Revenue Recognition After the Period of Sale
In an installment sale, a customer makes a small down payment and contracts to pay the balance over an extended period. Although the customer typically takes possession of the item, the seller retains title until payment is completed. The seller may recognize revenue at the time of the sale if collect-ability is reasonably assured or, if not, recognition
may be deferred. If recognition is deferred, either the installment method or the cost recovery method may be used. It is important to distinguish between an “installment sale” (a type of legal contract) and the “installment method” of revenue recognition. Under the installment method, some gross profit is recognized with each payment received from the customer. The amount recognized is determined by the gross profit ratio in the year of the sale. Under the more conservative and less common cost recovery method, no gross profit is recognized until all of the cost of the merchandise is recovered.
APB Opinion No. 10 found that the installment and cost recovery methods are acceptable only in exceptional cases. Where a customer is to make payments over a long period and where the collect ability of cash is not reasonably assured, the seller uses installment method. If collect ability is extremely uncertain, or there is no reasonable basis for estimating the degree
of collect ability, the cost recovery method is appropriate. Recently, an increase in complex sales transactions where the recognition of revenue at the time of sale is inappropriate has led to wider use of the two methods. The installment method is also used for income tax reporting under certain circumstances.
When using the installment method a company completes the following steps:
- During the year total sales, cost of goods sold, and Collections are recorded in the normal way
- At the end of the year, the sales for which the installment method is to be used are identified.
The revenue and related cost of goods sold are identified and reversed and deferred gross profit is recognized using the following entry:
On the companys income statement, Gross Profit Realized on Installment Method Sales is disclosed separately. In addition, if sales recognized under the installment method are material, the sales and related cost of goods sold must also be disclosed. On the company’s balance sheet, Installment Accounts Receivable less Deferred Gross Profit are usually included in current assets.
Several additional factors affect the company’s accounting under the installment method:
- Operating expenses under the installment method are recognized in the normal way on the accrual basis
- Each installment payment received is separated into two components: a reduction of the installment receivable and interest revenue. The interest revenue is recorded on the accrual basis in the normal way
- An allowance for doubtful accounts is appropriate if past experience indicates that the expected resale prices of repossessed items are not sufficient to cover the remaining payments on the installment sales
- When an item is repossessed, the inventory is recorded, and the related receivable and deferred gross profit are written off.
A company may use the installment method in special credit “sale” situations. In these cases, it may initially record a Deferred Gain at the time of the “sale.” Then, as it collects the cash, it reduces the deferred gain and recognizes a gain based on the percentage of the total cash collected.
Accounting for installment sales under the cost recovery method is the same as under the installment method except under the cost recovery method, a company recognizes gross profit at the end of each year to the extent
that the cash received to date exceeds the cost of the product sold.