Recording a cash discount: how does it work?

A cash discount is a discount that vendors grant their customers. Every entrepreneur is interested in their customers settling their invoices as soon as possible. With a cash discount, you can get customers to pay outstanding amounts early, by offering a certain percentage off the total price for early payments. For example, you offer a discount of X percent of the invoice amount for paying the invoice within a certain period of time. But then how do your record this in your accounting journal? Which booking records are used, and what has to be taken into consideration?

Recording a cash discount – a quick introduction

Discounts are popular with suppliers and buyers. The selling company can get their invoice settled quickly, and buyers save a few dollars without much effort - a win-win situation. First of all, there are a few things to consider when recording cash discounts:

  • A cash discount is a discount on the product sold
  • Discounts reduce acquisition costs: This is particularly noticeable with high-priced purchases.
  • Input tax is also affected, and decreased.

How do I record a cash discount?

In a previous article, we looked at how to calculate discounts. The article explains how discounts always refer to the gross amount of the invoice. This not only reduces the net amount for the payer, but also the input tax. The formula is:

Cash discount = gross amount x cash discount rate

Payment amount = gross amount - cash discount

Although discounts are purchase price reductions, and therefore fall into the same category as bonuses and reductions, they are usually handled differently in accounting terms. Since discounts are claimed and granted after invoicing, they must also be recorded in the accounts, unlike reductions, for example. They must be traceable in a proper balance sheet accounting.

An example for how to record a cash discount

What does a classic cash discount record look like? For many, the theory may be a little abstract. If a buyer pays with cash discount, then this must be traceable in a transparent accounting record, showing the cash discount at the buyer’s end as well as at the supplier.

A new sofa for your office

Suppose you buy a new sofa for $2,000 dollars for your office. The seller will grant you a discount of 3 percent if you pay the invoice within 14 days.

Calculate gross cash discount

3 percent of $2,000 dollars =$60 dollars

The gross cash discount amount is $60 dollars. After deducting this amount, you only pay $1,940 dollars instead of $2,000 dollars, and your supplier only receives this amount instead of the original invoice amount.

Calculate net cash discount

If the price of an order changes, this automatically also affects the sales tax, both at the supplier and at the buyer ends - because sales tax is included in the gross amount. To obtain the net cash discount, we can now calculate the sales tax from the gross cash discount amount. Let’s take Philadelphia as an example, which has a sales tax rate of 8%.

$60 dollars / 1.08 = $55.55 dollars net cash discount

The cash discount amount of $60 dollars therefore contains $4.45 dollars in sales tax.

Recording a cash discount: the two methods

If, as a buyer, you make use of a cash discount when paying for a purchase, both you and your supplier must post the cash discount amount as a discount on the original invoice amount. This can be done either with a gross or  net posting. The different bookings look like this in our example:

Cash discount records from the buyer

Gross entry method

Here the buyer records the full gross amount of the cash discount:

Debts

 

$2,000 Dollars

 

Discount

$60 Dollars

 

Bank

$1,940 Dollars

However, input tax has not yet been taken into account. Therefore, an adjustment posting is required as the second posting:

Discounts received

 

$4.45 Dollars

 

Input tax

$4.45 Dollars

Net entry method

With this method, the net amount of the cash discount and the corresponding input tax are recorded at once, and because it takes less time overall, this type of cash discount posting is used much more frequently in practice.

Debts

 

$2,000 Dollars

 

Discount

$55.55 Dollars

 

Input tax

$4.45 Dollars

 

Bank

$1,940 Dollars

In the net recording method, the net accounts are recorded directly, rather than in stages as with the gross entry method.

Cash discount records from the seller

Gross entry method

The vendor posts the full gross amount of the cash discount here:

Bank

 

$1,940 Dollars

Discount

 

$60 Dollars

 

outstanding

$2,000 Dollars

Input tax is also not yet taken into account here. Therefore, an adjustment record is necessary:

Sales tax

 

$4,45 Dollars

 

discount

$4,45 Dollars

Net entry method

With this method, the net amount of the cash discount and the corresponding input tax are recorded simultaneously (this type of cash discount posting is used much more frequently in practice).

Bank

 

$1,940 Dollars

Cash discount

 

$55.55 Dollars

Sales tax

 

$4.45 Dollars

 

outstanding

$2,000 Dollars

Here too, the net accounts are recorded directly and are not recorded in stages.

Net or gross records: advantages and disadvantages at a glance

Both accounting records for cash discounts work well, and are correct in accounting practice. Which method for recording cash discounts depends on what works best for you. Here is an overview of the pros and cons of both booking types:

Method

Pros

Cons

Gross

Clear records, because the tax adjustment is entered in a separate posting.

The gross recording method involves more effort because two postings are necessary.

Net

Only one booking is necessary - for this reason the net booking is more popular.

Records are not as clear,because the gross amounts of the cash discount are not directly visible, and are not collected in a separate account.

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