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Chapter Five - Income and Profitability:
FOB (Free on Board)
- Shipping Point (Buyer pays shipping and insurance, owns goods, records them as assets)
o Seller records revenues and expenses when product leaves seller’s doorstep
- Destination ( Seller pays shipping and insurance, owns goods, records them as assets)
o Seller records revenues and expenses when product arrives at buyer’s doorstep
Sales on Credit with Payments into the Future
- If cash flow is fairly certain and bad debts are reasonably estimatable, then use regular accounts receivable and an allowance for bad debts. This method allows for the recognition of revenue and cost of goods sold at the time of sale
- If cash flow is uncertain and/or bad debts are not reasonably estimatable, then use the installment sales or cost-recovery method.
- Cost-recovery method is the most conservative
Installment Sale and Cost-Recovery Practice Problem:
- Green buys a car from Red for $40,000, which originally cost red $28,000 on 1/1/08. Green will make four payments to Red for $10,000 at the end of each year. Record the journal entries for the first three years using 1) Installment Sales Method and 2) Cost-Recovery Method
1) (Gross Profit = $40,000 - $28,000 = $12,000 / $40,000 = 30%)
1/1/08 Debit Installment Receivable $40,000, Credit Inventory $28,000, Credit Deferred Gross Profit $12,000
12/31/08 Debit Cash $10,000, Credit Installment Receivable $10,000.
12/31/08 Debit Differed Gross Profit $3,000, Credit Realized Gross Profit $3,000
12/31/09 Debit Cash $10,000, Credit Installment Receivable $10,000.
12/31/09 Debit Differed Gross Profit $3,000, Credit Realized Gross Profit $3,000
12/31/10 Debit Cash $10,000, Credit Installment Receivable $10,000.
12/31/10 Debit Differed Gross Profit $3,000, Credit Realized Gross Profit $3,000
2) 1/1/08 Debit Installment Receivable $40,000, Credit Inventory $28,000, Credit Deferred Gross Profit $12,000
12/31/08 Debit Cash $10,000, Credit Installment Receivable $10,000
12/31/09 Debit Cash $10,000, Credit Installment Receivable $10,000
12/31/10 Debit Cash $10,000, Credit Installment Receivable $10,000
12/31/10 Debit Deferred Gross Profit $2,000, Credit Realized Gross Profit $2,000
Sales Returns
- Whenever possible we should estimate sales returns in advance. This is the conservative approach and follows the matching principle
- The Journal Entry for recording the estimated sales return is:
o Debit Revenues, Credit Allowance for Sales Returns
o Debit Inventory, Credit Cost of Goods Sold
- The Journal Entry for recording the receipt of a returned item is:
o Debit Allowance for Sales Returns, Credit Cash or A/R
- Sales Returns is a contra-asset account to A/R
- Record inventory on books, but do not physically possess it
Consignment
- Provide physical control over to another party to sell it on your behalf
- You still own the merchandise, are responsible for its damage, maintain its title, and recognize it in inventory until it is sold.
Complete Contract Method
- Wait till end of contract (whether service contract, construction, or whatever) to recognize expenses or revenues
- Not the favored approach it the revenue producing activity spans more than one or two reporting periods.
Percentage of Completion
- A better method for recognizing profit periodically over the life of the contract, rather than at the beginning or end
- You will know the costs incurred to date and the most recent estimate of the project total cost
- The amount billed and the cash actually received have no effect on income recognition
- Two special accounts are introduced in this methodology
o Construction-In-Progress – This account maintains the accumulated costs incurred during the project, as well as the realized gross profit. This is an asset account.
o Billings on Construction – This account maintains the amount billed to the customer, whether for cash or on account (A/R). This account is a contra-asset account to Construction-In-Progress.
- Example:
We win the contract to build the Will House for $700,000. We believe that it will cost us $300,000 in materials, labors, supplies, etc. The house is only being built on the weekends, so it will take us 3 years to build it. Please make the journal entries for each of the following time periods:
1) 1/1/08: Nothing
2) 2008: We spend $132,000 on materials and building. 132,000 / 300,000 = 44% complete. We will invoice Will for 44% of the sales price ($700,000 * 44%)
a. Debit Construction-In-Progress $132,000, Credit Cash/Inventory $132,000
b. Debit Cash $308,000, Credit Billings on Construction $308,000
c. Debit Construction-In-Progress $176,000, Credit Realized Gross Profit $176,000 (This is a recognition of profit for year one)
3) 2009: We know estimate costs to be $500,000 on the building and spent another $268,000 during the year. We are now 80% complete ([132,000+268,000]/500,000. We will invoice Will for 80% of the sales price ($700,000 * 80%) less the $308,000 we have already received ($560,000 - $308,000 = $252,000)
a. Debit Construction-In-Progress $268,000, Credit Cash/Inventory $268,000
b. Debit Cash $252,000, Credit Billings on Construction $252,000
c. Debit Realized Gross Profit Loss $16,000, Credit Construction-In-Progress $16,000 (Because we have recognized too much profit in 2008)
4) 2010: We complete the project with $120,000 more costs. We will invoice Will for the remaining amount ($700,000 total contract amount minus $560,000 in previous billings).
a. Debit Construction-In-Progress $120,000, Credit Cash/Inventory $120,000
b. Debit Cash $140,000, Credit Billings on Construction $140,000
c. Debit Construction-In-Progress $20,000, Credit Realized Gross Profit $20,000
5) 12/31/10: We turn over the house to will and wipe this project off our books:
a. Debit Credit Billings on Construction $700,000, Credit Construction-In-Progress $700,000
Let’s check our work. We produced Will’s House for a total of $520,000 and sold it for $700,000 for a total gain of $180,000. Using the percentage of completion calculation we have $176,000 (2008) + -$16,000 (2009) + $20,000 (2010) = $180,000 (total). They match up!
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