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Chapter 6

Generally, the point of sale is 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.
Installment sales may be regarded as calling for special treatment whereby gross
profit is related to the periods in which the installment receivables are collected
rather than to the periods in which the receivable are created. The inflow of cash
(collections) rather than the time of sale become the criterion for revenue
recognition. Accounting for installment method or installment basis could be best
illustrated by providing for the recognition of gross profit in proportion to collections.
Under this method, collections are regarded as both return of cost and realization of
profit in the ratio in which these two factors are found in the original sales price.
In applying the installment method in the accounts, the difference between the
contract sales price and the cost of goods sold is recorded as deferred gross profit.
This balance is recognized as revenue periodically in the proportion that the cash
collections in the period bear to sales price. Stated differently, the original gross
profit 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
profit balance remains on the book and is equal to the gross profit percentage
applied to the balance of installment receivables as to this date.
Since, collections become the criterion for revenue recognition in installment
method of accounting; determination of gross profit rate is an important factor to
compute the realized gross profit to be reported for a period. Gross profit rate may
be computed based on the data provided. Normally, it may be computed by dividing
the gross profit by the installment sales.
However, if this formula is not applicable, gross profit rate may also be computed by
dividing the deferred gross profit (beginning) by installment accounts receivable
(beginning); or by dividing the deferred gross profit (end) by the installment
accounts receivable (end).
The installment method of accounting recognizes profits at the point of collections,
thus realized profit is based on amount collected. Ordinarily, realized gross profit

may be computed by multiplying the gross profit 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. However, if this formula is not
applicable, realize gross profit may be computed by determining the difference
between the deferred gross profit (before adjustment) and deferred gross profit
(after adjustment).
Deferred Gross Profit
As stated earlier, the installment method of accounting recognizes profits at the
point of collection. If realized profit is based on amount collected, the deferred
gross profit is based on unpaid balance. The deferral of gross profit is, in effect, the
deferral of sales revenue accompanied by the deferral of cost of goods sold related
to such sales revenue. To compute the deferred gross profit at the beginning of a
period (before adjustment), installment accounts receivable at the beginning of the
period should be multiplied by the related gross profit rate; and the deferred gross
profit at the end of the period (after adjustment) is equal to installment accounts
receivable multiplied by the related gross profit rate.
In certain sales on the installment plan, companies will accept a trade-in as part of
payment on a new contract. The trade-in is recorded at the value allowed.
Frequently, as a special sales inducement, an allowance is given on the trade-in,
which is, in effect, 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 difference 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 profit on installment
sales should be regarded as the difference between the cost of goods sold and net
sales, the total installment sales less any trade-in over allowance.
Defaults and Repossessions
Default on an installment contract and subsequent repossession of the goods sold
calls for an entry on the books of the seller that reports the merchandise reacquired,
cancels the installment receivable together with the related deferred gross profit
balance, and records the gain or loss on repossession. As in the case of goods
acquired by trade-in, the repossessed article should be recorded at an amount that
will permit a normal gross profit on its resale.
Interest on Installment Contracts
Installment contract frequently provide for a charge for interest on the balance due.
The 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 requires 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 profit.