2.4 Installment sales
5 min read•august 20, 2024
Installment sales offer unique financing options, allowing sellers to receive payments over time. This method impacts revenue recognition, accounting for uncollectible receivables, and financial statement presentation differently than regular sales transactions.
Revenue recognition in installment sales can use the cost recovery or . These approaches defer profit recognition based on cash collections, ensuring a conservative or proportional distribution of over the contract term.
Installment sales overview
- Installment sales are sales transactions where the seller receives payment in periodic installments over an extended period of time instead of receiving the full payment upfront
- Allows sellers to offer financing options to customers and potentially increase sales volume by making products more affordable
- Introduces complexities in revenue recognition, accounting for uncollectible receivables, and financial statement presentation that differ from regular sales transactions
Revenue recognition for installment sales
Cost recovery method
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- Under the , the seller does not recognize any gross profit until the cost of the merchandise sold has been fully recovered through cash collections
- Revenue is recognized only to the extent of cash received until the cost is recovered, and any excess cash received thereafter is recognized as gross profit
- Provides a conservative approach to revenue recognition by deferring profit until the seller's investment in the merchandise is fully recovered
Installment method
- The installment method allows the seller to recognize a portion of the gross profit on each received
- Gross profit is recognized in proportion to the cash received, calculated as the gross profit percentage multiplied by the cash collection
- Gross profit percentage is determined by dividing the total gross profit on the sale by the total contract price
- Allows for a more even distribution of gross profit over the term of the installment contract
Accounting for uncollectible installment receivables
Allowance method for installment receivables
- Under the allowance method, the seller estimates the amount of installment receivables that may become uncollectible based on historical experience or other relevant factors
- An is established and adjusted periodically to reflect the estimated uncollectible portion of installment receivables
- is recognized in the period of sale, and the allowance is used to write off specific uncollectible accounts when identified
Direct write-off method for installment receivables
- The direct write-off method involves recognizing bad debt expense only when a specific installment receivable is determined to be uncollectible
- No allowance for doubtful accounts is established in advance, and bad debt expense is recognized at the time of write-off
- Generally not considered an acceptable method under generally accepted accounting principles (GAAP) due to the lack of matching bad debt expense with the related revenue
Deferred gross profit in installment sales
Calculating deferred gross profit
- represents the portion of gross profit that has not yet been recognized as revenue under the installment method
- Calculated as the total gross profit on the sale minus the cumulative gross profit recognized to date
- Determined by multiplying the gross profit percentage by the remaining unpaid balance of the installment contract
Recognizing deferred gross profit
- Deferred gross profit is recognized as revenue in future periods as cash is collected on the installment receivables
- The amount of deferred gross profit recognized in each period is proportional to the cash received, based on the gross profit percentage
- Ensures that gross profit is recognized in a manner consistent with the cash flow from the installment sale
Installment sales vs regular sales
Revenue recognition differences
- In a regular sale, revenue is typically recognized in full at the point of sale when the risks and rewards of ownership are transferred to the buyer
- Installment sales defer a portion of the revenue recognition over the term of the installment contract, based on the collection of cash from the customer
- The timing and pattern of revenue recognition differ between installment sales and regular sales
Balance sheet presentation differences
- Installment sales result in the creation of installment receivables, which represent the unpaid balance of the contract price
- Installment receivables are typically classified as current or non-current assets based on the expected timing of cash collections
- Regular sales may result in trade receivables, which are generally short-term and classified as current assets
- Deferred gross profit is a unique item in installment sales, representing the unrecognized portion of gross profit
Financial statement disclosures for installment sales
Required note disclosures
- Companies are required to disclose information about installment sales in the notes to the financial statements
- Disclosures may include the terms of the installment contracts, the total amount of installment receivables, the allowance for doubtful accounts, and the deferred gross profit balance
- Helps users of the financial statements understand the nature and extent of the company's installment sales activities
Supplementary schedules
- Companies may provide supplementary schedules detailing the aging of installment receivables and the expected future cash collections
- These schedules provide additional insight into the timing and collectibility of the installment receivables
- Helps users assess the liquidity and credit risk associated with the installment sales
Repossession of goods in installment sales
Accounting for repossessed goods
- When a customer defaults on an installment contract and the seller repossesses the goods, the repossessed inventory is recorded at its fair value less estimated costs to sell
- The carrying amount of the installment receivable is reduced by the fair value of the repossessed goods and any cash received
- Any remaining balance on the installment receivable is written off as a bad debt expense
Recognizing gains or losses on repossession
- If the fair value of the repossessed goods exceeds the carrying amount of the installment receivable, a gain on repossession is recognized
- If the fair value of the repossessed goods is less than the carrying amount of the installment receivable, a loss on repossession is recognized
- Gains or losses on repossession are typically included in the determination of net income for the period
Income tax considerations for installment sales
Installment sales vs accrual basis for taxes
- For income tax purposes, companies may have the option to report installment sales using the installment method or the accrual basis
- Under the installment method for tax purposes, the seller recognizes the gross profit for tax purposes in proportion to the cash collections, similar to the financial reporting treatment
- Under the accrual basis for tax purposes, the seller recognizes the entire gross profit in the year of sale, regardless of the timing of cash collections
Deferred tax liabilities in installment sales
- When a company uses the installment method for financial reporting but the accrual basis for tax purposes, temporary differences arise between the book and tax basis of the installment receivables and deferred gross profit
- These temporary differences result in the recognition of deferred tax liabilities, representing the future tax consequences of the timing differences
- Deferred tax liabilities are measured based on the enacted tax rates expected to apply when the temporary differences reverse in future periods
Key Terms to Review (19)
Allowance for Doubtful Accounts: Allowance for doubtful accounts is a contra-asset account that represents the estimated amount of accounts receivable that may not be collectible. This estimate is important because it allows businesses to present a more accurate picture of their financial health by recognizing the potential risk of bad debts in their revenue. The allowance is typically determined based on historical data, aging schedules, or specific identification of uncollectible accounts, and it directly relates to installment sales, accounts receivable, and notes receivable by adjusting the expected cash inflows from these financial assets.
Bad debt expense: Bad debt expense is an accounting term that represents the estimated amount of receivables that a company expects it will not collect. This concept is crucial because it affects the financial statements by reducing net income and accounts receivable. Companies often estimate bad debt expense based on historical data, economic conditions, and other relevant factors to ensure accurate financial reporting.
Balance Sheet: A balance sheet is a financial statement that presents a company's financial position at a specific point in time, detailing its assets, liabilities, and equity. This essential report helps stakeholders assess the company's net worth, liquidity, and overall financial health, making it crucial for understanding how investing activities impact the balance of assets and liabilities.
Cost Recovery Method: The cost recovery method is an accounting approach used to recognize revenue for long-term assets sold on installment, where no profit is reported until all costs associated with the asset have been recovered. This method is particularly useful in situations where the collectibility of future cash flows is uncertain, allowing businesses to defer recognizing profits until the cash has actually been received. It aligns revenue recognition closely with cash flow, ensuring that entities do not report profits they may never actually receive.
Deferred Gross Profit: Deferred gross profit refers to the portion of gross profit that is not recognized as revenue in the current accounting period, particularly in the context of installment sales. This profit is delayed until the related cash collections are received, reflecting the uncertainty of future payments. Recognizing deferred gross profit ensures that income is reported in line with the actual cash received, aligning with the revenue recognition principle.
Down payment: A down payment is an initial upfront payment made when purchasing a high-cost item, usually expressed as a percentage of the total purchase price. This payment reduces the amount financed through a loan or installment agreement, demonstrating the buyer's commitment and financial responsibility. In installment sales, the down payment plays a critical role in securing the transaction and can affect the terms of financing.
Effective interest rate: The effective interest rate is the actual interest rate that an investor earns or pays on a loan or investment over a specific period, taking into account the effects of compounding. It provides a more accurate measure of financial cost or benefit than the nominal interest rate, particularly in scenarios where interest is compounded more frequently than annually. Understanding the effective interest rate is essential for evaluating installment sales and comparing various financing options.
Gross Profit: Gross profit is the difference between total revenue from sales and the cost of goods sold (COGS). It reflects the efficiency of a company in producing and selling its goods, serving as an important indicator of financial health and operational performance.
Income Statement: An income statement is a financial document that summarizes a company's revenues, expenses, and profits over a specific period. It provides insight into the company's operational performance, helping stakeholders assess how well the business is generating profit from its operations, managing costs, and ultimately determining net income.
Initial measurement: Initial measurement refers to the process of determining the value of an asset or liability when it is first recognized in the financial statements. This valuation sets the foundation for how the item will be recorded, impacting subsequent measurements and financial reporting. Understanding initial measurement is crucial as it involves applying specific recognition and measurement principles to ensure accurate and consistent financial representation.
Installment method: The installment method is a revenue recognition approach where sales are recorded as income when cash payments are received, rather than when the sale is made. This method is particularly useful for installment sales, where payments are made over time, allowing companies to align revenue with cash flow and mitigate risks associated with credit sales. This approach ensures that businesses only recognize revenue they have actually collected, providing a more accurate reflection of their financial position.
Installment payment: An installment payment is a method of paying for a product or service where the total cost is divided into smaller, manageable amounts to be paid over time. This approach allows buyers to make a purchase without having to pay the entire price upfront, making it more accessible for consumers. Typically, installment payments come with interest and are used in various financing arrangements, like loans or credit purchases.
Interest revenue: Interest revenue is the income earned by a company from interest on loans made to customers or from investments in interest-bearing financial instruments. This revenue is typically recognized over time as the interest accrues, reflecting the ongoing economic benefit received by the lender. In the context of installment sales, interest revenue becomes significant as it represents an additional stream of income when customers make payments over time, often with an associated finance charge.
Matching principle: The matching principle is an accounting concept that requires expenses to be matched with the revenues they help to generate in the same period. This principle ensures that a company's financial statements accurately reflect its profitability and financial performance by aligning income and related expenses within the same time frame.
Present value of future cash flows: The present value of future cash flows refers to the current worth of a series of cash payments or receipts that are expected to occur in the future, discounted back to their value today using a specific interest rate. This concept is vital in evaluating investments, loans, and financial decisions, as it helps to determine how much future cash flows are worth in today's terms, allowing individuals and businesses to make informed choices regarding financial commitments.
Revenue Recognition Principle: The revenue recognition principle is an accounting guideline that dictates when and how revenue should be recognized in the financial statements. This principle ensures that revenue is recorded when it is earned, regardless of when cash is received, allowing for a clearer picture of a company's financial health. By adhering to this principle, businesses can provide more accurate and timely information to stakeholders, enhancing transparency and trust.
Sales Price: Sales price refers to the amount of money a buyer pays for a product or service. This price can be influenced by various factors including cost of goods sold, market demand, and sales agreements. In the context of installment sales, the sales price is particularly important as it represents the total amount to be paid by the buyer over time, which may include interest and fees in addition to the principal amount.
Subsequent measurement: Subsequent measurement refers to the process of valuing an asset or liability after its initial recognition on the financial statements, reflecting any changes in value due to events or transactions that occur over time. This concept is crucial as it ensures that financial statements accurately represent the current value of assets and liabilities, impacting income statements and balance sheets significantly. It encompasses various methods such as cost model, fair value model, and impairment assessments, all tailored to specific types of assets and liabilities.
Unearned Revenue: Unearned revenue refers to the money received by a business for goods or services that have not yet been delivered or performed. This liability is recorded on the balance sheet, indicating that the company owes the customer either the product or service. It plays a crucial role in understanding current liabilities, as it represents an obligation to provide future services or products and is essential for accurately presenting a classified balance sheet.