Allowance For Credit Losses: What is it?

A company’s assessment of the debts it is unlikely to be able to collect is called an allowance for credit losses. It is viewed from the standpoint of the selling business that offers credit to its customers.

How Credit Losses Are Calculated for Allowance

Most companies do business on credit, so they don’t have to pay upfront for purchases made from other companies. The selling company’s balance sheet shows accounts receivable due to the credit. The amount owed for rendering services or supplying commodities is designated as accounts receivable and is reported as a current asset.

The fact that not all payments will be guaranteed to be received when purchasing products on credit is one of the major hazards. Companies set aside money for credit loss entry to account for this potential.

A company’s balance sheet may overestimate its accounts receivable and, consequently, its working capital and shareholders’ equity if any portion of its accounts receivable is not recoverable, as current assets are, by definition, anticipated to convert to cash within a year.

Corporations might include these anticipated losses in their financial statements to prevent overstating prospective income by using the allowance for credit losses. A corporation will forecast how much of its receivables it expects to be past due to prevent an account overstatement.

Recording Credit Losses Allowance

Since it is possible to foresee a certain amount of credit losses, these anticipated losses are recorded in a counter-asset account on the balance sheet. The line item is sometimes referred to as a provision for doubtful accounts, allowance for credit losses, allowance for uncollectible accounts, allowance for dubious accounts, allowance for losses on customer financing receivables, or allowance for credit losses. The income statement includes bad debt expenses for any growth in the provision for credit losses. Businesses may keep a reserve for bad debts to cover credit losses.

Method For Allowing For Credit Losses

A business can utilize statistical modeling, such as default likelihood, to estimate its potential losses from past-due and bad debt. The statistical calculations can use past information from the company and the sector as a whole.

The allowance for credit loss entry is frequently modified by businesses to align with the most recent statistical modeling allowances. A corporation does not need to know explicitly which client will not pay or the precise amount to account for allowance for credit losses. It is possible to employ a roughly uncollectible sum.

Boeing Co. (BA) described how it determines its allowance for credit losses in its 10-K filing for the 2018 fiscal year. The company that makes rockets, satellites, rotorcraft, and missiles claimed that to identify which customers might not pay their debts in full; it reviews customer credit ratings, publishes historical credit default rates for various rating categories, and consults several third-party aircraft value publications every quarter.

There are no guarantees that the company’s calculations would be accurate, and real losses on receivables may easily be more or lower than anticipated, the company added. The allowance for Boeing as a percentage of gross customer financing in 2018 was 0.31%.

Example of Credit Loss Allowance

Let’s say that on September 30, a business has accounts receivable of $40,000 worth. It proceeds to make a credit entry for an allowance for credit losses of 10% x $40,000 = $4,000 based on its prediction that 10% of its accounts receivable will go uncollected. A debit entry for $4,000 will be recorded in the bad debts expenditure to reflect the adjustment to this balance.

Although the accounts receivable are not due until September, the business must include a bad debt expenditure of $4,000 for credit losses in its income statement for the month. The net amount shown on the balance sheet will be $36,000 if accounts receivable is $40,000 and allowance for credit losses is $4,000 in this example. Banks report uncollectible payments from borrowers who miss loans using the same procedure.

Conclusion

• A company’s assessment of the debts it is unlikely to be able to collect is called an allowance for credit losses.
• It is viewed from the standpoint of the selling business that offers credit to its customers.
• By using this accounting method, businesses can avoid overstating prospective income by accounting for projected losses in their financial statements.