Why is provision for doubtful debts created?

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Introduction

In the world of business, most of the transactions take place on credit rather than cash. This involves risk as the guarantee to repay might be low due to the financial instability of the company. To minimize this risk many organization decides to allocate a certain portion towards provision for all the future expenses and losses.

Provisions are created for future losses and this helps to give accurate financial reports as future liabilities are calculated in advance. This makes the organization’s financial statements look more precise. Provisions are necessary by the accounting standards and regulatory authorities to ensure transparency and accuracy in financial reporting. Provision is created from company profit to meet all the uncertain future obligations.

Provision is created because it accounts for particular company expenses and payments for the current year.

Meaning of Provision for Doubtful Debts

Provision for doubtful debts is created based on historical data of bad debts, economic conditions, and the creditworthiness of customers. Provision for doubtful debts is an accounting practice where a company sets aside some amount for the possibility that the accounts receivable might not be recoverable.

In other words, the term provision for doubtful debts refers to the estimated (or) predicted value of bad debts that arise from the sundry debtors that have been issued but have turned out to be uncollectible. It takes place when a credit sale to the customer is made. Provision for Doubtful debt is a contra account and it is also known as Provision for bad debts.

Reason for creating Provision for Doubtful Debts

• In Accounting, Provision for Doubtful debts is created to abide by the conservatism convention and prudence principle which states that “don’t account for future anticipated profits but account for all possible losses”.
• Provision for Doubtful debts is an expense that occurs in the normal course of business.
• Various organizations create a provision for all the future expected expenses and losses that may arise due to credit sales so the organization needs to make a percentage of such provision on the net value of sundry debtors to comply with all the future uncertainties.

Example

ABC Ltd. furnishes you with the following information about Total sales for the current accounting year,

The company decided to create a 5% provision for doubtful debts on sundry debtors. Comment upon its decision.

Calculation of Provision for Doubtful Debts-

Step 1– Calculate the Net value of sundry debtors

Net Sundry Debtors = Sundry Debtors – Bad Debts

= 4,00,000 – 40,000 => 3,60,000

Step 2 – Create a 5% provision on the net value of sundry debtors

Provision for Doubtful Debts = 3,60,000 * 5/100

= 18,000

The decision to create a provision for doubtful debts will help the company mitigate (or) reduce all the future obligations and uncertainties that arise due to the bad debts.