What is the Cost Recovery Method?
Cost Recovery Method is one of revenue recognition methods in which the company does not record gross profit or income generated against the goods that are sold to the customer until the total cost element related to the respective sale have been received fully by the company from the customer and after whole cost amount has been received, remaining amount will be recorded as an income.
Examples of Cost Recovery Method
For example, Company A ltd. sells the goods on credit to its customers. For revenue recognition, the company follows the cost recovery method as there is uncertainty concerning the recovery rate of the money from many of the customers of the business. On September 1, 2016, it sold some goods on credit to one of its customers, Mr. Y, for $ 250,000. The cost of the goods sold for company A ltd was $ 200,000.
At the time of sale, the company received $ 50,000 instantly, and the company received the rest of the payments in the subsequent years. $ 50,000 were received in the year 2017, $ 100,000 in the year 2018, and the balance of $ 50,000 was received in the year 2019. When to recognize the profits of the company as per the cost recovery method?
According to the cost recovery method, the company will not record the gross profitRecord The Gross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. or the income generated against the goods that are sold to the customer until the total cost element related to the respective sale has been received fully by the company from the customer. After the whole cost amount has been received, the remaining amount will be recorded as an income.
- In the present case, the company sold some goods on credit to Mr. Y on September 1, 2016, for $ 250,000. The actual cost of the goods sold was $ 200,000.
- The company received the payment against the goods sold in installment. $ 50,000 were received instantly, $ 50,000 were received in the year 2017, $ 100,000 in the year 2018, and the balance of $ 50,000 in the year 2019.
- Now, $ 50,000 ($ 250,000 – $ 200,000) is the profit of the company which it will not recognize in the accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. in which the sales is made rather the same will be recognized as income in the period in which payment is received after recovering the cost of goods sold.
- Sum of amount received in year 2016, 2017 and 2018 is $ 200,000 ($ 50,000 + $ 50,000 + $ 100,000) which is equivalent to cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company., so, no earnings will be recorded in those years.
- However, the amount received above the cost of goods sold in the year 2019, amounting to $ 50,000, will be recorded as the earnings of the year 2019.
On October 1, 2013, the Sapphire Corporation, a steelmaker, sold some steel bars for $80,000. The customers are required to satisfy four equal yearly payments of $20,000 along with interest payments on every October 1, starting November 1, 2013, as per the agreement. The steel bar formation cost is $56,000.The firm’s fiscal year concludes on December 31.
|Date||Cash Collected||Cost Recovery||Gross Profit Recognized|
|October 1, 2013||$20,000||$20,000||$ –|
|October 1, 2014||$20,000||$20,000||–|
|October 1, 2015||$20,000||$16,000||4,000|
|October 1, 2016||$20,000||–||20,000|
Here, the company has begun to recognize profits after 2 straight years of operations starting October 1, 2015, and after successful cost recovery.
- The company uses the cost recovery approach from the purpose of the revenue recognition in case there is reasonable uncertainty concerning the collection of money from the customers against the sales made on the credit basis because, by far, this method is most conservative out of all of the revenue recognition methods available.
- With the cost recovery method, there is a delay in the due date of the tax payment as the tax will be payable only after the company has recovered the full cost of the product. So, with this method, the owner of the business can be making some savings.
- Using the cost recovery method, although the company recognizes the cost and sales, the gross profit in respect of the same will not be recognized even if some sale is essentially the receivable for the company, and the gross profit will be recognized only in case the entire receipts have been received.
- In this method, the profits of the company are referred to the period when then the payment against that profit is received. So even if the sale pertains to one period, the company would not be able to show it as income of that period.
When to use the Cost Recovery Method?
- This method is utilized mainly in the situations when collection against the sales of the goods from the customers is highly uncertain for the company and also where it is difficult to justify for installment method.
- Also, in case the company is not able to determine the sale value accurately. This method is preferred because, in those cases, since total revenue earned by the is difficult to determine, recording the revenue equal to receipts that match with the cost incurred by the companyCost Incurred By The CompanyIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. is a prudent approach.
- With the cost recovery method, there is a delay in the due date of the tax payment as the tax will be payable only after the company has recovered the full cost of the product. So, with this method, the owner of the business can make some savings.
Thus, in case of the cost recovery method, the company will recognize the amount earned over and above the cost as gross profit or income when the same has been received after recovering all the cost incurred by the company, i.e., the company will recognize the revenue only when the actual money has been received by it from the customers against the sales made.
The company uses the cost recovery approach from the purpose of the revenue recognition in case there is reasonable uncertainty with respect to the collection of money from the customers against the sales made on the credit basis because by far this method is most conservative out of all of the revenue recognition methods available.
This article has been a guide to the Cost Recovery Method. Here we discuss an example of a cost recovery method with detailed explanation along with advantages, disadvantages, and limitations. You can learn more from the following accounting articles –