Installment sales contracts are arrangements where the buyer makes a small initial payment and the remaining balance is paid in installments.
The installment method of accounting is also an alternative accounting approach. It is more suitable for sales contracts where the buyers make regular installment payments.
Let us discuss what are installment sales and their pros and cons.
What are Installment Sales?
The installment method refers to an accounting approach where an entity defers gross profit recognition until cash is received. This method of revenue recognition records profit in proportion when an installment is received.
The installment method is an alternative accounting approach to accrual accounting. Unlike the accrual method, it does not fully recognize gross profit from a sale transaction at the time of sale.
In the installment method of accounting, the buyer received goods at the beginning and makes payments in installments over the contract period. However, the revenue and expenses are recorded at the time of cash receipts.
Common examples of installment sales contracts include:
- Real estate projects
- Vehicle sales
- Technology projects that require long-term commitments
- Heavy machinery
- Consumer appliances
How Do Installment Sales Work?
The installment method allows entities to defer gross profit until realized. The revenue recognition and expenses are also recorded when incurred.
An entity would first calculate its gross profit margin. It is calculated by deducting the cost of goods sold from the sales revenue amount. Then, the entity will calculate a gross profit rate that will be applied for installment cash receipts later.
The installment method follows these key steps.
- An entity should first separate the installment sales record. It will then record the sales and accounts receivable in the normal way in its account books.
- In the next step, the entity will start recording installment cash as received. However, the installment cash should be identifiable and separately accounted for every contract.
- 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.
- Next, the entity will calculate the gross profit rate for installment cash received by the year-end
The gross profit rate can be calculated by the following formula:
Gross profit rate = Installment sales revenue − Cost of installment sales
- Then, the entity will apply the gross profit rate to installment cash received for the current year. The same approach can be taken for the installment cash amounts for the previous years (if any). The resulting amount will give the gross profit on the installment sale.
- Finally, the entity will record the remaining gross profit to carry forward for the next years. This gross profit will be recorded as and when received in the future.
Accounting for Installment Sales Contracts
The accrual basis of accounting may underestimate the risk of losses due to uncollectible cash in a long-term contract such as in a twenty- or thirty-year contract. The installment method offers an alternative approach that considers the credit and default risk of the borrower.
As mentioned above, the entity records the sale at the time of the contract. However, the revenue and expenses are recognized as and when received in the form of installments. General and admin expenses related to the sale are also recorded in the accounting period of installments.
When installment sales contracts represent a significant proportion of the total sales, they should record them separately in the financial statements.
The financial statements should represent:
- Total Gross Profit (current year sales)
- Realized gross profit from current year’s sales
- Realized gross profit from previous years’ sales
Pros and Cons of Installment Sales
The installment sales contracts offer several advantages to sellers and buyers. It also offers an alternative accounting approach of recognizing deferred revenue.
Let us discuss some pros and cons of installment sales.
Pros Explained
Tax Benefits on Capital Gains
One of the main benefits of using installment sales contracts is to take advantage of the tax treatment of capital gains. An entity would defer the capital gain until realized.
The revenue is recognized in installments over a defined sales contract period. It means the seller does not incur large capital gains taxes at once.
In this method, the profit rate is calculated by the entity based on the proportion of the total sales amount. Revenue and expenses are recorded for the period of installment cash receipts as well.
Buyers can calculate the interest expense a similar way as well.
Smaller Upfront Payment with Installments – buyer
Buyers require small initial payments as down payments. They can buy large merchandise and large real estate projects using installment sales contracts that would otherwise require large upfront investments.
Installment sales contracts enable large transactions in real estate, heavy machinery, large merchandise, and technology projects with longer maturity periods.
On the other hand, sellers can find competitive prices and sell quickly using installment contracts. Otherwise, finding an investor for a large initial investment would get difficult. Also, sellers earn interest income on deferred payments that make up for the lost value of money.
Secured with the Forfeit and Foreclosure Options
Often, long-term sales contracts prove risky. Installment sales contracts are also prone to credit and default risks. However, both parties can mutually agree on the inclusion of certain clauses for forfeit and foreclosures.
Installment sales contracts can easily embed the foreclosure clause that empowers sellers to repossess assets if the buyers default on payments. These contracts and certain clauses can be legally endorsed as well.
Another possible way of securing the seller’s interest is to use third-party guarantees. These guarantees can be in the form of financial, performance, or other types.
The only concern for sellers should be the enforceability of these forfeit and foreclosure clauses.
Better Accounting for Bad Debts
The standard accounting approach is to estimate the reasonable amount for uncollectible cash out of the total sales amount at the time of sale. However, it cannot be determined accurately and often requires adjustments in later periods.
In the installment sales method, the approach is to write off bad debts completely. It means bad debts are not recognized until the amount receivable is confirmed as uncollectible.
The seller can reduce the losses by deducting the net realizable value of the repossessed asset. The net realizable value would be the resale value of the asset minus any additional costs.
Cons Explained
Here are a few disadvantages of using installment sales contracts.
Credit Risk
Installment sales contracts are made for longer periods. The borrower’s credit rating can significantly change over these years. Thus, it poses a credit risk for the seller.
Buyer’s credit profile changes can affect the borrowing interest rates, foreclosure, and other important terms and conditions of the sales contracts.
However, both parties can agree to mutually address the credit and default risk assessments.
Default Risk
Another major drawback of an installment sales contract is the default risk of the borrower. As the credit profile changes for the borrowers, their default risk also changes.
Since installment sales often involve a small initial down payment, they possess significant default risks.
Sellers can protect their interests by embedding foreclosure and forfeit clauses. The creditworthiness of the borrower would also determine the interest rate of the loan. With a change in credit profile, the default risk would increase and hence the interest rate.
Monetary Risk – Due to Change in the Value of Asset
Long-term sales contracts can possess the monetary risk of asset devaluation as well. For instance, if a borrower defaults on payment terms, the seller can repossess the asset.
However, the net realizable value of the repossessed asset can diminish over the years. The seller may not be able to recover the full remaining balance of the installment payments.
Accounting Complications
Both parties should account for under the same accounting method ideally with installment sales contracts. The seller would need to calculate the gross profit rate and gross profit margins for installments received for every year separately.
Also, when the installment sales contracts represent a significant portion of the total sales, they should be recorded separately in the financial statements.
Yearly computation of changing gross profit rates and record-keeping of installments sales can be a complex and cumbersome task for many entities.
Installment Sales Method Vs Accrual Method
The installment method is a conservative accounting approach. It protects sellers from the long-term credit and default risks somewhat.
The accrual method recognizes all revenue at the beginning of the sales contract. Thus, the installment method is a better approach to revenue recognition spread over years.
The installment method aligns revenue and expense recognition with the installment cash receipts. It means the entity can record gross profits, revenue, expenses, and taxes accurately using the installment method as compared to the conventional accrual method.
Installment Sales Method Vs Cost Recovery Method
The cost recovery method defers all revenue recognition until the cost of the sold asset is fully recovered by the seller. It means it is another conservative approach to accounting and revenue recognition.
The installment is more suitable where the borrower makes regular installment payments. A deferral of regular cash receipts does not offer an appropriate accounting approach. The cost recovery method is more suitable for bad debts and repossession of assets.
