Chapter 5, Problem 5.20P

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

The following tables showing the amount of gross profit to be recognized in each five years of the installment sales:

(a) Point of delivery revenue recognition

Particulars	08/31/2016	08/31/2017	08/31/2018	08/31/2019	08/31/2020
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Point of deliver method	$200,000 (1)	$0	$0	$0	$0

Table (1)

(b) Installment sales method

Particulars	08/31/2016	08/31/2017	08/31/2018	08/31/2019	08/31/2020
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Installment sales method (3)	$40,000	$40,000	$40,000	$40,000	$40,000

Table (2)

(c) Cost recovery method

Particulars	08/31/2016	08/31/2017	08/31/2018	08/31/2019	08/31/2020
Cash collection	$100,000	$100,000	$100,000	$100,000	$100,000
Cost recovery method (given)	$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:

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

3. Calculate the gross profit under installment sales

Here,

Cash collection is $100,000

Gross profit percentage is 40%

$\begin{array}{c}\text{Gross profit = Cash collection}\times \text{Percentage of gross profit}\\ =\left(\$100,000\times \frac{40}{100}\right)\\ =\$40,000\end{array}$ (3)

Requirement – 2

To determine

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

Explanation of Solution

The journal entry to record the recognized revenue in each five years of the installment sales are as follows:

Point of deliver method:

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

Table (4)

• Installment receivable is liability. There is a decrease in asset value. Therefore, it is debited.
• Sales revenue is revenue. There is an increase in value of stockholder’s equity. 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)

• Cost of goods sold is expense, and there is decrease in the value of stockholder’s equity. Therefore, it is debited.
• Inventory is an asset. There is a decrease in asset 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 2019 and 2020)

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.

Conclusion

Therefore, the journal entries of revenue recognition under point of delivery, installment sales and cost recovery method are recorded.

Requirement – 3

To determine

To prepare:  The partial balance sheet for the end of the 2016 and 2017.

Explanation of Solution

The partial balance sheet for the end of the 2016 and 2017 are as follows:

Partial balance sheet for the year ended 2016

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 for the year ended 2017

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)

Conclusion

Therefore, the partial balance sheet under point of delivery, installment sales and cost recovery method for the year ended 2016 and 2017 are prepared.