The Net Method of Accounting for Sales Discounts

A business can adopt a number of different measures to spur sales. Advertising and promotions help bring customers to your door. To cement the sale, you can offer sales discounts that reward customers who pay their bills promptly. The net method is one way to account for sales discounts.

You express sales discounts in a shorthand lingo that conveys a lot of information in a few words. For example “2/10 net 30” may look strange, but it simply means that you’ll reduce the purchase price by 2 percent if the customer pays the bill within 10 days. In any event, the customer must pay up within 30 days. In this case, the sales discount is 2 percent. The discount applies to credit sales you carry in your accounts receivable.

Net price is the gross price of goods or services sold minus the potential discount. For example, if you sell an appliance for $1,000 with terms of 2/10 net 30, you are offering to reduce the purchase price by $20 if the customer pays cash within 10 days. The net price is $980. After the 10th day, the price reverts to $1,000 and the customer is expected to pay this amount by the 30th day following the sale. If the customer doesn’t pay on time, you might revoke credit privileges, charge a late fee or turn the bill over to a collection agency.

In the net sales method, you book the original sale at the discounted price. For example, you record your appliance sale with a $980 debit to accounts receivable and a credit to sales revenues for the same amount. Should the customer pay within the discount period, debit cash and credit accounts receivable by $980. If the customer skips the discount, record the lost discount separately. In this example, make entries when you receive payment consisting of a debit to cash of $1,000, a credit to accounts receivable for $980 and a $20 credit to “sales discounts forfeited,” a revenue account that follows the sales revenue line on the income statement.

Conceptually, the net discount method treats the discounted price as the “real” price and the discount amount as interest on the delayed payment. For example, the appliance buyer saves $20 by paying the bill 20 days before it is due. While 2 percent might not seem like a motivating inducement, consider the annual effect. The buyer is "investing" $20 for 20 days at a rate of 2.04 percent, which is $20 divided by $980. To annualize this rate, multiply 2.04 percent by 365 days divided by 20 days. This works out to a whopping 37.23 percent annual rate, quite a handsome return. You might want to do the math for your credit customers so that they understand the benefit of paying within the discount period.