Cost Recovery Method

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, and after recovery of cost, the further income is shown as gross profit, and this method is mainly used in the organizations in which revenue recognition is uncertain in nature.

Explanation

Under the cost recovery method, income on sale is not to be recognized till the recovery of the cost. This method of revenue recognition is used by the company where there is uncertainty regarding the collection of revenue 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 cost in cash the income is not to be recorded in the accounts. Though the revenue is to be recognized when the sales are made, the profit or income is deferred until the collection. This method can give an accurate financial view of the organization, which is not misleading in nature.

Example of Cost Recovery Method

ABC Incorporation has achieved sales of $ 900,000 in the year 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 the year 2019-20 and collection of $ 400,000 is done by the end of the year 2020-21. Calculate the Revenue and income to be recognized each year 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 is to be recognized up to $ 500,000, and the corresponding cost is to be debited, but since the cost is not fully recovered, 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 is to be recognized, and the remaining cost is to be debited, and the income is recognized as under:

Sales – Balance Cost Recovered

= $ 400,000 – $ 200,000

= $ 200,000

When to Use It?

In the following cases, 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.
• When there is a long period, i.e. more than 1 year, it is involved in the collection of the revenue.
• When the cost involved is huge whereas 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 is to be deferred till the recovery of cost.
• The Revenue under the Cost Recovery Method is to be 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 the year 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:

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 it is actually 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 collection from customers.
• The cost collection method does not predict the 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 recovery of cost.
• The use of the method can become complicated as the record of revenue, cost and collection to be made separately.
• At the initial points, it shows the heavy loss in the accounts, and suddenly on the recovery of cost 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 to be recognized when the collection of sales is received from customers and income is to be recognized on the collection of cost. Till 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 the future revenue; it shows the accurate position so the investors could not get 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.

Recommended Articles

This is a guide to the Cost Recovery Method. Here we also discuss the definition and impact of the cost recovery method along with advantages and limitations. You may also have a look at the following articles to learn more –

1. Incurred Cost
2. Revenue Reserve
3. Fixed Cost
4. Revenue Streams