Chapter 5, Problem 5.19P

Requirement – 1

To determine

The revenue recognition principle

The revenue recognition principle refers to the revenue that should be recognized in the time period, when the performance obligation (sales or services) of the company is completed.

Installment sales method:

Under the installment sales, the revenue and costs are recognized only when the payment of cash is received from customer. Two composed components are involved in the each payment of cash, and components of sales are as follows:

• Partial recovery of the cost from sales
• Component of gross profit

These components are determined by the percentage of gross profit.

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

To calculate: The amount of gross profit that would be recognized in each year from installment sales.

Explanation of Solution

Gross profit in the year 2016:

Here,

Cash collection in 2016 is $120,000 

Gross profit is 40% (Refer to equation (1)).

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit}=\left(\begin{array}{l}\text{Cash collection}\times \\ \text{Gross profit}\end{array}\right)\\ =\text{\$120,000×40\%}\\ =\text{\$48,000}\end{array}$

Hence, the calculated gross profit is $48,000.

Working note:

Calculate the cost of recovery in 2016:

Given,

The cost of sales is $180,000

Sales are $300,000

Now, calculate the cost recovery:

$\begin{array}{c}\text{Cost recovery}=\left(\frac{\text{Cost of installment sales}}{\text{Installment sales}}\right)\\ \text{=}\left(\frac{\text{\$180,000}}{\text{\$300,000}}\right)\\ =\text{60\%}\end{array}$

Hence, the calculated cost recovery is 60%, than gross profit ratio is 40% $\left(100\%-40\%\right)$ (1)

Gross profit in the year 2017:

Here,

The cash collection form 2016 sales is $100,000,

Cash collection form 2017 sales is $150,000,

Calculated 2016 gross profit is 40% (Refer to equation (1)),

Gross profit is $30% (Refer to equation (2)).

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit}=\left(\begin{array}{l}\left(\begin{array}{l}\text{Cash collection form 2}0\text{16 sales}\times \\ \text{2}0\text{16 gross profit}\end{array}\right)\\ +\left(\begin{array}{l}\text{Cash collection form 2}0\text{17 sales}\times \\ \text{2}0\text{17 gross profit }\end{array}\right)\end{array}\right)\\ =\left(\$\text{1}00,000\times \text{4}0\%\right)+\left(\$\text{15}0,000\times \$\text{3}0\%\right)\\ =\$40,000+\$45,000\\ =\$85,000\end{array}$

Hence, the calculated gross profit is $85,000.

Working note:

Calculate the cost of recovery in 2017:

Given,

The cost of sales is $280,000

Sales are $400,000

Now, calculate the cost recovery:

$\begin{array}{c}\text{Cost recovery}=\left(\frac{\text{Cost of installment sales}}{\text{Installment sales}}\right)\\ =\left(\frac{\text{\$280,000}}{\text{\$400,000}}\right)\\ =\text{70\%}\end{array}$

Hence, the calculated cost recovery is 70%, than gross profit ratio is 30% $\left(100\%-70\%\right)$ (2)

Requirement – 2

To determine

To prepare: All necessary journal entries for each year.

Explanation of Solution

Journal entries for the year 2016 and 2017 are as follows:

In the year 2016

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$300,000
	Inventory			$180,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (1)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.
• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$120,000
	Installment receivables			$120,000
	(To record cash collections from installment sales)

Table (2)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit		$48,000
	Realized gross profit			$48,000
	(To record gross profit recognize from installment sales)

Table (3)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

In the year 2017

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$400,000
	Inventory			$280,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (4)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.
• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$250,000
	Installment receivables			$250,000
	(To record cash collections from installment sales)

Table (5)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit		$85,000
	Realized gross profit			$85,000
	(To record gross profit recognize from installment sales)

Table (6)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

Conclusion

Therefore, the journal entries for the year 2016 and 2017 are recorded.

Requirement – 3

To determine

To prepare: All necessary journal entries for each year in cost recovery method.

Explanation of Solution

Solution:

All necessary journal entries for each year in cost recovery method are as follows:

In the year 2016

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$300,000
	Inventory			$180,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (7)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.
• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$120,000
	Installment receivables			$120,000
	(To record cash collections from installment sales)

Table (8)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

In the year 2017

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Installment receivables		$400,000
	Inventory			$280,000
	Deferred gross profit			$120,000
	(To record installment sales)

Table (9)

• Installment receivable is a liability. There is a decrease in asset value. Therefore, it is debited.
• Inventory and deferred gross profits are assets. There is a decrease in assets value. Therefore, it is credited.
• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Cash		$250,000
	Installment receivables			$250,000
	(To record cash collections from installment sales)

Table (10)

• Cash is an asset. There is an increase in asset value. Therefore, it is debited.
• Installment receivable is a liability. There is an increase in liability value. Therefore, it is credited.

Date	Account Title and Explanation	Post Ref.	Debit	Credit
	Deferred gross profit (2)		$40,000
	Realized gross profit			$40,000
	(To record gross profit recognize from installment sales)

Table (11)

• Deferred gross profits are assets. There is an increase in assets value. Therefore, it is debited.
• Realized gross profit is a liability. There is an increase in liability value. Therefore, it is credited.

Working note:

Calculate the value of gross profit in 2016:

Given,

Cash collected is $120,000

Cost recovery is $120,000.

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit = Cash collected}-\text{Cost recovery}\\ \text{=\$120,000}-\text{\$120,000}\\ \text{=\$0}\end{array}$ (1)

Calculate the value of gross profit in 2017:

Given,

Cash collected form 2016 sales is $100,000

Cash collected form 2017 sales is $150,000

Cost recovery form 2016 is $120,000

Cost recovery form 2017 is $120,000

Now, calculate the gross profit:

$\begin{array}{c}\text{Gross profit =}\left(\begin{array}{l}\left(\begin{array}{l}\text{Cashcollected form 2}0\text{16 sales}\\ -\text{Cost recovery form 2}0\text{16}\end{array}\right)\\ +\left(\begin{array}{l}\text{Cash collected form 2}0\text{17 sales }-\\ \text{Cost recovery form 2}0\text{17}\end{array}\right)\end{array}\right)\\ =\left(\begin{array}{l}\left(\$\text{1}00,000-\$60,000\right)\\ +\left(\$\text{15}0,000-\$\text{15}0,000\right)\end{array}\right)\\ =\$40,000+\$0\\ =\$40,000\end{array}$ (2)

Conclusion

Therefore, the journal entries as per cost recovery method for the year 2016 and 2017 are recorded.