[flop310]

For the cost recovery method, can interest income be recognize before cash is greater than cost? When I look at my books and online it says that you don’t. But I found this question and it seems that interest is recognized.

The Radford Company bought four acres of land several years ago at a cost of $90,000 per acre. On January 1, Year One, Radford sold this same land for a total of $480,000. Starting on December 31, Year One, the buyer will make six annual payments of $80,000 per year plus interest on the unpaid balance at a 10 percent annual rate. The interest rate is viewed as reasonable and all payments are made on the required date. Because Radford officials felt that there was substantial doubt about the company’s ability to collect this money, the cost recovery method was chosen for reporting purposes. What is the total impact on the net income reported for Year Two?

A $40,000

B $50,000

C $60,000

D $70,000

ANSWER IS A

EXPLANATION: Under the cost recovery method, no profit is recognized until cash equal to the cost of the asset is received. For this transaction, the cost of the land was $360,000 (four acres at $90,000 per acre). Radford collected $80,000 of that amount in Year One and another $80,000 in Year Two. That total of $160,000 does not recover the entire cost of the property so that none of the gain can be recognized. However, the interest revenue form the receivable does increase income. The payment at the end of the first year was $80,000 reducing the receivable from $480,000 down to $400,000. Based on a 10 percent rate, the interest revenue to be collected in Year Two is $40,000 ($400,000 times 10 percent). This amount is the only income effect for this year.

PLEASE HELP!

THANKS!

[MCLKT]

Where did this problem come from?

I think it's wrong.

Cost Recovery Method ALL profits are deferred until cash is collected equivalent to the cost. This includes interest revenue.

Also, the problem suggests the cash collected is $80k PLUS interest on the unpaid balance

Year 1 Cash $128,000 {$80k + $48k (interest accrued 1/1/X1-12/31/X1 = 10%*480,000)}

Yerr 2 Cash $120,000 {$80k + $40k (10% * $400, 000)}

Total Cash Collected $248,000 < $360,000 cost = No Impact on Net Income

J/E 1/1/X1

Note Rec. $480,000

---

> Land $360,000

---

>Deferred Rev. $120,000

JE 12/31/X1

Interest Rec. $48,000

---

> Deferred Rev. $48,000

Cash $128,000

---

> Note Rec. $80,000

---

> Interest Rec. $48,000

JE12/31/X2

Interest Rec. $40,000

---

> Deferred Rev. $40,000

Cash $120,000

---

> Note Rec. $80,000

---

> Interest Rec. $40,000

A:[73]97 F:[74]85 R:86 B:[74]82
*NINJA 10 Pt. COMBO & Yaeger*

[jamesb]

I know for installment method, interest revenue is added to Cash collected x GP % to get to total income for year.

In theory, Cost method and installment are same, they don't recognize any profits, until cash collected. So I would assume interest received is revenue to the extent it exceed cost under cost method.

@MCKT..you are calculating interest wrong. It should be on UNPAID balance. 480 is the sales. And 80 is payment, which leaves 400 unpaid for next year.

I think answer should be 0. Because total cost 360 hasn't been recovered.

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[MCLKT]

@JamesB. true both wait until cash is collected before recognizing. That's why they are used when collection is doubtful.

Except Installment Method you are recognizing revenue regardless of the cost. So even if a small portion of cash was collected, you are allowed to recognize a portion of the income.

Whereas, in the Cost Method you recognize ZERO income until ALL costs are recovered. Cost Method is WAY more conservative.

A:[73]97 F:[74]85 R:86 B:[74]82
*NINJA 10 Pt. COMBO & Yaeger*

[FlipACoin]

I would tend to agree with those who posted here. To play devils advocate though, since interest in this case is ancillary and considered other income (usually not operations revenue), is it possible that it should be recognized when earned? Just a thought…

[flop310]

Thank you for the explanations. I found this question on this https://cpareviewforfree.com/exams.cfm?name=question&test_id=2500678

[jamesb]

@MCLKT…I agree..This question/answer is wrong..This is why I don't use FREE stuff.

AUD: TBA-
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[MCLKT]

I like cpareviewforfree, but I have found other errors in their info too. So now I only use it as my last review method when I'm VERY familiar with the principles. And I don't promote it as much as I used to.

@FlipACoin- I get where you're going. But even though interest is classified as a financial income in Other Income, it still doesn't get recognized until full cost has been recovered. It will need to be booked to Deferred Interest Income until $360k is collected 🙂

A:[73]97 F:[74]85 R:86 B:[74]82
*NINJA 10 Pt. COMBO & Yaeger*

[FlipACoin]

Thanks MCLKT! That makes complete sense…

[Author]

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