Discounts and sales returns

Subsequent measurement of accounts receivables

The subsequent measurement topics of accounts receivables relevant for the CMA exam can be discussed in the context of:

1. Trade discounts and cash discounts
2. Sales returns
3. Allowance for credit losses

These requirements allow companies to record the accounts receivable at the net amounts expected to be received and not simply the face value of the transaction price when preparing the balance sheet. Expected sales returns are the exception in how they are shown: they reduce revenue, but they are recorded as a separate refund liability rather than as a reduction of receivables.

This chapter covers discounts and sales returns; the allowance for credit losses - which addresses the risk that customers simply won’t pay, rounding out the net-realizable-value picture - is covered in detail in the next chapter, Allowance for credit losses: Journal entries.

Trade discounts

Trade discounts do not have subsequent measurement issues because the sales price after the application of the trade discounts becomes the transaction price. The list price becomes irrelevant for subsequent accounting purposes.

Cash discounts

The subsequent accounting for cash discounts related to the collection of the accounts receivables has already been covered in the discussion about the initial recognition. However, aside from that, there are certain subsequent measurement issues relevant for each method.

Subsequent measurement of cash discount: gross method

In the initial recognition discussion, the journal entries are simplified to show the impacts of taking the discount when the accounts receivable was initially recorded at gross.

Under the gross method, since the accounts receivables at year-end are recorded gross, revenue recognition rules (ASC 606 treats expected discounts as variable consideration) require companies to determine an estimate of discounts that the customers are expected to take in the future. This is relevant especially when the amount of discounts expected to be taken in the future is material since it means that there is risk that the accounts receivable are over-stated in the balance sheet.

By setting up an account called allowance for cash discounts, which is a contra-asset account in the balance sheet that decreases the amount of accounts receivables, the company is able to present the accounts receivables in the net amounts expected to be received. For example, assume a company records a $10,000 credit sale with terms 2/10, n/30 (a 2% discount if paid within 10 days) and estimates that the customer will take the full $200 discount ($2\%\times \$10,000$). The journal entry can be recorded as follows:

Account	Debit	Credit	Financial statement element
Cash discounts allowed	$200		Revenue (contra account)
Allowance for cash discounts		$200	Asset (contra account)
To record the cash discounts expected for the current sales

Definitions

Contra-revenue account

An account whose normal balance is a debit instead of a credit. It reduces total revenue on the income statement - here, “cash discounts allowed” reduces the $10,000 of gross sales.

Contra-asset account

An account whose normal balance is a credit instead of a debit. It reduces the related asset on the balance sheet - here, “allowance for cash discounts” reduces gross accounts receivable.

The ending balance of the “allowance for cash discounts” account in the balance sheet should be the total amount of cash discounts that the company is expected to grant to the customers for sales already recorded at gross.

The company should exercise judgment in determining this amount. The process of computing this expectation is the same as the concept of the allowance for credit losses covered in the next chapter.

In the case above, if the amounts was unpaid at year-end, the balance of the accounts receivable in the balance sheet will be presented as follows:

Accounts receivable, gross	10,000
Allowance for cash discounts	($200)
Accounts receivable, net	$9,800

As you can see, the allowance method ensures that for accounts receivables that are unpaid as at year-end, an allowance account is still set-up to ensure that the assets are not overstated. Alternatively, if the balance was paid before year-end, the following journal entry applies.

Account	Debit	Credit	Financial statement element
Cash	$9,800		Asset
Allowance for cash discounts	$200		Asset (contra account)
Accounts receivable		$10,000	Asset
To record the receipt of cash within the discount period

The whole balance of the accounts receivable from the transaction is removed from the balance sheet upon payment.

As shown above, when using an allowance account for cash discounts, every time a discount is taken, it is debited to the allowance account instead of the contra-revenue account. The contra-revenue account of “cash discounts allowed” is only used during the process of estimation.

Subsequent measurement of cash discount: net method

Under the net method, the subsequent measurement issue is on the discount periods elapsed. The risk under the net method is that every balance sheet date, the accounts receivable and the revenue may be understated because some of the discounts netted off in the initial recognition have already elapsed and will never be taken anymore.

To adjust for the elapsed discounts, the following entry is needed:

Account	Debit	Credit	Financial statement element
Accounts receivable	$200		Asset
Discounts forfeited		$200	Revenue (other income)
To record forfeited discounts on the same $10,000 receivable with terms 2/10, n/30

This entry has an impact of restoring the accounts receivable to the original transaction price for the unpaid accounts receivable with which the discounts have also elapsed.

Then during the subsequent period, when the receivable is collected, the journal entry is simply:

Account	Debit	Credit	Financial statement element
Cash	$10,000		Asset
Accounts receivable		$10,000	Asset
To record collections of accounts receivables

Since the discounts were already reversed, the entry is a simple collection of the gross value of the accounts receivable.

The reason why this method is not commonly used in practice is because for large companies, determining the elapsed discount periods for each specific sales contract can be tedious, while the gross method allows the company to simply estimate the value of the discounts to be taken in the future.

Watch out: The gross and net methods create opposite risks at year-end. The gross method initially records accounts receivable and revenue at the full invoice price, so it can overstate both if customers are expected to take discounts - that’s why the allowance for cash discounts is needed. The net method initially records accounts receivable and revenue net of the discount, so it can understate both once a customer’s discount period lapses without payment - that’s why the discounts-forfeited entry restores the balance to the full invoice price.

Sales returns and allowances

To report revenue at the amount the company expects to keep, it must take into account the expected returns on sold goods. These are recorded as sales are made to account for potential dissatisfaction of customers from the goods that are delivered and the amount is determined by company policy typically based on past experience of the company on the amounts of sales returns.

Under ASC 606, the estimated amount of returns is not netted against accounts receivable as a contra-asset. Instead, the company records a refund liability for the amount it expects to have to return to customers. If the company also expects to recover the goods being returned, it separately recognizes a right-of-return asset for their expected value - the refund liability and the right-of-return asset are not netted against each other.

The following is the journal entry to record sales returns and allowances:

Account	Debit	Credit	Financial statement element
Sales returns	$1,500		Revenue (contra account)
Refund liability		$1,500	Liability
To record the estimated refund liability for expected sales returns

The “sales returns” account is a contra-revenue account, decreasing total revenue. The “refund liability,” by contrast, is an ordinary liability - not a contra-asset - since it represents the company’s obligation to refund customers, separate from the accounts receivable balance itself.