Chapter 6 (Installment Sales)

Chapter 6 INSTALLMENT SALES Introduction Generally, the point of saleis the point of revenue recognition. And among the exceptions to the point of sale realization concept is the installment method. Under this method, income is recognized when collections are made, because the uncertainty of collecting accounts to be receive over an extended period of time may suggest the postponement of revenue recognition until the probability of collection can be reasonably estimated. GROSS PROFIT RECOGNITION ON INSTALLMENT SALES Installment sales may be regarded as calling for special treatment whereby gross prot is related to the periods in which the installment receivables are collected rather than to the periods in which the receivable are created. he infow o cash !collections" rather than the time of sale become the criterion for revenue recognition. Accounting for installment method or installment basiscould be best illustrated by providing for the recognition of gross prot in proportion to collections. Under this method, collections are regarded as both return of cost and realization of prot in the ratio in which these two factors are found in the srcinal sales price. In applying the installment method in the accounts, the di#erence between the contract sales price and the cost of goods sold is recorded asdeerred gross prot. his balance is recognized as revenue periodically in the proportion that the cash collections in the period bear to sales price. $tated di#erently, the srcinal gross prot percentage on the sales is applied to periodic collections in arriving at the amounts to be recognized as revenue. At the end of each period a deferred gross prot balance remains on the boo% and is e&ual to the gross prot percentage applied to the balance of installment receivables as to this date. GROSS PROFIT RATE $ince, collections become the criterion for revenue recognition in installment method of accounting' determination of gross prot rate is an important factor to compute the realized gross prot to be reported for a period. Gross prot rate may be computed based on the data provided. (ormally, it may be computed by dividing the gross prot by the installment sales. )owever, if this formula is not applicable, gross prot rate may also be computed by dividing the deferred gross prot !beginning" by installment accounts receivable !beginning"' or by dividing the deferred gross prot !end" by the installment accounts receivable !end". REALIZED GROSS PROFIT he installment method of accounting recognizes prots at the point of collections, thus realized prot is based on amount collected. *rdinarily,realized gross prot

may be computed by multiplying the gross prot rate by the amount collected. It should be pointed out that in case of defaulted contract, collections should be net of any unpaid balance on defaulted contract. )owever, if this formula is not applicable, realize gross prot may be computed by determining the di#erence between the deerred gross prot (beore adjustment)and deerred gross prot (ater adjustment). Deferred Gross Prot

As stated earlier, the installment method of accounting recognizes prots at the point of collection. If realized prot is based on amount collected, the deferred gross prot is based on unpaid balance. he deferral of gross prot is, in e#ect, the deferral of sales revenue accompanied by the deferral of cost of goods sold related to such sales revenue. o compute the deferred gross prot at thebeginning of a period (beore adjustment), installment accounts receivable at the beginning of the period should be multiplied by the related gross prot rate' and the deferred gross prot at the end of the period(ater adjustment) is e&ual to installment accounts receivable multiplied by the related gross prot rate. Trade-Ins In certain sales on the installment plan, companies will accept a trade+in as part of payment on a new contract. he trade+in is recorded at the value allowed. re&uently, as a special sales inducement, an allowance is given on the trade+in, which is, in e#ect, a reduction in the sales price. Under such circumstances, the trade+in should be recorded at no more than the company would pay on its purchase' the di#erence between the amount allowed and the value of the article to the company should be reported either as charge to an over allowance account or as a reduction in installment sales. In either case, the gross prot on installment sales should be regarded as the di#erence between the cost of goods sold and net sales, the total installment sales less any trade+in over allowance. Defauts and Re!ossessions -efault on an installment contract and subse&uent repossession of the goods sold calls for an entry on the boo%s of the seller that reports the merchandise reac&uired, cancels the installment receivable together with the related deferred gross prot balance, and records the gainor loss on repossession. As in the case of goods ac&uired by trade+in, the repossessed article should be recorded at an amount that will permit a normal gross prot on its resale. Interest on Insta"ent Contracts Installment contract fre&uently provide for a charge for interest on the balance due. he interest charge is ordinarily payable with the installment payment that reduces the principal. Although interest is included in the payment, use of the installment method re&uires that only that portion of a payment which reduces the principal balance of the installment contract receivable should be considered in computing the realized gross prot.