Bad debt recovery

Bad debt recovery is a payment received for a debt that was written off and considered uncollectible. The receivable may come in the form of a loan, credit line, or any other accounts receivable. Because it generally generates a loss when it is written off, 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. (By Julia Kagan Updated May 23, 2020, Reviewed by Thomas Brock) Debt recovery refers to the process of making people or companies pay the money that they owe to other people or companies, when they not paid back the debt at time that was arranged by two parties (Cambridge school of finance 2016).

Debt in businesses

Every business carries the risk of uncollectible claims. The most significant part occurs in several sectors such as:

1. manufacturing sector
2. trade sector
3. banking sector
4. healthcare sector and others.

In periods of economic crises, the number of companies that get into difficulties increases, which results in losses in business and increased problems in the collection of claims and a greater number of bankruptcies. The most important segment of working capital management in difficult business conditions is the collection of receivables, which should ensure an adequate amount of funds and liquidity. Banking business is specific and different from the business of a non-financial company. The bank, professionally and continuously approving loans as its most important active business, assumes the credit risk, i.e. the risk of non-payment by the debtor. In order to preserve the stability of operations, the bank sometimes applies the strategy of selling risky receivables in order to preserve liquidity and reduce risk in operations. A sudden increase in the share of bad loans can create stagnation and serious difficulties in banking operations, and consequently in the entire economy. (Žager, Hrvoje Master's thesis / Diplomski rad 2021) Also, for example the healthcare industry is often plagued by unpaid bills, collection agency fees, and outstanding medical testing costs. All these factors contribute significantly to the rising cost of healthcare. Health care providers often have to treat patients on credit, especially in emergency and trauma cases. Unlike financial institutions health care providers do not collect financial information about their patients. This lack of information makes it difficult to evaluate whether a particular patient-debtor is likely to pay bill. In recent years researchers have started to recognize the potential of data mining methods in improving our understanding of medical bad-debt, but there is relatively little research that examines the effectiveness of data mining methods in classifying bad debt in healthcare. (A Neuro-fuzzy Approach to Bad Debt Recovery in Healthcare, by Donghui Shi, Jozef Zurada, Jian Guan, 2014, 47th Hawaii International Conference on System Science)

Reduction of debts

In an effort to reduce the share of uncollectible debts, institutions and companies take various preventive measures, but also try to collect debts that have already been defined as uncollectible. The term bad debt refers to an amount of money that a creditor must write off as a result of a default on the part of the debtor. If a creditor has a bad debt on the books, it becomes uncollectible and is recorded as a charge-off. (By Alicia Touvila Updated March 22, 2022, Reviewed by Somer Anderson, Fact checked by Kirsten Rohrs Schmitt) Many bad debts are difficult to collect and are often written off. In most cases, a company has taken many steps before deeming it a bad debt including in-house and third-party collections or even legal action. Collection efforts may still take place after the debt is written off. Payment can still be made after the debt is written off, making it a bad debt recovery. Payment may come as partial payment from a bankruptcy trustee or because the debtor has decided to take a settlement to clear off the debt at a lower amount. The bad debt may also be recovered if a piece of collateral is sold. Bad debt is inevitable, as companies will always have customers who won't fulfill their financial obligations. That's why there is a high demand for bad debt recovery companies or (third-party) collection agencies. Any action taken with the bad debt must be noted in the company's books. When the debt is written off, it must be accounted for as a loss. If it is recovered, the company must reverse the loss. So when a business writes off a bad debt in one tax year and recovers some or all of the debt in the following tax year, the tax administration 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 does 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, the tax administration allows tax filers to write off non-business bad debts. These debts must be completely not collectible, and the taxpayer must be able to prove 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 the debtor is insolvent or has declared bankruptcy is significant proof. 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. (By Julia Kagan Updated May 23, 2020, Reviewed by Thomas Brock) In the sale of uncollectible receivables, the party that is ready to sell the receivables and the party that is ready to buy the same receivables at a certain purchase price participate. The party buying the receivables usually pays 10-30% of the total value of the receivables. In this way, the party that sells the claim clears the balance sheet of hard-to-collect receivables and obtains liquid funds, while the party that buys creates the possibility of earning in the future after collecting the receivables. In addition to easier access to liquid assets, the sale of bad debts improves cash flow, collection becomes more efficient, and the institutions become more competitive, and it is easier to protect itself from the risk of non-payment. (Žager, Hrvoje Master's thesis, 2021)

References

• Barukčić, A., [2015], Naplata potraživanja kao dio poslovnog procesa komercijalne banke, https://repozitorij.efzg.unizg.hr/islandora/object/efzg:832
• Kagan, J., [2020], Bad Debt Recovery, https://www.investopedia.com/terms/b/-debt-recovery.asp
• Nikšić, N., [2022] Naplata potraživanja , https://hgk.hr/documents/naplatapotrazivanja58aee6515fdfe.pdf
• Sakind, V., [2015] Debt Recovery and Financial Performance of Commercial banks in Rwanda http://197.243.10.178/bitstream/handle/123456789/5489/DEBT%20RECOVERY%20AND%20FINANCIAL%20PERFORMANCE%20OF%20COMMERCIAL%20BANKS%20IN%20RWANDA.pdf?sequence=1
• Shi, D., Zurada, J., Guan, J., [2014], A Neuro-fuzzy Approach to Bad Debt Recovery in Healthcare, https://ieeexplore.ieee.org/stamp/stamp.jsp?tp=&arnumber=6758961
• Touvila, A., [2022], What is Bad Debt? Write Offs and Methods for Estimated, https://www.investopedia.com/terms/b/baddebt.asp
• Žager, H., [2022] Učinak prodaje nenaplativih kredita na poslovanje banaka, https://zir.nsk.hr/islandora/object/efzg:7368

Author: Ivana Miškić