When a seller allows a customer to pay for a sale over multiple years, the transaction is frequently accounted for by the seller using the installment method. Because of the long period of time involved, the risk of loss from customer nonpayment is higher, so a prudent person would defer the recognition of some portion of the sale - which is what the installment method does.
The primary circumstance under which the installment method is used is a transaction in which the buyer makes a number of periodic payments to the seller, and it is not possible to determine the collectibility of cash from the customer. This is an ideal recognition method for large-dollar items, such as:
- Real estate
- Consumer appliances
The installment method is better than generic accrual basis accounting when payments may be received for a number of years, for the accrual basis may recognize all of the revenue up front, without factoring in all of the risk inherent in the transaction. The installment method is more conservative, in that revenue recognition is pushed off into the future, thereby making it easier to tie actual cash receipts to revenue.
An overview of the installment method is that someone using it defers the gross margin on a sale transaction until the actual receipt of cash. When accounts receivable are eventually collected, a portion of the deferred gross profit from the following calculation is recognized:
Gross profit % x Cash collected
Use of the installment method requires an enhanced level of record keeping for the duration of the associated installment payments. The accounting staff should track the amount of deferred revenue remaining on each contract that has yet to be recognized, as well as the gross profit percentage on installment sales in each separate year.
The following steps are used to account for an installment sale transaction:
- Record installment sales separately from other types of sales, and keep track of the related receivables, layered by the year in which the receivables were originally created.
- Trace cash receipts as they arrive to the installment sales to which they relate.
- At the end of each fiscal year, shift the installment sales revenues and cost of sales occurring in that year to a deferred gross profit account.
- Calculate the gross profit rate for installment sales occurring in that year.
- Apply the gross profit rate for the current year to cash collected on receivables from current year sales to derive the gross profit that can be realized.
- Apply the gross profit rate for prior years to the cash receipts arriving that relate to installment sales occurring in those prior periods, and recognize the resulting amount of gross profit.
- Any deferred gross profit at the end of the current year is carried forward to the next year, to be recognized at a later date when the associated receivables are paid.