Installment sales contracts are preferred when an entity can reasonably estimate that a sale has occurred but cannot determine the collectability of the total sale value.
The installment sales accounting method is an alternative accounting approach that allows entities to record installment revenues over the years as and when received.
Let us discuss what installment sales contracts and their accounting treatment are.
Installment Sales Contracts – Installment Sales Method
Installment sales contracts refer to agreements that allow buyers to make payments over an extended period of time in installments rather than a lump-sum payment.
In these contracts, the buyer receives goods at the time of agreement. The payments are made in installments over several months or years at a specified frequency. Expenses and revenues are recognized at the time of cash collection rather than at the time of sale contract.
From an accounting perspective, the sales method allows deferral of capital gains for future years resulting in tax savings. This accounting method is only applicable when the ownership of an asset is not fully transferred at the time of sale.
Accounting for Installment Sales Contracts
When the payment periods became longer for sales contracts, applying the usual accounting methods became increasingly difficult. The risk of default and the risk of loss resulting from uncollectible amounts increased significantly with sales contracts of longer periods.
The installment method of accounting was developed to counter these issues and to facilitate sales contracts that allowed buyers to make payments in installments over the long term.
With longer periods the risk of loss due to uncertainty with cash collections increased. Under these situations, the terms of contracts were more dictated by the risk of uncollectible cash payments. Thus, the approach required an alternative approach that could factor in these risks.
The installment method of accounting can be applied across different types of sales contracts where the payment terms are spread over a longer period of time. In most cases, the certainty of cash receivables cannot be estimated reasonably over the long term.
Common examples of sales contracts where the installment method of accounting can be used include:
- Real estate sales contracts
- Heavy equipment sales
- Home furnishing
- Construction Projects and
- Other contracts involving installment plans
One of the key aspects of the installment method of accounting is its contradiction with accrual accounting. However, it is acceptable under GAAP rules as it allows for matching the expenses and revenues in the same accounting period that accrual accounting may not offer for these types of contracts.
Under accrual accounting, entities would need to recognize full revenues at the front-end. For a sale contract of twenty or thirty years, accrual accounting may underestimate the risk of loss due to uncertain collections and also other future contracts costs.
Application of the Installment Method of Accounting
The installment method of accounting requires calculating a deferred profit recognition approach. The entity using this method must calculate the expected profit rate from the sales contract for every year separately. This profit rate could change every year.
Under this method, the entity will record revenue and costs of sale contracts at the time of sale. However, it will defer gross profit recognition until cash is received in installments in the future.
When the entity received cash in installments, it will recognize a proportion of gross profit. The gross profit recognition can be calculated through gross profit rate times the cash collected for each year.
Under this method, the entity must also keep a record of deferred revenues and accounts receivables for the sales contract for every year separately until the maturity of the contract.
An entity can take the following steps to apply the installment method of sales accounting.
- At inception, the entity will record the sales and cost of sales for the contract in a regular manner. However, it will need to set up an account of installments receivable for every year of the contract period. It should also record the installment sale contract separately from other sales.
- In the next phase, the entity will start recording the cash received from installment receivables. The installment cash receipts should be identifiable for every year separately though.
- At the year-end, the entity will transfer the installment sales revenue and installment sales costs for the year to the deferred gross profit account properly.
- The gross profit rate can be calculated by the following formula:
Gross profit rate = Installment sales revenue − Cost of installment sales
- Next, the entity will apply the gross profit rate to the current year’s installment cash collection. It will give the computed realized gross profit for the current year’s installment sales.
Realized gross profit = Cash collections from the current year’s installment sales × Current year’s gross profit rate
- Separately apply the profit rates of each previous years to cash collections for those years to compute the gross profit for each year’s installment sales.
Realized gross profit = Cash collections from the previous years’ installment sales × Previous years’ gross profit rate
- Defer the recent year’s unrealized gross profit for the future.
The deferred profit for future years can be calculated as:
Deferred gross profit = Ending balance installment account receivable × Gross profit rate
Interest on Receivables Under the Installment Method
The interest expense is the major component of installment sales contracts. Generally, both parties make agreements that involve equal installment payment plans over the life of the contract.
The installment amount comprises a portion of the remaining balance in the form of the principal payment plus the interest on the remaining amount. In the beginning, due to the large remaining balance, the proportion of principal payment is smaller and the interest takes the larger chunk.
As the installments progress, the principal proportion starts increasing and the interest expense lowers.
For the installment method, the interest amount must be deducted from the installment amount and the gross profit rate should then be applied to the difference.
Let us consider a simple working example to understand the accounting treatment for interest expense in an installment sales contract.
Suppose ABC Company sells machinery for $ 50,000 to a customer and enters into an installment sales contract with yearly installment plans. The machine costs $ 37,500.
The down payment for the machine is $ 10,000. The remaining payment of $ 40,00 will be made in installments of $ 14,010that includes a 15% annual interest rate for the next four years.
ABC Company will record the following cash receipt schedule for four years.
|Year||Cash (Debit)||Interest Revenue (Credit)||Installment Accounts Receivable (Credit)||Installment account balance||Realized Gross Profit|
|Year0||$ 10,000||–||$ 10,000||$ 40,000||$ 2,500|
|Year1||$ 14,010||$ 6,000||$ 8,010||$ 31,981||$ 2,002|
|Year2||$ 14,010||$ 4,797||$ 9,213||$ 22,771||$ 2, 305|
|Year3||$ 14,010||$ 3,416||$ 10,594||$ 12,183||$ 2,648|
|Year4||$ 14,010||$ 1,827||$ 12,183||–||$ 3,045|
|Total||$ 66, 040||$ 16,040||$ 50,000||$ 12,500|
Gross Profit Rate = 1 – (initial cost/sale price) = 1 – 37,500/50,000
Gross Profit rate = 25%
With every payment received, ABC company will recognize interest revenue on the proportion of the remaining amount that gradually reduces the accounts receivable amount.
The gross profit rate is only applicable on the principal amount of the remaining accounts receivable amount for every year.
Bad Debts and Repossessions Under the Installment Method
Accounting methods allow entities to accrue a bad debt loss in the year of sale by estimating the uncollectible amount. This approach is consistent with the matching and accrual accounting principles.
Accrual accounting sometimes allows entities to abandon revenue recognition for some sales installment plans. It also allows for abandoning the bad debt loss recognition.
The sales installment accounting takes a different approach for bad debt loss recognition. It allows entities to use the direct write-off method.
Under this method, bad debts are not recognized until the receivables are categorized as uncollectible.
The installment accounting method takes this approach because certain installment plans allow sellers to take repossession of sold Merchandise if the buyer defaults on payments. The seller can also recover part losses by reselling or reusing the repossessed merchandise.
An entity can take the following steps to record the bad debts and repossession of merchandise.
- The entity will eliminate the installment accounts receivable and deferred gross profit account.
- The repossessed Merchandise will be recorded at its net realizable value as it is a used inventory item.
- The net realizable value (NRV) of the repossessed Merchandise can be calculated by estimating the resale value minus any reconditioning, repairing, or maintenance costs.
- The net realizable amount should be the best estimate of its market fair value that is consistent with other accounting principles as well.
- The entity will then record the bad debt expense and a gain or loss on the repossession.
The bad debt expense or any repossession gain or loss is typically the difference between the unrecovered cost (installment account receivable minus deferred gross profit) and the net realizable value of the repossessed merchandise.