Installment sales
Installment sales
Installment sales
2
Cont…
Installment sales pose some challenging problems. The
most basic problems are:
– Difficulty of matching costs with related
revenue
– Greater risk of non-collection or higher
doubtful accounts expense
– Higher collection expenses
– Reconditioning and repairing costs for
repossessed property
– Substantial amount of working capital is tied up
in receivables 3
Methods for Recognition of
Profits on Installment Sales
• The determination of net income on installment sales is
complicated by the fact that the amounts of revenue
and related costs and expenses are seldom known in
the period when the sale is made.
• Substantial expenses such as collection, accounting,
repairs, and repossession are likely to be incurred in
subsequent periods.
• The first objective in development of accounting policies
for installment sales should be reasonable matching of
costs and revenue.
4
Cont…
3. Installment Method
•The third approach to the measurement of income from
installment sales is to recognize gross profit in
installments over the term of the contract on the basis of
cash collections.
•Collection of receivables rather than sales is used as the
basis for realization of gross profit.
•In other words, a modified cash basis of accounting is
substituted for the accrual basis. This modified cash basis
of accounting is known as the installment method of
accounting.
Cont…
3Installment Method
•Under installment method of gross profit and revenue
recognition, each cash collection consists of certain
percentage of gross profit and certain percentage of cost
recovery
Collection GP %age Realized Gross Profit
Year 1 90,000 35% 90,000 @ 35% =31,500
Year 2 60,000 35% 60,000 @ 35% =21,000
Year 3 50,000 35% 50,000 @ 35% =17,500
Total 200,000 70,000
The Installment Method of
Accounting
• Under this method, each cash collection on the contract
is regarded as including both a return of costs and a
realization of gross profit in the ratio in which these two
elements were included in the selling price.
• The gross profit is deferred and credited to Deferred
Gross Profit.
• At each collection, the gross profit is realized and the
realization is debited and credited to Deferred Gross
Profit and Realized Gross Profit, respectively.
Objective to Installment Method of
Accounting
•There is no sound accounting reason for the use of the
installment method for financial accounting purposes in
the case of closed transactions in which collection is
dependent upon lapse of time and the probabilities of
realization are properly evaluated.
•The postponement of recognition of revenues until they
can be measured by actual cash receipt is not in accordance
with the concept of an accrual accounting.
• The circumstances in which the use of the installment
method of accounting was permitted were:
• Collection of installment receivables is not
reasonably assumed
• Receivables are collectible over an extended
period of time; and
• There is no reasonable basis for estimating the
degree of collectibles.
In such situations, either the installment method or
the cost Recovery method of accounting may be
used.
Illustration: Single Sale of Real
Estate on the installment plan
• On November 1, Year 1, ZF Real Estate, which
maintained accounting records on a calendar year basis,
sold a building for Br 215,000 whose construction cost
was Br 140,000. Commission and other expenses
pertaining to the sale was Br 15,000. The Br 15,000 was
an expense treated as deductions in determining the
gross profit on the sale rather than as charges to specific
expense accounts.
• The net amount of receivable from the sale was
therefore Br 200,000, of which 70% represented the cost
and 30% represented deferred gross profit.
Cont…
20
Year 2 Cash 37,500
May.1 Interest Receivable 2,500
Interest Revenue 5,000
Notes Receivable 30,000
Collected Semiannual installment on notes receivable plus interest for
six months at 10% on Br 150,000