To know the accounting for bad debts recovered, it is necessary to know what bad debts are and how they arise.
When a company supplies goods to a customer or another business on credit, the company has to recognize the same amount of receivables in their books as to the value of sold items.
Let’s say after a certain period, our customer goes bankrupt and is not able to pay for our goods supplied to them.
We then recognize this as a loss which is called bad debts. Let’s assume that lately, our customer wants to pay either in full or in partial. We recognize the payment amount as our income. These are explained in detail below:
Receivables turn to bad debts:
Initially, a company recognizes a receivable amount owed by a customer to the company as a loss called bad debts.
When a company takes all the actions to make sure receivables are received in full. For example, they may take legal actions against the customer business if they don’t pay after official processes.
This makes the company believe that the receivables are no longer recoverable.
Let’s say the company has a receivable amount of $500 from ABC Company. After bankruptcy, the company will put the $500 receivable from ABC Company as bad debts.
This means that the company has recognized a loss against the receivables from ABC Company. The following accounting double entry will be passed in the books of the company:
Debit Bad debts $500 (P&L)
Credit Receivables account $500 (BS)
This entry will directly affect both the income statement and balance sheet. A bad debt amount of $500 will be recognized as expenses in the income statement, and the account receivable will be reduced by $500.
Read the full article on how to write off the account receivable
Bad debts recovered:
Bad debt recovery is the payment received that was previously written off against a company’s receivables.
As the bad debt creates a loss for the company initially when recorded as bad debt, bad debt recovery generates income for the company when they are recovered.
This recovered amount may be a partial payment received against the total of the written-off amount, or it may be a lower amount agreed with the company for the total written-off amount. In either case, the company will recognize it as income for the business.
The journal entry to record the bad debt recovered is debit cash and credit other income. The main reason that it is recorded as the other income since it is not the main source of income that the company generates from its normal business activities.
In the above example, we assumed that our business had a receivable amount of $500 against ABC Company. This total amount was expensed out as bad debt and was recognized as a loss or expense in the income statement.
Let’s assume, after a specific long time, ABC Company has started its operations again with improved performance and is wealthy now. They offered our company a settlement of $300 against the total amount of $500.
Our company has agreed to ABC Company and received a settled $300. As our company has recognized a loss recently, this will be turned back into income with the rest of $200 still as a loss.
Our company will perform the following account double entry after the payment is received from ABC Company.
Debit Cash/bank $300 (BS)
Credit Income $300 (P&L)
The receivables account is not affected in the last entry because we have already credited the receivables account.
Even if the further $200 is recovered from ABC Company, it will not affect the receivables account because in either case, the receivables account is credited by the whole amount.
Further $200 received will be treated the same as the $300 received from ABC Company.
When bad debts are recovered, the bad debts recovery account is other income in the income statement. It is the amount that the company collected or recovered from the account receivable that claim as uncollectable and was considered based on the company policies as bad debt. The entry to record this recover debt is debit cash and credit other income. In most cases, this other income is taxable.