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Installment Method

The installment method was developed to account for sales contracts allowing buyers to make payments over several years.  As the payment period becomes longer, the risk of loss resulting from uncollectible accounts increases; consequently, circumstances surrounding a receivable may lead to considerable uncertainty as to whether payments will actually be received.  Under these circumstances, the uncertainty of cash collection dictates that revenue recognition be deferred until the actual receipt of cash.

The installment method can be used in sales transactions for which payment is to be made through periodic installments over an extended period of time and the collectibility of the sales price cannot be reasonably estimated.  This method is applicable to the sales of real estate, heavy equipment, home furnishings, and other merchandise sold on an installment basis.  Installment method revenue recognition is not in accordance with accrual accounting because revenue recognition is not normally based upon cash collection; however, its use is justified in certain circumstances on the grounds that accrual accounting may result in “front-end loading” (i.e., all of the revenue from a transaction being recognized at the point of sale with an improper matching of related costs).  For example, the application of accrual accounting to transactions that provide for installment payments over periods of ten, twenty, or thirty years may underestimate losses from contract defaults and other future contract costs.

When a seller uses the installment method, both revenue and cost of sales are recognized at the point of sale, but the related gross margin is deferred to those periods during which cash will be collected.  As receivables are collected, a portion of the deferred gross profit equal to the gross profit rate times the cash collected is recognized as income.  When this method is used, the seller must compute each year’s gross profit rate and also must maintain records of installment accounts receivable and deferred revenue that are separately identified by the year of sale.

The steps to use in accounting for sales under the installment method are as follows:

1. During the current year, record sales and cost of sales in the normal manner.  Record installment sales transactions separately from other sales.  Set up installment accounts receivable identified by the year of sale.
2. Record cash collections from installment accounts receivable. Ensure that cash receipts are properly identified for the year in which the receivable arose.
3. At the end of the current year, transfer installment sales revenue and installment cost of sales to deferred gross profit, as identified by the year of sale. Compute the current year's gross profit rate on installment sales.
4. Apply the current year's gross profit rate to the cash collections from the current year's installment sales to compute the realized gross profit from the current year's installment sales.
5. Separately apply each of the previous years' gross profit rates to cash collections from those years' installment sales to compute the realized gross profit from each of the previous years' installment sales.
6. Defer the current year's unrealized gross profit to future years.

Related Topics

Completed contract method
Cost recovery method
Cost to cost method
Percentage of completion method
Revenue recognition criteria