What are Installment Sales?
Installment sales is basically a buy now and pay later policy of the seller, which allows the purchaser to make payment for the goods in installments and to obtain the goods at the starting of the period in this method of sales, proceeds from sales and expenses are not recorded at the time of sales, but these are recorded at the time of collection of cash.
Explanation of Installment Sales
In this sales method, the buyer purchases the goods but does not pay the corresponding dues immediately; rather, the buyer releases the payment in installments. An installment sale, revenue from sales, and expenses are recorded by the seller at the time of collection of cash and not at the time of sales to the customer. The taxpayer who wants to defer their capital gains used this method of sales.
How Does Installment Sales Work?
It is prudent to recognize revenue where the seller defers its revenue recognition until the collection of sales proceeds. This method is generally used where ownership is not transferred completely at the time of sales or there is uncertainty regarding the collection of amounts like in the real estate sector. However, it requires the buyer to make payments in installments along with the interest if the installments are payable in several years. At the time of sales, the following journal entry should be passed:
|Installment Receivable A/c Dr||XXX|
|To inventory A/c||XXX|
|To Deferred gross profit A/c||XXX|
|(Being installment sales taken place)|
At the time of collection of sales proceeds or installment, the following Journal entry should be passed:
|Cash or Bank A/c Dr||XXX|
|To installment receivable A/c||XXX|
|(Being installment received)|
|Deferred gross profit A/c Dr||XXX|
|Cost of goods sold A/c Dr||XXX|
|To Revenue or sales proceeds A/c||XXX|
|(Being sales proceeds and expenses are recognized at the time of collection of cash)|
Example of Installment Sales
For Example, Company XYZ is engaged in dealing with sanitary items and electrical fittings. In April end, it makes a sale of Bathroom furniture for $100,000, which costs $60,000 to the company. Thus, the gross margin on Bathroom furniture is 40%. Furthermore, the company allows the customer to make payments in ten monthly installments of $10,000 per month. What is the treatment of this type of sales in the books of Company XYZ?
Here, the company allows the customer to make payment in ten monthly installments (i.e., from May to February) and receive the entire goods in April (i.e., at the time of sale). It is the case of an Installment sale. Here, the seller can record the sales revenue and expenses at the time of collection of cash and not at the time of sales.
At the time of sales by the method of Installment sales, the gross margin is calculated by the company which is 40% (sales proceeds percentage-cost of goods percentage)in our case. An installment receivable account is debited by the company with the number of total sales, inventory is credited with the amount of cost of goods, and the company credits deferred gross profit with the amount of Sales proceeds*Gross Margin. The Journal entries in the books of Company XYZ are:
|30th April||Installment Receivable A/c||$100,000|
|To Deferred Gross Profit ($100,000*40%)||$40,000|
|(Installment sales were recognized initially. Out of the sales of $100,000, 60% of $100,000 is the cost of goods, and the remaining 40% is the Deferred gross profit.)|
|31st May||Bank A/c||$10,000|
|To installment Receivable A/c||$10,000|
|(Installment sale receipt entry)|
|31st May||Deferred Gross Profit ($10,000*40%)||$4,000|
|Cost of goods sold ($10,000*60%)||$6,000|
|To Revenue or sales proceeds||$10,000|
|(Revenue from sales proceeds and expenses are recorded at the time of collection of cash)|
The journal entries for the next 9 months are the same as above.
Advantages of Installment Sales
- By using this sales method, the seller can defer the recognition of revenue or gross profit until it falls under the desired tax bracket (lower tax rates). This helps sellers to keep the capital gain tax lower.
- It requires the buyer to make payments in installments along with the interest if the installments are payable in several years. So, it also creates interest income and added to the income of the seller.
- Installments sale provides easy financing to the buyers.
Disadvantages of Installment Sales
- In Installment sales, the seller does not receive the proceeds at the time of sale. There is always uncertainty regarding the collection of cash.
- The seller faces the biggest problem in reporting the revenue from installment sales. This is challenging for the seller to calculate the percentage of gross profit and profit earned each year. For this, it has to take the assistance of professionals for the accounting of investment sales.
Important points of Installment sales are provided and discussed below-
- Installments sale provides the buyer a facility to make the payment in installments.
- In Installment sales, proceeds from sales and expenses are recorded at the time of collection of cash and not at the time of sales. Thus, it allows the seller to defer the taxes over the years and not at the time of sales.
- It is generally used when there is uncertainty regarding the collection of cash, like in the real estate sector.
- It is generally used when ownership is not completely transferred at the time of sale.
Thus, in Installments, sales buyers obtain the goods at the time of sales and are not paid for the goods immediately. Here, the seller allows the buyer to make payments over several years or in installments. The seller does not get the upfront payment at the time of sales. The seller’s recognition of revenue is deferred in case of installment sales means revenue from sales and expenses are not recorded at the time of sales but it is recorded at the time of collection of cash. Seller uses this method to defer the recording of profit until it gets taxed at the desired rate (lower rate).
This is a guide to Installment Sales. Here we discuss the definition and how installment sales work along with their advantages and disadvantages. You may also have a look at the following articles to learn more –