Revenue Recognition Method 4: Cost Recoverability MethodThe most conservative revenue recognition method of all, the cost recoverability approach is used when a company cannot reasonably estimate the total expense required to complete a project. The result is that no profit is recognized at all until all of the expenses incurred to complete the project have been recouped. Examples would include the development of internal software and certain types of land.
Assume a law firm developed its own software at a total cost of one million dollars. Several years later, the partners decide to start licensing the software to other firms. In the first quarter, they have total sales of $250,000. Under the cost recoverability method of revenue recognition, however, all of this would serve as an offset to the original $1 million in development expense. Nothing would appear in the income statement as revenue until the entire original balance of $1 million had been wiped out.
Revenue Recognition Method 5: InstallmentWhen the actual collection of cash is suspect, a company should use the installment method of revenue recognition. This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is only calculated in proportion to cash received.
For example, assume a developer spent $500,000 improving an apartment. He sold the property for $750,000 but the buyer is going to pay in two installments one on January 1st and one on July 31st. On the first payment due date, the developer receives a check for half of what he is owed, or $375,000. His income statement is now going to reflect fifty-percent of the revenue and gross profit earned since he has collected fifty-percent of the cash (i.e., $375,000 revenue, $125,000 gross profit ($250,000 total gross profit [$750K selling price - $500K cost = $250K] x 50% = $125,000.) (Realize the actual rules governing accounting for real estate sales are more complex; this example is for simplicity sake only to illustrate the concept of the installment method.)