Applying the Matching Concept to Loan Loss Reserves

 

  

          The application of the matching concept becomes especially significant in a discussion of financial institutions and their loan loss reserves in the current economic climate. Many in the financial industry are concerned that financial institutions may not be contributing enough to their loan loss reserves, the reserve accounts for expected loan losses. An underestimation of necessary loan loss reserves may result in overstated Accounts Receivable and Net Income on financial statements.

            It is important for financial institutions to base contributions to loan loss reserves on current activity as well as recent collection experience in order to estimate the bad debt expense, or uncollectible accounts expense, and manage risk effectively. The amount contributed to a reserve account should be enough to cover the estimated losses resulting from bad debts, or uncollectible accounts. Firms may estimate their bad debt expense using the percentage of credit sales method, where the estimate of uncollectible accounts is based upon a simple assumption of how many credit sales are actually collectible during a given period of time. A more complex method of estimating bad debt expense is the aging of receivables method, where a firm analyzes its accounts receivable and estimates the net amount likely to be collected based on aging categories and estimated collection percentages of its credit sales accounts. Many companies also employ internal control policies to help limit the extent of their uncollectible accounts expenses, for example, sending delinquent accounts to collection agencies.

 

            By providing an estimate of bad debt expense as accurately as possible, companies are able to reserve funds to cover this expense; financial institutions call this reserve account the “loan loss reserve”. The capital reserved in the loan loss reserves is deducted from the Accounts Receivable in Accrual Accounting, so while it may reduce the net profit, it ensures that the company will not experience any more loss due to bad debt expenses. By keeping enough capital in its reserve account, a company can prevent showing any significant and unexpected loss due to uncollectible account expenses.

            The concepts of matching receivables, bad debt expense, and loan loss reserves are important in understanding the recent mortgage crisis and even more recent stock market recovery. The concern is that financial institutions, particularly mortgage and credit card companies, are underestimating the amount of capital necessary in their loan loss reserves. Underestimating necessary contributions to loan loss reserves is dangerous for two main reasons: First, if consumers do default on their mortgages and credit cards at the actual expected rate, these financial institutions will be unprepared to cover their uncollectible accounts expense and are likely to experience significant loss. Second, by not contributing capital to their loan loss reserves, these firms are overstating profit and earnings, resulting in a skewed perception of market recovery. Thus, it is critical for companies to estimate their uncollectible accounts expense as accurately as possible and to contribute to their loan loss reserves accordingly.

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Katherine Norton