Provision for Bad and Doubtful Debts: An Overview

Provision for bad and doubtful debts refers to the amount set aside by a business in anticipation of actual bad debts that may arise in the future. It is a provision made by businesses to account for potential losses due to non-payment of debts by customers.

Reasons for Creating Provision for Bad and Doubtful Debts

There are several reasons why businesses create provisions for bad and doubtful debts. These include:

1. Uncollectible Debts: Some customers may default on their payment obligations, resulting in losses for the business. Creating a provision helps to account for these potential losses.

2. Prudence: Businesses follow the principle of prudence, which means that they should anticipate and provide for potential losses. By creating a provision, businesses ensure that their financial statements reflect a realistic picture of the company's financial position.

3. Matching Principle: The provision for bad and doubtful debts helps in adhering to the matching principle of accounting. This principle states that expenses should be recognized in the same accounting period as the related revenue. By creating a provision, businesses match the potential losses with the revenue generated from the sales.

Methods of Creating Provision for Bad and Doubtful Debts

There are two common methods used for creating provision for bad and doubtful debts:

1. Percentage of Sales Method: Under this method, a certain percentage of sales is set aside as a provision for bad debts. The percentage is based on historical data and industry norms. This method assumes that a certain proportion of sales will eventually become bad debts.

2. Ageing of Receivables Method: This method categorizes the outstanding receivables based on their age. The older the receivable, the higher the probability of it becoming a bad debt. The provision is then calculated based on predetermined percentages for each category.

It is important to note that the provision for bad and doubtful debts is an estimate and may not accurately reflect the actual bad debts that will occur. Therefore, it is periodically reviewed and adjusted based on the business's experience and changes in economic conditions.

Conclusion

Provision for bad and doubtful debts is a prudent practice followed by businesses to account for potential losses due to non-payment of debts. It ensures that the financial statements reflect a realistic picture of the company's financial position. The provision can be created using methods such as the percentage of sales or ageing of receivables. However, it is important to review and adjust the provision periodically to ensure its accuracy.