Receivables adjustments - Recoveries of bad debts

Learning Outcomes

After reading this article, you will be able to explain how to account for recoveries of previously written-off bad debts, record the correct double-entries for such recoveries, and identify their effects on the statement of profit or loss and the statement of financial position. You will also be able to distinguish recovered bad debts from the allowance for receivables and irrecoverable debts.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how businesses account for debts that were thought to be uncollectible but are subsequently recovered. This area is examined through topics such as:

• The definition and accounting treatment of irrecoverable debts (bad debts)
• Preparation of accounting entries to record the cash received from previously written-off debts
• Adjustments to the irrecoverable debts expense account after recoveries
• The impact of recovered bad debts on financial statements (statement of profit or loss and statement of financial position)
• Distinction between irrecoverable debts, allowance for receivables, and recoveries

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. When a previously written-off debt is unexpectedly paid by the customer, which accounts need to be adjusted?
   1. Only the trade receivables account
   2. Only the irrecoverable debts expense account
   3. Cash at bank and irrecoverable debts expense
   4. Cash at bank and allowance for receivables

2. True or false? Recoveries of bad debts must be recognized as income in the statement of profit or loss for the period in which they are received.

3. Which is the correct double-entry when recovering a previously written-off bad debt?
   1. Debit Trade receivables, Credit Allowance for receivables
   2. Debit Cash at bank, Credit Irrecoverable debts expense
   3. Debit Irrecoverable debts expense, Credit Trade receivables
   4. Debit Allowance for receivables, Credit Cash at bank

4. Briefly explain why the recovery of a previously written-off debt does not affect the trade receivables (accounts receivable) total in the statement of financial position.

Introduction

Entities selling goods or services on credit risk non-payment from customers. If a customer defaults and collection is deemed impossible, the debt is written off as "irrecoverable" (bad debt) and removed from the trade receivables balance. Sometimes, however, an amount previously written off is unexpectedly recovered. Understanding the correct accounting treatment for such recoveries is critical for giving an accurate view of financial performance and for meeting ACCA FA2 exam requirements.

Key Term: irrecoverable debt
A receivable that is considered to be uncollectible and is removed from the accounts, with the value written as an expense.

Key Term: recovery of bad debt
Cash received relating to a debt previously written off as irrecoverable in earlier accounting periods. Treated as income on receipt.

Key Term: irrecoverable debts expense
The account in the statement of profit or loss where amounts written off and recoveries are recorded, reflecting the net impact on profit for the period.

Accounting for Recoveries of Bad Debts

What Happens When a Bad Debt Is Recovered?

A customer may settle a debt after it was written off in the past, perhaps due to improved finances or a legal settlement. Because the trade receivable has already been removed, the entity cannot simply reverse the original write-off. Instead, the receipt is treated as new income.

Double-Entry Required

The cash received is debited to the cash at bank account and credited to irrecoverable debts expense. This reflects a reduction in expenses (or an increase in income) in the current period.

Double-entry:

• Debit: Cash at bank (asset increases)
• Credit: Irrecoverable debts expense (expense decreases/income increases)

No entry is made to the trade receivables account, as the debt has already been removed from the records in the earlier period.

Effect on the Financial Statements

• Statement of profit or loss: The credited amount to irrecoverable debts expense reduces the total expense, effectively increasing net profit for the period in which the recovery is made.
• Statement of financial position: The increase in cash is offset by reduced expenses, with no effect on trade receivables balance.

Alternative Approach (Two-Step)

Some systems may temporarily reinstate the receivable before recording the cash, using two double-entries:

1. Debit: Trade receivables, Credit: Irrecoverable debts expense (to reinstate)
2. Debit: Cash at bank, Credit: Trade receivables (to record receipt)

The net effect is identical: income is recognized and cash increases.

The Role of Irrecoverable Debts Expense

The irrecoverable debts expense account is used to record both amounts written off as bad debts and any monies subsequently recovered from written-off debts. The total in this account is the net expense shown in the statement of profit or loss.

Key Term: trade receivables
Customers who owe the business money for goods or services supplied on credit.

Comparison with Allowance for Receivables

Recovered bad debts should not be confused with the allowance for receivables, which relates to debts still uncertain but not yet written off. Recoveries relate only to debts previously removed from trade receivables.

Worked Example 1.1

Worked Example 1.1

A business writes off a customer debt of $600 in December 20X7. In February 20X8, the customer pays back the $600.

Question: What double-entry should be made when the $600 is received in 20X8?

Answer:
Debit: Cash at bank $600
Credit: Irrecoverable debts expense $600
This records the recovery as income and increases cash. The trade receivables account is unaffected because the debt was already removed.

Exam Warning

Exam Warning Never credit the trade receivables account directly for recoveries of previously written-off debts. Only use cash at bank and irrecoverable debts expense.

Worked Example 1.2

Worked Example 1.2

Last year, Terry Ltd wrote off a debt of $400 from N Singh. This year N Singh pays $250 as part settlement.

Question: How is this part recovery recorded in the accounts?

Answer:
Debit: Cash at bank $250
Credit: Irrecoverable debts expense $250
Only the amount actually received is recorded; no action is taken for the remaining balance.

Summary

When previously written-off debts are recovered, they are recorded as income using a credit to the irrecoverable debts expense account. This ensures profit is correctly increased for the current period. The trade receivables account is never affected for recoveries, as the debt has already been removed. Always use the correct double-entry to comply with ACCA FA2 standards.

Key Point Checklist

This article has covered the following key knowledge points:

• Define irrecoverable debts and recoveries of bad debts
• Record the correct double-entry for bad debt recoveries
• Explain the impact on the profit or loss and financial position statements
• Identify the separation between recoveries, irrecoverable debts, and the allowance for receivables

Key Terms and Concepts

• irrecoverable debt
• recovery of bad debt
• irrecoverable debts expense
• trade receivables