CHAPTER 5 INSTALLMENT SALES

Characteristics
An installment sale of real or personal property or service provides for a
series of payments over a period of months or years. There is usually a
requirement for down payment as well as interest and carrying charges
on the unpaid balance.
The risk of non collection to the seller is generally higher due to:
 Weaker financial position of customers in relation to those who
buy on an open account
 Possible change in the credit rating and customers’ ability to pay
during the period covered by the installment contract
To protect themselves from such risk, sellers generally select a form of
contract called a security agreement that enables them to repossess the
property if the purchaser fails to make the payments. For service type
businesses, repossession obviously is not an available option. For certain
types of merchandise also the right to repossess may be more of threat
than a real assurance against loss as the merchandise sold may have
been damaged or depreciated to a point where that it is worth less than
the balance due.
A basic rule designed to minimize loss from non payment of installment
contract is to require sufficient down payment to cover the loss of value
when the merchandise moves out of the “new’ category. A corollary rule
is that the payments by the purchaser should not be outstripped by the
projected decline in value of the merchandise sold.
The following problems lead many retailers to sale of installment
receivables to finance companies that specialize in credit and collection
activities:
 Difficulty and expensiveness of the repossession process which
may entail reconditioning and repair
 Increased collection and accounting costs

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  Tie up of large amount of working capital
Realization of Gross Profit on Installment Sales
The measurement of income from installment sales is complicated by the
fact that the amounts of revenue and related costs and expenses are
seldom known in the accounting period when installment sales are
made. Substantial costs (as for collection, accounting, repairs, and
repossession) may be incurred in subsequent accounting periods. In
some situations, the risk of non collection may be so great as to raise
doubt that any revenue or profit is realized at the time of sale.
The first objective in the development of accounting policies for
installment sales should be a reasonable matching of expenses and
revenue. However, due to the inherent nature of installment sales, the
following three approaches are used for recognition of gross profit on
installment sales:
1. the accrual basis of accounting
2. the cost recovery method of accounting
3. the installment method of accounting
Accrual basis of accounting
The entire gross profit is realized at the time of installment sale like sales
on account. The excess of the installment receivables over the cost of
merchandise sold is realized gross profit. The journal entry consists of
debit to installment receivables and credit to installment sales. The cost
of merchandise sold is also credited to inventory and debited to cost of
goods sold. No recognition is given to the sellers’ retention of title to the
merchandise because the normal expectation is completion of the
contract through collection of the receivable. The implicit assumption is
that most expenses relating to the sale will be recognized in the same
accounting period.
Recognition of collection and doubtful installment receivables expenses
in the period of the sale requires estimates of the customer’s performance

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over the entire term of the contract. Even if making such estimates is
considerably more difficult than the normal provision for doubtful
accounts expense, reasonably satisfactory estimates may be made with
careful analysis of industry experience in most situations.
Journal entries Debit to expense and credit to asset valuation account
such as Allowance for doubtful installment receivables and allowance for
collection costs.
Cost Recovery Method of Accounting
Under the cost recovery method, no profit is recognized until all costs of
the merchandise sold have been recovered. After all costs are recovered,
additional collections are recognized as revenue (gross profit and interest
revenue), and only current collection costs are recognized as expenses.
This method is rarely used; therefore, it is not illustrated.
Installment Method of Accounting
Under the installment method of accounting, each cash collection on the
contract is regarded as including both a return of cost and a realization
of gross profit in the ratio that these two elements were included in the
selling price. Emphasis is shifted from the acquisition of installment
receivables to collection of the receivables as a basis for realization of
gross profit; in other words, a modified cash basis of accounting is
substituted for the accrual basis of accounting.
Example: assume that a farm equipment dealer sells for Br. 10,000 a
machine that cost Br. 7,000. The Br. 3,000 excess of the sales price
over cost is regarded as deferred gross profit and the 70: 30 ratio is
used to divide each collection between cost recovery and gross profit
realization. At the end of each period, the Deferred Gross Profit
account balance will equal 30% of uncollected installment receivables
and the Realized Gross Profit on Installment Sales account shows
30% of the amount collected during the period.

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The installment method may be used for the computation of taxable
income for “any disposition of property where at least one payment is
to be received after the close of the taxable year in which the
disposition occurs.” Although the income tax advantages of the
installment method are readily apparent, the theoretical support for it
in financial accounting is less impressive.
Accordingly APB Opinion No. 10 virtually removed the installment
method of accounting from the body of generally accepted accounting
principles because it reaffirmed the concept that income is realized
when sales is made, unless the circumstances are such that the
collection of the selling price is not reasonably assured.
The circumstances in which the use of the installment method of
accounting is permitted are:
1. collection of installment receivables is not reasonably assured
2. installment receivables are collectible over an extended period of
time, and
3. there is no reasonable basis for estimating the degree of
collectibility of the installment receivables
In such situations, either the installment method or the cost recovery
method of accounting may be used.
Illustration
Single Sale of Land on the Installment Plan
The owner of land that has appreciated in value often is willing to sell
only on the installment plan so that the gain may be spread over
several years for income tax purposes. Federal income tax regulations
permit the use of the installment method if the contract price will be
collected in two or more installments spanning two or more years.
Assume that Kane, whose fiscal year follows the calendar year, sold
for $100,000 a parcel of land with a carrying amount of $52,000.
Commission and other costs were $8,000. Thus, the gain on the sale

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 of the land is $40,000 (100,000-52,000-8,000), and all cash
collections are regarded as consisting of 60% cost recovery and 40%
realization of gain (profit).
The contract of sale required a down payment of $25,000 and
promissory notes in the amount of $75,000, with principal payments
every six months for five years in the amount of $7,500 plus interest
at 10% on the unpaid principal amount of the notes.
Journal entries
Year 1
Dec. 31 Cash (net of 8,000 commission) 17,000
Notes Receivable 75,000
Land 52,000

Deferred Gain on Installment Sales of Land40,000

To record of land on the installment plan
31 Deferred Gain on Installment Sales of Land 10,000
Realized Gain on Installment Sales of Land 10,000
To record realized gain on collection of down payment
(25,000*40%)
Year 2
June 30 Cash 11,250
Interest Revenue 3,750
Notes Receivable 7,500
To record semi-annual principal payment on notes receivable
($7,500), plus interest for six months (75,000*0.1*6/12
=3,750)
Dec 31 Cash 10,875
Interest Revenue 3,375
Notes Receivable 7,500

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 To record semi-annual principal payment on notes receivable
($7,500), plus interest for six months [(75,000-
7,500)*0.1*6/12 =3,375)]
31 Deferred Gain on Installment Sales of Land 6,000
Realized Gain on Installment Sales of Land 6,000
To record realized gain on collection of notes receivable
(15,000*40%)
If the land sales has been recorded as an ordinary sales, a gross profit of
$ 40,000 would have been recognized in Year 1; use of the installment
method resulted in the recognition of only $10,000 gross profit in Year 1,
and $6,000 in each of the next 5 years. If the sale in the installment plan
results in a loss, the entire loss must be recognized in the year of sale.
Illustration of Accounting for Installment Sales of Merchandise
Assume Oak Desk Company sells merchandise on the installment plan as well
as regular terms, and uses the perpetual inventory system. For an installment
sale, the customer’s account is debited for the full amount of the selling price,
including interest and carrying charges, and credited for the amount of down
payment. The installment receivables ledger account thus provides a complete
record of the transaction. Doubtful installment receivables are recognized when
the accounts are known to be uncollectible. The following are included in the
records of Oak Desk on Jan 1 Yr 5:
Installment receivables-Yr 3 20,000Dr
Installment receivables-Yr 4 85,000Dr
Deferred interest and carrying charges 17,500Cr
Deferred gross profit-Yr 3 installment sales 4,500Cr
Deferred gross profit-Yr 4 installment sales 19,460Cr
The gross profit rate on installment sales (excluding interest and carrying
charges) was 25% in Yr 3 and 28% in Yr 4. During Yr 5, the following
transactions were completed:
Information relating to Yr 5 installment sales
Installment sales (excluding 30,000 deferred
Interest and carrying charges) 200,000

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 Cost of installment sales 138,000
Deferred gross profit-Yr 5 (200,000-138,000) 62,000
Gross profit rate (62,000/200,000) 31%
Cash collections during Yr 5
Selling Interest and
Price Carrying Ch Total

Installment receivables-Yr 5 80,000 10,000 90,000

Installment receivables-Yr 4 44,500 12,500 57,000
Installment receivables-Yr 3 17,000 1,850 18,850
Totals 141,500 24,350 165,850
Customers who purchased merchandise in Yr 3 were unable to pay the balance
of Br. 1,150 consisting of 1,000 sales, 150 interest and carrying charges, and
250 (1000*.25) deferred gross profit. The net realizable value of the
merchandise repossessed was 650.
Recording Transactions and Events
Installment sales-Yr 5 230,000
Cot of installment sales 138,000
Installment sales 200,000
Deferred interest and C charges 30,000
Inventories 138,000
To record installment sales and cost of installment sales for Yr 5
Cash 165,850
Installment receivables- Yr 5 90,000
Installment receivables- Yr 4 57,000
Installment receivables- Yr 3 18,850
To record collections on installment contracts during Yr 5

Inventories (repossessed merchandise) 650

Deferred gross profit-Yr 3 250
Deferred interest and carrying 150
Doubtful installment rec. expense 100
Installment receivables Yr 3 1,150
To record default on Yr 3 installment receivables and repossession
of merchandise

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Adjusting entries on Dec 31 Yr 5
Installment sales 200,000
Cost of installment sales 138,000
Deferred gross profit-Yr 5 62,000
To record deferred gross profit on Yr 5 installment sales
Deferred gross profit-Yr 5 24,800
Deferred gross profit-Yr 4 12,460
Deferred gross profit-Yr 3 4,250
Realized gross profit on installment sales 41,510
To record realized gross profit on installment sales as follows:
Yr 5 (80,000*0.31) 24,800
Yr 4 (44,500*0.28) 12,460
Yr 3 (17,000*0.25) 4,250
Total realized gross profit 41,510
Deferred interest and carrying charges 24,350
Revenue from interest and carrying charges 24,350
To record revenue from interest and carrying charges for Yr 5
Trade-ins:
A familiar example is the acceptance by a dealer of a used car as partial
payment for a new car. An accounting problem exists only if the dealer
grants an over allowance on the used car taken in trade. An over
allowance is the excess of the trade in allowance over the net realizable
value of the used car. A rough approximation of the net realizable value
may be the currently quoted wholesale price for used cars of the
particular make and model.
Presentation of Installment Data in Financial Statements
The presentation of accounts relating to installment sales in the financial
statements raises theoretical issues, regardless of whether the accrual
basis of accounting or the installment method of accounting is used.
Income Statement

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A partial income statement of Oak Desk Company for Yr 5 under the
installment method:
OAK DESK CPMPANY
PARTIAL INCOME STATEMENT
For the Year Ended Dec 31 Yr 5

Installment Regular Combined

sales sales
Sales 200,000 300,000 500,000
Cost of Goods Sold 138,000 272,000 360,000
Gross profit 62,000 78,000 140,000
Less: Deferred gross profit
On Yr 5 installment sales 37,200 37,200
Realized gross profit on Yr 5 24,800 78,000 102,800
Add: Realized gross profit on
Prior years’ installment sales 16,710
Total realized gross profit 119,150
If the accrual basis of accounting is used for all sales, gross profit of
140,000 would be reported for the year. The formal illustrated above is
useful for internal purposes and not to report to outsiders. The 24,350
interest and carrying charges is reported as Other Revenue.
Balance Sheet
Installment receivables, net of deferred interest and carrying charges, are
classified as current assets, although the collection period often extends
more than a year beyond the balance sheet date. This rule is applicable
whether the accrual basis of accounting or the installment method of
accounting is used. The definition of current assets specifically includes
installment and notes receivables if they conform generally to normal
trade practices and credit terms in the industry. This classification is
supported by the concept that current assets include all resources
expected to be realized in cash, sold, or consumed during the normal
operating cycle of the business enterprise. The listing of installment

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receivables in the current asset section of the balance sheet is more
informative when the amounts maturing each year are disclosed.
The classification of deferred gross profit on installment sales in the
balance sheet when the installment method of accounting is used poses
some troubles. A common practice was to classify the deferred gross
profit in the liabilities section of the balance sheet. Critics of this
treatment pointed out that no obligation to an outsider existed and the
liability treatment was improper.
In view of these conflicting approaches, it is suggested that the deferred
gross profit be subdivided into three parts:
 an allowance for collection costs and doubtful receivables that
would be deducted from installment receivables
 a liability representing future income taxes on the gross profit not
yet realized
 a residual income element
The residual income element would be classified by some accountants as
a separate item in the stockholders’ equity section of the balance sheet
and by others in an undefined section between liabilities and
stockholders’ equity.
The lack of agreement as to classification of deferred gross profit is
evidence of the inherent contradiction between the installment method
and the accrual basis of accounting. A satisfactory solution in most
cases is to recognize gross profit on installment sales on the accrual
basis for financial reporting and to defer recognition of gross profit for
income tax purposes until installment receivables are collected.

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