Allowance for Doubtful Accounts (ADA)
Let's assume that Company XYZ sells $1,000,000 of goods to 10 different customers. Accord to accrual accounting, Company XYZ increases its revenue account by $1,000,000 and increases its accounts receivable account by $1,000,000. Assume the customers have 60 days to pay. One of those customers is Company ABC, which purchases $100,000 worth of goods.
If Company ABC becomes very overdue in paying Company XYZ -- whether due to cash flow problems, bankruptcy, or any number of other problems -- 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 $1,000,000 of accounts receivable and $100,000 as an allowance for doubtful accounts, for a net accounts receivable of $900,000.
Note that the ADA 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 and reduce the balance sheet's ADA 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 doubtful accounts. Instead, they may simply use a percentage of sales or accounts receivable, or they may use a historical trend percentage.
Almost every company records an allowance for doubtful accounts because invariably some customers will fail to pay. However, changes in the allowance for doubtful accounts can be an indicator of other trends within a company.
For example, if the ADA has increased, the company may be offering credit to riskier customers, which jeopardizes the reliability of the company's cash flow. Or, 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. For this reason, it's important for an analyst to closely examine major changes in ADA and understand why the changes are taking place.