# What Is Allowance for Credit Losses? Meaning and Accounting Explained

> **Definition**
>
> Allowance for credit losses is an accounting estimate that reflects the amount of debt a company expects it will not be able to collect from its customers.

## What is Allowance For Credit Losses?

Allowance for credit losses is an accounting estimate of the [debt](https://www.investopedia.com/terms/d/debt.asp) a company is unlikely to recover from customers who bought on [credit](https://www.investopedia.com/terms/c/credit.asp). Companies record this allowance on their balance sheets to reflect anticipated losses and maintain accurate financial statements. These estimates are often calculated using historical data and statistical models to project potential defaults.

### Key Takeaways

*   Allowance for credit losses is an estimate of uncollectible debts a company expects to face.
*   It helps adjust a company's financial statements to avoid overstating potential income.
*   This estimate is recorded as a contra asset account and impacts both the balance sheet and income statement.
*   Companies use statistical models and historical data to calculate the likelihood of credit losses.
*   The exact amount or specific customer default does not need to be known for this estimation.

## Understanding the Function of Allowance for Credit Losses

Most businesses buy from each other on credit, so they don't pay cash when they buy. This credit creates an accounts receivable on the seller's balance sheet. Accounts receivable is a [current asset](https://www.investopedia.com/terms/c/currentassets.asp), showing what is owed for goods or services.

One of the main risks of selling goods on credit is that not all payments are guaranteed to be collected. Companies account for this risk with an allowance for credit losses.

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](https://www.investopedia.com/terms/w/workingcapital.asp) and [shareholders' equity](https://www.investopedia.com/terms/s/shareholdersequity.asp) if any part of its accounts receivable is not collectible.

Companies use this account to consider expected losses and avoid overstating income. To avoid an account overstatement, a company will estimate how much of its receivables it expects will be delinquent.

## How to Record Allowance for Credit Losses in Financial Statements

Since some credit losses are expected, they are recorded in a [contra asset account](https://www.investopedia.com/terms/c/contraaccount.asp) on the balance sheet. This line item may be called allowance for credit losses, doubtful accounts, or uncollectible accounts.

Increases in allowance for credit losses are also recorded as [bad debt expenses](https://www.investopedia.com/terms/b/bad-debt-expense.asp) on the [income statement](https://www.investopedia.com/terms/i/incomestatement.asp).  

## Methods Used to Calculate Allowance for Credit Losses

A company can use statistical modeling such as [default probability](https://www.investopedia.com/terms/d/defaultprobability.asp) to determine its expected losses to delinquent and bad debt. These calculations use historical data from both the business and the industry.

Companies regularly make changes to the allowance for credit losses entry to correlate with the current statistical modeling allowances. Companies don't need to know which customers won't pay or the exact amount when accounting for credit losses. An approximate amount that is uncollectible can be used.

In its [10-K](https://www.investopedia.com/terms/1/10-k.asp) filing covering the 2018 [fiscal year](https://www.investopedia.com/terms/f/fiscalyear.asp), Boeing Co. ([BA](https://www.investopedia.com/markets/quote?tvwidgetsymbol=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](https://www.investopedia.com/terms/c/creditrating.asp), published historical credit [default rates](https://www.investopedia.com/terms/d/defaultrate.asp) 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 stated its estimates might not be accurate, and real losses could be higher or lower. In 2018, Boeing’s allowance as a percentage of gross customer financing was 0.31%.

![](https://www.investopedia.com/thmb/X8ePN0RtPEkyAbqBjECTiJWe5Fg=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Boeing_Customer_financing-dd3b8773bd8d4654b734575f23d51d62.png)

*Source: U.S. Securities and Exchange Commission.*

## Real-World Example of Calculating Allowance for Credit Losses

Say 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.

## The Bottom Line

Allowance for credit losses reflects the estimated portion of accounts receivable a company doesn't expect to collect, helping maintain accurate financial reporting and avoid overstating income. Businesses record this estimate as a contra asset on the balance sheet and report related bad debt expense on the income statement.

Using statistical models like default probability, companies rely on historical and industry data to anticipate losses. Many large firms, such as Boeing, incorporate these allowances to manage credit risk and strengthen financial stability.