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UNCERTAINTY ASSOCIATED WITH


COLLECTIBILITY
At the point of sale, if it is reasonably sure that collection of the receivable will ultimately 1 Objective
occur, revenues are recognized.1 Note that as long as it is possible to estimate uncollectible Discuss how to
amounts at the point of sale (perhaps based on historical data), the sale is booked and the deal with collection
potential uncollectible amount is accrued. Alternatively, when collectibility cannot be rea- uncertainty.
sonably assured, revenues cannot be recognized. In these cases, it is presumed that if col-
lectibility is not established at the time of sale, then in substance no real sale has been made.
Certain types of sales transactionssuch as sales that require or allow payment over
longer periodscreate greater collectibility risk. Instalment sales are an example of this type
of sale. If collectibility is established but the uncollectible amounts cannot be estimated, one
of two methods is generally used to defer income recognition until the cash is received:
1. Instalment sales method
2. Cost recovery method
In some situations, cash is received before delivery or transfer of the property. When
this occurs, the amount is recorded as a deposit because the sale transaction is incomplete.

Instalment Sales
The expression instalment sales is generally used to describe any type of sale which
requires payment of the amount owed in periodic instalments over an extended period of
time. It is used in retailing, where all types of farm and home equipment and furnishings
are sold on an instalment basis. It is also sometimes used in the heavy equipment industry,
in which machine installations are paid for over a long period.
Because of the greater risk to collectibility, various devices are used to protect the
seller. In merchandising, the two most common devices are (1) the use of a conditional
sales contract that provides that title to the item sold does not pass to the purchaser until
all payments have been made, and (2) use of notes secured by a chattel (personal prop-
erty) mortgage on the article sold. Both of these devices permit the seller to repossess the
goods sold if the purchaser defaults on one or more payments. The repossessed merchan-
dise is then resold at whatever price it can be sold for in order to compensate the seller for
the uncollected instalments and the expense of repossession.

Instalment Method
The instalment sales method is one way of dealing with sales agreements that allow 2 Objective
extended payment terms. It emphasizes collection rather than a sale, recognizing income Discuss how to
in the collection periods rather than the sale period. This method is justified as follows: deal with collection
when there is no reasonable approach for estimating the degree of collectibility, income uncertainty.
should not be recognized until cash is collected.
Under the instalment sales method of accounting, income recognition is Underlying
Concept
deferred until the period of cash collection. Both revenues and costs of sales are
recognized in the period of sale but the related gross profit is deferred to the peri- Realization is a
critical part of
ods in which cash is collected. Thus, instead of the sale being deferred to the future
revenue recognition. Thus,
periods of anticipated collection and then related costs and expenses being deferred, only if there is a high degree of
the proportional gross profit is deferred. uncertainty about collectibility,
revenue recognition must
1 be deferred.
CICA Handbook, Section 3400.16.
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Other expenses, such as selling and administrative expense, are not deferred. Thus,
International
Insight the theory that costs and expenses should be matched against sales is applied in instalment
sales transactions through the gross profit figure, but no further. Companies that use the
IAS 18 gives
instalment sales method of accounting generally record their operating expenses without
more extensive
application guidancei.e., considering that a portion of the years gross profit will be deferred. This practice is often
revenue is measured at the justified on the basis that (1) these expenses do not follow sales as closely as does the cost
PV of future cash flows when of goods sold, and (2) accurately dividing the expenses between the periods would be so
settlement of cash is deferred. difficult that it could not be justified by the benefits that would be gained.

Procedures for Deferring Income


To defer income for any specific year, do the following:
International
Insight 1. During the year, record both sales and cost of sales in the regular way, using the spe-
In Japan, cial accounts described later, and calculate the rate of gross profit on instalment
instalment sales transactions.
method accounting is
frequently used whenever the 2. At year end, apply the rate of gross profit to the cash collections of the current years
collection period is more than instalment sales to arrive at the realized gross profit.
two years, whether or not
there is uncertainty about the 3. The gross profit that has not been realized should be deferred to future years.
collectibility of cash.
For sales made in prior years, the gross profit rate of each years sales must be applied
against cash collections of accounts receivable from that years sales to arrive at the realized
gross profit.
From the discussion above of the general practice that is followed in recording income
from instalment sales, it is apparent that special accounts must be used. These accounts
provide certain special information that is needed in order to determine the realized and
unrealized gross profit in each year of operations. The requirements for special accounts
are as follows:
1. Instalment sales transactions must be kept separate in the accounts from all other
sales.
2. The gross profit on instalment sales must be determinable.
3. The amount of cash that is collected on accounts receivable from instalment sales
must be known, and the total collected on the current years and on each preceding
years sales must be determinable.
4. It must be possible to carry forward each years deferred gross profit.
In each year, ordinary operating expenses are charged to expense accounts and are
closed to the Income Summary account, just as under customary accounting procedure.
Thus, the only specific difference in calculating net income under the instalment sales
method, as it is generally applied, is the deferral of gross profit until it is realized by
accounts receivable collections.
To illustrate the instalment sales method in accounting for the sales of merchandise,
assume the following data:

2008 2009 2010


Instalment sales $200,000 $250,000 $240,000
Cost of instalment sales 150,000 190,000 168,000
Gross profit $ 50,000 $ 60,000 $ 72,000

Rate of gross profit on sales 25% (a) 24% (b) 30% (c)
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Cash receipts
2008 sales $ 60,000 $100,000 $ 40,000
2009 sales 100,000 125,000
2010 sales 80,000

(a) $50,000 200,000 (b) $60,000 250,000 (c) $72,000 240,000

To simplify the illustration, interest charges are not included. Summary entries in general
journal form for the year 2008 are as follows:

2008
Instalment Accounts Receivable, 2008 200,000
Instalment Sales 200,000
(To record sales made on instalment in 2008)
Cash 60,000
Instalment Accounts Receivable, 2008 60,000
(To record cash collected on instalment receivables)
Cost of Instalment Sales 150,000
Inventory (or Purchases) 150,000
(To record cost of goods sold on instalment in
2008 on either a perpetual or a periodic
inventory basis)
Deferred (unrealized) Gross Profitcurrent year
(income statement) 35,000
Deferred Gross Profit (balance sheet) 35,000
(to defer gross profit recognition for unrealized
gross profits [25% ($200,000 60,000)])

The summary entries in journal form for year 2 (2009) are:

2009
Instalment Accounts Receivable, 2009 250,000
Instalment Sales 250,000
(To record sales made on instalment in 2009)
Cash 200,000
Instalment Accounts Receivable, 2008 100,000
Instalment Accounts Receivable, 2009 100,000
(To record cash collected on instalment receivables)
Cost of Instalment Sales 190,000
Inventory (or Purchases) 190,000
(To record cost of goods sold on instalment in 2009)
Deferred Gross Profit (balance sheet) 25,000
Realized Gross Profitprior year sales
(income statement) 25,000
(to record 2008 realized gross profits
[25% $100,000])
Deferred (unrealized) Gross Profitcurrent year
(income statement) 36,000
Deferred Gross Profit (balance sheet) 36,000
(to defer gross profit recognition for unrealized
gross profits [24% ($250,000 100,000)])

The two income statement accounts, Realized Gross ProfitPrior Year Sales and
Deferred (unrealized) Gross ProfitCurrent Year, would generally be netted against each
other. The entries in 2010 would be similar to those of 2009, and the gross profit realized
on prior years sales would be $40,000, as shown by the following calculations:
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From 2008 $ 40,000 25% $10,000


From 2009 $125,000 24% $30,000
$40,000

Deferred gross profit on 2010 sales would be calculated as follows.

30% ($240,000 80,000) $48,000

Additional Problems of Instalment Sales Accounting


In addition to the problems of calculating the current realized and deferred gross profit,
there are also other problems in accounting for instalment sales transactions. These prob-
lems relate to:
1. Interest on instalment contracts
2. Uncollectible accounts
3. Defaults and repossessions

Interest on Instalment Contracts Because the collection of instalment receivables is


spread over a long period, it is customary to charge the buyer interest on the unpaid bal-
ance. A schedule of equal payments consisting of interest and principal is set up.
As Illustration 6-1 shows, a smaller amount of each successive payment is attributed to
interest and a correspondingly larger amount is attributed to the principal. This illustra-
tion assumes that an asset costing $2,400 is sold for $3,000 with interest of 8% included in
the three instalments of $1,164.10.

Illustration 6-1
Interest Instalment Instalment Realized
Instalment Payment Schedule Cash Earned Receivables Unpaid Gross
Date (Debit) (Credit) (Credit) Balance Profit (20%)
1/2/08 $3,000.00
1/2/09 $1,164.10(a) $240.00(b) $ 924.10(c) 2,075.90(d) $184.82(e)
1/2/10 1,164.10 166.07 998.03 1,077.87 199.61
1/2/11 1,164.10 86.23 1,077.87 0 215.57
$600.00

(a) Periodic payment Original unpaid balance / PV of an annuity of $1.00 for three periods at
8%; $1,164.10 $3,000 2.57710.
(b) $3,000.00 .08 $240.
(c) $1,164.10 $240.00 $924.10.
(d) $3,000.00 $924.10 $2,075.90.
(e) $924.10 .20 $184.82.

Interest should be accounted for separately from the gross profit recognized on the
instalment sales collections during the period. It is recognized as interest revenue at the
time of the cash receipt.

Uncollectible Accounts The problem of bad debts or uncollectible accounts receivable


is somewhat different for businesses that sell on an instalment basis, because of a repos-
session feature that is often part of the sales agreement. This feature gives the selling
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company an opportunity to recoup any uncollectible accounts through repossession and


resale of the repossessed merchandise. If the company knows from experience that its
repossessions do not, as a rule, compensate for uncollectible balances, it may be advisable
to provide for such losses by charging them to a special bad debt expense account just as
is done for other credit sales.

Defaults and Repossessions Depending on the sales contract terms and credit depart-
ment policy, the seller can repossess merchandise sold under an instalment arrangement if
the purchaser fails to meet payment requirements. Repossessed merchandise may be recon-
ditioned before it is offered for resale. It may be resold for cash or instalment payments.
The accounting for repossessions recognizes that the related instalment receivable
account is not collectible and that it should be written off. Along with the account
receivable, the applicable deferred gross profit must be removed from the ledger using
the following entry:

Repossessed Merchandise (an inventory account) xx


Deferred Gross Profit (balance sheet) xx
Instalment Accounts Receivable xx

The above entry assumes that the repossessed merchandise should be recorded on the
books at exactly the amount of the uncollected account less the deferred gross profit appli-
cable. This assumption may or may not be proper. The condition of the repossessed mer-
chandise, the cost of reconditioning it, and the market for second-hand merchandise of
that particular type must all be considered. The objective should be to put any asset
acquired on the books at its fair value or, when fair value cannot be determined, at the best
possible approximation of fair value. If the fair value of the repossessed merchandise is less
than the uncollected balance less the deferred gross profit, a loss on repossession should
be recorded at the repossession date.
To illustrate the required entry, assume that a refrigerator was sold to Marilyn Hunt
for $500 on September 1, 2008. Terms require a down payment of $200 and $20 on the
first of every month for 15 months, starting October 1, 2008. It is further assumed that the
refrigerator cost $300 and that it is sold to provide a 40% rate of gross profit on the selling
price. At the year end of December 31, 2008, a total of $60 should have been collected in
addition to the original down payment.
If Hunt makes her January and February payments in 2009 and then defaults, the
account balances that apply to Hunt at the time of default would be:

Instalment Account Receivable


($500 $200 $20 $20 $20 $20 $20) 200 (dr.)
Deferred Gross Profit (Balance Sheet)
[40% ($500 $200 $20 $20 $20)] 96 (cr.)

The deferred gross profit on the Hunt account still has the December 31, 2008, bal-
ance ($96) because no entry has yet been made to recognize the gross profit realized by
2009 cash collections ($40 40% $16). If the repossessed articles estimated fair value
is set at $70, the following entry would be required to record the repossession. Assume
that the $16 of realized gross profit will be recognized at year end with the regular entry to
recognize realized gross profit.
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A L SE Deferred Gross Profit 80


$130 $80 $50 Repossessed Merchandise 70
Loss on Repossession 50
Cash flows: No effect Instalment Account Receivable (Hunt) 200

The loss amount is determined by (1) subtracting the deferred gross profit from the amount
of the account receivable, to determine the unrecovered cost (or book value) of the mer-
chandise repossessed, and (2) subtracting the estimated fair value of the repossessed mer-
chandise from the unrecovered cost, to get the amount of the loss on repossession.

Financial Statement Presentation of Instalment Sales Transactions If instalment


sales transactions are a significant part of total sales, it is desirable to give full disclosure of
instalment sales, the cost of instalment sales, and any expenses that are allocable to instal-
ment sales. If, however, instalment sales transactions are an insignificant part of total sales,
it may be satisfactory to include only the realized gross profit in the income statement as a
special item following the gross profit on sales, as Illustration 6-23 shows.

Illustration 6-2
HEALTH MACHINE CORP.
Disclosure of Instalment Statement of Income
Sales Transactions For the Year Ended December 31, 2009
Insignificant Amount
Sales $620,000
Cost of goods sold 490,000
Gross profit on sales 130,000
Gross profit realized on instalment sales 51,000
Total gross profit on sales $181,000

If more complete disclosure of instalment sales transactions is desired, a presentation sim-


ilar to the one in Illustration 6-3 may be used.

Illustration 6-3
HEALTH MACHINE CORP.
Disclosure of Instalment Statement of Income
Sales Transactions For the Year Ended December 31, 2009
Significant Amount
Instalment Other
Underlying Sales Sales Total
Concept Sales $248,000 $620,000 $868,000
This level of Cost of goods sold 182,000 490,000 672,000
detail might Gross profit on sales 66,000 130,000 196,000
result in information Less: Deferred gross profit
overload for some users. on instalment sales of this year 47,000 47,000
Realized gross profit on this years sales 19,000 130,000 149,000
Add: Gross profit realized on
instalment sales of prior years 32,000 32,000
Gross profit realized this year $ 51,000 $130,000 $181,000

The apparent awkwardness of this presentation method is difficult to avoid if manage-


ment wants to fully disclose the instalment sales transactions in the income statement. One
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solution, of course, is to prepare a separate schedule that shows instalment sales transac-
tions and to then present only the final figure in the income statement.
In the balance sheet, it is generally considered desirable to classify instalment accounts
receivable by their year of collectibility. There is debate about whether instalment
accounts that are not collectible for two or more years should be included in current assets.
If instalment sales are part of normal operations, they may be considered current assets
because they are collectible within the business operating cycle. If this practice is followed,
there should not be much confusion as long as the maturity dates are fully disclosed, as
shown in Illustration 6-4.

Illustration 6-4
Current assets
Notes and accounts receivable Disclosure of Instalment
Trade customers $78,800 Accounts Receivable, by Year
Less: Allowance for doubtful accounts 3,700
75,100
Instalment accounts collectible in 2009 22,600
Instalment accounts collectible in 2010 47,200 $144,900

On the other hand, receivables from an instalment contract for a transaction that is
not related to normal operations should be reported in the Other Assets section if the
instalments are due beyond one year.
Repossessed merchandise is a part of inventory and should therefore be included as
inventory in the Current Assets section of the balance sheet. Any gain or loss on reposses-
sions should be included in the income statement in the Other Revenues and Gains or
Other Expenses and Losses sections.
Deferred gross profit on instalment sales may be treated either as unearned revenue
(current liability) or a contra asset account (as a valuation of instalment accounts receivable).

Cost Recovery Method


Under the cost recovery method, no profit is recognized until cash payments by the 3 Objective
buyer add up to more than the sellers cost for the merchandise sold. After all costs have Explain and apply the
been recovered, any additional cash collections are included in income. This method is cost recovery method of
therefore the most conservative method of recognizing income under accrual accounting.2 accounting.
The income statement for the period of the sale reports sales revenue, the cost of goods
sold, and the gross profitboth the amount (if any) that is recognized during the period
and the amount that is deferred. The deferred gross profit is either presented as unearned
revenue or it is offset against the related receivable (reduced by collections) on the balance
sheet. Subsequent income statements report the gross profit as a separate revenue item
when it is recognized as earned.
To illustrate the cost recovery method, assume that early in 2008 Fesmire
Manufacturing sells inventory with a cost of $25,000 to Higley Limited for $36,000, with
payments receivable of $18,000 in 2008, $12,000 in 2009, and $6,000 in 2010. If the cost
recovery method applies to this sale transaction and the cash is collected on schedule, then
cash collections, revenue, cost, and gross profit are recognized as in Illustration 6-5.

2
Omnibus Opinion 1966, Opinions of the Accounting Principles Board No. 10 (New York: AICPA, 1969),
p. 149, fn. 8; Accounting for Franchise Fee Revenue, Statement of Financial Accounting Standards No. 45
(Stamford, Conn.: FASB, 1981), par. 6; Accounting for Sales of Real Estate, Statement of Financial
Accounting Standards No. 66, pars. 62 and 63. In Canada, CICA Accounting Guideline No. 2 (franchise
fee revenue) mentions that either the instalment method or cost recovery method may be used when
there is no reasonable basis for estimating collectibility.
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Illustration 6-5
2008 2009 2010
Calculation of Gross Profit
Cost Recovery Method Cash collected $18,000 $12,000 $6,000

Revenue $36,000 0 0
Cost of goods sold 25,000 0 0
Deferred gross profit $11,000 $11,000 $6,000
Recognized gross profit 0 5,000* 6,000
Deferred gross profit balance (end of period) $11,000 $ 6,000 $0

*$25,000 $18,000 $7,000 of unrecovered cost at the end of 2008; $12,000 $7,000 $5,000, the
excess of cash received in 2009 over unrecovered cost.

Under the cost recovery method, total revenue and cost of goods sold are reported
in the period of sale, similar to the instalment sales method. However, unlike the
instalment sales method, which recognizes income as cash is collected, the cost
recovery method recognizes profit only when cash collections exceed the total cost
of the goods sold.
The journal entry to record the deferred gross profit on this transaction at the end of
2008 (after the sale and the cost of sale were recorded in the normal manner) is as follows:

2008
Deferred (unrealized) Gross Profit
(income statement) 11,000
Deferred Gross Profit (balance sheet) 11,000
(To record deferred gross profit on sales
accounted for under the cost recovery method)

In 2009 and 2010, the deferred gross profit becomes realized gross profit as the cumulative
cash collections exceed the total costs. The following entries are recorded in these years:

2009
Deferred Gross Profit (balance sheet) 5,000
Realized Gross Profit (income statement) 5,000
(To recognize gross profit to the extent
that cash collections in 2009 exceed costs)

2010
Deferred Gross Profit (balance sheet) 6,000
Realized Gross Profit (income statement) 6,000
(To recognize gross profit to the extent that
cash collections in 2010 exceed costs)