Consignment Income Statement by mzh44232

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March 11, 2002

For next time:
Readings: Chapter 8 (Cash section only)
Homework: E8-1,2

Today:
Finish Chapter 7
In class exercise


Last time we talked about revenue recognition at two points on the time line –
         Revenue at delivery (the easy way!)
         Revenue before delivery or completion (Percentage completion)

Today we will concentrate on the other side of the time-line –
       Revenue after delivery:
                1) Because of the buyer’s right to change his/her mind
                2) Because of the buyer’s inability to pay us in the short-term

The necessary conditions for revenue recognition are:
        1) The earnings process is complete
        2) All costs have been incurred or can be reasonably estimated,
        3) Collection is reasonably assured.


Revenue and the right to return
(this applies primarily to wholesalers' sales to retailers)
If the buyer has the right to return the goods, this kind of messes up condition number 2 above. Think
about it: You ship your newly developed THINFIN quick weight-loss gum to drugstores across the
country, with a 3 month right of return. Even if the gum is an overnight sensation, you really don’t know
until the 3 months is up whether or not you have made a sale.

With no experience, your most conservative move (and the one that SFAS 48 –see page 283 for the details
- requires) is to defer the gross margin on the shipments until the right of return has expired.
Entry at time of shipment:
(A)Accounts receivable                                           $for the sales price
(A)      Inventory                                                                  $cost of inventory shipped
(A)      Deferred gross margin*                                                     $plug


What kind of account is this? Contra-asset, presented as part of accounts receivable.
Any income statement impact yet? Why not?

Entry if goods are returned:
(A)Inventory                                                    $for the cost of the goods returned
(A)Deferred gross margin                                        $plug
          (A)Cash (or A/Rec)                                              $for the sales price
Any income statement impact?
Entry if goods are not returned and “right of return” expires:

(E)Cost of goods sold                                           $for the cost of inventory shipped
(A)Deferred gross margin                                        $to clear out this account
          (R)Sales revenue                                                          $for the sales price
At last, an income statement effect!

This would change as your product became more established – you would develop some experience with
returns so that you COULD REASONABLY ESTIMATE the amount of goods to be returned. In this case,
the entries would be:

Entry at the time of shipment:
(A)Accounts receivable                                          $for the sales price
        (R)Sales revenue                                                            $for the sales price
(E)Cost of goods sold                                           $for the cost of inventory shipped
        (A)Inventory                                                      $for the cost of inventory

Adjusting journal entry at year end (what kind? – revaluation entry!)
(R)Sales returns (a contra-revenue account)                $for the estimated amount of returns
        (E)Cost of goods sold                                        $for the cost of the est. returns
        (A)Deferred gross margin                                               $plug

In the next period:
If the estimate is exactly right (hah!):
(A)Inventory                                                    $for the cost of the returned items
(A)Deferred gross margin                                        $to wipe out the account
          (A)Cash (or A/Rec)                                              $for the sales price of the returned
Any income statement impact?

If the estimate is wrong (as it probably will be):
(A)Inventory                                                    $for the cost of the returned items
(E)Cost of goods sold                                           $for the cost of items NOT returned
(A)Deferred gross margin                                        $to clear out the account
          (A)Accounts receivable                                          $for the sales price on the returned
          (R)Sales                                                        $for the sales price-items NOT retd
Any income statement impact?

What about goods on consignment? Are these revenues? NO, see the details of SFAS 48.


NOW let’s turn to the situation when collection is not assured (Part 3 of the revenue recognition criteria
above):

The Installment Sales Method and the Cost recovery method are alternatives for deferring revenues until
cash is received. But neither is used very often (the uncertainty regarding collection must be extremely
high – too high to estimate bad debts). One example: The purchase of real estate when the down payment
is VERY small and the ultimate collection is not reasonably assured.

You essentially defer the recognition of gross profit until you have resolved the uncertainty regarding cash
collection.

The issue is really when do you recognize any gross profit on these types of sales. The difference between
the two methods boils down to this:
INSTALLMENT SALE: You recognize some gross profit each time you receive cash (based on the gross
margin %)

COST RECOVERY METHOD: You don't recognize any gross profit until you have recovered the cost
of the goods sold (so it might be years until you first recognize gross profit)
>IN CLASS EXAMPLE
What does the accounting look like? Look at review problem , pg. 295 (go through this in class and
address questions)
 Is there an analogy here to the revenue recognition on long-term contracts? Think about it.
 Before you look at the entries, what is the gross margin percentage?
  How much revenue will be recognized under the installment sales method in 2001? Cost recovery method
in 2001? How about 2002?

Another example:
Example: Suppose your uncle, who is in the business of buying and selling land, agrees to sell you some
land in installments. The land has a sales price of $100,000 and you agree to pay for it over 25 years,
making annual payments of $4000 (your uncle is not the brightest bulb in the carton – he didn’t bother with
charging you interest), starting today. If the land cost your uncle $80,000 to purchase, then his gross
margin on the sale would be 20%. What entries would he make?


INSTALLMENT METHOD:
Installment method – you recognize a portion of the gross margin as realized EACH TIME you receive
cash.

Day of sale:
         Installment sales receivable                  $96,000
         Cash                                          $4000
                   Installment Sales                            $100,000
         To record the sale.
         Cost of land sales                            $80,000
                   Land inventory                               $80,000
         To record the COGS.
This is no different that what we do for a normal vanilla sale.

At the end of the year we need to make certain that we don’t recognize the gross profit:
         (R)Installment sales                                  $100,000
         (E)      Cost of land sales                                    $80,000
         (CA)     Deferred Gross margin on installment sales            $20,000
         To reverse the sale and record the unrealized gross margin.


         (CA)Deferred Gross margin                            $800
         (R)     Realized gross margin on installment sales          $800
         To recognize the gross margin associated with the $4000 payment received this year.

Where do these deferred accounts go in the financial statements?
         Deferred Gross margin is a contra-account to the Installment Receivables account – why?
         (Think about the definition of an asset, in this case the installment receivable – if we left it at the
full $96,000 amount, that would imply that our best estimate of the future benefit would be $96,000. Using
the deferred gross margin as an offset to this asset provides us a way of recognizing the uncertainty
regarding the collection of the full $96,000. The net balance in the installment receivable, $76,000, is
actually equal to the unrecovered cost of the land inventory.)
         Realized gross margin on installment sales is a temporary account, shown on the income
statement below Gross margin on sales .
These entries would repeat, with each cash receipt leading to a recognition of an associated 20% gross
margin.

COST RECOVERY METHOD:

Cost recovery method – you recognize the gross margin as realized ONLY AFTER you have received
enough cash to cover the cost of the item sold (This is the most conservative method of the two!)

Day of sale: Same entries as above

End of year:
                   Installment Sales                           $100,000
                            Cost of land sold                           $80,000
                            Deferred gross margin                       $20,000
                   To reverse the revenue and expense associated with the installment sale and to recognize
the uncertainty assoc. with the sale.
(this is the same as under the installment method so far…)
                   NO ENTRY TO REALIZE ANY GROSS MARGIN IN YEAR 1

In what year would your uncle first realize any gross margin associated with this sale? YEAR 21!!!! It
will take that long for you to have covered the $80,000 in cost. Each year’s payment before then would
simply be:
                   Cash                                         $4000
                             Installment sales receivable               $4000
                   To record the payments on sale of land.

On the balance sheet, the installment sales receivable account would be equal to the unrecovered cost of the
land sold. For years 21 through 25, the cash received would generate the following entries:
                  Cash                                         $4000
                            Accounts receivable                         $4000
                  Deferred gross margin on sales               $4000
                            Realized gross margin                       $4000

								
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