What is an allowance for loan losses?

Have you been wondering what an allowance for loan losses is all about? You should know that calculating the allowance for loan losses is a part of financial institutions’ accounting processes.

Over the years, its importance has grown. The larger the allowance for loan losses reserve, the greater the estimated risk of uncollectable assets.

When accounting for loan losses, a company does not need to know which customers will not pay. They also do not need to know the exact amount. It is possible to use an approximate amount that is uncollectible.

This article breaks down all you should know about the allowance for loan losses. It also contains how you can calculate ALL and the possible challenges you may face. Let’s get started.

You can also read how to become a financial advisor to better understand the allowance for loan losses.

What is Allowance for Loan Losses?

Allowance for loan losses is a calculation of the amount of debt that a company is unlikely to recover. According to Wikipedia, it is usually from the standpoint of the selling company.

It is the selling company that extends credit to its buyers. The allowance for loan and lease losses (ALLL) is a reserve used to estimate the uncollectible amount of a loan. This helps to reduce the loan’s value to the amount expected to receive eventually.

Assume a bank has made a loan to a group of homeowners. The total monetary value is $100 million.

There are 200 individual mortgages, each with a balance of $500,000. , the bank records the mortgages as a $100 million asset on its books.

Yet, the bank has discovered that 10% of the 200 mortgage holders are behind on their first payment. The bank thinks to itself, “How will a homeowner be able to make any payments if they can’t make the first one?”

When the bank realizes that the mortgages are worth less than $100 million, the book value should decrease the allowance for loan losses.

For example, the bank may decide that the true value is $90 million. The bank then applies a charge to lower the book value and raise the allowance for loan losses from $0 to $10 million.

The allowance for loan losses is a temporary account. It estimates which loans or leases will not be repaid.

Consider this reserve to be a ‘time out.’ It is the temporary location of ‘bad’ loans before they are written off or reinstated as an asset that the bank/institution expects to receive.

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How does Allowance for Loan Losses work?

Most businesses conduct loan and credit transactions with one another. This means they do not have to pay cash when making purchases from another business.

The credit results in accounts receivable on the selling company’s balance sheet. Accounts receivable is a current asset that describes the amount owed.

One of the risks associated with selling goods on credit and giving loans is that not all payments guarantee to get back. Companies set aside money for an allowance of loan losses to account for this possibility.

Since current assets should convert to cash within a year, a company’s balance sheet may overstate its accounts receivable. This includes the working capital and shareholders’ equity.

The allowance for loan losses is an accounting technique that allows businesses to account for these anticipated losses in their financial statements to limit the overstatement of potential income.

To avoid overstating an account, a company will estimate an allowance for loan losses. This includes how much of its receivables it expects to be likely to default.

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How is the Allowance for Loan Losses Recorded?

Since a certain amount of loan losses are foreseen, these losses are set down in a balance sheet as a contra asset account.

Allowance for loan losses, allowance for uncollectible accounts, allowance for doubtful accounts, allowance for losses on customer financing receivables, or provision for doubtful accounts all fall into an allowance for loan losses.

Any increase in the allowance for loan losses is also recorded as bad debt expenses on the income statement. A bad debt reserve is in place for a company to offset loan losses.

The allowance is usually kept in a contra account, which pairs with and offsets the lender’s loans receivable line item on the balance sheet.

When the allowance has increased, the offset in the accounting records is an increase in bad debt expense.

When a bad debt is discovered, it is removed from the seller’s loans receivable account and the allowance for credit losses is reduced by the same amount.

Common Allowance for Loan Losses Challenges

When it comes to allowance for loan losses, there are challenges. These include:

  • The manual, time-intensive nature of the calculation of allowance for loan losses processes each month or quarter.
  • Producing adequate documentation and disclosures.
  • Incorporating new accounting standards and regulations released by FASB; and
  • Federal regulatory bodies

Breaking this down, the common allowance for loan losses challenges are-

The process is manual and time-consuming.

The procedure can take several days, if not more. Due to the people participating in the estimation being high-level executives with limited time. This allows them to dedicate more time to the ALLL can be a challenge.

In addition, the use of a variety of Excel spreadsheets- which lend themselves to version control concerns and formula errors, among other possible issues, makes this process labor-intensive, manual, and prone to error.

Maintaining compliance with new accounting standards and regulatory requirements imposed on the institution.

The financial institution must stay up to date with new accounting standards. Usually issued by FASB, as well as regulatory demands from the institution’s specific regulators. These may or may not coincide exactly with the two sets of standards.

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Extra reporting and disclosure requirements.

FASB has continued to publish extra rules through its Accounting Standards Updates in recent years. While this usually comprises simple reports and the aggregation of already-used data. As a result, it can be time-consuming and put more strain on limited resources.

The assumptions used to calculate the ASC 450-20 (FAS 5) reserves are being scrutinized.

This can include questions about how to segment the ASC 450-20 (FAS 5) pools. It can also include assumptions used for the number of periods of historical data to include for the establishment of the Historical Loss Reserve of the ASC 450-20 (FAS 5) reserves.

The judgment and defense of qualitative factor adjustments in the assessment of the ASC 450-20 reserves are also issues here. ASC 310-10-35 (FAS 114) reserves are being scrutinized.

This includes determining which loans you should check for impairment under ASC 310-10-35 (FAS 114).

It also includes determining whether you should consider the loan “collateral-dependent”. Evaluating using the “Fair Market Value of Collateral” method or the “Present Value of Future Cash Flows” method is another factor. This is only if the borrower is still expected to make payments on the loan.

The correct assumptions to use in either method and other factors.

The Financial Accounting Standards Board (FASB) has announced plans to alter how banks account for asset impairment in the ALLL.

Bad Debt Expense vs. Loan Loss Provision- What’s the Difference?

When calculating the allowance for loan losses, it is often mistaken for bad debt. A receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems, it is a bad debt expense.

Companies that extend credit to their customers report bad debts on their balance sheets as an allowance for doubtful accounts. This is also known as a provision for credit losses.

A loan loss provision is money set aside by a bank, company, or even organization to cover bad loans. It means those that aren’t repaid because the customer defaults or that provide less interest income.

It could also be because the borrower negotiated a lower rate. They are a company’s best guess at what percentage of a loan may not be repaid.

Once made, the estimate will is an expense in the company’s financial statement so that investors can get a good sense of the company’s financial health.

A loan loss is still a lost asset for the bank. The loan loss provision’s goal is to protect the Company’s cash flow so that it can continue to provide services to other borrowers and depositors.

What does an Allowance for Loan Losses mean for your Company?

The allowance for loan losses purpose is to reflect estimated credit losses within a bank’s loan and lease portfolio.

Estimated credit losses are estimates of the current amount of loans that are likely to be uncollectible by the bank based on the facts and circumstances since the evaluation date (generally the balance sheet date).

In other words, estimated credit losses are net charge-offs that are likely to occur for a loan or group of loans as of the evaluation date.

The allowance for loan losses is on the balance sheet as a contra asset account that reduces the loan portfolio reported on the balance sheet.

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Also, you can check this: What Is Collateralized Loan Obligations? How it Works, Pros and Cons

How to Calculate Allowance for Loan Losses?

If a company has $40,000 in accounts receivable as of September 30. It estimates that 10% of its accounts receivable will go uncollected and creates a credit entry for 10% x $40,000 = $4,000 in allowance for loan losses. To correct this balance, a $4000 debit entry is in the bad debts expense.

Even though the accounts receivable is not due until September, the company must still report $4,000 in loan losses as bad debts expense.

This should be in its income statement for the month. If accounts receivable are $40,000 and loan losses are $4,000, the net amount reported on the balance sheet is $36,000.

Banks use the same procedure to report uncollectible payments from borrowers.

Frequently Asked Questions

What is the purpose of the allowance for loan losses?

The allowance for loan losses purpose is to reflect estimated loan losses within a bank’s loan and lease portfolio. With this, a company, organization, or bank can avoid a lot of losses in the business.

What exactly is a net allowance for loan losses?

Allowance for loan losses is a calculation of the amount of debt that a company is unlikely to recover. It is from the standpoint of the selling company, which extends credit to its buyers.

What exactly is a loss allowance?

In the context of IFRS 9, a loss allowance is an estimate linked to expected loan losses on a financial asset.

Its purpose is to reduce the carrying amount of the financial asset in the Statement of Financial Position.

What exactly is loan loss provision?

A loan loss provision is an income statement expense that is set aside as a reserve for uncollected loans and loan payments.

This provision is for covering a variety of loan losses, including non-performing loans, customer bankruptcy, and renegotiated loans with estimated payments.

How is ALLL determined?

Loan classification, the ASC 450-20 (FAS 5) calculation (which includes various loss measures), and the ASC 310-10-35 (FAS 114). The calculation comprises part of the ALLL calculation (various methods of collateral valuation).

Is CECL a replacement for ALLL?

The current Allowance for Loan and Lease Losses (ALLL) accounting standard is being replaced by CECL. The CECL standard focuses on estimating expected losses over the loan’s life cycle.

Conclusion

Lending standards and reporting requirements are changing, and constraints are tight since the 2008 financial crisis’s peak.

Improved bank regulations as a result of the Dodd-Frank Act focused on raising lending standards, which required higher credit quality borrowers and increased the bank’s capital liquidity requirements.

Despite these advancements, you should account for the loan defaults and expenses incurred.

References

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