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How does a business account for customers who may not pay, using bad debts written off and an allowance for doubtful debts?

Distinguish bad debts from doubtful debts, write off a bad debt, create and adjust an allowance for doubtful debts, and present accounts receivable at net realisable value

WACE Year 12 Accounting and Finance Unit 3 on receivables: writing off bad debts, creating and adjusting the allowance for doubtful debts, recording doubtful debts expense, and presenting accounts receivable at net realisable value on the balance sheet.

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What this dot point is asking
Bad debts versus doubtful debts
Writing off a bad debt
The allowance for doubtful debts
Why write-offs against the allowance do not touch profit
Recovering a debt previously written off
Net realisable value

What this dot point is asking

SCSA wants you to distinguish the two, record the write-off and the allowance adjustment, and present receivables net of the allowance.

Bad debts versus doubtful debts

Writing off a bad debt

When a debt is known to be bad, remove it: debit Allowance for Doubtful Debts (if an allowance exists) or Bad Debts Expense, and credit Accounts Receivable. Writing a debt off against an existing allowance does not affect profit again, because the expense was already recognised when the allowance was created.

The allowance for doubtful debts

The allowance applies the matching principle: the estimated cost of uncollectable sales is recognised in the same period the sales revenue is earned, not later when specific debts go bad.

Why write-offs against the allowance do not touch profit

A point students often miss is that writing off a bad debt against an existing allowance is profit-neutral. The expense was already recognised in an earlier period when the allowance was created or topped up. The write-off simply removes the specific uncollectable receivable and draws down the allowance that was set aside for exactly this purpose: debit Allowance for Doubtful Debts, credit Accounts Receivable. Both accounts fall, net realisable value is unchanged, and the Income Statement is untouched. Profit is affected only when the allowance is later adjusted back up to its required level, which is a separate step. If no allowance exists, the write-off instead debits Bad Debts Expense directly, which does hit profit; but under the allowance method the two steps are kept distinct.

Recovering a debt previously written off

Occasionally a customer pays a debt that was already written off. This is handled by reversing the write-off to reinstate the receivable, then recording the cash collection normally. The reinstatement restores the asset and the cash receipt clears it, recognising a recovery rather than ordinary revenue. The point for the exam is that the recovery is not new sales income; it corrects an earlier estimate that turned out to be too pessimistic.

Net realisable value

On the Balance Sheet, accounts receivable is shown at gross, less the allowance, to give net realisable value:

\text{Net realisable value} = \text{Accounts receivable} - \text{Allowance for doubtful debts}

Write-off then adjust the allowance

At year end, Tarin Ltd has accounts receivable of $80 000 and an existing Allowance for Doubtful Debts of$ 2 000. A customer owing $1 200 is confirmed uncollectable, and the allowance must then be adjusted to management's estimate.

Step 1: Write off the bad debt

Because an allowance already exists, the write-off goes against the allowance rather than to expense, keeping the Income Statement untouched at this step. The entry is debit Allowance for Doubtful Debts $1 200, credit Accounts Receivable$ 1 200. After the write-off, accounts receivable falls to $78 800 and the allowance balance falls to$ 800.

Step 2: Calculate the required allowance

Management estimates that 5 per cent of the remaining receivables will not be collected. Applying the rate to the post-write-off balance:

0.05 \times 78\,800 = 3\,940

This $3 940 is the closing allowance balance needed, not an additional charge on top of what already exists.

Step 3: Compute the adjustment needed

The allowance currently stands at only $800, so an additional$ 3 140 must be recognised as Doubtful Debts Expense to bring it up to the required $3 940. The entry is debit Doubtful Debts Expense$ 3 140, credit Allowance for Doubtful Debts $3 140. Only the top-up hits the Income Statement; the earlier write-off against the existing allowance was profit-neutral.

3\,940 - 800 = 3\,140 \text{ expense}

Step 4: Present net realisable value

On the Balance Sheet, accounts receivable is shown at its gross amount less the closing allowance, giving the amount the business expects to collect:

78\,800 - 3\,940 = 74\,860

Final answer: Doubtful Debts Expense is $3 140 and net realisable value of accounts receivable is$ 74 860.

Exam-style practice questions

Practice questions written in the style of SCSA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

WACE 20218 marksAt 30 June, Dorrin Ltd has accounts receivable of

120 000 and an Allowance for Doubtful Debts of

3 500. A customer owing $2 000 is confirmed uncollectable. Management then estimates the required allowance at 4 per cent of remaining receivables. Record the write-off and the allowance adjustment, calculate net realisable value, and state the total expense recognised.

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An 8 mark response needs the write-off, the new required allowance, the adjustment, and net realisable value.

Write-off. Debit Allowance for Doubtful Debts $2\,000$ , credit Accounts Receivable $2\,000$ . Receivables now $118\,000$ ; allowance now $1\,500$ .

Required allowance $= 0.04 \times 118\,000 = 4\,720$ . The allowance must rise from $1\,500$ to $4\,720$ , a top-up of $3\,220$ . Adjustment: debit Doubtful Debts Expense $3\,220$ , credit Allowance $3\,220$ .

Net realisable value $= 118\,000 - 4\,720 = 113\,280$ . The expense recognised this year is the $3\,220$ doubtful debts expense (the write-off itself hit the existing allowance, not the Income Statement).

Markers reward the write-off against the allowance, the correctly apportioned top-up (not the full $4\,720$ ), net realisable value, and identifying the expense as the adjustment only.

WACE 20235 marksDistinguish a bad debt from a doubtful debt, and explain how using an Allowance for Doubtful Debts applies the matching principle better than only writing off debts when they actually go bad.

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A 5 mark response needs the distinction and the matching argument.

A bad debt is a specific receivable now known to be uncollectable and is written off. A doubtful debt is an estimate at balance day of receivables that may not be collected, recognised through the Allowance for Doubtful Debts (a contra-asset).

Matching. The allowance recognises the estimated cost of uncollectable sales in the same period the sales revenue is earned, rather than waiting until a later period when specific debts are confirmed bad. Writing off only when debts actually fail would understate expenses in the year of sale and overstate them later, breaching the accrual basis. Markers reward the clear distinction and the explicit link to recognising the expense in the period of the related revenue.