The area of discounts can cause some confusion for accounting students, in particular when it comes to discounts given for cash and trade discounts in general. In an earlier article, which you can find here, we look at trade discounts and the “interesting” fact that no accounting is normally made for. However, for today we are looking at when a business offers a discount for cash or early repayment of an account (often referred to as discount allowed) and what the appropriate journal entry is.
If one is in bit of hurry the quick answer is when the cash/payment is received the difference between the larger credit to accounts receivable and the smaller cash/payment debit is a a debit to the discount allowed expense account. If you would like more details, please read on.
Defining Discount Allowed
In the normal course of trade businesses will often offer discount for either cash or credit sales settled early; ie the customer pays the account before the due date. Although there is a cost to the business this expense helps them improve their liquidity, ie their access to cash, and solvency, ie their ability to meet their obligations – as they say, cash is king (or as our friend Dave Ramsey would say “debt is dumb, cash is king”).
What often can be a problem for business, in particular those in the small business enterprise (SME) group and those starting out, is access to cash. Profitability can be very good for those starting out, but what gets many otherwise profitable businesses is they run out of cash. Without access to money bills don’t get paid and creditors soon come knocking.
So offering discounts for customers to pay straight away or to pay their accounts can be seen as cost of financing short-term cash requirements.
Example Journal Entry of Discount Allowed
So let’s now turn to a couple of examples of discount being offered by a business – in our case it’s going to be our trusty ABC Ltd.
ABC Ltd offers discount on sales in two parts. First, if the customer pay cash at the point of sale they receives a 7 per cent discount on sale. Second, for credit sale customers if they pay their account within 5 days of the invoice being issued they receive a 7 per cent discount. Both of these we are going to look at now.
Discount Allowed for Cash Sale
On October 10 a customer, we’ll call him Brian, ordered top soil to be delivered to his home and paid cash for the order as he wanted to take advantage of the 5 per cent discount offered by ABC Ltd. Brian paid $465 in cash, discount included. So ABC’s accounting system would in effect make the following entry. The gross sale value is:
$465 / (1 – .07) = $500
The discount allowed was:
$500 (gross sale) – $475 (cash received) = $25
I know setting out the calculations like that above is a bit OTT, but setting out the steps in a simple case means in a more complex case you know how to get to the correct answer. So the debit of $475 shows the increase in cash received from the customer. The $500 credit shows our gross sales amount; which is how we normally record revenue information. Be very careful in accounting ever netting figures together. It causes two problems. First, it distorts the information provided to the user – which may or may not be material to them. And second, it can create real headaches trying to review/audit information.
So obviously the $35 debit is the discount allowed expense that ABC Ltd incurs in this transaction. We now move onto the discount allowed for early settlement of credit account.
Discount Allowed for Early Account Settlement
As mentioned above ABC Ltd offers a 5 per cent discount to credit customers for settlement of their accounts within seven days of receipt of the invoice. Let’s say Brian instead put the initial sale on account, which he then has 30 days to settle. However Brian, being the shrew chap that he is, decides to take advantage of the discount and so pays his $500 account within the seven day discount window.
Initially the accounting system would record the credit sale with the following entry:
|October 10||Accounts Receivable||500|
The system has recorded a debit to accounts receivable, reflecting the new current asset ABC has in the form of a debtor call Brian. And with the creation of the asset the credit to revenue reflects the economic benefits coming to ABC Ltd. So it is obvious that ABC is running a full accrual system with this entry as it is recording the movement of economic benefits and not just when cash is moving around.
Five days later Brian settles the account for $475. The ABC accounting system would make the following journal entry:
$475 / (1 – .05) = $500
$500 – $475 = $25
This is pretty much the same as the previous example, with the only difference being the credit is now to accounts receivable instead of sales.
And that brings us to the end of our accounting tutorial looking at the journal entry involved in accounting for discount allowed. The two entries will looked at are pretty much the same, it’s just which account the credit is going to be applied to. Remember to not get this confused with trade discounts, as we discussed here. If you are dealing with a trade discount, applied at the time of sale, there is no journal entry to record.