Why is the Provision for Doubtful Debts a Liability?
Q: Why is the provision for doubtful debts a liability?
A provision is a loss or expense that will definitely occur in the future, but we don't know exactly how much or when the loss/expense will occur.
Usually a business decides (based on past records) that they expect a certain percentage of their debtors (receivables) not to pay them next year.
Let's say it's 5%. If their debtors come to $100,000, then they expect $5,000 to go "bad," and the real (net) debtors in their records will be $95,000 ($100,000 - $5,000).
The provision for doubtful debts or bad debts is different to doubtful debts or bad debts. Doubtful debts or bad debts is an expense and has already occurred. The provision is a future loss. A future loss that must be recorded as soon as it becomes likely to occur. This future loss is like owing someone. Sort of. So it is a liability. But a special type of liability.
In other words, doubtful debts or bad debts have already
occurred - the debt is bad right now
. For example, Joe Shmoe (debtor) owed you $500 and he just told you he is filing for bankruptcy and can't pay anything. So you record the loss (expense account) called doubtful debts or bad debts of $500.
The provision, on the other hand, is for debts that will definitely occur - but in the future
. The debts are not bad yet, but we are sure they will be bad. It is an estimate of bad debts in the future.
Please note that I only provide full lessons, examples and exercises about provision for bad debts (and bad debts) in my basic accounting book
, which you are welcome to purchase.