Explanation:

Bad debts are debts that are considered unrecoverable and cannot be collected from the debtors. In this case, there are 20,000 debtors who are categorized as bad debts.

Creation of Provision for Doubtful Debts:

To account for potential losses from doubtful debts, a provision is created. A provision for doubtful debts is an estimated amount set aside by a company to cover potential losses from customers who may default on their payments. In this case, a provision of 5% is to be created for doubtful debts.

Reason for Creating Provision for Doubtful Debts:

The provision for doubtful debts is created to reflect the uncertainty and risk associated with collecting payments from debtors. It is a precautionary measure taken by companies to account for potential losses that may arise from customers failing to pay their debts.

Calculation of Provision for Doubtful Debts:

To calculate the provision for doubtful debts, the company applies a percentage to the total outstanding debtors. In this case, a provision of 5% is to be created.

The provision for doubtful debts can be calculated as follows:

Provision for Doubtful Debts = Total Outstanding Debtors * Provision Percentage

Application of Provision for Doubtful Debts:

Once the provision for doubtful debts is calculated, it is recorded as an expense in the company's financial statements. This expense reduces the company's net income and reflects the potential losses from doubtful debts.

The provision for doubtful debts is also shown as a contra-asset account in the balance sheet. It reduces the accounts receivable balance and reflects the estimated amount that may not be collected from debtors.

Conclusion:

In this scenario, a provision of 5% is to be created for doubtful debts. This provision is created to account for potential losses from debtors who may default on their payments. The provision for doubtful debts is calculated by applying the provision percentage to the total outstanding debtors. Once calculated, it is recorded as an expense in the financial statements and shown as a contra-asset account in the balance sheet.