Chapter 18: Installment Sales and Cost Recovery

1
Chapter 18 Installment Sales and Cost Recovery
2
Revenue Recognition After Delivery

• Revenue recognition is deferred when collection
  of sales price is not reasonably assured and no
  reliable estimates can be made.
• The two methods that are used are
• the installment sales method
• the cost recovery method
• If cash is received prior to delivery, the
  method used is the deposit method.

3
The Installment Sales Method

• This method emphasizes income recognition in
  periods of collection rather than at point of
  sale.
• Title does not pass to the buyer until all cash
  payments have been made to the seller.
• Gross profit is deferred to the periods of
  collection.
• Other expenses, selling and administrative, are
  not deferred.

4
The Installment Sales Method Issues

• Installment sales must be kept separate
• Gross profit on installment sales must be
  determinable
• The amount of cash collected from installment
  accounts must be known
• The cash collected from current years and prior
  years accounts must be known
• Provision must be made for the carry forward of
  each years deferred gross profit

5
The Installment Sales Method Steps

• For installment sales in any year
  
• For installment sales made in prior years
  (realized gross profit)

• Determine rate of gross profit on installment
  sales
• Apply this rate to cash collections of current
  years installment sales to yield realized gross
  profit
• The gross profit not realized is deferred
• Apply the relevant rate to cash collections of
  prior years installment sales

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The Installment Sales Method Example

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000
  72,000
• Cash received in
• from 2003 sales 60,000 100,000 40,000
• from 2004 sales -0- 100,000 125,000
• from 2005 sales -0- -0-
  80,000
• Determine the realized and deferred gross profit.

7
The Installment Sales Method Example

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Gross Profit 50,000 60,000 72,000
• Gross profit rate 25 24
  30

50,000 / 200,000 0.25
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The Installment Sales Method Example

• 2003 2004 2005
• Gross profit rate 25 24
  30
• Realized Gross Profit
• From 2003 sales (e.g., 60,000 x 25)
• Realized in 15,000
  25,000 10,000
• From 2004 sales
• Realized in -0-
  24,000 30,000
• From 2005 sales
• Realized in -0-
  -0- 24,000

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The Installment Sales Method Partial Journal
Entries (2003) for Gross Profit

• When an installment sale is made
• Installment A/R (2003) 200,000
• Installment Sales 200,000
• Installment Sales 200,000
• Cost of Sales 150,000
• Deferred Gross Profit, 2003
  50,000
• (To close 2003 accounts not the same as closing
  I/S accounts)
• Cash 60,000
• Installment A/R (2003) 60,000
• Deferred Gross Profit, 2003 15,000
• Realized Gross Profit (I/S)
  15,000 (Realized 60,000 x 25)

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Interest and Repossessions

• Interest recognize at time of receipt (do not
  defer)
• Repossessions
• Be sure to account for all payments and
  recognition of gross profit until the repo date
• Set up repossessed goods at their fair value at
  repossession (not what they were worth when
  originally sold) more precisely, NRV less
  normal profit margin
• Write off any remaining A/R and deferred GP,
  plugging a loss to make entry balance

11
The Cost Recovery Method

• Seller recognizes no profit until cash payments
  by buyer exceed sellers cost of merchandise.
• After recovering all costs, seller includes
  additional cash collections in income.
• This method is to be used where there is no
  reasonable basis for estimating collectibility as
  in franchises and real estate.
• The income statement reports the amount of gross
  profit recognized and the amount deferred.

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The Original Example Cost Recovery Method

• Given 2003 2004 2005
• Installment sales 200,000 250,000 240,000
• Cost of sales 150,000 190,000 168,000
• Gross Profit 50,000 60,000
  72,000
• Cash received in
• from 2003 sales 60,000 100,000 40,000
• from 2004 sales -0- 100,000 125,000
• from 2005 sales -0- -0- 80,000
• Determine the realized and deferred gross profit.

13
The Cost Recovery Method

• Journal entries for same example
• 2003
• Installment A/R (2003) 200,000
• Installment Sales 200,000
• (sale is made)
• Installment Sales 200,000
• Cost of Installment Sales 150,000
• Deferred Gross Profit 50,000
• (defer profit recognition)
• Cash 60,000
• Installment A/R (2003) 60,000
• (receive payments)
• Note costs remaining to recover 150,000
  60,000 90,000 before any recognition of profit

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The Cost Recovery Method

• 2004
• J/Es for sales and deferral of GP are same as in
  installment method
• Cash 100,000
• Installment A/R (2003) 100,000
• (receive payments in 2004 for 2003 sales)
• Note costs remaining to recover 90,000
  100,000 10,000 to be recognized
• Deferred GP, 2003 sales 10,000
• Recognized GP, 2003 sales 10,000
• All of the cash receipts in 2005 for 2003 sales
  would result in recognition of deferred 2003
  gross profit

15
The Deposit Method

• Seller receives cash from buyer before transfer
  of goods or performance.
• The seller has no claim against the purchaser.
• There is insufficient transfer of risks to buyer
  to warrant recording a sale by seller.
• In the case of such incomplete transactions, the
  deposit method is used.
• The deposit method thus defers sale recognition
  until a sale has occurred for accounting
  purposes.
• i.e., the deposit is unearned revenue

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Franchise Fees

• A franchise is an arrangement where the
  franchisor grants the franchisee the right to use
  a business name (e.g., Kentucky Fried Chicken),
  and the right to sell franchisor products /
  services (e.g., using a patented system for
  cleaning carpets)
• Other services often provided by franchisor to
  franchisee include
• Consulting on site selection, building or lease
  negotiation, bookkeeping, training, quality
  control, and advertising
• There is usually an initial franchise fee, plus
  ongoing fees
• Revenue is to be recognized by the franchisor
  when there is substantial performance