Question

What are two methods of recording accounts receivable transactions when a cash discount situation is involved? Which is more theoretically correct? Which is used in practice more of the time? Why?

Short answer

Two methods of recording transactions of accounts receivables, including cash discount, are:

1. Gross method

2. Net method

Step-by-step solution

Definition of Discount Allowed

Discount allowed can be defined as figures reflecting reduction in the price of goods provided by the seller. It is generally provided for earlier cash payment. It can be classified as trade and cash discounts.

Two different methods of recording accounts receivables

1. Gross Method: Under this method, the business entity first records credit sales on gross amount without adjusting the discount provided if payment is made within a specified period. The journal entry will report debit of discount allowed, cash, and credit to accounts receivables on cash receipt.

2. Net method: The business entity reports credit sales after adjusting the discount allowed under net method. This method first reports debit of accounts receivables and credit of sales revenue. A second journal entry reports debit of cash and credit of accounts receivables.

From the theoretical point of view, net method is more reliable because it reports the accounts receivables equal to the amount that can be realized from them.

In practice, business entities generally use gross method because the financial statement representation does not change under this method.