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Bad Debt Recovery + SUBSCRIBE SHARE
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What is a 'Bad Debt Recovery'
A bad debt recovery is business debt from a loan, credit line or accounts receivable that is recovered either in whole or in part after it has been written off or classified as a bad debt. Because it generally generates a loss when it is written off, a bad debt recovery usually produces income. In accounting, the bad debt recovery credits the allowance for bad debts or bad debt reserve categories and reduces the accounts receivable category in the books.
BREAKING DOWN 'Bad Debt Recovery'
Not all bad debt recoveries are like-kind recoveries. For example, a collateralized loan that has been written off may be partially recovered through sale of the collateral, or a bank may receive equity in exchange for writing off a loan, which could later result in recovery of the loan and, perhaps, some additional profit.
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How to Report Bad Debt Recoveries to the IRS
If a business writes off a bad debt in one tax year and recovers some or all of the debt in a following tax year, the Internal Revenue Service requires the business to include the recovered funds in its gross income. The business only has to report the amount of the recovery equal to the amount it previously deducted. However, if a portion of the deduction did not trigger a reduction in the business's tax bill, the business does not have to report that part of the recovered funds as income. In some cases, bad debt deductions do not reduce tax in the year they are incurred, but they create a net operating loss (NOL). These losses carry over for a set number of years before they expire. If a business's bad debt deduction triggered an NOL carryover that has not expired, that constitutes a tax deduction, and thus, the bad debt recovery must be reported as income. However, if the NOL carryover has expired, the business essentially never received the tax reduction and thus does not need to report the corresponding recovery.
Recovering Nonbusiness Bad Debts
In some cases, the IRS allows tax filers to write off nonbusiness bad debts. These debts must be completely not collectible, and the taxpayer must be able to prove that he did as much as possible to recover the debt. However, the filer does not have to take the debtor to court. In most cases, showing that the debtor is insolvent or has declared bankruptcy is significant proof. For example, if someone lent his friend or neighbor money in a transaction completely unrelated to either of their businesses, and the borrower failed to repay the loan, that is a nonbusiness bad debt, and the taxpayer may report is as a short-term capital loss. If the debt is repaid after it was claimed as a bad debt, the tax filer has to report the recovered funds as income. However, he only needs to report an amount equal to the bad debt deduction that reduced his tax obligation in the year he claimed the bad debt.
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Bad Debt Expense + SUBSCRIBE SHARE
Bad debt expense represents the amount of Video Definition uncollectible accounts receivable that occurs in a given period. Bad debt expense Loading the player... occurs as a result of a customer being unable to fulfill its obligation to pay an outstanding debt due to bankruptcy or other financial problems. This expense is the cost of a business having the inability to collect its debts.
BREAKING DOWN 'Bad Debt Expense'
Even if a receivable has been deemed uncollectible and written off to bad debt expense, the business retains the right to collect funds in the event of a bankruptcy court asset distribution or sudden change in the vendor’s ability to pay. Bad debt expense occurs because an entity extends credit to customers. Since a company may elect to forgo upfront payment, it incurs the risk of customers having the inability to pay for goods or services. Therefore, bad debt expense is used as a financial metric to determine if the credit and collection process is efficient.
Direct Write-Off vs. Allowance Method
There are two different application methods of recognizing bad debt expense. One is called the direct write-off method. Using this method, uncollectible accounts are specifically written off as they become uncollectible. This occurs upon receipt of a bankruptcy notice or after a specified period of time. Although the direct write-off method ensures the exact amount of uncollectible accounts is recorded, it fails to uphold the matching principle in which the expense is not always recognized in the same period as the revenue. For this reason, bad debt expense may be calculated using the allowance method. The allowance method establishes an estimated dollar amount of uncollectible accounts in the period the revenue is earned. Read More +
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