is Allowance For Credit Losses?

Let me explain allowance for credit losses directly: it's my estimate as a company of the debt I probably won't recover from my customers. I take this from my viewpoint as the seller extending credit to buyers.

How Allowance For Credit Losses Works

You know most businesses deal with each other on credit, so they don't pay cash right away when buying from another company. This creates accounts receivable on my balance sheet as the seller, which I record as a current asset representing what's owed for goods or services I've provided.

The big risk here is that not every payment will come in. To account for that, I set up an allowance for credit losses. Since current assets should turn into cash within a year, if some receivables aren't collectible, my balance sheet would overstate my accounts receivable, working capital, and shareholders' equity.

This allowance is the accounting method I use to factor in those expected losses in my financial statements, preventing any overstatement of income. I estimate how much of my receivables might go delinquent to keep things accurate.

Key Takeaways

To sum it up for you: allowance for credit losses is my estimate of unrecoverable debt. I view it as the seller extending credit. This technique lets me include anticipated losses in financial statements to avoid inflating potential income.

Recording Allowance For Credit Losses

Since I can anticipate some credit losses, I include these expected losses in a contra asset account on my balance sheet. You might see it labeled as allowance for credit losses, allowance for uncollectible accounts, allowance for doubtful accounts, allowance for losses on customer financing receivables, or provision for doubtful accounts.

Any increase in this allowance also shows up in my income statement as bad debt expenses. I might keep a bad debt reserve to offset these credit losses.

Allowance For Credit Losses Method

I can use statistical modeling, like default probability, to figure out my expected losses from delinquent and bad debt. These calculations draw on historical data from my business and the industry overall.

I regularly adjust the allowance for credit losses to match current statistical models. When I account for this, I don't need to pinpoint exactly which customer won't pay or the precise amount; an approximate uncollectible figure works fine.

Take Boeing Co. from their 2018 fiscal year 10-K filing: they review customer credit ratings, historical default rates by category, and third-party aircraft value publications quarterly to assess who might not pay. They note there's no guarantee their estimates are spot on, and actual losses could vary. In 2018, Boeing's allowance was 0.31% of gross customer financing.

Example of Allowance For Credit Losses

Suppose I have $40,000 in accounts receivable on September 30. I estimate 10% won't be collected, so I create a credit entry of 10% x $40,000 = $4,000 in allowance for credit losses. To adjust, I debit bad debts expense for $4,000.

Even if the receivables aren't due in September, I report $4,000 as bad debts expense in my income statement for the month. With $40,000 in receivables and $4,000 allowance, the net on my balance sheet is $36,000.

Banks follow this same process to report uncollectible loan payments from defaulting borrowers.