While many sales are in certain collection, some others are uncertain. A good example of sales with uncertain collection is a stationary supplier delivers stationary stuffs to one of its customer with a deal that the customer settles the payment in four years time-span, and with interest. The degree of the uncertainty (on the collection) may vary—some could be not so uncertain (with shorter time-span) and others are heavily uncertain. So, how do we treat sales when collection is uncertain, under the IFRS?
There are two issues that an accountant would need to address under such situation. First is the revenue-expense matching, and second is the interest recognition that usually comes along the transaction.
Under the IASB’s Framework, revenue is defined as income arising from the ordinary activities of an entity and may be referred to by a variety of names including sales, fees, interest, dividends, and royalties. The most common revenue recognition system is based on the accrual method. Under this approach, if the revenue recognition rules presented in the previous section have been met, then revenue may be recognized in full. In addition, expenses related to that revenue should be recognized and matched against the revenue. Is this system applicable in the case that there is a long string of expected payments from a customer that are related to a sale, and for which the level of collectibility of individual payments cannot be reasonably estimated? Read on…
The determination of the point in time when a reporting entity is considered to have transferred the significant risks and rewards of ownership in goods to the buyer is critical to the recognition of revenue from the sale of goods. Two methods are used to record sales when the collection of those sales is uncertain: (a) installment method; and (b) cost recovery method.
Sales Under the Installment Method
Under the installment method, both revenue and the associated cost of goods sold are recognized at the time of the initial sale, but gross profit recognition is deferred until cash payments are received. This method requires the accountant to track the gross margin percentage for each reporting period, so the correct percentage can be recognized when the associated cash receipts arrive at a later date.
A typical component of installment sales is interest income—which is included in the periodic installment payments. Since installment payments typically are designed to be in equal amounts, the interest income component of these billings will comprise a gradually decreasing amount as more of the installment receivable is paid off.
In order to properly account for the interest income component of installment sales, interest income must be stripped out of each payment made and credited to the interest income account, leaving the remaining balance of the payment subject to accounting under either the installment or cost recovery method which will be discussed after the installment case example.
Installment Method Case Example
The Lie Dharma Company sells stationary stuffs in bulk to local schools. Under one recent deal, it sold $10,000 of books to a school in Costa Mesa at a gross profit of 30% The school paid for the books in four annual installments that included 8% interest. So how will Lie Dharma recognize the interest income and gross profit?
The next table illustrates the recognition of both interest income and gross profit under the deal:
Equal cash payments of $3,019.21 are made at the end of each year (see first column), from which interest income is separated and recognized (see second column), leaving an annual net receivable reduction (see third column). The gross profit on the deal (see fifth column) is recognized in proportion to the amount of accounts receivable reduction each year, which is 30% of third column.
In this case, Lie Dharma will recognized 30% of the deferred gross profit contained within each cash payment and net of interest income, by making the following journal entry on 12/31/2013:
[Debit]. Cash = $3,019.21
[Credit]. Interest income = $800.00
[Credit]. Accounts receivable = $2,219.21
[Debit]. Deferred gross profit = $665.76
[Credit]. Recognized gross profit = $665.76
Note: Installment accounts receivable are recognized as current assets, since the full term of the installment sale represents the normal operating cycle of the company. If installment sales are not a part of normal company operations, then the receivables are classified as long-term assets. In either case, installment accounts receivable should be itemized on the statement of financial position by year. For example, all outstanding receivables due for payment in 2012 would be listed next to the title “Installment Receivables Due in 2012” in the statement of financial position.
From the case example, you can see the collection is not really uncertain. What if the degree of the uncertainty is greater? You would use the cost recovery method. But before that, what will happen if the school, on the Lie Dharma above case, returns some books? Let’s address this question first. Read on…
Goods Returned Under the Installment Sales
It is allowed to recognize “bad debt” (only under installment sales)—since the seller can usually return the goods. When the goods are returned, however, their value must be adjusted to their net realizable value, which in most cases calls for the recognition of a loss (see the next example)
Goods Return Case Example (Under the Installment Method)
Let say, in 2014, the school (following on the previous example) returns some books, for which $5,384.04 of accounts receivable is still outstanding, as well as $1,615.22 of deferred gross profit. The returned-books have a total fair market value of $ 2,800.00.
In this case, Lie Dharma would make the following journal entry:
[Debit]. Deferred gross margin = $1,615.22
[Debit]. Finished goods inventory = $2,800.00
[Debit]. Loss on inventory write-down = $968.82
[Credit]. Accounts receivable = $5,384.04
(To eliminate the receivable and deferred gross profit, while recognizing a loss of $968.82 on the write-down of the books.)
Recording Sales Under the Cost Recovery Method
Under the cost recovery method, recognition of all gross profit is delayed until cash payments have been received that equal the entire cost of goods sold. The cost recovery method is the more conservative method and used when the collection of sales is highly uncertain.
For the cost recovery method, interest income related to any long-term installment sales increases the unrecognized gross profit until the aggregate customer payments exceed the asset cost, after which the interest income is recognized. Next is a case example.
Cost Recovery Method Case Example
We use the same assumptions for the Lie Dharma case under the cost recovery method. Cash payments are the same, as are the interest charges and beginning balance. However, no gross profit or interest income is realized until all $7,000 of product costs have been recovered through cash payments net of interest income. Instead, interest income is shifted to a deferred account. See below table:
As you can see on the above table, fifth column shows a declining balance of “unrecovered costs” that are eliminated when the third periodic payment arrives. This allows Lie Dharma’s controller to recognize a small amount of deferred interest income in the third year—representing the net amount of cash payment left over after all costs have been recovered. In the final year, all remaining deferred interest income can be recognized, leaving the deferred gross margin as the last item to be recognized.
Note: As when you’re using the installment method, installment accounts receivable are recognized as current assets (see note on the installment method).
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