Tidal Trails: Adjusting a Sole Trader’s Profit
Tania owns Tidal Trails, a sole trader selling kayaks and accessories. At 31 March 2025, her trial balance shows Accounts receivable $18,400, Allowance for doubtful debts $320 credit, Inventory $22,750, Equipment $48,000, Accumulated depreciation – equipment $19,200, Wages expense $62,300, Insurance expense $3,600, and Profit before adjustments $14,250. Additional information: wages owing at 31 March are $1,850; insurance of $1,200 was paid on 1 February 2025 for the six months to 31 July 2025 and is included in the $3,600; equipment is depreciated at 12% straight-line (residual value $4,800); an account of $900 from a customer who has been declared bankrupt is to be written off; the allowance for doubtful debts is to be 4% of remaining accounts receivable. Tania is unsure whether to treat the $900 as a bad debt or leave it in receivables because the customer promised to pay later.
1. Calculate the adjusted profit for the year ended 31 March 2025. Show the treatment of each adjustment and explain why each is made.
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Start with profit before adjustments: $14,250.
| Adjustment | Calculation | Effect on profit |
|---|---|---|
| Wages owing | $1,850 accrued | -$1,850 |
| Prepaid insurance | $1,200 × 4/6 = $800 prepaid; expense should be $2,800 | +$800 |
| Depreciation | ($48,000 - $4,800) × 12% = $5,184 | -$5,184 |
| Bad debt write-off | $900 irrecoverable | -$900 |
| Allowance increase | Required: 4% × ($18,400 - $900) = $700; existing $320; increase $380 | -$380 |
Adjusted profit = $14,250 + $800 - $1,850 - $5,184 - $900 - $380 = $6,736.
Reasoning: accrual accounting matches expenses to the period they relate to (wages, insurance). Prudence requires recognising the bad debt and a reliable estimate of doubtful debts. Depreciation allocates the equipment’s cost over its useful life.
2. Explain why the $900 should be written off rather than left in accounts receivable, and how the allowance for doubtful debts differs from the write-off.
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The $900 should be written off because the customer is bankrupt; it is not probable that future economic benefit will flow to Tania. Leaving it in accounts receivable overstates assets and profit and breaches prudence. A write-off is a specific debt removed from the ledger. The allowance for doubtful debts is a general estimate for the remaining receivables based on past experience; it does not remove a specific customer’s debt, but reduces the carrying amount of receivables to expected recoverable amount.
3. State one qualitative factor Tania should consider before increasing the allowance to 4%.
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She should consider whether 4% is based on reliable past evidence or is simply a prudent guess. Overstating the allowance understates profit and equity, which could breach a bank covenant or affect the sale value of the business. She should also consider the effect on her relationship with the bank and whether the estimate is consistent with prior years.