Revenue Recognition - Instalment Sales

An instalment sale occurs when a firm finances the sale of a product and the payments are expected to be received over multiple periods.

If the payment collectability is certain, the revenue is recognized when the sale is made as per normal revenue recognition principle.

However, when we are uncertain about the collectability of the sales revenue, we should defer revenue recognition. Two commonly used accounting methods are:

• Instalment sales method
• Cost recovery method

Instalment Sales Method

• Sale and cost of sale recorded as usual.
• Compute gross margin rate on the instalment sales.
• Recognize gross margin as cash is received.
• Gross margin not realized is deferred until a future period.

Cost Recovery Method

• Like the instalment sales method, cost recovery is used when we are uncertain about the collectability of the sales revenue.
• No profit is recognized until cost of item sold is fully recovered.

Example

Wonder’s Appliances made sales of $200,000 in 2012. The items sold have a cost $150,000.  During 2012, the company collected cash from installment customers of $90,000.  The remaining amount will be collected in 2013.

Under the instalment sales method, profit will be determined as follows:

Company’s gross margin is = (200,000 – 150,000)/200,000 = 25%

Profit recognized in 2012 = 25% of 90,000 = $22,500

Profit recognized in 2013 = 25% of 110,000 = $27,500

Note that 110,000 is the balance cash collected in 2013 (200,000 – 90,000).

Under the cost recovery method, the money collected in 2012 is applied to recovery of costs. So, profit reported in 2012 is zero, and the profit reported in 2013 is $50,000.

Treatment of Instalment Sales under IFRS

Under IFRS, if the outcome can be reliably estimated, we calculated the present value of the instalment payments and recognize them at the time of sale. The difference between the instalment payments when received and its present value is recognized as interest over time. If outcome cannot be reliably estimated, then treatment is similar to cost recovery method.