Installment sales

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Installment Sales

• An installment sale is a sale of real or personal


property or services which provides for a service
of payments over a period of months or years.
• A down payment usually, but not always, is
required.
• Since, the seller must wait period of time to
collect the full sales price;
• it is customary to provide interest on the unpaid
balances
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Cont…

• The risk of non-collection to the seller is greatly


increased when sales are made on the installment plan.
• Customers generally are in weaker financial condition,
furthermore, the credit rating of the customers and
their ability to pay may change significantly during the
period covered by installment contract.
• The risk of non-collection is guaranteed by security
agreement which enables them to repossess the
property if the buyer falls to make payments.

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…

• However, in recognition of the diverse business


conditions under which installment sales are made,
three approaches are used:
• Recognition of Gross Profit at the Time of Sale (Accrual
Method)
• Cost Recovery method; and
• Recognition of Gross Profit through the use of
installment method of accounting.
1. Accrual Method
•To recognize the entire gross profit at the time of
an installment sale is to say in effect that
installment sales should be treated like regular
sales on credit.
•The merchandise has been delivered to the
customers and an enforceable receivable of
definite amount has been acquired.
•The excess of the receivable contract over the cost
of merchandise delivered is realized gross profit in
the traditional meaning of the term.
Cont…

The journal entry


Installment contracts receivable--------------xx
Installment sales --------------------------------xx
•If a perpetual inventory system is maintained, another
journal entry is needed to transfer the cost of
merchandise from the inventories account to the cost of
installment sales account.
Cont…

2.Cost Recovery Method


•In some cases accounts receivable may be collectible
over a long period of time.
•In addition the terms of sale may not be definite, and the
financial position of customers may be extremely
unpredictable, thus making it virtually impossible to find a
reasonable basis for estimating the degree of collectability
of the receivable. In such cases, either the installment
method or the cost recovery method of accounting may
be used for installment sales.
Cont…

• Under the cost recovery method, no profit is recognized


unit all costs of the item sold have been fully recovered.
• After all costs have been recovered, additional
collections on the installment receivables would be
recognized as revenue (profit), and only current
collection expenses would be charged to such revenue.
The cost recovery method of accounting is rarely used.
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…

Example 3.1: At the beginning of Year 3, SANCHO


Company sold merchandise on installment basis for Br
200,000 that have cost of Br 130,000. The first payment is
to be collected at the end of Year 3. The cash collection
performances are as follows:
Year 1 Br 90,000
Year 2 Br 60,000
Year 3 Br 50,000
Cont…

• Instruction: Determine the realized gross profit to be


reported each year under Accrual Method; Cost
Recovery Method; and Installment Method
1. Accrual Method
Year 1 Installment Sales Br 200,000 100%
Cost of Installment Sales 130,000 65%
Realized Gross Profit Br 70,000 35%
Year 2 Realized Gross Profit -0-
Year 3 Realized Gross Profit -0-
Cont…

2. Cost Recovery Method


Collection Cost Realized GP
Year 1 90,000 130,000 Br0
Year 2 60,000 40,000 Br20,000
Year 3 50,000 0 Br50,000
Total 200,000 Br70,000
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…

• All collections from the buyer including the down payment


were regarded as consisting of 70% cost recovery of 30%
realization of Gross Profit or gain.
• The contract of sale called for a down payment of Br
65,000 and a promissory note, with payment every six
months in the amount of Br 30,000 plus interest (finance
charges) of the annual interest rate of 10% on the unpaid
balance.
• Instruction: Record the transaction under the installment
method.
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ZF Real Estate
Journal Entries to Record Sale of Building on Installment Plan
Year 1 Cash 50,000
Nov. 1 Notes Receivable 150,000
Building 140,000
Deferred Gain 60,000
Net cash is the difference between the Br 65,000 down payment and the
Br 15,000 commission expense (65,000 – 15,000)
Dec.31 Deferred Gain on sale of Building 15,000
Realized Gain on sale of building 15,000
Realized Gain Computed at 30% of cash collected on the contract during
Year1
Dec.31 Interest Receivables 2,500
Interest Revenue 2,500
To accrue interest for two months at 10% on notes receivables of Br
150,000. Br 150,000 @ 10% @ 2/12 = 2,500

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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

Nov. 1 Cash 36,000


Interest Revenue 6,000
Notes Receivable 30,000
Collected Semiannual installment on notes receivable plus interest for six
months at 10% on unpaid balance of Br 120,000 (Br 150,000 – 30,000)
Dec.31 Deferred Gain on sale of Building 18,000
Realized Gain on sale of building 18,000
Realized Gain Computed at 30% of cash collected on the contract during
Year2 (Br 60,000 @ 30% = Br 18,000)
Dec.31 Interest Receivables 1,500
Interest Revenue 1,500
To accrue interest for two months at 10% on notes receivables of Br
90,000. Br 90,000 @ 10% @ 2/12 = 1,500
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Year 3 Cash 34,500
May.1 Interest Receivable 1,500
Interest Revenue 3,000
Notes Receivable 30,000
Collected Semiannual installment on notes receivable plus interest for
six months at 10% on Br 90,000
Nov. 1 Cash 33,000
Interest Revenue 3,000
Notes Receivable 30,000
Collected Semiannual installment on notes receivable plus interest for six
months at 10% on unpaid balance of Br 60,000 (Br 90,000 – 30,000)
Dec.31 Deferred Gain on sale of Building 18,000
Realized Gain on sale of building 18,000
Realized Gain Computed at 30% of cash collected on the contract during Year2
(Br 60,000 @ 30% = Br 18,000)
Dec.31 Interest Receivables 500
Interest Revenue 500
To accrue interest for two months at 10% on notes receivables of Br
30,000. Br 30,000 @ 10% @ 2/12 = 500
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