The selling company that extends credit to buyers needs to consider allowance for credit losses. It is an estimate of debt that probably will not be recovered by the company. Typically, companies do not conduct cash transactions with each other but rather use payment on credit. Selling goods or services on credit can be viewed as risky since not all payments are guaranteed to be collected. To anticipate this possibility, companies establish a certain amount of allowance for credit losses.
The main purpose
When creating financial statements, the allowance helps companies to take into consideration these possible losses and not overestimate the potential income. A company then states how much of its receivables will be irresponsible. In fact, it is not necessary to know which client or what debt amount will not be paid. Instead, an approximate amount that will be uncollectable should be used. In accounting, these expected losses are placed in a balance sheet contra asset account and called:
- Allowance for credit losses
- Allowance for doubtful accounts
- Allowance for losses on consumer financing receivables
- Allowance on uncollectible accounts
- Provision for doubtful accounts.
For compensating credit losses, companies have a bad debt reserve, and that’s where any increase of allowance for credit losses should be included.
Calculations allowance for credit losses
Delinquent or bad debts can be calculated by using statistical modeling, for example, default probability. This can be performed on the basis of historical data taken from the given company or the whole industry. The current statistical modeling allowance changes all the time. This is the reason why companies need to change the allowance for credit losses on the regular basis.
This accounting technic is not only used by businesses providing goods and services, but also by financial institutions. For example, banks report uncollectible debts on loan payments.
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