Question

Identify the applicable accounting convention for the following business scenario and explain your choice

The Morrison Company receives much of its revenue from those customers who buy or rent furniture and appliances on the installment plan. Because the company uses an accrual-based accounting system, revenue is recognized at the point of sale, even though cash comes in on a monthly basis from customers. Lately, the company's accountant is questioning the use of the accrual basis for recognizing revenue, because several customers have defaulted on their contracts, causing problems in the accounting system.

Answer 1

The accounting convention applicable in this scenario is the convention of 'Conservatism'.

When installment sales are made and the accrual accounting convetion is followed, the gross profit is recognized at the point of sale, ignoring the fact that the cash is collected over a long period of time and as such has a hgiher probability of default. Thus, the accrual method goes against prudence, which requires that possibility of loss arising out of default should be considered while accounting for revenues.

The alternative methods available to the company are:

1) Recognizing the gross profit only after the cost is realized through the periodic installments,

2) Recognizing the gross profit rateably as the installments are received.

Choice:

Choice would be the recognition of gross profit rateably; ie: by applying the gross profit rate to the installements collected during the period.

Such a system is conservative and affords for deferment of gross profit until it is realized. It also avoids payment of tax in advance on amounts that are defaulted later.