Installment Sales Definition

The Installment Method of revenue recognition under the revenue principle deals with sales that require periodic payments over a specified time period usually established within a contract called the installment sales contract.

Installment Sales Explanation

Due to conservative practices in business, the installment sales method of accounting finds the gross profit percentage associated with the total sale and recognizes this percentage as gross profit as the periodic or installment payments are received. Therefore, the company does not recover the cost of the goods sold or the gross profit until the last payment has been made by the customer. The installment method is generally used by real estate companies because the cost of land can be substantial and paying for the total cost up front is simply not possible.

Installment Sales Method Example

The following Installment sales method example explains how a company would use the Installment Sales method:
For example, Real Estate Company has just sold a large parcel of land to Case Co. at a price of $1 million. Case signed an installment sales contract that requires payments of $150,000 over the next 6 years and an up-front payment of $100,000. The cost of the land sold for Real Estate is $600,000. Thus the gross profit they will recognize under the method at the end of the installment sales agreement would be $400,000.
Gross Profit percentage = Gross Profit/Sale Price = $400,000/$1 Million = 40% Year 1 during the year:
Installment Accounts Receivable (A/R) ………………………$1,000,000
Installment Sales …………………………………………………………………………$1,000,000
Cost of Land Sold ………………………………………………………$600,000
Land………………………………………………………………………………………………$600,000
Cash…………………………………………………………………………….$250,000
(up-front payment of 100,000 + year 1 periodic of $150,000)
Installment A/R……………………………………………………………………………..$250,000
Year 1 end of year:
Installment Sales………………………………………………………..$1,000,000
Cost of Land ………………………………………………………………………………..$600,000
Deferred Gross Profit………………………………………………………………….$400,000
Deferred Gross Profit ……………………………………………….$100,000 (250,000*40%)
Realized gross profit on Installment Sales……………………………………$100,000
Year 2-6 end of year:
Deferred Gross Profit…………………………………………………$60,000
Realized gross profit on Installment Sales………………………………………..$60,000
Notice that the total amount at the year 6 end will show the total amount of gross profit.
Year 1 Gross Profit realized=$100,000
Year 2 Gross Profit realized=$60,000
Year 3 Gross Profit realized=$60,000
Year 4 Gross Profit realized=$60,000
Year 5 Gross Profit realized=$60,000
Year 6 Gross Profit realized=$60,000
Total Gross Profit realized =$400,000
Note: To simplify the transaction accounting, interest has been left out. There is also an assumption that the company has not made any other sale outside of this one. If the company had made any other installment sales, then the gross profit percentage would need to be recalculated each year and applied to the cash receipts.

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