What is Allowance For Credit Losses?

Allowance for credit losses is an estimate of the debt that a company is unlikely to recover. It is taken 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 purchases from another entity is made. The credit results in an accounts receivable on the balance sheet of the selling company. Accounts receivable is recorded as a current asset and describes the amount that is due for providing services or goods.

One of the main risks of selling goods on credit is that not all payments are guaranteed to be collected. To factor in this possibility, companies create an allowance for credit losses entry.

Since current assets by definition are expected to turn to cash within one year, a company’s balance sheet could overstate its accounts receivable and, therefore, its working capital and shareholders’ equity if any part of its accounts receivable is not collectible.

The allowance for credit losses is an accounting technique that enables companies to take these anticipated losses into consideration in its financial statements to limit overstatement of potential income. To avoid an account overstatement, a company will estimate how much of its receivables it expects will be delinquent.

Recording Allowance For Credit Losses

Since a certain amount of credit losses can be anticipated, these expected losses are included in a balance sheet contra asset account. The line item can be called 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 to allowance for credit losses is also recorded in the income statement as bad debt expenses. Companies may have a bad debt reserve to offset credit losses.

Allowance For Credit Losses Method

A company can use statistical modeling such as default probability to determine its expected losses to delinquent and bad debt. The statistical calculations can utilize historical data from the business as well as from the industry as a whole. 

Companies regularly make changes to the allowance for credit losses entry to correlate with the current statistical modeling allowances. When accounting for allowance for credit losses, a company does not need to know specifically which customer will not pay, nor does it need to know the exact amount. An approximate amount that is uncollectible can be used.

In its 10-K filing covering the 2018 fiscal year, Boeing Co. (BA) explained how it calculates its allowance for credit losses. The manufacturer of airplanes, rotorcraft, rockets, satellites, and missiles said it reviews customer credit ratings, published historical credit default rates for different rating categories, and multiple third-party aircraft value publications every quarter to determine which customers might not pay up what they owe.

The company also disclosed that there are no guarantees that its estimates will be correct, adding that actual losses on receivables could easily be higher or lower than forecast. In 2018, Boeing’s allowance as a percentage of gross customer financing was 0.31%.

Example of Allowance For Credit Losses

Say a company has $40,000 worth of accounts receivable on September 30. It estimates 10% of its accounts receivable will be uncollected and proceeds to create a credit entry of 10% x $40,000 = $4,000 in allowance for credit losses. In order to adjust this balance, a debit entry will be made in the bad debts expense for $4,000.

Even though the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for credit losses is $4,000, the net amount reported on the balance sheet will be $36,000.

This same process is used by banks to report uncollectible payments from borrowers who default on their loan payments.

What Is an Available-for-Sale Security?

An available-for-sale security (AFS) is a debt or equity security purchased with the intent of selling before it reaches maturity or holding it for a long period should it not have a maturity date. Accounting standards necessitate that companies classify any investments in debt or equity securities when they are purchased as held-to-maturity, held-for-trading, or available-for-sale. Available-for-sale securities are reported at fair value; changes in value between accounting periods are included in accumulated other comprehensive income in the equity section of the balance sheet.

How an Available-for-Sale Security Works

Available-for-sale (AFS) is an accounting term used to describe and classify financial assets. It is a debt or equity security not classified as a held-for-trading or held-to-maturity security—the two other kinds of financial assets. AFS securities are nonstrategic and can usually have a ready market price available.

The gains and losses derived from an AFS security are not reflected in net income (unlike those from trading investments), but show up in the other comprehensive income (OCI) classification until they are sold. Net income is reported on the income statement. Therefore, unrealized gains and losses on AFS securities are not reflected on the income statement.

Net income is accumulated over multiple accounting periods into retained earnings on the balance sheet. In contrast, OCI, which includes unrealized gains and losses from AFS securities, is rolled into “accumulated other comprehensive income” on the balance sheet at the end of the accounting period. Accumulated other comprehensive income is reported just below retained earnings in the equity section of the balance sheet.

Available-for-Sale vs. Held-for-Trading vs. Held-to-Maturity Securities

As mentioned above, there are three classifications of securities—available-for-sale, held-for-trading, and held-to-maturity securities. Held-for-trading securities are purchased and held primarily for sale in the short term. The purpose is to make a profit from the quick trade rather than the long-term investment. On the other end of the spectrum are held-to-maturity securities. These are debt instruments or equities that a firm plans on holding until its maturity date. An example would be a certificate of deposit (CD) with a set maturity date. Available for sale, or AFS, is the catch-all category that falls in the middle. It is inclusive of securities, both debt and equity, that the company plans on holding for a while but could also be sold.

From an accounting perspective, each of these categories is treated differently and affects whether gains or losses appear on the balance sheet or income statement. The accounting for AFS securities is similar to the accounting for trading securities. Due to the short-term nature of the investments, they are recorded at fair value. However, for trading securities, the unrealized gains or losses to the fair market value are recorded in operating income and appear on the income statement. 

Changes in the value of available-for-sale securities are recorded as an unrealized gain or loss in other comprehensive income (OCI). Some companies include OCI information below the income statement, while others provide a separate schedule detailing what is included in total comprehensive income.

Recording an Available-for-Sale Security 

If a company purchases available-for-sale securities with cash for $100,000, it records a credit to cash and a debit to available-for-sale securities for $100,000. If the value of the securities declines to $50,000 by the next reporting period, the investment must be “written down” to reflect the change in the fair market value of the security. This decrease in value is recorded as a credit of $50,000 to the available-for-sale security and a debit to other comprehensive income.

Likewise, if the investment goes up in value the next month, it is recorded as an increase in other comprehensive income. The security does not need to be sold for the change in value to be recognized in OCI. It is for this reason these gains and losses are considered “unrealized” until the securities are sold.

What Is an Allowance for Bad Debt?

An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.

How an Allowance for Bad Debt Works

Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.

Methods of Estimating an Allowance for Bad Debt

There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.

Sales Method

The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.

Accounts Receivable Method

The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.

However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.

Requirements for an Allowance for Bad Debt

According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumb, or numbers from another business.

Default Considerations

When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.

Adjustment Considerations

The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.