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 year’s deferred gross profit

5. 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 year’s installment sales to yield realized gross profit The gross profit not realized is deferred Apply the relevant rate to cash collections of prior year’s installment sales The Installment Sales Method: Steps

6. 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

8. 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

9. 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%)

10. 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 seller’s 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.

12. 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

14. The Cost Recovery Method 2004: J/E’s 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 salerecognitionuntil a sale has occurred for accounting purposes. • i.e., the deposit is unearned revenue

16. 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