What is an Installment Sale Method?
Installment Sale is one of the revenue recognition methods in which the seller allows the buyer to make payment in Installment over the specified period without fully transferring the risk and rewards at the time of sale. The seller recognizes the revenue and expense at the time of cash collection rather than at the time of sale.
Example of Installment Sale Method
For example, Company Y ltd. sells the goods on installment sales basis on 01-August 2019. An agreement is made between the buyer and seller to deliver goods to the buyer at the starting of the Installment. For this, the seller allows him to make payment in Installment over the specified period. The details of the transactions are as below:
- Installment Sales: $1,000,000
- Cost of installment goods sold: $800,000
- Gross profit percentage: 20%
It is decided that the buyer will pay the cash on worth $ 250,000 each year for the four years starting from the year 2019 itself. How is the revenue to be recognized in the books of accounts of the company for the year 2019?
In the above example Company Y ltd. sales the goods on the installment basis of $1,000,000, where it is decided that the buyer will pay the cash on installment sales worth $ 250,000 each year for the four years starting from the year 2019. Out of the sales Cost of installment goods sold is $800,000, and the gross profit percentageGross Profit PercentageGross profit percentage is used by the management, investors, and financial analysts to know the economic health and profitability of the company after accounting for the cost of sales. Gross profit percentage formula = Gross profit / Total sales * 100% is 20%. So, total gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services. comes to $ 200,000 ($1,000,000 * 20%).
It is one of the revenue recognition methods under which the seller recognizes the revenue and expense at the time when the cash has been collected rather than recognizing at the time when the sale is made. Now the income which will be recognized in the year 2019 will be calculated by multiplying the cash collection of the year with the profit percentageProfit PercentageThe profit percentage formula calculates the financial benefits left with the entity after it has paid all the expenses. Profit percentage is of two types - markup expressed as a percentage of cost price or profit margin calculated using the selling price., which comes to $ 50,000 ($ 250,000 * 20%).
Apart from this, the deferred gross profit that will be carried forward to next year will be calculated by subtracting the recognized income from the total gross profit of the company, i.e., $ 150,000 ($ 200,000 – $ 50,000).
The different advantages are as follows:
- The buyer of the goods gets an extended period from the seller for the payment against the goods purchased by him. So, the buyer needs not to arrange the whole amount of money in the starting and is allowed time to arrange the funds while getting the delivery of the required goods in the starting.
- From the perspective of the seller, revenue and expense under the installment sale revenue recognition method are recognized by the seller at the time when the cash has been collected rather than recognizing at the time when the sale is made. It is useful when there exists the uncertainty in the collection of the cash by the seller from the buyer against the goods sold by him.
- This method for recognizing the revenue by the seller against the goods sold by him is the conservative method for the revenue recognition as in this case there is a deferral of the gross profit in the books of accounts of the seller because in case of the uncertainty it is not appropriate to recognize the profits whose collection is not certain.
- Under the installment method, partial deferral of the capital gain, if any arises during the transaction of goods, is allowed to the taxation years in the coming futures.
- In case the person is the dealer in the real estate market. It is not allowed to follow the Installment Sale method for recognizing the revenue, and only the individual sellers and buyers can use this method of revenue recognition.
- The accounting for this method of recognition of the revenue is the tedious task and is time-consuming, which then leads to an increase in the cost to the company.
- Installment sales method for recognizing the revenue is one of the conservative methods for revenue recognition as, in this case, there is a deferral of the gross profit in the books of accounts of the seller.
- In the case of the Installment, sales buyers are required to make the regular payments to the seller timely as decided between them in the agreement along with the specified interest in case the Installment is payable by the buyer in the subsequent taxation years.
- It is very common and can be easily seen in the market of the real estate market. Still, in case the person is the dealer in the real estate market. It is not allowed to follow the Installment Sale method for recognizing the revenue, and only the individual sellers and buyers can use this method of revenue recognition.
Installment Sale is one of the approaches of revenue recognition by the seller against the goods sold by him, where the seller recognizes the revenue and expenses at the time when the cash has been collected rather than recognizing at the time when the sale of the goods is made. Under this method, partial deferral of the capital gain if any arises during the transaction of goods is allowed to the taxation years in the coming futures
This article has been a guide to what is Installment Sale and its definition. Here we discuss its example along with advantages and disadvantages. Here are the other articles in accounting that you may like –