What does the allowance for credit losses mean?
The allowance for credit losses (PCL) is an estimate of the potential losses a business could incur due to credit risk. The allowance for credit losses is treated as an expense in the company’s financial statements. These are expected losses on overdue and irrecoverable receivables or on other credits that may default or become irrecoverable. If, for example, the company calculates that accounts overdue for more than 90 days have a recovery rate of 40%, it will make a provision for credit losses based on 40% of the balance of these accounts.
Understanding the allowance for credit losses (PCL)
Because accounts receivable (AR) are expected to turn into cash over the course of a year or in an operating cycle, they are presented as a short-term asset on a business’s balance sheet. However, as accounts receivable may be overstated if a portion is not recoverable, the working capital and equity of the company may also be overvalued.
To guard against overestimation, a business can estimate the proportion of its accounts receivable that is unlikely to be collected. The estimate is presented in a balance sheet account against assets called a provision for credit losses. Increases in the account are also recorded in the income statement charges for uncollectible accounts.
Example of provision for credit losses
Company A’s AR has a debit balance of $ 100,000 on June 30. It is anticipated that approximately $ 2,000 will not be converted to cash. Consequently, a credit balance of $ 2,000 is recorded as an allowance for credit losses. The accounting entry for the adjustment of the balance of the provision account involves the charge of non-recoverable accounts in the income statement.
Since June was the first month of activity for Company A, its bad debt provision account started the month with a zero balance. As at June 30, upon publication of its first balance sheet and first income statement, its provision for credit losses will have a credit balance of $ 2,000.
Since the allowance for credit losses reports a credit balance of $ 2,000 and AR declares a debit balance of $ 100,000, the balance sheet shows a net amount of $ 98,000. Since the net amount is likely to turn into cash, it is called the net realizable value of the AR.
Company A’s uncollectible account expenses show credit losses of $ 2,000 in its June income statement. The expense is reported even if none of the ARs were due in June since the terms are net 30 days. Company A attempts to follow the matching principle by matching bad debt charges to the accounting period in which the credit sales took place.