Credit plays a cardinal role in modern economies. From business corporations and non-profit institutions to governments and consumers, a large part of economic activity is credit-related. A financial institution, such as a bank or an insurance company, that frequently engages in lending activities must develop provisions for credit losses to account for potential defaults.
Credit Loss Defined
Credit loss is a loss that a corporation incurs due to credit risk. It emanates from a counterparty's (business partner's) default or inability to fulfill financial commitments when they become due. A business partner may default because of bankruptcy or temporary monetary difficulties. For instance, an investment bank lends $1 million to an oil refining company, and the borrower must reimburse within two years. After six months, the company is out of business. The bank may incur $1 million in credit losses if it is unable to recover any amount in court.
Occasionally, a corporate credit officer reviews customer loans and detects potential liquidity problems based on payment delays and the account's status. The officer reviews accounts that are one year, six months, three months and one month past due. Amounts that are over six months past due may be considered delinquent, and they are referred to collection agencies. Amounts that are between three and six months past due are deemed bad debt.
Provision for Credit Loss
A financial company analyzes its loan portfolio and "provides" for credit losses. Providing for a loss, in finance or accounting parlance, means estimating the potential loss resulting from a default and treating such a loss as actual expense. For example, a credit card company's loan officer notes that accounts over 90 days past due have a 50 percent chance of recoverability (collection). These account balances in the company's portfolio amount to $1 million. The officer then makes a $500,000 provision for credit loss.
Accounting for Credit Loss Provision
To record the $500,000 credit loss provision, an accountant at the credit card company debits the bad debt expense account for $500,000, and he credits the allowance-for-doubtful-items account for the same amount. (Allowance for doubtful items is also referred to as allowance for doubtful accounts, and it is the account used to record the provision for credit losses.)
Significance of Loss Provision
Credit loss provision is a pivotal tool that helps a financial institution's top leadership assess the quality, or recoverability, of a loan portfolio. An investor who wants to purchase a corporation's shares also may review levels of loss provisions to evaluate how the firm manages its loan agreements as well as trends in bad debt expenses. Increased levels of bad debt from one period to another may indicate that the firm's loan approval process is inadequate.