Why do we use installment sales? Installment sales are only used for financial reporting when there is no reasonable basis for estimating the degree of collection ability. Revenue recognition occurs when cash is actually collected, rather than at the point of sale.
The Rule of Conservatism
We delay revenue recognition because of the conservatism principle. The rule of conservatism states that we can only recognize revenue when it is considered to be earned or realized/realizable. Revenues are considered earned when goods have been delivered or services have been performed. Realization occurs when the goods are exchanged for cash, other goods, or claims to cash. When we are uncertain that cash will be collected, realization does not take place until we have the cash in hand.
The key point to remember about installment sales is, we have already “earned” the revenue, but we have not “realized” the cash. It is critical to note that even though we have no initial profit recognition (or limited profit recognition if partial payment is made at the point of sale), we do recognize the full cost of goods sold and accordingly reduce the inventory asset account.
Calculating Installment Sales
Calculating installment sales is a four step process which will be illustrated below. In step 1, we calculate the total gross profit. Gross profit is needed in order to establish how much profit we have earned from the sale, but not yet realized. In step 2, we calculate the gross profit percentage based on gross profit calculated in step 1. In step 3, we take our gross profit percentage and apply it to our total cash collections (i.e. cash received from the customer). This gives us an amount of profit that can be recognized on the financial statements. Step 4 applies the gross profit percentage to the amount that is still in accounts receivable. This calculation gives us the amount of deferred gross profit.
As future payments are received, deferred gross profit will decrease and realized profit will increase. When the total outstanding payments have been received, realized profit will equal our total gross profit calculated in step 1 and deferred profit will be zero.
1) Sales on Installment – Cost of Goods Sold = Gross Profit
2) Gross Profit / Sales on Installment = Gross Profit Percentage
3) Gross Profit Percentage x Cash Collected = Earned Gross Profit
4) Gross Profit Percentage x Installment Accounts Receivable = Deferred Gross Profit
This can be a tricky item in your financial reporting. TGG Accounting can help you manage this process in your business.Written by: Jake Cavanagh TGG Accounting