Chapter 5: Returns, discounts and sales tax

I. Recording sales returns

Meredith runs the florist. She sells her Flowers to cash customers, but she also has
some contracts with local businesses. These local businesses have credit accounts with
Meredith and pay on a monthly basis.

Sales returns from cash sales

Meredith prides herself on the quality of the Flowers. One of her regular cash customers
comes into the shop to express their dissatisfaction with the last bouquet. Meredith
refunds the customer with the amounts they paid.

When they bought the roses, the original transaction would be debited cash. This would
show the increase in the cash. The opposite entry would be to credit sales revenue.
This recognise the income Meredith has earned from selling her flowers.

Now that Meredith has returned the money to the customer. Firstly, we need to consider
what happen to cash. Meredith will have less cash. So, we would credit cash to reduce
the asset. Secondly, we need to recognize sales return. We wouldn't put this into the
sales revenue account. We need to include this in a separate account called sales
returns (return inwards).

Sales returns from credit sales

Sales on credit would mean that the local business is not yet paid Meredith for the
Flowers that she has sold to them. So, Meredith will not need to give them any cash.
Instead, we would need to reduce the receivables for that customers, ensuring that the
amount reflects how much they actually owed for the roses we sold. In order to do this,
we would credit receivables, but would still debit sales return.

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II. Discounts

It might be that we have received a discount from a supplier, so we can pay them less
than our original invoice amount to settle outstanding liability. Perhaps, we offer a
discount to our customer, so that they need to pay us less than their original invoice
amount.

Trade discounts
Trade discounts are offered to encourage customers to increase the volume of goods
they buy from a business. They're offered to existing and new customers who are buying
in bulk. For example, the standard selling price we sell at $5 per unit. However, we might
say to a customer that if they buy more than 200 units in one order, we will drop the price
per unit by 5%. So, the cost per unit will be cheaper to the customer. This may
encourage customers to purchase more from us than they might have purchased before
the discount was offered.

Accounting for trade discounts

Trade discount is deducted at the point of sale by the seller when preparing the sale
invoice and is NOT accounted for in the accounting records of either the seller or the
purchaser i.e. only the net (discounted) amount will be recorded.

1 January, XY sold goods on credit to AB, with a list price of $250, subject to a trade
discount of 20 per cent.

What we want to find out is the amount of the trade discount and what the accounting
entries will be required to record this sale of goods.

So, first of all, we know that the full price of a good was $250. AB has been offered a
trade discount of 20%. Therefore, the net amount that is receivable by XY will be $250
less the trade discount which is $200. This $200 is therefore the amount XY will be
recording in their ledgers when they record the transaction.

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Cash discounts
Settlement discounts are also referred to as ‘cash discounts’ or ‘prompt payment
discounts.

It is offered to encourage prompt payments by our credit customers. For example, your
standard payment terms for a customer to settle their invoice may be a month. If you
want them to pay their debt sooner, you might tell them that if they pay within a certain
number of days, 10 days for example. You will offer them an early settlement discount of
5% of the invoice amount.

Note that whilst they may encourage a customer to pay early, a seller cannot force a
customer to pay for goods earlier than they have previously agreed. Customers may
prefer to wait and then settle the full amount. They may not have the funds available to
pay any sooner even if it's at a reduced amount.

As a result, accounting for a cash discount poses a challenge. As we must record the
transaction at the point of sale, however, as the business doesn't know whether the
customer will pay early or not, it raises the question what amount should we account for.

Accounting for cash discounts

Discounts received: when a discount is offered from a supplier. This is classified as a
form of income.

Discounts allowed: when a discount is offered to a customer. This is adjusted against

sales revenue.

Settlement discount offered by supplier

When offered a discount by our supplier, it is our choice whether we take up the offer.

Pay early to earn discount

• Dr Payable to decrease the liability owed to the supplier by the full amount of the
original invoice.
• Cr Cash to decrease the asset by the amount paid to the supplier.
• Cr Discount received to recognise the discount as a form of income.

Do not pay early to earn discount

• Dr Payable to decrease the liability owed to the supplier by the full amount of the
original invoice.
• Cr Cash to decrease the asset by the amount paid to the supplier.

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Settlement discount offered to a customer

Customer expected to settle early

Customer settles early
1. Original invoice would be posted as
• Dr receivables with amount less discount
• Cr sales revenue with amount less discount
2. Customer pays invoice in full
• Dr cash
• Cr receivables

Customer does not settle early

1. Original invoice would be posted as
• Dr receivables with amount less discount
• Cr sales revenue with amount less discount

2. Customer pays invoice in full

• Dr cash with full amount received
• Cr receivables with amount less discount
• Cr sales revenue with the discount amount

Example 1
Hannah entered into the following transactions:
1. Sold goods to Alex which had a list price of $10,000, and which were subject to an
early settlement discount of 5% if Alex paid within seven days. Alex was expected
to pay early and did subsequently make early payment to take advantage of the
early settlement terms.

2. Sold goods to Lynn which had a list price of $6,000, and which were subject to an
early settlement discount of 5% if Lynn paid within seven days. Lynn was expected
to pay early to take advantage of the discount terms offered but did not do so.

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Customer not expected to settle early
Customer settles early
1. Original invoice would be posted as
• Dr receivables with list price
• Cr sales revenue with list price
2. Customer pays invoice in full
• Dr cash with amount received
• Dr sales revenue with the discount allowed
• Cr receivables with the invoice amount

Customer does not settle early

1. Original invoice would be posted as
• Dr receivables with list price
• Cr sales revenue with list price
2. Customer pays invoice in full
• Dr cash with full amount received
• Cr receivables with the invoice amount

Example 1 (continued)
3. Sold goods to Alison which had a list price of $9,000, and which were subject to an
early settlement discount of 5% if Alison paid within seven days. Alison was not
expected to pay early to take advantage of the discount terms offered and
subsequently paid, as expected, after 30 days.

4. Sold goods to Lisa which had a list price of $8,000, and which were subject to an
early settlement discount of 5% if Lisa paid within seven days. Lisa was not
expected to pay early. However, Lisa subsequently did pay early to take
advantage of the early settlement discount terms.

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III. Sales tax
a) Overview
Registered entities are required to charge a sales tax on their goods or services. Sales
tax is added on to the net value of the goods and therefore this increases the amount
that businesses charge their customers for goods and services. So, when we as the
business invoice our customer this will be the net amount of the purchase plus the sales
tax. The customer therefore owes the gross amount including the sales tax.

Think about yourself when you pop into a shop. You always pay the amount including
the sales tax over to the cashier. Now when the customer pays the business, we have to
remember that this tax does not belong to us. We simply collecting it on behalf of the tax
authorities and we will then need to pay over to tax authorities on a regular basis.

The term that we give to sales tax that we charge to customers is output tax. This
outputs actually shown in our accounts as a liability as it isn't actually ours. We need to
pay it over to the relevant tax authorities.

Now as a business may also have to pay sales tax on goods and services that we buy
we're also having to add the output tax on the goods or services in the same way that we
just mentioned this is known as input tax. This sales tax we pay on purchases could
normally be reclaimed. So, when we enter the transaction into our legers, this will be
shown as a receivable. Since the money is owed back to us from the tax authorities.

Over period of time, a business could be both receiving and paying sales tax. So, in our
accounts we net off any sales tax liability with any sales tax receivable. So, we only need
to pay or receive the difference.

Note:
If the entity is non registered, they are not allowed to add sales tax to the net sales
amount nor they couldn't be claim sales tax on their purchases.

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b) Calculation of sales tax
The rate of sales tax charged is different depending on the country and the type of product.
The rate will always be given to you in the question.

Net selling price (tax exclusive)

This is the price set by the seller and is the amount recorded as sales revenue.

Sales tax
This is the percentage of sales tax charged on behalf of the tax authority.

Gross selling price (tax inclusive)

This is the total amount charged to the customers.

Question 1
What is the sales tax amount for each scenario?

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c) Accounting for sales tax: ledger entries
If an organization is registered for sales tax, any output tax it receives needs to be paid
to the tax authorities and any input taxes paid can be reclaimed.

When making a sale, we would debit receivables or cash with the gross amounts
including the sales tax. This is what the customer will pay us.

We would credit sales with the net amount. This is the amount excluding the sales tax.
Sales all posted net as a tax belongs to the tax authorities, not to the business.

We would credit sales tax payable with the amount of the sales tax. This is what we owe
to the tax authorities.

When making a purchase, we would debit purchases with the next amount of the
purchase so excluding sales tax. This is the cost of the goods we purchased.

We would debit sales tax receivable with the amount of the sales tax. This is what we
can reclaim from the tax authorities.

We would credit payables or cash with the gross amount of the purchase. This is the
total amount that we need to pay the supplier.

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 Question 1:
Handle entered into the following transactions:
1. Sold goods to Mozard which had a sale price of $5,000, on which sales tax of 20%
should be charged.

2. Sold goods to Bach for $5,500, which was inclusive of sales tax at 10%.

3. Purchased goods from Liszt at a gross cost of $4,600, which was inclusive of sales tax
charged at 15%.

4. Purchased goods from Brahms at a cost of $2,500 on which sales tax of 12% was
charged.

For each transaction, state the net, sales tax and gross value that will be recorded
in the accounting records.

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Question 2:
Please complete the day books, showing the accounting entries below. Drag the entries
into the areas below.

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IV. Self-study
Question 1:
A business entity had a balance at the bank of $2,500 at the start of the month. During
that month, it paid for materials invoiced at $1,000 less trade discount of 20 per cent and
cash discount of 10 per cent. It received a cheque from a receivable in respect of an
invoice for $200, subject to cash discount of 5 per cent.

What is the bank balance after these transactions have taken place?

Question 2:

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