Allowance for credit losses definition
/What is the Allowance for Credit Losses?
The allowance for credit losses is a reserve for the estimated amount of loans that a lender will not collect from its borrowers. When a lender issues loans, there is a chance that some portion of the resulting loans receivable will not be collected. The lender is required to set up an allowance for credit losses that contains its best estimate of how much this bad debt may be. Without this allowance, it is likely that a lender will overstate the amount of its loans receivable that will actually be collected.
How to Account for the Allowance for Credit Losses
The allowance is recorded in a contra account, which is paired with and offsets the loans receivable line item on the lender’s balance sheet. When the allowance is created and when it is increased, the offset to this entry in the accounting records is an increase in bad debt expense. It is also possible that the allowance may be decreased, in which case the offset to this entry is a decline in the bad debt expense.
When a bad debt is identified, it is removed from the seller’s loans receivable account, while the allowance for credit losses is drawn down by the same amount.
Related AccountingTools Courses
Credit and Collection Guidebook
Example of an Allowance for Credit Losses
The collections manager of a lender reviews the outstanding loans receivable at the end of the month and guesstimates that $27,000 of it may not be collectible. The current balance in the allowance for credit losses is $23,000, so the accounting department increases it by $4,000 with a debit to the bad debt expense account and a credit to the allowance for credit losses account. A few weeks later, it becomes clear that a $1,000 loan will definitely not be collected, so the accounting staff removes it from the loans receivable account with a $1,000 credit, while also drawing down the allowance with an offsetting $1,000 debit.