What Is Allowance For Credit Losses?
Allowance for Credit Losses (ACL) refers to that reserve that a lender maintains in their accounting books to record the assumed bad debts on the loans or advances it has extended to the borrowers. It is a valuation account prepared by the banks to avoid overstatement of the loans receivable.
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For eg:
Source: Allowance For Credit Losses (wallstreetmojo.com)
As it is recorded as a contra-asset account in the creditor’s balance sheet, it helps offset the loans receivable. Thus, whenever there is a bad debt, the lender writes it off against the allowance for credit losses to ensure the proper closure of such a loan receivable account.
Table of contents
- What Is Allowance For Credit Losses?
- Allowance For Credit Losses Explained
- How to calculate?
- Examples
- Allowance For Credit Losses Vs. Provision For Credit Losses Vs. Allowance For Doubtful Accounts
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The allowance for credit losses refers to a reserve created by the lenders or creditors for the anticipated bad debts likely to arise due to the non-recovery of the loans or credit from the borrowers.
- It is a contra-asset account used to write off the loan receivables in the lender’s balance sheet.
- Also, it directly impacts the bad debt expenses in the income statement.
- It is evaluated as an assumed percentage of debt amount that may not be recovered.
Allowance For Credit Losses Explained
The allowance for credit losses is an accounting method for financial assets where they are recorded at their amortized cost in the financial statements. In the lending business, credit risk is significant; thus, it is crucial to understand the credit losses that may arise out of the non-repayment of loans by borrowers. The ones that are never recovered result in bad debts for the lender or creditor. Such losses are more common with loans or credits not backed by collateral.
The allowance amount for estimated credit losses depends on the nature of the business, the type of credit extended, previous losses, and the value of collateral, if any. Thus, the lenders who allow unsecured credit or loans to the borrowers have to keep a higher ACL balance when compared to those who provide loans against collateral. Similarly, if the creditor has a previous record of inability to recover the debt, they must maintain a considerable ACL balance.
The federal reserve has simplified the banks’ evaluation process of the allowances for credit losses by introducing a spreadsheet-based tool, Expected Losses Estimator (ELE), under the new Current Expected Credit Losses (CECL) accounting standard in July 2022. However, this tool will be helpful to small banks with a less complex accounting system compliant with the CECL.
How To Calculate?
There is no particular formula for determining the allowance for credit losses. It is an anticipated percentage of debt that may not be recovered based on the previous instances, the value of the collateral, the type of loan, and the borrower’s credibility.
The basic steps a lender can follow to figure out the amount of ACL are as follows:
- Assume a percentage of loans and advances that may result in bad debt.
- Then evaluate the value of ACL by taking out the percentage of debt that may not be recovered.
Examples
Check out these examples to get a better idea:
Example #1
Suppose a bank has a current balance of $8,700 in the allowance for credit losses. The bank has $100,000 worth of loans receivable due at the end of the month. However, it has been estimated that 10% of this sum may not be recovered. Thus, the ACL should be $10,000 (10% of $100,000). But, at present, it has a current balance of $8700. Therefore, the bank needs to put $1,300 ($10,000 – $8,700) more in the ACL to balance the loans receivable.
Example #2
Let us now take a real-world example; a part of the Balance Sheet of the Ecowas Bank For Investment And Development as on December 31, 2018, reads as follows:
Here, we can see that the bank has total loans and advances worth $570,748,457 while it has an ACL balance of $62,533,030.
Allowance For Credit Losses vs Provision For Credit Losses vs Allowance For Doubtful Accounts
Although the allowance for credit losses, provision for credit losses, and allowance for doubtful accounts aim at reserving funds for the uncertainties or losses arising out of the non-realization of the loan, credit, or receivables, they have the following dissimilarities:
| Basis | Allowance for Credit Losses | Provision for Credit Losses | Allowance for Doubtful Accounts |
|---|---|---|---|
| Meaning | It is a reserve for recording the possible bad debts due to the non-recovery of loans or credit extended to the borrowers. | It is the sum a business keeps aside to offset any possible losses arising from the bad debts on accounts receivable. | It is a reserve maintained by a company for recording the expected percentage of receivables that will result in bad debts. |
| Treatment in Financial Statement | Recorded as contra asset account in the balance sheet and shown as bad debt expenses in the income statement | Recorded as an expense account and written off from the accounts receivable in the current assets | Contra asset account that offsets the asset, I.e., accounts receivable |
| Maintained By | Lending institutions like banks | Companies, banks, and other financial institutions | Companies that make credit sales of goods or services |
| Effect on Income | Doesn’t affect the income as it is an assumption of losing money due to the non-recovery of a debt | Charged against the business income | Doesn’t affect the income as it is an assumption of losing money due to the non-recovery of a debt |
Frequently Asked Questions (FAQs)
No, an allowance for credit losses is not an expense but a contra account used to write off the loans receivable. In other words, it is a reserve that a lender creates for the possible bad debts which may arise due to the non-repayment of the loan by the borrowers.
The International Financial Reporting Standards (IFRS) 9 prescribes that lenders adopt the expected credit losses (ECL) approach for identifying and evaluating credit losses on financial assets. The formula for current losses or cash shortfall is:
Present Value of Contractual Cash Flows – Present Value of Expected Future Cash Flows
The allowance of estimated credit losses is shown in the balance sheet of the bank or other lender as a contra-asset account. It even appears as bad debt expenses in the income statement.
Recommended Articles
This article has been a guide to what is Allowance For Credit Losses. We explain how to calculate it, comparison with provisions for credit losses, and examples. You may also find some useful articles here –
- Withholding Allowance
- Credit Balance
- Accounting Estimates
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
