Chapter 5, Problem 5.16P

Installment sales; alternative recognition methods

On August 31, 2018, the Silva Company sold merchandise to the Bendix Corporation for $500,000. Terms of the sale called for a down payment of $100,000 and four annual installments of $100,000 due on each August 31, beginning August 31, 2019. Each installment also will include interest on the unpaid balance applying an appropriate interest rate. The book value of the merchandise on Silva’s books on the date of sale was $300,000. The perpetual inventory system is used. The company’s fiscal year-end is December 31.

Required:

1. Prepare a table showing the amount of gross profit to be recognized in each of the five years of the installment sale applying each of the following methods:

a. Point of delivery revenue recognition

b. Installment sales method

c. Cost recovery method

2. Prepare journal entries for each of the five years applying the three revenue recognition methods listed in requirement 1. Ignore interest charges.

3. Prepare a partial balance sheet as of the end of 2018 and 2019 listing the items related to the installment sale applying each of the three methods listed in requirement 1.

To determine

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.

Cost recovery method:

Under the cost recovery method, gross profit is recognized when the cost of the sales is recovered. Where there is an extremely high degree of uncertainty in the installment sales, then this method can be used.

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 prepare: A table showing the amount of gross profit to be recognized in each five years of the installment sales.

Explanation of Solution

(a) Point of delivery revenue recognition

Particulars	08/31/2018	08/31/2019	08/31/2020	08/31/2021	08/31/2022
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Point of deliver method	$200,000	$0	$0	$0	$0

Table (1)

(b) Installment sales method

Particulars	08/31/2018	08/31/2019	08/31/2020	08/31/2021	08/31/2022
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Installment sales method ($100,000×40%)	$40,000	$40,000	$40,000	$40,000	$40,000

Table (2)

(c) Cost recovery method

Particulars	08/31/2018	08/31/2019	08/31/2020	08/31/2021	08/31/2022
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Cost recovery method	$0	$0	$0	$100,000	$100,000

Table (3)

Working note:

1. Calculation of total profit:

Given,

Sale is $500,000

Book value is $300,000

Now, calculate the total profit:

$\begin{array}{c}\text{Total profit=}\left(\begin{array}{l}\text{Sales}\\ -\text{Book value}\end{array}\right)\\ \text{=}\left(\$\text{5}00,000-\$300,000\right)\\ \text{=}\$200,000\end{array}$ (1)

2. Calculation of gross profit percentage:

Given,

Sale is $500,000

Total profit is $200,000 (1)

Now, calculate the gross profit percentage:

$\begin{array}{c}\text{Gross profit percentage=}\left(\frac{\text{Total profit}}{\text{Sales}}\right)\\ \text{=}\left(\frac{\$200,000}{\text{\$500,000}}\right)\\ \text{=40\%}\end{array}$ (2)

Hence, the calculated gross profit percentage is 40%.

To determine

To prepare: The journal entry to record the recognized revenue in each five years of the installment sales.

Explanation of Solution

Point of deliver method:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$500,000
	Sales revenue			$500,000
	(To record sales on 08/31/2018)

Table (4)

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

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cost of goods sold		$300,000
	Inventory			$300,000
	(To record cost of inventory)

Table (5)

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

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$100,000
	Installment receivables			$100,000
	(To record cash collections from installment sales)

Table (6)

• 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.

Installment sales method:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$500,000
	Inventory			$300,000
	Deferred gross profit			$200,000
	(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		$100,000
	Installment receivables			$100,000
	(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.

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

Table (9)

• 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.

Cost recovery method:

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$500,000
	Inventory			$300,000
	Deferred gross profit			$200,000
	(To record installment sales)

Table (10)

• 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		$100,000
	Installment receivables			$100,000
	(To record cash collections from installment sales)

Table (11)

• 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		$100,000
	Realized gross profit			$100,000
	(To record gross profit recognize from installment sales on 2021 and 2022)

Table (12)

• 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.

To determine

To prepare:  The partial balance sheet at the end of the 2018 and 2019.

Explanation of Solution

Partial balance sheet at the year ended 2018

Assets	Point of delivery	Installment sales
Installment receivables	$400,000	$400,000
Less: Deferred gross profit		($160,000)
Installment receivables		$240,000

Table (13)

Partial balance sheet at the year ended 2019

Assets	Point of delivery	Installment sales	Cost recovery
Installment receivables	$300,000	$300,000	$300,000
Less: Deferred gross profit		($120,000)	($200,000)
Installment receivables		$180,000	$100,000

Table (14)