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. 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 >>
  5. 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 >>
  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. Investing

    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. Investing

    What is a Contra Account?

    A contra account is an offset that reduces the value of a related account.
  3. Investing

    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.
  4. Personal Finance

    What is an Account Balance?

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

    Spotting Creative Accounting On The Balance Sheet

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

    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. Managing Wealth

    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. Investing

    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 ...
  9. Investing

    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.
  10. Investing

    Retained Earnings

    Learn more about this calculation and why companies include it on the balance sheet.
RELATED TERMS
  1. Net Receivables

    The total money owed to a company by its customers, minus the ...
  2. Receivables

    An asset designation applicable to all debts, unsettled transactions ...
  3. Allowance For Doubtful Accounts

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

    The approximate amount of time that it takes for a business to ...
  5. Account Balance

    1. The amount of money in a financial repository, such as a checking ...
  6. Allowance For Credit Losses

    An estimation of the debt that a company is unlikely to recover. ...
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center