# Provision for Credit Losses Explained: Uses and Examples

## What Does Provision for Credit Losses Mean?

The provision for credit losses (PCL) is a crucial element in a company's financial statements, reflecting expected losses from [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp), such as delinquent or defaulting accounts. Companies use PCL to safeguard against overstating their assets, ensuring that balance sheets represent a more accurate financial position. This article provides insight into how companies estimate these potential losses, the financial reporting involved, and offers a practical example of PCL in action.

The provision for credit losses is treated as an expense on the company's financial statements. They are [expected losses from delinquent and bad debt](https://www.investopedia.com/terms/c/credit_loss_ratio.asp) or other credit that is likely to [default](https://www.investopedia.com/terms/d/default2.asp) or become unrecoverable. For instance, if accounts over 90 days past due have a 40% [recovery rate](https://www.investopedia.com/terms/b/bad-debt-recovery.asp), the company makes a provision for 40% of their balance.

### Key Takeaways

*   The provision for credit losses (PCL) is an estimated amount that represents potential credit losses in a company's financial statements.
*   PCL is necessary to adjust for overstatements in accounts receivable, helping prevent inflated working capital and stockholders' equity.
*   A company calculates PCL based on expected recovery rates and reports it as an expense, reflecting the estimated unrecoverable credit.
*   The provision for credit losses affects both the balance sheet and the income statement, emphasizing the matching principle in accrual accounting.  
    

## How Provision for Credit Losses (PCL) Impacts Financial Statements

Because [accounts receivable](https://www.investopedia.com/terms/a/accountsreceivable.asp) (AR) is expected to turn to cash within one year or an operating cycle, it is reported as a current asset on a company’s balance sheet. If some accounts receivable aren’t collectible, both working capital and stockholders' equity might be overstated.

To guard against overstatement, a business may estimate how much of its accounts receivable will most likely not be collected. The estimate is reported in a balance sheet [contra asset account](https://www.investopedia.com/terms/c/contraaccount.asp) called provision for credit losses. Increases in this account are noted in the uncollectible accounts expense on the income statement.

## Practical Example: Calculating and Reporting PCL

Company A’s AR has a debit balance of $100,000 on June 30. Approximately $2,000 is expected to not turn to cash. As a result, a credit balance of $2,000 is reported as a provision for credit losses. The accounting entry for adjusting the balance in the allowance account involves the income statement account uncollectible accounts expense.

Since June was Company A's first month, its provision account started with a zero balance. As of June 30, when it issues its first balance sheet and income statement, its provision for credit losses will have a credit balance of $2,000.

With a credit balance of $2,000 and AR at $100,000, the balance sheet shows a net of $98,000. As the net amount will likely turn into cash, it is called the net realizable value of the AR.

Company A’s uncollectible accounts expense reports credit losses of $2,000 on its June income statement. Although no AR was due in June, the expense is noted as terms are 30 days net. Company A is attempting to follow [the matching principle](https://www.investopedia.com/terms/a/accrualaccounting.asp) by matching the bad debts expense to the accounting period in which the credit sales occurred.

## The Bottom Line

The provision for credit losses (PCL) is crucial for companies to estimate potential financial hits from credit risks, ensuring more accurate financial statements. By accounting for expected losses from delinquent accounts or defaults, businesses prevent overstating assets and equity. This process is reflected as an expense, aligning with sound financial practices like the matching principle. For instance, Company A creates a provision to mirror potential credit losses, reflecting them in its financial statements to provide clarity and transparency.

Understanding PCL equips organizations to manage credit risk proactively and maintain healthier financial records.