An allowance that constitutes an estimate of a debt/ obligation (credit extended to customers/ buyers) that an entity determines and considers unlikely to recover. In other words, it is an estimated amount of losses (expected credit losses, ECLs) that may rise from bad debts in the future. The allowance for credit losses (ACL) is deducted from the amortized cost basis of a respective financial asset or a group of financial assets so the net amount an entity expects to collect appears on the balance sheet. Amortized cost reflects the principal balance outstanding, net of purchase premiums and discounts, deferred fees and costs, and any fair value adjustments (fair value hedge accounting adjustments).

Subsequent changes (favorable and unfavorable) in expected credit losses are recognized immediately the income statement, impacting an entity’s net income, as a credit loss expense or a reversal of credit loss expense.

An entity’s management usually determines the allowance for credit losses by projecting factors such as probability-of-default (PD), loss-given-default (LGD) and exposure-at-default (EAD) based on all relevant economic parameters for each month of the remaining part of a contractual term.