Why provision for doubtful debts is created? How it is show in the balance sheet
Answers
The provision for doubtful debts is the estimated amount of bad debt that will arise from accounts receivable that have been issued but not yet collected. It is identical to the allowance for doubtful accounts. The provision is used under accrual basis accounting, so that an expense is recognized for probable bad debts as soon as invoices are issued to customers, rather than waiting several months to find out exactly which invoices turned out to be uncollectible. Thus, the net impact of the provision for doubtful debts is to accelerate the recognition of bad debts into earlier reporting periods.
A business typically estimates the amount of bad debt based on historical experience, and charges this amount to expense with a debit to the bad debt expense account (which appears in the income statement) and a credit to the provision for doubtful debts account (which appears in the balance sheet). The organization should make this entry in the same period when it bills a customer, so that revenues are matched with all applicable expenses (as per the matching principle).
The provision for doubtful debts is an accounts receivable contra account, so it should always have a credit balance, and is listed in the balance sheet directly below the accounts receivable line item. The two line items can be combined for reporting purposes to arrive at a net receivables figure.
Later, when you identify a specific customer invoice that is not going to be paid, eliminate it against the provision for doubtful debts. This can be done with a journal entry that debits the provision for doubtful debts and credits the accounts receivable account; this merely nets out two accounts within the balance sheet, and has no impact on the income statement. If you are using accounting software, create a credit memo in the amount of the unpaid invoice, which creates the same journal entry for you.
It is highly unlikely that the provision for doubtful debts will always exactly match the amount of invoices that are actually unpaid, since it is only an estimate. Thus, you will need to adjust the balance in this account over time to bring it into closer alignment with the ongoing best estimate of bad debts. This can involve an additional charge to the bad debt expense account (if the provision appears to initially be too low) or a reduction in the expense (if the provision appears to be too high).
I'll give you a very simple answer just for your understanding instead of confusing you with heavy words.
Provision is an amount we set aside from the profit for a possible loss or liability...it's very much possible that the debt arising from the credit sale of year 1 may prove bad in year 2. Such bad debt is a loss of year 1.To overcome such a loss a specific amout is set aside to take care of the loss that might occur...You can say it's a precaution. Doubtful debts are debts which may or may not be a loss for us but just so we don't face the possible loss we take this precaution to keep our business going.
In the balance sheet it is deducted from the debtors .
I hope this answers your question. If it doesn't then I am sorry I tried.