Accounting is a system of rules and conventions that keeps track of business assets, liabilities, income, expenses and cash flow. It's also important to recognize revenue and associated expenses in the period when the revenue is incurred, which poses a challenge for long-term projects or high-priced sales made on credit. In these cases, sales are not recognized all at once, but in installments.
The installment method of accounting does not recognize revenue until cash is actually received for the product or service. Not only does the method provide a way to defer income and sales into the following tax year, but it also provides a way to defer taxes. The alternative to the installment method is referred to as the percentage of completion method, which recognizes revenue as the project or sale is completed.
Gross profit is the difference between sales and costs. The installment method defers gross profit into the following accounting period until cash is collected according to the terms of the original sales agreement. Because an installment sale is a promise of future payment, it is considered a receivables account. That is, it is a sale on credit until cash is received.
Because the project has not been completed, you will need to estimate the deferral. Use the historical gross profit percentage as a guideline for your estimation. First, calculate the gross profit percentage received on actual cash received. So, if you received $10,000 in cash and can associate $2,000 in costs to the project, your gross profit is $8,000. The percentage is calculated by dividing gross profit by the total cash received -- $8,000 divided by $10,000, or 80 percent. Second, multiply the amount owed on the installment by this percentage for an estimate of deferred gross profit.
When cash is received, the deferred account is actualized, which triggers a debit to the deferred gross profit account. You will not see the deferred gross profit account on the balance sheet because it is a contra-asset account -- the balance is contained within accounts receivable. When cash is received, debit deferred gross profit and credit realized gross profit. When you debit deferred gross profit and credit realized gross profit, it transfers the deferral from the balance sheet to the income statement. It is then actualized and recognized as net income.
