Bad debts and the allowance for doubtful debts (VCE Accounting Unit 4)
“Recording bad debts written off and establishing an allowance for doubtful debts as a balance day adjustment, and reporting the net realisable value of accounts receivable”
A bad debt is a confirmed uncollectable amount, written off by debiting Bad Debts expense and reducing Accounts Receivable. An allowance for doubtful debts estimates future uncollectable amounts at balance day, debiting a Doubtful Debts expense and crediting a contra asset. The allowance is deducted from Accounts Receivable so the Balance Sheet reports the net realisable value expected to be collected.
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What this dot point is asking
VCAA wants you to record a bad debt write-off, establish and adjust an allowance for doubtful debts as a balance day adjustment, and report accounts receivable at the amount expected to be collected, justifying the treatment with the Conceptual Framework.
Bad debts versus doubtful debts
A bad debt is an account receivable now known to be uncollectable, which is written off. A doubtful debt is an estimate at balance day of accounts receivable that may not be collected in future; it is recognised through an Allowance for Doubtful Debts, a contra asset that reduces the reported value of receivables.
Writing off a confirmed bad debt is certain; the allowance is an estimate that applies the accrual basis by recognising the expected loss in the period the related credit sales were made, not when a specific debt later fails.
Recording each
- Bad debt written off: Debit Bad Debts (expense), Debit GST Clearing (to reverse GST on the original sale), Credit Accounts Receivable. The customer's balance is removed.
- Allowance created or increased at balance day: Debit Doubtful Debts (expense), Credit Allowance for Doubtful Debts (contra asset).
The Allowance for Doubtful Debts is deducted from Accounts Receivable in the Balance Sheet. It does not reduce cash; it reduces the carrying amount of receivables to the net realisable value the business expects to actually collect.
Worked example
Bad debt write-off
A customer who owes 1,100 dollars (including 100 GST) is declared uncollectable. Entry: Debit Bad Debts 1,000, Debit GST Clearing 100, Credit Accounts Receivable 1,100. Bad Debts expense of 1,000 reduces profit; GST charged on the original sale is reversed.
Establishing the allowance
After the write-off, Accounts Receivable stands at 50,000 dollars. Past experience suggests 4 percent will prove uncollectable. Required allowance = 50,000 times 4 percent = 2,000 dollars. Entry at balance day: Debit Doubtful Debts 2,000, Credit Allowance for Doubtful Debts 2,000.
Reporting net realisable value
In the Balance Sheet under current assets: Accounts Receivable 50,000 less Allowance for Doubtful Debts 2,000 = net 48,000 dollars. This is the net realisable value, the amount the business expects to collect.
The following period
If a specific 700 dollar debt later goes bad, it is written off against the allowance: Debit Allowance for Doubtful Debts 700, Credit Accounts Receivable 700 (plus GST). No new expense arises because the loss was already anticipated when the allowance was created.
Adjusting an existing allowance
A frequent exam twist is that an allowance already exists at balance day and must be adjusted to a newly required figure. The allowance is not recreated from scratch each year; instead the business tops it up or reduces it to the required closing balance. If the required allowance is $3 600 and the account already carries $3 000 (after any write-offs during the year), only the $600 shortfall is recorded: Debit Doubtful Debts $600, Credit Allowance for Doubtful Debts $600. If the existing balance already exceeds the required figure, the excess is reversed instead, reducing the expense.
The required figure itself is usually set as a percentage of either closing Accounts Receivable or net credit sales (credit sales less sales returns). Read the question carefully to see which base applies, because using gross sales instead of net credit sales, or using receivables instead of sales, is a common error. The percentage reflects the proportion of credit business the firm expects, from experience, not to collect.
Reporting net realisable value
In the Balance Sheet, Accounts Receivable is reported gross, then the Allowance for Doubtful Debts is deducted to give the net realisable value, the amount the business genuinely expects to collect. This presentation keeps both figures visible: users see the full amount owed and the estimated shortfall. The net figure feeds into liquidity indicators, so an understated allowance flatters both the asset and the working capital position.
Why this matters
The allowance applies the accrual basis and period assumption: the expense of expected non-collection is matched to the period of the credit sales that created the risk. Reporting receivables net of the allowance gives a faithful representation of the asset, avoiding overstating both the asset and profit. The estimate must also be neutral and complete, not deliberately understated to inflate profit. Examiners test the difference between writing off against the expense and writing off against the allowance, and the difference between creating an allowance and merely adjusting an existing one.
When an allowance already exists, writing off a later specific bad debt is charged against the Allowance for Doubtful Debts, not to a fresh Bad Debts expense. Charging it to Bad Debts again would double count the loss, because the allowance had already recognised it. Only debts written off before any allowance, or beyond the allowance, hit the expense directly.
Exam-style questions
Questions in the style of VCAA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
2022 VCAA-style3 marksWith reference to one accounting assumption, explain the purpose of the Allowance for Doubtful Debts account.Show worked answer →
Name the assumption and explain the allowance as a balance day adjustment.
The relevant assumption is the accrual basis: expenses are recognised in the period in which they are incurred, not when cash changes hands.
Some credit sales of the current period are unlikely to be collected. The Allowance for Doubtful Debts estimates that probable future loss now, so the expected expense is matched against the revenue (sales) of the same period.
It is a negative asset (offset against Accounts Receivable) so that the Balance Sheet reports receivables at their net realisable value, the amount actually expected to be collected. Marks: name the assumption, explain matching the expected loss to the period, and link to net realisable value.
2022 VCAA-style3 marksOn 30 June 2022, PSF decided to write off a debt of $3 960 from Forrest Sushi after this restaurant was declared bankrupt (Memo 70). Prepare the General Journal entry to write off Forrest Sushi's debt. A narration is not required.Show worked answer →
The $3 960 owed includes GST, and under the allowance method the write-off is charged against the existing allowance, with the GST recovered.
Split the amount: 3 960 / 1.1 = 360.
General Journal entry:
Debit Allowance for Doubtful Debts $3 600; Debit GST Clearing $360; Credit Accounts Receivable (Forrest Sushi) $3 960.
One mark each for: debiting the Allowance (not Bad Debts again, since the loss was already estimated); recovering the $360 GST; and removing the full $3 960 from Accounts Receivable.
2021 VCAA-style2 marksNetball House had Accounts Receivable of $110 000 and an Allowance for Doubtful Debts of $3 000 at 30 June 2021. It wrote off $2 750 owed by R Ramsay and set the allowance at 4% of net credit sales (credit sales $90 500, sales returns $500). Show how Accounts Receivable would be reported in the Balance Sheet as at 30 June 2021.Show worked answer →
Report receivables at net realisable value: gross Accounts Receivable less the closing Allowance.
Accounts Receivable after the write-off = 110 000 - 2 750 = $107 250.
Allowance for Doubtful Debts = 4% of net credit sales = 4% x (90 500 - 500) = 4% x 90 000 = $3 600.
Balance Sheet (Current Assets):
Accounts Receivable 107 250
less Allowance for Doubtful Debts (3 600)
= $103 650 (net realisable value).
One mark for the $107 250 receivable after write-off, one for deducting the $3 600 allowance to show $103 650.