Let us understand this with the help of an example. Ramesh makes credit sales to Naresh for Rs.3000. Journal entry for this in the books of Ramesh will be:
Naresh A/c Dr. 3000
To Sales A/c 3000
Naresh does not pay Rs.3000 on due date. Ramesh makes several attempts to recover his dues from Naresh, but Naresh did not pay because of his bad financial situation. Assuming this to be a bad debt, Ramesh writes off Naresh's account from his books. Journal entry for that will be:
Bad Debts A/c Dr. 3000
To Naresh A/c 3000
After 3 months Naresh's financial situation improves and he pays his dues of Rs.3000. What shall be the journal entry for this receipt? I give you two options:
1. Cash A/c Dr. 3000
To Naresh A/c 30000
2. Cash A/c Dr. 3000
To Bad Debts Recovered A/c 3000
Now let us discuss both the journal entries.
If we pass the entry stated at sl. no. 1 above, then Naresh’s A/c will stand credited in Ramesh’s books. A credit balance in a Personal Account represents a liability. Is amount standing at the credit of Naresh’s Account a liability for Ramesh? Certainly not. So to avoid this situation we will treat this receipt of Rs.3000 from Naresh as an income. So the right entry will be entry shown at sl. no. 2 above.