Lenders set provisions for loan losses to prevent small credit issues from becoming significant financial annoyances. They do so to keep corporate balance sheets lean and clean -- devoid of bad loans, additional expenses coming from collection efforts, and amounts recoverable from customers who are scraping by in near-insolvency or who have filed for bankruptcy.
A loan loss provision is an expense, or allowance, a lender sets aside to recognize that a borrower may be unable to repay a loan in part or in total. Credit specialists often use the terms “valuation reserve” or “valuation allowance” when referring to a provision for loan losses. Another term frequently used is “allowance for loan impairment.” For a lender, the valuation reserve account is an expense account because the creditor anticipates that losses could result from debtors’ financial woes.
How It Works
To set a loan loss provision, a credit officer periodically reviews a bank’s loan portfolio, heeding things like maturity, credit rating and geographical dispersion. For example, the officer may focus on loans that become due in the next 12 months or may pay attention to borrowers with less-than-stellar credit scores and shaky financial profiles. After selecting the group to review, the loan officer studies the payment patterns of all borrowers in the group, focusing on whether they pay on time, before the due date or way after. During this review, poring over borrowers’ financial situations is helpful. Debtors who consistently miss payment dates or who are behind schedule -- say 60 or 90 days overdue -- implicitly are telling a lender that operating activities have embarked on a negative path with respect to revenue generation and solvency. The creditor may review a financially shaky corporate borrower to determine whether the business has restarted making money and if the tide of competitive battle is shifting in its favor. If not, the lender may record a loan loss provision.
To record a loan loss provision, a bookkeeper working for a lender debits the loan loss provision account and credits the “allowance for loan losses” account, which is a contra-account, meaning it reduces the value of, or offsets, the loan account. This makes sense given that loans are assets in lenders’ books although they represent liabilities for debtors.
As an operating expense, loan loss provision is integral to a statement of profit and loss, also called an income statement or statement of income. “Allowance for loan losses” is a balance sheet component as are corporate assets and liabilities.