In this post, I am going to reveal “how to apply revenue recognition under Installment method” in step-by step. As the title says, it is typically a technical topic in “Revenue Recognition” area. It is coming with case example in a step-by-step way, aided with screenshot to ensure that you can understand what really I am saying that impossible you can miss. Can you go without equation and formula? You know that answer is “you cannot”, don’t worry, you will get the exact equation and formula. The following various related topic are also going to be discussed: Revenue Recognition When Collection Is Uncertain under GAAP sources, accompanied with the term and definition for jargon used in this topic will be discussed at first stage as a steady fundament. Installment payment of receivables sometimes followed with interest, so “Interest On Installment Method Receivables” will be discussed as well, How about bad debt under installment method? Yes It is fully loaded “Bad Debts And Repossessions” is also on the note. Finally “Disclosure Of Installment Sales” will close this discussion.
Here we go…
Revenue Recognition When Collection Is Uncertain under GAAP
Under generally accepted accounting principles, revenue recognition customarily does not depend on the collection of cash. Accrual accounting techniques normally record revenue at the point of a credit sale by establishing a receivable. When uncertainty arises surrounding the collectibility of this amount, the receivable is appropriately adjusted by establishing a valuation allowance. In some cases, however, the collection of the sales price may be so uncertain that an objective measure of ultimate collectibility cannot be established. When such circumstances exist, the seller uses either the installment method or the cost recovery method to recognize the transaction (APB 10). Both of these methods allow for a deferral of gross profit until cash has been collected. The Accounting Principles Board specifically noted that these installment methods are “not acceptable” if revenues and a provision for uncollectible accounts can be reasonably estimated.
An installment transaction occurs when a seller delivers a product or performs a service and the buyer makes periodic payments over an extended period of time. Under the installment method, revenue recognition is deferred until the period(s) of cash collection. The seller recognizes both revenues and cost of sales at the time of the sale; however, the related gross profit is deferred to those periods in which cash is collected. Under the cost recovery method, both revenues and cost of sales are recognized at the time of the sale, but none of the related gross profit is recognized until the entire cost of sales has been recovered. Once the seller has recovered all costs of sales, any additional cash receipts are recognized as revenue.
APB 10 does not specify when one method is preferred over the other. However, the cost recovery method is more conservative than the installment method because gross profit is deferred until all costs have been recovered; therefore, it is more appropriate for situations of extreme uncertainty.
Term and Definitions Used
Before you go to the main course, its is worth reviewing and understanding the term and definitions used in this topic. Read it carefully:
Cost recovery method: The method of accounting for an installment basis sale whereby the gross profit is deferred until all cost of sales has been recovered.
Deferred gross profit: The gross profit from an installment basis sale that will be recognized in future periods.
Gross profit rate: The percentage computed by dividing gross profit by revenue from an installment sale.
Installment Method: The method of accounting for a sale whereby gross profit is recognized in each period in which cash from the sale is collected.
Installment sale: A sales transaction for which the sales price is collected through the receipt of periodic payments over an extended period of time.
Net realizable value: The portion of the recorded amount of an asset expected to be realized in cash upon its liquidation in the ordinary course of business.
Realized gross profit: The gross profit recognized in the current period.
Repossessions: Merchandise sold by a seller under an installment arrangement that the seller physically takes back after the buyer defaults on the payments.
Revenue Recognition Under Installment Method
The installment method was developed in response to the increasing incidence of sales contracts that allowed buyers to make payments over several years. As the payment period becomes longer, the risk of loss resulting from uncollectible accounts increases; consequently, circumstances surrounding a receivable may lead to considerable uncertainty as to whether payments will actually be received. Under these circumstances, the uncertainty of cash collection dictates that revenue recognition be deferred until the actual receipt of cash.
The installment method can be used in most sales transactions for which payment is to be made through periodic installments over an extended period of time and the collectibility of the sales price cannot be reasonably estimated. This method is applicable to the sales of real estate, heavy equipment, home furnishings, and other merchandise sold on an installment basis. Installment method revenue recognition is not in accordance with accrual accounting because revenue recognition is not normally based on cash collection; however, its use is justified in certain circumstances on the grounds that accrual accounting may result in “front end loading” (i.e., all of the revenue from a transaction being recognized at the point of sale with an improper matching of related costs). For example: the application of accrual accounting to transactions that provide for installment payments over periods of 10, 20, or 30 years may underestimate losses from contract defaults and other future contract costs.
Applying The Installment Method – The Main Course
When a seller uses the installment method, both revenue and cost of sales are recognized at the point of sale, but the related gross profit is deferred to those periods during which cash will be collected. As receivables are collected, a portion of the deferred gross profit equal to the gross profit rate times the cash collected is recognized as income. When this method is used, the seller must compute each year’s gross profit rate and also must maintain records of installment accounts receivable and deferred revenue that are separately identified by the year of sale. All general and administrative expenses are normally expensed in the period incurred.
The steps to use in accounting for sales under the installment method are as follows:
. During the current year, record sales and cost of sales in the regular manner. Record installment sales transactions separately from other sales. Set up installment accounts receivable identified by the year of sale (e.g., Installment Accounts Receivable—2007).
. Record cash collections from installment accounts receivable. Care must be taken so that the cash receipts are properly identified as to the year in which the receivable arose.
. At the end of the current year, transfer installment sales revenue and installment cost of sales to deferred gross profit properly identified by the year of sale. Compute the current year’s gross profit rate on installment sales as follows:
Gross profit rate = 1 [-] Cost of installment sales [:] Installment sales revenue
Alternatively, the gross profit rate can be computed as follows:
Gross profit rate = [Installment sales revenue – Cost of installment sales] [:] Installment sales revenue
. Apply the current year’s gross profit rate to the cash collections from the current year’s installment sales to compute the realized gross profit from the current year’s installment sales.
Realized gross profit = Cash collections from the current year’s installment sales [x] Current year’s gross profit rate
. Separately apply each of the previous year’s gross profit rates to cash collections from those year’s installment sales to compute the realized gross profit from each of the previous years’ installment sales.
Realized gross profit = Cash collections from the previous years’ installment sales [x] Previous years’ gross profit rate
. Defer the current year’s unrealized gross profit to future years. The deferred gross profit to carry forward to future years is computed as follows:
Deferred gross profit (2007) = Ending balance installment account receivable (2007) [x] Gross profit rate (2007)
Example of the Installment Method of Accounting
Accounting entries are made for steps 1 and 2 above using this data; the following computations are required for steps 3 through 6
Step 3: Compute the current year’s gross profit rate.
Step 4: Apply the current year’s gross profit rate to cash collections from current year’s sales.
Step 5: Separately apply each of the previous years’ gross profit rates to cash collections from that year’s installment sales.
Step 6: Defer the current year’s unrealized gross profit to future years.
Financial Statement Presentation
If installment sales transactions represent a significant portion of the company’s total sales, the following three items of gross profit would, theoretically, be reported on the company’s income statement:
- Total gross profit from current year’s sales
- Realized gross profit from current year’s sales
- An income statement using the previous example would be presented as follows (assume all sales are accounted for by the installment method):
However, when a company recognizes only a small portion of its revenues using the installment method, the illustrated presentation of revenue and gross profit may be confusing. Therefore, in practice, some companies simply report the realized gross profit from installment sales by displaying it as a single line item on the income statement as follows:
The balance sheet presentation of installment accounts receivable depends on whether installment sales are a normal part of operations. If a company sells most of its products on an installment basis, installment accounts receivable are classified as a current asset because the operating cycle of the business (the length of which is to be disclosed in the notes to the financial statements) is the average period of time covered by its installment contracts. If installment sales are not a normal part of operations, installment accounts receivable that are not to be collected for more than a year (or the length of the company’s operating cycle, if different than a year) are reported as non-current assets. In all cases, to avoid confusion, it is desirable to fully disclose the year of maturity next to each group of installment accounts receivable as illustrated by the following example:
Accounting for deferred gross profit is addressed in CON 3, which states that deferred gross profit is not a liability. The reason is that the seller company is not obligated to pay cash or provide services to the customer. Rather, the deferral arose because of the uncertainty surrounding the collectibility of the sales price. CON 3 goes on to say, “Deferred gross profit on installment sales is conceptually an asset valuation—that is, a reduction of an asset”. However, in practice, deferred gross profit is generally presented either as unearned revenue classified in the current liability section of the balance sheet or as a deferred credit displayed between liabilities and equity.
Following the guideline in CON 3, the current asset section would be presented as follows (using information from the Partial Income Statement example above and assuming a 12/31/09 balance sheet):
To avoid a heavy page load, I split this topic into two post, you can read the series here [Interest, Bad Debt, and Repossessions On Installment Method Receivables]