AFAR - Income Recognition: Installment Sales, Franchise, Long-term Construction

THE CPA BOARD EXAMS OUTLINES SERIES by John Mahatma Agripa, CPA

ADVANCED FINANCIAL ACCOUNTING AND REPORTING

INCOME RECOGNITION: INSTALLMENT SALES + FRANCHISE + LONG-TERM CONSTRUCTION Based on lectures and materials by Rodiel C. Ferrer, CPA, Ph.D. (CPAR, 2016)

INSTALLMENT SALES

 The installment method of recording revenue involves recognition of both profit and recovery of cost with every collection, usually used when such collections are uncertain. Problems dealing with installment sales usually require computation of net income Collectibles are recorded with the ‘installment receivable’ account, which is always a current account regardless of the expected time of collection. The nominal account ‘installment sales’ must be maintained according to year of sale – meaning one is kept for every year when installment sales were made  Net income from installment and regular sales can be computed as follows: Gross profit, regular sales ADD: Realized gross profit, installment sales Total realized gross profit ADD: Other income (e.g., gains on repossession) DEDUCT: Administrative expenses (e.g., bad debts) DEDUCT: Selling expenses DEDUCT: Other expenses (e.g., interest, losses on reposs.) Net income

xx xx xx xx xx xx xx xx

 Realized gross profit from installment sales can be computed with the following. RGP must also be maintained as to year of sale to distinguish it from other years Collections, excluding interest MULTIPLY: Gross profit rate, based on sales (for 20xx) Realized gross profit, 20xx

xx xx xx

The flip side of this account is deferred gross profit, which is based on the outstanding balance of installment receivable. This is also maintained as to year of installment sale Installment receivable balance, year-end MULTIPLY: Gross profit rate, based on sales (for 20xx) Deferred gross profit, 20xx

xx xx xx

The gross profit rate may also be different for every year

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ILLUSTRATION (Actual CPAR 2016 handout item)

The Abokado Company recognizes profit on credit sales on installment basis. At the end of 2016, before the accounts are adjusted, the ledger shows the following: Installment accounts receivable, 2015 Installment accounts receivable, 2016 Deferred gross profit, 2015 Deferred gross profit, 2016 Regular sales Cost of regular sales

Php 337,500 525,000 185,000 272,500 1,500,000 960,000

Each year, the gross profit on installment sales was 8% lower than regular sales. In 2016, the gross profit on installment sales was 4% higher than that of 2015. Determine the total realized gross profit in 2016 ANALYSIS

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Total realized gross profit is composed of the gross profit from both regular and installment sales. Gross profit from regular sales amounts to Php 540,000, with 36% GPR Determine first the respective installment sale GPRs for 2015 and 2016. According to the final paragraph, the 2016 installment GPR should be 28% (36% - 8%) and 2015 installment GPR must be 24% (28% - 4%) The problem states that the accounts are not yet adjusted. This means that the deferred gross profit balance for the years is the beginning balance. If you multiply 337,500 with 24%, Php 81,000 will emerge – which should be the DGP ending balance for 2015. The difference should be the realized gross profit for 2015: 185,000 – 81,000 = Php 104,000 Do the same for 2016, and you should arrive with Php 125,000 (272,500 – 147,000) Using the formula, total realized gross profit should be Php 769,500. The previous year, 2015, is included since some collections for 2015 were collected in 2016

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REPOSSESSIONS AND TRADE-INS

 When the buyer defaults on his installment payments, the seller may opt to repossess the item, doing which will likely cause recognition of gains and losses – recorded as other income and expense. This is computed as follows Estimated selling price after reconditioning DEDUCT: Reconditioning cost DEDUCT: Profit margin Fair value of repossessed merchandise DEDUCT: Unrecovered cost Installment receivable-repossessed MULTIPLY: (1-GPR) Gain or loss on repossession

xx xx xx xx xx xx%

xx xx

Installment receivable-repossessed is the outstanding balance of the installment receivable on the repossessed item  Buyers may also give a trade-in in addition to monetary considerations, which is usually a second-hand version of the item being bought. In such case, formula for realizes gross profit on installment sales becomes a little different: Collections, net of interest ADD: Trade-in value ADD: Cash down payment Fair value of repossessed merchandise MULTIPLY: Gross profit rate Realized gross profit

xx xx xx xx xx% xx

However, when a trade-in happens, the gross profit rate of the particular installment sale is affected. This is recomputed as follows: Installment sale (the price) ADD: Fair value of trade-in DEDUCT: Allowance on trade-in Adjusted installment sale DEDUCT: Cost of goods sold Gross profit DIVIDE: Adjusted installment sale New gross profit rate

xx xx xx xx xx xx xx xx%

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Note that the installment sale amount, in all cases, is always net of trade discount. Also, the adjusted installment sale amount is used only for computing the new gross profit rate

FRANCHISES

 A franchise is an intangible asset which gives its holder right to operate business under a trade name. Problems surrounding franchise accounting involves determining franchise revenue and net income of the franchisor (the owner of the trade name) from the franchise contract  The franchise revenue is usually divided into the initial franchise fee and the continuing franchise fee. The former is paid usually with a downpayment upon signing the franchise contract and the rest in a note payable. The latter is a percentage of periodic earnings of the franchisee  As mentioned, the initial franchise fee is paid either whole, or in a downpayment and note payable. To be recorded as franchise revenue by the franchisor, certain conditions must exist – substantial service must’ve been already rendered by the franchisor, the fee is nonrefundable (or the term for the refund has expired), and there are no adverse buy-back agreements. If either one of these conditions are absent, there is no franchise revenue from the initial franchise fee to be recorded As to be seen in the formulas below, the amount of franchise revenue from the IFF to be recorded also depends if the note payable is collectible with or without reasonable assurance. If reasonably assured, the entire IFF shall be recorded as revenue – including the unpaid note. If not reasonably assured, installment method shall be used  The computation of net income depends on the terms of payment of the franchise fee – if through interest-bearing or non-interest-

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bearing note, and if the collection of the fee is reasonably or nonreasonably assured If the note payable is interest-bearing and collection is reasonably assured, accrual method is used for the initial franchise fee: Initial franchise fee, total DEDUCT: Direct cost for initial services Gross profit ADD: Continuing franchise fee ADD: Interest income, nominal DEDUCT: Expenses Net income

xx xx xx xx xx xx xx

If the note is interest-bearing but collection is not reasonably assured, installment method is used for the IFF, as follows: Downpayment ADD: Collections during the year (net of interest) Total collection for the year MULTIPLY: Gross profit rate Realized gross profit ADD: Continuing franchise fee ADD: Interest income, nominal DEDUCT: Expenses Net income

xx xx xx xx% xx xx xx xx xx

If the note is non-interest-bearing and collection is reasonably assured: Initial franchise fee, total DEDUCT: Direct cost for initial services Gross profit ADD: Continuing franchise fee ADD: Interest income, effective DEDUCT: Expenses Net income

xx xx xx xx xx xx xx

In the case of most problems in franchises, if the note is noninterest-bearing and collection is not reasonably assured: Downpayment ADD: Collections during the year (net of interest) Total collection for the year MULTIPLY: Gross profit rate

xx xx xx xx%

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Realized gross profit ADD: Continuing franchise fee ADD: Interest income, effective DEDUCT: Expenses Net income

xx xx xx xx xx

 The gross profit rate in all cases can be computed as follows: Downpayment ADD: Note payable (face val if int.-bearing; present val if not) Initial franchise fee DEDUCT: Direct cost for initial services Gross profit DIVIDE: Initial franchise fee Gross profit rate

xx xx xx xx xx xx xx%

 Expenses to be deducted against the gross profit include indirect costs for initial services, direct costs for continuing services and indirect costs for continuing services

LONG-TERM CONSTRUCTION

 Problems surrounding long-term construction contracts include the determination of gross profit for the period, the balance of construction in progress account, costs incurred as of or on a particular year and the percentage of completion. The standard takes the point of view of the contractor  Some costs incurred in construction projects include costs on site supervision, materials and labor, moving materials and equipment to site, expected warranty, depreciation and other indirect costs. Such costs need to be reimbursable to be recognized Collections by the contractor may be derived from mobilization fees and billings that are accepted by the client. Portions of such collections may be retained by the client to ensure performance, in such case the contractor records this as contract retention – a current asset

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 The most common income recognition methods in long-term construction projects are the percentage of completion and costrecovery (zero-profit) methods. Under the former, realized gross profit shall be based on the percentage of completion as of the year in question, less previously recognized gross profit. Under the latter, profit is only recognized at a certain point where profits have been estimated, before which no profit is recorded. Collections are considered recovery of costs  The construction in progress account is composed of cost incurred to date and profit realized to date. In cost-recovery method, CIP is composed of cost incurred to date only since no profit is recorded. The balance of this account must equal the contract price on the last year This account is oftentimes deducted with the balance of progress billings to date for the due from/due to customer balance (also called construction-in-progress, net of progress billings). The total progress billings must, of course, equal the contract price. On the last year, the due from/due to account must be zero

ILLUSTRATION (Actual CPAR 2016 handout item)

On July 1, 2016, K.O.K.K. Constructions was contracted to build for Girly, Inc. for a contract price of Php 975,000. The following are some relevant data 2016 Contract cost incurred to date Php 75,000 Estimated cost to complete 675,000 Progress billings to Girly 150,000

2017 Php 600,000 400,000 550,000

2018 Php 1,050,000 275,000

ANALYSIS

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Requirement: determine the balance of construction of progress account as of December 31, 2017 using percentage of completion. As mentioned, this requires cost incurred to

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date and profit to date as of 2017. The following solutions are made, starting with 2016 Contract price DEDUCT: Costs incurred to date DEDUCT: Estimated costs to complete Estimated gross profit MULTIPLY: Percentage of completion Gross profit to date DEDUCT: Prior gross profit Gross profit, 2016

975,000 75,000 675,000 225,000 10% 22,500 0 22,500

Contract price DEDUCT: Costs incurred to date DEDUCT: Estimated costs to complete Estimated gross profit (loss) MULTIPLY: Percentage of completion Gross profit to date DEDUCT: Prior gross profit Gross profit, 2016

975,000 600,000 400,000 (25,000) 100% (25,000) 22,500 (47,500)

Cost incurred to date ADD: Profit to date Construction in Progress, 2017 DEDUCT: Progress billing to date Due to customer (liability)

600,000 (47,500) 575,000 700,000 (125,000)

Note that on 2017, total estimated costs exceeded the contract price, resulting to a loss on the contractor. In this case, the percentage of completion is automatically made to 100% to fully report the loss. The same CIP balance will appear if zero-profit method is to be used since losses as also fully recognized under this method As mentioned, on 2018, both construction in progress and progress billings must equal to the contract price so as to make the due from/due to account zero

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