However cautious a business maybe, there will be some debtors regarding whom there is no certainty whether they will pay or not. So there is an element of doubt related to realisation of payment from some specific debtors. However, since there is still hope that the debts may be realised, we cannot classify them as bad debts and write them off in the current year. We only write off a debt as bad when all reasonable efforts to realise that debt have failed.
We have concluded above that we cannot write off a debt as bad that just because the recovery of the amount is doubtful. So what to do in this case? Can we as an accountant just ignore the doubt element? The answer is No. As per Doctrine of Conservatism, any anticipated business loss must be considered in the accounts and should be provided for in the current year. So whenever a business learns of doubtful accounts as they become increasingly overdue, it must create a provision for them when preparing its final accounts. This is done for the following two reasons:
- The sales ledger that is debtors ledger contains accounts that are doubtful as they are not written off and thus to show the debts at a realistic value in the balance sheet, amount of provision for doubtful debts must be deducted from the value of debtors.
- The anticipated loss from the doubtful debts must be charged as an expense against sales to which they relate. That means proper matching of bad debt losses is to be done against revenues of the same period.
Methods to estimate the amount of provision to be created:
Estimating the amount of provision to be created is a very crucial job as the correctness of the profit or loss of a particular period will depend on the correctness of the estimated amount. Over or under estimate will under book or over book the profits respectively. Let us see the methods in practice for estimating the amount of provision to be made:
- To decide on a percentage, based on past records and experience, of the total debtors at the end of the accounting period;
- To provide for specific dates considered likely to become bad;
- A combination of 1 and 2
The most widely used method is Method 1.
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