Discounts play a crucial role in business transactions, helping to attract customers, encourage early payments, and improve cash flow. In accounting, discounts are categorized as either discounts allowed (offered by a seller) or discounts received (received by a buyer). Understanding the differences and their accounting treatment ensures accurate financial reporting. This article explores the definitions, types, accounting entries, and examples of discounts allowed and discounts received.
1. Discounts Allowed
Definition
Discounts allowed refer to reductions in the invoice price given by a seller to customers. These discounts encourage prompt payment and build customer loyalty. Discounts allowed are recorded as an expense in the seller’s books.
Types of Discounts Allowed
- Trade Discount: A discount given to customers at the time of sale, usually based on bulk purchases or business relationships.
- Cash Discount: A discount offered to customers for making prompt payments within a specified period.
Accounting Treatment
A. Trade Discount
Trade discounts are deducted before recording the sale and do not appear in financial statements.
Example: A business sells goods worth $10,000 and offers a 10% trade discount.
Net Price = $10,000 – ($10,000 × 10%) = $9,000
Only $9,000 is recorded as revenue.
B. Cash Discount
Cash discounts are recorded as an expense in the profit and loss account.
Journal Entry for Discounts Allowed:
Debit: Discount Allowed (Expense)
Credit: Accounts Receivable
Example of Discounts Allowed
A customer owes $5,000 and is offered a 5% cash discount for early payment.
Discount = $5,000 × 5% = $250
Amount Paid = $5,000 – $250 = $4,750
Journal Entry (for Seller):
Debit: Cash $4,750
Debit: Discount Allowed $250
Credit: Accounts Receivable $5,000
2. Discounts Received
Definition
Discounts received refer to reductions in the amount payable by a business when purchasing goods or services. These discounts help businesses save costs and improve cash flow. Discounts received are recorded as income in the buyer’s books.
Types of Discounts Received
- Trade Discount: A reduction in the listed price of goods offered by the supplier to encourage bulk purchases.
- Cash Discount: A discount granted by the supplier when the buyer makes an early payment.
Accounting Treatment
A. Trade Discount
Trade discounts are deducted from the purchase price before recording the transaction and do not appear in financial statements.
Example: A business purchases goods worth $8,000 and receives a 5% trade discount.
Net Purchase Price = $8,000 – ($8,000 × 5%) = $7,600
Only $7,600 is recorded as the cost of purchases.
B. Cash Discount
Cash discounts received are recorded as income in the profit and loss account.
Journal Entry for Discounts Received:
Debit: Accounts Payable
Credit: Discount Received (Income)
Example of Discounts Received
A business purchases inventory worth $3,000 and is offered a 4% cash discount for early payment.
Discount = $3,000 × 4% = $120
Amount Paid = $3,000 – $120 = $2,880
Journal Entry (for Buyer):
Debit: Accounts Payable $3,000
Credit: Cash $2,880
Credit: Discount Received $120
3. Differences Between Discounts Allowed and Discounts Received
| Aspect | Discounts Allowed | Discounts Received |
|---|---|---|
| Definition | A reduction in price given by a seller to customers. | A reduction in price received by a buyer from suppliers. |
| Accounting Treatment | Recorded as an expense. | Recorded as income. |
| Journal Entry | Debit: Discount Allowed, Credit: Accounts Receivable. | Debit: Accounts Payable, Credit: Discount Received. |
| Impact on Financial Statements | Reduces revenue or increases expenses. | Reduces expenses or increases income. |
| Example | A store offers a 10% discount to customers for early payment. | A business receives a 5% discount from suppliers for early payment. |
4. Importance of Discounts in Business
A. Encourages Prompt Payment
Cash discounts encourage customers to make payments faster, improving cash flow.
B. Increases Sales
Trade discounts attract bulk buyers and increase revenue for sellers.
C. Cost Savings
Buyers benefit from discounts received, reducing overall purchasing costs.
D. Strengthens Business Relationships
Offering and receiving discounts fosters better relationships between businesses and customers or suppliers.
5. Common Mistakes in Handling Discounts
A. Recording Trade Discounts as Expenses or Income
Trade discounts should be deducted from the selling price and not recorded in financial statements.
B. Failing to Recognize Cash Discounts
Businesses should record cash discounts separately to reflect accurate income and expense balances.
Properly Managing Discounts for Financial Accuracy
Discounts allowed and discounts received are vital in business transactions. Sellers offer discounts to increase sales and improve cash flow, while buyers benefit from discounts to reduce costs. Proper accounting treatment ensures financial statements accurately reflect these transactions, supporting better decision-making and financial management.