Sales Discounts

Lesson:

They say that cash flow is king when running a business.

Having cash in one's hand eliminates the risk of non-payment or late payment.

Having cash in one's hand also allows one to pay off his own debts sooner and to enter into negotiations with a greater degree of bargaining strength.

Because cash is so important, many businesses will offer discounts to customers who pay early.

For instance, a company may bill a customer $500, but then promise to knock off 3% if payment is received within 5 days.

This is all well and good, but how should this practice be noted in a vendor's financials?

There are two accepted methods:

  • Gross Method - Record the sale as if no discount will be taken
  • Net Method - Record the sale as if a discount will be taken

The vendor will deal with a customer payment differently, depending upon which method has been chosen and whether the customer pays his bill early.

David Co., the profitable violin manufacturer, made a $131.00 sale under the following terms: 4/5, net 30 (4% discount if paid within 5 days, all payments due within 30 days).
Assuming that the customer does not pay early, what are the journal entries required for the sale and payment under the net method?

Answer:

  • The initial sale is recorded as follows:
    Accounts Receivable     $125.76    
         Sales Revenue     $125.76    


    The firm's records assumed an early payment, but there was no early payment:
    Cash     $131.00    
         Accounts Receivable     $125.76    
         Other Income     $5.24    

Explanation:

  1. Remember the formula for the potential discount.
    DOLLAR DISCOUNT = DISCOUNT PERCENT * GROSS COST
  2. Fill in the numbers
    $5.24 = 4% * 131.00
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