Lesson Objectives:- When the cost recovery method is used
- How to use the cost recovery method to recognize revenue
- Recording journal entries for revenue recognition and deferred income
We've reviewed the percentage of completion revenue recognition in the past few lessons, now let's talk about the cost recovery method.
This method is used for public companies under IFRS standards and is considered an alternative to the POC method when costs and collectibility are uncertain. The cost recovery method is often used when the company feels that the collectible amounts have a higher risk of turning into bad debt.
We will revisit the same example from the previous lessons with the government contract for the construction of a laboratory building. We will change the cash collected in 2014 from $3,000,000 to $2,000,000.
Keep in mind that with the cost recovery method the gross profit figure will not be recognized until the amount of cash received exceeds the costs.
First, let's apply the cost recovery method to 2013 to see if the revenue can be recognized using this method.
We will first take a look at how revenue would be recorded for the year of 2013. The amount of revenue for this year is $4,304,000 less the amount of expenses would net an amount of $1,804,000. For now, we will refer to this value as deferred income.
If we take a look at the amount of cash received versus the costs for 2013, the cash does not yet exceed the costs. Therefore, we cannot yet recognize the revenue and the $1,804,000 would be recorded on the income statement and balance sheet as deferred income.
The journal entry under the Cost Recovery method to record 2013 transactions would be as shown above.
Let's go ahead and move on to the year of 2014 and use the same method to determine if revenue can be recognized.
The amount of revenue for 2014 is $2,064,000 and the expense amount is $1,200,000. If we subtract the revenues from the expenses, we will see a potential amount of income for
$864,000. Again, we will refer to this value as deferred income until we compare the cash to the costs.
At this point, we have now collected $4,000,000 in cash; $2,000,000 from the previous year and $2,000,000 from this year. If we add our costs for 2013 to the costs for 2014, we will come up with $3,700,000.
Using the cost recovery method, we see that the amount of cash received now exceeds the cost amount. Therefore, we would recognize the difference between the cash and the cost which is $300,000 in gross profit.
In order to record the income, we are recognizing on the balance sheet, we will first need to debit the deferred gross profit account for the $300,000 in gross profit that we are recognizing. We would then credit recognized gross profit for $300,000.
Next, in order to record the remaining amount of income, which will be deferred on the income statement, we will prepare the entry like #5 above and debit Revenue on Long Term Contracts for $2,064,000, credit Construction Expense for $636,000 and credit Deferred Gross Profit for the $564,000 that is left over after costs were covered.
Now that we've reviewed how to calculate the revenue that should be recognized using the cost recovery method, you should be able to calculate the amount of revenue that can be recognized for 2015.
If you have any questions, refer back to how we used the cost recovery method in this lesson for both 2013 and 2014.