why people should create a provision for doubtful debts?

Answer 1

Any organisation dealing with (a lot of) customers/clients may find it difficult to realise the entire money towards various goods sold/serices provided during the ordinary course of business. These customers/clients lie as 'Debtors' in the books of account after the Company has sold the goods or provided sevices to them.
The non-realisation could be on account of various reasons for eg. bankruptcy of customers/clients, disputes or legal battle with them etc.
And if the organisation, having aware of these facts, discloses the debtors at their full value in the books, it will amount to showing a wrong picture of the current assets as of a paticular date.
This is why the debtors need to be discounted to the extent of their unrealisability to depict a correct picture of realisable debtors in the books.
And this discounting is called as 'Provision for bad and doubtful debts'. It requires mention here that the debtors are not written off fully in the books but are shown as follows:
Debtors:
Less: Provision for bad and doubtful debts

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Answer 2

Provision For Doubtful Debts

Answer 3

Provision for doubtful debts confirms to the basic principle of 'conservatism' where an accountant is prohibited from over estimating the profits. This provision indicates the extent of receivables i.e trade debts which are unlikely to be received. So it is charged as an expense in the Revenue statement. It reduces the profit and hence the tax payment is also reduced. This also gives time value of money to the firm (On the tax not paid today due to the provision created).

Also, creation of provision for doubtful debts is in compliance with Revenue and expense recognition principle which advocated that expenses should be recognised as soon as they are likely to be incurred. So if the company/person knows that some part of the receivable is not likely to be received it should be charged to the revenue statement as a provision for bad and doubtful debt. When the real default occurs the provision account is debited by the actual bad debt.

Answer 4

It is a way of telling you that not all of your receivables shown on your balance sheet are good (collectible assets), and the one that you have removed to the provision means have been charged as your loss (recorded as your expense on the certain years Profit/Loss report).

By law (in my country) then you'll be able to waive the receivable + its provision if it is proven uncollectible, the accounts must be able to meet certain criteria to be classified as proven uncollectible.

But, if the following years the receivable were really collected then you should recognize it as your income, coz you have charged it to your expense on the previous year when you were not sure of its collectibility (create a provision for doubtful accounts)

Agree to the previous answer, it's a conservatism in accountancy.

Answer 5

You have received good answers. I agree with them. I will add though that most consumer lenders borrow the money they lend out from corporate banks.

Those banks generally lend a set % of the companies net oustanding / receivables. They will not lend money on bad debts. Therefore, a set % is put aside to charge those bad debts to. The historical trend of the company guides in how much the % is. 4% is not unrealistic.

And yes, when the account is collected - it then goes as a profit. Charged off debt minus collected $ on charged off debt = net charge off. Where does that fit in the 4% mentioned above? That is one of the guidelines.

Clear as mud huh?

Answer 6

Simple answer- just go to the answers for credit or personal finance. 95% are talking and asking questions about how they did not pay their bills and how their credit is bad. Well the company already knows that percentage of their customers will not pay their bills for the goods/services purchased so they write them off as expense. Usually the percentage for bad debts is based on historical experience of the company.