A company’s assessment of the debts it is unlikely to be able to collect is called an allowance for credit losses. It is viewed from the standpoint of the selling business that offers credit to its customers. Most companies do business on credit, which means they don’t have to pay up front for purchases made from other companies. The selling company’s balance sheet shows an accounts receivable as a result of the credit. The amount owed for rendering services or supplying commodities is designated as accounts receivable and is reported as a current asset.
The fact that not all payments will be guaranteed to be received when purchasing products on credit is one of the major hazards. Companies set aside money for credit losses in order to account for this potential.
A company’s balance sheet may overestimate its accounts receivable and, consequently, its working capital and shareholders’ equity if any portion of its accounts receivable is not recoverable, as current assets are by definition anticipated to convert to cash within a year.
In order to prevent overstating prospective income, corporations might include these anticipated losses in their financial statements by using the allowance for credit losses. A corporation will forecast how much of its receivables it expects to be past due in order to prevent an account overstatement.