Updated July 14, 2023
Definition of Cost Recovery Method
The cost Recovery method is one of the revenue recognition methods under which revenue, i.e., gross profit, is not recognized till the cost is fully recovered. After the cost recovery, the further income is shown as gross profit, and this method is mainly used in organizations where revenue recognition is uncertain.
Explanation
Under the cost recovery method, income on sale will not be recognized until the cost recovery. This method of revenue recognition is used by the company where there is uncertainty regarding revenue collection and also to follow the principle of conservatism. Under this method, Profit is to be recognized when the revenue is collected in cash till it exceeds the cost of goods sold. Until the real collection of costs in cash, the income will not record in the accounts. The revenue will recognize when the sales are made, but the profit or income is deferred until the collection. This method can give an accurate financial view of the organization, which is not misleading.
Example
ABC Incorporation achieved sales of $ 900,000 in 2019-20. The cost of purchase was $ 700,000. The sales were made on a credit basis, and the collection of $ 500,000 was done by the end of 2019-20, and the collection of $ 400,000 was done by the end of 2020-21. Calculate the Revenue and income to be recognized annually in 2019-20 and 2020-21.
Solution:
In the Year 2019-20,
As the Sales of $ 900,000 are made, and the collection of only $ 500,000 is done, the revenue to recognize up to $ 500,000, and the corresponding cost is to debates, but since the cost not fully recover, there will be no income recognition in the year 2019-20.
In the Year 2020-21,
As the collection of the remaining $ 400,000 is done, the revenue of $400,000 to recognize, the remaining cost to debit, and the income are recognized under the following:
Sales – Balance Cost Recovered
= $ 400,000 – $ 200,000
= $ 200,000
When to Use It?
In the following cases, the cost recovery method is to be used:
- When the Collection of revenue is uncertain or unpredictable.
- When the organization wants to follow the conservative basis of accounting.
- It collects the revenue when there is a long period, i.e., more than 1 year.
- When the cost involved is huge, comparative sales are low.
Impact of Cost Recovery Method
. The impact of the cost recovery method is summarized as under:
- With the Cost Recovery Method, the Income to defer till the cost recovery.
- The Revenue under the Cost Recovery Method is recognized in the year of collection from the customer.
- There are no chances of default under the cost recovery method.
- It gives an accurate view of the financial position, i.e., actual collection and actual cost recovered.
Journal Entries for Cost Recovery Method
ABC Incorporation has achieved sales of $ 300,000 in the year 2018-19 and $ 200,000 in the year 2019-20, and $ 150,000 in 2020-21. The cost of purchase was $ 600,000. The sales were done on a credit basis, and the collection of sales is done by the end of the respective years. Pass the journal entries.
Solution:
| Date | Particulars | Debit ($) | Credit ($) |
| For 2018-19 | Sales Revenue A/c Dr. | 300,000.00 | |
| To Cost of Goods Sold | 300,000.00 | ||
| (Being Revenue is recognized under the cost collection method on collection) | |||
| For 2019-20 | Sales Revenue A/c Dr. | 200,000.00 | |
| To Cost of Goods Sold | 200,000.00 | ||
| (Being Revenue is recognized under the cost collection method on collection) | |||
| For 2020-21 | Sales Revenue A/c Dr. | 150,000.00 | |
| To Cost of Goods Sold | 100,000.00 | ||
| To Gross Profit | 50,000.00 | ||
| (Being Revenue is recognized under the cost collection method on collection and profit is recognized on a collection of cost) |
Advantages
The advantages of the cost recovery method are explained as under:
- It gives a true and correct view of the accounts as the revenue is recognized when collected.
- With the implication of the cost recovery method, there is no recognition of bad debts or default due to non-collection from the customers as the recognition in the accounts is done on customer collection.
- The cost collection method does not predict future revenue hence the most reliable accounting method.
- It is very useful when the revenue collection is uncertain as it shows the correct position of collection of revenue, and investors cannot get deceived.
- It is the most reliable method.
- The tax implications will apply only after the recovery of cost.
- With the application of the cost recovery method, a business can perform better and save more due to the deferment of tax and other expenses.
Limitations
The limitations of the cost recovery method are explained as under:
- It does not comply with the matching concept as the sales are recorded on the collection, and the profit is deferred until the cost recovery.
- The use of the method can become complicated as the record of revenue, cost, and collection is to be made separately.
- At the initial points, it shows the heavy loss in the accounts, and suddenly the cost recovery shows the huge profits that can create the wrong impact.
- Due to the deferment of income recognition, the tax payment is to be deferred, which is a loss for the government, and of this, the organization can take advantage.
Conclusion
The cost recovery method is one of the accounting methods in which the revenue is recognized when the sales collection receives from customers, and income to recognize on the cost collection. Till the collection of cost, the income is to be deferred. This method is used when the collection is uncertain or the huge risk involved in the business. The cost collection method does not predict future revenue; it shows the accurate position so investors are not deceived. But as the method defer the income, the tax is also deferred, which is the loss to the governmental organizations. The organization can take advantage by inflating the cost.
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