Cost recovery is a way to recognize and classify revenue in business accounting. It is a form of revenue recognition, which is one of the key processes in accrual accounting, and it is generally considered to be the most conservative method of the different methods for recognizing and reporting revenue. It holds off on recording revenue until the money received from a sale has covered all of the costs related to it.
In practice, cost recovery is used when there is an improbability of receiving the full amount of the sale in cash, such as with a product that is sold on credit or to customers that pay in installments. The technique also works well in situations where the owner cannot reasonably arbitrate the sale value accurately, such as when a company sells goods to customers that have already paid for them.
The main reason for using cost recovery is to defer revenue until there’s a guarantee that all of the costs associated with a sale will be recovered in some fashion. As a result, the gross profit on a sale is not recognized until the cost of goods sold is fully recovered, which makes it less likely that companies will overstate their net income when comparing it to operating cash flow.
For example, if Sam’s Company has sold machinery to Gilbert for $40,000 and Gilbert pays in installments over the next three years, each payment covers all of the equipment’s costs. Therefore, the sales transaction is a loss to Sam’s in year one and will not produce a profit in any of the following years. However, if Sam’s had booked a part of the profit in year one and then stopped paying Gilbert in the following years, this would overstate net income and the company may be required to write off its accounts receivable and make tax payments that aren’t owed.
Internal cost recovery is the process of recording a transaction to recover expenses from one department or unit to another department or unit. Typically, the billing department will be responsible for this. This type of transaction should be recorded in a fund that has a reimbursable project code to ensure that the transaction is auto-billed at the end of each month.
It is recommended that all departments that have a cost recovery policy and procedures use the standard budgeting templates to ensure consistency in practices. These templates are available in the eBudgets template folder under “Documents”. If you have any questions or concerns, please contact your campus finance representative.