When an amount previously written off as a bad debt is paid after all, this is known as a bad debt recovery. The accounting treatment accorded a recovered bad debt depends on whether the business uses the cash or accrual basis of accounting.
When an accounts receivable balance appears to be uncollectible, many businesses write it off as a bad debt. Doing so takes the uncollected debt off the books so that the accounts receivable balance relates more closely to the amount that will be collected. How the bad debt is handled on the books depends on whether the business is on the accrual or cash basis. If the business uses the cash basis of accounting, no entry is necessary to write off or recover a bad debt. Money is simply recorded as it is received. Accrual based accounting does require entries, however, to properly record the recovery of bad debts.
Businesses that engage in recovery of bad debt accounting do so by setting up an "Allowance for Bad Debts" account. Based on past experience or the best estimate it can make, the business makes an entry to reduced taxable income by the amount of bad debt expected (the allowance amount). When the business decides that a particular account receivable cannot be collected, it taps into the allowance to pay for the debt, making a credit entry to accounts receivable balance and debit to bad debt expense.
When a bad debt recovery takes place, another accounting entry is required. In the case of a recovered bad debt, accounts receivable would be debited for the amount recovered while the allowance account would be credited. In addition, cash would be debited for the same amount, while accounts receivable would be credited. While the debit and credit to accounts receivable are basically a "wash," they do create a good paper trail of the bad debt recovery.
Recovery of bad debt accounting keeps the income statement more accurate when a bad debt occurs. By creating a reasonable allowance for bad debts whenever income is earned, the use of an allowance account effectively matches the future expected bad debt expense with the appropriate income. Thus an "Allowance for Bad Debts" is like a savings account for bad debts, helping the business to plan ahead and set aside funding for bad debts. In addition, an allowance for bad debts also helps to prevent the business from paying taxes on the percentage of income that will eventually become a bad debt.
To account for bad debt recovery, a business must have some historical idea of the percentage of sales that will result in bad debts. Otherwise, no estimation of bad debts can be made. Also, companies that require their financial statements to reflect a bad debt allowance and the recovery of bad debts will necessarily have to be on the accrual basis of accounting since, as mentioned earlier, cash basis fails to take bad debt into consideration.
Auditors like to keep an eye on the level of bad debt recovery. If a high percentage of accounts written off as bad debts are later recovered, the allowance for bad debts could be too high. Conversely, a low allowance for bad debts, with large write-offs later, could be a sign of financial statement manipulation--where a company doesn't want the bank or others to know that a significant percentage of the accounts receivable balance is uncollectible.
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