Chapter 5, Problem 5.15P

To determine

Requirement – 1

The revenue recognition principle

The revenue recognition principle refers to the revenue that should be recognized in the time period, when the performance obligation (sales or services) of the company is completed.

Installment sales method:

Under the installment sales, the revenue and costs are recognized only when the payment of cash is received from customer. Two composed components are involved in the each payment of cash, and components of sales are as follows:

• Partial recovery of the cost from sales
• Component of gross profit

These components are determined by the percentage of gross profit.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

To calculate: The amount of gross profit that would be recognized in each year from installment sales.

Explanation of Solution

Gross profit in the year 2018:

Here,

Cash collection in 2018 is $120,000

Gross profit is 40% (Refer to equation (1)).

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit}=\left(\begin{array}{l}\text{Cash collection}\\ \times \text{Gross profit}\end{array}\right)\\ =\text{\$120,000×40\%}\\ =\text{\$48,000}\end{array}$

Hence, the calculated gross profit is $48,000.

Working note:

Calculate the cost of recovery in 2018:

Given,

The cost of sales is $180,000

Sales are $300,000

Now, calculate the cost recovery:

$\begin{array}{c}\text{Cost recovery}=\left(\frac{\text{Cost of installment sales}}{\text{Installment sales}}\right)\\ \text{=}\left(\frac{\text{\$180,000}}{\text{\$300,000}}\right)\\ =\text{60\%}\end{array}$ (1)

Hence, the calculated cost recovery is 60%, than gross profit ratio is 40% $\left(100\%-40\%\right)$

Gross profit in the year 2019:

Here,

The cash collection form 2018 sales is $100,000,

Cash collection form 2019 sales is $150,000,

Calculated 2018 gross profit is 40% (Refer to equation (1)),

Gross profit is $30% (Refer to equation (2)).

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit}=\left(\begin{array}{l}\left(\begin{array}{l}\text{Cash collection form 2}0\text{16 sales}\\ \times \text{2}0\text{16 gross profit}\end{array}\right)\\ +\left(\begin{array}{l}\text{Cash collection form 2}0\text{17 sales}\\ \times \text{2}0\text{17 gross profit }\end{array}\right)\end{array}\right)\\ =\left(\$\text{1}00,000\times \text{4}0\%\right)+\left(\$\text{15}0,000\times \$\text{3}0\%\right)\\ =\$40,000+\$45,000\\ =\$85,000\end{array}$

Hence, the calculated gross profit is $85,000.

Working note:

Calculate the cost of recovery in 2019:

Given,

The cost of sales is $280,000

Sales are $400,000

Now, calculate the cost recovery:

$\begin{array}{c}\text{Cost recovery}=\left(\frac{\text{Cost of installment sales}}{\text{Installment sales}}\right)\\ =\left(\frac{\text{\$280,000}}{\text{\$400,000}}\right)\\ =\text{70\%}\end{array}$ (2)

Hence, the calculated cost recovery is 70%, than gross profit ratio is 30% $\left(100\%-70\%\right)$

Requirement – 2

To determine

To prepare: All necessary journal entries for each year.

Explanation of Solution

In the year 2018

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$300,000
	Inventory			$180,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (1)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$120,000
	Installment receivables			$120,000
	(To record cash collections from installment sales)

Table (2)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit		$48,000
	Realized gross profit			$48,000
	(To record gross profit recognize from installment sales)

Table (3)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

In the year 2019

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$400,000
	Inventory			$280,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (4)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$250,000
	Installment receivables			$250,000
	(To record cash collections from installment sales)

Table (5)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit		$85,000
	Realized gross profit			$85,000
	(To record gross profit recognize from installment sales)

Table (6)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

Requirement – 3

To determine

To prepare: All necessary journal entries for each year in cost recovery method.

Explanation of Solution

In the year 2018

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$300,000
	Inventory			$180,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (7)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$120,000
	Installment receivables			$120,000
	(To record cash collections from installment sales)

Table (8)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

In the year 2019

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$400,000
	Inventory			$280,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (9)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$250,000
	Installment receivables			$250,000
	(To record cash collections from installment sales)

Table (10)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit (2)		$40,000
	Realized gross profit			$40,000
	(To record gross profit recognize from installment sales)

Table (11)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

Working note:

1. Calculate the value of gross profit in 2018:

Given,

Cash collected is $120,000

Cost recovery is $120,000.

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit = Cash collected}-\text{Cost recovery}\\ \text{=\$120,000}-\text{\$120,000}\\ \text{=\$0}\end{array}$ (1)

2. Calculate the value of gross profit in 2019:

Given,

Cash collected form 2018 sales is $100,000

Cash collected form 2019 sales is $150,000

Cost recovery form 2018 is $120,000

Cost recovery form 2019 is $120,000

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit =}\left(\begin{array}{l}\left(\begin{array}{l}\text{Cashcollected form 2}0\text{16 sales}\\ -\text{Cost recovery form 2}0\text{16}\end{array}\right)\\ +\left(\begin{array}{l}\text{Cash collected form 2}0\text{17 sales }-\\ \text{Cost recovery form 2}0\text{17}\end{array}\right)\end{array}\right)\\ =\left(\begin{array}{l}\left(\$\text{1}00,000-\$60,000\right)\\ +\left(\$\text{15}0,000-\$\text{15}0,000\right)\end{array}\right)\\ =\$40,000+\$0\\ =\$40,000\end{array}$ (2)