No doubt, selling products and services is the mainstream of revenue for businesses of all sizes. These businesses allow their customers to avail of discounts if they make early payments or pay the full amount upfront.
Discounts allowed work like a charm in order to boost their sales, increase brand awareness, receive quick & early payments, boost reputation, boost customer loyalty and help to achieve a competitive edge over rivals.
However, it is also important for businesses to record it as a proper journal entry in the books of accounts to get a fair picture of sales. In this article, you will find all about discounts allowed in the world of accounting, how to pass its journal entries, and relevant examples.
By definition, a discount allowed is the reduction in the sale price of a good or service sold, allowed to the buyer by the seller.
It is an income to the buyer but an expense for the seller. Usually, sellers allow discounts on credit sales when payments are made early.
However, it is applicable in some other situations as well including making full payment up-front, buying goods in bulk, products bought during promotions, or if the seller is intentionally selling at a reduced price to eliminate old stock and make room for the new ones. Some important characteristics of discounts allowed include the following:
- It is offered to customers on early payments and recorded only at the time of recovery.
- Discounts allowed to facilitate working capital and work as a motivating factor to recover accounts receivables early.
- It is an expense for the seller.
Discounts allowed are often confused with discounts received. However, both are completely different subjects.
The primary difference is the role of the seller/company as a recipient or as a provider. As discount received is something the buyer asks for (concession) instead of the seller offering himself. Generally, discounts allowed are divided into two major categories:
- Trade Discounts
- Cash Discounts
A seller offers a trade discount also known as a functional discount with a reduction in price (invoice or catalog) to the reseller.
The reseller as the result resells to the end customer by charging the full amount to maximize profits Businesses usually offer trade discounts to make sales in bulk. It is the most common in B2B type of business. Let’s consider an example to further investigate this type of discount allowed.
Assume, Rob is a trader who sells furniture, particularly office furniture. Mr. John buys 15 office chairs from Rob on March 01, 2021.
The selling price of each chair is $100 with a credit period of 30 days. Rob offers a 10% discount as and 3% further if an immediate payment is made. In this case, the 10% discount being offered is a trade discount as the buyer is willing to buy chairs in bulk as we have discussed in the definition.
On the other hand, a cash discount also known as an early payment discount is an incentive for customers who make early payments or make full payments on the spot. The seller offers cash discounts for two reasons; first, he/she is in need of cash (cash shortage).
Secondly, to obtain immediate cash payment to avoid the efforts of billing. Let’s consider an example of a seller who offers a 5% discount on an invoice that is due in 30 days i.e. 5% 10/Net 30.
In case, the buyer pays the invoice within 10 days, he/she can avail of the discounts offered. Giving such discounts helps the seller to put the money back into the business as soon as possible to purchase more inventory and grow the business.
Cash discounts are usually a percentage of the invoiced amount but sometimes a stated fixed amount as well. However, in terms of cash discounts there is much variation and tend to be standardized as per the particular industry.
JOURNAL ENTRIES FOR DISCOUNTS ALLOWED
Companies can pass the journal entry for discount allowed by debiting the account receivable and cash accounts while crediting the discount allowed against it.
The cash account is being debited as the assets (actual payment received against the sales) of the company are increasing while the discount allowed is increasing as a result of an increase in expense (giving discount is actually bearing that part of the amount) and account receivable is representing the debtor’s account which is being credited as the decrease in the asset. It should look like the one below.
In the above journal entry, the discount allowed is representing a contra account for the sales. It will reduce both the net sales revenue on the profit and loss statement and total assets on the balance sheet by the amount equal to the discount allowed.
On the other hand, unlike cash discounts, we have to make an additional entry to record the actual sale of the product for trade discount in the books as below.
Example #1: Assume a company has received payment for the product sold for $5,000 on credit 2 weeks ago on 1st January 2020. On early payment by the customer, the company allows giving a 3% discount. Hence, the cash payment will be $4,850. Considering this scenario, the bookkeeper will make the following journal entry.
The above entry reveals the net balance of these sales is reduced by $150 as a result of the 3% discount that the customer has availed on early payment.
Example #2: Let’s assume, on 17th August 2021 Mr. Tim sells a cooler for $50,000 and offers to give 10% if the buyer purchases 2 coolers. He also agrees to give a 5% further discount in case of advance payment.
We can see this example incorporates both types of discounts allowed that we have discussed earlier. 10% is a trade discount to boost the sale and a further 5% to get quick payment from the buyer. In this scenario, the journal entry will be.
- To record the overall sales transaction
- To record trade discount entry
IMPACT OF DISCOUNT ALLOWED ON FINANCIAL STATEMENTS
As the profit and loss statement records incomes from other operating activities as well as all the indirect expenses of the company.
Similarly, the discounts allowed by the seller are a sacrificed income ultimately an expense, by the seller or the company but an incentive to the buyer for early payment. Hence, it affects the revenue and then net profits of the accounting period.
Therefore, discounts allowed are always recorded as a debit in the profit and loss statement. On the other hand, the discounts allowed do not have a direct impact on the balance sheet.
In case, a customer takes advantage of discounts if he/she is not eligible (does not meet the credit criteria) it will leave outstanding accounts receivables on the balance sheet and will then be treated as a bad debt.