| Mulcahey Builders (MB) remodels office buildings in low-income urbanareas that are undergoing economic revitalization. MB typically accepts a 25% down payment when they complete a job and a note that requires that the remainder be paid in three equal installments over the next three years, plus interest. Because of the inherent uncertainty associated with receiving these payments, MB has historically used the cost recovery method to recognize revenue. |
| As of January 1, 2016, MB’s outstanding gross installment accounts receivable (not net of deferred gross profit) consist of the following: |
| 1. | $414,000 due from the Bluebird Motel. MB completed the Bluebird job in 2014, and estimated gross profit on that job is 25%. |
| 2. | $173,000 due from the PitStop Gas and MiniMart. MB completed the PitStop job in 2013, and estimated gross profit on that job is 30%. |
| Dan Mulcahey has been considering switching from the cost recovery method to the installment sales method, because he wants to show the highest possible gross profit in 2016 and he understands that the installment sales method recognizes gross profit sooner than does the cost recovery method. |
| Required: | |
| 1. | Calculate how much gross profit is expected to be earned on these jobs in 2016 under the cost recovery method, and how much would be earned if MB instead used the installment sales method. Ignore interest. |
| 2. | If Dan is primarily concerned about 2016, do you think he would be happy with a switch to the installment sales method? | ||||
|
1
Calculate how much gross profit is expected to be earned on these jobs in 2016 under the cost recovery method, and how much would be earned if MB instead used the installment sales method. Ignore interest.
Answer:
.All jobs consist of four equal payments: one payment when the job is completed and three payments overthe next three years.
Bluebird:
Job completed in 2014, so down payment made in 2014, another payment in 2015, and two paymentsremain. $414,000 gross receivable at 1/1/2016 implies payments of ($414,000 ÷ 2) = $207,000 in 2016 and2017. Four payments of $207,000 implies total revenue of 4 × $207,000 = $828,000 on the job. Twenty fivepercent gross profit ratio implies cost of 75% × $800,000 = $621,000.
Cost recovery method gross profit: Payments in 2014 and 2015 have already recovered $414,000 of cost,so cost remaining to be recovered as of 1/1/2016 is $621,000 total – $414,000 already recovered =$207,000. Therefore, the entire 2016 payment of $207,000 will be applied to cost recovery, and no grossprofit is recognized in 2016
Installment sales method gross profit: $207,000 payment × 25% gross profit ratio = $51750 of gross profit recognized in 2016.
PitStop:
Job completed in 2013, so down payment made in 2013, another payment in 2014, another in 2015, andone payment remains. $173,000 gross receivable at 1/1/2016 implies a single payment of $173,000 in2016. Four payments of $173,000 implies total revenue of 4 × $173,000 = $692,000 on the job. Thirty percent gross profit ratio implies cost of 70% × $692,000 = $484400.
Cost recovery method gross profit: Payments in 2013, 2014, and 2015 of a total of $519,000 have alreadyrecovered the entire $484400 of cost and allowed recognition of $38600 of gross profit. Therefore, theentire 2016 payment of $173,000 will be applied to gross profit.
Installment sales method gross profit: $173,000 payment × 30% gross profit ratio = $51,900 of gross profitrecognized in 2016.
Totals:
Cost recovery method: $0 (Bluebird) + 173,000 (PitStop) = $173,000.
Installment sales method: $51750 (Bluebird) + 51900 (PitStop) = $103650
2
If Dan is primarily concerned about 2016, do you think he would be happy with a switch to the installment sales method?
answer : NO
