Why is provision for doubtful debts created?

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In this business world, most of the transactions take place on credit rather than cash so the amount of risk involved is high. To minimize this risk many organization decides to allocate a certain portion towards provision for all the future expenses and losses.

Provision is created because they account for particular company expenses and payments for the current year. This makes the organization financial statements look more precise. Provision is created from company profit to meet all the uncertain future obligations.

 

Meaning of Provision for Doubtful Debts

The term provision for doubtful debts refers to the estimated (or) predicted value of bad debts that arises 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 which may arise due to the credit sales so the organization needs to create a percentage of such provision on the net value of sundry debtors for complying with all the future uncertainties.

 

Example: ABC Ltd furnishes you with the following information about Total sales for the current accounting year

Particulars Amount
Total Sales – 6,00,000
Cash Sales – 2,00,000
Credit Sales – 4,00,000
Bad Debts – 40,000

The company decided to create a 5% provision of 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 5% provision on net value of sundry debtors

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

= 18,000

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