30/04/2024, 22:15 Accounting for Special Transactions | myLPU

Accounting for Special Transactions

Site: myLPU e-Learning Portal Printed by: Angel Madelene Bernardo
Accounting for Special Transactions (ACTN10B) - AY2023-24 2nd Date: Tuesday, April 30, 2024, 10:15 PM
Course:
Semester (De Jesus, Paul Anthony)
Book: Accounting for Special Transactions

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Description

Accounting for Special Transactions

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Table of contents

1. Corporate Liquidation

2. Accounting for Installment Sales

3. Long-term Construction Contracts

4. Franchise Operation

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1. Corporate Liquidation

Corporate Liquidation

Not all corporations are able to obtain their planned profits; some even have no profit at all, and in
reaching their goals to be successful and to be on top. The primary reason for this may be the inability to
pay its liabilities as they become due to its creditors. Corporations that face difficulties in paying their
liabilities are a quitting concern, not a going concern.

The process of liquidation includes selling of assets to try and get as much of the money owed to them as
possible. They have first priority to whatever is sold off, first to the different creditors, fully and partially
secured and unsecured, then the balance to shareholders, if any.

Corporations may decide for themselves to end the operations, in which they will enter the process of
bankruptcy, also known as voluntary. This wouldn’t be easy because it requires them to file a court
petition for bankruptcy. In addition, their creditors may also submit court petition to the court, or also
known as involuntary, for resolution and a statement comprising their debts and their assets at fair value.
This statement is called statement of affairs.

Statement of Affairs

Creditors would want to know the relative position of their claims and estimated amount that they can
collect on their claims. For this purpose, a statement of affairs should prepare. This initial report shows the
available asset values and debts of the debtor corporation.

The asset and liabilities are reported according to the classifications relevant to liquidation.

Consequently, assets are classified into three categories as follows:

1) Assets Pledged with Fully Secured Creditors – are assets with estimated market value equal to or
exceeding the liens of creditors to whom they have been pledged.

2) Asset pledge to partially secured creditors - other assets that are pledges as security for a
particular liability and the realizable value of the assets is not sufficient, therefore, less than the amount of
the liability.

3) Free Assets - assets that is not pledge for any particular liability, and thus available to meet the
claims of priority liabilities and unsecured creditors.

The liabilities of the company are classified into following four (4) categories:

1) Unsecured Liabilities with priority - You must pay priority claims in full. This refers to creditors
that, as specified by law, should have priority over other unsecured creditors.

2) Fully Secured Creditors – these are liabilities that are equal to or less than the market value of the
assets used as security.

3) Partially Secured Creditors – these are liabilities that exceed the market value of assets used as
collateral. The unsecured portion is added to the claims of unsecured creditors.

4) Unsecured Liabilities - this refers to liabilities without priority and for which no security was given.

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Estimated Amount Available, Unsecured Amount, and Estimated Deficiency to Unsecured Creditors

1) Estimated Amount Available – The excess of the market value of assets pledged with fully secured
creditors over the corresponding liability so secured and market values of free assets comprise the
estimated amount available to creditors with priority and unsecured creditors (without priority). It is
computed as follows:

Estimated amount available:

Assets pledged with fully secured creditors XX

Less - Fully secured creditor XX

Add - Free assets ____ ______XX

Estimated amount available XX

2) Unsecured Amount of Liabilities – the unsecured amount of liabilities as shown on statement of

affairs is equal to the total of the unsecured portion of partly secured creditors and the unsecured
obligations. The unsecured amount is computed as follows:

Unsecured amount of liabilities:

Partly secured creditors XX

Less – Assets pledged with partially secured ___XX

Unsecured portion of partly secured creditors XX

Add – Unsecured Creditors XX

Unsecured Amount of Liabilities XX

3) Estimated Deficiency to Unsecured Creditors – when the estimated amount available to unsecured
creditors is not sufficient to cover their claims, the difference is called the estimated deficiency to
unsecured creditors.

Statement of Realization and Liquidation

An account or statement used in settling or winding up a business or estate to show the results of the
disposition of assets and the liquidation of the debts. This statement shows a complete record of the
transactions of the receiver for a period of time.

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2. Accounting for Installment Sales

Accounting for Installment Sales

THE REVENUE RECOGNITION

Traditionally, under the Revenue Recognition Principle, revenue should be recognized when two
conditions exist:

· The earning process is COMPLETE OR VIRTUALLY COMPLETE, and

· An EXCHANGE HAS TAKEN PLACE.

These conditions were similarly indicated under PAS No 18, wherein revenue is recognized when:

· It is PROBABLE THAT FUTURE ECONOMIC BENEFITS WILL FLOW TO THE ENTERPRISE.

· These benefits CAN BE MEASURED RELIABLY.

TYPES OF SALE

There are two types of sales in the ordinary course of ordinary activities:

· REGULAR SALES – may either be cash and credit sales. The time of sale (or the full accrual method)
of revenue recognition is applied to this particular type of sales.

· INSTALLMENT SALES – are generally used to describe any type of sales for which payment is
required in periodic installments over an extended period of time.

METHODS OF GROSS PROFIT RECOGNITION ON INSTALLMENT SALES

Two general approaches may be taken in recognizing gross profit on installment sales:

· TIME OF SALE (Sales basis or Accrual basis) – profit is recognized in the period in which the sales
is made. Outright recognition of revenue, costs and gross profit should be made at point of sale. No
deferred items are recognized.

· TIME OF COLLECTION – profit is recognized in the periods in which cash is collected. Initially, the
gross profit is deferred then subsequently gross profit is realized when collections are made.

INSTALLMENT SALES METHOD

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The installment sales method emphasizes collection rather than sale. It recognizes income in the
periods of collection rather than in the period of sale. The installment basis of accounting is justified on
the basis that when there is no reasonable basis for estimating the degree of collectability, revenue
should not be recognized until cash is collected.

RECOGNITION OF GROSS PROFIT ON INSTALLMENT SALES USING INSTALLMENT SALES METHOD

To compute for the realized gross profit on installment sales using installment sales method, the
following steps are to be followed:

1] Compute for the gross profit rate (GPR).

CURRENT YEAR’S SALES:

GPR = Gross Profit/Installment Sales

or

GPR = 1 – Cost Rate*

*Cost of Goods Sold/Sales

PRIOR YEAR’S SALES:

The above formula may also be used for prior year’s sales if given, but in its absence, the alternative
formula should be as follows:

Deferred gross profit, beginning of the current year (DGP, beg)

Installment accounts receivable, beginning of the current year (IAR, beg)

2] Multiply the collections by the GPR to get the realized gross profit (RGP) for the year.

RGP = Collections x GPR

Or, alternatively:

1] Compute for the deferred gross profit at the beginning of the year. (DGP, beg)

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DGP, beg = Sales x GPR

2] Multiply the Installment Accounts Receivable at the end of the year (IAR, end) by the gross profit rate
and subtract the product from the DGP, beg to get the RGP for the year.

DGP, end = IAR, end* x GPR

*IAR, end = Sales – Cash Collections

RGP = DGP, beg – DGP, end

ILLUSTRATIVE EXAMPLE I:

Assume that on August 1, 2014, an installment sale of real property costing P300,000 was sold for
P500,000. A down payment of P125,000 is made and the balance is payable in twenty four monthly
payments of 15,625 at the end of each month commencing the month of sale.

Required:

Compute for the RGP on 2014.

Solution:

1] Compute for the gross profit rate (GPR).

Sales P500,000

- Cost of Sales 300,000

Gross Profit 200,000

GPR = Gross Profit/Sales

= 200,000/500,000

= 40%

or

GPR = 1 – Cost Rate

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= 1 – (300,000/500,000)

= 1 – 60%

= 40%

2] Multiply the collections by the GPR to get the realized gross profit (RGP) for the year.

Down Payment P125,000

Collections (15,625 x 4) 62,500

Total Collections 187,500

Multiply by: x 40%

RGP P 75,000

or, alternatively

1] Compute for the deferred gross profit at the beginning of the year. (DGP, beg)

DGP, beg = Sales x GPR

= 500,000 x 40%

= P200,000

2] Multiply the Installment Accounts Receivable at the end of the year (IAR, end) by the gross profit rate
and subtract the product from the DGP, beg to get the RGP for the year.

DGP, end = IAR, end x GPR

= [500,000 – 125,000 – (15,625 x 4)] x 40%

= 312,500 x 40%

= P125,000

RGP = DGP, beg – DGP, end

= P200,000 – P125,000

= P75,000

ACCOUNTING PROCEDURES

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The following are the pro-form journal entries in accounting for sale of merchandise both in regular basis
and installment basis is as follows:

1] To record regular sales

Cash (if there is down payment)

Accounts receivable

Sales

2] To record installment sales

Cash (if there is down payment)

Installment accounts receivable

Installment sales

3] To record cost of sales:

Periodic Method: No entry

Perpetual Method:

Regular Sales:

Cost of sales

Merchandise inventory

Installment Sales:

Cost of installment sales

Merchandise inventory

4] To record collections:

Regular Sales:

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Cash

Accounts receivable

Installment Sales:

Cash

IAR

Interest income (if applicable)

5] To record payment of operating expenses:

Operating expenses

Cash

Adjusting entries at the end of the year:

6] To recognize accrued interest receivable

Interest receivable

Interest income

7] To set-up Cost of sales:

Periodic Method:

Cost of installment sales

Merchandise inventory

Perpetual Method: No entry

8] To set-up Cost of Installment Sales:

Periodic Method:

Cost of installment sales

Shipments on installment sales

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Perpetual Method: No entry

9] To set-up Deferred Gross Profit

Installment sales

Cost of installment sales

Deferred gross profit

10] To record realized gross profit on installment sales:

Deferred gross profit

RGP on installment sales

Closing entries:

11] To close realized gross profit account:

Realized gross profit on installment sales

Income summary

12] To close other nominal accounts

Sales

Interest income

Cost of sales

Operating expenses

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Income summary

13] To close results of operations:

Income summary

Retained earnings

ILLUSTRATIVE EXAMPLE 2

Assume the following information detailing the transactions for two years of MENDOZA Corporation:

2014 2015

Sales:

Regular -

2014: Cash, P250,000, On account, P500,000

P250,000

2015: Cash, P400,000, On account, P1,000,000

P600,000

Installment Sales:

Down payment – 20% 150,000 200,000

Balance 600,000 800,000

Cost of sales:

Regular 200,000 250,000

Installment 450,000 700,000

Collections:

Accounts receivable 125,000 200,000

Installment accounts receivable-

2014 Sales, applying to

Principal 100,000 100,000

Interest 10,000 9,000

2015 Sales, applying to

Principal 200,000

Interest 24,000

Accrued interest receivable, December

31:

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2014 sales 1,000 1,000

2015 sales 1,500

Operating expenses paid 50,000 100,000

Required:

a. Prepare the entries to record the above transactions.

b. Prepare the entries to recognize the gross profit and close the accounts for 2014 and 2015.

Solution:

Requirement A

1] To record regular sales 2014 2015

Cash 250,000 400,000

Accounts receivable 250,000 600,000

Sales 500,000 1,000,000

2] To record installment sales

Cash 150,000 200,000

IAR 600,000 800,000

Installment sales 750,000 1,000,000

3] To record cost of sales:

Periodic Method: No entry

Perpetual Method:

Regular Sales:

Cost of sales 200,000 250,000

Merchandise inventory 200,000 250,000

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Installment Sales:

Cost of installment sales 450,000 700,000

Merchandise inventory 450,000 700,000

4] To record collections:

Regular Sales:

Cash 125,000 200,000

Accounts receivable 125,000 200,000

Installment Sales:

Cash 110,000 333,000

IAR – 2014 100,000 100,000

IAR – 2015 200,000

Interest income 10,000 33,000

5] To record payment of operating expenses:

Operating expenses 50,000 100,000

Cash 50,000 100,000

Adjusting entries at the end of the year:

6] To recognize accrued interest receivable

Interest receivable 1,000 2,500

Interest income 1,000 2,500

7] To set-up Cost of sales:

Periodic Method:

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Cost of installment sales 200,000 250,000

Merchandise inventory 200,000 250,000

Perpetual Method: No entry

8] To set-up Cost of Installment Sales:

Periodic Method:

Cost of installment sales 450,000 700,000

Shipments on installment sales 450,000 700,000

Perpetual Method: No entry

9] To set-up Deferred Gross Profit

Installment sales 750,000 1,000,000

Cost of installment sales 450,000 700,000

Deferred gross profit 300,000 300,000

Requirement B

1] To record realized gross profit on installment sales:

Deferred gross profit – 2014 40,000 40,000

Deferred gross profit – 2015 60,000

RGP on installment sales 40,000 100,000

2014: Realized gross profit on installment sales:

Collections applying as to principal P100,000

Multiplied by: Gross profit rate x 40 %

Realized gross profit P 40,000

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2015: Realized gross profit on installment sales:

2014 2015

Collections – principal P100,000 P200,000

Multiplied by: Gross profit % x 40% x 30%

Realized gross profit P 40,000 P 60,000 P100,000

Closing entries:

To close realized gross profit account:

RGP on installment sales 40,000 100,000

Income summary 40,000 100,000

To close other nominal accounts

Sales 500,000 1,000,000

Interest income 11,000 35,500

Cost of sales 200,000 250,000

Operating expenses 50,000 100,000

Income summary 261,000 685,500

To close results of operations:

Income summary 301,000 785,500

Retained earnings 301,000 785,500

DETERMINING GROSS PROFIT AT YEAR-END

To compute for the DGP, end, multiply the IAR, end by the GPR.

IAR, end xx

Multiply by: GPR xx%

DGP, end xx

or, alternatively:

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Subtract the DGP before adjustment for RGP by the RGP on installment sales.

DGP before adjustment for RGP xx

Less: RGP (xx)

DGP, end xx

DEFAULTS AND REPOSSESSIONS

Depending on the terms of the sales contract and the policy of the credit department, the seller
can repossess merchandise sold under an installment arrangement if the purchaser fails to meet payment
requirements. Repossessed merchandise may be reconditioned before being offered for sale. It may be
resold for cash or installment payments.

DETERMINING GAIN OR LOSS ON REPOSSESSION

To compute for the gain or loss on repossession \, the following steps are to be followed:

1] Compute for the net realizable value of the merchandise at the time of repossession.

Estimated Selling Price after Reconditioning Cost xx

Less: Reconditioning Cost xx

Cost to Sell xx

Normal Profit xx xx

Net Realizable Value xx

2] Compute for the Unrecovered Cost (URC).

IAR, unpaid balance xx

Less: Deferred gross profit xx

Unrecovered Cost xx

3] Subtract the NRV of the repossessed merchandise by the URC. If the NRV > Unrecovered Cost, it is a
gain on repossession. If the NRV < Unrecovered Cost, it is a loss on repossession.

NRV xx

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Less: URC xx

Gain (Loss) on Repossession xx

The pro-forma entry in accounting for repossessed merchandise is as follows:

Repossessed merchandise xx

Deferred gross profit xx

Loss on repossession (if applicable) xx

Installment Accounts receivable xx

Gain on repossession (if applicable) xx

Repossessed merchandise xx

Cash, etc. (Various credits) xx

ILLUSTRATIVE EXAMPLE 3:

Assume the following information in relation to the defaulted accounts that eventually result to a
repossession of merchandise in 2015:

Installment accounts receivable – 2014, unpaid balance on the P200,000

defaulted contract

Gross profit rate in 2014 35%

Estimated selling price after reconditioning costs 150,000

Reconditioning costs 20,000

Costs to sell and dispose 10,000

Gross profit rate in 2015 (also the normal gross profit on 20%
repossessed merchandise)

1] Compute for the net realizable value of the merchandise at the time of repossession.

Estimated Selling Price after Reconditioning Cost 150,000

Less: Reconditioning Cost 20,000

Cost to Sell 10,000

Normal Profit (150,000 x 20%) 30,000 60,000

Net Realizable Value 90,000

2] Compute for the Unrecovered Cost (URC).

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IAR, unpaid balance 200,000

Less: Deferred gross profit 70,000

Unrecovered Cost 130,000

3] Subtract the NRV of the repossessed merchandise by the URC.

NRV 90,000

Less: URC 130,000

Loss on Repossession (40,000)

Repossessed merchandise 90,000

Deferred gross profit 70,000

Loss on repossession 40,000

Installment accounts receivable 200,000

Repossessed merchandise 20,000

Cash, etc. (Various credits) 20,000

DETERMINING OVER OR UNDER ALLOWANCE OF TRADE-IN MERCHANDISE

To compute for the over or under allowance of trade-in merchandise, subtract the trade-in allowance by
the NRV of the merchandise traded-in. If the trade-in allowance > NRV of trade-in merchandise, it is an
over-allowance and it is a deduction in the sales price. If the trade-in allowance is < NRV of trade-in
merchandise, it an under-allowance and it is an addition in the sales price.

Trade-in Allowance xx

Less: Net Realizable Value:

Estimated Resale Price after Reconditioning Costs xx

Less: Reconditioning Costs xx

Cost to Sell xx

Normal profit xx xx

Over (under) Allowance xx

The pro-forma entry in accounting for trade-in merchandise is as follows:

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Trade-in Merchandise xx

Cash (if there is down payment) xx

IAR xx

Over-allowance (if applicable) xx

Installment Sales xx

Under-allowance (if applicable) xx

Trade-in Merchandise xx

Cash, etc. (Various credits) xx

To compute for the gross profit on installment sales with trade-in merchandise, the following format is
used:

Installment Sales xx

Add (Deduct) Under (Over) Allowance xx

Adjusted Sales xx

Less: Cost of installment sales xx

Gross Profit xx

GPR = Gross Profit/Installment Sales

or

GPR = 1 – Cost Rate

ILLUSTRATIVE EXAMPLE 4:

Assume that on March 1, 2014, the MENDOZA Car Sales Company sells a sport utility vehicle for
P5,155,000 with the vehicle costing P3,000,000. An old vehicle was accepted as down payment and an
allowance of P1,000,000 was allowed on the trade-in. In addition to the trade-in vehicle a down-payment
of P750,000 cash and the balance to be paid at the end of each month in fifteen monthly installments of
P227,000 commencing the month of sale. The company estimated that the old vehicle have an estimated
resale price of P1,500,000 after reconditioning costs of P250,000. The company expects a 25% profit from
the resale and costs to sell (commission) of 5%.

Required:

Give the entry to record the above transactions for the year 2014.

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Solution:

Trade-in Allowance 1,000,000

Less: Net Realizable Value:

Estimated Resale Price after Reconditioning Costs 1,500,000

Less: Reconditioning Costs 250,000

Cost to Sell (1,500,000 x 25%) 375,000

Normal profit (1,500,000 x 2%) 30,000 845,000

Over (under) Allowance 155,000

Trade-in merchandise 845,000

Over-allowance 155,000

Cash 750,000

IAR 3,405,000

Installment Sales 5,155,000

Trade-in Merchandise 250,000

Cash 250,000

To compute for the gross profit on installment sales with trade-in merchandise:

Installment Sales 5,155,000

Add (Deduct) Under (Over) Allowance (155,000)

Adjusted Sales 5,000,000

Less: Cost of installment sales 3,000,000

Gross Profit 2,000,000

GPR = Gross Profit/Adjusted Sales

= 2,000,000/5,000,000

= 40%

To compute for the realized gross profit on sales

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Trade-in 845,000

Down payment 750,000

Collections (227,000 x 9) 2,043,000

Total Collections 3,638,000

Multiply by: GPR x 40%

Realized gross profit 1,455,200

COMPUTATION OF NET INCOME

ILLUSTRATIVE EXAMPLE 5:

MENDOZA COMPANY began operations on June 1, 2013. The following information are extracted from
its records at year-end. Cost of installment sales, P1,500,000; Cost of Regular Sales, P1,500,000. Mark-up
on installment sales is 25% of cost while regular sales is 25% bases on sales. At the end of 2013, the
balance of Installment accounts receivable is P1,200,000; Accounts receivable is P750,000. Operating
expenses (includes losses on repossession) total to 80% of the realized gross profit.

Required:

What is the net income for the year ended December 31, 2013?

Solution:

Regular Sales (1,500,000/75%) 2,000,000 100%

Cost of Regular Sales 1,500,000 75%

Gross Profit on Regular Sales 500,000 25%

Installment Sales (1,500,000 x 125%) 1,875,000 125%

Cost of Installment Sales 1,500,000 100%

Gross Profit on Installment Sales 375,000 25%

DGP, beg 375,000

Less: DGP, end [1,200,000 x (25%/125%)] 240,000

RGP on Installment Sales 135,000

RGP on Regular Sales 500,000

Total RGP 635,000

Less: Operating expenses (635,000 x 80%) 508,000

Net income 127,000

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ADDITIONAL PROBLEMS OF INSTALLMENT SALES ACCOUNTING

· INTEREST ON INSTALLMENT CONTRACTS – Because the collection of installment accounts

receivable is spread over a long period, it is customary to charge the buyer interest on the unpaid
balance. A schedule of equal payments consisting of interest and principal is set-up. Each successive
payment is attributable to the principal.

· UNCOLLECTIBLE ACCOUNTS – The Problem of bad debts or uncollectible accounts receivable is

somewhat different for concerns selling on an installment basis because of a repossession feature
commonly incorporated in the sales agreement. This feature gives the selling company an opportunity to
recoup any uncollectible accounts through repossession and sale of repossessed merchandise. If the
experience of the company indicates that repossessions do not, as a rule compensate for uncollectible
balances, it may be advisable to provide for such losses through charges to a special bad debt expenses
account, just as is done for other credit sales.

COST RECOVERY METHOD

Under exceptional circumstances, however, the cost recovery method may be used.

· The cost recovery method may be used where collectability of proceeds is HIGHLY UNCERTAIN,
where an investment is very speculative, in nature, and/or where the final sale price is to be determined
by future events.

· Under the cost recovery method, ALL AMOUNTS COLLECTED ARE TREATED AS A RECOUPMENT
OF THE COST OF THE ITEM SOLD, UNTIL THE ENTIRE COST ASSOCIATED WITH THE TRANSACTION
HAS BEEN RECOVERED. ONLY AT THIS POINT PROFIT IS RECOGNIZED.

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3. Long-term Construction Contracts

Long-term Construction Contracts

Construction Contracts

The main objective addressed by PAS 11 is how to account for revenues and costs in connection with
long-term construction contract. The start of construction activities and their completion very often
crosses several accounting periods; therefore the main issue is how to allocate revenues and costs
appropriately to the affected construction periods.

Ø Cost Incurred to Date – it is the cumulative cost of construction incurred by the contractor from the
time the project started up to a particular Statement of Financial position date.

Ø Estimated Cost to Complete – it is the additional cost of construction reasonably expected to be

incurred to complete the project. The engineer makes an estimate of the cost to complete at every
Statement of Financial Position date.

Ø Total Estimated Cost – it is the sum of the cost incurred to date and the estimated cost to complete.

Gross Profit Recognition

The gross profit on a construction project be recognized upon its completion or each year as the
construction progresses. There are two alternative methods of gross profit recognition to as:

1) Zero Profit Method

This method is used when reasonable estimate of the percentage of completion cannot be made. Under
this method, revenue is recognized each year in an amount exactly equal to costs incurred until
reasonable estimates of the percentage of completion is available. The total gross profit on the project is
recognized in the year of completion of the project.

2) Percentage of Completion Method

Under this method, gross profit is recognized at the end of each accounting period based on the
percentage of completion of the project. The percentage of completion is usually computed by dividing
the cost incurred to date b the total cost to complete the project.

Construction Activities

The following are the journal entries to record the different transaction of a construction firm.

1. To record purchase of construction material

Construction Material
xx

Cash (or accounts payable)

xx

2. To record cost of materials incurred in construction

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Construction in progress
xx

Construction Material xx

3. To record payment of construction overhead cost

Construction in progress xx

Payroll
xx

4. To record payment of construction overhead cost

Construction in progress
xx

Cash xx

5. To record other construction overhead cost

Construction in progress
xx

Accrued expense / Various Account xx

6. To record billings to customers

Account Receivable
xx

Progress billings on construction contracts

xx

7. To record collection from customers

Cash
xx

Account Receivable xx

At the end of each accounting period, a journal entry is prepared to record the revenue, cost of revenue
and gross profit recognized for that period. Another entry is prepared upon completion of the project top
close the balances of Construction in Progress and Progress Billings on Construction Contracts accounts.
Following are the pro-forma journal entries:

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1. To record recognized revenue, cost of revenue and gross profit

Cost of Long-Term Construction Contracts xxx

Construction in Progress xxx

Revenue from Long-Term Construction Contracts xxx

2. To record recognized revenue, cost revenue and anticipated loss

Cost of Long-Term Construction Contracts xxx

Construction in Progress xxx

Revenue from Long-Term Construction Contracts xxx

3. To close the balances of construction in progress and progress billings on Construction contracts

Progress Billings on Construction Contracts xxx

Construction in Progress xxx

Illustrative Problem A: The Quality Builders Co. is awarded a contract in 2006 to construct a ten-storey
building at a total price of P40,000,000. The project is completed in three years. The company uses the
cost-to-cost method in estimating the percentage of work completed. Data relating to the project follow:

Year Cost Incurred Estimated Cost to Billings to Collections

Complete Customers

2006 P 8, 000, 000 P 24, 000, 000 P 7, 000, 000 P 6,000,000

2007 10,000,000 12,000,000 14,000,000 13,000,000

2008 13,000,000 19,000,000 21,000,000

Step 1 – Prepare a schedule of total estimated cost, total estimated gross profit and percentage of
completion using the cost-to-cost method.

2006 2007 2008

a. Contract price P40,000,000 P40,000,000 P40,000,000

b. Cost incurred to date P 8,000,000 P18,000,000 P31,000,000

c. Estimated cost to complete 24,000,000 12,000,000

d. Total estimated cost (b + c) P32,000,000 P30,000,000 P31,000,000

e. Total estimated gross profit (a P 8,000,000 P10,000,000 P 9,000,000

– d)

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f. Percentage of completion 25% 60% 100%

( b / d)

Step 2 – Determine the amount of revenue, cost of revenue and profit to be recognized each year.

2006 To Date Recognized in Prior Year/s To be Recognized in

Current Year

Recognized revenue P 10,000,000 P10,000,000

( P40,000,000 x 25%)

Cost of rvenue (P32,000,000 x P 8,000,000 P 8,000,000

25%)

Gross Profit (P8,000,000 x 25%) P 2,000,000 P

2,000,000

2007

Recognized revenue P 24,000,000 P10,000,000 P14,000,000

(P40,000,000 x 60%)

Cost of rvenue (P32,000,000 x 18,000,000 8,000,000 10,000,000

60%)

Gross Profit (P8,000,000 x P 6,000,000 P 2,000,000 P 4,000,000

60%)

2008

Recognized revenue P40,000,000 P24,000,000 P16,000,000

(P40,000,000 x 100%)

Cost of rvenue (P31,000,000 x 31,000,000 P18,000,000 13,000,000

100%)

Gross Profit (P9,000,000 x 60%) P P P3,000,000

9,000,000 6,000,000

2006

Debit Credit

Construction in Progress 8,000,000

Cash, Materials, etc. 8,000,000

To record costs incurred.

Accounts Receivable 7,000,000

Progress Billings on Construction Contracts 7,000,000

To record billings to customers.

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Cash 6,000,000

Accounts Receivable 6,000,000

To record collections from customers

Cost of Long-Term Construction Contracts 8,000,000

Construction in Progress 2,000,000

Revenue from Long Term Construction Contracts 10,000,000

To record periodic profit on the project

Progress Billings on Construction Contracts

Construction in Progress

To close the balances of the two accounts upon

completion of the project

2007

Debit Credit

Construction in Progress 10,000,000

Cash, Materials, etc. 10,000,000

To record costs incurred.

Accounts Receivable 14,000,000

Progress Billings on Construction Contracts 14,000,000

To record billings to customers.

Cash 13,000,000

Accounts Receivable 13,000,000

To record collections from customers

Cost of Long-Term Construction Contracts 10,000,000

Construction in Progress 4,000,000

Revenue from Long Term Construction Contracts 14,000,000

To record periodic profit on the project

Progress Billings on Construction Contracts

Construction in Progress

To close the balances of the two accounts upon

completion of the project

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2008

Debit Credit

Construction in Progress 13,000,000

Cash, Materials, etc. 13,000,000

To record costs incurred.

Accounts Receivable 19,000,000

Progress Billings on Construction Contracts 19,000,000

To record billings to customers.

Cash 21,000,000

Accounts Receivable 21,000,000

To record collections from customers

Cost of Long-Term Construction Contracts 13,000,000

Construction in Progress 3,000,000

Revenue from Long Term Construction Contracts 16,000,000

To record periodic profit on the project

Progress Billings on Construction Contracts 40,000,000

Construction in Progress 40,000,000

To close the balances of the two accounts upon

completion of the project

ANTICIPATED LOSS ON LONG-TERM CONSTRUCTION CONTRACTS

The expected or anticipated loss should be recognized as expense immediately when it is

probable that total contract costs for a particular project will exceed total contract revenue. PAS No. 11
provides that the amount of loss is determined irrespective of:

1. whether or not work has commenced on the contract;

2. the stage of completion of contract activity; or

3. the amount of profits expected to arise on other contracts.

Illustrative Problem B. Assume the following information pertaining to a project accepted by Quality
Builders Co. at a total contract price of P20,000,000:

2006 2007 2008

Cost incurred P 6,000,000 P 10,000,000 P 9,000,000

Estimated Cost to Complete 12,000,000 8,000,000 -

The total estimated gross profit (loss) at the end of each year is computed as follows:

2006 2007 2008

Contract Price P 20,000,000 P 20,000,000 P 20,000,000

Cost to incurred to date P 6,000,000 P 16,000,000 P 25,000,000

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Estimated cost to complete 12,000,000 8,000,000 __________

Total estimated cost P 18,000,000 P 24,000,000 P 25,000,000

Total estimated gross profit (loss)P 2,000,000 (P 4,000,000) (P 5,000,000)

The profit (loss) to be recognized each year will be determined as follows:

a. Determine the percentage of completion at the end of each year:

2006 = 6,000,000 / 18,000,000 = 33 1/3%

2007 = 16,000,000 / 24,000,000 = 66 2/3%

2008 = 25,000,000 / 25,000,000 = 100%

b. Determine revenue, cost of revenue and gross profit (loss) at the end of each year.

To be

Recognized Recognized

2006 To Date in Prior Years in Current Year

Recognized Revenue

(P20,000,000 x 33 1/3%) P6,666,667 P6,666,667

Cost of Revenue

(P18,000,000 x 33 1/3%) 6,000,000 6,000,000

Gross profit

(P2,000,000 x 33 1/3%) P 666,667 P 666,667

2007

Recognized revenue

( P20,000,000 x 66 2/3% ) P 13,333,333 P6,666,667 P 6,666,666

Cost of revenue 17,333,333 6,000,000 11,333,333

Gross Profit (Loss) (P 4,000,000) P

666,667 (P 4,666,667)

2008

Recognized revenue

( P20,000,000 x 100% ) P 20,000,000 P 13,333,333 P 6,666,667

Cost of revenue (actual) 25,000,000 17,333,333 7,666,667

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Gross Profit (Loss) (P 5,000,000) (P

4,000,000) (P 1,000,000)

c. The journal entries to record the profit (loss) at the end of each year follows:

2006:

Cost of Long-term Construction Contract 6,000,000

Construction in Progress 666,667

Revenue from Long-term Construction Contract 6,666,667

2007:

Cost of Long-term Construction Contract 11,333,333

Construction in Progress 4,666,667

Revenue from Long-term Construction Contract 6,666,666

2007:

Cost of Long-term Construction Contract 7,666,667

Construction in Progress 1,000,000

Revenue from Long-term Construction Contract 6,666,667

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4. Franchise Operation

Franchise Operation

Definition of terms:

Franchise – is a privilege of granting business rights.

Franchisor – party granting the privilege.

Franchisee – party given by the privilege.

Kinds of franchise agreements

1. Government granting the privilege to use public property in performing its services. Examples are
those granted to shipping companies (for the use of public waters), bus lines and telephone companies
(for the use of highways and streets).

2. Private entities granting the use of trademarks, patents and processes of the franchisor. An example
is the right to operate n eatery “Joliibee”, “Mcdonald’s” or as “Kentucky Fried Chicken”

Kinds of payment

1. Initial franchise fee – means the initial payment by the franchisee, For initial franchise fee, the
franchisor normally provides the franchisee with the following services:

ü Assistance in site selection

ü Evaluation of potential revenue

ü Supervision of potential income

ü Assistance in the acquisition of signs, fixtures, and equipment

ü Provision of bookkeeping and advisory services

ü Provision of employee and management training

ü Provision of quality control

The initial franchise fee is the consideration for establishing the franchise relationship and providing some
initial services. Initial franchise fees are to be recorded as revenue only when and as the franchise makes
substantial performance of the services it is obligated to perform and collection of the fee is reasonably
assured.

· Substantial performance (90% or more) occurs when the franchisor has no remaining obligation to
refund any cash received or excuse any nonpayment of a note and has performed all the initial services
required under the contract

2. Continuing franchise fee – consideration coming from the income of operations.

An enfranchisement contract may stipulate the payment of Continuing Franchise Fees based on
operations of the franchisee. These fees are recorded as revenue and as expense by the franchisor and the
franchisee, respectively.

Methods of Accounting

1. Accrual Method – is used when reasonable assurance of collection

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2. Installment Method – is used when revenue is collectible over an extended period of time and
there is no reasonable basis for estimating collectability.

ILLUSTRATIVE PROBLEM 1

Initial Franchising fee

Maxim Donuts granted a franchise to Digna Santos. The transactions are as follows.

Jan 1 - The franchisor receives down payment for the franchise of P100,000 with the balance in a
promissory note collectible in five semi-annual installment of P40,000.

31 - Direct cost of franchise services incurred, P60,000.

May 31 - Direct cost of franchise services incurred, P150,000. As of this date, initial services by the
franchisor are substantially performed.

July 1 - The first semi-annual installment is collected.

The entries under the accrual and installment methods are as follows:

Accrual Method Installment Method

Jan 1 Cash P100,000 Cash P100,000

Notes Receivable 200,000 Notes Receivable 200,000

Unearned Franchise Fees P300,000 Unearned Franchise Fees

P300,000

31 Cost of Franchise Services 150,000 Cost of Franchise Services 60,000

Cash 60,000 Cash

60,000

May 31 Cost of Franchise Services 150,000 Cost of Franchise Services

150,000

Cash 150,000 Cash

60,000

Unearned Franchise Fees 300,000

Franchise Fee Revenue 300,000

July 1 Cash 40,000 Cash

40,000

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Notes Receivable 40,000 Notes Receivable

40,000

Dec 31 Franchise Fee Revenue 300,000 Unearned Franchise Fee Revenue

300,000

Cost of franchise Services 210,000 Cost of Franchise

Services 210,000

Income and Expense Summary 90,000 Deferred Gross

Revenue 90,000

Deferred Gross Revenue

42,000

Realized Gross
Revenue 42,000

Realized Gross Revenue

42,000

Income and Expense

Summary 42,000

The realized gross revenue under the installment method is arrived at as follows:

Collection during the year (P100,000 +40,000) P140,000

Gross Profit Rate (P90,000/P300,000) 30%__

Realized Gross Profit 42,000

Franchise Fee in Cash and Promissory Note with Cost of Money Given. The total consideration is
taken up at its present value. Assume that in preceding example, prevailing interest rate is 24% per
annum. Present value of an annuity of P1 for 5 periods discounted at 12% is 3.6047755 so that the
present value of five semi-annual payments is discounted at 12% must be P144,191. The entries under the
accrual and the installment methods must be:

Accrual Method Installment Method

Jan 1 Cash P100,000 Cash

P100,000

Notes Receivable 200,000 Notes Receivable

200,000

Discount on Notes Receivable P55,809 Discount on Notes

Receivable P55,809

Unearned Franchise Fee 244,191 Unearned Franchise Fee

244,191

31 Cost of Franchise Services 150,000 Cost of Franchise Services 150,000

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Cash 150,000 Cash

150,000

May 31 Cost of Franchise Services 150,000 Cost of Franchise Services 150,000

Cash 150,000
Cash 150,000

Unearned Franchise Fee 244,191

Franchise Fee Revenue 244,191

July 1 Cash P 40,000 Cash P

40,000

Notes Receivable 40,000 Notes Receivable

40,000

Discount on Notes Receivable 17,303 Discount on Notes Receivable

17,303

Interest Income 17,303 Interest Income

17,303

Dec 31 Franchise Fee Revenue 244,191 Unearned Franchise Fee Revenue

244,191

Interest Income 17,303 Cost of Franchise

Services 210,000 Cost of Franchise A Services 210,000
Deferred Gross Revenue 51,494

Income and Expense Summary 51,494 Deferred Gross Revenue

17,180

Realized Gross
Revenue 17,180

[P122,697 x
(P34,191/P244,191)]

Realized Gross
Revenue 17,180

Interest Income
17,303

Income and Expense

Summary 34,483

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The discount on note receivable arrived at by comparing the face value of the promissory note and
the present value of the installments to be collected on the said note as follows:

Face value of promissory P200,000

Present value of annual payments of P40,000 discounted

at 12% or (P40,000x3.6047755) _144,191

Discount on notes receivable P 55,809

The effects of the entities for the semi -annual collections on the promissory note are tabulated as
follows:

Semi-annual APPLIED TO: Balance of

Collections Interest Principal Principal

P144,191

July 1, 2010 P40,000 P17,303 P22,697 121,494

Jan. 1, 2011 P40,000 14,579 25,421 96,073

July 1, 2012 P40,000 11,529 28,471 67,602

Jan. 1 2013 P40,000 8,112 31,888 35,714

July 1, 2014 P40,000 4,286 35,714 ----

The realized gross profit under installment method arrived at as follows:

Total consideration (cash of P100,000 plus P244,191

principal of promissory note of P144,191)

Cost of franchise services (210,000)

Gross Profit P 34,191

Gross profit rate = (P34,191/244,191) .1400174

Time collections (100,000 down payment

Plus collection on principal of P22,697) P122,697

Realized gross profit P 17,180

Substantial Services to be Performed yet by Franchisor and Down payment is not Refundable. In cases
wherein the franchisor still has perform to perform substantial services but the down payment made by
the franchise is no longer refundable, the same is credited to revenue and the remainder, to unearned
revenue and the remainder, to unearned revenue. Under this assumption, the entry based on the given
example would be as follows:

Cash P100,000

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Notes receivable 200,000

Discount on Notes Receivable P 55,809

Unearned Franchise Fees 144,191

Franchise Fee Revenue 100,000

ILLUSTRATIVE PROBLEM 2

Continuing franchise fee

Example: LAGRADA Corporation which operates an eatery called “Pasig Lechon” granted X
Corporation the right to operate an outlet using the name “Pasig Lechon”. For 2014, sales by the latter
amount to P3,000,000. Franchise fee is 5%. To record the franchise fee paid by the franchise, the entries
on books of both parties would be as follows:

Books of franchisor Books of franchisee

Cash P150,000 Franchise Fee Expense P150,000

Franchise Fee Revenue P150,000 Cash

P150,000

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