Credit risk
What is allowance for credit losses (ACL)?
Allowance for credit losses (ACL) is a valuation reserve that reduces the carrying value of loans to the amount a lender expects to collect.
Formula
Ending allowance = Beginning allowance + Provision - Charge-offs + Recoveries
The allowance for credit losses is a contra-asset account on a lender's balance sheet that offsets the gross loan balance. It represents management's estimate of credit losses that will not be collected. Under the CECL standard, the allowance reflects lifetime expected losses. Before CECL, the equivalent account was commonly called the allowance for loan and lease losses (ALLL) and reflected incurred losses.
The allowance changes through a few defined flows. Provision expense, recorded on the income statement, increases it. Charge-offs reduce it, and recoveries on previously charged-off loans add back to it. The allowance is typically estimated on pooled loans with similar risk characteristics, with individual evaluation for loans that do not share those characteristics, such as certain collateral-dependent loans.
An allowance that does not move with changes in portfolio risk, risk ratings or economic forecasts is a warning sign for auditors and examiners. Inaccurate risk ratings flow directly into allowance estimates. Lenders should document the rationale for qualitative adjustments, support the economic forecasts used, and reconcile the allowance roll-forward each period.
