Can someone explain the cost recovery method and when it applies?

The cost recovery method is the most conservative revenue recognition approach. Under this method, no profit is recognized until the seller has recovered the entire cost of the goods sold. Only after cumulative cash collections exceed total cost does any profit hit the income statement.

Worked Example:

Northbridge Machinery sells a custom press for $120,000 (cost = $84,000) to a financially distressed buyer on January 1. Payments of $30,000 are due annually.

In years 1 and 2, all cash received is applied against the $84,000 cost. In year 3, the first $24,000 covers the remaining cost, and only the excess $6,000 is profit. By year 4, the full cost has been recovered, so the entire $30,000 collection is profit.

Comparison with the installment method:

Under the installment method, the gross profit rate would be ($120,000 - $84,000) / $120,000 = 30%. So each year's $30,000 payment would yield $9,000 in profit. The cost recovery method would recognize $0, $0, $6,000, and $30,000 respectively.

Total profit is the same ($36,000) under both methods — only the timing differs. The cost recovery method pushes all profit recognition to later periods.

When is it used? Under legacy GAAP, it applied when collectibility was highly uncertain (worse than the installment method threshold). Under IFRS 15 and ASC 606, an analogous outcome arises when a contract does not meet the criteria for revenue recognition and the entity constrains revenue to the extent of costs incurred that are expected to be recovered.

Exam tip: If a CFA Level I question says collectibility is "not reasonably assured" or "highly uncertain," think cost recovery method. The key rule is simple: no profit until you've gotten your money back.

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