Cost Recovery Accounting Method

Definition

The term cost recovery refers to an accounting method that reports revenue and the cost of goods sold in the period of sale, but delays recognizing profit until the cash received from customers is in excess of the cost of goods sold.  Along with the installment sales method, this approach can be used when companies recognize revenue after delivery.

Explanation

The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until they are realized or realizable, and the company has substantially completed what it needs to do in order to be entitled to payment.  Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction.

If the sales price is not reasonably assured after delivery of the product or service to a customer, the company may choose to defer recognizing revenue until cash is received.  Generally, there are two accepted ways to account for these transactions: the installment method and the cost recovery method.

The cost recovery method is similar to the installment method, since both approaches recognize total revenue and the cost of goods sold in the period of the sale.  However, while the installment method recognizes income as cash is collected from customers, the cost recovery method delays recognizing profit until the cash received is in excess of the cost of goods sold.

APB Opinion No. 10 allows sellers to use the cost-recovery method when there is no reasonable basis for estimating collectability.  FASB Statements No. 45 (Franchises) and No. 66 (Real Estate) require use of this approach when there is a high degree of uncertainty related to the collection of receivables.

Example

Company A recorded $7,500,000 in installment sales in the current fiscal year.  The cost of goods sold associated with these sales was $6,000,000.  Company A was also able to collect $3,000,000 from customers through their scheduled installment payments.  The determination of gross profit to record in the current fiscal period would be as follows:

Installment Sales $7,500,000
Cost of Goods Sold $6,000,000
Gross Profit $1,500,000
   
Cash Receipts $3,000,000
Realized Gross Profit $0
Deferred Gross Profit $1,500,000

Since the cash receipts of $3,000,000 in the current accounting period is less than the cost of goods sold, Company A would defer all gross profit.  The journal entries associated with these transactions would be as follows.

To record the sales for the current fiscal year:

  Debit Credit
Installment Accounts Receivable $7,500,000  
Installment Sales   $7,500,000

The journal entry to record the collection of cash from customers:

  Debit Credit
Cash $3,000,000  
Installment Accounts Receivable   $3,000,000

The journal entry to record the cost of goods sold:

  Debit Credit
Cost of Installment Sales $6,000,000  
Inventory (Goods Sold on Installment)   $6,000,000

The journal entry to record the installment sales:

  Debit Credit
Installment Sales $7,500,000  
Cost of Installment Sales   $6,000,000
Deferred Gross Profit (Installment Sales)   $1,500,000

Since the cash collected from customers ($3,000,000) is less than the cost of goods sold ($6,000,000) in the current accounting period, all gross profit is deferred.

Related Terms

revenues, revenue recognition principle, revenue recognition: before delivery, revenue recognition: point of sale, revenue recognition: during productionrevenue recognition: after delivery, installment method