What it means
Ordinary revenue recognition assumes that the seller will collect what it is owed. A sale on credit is recognised as revenue when the goods are delivered, and the receivable is an asset; an allowance covers the expected shortfall.
But some sales are so uncertain that the assumption fails: the buyer's ability to pay depends on events that may not happen, the terms extend over years, defaults are frequent, and the seller's experience gives no basis for estimating what will be collected. The cost recovery method responds by refusing to recognise any profit until the seller has at least got its money back.
The mechanics are simple. At the sale, the seller records the receivable and defers the gross profit (the difference between the sale price and the cost).
As cash is collected, it is applied against the cost; no profit is recognised. Once cumulative collections equal the cost, every further dollar is profit and is recognised as received.
If the buyer defaults before the cost is recovered, the seller has recognised no profit and writes off the shortfall of cost against the receivable and the deferred profit. The method is more conservative than the instalment method (which recognises a proportion of profit on each receipt) and far more conservative than accrual recognition.
Historically the method was permitted under US GAAP for instalment sales and real estate sales where collectability was highly uncertain, and it appeared in practice in the accounts of land developers selling lots on long-term contracts with small deposits, of retailers selling on instalment to sub-prime customers, and of companies selling into markets where enforcement of contracts was weak. The current revenue standards replaced the range of methods with a single model: a contract exists for accounting purposes only if collection of the consideration is probable; if it is, revenue is recognised as control transfers, with consideration measured at the amount expected including a reduction for expected credit losses (as impairment, not as a reduction of revenue) or, where the price itself is uncertain, as variable consideration constrained to the amount unlikely to reverse; if it is not, the contract fails the recognition criteria and the seller records nothing until either collection becomes probable, the contract is terminated, or all consideration has been received and is non-refundable.
That final route, recognising revenue only when cash is received and the arrangement is complete, is the current standards' version of cost recovery. Tax rules diverge.
In the United States, the instalment method (recognising gain in proportion to collections) applies to certain sales of property, and a cost recovery approach may be available where the selling price is contingent or cannot be determined. Tax deferral through these methods creates deferred tax differences against the book treatment.
For readers of accounts, the method's presence (or the current standards' equivalent) signals a seller in a difficult market or with doubtful customers: revenue lags cash, profit appears late and lumpily, and the balance sheet carries deferred profit or unrecognised contracts. Its absence where it should apply is the more common concern: a seller recognising full revenue and profit on sales it may never collect, with an inadequate allowance, is the classic overstatement, and the standards' collectability criterion exists to prevent it.
In practice
Real-world examples
Example 1
A furniture retailer selling on instalment to customers with no credit history recognises profit only after each customer's payments have covered the cost of the goods.
Example 2
A developer selling holiday lots with 5% deposits and 15-year terms in a market with a 40% default history recognises no profit until costs are recovered.
Example 3
A company selling equipment into a country with exchange controls, where remittance of payment is uncertain, defers profit until cash is received.
Think of it
Cost recovery recognizes profit only after you've gotten all your costs back-very conservative.
Formula
Calculation
At sale: Receivable = Sale price; Deferred gross profit = Sale price minus Cost; Profit recognised = 0
On each collection: Profit recognised to date = Max(0, Cumulative collections minus Cost); each period's profit is that figure minus the profit previously recognised
On default: Write off the remaining receivable against the remaining deferred profit; the loss is the unrecovered cost, less the value of any asset recovered
Worked example. A land developer sells a plot for $300,000 to a buyer who pays a $15,000 deposit and the balance over ten years at $28,500 a year (interest ignored for simplicity). The plot cost the developer $180,000. Default rates in this market are high and unpredictable, so collections cannot be estimated reliably.
- At sale: receivable $285,000, deferred gross profit $120,000, collections $15,000, unrecovered cost $165,000; profit recognised nil
- Year 1: collection $28,500, cumulative $43,500, unrecovered cost $136,500; profit nil
- Years 2 to 5: four more collections of $28,500 take the cumulative total to $157,500, leaving unrecovered cost of $22,500; profit nil
- Year 6: collection of $28,500 takes the cumulative total to $186,000, which exceeds the $180,000 cost by $6,000, so profit of $6,000 is recognised
- Years 7 to 10: four collections of $28,500 are all profit, $114,000, so total profit of $120,000 is recognised across years 6 to 10
Default scenario: the buyer defaults after year 3, having paid $100,500 in total ($15,000 plus three instalments of $28,500). The developer repossesses the plot, now worth $150,000. Cash plus plot is worth $250,500 against a cost of $180,000, so a gain of $70,500 is recognised when the plot is recovered. Had the plot fallen to $60,000, the result would be $160,500 against $180,000, a loss of $19,500. Either way, none of the $120,000 of deferred profit was ever recognised, so there is nothing to reverse.
Under current standards: if collection is not probable at the outset, no contract is recognised, the $15,000 deposit is held as a liability and the plot stays in inventory until collection becomes probable or the contract is complete. If collection is probable at the outset, full accrual applies with an allowance for expected credit losses.Case study
Seen in the real world
This is a fictional, illustrative scenario. A vacation property developer sold lots on 10% deposits and ten-year contracts and recognised full profit at sale under an aggressive reading of the rules then in force, on the basis that buyers had signed binding contracts. Its reported profits were strong for five years and its shares were popular. Default rates ran at 35%, but the developer's allowance was set at 10% on the reasoning that repossessed lots could be resold at a profit.
When the market turned, defaults rose to 60%, repossessed lots could not be resold, and the developer wrote off $180,000,000 of receivables and deferred profit in one year, wiping out the previous five years' reported earnings. A restatement followed, and the regulator's report concluded that the sales had never met the standard for full accrual recognition because collectability had never been reasonably assured, and that the cost recovery method, which the developer's auditors had proposed and the developer had resisted as "unrepresentative of the business", would have recognised about a fifth of the reported profit and none of the subsequent loss. The developer's successor company adopted the current standards' approach: contracts recognised only when collection is probable, which for its buyer profile meant after two years of payments, and deposits held as liabilities until then. Its reported profits were lower, later and real.
Watch out
Common mistakes
- Recognising full revenue and profit on sales whose collection is genuinely uncertain, with an allowance that reflects hope rather than experience.
- Applying cost recovery (or the current standards' deferral) to sales where collection is probable, which understates revenue and profit and misrepresents the business as more uncertain than it is.
- Confusing the cost recovery method with the instalment method. Cost recovery recognises no profit until cost is fully recovered; the instalment method recognises a proportion of profit with each collection.
Questions
People also ask
Is the cost recovery method still allowed?
Not as a free choice under IFRS 15 or ASC 606. Where collection is not probable, those standards defer recognition entirely until it becomes probable or the contract is complete and consideration is received, which produces a similar effect. Some tax rules and other frameworks still permit or require it.
When would the current standards produce a cost-recovery-like result?
When a contract fails the collectability criterion at inception: no revenue is recognised until collection becomes probable, the contract is terminated, or all consideration is received and non-refundable.
How does the cost recovery method treat interest on instalment receivables?
Interest is normally recognised separately as received or accrued, depending on collectability; the cost recovery mechanics apply to the principal consideration for the goods or property sold.
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