Accounting, Financial, Taxation

Examples presented on the previous post [Applying Installment Method] ignored interest, a major component of most installment sales contracts. It is customary for the seller to charge interest to the buyer on the unpaid installment receivable balance. Generally, installment contracts call for equal payments, each with an amount attributable to interest on the unpaid balance and the remainder to the installment receivable balance. As the maturity date nears, a smaller amount of each installment payment is attributable to interest and a larger amount is attributable to principal. Therefore, to determine the amount of gross profit to recognize, the interest must first be deducted from the installment payment, and then the difference (representing the principal portion of the payment) is multiplied by the gross profit rate as follows:

Realized gross profit = [Installment payment – Interest portion] × Gross profit rate

The interest portion of the installment payment is recorded as interest revenue at the time of the cash receipt. Appropriate accounting entries are required to accrue interest revenue when the collection dates do not correspond with the period-end.

To illustrate the accounting for installment sales contracts involving interest, assume that Lie Dharma Equipment Company sells a machine for $5,000 on December 31, 2006, to a customer with a dubious credit history.

The machine cost Lie Dharma $3,750. The terms of the agreement require a $1,000 down payment on the date of the sale. The remaining $4,000 is payable in equal annual installments of $1,401.06, including 15 percent annual interest, at the end of each of the next four years.

For each payment it receives, Lie Dharma must compute the portion to record as interest revenue with the remaining portion of the payment (the principal) to be applied to reduce the installment account receivable balance. Gross profit is recognized only on the principal portion of each payment that is applied to reduce the installment receivable balance. The following schedule illustrates that gross profit is recognized on the entire down payment (which contains no element of interest revenue), whereas the annual installment payments are separated into their interest and principal portions, with gross profit being recognized only on the latter portion.

Bad Debts And Repossessions

The standard accounting treatment for uncollectible accounts is to accrue a bad debt loss in the year of sale by estimating the amount expected to be uncollectible. This treatment is consistent with the accrual and matching concepts. However, just as revenue recognition under the accrual basis is sometimes abandoned for certain installment-basis sales, the accrual basis of recognizing bad debts is also sometimes abandoned.

When the installment method is used, it is usually appropriate to recognize bad debts by the direct write-off method (i.e., bad debts are not recognized until the receivable has been determined to be uncollectible).

This practice is acceptable because most installment contracts contain a provision that allows the seller to repossess the merchandise when the buyer defaults on the installment payments. The loss on the account may be eliminated or reduced because the seller has the option of reselling the repossessed merchandise. To write off an uncollectible installment receivable, the following three steps are followed:

1. The installment account receivable and the deferred gross profit are eliminated.
2. The repossessed merchandise is recorded as used inventory at its net realizable value. Net realizable value is resale value less any selling or reconditioning costs. The repossessed asset is recorded at this fair value because any asset acquired is recorded at the best approximation of its fair value.
3. Bad debt expense, and a gain or loss on repossession are recognized.

The bad debt expense or repossession gain or loss is the difference between the un-recovered cost (Installment account receivable – Deferred gross profit) and the net realizable value of the repossessed merchandise.

To illustrate, assume that Royal Bali Cemerlang Company determined that a $3,000 installment receivable is uncollectible. The deferred gross profit ratio on the original sale was 30%; thus, $900 deferred gross profit exists ($3,000 × 30%). If the repossessed equipment has a $1,500 net realizable value, a $600 repossession loss (or bad debt expense) should be recorded.

Royal Bali Cemerlang would record this loss by making the following entry:

[Debit]. Deferred gross profit = $900
[Debit]. Inventory—repossessed merchandise = $1,500
[Debit]. Repossession loss = $600
[Credit]. Installment account receivable = $3,000

Disclosure Of Installment Sales

If installment sales comprise a significant proportion of corporate sales, a footnote should disclose the revenue recognition policy used, as well as the amounts of gross profit recognized from the current and prior years, the total amount of deferred gross profit, and its placement on the balance sheet. An example is as follows:

The company sells kitchen appliances on various installment payment plans. Given the extreme uncertainty associated with the collection of receivables under this plan, the company uses the cost recovery method to recognize profits, under which it recognizes no gross profit until all costs of goods sold have been paid back through cash receipts. In 2005, the company recognized $397,000 of gross profit earned in the current year, as well as $791,000 deferred from prior years. An additional $2,907,000 of deferred gross profits is classified as a current liability in the Unrecognized Gross Profit on Installment Sales account.

In this post, I am going to reveal “how to apply revenue recognition under Installment method” in step-by step. As the title says, it is typically a technical topic in “Revenue Recognition” area. It is coming with case example in a step-by-step way, aided with screenshot to ensure that you can understand what really I am saying that impossible you can miss. Can you go without equation and formula? You know that answer is “you cannot”, don’t worry, you will get the exact equation and formula. The following various related topic are also going to be discussed: Revenue Recognition When Collection Is Uncertain under GAAP sources, accompanied with the term and definition for jargon used in this topic will be discussed at first stage as a steady fundament. Installment payment of receivables sometimes followed with interest, so “Interest On Installment Method Receivables” will be discussed as well, How about bad debt under installment method? Yes It is fully loaded “Bad Debts And Repossessions” is also on the note. Finally “Disclosure Of Installment Sales” will close this discussion.

Here we go…

Revenue Recognition When Collection Is Uncertain under GAAP

Under generally accepted accounting principles, revenue recognition customarily does not depend on the collection of cash. Accrual accounting techniques normally record revenue at the point of a credit sale by establishing a receivable. When uncertainty arises surrounding the collectibility of this amount, the receivable is appropriately adjusted by establishing a valuation allowance. In some cases, however, the collection of the sales price may be so uncertain that an objective measure of ultimate collectibility cannot be established. When such circumstances exist, the seller uses either the installment method or the cost recovery method to recognize the transaction (APB 10). Both of these methods allow for a deferral of gross profit until cash has been collected. The Accounting Principles Board specifically noted that these installment methods are “not acceptable” if revenues and a provision for uncollectible accounts can be reasonably estimated.

An installment transaction occurs when a seller delivers a product or performs a service and the buyer makes periodic payments over an extended period of time. Under the installment method, revenue recognition is deferred until the period(s) of cash collection. The seller recognizes both revenues and cost of sales at the time of the sale; however, the related gross profit is deferred to those periods in which cash is collected. Under the cost recovery method, both revenues and cost of sales are recognized at the time of the sale, but none of the related gross profit is recognized until the entire cost of sales has been recovered. Once the seller has recovered all costs of sales, any additional cash receipts are recognized as revenue.

APB 10 does not specify when one method is preferred over the other. However, the cost recovery method is more conservative than the installment method because gross profit is deferred until all costs have been recovered; therefore, it is more appropriate for situations of extreme uncertainty.

Term and Definitions Used

Before you go to the main course, its is worth reviewing and understanding the term and definitions used in this topic. Read it carefully:

Cost recovery method: The method of accounting for an installment basis sale whereby the gross profit is deferred until all cost of sales has been recovered.

Deferred gross profit: The gross profit from an installment basis sale that will be recognized in future periods.

Gross profit rate: The percentage computed by dividing gross profit by revenue from an installment sale.

Installment Method: The method of accounting for a sale whereby gross profit is recognized in each period in which cash from the sale is collected.

Installment sale: A sales transaction for which the sales price is collected through the receipt of periodic payments over an extended period of time.

Net realizable value: The portion of the recorded amount of an asset expected to be realized in cash upon its liquidation in the ordinary course of business.

Realized gross profit: The gross profit recognized in the current period.

Repossessions: Merchandise sold by a seller under an installment arrangement that the seller physically takes back after the buyer defaults on the payments.

Revenue Recognition Under Installment Method

The installment method was developed in response to the increasing incidence of sales contracts that allowed buyers to make payments over several years. As the payment period becomes longer, the risk of loss resulting from uncollectible accounts increases; consequently, circumstances surrounding a receivable may lead to considerable uncertainty as to whether payments will actually be received. Under these circumstances, the uncertainty of cash collection dictates that revenue recognition be deferred until the actual receipt of cash.

The installment method can be used in most sales transactions for which payment is to be made through periodic installments over an extended period of time and the collectibility of the sales price cannot be reasonably estimated. This method is applicable to the sales of real estate, heavy equipment, home furnishings, and other merchandise sold on an installment basis. Installment method revenue recognition is not in accordance with accrual accounting because revenue recognition is not normally based on cash collection; however, its use is justified in certain circumstances on the grounds that accrual accounting may result in “front end loading” (i.e., all of the revenue from a transaction being recognized at the point of sale with an improper matching of related costs). For example: the application of accrual accounting to transactions that provide for installment payments over periods of 10, 20, or 30 years may underestimate losses from contract defaults and other future contract costs.

Applying The Installment Method - The Main Course

When a seller uses the installment method, both revenue and cost of sales are recognized at the point of sale, but the related gross profit is deferred to those periods during which cash will be collected. As receivables are collected, a portion of the deferred gross profit equal to the gross profit rate times the cash collected is recognized as income. When this method is used, the seller must compute each year’s gross profit rate and also must maintain records of installment accounts receivable and deferred revenue that are separately identified by the year of sale. All general and administrative expenses are normally expensed in the period incurred.

The steps to use in accounting for sales under the installment method are as follows:

[1]. During the current year, record sales and cost of sales in the regular manner. Record installment sales transactions separately from other sales. Set up installment accounts receivable identified by the year of sale (e.g., Installment Accounts Receivable—2007).

[2]. Record cash collections from installment accounts receivable. Care must be taken so that the cash receipts are properly identified as to the year in which the receivable arose.

[3]. At the end of the current year, transfer installment sales revenue and installment cost of sales to deferred gross profit properly identified by the year of sale. Compute the current year’s gross profit rate on installment sales as follows:

Gross profit rate = 1 [-] Cost of installment sales [:] Installment sales revenue

Alternatively, the gross profit rate can be computed as follows:

Gross profit rate = [Installment sales revenue - Cost of installment sales] [:] Installment sales revenue

[4]. Apply the current year’s gross profit rate to the cash collections from the current year’s installment sales to compute the realized gross profit from the current year’s installment sales.

Realized gross profit = Cash collections from the current year’s installment sales [x] Current year’s gross profit rate

[5]. Separately apply each of the previous year’s gross profit rates to cash collections from those year’s installment sales to compute the realized gross profit from each of the previous years’ installment sales.

Realized gross profit = Cash collections from the previous years’ installment sales [x] Previous years’ gross profit rate

[6]. Defer the current year’s unrealized gross profit to future years. The deferred gross profit to carry forward to future years is computed as follows:

Deferred gross profit (2007) = Ending balance installment account receivable (2007) [x] Gross profit rate (2007)

Example of the Installment Method of Accounting

Accounting entries are made for steps 1 and 2 above using this data; the following computations are required for steps 3 through 6

Step 3: Compute the current year’s gross profit rate.

Step 4: Apply the current year’s gross profit rate to cash collections from current year’s sales.

Step 5: Separately apply each of the previous years’ gross profit rates to cash collections from that year’s installment sales.

Step 6: Defer the current year’s unrealized gross profit to future years.

Financial Statement Presentation

If installment sales transactions represent a significant portion of the company’s total sales, the following three items of gross profit would, theoretically, be reported on the company’s income statement:

1. Total gross profit from current year’s sales
2. Realized gross profit from current year’s sales
3. An income statement using the previous example would be presented as follows (assume all sales are accounted for by the installment method):

However, when a company recognizes only a small portion of its revenues using the installment method, the illustrated presentation of revenue and gross profit may be confusing. Therefore, in practice, some companies simply report the realized gross profit from installment sales by displaying it as a single line item on the income statement as follows:

The balance sheet presentation of installment accounts receivable depends on whether installment sales are a normal part of operations. If a company sells most of its products on an installment basis, installment accounts receivable are classified as a current asset because the operating cycle of the business (the length of which is to be disclosed in the notes to the financial statements) is the average period of time covered by its installment contracts. If installment sales are not a normal part of operations, installment accounts receivable that are not to be collected for more than a year (or the length of the company’s operating cycle, if different than a year) are reported as non-current assets. In all cases, to avoid confusion, it is desirable to fully disclose the year of maturity next to each group of installment accounts receivable as illustrated by the following example:

Accounting for deferred gross profit is addressed in CON 3, which states that deferred gross profit is not a liability. The reason is that the seller company is not obligated to pay cash or provide services to the customer. Rather, the deferral arose because of the uncertainty surrounding the collectibility of the sales price. CON 3 goes on to say, “Deferred gross profit on installment sales is conceptually an asset valuation—that is, a reduction of an asset”. However, in practice, deferred gross profit is generally presented either as unearned revenue classified in the current liability section of the balance sheet or as a deferred credit displayed between liabilities and equity.

Following the guideline in CON 3, the current asset section would be presented as follows (using information from the Partial Income Statement example above and assuming a 12/31/09 balance sheet):

To avoid a heavy page load, I split this topic into two post, you can read the series here [Interest, Bad Debt, and Repossessions On Installment Method Receivables]

Following on my previous post (Evolving Problems In Revenue Recognition), the following controls can be used to spot transactional errors or attempts to alter the reported level of revenue for the standard revenue recognition systems:

Investigate all journal entries increasing the size of revenue. Any time a journal entry is used to increase a sales account, this should be a “red flag” indicating the potential presence of revenues that were not created through a normal sales journal transaction. These transactions can be legitimate cases of incremental revenue recognition associated with prepaid services, but can also be barter swap transactions or fake transactions whose sole purpose is to increase revenues. It is especially important to review all sales transactions where the offsetting debit to the sales credit is not accounts receivable or cash. This is a prime indicator of unusual transactions that may not really qualify as sales. For example, a gain on an asset sale or an extraordinary gain may be incorrectly credited to a sales account that would mislead the reader of a company’s financial statements that its operating revenues have increased.

Compare the shipping log and shipping documents to invoices issued at period-end. This control is designed to spot billings on transactions not completed until after the reporting period had closed. An invoice dated within a reporting period whose associated shipping documentation shows the transaction as having occurred later is clear evidence of improper revenue reporting. If invoices are based on services instead of goods provided, then invoices can be matched to service reports or timesheets instead.

Issue financial statements within one day of the period-end. By eliminating the gap between the end of the reporting period and the issuance of financial statements, it is impossible for anyone to create additional invoices for goods shipping subsequent to the period-end, thereby automatically eliminating any cutoff problems.

Compare customer-requested delivery dates to actual shipment dates. If customer order information is loaded into the accounting computer system, run a comparison of the dates on which customers have requested delivery to the dates on which orders were actually shipped. If there is an ongoing tendency to make shipments substantially early, there may be a problem with trying to create revenue by making early shipments. Of particular interest is when there is a surge of early shipments in months when revenues would otherwise have been low, indicating a clear intention to increase revenues by avoiding customer-mandated shipment dates. It may be possible to program the computer system to not allow the recording of deliveries if the entered delivery date is prior to the customer-requested delivery date, thereby effectively blocking early revenue recognition.

Compare invoice dates to the recurring revenue database. In cases where a company obtains a recurring revenue stream by billing customers periodically for maintenance or subscription services, there can be a temptation to create early billings in order to record revenue somewhat sooner. For example, a billing on a 12-month subscription could be issued after 11 months, thereby accelerating revenue recognition by one month. This issue can be spotted by comparing the total of recurring billings in a month to the total amount of recurring revenue for that period as compiled from the corporate database of customers with recurring revenue. Alternatively, one can compare the recurring billing dates for a small sample of customers to the dates on which invoices were actually issued.

Identify shipments of product samples in the shipping log. A product that is shipped with no intention of being billed is probably a product sample being sent to a prospective customer, marketing agency, and so on. These should be noted as product samples in the shipping log, and the internal audit staff should verify that each of them was properly authorized, preferably with a signed document.

Verify that a signed Acknowledgment of Bill-and-Hold Transaction has been received for every related transaction. If a company uses bill-and-hold transactions, then this control is absolutely mandatory. By ensuring that customers have agreed in advance to be
billed for items to be kept in the company’s warehouse, one can be assured of being in compliance with the strict GAAP rules applying to these transactions. Also, a continual verification of this paperwork (shown earlier in Exhibit 1-2) will keep managers from incorrectly inflating revenues by issuing false bill-and-hold transactions.

Confirm signed Acknowledgment of Bill-and-Hold Transactions with customers. If a company begins to match bill-and-hold acknowledgment letters to invoices issued to customers (see last control), the logical reaction of any person who wants to fraudulently continue issuing bill-and-hold invoices is to create dummy acknowledgments. Consequently, it is useful to contact the persons who legedly signed the acknowledgments to verify that they actually did so.

Do not accept any product returns without an authorization number. Customers will sometimes try to return products if there is no justification required, thereby clearing out their inventories at the expense of the company. This can be avoided by requiring a return authorization number, which must be provided by the company in advance and prominently noted on any returned goods. If the number is not shown, the receiving department is required to reject the shipment.

Compare related company addresses and names to customer list. By comparing the list of company subsidiaries to the customer list, one can determine if any inter-company sales have occurred and whether these transactions have all been appropriately backed out of the financial statements. Since employees at one subsidiary may conceal this relationship by using a false company name or address, one can verify the same information at all the other subsidiaries by matching subsidiary names and addresses to their supplier lists, since it is possible that the receiving companies are not trying to hide the inter-company sales information.

Require a written business case for all barter transactions. Require the creation of a business case detailing why a barter transaction is required and what type of accounting should be used for it. The case should be approved by a senior-level manager before any associated entry is made in the general ledger. The case should be attached to the associated journal entry and filed. This approach makes it less likely that sham barter swap transactions will be created.

Verify that cash-back payments to customers are charged to sales. Compare the customer list to the cash disbursements register to highlight all cash payments made to customers. Investigate each one and verify that the revenue account was debited in those instances where cash-back payments were made. This should not apply to the return of overpayments made by customers to the company.

Create a revenue accounting procedure to specify the treatment of gross or net transactions. When a company deals with both gross and net revenue transactions on a regular basis, there should be a procedure that clearly defines for the accounting staff the situations under which revenues shall be treated on a gross or net basis. This reduces the need for internal audit reviews (see next control) to detect revenue accounting problems after the fact.

Review the revenue accounting for potential pass-through transactions. In situations where there is either an extremely high cost of goods sold (indicating a possible pass-through transaction) or where there is no clear evidence of the company’s acting as principal, taking title to goods, or accepting risk of ownership, the internal audit staff should review the appropriateness of the transaction.

Trace commission payments back to underlying sale transactions. One can keep a list of all business partners who pay the company commissions, and run a periodic search on all payments made by them to the company. The internal audit staff can then trace these payments back to the underlying sales made by the company and verify that they were recorded at net, rather than at gross.

I realize the controls noted here are not comprehensive enough to cover revenue recognition of every kind of business operations; additional controls will be listed in subsequent entries I am going to post in the future that apply to more detailed revenue recognition scenarios.