Revenue Recognition: Sales Method vs. Installment Method¶

This document compares the sales method and the installment method of revenue recognition using a practical example.

Scenario¶

Mars Electronics sells electronics on installment plans (6 or 12 months). Their profit margin is 30% (cost of sales is 70% of sales). Currently, they use the sales method, recognizing revenue upon invoice generation. They are considering switching to the installment method.

We have monthly sales and collection data for the past year and need to calculate monthly revenue, cost of sales, and profit under both methods.

Data¶

Screenshot (443)

Sales Method¶

Under the sales method, revenue is recognized when the sale is made (invoice generated), regardless of when cash is collected.

Calculations:

Cost of Sales = 70% of Sales = 0.70 * ₹4,000,000 = ₹2,800,000
Profit = Sales - Cost of Sales = ₹4,000,000 - ₹2,800,000 = ₹1,200,000

Example (Monthly Calculation):

Let's say January sales were ₹300,000.

Cost of Sales (January) = 0.70 * ₹300,000 = ₹210,000
Profit (January) = ₹300,000 - ₹210,000 = ₹90,000

This calculation is repeated for each month. The sum of all monthly profits will equal the total profit of ₹1,200,000.

Summary (Sales Method):

Total Revenue: ₹4,000,000
Total Cost of Sales: ₹2,800,000
Total Profit: ₹1,200,000

Installment Method¶

Under the installment method, revenue is recognized proportionally to cash collected.

Calculations:

Recognized Revenue = Collections
Cost of Sales = 70% of Collections
Profit = Collections - Cost of Sales

Example (Monthly Calculation):

Let's say January collections were ₹240,000.

Recognized Revenue (January) = ₹240,000
Cost of Sales (January) = 0.70 * ₹240,000 = ₹168,000
Profit (January) = ₹240,000 - ₹168,000 = ₹72,000

This calculation is repeated for each month.

Summary (Installment Method):

Total Revenue (Collections): ₹3,520,000
Total Cost of Sales: 0.70 * ₹3,520,000 = ₹2,464,000
Total Profit: ₹3,520,000 - ₹2,464,000 = ₹1,056,000

Comparison¶

Metric	Sales Method	Installment Method
Total Revenue	₹4,000,000	₹3,520,000
Total Profit	₹1,200,000	₹1,056,000

Analysis¶

The sales method recognizes higher revenue and profit in the period of sale, regardless of collections.
The installment method recognizes revenue and profit only when cash is collected, resulting in lower reported profits initially, especially if collections are slow.
In this example, the difference in profit between the two methods is ₹144,000 (₹1,200,000 - ₹1,056,000).

When to Use Each Method¶

Sales Method: Suitable when the risk of non-collection is low. It provides a more immediate picture of sales performance.
Installment Method: Suitable when the risk of non-collection is significant or when collections are extended over a long period. It is a more conservative approach, as it ties revenue recognition to actual cash inflow.

Revenue Recognition: Completed Contract vs. Percentage of Completion Methods¶

Th

Scenario¶

Space Construction previously worked on smaller projects completed within one year, using the completed contract method. They have now undertaken a large, three-year airport project worth ₹1,440 crore, with a 20% profit margin. This project has significantly increased their work-in-progress (WIP). The company is considering switching to the percentage of completion method.

We have data on project spending, completed contract values, and WIP for the past three years and projected data for the next two years. We need to calculate profits under both methods.

Data Summary (in ₹ Crore)¶

Year	Opening WIP	Amount Spent	Completed Contracts	Closing WIP
2022	0	200	180	20
2023	20	250	243	27
2024	27	580 (incl. 300 for Airport)	270	337
2025 (Projected)	337	700 (incl. remaining for Airport)	1,550	37
2026 (Projected)	37	100	110	27

Completed Contract Method¶

Under this method, revenue and profit are recognized only when the project is completed.

Calculations:

Cost of Sales = Value of Completed Contracts
Profit Markup = 20% / 80% = 25% (Profit / Cost)
Revenue = Cost of Sales * 1.25
Profit = Revenue - Cost of Sales

Profit Calculation (Completed Contract Method):

Year	Cost of Sales	Revenue	Profit
2022	180	225	45
2023	243	303.75	60.75
2024	270	337.5	67.5
2025	1,550	1,937.5	387.5
2026	110	137.5	27.5
Total			588.25

Percentage of Completion Method¶

Under this method, revenue and profit are recognized proportionally to the work completed during the period. We'll use the cost-to-cost method, where the percentage of completion is determined by the ratio of costs incurred to total estimated costs. Since we are using an estimated 20% margin, we can simplify this calculation by applying the markup to the costs incurred each year.

Calculations:

Revenue = Amount Spent * 1.25
Profit = Revenue - Amount Spent

Profit Calculation (Percentage of Completion Method):

Year	Amount Spent	Revenue	Profit
2022	200	250	50
2023	250	312.5	62.5
2024	580	725	145
2025	700	875	175
2026	100	125	25
Total			462.5

Note: The total profit under the percentage of completion method should ideally be the same as under the completed contract method over the entire project lifecycle. Discrepancies may arise due to estimations and simplifications in the example.

Comparison¶

Metric	Completed Contract Method	Percentage of Completion Method
Profit Pattern	Fluctuating, large jump in completion year	More stable, gradual increase
Total Profit (5 Years)	588.25	462.5

Analysis¶

The completed contract method results in highly fluctuating profits, with a significant spike in the year of project completion. This can distort the company's financial performance in different periods.
The percentage of completion method provides a smoother, more consistent profit recognition over the project's duration. This gives a more accurate representation of the company's performance during the project's life.

Provision for Doubtful Debts: Flat Rate vs. Age Analysis¶

This document compares two methods of calculating the provision for doubtful debts: a flat rate method and an age analysis method.

Scenario¶

Sigma Steel Limited sells steel products on 30-day credit terms. They currently use a flat 5% provision on year-end outstanding receivables. An audit committee member suggested switching to age analysis.

The recommended age analysis percentages are:

0-30 days: 5%
31-45 days: 8%
46-60 days: 10%
Over 60 days: 100%

As of March 31, 2024, outstanding receivables are ₹200 crore, and the existing provision balance is ₹8 crore. The age analysis is as follows:

0-30 days: ₹180 crore
31-45 days: ₹12 crore
46-60 days: ₹6 crore
Over 60 days: ₹2 crore

We need to calculate the incremental provision required under both methods.

Flat Rate Method¶

Under this method, a fixed percentage is applied to total outstanding receivables.

Calculations:

Receivables: ₹200 crore
Provision Required (5%): ₹200 crore * 5% = ₹10 crore
Existing Provision: ₹8 crore
Incremental Provision Required: ₹10 crore - ₹8 crore = ₹2 crore

Accounting Entry (Flat Rate):

Account	Debit (₹ Crore)	Credit (₹ Crore)
Bad Debts Expense	2
Provision for Doubtful Debts		2

Age Analysis Method¶

This method categorizes receivables by age and applies different percentages based on the likelihood of collection.

Calculations:

Age Category	Receivables (₹ Crore)	Provision Percentage	Provision Required (₹ Crore)
0-30 days	180	5%	9
31-45 days	12	8%	0.96
46-60 days	6	10%	0.6
Over 60 days	2	100%	2
Total	200		12.56

Total Provision Required (Age Analysis): ₹12.56 crore
Existing Provision: ₹8 crore
Incremental Provision Required: ₹12.56 crore - ₹8 crore = ₹4.56 crore

Accounting Entry (Age Analysis):

Account	Debit (₹ Crore)	Credit (₹ Crore)
Bad Debts Expense	4.56
Provision for Doubtful Debts		4.56

Comparison¶

Metric	Flat Rate Method	Age Analysis Method
Incremental Provision Required	₹2 crore	₹4.56 crore

Analysis¶

The age analysis method requires a significantly higher incremental provision (₹4.56 crore) compared to the flat rate method (₹2 crore).
The flat rate method assumes a uniform risk of non-collection across all receivables, regardless of age.
The age analysis method is more granular and considers the increasing risk of non-collection as receivables become overdue. It is a more conservative and prudent approach.

Accounting for Consignment Sales¶

This document explains the accounting treatment for consignment sales, where goods are sent to a consignee (distributor) who sells them on behalf of the consignor (company). Revenue is recognized only when the consignee sells the goods to the end customer.

Scenario¶

ATR Limited supplies ready-to-eat food to retailers through distributors on a consignment basis. Their margin is 50% (cost of sales is 50% of sales). Products have a shelf life of 5-60 days. Expired goods are the responsibility of ATR Limited.

We have the following details for the year ending March 31, 2024 (all figures in ₹ Lakhs):

Goods sent to distributors: 800
Cost of sales related to these goods: 400
Value of expired goods: 80
Value of goods still within expiry date (but unsold): 120

We need to compute the profit for the year and show the accounting entries.

Profit Calculation¶

Goods available for sale by consignee: 800
Less: Goods still with consignee (within expiry): 120
Less: Expired goods: 80
Goods sold to end customers: 600
Cost of sales of goods sold: 600 * 50% = 300
Cost of sales of expired goods: 80 * 50% = 40
Profit for the period: 600 (Revenue) - 300 (COS of goods sold) - 40 (COS of expired goods) = 260

Accounting Entries¶

1. Goods sent to distributors:

This entry reflects the transfer of goods to the consignee's possession but not a sale. The ownership remains with ATR Limited.

Account	Debit (₹ Lakhs)	Credit (₹ Lakhs)
Inventory with Consignees	400
Inventory		400

2. Goods sold to end customers (by consignee):

This is when revenue is recognized.

Account	Debit (₹ Lakhs)	Credit (₹ Lakhs)
Accounts Receivable (from Distributor)	600
Sales Revenue		600
Cost of Goods Sold	300
Inventory with Consignees		300

3. Expired Goods:

This entry recognizes the loss on expired goods.

Account	Debit (₹ Lakhs)	Credit (₹ Lakhs)
Loss on Expired Goods	40
Inventory with Consignees		40

Summary of Financial Statement Impact¶

Revenue: ₹600 Lakhs
Cost of Sales: ₹300 Lakhs
Loss on Expired Goods: ₹40 Lakhs
Profit: ₹260 Lakhs
Balance Sheet:
- Accounts Receivable: ₹600 Lakhs
- Inventory with Consignees: ₹60 Lakhs (120 lakhs value - 60 lakhs cost of sales remaining)

Key Points¶

Consignment sales are not recognized as revenue until the goods are sold to the end customer by the consignee.
The consignor retains ownership of the goods until they are sold by the consignee.
The cost of expired goods is borne by the consignor and is recognized as an expense.
The inventory held by the consignee is still considered the consignor's inventory and is recorded at cost.

This example illustrates the proper accounting treatment for consignment sales, ensuring that revenue is recognized appropriately and the cost of expired goods is accounted for.

Revenue Recognition Methods: Percentage of Completion vs. Cost Recovery¶

Scenario: Digi Software Limited¶

Contract Value: 600 crore
Project Duration: 3 years
Estimated Expenses:
- Year 1: 80 crore
- Year 2: 150 crore
- Year 3: 150 crore
- Total: 380 crore
Estimated Profit: 600 crore - 380 crore = 220 crore
Customer Payments: 200 crore at the end of each year.

1. Percentage of Completion Method (POCM)¶

POCM recognizes revenue and profit as the project progresses based on the percentage of work completed.

Calculations¶

Year	Amount Received (Crore)	Amount Spent (Crore)	% of Completion	Profit Recognized (Crore)	Revenue (Crore)	Cost of Sales (Crore)	Receivable/Advance (Crore)
1	200	80	80/380 = 21.05%	220 * 21.05% = 46.32	80 + 46.32 = 126.32	80	200 - 126.32 = 73.68 (Advance)
2	200	150	150/380 = 39.47%	220 * 39.47% = 86.84	150 + 86.84 = 236.84	150	73.68 + 236.84 - 200 = 110.52 - 200 = -89.48(Advance)
3	200	150	150/380 = 39.47%	220 * 39.47% = 86.84	150 + 86.84 = 236.84	150	-89.48 + 236.84 - 200 = -52.64

Explanation:

% of Completion: Calculated as (Amount Spent to Date) / (Total Estimated Expenses).
Profit Recognized: Calculated as (Total Estimated Profit) * (% of Completion).
Revenue: Calculated as (Amount Spent) + (Profit Recognized).
Work in Progress: Remains zero as all costs are expensed immediately.
Receivable/Advance: Tracks the difference between revenue recognized and cash received. A positive value indicates an advance from the customer; a negative value indicates a receivable from the customer.

2. Cost Recovery Method¶

The Cost Recovery Method recognizes revenue only to the extent of costs incurred until the costs are fully recovered. After full cost recovery, profit is recognized.

Calculations¶

Year	Amount Received (Crore)	Amount Spent (Crore)	Profit Recognized (Crore)	Revenue (Crore)	Work in Progress (Crore)	Receivable/Advance (Crore)
1	200	80	0	80	80	200-80 = 120 (Advance)
2	200	150	133.16	150+133.16 = 283.16	0	120 + 283.16 - 200 = 203.16-200 = 3.16
3	200	150	86.84	150 + 86.84 = 236.84	0	3.16+236.84 - 200 = 40

Explanation:

Year 1: Cash received (200) exceeds costs incurred (80). However, no profit is recognized as the total project cost (380) has not yet been recovered. Revenue is equal to cost incurred.
Year 2: Cumulative cash received (400) now exceeds the total estimated project cost (380). At this point, profit recognition begins. In this specific example, since the project is near completion in year 2, the profit recognized is equivalent to the cumulative profit recognized under POCM at the end of year 2 (46.32 + 86.84 = = 133.16).
Year 3: The remaining profit is recognized.
Work in Progress: Costs are accumulated as work in progress until cost recovery occurs.
Receivable/Advance: Same principle as POCM.

Comparison¶

Feature	Percentage of Completion	Cost Recovery
Profit Recognition	Based on % of completion	After cost recovery
Revenue Recognition	As work progresses	To the extent of costs until full recovery, then based on completion
Conservatism	Less conservative	More conservative than POCM, less than Completed Contract Method
Complexity	More complex	Simpler than POCM

Key Differences:

POCM recognizes profit proportionally throughout the project, whereas the Cost Recovery Method delays profit recognition until costs are recovered.
Cost recovery method is more conservative than POCM.

In the example, the total profit recognized over the three years is the same (220 crore) under both methods. However, the timing of profit recognition differs significantly. The Cost Recovery method is a middle ground between the Percentage of Completion method (more aggressive) and the Completed Contract method (most conservative).

Provision for Warranty Expenses Exercise: Xcool Limited¶

Background¶

Companies offering warranties often use the matching principle to recognize warranty expenses in the same period as the related sales revenue. This is achieved by creating a "Provision for Warranty Expenses" account. When warranty claims arise, this provision account is used instead of directly charging the current period's profit and loss statement.

Exercise: Xcool Limited¶

Scenario:

Xcool Limited provides a five-year warranty on its products.
Based on past experience and industry standards, the company estimates warranty expenses to be 10% of sales value.
Opening balance of the Provision for Warranty Expenses account on April 1, 2023: ₹400 lakhs.
Sales for the year 2023-24: ₹6,000 lakhs.
Warranty expenses incurred during the year: ₹80 lakhs (₹60 lakhs for components, ₹20 lakhs for salary and travel).

Objective: Record the transactions and update the Provision for Warranty Expenses account.

Accounting Entries and Account Updates¶

Here's a breakdown of the accounting entries and their impact on the Provision for Warranty Expenses account:

Opening Balance (April 1, 2023):
- Provision for Warranty Expenses: ₹400 lakhs (Credit)
Warranty Expenses Incurred:
- Inventory (Components): ₹60 lakhs (Debit)
- Cash/Bank (Salary & Travel): ₹20 lakhs (Debit)
- Provision for Warranty Expenses: ₹80 lakhs (Debit)
Explanation: When warranty expenses are incurred, the provision account is debited, reducing its balance. The corresponding credits go to the relevant expense accounts (Inventory for component replacement and Cash/Bank for salary and travel).
Sales for the Year:
- Cash/Accounts Receivable: ₹6,000 lakhs (Debit)
- Sales Revenue: ₹6,000 lakhs (Credit)
Explanation: This entry records the sales revenue for the year.*
Provision for Warranty Expenses for Current Period Sales:
- Warranty Expense: ₹600 lakhs (Debit) (10% of ₹6,000 lakhs sales)
- Provision for Warranty Expenses: ₹600 lakhs (Credit)
Explanation: This entry creates the provision for estimated warranty expenses related to the current year's sales. The Warranty Expense account is debited, and the Provision for Warranty Expenses account is credited. This adheres to the matching principle by recognizing the potential future warranty costs in the same period as the related sales revenue.*

Updating the Provision for Warranty Expenses Account¶

Here's how the Provision for Warranty Expenses account changes:

Description	Debit (₹ lakhs)	Credit (₹ lakhs)	Balance (₹ lakhs)
Opening Balance (April 1, 2023)		400	400
Warranty Expenses Incurred	80		320
Provision for Current Period Sales		600	920
Closing Balance (March 31, 2024)			920

Explanation of the Closing Balance¶

The closing balance of ₹920 lakhs in the Provision for Warranty Expenses account represents the estimated future cost of fulfilling warranty obligations for products sold in both the current and previous years. The ₹400 lakhs opening balance covers warranties on previous years' sales, while the ₹600 lakhs provision created this year covers warranties on the current year's sales. The ₹80 lakhs spent during the year reduced the balance.

Important Points¶

The provision is based on an estimate (10% of sales). The actual warranty expenses may differ.
The five-year warranty period means that expenses related to products sold in previous years can still be incurred in the current year and future years. This is why the opening balance is important.
The company could perform a periodic review (e.g., every five years) to reconcile the provision balance with the actual expected warranty costs based on the remaining warranty periods of sold products. This would help ensure the provision is adequate.

This exercise demonstrates how the Provision for Warranty Expenses account is used to match warranty costs with the related sales revenue, providing a more accurate representation of the company's financial performance.

Provision for Sales Returns Exercise: Sigma Traders¶

Background¶

Companies often allow customers to return goods. To account for potential future returns, they create a "Provision for Sales Returns" or "Allowance for Sales Returns" account. This provision is an estimate of future returns based on past experience.

Exercise: Sigma Traders¶

Scenario:

Sigma Traders sells goods to online portals.
Selling price is cost plus 10-20%.
Customers can return goods within seven days.
Provision for sales returns is 5% of sales.
Opening balance of the Provision for Sales Returns account on April 1, 2023: ₹10 lakhs.
Cash sales for 2023-24: ₹2,000 lakhs.
Cost of sales for these sales: ₹1,700 lakhs.
Goods returned during the year: Sales value ₹120 lakhs, cost of sales ₹100 lakhs.
Resale of returned goods:
- ₹50 lakhs (cost) sold for ₹52 lakhs.
- ₹40 lakhs (cost) sold for ₹35 lakhs (₹5 lakh loss).
- ₹10 lakhs (cost) scrapped.
Losses on returned sales are charged to the Provision for Sales Returns.

Objective: Record the transactions, update the Provision for Sales Returns account, and determine the profit for 2023-24.

Accounting Entries and Account Updates¶

Here's a breakdown of the accounting entries and their impact:

Opening Balance (April 1, 2023):
- Provision for Sales Returns: ₹10 lakhs (Credit)
Sales for the Current Year:
- Cash: ₹2,000 lakhs (Debit)
- Sales Revenue: ₹2,000 lakhs (Credit)
Cost of Sales:
- Cost of Goods Sold: ₹1,700 lakhs (Debit)
- Inventory: ₹1,700 lakhs (Credit)
Sales Returns:
- Sales Returns: ₹120 lakhs (Debit)
- Cash: ₹120 lakhs (Credit)
Return of Goods to Inventory:
- Inventory: ₹100 lakhs (Debit)
- Cost of Goods Sold: ₹100 lakhs (Credit)
Sale of Returned Goods (Scenario 1):
- Cash: ₹52 lakhs (Debit)
- Sales Revenue: ₹52 lakhs (Credit)
- Cost of Goods Sold: ₹50 lakhs (Debit)
- Inventory: ₹50 lakhs (Credit)
Sale of Returned Goods (Scenario 2 - Loss):
- Cash: ₹35 lakhs (Debit)
- Sales Revenue: ₹35 lakhs (Credit)
- Cost of Goods Sold: ₹40 lakhs (Debit)
- Inventory: ₹40 lakhs (Credit)
- Provision for Sales Returns: ₹5 lakhs (Debit) This is where the loss is charged.
Scrapping of Returned Goods:
- Provision for Sales Returns: ₹10 lakhs (Debit)
- Inventory: ₹10 lakhs (Credit)
Provision for Sales Returns for Current Year Sales:
- Sales Returns Expense: ₹100 lakhs (Debit) (5% of ₹2,000 lakhs sales)
- Provision for Sales Returns: ₹100 lakhs (Credit)

Updating the Provision for Sales Returns Account¶

Description	Debit (₹ lakhs)	Credit (₹ lakhs)	Balance (₹ lakhs)
Opening Balance		10	10
Loss on Sale of Returned Goods (Scenario 2)	5		5
Scrap of Returned Goods	10		-5
Provision for Current Period Sales		100	95
Closing Balance			95

Profit Calculation¶

Net Sales: ₹2,000 lakhs (Initial Sales) - ₹120 lakhs (Returns) + ₹52 lakhs + ₹35 lakhs = ₹1,967 lakhs
Net Cost of Goods Sold: ₹1,700 lakhs (Initial COGS) - ₹100 lakhs + ₹50 Lakhs + ₹40 Lakhs = ₹1,690 Lakhs
Gross Profit: ₹1,967 lakhs - ₹1,690 lakhs = ₹277 Lakhs
Sales Return Expense: ₹100 Lakhs
Net Profit: ₹277 Lakhs - ₹100 Lakhs = ₹177 Lakhs.

Correction in original calculation: The original calculation had an error in calculating net sales and COGS leading to an incorrect profit. The correct profit for the year is ₹177 Lakhs.

Explanation¶

The Provision for Sales Returns account is used to absorb losses from returned goods.
Creating the provision in the same period as the sales aligns with the matching principle.
The closing balance of ₹95 lakhs represents the estimated future returns related to current year sales.
The sales of returned goods are treated as separate transactions, with any profit or loss recognized in the current period.

This exercise demonstrates how the provision account helps companies manage the financial impact of sales returns.

Ask Hive Chat

Hive Chat

Hi, I'm Hive Chat, an AI assistant created by CollegeHive.
How can I help you today?