Accounting for Cash Discount on Sales

Cash discount is a discount on credit sales offered by the seller as an incentive for the customers to settle their payable earlier than the final due date. Credit sales often have stipulations such as final due date for payment e.g. 30 days, 60 days etc. However, in order to push the customers to pay earlier than the due date instead of delaying payment as much as possible, sellers often offer a discount if payment is made early e.g. within 10 days of the date of sale. Such a discount is called cash discount.

There is no point of a cash discount arising on cash sales because those are paid for in cash on the spot anyway. Therefore, cash discount is only offered on credit sales where the customers do not pay at the time of sale, but promise to pay within certain duration, as agreed in the contract of sale.

At the time of sale, it is not known whether the customer will pay earlier and avail the discount. A question therefore arises whether to record the sale net of the discount offered, or alternatively to record the sale at full amount and account for the discount as a separate expense.

Two methods of accounting for cash discounts from the perspective of the seller are:

1. Gross method, and
2. Net method.

These two methods are explained using the following example:

Example

Suppose Company A sells certain goods at a price of $4,400 with terms of payment of 2/10, n/20. These terms of payment mean two things. Firstly, the customer must pay within 20 days after the sale or, in other words, they have right to postpone the payment up to the 20th day after sale. Secondly, if the payment is made within 10 days, the customer will also be entitled to a 2% cash discount. Since most customers would rather benefit from the cash discount, such a practice encourages customers to pay early.

On a side note, in real world, the customer's decision to choose between the cash discount and retaining credit and paying later will depend upon whether the discount allowed is higher than the customer's cost of capital.

Now let us try to journalize the sale which offers a cash discount.

Since at the time of sale, it is not possible to know whether the customer will actually avail the discount, therefore Company A would choose either gross method or net method. Once one of the methods is selected, all sales must be recorded according to that method for consistency.

Gross method

According to the gross method, the company needs to initially record the sale at gross or full price of $4,400. The journal entry would be:

Subsequently, if the customer pays within 10 days, they would be entitled to avail the cash discount. The journal entry to record payment would be:

However, if the customer does not pay within 10 days, they would not be entitled to avail the cash discount and the journal entry to record the payment would simply be:

Net method

According to the net method, the company would initially record the sale at net price.

Net Price = Gross Price − Potential Cash Discount

Net Price = $4,400 − 88 = $4,312

For payment within 10 days:

For payment after 10 days:

by Irfanullah Jan, ACCA and last modified on Oct 25, 2020