Cost Recovery MethodExplained & Defined

The cost recovery method is a form of revenue recognition in which a business will only recognize profit from a sale once the cash collected outweighs the cost of the good or service sold.

This is one of the most conservative methods of revenue recognition and is typically used when there is considerable uncertainty regarding the ability to collect on a receivable.

Understanding the Cost Recovery Method

The cost recovery method is a form of revenue recognition which is the point at which income becomes revenue.

The cost recovery method is a form of revenue recognition that is designed to account for situations in which it is uncertain whether income will be realized off of a sale.

As a result, income will only be recognized under the cost recovery method once the cost of providing the goods or services has been recovered in cash.

After the cost of the product has been collected, all remaining receipts of cash will be recorded as income by the seller.

Example of the Cost Recovery Method

As an example, let’s consider High Tech Computers, which is a vendor providing computers to businesses.

At the start of its accounting period, High Tech Computers acquired $300,000 worth of equipment which is then sold to several customers for a total of $400,000.

This would equate to a profit of $100,000, but High Tech Computers is not certain what recovery rate it can expect from its customers.

As a result, the company chooses to use the cost recovery method to recognize the revenue from these sales.

In the first quarter of High Tech Computer’s accounting period, it sold $300,000 worth of inventory, and in the remaining three quarters, it received payments of $220,000, $100,000, and $80,000, sequentially.

Here is what this looks like:

1st Quarter	2nd Quarter	3rd Quarter	4th Quarter
($300,000)	$220,000	$100,000	$80,000

Under the cost recovery method, no profit will be recognized until costs have been recovered.

For High Tech Computers, profits will be recognized starting in the third quarter when payments from customers exceed its costs in making the sale.

Specifically, it would recognize profit of $20,000 in the third quarter and $80,000 in the fourth quarter.

Here is how High-Tech Computers would prepare journal entries for these sales:

Date	Account Title	Debit	Credit
Quarter 1	Sales Revenue	$400,000
	Cost of Goods Sold		$300,000
	Deferred Gross Profit		$100,000

 

Date	Account Title	Debit	Credit
Quarter 2	No Entry

 

Date	Account Title	Debit	Credit
Quarter 3	Deferred Gross Profit	$20,000
	Realized Gross Profit		$20,000

 

Date	Account Title	Debit	Credit
Quarter 4	Deferred Gross Profit	$80,000
	Realized Gross Profit		$80,000

How the Cost Recovery Method Affects Earnings

In the example using High Tech Computers, if the sale were accounted on as an ordinary sale, the profit would have been immediately recognized, and the company’s earnings would have been affected accordingly.

However, under the cost recovery method, payment is uncertain, and as a result, no earnings are recognized until cash payments exceed the cost of making the sale.

Because of this, High Tech Computers did not recognize earnings from this sale until its third quarter.

This method of accounting means that no earning will be recognized until the cost of making a sale has been recovered, and correspondingly tax payments for these sales will not be made until this occurs as well.

Advantages and Disadvantages of the Cost Recovery Method

Advantages of the Cost Recovery Method

• The cost recovery method can protect businesses in transactions that have a high potential for non-payment.
• Using the cost recovery method ensures that tax payments only have to be made once the cost of a product has been recovered. This ensures that the company has the cash to make these payments.

Disadvantages of the Cost Recovery Method

• When using the cost recovery method, a company will see a delay in recognizing gross profit, which could leave a negative impression on potential investors.
• The cost recovery method could make financial statements more confusing for analysts as the period in which a company makes a sale and the period in which the profit is recorded may not match.

Key Takeaways

• The cost recovery method is a form of revenue recognition that only recognizes profits once the seller has recovered their costs.
• The cost recovery method is used in instances where there is a significant degree of uncertainty regarding repayment.
• The cost recovery method may be used in situations where a company provides goods or services to customers on credit.