# Loan Loss Provision Explained: Definition, Purpose, and Accounting Use

## What Is a Loan Loss Provision?

A loan loss provision is a financial safeguard used by banks to cover losses from unpaid loans or loan defaults. Banks allocate these expenses on their [income statement](https://www.investopedia.com/terms/i/incomestatement.asp) to ensure accurate reporting of their financial status and manage risks associated with lending. By adding to their loan loss reserves, banks prepare for potential defaults, thereby giving a precise picture of their overall financial health.

### Key Takeaways

*   A loan loss provision is an expense on the income statement set aside to cover potential uncollected loans.
*   Banking regulations have tightened since the 2008 financial crisis, improving lending standards and requiring banks to account for potential loan defaults.
*   Loan loss provisions contribute to the accuracy of a bank's financial health assessment, by adjusting for customer defaults and credit losses.
*   Loan loss reserves, reflected on the balance sheet, are updated regularly with adjustments from loan loss provisions to reflect changing conditions.

![Loan Loss Provision: An income statement expense set aside as an allowance for uncollected loans and loan payments.](https://www.investopedia.com/thmb/ZZtQ5XPiFekCdQAUOB-75U6G1XA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Loanlossprovision_final-675a5e2fa8094fb791870f4cefb06c10.png)

*— Investopedia / Michela Buttignol*

## The Functionality of Loan Loss Provisions

Banking industry lenders generate revenue from the interest and expenses they receive from lending products. Banks lend to a wide range of customers, including consumers, small businesses, and large corporations.

Lending standards and reporting requirements are constantly changing, and constraints have been rigorously tightened since the height of the [2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp). The [Dodd-Frank Act](https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp) improved regulations by raising lending standards, requiring higher credit quality borrowers, and increasing banks' capital [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) requirements.

Despite these improvements, banks still have to account for loan [defaults](https://www.investopedia.com/terms/d/default2.asp) and expenses that occur as a result of lending. Loan loss provisions are a standard accounting adjustment made to a bank’s loan loss reserves, included in the financial statements of banks. [Loan loss provisions](https://www.investopedia.com/ask/answers/030215/whats-difference-between-accrued-expenses-and-provisions.asp) are consistently made to incorporate changing projections for losses from the bank’s lending products. While standards for lending have greatly improved, banks still experience late loan payments and loan defaults.

> **Important**
>
> Because the loan loss provision appears on the income statement as an expense, it will lower operating profits.

## Understanding Loan Loss Reserves in Financial Accounting

Loan loss reserves are typically accounted for on a bank’s [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp), which can increase by the amount of the loan loss provision or decrease by the amount of net [charge-offs](https://www.investopedia.com/terms/c/chargeoff.asp) each quarter.

Loan loss provisions are constantly made to update estimates and calculations based on statistics for the bank’s customer defaults. These estimates are calculated based on average historical default rates by different levels of borrowers. Credit losses for late payments and collection expenses are also included in loan loss provision estimates and are calculated using a similar methodology, which takes into account the previous payment statistics of a bank’s credit clients.

By maintaining loan loss reserves and updating estimates through provisions, banks ensure accurate financial position assessments. This financial position is often released publicly through the bank’s quarterly financial statements.

## The Bottom Line

Loan loss provisions are a crucial accounting practice for banks to ensure they maintain an accurate financial picture of their lending activities. These provisions account for potential loan defaults and reduce operating profits as an expense on the income statement. By regularly updating loan loss reserves and incorporating changing loss projections, banks can better manage financial risks and maintain regulatory compliance. This ensures that they present an accurate and transparent financial position to stakeholders and regulators.

> **Article Sources**
>
> 1.  Congress. "[H.R.4173 - Dodd-Frank Wall Street Reform and Consumer Protection Act](https://www.congress.gov/bill/111th-congress/house-bill/4173/text)."