The Cost-Recovery Method of Revenue Recognition
The installment-sale method isn’t exactly an optimal way of recording sales transactions, and the cost-recovery method takes it down another notch. If a company isn’t reasonably assured of recovering the cost of the goods sold if the buyer defaults on the financing arrangement, the sales transaction records it using the cost-recovery method.
Under the cost-recovery method, the seller can’t record profit on the sales transaction until the customer’s payments cover at least the cost of the goods sold.
If you’re planning to take an advanced financial accounting class, file in the back of your mind that the cost-recovery method differs slightly if the debt is nonrecourse: Then the borrower isn’t liable for any unrecovered portion of the debt. In other words, the customer owes nothing if the goods are repossessed for nonpayment and the value of the repossessed goods is less than the balance on the debt.
So how do you figure gross profit for a simple cost-recovery transaction? Suppose Baldwin Park Manufacturing sells a machine costing them $50,000 to Grand Central Freight, which has a dubious credit history, for $72,000. The terms of the contract call for payments of $36,000, $24,000, and $12,000 over a three-year period.
The following figure shows how to figure gross profit if the Baldwin Park and Grand Central transactions play out according to the contract.
One additional method that your intermediate accounting textbook quickly discusses is the deposit method. This method comes into play when the buyer gives the seller a deposit on the eventual transaction. The seller records this as a liability, like customer advances.