Revenue recognition methods for installment sales

March 22, 2014

Many sales transactions are paid for immediately by the customer, and are relatively straightforward to account for. On the other hand, a sales contract might call for annual payments. The question then becomes, when should revenue be recognized? There are three general ways to account for the sale revenue, and the method used depends on the reliability of future cash payments.

1. Point of sale method

When you buy groceries at a store, you pay the cashier, who then allows you to take the items home. Even if you pay by credit card, the supermarket can be certain that the credit card company will honor the charge immediately or within a few days. The store would make the following journal entries at the time of sale.

Account Names

Debit

Credit

     

Cash (or Accounts Receivable)

xxx

 

†††† Sales Revenue

 

xxx

     

Cost of Goods Sold

xxx

 

†††† Inventory

 

xxx

When a business sells property or equipment and signs a contract with the buyer that calls for paying off the purchase in several annual installments, the simplest way to account for the sale is with the exact same entries as shown above. This is called the point of sale method. For example, letís say a company sells a machine costing $180,000 for $300,000. The sales contract calls for 4 annual payments of $75,000. Under the point of sale method, we would debit Accounts Receivable and credit Sales Revenue for $300,000 while debiting Cost of Goods Sold and crediting Inventory for $180,000. The entries made in future years serve only to convert Accounts Receivable into Cash.

2. Installment method

Letís assume the same facts as above for a machinery sale. If collection of the full account is somewhat uncertain, we need to use the installment method for the contract. We will only make one journal entry at first: debit Accounts Receivable for $300,000, credit Inventory for $180,000, and credit Deferred Gross Profit for $120,000. Revenue and cost of goods sold are recognized as each installment payment is made. In addition, deferred gross profit is reduced.

Under the installment method, we must split each cash payment between those three accounts using a gross profit percentage. In the example given, $120,000 out of the $300,000 sale is profit, so the percentage is (120,000 ų 300,000) x 100, or 40%. For each cash payment, we would debit Cash and credit Accounts Receivable for $75,000. In addition, we would debit Cost of Goods Sold for $45,000, debit Deferred Gross Profit for $30,000, and credit Sales Revenue for $75,000. In this way, profit is recognized throughout the entire payment schedule.

3. Cost recovery method

The final method, cost recovery, should be used if cash collections are highly doubtful. For this method, the initial entry is the same as for the installment method: debit Accounts Receivable, credit Inventory and Deferred Gross Profit. For each cash payment, Cash is debited while Accounts Receivable is credited.

The major difference lies in the second entry recorded with each cash payment. Instead of reducing Deferred Gross Profit over time, we only recognize Cost of Goods Sold and Sales Revenue until the entire amount credited to Inventory is collected. The first paymentís entry, therefore, would be to debit Cost of Goods Sold and credit Sales Revenue for $75,000. Once the cost of the sale is completely paid off, we only debit Deferred Gross Profit. Entries for the last cash payment, for instance, would debit Deferred Gross Profit and credit Sales Revenue for $75,000.

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