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Allowance for Credit Losses (ACL) is an estimate of the amount of debt that a lender expects not to recover from its borrowers. It is a reserve that the lender sets up to cover any potential losses brought on by defaults, delinquencies, or other circumstances that might make it difficult for borrowers to repay their loans.Â
ACL is another name for provision for credit losses, allowance for dubious accounts, and allowance for uncollectible accounts. As a contra-asset account, ACL lowers the balance sheet value of the loans receivable. For instance, if a lender has $10 million in ACL and $100 million in loans receivable, the net amount of loans receivable is $90 million. This shows how much the lender anticipates getting paid by the borrowers.
ACL has an impact on the income statement as well because it is a lender expense. Bad debt expense or recovery of bad debt are recorded in accordance with whether the ACL increased or decreased. For instance, a lender will record a $2 million bad debt expense in its income statement if it increases its ACL by $2 million in a given month. In contrast, a lender registers a $1 million recovery of bad debt in its revenue statement if it reduces its ACL by $1 million in a quarter.
The ECLs for each loan in the portfolio are then added up to determine the overall ACL. However, some lenders might adopt a less complex strategy by applying a single predicted loss rate to the whole amount of loans they have outstanding.
ACL has an impact on the income statement as well because it is a lender expense. Bad debt expense or recovery of bad debt are recorded in accordance with whether the ACL increased or decreased. For instance, a lender will record a $2 million bad debt expense in its income statement if it increases its ACL by $2 million in a given month. In contrast, a lender registers a $1 million recovery of bad debt in its revenue statement if it reduces its ACL by $1 million in a quarter.
How is ACL calculated?
Since each lender may employ a different methodology and set of assumptions depending on their business models, credit regulations, historical data, and industry standards, there is no set formula for determining ACL. However, some common factors that influence the estimation of ACL are:- The type and quality of the loans: Depending on the borrower's characteristics, the loan's purpose, its length, its interest rate, and the collateral, some loans are riskier than others (if any). For instance, long-term loans are riskier than short-term loans, and unsecured loans are more likely to default than secured loans.
- The historical loss rate: This represents the proportion of loans that have already defaulted or become uncollectible. The projected loss rate for a lender's current loan portfolio can be calculated using previous data from their own portfolio or industry benchmarks.
- The current and future economic conditions: This is the effect of macroeconomic conditions on borrowers' ability and willingness to repay their loans, including GDP growth, inflation, unemployment, interest rates, and consumer confidence. Based on anticipated changes in the economy, lenders can modify their estimated loss rate using predictions or scenarios.
- The specific characteristics of each loan: Each loan is analyzed individually to evaluate its exposure to default, loss given default, and probability of default (PD, LGD) (EAD). The risk that a borrower will default on a loan is measured by PD, the portion of the loan that won't be repaid in the event of a default is measured by LGD, and the amount of the loan that is still outstanding at the time of default is measured by EAD. These three variables are multiplied to determine the expected credit loss (ECL) for each loan.
The ECLs for each loan in the portfolio are then added up to determine the overall ACL. However, some lenders might adopt a less complex strategy by applying a single predicted loss rate to the whole amount of loans they have outstanding.
Why is ACL relevant?
ACL is important for both risk management and financial reporting. ACL makes sure that lenders display their loans receivable at their net realizable value on their balance sheets for the purposes of financial reporting. A more precise and realistic view of their financial situation and performance is thus provided. Additionally, it complies with accounting regulations like GAAP or IFRS, which mandate that creditors report credit losses based on anticipated rather than actual losses.
ACL assists lenders in managing their credit risk exposure and capital adequacy for risk management. Lenders can modify their capital buffers, pricing tactics, provisioning levels, and credit rules in accordance by assessing the probable losses from their loan portfolio. They can reduce their credit risk and raise their profitability and solvency thanks to this.
