Accounting treatment for discount to customers for early payment (“cash discount”)

There are situations where you might be in need of cash or to simply motivate your customers to pay up quicker to have some buffer when it comes to more liquid resources, you’d implement something called a cash discount.

The way cash discount works is simple – there’s the expected payment deadline and in addition, if the customer pays earlier, say instead of the normal period that’s 14 days, they pay within 7 days, they get an additional discount of 5% (the discount rate here is entirely up to you, but keep in mind that on one hand it should not be significant so that it would hurt your profits and on the other hand it cannot be too small since it wouldn’t motivate any more). 

When it comes to accounting such discounts you should keep in mind that there’s no way of knowing how many and if any of your customers will actually use the discount. They may use it sometimes and not always. As such you ought to initially account for the sale in its gross amount and once the customer is eligible for the discount that is they did pay within the 7 days as in our example, you discount the receivable and the sales revenue similarly.

Say the sale itself is in the amount of 100 and the discount rate is 5%. Your initial entry is as follows:

Db Accounts receivable                 100

Cr Sales revenue               100

Now that your customer has paid up within the 7 days, they’ve paid the discounted amount which is 95. You’d account for the discount (and the payment as such) as follows:

Db Cash                               95

Db Sales revenue             5

Cr Accounts receivable   100