What is Provision for Credit Losses (PCL)?
The provision for credit losses (PCL) estimates potential losses that a company might face due to credit risk. It’s reported as an expense on the company’s financial statements resulting from anticipated losses from delinquent debts or other potential default scenarios. For example, if a company calculates that accounts over 90 days past due have a 40% recovery rate, it will make a provision for credit losses based on 40% of these accounts’ balance.
Mastering the Concept of Provision for Credit Losses (PCL)
Accounts receivable (AR) is expected to turn into cash within a year or operational cycle. It is listed as a current asset on the company’s balance sheet. However, to avoid overstating assets, it’s essential to estimate uncollectible accounts, encompassing accounts at risk of becoming unrecoverable.
To mitigate this risk, businesses report such estimates in a balance sheet contra asset account called provision for credit losses, and the increases are documented in the income statement under uncollectible accounts expense.
Inspirational Example of Provision for Credit Losses
Imagine Company A with AR at $100,000 as of June 30. Suppose $2,000 is unlikely to convert to cash. Consequently, a $2,000 credit balance is recorded as the provision for credit losses. When adjusting the allowance account, the entry affects the uncollectible accounts expense on the income statement.
Since June marks Company A’s first operation month, the provision for credit losses account starts at zero. By June 30, its balance sheet will reflect a $2,000 credit balance for provisions, implying an adjusted AR balance is net $98,000. This net realizable value likely turns into cash.
Furthermore, Company A’s uncollectible accounts expense reports $2,000 in credit losses for June despite none of the AR being due then. This approach adheres to the matching principle by ensuring bad debts align with the period when the credit sales were made.
Related Terms: Bad Debt, Credit Risk, Accounts Receivable, Contra Asset Account, Uncollectible Accounts Expense, Matching Principle.
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What is Provision for Credit Losses (PCL)?
- [x] Funds set aside by financial institutions to cover potential loan defaults
- [ ] Surplus cash in a company's accounts
- [ ] Emergency relief funds provided by the government
- [ ] Financial aid for bank employees
## Which type of institutions primarily use Provision for Credit Losses (PCL)?
- [ ] Retail stores
- [ ] Manufacturing companies
- [x] Banks and other financial institutions
- [ ] Healthcare providers
## How does a high Provision for Credit Losses impact a bank’s financial statements?
- [x] Reduces net income
- [ ] Increases shareholder equity
- [ ] Leads to higher capital expenditure
- [ ] Results in lower assets
## What triggers the need for a Provision for Credit Losses?
- [ ] Increase in employee strength
- [ ] Opening of new bank branches
- [ ] Expansion of customer service networks
- [x] Expected increase in loan defaults
## Who determines the appropriate amount for Provision for Credit Losses?
- [ ] Credit card holders
- [ ] Stock market analysts
- [ ] Bank customers
- [x] Financial analysts and accountants within the institution
## What is an example of an event that might necessitate a higher Provision for Credit Losses?
- [ ] Central bank reducing interest rates
- [ ] Increase in global oil prices
- [x] A recession impacting borrowers' ability to repay loans
- [ ] Launch of a new banking product
## How frequently is the Provision for Credit Losses typically reviewed?
- [ ] Annually
- [x] Quarterly
- [ ] Every five years
- [ ] Daily
## In which section of the financial statements would you most likely find the Provision for Credit Losses?
- [ ] On the balance sheet under assets
- [x] On the income statement under expenses
- [ ] In the cash flow statement
- [ ] In the shareholders' equity section
## What happens if the actual loan losses are greater than the Provision for Credit Losses?
- [ ] Banks generate more revenue
- [ ] No impact on the financial statement
- [x] Additional losses are recorded on the income statement
- [ ] Increased market share for the bank
## Why is it important for banks to maintain appropriate Provisions for Credit Losses?
- [ ] To distribute higher dividends to shareholders
- [ ] To increase non-performing assets
- [x] To protect the financial health of the institution in case of loan defaults
- [ ] To reduce the need for employee training
