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
The term cash flow return on revenues refers to a metric that allows the investor-analyst to understand the ability of a company to generate cash at various revenue volumes. Cash flow return on revenues is not linear meaning it does not scale evenly.
Moneyzine EditorJanuary 10th, 2024- The financial accounting term Revenue Recognition Principle refers to a standard condition under which revenues are recorded in a company's financial statements. According to the Revenue Recognition Principle, revenue is recorded when it is realized or realizable and earned.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition before delivery refers to the process of recording revenue before goods or services are provided to a customer. The revenue recognition principle states a company can record revenue when they are realized or realizable, and earned. Under certain conditions, a company may be able to record revenue before the product is delivered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition at the point of sale refers to the process of recording revenue from manufacturing and selling activities at the time of sale. The revenue recognition principle states a company can record revenue when two conditions are met. They must be realized or realizable, and earned. These requirements are typically met when a product is delivered or a service is rendered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition during production refers to the process of recording revenue as various milestones in a project are reached. The revenue recognition principle states a company can record revenue when they are realized or realizable and earned. Under certain conditions, a company may be able to record revenue before the product is delivered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition after delivery refers to the process of recording revenue after a product or service has been delivered to a customer. The revenue recognition principle states a company can record revenue when they are realized or realizable, and earned. Under certain conditions, a company may choose to defer the recognition of revenue until after cash has been received from a customer.Moneyzine EditorSeptember 21st, 2023
The term installment sales refers to an accounting method that emphasizes the collection of cash from customers rather than the sales transaction. The installment sales method recognizes income in the accounting periods it's collected, and not at the time of sale.Moneyzine EditorJanuary 22nd, 2024
