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334253806-AFAR-Income-Recognition-Installment-Sales-Fra
nchise-Long-term-Construction
Advanced Financial Accounting (University of Iloilo - PHINMA)

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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)

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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 xx

ADD: Realized gross profit, installment sales xx
Total realized gross profit xx
ADD: Other income (e.g., gains on repossession) xx
DEDUCT: Administrative expenses (e.g., bad debts) xx
DEDUCT: Selling expenses xx
DEDUCT: Other expenses (e.g., interest, losses on reposs.) xx
Net income 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 xx

MULTIPLY: Gross profit rate, based on sales (for 20xx) xx
Realized gross profit, 20xx 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 xx

MULTIPLY: Gross profit rate, based on sales (for 20xx) xx
Deferred gross profit, 20xx 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 Php 337,500

Installment accounts receivable, 2016 525,000
Deferred gross profit, 2015 185,000
Deferred gross profit, 2016 272,500
Regular sales 1,500,000
Cost of regular sales 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 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
o 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%)
o 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
o Do the same for 2016, and you should arrive with Php
125,000 (272,500 – 147,000)
o 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 xx

DEDUCT: Reconditioning cost xx
DEDUCT: Profit margin xx
Fair value of repossessed merchandise xx
DEDUCT: Unrecovered cost
Installment receivable-repossessed xx
MULTIPLY: (1-GPR) xx% xx
Gain or loss on repossession 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 xx

ADD: Trade-in value xx
ADD: Cash down payment xx
Fair value of repossessed merchandise xx
MULTIPLY: Gross profit rate xx%
Realized gross profit 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) xx

ADD: Fair value of trade-in xx
DEDUCT: Allowance on trade-in xx
Adjusted installment sale xx
DEDUCT: Cost of goods sold xx
Gross profit xx
DIVIDE: Adjusted installment sale xx
New gross profit rate 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 non-

reasonably 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 xx

DEDUCT: Direct cost for initial services xx
Gross profit xx
ADD: Continuing franchise fee xx
ADD: Interest income, nominal xx
DEDUCT: Expenses xx
Net income xx

If the note is interest-bearing but collection is not reasonably

assured, installment method is used for the IFF, as follows:

Downpayment xx
ADD: Collections during the year (net of interest) xx
Total collection for the year xx
MULTIPLY: Gross profit rate xx%
Realized gross profit xx
ADD: Continuing franchise fee xx
ADD: Interest income, nominal xx
DEDUCT: Expenses xx
Net income xx

If the note is non-interest-bearing and collection is reasonably

assured:

Initial franchise fee, total xx

DEDUCT: Direct cost for initial services xx
Gross profit xx
ADD: Continuing franchise fee xx
ADD: Interest income, effective xx
DEDUCT: Expenses xx
Net income xx

In the case of most problems in franchises, if the note is non-

interest-bearing and collection is not reasonably assured:

Downpayment xx
ADD: Collections during the year (net of interest) xx
Total collection for the year xx
MULTIPLY: Gross profit rate xx%

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Realized gross profit xx

ADD: Continuing franchise fee xx
ADD: Interest income, effective xx
DEDUCT: Expenses xx
Net income xx

 The gross profit rate in all cases can be computed as follows:

Downpayment xx
ADD: Note payable (face val if int.-bearing; present val if not) xx
Initial franchise fee xx
DEDUCT: Direct cost for initial services xx
Gross profit xx
DIVIDE: Initial franchise fee xx
Gross profit rate 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 cost-
recovery (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 2017 2018

Contract cost incurred to date Php 75,000 Php 600,000 Php 1,050,000
Estimated cost to complete 675,000 400,000 -
Progress billings to Girly 150,000 550,000 275,000

ANALYSIS

o 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 975,000

DEDUCT: Costs incurred to date 75,000
DEDUCT: Estimated costs to complete 675,000
Estimated gross profit 225,000
MULTIPLY: Percentage of completion 10%
Gross profit to date 22,500
DEDUCT: Prior gross profit 0
Gross profit, 2016 22,500

Contract price 975,000

DEDUCT: Costs incurred to date 600,000
DEDUCT: Estimated costs to complete 400,000
Estimated gross profit (loss) (25,000)
MULTIPLY: Percentage of completion 100%
Gross profit to date (25,000)
DEDUCT: Prior gross profit 22,500
Gross profit, 2016 (47,500)

Cost incurred to date 600,000

ADD: Profit to date (47,500)
Construction in Progress, 2017 575,000
DEDUCT: Progress billing to date 700,000
Due to customer (liability) (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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