Why Use the Recovery Method?
Most businesses that utilize the accrual method of accounting do not employ the recovery cost method within their financial books or records. In the accrual method, using the above example, both the sales and costs of sales would be recorded along with the gross profit of $5,000. The $1,000 down payment would be recognized as a cash receipt and the remaining $9,000 due, if not paid by the tax year end would remain on the financial records as an asset in an accounts receivable account. The accrual method would allow the business to show a gross profit of $5,000 on this particular transaction.
With the recovery method of accounting, the purpose is to not place the gross profit on the income statement until the entire cost of sale is achieved. If in the above transaction, this business had only received $2,000 out of the accounts receivable due by year end, this still would not cover the entire cost of the sale ($5,000). The gross profit would not be considered but would carry over to the next tax year until recouped. In order for the business to report income from this sale using the cost recovery method, it would have to receive the entire cost of sales to report the sale on the income statement and show a gross profit which in turn would be reported on a tax return as revenues and hence, taxed.
If a company were a pass through entity such as a Limited Liability Company (LLC) or an S-Corp, the use of this recovery cost method would really not affect the business taxes as pass through entities do not pay tax. In a pass through entity, all profits (or losses) for the accounting tax year are passed through to the partners or shareholders in the form of a K-1 statement that is used to prepare their personal tax return.
If a business were a sole proprietorship, the cost recovery method may be beneficial to avoid reporting the gross profit (and pay tax on that gross profit) until all costs of sales are collected or recovered. Further, a corporation or entity such as an LLC or S Corp would most likely have more expenses to offset income than would a sole proprietorship.
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