What is an Installment Sale?
An installment sale is an arrangement in which the seller allows the buyer to make payments over an extended period of time. In an installment sale, the buyer receives the goods at the beginning of the installment period and makes payments over the installment period. In other words, revenue and expense are recognized at the time of cash collection and not at the time of sale.
Installment Sales Method of Revenue Recognition
The installment sales method of revenue recognition defers gross profit until cash from the sale is received. Therefore, the installment sales method is a conservative method of revenue recognition as revenue is not immediately recognized at the point of sale. The installment sales method is only applied in situations where the risk and rewards of the good are not fully transferred at the time of sale. In addition, the installment sales method is used when there is a degree of uncertainty over the amount that will be collected (therefore, it would be inappropriate to recognize all profits at the time of sale).
Journal Entries in the Installment Sales Method
The journal entries for installment sales are as follows:
Example of Installment Sales Method
Company A is a furniture company and makes a sale for a piece of furniture with a retail price of $10,000 at the end of January. The cost of the furniture to the company is $4,000. Therefore, the gross margin for this good is 60%.
The company strikes a deal with the customer in which the customer is required to make installment payments of $2,500 each month for the furniture until the principal amount is paid ($10,000).
The journal entries for Company A would be as follows:
The journal entries for the end of March, April, and May would be the same as the journal entry above.
Here are the key takeaways from the installment sales method of revenue recognition:
- An installment sale allows the buyer to make payments over an extended period of time.
- The installment sales method of revenue recognition recognizes revenue and expense at the time of cash collection and not at the time of sale.
- The installment sales method of revenue recognition is a conservative method of revenue recognition due to the deferral of gross profit.
- It applies when risk and rewards of the good are not fully transferred at the point of sale.
- It is used when there is a degree of uncertainty in the collection of cash.
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