Examples presented on the previous post [Applying Installment Method] ignored interest, a major component of most installment sales contracts. It is customary for the seller to charge interest to the buyer on the unpaid installment receivable balance. Generally, installment contracts call for equal payments, each with an amount attributable to interest on the unpaid balance and the remainder to the installment receivable balance. As the maturity date nears, a smaller amount of each installment payment is attributable to interest and a larger amount is attributable to principal. Therefore, to determine the amount of gross profit to recognize, the interest must first be deducted from the installment payment, and then the difference (representing the principal portion of the payment) is multiplied by the gross profit rate as follows:
Realized gross profit = [Installment payment – Interest portion] × Gross profit rate
The interest portion of the installment payment is recorded as interest revenue at the time of the cash receipt. Appropriate accounting entries are required to accrue interest revenue when the collection dates do not correspond with the period-end.
To illustrate the accounting for installment sales contracts involving interest, assume that Lie Dharma Equipment Company sells a machine for $5,000 on December 31, 2006, to a customer with a dubious credit history.
The machine cost Lie Dharma $3,750. The terms of the agreement require a $1,000 down payment on the date of the sale. The remaining $4,000 is payable in equal annual installments of $1,401.06, including 15 percent annual interest, at the end of each of the next four years.
For each payment it receives, Lie Dharma must compute the portion to record as interest revenue with the remaining portion of the payment (the principal) to be applied to reduce the installment account receivable balance. Gross profit is recognized only on the principal portion of each payment that is applied to reduce the installment receivable balance. The following schedule illustrates that gross profit is recognized on the entire down payment (which contains no element of interest revenue), whereas the annual installment payments are separated into their interest and principal portions, with gross profit being recognized only on the latter portion.
Bad Debts And Repossessions
The standard accounting treatment for uncollectible accounts is to accrue a bad debt loss in the year of sale by estimating the amount expected to be uncollectible. This treatment is consistent with the accrual and matching concepts. However, just as revenue recognition under the accrual basis is sometimes abandoned for certain installment-basis sales, the accrual basis of recognizing bad debts is also sometimes abandoned.
When the installment method is used, it is usually appropriate to recognize bad debts by the direct write-off method (i.e., bad debts are not recognized until the receivable has been determined to be uncollectible).
This practice is acceptable because most installment contracts contain a provision that allows the seller to repossess the merchandise when the buyer defaults on the installment payments. The loss on the account may be eliminated or reduced because the seller has the option of reselling the repossessed merchandise. To write off an uncollectible installment receivable, the following three steps are followed:
- The installment account receivable and the deferred gross profit are eliminated.
- The repossessed merchandise is recorded as used inventory at its net realizable value. Net realizable value is resale value less any selling or reconditioning costs. The repossessed asset is recorded at this fair value because any asset acquired is recorded at the best approximation of its fair value.
- Bad debt expense, and a gain or loss on repossession are recognized.
The bad debt expense or repossession gain or loss is the difference between the un-recovered cost (Installment account receivable – Deferred gross profit) and the net realizable value of the repossessed merchandise.
To illustrate, assume that Royal Bali Cemerlang Company determined that a $3,000 installment receivable is uncollectible. The deferred gross profit ratio on the original sale was 30%; thus, $900 deferred gross profit exists ($3,000 × 30%). If the repossessed equipment has a $1,500 net realizable value, a $600 repossession loss (or bad debt expense) should be recorded.
Royal Bali Cemerlang would record this loss by making the following entry:
[Debit]. Deferred gross profit = $900
[Debit]. Inventory—repossessed merchandise = $1,500
[Debit]. Repossession loss = $600
[Credit]. Installment account receivable = $3,000
Disclosure Of Installment Sales
If installment sales comprise a significant proportion of corporate sales, a footnote should disclose the revenue recognition policy used, as well as the amounts of gross profit recognized from the current and prior years, the total amount of deferred gross profit, and its placement on the balance sheet. An example is as follows:
The company sells kitchen appliances on various installment payment plans. Given the extreme uncertainty associated with the collection of receivables under this plan, the company uses the cost recovery method to recognize profits, under which it recognizes no gross profit until all costs of goods sold have been paid back through cash receipts. In 2005, the company recognized $397,000 of gross profit earned in the current year, as well as $791,000 deferred from prior years. An additional $2,907,000 of deferred gross profits is classified as a current liability in the Unrecognized Gross Profit on Installment Sales account.