Understanding Allowance for Credit Losses and Its Impact on Financial Health
Allowance for credit losses is an estimate of the debt that a company is unlikely to recover. It is assessed from the perspective of the selling company that extends credit to its buyers.
How Allowance For Credit Losses Works
Most businesses conduct transactions with each other on credit, meaning they do not have to pay cash at the time of purchase from another entity. This credit results in an accounts receivable entry on the balance sheet of the selling company. Accounts receivable is recorded as a current asset, defining the amount due for provided services or goods.
One of the key risks of selling goods on credit is the uncertainty of payment collection. To factor in this variability, companies create an allowance for credit losses entry.
Since current assets are expected to turn into cash within one year, a company’s balance sheet could overstate its accounts receivable and, consequently, its working capital and shareholders’ equity if any part of its accounts receivable is not collectible.
This allowance is an accounting practice that enables companies to account for these anticipated losses in their financial statements, thereby preventing potential overstatement of income. To avoid an account overstatement, companies estimate how much of their receivables are expected to be delinquent.
Key Takeaways
- Allowance for Credit Losses: An estimate of the debt that a company is unlikely to recover.
- From the Seller’s Perspective: It is evaluated from the perspective of the selling company extending credit to its buyers.
- Financial Prudence: This accounting technique mitigates overstated potential income in financial statements by accounting for anticipated losses.
Recording Allowance For Credit Losses
Since some amount of credit losses can be anticipated, these are included in a balance sheet contra asset account. The line item can be called various names: allowance for credit losses, allowance for uncollectible accounts, provision for doubtful accounts, among others.
Any increase to allowance for credit losses is also recorded in the income statement as bad debt expenses. Companies may maintain a bad debt reserve to offset these credit losses.
Allowance For Credit Losses Method
A company can use statistical modeling to determine its expected losses. These statistical calculations can utilize historical data from the business and the industry.
Companies adjust the allowance for credit losses entry regularly to reflect current statistical modeling allowances. It’s important to note that companies do not need to know exactly which customers will not pay; an approximate uncollectible amount is sufficient.
For example, in its 2018 fiscal year reports, Boeing Co. disclosed that it reviews customer credit ratings and other industry data to estimate its allowance for credit losses. The actual reported vs. estimated losses can vary, but in 2018, Boeing’s allowance was 0.31% of gross customer financing.
Example of Allowance For Credit Losses
Imagine a company with $40,000 worth of accounts receivable as of September 30. It estimates that 10% of its accounts receivable will be uncollected and proceeds to create a credit entry of $4,000 (10% x $40,000) in allowance for credit losses. To adjust this balance, a debit entry of $4,000 is made to the bad debts expense account.
Though the accounts receivable amount is not due in September, the company still has to report the $4,000 as bad debt expense in its income statement for the month. If accounts receivable is $40,000 and the allowance for credit losses is $4,000, the net amount reported on the balance sheet is $36,000.
Banks use a similar process to report uncollectible payments from borrowers who default on their loans.
Related Terms: Accounts Receivable, Credit, Balance Sheet, Bad Debt Expense.
