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. How should investors interpret accounts receivable information on a company's balance ...

    Analyze accounts receivable information on a company's balance sheet carefully. Receivables offer confidence of future cash ... Read Answer >>
  2. How are the three major financial statements related to each other?

    Learn why investors analyze a company's financial statements, and how the income statement, balance sheet and cash flow statement ... Read Answer >>
  3. How is cash flow affected by Average Collection Period?

    See how reducing a company's average collection period can help cash flow, and learn why collections practices are so important ... Read Answer >>
  4. Why is Average Collection Period important to a company?

    Discover why the average collection period can be a particularly important accounting ratio for a company that relies heavily ... Read Answer >>
  5. What's the difference between an income statement and a balance sheet approach?

    Understand more about the principle purposes and primary differences between a company's income statement and its balance ... Read Answer >>
  6. What is the formula for calculating the receivables turnover ratio?

    Find out how to calculate the accounts receivable turnover ratio for a business, which should highlight how efficiently the ... Read Answer >>
Related Articles
  1. Economics

    What's an Allowance for Doubtful Accounts?

    The allowance for doubtful accounts represents the percentage of the accounts receivable the company expects to write-off as uncollectible.
  2. Fundamental Analysis

    The Importance Of Analyzing Accounts Receivable

    While investors often focus on revenues, net income, and earnings per share, they should not overlook the importance of analyzing accounts receivable.
  3. Economics

    What is a Contra Account?

    A contra account is an offset that reduces the value of a related account.
  4. Credit & Loans

    What is an Account Balance?

    An account balance represents the total amount of money in a financial account at any given moment.
  5. Fundamental Analysis

    Spotting Creative Accounting On The Balance Sheet

    Companies have ways of manipulating their balance sheets that investors should be aware of.
  6. Forex Education

    Accounting Basics: Financial Statements

    By Bob Schneider Financial statements present the results of operations and the financial position of the company. Four statements are commonly prepared by publicly-traded companies: balance ...
  7. Executive Compensation

    Accountant: Job Description & Average Salary

    Discover what the job description of an accountant entails, along with education and training, salary and skills necessary for success.
  8. Professionals

    Accounts Receivable

    Accounts Receivable (A/R) is an accounting term used to refer to the money that is owed to a company by its customers.
  9. Investing Basics

    What are Financial Statements?

    Financial statements are a picture of a company’s financial health for a given period of time at a given point in time. The statements provide a collection of data about a company’s financial ...
  10. Economics

    What are Receivables?

    Receivables are debts, transactions or other obligations owed to a company by its debtors or customers.
RELATED TERMS
  1. Allowance For Doubtful Accounts

    A contra-asset account that records the portion of a company's ...
  2. Average Collection Period

    The approximate amount of time that it takes for a business to ...
  3. Allowance For Credit Losses

    An estimation of the debt that a company is unlikely to recover. ...
  4. Net Receivables

    The total money owed to a company by its customers, minus the ...
  5. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  6. Chart Of Accounts

    A listing of each account a company owns, along with the account ...
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center