 Hello and welcome to the session in which we will discuss the installment sales method, which is a revenue recognition method. Now, when do we use the installment sales method? It's when there's a high risk of not receiving cash from the buyer. So if we make a sale and there's no chance of receiving the cash, we really cannot recognize the profit. Therefore, we're going to utilize the installment sales method or there's no reasonable basis for estimating the incollectible amount. Okay, we make the sale but we don't know how much of that will be incollectible. There's this uncertainty whether we receive the cash and how much or if or we cannot estimate how much incollectibles. Under those circumstances you are allowed to use the installment sales method. It's very similar. The installment sales method, think about the cash method. It's very similar to the cash method because you're going to recognize the profit in proportion of cash collected. As installment payments are made, you would recognize the profit. This is the installment sales method. Now, how would you use what measure, for example, if you received you know $100,000 in cash. How much of that is profit? Well, you're going to have to use the gross profit percentage from the sale. So first you compute the gross profit percentage and I hope you know how to do so. Gross profit percentage is sales minus cost of goods sold will give us gross profit and let's assume sales is $100, cost of goods sold is 60, gross profit is 40. To find the gross profit percentage you will take 40 divided by 100 and we would know that the gross profit on the sale is 40%. So going back to the 100,000, if I received 100,000 in cash from that sale, which is you know let's assume it's a different number because sales is only $100 but let's assume the gross profit is 40%. I would recognize 40% of profit for that particular period from this cash collection. So the installment sales method, you wait for the cash. Once you receive the cash part of that cash is profit, is recognized as profit. Now the best way to illustrate this is to do what? Look at an example. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead start your free trial today. No obligation, no credit card required. So let's take a look at this example. In year one we had sales for this particular company of 1.4 million, cost of sales 900,000. The gross profit is half a million. Now the gross profit percentage is 35.71 which is 500,000 divided by 1.4 million. Now bear in mind this is rounding so if you increase it it's or you decrease it you know 7.413. The cash collected for that particular year from the client, from the customer is 400,000. Now let's journalize the entry for year one for this customer. Well we debit a count receivable for 1.4 million, credit installment sales for 1.4 million for the same amount. This is for year one. Then we debit cost of goods sold which is cost of goods sold for this particular company for this particular year for the transaction is 900,000, credit inventory 900,000. Now looking at the income statement you would say well if I reported 1.4 of sales minus 900,000 of cost I have half a million in profit. Well if I'm using the installment sales method I cannot have a million in profit unless I received the full amount in cash. So how much cash did I receive? I received only from this client 400,000. Well if I received 400,000 then I have to do something about this half a million. It cannot be reported as half a million. How much profit will I need to report? I will need to report 400,000 times this percentage rounding 0.3571. Now this is the amount I need to report as profit. Simply put if this is the amount I need to report as profit I know I'm reporting half a million so I have to deduct something here that I'm going to deferring. So how much am I going to defer? Well here's what's going to happen. I am going to defer what's not applicable. What's not applicable? I still have a million dollar in account receivable. Remember my receivable started at 1.4 million that was my total account receivable then I received 400,000 minus 400,000. What's left in my receivable is a million. Now what I need to do? I need to multiply this million by my percentage that I cannot collect that I have not received yet. So part of that million include 0.3571 again rounding 0.357143 that's not that's not collected yet. It means I have to back it out out of the half a million which is the amount of 357143. Now I have to back out. Let me use a different color. I have to back out 357143 from half a million and what's left is the profit which is it's going to be it's going to be 400,000 times 0.3571. It's going to end up to be that number. But let me show you the journal entries. From the journal entry perspective I will debit an account called the third gross profit for the amount I need to defer. How did I came up with this amount? 1 million which is the remaining receivable times the gross profit percentage. In this amount it's going to be like an expense and it was an expense as I showed you right now it went up here and it reduced your gross profit. Then I'm going to credit another the third gross profit. This one goes on the balance sheet and this is an AR adjustment. It's a Contra account receivable. It means I'm going to be receiving 1 million of receivable minus this 357143 because that's that's that is a a the third profit. Now let me show you what the income statement would look like. So if we go to the income statement here it's going to look something like this. Let me go to the income statement and show you what the income statement would look like. We'll go here and we'll see 1.4 million of sales 900 of cost gross profit half a million. Then we will back out 357. This is less. This is less. So this is backing out 357143. So the only remaining gross profit is 142857 which is half a million minus that which is again how do I come up with this number if I take 400 000 times 0.35 what's the percentage 3571 400 000 times 3571. Let's see how the rounding is going to work or not 400 000 times 0.3571 it is 142840 14257 again rounding. Okay it doesn't really matter but it's rounding so that's the only profit I can recognize for this year because that's the only cash I received for this year. Now another way to do this another way you might see it in a different textbook in a different CPA company some a CPA prep company something like this they will debit receivable this is an alternative method 1.4 million for the sale they will credit inventory 900 000 for the cost of the inventory then they will credit the third gross profit immediately for half a million so they'll put the gross the third gross profit then they receive the cash then they back out what they need to back out so from the half a million they will back out the 142857 by debiting the third gross profit and crediting profit from the third profit they turn it into a profit so that's an alternative way you might see it this way that's fine let's take a look at year two for this company in year two they had sales of 1.35 cost of sales 934 000 gross profit is 416 the gross profit percentage for year two is 30.81 again if you want to just want to let you know this could be rounding just I rounded it to 30.81 which is gross profit divided by sales for year two I collected from year one 400 600 000 this 600 000 is from the account receivable of year one and from year two I collected 340 000 from the sale now you want to keep those collection cash collection separately why because you are dealing with a different gross profit the cash collected for year one will use 35.71 gross profit 7143 the cash collected in year two will use a different gross profit let's take a look at journal entries for year two the journal entries should be straightforward and they should be straightforward debit account receivable 1.1 1.1 1 million 350 let me reduce this a little bit credit sales 1 million 350 debit cost 4934 credit inventory now the cash collected it's going to be two cash collected in total 940 the cash collected from year one is 600 000 and the cash collected from year two is 340 so now how much profit do I recognize well it's going to be 600 000 times year one gross profit 300 000 times year two gross profit this is how much it's going to be and we have two different gross profit now again what do I need to do I will need to back out I will need to the the back out the gross profit I need to back out from year two the gross profit in year two was I sold let's start from receivable let me show you how we compute how much do I need to back out because right now for year two right now if I don't back out anything in year two it would look something like this 416 in profit if I don't back out anything this is what it looks like and this is incorrect because sales minus cost of goods sold is gross profit but that gross profit is incorrect the only amount of cash I received for year two is 340 therefore the only profit and I can recognize from year two sales is 340 times 30.81 percent therefore whatever that number here this is the profit I need to recognize so I need to only keep from the 416 the profit that I find here so how do I do so I will take my let me go back here my sales which is 1 million 350 minus the cash that I received what's left times 0.3 which is let me do it let me do it step by step so I'm going to take 1 million 350 which is my account receivable minus 340 and this should be 1 million and 10,000 if my math is right should be 1 million and 10,000 now I'm going to multiply this amount by 30.81 and this is the amount I need to back out back out from the 416 and it happens to be 311 230 so let's take a look at the income statement we have sales 1 million 350 cost of sales 934 the gross profit right now is 416 well that 416 cannot stay because I did not receive the full amount in cash therefore I have to back out 311 230 and I showed you how did I came up with 311 230 here which is the account receivable times the gross profit percentage for year two therefore 416 minus 311 230 it's going to give me the gross profit I'm going to recognize in this year which is what basically it amounts to is the amount of cash I received for year two year two I received 340 and year two I received 340 times the gross profit percentage for year two then for year one then I'm going to add the gross profit I'm going to recognize from year one from year two I received 600,000 from year one this is year one receivable this is the year one I received 600 from year one and the gross profit for year one was 0.3571 so this amount times 0.3571 what let me do let me do the sorry let me do the percentage properly because that's not the correct percentage times 0.3571 and that's going to give me 214 285 and then the profit I would be recognizing for this year is those two numbers together which is 319 for the prior year my profit is only 142 857 so this is the profit I would recognize for year one this is the profit I recognize for year two notice in year two some cash is collected for year two and some cash is collected from year one they use two different percentages so this is how you would this is how you would solve a problem using the installment method the installment method is similar to the cash method it means you only recognize the profit as you do what receive the cash as you receive the cash you would apply the gross profit percentage at the same time any account any account receivable that's not collected yet you're going to have to create a deferred the third profit for that account and make sure the profit is is backed backed out out of account receivable as a deferred gross profit I hope this is helpful for explaining the installment sales method the installment sales method also is used in your tax course so you want to make sure you're comfortable with it what should you do now go to farhat lectures work mcq's look at additional information that's going to help you with the installment sales method good luck study hard and of course stay safe