Page 205 - Accounting Principles (A Business Perspective)

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examples illustrate the effect that the business environment has on the development of accounting principles and
standards.
Cash collection as point of revenue recognition Some small companies record revenues and expenses at

the time of cash collection and payment, which may not occur at the time of sale. This procedure is the cash basis of
accounting. The cash basis is acceptable primarily in service enterprises that do not have substantial credit
transactions or inventories, such as business entities of doctors or dentists.
Installment basis of revenue recognition When collecting the selling price of goods sold in monthly or
annual installments and considerable doubt exists as to collectibility, the company may use the installment basis of
accounting. Companies make these sales in spite of the doubtful collectibility of the account because their margin of
profit is high and the goods can be repossessed if the payments are not received. Under the installment basis, the

percentage of total gross margin (selling price of a good minus its cost) recognized in a period is equal to the
percentage of total cash from a sale that is received in that period. Thus, the gross margin recognized in a period is
equal to the cash received times the gross margin percentage (gross margin divided by selling price). The formula to
recognize gross profit on cash collections made on installment sales of a certain year is:
Cash collectionsx Gross margin percentage=Gross margin recognized
To be more precise, we expand the descriptions in the formula as follows:
Cash collections this year resulting X Gross margin percentage = Gross margin recognized
from installment sales made in a for the year of sale this year on cash collections
certain year this year from installment sales
made in a certain year
To illustrate, assume a company sold a stereo set. The facts of the sale are:
Date of sale Selling price Cost Gross margin (Selling price – Gross margin percentage (Gross
Cost) margin/Selling price)
2010 Oct. 1 USD 500 USD 300 (500-300) – 200 (200/500) = 40 per cent

The buyer makes 10 equal monthly installment payments of USD 50 to pay for the set (10 X USD 50 = USD
500). If the company receives three monthly payments in 2010, the total amount of cash received in 2010 is USD
150 (3 X USD 50). The gross margin to recognize in 2010 is:
2010 cash collections from X Gross margin percentage = 2010 gross margin
2010 installment sales on 2010 installment sales recognized on 2010 cash
collections from 2010
installment sales
USD 150 X 40 per cent = USD 60
The company collects the other installments when due so it receives a total of USD 350 in 2011 from 2010
installment sales. The gross margin to recognize in 2011 on these cash collections is as follows:
2011 cash collections from 2010 X Gross margin percentage on 2010 = 2011 gross margin recognized on
installment sales installment sales 2011 cash collections from 2010
installment sales
USD 350 X 40 per cent = USD 140
In summary, the total receipts and gross margin recognized in the two years are as follows:
Total Amount of Gross Margin
Year Cash Recognized Recognized
2010 $150 30% $ 60 30%
2011 ..... 350 70% 140 70%
$500 100% $200 100%
Because the installment basis delays some revenue recognition beyond the time of sale, it is acceptable for
accounting purposes only when considerable doubt exists as to collectibility of the installments.

Accounting Principles: A Business Perspective 206 A Global Text