Allowance for Credit Losses (ACL)

The Allowance for Credit Losses (ACL) represents a bank's estimate of potential loan and credit losses due to defaults. As a contra-asset account on the balance sheet, ACL includes past credit loss provisions (PCL), write-offs, and any recovered amounts to reflect expected uncollectible debt. ACL offsets the net carrying value of loans and accounts receivables. It increases with positive PCL and recoveries, and it decreases with write-offs.

All Values Are in Millions of CAD$

Source: WOWA Data Labs

Banks and financial institutions often manage large loan portfolios. The income from these loans and other fixed-income assets forms a significant part of their business. While these loans are usually expected to be repaid with interest, sometimes borrowers may not be able to repay them in full, creating a credit risk.

To ensure transparency, accounting standards, and Canadian financial regulators require banks and financial institutions to disclose accurate credit risk metrics, including the allowance for credit losses. The ACL is an aggregate measure of provisions for credit losses (PCL) adjusted for write-offs and recoveries.

Provisions for credit losses, the building blocks of ACL, are estimated using a statistical analysis of historical data, current economic conditions, and forward-looking information. This makes ACL an estimate of expected unrepaid loans, and it may change drastically in response to changing economic conditions.

The Allowance for Credit Losses reflects a bank's estimate of potential losses from loan defaults. This key risk metric indicates how exposed a financial institution is to credit losses based on expected borrower defaults and the potential loss from defaults. This may help investors and other stakeholders to make informed decisions about their investments and capital allocation. ACL is an important metric for most stakeholders for the following reasons:

• Risk Management: The ACL metric, combined with the gross value of loans, allows companies to understand their credit risks. Understanding credit risks allows companies to adjust their risk management strategies to optimize loan portfolio returns while ensuring they can stay afloat when loans are not being repaid.
• Reporting Uniformity: ACL is a complex metric, but it is uniform across all banks and financial institutions. This uniformity allows financial regulators to ensure transparency and comparability across the financial sector. Increased transparency also increases market confidence and participation while reducing fraud and market manipulation opportunities.
• Investor Confidence: Clear metrics like ACL give the public an understanding of what the company expects to lose due to credit risk. This allows investors to make informed financial decisions for optimal capital allocation during uncertain times.

Allowance for credit losses is an accounting term introduced in the Current Expected Credit Losses (CECL) accounting standard. It is a balance sheet contra-asset account, and it mostly applies to banks and financial institutions. Similar but less accurate metrics exist in other companies. Smaller and non-financial companies may use the following accounts on their balance sheet:

• Allowance for uncollectible accounts;
• Allowance for doubtful accounts;
• Allowance for losses on customer financing receivables.

An allowance change recorded on the balance sheet also has a related expense in the income statement that adjusts the income based on the expected credit loss during a specified period. Companies may set aside money in the reserve to offset unexpected credit losses.

Let’s say a bank added $10 million of outstanding loans to its loan portfolio during its fiscal year. Using statistical methods based on previous data, the bank estimates that 8% of those loans will not be repaid, so it estimates the Provision for Credit Losses to expense it from the income statement.

The bank reduces its income for the fiscal year by the PCL number, and it needs to reflect it in the balance sheet in Allowance for Credit Losses.

At the end of the previous fiscal year, the bank had a $100 million loan portfolio and an ACL of $10 million. Assuming there was no change in the net carrying value of loans, to adjust the balance sheet to the current fiscal year, the bank needs to add new loans to the outstanding loans and the current-year PCL to the previous-year ACL.