What happens if a company doesn't think it will collect on some of its receivables?

By Matt Lee AAA
A:

The accounts receivable account, or receivables for short, is created when a company extends credit to a customer based on a sale. However, there are times when a company will not collect on a particular sale, and the company must account for this on its financial statements. The account created for this is called the allowance for doubtful accounts (AFDAs), and is presented usually on the balance sheet within the accounts receivable. The AFDA is called a contra account, which reduces the value in another account, and it is calculated using past experience and educated guesses.

There are two separate ways AFDA can be calculated, but the net result is similar. The first way is to multiply sales by a certain percentage believed to be uncollectible. The percentage used may be based on a historic number and then adjusted for current economic and changing customer circumstances. The second way to calculate AFDA is to multiply total receivables by a percentage and adjust in the same manner. No matter which way the AFDA is calculated, the balance will reduce the total amount of receivables that may be collected, and subsequently lower current assets on the balance sheet. The AFDA also is expensed on the income statement every reporting period, which reduces the net income. The higher the AFDA balance, the more likely it is that the company needs to adjust its credit practices.

An excessively high AFDA amount would be a red flag for investors, as this can result in a larger loss of net income and a higher opportunity cost on the company's resources. The credit extending practices of any company represents the trade-offs between generating revenue and allowing for bad debts to occur. Credit extensions allow a company to boost sales by selling goods to people who may be able to pay for them later. However, some people may not pay for the good they received. There is a fine balance between the two, and a company must carefully weigh the costs and benefits in order to determine the most appropriate level of credit to extend.

To learn more about the meaning of a company's financial statements, have a look at our Fundamental Analysis Tutorial or Reading The Balance Sheet.

RELATED FAQS

  1. Which leverage ratios are most useful for analyzing manufacturing companies?

    See which leverage ratios investors and creditors are likely to use when analyzing the debt burdens for manufacturing companies.
  2. What are the main components of the Federal Reserve's balance sheet?

    Find out which items are listed as assets and liabilities on the balance sheet of the Federal Reserve, and how to read the ...
  3. What's more important, cash flow or profits?

    Learn about the different effects that cash flow and profit have on a business so you can decide which aspect to focus on.
  4. What are some examples of how cash flows can be manipulated or distorted?

    Read about some of the most common accounting techniques that can be used to manipulate the operating cash flow on a company's ...
RELATED TERMS
  1. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  2. Insurance Regulatory Information System (IRIS)

    A collection of databases and tools used to analyze the financial ...
  3. Book Value Reduction

    Reducing the value at which an asset is carried on the books ...
  4. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  5. Working Capital

    This ratio indicates whether a company has enough short term ...
  6. Amortization

    1. The paying off of debt in regular installments over a period ...
Related Articles
  1. Can Getting One Month Ahead Save Your ...
    Budgeting

    Can Getting One Month Ahead Save Your ...

  2. What Documents Do I Need For Mortgage ...
    Credit & Loans

    What Documents Do I Need For Mortgage ...

  3. Material Adverse Effect A Warning Sign ...
    Markets

    Material Adverse Effect A Warning Sign ...

  4. SEC Filings: Forms You Need To Know
    Investing Basics

    SEC Filings: Forms You Need To Know

  5. Footnotes: Early Warning Signs For Investors
    Retirement

    Footnotes: Early Warning Signs For Investors

Trading Center