The installment method is an accounting practice used for recognizing revenue and expenses related to sales or services over a period of time, rather than entirely at the point of sale. This method is typically used when payments for a product or service are made in multiple installments over a period of time, or when there’s a significant risk of nonpayment.
Under the installment method, revenue (and corresponding cost of goods sold) is recognized proportionately as payments are received, rather than when sales are made. In other words, when a payment installment is received, a proportionate amount of revenue is recognized, based on the fraction of the total sales price that the payment represents.
For example, let’s say a business sells an item for $1,000 in total, to be paid in five equal installments of $200. When the business receives the first $200 payment, it would recognize $200 of the sales revenue and a corresponding proportion of the cost of goods sold.
It’s important to note that the installment method is generally not acceptable under U.S. GAAP (Generally Accepted Accounting Principles) when the seller can reasonably estimate the amount of bad debt. However, it’s allowed under the U.S. Internal Revenue Code for tax purposes in certain situations.
Please note that the rules for the installment method can vary depending on the jurisdiction and specific accounting standards, and it may not be permissible or appropriate in all circumstances.
Example of the Installment Method
Let’s consider a simple example of how the installment method works.
Imagine a company, AutoWorld, sells a car for $20,000. The customer pays for the car in five equal annual installments of $4,000.
According to the installment method, AutoWorld doesn’t recognize the full $20,000 as revenue immediately upon the sale. Instead, it recognizes revenue as it receives each installment.
So, when AutoWorld receives the first installment of $4,000, it recognizes that amount as revenue for the year. It does the same for each subsequent installment in the following years.
Let’s also assume the cost to AutoWorld for the car was $15,000. Similar to the revenue, AutoWorld would spread out the recognition of this cost over the five years. Each year, when an installment is received and revenue is recognized, AutoWorld would also recognize $3,000 ($15,000/5 years) of the cost.
This approach continues for each installment until all the revenue and costs are recognized. After five years (the length of the installment agreement), all $20,000 of the revenue and all $15,000 of the costs have been recognized.
This example illustrates the basic principles of the installment method, but please note that real-world scenarios may involve more complex considerations.