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 lossessince 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 methoda 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 lossessay 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 