There are four primary methods that accountants use to recognize business sales revenue: percentage of completion, completed contract, cost recovery and installment sales. In some circumstances, complications in a transaction make it uncertain as to how much revenue from a particular sale is collectible immediately – or at all.
Businesses determine which method to use based on the type of transaction and the type of revenue collection uncertainty they face. Where there is extreme uncertainty, accountants use either the installment sale method or the cost recovery method.
If a product is sold through an installment plan, in which the customer is allowed to make payments over a long period of time, then a company would use an installment sales method. The cost recovery method is used in much more uncertain transactions, in which accountants are either unable to assume payment confidently or if the value of the sale is difficult to estimate.
Installment Method
When a sale is made, but payments are delayed over a period of time, the transaction is called an installment sale. Accountants do not want to recognize the full amount of the sale on the outset, because there is a sufficient risk of not collecting that makes the receivables questionable.
Therefore, both revenue and costs are only recognized when payments are received by the company from the customer. Each payment is further broken down into two components: an amount used to show a partial recovery of the cost of item sold and an amount dedicated to gross profit.
Cost Recovery Method
Cost recovery is an even more conservative method of revenue recognition. Here, all gross profit is deferred until the cost of the item sold is recovered. The initial journal entry, however, is identical to installment method.
It is really only acceptable to use the cost recovery method if bad debts cannot be reasonably estimated. Otherwise, delaying revenue recognition violates the realization principle.