Bad debt recovery definition
/What is Bad Debt Recovery?
A bad debt recovery is a payment received after it has been designated as uncollectible. This may occur after legal action has been taken to recover a receivable, as a partial payment from a bankruptcy administrator, the acceptance of equity in exchange for cancellation of the receivable, or some similar situation. It could also arise simply because an invoice was written off too soon, before all possible collection alternatives had been explored.
A bad debt recovery can also come from the sale of a borrower's collateral. For example, a lender might repossess a car after a borrower on a car loan has been delinquent in making payments. The lender sells the car, and the proceeds from the sale are considered a bad debt recovery.
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Credit and Collection Guidebook
Accounting for a Bad Debt Recovery
The accounting for a bad debt recovery is a two-step process, as noted below:
Reverse the original recordation. The first step is to reverse the original recordation of a bad debt. This means creating a debit to the accounts receivable asset account in the amount of the recovery, with the offsetting credit to the allowance for doubtful accounts contra asset account. If the original entry was instead a credit to accounts receivable and a debit to bad debt expense (the direct write-off method), then reverse this original entry.
Record the cash receipt. The second step is to record the cash receipt from the bad debt recovery, which is a debit to the cash account and a credit to the accounts receivable asset account.
In effect, this process reverses a loss on the assumed bad debt, replacing it with income in a later reporting period. This increases the amount of taxable income in the period in which the bad debt recovery is recorded.
Tax Treatment of a Bad Debt Recovery
The tax treatment of a bad debt recovery depends on whether the taxpayer previously claimed a deduction for the bad debt. The options are as follows:
Previously deducted bad debt. If a business previously wrote off a bad debt and claimed a tax deduction (usually under the accrual method of accounting), then any recovery of that debt in a later year is taxable income in the year it is received. This follows the tax benefit rule, which requires that recovered amounts be included in income to the extent they previously reduced taxable income.
No prior deduction taken. If the taxpayer did not claim a deduction for the bad debt in a prior year, then the recovery is not taxable, as it did not provide a previous tax benefit.
For example, a company writes off a $5,000 customer account in 2023 and deducts it as a bad debt. In 2025, the customer unexpectedly pays $3,000. The company must report the $3,000 as taxable income in 2025, since it previously benefited from a deduction.
This ensures tax neutrality by preventing a double tax benefit.