Accounting principles have specific revenue recognition standards to dictate when a business should record revenue from sales. Generally speaking, when a company receives cash from a customer, it’s a trigger that’s important enough to account for revenue. In practice, there are many different scenarios that are proven to be not as straightforward as that. One way of recognizing revenue is called the installment method. In this article, we will be explaining the installment sales along with the installment method of revenue recognition. To deepen your knowledge on the topic, we will also explain when companies use the installment method and how to account for an installment sale.
Installment Sale [What is it?]
When a transaction between a seller and a buyer is agreed upon an installment sale, this means the buyer will be paying the seller in installments. Instead of paying for the goods or services at the time of purchase, the buyer is making payments more than once, generally on a regular basis. Common examples of companies using installment sales are construction companies or in the real estate industry.
Installment sales can be beneficial for sellers since this method allows the income to be spread out over multiple financial periods. By doing so, the income is lowered and so is the tax rate.
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Installment Method of Revenue Recognition [Explained]
In accounting, the revenue recognition standard dictates the conditions needed for a company to recognize their revenue. For companies doing installment sales, the installment method of revenue recognition is used to account for revenue. This method allows the seller to record the revenue and related cost of goods sold at each installment the buyer makes. In other words, the seller is deferring the gross income on the sale until the buyer makes a payment. For each installment received from the buyer, the seller will be recording a portion of the gross income until all installments are received.
When making an installment sale, the seller takes risks that the buyer will not be paying in full. Therefore, the installment method of revenue recognition is a safe way of accounting for revenue generated by installment sales.
When to Use Installment Method
The installment method is good for businesses that are dealing with a lot of installment sales where they agree with customers that several payments will be made for goods and services over a period of longer than a year. When unsure whether a customer will fully pay all installments, the installment method of revenue recognition is more appropriate than the accrual accounting method.
Real estate transactions, construction companies, large appliance sales or big machinery equipment sales are all good candidates for the installment method of revenue recognition.
Accounting for Installment Sale [Step by Step]
If the installment method of revenue recognition fits your business, follow the below step by step to apply this method:
- Track installment sales and cost of goods sold for installment sales separately: It is especially important not to mix regular sales with installment sales and regular cost of goods sold with cost of goods sold from installment sales. That way, we remove a layer of complexity already.
- Track receivables from installment sales: Installment sales will always have a portion sitting in account receivables since the customer is paying over a long period of time. Keeping note of the date the account receivable has been created for each installment sale will be paramount.
- Track cash payments from customers: When a client pays an installment, track the payment to the installment sale and the related receivables.
- Transfer revenue and cost of goods sold from installment sales to a deferred account : For all financial periods where installment sales occurred, transfer all the revenue generated and related cost of goods sold from installment sales to a deferred gross income account at the end of each period.
- Calculate gross income ratio: With all the information collected from step 1 for a financial period, calculate the gross income ratio on installment sales. The following formula will help:
(Sales from installment sales – cost of goods sold) x 100%
Sales from installment sales
- Calculate realized gross income: With the gross income ratio calculated at step 5, calculate the realized gross income for a financial period with the following formula:
Gross income ratio (from step 5) x cash collected (from step 3)**
The result from the above formula can be recorded as gross income in the income statement of the financial period. This will decrease the deferred account (from step 4).
**If cash payment is received for a receivable from a prior period (here’s why step 2 is important), then use the gross income ratio calculated from that prior period to calculate the realized gross income. The resulting amount will be recorded in the income statement during the period the cash has been received.
- Carry forward the deferred gross income account balance: The balance of the deferred gross income account will carry forward to future periods. Amounts in this account will decrease as payments are received and more realized income is recognized in revenue or increase when more installment sales are made.
As can be seen with the steps above, the installment method is not as easy as it sounds. A lot of information needs to be tracked by management in order to ensure transactions are recorded as accurately as possible.
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Final Thoughts: Installment Method of Revenue Recognition
The installment method of revenue recognition doesn’t suit all businesses. It’s applicable for companies that are engaged in installment sales where the customers pay for goods and services over a long period of time. Companies in the construction or real estate industries are well suited to use this method as it’s more appropriate than using accrual accounting. It’s a conservative way of accounting revenue when there is some level of uncertainty in whether a company can recover full payment. If this method suits your business, keep our step-by-step handy!
