What are Accounts Uncollectible?
Accounts uncollectible, also called allowance for doubtful accounts (ADA), is a reduction in a company's accounts receivable. Accounts uncollectible equals the amount of those receivables that the company's management does not expect to actually collect.
How Do Accounts Uncollectible Work?
Let's assume Company XYZ sells $1 million of goods to 10 different customers. Accordingly, Company XYZ increases its revenue account by $1 million and increases its accounts receivable account by $1 million (we are assuming the customers have 60 days to pay). One of those customers is Company ABC, which purchases $100,000 of those goods.
If Company ABC suddenly declares bankruptcy or just incurs cash flow problems and becomes very overdue in paying Company XYZ, Company XYZ may determine that all or some of the $100,000 Company ABC owes is uncollectible. Company XYZ's balance sheet would then be adjusted to show $1 million of accounts receivable and $100,000 in an allowance for doubtful accounts, for a net accounts receivable of $900,000.
Note that accounts uncollectible is for amounts Company XYZ suspects will not be collected. When Company XYZ in fact cannot collect the $100,000 (because Company ABC is liquidated, for example), Company XYZ will record $100,000 on the income statement as bad debt expense (note that this reduces profits) and reduce the balance sheet's allowance for doubtful accounts by the same amount.
How Company XYZ determines that a receivable is uncollectible is a matter of judgment and negotiation. In the real world, companies may not analyze the collectibility of every single account when determining how much to record in their allowance for accounts uncollectible. Instead, they may simply use a percentage of sales or accounts receivable, or they may use a historical trend percentage.
Why Do Accounts Uncollectible Matter?
Almost every company records accounts uncollectible because invariably some customers will fail to pay. However, changes in accounts uncollectible can indicate other trends in a company.
For example, if accounts uncollectible has increased, the company may be offering credit to riskier customers, which jeopardizes the reliability of the company's cash flow. However, the company may be padding the allowance in order to make things look worse than they are -- because that can make future performance look better.