The area of discounts can cause some confusion for accounting students, particularly when it comes to discounts given for cash and trade discounts in general. In an earlier article, which you can find here, we looked at trade discounts and the fact that, typically, no accounting entry is made. However, 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 a bit of a hurry, the quick answer is when the cash/payment has been received, the difference between the larger credit to accounts receivable, and the smaller cash/payment debit, is a debit to the discount allowed expense account. If you would like more details, please read on.
Defining Discount Allowed
In the ordinary course of trade, businesses will often offer discounts for either cash or credit sales settled early, i.e. the customer pays the account before the due date. Although there is a cost to the business, this expense helps them improve their liquidity (access to cash). At the same time, discounts can also help with business solvency (the ability to meet current obligations). In these cases, cash is indeed king (or as our friend Dave Ramsey would say, “debt is dumb, cash is king”).
What often can be a problem for businesses, particularly those in the small business enterprise (SME) group and those starting, is access to cash. Profitability can be very good for new businesses, but what gets many of them is running 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 early can be seen as a cost of financing short-term cash requirements.
Example Journal Entry of Discount Allowed
So let’s now turn to a couple of examples of discounts being offered by a business – in our case, it will be our trusty ABC Ltd.
ABC Ltd offers discounts on sales in two parts. First, if the customer pays cash at the point of purchase, they receive a 7 per cent discount on their purchase. Second, for credit sale customers, if they pay their account within five days of invoice issue, 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 Brian, ordered topsoil 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 that you know how to get to the correct answer in a more complex case. 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 usually 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.
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, being the wise chap he is, Brian decides to take advantage of the discount and 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 asset creation, the revenue credit reflects the economic benefits coming to ABC Ltd. So it is evident that ABC is running an 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 journal entry is 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 journal entries are similar; it’s just which account the credit is applied to. Remember not to 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.