Cost recovery method definition
/What is the Cost Recovery Method?
Under the cost recovery method, a business does not recognize any income related to a sale transaction until the cost element of the sale has been paid in cash by the customer. Once the cash payments have recovered the seller's costs, all remaining cash receipts (if any) are recorded in income as received. This approach is to be used when there is considerable uncertainty regarding the collection of a receivable. This is by far the most conservative of all revenue recognition methods. Realistically, its use calls into question why the seller is even doing business with the buyer.
The Theory Behind the Cost Recovery Method
The reasoning for having a cost recovery method is that there are times when the receipt of payments from customers is so uncertain that it makes no sense to recognize any profit until the cash is in hand. Otherwise, a business might recognize a profit at the point of sale, and then recognize a large loss several months later when the customer does not pay. This can trigger some consternation by the seller’s owners, who will never know if the profits being recognized are realistic. Hence, the need for the cost recover method.
Accounting for the Cost Recovery Method
The mechanics of the cost recovery method are as follows:
Revenue and cost of sales are both recognized when a sale transaction occurs, while the gross profit associated with the sale is initially deferred.
When cash is received, apply all of it to recover the cost of goods sold.
After the entire cost of goods sold has been recovered, recognize all remaining cash receipts as profit.
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Example of the Cost Recovery Method
Hammer Industries sells a jack hammer to a customer on 12/31/X1 who has a questionable history of making payments in a timely manner. The sale price is $2,500. The cost to Hammer for the jack hammer was $1,875. Hammer requires the customer to make an initial $500 down payment at the time of sale, and requires that the remaining $2,000 be paid in equal installments over the next four years, including a high 15% interest rate that is based on the risk incurred by Hammer in extending credit to the customer. Based on these facts, Hammer can recognize the various customer payments in the following manner:
