Sales Discounts

Sales discounts are reductions in the amount a customer owes, offered by a seller as an incentive to pay an invoice before the normal due date. They are also called cash discounts or early payment discounts. The offer is written into the credit terms on the invoice, most commonly as 2/10, net 30, meaning the customer may deduct 2 percent if it pays within 10 days, and otherwise must pay the full amount within 30 days.

In the seller's books, discounts taken are recorded in a sales discounts account, a contra account to revenue with a debit balance that is subtracted from gross sales in arriving at net sales. The same event in the buyer's books is a purchase discount. Sales discounts differ from trade discounts, which are reductions from list price agreed before a sale and are never recorded separately.

An early payment discount speeds up cash collection, reduces the amount tied up in accounts receivable, lowers days sales outstanding and reduces the risk of bad debts. For the buyer, the discount is often very valuable. Skipping a 2/10, net 30 discount is equivalent to borrowing the money for 20 extra days at a high cost. The approximate annual rate is:

• $d$ is the discount rate as a decimal, here 0.02.
• $N$ is the full credit period in days, here 30.
• $D$ is the discount period in days, here 10.

For 2/10, net 30 this gives 0.02 divided by 0.98, times 365 divided by 20, or about 37.2 percent a year, far above most bank borrowing rates. That is why well-financed buyers usually take the discount, and why sellers treat the discount as a cost of faster cash flow. Modern dynamic discounting programs extend the idea by offering a sliding discount depending on how early an invoice is paid.

On 1 March a wholesaler sells goods for $20,000 on terms 2/10, net 30. Under the gross method, it records the sale at the full price: debit accounts receivable $20,000, credit sales $20,000.

• If the customer pays on 9 March, within the discount period, it pays $19,600. The wholesaler debits cash $19,600 and sales discounts $400, and credits accounts receivable $20,000.
• If the customer pays on 28 March, it pays the full $20,000, and the entry is simply a debit to cash and a credit to accounts receivable.

If the wholesaler had $1,500,000 of gross sales for the year, $30,000 of sales returns and allowances and $18,000 of sales discounts, net sales would be $1,452,000.

The gross method described above is the most common in practice. Under the net method, the seller records the sale at the discounted amount, $19,600 in the example, on the assumption that the customer will pay early; if the customer pays late, the extra $400 is recorded as sales discounts forfeited, a form of other income. The net method highlights lost discounts, which is more often useful on the purchasing side.

Under ASC 606 and IFRS 15, prompt payment discounts are a form of variable consideration. A seller that expects many customers to take the discount should estimate it and recognize revenue at the amount it expects to receive, rather than waiting for each payment. At the period end, a seller using the gross method may need an allowance for discounts expected on receivables still outstanding. Sales discounts are reported on the income statement as a deduction from sales, not as an operating expense, although some businesses include them in finance costs for internal reporting. Card-payment surcharges and discounts for paying by cash are a separate issue governed by card network rules and state law.