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.

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