Installment Sales Accounting Method

Definition

The term installment sales refers to an accounting method that emphasizes the collection of cash from customers rather than the sales transaction.  The installment sales method recognizes income in the accounting periods it's collected, and not at the time of sale.

Explanation

The FASB Concept Statement No. 5 states that companies cannot recognize revenues as being earned until they are realized or realizable, and the company has substantially completed what it needs to do in order to be entitled to payment.  Revenue can be recognized at the point of sale, before, and after delivery, or as part of a special sales transaction.

If the sales price is not reasonably assured after delivery of the product or service to a customer, the company may choose to defer recognizing revenue until cash is received.  Generally, there are two accepted ways to account for these transactions: the installment sales method and the cost recovery method.

The term installment refers to a sales approach that allows customers to make periodic payments over an extended timeframe.  Installment sales are oftentimes used by industries that manufacture furniture, automobiles, and heavy equipment.  The risk of bad debt associated with uncollectible accounts increases for these companies, since payment is received over a relatively long period of time.  To reduce this risk, the seller may ask the buyer to provide collateral, or have the right to repossess the asset if the buyer fails to make the required payments on time.

With the installment sales method, both the revenue and cost of goods sold is recognized in the period of the sale, but the gross profit on the sale is delayed until the cash is collected from the customer.  The following requirements apply to companies using this approach:

  • Transactions involving installment sales must be kept in separate accounts from other types of sales.
  • The company needs to have a method that can reliably determine the gross profit on installment sales.
  • The amount of money collected for installment sales accounts receivable must be traceable over multiple accounting periods

Example

Company A recorded $7,500,000 in installment sales in the current fiscal year.  The cost of goods sold associated with these sales was $6,000,000.  Company A was also able to collect $3,000,000 from customers through their scheduled installment payments.  The determination of gross profit to record in the current fiscal period would be as follows:

Installment Sales $7,500,000
Cost of Goods Sold $6,000,000
Gross Profit $1,500,000
Gross Profit Margin ($1,500,000 / $7,000,000) 20%
   
Cash Receipts $3,000,000
Realized Gross Profit ($3,000,000 x 20%) $600,000
Deferred Gross Profit ($1,500,000 - $600,000) $900,000

The journal entry associated with these transactions would be as follows.  To record the installment sales for the current fiscal year:

  Debit Credit
Installment Accounts Receivable $7,500,000  
Installment Sales   $7,500,000

The journal entry to record the collection of cash from customers:

  Debit Credit
Cash $3,000,000  
Installment Accounts Receivable   $3,000,000

The journal entry to record the cost of goods sold:

  Debit Credit
Cost of Installment Sales $6,000,000  
Inventory (Goods Sold on Installment)   $6,000,000

The journal entry to record the installment sales:

  Debit Credit
Installment Sales $7,500,000  
Cost of Installment Sales   $6,000,000
Deferred Gross Profit (Installment Sales)   $1,500,000

The journal entry to record the realized gross profit:

  Debit Credit
Deferred Gross Profit (Installment Sales) $600,000  
Realized Gross Profit (Installment Sales)   $600,000

Finally, the journal entry to move the realized gross profit to the income statement:

  Debit Credit
Realized Gross Profit (Installment Sales) $600,000  
Income Summary   $600,000

Related Terms

revenues, revenue recognition principle, revenue recognition: before delivery, revenue recognition: point of sale, revenue recognition: during productionrevenue recognition: after deliverycost recovery method