What it means
For non-finance managers, understanding the instalment method is vital when your company sells high-value items and offers buyer financing. Normally, businesses use accrual accounting, recording the whole sale and the associated tax the moment the contract is signed.
However, if the customer takes three years to pay, you might face a large tax bill before you have actually collected the cash, creating a cash flow crunch. The instalment method solves this timing mismatch.
It lets you spread your profit recognition and your tax liability across the periods when cash is actually received. Each time the customer makes a payment, a portion is treated as the original cost, a portion as profit, and a portion as interest.
You only pay tax on the profit portion collected in that specific accounting period. While helpful for cash flow, this method requires careful tracking.
Your finance team must maintain a schedule to monitor outstanding balances and calculate the exact taxable profit in each payment. It is worth noting that tax authorities often have strict rules about who can use this method, especially for inventory or certain types of property, so you should always check local regulations before applying it.
Imagine baking a large birthday cake and selling slices to a friend over several weeks. Instead of paying for the whole cake today, your friend pays for each slice as they eat it.
You only count the sale and pay tax on the slice as it is eaten, rather than for the whole cake on day one.
In practice
Real-world examples
Example 1
An interior design studio sells a commercial fit-out for $50,000. Instead of paying upfront, the client pays $10,000 per year for five years. The studio reports one fifth of its profit each year, so its tax bill follows the cash it actually receives.
Example 2
A boutique consultancy sells its proprietary software licence to a regional firm for $30,000, structured as six annual payments of $5,000 to ease the client's cash flow. If the licence has a 60% gross margin, the consultancy reports $3,000 of profit with each payment. The finance team keeps a simple schedule showing the balance still owed.
Example 3
A commercial kitchen supplier sells an industrial oven for $100,000 to a bakery start-up, agreeing to four yearly instalments of $25,000. With the oven costing the supplier $70,000, the gross profit percentage is 30%. Each year the supplier reports $7,500 of taxable profit, even though the full sale was agreed on day one.
Think of it
Imagine baking a large birthday cake and selling slices to a friend over several weeks. Instead of paying for the whole cake today, your friend pays for each slice as they eat it. You only count the sale and pay tax on the slice as it is eaten, rather than for the whole cake on day one.
Formula
Calculation
Gross Profit Percentage = (Gross Profit / Total Contract Price) x 100. Taxable Profit per Instalment = Cash Collected x Gross Profit Percentage.
Example: a contract is priced at $10,000 and the goods cost $6,000, so gross profit is $4,000 and the gross profit percentage is 40%. When the customer pays a $2,500 instalment, taxable profit is $2,500 x 0.40 = $1,000, and the other $1,500 is simply recovery of cost.
Check the full schedule: four instalments of $2,500 each produce $1,000 of profit, so the total is 4 x $1,000 = $4,000, which equals the gross profit on the sale. Any interest charged on the unpaid balance is a separate item and is taxed as interest income as it is earned.Case study
Seen in the real world
This is a fictional, illustrative scenario. Oakwood Office Solutions sold an ergonomic workstation package to a growing tech company for $50,000. The cost of goods sold for these workstations was $30,000, leaving a gross profit of $20,000, or 40%. Under the sales agreement, the tech company paid $10,000 per year for five years.
Without the instalment method, Oakwood would have had to report the entire $20,000 of profit in year one and pay tax on it immediately, despite holding only $10,000 of cash from the sale. Instead, Oakwood's finance manager used the instalment method. In year one, when the first $10,000 was collected, Oakwood reported $4,000 of taxable profit (40% of the cash received). The same calculation was repeated for the following four years.
This protected Oakwood from a severe cash flow shortage, allowing the company to pay its tax bill in step with the cash arriving in its bank account. Over the five years the taxable profit totalled 5 x $4,000 = $20,000, exactly the gross profit on the sale, so the method changed the timing of tax rather than the total. The finance manager kept a schedule recording the contract price, cost, gross profit percentage and cumulative cash collected, which made the annual tax return straightforward to prepare and easy for auditors to review.
Watch out
Common mistakes
- Assuming you can use this method for all types of sales, ignoring specific tax rules regarding inventory and marketable securities.
- Forgetting to calculate and report the interest component separately from the principal and profit portions of each payment.
- Failing to keep accurate, long-term tracking schedules, which leads to reconciliation errors across multiple financial years.
Questions
People also ask
Is the instalment method allowed for all businesses?
No. Tax authorities often restrict its use for certain items like inventory, publicly traded property, or sales at a loss.
Does this method reduce the total tax I will pay?
No, it does not reduce your total tax. It only delays when you pay it, matching the tax timing to when you actually collect the cash.
What happens if the customer defaults on a payment?
If a customer defaults, you may need to adjust your accounting records to write off the remaining balance and handle any repossessed assets.