Cost Recovery Method Definition
Also known as the collection method, cost recovery method accounting is a way of recognizing revenue under the revenue principle. The method is commonly used in conjunction with companies who do not believe that they will receive a future payment of cash or it is highly unlikely that they will.
Cost Recovery Explanation
When using collection method accounting a company will commonly reduce the accounts receivable account through the allowance for doubtful accounts. It will then only recognize the revenue upon the receipt of cash up to the inventory or service amount. In other words, if a company only receives cash of $20,000 for an inventory item costing $50,000, then the company will defer this recognition of revenue until the other $30,000 has been received in cash. Because the company has reduced the amount of revenue that it would normally recognize under the accounts receivable account, cost recovery accounting is the most conservative form of revenue recognition.
Cost Recovery Example
For example, Steel Company is a company that supplies steel to customers who use that steel to make all sorts of items. These items range from beams to construct buildings to ship building companies. One of Steel’s long time customers Ship Builders R’ Us has recently been going through some trouble. It is becoming more and more likely that the company will need to file for bankruptcy. Because of this Steel Company has decided to use the cost recovery method of revenue recognition. The inventory that has been sold to Ship Builders is in total around $500,000 with a cost to Steel Company of $400,000.
The company is expected to pay Steel in installments of $100,000 in the next three years (2008, 2009 and 2010). They have already paid Steel $200,000 upon the sale in 2007. Thus the company needs to take the installments out of accounts receivable to reduce the amount of revenue. Then the company will not recognize revenue until the end of 2009 when the total cash paid is $400,000 or the cost to Steel Co. The last payment in 2010 is like any normal sale assuming that it occurs because the full cost was recovered in 2009.
Note: The above example does not account for interest.
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