Basic Concepts Of Revenue Recognition - Installment Principle
One of basic concepts of revenue recognition is Installment principle. The essence of installment payments is that the customer pays certain amount of cash for the purchase in the beginning of sales contract and the remaining part is being paid in specified amounts during a particular determined period of time. The seller usually retains ownership title to the goods and implements other means to secure the goods or assets if the customer fails with the payments.
Applying this one of basic concepts of revenue recognition, revenue is not recognized at the point of sale. In this case each installment is considered as separate share of revenue which is being recognized separately.
For easier understanding let's analyze practical example:
Suppose company ABC sells goods for $400.000. cost of these goods is $240.000 and gross profit is $160.000, i.e.:
| Sales price of goods |
$400.000 |
| Cost of goods |
$240.000 |
| Gross profit |
$160.000 |
The customer will be paying for goods within 3 years, during the 1st year $184.000 will be paid, during the second year $132.000 will be paid and during the 3rd year the remaining $84.000 will be paid.
In case point of sale method would be applied, ABC company would recognize $400.000 sales revenue on the date the customer acquired ownership title to the goods, despite the date payment for the goods will be made and the following journal entry would be recorded:
Date |
Description |
D
|
C
|
| Ownership title transfer |
Accounts Receivable |
$400.000 |
|
| |
Revenue |
|
$400.000 |
| |
Recognition of sales revenue |
|
|
In case one of basic concepts of revenue recognition - Installment Principle - is applied, revenues will be recognized in 3 installments, i.e.
1st year |
$184.000 |
2nd year |
$132.000 |
3rd year |
$84.000 |
Gross profit should be also recognized according to the revenue recognition method applied. In the above example gross profit is 40% of sales revenue, i.e. $160.000/$400.000=40%
This means that each year 40% gross profit of recognized sales revenue should be recorded in the books of ABC company, i.e.:
| 1st year |
$184.000*40% |
$73.600 |
| 2nd year |
$132.000*40% |
$52.800 |
| 3rd year |
$84.000*40% |
$33.600 |
| Total |
$400.000 |
$160.000 |
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