What Is the Allowance for Loan and Lease Losses?
Understand the valuation reserve financial institutions use to absorb estimated credit losses and how this calculation impacts financial reporting.
The Allowance for Credit Losses (ACL) is an estimate for financial institutions, representing a reserve built to cover potential credit losses from their loan portfolios. Historically known as the Allowance for Loan and Lease Losses (ALLL), the name and calculation methodology were updated by the Current Expected Credit Loss (CECL) standard. This valuation allowance is netted against the total value of loans and leases on an institution’s balance sheet to present the loan portfolio at its net realizable value. The allowance functions as a buffer, maintained by charges against a bank’s operating income, and is a focus for regulators to ensure an institution can maintain its safety and soundness.
The Incurred Loss Methodology
The incurred loss methodology was the long-standing approach for calculating the allowance for loan and lease losses. Under this framework, a financial institution could only recognize a credit loss when it was deemed “probable” that a loss had been incurred and the amount could be reasonably estimated. This model is backward-looking, as it requires a specific loss event, such as a borrower’s default or significant payment delinquency, to have already occurred before a reserve can be established.
This approach was principally guided by accounting standards ASC 450-20 for general allowances and ASC 310-10-35 for specific allowances. For pools of smaller loans with similar risk characteristics, institutions would establish a general reserve based on historical loss experience. For larger loans, when a specific loan was identified as impaired, an individual allowance was calculated based on the fair value of the loan’s collateral, the present value of expected future cash flows, or the loan’s observable market price.
The CECL Methodology
The Current Expected Credit Loss (CECL) model, introduced under ASC Topic 326, changed how financial institutions account for credit losses. This standard replaces the “incurred loss” model with a forward-looking “expected loss” approach and renames the allowance to the Allowance for Credit Losses (ACL). CECL was largely a response to the 2008 financial crisis, where the previous model was criticized for delaying loss recognition. An exception exists for federally insured credit unions with less than $10 million in assets.
The core change under CECL is the requirement to forecast and reserve for total expected credit losses over the entire contractual life of a loan from its origination. This eliminates the “probable” threshold and mandates a more proactive stance on credit risk management. The objective is to provide a more timely and accurate reflection of the net amount an entity expects to collect.
To achieve this, an institution must consider past events, current economic conditions, and “reasonable and supportable forecasts” about the future. This forward-looking component is the most significant departure from the prior methodology, compelling institutions to incorporate predictions about economic trends into their allowance calculations.
Key Factors in Estimating Credit Losses
The estimation process begins with an analysis of historical loss information, which serves as a foundational starting point. This includes data such as past charge-off rates, recovery trends, and delinquency patterns for loans with similar risk characteristics. Building on this historical base, institutions must then adjust for current conditions. Factors considered here include changes in lending policies, shifts in the composition of the loan portfolio, and variations in the value of underlying collateral.
The forward-looking component requires institutions to develop projections for macroeconomic indicators that could impact borrowers’ ability to repay. Common forecasted variables include:
- Unemployment rates
- Gross domestic product (GDP) growth
- Interest rate movements
- Changes in real estate or other asset values
Finally, the quantitative estimate is often refined with qualitative adjustments. These adjustments allow management to use its judgment to account for factors not fully captured by the model, such as the economic health of a specific industry or other emerging risks.
Financial Statement Reporting and Impact
The allowance for credit losses and its related expenses have a direct impact on an institution’s financial statements. On the balance sheet, the allowance for credit losses (ACL) is a contra-asset account presented as a reduction from the gross value of loans and leases, with the resulting figure reported as “net loans.”
The income statement reflects the cost of building this reserve through an expense line item called the Provision for Credit Losses. When an institution needs to increase its allowance, it records a provision expense, which directly reduces the institution’s pre-tax income.
The ACL balance at the beginning of a period is increased by the provision for credit losses and decreased by net charge-offs. Net charge-offs are the actual loans deemed uncollectible and written off the books, minus any subsequent recoveries of previously charged-off loans.