Which method is most likely used when a company offers customer discounts for prompt payment?

How to Account for Sales Discounts

A sales discount is a reduction in the price of a product or service that is offered by the seller, in exchange for early payment by the buyer. A sales discount may be offered when the seller is short of cash, or if it wants to reduce the recorded amount of its receivables outstanding for other reasons.

An example of a sales discount is for the buyer to take a 1% discount in exchange for paying within 10 days of the invoice date, rather than the normal 30 days (also noted on an invoice as "1% 10/ Net 30" terms). Another common sales discount is "2% 10/Net 30" terms, which allows a 2% discount for paying within 10 days of the invoice date, or paying in 30 days.

If a customer takes advantage of these terms and pays less than the full amount of an invoice, the seller records the discount as a debit to the sales discounts account and a credit to the accounts receivable account.

A company may choose to simply present its net sales in its income statement, rather than breaking out the gross sales and sales discounts separately. This is most common when the sales discount amount is so small that separate presentation does not yield any material additional information for readers.

Example of a Sales Discount

ABC International issues a $10,000 invoice to a customer that offers a 2% discount if the customer pays the invoice within 10 days. The customer does so, sending in a payment of $9,800.  ABC records the payment with this transaction:

If this billing were the only invoice issued by ABC during the reporting period, and if the customer paid within the reporting period, then the revenue section of ABC's income statement would look like this:

If the number of discounts taken by customers are few and the impact of these discounts on reported sales results are minimal, then the accounting treatment just noted is acceptable. However, what if many discounts are taken? You could have a situation where a company issues most of its invoices at the end of a month (a common scenario) and then customers take discounts in the following month, which reduces sales in a different period from the one in which the invoices were originally generated. This scenario does not pass the standard set by the matching principle, where all revenues and expenses associated with a transaction should be recognized within the same period.

If there is a risk that a large proportion of sales discounts will be recognized in a later period, create a sales discounts allowance account, in which you record an estimate of what the sales discounts will actually be in a later period. By doing so, you can immediately reduce sales by the amount of estimated discounts taken, thereby complying with the matching principle.

If ABC International were to use an allowance account to record the preceding transaction, the entry at the time when it issued the $10,000 would include the following:

Then, when the customer later paid the invoice, the entry would be:

Thus, the net effect of the allowance technique is to recognize the estimated amount of the discount at once and park that amount in an allowance account on the balance sheet. Then, when the customer actually takes the discount, you charge it against the allowance, thereby avoiding any further impact on the income statement in the later reporting period.

Most businesses do not offer early payment discounts, so there is no need to create an allowance for sales discounts.

Which of the following provides a means to both improve the efficiency of processing customer payments?

Which document is used to Authorise the release of merchandise from inventory control warehouse to shipping?

Which provides information for evaluating current credit policies and deciding whether to increase the credit limit for specific customers?

Which of the following activities is included in the open invoice method?