Normally, a seller must deliver a completed product before he can recognize revenue on a sale. However, this creates challenges for companies that perform a large project or are party to a contract that spans several years. Generally accepted accounting principles, or GAAP, allow sellers to recognize profit from multiyear projects over time using the installment sales method. To calculate realized gross profit under the installment method, you must first calculate the accounts receivable balance, the gross profit percentage and the deferred gross profit.
Record installment sales as accounts receivable and mark them as such. Because the revenue on installment sales is treated differently from other types of revenue, include the words "installment sale" in the account name. Record the value of the accounts receivable as the initial selling price of the project. For example, if a company agreed to construct a bridge over three years and priced the project at $500,000, the receivable equals $500,000.
Calculate the gross profit percentage on the project. Gross profit percentage equals the total profit from the project divided by the project sales price. For example, say the bridge that a company is charging $500,000 to build will cost the company $300,000 to complete. The gross profit on the project is $500,000 minus $300,000, or $200,000. The gross profit percentage is $200,000 divided by $500,000, or 40 percent.
Calculate deferred gross profit and record it on the balance sheet as a contra-asset to accounts receivable. To calculate deferred gross profit, multiply the installment receivable balance by the gross profit percentage. For example, say the company has only collected $140,000 for a project priced at $500,000. The installment receivable balance is $500,000 minus $140,000, or $360,000. Deferred gross profit is $360,000 multiplied by 0.4, or $144,000. Record this $144,000 as a reduction to accounts receivable. For example, if total accounts receivable is $700,000 and deferred gross profit is $144,000, net accounts receivable is $556,000.
Calculate realized gross profit for the year and record it on the income statement as "Realized gross profit on installment sales." Realized gross profit under the installment sales method equals the amount of cash collected multiplied by the gross profit percentage. For example, say that the business collects $140,000 in cash from the customer the first year and the gross profit rate is 40 percent. The realized gross profit is $140,000 multiplied by 0.4, or $5,600. Reduce the deferred gross profit account by the amount of gross profit realized. For example, if the deferred gross profit account was $144,000, it's now reduced by $5,600 and equals $138,400.