When a business sells goods on credit to a customer the terms will stipulate the date on which the amount outstanding is to be paid. In addition the terms will often allow a sales discount to be taken if the invoice is settled at an earlier date.
The sales discount is based on the sales price of the goods and is sometimes referred to as a cash discount on sales, settlement discount, or discount allowed.
Sales Discount Example
For example, if a business sells goods to the value of 2,000 on 2.5/10, n/30 terms, it means that the full amount is due within 30 days but a 2.5% sales discount can be taken if payment is made within 10 days. The sales discount in this example is calculated as follows.
Sales price = 2,000 Sales discount % = 2.5% Sales discount = Sales price x Discount % Sales discount = 2,000 x 2.5% = 50 Amount to pay = Sales price - Sales discounts Amount to pay = 2,000 - 50 = 1,950
If the customer pays within 10 days then a 2.5% sales discount amounting to 50 can be deducted from the sales invoice, and the customer will pay only 1,950 to settle the account.
Sales Discount Journal Entry
Accounting for sales discounts requires two journal entries.
Sales Invoice Posted
At the date of sale the business does not know whether the customer will settle the outstanding amount early and take the sales discounts or simply pay the full amount on the due date. In these circumstances the business needs to record the full amount of the sale when invoiced and ignore any discount offered in the sale terms.
The journal to record the sale is as follows.
The full amount owed by the customer is shown as a balance sheet asset (accounts receivable) and included as revenue in the income statement. This transaction is more fully explained in our sales on account example.
Sales Discount Taken
If the customer pays within the 10 days and takes the sales discount of 50, then the business will only receive cash of 1,950 and accounts for the difference with the following sales discounts journal entry.
The business receives cash of 1,950 and records a sales discount of 50 to clear the customers accounts receivable account of 2,000.
The sales discount normal balance is a debit, a cost to the business. The discount is recorded in a contra revenue account which is offset against the revenue account in the income statement.
|Sales discounts||– 50|
Sales Discount Not Taken
If the customer does not pay within the discount period and does not take the sales discount the business will receive the full invoice amount of 2,000 and the discount is ignored.
In this instance the accounts receivable is cleared by the receipt of cash and no sales discount is recorded.
Advantages and Disadvantages
The purpose of a business offering sales discounts is to encourage the customer to settle their account earlier (10 days instead of 30 days in the above example). By receiving payment earlier the business now has use of the cash for an extra 20 days and reduces the chances that the customer will eventually default.
The downside of offering a discount is that the business now has an extra cost. If we use the example above, the cost to the business of receiving 1,950 20 days earlier than expected was the sales discount of 50. The ‘interest rate’ for the 20 days is calculated as follows.
Interest rate for 20 days = Interest / Principal Principal = 1,950 (amount received from customer) Interest = 50 (discount offered) Term = 20 days (normal terms - discount terms) Interest rate for 20 days = 50 / 1,950 = 2.56%
This is the rate for the use of the funds for 20 days, to convert this to an annual percentage rate (APR) we simply divide by 20 to convert it to a daily rate, and then multiply by 365.
Interest rate for 20 days = 2.56% Daily interest rate = 2.56% / 20 Annual interest rate = (2.56% / 20) x 365 Annual interest rate = 46.72%
It effectively costs the business 46.72% to offer sales discounts to the customer. Due to its high cost, it can be seen that sales discounts should be offered sparingly.
From the customers point of view, the benefit of paying early is that they get cheaper prices for the goods they purchase. Providing they have the funds or can borrow at a rate cheaper than 46.72% (in the above example), the customer is better off borrowing and taking the discount.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.