A sales discount is a reduction in the price of a product or service that is offered by the seller, in exchange for early payment by the buyer. A sales discount may be offered when the seller is short of cash, or if it wants to reduce the recorded amount of its receivables outstanding for other reasons.
An example of a sales discount is for the buyer to take a 1% discount in exchange for paying within 10 days of the invoice date, rather than the normal 30 days (also noted on an invoice as "1% 10/ Net 30" terms). Another common sales discount is "2% 10/Net 30" terms, which allows a 2% discount for paying within 10 days of the invoice date, or paying in 30 days.
If a customer takes advantage of these terms and pays less than the full amount of the invoice, the seller records the discount as a debit to the sales discounts account and a credit to the accounts receivable account. The sales discounts account appears in the income statement and is a contra revenue account, which means that it offsets gross sales, resulting in a net sales figure. The presentation of a sales discount in the income statement is:
|Less: sales discounts||(xxx,xxx)|
For example, ABC International issues a $10,000 invoice to a customer that offers a 2% discount if the customer pays the invoice within 10 days. The customer does so, sending in a payment of $9,800. ABC records the payment with this transaction:
If this billing were the only invoice issued by ABC during the reporting period, and if the customer paid within the reporting period, then the revenue section of ABC's income statement would look like this:
|Less: sales discounts||(200)|
If the number of discounts taken by customers are few and the impact of these discounts on reported sales results are minimal, then the accounting treatment just noted is acceptable. However, what if many discounts are taken? You could have a situation where a company issues most of its invoices at the end of a month (a common scenario) and then customers take discounts in the following month, which reduces sales in a different period from the one in which the invoices were originally generated. This scenario does not pass the matching principle, where all revenues and expenses associated with a transaction should be recognized within the same period.
If there is a risk that a large proportion of sales discounts will be recognized in a later period, then create a sales discounts allowance account, in which you record an estimate of what the sales discounts will actually be in a later period. By doing so, you can immediately reduce sales by the amount of estimated discounts taken, thereby complying with the matching principle.
If ABC International were to use an allowance account to record the preceding transaction, the entry at the time when it issued the $10,000 would include the following:
|Allowance for sales discounts||200|
Then, when the customer later paid the invoice, the entry would be:
|Allowance for sales discounts
Thus, the net effect of the allowance technique is to recognize the estimated amount of the discount at once and park that amount in an allowance account on the balance sheet. Then, when the customer actually takes the discount, you charge it against the allowance, thereby avoiding any further impact on the income statement in the later accounting period.
Most business do not offer early payment discounts, so there is no need to create an allowance for sales discounts.