CHAPTER 5 Revenue Recognition and Profitability Analysis 305 basis with relatively small down payments and long payment periods, perhaps 25 years or more. These payment characteristics, combined with the general speculative nature of many of these transactions, may translate into extreme uncertainty concerning the collectibility of the installment receivable. 36 When extreme uncertainty exists regarding the ultimate collectibility of cash, GAAP previously required the use of one of two accounting techniques, the installment sales method or the cost recovery method. We discuss each in turn. Installment Sales Method. The installment sales method recognizes revenue and costs only when cash payments are received. Each payment is assumed to be composed of two components: (1) a partial recovery of the cost of the item sold and (2) a gross profit component. These components are determined by the gross profit percentage applicable to the sale. For example, if the gross profit percentage (gross profit 4 sales price) is 40%, then 40% of each dollar collected represents gross profit and the remaining 60% represents cost recovery. Consider the example in Illustration 5–A3 . On November 1, 2016, the Belmont Corporation, a real estate developer, sold a tract of land for $800,000. The sales agreement requires the customer to make four equal annual payments of $200,000 plus interest on each November 1, beginning November 1, 2016. The land cost $560,000 to develop. The company’s fiscal year ends on December 31. 36 In fact, the installment sales method was required for retail land sales that met certain conditions. FASB ASC 360–20: Property, Plant, and Equipment—Real Estate Sales (previously “Accounting for Sales of Real Estate,” Statement of Financial Accounting Standards No. 66 (Stamford, Conn.: FASB, 1982)). Illustration 5–A3 Installment Sales Method The gross profit of $240,000 ($800,000 2 560,000) represents 30% of the sales price ($240,000 4 $800,000). The collection of cash and the recognition of gross profit under the installment method are summarized below. In this example, we ignore the collection of interest charges and the recognition of interest revenue to concentrate on the collection of the $800,000 sales price and the recognition of gross profit on the sale. Amount Allocated to: Date Cash Collected Cost (70%) Gross Profit (30%) Nov. 1, 2016 $200,000 $140,000 $ 60,000 Nov. 1, 2017 200,000 140,000 60,000 Nov. 1, 2018 200,000 140,000 60,000 Nov. 1, 2019 200,000 140,000 60,000 Totals $800,000 $560,000 $240,000 The gross profit recognized in a period will be equal to the gross profit percentage multiplied by the period’s cash collection. The following journal entries are recorded (interest charges ignored): Make Installment Sale: November 1, 2016 Installment receivables ............................................................... 800,000 Inventory ................................................................................ 560,000 Deferred gross profit ............................................................. 240,000 To record installment sale. The first entry records the installment receivable and the reduction of inventory. The difference between the $800,000 selling price and the $560,000 cost of sales represents the gross profit on the sale of $240,000. As gross profit will be recognized in net income only as collections are received, it is recorded initially in an account called deferred gross profit. The installment sales method recognizes the gross profit by applying the gross profit percentage on the sale to the amount of cash actually received.
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