The deferred gross profit concept arises when a business uses the installment sales approach to recognizing its sales transactions. Under the installment method, only the gross profits on those sales for which cash payment has been received are recognized. All gross profits associated with uncollected receivables are parked on the balance sheet as an offset to receivables, where they remain until customer payments are received.
The deferred amount of gross profit is stated on the balance sheet as an offset to the accounts receivable account. As such, the deferred profit appears as a contra account immediately below the accounts receivable line item in the assets section of the balance sheet. When this approach is used, the content of the relevant line items in the balance sheet are:
Accounts receivable (contains cost of sales + profit)
Less: Deferred gross profit (contains unrealized profit)
= Net accounts receivable (contains cost only)
For example, ABC International sells $100,000 of goods under a periodic payment plan. The cost of the goods sold is $70,000, so there is $30,000 of gross profit associated with the sale. The initial presentation in ABC's balance sheet is:
Accounts receivable = $100,000
Less: Deferred gross profit = $(30,000)
Net accounts receivable = $70,000
After one month, the customer makes an initial payment of $10,000. Based on the 30% gross profit margin, this payment is comprised of $7,000 cost reimbursement and $3,000 of profit. ABC can now recognize $3,000 of gross profit, which reduces the balance in the deferred gross profit contra account to $27,000.