How do you record cash discounts? Explanation and example

With an early payment discount, you encourage customers to pay outstanding amounts sooner by offering a price reduction for paying the invoice within a specific time frame. But how exactly do you record a discount? Which journal entries should be used, and what should be considered?

What is a cash discount?

A discount is a price reduction often granted by suppliers when buyers pay quickly. This allows the supplying company to receive their payment sooner, while buyers save a few dollars easily – a win-win situation. When recording a cash discount, the following points are important:

• Price reduction: A discount reduces the price
• Purchase costs: A discount lowers the purchase costs, especially for expensive items
• Sales tax: The sales tax is also reduced accordingly

How do I record a cash discount? An example

In a previous article, we discussed how to calculate cash discounts. This article explains that discounts are typically applied to the gross amount of the invoice. This reduces the net amount for the buyer, as well as the input tax (sales tax). The formula is:

• Cash discount = gross amount x cash discount rate
• Payment amount = gross amount - cash discount

Although discounts are reductions in purchase price and fall into the same category as rebates and allowances, they are usually treated differently in accounting. Since discounts are applied after invoicing, they must be recorded in the accounts, unlike reductions, for example. They must also be traceable in proper balance sheet accounting.

Calculate the gross cash discount

• 3% of $2,000 = $60

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

Calculate the net cash discount

If the price changes, it also affects the sales tax for both the buyer and the supplier since sales tax is based on the gross amount. To calculate the net cash discount, we subtract the sales tax from the gross discount amount. Let’s take Philadelphia as an example, which has a sales tax rate of 8%.

• $60 / 1.08 = $55.55 net cash discount

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

How to record a cash discount using two methods

If you, as the buyer, take advantage of a cash discount when paying for a purchase, both you and the supplier must record the cash discount as a reduction in the original invoice amount. This can be done using either the gross or net method. The entries look like this in our example:

Cash discount entries from the buyer

Gross entry method:

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

• Debits: $2,000
• Discount: $60
• Bank: $1,940

However, the input tax (sales tax) hasn’t been taken into account yet, so a second entry is needed:

• Discounts received: $4.45
• Input tax: $4.45

Net entry method:

With the net method, the net amount of the cash discount and the corresponding input tax are recorded at once, which makes it quicker. This method is more commonly used in practice:

• Debits: $2,000
• Discount: $55.55
• Input tax: $4.45
• Bank: $1,940

In the net method, the net amounts are recorded directly, unlike the gross entry method where two separate entries are made.

Cash discount entries from the seller

Gross entry method:

The seller records the full gross amount of the cash discount:

• Bank: $1,940
• Discount: $60
• Outstanding balance: $2,000

Again, input tax isn’t recorded yet, so an adjustment is necessary:

• Sales tax: $4.45
• Discount: $4.45

Net entry method:

With the net method, both the net cash discount and the corresponding input tax are recorded simultaneously:

• Bank: $1,940
• Cash discount: $55.55
• Sales tax: $4.45
• Outstanding balance: $2,000

As with the buyer’s net method, the net amounts are recorded directly.

Advantages and disadvantages of net or gross records

Both accounting methods for cash discounts are valid when it comes to US accounting practices. The method you choose depends on your preference and the nature of your business. Here’s an overview of the pros and cons of both methods:

Please refer to the legal disclaimer for this article.