How Do You Account for a Sales Discount
Sales discounts are typically accounted for in two main ways: the gross method and the net method. These methods handle discounts differently, and the choice between them can affect how a company records sales, accounts receivable, and cash flow.
1. Gross Method:
Under the gross method, sales and accounts receivable are recorded at the full sales price, and sales discounts are accounted for when they are taken. This method treats sales discounts as a separate account.
Here’s an example:
A company sells goods for $1,000 with terms 2/10, n/30, which means the customer can take a 2% discount ($20) if they pay within 10 days; otherwise, the full amount is due in 30 days.
At the time of sale, the entry would be:
Debit Accounts Receivable $1,000
Credit Sales Revenue $1,000
If the customer takes the discount and pays within 10 days, the entries would be:
Debit Cash $980
Debit Sales Discounts $20
Credit Accounts Receivable $1,000
2. Net Method:
Under the net method, sales and accounts receivable are recorded at the net amount after discount. If customers fail to take the sales discount, the missed discount is reported as interest revenue or sales discount forfeited.
Using the same example as above, under the net method, at the time of sale, the entry would be:
Debit Accounts Receivable $980 (=$1,000 – $20)
Credit Sales Revenue $980
If the customer takes the discount and pays within 10 days, the entries would be:
Debit Cash $980
Credit Accounts Receivable $980
If the customer does not take the discount and pays the full price at 30 days, the entries would be:
Debit Cash $1,000
Credit Accounts Receivable $980
Credit Interest Revenue (or Sales Discounts Forfeited) $20
Under both methods, sales discounts are treated as a contra-revenue account, which means they are deducted from gross sales to arrive at net sales.
The choice between these two methods does not change the company’s cash flows; it only affects the timing of revenue and expense recognition. Companies should choose the method that best reflects the substance of their transactions and provides the most useful information to users of their financial statements.
Example of How to Account for a Sales Discount
Let’s work with a scenario.
Example using the Gross Method:
A company, XYZ Corp., sells products worth $1,000 on terms 2/10, n/30, meaning the buyer can get a 2% discount if they pay within 10 days, or else the full amount is due in 30 days.
Initially, XYZ Corp. would record the total sales revenue:
Debit: Accounts Receivable $1,000
Credit: Sales Revenue $1,000
If the customer pays within 10 days and takes the discount, the following entries will be made:
Debit: Cash $980 (1000-2%*1000)
Debit: Sales Discounts $20 (2%*1000)
Credit: Accounts Receivable $1,000
The sales discount of $20 is recorded as a contra revenue account which reduces the total sales revenue.
Example using the Net Method:
Using the same initial conditions, under the net method, XYZ Corp. would record the potential revenue after discount:
Debit: Accounts Receivable $980 (1000-2%*1000)
Credit: Sales Revenue $980
If the customer pays within 10 days and takes the discount, the following entries will be made:
Debit: Cash $980
Credit: Accounts Receivable $980
But, if the customer does not take the discount and pays the full price at 30 days, the entries would be:
Debit: Cash $1,000
Credit: Accounts Receivable $980
Credit: Interest Revenue (or Sales Discounts Forfeited) $20
So, under the net method, the company initially assumes the customer will take the discount, and if the discount is not taken, it is considered as interest revenue or sales discount forfeited.
