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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

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

o
o

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

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%

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 mustve 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-

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%

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

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

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

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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