Question

On January 1, 2011, Draper Co. sold land that cost $420,000 for $560,000, receiving a note bearing interest at 10%. The note will be paid in three annual installments of $225,190 starting on December 31, 2011. Because collection of the note is very uncertain, Draper will use the cost-recovery method. How much revenue from this sale should Draper recognize in 2011? >$70,000 >$42,000 >$0 >$56,000

Answer 1

Using the cost-recovery method, Draper Co. recognizes no revenue in 2011 from the sale of the land since the first installment payment of $225,190 is applied entirely towards the recovery of the land's cost, which is $420,000.

Step-by-step explanation:

The question pertains to recognizing revenue using the cost-recovery method in a transaction where payment is received in instalments and collection is uncertain. According to the cost-recovery method, revenue is recognized only to the extent of costs recovered. In the given scenario, Draper Co. sold land that cost $420,000 for $560,000, with the first annual installment being $225,190 on December 31, 2011.

Since the cost of the land is $420,000, and Draper Co. will receive $225,190 in the first installment, the entire amount of this first installment would go toward recovering the cost of the land. Draper Co. should not recognize any profit in 2011, as the revenue received via the first installment does not exceed the cost base of the land sold. Therefore, the revenue Draper should recognize in 2011 is $0.

Answer 2

Draper Co. should recognize $42,000 in revenue from the sale in 2011.

Step-by-step explanation:

Draper Co. sold land for $560,000 with a cost of $420,000, resulting in a gain of $140,000. However, due to uncertainty in collecting the note, the cost-recovery method is applied. The recoverable amount is the cost of the asset, and since the annual installment of $225,190 exceeds the gain, only $42,000 ($140,000 - $225,190) should be recognized as revenue in 2011. The remaining gain will be recognized in subsequent years as payments are received.

The cost-recovery method is chosen when collection is uncertain, and revenue recognition is delayed until the cash collected equals the cost. In this case, the cash received in the first year is less than the gain, so only a portion of the gain is recognized. By using this method, financial reporting reflects the conservative approach, aligning with the prudence concept in accounting. It ensures that revenue is only recognized when there is reasonable certainty of its realization, safeguarding the accuracy and reliability of financial statements. The $42,000 recognized in 2011 represents a prudent estimation of the amount expected to be collected in the uncertain circumstances of the note's payment.