Businesses are both buyers and sellers. They need to buy supplies, raw materials, merchandise and equipment. They sell products that they buy or produce and services that they provide. Credit helps promote business activity by allowing businesses and customers to pay for purchases some time after the sale. The gross method is one way to account for payment of credit sales.
Credit terms have their own cryptic lingo. It’s a shorthand for expressing the discount the buyer receives for paying off purchases within a set period, as well as the ultimate due date. For example “2/10 net 30” states that you receive a 2 percent discount if you pay for your purchase within 10 days, but that in any event the cash is due within 30 days. In effect, you earn 2 percent interest for paying a bill 20 days before it is due. On an annualized basis, this amounts to 365 days divided by 20 days and multiplied by 2 percent, or 36 percent. Thus, a 2 percent cash discount might seem small but is actually quite generous.
A business that offers cash discounts on credit sales can use the gross method to account for those sale. Under this method, you do not assume your customer will take advantage of your discount offer. For example, suppose you sell original artwork to a home store for $500 on terms of 2/10 net 30. You record $500 as a debit to accounts receivable and a credit to sales. If the home store pays for the artwork within 10 days of the sale, enter a $500 credit to accounts receivable, a debit to cash of $490 and a debit to sales discounts of $10. The $10 sales discount is 2 percent of $500.
Suppose in this example you are the home store instead of the art dealer. Under the gross purchase method, you enter a $500 debit of purchases on the date of sale. You enter a credit for the same amount to accounts payable. If you pay the bill within 10 days, you debit accounts payable for $500, credit cash for $490 and credit purchase discounts for $10 days. If you wait 30 days to pay the bill, you debit accounts payable for $500 and credit cash for the same amount.
The net method assumes that the buyer will take advantage of the cash discount. In the example, the original entries to accounts payable or accounts receivable are for $490 instead of $500. If the purchaser declines the discount, the seller records a $10 credit to sales discounts forfeited, and the buyer books a $10 debit to purchase discounts lost when the payment occurs. The net method draws attention to discounts not taken and thus conveys a little more information than does the gross method.