The installment method is an approach to revenue recognition in which the business owner defers gross profit on a sale until receiving cash for the sale from the buyer. The installment method of revenue recognition records proportionate profit when an installment is received.
The installment method is usually used in situations where a customer has permission to pay off an invoice in periodic instalments over multiple years. In those situations, there is significant risk to the seller that they may not collect the full amount owing. Because of the risk, the business doesn’t want to recognize the full amount owed at the time of the sale. To account for this risk, the business can use the installment method to recognize revenue on the sale.
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 collectability of cash from the customer. This is an ideal recognition method for large-dollar items, such as real estate, machinery, and 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.
The installment method of revenue recognition is used widely in the construction industry, as well as other industries that tend to receive payments from clients over long periods of time, often several years. This includes:
- Real estate
- Machinery manufacturing
- Consumer appliance sales
Small businesses tend to use the installment method of accounting in instances where they’ve made an agreement with a buyer to accept payments in periodic installments over a long span of time, often longer than a year. The installment method of revenue recognition is used in those circumstances if the business is not assured of the collectibility of cash payments from the buyer.
Accounting steps to account for an installment sale transaction:
Separate Installment Sales Records
Record your installment sales separately from all other types of sales. Record all the receivables related to an installment sale, sorted by the year in which the receivable was created.
Track Cash Receipts
Every time you receive cash related to an installment sale, track it to the installment sale to which it relates.
Shift Sales Revenue Each Year
At the end of every fiscal year, move the installment sale revenue and the cost of sales from that year to an account for deferred gross profits.
Calculate Gross Profit
Calculate the gross profit rate for all installment sales occurring in that fiscal year.
Apply the Gross Profit Rate
Apply your gross profit rate for previous years to all cash receipts that are related to installment sales from previous periods. Record the resulting gross profit amount.
Carry Forward Deferred Gross Profit
Carry forward any deferred gross profit remaining at the end of the year to the next fiscal year. You’ll recognize and record it at a later date, when you receive payment for it from the buyer.
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