425662626 Installment Sales Punzalan PDF

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Chapter 6 INSTALLMENT SALES

Introduction Generally, the point of sale is the point of revenue recognition. And among the exceptions to the point of sale realization concept is the installment method. Under this method, income is recognized when collections are made, because the uncertainty of collecting accounts to be receive over an extended period of time may suggest the postponement of revenue recognition until the probability of collection can be reasonably estimated. GROSS PROFIT RECOGNITION ON INSTALLMENT SALES ! Installment sales may be regarded as calling for special treatment whereby gross profit is related to the periods in which the installment receivables are collected rather than to the periods in which the receivable are created. The inflow of cash (collections) rather than the time of sale become the criterion for revenue recognition. Accounting for installment method or installment basis could be best illustrated by providing for the recognition of gross profit in proportion to collections. Under this method, collections are regarded as both return of cost and realization of profit in the ratio in which these two factors are found in the original sales price. In applying the installment method in the accounts, the difference between the contract sales price and the cost of goods sold is recorded as deferred gross profit. This balance is recognized as revenue periodically in the proportion that the cash collections of the period bear to sales price. Stated differently, the original gross profit percentage on the sales is applied to periodic collections in arriving at the amounts to be recognized as revenue. At the end of each period a deferred gross profit balance remains on the books and is equal to the gross profit percentage applied to the balance of installment receivables as of this date. Gross Profit Rate Since, collections become the criterion for revenue recognition in installment method of accounting, determination of gross profit rate is an important factor to compute the realized gross profit to be reported for a period. Gross profit rate may be computed based on the data provided. Normally, it may be computed by dividing the gross profit by the installment sales. However, if this formula is not applicable, gross profit rate may also be computed by dividing the deferred gross profit (beginning) by the installment accounts receivable (beginning); or by dividing the deferred gross profit (end) by the installment accounts receivable (end). Realized Gross Profit The installment method of accounting recognizes profits at the point of collections, thus realized profit is based on amount collected. Ordinarily, realized gross profit may be computed by multiplying the gross profit rate by the amount collected. It should be pointed out that in case of defaulted contract, collections should be net of any unpaid balance on defaulted contract. However, if this formula is not applicable, realized gross profit may be computed by determining the difference between the deferred gross profit (before adjustment) and deferred gross profit (after adjustment). Deferred Gross Profit As stated earlier, the installment method of accounting recognizes profits at the point of collection. If realized profit is based on amount collected, the deferred gross profit is based on unpaid balance. The deferral of gross profit is, in

effect, the deferral of sales revenue accompanied by the deferral of cost of goods sold related to such sales revenue. To compute the deferred gross profit at the beginning of a period (before adjustment), installment accounts receivable at the beginning of the period should be multiplied by the related gross profit rate; and the deferred gross profit at the end of the period (after adjustment) is equal to installment accounts receivable multiplied by the related gross profit rate.

Trade-Ins In certain sales on the installment plan, companies will accept a trade-in as part of payment on a new contract. The trade-in is recorded at the value allowed. Frequently, as a special sales inducement, an over allowance is given on the trade-in, which is, in effect, a reduction in the sales price. Under such circumstances, the trade-in should be recorded at no more than the company would pay on its purchase; the difference between the amount allowed and the value of the article to the company should bereported either as charge to an overallowance account or as a reduction in installment sales. In either case, the gross profit on installment sales should be regarded as the difference between the cost of goods sold and net sales, the total installment sales less any trade-in overallowance. Defaults and Repossessions Default on an installment contract and subsequent repossession of the goods sold calls for an entry on the books of the seller that reports the merchandise reacquired, cancels the installment receivable together with the related deferred gross profit balance, and records the gain or loss on repossession. As in the case of goods acquired by trade-in, the repossessed article should be recorded at an amount that will permit a normal gross profit on its resale. Interest on Installment Contracts Installment contracts frequently provide for a charge for interest on the balance due. The interest charge is ordinarily payable with the installment payment that reduces the principal. Although interest is included in the payment, use of the installment method requires that only that portion of a payment which reduces the principal balance of the installment contract receivable should be considered in computing the realized gross profit.

MULTIPLE CHOICE QUESTIONS PROB. 6-1 (AICPA) Cash collection is a critical event for income recognition in the Cost recovery method

Installment method

a.

No

No

b.

Yes

Yes

c.

No

Yes

d.

Yes

No

PROB. 6-1 Suggested answer (b) The installment method is used when collection of the sales price is not reasonably assured. However, when the uncertainty of collection is so great that even the use of the installment method is precluded, then the cost recovery method may be used. Having no reasonable basis for estimating collectability would provide a great enough uncertainty to use the cost recovery method. PROB. 6-2 (AICPA) The installment method of recognizing profit for accounting purposes is acceptable if a. Collections in the year of sale do not exceed 30% of the total sales price. b. An unrealized profit account is credited. c. Collection of the sales price is not reasonably assured. d. The method is consistently used for all sales of similar merchandise. PROB. 6 —2 Suggested answer (c) Generally, the profit on sale in the ordinary course of business is considered to be realized at the time of sale unless it is uncertain whether the sale price will be collected. Thus, if collection of the sales price is not reasonably assured, the installment method shall be used. PROB. 6-3 (AICPA) Under the installment sales method, a. Revenue, costs, and gross profit are recognized proportionately to the cash that is received from the sale of the product. b. Gross profit is deferred proportionately to cash uncollected from sale of the product, but total revenue and costs are recognized at the point of sale. c. Gross profit is not recognized until the amount of cash received exceeds the cost of the item sold. d. Revenues and costs are recognized proportionately to the cash received from the sale of the product, but gross profit is deferred until all cash is received. PROB. 6 -3 Suggested answer (b) The installment method of accounting is used when there is a high degree of uncertainty regarding the collectability of the sales price. Under this method, sales revenues and the related cost of goods sold are recognized in the period of the sale. However, the gross profit is deferred to the periods in which cash is collected.

PROB. 6-4 (AICPA) Under the cost recovery method of revenue recognition, a. Income is recognized on a proportionate basis as cash is received sale of the product on the sale of the product. b. Income is recognized when the cash received from the sale product is greater than the cost of the product. c. Income is recognized immediately. d. None of these. PROB. 6 - 4 Suggested answer (b) Under the cost recovery method, gross profit is deferred and recognized only when the cumulative receipts exceed the cost ofthe asset sold. ! PROB. 6-5 (Intermediate Accounting by Kieso) Which of the following are recognized each period under the cost method? a.Costs only b.Revenues only c.Both costs and revenues d.None of these PROB. 6-5 Suggested answer (c) Under the cost recovery method, revenue and cost are recognized during the production, but gross profit is deferred until all costs are incurred.

PROB. 6-6 (AICPA) Chris Co. sells equipment on installment contracts. Which of the following statements best justifies Chris' use of the cost recovery method of revenue recognition to account for these installment sales? a. The sales contract provides that title to the equipment passes to the buyer only when all payments have been made. b. No cash payments are due until one year from the date of sale. c. Sales are subject to a high rate of return. d. There is no reasonable basis for estimating collectability. PROB. 6-6 Suggested answer (d) Ordinarily, revenues should be accounted for when a transaction is completed, with appropriate provision for uncollectible accounts. However, when there is no reasonable basis for estimating the degree of collectability, either the installment method or the cost recovery method may be used. The cost recovery method recognizes profit only after collections exceeded the cost, of the item sold.

PROB. 6 - 7 (AICPA) Winner Co. is engaged in extensive exploration for water in Utah. If, upon discovery of water, Winner does not recognize any revenue from water sales until the sales exceed the costs of exploration, the basis of revenue recognition being employed is the a. Production basis b. Cash (or collection) basis c. Sales (or accrual) basis d. Cost recovery basis PROB. 6-7 Suggested answer (d) Under the cost recovery method, no profit of any type is recognized until the cumulative receipts (principal and interest) exceed the cost of the asset sold

PROB. 6 - 8 (AICPA) Leopard Co. uses the installment sales method to recognize revenue. Customers pay the installment notes in 24 equal monthly amounts, which include 12% interest. What is the balance of an installment note receivable 6 months after the sale? a. 75% of the original sales price. b. Less than 75% of the original sales price. c. The present value of the remaining monthly payments discounted at 12%. d. Less than the present value of the remaining monthly payments discounted at 12%. PROB. 6-8 Suggested answer (c) The balance of an installment note receivable equals the unpaid balance of ! principal. The difference between the gross receivable and the unpaid principal is the interest. Therefore, the balance of the note is equal to the present value of the remaining payments discounted at the contract interest rate.

PROB. 6-9 (AICPA) On January 2, 2016, Colt Co. sold land that cost P600,000 for P800,000, receiving a note bearing interest at 10%. The note will be paid in three annual installments of P321,700 starting on December 31, 2016. Because collection of the note is very uncertain, Colt will use the cost recovery method. How much revenue from this sale should Colt recognize in 2016? a. 0 b. 6,000 c. 8,000 d. 20,000 PROB. 6-9 Suggested answer (a) 0 ! Under the cost recovery method, no profit of any type is recognized until the cumulative receipts (principal and interest) exceed the cost of the asset sold. The cost ofP600, 000 is not yet recovered 2016, thus no amount of revenue will be recognized.

PROB. 6-10 (AICPA) Several of Pitt, Inc.'s customers are having cash flow problems. Information pertaining to these customers for the years ended March 31, 2016 and 2017 follows:

Sales Cost of sales Cash collections: On 2016 sales On 2017 sales

2016 __2017__ 10,000 15,000 8,000 9,000 7,000

3,000 12,000

If the cost recovery method is used, what amount would Pitt report as gross profit a. 2,000 b. 3,000 c. 5,000 d. 15,000 PROB. 6-10 Suggested answer (c) P5,000 ! Collections on 2016 sales (7,000 + 3,000) Less cost of sales 2016

10,000 8,000

2,000

Collections on 2017 sales Less cost of sales 2017 Total gross profit

12,000 9,000 3,000 5,000

The cost recovery method recognizes profit only after collections exceed the cost of sales, that is, when the full cost has been recovered. Subsequent amounts collected are treated entirely as realized gross profit.

PROB. 6-11 (AICPA) The following information pertains to a sale of real estate by South Co. to Nord. Co. dn December 31, 2016: Carrying Amount 4,000,000 Sales Price: Cash 600,000 Purchase money mortage 5,000,000 6,000,000 The mortgage is payable in nine annual installments of P600,000 beginning December 31, 2017, plus interest of 10%. The December 31, 2017 installment was paid as scheduled, together with interest of P540,000. South uses the cost recovery method to account for the sale. What amount of income should South recognize in 2017 from the real estate sale and its financing? a. 1,140,000 b. 740,000 c. 540,000! d. 0 PROB. 6-11 Suggested answer (d) P 0 ! Again, the cost recovery method recognizes profit only after collections exceed the cost of item sold, that is, when thefull cost has been recovered. As of December 31, only PI, 200, 000 of the P4, 000, 000 cost has been recovered; ! thus, no income should be recognized PROB. 6-12 (AICPA) Hill Company began operations on January 1, 2016, and appropriately uses the installment method of accounting. Data available for 2016 are as follows Installment accounts receivable, 12/31/2016 Installment sales Cost of goods sold, as percentage of sales

500,000 900,000 60%

Using the installment method, Hill's realized gross profit for 2016 would be a. 360,000 b. 240,000 c. 200,000 d. 160,000 PROB. 6-12 Suggested answer (d) PI 60,000 Installment sales 900,000 ! Less installment accounts receivable, 12/31/2016 500,000 2016 collections 400,000 ! Multiply by gross profit on sales 40% Realized gross profit,2016 160,000 Under the installment method of accounting, income is recognized when ! collections are made. The realized gross income is equal to the collections multiplied by the gross profit rate on sales. Each collection on a contract is regarded as representing both a return of cost and a realization of gross profit in the ratio in which these two factors are found in the original sales price. This method serves to spread the gross profit on installment sales over the full life of the installment contract. Continuing expenses on an installment contract are matched against the gross profit that is recognized in successive periods; the possible failure to realize the full amount of the gross profit in the event of default by the buyer is anticipated.

PROB. 6-13 (AICPA) Luge Co., which began operations on January 2, 2016, appropriately uses the installment method of accounting. The following information is available for 2016: ! Installment accounts receivable December 31, 2016 Deferred gross profit, Dec. 31 (before Recognition of realized gross profit for 2016) ! Gross profit on sales

800,000 560,000 40%

For the year ended December 31, 2016, cash collections and realized gross profit on sales should be Cash Realized Collections Gross Profit a. 400,000 320,000 b. 400,000 240,000 c. 600,000 320,000 d. 600,000 240,000 PROB. 6-13 Suggested answer (d) P600,000 P240,000 Installment sales (560,000/40%) 1,400,000 Less installment accounts Receivable 12/31/2016 800,000 Cash collections in 2016 600,000 Multiply by gross profit rate on sales 40% Realized gross profit, 2016 240,000 Installment sales may be regarded as calling for special treatment where gross profit is related to the periods in which the installment receivable are collected rather than to the periods in which the receivables are created The inflows of cash rather than the time of sale become the criterion for revenue recognition. This is in line with realization principle that in long-term installment sales, revenue is recognized at the point of collection, because there is possibility of cancellation of the contract, and substantial collection costs may be incurred. When gross profit is regarded as contingent upon ! collection of cash, there is stronger support for its recognition over the entire collection period. Therefore, periodic collection, which is regarded as representing both a recovery of cost and a realization of gross profit, must be multiplied by gross profit rate on sale to determine the realized gross profit for the period. Due to year-end entry to adjust the deferred gross profit for purposes of recognizing the realized profit by debiting Unrealized Gross Profit account md crediting Realized Gross Profit account, the gross profit rate on sales of prior years installment sales may be computed by determining the ratio of unrealized gross profit with the installment accounts receivable at the same period. PROB. 6-14 (RPCPA) The books of Paiyakan Company show the following balances on December 31, ! 2016: Accounts receivable Deferred gross profit (before adjustment)

313,750 38,000

Analysis of the accounts receivable reveal the following: Regular accounts 2015 installement accounts 2016 installement accounts

207,500 16,250 90,000

Sales on an installement basis in 2015 were made at 30% above cost; in 2016, at 33 1/3% above cost. Expenses paid was P1,500 relating to installement sales. How much is the net income on installment sales? a. 11,000 b. 11,500 c. 16,000!

d. 10,250 PROB. 6-14 Suggested answer (d) P 10,250! Deferred goss profit (before adjustment) Less deferred gross profit (after adjustment) 2015 Sales (16,250 x 30/130) ! 2016 Sales (90,000 x 33 1/3/ 133 1/3) Realized gross profit ! Less expenses relating to installment sales ! Net income on installment sales

38,000 3,750 22,500

26,250 11,750 1,500 10,250

The computations of realized gross profit for a given period is not confined on the traditional computation by applying the gross profit percentage for the year in which the contract originated to the amounts collected on such contracts. An alternative procedure for calculating realized gross profit is by calculating the amount of deferred gross as of the end of the period reducing the deferred gross profit account to this balance. Therefore, the difference between deferred gross profit before adjustment and deferred gross profit after adjustment is the realized gross profit. PROB 6-15 (RCPA) A company uses the installment method of accounting to recognize income and pertinent data are as follows: 2014 Installment sales Cost of sales Balance of gross Profit at year-end 2014 2015 2016

300,000

2015 360,000

375,000 225,000

285,000

52.500

The balance of the receivable on December 31, 2016 is: a. 270,000 b. 277,500 c. 279,000! d. 300,000 PROB. 6-15 Suggested answer (b) P277,500 2015 Installment sales 375,000(100%) Cost of sales 285,000( 76%) Gross profit 90,000( 24%) ! Installment rec. from 2015 sales (9,000/24%) Installment rec. from 2016 sales (72,000/30%) Total installment rec., 12/31/2016

2016 252,000

15,000 54,000

9,000 72,000

2016 360,000 (100%) 252,000 ( 70%) 108,000 ( 30%) 37,500 240,000 277 500

In applying the installment method in the accounts, the difference between the sales price and the cost of sales is recorded initially as deferred gross profit. This balance is recognized as revenue periodically in the proportion that the cash collections of the period bear to the sales price. Sta...