Cost Recovery Method of Revenue Recognition
Cost recovery method (also known as cost recoverability method) is one of the methods of revenue recognition others being installment method, percentage of completion method and completed contract method. Under this method revenue from a sale is recognized only to the extent of receipts from the buyer.
In periods in which the initial payments are received no gross profit is reported because the revenue recognized equals the amounts received and a cost equal to the revenue recognized is charged to the income statement. Once all the cost has been recovered the final payments consist of the gross profit earned on the sale.
Cost recovery method is used to account for revenue in situations when the recoverability of revenue is not certain or the value of the sale cannot be determined accurately. IAS 18 Revenue requires companies to recognize revenue only when the consideration is measurable. In this scenario since total revenue is not determined it is more prudent to record revenue equal to the receipts and match costs. Recording the total sales value as revenue would overstate gross profit.
Prudence Inc. is engaged in manufacture and sale of specialized manufacturing equipment. It has excess capacity of 30% so on 1 January 2011 the company's management sold equipment worth $20 million to Uncertainty Inc. a company which is facing a liquidity crunch. The equipment cost $10 million in manufacturing costs. The receipts from Uncertainty in FY 2011 we as follows:
- First Quarter $3 million
- Second Quarter $6 million
- Third Quarter 4 million
- Fourth Quarter 7 million
Determine the gross profit earned in each quarter under cost recovery method.
Under cost recovery method revenue is recognized only to the extent of receipts. So in Q1 revenue recognized is $3 million which is matched with cost of $3 million resulting in zero gross profit. In Q2 revenue recognized is $6 million matched with $6 million cost resulting in zero gross profit. In Q3 revenue recognized is $4 million matched with the remaining cost of $1 million ($10 million - $3 million - $6 million) resulting in a gross profit of $3 million. In Q4 no cost is left and the revenue recognized is $7 million so gross profit is $7 million.
Total revenue recognized and total gross profit earned under cost recovery method would equal all other methods but its distribution among various periods would be different.