Cost recovery is a method of bookkeeping in which the income a business earns from a transaction isn’t recognized until the company has recouped all its costs associated with it. The method helps businesses better keep tabs on their profits while ensuring that their books are kept close to operating cash flow. The method also ensures that tax obligations aren’t overstated by recognizing only the amount of profit earned when it is actually earned.
While it isn’t an ideal accounting method for most businesses, if you are working with a client who is slow to pay or doesn’t always pay in full, you may need to consider using the cost recovery method. The method is especially useful when you are paid in installments or have a contract that extends over a long period of time.
For example, say you have a contract with a client to develop their website for an agreed upon fee. The initial payment was large, but you are unsure whether or not Gilbert will consistently make incremental payments on time. Because the project has a longer than normal payment period, you are hesitant to recognize any of the revenue until you know for sure that you will have enough money to pay your copywriter for the entire project. Because of the uncertainly around repayment, you would use the cost recovery method for this project.
The process of calculating the cost recovery ratio is simple. You start by determining the total expenses for the project. Once you have this number, you divide it by the total revenue and multiply by 100 to generate a percentage. A higher percentage indicates that the project has produced more revenue than it costs to produce the goods or services. A lower percentage indicates that the project has not produced sufficient revenues to cover its costs.
A company should not use the cost recovery method for run-of-the-mill installment sales because it runs counter to the accounting principle of realization that states that revenue is only recognized when a good or service is transferred to a customer. If you use this method for these types of sales, auditors are likely to be uneasy.
Note: FreshBooks support team members are not certified income tax or accounting professionals and are unable to provide you with any advice outside of helping you set up your financial accounts in our software. If you have any questions about how to apply the cost recovery method to your business, we recommend speaking with a certified professional.
To record expenses and revenue in FreshBooks, follow the steps below: