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
- The financial accounting term revenue is used to describe the price charged to customers for good sold, or services rendered. Revenues are reported on a company's income statement.
Moneyzine EditorSeptember 21st, 2023 - The financial accounting term Revenue Recognition Principle refers to a standard condition under which revenues are recorded in a company's financial statements. According to the Revenue Recognition Principle, revenue is recorded when it is realized or realizable and earned.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition before delivery refers to the process of recording revenue before goods or services are provided to a customer. The revenue recognition principle states a company can record revenue when they are realized or realizable, and earned. Under certain conditions, a company may be able to record revenue before the product is delivered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition at the point of sale refers to the process of recording revenue from manufacturing and selling activities at the time of sale. The revenue recognition principle states a company can record revenue when two conditions are met. They must be realized or realizable, and earned. These requirements are typically met when a product is delivered or a service is rendered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition during production refers to the process of recording revenue as various milestones in a project are reached. The revenue recognition principle states a company can record revenue when they are realized or realizable and earned. Under certain conditions, a company may be able to record revenue before the product is delivered to a customer.Moneyzine EditorSeptember 21st, 2023
- The term revenue recognition after delivery refers to the process of recording revenue after a product or service has been delivered to a customer. The revenue recognition principle states a company can record revenue when they are realized or realizable, and earned. Under certain conditions, a company may choose to defer the recognition of revenue until after cash has been received from a customer.Moneyzine EditorSeptember 21st, 2023
The term cost recovery refers to an accounting method that reports revenue and the cost of goods sold in the period of sale, but delays recognizing profit until the cash received from customers is in excess of the cost of goods sold. Along with the installment sales method, this approach can be used when companies recognize revenue after delivery.Moneyzine EditorJanuary 12th, 2024
