Accounting, Financial, Taxation

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]

A daily question faced by managers is whether the right components and services will be available at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured themselves of service and part availability and quality by controlling all functions internally. However, there is a growing trend toward “outsourcing” (buying) a greater percentage of required materials, components, and services.

This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal production and opportunity costs with purchase cost and assesses the best uses of available facilities. Consideration of an in-source (make) option implies that the company has available capacity for that purpose or has considered the cost of obtaining the necessary capacity. Relevant information for this type of decision includes both quantitative and qualitative factors. Here is lists the top motivations for companies to pursue outsourcing.

Top Ten Reasons to Outsource

1. Reduce and control operating costs.
2. Improve company focus.
3. Gain access to world-class capabilities.
4. Free internal resources for other purposes.
5. Obtain resources not available internally.
6. Accelerate reengineering benefits.
7. Eliminate a function difficult to manage/out of control.
8. Make capital funds available.
9. Share risks.
10. Obtain cash infusion.

Source: The Outsourcing Institute, Survey of Current and Potential Outsourcing End-Users

And below figure presents factors that should be considered in the outsourcing decision. Several of the quantitative factors, such as incremental direct material and direct labor costs per unit, are known with a high degree of certainty. Other factors, such as the variable overhead per unit and the opportunity cost associated with production facilities, must be estimated. The qualitative factors should be evaluated by more than one individual so personal biases do not cloud valid business judgment.

Outsource Decision Considerations

Relevant Quantitative Factors:

1. Incremental production costs for each unit
2. Unit cost of purchasing from outside supplier (price less any discounts available plus shipping, etc.)
3. Number of available suppliers
4. Production capacity available to manufacture components
5. Opportunity costs of using facilities for production rather than for other purposes
6. Amount of space available for storage
7. Costs associated with carrying inventory
8. Increase in throughput generated by buying components

 

Relevant Qualitative Factors:

1. Reliability of supply sources
2. Ability to control quality of inputs purchased from outside
3. Nature of the work to be subcontracted (such as the importance of the part to the whole)
4. Impact on customers and markets
5. Future bargaining position with supplier(s)
6. Perceptions regarding possible future price changes

 

Although companies may gain the best knowledge, experience, and methodology available in a process through outsourcing, they also lose some degree of control. Thus, company management should carefully evaluate the activities to be outsourced. The pyramid shown below is one model for assessing outsourcing risk.

Factors to consider include whether:

(1) a function is considered critical to the organization’s long-term viability (such as product research and development)

(2) the organization is pursuing a core competency relative to this function; or

(3) issues such as product/service quality, time of delivery, flexibility of use, or reliability of supply cannot be resolved to the company’s satisfaction.

Case Example: Outsource Decision

Here is information about inkjet printers produced by Online Computers. The total cost to manufacture one case is $5.50. The company can purchase the case from a chemical products company for $4.30 per unit. Online Computers’ cost accountant is preparing an analysis to determine if the company should continue making the cases or buy them from the outside supplier.

Production of each case requires a cost outlay of $4.10 per unit for materials, labor, and variable overhead. In addition, $0.50 of the fixed overhead is considered direct product cost because it specifically relates to the manufacture of cases.

This $0.50 is an incremental cost since it could be avoided if cases were not produced. The remaining fixed overhead ($0.90) is not relevant to the outsourcing decision. This amount is a common cost incurred because of general production activity, unassociated with the cost object (cases). Therefore, because this portion of the fixed cost would continue under either alternative, it is not relevant.

The relevant cost for the in-source alternative is $4.60—the cost that would be avoided if the product were not made. This amount should be compared to the $4.30 cost quoted by the supplier under the outsource alternative. Each amount is the incremental cost of making and buying, respectively. All else being equal, management should choose to purchase the cases rather than make them, because $0.30 will be saved on each case that is purchased rather than made. Relevant costs are those costs that are avoidable by choosing one decision alternative over another, regardless of whether they are variable or fixed. In an outsourcing decision, variable production costs are relevant. Fixed production costs are relevant if they can be avoided when production is discontinued.

The opportunity cost of the facilities being used by production is also relevant in this decision. If a company chooses to outsource a product component rather than to make it, an alternative purpose may exist for the facilities now being used for manufacturing. If a more profitable alternative is available, management should consider diverting the capacity to this use.

Assume that Online Computers has an opportunity to rent the physical space now used to produce printer cases for $90,000 per year. If the company produces 600,000 cases annually, there is an opportunity cost of $0.15 per unit ($90,000:600,000 cases) from using, rather than renting, the production space. The existence of this cost makes the outsource alternative even more attractive.

The opportunity cost is added to the production cost since the company is foregoing this amount by choosing to make the cases. Sacrificing potential revenue is as much a relevant cost as is the incurrence of expenses.

The next figure shows calculations relating to this decision on both a per-unit and a total cost basis. Under either format, the comparison indicates that there is a $0.45 per-unit advantage to outsourcing over in-sourcing.

Another opportunity cost associated with in-sourcing is the increased plant throughput that is sacrificed to make a component. Assume that case production uses a resource that has been determined to be a bottleneck in the manufacturing plant. Management calculates that plant throughput can be increased by 1 percent per year on all products if the cases are bought rather than made. Assume this increase in throughput would provide an estimated additional annual contribution margin (with no incremental fixed costs) of $210,000. Dividing this amount by the 600,000 cases currently being produced results in a $0.35 per-unit opportunity cost related to manufacturing. When added to the production costs of $4.60, the relevant cost of manufacturing cases becomes $4.95.

Based on the above information (even without the inclusion of the throughput opportunity cost), Online Computers’ cost accountant should inform company management that it is more economical to outsource cases for $4.30 than to manufacture them. This analysis is the typical starting point of the decision process—determining which alternative is preferred based on the quantitative considerations.

Managers then use judgment to assess the decision’s qualitative aspects. Assume that Online Computers’ purchasing agent read in the newspaper that the supplier being considered was in poor financial condition and there was a high probability of a bankruptcy filing. In this case, management would likely decide to in-source rather than outsource the cases from this supplier. In this instance, quantitative analysis supports the purchase of the units, but qualitative considerations suggest this would not be a wise course of action because the stability of the supplying source is questionable.

This additional consideration also indicates that there are many potential long run effects of a theoretically short-run decision. If Online Computers had stopped case production and rented its production facilities to another firm, and the supplier had then gone bankrupt, the company could be faced with high start-up costs to revitalize its case production process. This was essentially the situation faced by Stonyfield Farm, a New Hampshire-based yogurt company. Stonyfield Farm subcontracted its yogurt production, and one day found its supplier bankrupt—creating an inability to fill customer orders. It took Stonyfield two years to acquire the necessary production capacity and regain market strength.

These costs should be referred to as long-run variable costs because, while they do not vary with volume in the short run, they do vary in the long run. As such, they are relevant for long-run decision making.

For example: assume a part or product is manufactured (rather than outsourced) and the company expects demand for that item to increase in the next few years. At a future time, the company may be faced with a need to expand capacity and incur additional “fixed” capacity costs. These long-run costs would, in turn, theoretically cause product costs to increase because of the need to allocate the new overhead to production. To suggest that products made before capacity is added would cost less than those made afterward is a short-run view. The long-run viewpoint would consider both the current and “long-run” variable costs over the product life cycle. However, many firms expect prices charged by their suppliers to change over time and actively engage in cooperative efforts with their suppliers to control costs and reduce prices.

Outsourcing decisions are not confined to manufacturing entities. Many service organizations must also make these decisions. For example, accounting and law firms must decide whether to prepare and present in-house continuing education programs or to outsource such programs to external organizations or consultants.

Private schools must determine whether to have their own buses or use independent contractors. Doctors investigate the differences in cost, quality of results, and convenience to patients between having blood samples drawn and tested in the office or in an independent lab facility. Outsourcing can include product and process design activities, accounting and legal services, utilities, engineering services, and employee health services.

Outsourcing decisions consider the opportunity costs of facilities. If capacity is occupied in one way, it cannot be used at the same time for another purpose. Limited capacity is only one type of scarce resource that managers need to consider when making decisions.

Accounting extends into virtually every walk of life. You’re doing accounting when you make entries in your checkbook and when you fill out your income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand accounting basics in order to figure their return on invested capital. And it goes without saying that every organization, profit-motivated or not, needs to know how it stands financially.

Here’s a quick sweep to give you an idea of the range of accounting:

1. Accounting for organizations and accounting for individuals
2. Accounting for profit-motivated businesses and accounting for nonprofit organizations (such as hospitals, homeowners’ associations, churches, credit unions, and colleges)
3. Income tax accounting while you’re living and estate tax accounting when you die
4. Accounting for farmers who grow their products, accounting for miners who extract their products from the earth, accounting for producers who manufacture products, and accounting for retailers who sell products that others make
5. Accounting for businesses and professional firms that sell services rather than products, such as the entertainment, transportation, and healthcare industries
6. Past-historical-based accounting and future-forecast-oriented accounting (budgeting and financial planning)
7. Accounting where periodic financial statements are legally mandated (public companies are the primary example) and accounting where such formal accounting reports are not legally required
8. Accounting that adheres to historical cost mainly (businesses) and accounting that records changes in market value (mutual funds, for example)
9. Accounting in the private sector of the economy and accounting in the public (government) sector
10. Accounting for going-concern businesses that will be around for some time and accounting for businesses in bankruptcy that may not be around tomorrow.
11. What else?

Accounting is necessary in a free-market, capitalist economic system. It’s equally necessary in a centralized, government-controlled, socialist economic system. All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, institutions, individuals, and other players in the economic system.

Some of the earliest records of history are the accounts of wealth and trading activity. The need for accounting information was a main incentive in the development of the numbering system we use today. The history of accounting is quite interesting (but beyond the scope of this book). Taking a Peek into the Back Office. Every business and not-for-profit entity needs a reliable bookkeeping system.

Keep in mind that accounting is a much broader term than bookkeeping:

Accounting encompasses the problems in measuring the financial effects of economic activity. Furthermore, accounting includes the function of financial reporting of values and performance measures to those that need the information. Business managers and investors, and many other people, depend on financial reports for information about the performance and condition of the entity.

Bookkeeping refers to the process of accumulating, organizing, storing, and accessing the financial information base of an entity, which is needed for two basic purposes:

1. Facilitating the day-to-day operations of the entity
2. Preparing financial statements, tax returns, and internal reports to managers

Bookkeeping (also called recordkeeping) can be thought of as the financial information infrastructure of an entity. Of course the financial information base should be complete, accurate, and timely. Every recordkeeping system needs quality controls built into it, which are called internal controls or internal accounting controls.

Accountants design the internal controls for the bookkeeping system, which serve to minimize errors in recording the large number of activities that an entity engages in over the period. The internal controls that accountants design are also relied on to detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure.

I have discussed about internal control (financial and operation) a lot. Here (in this post), I want to stress the importance of the bookkeeping system in operating a business or any other entity. These back-office functions are essential for keeping operations running smoothly, efficiently, and without delays and errors. This is a tall order, to say the least.

Most people don’t realize the importance of the accounting department in keeping a business operating without hitches and delays. That’s probably because accountants oversee many of the back-office functions in a business—as opposed to sales, for example, which is front-line activity, out in the open and in the line of fire. Go into any retail store, and you’re in the thick of sales activities. But have you ever seen a company’s accounting department in action?

Folks may not think much about these back-office activities, but they would sure notice if those activities didn’t get done. On payday, a business had better not tell its employees, “Sorry, but the accounting department is running a little late this month; you’ll get your checks later.” And when a customer insists on up-to-date information about how much he or she owes to the business, the accounting department can’t very well say, “Oh, don’t worry, just wait a week or so and we’ll get the information to you then”.

Typically, the accounting department is responsible for the following 5 (five) main areas:

Payroll

The total wages and salaries earned by every employee every pay period, which are called gross wages or gross earnings, have to be calculated. Based on detailed private information in personnel files and earnings-to-date information, the correct amounts of income tax, social security tax, and several other deductions from gross wages have to be determined. Stubs, which report various information to employees each pay period, have to be attached to payroll checks. The total amounts of withheld income tax and social security taxes, plus the employment taxes imposed on the employer, have to be paid to provincial (state) and the national (federal) government agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees have to be updated every pay period. In short, payroll is a complex and critical function that the accounting department performs. Many businesses outsource payroll functions to companies that specialize in this area.

Cash Collections

All cash received from sales and from all other sources has to be carefully identified and recorded, not only in the cash account but also in the appropriate account for the source of the cash received. The accounting department makes sure that the cash is deposited in the appropriate checking accounts of the business and that an adequate amount of coin and currency is kept on hand for making change for customers. Accountants balance the checkbook of the business and control who has access to incoming cash receipts. (In larger organizations, the treasurer may be responsible for some of these cash flow and cash handling functions).

Cash Payments (disbursements)

In addition to payroll checks, a business writes many other checks during the course of a year — to pay for a wide variety of purchases, to pay property taxes, to pay on loans, and to distribute some of its profit to the owners of the business, for example. The accounting department prepares all these checks for the signatures of the business officers who are authorized to sign checks. The accounting department keeps all the supporting business documents and files to know when the checks should be paid, makes sure that the amount to be paid is correct, and forwards the checks for signature.

Procurement and Inventory

Accounting departments usually are responsible for keeping track of all purchase orders that have been placed for inventory (products to be sold by the business) and all other assets and services that the business buys — from postage stamps to forklifts. A typical business makes many purchases during the course of a year, many of them on credit, which means that the items bought are received today but paid for later. So this area of responsibility includes keeping files on all liabilities that arise from purchases on credit so that cash payments can be processed on time. The accounting department also keeps detailed records on all products held for sale by the business and, when the products are sold, records the cost of the goods sold.

Property Accounting

A typical business owns many different substantial long-term assets called property, plant, and equipment — including office furniture and equipment, retail display cabinets, computers, machinery and tools, vehicles (autos and trucks), buildings, and land. Except for relatively small-cost items, such as screwdrivers and pencil sharpeners, a business maintains detailed records of its property, both for controlling the use of the assets and for determining personal property and real estate taxes. The accounting department keeps these property records.

The accounting department may be assigned other functions as well, but this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time. And to repeat one point: To do these back-office functions well the accounting department must design a good bookkeeping system and make sure that it is accurate, complete, and timely.