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I know the completed contract method is different from the cost recovery method, but I am asking in regards to the cost recovery method used in the installment sales method and the construction project method my question is profit is recognized when revenue is greater than costs? Accounting for installment sales include the following steps: At the time of sale, recognize the revenue and related cost of goods sold. Defer the gross profit on the sale. At the end of each period, make a journal entry to recognize profit equal to the product of the gross profit rate on the.
The installment sales method is one of several approaches used to recognize revenue under the US GAAP, specifically when revenue and expense are recognized at the time of cash collection rather than at the time of sale.[1] Under the US GAAP, it is the principal method of revenue recognition when the recognition occurs subsequently to the sale.[2]
Installment sales method[edit]
The installment sales method, is used to recognize revenue after the sale has occurred and when sales are stipulated under very extended cash collection terms.[3] In general, when the risk of not being able to collect is reasonably high and when there is no reasonable basis for estimating the proportion of installment accounts, revenue recognition is deferred, and the installment sales method is used. The installment sales method is typically used to account for sales of consumer durables, retail land sales, and retirement property.[3] Under the cost recovery method, another method to recognize income after the sale is made, no profit is recognized until all the costs are recovered.[4]
Calculation under the installment sales method[edit]
The installment sales method recognizes revenue and income proportionately as cash is collected. The amount recognized in any period is thus based on two factors:[5]
- The gross profit percentage:
- The amount of cash collected on installment accounts receivable.
Below is an example of calculation of installment sales for years 2009 and 2010.[5]
2009 | 2010 | |
---|---|---|
Installment sales | $1,200,000 | $1,300,000 |
Cost on installment goods sold | $840,000 | $884,000 |
Gross profit | $360,000 | $416,000 |
Gross profit percentage | 30% | 32% |
Cash collections | ||
On 2009 installment sales | $300,000 | $600,000 |
On 2010 installments sales | $340,000 |
- 2009 income from installment sales calculation:
The income recognized in 2009 equals cash collections in 2009 multiplied by the gross profit percentage in 2009 and is calculated as follows:
- $300,000×30% = $90,000
Such income is shown on the 2009 income statement as 2009 income from installment sales.
- 2009 Deferred Gross Profit calculation:
The deferred gross profit is an A/R contra-account and is the difference between gross profit and recognized income and is calculated as follows:
- $360,000 − $90,000 = $270,000
The deferred gross profit is thus deferred and recognized in income in subsequent periods, i.e. when the installment receivables are collected in cash.
- 2010 income from installment sales is $288,800 and calculated as follows:
Total 2010 installment sales income | |
---|---|
Gross profit recognized | |
Component relating to 2009 Sales | |
Cash collections in 2010 from 2009 sales | $600,000 |
Multiplied by year 2009 gross profit percentage | 30% |
$180,000 | |
Component relating to 2010 sales | |
Cash collections in 2010 from 2010 sales | $340,000 |
Multiplied by year 2010 gross profit percentage | 32% |
$108,800 | |
Total installment sales income recognized in 2010 | $288,800 |
A more comprehensive table would clearly show gross profit and deferred income recognized for each year: 2009 and 2010.
2009 | 2010 | |
---|---|---|
Installment sales | $1,200,000 | $1,300,000 |
Cost of installment goods sold | ($840,000) | (884,000) |
Gross profit | 360,000 | 416,000 |
Less: Deferred gross profit on installment sales of current year | (270,000) | (307,200) |
Gross profit recognized on current year's sales | 90,000 | 108,800 |
Plus: Gross profit recognized on installment sales of prior years | 180,000 | |
Total gross profit recognized in the year | $90,000 | $288,800 |
Installment sales and the related costs of good sold must be tracked by individual year in order to compute the gross profit percentage that applies to each year. Furthermore, the accounting system must correctly match the cash collections with the specific sales year so that the correct gross profit percentage be applied.[6]
On the balance sheet, 'the accounts receivable - installment sales' is classified as current assets if it is due within 12 months of the balance sheet. Otherwise, it is classified as long term assets.[6]
Under the GAAP, the interest component of the periodic cash proceeds is computed separately. In fact, interest payments are not considered when the recognized gross profit is computed on installment sales. Certain procedures differentiate between principal and interest payments on customer receivables.[7]
Comparison to the cash and accrual method[edit]
Cash method – The cash method requires that an amount be included in gross income when it is actually or constructively received. The installment method allows greater deferral when the payment is received in the form of a negotiable note. The cash method does not allow for differing between cost recovery and gain.
Accrual method – The accrual method requires income to be recognized as soon as the taxpayer has a right to the income regardless of when the payment is actually received. As such, the taxpayer would have to recognize the full amount of the sale despite the fact that the purchase price may not be paid in full for years.
See also[edit]
References[edit]
- ^Revsine 2002, p. 48
- ^Revsine 2002, p. 110
- ^ abRevsine 2002, p. 101
- ^Siegel 2000, p. 112
- ^ abRevsine 2002, p. 111
- ^ abRevsine 2002, p. 112
- ^Revsine 2002, p. 113
Sources[edit]
- Revsine, Lawrence (2002), Financial reporting & analysis, Prentice Hall, ISBN978-0-13-032351-4
- Siegel, Joel G. (2000), Dictionary of accounting terms, Barron's Educational Series, ISBN978-0-7641-1259-1
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Definition
The term cost recovery refers to an accounting method that reports revenue and the cost of goods sold in the period of sale, but delays recognizing profit until the cash received from customers is in excess of the cost of goods sold. Along with the installment sales method, this approach can be used when companies recognize revenue after delivery.
Explanation
The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until they are realized or realizable, and the company has substantially completed what it needs to do in order to be entitled to payment. Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction.
If the sales price is not reasonably assured after delivery of the product or service to a customer, the company may choose to defer recognizing revenue until cash is received. Generally, there are two accepted ways to account for these transactions: the installment method and the cost recovery method.
The cost recovery method is similar to the installment method, since both approaches recognize total revenue and the cost of goods sold in the period of the sale. However, while the installment method recognizes income as cash is collected from customers, the cost recovery method delays recognizing profit until the cash received is in excess of the cost of goods sold.
APB Opinion No. 10 allows sellers to use the cost-recovery method when there is no reasonable basis for estimating collectability. FASB Statements No. 45 (Franchises) and No. 66 (Real Estate) require use of this approach when there is a high degree of uncertainty related to the collection of receivables.
Example
Company A recorded $7,500,000 in installment sales in the current fiscal year. The cost of goods sold associated with these sales was $6,000,000. Company A was also able to collect $3,000,000 from customers through their scheduled installment payments. The determination of gross profit to record in the current fiscal period would be as follows:
Installment Sales | $7,500,000 |
Cost of Goods Sold | $6,000,000 |
Gross Profit | $1,500,000 |
Cash Receipts | $3,000,000 |
Realized Gross Profit | $0 |
Deferred Gross Profit | $1,500,000 |
Since the cash receipts of $3,000,000 in the current accounting period is less than the cost of goods sold, Company A would defer all gross profit. The journal entries associated with these transactions would be as follows.
To record the sales for the current fiscal year:
Debit | Credit |
Installment Accounts Receivable | $7,500,000 |
Installment Sales | $7,500,000 |
The journal entry to record the collection of cash from customers:
Debit | Credit |
Cash | $3,000,000 |
Installment Accounts Receivable | $3,000,000 |
The journal entry to record the cost of goods sold:
Debit | Credit |
Cost of Installment Sales | $6,000,000 |
Inventory (Goods Sold on Installment) | $6,000,000 |
The journal entry to record the installment sales:
Debit | Credit |
Installment Sales | $7,500,000 |
Cost of Installment Sales | $6,000,000 |
Deferred Gross Profit (Installment Sales) | $1,500,000 |
Since the cash collected from customers ($3,000,000) is less than the cost of goods sold ($6,000,000) in the current accounting period, all gross profit is deferred.
Related Terms
revenues, revenue recognition principle, revenue recognition: before delivery, revenue recognition: point of sale, revenue recognition: during production, revenue recognition: after delivery, installment method