Efficient and timely cash flow is imperative for every business to survive. Money is constantly needed by businesses to run their daily operations, service financing costs and undertake any growth plans. One of the biggest cash flow issues faced by businesses is collections of dues. Several vendors offer their customers a cash discount as an incentive to make timely payments. A cash discount is the price reduction offered to customers in exchange for early payment of the invoice. This discount is offered on the invoice value of the goods supplied.
This article looks at meaning of and differences between two methods of accounting for cash discount offered in the books of accounts of the seller or vendor – gross method and net method of cash discount.
Definitions and meanings
Gross method
Gross method of cash discount is the accounting method in which sales are accounted for at invoice value and cash discount is separately accounted for when availed by the customer.
In this method, vendor does not make the assumption that the customer will prepay and avail the cash discount. Multiple entries are made at different points of time in the transaction flow to account for sales and cash discount availed by the customer.
An example of the set of journal entries that are typically made in case of gross method of accounting for cash discount is detailed below:
Example of gross method:
The Abraham Inc. has sold goods of invoice value $10,000 to its customer Mr. John on 1 January 2020. The payment terms offered by Abraham Inc. is 3/10, n/30. This means that normal credit period is 30 days and cash discount of 3% is offered if payment is made within 10 days. The accounting entries to be recorded by Abraham Inc. are:
Recording of sales on January 1, 2020:
Accounts receivable (Mr. X) a/c 10,000 [Dr.]
Sales 10,000 [Cr.]
(Being sales to Mr. X recorded in the books)
If payment is made on January 8, 2020 (i.e., within 10 days):
Bank 9,700 [Dr.]
Cash discount 300 [Dr.]
Accounts receivable (Mr. X) a/c 10,000 [Cr.]
(Being payment received at 3% cash discount)
The cash discount is transferred to the profit and loss account as an expense.
In case payment is made on January 28, 2020 (i.e., after 10 days), cash discount cannot be availed. In such situation, the payment entry will be modified as follows:
Bank 10,000 [Dr.]
Accounts receivable (Mr. X) 10,000 [Cr.]
(Being payment received from customer X)
Net method
Net method of cash discount is the accounting method in which sales are accounted for assuming the cash discount will be availed by the customer. Sales under this method are thus not recorded at the full invoice value but at the reduced value after considering the effect of cash discount.
In this method, the vendor makes an assumption at the time of the sale itself that the customer will make a prepayment and thus avail of the cash discount.
Example of net method:
Continuing the same example as above, the set of journal entries that are typically made in case of net method of accounting for cash discount is given below:
Recording of sales January 1, 2020:
Accounts receivable (Mr. X) 9,700 [Dr.]
Sales 9,700 [Cr.]
(Being sales to Mr. X recorded on net basis considering cash discount of 3%)
If payment is made on January 8, 2020 (i.e., within 10 days):
Bank 9,700 [Dr.]
Accounts receivable (Mr. X) 9,700 [Cr.]
(Being payment received against outstanding of Mr. X)
In case payment is made on January 28, 2020 (i.e., after 10 days), cash discount cannot be availed. In such situation, a reversal entry for forfeiting the cash discount would be passed as follows:
Bank 10,000 [Dr.]
Accounts receivable (Mr. X) 9,700 [Cr.]
Cash discount forfeited 300 [Cr.]
(Being full payment received from customer X and cash discount forfeited)
The cash discount forfeited is transferred as other income to the profit and loss account.
Difference between gross method and net method of cash discount
The key points of difference between gross method and net method of cash discount have been detailed below:
1. Meaning
- Gross method of cash discount is a method of accounting for credit sales wherein sales are accounted for at gross value without assuming availing of cash discount by customers.
- Net method of cash discount is a method of accounting for credit sales wherein sales are accounted for at net value (invoice value less cash discount) assuming that cash discount will be availed by customers.
2. Assumption
- Gross method does not assume that the customer will make a prepayment and avail cash discount.
- Net method assumes prepayment by the customer and thus availing of the cash discount.
3. Amount at which sales are recorded
- Under gross method, sales are recorded at full invoice value without considering discount.
- Under net method, sales are recorded at value arrived at after reducing cash discount from invoice value.
4. Timing of entry for recording discount
- Under gross method, entry for cash discount is made when the customer avails it on prepayment. Cash discount is recorded separately as an expense.
- Under net method, no entry is made for cash discount separately. Cash discount forfeited would be recorded as an income in case cash discount is not availed.
5. Impact on profit and loss account
- Under gross method, the sales are recorded at full value and hence income is recorded at a higher value initially.
- Under net method, the sales are automatically recorded at a reduced value and hence the income reflects at a lower amount initially itself.
6. Accuracy
- Gross method is considered as a more accurate and complete way of recording credit sales as it follows the complete transaction flow.
- Net method on the other hand is considered less accurate as it may have an impact of understating income at the outset.
7. Effect if cash discount availed
- Under gross method, the discount entry will be recorded and an expense will be debited.
- No impact under net method, as discount is already considered. Hence only payment entry is recorded.
8. Effect if cash discount not availed
- Under gross method, there is no impact on accounting if cash discount is not availed.
- Under net method, an entry for forfeiting cash discount is recorded in this case which has the effect of increasing income.
Conclusion – gross method vs net method of cash discount:
The overall monetary impact on financials of the company remains the same under both these methods once the entire transaction flow from sales to payment is complete. The difference is primarily in timing of impact and disclosure in financial statements. This will particularly have impact when such sales transactions are recorded across financial statements.
