A provision for doubtful debts is an estimate set aside by a business to cover potential losses from customers who may not pay their invoices. There are several key reasons why a business maintains such a provision:

• Realism and Accuracy: It provides a more realistic and accurate representation of a business's assets. Instead of overstating the value of accounts receivable, the provision acknowledges the possibility that some debts may be uncollectible.
• Matching Principle: The provision for doubtful debts aligns with the matching principle of accounting. This principle requires expenses to be recognized in the same period as the revenues they helped to generate. By recognizing a potential expense (bad debts) in the same period as the sale of goods or services, the financial statements provide a more accurate picture of profitability.
• Compliance with Accounting Standards: Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) require businesses to assess and provide for potential bad debts. Failure to do so could lead to misrepresentation of the company's financial position.
• Investor Confidence: A properly calculated provision for doubtful debts demonstrates financial prudence and helps to build investor confidence. It shows that the business is managing its risks effectively.
• Accurate Profitability Assessment: By reducing the carrying amount of accounts receivable, the provision for doubtful debts ensures that the profit figure reported on the income statement is not overstated. This provides a more accurate assessment of the business's performance.

The impact on the financial statements is significant. The provision reduces the carrying value of accounts receivable on the balance sheet. It also reduces profit on the income statement, providing a more realistic view of the business's profitability. A well-maintained provision helps to present a more reliable and trustworthy financial picture.

Journal Entry:

Ledger Accounts:

Debtors Account (Ms. Smith)

Explanation: The journal entry debits the Debtors account (increasing the balance) and credits the account from which the debt was previously written off. The ledger accounts show the initial write-off, the partial payment, and the resulting final balance.

Businesses employ various methods to estimate the amount of doubtful debts. The most common methods include:

• Percentage of Sales Method: This method calculates the provision as a percentage of credit sales. The percentage is based on the historical experience of the business with bad debts.
• Aging of Accounts Receivable Method: This method categorizes accounts receivable by how long they have been outstanding (e.g., 30-60 days, 60-90 days, over 90 days). A higher percentage is applied to older debts, reflecting a greater likelihood of non-payment.
• Creditworthiness Assessment Method: This method involves assessing the creditworthiness of individual customers and assigning a probability of non-payment to each. The provision is then calculated based on the weighted average of these probabilities.

Percentage of Sales Method:

Advantages: Simple to calculate and easy to understand. It requires minimal record-keeping.

Disadvantages: Does not take into account the age of the debts, meaning that it may not accurately reflect the risk of non-payment. It can be inaccurate if the business's credit policies change.

Aging of Accounts Receivable Method:

Advantages: More accurate than the percentage of sales method because it considers the age of the debts. Older debts are more likely to be uncollectible. Provides a more realistic estimate of bad debts.

Disadvantages: More complex to calculate than the percentage of sales method. Requires detailed record-keeping of the age of accounts receivable. The percentages applied to each age category may need to be adjusted periodically.