Whether your clients pay in one lump sum or over time, you’ll want to keep track of all the cash flowing into your business and the profit you’re making on each project. Typically, you’ll use the method of Cost recovery to do this. This method of recognizing revenue allows you to better defer taxes in situations where repayment isn’t guaranteed.
If you know your client is in dire financial straits and is unable to pay back what they owe, the best thing to do is not to approve their transaction. However, sometimes you’ll be tempted to approve a transaction against your better judgement. This could be because of the relationship you have with the customer, or because you’re convinced the individual can make incremental payments over a few years. In either case, the risk is high that you won’t get paid and the loss can be devastating to your business.
The Cost recovery method of recognizing revenue is used in these instances where it’s likely you won’t receive full payment for the goods or services you’ve sold. This method of recognizing income is a part of the accrual accounting principle and enables you to defer taxes until you’re certain your costs have been recovered. This is a more conservative approach to recognizing revenue and helps you avoid overestimating your profits.
Example:
If your company sells goods and services to customers on credit, the cost recovery method is an excellent way to make sure that you’re able to recover all of your costs before you have to file your taxes. Assume that Sam’s Hardware, a home improvement store, is contracted with Gilbert to perform a series of work on his house over the next few years. The work will require a lot of expensive materials and it’s not clear whether or not Gilbert can afford to pay for them all upfront. Sam’s decides to use the cost recovery method and recognizes its revenue and its cost of goods sold, but keeps gross profit on hold until it can be assured that it will receive its entire invoice amount.
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