June 22, 2021

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Calculating cash discount and its double-entry principle

Calculating cash discount and its double-entry principle
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A cash discount is a separate type of price reduction. It is different from the trade discount. While trade discount is not recorded in the accounting records of a business, its counterpart forms part of it and maybe an income or expense to the business. In this article, we will briefly define this term, illustrate how it is calculated, and show how to record it in the books of account of the business by applying a double-entry principle.

What is a cash discount?

A cash discount is a price reduction given by a seller to his or her customers to encourage prompt payment for goods or services.

Explanations

It is usually given out as a percentage. Many entities give cash discounts to avoid the stress of requesting payment of goods sold on credit.

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It is mostly stated in an invoice. For example, it may be stated as 5/15 net 30. What this means is that the seller will give the buyer a 5 percent reduction if the buyer pays within 15 days. Further, the net 30 means the number of days the buyer is allowed credit. In this case, 30 days.

If the buyer pays on or before the 15 days, he earned a price reduction of 5%. Assuming, the buyer will pay 50,000 Naira for the goods, then he will enjoy 2,500 Naira off the selling price. He is expected to pay the balance of 47,500 Naira.

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It can either be a discount received or allowed. In the above illustration, to the seller, the cash discount is a discount allowed. But, the buyer will see it as a discount received.

If an entity is known as ABC, purchases goods on credit and pays for them later to earn a cash discount, it implies that the business has received a cash discount.

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Moreover, if ABC sold goods to a client and issued a cash discount, this is referred to as a discount allowed.

In summary, both discounts can be explained as follows.

Sales involve discount allowed

Purchases involve discount received

Discount allowed is an expense to the business and discount received is an income to the business.

How to calculate cash discount

The manner of calculating the cash discount is similar to a trade discount. To illustrate, a cash discount of 2 percent is given on goods sold at 12,000 Naira. The cash discount is 240 Naira. That is 2 × 12,000 ÷ 100.

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If it is 5 percent on goods worth 22,000 Naira, the price reduction is 1,100 Naira (that is, 5 × 22,000 ÷ 100). Please, use a calculator to solve it.

The double entry

Unlike trade discounts, cash discounts are recorded in the books of accounts of a business. Also, it has a relationship with purchases and sales. When there is a sale, there will be a discount allowed. While the purchase of goods will lead to a discount received.

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1. When a sale of a good is made on credit

Debit: Account Receivables
Credit: Sales Account

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When the client pays for the goods and price reduction is given

Debit: Cash/Bank Account (with the net amount)
Debit: Discount allowed Account (with the discount)
Credit: Account Receivables (with the total amount)

When the client pays for the goods and no cash discount is given

Debit: Cash/Bank Account
Credit: Account Receivables

2. When goods are purchased on credit

Debit: Purchases Account
Credit: Account Payables

When payment is made and cash discount is given

Debit: Account Payables
Credit: Cash/Bank Account
Credit: Discount Received Account

When payment is made and no price reduction is given

Debit: Account Payables
Credit: Cash/Bank Account

A worked example

John purchases and sells his goods on credit. The following information relates to the week ending the 8th of April.

Calculating cash discount and its double-entry principle

John received a 2% price reduction from his suppliers and gives out a 2.5% cash discount to his customers if cash is paid within a week. Assumed that John and his customers take advantage of the price reduction.

Therefore, Goods purchased on April 7 and April 4 were settled by cash, and a cash discount of 2% was received from the suppliers on April 9.

And his customers for April 1, April 2, and April 3 paid him on April 9 to enjoy a cash discount of 2.5 percent.

1. Calculate the total discount allowed and discount received.

2. And show the double entry to record the above information in the books of account of John.

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Solution

1. The table below shows the cash discount computation. John and his customers pay the rebate on April 9. And it’s calculated on that date. Examples of how to calculate cash discounts are already shown above.

Calculating cash discount and its double-entry principle

2. Here are the double entries for purchases, sales, and cash discounts.

When the goods were purchased, debit: Purchases A/c and credit: A/c payable.

Cash is paid and reduction in price is given as shown in the table, debit: cash a/c credit: A/C Payables and discount received

Calculating cash discount and its double-entry principle

3. For sales of goods, the double-entry is already explained, but for emphasis sake. When the goods were sold debit: A/C Receivables credit: sales A/c

When the customers made a payment on April 9, debit: Cash A/C and Discount allowed a/c credit: A/c Receivables. This is illustrated in the table below.

Calculating cash discount and its double-entry principle

Calculating cash discount and its double-entry principle

In conclusion, a cash discount is of advantage to the businesses and their customers. Customers can utilize it when it buys goods now and pay a lower price for the goods later on. Also, it applies when goods are sold or purchased on credit.

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