Accounting for Recovery of Bad Debts

When cash is collected on account of a receivable that was previously written-off, it is recorded by reversing the write-off and debiting cash or bank. The exact journal entries that need to be passed however, depend on how the write-off of the receivable was recorded in the first place.

When an account receivable is reasonably expected to be uncollectible, it is written off either directly or through a bad debts provision account, in the period in which it becomes uncollectible. Since the write-off decision is based on judgment, it may eventually be collected. For example, cash may be received against a written-off account receivable when the customer’s financial situation improves or when its assets are liquidated to pay its debts, etc.

In case of bad debts that were written-off directly, the subsequent recovery results in an increase in cash and decrease of bad-debts expense for the current period. I doesn't matter if the receivable was written-off in a prior year.

On the other hand, if bad debts are accounted for using allowance / provision method, the reversal involves increase i.e. a credit in bad debts allowance and an increase in cash or bank. These are illustrated below.

Journal entries

Where bad debts were directly written-off without using a provision for bad debts account, the reversal will involve the following journal entries:

  1. To reverse the write-off of the debt:
    Accounts receivableABC
    Bad debts expenseABC
  2. To record the collection of cash:
    BankABC
    Account receivableABC

Where bad debts were initially accounted for using allowance for bad debts, the reversal will be performed using the following journal entries:

  1. To reverse the write-off of the debt:
    Accounts receivableABC
    Provision for bad debtsABC
  2. To record the collection of cash:
    BankABC
    Account receivableABC

As seen in the above journal entries, the direct write-off method can potentially misstate the bad debts expense between the periods because a write-off from previous period may results in a gain in current period if the receivable is eventually recovered. The allowance method for bad debts mostly resolves this problem as long as the estimate set at the end of previous period is reasonably accurate and takes into the account, the chances of any recoveries.

Example

Redway, Inc. (RD), a major client of Pluscore, LLC (PS) went bankrupt in financial year 20X4. At the time of its bankruptcy, RD owed PS an amount of $3.5 million. During the financial year ended 31 December 20X4, PS wrote off RD account as follows because it expected zero recovery.

Provision for bad debts$3,500,000
Accounts receivable$3,500,000

In the first half of the financial year 20X5, a court appointed a major accounting firm as RD liquidator which had significant success in getting maximum cash for the company’s assets. In the second half of the financial year 20X5, PS received a cash of $2,100,000 as the final settlement of $3.5 million due to it from RD.

PS shall recognize the recovery by proportionately reversing the related write-off:

Accounts receivable$2,100,000
Provision for bad debts$2,100,000

Cash received is recorded as follows:

Cash$2,100,000
Accounts receivable$2,100,000

by Irfanullah Jan, ACCA and last modified on

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